On September 19, 2022, the SEC’s Division of Examination issued a Risk Alert concerning the new investment adviser marketing rule, Advisors Act Rule 206(4)-1 (“the Marketing Rule”). In connection with the Marketing Rule, the Commission also amended the Books and Records Rule, Advisors Act Rule 204-2 and the Form ADV. The Marketing Rule became effective on May 4, 2021 but firms were given an 18-month transition period. Thus, firms must be compliant with the Marketing Rule by November 4, 2022.
According to the Staff’s announcement, examinations will focus on four areas: a) Policies and Procedures, b) the Substantiation Requirement, c) Performance Advertising Requirements, and d) Books and Records
With regard to policies and procedures, the Commission’s noted that the Marketing Rule Adopting Release, stated that firms must adopt procedures that, “include objective and testable means” of preventing violations of the Marketing Rule. Examples of such means are:
- internal pre-review and approval of advertisements,
- reviewing a sample of advertisements based on risk, or
- pre-approving templates.
As discussed in more detail below, many of the Marketing Rule restrictions are inherently subjective thus, it remains to be seen how supervisory reviews or even pre-approved templates can ever be “objective and testable.”
The next area of examination, the Substantiation Requirement is a perfect example of the subjective nature of many parts of the Marketing Rule. The Marketing Rule prohibits advertisements that “[i]nclude 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 Commission.” (emphasis added). The Staff advises firms to make contemporaneous records with each advertisement demonstrating the basis for their belief that a fact was accurate. They also advise firms to draft policies and procedures to address how the requirement is met. Ultimately, however, a violation of the Substantiation Requirement hinges upon the subjective element of “reasonable” belief.
Many Performance Advertising Requirements present similar subjective judgements while some are objectively straightforward. For instance, firms may not present gross performance in an advertisement unless they also present net performance. Similarly, firms may not advertise performance results unless they specify the time-period. Let us examine, however, three prohibitions listed by the Staff that are not so black and white.
- to the extent an advertisement includes the performance of portfolios other than the
portfolio being advertised, performance results from fewer than all portfolios with
substantially similar investment policies, objectives, and strategies as the portfolio being
offered in the advertisement.
This prohibition requires a firm to make a very subjective determination as to which portfolios have “substantially similar investment policies, objectives, and strategies” to the portfolio being advertised. It is not hard to imagine that a firm and the SEC Staff may disagree on what makes a portfolio “substantially similar.”
Firms are prohibited from including hypothetical performance in an advertisement:
- unless the adviser adopts and implements policies and procedures reasonably designed to ensure that the performance is relevant to the likely financial situation and investment objectives of the intended audience.
This prohibition contains the seemingly impossible subjective test of determining if the hypothetical performance would be “relevant to the likely financial situation and investment objectives of the intended audience.” The use of the word “likely” here is tantamount to making a good guess.
As a final example, firms cannot include predecessor performance in an advertisement:
- unless the personnel primarily responsible for achieving the prior performance manage accounts at the advertising adviser and the accounts that were managed by those personnel at the predecessor adviser are sufficiently similar to the accounts that they manage at the advertising adviser.
First, in this prohibition there is the subjective question of which personnel were “primarily responsible” for the prior performance. This is a question that no examiner could ever objectively answer. Second, the prohibition requires a determination that the predecessor accounts were “substantially similar” to the accounts being advertised. Again, an entirely subjective question.
Finally, the SEC’s announcement states that exams will focus on firm’s books and records. The SEC amended Advisors Act Rule 204-2 in connection with the new Marketing Rule. Firms are required to maintain certain advertising related records, “such as records of all advertisements they disseminate, including certain internal working papers, performance related information, and documentation for oral advertisements, testimonials, and endorsements.”
Despite the Staff’s instructions that firm’s policies and procedures must have “objective and testable means” of preventing Marketing Rule violations, the fact remains that compliance with new Marketing Rule requires a slew of subjective judgements. The words “reasonable”, “reasonably” and “likely” appear 13 times in the Marketing Rule. The word “material,” the definition of which also contains the word “reasonably,” appears no less than 12 times in the Marketing Rule. Unfortunately, as with so many other rules, “reasonable” is likely to be in the eye of the examiner.
Herskovits PLLC has a nationwide practice defending RIAs with inquiries from the SEC or state securities regulators. Feel free to call us for a consultation. (212) 897-5410.