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:
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.
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:
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.
For advertising showing investment performance, the proposed rule would draw a distinction between “Non-Retail Persons” and “Retail Persons.”
While this type of distinction is 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” defined to include 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 generally 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.
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.
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.
Initial market reaction to the rule proposal has been positive, in part because the headlines focused 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: