The Securities and Exchange Commission (the “Commission” or the “SEC”), on November 4, approved the publication of a substantial release (the “Release”)1 proposing significant amendments to the rules under the Investment Advisers Act of 1940 (the “Advisers Act”) that govern advertising by investment advisers and the solicitation of advisory and fund investments, as well as related recordkeeping and SEC Form ADV disclosure requirements. This memorandum provides a summary of the proposed amendments to the advertising rule and related recordkeeping requirements; a separate memorandum addresses the proposed amendments to the solicitation rule.2
The Advisers Act advertising rule, Rule 206(4)-1, has not been amended significantly since it was first adopted in 1961.3 The changes now proposed by the SEC are largely motivated by the SEC’s desire to modernize the rule and create a more “principles-based” approach to advertising regulation.
I. Overview of the Amendments
- Broadened Definition of “Advertisement”: The proposed amendments to Rule 206(4)-1 would broaden the definition of “advertisement” to cover all communications that promote an investment adviser’s services, even if sent to a single person, subject to specific exemptions.
- Advertising Standards: The amendments would replace the current list of prohibited forms of advertisement with general prohibitions on misleading advertising practices. The proposed amendments would also adopt new requirements for advertisements that include gross, past, extracted, related or hypothetical performance.
- Administrative Provisions: Advisers would have to designate specific employees to review and approve advertisements before distribution. Advisers would also be required to report certain of their advertising practices on Form ADV, and would be subject to new recordkeeping obligations under Rule 204-2 intended to require advisers to demonstrate their compliance with the new obligations under Rule 206(4)-1.
- Comment Period: The comment period will end 60 days after the Release is published in the Federal Register.
- Compliance Date: Compliance with the amended rules would be required one year after the effective date.
II. Broadened Definition of “Advertisement”
Rule 206(4)-1 currently defines “advertisement” to mean “any notice, circular, letter or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television [emphasis added].”
Under Proposed Rule 206(4)-1(e), “advertisement” would be defined to mean “any communication, disseminated by any means, by or on behalf of an investment adviser, that offers or promotes the investment adviser’s investment advisory services or that seeks to obtain or retain one or more investment advisory clients or investors in any pooled investment vehicle advised by the investment adviser [emphasis added].” The proposed rule would expand the definition of “advertisement” to apply to any communication that promotes an investment adviser’s services, regardless of the form of the communication or the manner in which it is distributed (e.g., in writing, electronically, in audio or video files, blogs or social media), and even if sent to a single person.
Certain communications would nonetheless be excluded from the proposed expanded definition of “advertisement”: (i) live oral communications not broadcast on electronic media;4 (ii) responses to unsolicited requests for information about an adviser’s services, except for (a) communications about performance results to Retail Persons and (b) all communications about Hypothetical Performance;5 (iii) communications about registered investment companies (“RICs”) or business development companies (“BDCs”);6 and (iv) disclosures required by statute or regulation (e.g., information required by Part 2 of Form ADV or Form CRS).
B. Key Terms
Certain of the terms used in the proposed definition of “advertisement” are further explained or defined in the Release or in the proposed amendments. The key terms are as follows:
- Disseminated by any means. This phrase would replace the current limitation to written communications or announcements made over radio or television. The Release emphasized that the focus of the amended rule is “on the goal of the communication, and not its method of delivery.”
- By or on behalf of an investment adviser. The proposed rule would apply to material disseminated by an adviser’s agents, such as consultants and solicitors,7 or by an investment adviser’s affiliates, and may apply, depending on the facts and circumstances, to material disseminated by unaffiliated third parties.8 The determination of whether material distributed by a third party is considered an “advertisement” of the adviser will depend on the adviser’s involvement in the content or production of the material (g., whether the investment adviser assists in preparing the content, influences or controls the substance of the content or pays for the distribution). Advisers should thus implement appropriate procedures to monitor materials distributed on their behalf to assure compliance with the requirement of any newly adopted rules.
- Offers or promotes the investment adviser’s investment advisory services. Material providing a client with general account information in the regular course of business or disseminating general educational materials about investing and markets would not be considered advertisements. However, the Commission may consider an adviser’s market commentary to be an advertisement if the commentary offers or promotes the adviser’s services.9
- Investors in any pooled investment vehicle. This provision treats investors in a pooled investment vehicle, other than investors in a RIC or a BDC,10 as clients of the adviser. This provision would provide additional protections for investors in pooled investment vehicles beyond those already provided under Rule 206(4)-8 (prohibiting fraudulent practices with respect to pooled investment vehicles).
