The Nov. 4 deadline is rapidly approaching for the U.S. Securities and Exchange Commission’s (SEC) new Marketing Rule for Registered Investment Advisers. The rule expands the definition of an advertisement, consolidates the Advertising and Cash Solicitation Rules, and creates new disclosure and compliance requirements.
We conducted a Q&A with three leading authorities in the RIA community: Anna Povinelli, Matt Soldato, and Betty Valouktzis from the Financial Services Compliance and Regulation practice at Kroll.
Here is the summary to their thoughts on the steps RIA teams should be taking to achieve compliance.
The SEC’s previous rules were outdated. They hadn’t been updated in decades and didn’t reflect the modern realities of digital communication and social media. Over the years, the SEC put out a patchwork of rules and no action letters without a real holistic vision. This update, while a significant overhaul, also serves to provide better clarity to the rules, and more fulsome disclosure to existing and prospective clients and/or investors.
Under the updated rules, the SEC has redefined advertising to include the following:
- Any “direct or indirect” communication that offers in writing the investment adviser’s services with regard to securities to prospective clients or investors in a private fund advised by the investment adviser (“private fund investors”); or offers new investment advisory services with regard to securities to current clients or private fund investors
- Any endorsements or testimonials for which the adviser provided cash or non-cash compensation, directly or indirectly
The impact here is considerable. Whereas once advertising was largely interpreted to mean brochures, market updates, websites, certain public speaking events, magazine ads and the like, it now applies to nearly any digital communication (e.g., email, instant messaging and social media), including certain one-on-one messages.
As Povinelli explains, ongoing communications to clients or private fund investors would be most likely be excluded from the definition of an “advertisement.”
“A client letter, for example, would not be considered an advertisement,” she says. “However, oftentimes advisers do provide samples of those letters to their prospective clients. So to be safe, assume that everything you put in writing is an advertisement. You should probably look at it through that lens.”
Under the Marketing Rule, the SEC replaced the previous four specific prohibitions with seven new general prohibitions. Namely these prohibitions state that investment advisers may not disseminate any advertisement that:
- Includes untrue statements and omissions
- Includes unsubstantiated material statements of fact
- Includes untrue or misleading implications or inferences
- Fails to provide fair and balanced treatment of material risks or material limitations
- Fails to present specific investment advice in a fair and balanced manner
- Cherry-picks performance results or otherwise presents performance in a manner that is not fair and balanced
- Is materially misleading
When advertising, advisers are subject to a burden of proof, meaning they must maintain sufficient evidence to back up their advertising claims.
Compensated endorsements and testimonials
The regulation includes new rules related to testimonials and endorsements. It replaces the previous “Cash Solicitation Rule” which regulated the compensation of RIA referral sources.
As with the Cash Solicitation Rule, the Marketing Rule requires a written agreement between an RIA and a compensated party. However, it establishes additional requirements and disclosures for payments and client referrals.
The RIA must provide a “clear and prominent” disclosure when a compensated endorsement or testimonial is made. To meet the standard, the disclosure should be presented with equal prominence as the endorsement itself. It must also include the specific type and amount of compensation paid to the promoter.
Of particular note is the broadened definition of “compensation” here. Under the new Marketing Rule, compensation could include cash payments, commissions, fees, gifts, entertainment, or a reduction of advisory fees – anything that totals more than $1000 in value over a twelve month period.
“Wealth advisers are frequently referring clients back and forth with attorneys and accountants,” said Povinelli. “The rules here are pretty clear cut. You should have a written agreement with these regular referral sources and corresponding disclosures to your clients. Because although you might not be exchanging cash for those referrals, you may ultimately be receiving client fees in excess of $1000.”
The rule explicitly prohibits the use of gross performance information unless net performance is also included.
“If you're providing gross performance, you must provide net performance in a way that’s just as equal and as prominent,” said Valouktzis.
Additional rules govern the presentation of hypothetical, related, and extracted performance. For example, hypothetical performance can only be presented to sophisticated investors or “investors who have the resources and financial expertise.” “What’s going to be challenging for advisers is assessing if the investor provided with the hypothetical performance understands the criteria, assumptions, risks and limitations of hypothetical performance. Investment advisers using hypothetical performance must provide additional information about the hypothetical performance and meet other conditions to address its potentially misleading nature,” Valouktzis said.
Povinelli reiterated the importance of knowing your audience. “If I’m communicating with a family office, for example, they’re probably highly sophisticated. You still have to explain your metrics in the disclosures, but you can do it at a higher level.”
“But if you’re communicating to a high net worth individual, you can’t just assume that person has investment sophistication. So you need to ensure your disclosures could be easily understood,” she said.
Record keeping and archiving
Advisers must also maintain all written communication regarding performance or rate of return – including any documents necessary to demonstrate a performance calculation.
“We recommend advisers backup data, calculations, assumptions – any documentation supporting the presentation of performance and its calculations,” said Valouktzis. “This includes archived copies of anything you pulled online. These digital sources can disappear or change over time, so you should have a log and a way to retrieve these backups.”
Adoption and entanglement
Under the Marketing Rule, third party communication can become an “advertisement” through adoption and entanglement.
This idea is perhaps clearest when it comes to non-compensated testimonials. Let’s say a client provides a testimonial that your firm then repurposes on its website or reshares through social media. In doing so, your firm implicitly endorses that testimonial and must therefore ensure it adheres to the Marketing Rule’s general prohibitions (as stated above). Essentially, the firm cannot promote a testimonial that is untrue or misleading.
Where adoption and entanglement gets stickier, however, is in issues of social media likes and retweets – and in the sharing of links to third party information.
“Advisers can use hyperlinks in their marketing materials to third parties, social media or other media pages. However, they need to feel confident that the information is true and current and that there are no misstatements,” Valouktzis said.
“And again, because third-party sites can edit their content at any time, firms should consider whether they need backup information that shows what an adviser linked to and promoted at any given point in time,” Valouktzis continued.
What you should be doing now
RIAs need to be reviewing and reevaluating their policies and procedures. It’s not enough to be using a boilerplate code of conduct. Look over your policies to make sure they’re up-to-date, tailored and in compliance with the new Marketing Rule as well as the Investment Advisers Act of 1940.
Then communicate with your supervised persons, in particular those individuals involved in marketing or silicification activities about new requirements, expectations and record keeping. Talk about the expanded definition of advertisement and decide how your firm will move forward in monitoring, vetting and archiving client and investor communication.
Be sure to review any references to performance and determine how you’ll meet the disclosure requirements to ensure they’re a) appropriate to the audience, and b) of equal prominence. Likewise, review your client and investor referral agreements and ensure they’re documented and disclosed in adherence with the new rules.
Many firms are in a wait-and-see mode – watching to see how other firms adapt their marketing practices and how examiners interpret the new rules. Nevertheless, the industry has had 18 months to prepare since the rules were first announced, so don’t count on a great deal of leniency from regulators. If you haven’t already updated your policies, it’s time to act.