NEW YORK (Thomson Reuters Regulatory Intelligence) - U.S. Securities and Exchange Commission oversight of advertising by investment advisers may be up for revision this year, following indications by agency Chairman Jay Clayton that he would like to see some long-standing agency rules revisited.
The Advertising Rule(here) -- Rule 206(4)-1(here) of the Investment Advisers Act of 1940 -- was adopted in 1962 when industry communications were primarily in print and no one had yet conceived of email or social media. The advisory landscape was different too, with the commission focused mainly on retail investors, and not the most sophisticated products targeted to institutional and accredited investors.
The timetable for any revisions is unclear, but with the potential for change looming, registered investment advisers (RIAs) should carefully review their advertising materials to ensure compliance with specific SEC mandates and to avoid distributing advertisements that contain untrue statements of material fact or are otherwise false or misleading.
ADVERTISING DEFINED AND THE QUESTIONS THAT LINGER
Rule 206 prohibits advertisements that contain “any untrue statement of a material fact” or that are “otherwise false or misleading” as a catch-all to address conduct that might not otherwise violate a specific rule.
Accordingly, the SEC considers the circumstances surrounding each advertisement, including the recipient’s sophistication and the inferences that might be drawn from the information presented in the advertisement.
The rule’s definition of what constitutes an advertisement says, in part, that an advertisement is “any notice, circular, letter or other written communication addressed to more than one person.”
This leaves some confusion in today’s marketplace as email notes targeted to one or more customers can be customized, so the question is whether such communications are advertisements under the rule.
Last September, the Commission issued a Risk Alert(here) to highlight observations made in its examinations on the risks and problems associated with the Advertising Rule.
The trade group Investment Adviser Association, sent a letter to Clayton last May(here), urging him to look at several existing rules, the Advertising Rule among them.
“We would like him to take a fresh look at the way some of the rules are working and see if we can make some improvements to their effectiveness and to the efficiency of the regulatory regime,” IAA President Karen Barr said.
“Technology has removed traditional barriers to obtaining information,” the IAA said in its February 2018 newsletter. “The internet, the use of social media, and other modern achievements in communications have led to the significant proliferation of the availability of information. Investors can now access and assimilate a vast trove of information into their decision-making process.”
Mobile devices have changed the way by which investors read and respond to marketing and disclosures, the association said. “The SEC should carefully consider the role technology plays in how investors communicate and obtain information today and into the future.”
That the SEC seems willing to look at the rule with an eye toward revision and greater flexibility. Clayton, in a July 2017 New York City speech, said that “the commission should review its rules retrospectively. We should listen to investors and others about where rules are, or are not, functioning as intended. We cannot be shy about being introspective and self-critical.”
During his April 2017 confirmation hearings, he testified that he has a problem with “unnecessarily complex” regulations and that, “to the extent possible, reducing complexity, clarity, are very important. If people know the rules, they can operate more efficiently.”
The SEC did not list amendments to Advisers Act advertising rules under its short-term regulatory flexibility agenda, but it did so under its long-term list, both published this past December.
The commission did not specifically list marketing/advertising in its examinations priorities letter issued earlier this month(here). However, advertising could fit within its "Protecting Main Street investors" category. The SEC's Office of Compliance Inspections and Examinations (OCIE) said it will focus examinations on the general disclosure of fees, expenses, and other charges investors pay and the supervision of representatives selling products and services to investors, plus the execution of customer orders in fixed income securities.
The main concerns about the Advertising Rule appear to fall around four of its five main prohibitions involving a “fraudulent, deceptive or manipulative act, practice or course of business.”
Advisers are prohibited from publishing, circulating or distributing an advertisement that:
--Makes use of past specific recommendations that were profitable to any person;
--States that a graph, chart, formula or other device can, by itself, be used to make investment decision, without also prominently disclosing the limitations of doing so; and
--Offers a report, analysis or other service “free or without charge,” when in fact there may be some condition or obligation attached to it.
The bans on testimonials and past specific recommendations have received ample attention.
In its May letter to Clayton, the IAA suggested that violations of these prohibitions should not be considered, by themselves, as fraud.
“We suggest, at a minimum, that the specific prohibitions in the Rule not be considered per se fraudulent – something that the SEC staff implicitly has recognized through their many no-action letters,” the association said.
“The general anti-fraud section of the Advisers Act and ‘catch-all’ provision included in the Rule itself, which clearly apply to all disclosures and statements made by investment advisers in advertisements, effectively prohibit misleading advertising practices and protect investors.”
Here, the IAA is invoking the Advisers Act’s Sections 206 (1) and (2), which prohibit fraud. They are rules that can be used when false or misleading advertisements come into play, so the IAA is suggesting that this general advertising anti-fraud rule could simply state: “You can put out any advertising that is not false or misleading,” and the other aspects of the rule (regarding past performance, etc.) could be eliminated as falling under the anti-fraud umbrella.
It is unclear whether the SEC is ready to make such a leap. An alternative the agency could take is to leave the rule as it is for advertisements to retail clients, but provide greater flexibility for more sophisticated institutional clients.
“Consumers today are accustomed to conducting research on the internet, creating and evaluating user reviews, and sharing views publicly,” the IAA said.
“The ban on testimonials is particularly dated in this regard, in effect, thwarting common uses of social media. For example, based on staff interpretations, it is questionable whether members of the public can ‘like’ an adviser’s online posts or endorse a skill on LinkedIn without running afoul of the Rule. This stance materially impedes investment advisers’ marketing activities and does not reflect investor expectations.”
