Background of the New Marketing Rule

As most Registered Investment Adviser firms (“RIAs” or “Advisers”) are aware, the Securities and Exchange Commission (SEC) adopted amendments to existing Rule 206(4)-1 (the advertising rule), under the Investment Advisers Act of 1940 (the “Act”), which modernized rules relative to RIA advertising and solicitation activity (known as the new “Marketing Rule”). The new Marketing Rule will still be set forth under Rule 206(4)-1, but Rule 206(4)-3 (which addressed payments to solicitors) has been rescinded. The new Marketing Rule was approved in December 2020 and became effective on May 4, 2021. Advisers were given an 18-month transition period to develop policies and procedures for compliance with the new Marketing Rule, related recordkeeping requirements and Form ADV updates. As of November 4, 2022, compliance with all provisions of the Marketing Rule will be required for SEC-registered firms. To the extent certain state regulatory schemes follow SEC guidelines, or if state regulators determine to revise state-level marketing rules to mirror SEC requirements, state-registered RIAs must also remain vigilant to these changes.

What May Be Considered An Advertisement

RIAs should become familiar with key elements of the Marketing Rule, beginning with what is considered an “advertisement.” The SEC modified the “advertisement” definition to include any direct or indirect communication to more than one person that offers the adviser’s services with regard to securities to prospective clients or investors in a private fund advised by the RIA. There is an exception: When hypothetical performance material is presented, an advertisement is defined to include a communication to just one person. The advertising definition also applies to communications offering new advisory services to current clients or to private fund investors. This definition expressly excludes several items, including one-on-one communications with a single person or household (when that communication does not contain hypothetical performance information). Second, the definition generally includes any endorsement or testimonial for which an adviser provides cash and non-cash compensation directly or indirectly (e.g., directed brokerage, awards or other prizes, and reduced advisory fees).

Significantly, the Marketing Rule allows for the use of testimonials (client statements regarding the RIA’s services that serve to approve the Adviser’s business and are intended to encourage the direction of business to the Adviser’s firm) and Endorsements (such as statements from non-clients, which encourage prospective clients to engage with the RIA). Use of testimonials and endorsements comes with various disclosure requirements, including disclosure of material information in relation to (direct or indirect) compensation arrangements and applicable conflicts of interest. Advisers should be aware that lead generation firms, referral programs and other platforms that tout Advisers, and serve to direct business to an Adviser, will likely be considered endorsers.

The new Marketing Rule also permits the use of third-party ratings in advertisements. A third-party rating is defined in the Marketing Rule as a rating or ranking of the Adviser by another person who is not a related party and who is in the business of providing such rankings or ratings.

General Prohibitions

The Marketing Rule also contains seven general prohibitions that apply to all RIA advertisements, including testimonials and endorsements:

• An advertisement may not include any untrue statement of a material fact or omit to state a material fact necessary in order to make the statement made, in the light of the circumstances under which it was made, not misleading.

• An advertisement may not include 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.

• An advertisement may not include information that would reasonably be likely to cause an untrue or misleading implication or inference to be drawn concerning a material fact relating to the investment adviser.

• An advertisement may not discuss potential benefits to clients or investors connected with, or resulting from, the investment adviser’s services or methods of operation without providing fair and balanced treatment of any material risks or material limitations associated with the potential benefits.

• An advertisement may not include a reference to specific investment advice provided by the investment adviser where such investment advice is not presented in a manner that is fair and balanced.

• An advertisement may not include or exclude performance results, or present performance time periods, in a manner that is not fair and balanced.

• An advertisement may not be materially misleading.

In connection with the foregoing guidance on prohibitions, the SEC provided numerous examples of advertisements which may not meet the “fair and balanced” standard. The last standard serves as catch-all provision to address advertising that does not specifically violate the first six general prohibitions, but is otherwise presented in a manner that misleads the reader.

Performance Reporting

The Marketing Rule provided substantial guidance with respect to use of performance marketing.

First, when displaying gross performance, Advisers must also reflect net performance with at least equal prominence and in a format designed to facilitate comparison between the two performance presentations. Gross and net performance must be calculated over the same period, using the same performance calculation methodology.

