November 4, 2019, the SEC proposed major changes to the Advertising Rule and the Cash Solicitation Rule. We would recommend at least glancing through the 505 pages release, which includes much more detail. At the end of the release are three appendices: Appendix A, identifying the changes to Form ADV; Appendix B, an Investor Feedback Flyer; and Appendix C, a Smaller Adviser Feedback Flyer.
In adopting the current rule in 1961, the Commission used its authority under section 206(4) of the Advisers Act to target advertising practices that it believed were likely to be misleading by imposing four very familiar specific prohibitions:
First, testimonials concerning the investment adviser or its services;
Second, direct or indirect references to specific profitable recommendations that the investment adviser has made in the past (“past specific recommendations”);
Third, representations that any graph or other device being offered can by itself be used to determine which securities to buy and sell or when to buy and sell them; and
Fourth, any statement to the effect that any service will be furnished free of charge, unless such service actually is or will be furnished entirely free and without any condition or obligation.
In addition, the current rule prohibits any advertisement which contains any untrue statement of a material fact, or which is otherwise false or misleading. This prohibition operates more generally than the specific prohibitions to address advertisements that do not violate them but still may be fraudulent, deceptive, or manipulative and, accordingly, be misleading.
Some of the most common questions related to the current rule (and the anti-fraud provisions of the Advisers Act) relate to the appropriate presentation of performance in advertisements, which the current rule does not explicitly address, resulting in no-action letters.
The proposed rule would define “advertisement” as “any communication, disseminated by any means, by or on behalf of an investment adviser, that offers or promotes the investment adviser’s investment advisory services or that seeks to obtain or retain one or more investment advisory clients or investors in any pooled investment vehicle advised by the investment adviser.”
The proposed definition of “advertisement” would not include the following four categories of communications: (A) Live oral communications that are not broadcast on radio, television, the internet, or any other similar medium; (B) A communication by an investment adviser that does no more than respond to an unsolicited request for specified information about the investment adviser or its services, other than (i) any communication to a Retail Person that includes performance results or (ii) any communication that includes hypothetical performance; (C) An advertisement, other sales material, or sales literature that is about an Registered Investment Company or about a Business Development Company that is within the scope of rule 482 or rule 156 under the Securities Act of 1933 (the “Securities Act”); or (D) Any information required to be contained in a statutory or regulatory notice, filing, or other communication.
This proposal would result in “a restructured and more tailored rule that: (i) modifies the definition of “advertisement” to be more “evergreen” in light of ever-changing technology; (ii) replaces the current four prohibitions with a set of principles that are reasonably designed to prevent fraudulent or misleading conduct and practices; (iii) provides certain additional restrictions and conditions on testimonials, endorsements, and third-party ratings; and (iv) includes tailored requirements for the presentation of performance results, based on an advertisement’s intended audience. The proposed rule also would require internal review and approval of most advertisements and require each adviser to report additional information regarding its advertising practices in its Form ADV.” (emphasis added)
Cash Solicitation Rule
Another way that advisers attract clients and investors, beyond advertising, is through compensating firms or individuals to solicit new investors. Some investment advisers directly employ individuals to solicit new investors on their behalf, and some investment advisers arrange for related entities or third parties, such as broker-dealers, to solicit new investors. The solicitor has a financial incentive to recommend the adviser to the investor. Without appropriate disclosure, this compensation creates a risk that the investor would mistakenly view the solicitor’s recommendation as being an unbiased opinion about the adviser’s ability to manage the investor’s assets and would rely on that recommendation more than he or she otherwise would if the investor knew of the incentive.
The SEC adopted rule 206(4)-3, the cash solicitation rule, in 1979 to help ensure that clients become aware that paid solicitors have a conflict of interest and has not been amended since. The current rule makes the adviser’s payment of a cash fee for referrals of advisory clients unlawful unless the solicitor and the adviser enter into a written agreement that, among other provisions, requires the solicitor to provide the client with a current copy of the investment adviser’s Form ADV brochure and a separate written solicitor disclosure document. The solicitor disclosure must contain information highlighting the solicitor’s financial interest in the client’s choice of an investment adviser. In addition, the rule requires an adviser to receive a signed and dated client acknowledgment of receipt of the required disclosures. The current rule also prohibits advisers from making cash payments to solicitors that have previously been found to have violated the Federal securities laws or have been convicted of a crime.
“Therefore, we are proposing to expand the rule to cover solicitation arrangements involving all forms of compensation, rather than only cash compensation. We are proposing to expand the rule to apply to the solicitation of current and prospective investors in any private fund, rather than only to “clients” (including prospective clients) of the investment adviser. Our proposal would require solicitor disclosure to investors, which alerts investors to the effect of this compensation on the solicitor’s incentive in making the referral. In addition, we are proposing changes to eliminate: (i) the requirement that solicitors provide the client with the adviser’s Form ADV brochure; and (ii) the explicit reminders of advisers’ requirements under the Act’s special rule for solicitation of government entity clients and their fiduciary and other legal obligations. Our proposal would also eliminate the requirement that an adviser obtain a signed and dated acknowledgment from the client that the client has received the solicitor’s disclosure, and instead would afford advisers the flexibility in developing their own policies and procedures to ascertain whether the solicitor has complied with the rule’s required written agreement. We are also proposing two new exceptions to the solicitation rule, an exception for de minimis payments (less than $100 in any 12-month period) and one for nonprofit programs designed to provide a list of advisers to interested parties. Finally, we are proposing to refine the rule’s solicitor disqualification provision to expand the types of disciplinary events that would trigger the rule’s disqualification provision, while also providing a conditional carve-out for certain types of Commission actions.”
Although some may argue that updating these two rules is long overdue, we find the proposal timely, if only because the number of no-actions letters was becoming unmanageable. Maybe the industry has reached the point at which the SEC believes that “principles-based rules” are appropriate, although we suspect there are registrants out there who will continue to “push the envelope.”
We would expect to see comment on both sides, arguing that this will make advertising more complicated and others arguing that this proposal allows too much leeway, and that many firms are not “principled” based on the number of enforcement actions. At the time of this writing, there were only two comments, both generally in favor of the proposal.
We do like the two Feedback Flyers, one for investors and one for smaller advisers, both of whom may have considered their opinions not valued in the past.