Two facts may come as a surprise about the U.S. Securities and Exchange Commission’s existing investment adviser advertising rule: that it literally fits on one page, and that it has not been updated since 1961. These facts point to the deeper reality: the market and the SEC have been grappling with the limitations of an increasingly timeworn rule for years. The SEC and its staff have published dozens of guidance letters, speeches and other pronouncements—to the point that the “guidance” overshadows the rule.
With those challenges top of mind, on November 4, 2019, the Securities and Exchange Commission (SEC) announced that it is proposing amendments to its rules governing investment adviser advertisements and payment to solicitors under the Investment Advisers Act of 1940 (Advisers Act). The comment period for both rulemakings is expected to close in January 2020. In this client alert, we summarize the proposed amendments to the advertising (Rule 206(4)-1). A separate alert, SEC Proposes Solicitation Rule Amendments, covers the solicitor proposal.
Key elements of the advertising rule proposal are:
- Clarification and expansion of the term “advertisement”;
- Elimination of the current rule’s limits on testimonials, endorsements, third-party ratings and “past specific recommendations” in favor of broad “fair and balanced” principles;
- Revision of guidelines on performance information (based in part on distinctions between retail and non-retail communications); and
- Mandated internal pre-use review processes.
‘Advertisement,’ Redefined
As proposed the term “advertisement” would include any communication disseminated by any means, by or on behalf of an investment adviser, that offers or promotes investment advisory services or that seeks to obtain or retain advisory clients or investors in any pooled investment vehicle advised by the adviser.
The following modes of communication would be exempt from the definition: (1) live oral communications that are not broadcast, (2) responses to certain unsolicited requests for specified information, (3) advertisements, other sales material or sales literature that is about a registered investment company or a business development company and is within the scope of other SEC rules; and (4) information required to be contained in a statutory or regulatory notice, filing or other communication.
The second of these proposed exceptions, “unsolicited requests for specified information,” is likely subject to the most tension in application. RFP responses already are widely treated as exempt (on the same theory underlying the proposal, that the nature and structure of the RFP response is driven by the prospect’s question more than the adviser’s own interests), but RFP responses nonetheless tend to be closely monitored by compliance personnel and often are de facto subject to the same procedures and rules as advertising. The SEC also recognizes the risks of this blanket exception and proposes that unsolicited requests be subject to the advertising rule when they involve performance presentations to retail investors or, regardless of the audience, presentations of hypothetical performance.
‘Fair and Balanced’ Standard to Replace Existing Specific Limits on Content
Under the proposed rule, the various limits on certain types of statements under the current rule would be superseded by a package of more general principles:
- An advertisement should not contain material “untrue statements or omissions”;
- All material statements in an advertisement should be subject to “substantiation”;
- An advertisement should not give rise to materially “untrue or misleading implications or inferences”;
- Any implication in an advertisement of benefits from an adviser’s services should be accompanied by “clear and prominent” discussion of the associated risks or limitations on the services;
- An advertisement referring to past investment picks, or discussing investment performance, should be “fair and balanced,” notably in terms of what is selected for inclusion or exclusion; and
- An advertisement should not be “otherwise materially misleading.”
Most of these principles will read as saying much the same thing: “Be fair and balanced.” One element that might be taken as going further than that is the proposed requirement that advertising include discussion of risks.
Testimonials, endorsements and third-party ratings—all of which are subject to strict limitations at present—would be specifically permitted, subject to the general principles above and a number of mandated disclosures. Discussion of specific investments—also subject to strict limitations at present—also would be permitted, again subject to these general principles.
Performance Information Guidelines Revised
For advertising showing investment performance, the proposed rule would draw a distinction between “Non-Retail Persons” and “Retail Persons.”
- Clients and investors that are “qualified purchasers” for purposes of Section 3(c)(7) under the Investment Company Act of 1940 would be identified as “Non-Retail Persons.” A firm’s “knowledgeable employees” also would be “Non-Retail Persons.”
- All other clients and investors, including those meeting the “accredited investor” or “qualified client” standards under the Securities Act of 1933 or the Advisers Act, would be identified as “Retail Persons.”
While such a distinction is deeply embedded in practices for broker-dealer members of the Financial Industry Regulatory Association (FINRA), it historically had less significance on the investment adviser side.
As proposed, advertising for Retail Persons would be subject to heightened requirements. In particular, information on net performance—showing investment results after giving effect to fees and expenses—would be included with any presentation of gross performance, and performance results would be presented according to standardized time periods, generally one, five and ten years.
Advertising for Non-Retail Persons would be exempt from those specific requirements so long as a firm establishes procedures that allow for reasonable certainty that Non-Retail Person advertising not be disseminated to Retail Persons. It follows that Non-Retail Person advertising would not be in the media, on unrestricted websites, or freely available in a firm’s offices.