The Marketing Rule requires that advisers present portfolio performance by including performance for 1-, 5-, and 10-year periods (or, from inception if the portfolio did not exist for a given period). Performance for each period must be presented with equal prominence and end on a date no less recent than the most recent calendar year-end. Advisers to private funds are exempt from time period requirements. Also, an adviser may advertise performance results for periods other than one, five, and ten years, so long as the advertisement presents results for the required one-, five-, and ten-year time periods.

Hypothetical performance is permitted under the Marketing Rule. This includes portfolio performance results not tied to any actual portfolio managed by the Adviser (where results were not actually achieved). Hypothetical performance information must be developed and presented so as to be relevant to the financial circumstances of the prospective investors, i.e., prospective investors should have the knowledge and expertise to understand and evaluate the hypothetical performance material. Advisers using hypothetical portfolios should be sure to furnish sufficient information regarding underlying portfolio performance assumptions, along with any risks and limitations associated with hypothetical performance (e.g., how the portfolio might perform under different market conditions). This includes showing net performance that reflects the advisory fee that would have been paid if the hypothetical performance had been achieved by an actual portfolio.

CAVEAT: Hypothetical presentations will continue to receive very aggressive SEC scrutiny, and advisers should consider whether such presentations are compelling to the advisory process. Accordingly, we continue to strongly recommend that the use of such presentations be limited to those situations where a client or prospect has requested same.

The Marketing Rule allows Advisers to display extracted and related performance results for a portion of portfolio investments so long as the Adviser also provides performance results for the entire portfolio from which portfolio investment subset was obtained. Extracted performance must contain disclosure of the effect of any cash allocations held by the total portfolio on the performance results actually presented. The SEC remains very clear about avoiding performance presentations that “cherry-pick” results from one or more RIA portfolios. Thus, performance material derived from a composite of several Adviser portfolios may not comply with extracted performance rules because it is not a subset of investments extracted from a single investment portfolio. Advertisements may include performance results of related portfolios. However, Advisers should only include performance results from related portfolios which are similar enough in design, structure and strategy to the portfolio being presented in the advertisement. Where an RIA manages one or more related portfolios, the Marketing Rule allows it to exclude certain related portfolios so long as the advertised performance results are not “materially higher” than if all related portfolios were included.

Advisers may present predecessor firm performance if the person(s) primarily responsible for achieving the prior performance manage portfolios at the Adviser’s firm. Also, portfolios managed at the prior firm must be sufficiently similar to the portfolios being managed at the Adviser’s current firm. Other relevant disclosures pertaining to the use of predecessor performance are contained in the Marketing Rule. Advisers must also maintain records to affirm accuracy of the predecessor firm performance, as presented in current material.

Form ADV Part 1

The SEC has added Item 5.L. to Form ADV Part 1A. This section requests information regarding adviser advertisements and presentation of performance results, a reference to specific investment advice, hypothetical performance, predecessor performance, testimonials, endorsements, or third-party ratings. Item 5.L. also seeks information regarding cash and non-cash compensation in connection with the use of testimonials, endorsements and third party ratings. Advisers will be required to update responses to Item 5.L. in their annual updating amendment. Nonetheless, we recommend that RIA firms consider making appropriate Form ADV revisions prior to November 4th, 2022 to avoid potential regulatory scrutiny.

Books and Records

The SEC also amended the Books and Records Rule 204-2 under the Act. In connection with the new Marketing Rule, RIAs will need to maintain more detailed documentation relative to preparation and use of advertisements, including testimonial and endorsement arrangements.

The new Marketing Rule will drive the need for substantial changes to RIA Compliance Manuals, in addition to the procedures and guidelines used to create, evaluate and approve marketing material. Stark & Stark can assist your firm with making sure you are ready for the November 4, 2022 compliance date. The Marketing Rule presents some exciting new opportunities for RIA marketing, but these new opportunities come with a complex framework of compliance requirements which must be addressed in a timely and accurate manner to avoid future regulatory concerns.