SEC Modernizing Investment Adviser Advertising

On December 22, 2020, the U.S. Securities and Exchange Commission (“SEC”) unanimously adopted a NEW Rule 206(4)-1 under the Investment Advisers Act of 1940, as amended (the ”IA Act”), replacing old Rule 206(4)-1 originally adopted in 1961, and also eliminating Rule 206(4)-3 originally adopted in 1979. Old Rule 206(4)-1, known as the Marketing Rule, regulated how investment advisers could utilize advertising for their services and focused primarily on written communications, as well as radio and television. Rule 206(4)-3, known as the Solicitation Rule, regulated how investment advisers might lawfully employ the assistance of third parties to “solicit” business from new investment adviser clients and was tied to situations where the solicitor received cash compensation for that marketing assistance. Over the intervening years, the SEC had issues over 200 interpretive guidance statements as to how to comply with the old rules. New Rule 206(4)-1 (the “New Rule”) addresses the subjects of both of the old rules and was published in an Adopting Release (No. IA-5653) over 400 pages long. Then SEC Chair Jay Clayton (who resigned as of December 23, 2020) is quoted in the SEC Press Release announcing the adoption of the New Rule: “… [the New Rule] reflects important updates to the traditional advertising and solicitation regimes, which have not been amended for decades, despite our evolving financial markets and technology.” He further said, “This comprehensive framework for regulating advisers’ marketing communications recognizes the increasing use of electronic media and mobile communications and will serve to improve the quality of information available to investors.”

Regulatory Schizophrenia

The financial press regularly reports on the changed focus of quite a number of major investment banks from transactional work to investment advice. Particularly noteworthy have been the changes, since the Great Recession of 2007-2009, in the business models of Morgan Stanley & Co, Inc., Citigroup, and even Goldman, Sachs & Company, Inc. At the same time, more mass-market firms such as Charles Schwab & Co, Inc., Ameritrade, and even Fidelity Investment Co. have sought to broaden their appeal to “retail” investors. During the past 50+ years, the so-called baby-boomer generation has generally prospered, accumulating significant investment assets; at the same time, defined payment retirement plans (pensions, etc.) have grown rarer, while both defined contribution and voluntary contribution plans (401[k]’s, 403 plans, and IRA’s) have become ever more common. Investment advice has become a giant industry. It is against this background that the SEC has adopted the New Rule.

It is noteworthy that, despite its unanimous approval, four of the five Commissioners felt compelled to issue statements on December 22, 2020, expressing concern, disagreement, and disappointment with the New Rule. What is it about investment adviser advertising that is so controversial? I have written previously about a fundamental contradiction in the “mission” of the SEC – to insure the fair and efficient working of America’s capital markets AND to protect investors (especially the so-called “Main Street” retail investors) from fraud. See my September 15, 2020, blog post, “‘Accredited Investor’: Regulatory Design, the Revised Definition, and the Unfinished Result,” in which I observed:

Once again the Commission approached Section 4(2) with two minds – one seeking to foster capital formation and the other clearly concerned about possible misuse of the [accredited investor] exemption to take money from the unsuspecting.

Commissioners Allison Herren Lee (named Acting Chair of the SEC on January 21, 2021) and Caroline A. Crenshaw were extraordinarily distressed that a requirement in the 2019 Proposal for a “New Rule,” a requirement that any investment adviser advertising be “pre-reviewed” by the adviser’s compliance personnel BEFORE USE, was “abandoned” (their word). In their view:

Pre-review is the best and most logical way to reduce the risk of advisers’ using advertisements that could mislead clients and prospective clients… However, certain commenters strongly objected to the proposal’s pre-review requirement.

They further assert:

[The New] rule reflects a determination by a majority of the Commission to eliminate important safeguards for investors.

The SEC “Modernizes”

The two Commissioners cite, in contrast, the findings by the Division of Examinations (“DivEx”; formerly the Office of Compliance Inspections and Examination) recited in a November 19, 2020, Risk Alert that DivEx examiners “identified a pattern of compliance deficiencies relating to …advertisements.” See my December 8, 2020, blog post, “Meeting Specified Standards: the SEC’s OCIE Assesses Compliance,” for a fuller description of the DivEx findings that led to the issuance of the November 19 Risk Alert.

The same two Commissioners were also troubled by the way the New Rule allows the use of investment adviser advertising incorporating hypothetical performance examples. Because these “performance results” do not reflect actual, “real-world” results, they can (in their words) “pose a heightened risk of misleading investors because they can be readily optimized through hindsight.” They are concerned that hypothetical performance examples are allowed in response to “unsolicited [oral] requests from retail investors and one-on-one communications with prospective or current investors in private funds.” With respect to the latter, they once again raise the criticism they made of the revised definition of “accredited investor” (see my September 25 blog post cited above) that the “wealth” thresholds are almost 40 years old, and thus allow far too many persons to be classified as “accredited.” As the two Commissioners say:

Advisers may therefore actively “tout” [their word] performance results that they never achieved without having to provide basic disclosure about the performance presentation to enable investors to assess the risks and limitations of relying on it.

In the end, however, they accept that the New Rule “makes a number of improvements in an area that is of paramount importance to investors.”

Commissioner Roisman (Acting Chair of the SEC from December 23, 2020, until January 21, 2021) is very concerned that the New Rule “explicitly extend[s] to communications made by private fund advisers to private fund investors …potentially [including] private placement memoranda (“PPM”).” This he sees as an “unintended consequence,” with the possibility that a private fund using (as is typical in the industry) a PPM, which survives claims for violation of the level of disclosure required in such an offering, might still be subject to SEC (or, theoretically, even FTC) enforcement action on “bad advertising” grounds.

