Reviewing The SEC Marketing Rule
The new Marketing Rule adopted by the Securities and Exchange Commission in 2020 has been a source of substantial confusion and misinterpretation by advisers since enforcement began at the end of 2022. In June 2023, the Division of Examinations issued a Risk Alert identifying those areas the Division considered critical to compliance under the new rule. After nearly two years since its implementation, a review of this Risk Alert is warranted to examine the impact of the rule on common marketing initiatives of investment advisers.
Policies and Procedures
Implementation of effective, updated written policies and procedures that adequately prevent violations of the Marketing Act is the essential first step. Critical to these procedures is a full explanation of the definition of an advertisement. “Advertisement” includes communication to two or more prospective customers or investors in a private fund managed by the adviser, which offers the investment adviser’s advisory services with regard to securities. “Advertisement” also includes a communication to two or more existing customers or existing investors in a private fund managed by the adviser, if the communication constitutes an offer of new services. Finally, an “advertisement” includes a communication to one prospective customer or private fund investor if that communication includes unsolicited hypothetical performance, which includes any model performance, backtested performance, or projected performance data. This definition is specific and should be clearly stated in policy procedures.
An “Advertisement” also includes third-parties, whether customers or not, who solicit or otherwise advocate for the investment adviser’s business (e.g., “promoters”), provided those third parties are compensated by the adviser. Accordingly, advisers may pay third parties, including current customers, to promote the adviser’s business, provided the adviser complies with the rules. The promoter’s rule included in the new Marketing Rule supplants the old rules governing cash payments to solicitors.
Understanding what constitutes an advertisement is critical to the development of written procedures. If, for example, an adviser’s investment adviser representative wishes to send an email to 10 people who are not yet customers of the adviser, and the email is intended to ask the recipients to invest with the firm, that would obviously constitute an advertisement, which would require documented pre-approval from compliance. However, if an investment adviser representative wished to send an email to 10 existing customers explaining how great the firm’s portfolios are performing, no pre-approval would be needed, because the email would not be an advertisement (assuming there is no offer of “new” advisory services). In the latter case, the investment adviser representative’s email correspondence would be subject to the firm’s correspondence review procedures, but not documented pre-approval.
Now take a more complicated issue, the investment adviser representative wants to send an email to one person who is not yet a customer, offering to provide that person advisory services. Is that subject to the Marketing Rule pre-approval requirements? No, an email to one person offering services is not an advertisement under the rule. What if the email is a standard email that the investment adviser representatives send to prospective customers, but only through one email at a time? Would that be an advertisement? Yes, because the investment adviser representative has created a standardized document (form email) that is intended to be sent to more than one prospective customer, even though it is sent one email at a time. Issues such as these must be carefully considered by a detailed understanding of the definition of advertisement in the Marketing Rule.
Similarly, rules relating to performance, hypothetical performance, third-party rankings (e.g., “top ten advisers in the state”), and promoters all have specific conditions that may or may not apply to any given communication. Defining what is and what is not an advertisement, and then proceeding to determine what specific type of advertisement the communication entails are essential steps that should be laid out in the firm’s procedures so that all personnel understand what is covered by the pre-approval requirements.
Substantiation Requirement
Once a communication is determined to be an advertisement, the statements in the advertisement must be true and not misleading. This condition requires the adviser to maintain records or some recorded basis for making statements in the communication. For example, stating that your adviser has the most Certified Financial Advisers in the area must be supported by a definition of what area you are referring to and why you assert more CFAs than any other adviser in that area. Similarly, if you make statements concerning the quality of service, types of investments, and overall assertions of skill or qualifications, there must be contemporaneous documents in the file showing the basis for these assertions. Reasonable belief that a statement is accurate may not be sufficient; written support should be included in the file with the approval of the advertisement.
Performance Advertising
The rule has specific conditions for actual and hypothetical performance. For actual performance data, the adviser must present results that are net of fees and costs, that compare any performance period to one-year, five-year, and ten-year performance data (or any interim period), and must not be misleading, including cherrypicking or misrepresentation of portfolio segments.
Hypothetical performance, which includes any performance results that were not achieved, such as backtested data, projections, and model performance, must be limited in distribution to only those prospective customers who can understand the nature of the hypothetical information and can apply it to their particular circumstances. The hypothetical performance information must also include the basis or means by which the adviser calculated the performance and the limitations on relying on such information. It is not sufficient to state that “actual results may vary”; rather, the adviser must explain how the hypothetical performance was determined, and why the actual results could differ (e.g., backtested data was calculated during a time of low interest rates and low inflation, which may no longer be the case).
Books and Records
Recordkeeping requirements under the Marketing Rule start of course with the compliance manual. The manual is a document that must be maintained and updated in accordance with the SEC rules. Records also include pre-approval of all advertisements. Advisers and CCOs may not just orally approve an ad; documents must show that the advertisement was reviewed by compliance, the rule was considered, and the contents of the advertisement complied with the requirements.
It should be expected that the SEC will continue to focus on whether advisers’ advertisements violate the specific restrictions governing performance, promoters, and recordkeeping, as well as the general prohibitions, including:
Making untrue statements of material facts or omitting material facts that could make the advertisement misleading.
Presenting information that could create misleading implications.
Discussing potential benefits without also including a discussion of associated risks.
Referencing specific investment advice in a way that is not balanced and transparent.
Presenting performance results or time periods in a misleading or dishonest manner.
Starting with a detailed compliance procedure that defines the scope of the rule and the particular content restrictions will enable supervised persons to identify issues and promptly seek guidance from compliance officers. You can learn more about the SEC’s observations related to this topic on the resources page of our website.
