The Securities & Exchange Commission’s 18-month window for getting into compliance with its new marketing rule closes November 4 and registered investment advisors shouldn’t be surprised if the SEC soon scrutinizes their marketing practices.
The SEC issued a risk alert in September and “basically put the industry on notice that they were going to be examining under their rule relatively quickly after implementation,” says Jennifer Klass, a partner and co-chair of the North America Financial Regulation and Enforcement Practice at law firm Baker McKenzie in New York. “I would imagine that we’re going to see a lot of exams and requests in the fourth quarter.”
“My sense is that the first wave of examinations after the compliance date will really be focused on whether investment advisors have made reasonable efforts to update their policies and procedures and compliance infrastructure to address the rule,” she says.
She presumes the SEC will then put together another risk alert that “identifies key themes or findings from their initial round of exams,” she says. After that, exams “may become more specific, more targeted,” she says, noting that this is how the SEC has addressed other exams after a significant rule change.
During its first wave, Klass expects the SEC will conduct sweep exams and also review marketing-rule compliance efforts of firms undergoing routine exams. With a sweep exam, advisors will generally receive a letter asking their firm to provide information, and with a routine exam, they’ll see marketing-related questions included in document requests, she says.
The SEC is still largely conducting exams remotely, says Klass. Advisors are asked to submit information to the SEC through its secure portal. Follow-up questions or telephone conversations are common when additional clarity is needed, she says.
Boiling down 400+ pages
The SEC created its new marketing rule (published in December 2020 and issued in May 2021) by amending the Investment Advisers Act of 1940. The new rule merges and modernizes the advertising and cash solicitation rules that were adopted decades ago. It’s complicated and includes 430 pages of explanation. Many investment firms have waited to the last minute to comply.
The new rule provides more specifics about what advisors are required to show regarding actual and hypothetical performance, creates a new framework around referral arrangements, and redefines what an advertisement is, says Klass.
“Essentially, the SEC has taken the position that if you have a third party who is endorsing or promoting the firm or referring clients to the firm, then they are viewed as a promoter,” she says. A “third party could be anyone from other investment advisors or broker-dealers who refer clients to an investment advisor, it could be online advertising arrangements, it could be social-media influencers.”
Creating an action plan
Firms need to review and update their written policies and procedures to make sure they comply with the new rule, says Klass. They must also make sure that the people reviewing their advertisements are familiar with the changes and current requirements, she says.
“And then the last piece is really recordkeeping,” she says — ensuring investment advisors have appropriate controls in place to keep records of the advertisements they’ve created and approved and the documentation to substantiate statements or performance they may have included.
Klass, who works mostly with investment advisors and dual registrants, says the bulk of her clients are focusing on changes related to promoter arrangements and performance. “I’ve heard these concerns or these issues echoed by everyone in the industry, so I don’t know that it’s unique to our particular client base,” she says.
Something else to bear in mind: Even if a particular communication is “not considered an advertisement, an investment advisor would still be subject to the anti-fraud provisions,” says Klass.
Hopefully you’ve already taken the time to review the SEC’s risk alert, which spells out specific focus areas the SEC intends to look at — including some of the points Klass mentioned. It’s a good document to keep on hand.
With regard to performance-related advertising requirements, the SEC notes in the risk alert that RIAs are prohibited from listing, among other things:
- Gross performance, unless the advertisement also presents net performance.
- Any performance results, unless they are provided for specific time periods (although it notes this is not applicable to the performance of private funds).
The 40,000-foot view
At a high level, the new marketing rule expands the definition of advertisements to include, subject to a number of exceptions, “all communications to prospective clients and investors and offers of new investment advisory services to current clients and investors,” Klass noted in an outline she shared with us. “The new rule also eliminates prohibitions on the use of testimonials and past specific recommendations, relying instead on general content standards based on anti-fraud principles.”
Among other things, the new rule “requires advisers to adopt policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the audience, and to disclose the criteria, assumptions, risks, and limitations,” she noted in her outline.
Advisors should first consider whether or not the performance is considered hypothetical, she says, noting that there are some exceptions under the rule.
‘Facts and circumstances’
The SEC excludes one-on-one communications from its definition of advertising in its new rule, as its old rule had, too. The new rule also lays out exceptions for market commentary, educational content and brand content, notes Klass.
Brand content or communications “could include a blog post about their community activism or philanthropy efforts, or the fact that they might have openings for new employees — those sorts of things are more related to the brand and to the corporate side of the firm and not the advisory services,” she says.
But a lot of what is and isn’t considered an advertisement “depends very much upon the facts and circumstances,” says Klass.
For example, if advisors tell a story about a client, it “probably wouldn’t be a testimonial,” she says. “But then if they say things like, ‘And this client told me how grateful they were for all the wonderful advice I provided and sent me six other referrals,’ then they’re effectively incorporating a testimonial into their story.”
At one point, the SEC contemplated separately addressing retail and institutional investors in its new marketing rule. However, “I think that some of the comments they got questioned how you would make that distinction, where you would draw the line,” says Klass. “And so rather than go down that path, the SEC just eliminated that distinction as part of the rule itself.”
Instead, “the intended audience becomes part of the facts and circumstances you would take into consideration in terms of how you apply the requirements under the marketing rule,” she says.
Easier to implement
“One of the problems with the prior rule was that all of the guidance really sat outside of the rule, in the form of no-action letters,” says Klass. By codifying and incorporating all that interpretive guidance into a single rule, the SEC now “makes it easier to implement because everything’s in one place, and they have incorporated flexibility in some circumstances.”
“So, I think overall it’s a positive,” she says, of the new marketing rule. However, “I don’t want to undermine or underestimate the difficulty … firms have had a heavy lift associated with implementing and complying, because it really has been a sea change in a number of respects.”