Amy Lynch, who has spent 25-plus years as a compliance professional and regulator with the SEC and FINRA, is founder and president of FrontLine Compliance, a consultancy to investment firms. We asked her to comment on the new SEC rule intended to expand the ability of investment firms and funds to advertise their products and services to investors.
Why was advertising by investment purveyors strictly prohibited or limited in the past?
The advertising rules under the Advisers Act are very old and have not had any kind of major revision since the 1960s. The industry has evolved and grown exponentially since then. Over the years, the SEC has attempted to keep up with the industry by issuing various No-Action Letter positions, which have served as rule updates. However, only those in the know, such as compliance and legal professionals, have been able to keep up with those No-Action Letter requirements. The typical adviser or fund manager cannot begin to navigate those No-Action Letters and rule interpretations themselves to understand the compliance requirements without professional help, as the rule itself is not proscriptive or reflective of actual current requirements. It is this lack of knowledge that has made it very difficult for firms to advertise in both a compliant and effective way without running afoul of the rule. From a sales perspective, firms prefer to focus on the positive side of outcomes when marketing, and this is the very reason why regulators have restricted how advisory firms can market to client investors and require fair and balanced presentations in order for them to be deemed not misleading.
Why did this rule change come now?
It’s been a long time coming. The rule proposal was talked about for many years within the SEC; finally written, then proposed in late 2019, and now just adopted. The proposal was hotly contested within the industry with about a hundred comment letters received. It seems it was pushed through as a last-ditch effort by chairman Jay Clayton along with several other rules that were finalized at year-end. This is not atypical of an outgoing chairman.
Was this a unanimous decision among SEC commission members or were there dissenters?
The exact voting is not known because it was not discussed at an open commission meeting. The discussion was originally placed on the commission meeting agenda, and then removed. So, clearly, the commission was not ready or comfortable with an open discussion on this rule. Its passage was announced only on its website. Most likely, this one was voted strictly along party lines. No statements on the rule have been released yet from any of the democratic commissioners who voted against it.
If there were dissenters, what were their reservations?
Again, this is not known. Dahlia Blass, director of investment management, announced her resignation on the same day as the adopted rule release. This may not be a coincidence as the division may have thought the rule needed additional work before passage.
How does the prevalence of social media channels come into play with regard to this rule change?
Social media is addressed vaguely under the rule changes. The industry had hoped that the SEC would make things clearer with this rule change, but that did not happen. The biggest impact on social media use will come from the guidance the rule change gives regarding the use of testimonials and endorsements. The new rule actually allows testimonials and endorsements that previously were prohibited. They are now allowed under specific criteria such as disclosures in close proximity. Disclosures in close proximity can be difficult to achieve logistically when utilizing social media platforms that limit space. It will be interesting to see how firms deal with this challenge and what the SEC ultimately accepts or rejects once conducting examinations under the new rule.
Talk about who is most affected by this rule change and how it is likely to play out.
SEC-registered advisers to both retail and non-retail clients are affected by the new rule. Interestingly, private funds are both addressed and exempted under certain sections of the new rule. For example, only materials presented to sophisticated investors such as those in private funds will be allowed to show hypothetical performance and even then, only under specific circumstances. Private equity funds are specifically addressed as to the use of case studies, and the new rule makes it clear that case studies fall under specific recommendations, past or current, and must follow the rule. However, private funds also have certain carve-outs; for example, they don’t have to meet the one-, five- or 10-year time period requirements for the presentation of performance information. All firms affected by the new rule will have to update their policies and procedures regarding marketing materials in order to comply with the new rule.
Certainly, there are limitations about what can be advertised. What are the new do’s and don’ts?
A few things are specifically outlined under the new rule, such as the requirement to show both gross and net performance equally and how those numbers are to be calculated. It also prohibits the use of gross-only figures even for one-on-one presentations. This was previously allowed under certain conditions. It now requires the use of standardized performance time periods under a one-, five- and 10-year structure, as available. This is to make comparisons of advisers more meaningful when considering performance. The general anti-fraud section of the rule has been extended and is now even more principle-based, making compliance more difficult because staff interpretation is brought into play. Regulation by enforcement will result.
How is the ability to advertise likely to affect or accelerate the conduct of business among investment funds and product sponsors and the like?
Private fund issuers and sponsors will only have to make changes if they have not already been following the various staff No-Action Letters. Those firms well versed in the existing guidance should be in relatively good shape as the new rule simply codifies that guidance. However, the true extent of that will not be known until the staff issues the list of No-
Action Letters withdrawn under Rule 206(4)-1. Not until we know which letters are no longer applicable will the true extent of the new rule be known. For promotors of private funds, they no longer need to worry about the cash solicitation rule and its disqualification provision as the new rule makes it clear that Reg D prevails in this regard. Private fund promotors need to comply with Reg D requirements and consider Rule 3a-4 of the Exchange Act regarding closely held associate/employee marketing.
Which organization(s) lobbied the SEC to instigate the rule change?
Investment Adviser Association primarily, the Managed Funds Association, and the American Investment Council. However, almost every reputable industry association in the United States sent in a comment letter on this one.
Anything else we should know about the import of this rule change?
As stated before, the most important piece of this new rule is still missing — the list of No-Action Letters that will be withdrawn. This is crucial because since 1961 the industry has learned to look at the rule first, then the plethora of No-Action Letters to find the one specific to the intended marketing strategy and apply it. The staff should issue that list soon and how soon will be a good indication of the new rule’s footing. The rule will be phased in over 18 months, so firms will not need to follow it until around June 2022. That’s a long way from now, and a new SEC chairperson will be announced shortly. With the new democratic administration coming in, this rule is not yet set-in-stone.