In a recent STRAIT Compliance roundtable discussion, STRAIT General Counsel and Director Daryoush Niknejad provided fund managers with an overview of the new Advertising Rules and 506(c) general solicitation.
We spoke with Daryoush to address common questions from fund managers and understand what action needs to be taken to comply with the updated rules.
Please provide some background as to why the Securities and Exchange Commission (the “SEC”) updated the Advertising Rule.
DN: It should come as no surprise to anybody in the private fund industry that there are restrictions on how investment advisers can market their funds and the adviser (i.e., themselves). Traditionally, there has been a patchwork of SEC rules, anti-fraud provisions, and no-action guidance related to adviser advertising and “cash solicitation”, or payments to third-party solicitors. These rules often led to confusion – a feeling that the rules and guidance were outdated and didn’t really fit how private fund advisers were marketing and interacting with prospective and current investors, including through the use of social media. So, in the new rule, the SEC explicitly addressed the problem with some success.
What specifically was amended?
DN: Grab your seat. I’m about to get into the compliance nerdy stuff, but I promise to get past it quickly. Essentially, the SEC amended Rule 206(4)-1 under the Investment Advisers Act of 1940 (the “Advertising Rule”), rescinded Rule 206(4)-3 (the “Cash Solicitation Rule”) in favor of new cash solicitation rules that are part of the new Rule 206(4)-1 – now the unified “Marketing Rule,” applicable to all SEC-registered investment advisers.
The SEC also adopted related amendments to Rule 204-2 under the Advisers Act (the “Books and Records Rule”) and Form ADV.
Since Rule 206(4)-3, the old “Cash Solicitation Rule,” has been rescinded, all no action letters related to it are now void. The SEC has also said it will go through a similar process to void no action letters based on the old advertising rule.
So, what really changed in terms of what Investment Advisers can and can’t do?
DN: One big change is to the definition of "advertisement". The definition is still broad but much better. Essentially, an advertisement is:
- Any direct or indirect communication with more than one prospect
- Any direct or indirect communication with more than one current client(s), or investors, offering new investment advisory services
- Certain one-on-one communications that include hypothetical performance
You can see that one off conversations are excluded, as are communications with current investors that don't involve an offer or services--such as when providing reporting. Additionally, testimonials and endorsements are now allowed. Their inclusion as “advertisements” for which you are responsible depends on (a) whether they are actually designed to solicit or refer an investor or client and (b) the extent to which you were involved in the endorsement or testimonial. A good example of this is social media. If people post without your participation, okay. If posts are made without you selectively eliminating or editing posts, still okay. Also, it looks like the "ratification theory", where you are responsible for the post by "liking" it, no longer applies.
This should come as good news to advisers.
Now, let’s discuss what is excluded from the definition of an “advertisement.”
DN: The list of what is excluded from the definition of an “advertisement” is longer than what is included, so bear with me.
- Extemporaneous, live, oral communications
- Information contained in a statutory or regulatory notice, filing, or other required communication
- A communication that includes hypothetical performance that is provided in response to an unsolicited request for such information from a prospective or current client or investor or to a prospective or current investor in a private fund advised by the adviser in a one-on-one communication
What is out-and-out prohibited has also changed. It is more principles based. The principles are that you can’t:
- Include any untrue statement of a material fact or omit to state a material fact necessary in order make the statement, in the light of the circumstances under which it was made, not misleading
- Include a material statement of fact that you don’t have a reasonable basis for believing can be substantiated
This is an annoying one for me, so I’ll spend a little time on it. You might have heard from your attorney or me that using "superlative" language that cannot be specifically supported, such as your “top-notch” team, or that you produce "outperforming" results, is an issue. It looks like that may still be an issue. There are ways to soften this language, so this Is manageable.