And then there is Commissioner Hester M. Peirce, who noted that “Having qualified for its AARP card nearly a decade ago, the advertising rule was long overdue for amendment.” The New Rule is intended to “create a regulatory framework flexible enough to accommodate the dynamism of technology.” “An even more technology-neutral approach would have been to replace the [old rule 206(4)-1] with…nothing.” As she wrote, “we instead could have relied on existing fiduciary duties and anti-fraud rules.”

As part of adopting the New Rule, the SEC announced that it would “withdraw” certain of the 200+ staff interpretations issued over the last 59 years (although the SEC did not give any indication of how many would be withdrawn). The SEC said it would publish a list of those interpretations being withdrawn, and that those interpretations would then no longer be able to be relied upon for guidance. At the same time, as part of the New Rule, investment advisers were informed not only that they have 18 months to “transition” to the New Rule after it becomes effective (60 days after publication in the Federal Register), but also that interpretive guidance could be sought from SEC staff (the SEC Press Release thoughtfully provides an e-mail address to which to send inquiries). This led Commissioner Peirce to observe:

I anticipate a steady flow of requests for interpretation and clarification as advisers work to implement the…{New Rule]. If we are not careful, we could find ourselves right back where we started: regulatory obligations understood as much or more by reading the swelling corpus of staff interpretations than by reading the regulatory text itself.

And, of course, the SEC itself will change with the expected confirmation of President Biden’s selection to be the SEC Chair, Gary Gensler, who was Chair of the Commodity Futures Trading Commission from 2009 to 2013. According to lawyers, regulators, and lobbyists cited as sources in The Wall Street Journal Weekend Edition, January 16-17, 2021, Mr. Gensler is “the most active, pro-regulatory SEC chairman…since the early 2000’s.”

Investment Adviser Advertising

So what is it that makes the New Rule so complicated and the source of so many policy disagreements? A major reason is the sheer complexity of the regulatory design it reflects. The SEC Press Release states with confidence that the “[New Rule] is designed to comprehensively and EFFICIENTLY regulate investment advisers’ marketing communications” [emphasis added]. Yet as noted above, the Adopting Release runs over 400 pages, surely an indication of micro-management. That impression is confirmed by the length of BigLaw write-ups explaining the “Key Takeaways” of the New Rule, two of which run 26 and 23 pages respectively. The New Rule covers four main topics:

1. It defines “advertisement” to include any direct or indirect communication by or on behalf of an investment adviser that either offers advisory services about securities to prospective clients or to investors in a private fund advised by the adviser or offers new advisory services about securities to current clients or private fund investors (most one-on-one communications are excluded from the definition)
2. The definition of “advertisement” also includes any testimonial or endorsement where the adviser compensates (cash or benefits, over a de minimis limit of $1000 per year) the giver of the same
3. Advisers are prohibited from making material misstatements or omissions, including any discussion of benefits that is not “fair and balanced” or that provides misleading performance results (note that these prohibitions impose negligence, not a scienter driven, standard for liability)
4. There are substantial restrictions on performance advertising, e.g., gross performance figures must be accompanied by net information, comparisons must use the same methodology over like periods of time, performance (except for private funds) must be shown for one, five, or ten year periods, citations to related portfolios require citation to all related portfolios, neither extracted nor hypothetical performance is permitted except under special conditions, and predecessor performance may be cited only by the actual adviser of the prior portfolio, similarly managed with the disclosure that the performance was at a prior entity
5. There are also substantial restrictions and requirements concerning the use of endorsements, testimonials, and/or third-party ratings, including disclosure of compensation in any form and of any conflicts of interest, as well as a general prohibition on using any statement from a “disqualified person” (i.e., anyone who has, within 10 years, been subject to enforcement action or prosecution for violation of securities or commodities regulations or similar laws) unless the “disqualified person” receives no compensation

In addition to the foregoing, the Adopting Release amends the requirements for the Form ADV filed with the SEC by each registered investment adviser under the IA Act to describe what kind of marketing the adviser uses, specifically endorsements, testimonials, and/or third-party ratings; to disclose what compensation the adviser pays to the sources of those items; and whether it uses performance advertising, especially hypothetical or predecessor performance. These disclosures are to be reviewed and revised as part of the adviser’s annual update of its Form ADV. It is not impossible that the SEC will also require promptly amending the ADV in case of any material change in the adviser’s marketing program. In concert with these changes, the applicable SEC books and records rule is revised to require the adviser to keep a copy of ALL advertising, including memorializing any oral communications. An adviser must maintain those copies for at least five years, during the first two years of which the copies must be maintained on-site at the office where the advertising was “published.” Finally, to “ensure compliance,” the Adopting Release requires each adviser firm to draft and implement written policies and procedures that “include objective and testable means reasonably designed to prevent violations” of the New Rule and these related requirements. Such policies and procedures, of course, will also provide the basis for future compliance examinations by the SEC’s DivEx personnel.

An investment adviser is permitted to advertise their existence (what could be called “Brand” advertising) without complying with the New Rule because those types of advertisements do not offer services in connection with investing in securities. Similarly, an adviser may use advertising, such as their name and/or logo, on letters, account statements, and the like. Further, it appears from the definition of “advertisement” that an adviser may even OFFER existing services to an existing client without risking a violation of the New Rule, although a careful adviser will still take care to avoid any material misstatements or omissions.

In sum, the New Rule continues to reflect the contradictions inherent in the SEC’s “mission”: strengthening the functioning of the capital markets, while at the same time protecting investors from fraud. The New Rule does attempt to find some balance between these objectives and to provide greater clarity about allowable marketing activity by persons whom many at the SEC (Acting Chair Lee, for example) fundamentally distrust.