November 4, 2022

The SEC’s New Marketing Rule is Effective Now – What It Means for Registered Investment Advisors

By David Albrecht, CPA, Manager, Alternative Investment Group & Marni Pankin, CPA, Partner, Alternative Investment Group

Alternative Investments

A rule amendment adopted by the Securities and Exchange Commission (SEC) 18 months ago is now in full effect and enforces a significantly more complex set of marketing compliance regulations for Registered Investment Advisers (RIAs).

Background

In December 2020, the SEC adopted amendments to modernize and combine two existing and related rules under the Investment Advisers Act of 1940 (the Act) into one unified, updated rule. The previous “advertising rule” (Rule 206(4)-1) and the “cash solicitation rule” (Rule 206(4)-3) of the Act were merged into the new “marketing rule” (Rule 206 (4)-1), effective May 4, 2021.

Entities impacted by the marketing rule include any investment adviser registered or required to be registered with the SEC. Impacted investment advisers received an 18-month window to ensure any of their materials, which constitute an “advertisement,” were brought up to the revised standards.

The 18-month adoption window has recently closed and the stipulated compliance date of November 4, 2022, has passed.

What changed with the new marketing rule and what should investment advisers be aware of?

Much has changed since the original advertising and solicitation rules were contemplated. Technological developments in communication, such as the internet, social media, and text messaging, did not come about until decades thereafter. As a component of modernizing these rules to reflect material changes in the way we communicate in the 21st century, the SEC amended the definition of what constitutes an “advertisement.” The new marketing rule amends the definition to consider exchanges such as social media posts, information displayed on advisers’ websites, third party communications by entities such as placement agencies on behalf of advisers, and paid testimonials or endorsements.

In addition to modernizing the definition of what constitutes an advertisement, the SEC also amended what is prohibited in those advertisements. The original four prohibitions under the old rules have been expanded to seven principle-based prohibitions. Prohibited items now include:

Untrue statements of a material fact, or omitting a material fact, and
- Material statements of fact that cannot be reasonably substantiated, including information likely to cause an untrue or misleading implication or inference to be drawn;
- Discussing potential benefits without providing commensurate and balanced discussion of associated risks;
- Referencing specific investment advice provided by the adviser that is not presented in a fair and balanced manner;
- Including or excluding performance results, or presenting performance time periods, in a manner that is not fair and balanced; and
- That is materially misleading.

Advisers and their legal and compliance teams should thoroughly vet their private placement memorandums, websites, social media platforms, and policies and procedures to ensure they are updated and in compliance with these new principle-based rules.

The revised books and records rule and performance advertising rules.

One of the more significant components of the new marketing rule relates to the revised books and records rule and the revised performance advertising rules. As previously noted, one of the seven general prohibitions relates to “including or excluding performance results, or presenting performance time periods, in a manner that is not fair and balanced.” The SEC further clarifies this one general prohibition with a subset of specifically prohibited items, including prohibitions of:

Disclosure of gross performance, unless the advertisement also presents net performance of all investment advisory fees and expenses;
Any performance results, unless they are provided for specific time periods;
Statements asserting that the SEC has approved or reviewed any calculation or presentation of performance results;
Performance results from less than all portfolios with similar investment policies, objectives, and strategies as those being offered in the advertisement;
Performance results of a subset of investments extracted from a portfolio, unless the advertisement provides the performance results of the total portfolio;
Hypothetical performance, unless the adviser has policies and procedures in place to ensure that the performance is relevant to the likely financial situation and investment objectives of the intended audience and the adviser provides certain information underlying the hypothetical performance; and
Inclusion of predecessor performance, unless there is appropriate similarity with regard to the personnel and accounts, and all relevant disclosures must be included in the advertisement.

These specifically prohibited items related to performance disclosures give today’s advisers much to consider as they prepare their marketing and advertising materials and form their social media strategies.

Furthermore, the books and records rule was also amended in the marketing rule. Advisers are now required to maintain copies of all marketing materials, including supporting documentation related to the calculation of performance statistics, which adds an additional compliance component to the performance advertising rules.