- Include any 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 adviser
- Discuss any potential benefits to clients or investors connected with or resulting from the advisers’ services or methods of operation without providing fair and balanced treatment of any material risks or material limitations associated with the potential benefits
- Include a reference to specific investment advice provided by the adviser where such investment advice is not presented in a fair and balanced manner. The good news here is that many firms have agonized about providing selective results of a portfolio, such as a sub-strategy. Under the new rule, presenting extracted performance is permitted as long as it is presented in a fair and balanced way. Otherwise, it could be construed as materially misleading.
Similar to the old rule, the use of gross and net performance should be shown together and covering the same period.
You can also show hypothetical performance, including models, back tested or projected performance, but must have policies and procedures in place to provide investors with enough information so they understand the criteria used and the general assumptions, as well as the risks and limitations of the hypothetical performance data.
Let’s discuss endorsements and testimonials. What are advisers able to participate in? Are there certain requirements they need to meet?
DN: First of all, interestingly, you can pay for them. You can now pay somebody to endorse you. And you can use the endorsements and testimonials as part of the formal advertising like the adviser’s website. However, there are conditions, such as disclosing whether it’s coming from a current investor or a prospect and whether they are paid for.
There’s also an adviser oversight and compliance condition, which means you have to have a reasonable belief that the marketing rule is being lived up to with those testimonials and endorsements. There’s also a written agreement requirement related to the folks that are providing the endorsements and testimonials. If you happen to pay them above a de minimis amount ($1,000), you need to have a written agreement.
Something absolutely new in this rule is the use of third-party ratings and rankings in advertising. You may be familiar with certain indices out there, like the Hedge Fund Index that HFR or Bloomberg puts out. They’ll place advisers in quartiles as to what strategy is performing the best and the worst and which participating funds perform the best or the worst within those strategies. You’re able to use these now so long as you disclose in your materials: (i) the date of the rating and the period of time upon which the rating was based; (ii) the identity of the third-party that created and tabulated the rating; and (iii) if applicable, the compensation that has been provided directly or indirectly by the adviser in connection with obtaining or using the third-party rating. Also, the ratings themselves can't be "rigged" in that they take the bad data with the good data in constructing them.
You mentioned earlier potential changes to Form ADV. What are they?
DN: There is going to be a new section in Item 5 under the ADV Part 1A. This section reports certain advertising practices, including performance advertising or references to specific investment advice.
There will also be amendments to the Books and Records Rule that will require an adviser to maintain certain records regarding all advertisements it disseminates, subject to certain exemptions or different requirements with respect to oral advertisements.
Wow, a lot has changed. What do advisers need to do now?
DN: Right now, nothing. The rule is not officially in effect but will be 60 days from its publication in the federal register. There is also an 18-month transition period where advisers can rely on the old rule. However, during this period, policies and procedures will need to be updated, and staff will need to be trained on the new rule.
What is the 506(c) exemption, and how does it affect the marketing rule?
DN: Most private fund advisers claim exemption from registration of fund securities under 506(b), which prevents “general solicitation”. Private fund advisers still need to be careful about this even with the new amendments to the advertising rules--they are not a license to broadcast.
The JOBS Act created 506(c), which allows general solicitation but requires “verification” of accredited investor status, rather than just relying on the "check the box in the subscription document" method. There are a number of ways to accomplish this. The most common way of doing this is a representation letter from an attorney or an accountant that says yes, the investor is an accredited investor. At any rate, 506(c) is a license to broadcast, subject to the advertising and marketing rules. I’m seeing a trend in advisers opting for 506(c), mostly driven by how restrictive we all were on advertising and especially the use of social media. If an adviser has already made the 506(c) election, it is probably best to keep it. If considering the election because of how restricting the old advertising rules were, it may be a good idea to revisit that decision to see if the loosening is enough to not make the election. Also, something to consider is how the new advertising rules might interplay with 506(c). That combination of somewhat greater freedom in terms of the content of advertising, and the greater freedom to broadcast it, could be quite powerful.
It will be important for advisers to work with their legal counsel or compliance firm to ensure that their marketing materials and processes and procedures are compliant with the new advertising rules as there are still disclosures that need to be made and certain guidelines that must be followed.
My door is always open, so feel free to reach out to me if my team or I can answer any questions.
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