As a brief aside on gross versus net performance presentations, the rule generally would represent a relaxation relative to current guidance, which requires net performance in most presentations, with only limited exceptions. As proposed, gross performance could be permitted in any Non-Retail Person advertising, so long as the overall effect is not misleading and information on fees and expenses is provided (or offered) that allows for calculation of the net returns.
The proposed rule also would include detailed guidance and requirements around the use of “related performance” (referring to investment performance of an account other than the one being advertised). This would include specific guidance and requirements around “extracted performance” and “ported performance” (with extraction referring to instances when only a subset of a portfolio is highlighted and portability referring to when the performance may have been realized at a prior firm or by prior personnel). Firms for which extracted or ported performance principles are important will want to monitor these developments closely.
The proposed rule also gives significant attention to “hypothetical performance” such as backtested, model or projected or targeted performance. Any such performance would be subject to internal procedures intended to assess suitability of the presentation to the audience and to ensure appropriate explanatory information. For Retail Persons, specific disclosure regarding the risks and limits of the hypothetical performance would be required (for Non-Retail Persons the same risk and limits disclosure would be required upon request of the recipient). While still unclear at this stage, the proposed requirements for showing hypothetical performance—when taken as a whole—may be a general “raising of the bar” in terms of required disclosure of assumptions, calculation criteria, limitations and the like.
Two provisions of the proposed rule would have the effect of continuing a longstanding difference in regulatory treatment between the SEC and FINRA. FINRA member broker-dealers presumably will continue to be subject to FINRA rules disallowing related performance presentations for Retail Persons, whereas the SEC’s proposed rule would permit them. Likewise, FINRA rules presumably will continue to broadly prohibit hypothetical performance presentations for most audiences, whereas the SEC’s proposed rule would permit them, subject to special scrutiny and oversight.
Internal Pre-use Review Process
Most investment advisers already have procedures that require internal review of their advertising. The proposed rule, however, would mandate pre-use review and require related review and approval records. The rule would exempt certain types of advertisements, including communications to a single person or household.
Form ADV
The SEC proposes adding a new section to Form ADV (the public registration form used by SEC and state-registered advisers) in which advisers would respond to questions about their advertising practices. The SEC readily acknowledges that a principal purpose of this section is to collect information that it will use in assessing where to focus its investment adviser inspection efforts.
Our Take
Initial market reaction to the rule proposal has been positive, in part because the headlines focus on a long overdue overhaul of a dated rule. That is a fair characterization, but we also call out some additional themes and areas of uncertainty. For example:
- As the industry considers the proposed definition of advertising, it is possible that its breadth may become a concern. The more communications not currently considered to be advertisements that are found to be within the proposed definition, the more likely there will be pushback.
- An implicit goal embedded in a number of the changes is to allow freer use of social media and other technologies. This is evident more by what is not in the proposal than what is actually there. The proposed definition of advertising pointedly drops old-media terminology (“written communications”) in favor of fresher language (“disseminated by any means”). Similarly, withdrawing restrictions on testimonials and endorsements addresses a hindrance in adopting social media communications for investment advisers—social media, after all, being built around “likes” and other forms of endorsement.
- Another point where silence speaks volumes is the proposal’s absence of required legends. Thus, how a firm discloses limitations in its advertising would be left solely to the firm. We expect, however, that the reality will be more nuanced. Industry practice and regulatory expectations are likely to coalesce over time around a number of widely used legends and disclaimers.
- The proposed retail / non-retail distinction reflects a common-sense philosophy (and resonates with the SEC Chair’s repeated emphasis on protecting “Main Street” investors). We anticipate this will come with some evolution; it is predictable that future guidance and industry practice will build on the distinction over time.
- The proposed shift away from specific restrictions in favor of general principles, while welcome, carries an element of “be-careful-what-you-wish-for” risk. Yes, flexibility can drive new and more on-point messaging. But that new content also can be second-guessed. Judgment calls—for example about completeness or balance—are always susceptible to benefit-of-hindsight review.
- The SEC is considering withdrawing dozens of no-action letters issued over the years addressing specific circumstances and questions. Is that a good thing? It fits the general goal of “starting fresh” with a new rule. But some firms built practices and processes around the earlier guidance and will wonder whether they continue to be equally appropriate. And it seems doubtful that SEC personnel steeped in expectations around prior guidance will drop those expectations all at once. More likely, the prior letters and guidance will live on in some form.
- It is worth closing with the simple observation that these various rules—both existing and as proposed—restrict otherwise applicable principles of commercial free speech. All of which reflects the SEC’s long-held view, largely accepted by the industry, that investment adviser advertising should be held to a higher standard than general commercial advertising. That is not to change in any way.
