CONNOR EVANS—On December 22, 2020, for the first time in over 40 years, the SEC voted unanimously to modernize its rules governing the way investment advisers advertise their services. The 430-page amendment streamlines the current rules regarding advertising and cash solicitation into a single rule. The original rules were adopted to prevent investment advisers from engaging in misleading advertising practices and to ensure investors knew that a conflict of interest existed between advisers and those paid to refer clients to advisers. While this goal has not changed, the SEC has updated the rules because the significant technological advances of the past four decades have changed both investor expectations and advertising practices. For example, investment advisers now use the internet, smartphone apps, and social media to interact with customers—all technologies that were nonexistent when the original rules were written.
The amendment first redefines the word “advertisement” so it can weather further technological advances. The new definition of advertisement is a direct or indirect communication made by an investment adviser that either offers investment advisory services or offers new advisory services to current clients. The old rule defined advertising as a “written communication or a notice or other announcement by radio or television.” With the rise of the internet and social media, the change to the definition of advertisement is crucial because online ads and social media posts would not otherwise be governed by the old advertising rule. Notably, the new definition does not include any reference to specific modes of communication to prevent the rule from becoming obsolete as a result of further technological advances. The new rule also holds advisers responsible for ensuring advertisements made on their behalf by a third-party comply with SEC advertising and marketing rules.
The new rule also removed the prohibition on the use of testimonials, however, there is certain criteria a testimonial must meet before an adviser can use it. For example, the adviser must disclose whether the person who made the testimonial or endorsement is a customer and whether they were compensated, including any noncash compensation like reduced advisory fees. The rule also requires advisers to have a written agreement with promoters and disqualifies certain “bad actors” from working as promoters. This change not only opens up another form of advertising for advisers, but it also highlights any conflicts of interest that may inadvertently mislead investors.
The rule makes several general prohibitions on certain practices, applicable to all forms of advertising. The SEC included this prohibition to further the goal of preventing advisers from engaging in fraudulent, deceptive, or manipulative acts. Advertisements may not:
- Include any untrue statements or omit material facts;
- Include material statements that an adviser does not have a reasonable basis for believing;
- Include any information that may cause an untrue implication or inference to be drawn;
- Discuss any gain or benefit derived from the adviser’s services without also discussing the associated risks;
- Reference specific investment advice unless it is presented in a “fair and balanced” manner; and
- Include or exclude performance results in a way that is not “fair and balanced.”
To comply with the general prohibitions, advisers must consider the audience to which the advertisement is directed. For example, the information included in advertisements targeted for retail investors, i.e. nonprofessional investors, will vary from the information included in advertisements targeted for institutional investors. By requiring advisers to consider their audience, and thus the knowledge and sophistication of different investors, the rule protects less sophisticated investors from being taken advantage of by more knowledgeable advisory firms.
The rule prohibits ratings made by third parties in advertisements, unless the rating complies with the general prohibitions and other conditions. Third-party ratings are made by someone who is not affiliated with the adviser and makes ratings during the ordinary course of business. This distinguishes third party ratings from testimonials, which are not made by people in the business of providing ratings and rankings. Surveys used in the rating or ranking process must be written in a way that makes it easy for participants to record favorable and unfavorable responses and cannot be designed to produce a certain result. The use of a third-party rating must also be accompanied with the following disclosures: the date the rating was given and for what period the rating was based on; who made the rating; and whether any compensation was provided to the third-party.
Finally, the new rule places restrictions on performance advertising, which can lead customers to make unwarranted assumptions based on the metrics being advertised. For example, advisers cannot advertise gross performance without also disclosing the net performance, which includes fees and expenses charged by the adviser. Any performance must also be accompanied with a corresponding time period to show how long the portfolio took to grow. Advisers cannot cherry-pick higher performing portfolios to advertise either; generally speaking, advisors must also show related portfolios. Advisors also cannot cherry-pick well-performing funds from portfolios to advertise without also showing the total performance of the portfolio.
Although the new rule was passed unanimously, this does not mean there is a consensus on how to protect investors from misleading advertisements. The SEC commissioners each issued statements offering some criticism of the new rule. One commissioner felt the advertising rule could be done away with entirely leaving advertisements to be governed by the anti-fraud provisions of existing securities laws, while other commissioners felt the rule excluded certain customer safeguards. However, all were in agreement that the old advertising rule was in desperate need of a refresh. This refresh, while not perfect, furthers the SEC’s principal goal, to protect investors from being defrauded or misled by investment brokers and advisers. The new rule will not be overly burdensome on advisers, as most advertisements already conform to the new rule, but its implementation will foreclose the possibility of investors being misled by advertisements that are made to abide by the archaic, pre-internet advertising rules.