SEC Proposes to Modernize the Advertising and Cash Solicitation Rules for Investment Advisers

The Securities and Exchange Commission (the SEC) announced on Monday that it had voted to propose amendments to modernize Rule 206(4)-1 (which addresses investment adviser advertisements) (the Advertising Rule) and Rule 206(4)-3 (which deals with payments to solicitors) (the Cash Solicitation Rule and, together with the Advertising Rule, the Rules) under the Investment Advisers Act of 1940, as amended (the Advisers Act). The Rules have not been significantly updated since their adoption in 1961 and 1979, respectively, and the proposed rule amendments are intended to reflect changes in technology, investors’ expectations and the evolution of industry practices as a whole.

The Advertising Rule

The Advertising Rule currently prohibits an investment adviser, directly or indirectly, from publishing, circulating, or distributing any advertisement that contains any untrue statement of material fact, or that is otherwise false or misleading and specifically prohibits (1) advertisements that refer, directly or indirectly, to any testimonial concerning the investment adviser or any advice, analysis, report or other service rendered by the investment adviser; (2) an investment adviser from advertising past specific recommendations of the investment adviser that were or would have been profitable to any person; (3) advertisements claiming that any graph, chart, formula or other device can by itself determine whether to buy or sell a security; and (4) advertisements that offer purportedly free reports, analyses, or services.

Key elements of the proposed amendments to the Advertising Rule are:

• Definition of Advertisement. An “advertisement” would include any communication, disseminated by any means, by or on behalf of an investment adviser, that offers or promotes investment advisory services or that seeks to obtain or retain advisory clients or investors in any pooled investment vehicle advised by the investment adviser. The SEC proposes to exclude from this definition:  (1) live oral communications that are not broadcast; (2) responses to certain unsolicited requests for specified information; (3) advertisements, other sales material, or sales literature that is about a registered investment company or a business development company and is within the scope of other SEC rules; and (4) information required to be contained in a statutory or regulatory notice, filing, or other communication.

This proposed definition reflects several key differences from the current Advertising Rule: (1) it expands the types of communications that would qualify as “advertisements” to include evolving methods of communication, rather than only the methods that were most common when the Advertising Rule was originally adopted (e.g., newspapers, television, and radio); (2) the proposed definition applies explicitly to advertisements disseminated to investors in pooled investment vehicles, with the exception of registered investment company investors; and (3) the proposed definition specifically carves out information required to be disseminated to investors by applicable statutory or regulatory requirements.

• General Prohibitions. The following advertising practices would be prohibited: (1) making an untrue statement of a material fact, or omission of a material fact necessary to make the statement made, in light of the circumstances under which it was made, not misleading (which, according to the SEC, would capture the current explicit prohibition on advertisements that contain statements to the effect that a report, analysis, or other service will be furnished free of charge, unless the analysis or service is actually free and without condition); (2) making a material claim or statement that is unsubstantiated; (3) making an untrue or misleading implication about, or being reasonably likely to cause an untrue or misleading inference to be drawn concerning, a material fact relating to the investment adviser; (4) discussing or implying any potential benefits without clear and prominent discussion of associated material risks or other limitations; (5) referring to specific investment advice provided by the investment adviser that is not presented in a fair and balanced manner (which would replace the current prohibition with a principles-based restriction on the presentation of specific investment advice to allow investment advisers to better tailor (based on the facts and circumstances of the advertisement, including the nature and sophistication of their audience) the information that they include in advertisements that contain references to specific investment advice (including past advice) in a manner that does not mislead investors); (6) including or excluding performance results, or presenting performance time periods, in a manner that is not fair and balanced; and (7) being otherwise materially misleading.
  
  
• Testimonials, Endorsements, and Third-Party Ratings. The proposed amendments relax the current Advertising Rule’s broad restrictions on the use of testimonials in that they would allow testimonials and endorsements, subject to specified disclosures, including whether the person giving the testimonial or endorsement is a client and whether compensation has been provided by or on behalf of the investment adviser. The proposed amendments would also permit third-party ratings, subject to specified disclosures and certain criteria pertaining to the preparation of the rating.
  
