On June 8th, the SEC Division of Examinations (the “Division”) published a risk alert expanding the areas of focus for its ongoing examination sweep of compliance with Rule 206(4)-1 (the “Marketing Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”). The Division announced its initial focus areas in a September 2022 risk alert, covering (1) policies and procedures, (2) substantiation, (3) performance advertising and (4) books and records. It has not yet released any observations from the sweep, nor has there been guidance on the Marketing Rule’s requirements from the Division of Investment Management. This risk alert’s addition of the “general prohibitions” to the sweep’s focus areas could signal the staff’s intent to issue deficiencies for violations of the broad and undefined “fair and balanced” and “materially misleading” standards. The risk alert also adds, as expected, endorsements and testimonials to the areas of focus, which is likely an unwelcome addition for advisers having difficult negotiations with placement agents over those requirements.
The staff reiterates that it will be testing for the more nebulous general prohibitions under the Marketing Rule. This suggests that certain recurring inadequacies the staff have identified in the sweep may not fit neatly into the proscriptive section of the rule. Substantiation of factual claims in advertisements is likely to be chief among the areas of the staff’s focus, and the staff also mention website advertisements and the use of extracted and hypothetical performance.
The general prohibitions most likely to be tested in exams are:
- including a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate upon demand by the SEC;
- discussing any potential benefits to clients or investors connected with or resulting from the adviser’s services or methods of operation without providing fair and balanced treatment of any associated material risks or limitations;
- referencing specific investment advice provided by the adviser in a manner that is not fair and balanced; and
- including or excluding performance results, or presenting performance time periods, in a manner that is not fair and balanced.
Testimonials and Endorsements
The staff state that they are reviewing whether advisers are in compliance with the Marketing Rule requirements regarding the use of testimonials and endorsements in advertisements, with a focus on the requirements below. Advisers who experienced challenging negotiations with placement agents as a result of the testimonial and endorsement requirements were hoping that the staff would issue guidance on what practices would satisfy the requirements. Unfortunately, the risk alert only serves as notice that the staff will pay close attention in exams and advisers should expect deficiencies.
The specific new areas of focus identified by the staff are:
- Disclosures are provided, including clear and prominent disclosure of whether the person giving the testimonial or endorsement (the “promoter”) is a client or investor, that the promoter is compensated, if applicable, and of material conflicts of interest.
- Oversight conditions are met, such as whether advisers have a reasonable basis for believing that the testimonials or endorsements disseminated comply with the requirements of the Marketing Rule.
- In our experience, advisers have had mixed results in obtaining the commitments needed from paid endorsers such as placement agents in order to comply with the letter of these requirements. Advisers should expect exam staff to ask for support and documentation, which the advisers will need to request from placement agents, to confirm that the advisers are meeting their oversight requirements.
- Written agreements are entered into, where required, such as written agreements with promoters, unless the promoters are applicable affiliates of the advisers and such affiliation is readily apparent or disclosed.
- Ineligible persons have been compensated for testimonials or endorsements, if the adviser knew or reasonably should have known the person was ineligible, including certain “bad actors” that are prohibited from acting as promoters, unless such promoters meet the conditions for exemptions.
- This was another area of the Marketing Rule where advisers wanted to see staff guidance issued, as numerous interpretive issues have arisen as to the precise contours of the prohibition. This is also an issue where advisers have faced challenging negotiation with placement agents, who are not themselves subject to the Advisers Act and the Marketing Rule.
The staff stated they will review advisers’ compliance with the Marketing Rule requirements regarding the use of third-party ratings in advertisements, including:
- The adviser provides, or reasonably believes that the third-party rating provides, clear and prominent disclosure of: (i) the date on which the rating was given and the period of time upon which the rating was based; (ii) the identity of the third party that created and tabulated the rating; and (iii) if applicable, that compensation has been provided directly or indirectly by the adviser in connection with obtaining or using the third-party rating.
- The “compensation” requirement is likely to be most closely reviewed by the staff given that is captures both paying to use the rating in marketing materials and paying to be part of a pool of advisers from which the rating is determined. Like general testimonial and endorsements, it also includes both cash and non-cash remuneration.
- Questionnaires or surveys used in preparation of a third-party rating meet certain conditions, such as that the adviser has a reasonable basis for believing that such questionnaire or survey is structured to make it equally easy for a participant to provide favorable and unfavorable responses, and is not designed or prepared to produce any predetermined result.
- Concerns had been raised in the Marketing Rule comment period about an adviser’s ability to conduct due diligence regarding the methodology of a third party rating provider. In the adopting release, the SEC identified several possible approaches, such as seeking representations from the rating provider or reviewing publicly available disclosure. However, these may not be possible for all ratings providers, and the staff has not issued guidance as to potential alternate methodologies. In addition, advisers should expect particular scrutiny on their diligencing of ESG-related ratings.
With this expansion of the focus areas for the Marketing Rule examination sweep, the entirety of the Marketing Rule is now generally in scope. Advisers should continue to expect prompt examination upon registration with the SEC and existing advisers should ensure that their current and evolving marketing practices are correctly and fully reflected in their policies, procedures and recordkeeping.