1961, Was it really a "good year?" Some of us couldn’t say for sure since we weren’t even born yet! For those of us that were, gas was about 27 cents/gallon. John F. Kennedy was President and about to deal with the "Bay of Pigs" debacle which would tarnish his first year in office. East German authorities closed the border between East and West Berlin and construction of the Berlin wall would commence. Pampers were introduced as the world’s first disposable diaper. Oh, and the Securities and Exchange Commission published the first rule on advertising!
You know how the story goes. Today, regular gasoline is, on average, $2.47/gallon. Kennedy was assassinated. The Berlin Wall fell in November 1989. There are now too many different types/brands of disposable diapers from which to choose. But one thing hasn’t changed since 1961 – the Advertising Rule has been sitting around collecting dust for almost 60 years with no updates…until now!
In the proposal to modernize the Advertising Rule, which was published (https://www.sec.gov/rules/proposed/2019/ia-5407.pdf) in the Federal Register in November 2019, the SEC actually conceded that changes "have occurred since the current rule’s adoption lead(ing) us to believe providing a more principles-based approach would be beneficial." Oh, and they also acknowledged that there have been "changes in technology used for communication" and the new proposal would address those changes. Talk about understating the obvious!
Over the years, the industry has been grappling with the limitations of the outdated rule and the SEC has been responding by issuing "no-action letters" and enforcement actions which has done nothing more than show that "guidance" has been overshadowing the actual rule for quite some time.
While the comment period for the proposed changes recently ended in January 2020 and no formal new rule filing has happened yet, we thought it might be beneficial to discuss some of the key points of the proposed amendments to the advertising rule (Rule 206(4)-1).
- Clarification and expansion of the term "advertisement";
- Elimination of the current rule’s limits on testimonials, endorsements, third-party ratings and "past specific recommendations" in favor of broad "fair and balanced" principles; (Note: cue the Hallelujah Chorus here)
- Revision of guidelines on performance information (based in part on distinctions between retail and non-retail communications); and
- Mandated internal pre-use review processes.
At the heart of the proposed amendments is the new definition of "advertisement," and the SEC’s intent to define the term so that it is flexible enough to remain relevant and effective. The proposal defines "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."
It is important to note that the following modes of communication are exempt from the definition:
- Live oral communication broadcast on the radio;
- Responses to certain unsolicited requests for information;
- 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
- Information that must be included in a statutory or regulatory notice, filing, or other communication.
Neither Form ADV 2A or Form CRS would be treated as an advertisement under the proposed rule.
Existing Specific Limits on Content to be replaced by "Fair and Balanced" Statement
The existing five subsections of the current Advertising Rule would be replaced with general advertising prohibitions such as:
- Advertisements should not contain material "untrue statement or omissions";
- Making an unsubstantiated material statement or claim;
- Advertisements should not give rise to materially "untrue or misleading implications or inferences";
- Discussing or implying any potential benefits without a clear and prominent disclosure of related material risks or other limitations;
- When discussing or referring to past investment picks, or investment performance, a "fair and balanced" approach should be taken, notably in terms of what is selected for inclusion or exclusion; and
- Advertisements should not be "otherwise materially misleading."
While you may be thinking to yourself, "Well, yeah, I know I cannot misstate, overstate or make false claims," what is noteworthy is that the proposed changes require that advertising include discussion of risks.
Testimonials and endorsements
This is, perhaps, the area that will come as the most welcome relief to most advisers. In the past, any testimonials, endorsements or third-party ratings were subject to strict limitations. Under the new proposal (which follows the lead of existing FINRA regulations) these would be permitted as long as the general principles listed above were followed and accompanied by a number of mandated disclosures. Discussion of specific investments – which are also very restricted at this point – would be permitted, again subject to these general principles.
While it appears that the days of having a Facebook or LinkedIn business page and potentially running afoul simply because someone "liked" or "endorsed" you or your business may be over if the rule is adopted, that doesn’t mean that the gates are open and all bets are off. There are specific disclosures that must accompany these testimonials and endorsements. And by the way, you still cannot cherry-pick your testimonials and only include the good ones in advertising and omit the negative ones.
The proposed amendments draw distinctions between "retail advertising" and "non-retail advertising."
- Non-retail advertising is where an adviser has implemented policies and procedures to ensure it is only disseminating to "non-retail persons." The term "non-retail persons" includes "qualified purchasers" (Investment Company Act of 1940, Section 3(c)(7)) as well as "knowledgeable employees" of the firm.
- Retail advertising is advertising that does not fall under the definition of "non-retail advertisement." Retail clients and investors include those meeting the "accredited investor" or "qualified client" standards under the ’33 Act or the Advisers Act.
The proposed amendments would subject advertisements disseminated to retail persons to heightened requirements. In particular, information on net performance (showing investment results after giving effect to fees and expenses) would be included with any presentation of gross performance, and performance results would be presented according to standardized time periods, generally one, five and ten years.
For non-retail persons, firms would be exempt from these requirements as long as they could show that the advertisement would not be disseminated to any retail persons. Obviously, you couldn’t advertise in the media, on unrestricted websites or make the advertisement readily available in the lobby of your offices.
The proposed rule includes detailed guidance and requirements around the use of "related performance" and "hypothetical performance".
The proposed changes are principles-based and as such, make no specific mention of various social media platforms like Facebook, LinkedIn or Twitter. This was intentionally done so as not to limit new forms of social media long after current-day platforms become antiquated.
The proposed rule could lead to making the job of the CCO more difficult. No longer can they stand on the "advertisement violates the Testimonial Rule"; the CCO will now have to analyze all of the facts and circumstances and look at all of the prohibitions that could potentially apply. Where things were once "black and white," there may now be shades of gray and policies and procedures will need to be reviewed and updated to address the new requirements, as well as any potential compliance problems.
If, and when, the SEC adopts a final rule, Joot will be ready to assist our clients with the implementation.