As new SEC marketing rule takes effect, many questions remain

The rule, which was promulgated and passed in December 2020, will be enforced by the SEC beginning Nov. 4. The rule combines and replaces the SEC’s advertising and cash solicitation rules, setting new requirements that govern investment adviser advertisements and payments to solicitors.

The rule allows certain types of marketing, advertising, endorsements, and testimonials that were previously either prohibited by the SEC or so difficult to comply with that they were effectively banned.

Investment advisers have generally welcomed the new rule for providing significant opportunities to drum up new business and promote new investment opportunities.

In September, the SEC’s Division of Examinations issued a risk alert on the marketing rule, notifying investment advisers they must update their policies and procedures to prevent violations by advisers and their supervised persons of the marketing rule. Under the rule, investment advisers will be required to substantiate material statements of fact made in all advertisements, which will need to be backed up with documentation.

The rule also covers performance advertising requirements, which require an advertisement naming gross performance of a particular investment or fund to give equal prominence to its net performance. Advertisements must also specify the time period covered by any performance claims and use the same methodologies and assumptions. Advertisements cannot “cherry-pick” the performance of subsets of a portfolio without including the results of the entire portfolio (or providing easy access to the full portfolio results) and cannot state that any performance results are approved or reviewed by the SEC.

Compliance officers must pay particular attention to the gross vs. net requirement in advertisements in order to be in compliance with the rule, said Ken Joseph, managing director at Kroll who previously served for 21 years at the SEC, including as a supervisor within the agency’s Division of Enforcement.

One of the more difficult sections of the rule with which to comply, Joseph said, is when private fund managers attempt to determine net performance at the deal or transaction level, especially when unrealized investments with longer “tails” are involved.

“Given the uncertainties of the rule’s requirements, some advisers are struggling to devise workable, compliant solutions to present net performance based on the particular set of facts and circumstances of their investments,” Joseph wrote Tuesday in a Kroll alert that was co-written by Kroll Director Betty Valouktzis and Managing Director Anna Povinelli.

The Kroll alert laid out a number of strategies for investment advisers to use to keep their advertisements compliant with the marketing rule, including:

• Calculating and displaying net performance each time gross performance is featured in an advertisement;
• Designing and implementing risk-based and tailored compliance policies regarding the testing calculation, testing, and documentation of all performance determinations;
• Clearly disclosing the methodology, assumptions, limitations, and hypotheticals used; and
• Maintaining documentary support for the material accuracy of all performance numbers used.

The marketing rule also requires investment advisers to disclose “any form of compensation—whether cash or noncash—that an adviser provides, directly or indirectly, for an endorsement or testimonial.”

Joseph said that the SEC may need to provide further guidance on disclosing net performance.

“In the private fund space, it is difficult to attribute fees to a deal that has not been realized,” he said. “The rule is not very clear on that point.”

While the marketing rule does provide a lot more structure for using social media to both distribute advertisements and solicit testimonials, there are some areas to watch for compliance professionals. According to a blog post by the firm BakerHostetler, advisers may be liable for third-party statements, including hyperlinks to independent webpages or public commentary on an adviser’s own website or social media page.

“While the SEC does not require advisers to oversee all activities of those third parties, it expects advisers to ensure that advertisements, including those created or disseminated by third parties, comply with the marketing rule through, for example, a formal authorization and review/comment process for third-party statements,” the blog post said.

Testimonials and endorsements are permitted, the BakerHostetler blog post said, provided they disclose the speaker’s relationship to the adviser, the cash or noncash compensation provided by the adviser, and a description of any material conflicts of interest.

Similarly, third-party ratings can be included in advertisements if they disclose the date the rating was given and the period of time the rating was based; the identity of the party making the rating; and the compensation, if any, the adviser provided to the rater.