The testimonial ban makes it difficult for new advisers to promote their services when competing against existing firms, especially in light of the fact that customer sentiments regarding their products and services likely abound on social media platforms already anyway, as with Facebook "likes," and consumer review platforms(here).
PAST SPECIFIC RECOMMENDATIONS
The IAA took issue with the SEC’s ban on advertising a firm’s record of winning investments, or “past specific recommendations.”
“The past specific recommendation ban highlights another unfortunate consequence of the Advertising Rule -- it restricts the ability of an investment adviser to provide complete and accurate information to investors that may be useful in making decisions,” the IAA said.
“Investors would like more current and relevant information than their advisers are currently permitted to provide. For example, investors could benefit greatly from specific examples demonstrating how an adviser’s investment process or philosophy has been put to work by the adviser’s personnel in managing actual accounts.
“This is particularly acute in the private equity context, where case studies are extremely useful in explaining the adviser’s services and approach and do not necessarily include performance information.”
The SEC’s main concern with the dissemination of past specific performance is related to so-called “cherry-picking.” The agency does not want advisers offering testimonials that only state the successes and potentially distort the record of the advisory firm.
As part of the more specific requirements associated with this prohibition, an adviser must provide a list of all recommendations it has made over the immediately preceding year.
The SEC has shown some flexibility on the topic, in the firm of no-action letters issued to specific firms.
In the Franklin Management no-action letter issued in December 1998(here), the agency staff took the position that quarterly reports that identified some, but not all, securities that were bought, sold or held for advisory accounts within a particular investment category could be sent to existing and prospective clients if certain conditions were met.
Among these conditions was that the securities in the reports must be selected using objective, non-performance criteria.
In the TCW Group no-action letter issued in November 2008(here), the SEC staff said that as long as an objective, non-discretionary, unbiased and mechanical methodology was used to select holdings, that the performance of these holdings could be discussed in a presentation.
Other criteria must also apply, including that the calculation methodology must apply to all holdings in the representative account that contributed to the account’s performance.
The TCW letter does not go so far as to permit investment advisers to show the actual performance or discuss the absolute profitability of particular holdings, but it moves closer to the idea that the identification and discussion of partial lists of portfolio holdings should not be prohibited if the holdings are selected on an objective basis and presented in a fair and balanced manner.
The SEC has a balancing act. It can modernize the Advertising Rule to reflect a changed business world and the advancements in technology, possibly giving advisers more freedom and giving sophisticated investors more access to information. But the agency and the firms it oversees must also make sure that unsophisticated investors are protected and bad information is prevented.
Since the Advertising Rule has yet to be changed, and the SEC continues to define “advertisement” broadly under it, a good rule of thumb is to assume that any written materials sent to clients or potential clients are subject to these rules.
All RIAs should have detailed policies and procedures regarding advertising materials memorialized within their compliance program. It is advisable for investment advisors, as part of their on-going compliance program, to have in place policies requiring the pre-approval of all marketing materials.
As it stated in last year’s Risk Alert, the SEC is particularly concerned about performance advertising. The agency noted adviser advertisements that compared results to a benchmark but lacked disclosures about the limitations inherent in such comparisons.
In this situation, the problematic advertisement did not disclose that the advertised strategy materially differed from the composition of the benchmark to which it was compared.
Compliance departments must work with relevant departments in the firm -- those who created the advertisement and those who might have passed on the performance data to them -- to ensure they know that performance claims will be scrutinized for inclusion of the details needed to make the investing public aware of the context in which they are being presented.
According to OCIE, some advisers also sometimes touted in one-on-one presentations performance results that failed to reflect a deduction of advisory fees, even though client returns would be reduced by such fees and expenses.
Compliance departments must determine whether performance claims are gross of fees, and if so, that it is disclosed.
OCIE also said that advisers cherry-picked in their advertising and presentations, including “only profitable stock selections or recommendations in presentations, client newsletters, or on their websites,” which is not in compliance with industry rules.
Presentations that offer any information about investment results must be backed by facts and with the appropriate comparisons to stock selections and strategies within the same timeframe that did not fare as well. A truly representative picture should be portrayed such that the firm can say that it gave customers and prospects a fair overview of their portfolio of results.
A blanket rule barring presentation of outdated performance results should be instituted and followed.
In general, it is important to substantiate claims with specific facts.
In other words, it is better to say that a firm has the “fifth largest total assets under management for firms located in a given state” than to say it is “one of the most popular RIAs in a given state.” The latter might seem innocuous enough, but to regulators, it could seem problematic, plus send up red flags that the adviser might be exaggerating in other marketing materials.
For now, a Facebook “like” on an advisory firm’s Facebook page -- even an unsolicited one -- that by its very nature commends the firm’s advisory services could be considered a testimonial and the RIA should prohibit and delete such posts.
Endorsements on LinkedIn are almost certainly considered testimonials and investment advisers should not accept and delete them.
Until the commission passes along more details about how its Advertising Rule is to interpreted today -- describing what changes or nuances might be included in a revised rule -- advisers would proceed with caution. Such firms must appreciate they are accountable for all of the information that is included in their advertising, on every platform where it exists.
The information must be truthful and supportable, and if it includes any performance results, the firm must be truthful, offer context, disclose any limitations or deviations in the data, and have documentation both supporting the performance cited and the decision to offer it in that manner.
(Julie DiMauro is a regulatory intelligence expert in the Enterprise Risk Management division of Thomson Reuters Regulatory Intelligence. Follow Julie on Twitter @Julie_DiMauro. Email Julie at email@example.com.)