Highlights of these prohibitions and other facets of the performance rules are discussed below.

Calculating Returns

A particular method of calculating returns is not prescribed in the new rules. For instance, many private funds use money-weighted returns, whereas managed accounts may use time-weighted returns. Advisers may choose the types of returns appropriate for their strategies, provided that the rules’ general prohibitions are not violated. An adviser should disclose how cash flows and other factors are reflected in the returns. Similarly, if an adviser’s presentation of gross performance does not reflect the deduction of transaction fees and expenses, the adviser should disclose that fact to avoid being misleading.

Deduction of Model Fees

The marketing rule permits the use of a model fee in calculating net performance stated in an advertisement, subject to conditions. The model fee disclosed must be equal to the highest fee charged to a potential investor, resulting in performance figures no higher than if the actual fee had been deducted. For example, in a private fund with multiple series or classes where each series or class has different fees, an adviser may display the performance of the highest fee class.

Prescribed Time Periods

A one-, five-, and 10-year time period presentation of performance results is required. If the portfolio did not exist for a particular prescribed period, the adviser must present performance information for the life of the portfolio. There is an exemption, however, for all private fund vehicles.

Commenters on the proposed rules argued that for certain closed-end funds, including this information could be misleading. For example, the presentation of one-year performance for a private equity fund is often not meaningful because the fund is likely not fully invested, investments have not been harvested, and significant changes in fair value are not likely. Accordingly, all private funds, whether they be closed or opened ended funds, are not mandated to present performance for any specific time, but are still subject to the prohibition of including or excluding performance results, or presenting performance time periods, in a manner that is not fair and balanced.

Further, the marketing rule requires that the prescribed time period end on a date no less recent than the most recent calendar year-end. There may also be circumstances under which the adviser may be required to present performance results as of an even more recent date to comply with the rule’s general prohibitions. For example, if subsequent quarter-end performance is available and events have occurred since that time that would have a significant negative effect on the adviser’s performance, it would be misleading not to include this performance data.

Extracted Performance

In an effort to prevent investment advisers from cherry-picking certain performance results, the marketing rule prohibits an adviser from presenting extracted performance in an advertisement unless the advertisement provides, or offers to provide promptly, the performance results of the total portfolio from which the performance was extracted. Permitting extracted performance, even conditionally, is beneficial since it can provide useful information to investors to assist them in evaluating a particular investment adviser or investment strategy within a multi-adviser platform or multi-strategy portfolio.

Best Practices when Presenting Performance Results

With the changing rules and data retention requirements surrounding performance reporting comes increased regulatory risk to impacted advisers. Advisers should be taking proactive measures now to ensure they are in compliance. When presenting portfolio performance results, it is a best practice to consult with an accounting professional to review the accuracy of the computations and completeness of the information. This is an essential component of risk mitigation and should be a standard part of the adviser’s program.

Further, an accountant can provide a variety of reports on performance results in accordance with attestation standards established by the AICPA. Services range from consultation and assist on performance computations to attest engagements, such as agreed-upon procedures and reviews and examinations of schedules of performance statistics.

An agreed-upon procedures attest engagement provides a report of findings based on specific procedures performed on a subject matter. This report would generally be considered for unique strategies, portfolios, performance calculations, or other agreed parameters.

A review or examination may be more appropriate to report on the historical performance results of a portfolio measured at fair value on a regular basis and could help validate performance results presented in a marketing deck. Review reports are generally issued when only a moderate level of assurance is needed. The procedures performed limit the attestation risk to a moderate level and the conclusion is expressed in the form of negative assurance.

An examination engagement involves procedures designed to achieve a higher level of assurance and includes inspection, independent confirmation, and/or observation. In contrast to a review, the practitioner’s conclusion is expressed in the form of an opinion.

Conclusion

The new marketing rule is another example of the SEC’s demand for more transparency and standardization of information provided to existing and potential investors by investment advisors. A review of compliance programs, including marketing practices has been included in their exam priorities for new RIAs in 2022. Advisors should review their programs and reach out to compliance and accounting professionals for guidance on implementing best practices.