III. Advertising Standards
A. General Prohibitions
The current rule contains a general prohibition on false or misleading statements, and additionally prohibits four specific types of communications in advertisements: (i) testimonials; (ii) past specific recommendations; (iii) representations that a chart or graph alone can be relied upon to make investment decisions; and (iv) misrepresentations about the cost of services. The proposed amendments replace these specific prohibitions by instead creating General Prohibitions that largely incorporate principles developed through the Commission’s prior no-action letters and are consistent with other anti-fraud provisions in the Federal securities laws.11
Under Proposed Rule 206(4)-1, advisers would be prohibited from making untrue or misleading statements or omissions, making material claims that are unsubstantiated,12 failing to “clearly and prominently” disclose potential risks, or referencing performance results and specific investment advice in a way that is not fair and balanced.13 A finding of negligence would be sufficient to establish a violation of the General Prohibitions.14
B. Specific Investment Advice
The SEC proposes to replace the prescriptive requirements currently applicable to advertisements that include discussions of “past specific recommendations” with a principles-based approach that would permit material that discusses “specific investment advice” as long as it is “fair and balanced.”15 The Release notes that the following current guidance may be helpful to advisers in satisfying the “fair and balanced” requirement:
- referring to the information that must currently be included when presenting a list of all past specific recommendations made by the adviser within the past year;16
- using objective, non-performance based criteria to select the securities discussed in advertisements;17 and
- considering “the facts and circumstances of the advertisement, including the nature and sophistication of the audience.”
While reference to current guidance may be useful, the proposed rule would provide advisers with greater flexibility to include discussions of specific investment advice in advertising material, provided that the discussion is fair and reasonable, and includes sufficient information and context to enable recipients to evaluate the discussion.18 Advisers would, however, be subject to the specific requirements applicable to performance information discussed in Section D below.
C. Testimonials, Endorsements, and Third-Party Ratings
The proposed amendments establish conditions that, if followed, allow for the use of testimonials, endorsements and third-party ratings in advertisements.19
- Advisers using Testimonials20 or Endorsements21 in advertisements must “clearly and prominently disclose”: (i) that the testimonial was given by a client or investor, and the endorsement was given by a person who is not a client or investor; and (ii) whether the adviser, or anyone acting on its behalf, provided (cash or non-cash) compensation for the testimonial or endorsement.22
- Third-Party Ratings23 may be used if: (i) the adviser “reasonably believes”24 that the questionnaires used to produce the ratings were designed to produce unbiased results; and (ii) the adviser or third party clearly and prominently discloses information including the rating date, time period on which the rating was based, the identity of the third party that produced the rating and whether the adviser, or anyone acting on its behalf, provided compensation, in the form of cash or otherwise.
D. Performance Advertising
The current rule does not address the appropriate presentation of an adviser’s performance results. Guidance on performance advertising has been developed through SEC no-action letters.25 The proposed rule would establish explicit requirements as to the use of performance results, setting different standards depending on whether the advertisement is a Retail or Non-Retail Advertisement, as defined below.
- Non-Retail Advertisements would mean advertisements directed at Non-Retail Persons, defined for this purpose as “qualified purchasers” or “knowledgeable employees,”26 as defined in the Investment Company Act.27 For such advertisements, an adviser would be required to implement “policies and procedures reasonably designed to ensure that the advertisement is disseminated solely to qualified purchasers and knowledgeable employees.”
- Retail Advertisements would mean advertisements directed at Retail Persons, meaning anyone other than a Non-Retail Person.
Under the SEC proposal, performance information would be subject to the following requirements:
- All Portfolio28 performance results included in Retail Advertisements must be presented in 1-, 5-, and 10-year periods, “each presented with equal prominence and ending on the most practicable date.”29
- To use Gross Performance30 in a Retail Advertisement, the advertisement must: (i) present Net Performance31 results “with at least equal prominence,” in a format designed to facilitate comparison with the Gross Performance, using the same calculation methods and calculated over the same prescribed time periods;32 and (ii) provide, or offer to provide promptly, a percentage schedule of the fees and expenses deducted to calculate Net Performance.33
- To use Gross Performance in a Non-Retail Advertisement, an adviser must provide or offer to provide promptly, a percentage schedule of the fees and expenses deducted to calculate Net Performance. The Non-Retail Advertisement would not, however, be required to include Net Performance results.34
- An advertisement may include Related Performance35 only if it includes the performance of all Related Portfolios,36 unless (a) the performance results advertised are no higher than they would have been if no Related Portfolios were excluded, and (b) for Retail Advertisements, the performance results must be presented for the required time periods noted above, notwithstanding the exclusion of some Related Portfolios.37
- Extracted Performance38 may be used only “if the advertisement provides, or offers to provide promptly, the performance results of all investments in the Portfolio from which the performance was extracted.”
