So, you’ve plowed through the 500 plus pages of the SEC’s release IA-5407 discussing the proposed new advertising rule for investment advisers. It’s a proposal with a 60-day comment period. Will you wait to see the final rule before preparing for the inevitable compliance date?
The proposed Rule 206(4)-1 modernizes the regulatory regime currently in place by expanding the definition of “advertisement” to include electronic communications. It will potentially codify the interpretations and various no-action letters and interpretations issued over the years. It requires documentation of compliance review and approval of most, if not all advertisements, and although the proposed rule loosens some restrictions, on client reviews and endorsements for example, it provides a “principles based” approach rather than explicit restrictions and conditions.
It is unclear how the proposed rule, which seems to overcorrect the outdated limitations of the existing regulation, will be interpreted. Principles-based rules could allow too much discretion – the proverbial “enough rope to hang yourself.” Some express concern that the new rule’s vague approach might lead to interpretation and regulation through enforcement. Although the proposed rule seems to say that existing disclosures and legends used throughout the industry will no longer be required, they may still be used because the SEC hasn’t provided an example of disclosures to comply with the new requirements.
As a Chief Compliance Officer performing an annual and/or year-end review, it is important to think about how the proposed rule, if adopted substantially as proposed, would change your responsibilities and your staff’s. To be prepared for the eventuality of the new rule, additional resources, as well as new or enhanced policies and procedures will likely be required.
Discuss the (proposed) new rule with your company’s chief operating officer, as well as colleagues in sales and in client-facing roles to help assess future compliance needs. During your annual review /year-end checklist, and in preparation for your next Compliance Committee Meeting, CCOs should examine their firms’ policies and procedures as well as current operations in light of the proposed rule as follows:
The definition of advertisement will expand to include electronic communications as well as certain oral communications that “offer or promote” investment advisory services.
• Examine the new definition of “advertisement.”
o Do your current policies and procedures enable your firm’s compliance team to monitor all types of advertisements covered by the proposed rule?
o How might they change for that and what would your needs be with regard to resources and staffing?
o Advance notice to your firm’s management team can enable you to stay in front of compliance when the rule is enacted.
• Do your policies and procedures include testing to detect unauthorized communication with advertisements that could be an advertisement? What new or enhanced testing should be implemented in light of the new rule and the expanded definition of advertisement?
The proposed rule contains a requirement that a designated employee review and approve advertisements for compliance and that the adviser maintain records of each such review and approval. Communications to one person would be excluded, but this requirement could add substantial workload for CCOs. Note that FINRA Rule 2210, applicable to broker-dealers, has a similar rule distinguishing between retail and non-retail customers, and requiring (recorded) review and written approval for “retail communications.”
• How do you currently record approval of advertisements and where are the records stored? Who is authorized to create and issue advertisements? What automated system or CRM, if any, is currently used by your firm and is it used to record compliance review and approval of advertisements? Will it still be effective given the new definition?
The proposed rule includes different requirements for two types of clients –“Non-Retail” and “Retail”, defining “Non-Retail” as qualified purchasers. Retail advertisements would require both gross and net performance for one, five and ten-year periods; Non-Retail advertisements would not require net of fee performance but would require the advertisement to include an offer to provide a schedule of fees and expenses.
With regard to performance advertising, consider the performance records your firm currently uses.
• What types of clients does your firm have and market to?
• Do you have performance analysts or outside consultants that can upgrade your firm’s performance records to compliance?
• How much change is required? Will your firm need two sets, one for “Retail Advertisements” and one for “Non-Retail”?
• How will you define “fair and balanced” for your firm’s performance data?
• Will your firm want to create advertisements using specific investment advice, related, extracted or hypothetical performance? Each has its own set of principles-based compliance requirements and will require judgment as to the risks and benefits in presenting such data, as well as drafting compliant disclosures.
• Will you develop new policies and procedures to show Related Performance, Extracted Performance and Hypothetical Performance?
The proposed rule permits advisers to use testimonials and endorsements, previously considered to be per se misleading. When doing so, the adviser must state whether the person endorsing or giving the testimonial is a client or non-client and whether such person was paid by the adviser to provide the testimonial/endorsement. Likewise, third-party ratings can be used but require disclosure of how the ratings were devised, whether the adviser paid for them and whether the questionnaires were written in a way to elicit a positive response.
Some additional considerations:
• Will your firm want to use testimonials, third party ratings or endorsements?
• How will they be used, where will they be published and how will you maintain such information?
• Will your firm want control over what testimonials, third-party ratings or endorsements are published?
Confirm that policies, procedures and testing are in place to monitor social media and posts and that staff will be have the authority and ability to revise, review and footnote such advertisements in compliance with the advertising rule.
The new advertising rule, when adopted, will likely provide sweeping changes to how investment advisers communicate with clients and prospects. The November proposal is a road map to the changing concepts and should guide CCOs in thinking about their future needs for the next iteration of their advertising policies and procedures.
Lauri B. London is counsel at Cohen & Buckmann and counsels investment advisers on legal matters including regulation and compliance.