  
• Performance Advertising. While the current Advertising Rule does not specifically address performance result calculations, the proposed amendments would prohibit including in any advertisement:  (1) gross performance results unless they provide (or offer to provide promptly) a schedule of fees and expenses deducted to calculate net performance; (2) performance results from fewer than all portfolios with substantially similar investment policies, objectives, and strategies as those being offered or promoted in the advertisement, with limited exceptions (e.g., composites construction for GIPS purposes, exclusion of one or more related portfolios permitted so long as the advertised performance results are no higher than if all related portfolios had been included); (3) performance results of a subset of investments extracted from a portfolio, unless the investment adviser provides or offers to provide promptly the performance results of all investments in the portfolio; and (4) hypothetical performance, unless the investment adviser adopts and implements policies and procedures reasonably designed to ensure that the performance is relevant to the financial situation and investment objectives of the recipient and the investment adviser provides certain specified information underlying the hypothetical performance.
  
  
• Performance Information in a Retail Advertisement. For an advertisement targeted to a retail audience, the proposed amendments would also require the presentation of net performance alongside any presentation of gross performance and would generally require the presentation of the performance results of any portfolio or certain composite aggregations across 1-, 5-, and 10-year periods.
  
  
• Internal Pre-Use Review and Approval. The proposed amendments would impose new procedural requirements as advertisements would need to be reviewed and approved in writing by a designated employee of the investment adviser before dissemination, except for advertisements that are communications disseminated only to a single person or household or to a single investor in a pooled investment vehicle or live oral communications broadcast on radio, television, the internet, or any other similar medium.
  
  
• Proposed Amendments to Form ADV. The SEC also proposes to amend Item 5 of Part 1A of Form ADV to enhance publicly available information about investment advisers’ advertising practices.

The Cash Solicitation Rule

The Cash Solicitation Rule generally prohibits an investment adviser from paying a cash fee to a solicitor for referrals of advisory clients unless the solicitor and the investment adviser enter into a written agreement that, among other things, 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. The Cash Solicitation Rule also prohibits investment 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.

Key elements of the proposed amendments to the Solicitation Rule are:

• Changes in Scope
  • The proposed amendments would apply regardless of whether an investment adviser pays cash or non-cash compensation to a solicitor. The current Solicitation Rule does not cover non-cash compensation. Non-cash compensation would include directed brokerage, awards or other prizes and free or discounted services.
    
    
  • The proposed amendments would also apply to the solicitation of current and prospective investors in private funds, rather than only to the solicitation of current and prospective clients of the investment adviser.
    
    
  • The proposed amendments would substantially retain the Solicitation Rule’s current partial exemptions for solicitors that refer investors for impersonal investment advice and solicitors that are employees or otherwise affiliated with the investment adviser. However, these arrangements would no longer be subject to a written agreement requirement, as currently set forth in the Solicitation Rule. The proposed amendments would also add two new full exemptions for de minimis compensation to solicitors and investment advisers that participate in certain nonprofit programs.
    
    
  • The proposed amendments contain an expanded list of disciplinary events for which persons would be disqualified from acting as a solicitor, with a limited carve out for persons whose only disqualifying events are those for which the SEC has issued a waiver under the Investment Company Act of 1940 or the SEC has issued an opinion or order that is not “disqualifying SEC action” (e.g., an order that does not bar or suspend the person from association with an SEC-registered entity or prohibit the person from acting in any capacity under the Federal securities laws).
    
    
• Written Agreement Requirement. The proposed amendments would eliminate the requirements that the solicitor agrees to deliver the investment adviser’s Form ADV brochure and performs its solicitation activities in a manner consistent with the instructions of the investment adviser.
  
  
• Disclosure Requirements. The solicitor disclosure required under the proposed amendments would modify the current solicitor disclosure to include additional information about a solicitor’s conflict of interest and eliminate the Solicitation Rule’s current requirement that the investment adviser obtains from each investor a written acknowledgment of receipt of the disclosures.

The SEC is also reviewing certain of its no-action letters and other guidance regarding the application of the Rules to determine whether any such letters should be withdrawn as a result of the adoption of its proposal (e.g., the Mayer Brown LLP no-action letter^[1] regarding the application of the Cash Solicitation Rule to cash payments by registered investment advisers to persons who solicit investors to invest in investment pool managed by the investment adviser).

Comments on the proposals are due 60 days following publication of the proposing release in the Federal Register. The SEC also encourages investors and smaller investment advisers to use two short-form tear sheets to submit additional feedback about their experiences with investment adviser marketing and how the proposed rules would affect them, respectively.

The proposed amendments are available here.

^[1]  Publicly available July 15, 2008, superseded by letter with minor, non-substantive changes, publicly available July 28, 2008.