- To use Hypothetical Performance,39 an adviser would be required to:
- adopt policies and procedures “reasonably designed to ensure that the Hypothetical Performance is relevant to the financial situation and investment objectives” of the recipient. The purpose of this requirement is to ensure that an adviser only provides hypothetical performance “where the recipient has the financial and analytical resources to assess the hypothetical performance and that the hypothetical performance would be relevant to the recipient’s investment objective”;40
- provide, in both Retail and Non-Retail Advertisements, “calculation information” that is tailored to the audience receiving it, to enable recipients to understand the criteria and assumptions used in calculating Hypothetical Performance; and
- provide in Retail Advertisements, or offer to provide promptly in Non-Retail Advertisements, “risk information” tailored to the audience receiving it, to enable recipients to understand the risks and limitations of using the Hypothetical Performance in making investment decisions.
All performance advertisements must comply with the General Prohibitions. Though the Commission declined to require specific disclosures, the Release noted that examples of disclosures currently used by advisers in performance advertisements include: “(1) the material conditions, objectives, and investment strategies used to obtain the results portrayed; (2) whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings; (3) the effect of material market or economic conditions on the results portrayed; (4) the possibility of loss; and (5) the material facts relevant to any comparison made to the results of an index or other.”41 In line with its principles-based approach, advisers would be required to include appropriate disclosures to reflect the assumptions and factors relevant to the calculation of performance information.42
The Commission has issued a number of no-action letters on when investment advisers may advertise performance results from the firm’s predecessor entities or from entities at which the firm’s employees were previously employed.43 Neither the current rule nor the proposed amendments set explicit standards for portability; the determination is subject to analysis under whether the porting of the prior results would be misleading. However, the Release does summarize and discuss the Commission’s considerations as to when portability is appropriate:
“(i) the person responsible for such results is still the adviser;
(ii) the prior account and the present account are similar enough that the performance results would provide relevant information;
(iii) all prior accounts that are being managed in a substantially similar fashion to the present account are being factored into the calculation; and
(iv) the advertisement includes all relevant disclosures.”44
The Release stated that the portability of testimonials, endorsements, and third-party ratings would be governed by the same considerations as predecessor performance results.
IV. Administrative Provisions
A. Internal Review and Approval of Advertisements
Proposed Rule 206(4)-1(d) creates a new requirement that investment advisers designate an employee to review and approve all advertisements before they are disseminated. The only exceptions to this rule are for (1) communications to only a single person, household, or investor in a pooled investment vehicle and (2) live oral communications broadcast on electronic media. The SEC did not propose an exemption from pre-distribution reviews for Non-Retail Advertisements.45
B. Amendments to Form ADV
The proposed rule would amend Item 5 of Part 1A of Form ADV to add a subsection “L. Advertising Activities” to help SEC staff prepare for on-site examinations. This five-question subsection would ask advisers to respond yes or no to the following questions:
(1) Whether any of the adviser’s advertisements contain performance results;
(2) If so, whether all of those performance results were verified or reviewed by a person who is not a “related person” (i.e., an entity unaffiliated with the adviser);
(3) Whether any of the adviser’s advertisements include testimonials, endorsements, or third-party ratings, and if so, whether the adviser provides direct or indirect compensation in connection with their use; and
(4) Whether any of the adviser’s advertisements includes a reference to specific investment advice provided.
C. Amendments to the Books and Records Rule
First, the recordkeeping requirements of Rule 204-2(a)(11) would be expanded to require advisers to keep copies of all advertisements disseminated, whereas the rule currently requires that advisers only keep records of written communications disseminated to 10 or more people. This provision would require that advisers retain records of the risk and calculation information for Hypothetical Performance that they are required to provide under amended Rule 206(4)-1(c)(1)(v) because the Commission views such additional information as part of the advertisement itself.46
Second, the amended recordkeeping rule would require investment advisers make and keep originals of: (1) written communications sent or received relating to the performance or rate of return of any or all Portfolios and (2) supporting records regarding the calculation of the performance or rate of return of any or all Portfolios.
Third, advisers would be required to retain records of any questionnaires and surveys used to obtain third-party ratings for advertisement purposes.
Finally, advisers would be required to maintain records of the written approvals for all advertisements.
V. Summary and Policy Considerations
The SEC has issued a thoughtful proposal that would adopt a technology-neutral, principles-based approach to investment adviser advertising. The Release includes extensive questions on all aspects of the proposal, and industry participants should carefully consider whether to submit responses.
One issue that is not specifically addressed in the Release is the degree to which the amended rules should be harmonized more closely with equivalent FINRA standards for broker-dealer communications and NFA standards for promotional material distributed by CFTC-registered firms. These considerations are particularly relevant to SEC-registered investment advisers that are also registered with the CFTC as CPOs or CTAs, which are subject to both SEC and NFA requirements, and advisers who market interests in funds they advise through broker-dealers, in which case the sales material would be subject to both the SEC and FINRA requirements. Finally, we note that the Release contains a wealth of material on current requirements for investment adviser advertising, which firms may consult to confirm that their current advertising practices conform to applicable SEC standards.