Loyola University Chicago School of Law, JD 2024
The Securities and Exchange Commission’s (SEC) new marketing rule will take effect on November 4, 2022. Advertising and solicitation regulations have undergone a major overhaul after decades of continuity. Further, testimonials and endorsements are no longer prohibited, but their use will be conditioned on compliance with certain provisions. The new rule only applies to financial adviser’s communications that are advertisements, as defined in the new rule.
What constitutes an advertisement
Under the new marketing rule, the definition of an advertisement has a two-prong approach. A communication will be considered an advertisement if it meets either of the two prongs.
- First Prong
Under the first prong, an advertisement includes any direct or indirect communication that (a) offers investment advisory services with regard to securities to prospective clients or private fund investors or (b) offers new investment advisory services with regard to securities to current clients or private fund investors. This prong will exclude most one-on-one communications.
However, if the communication includes a hypothetical performance advertisement that is not made in response to an unsolicited investor or to an existing investor in a private fund, the advertisement will not be excluded from the general rule. The exception makes sense as private fund advisers typically will have the opportunity to question and assess the limitations of the information in a one-on-one meeting.
- Second Prong
The second prong of the rule includes any endorsement or testimonial for which an adviser provides cash and non-cash compensation directly or indirectly. As mentioned earlier, testimonials and endorsements are now permitted, and each have new definitions. Endorsements are any statements by a person other than a current client investor in a private fund advised by the investment adviser that will be deemed an endorsement in one of three ways. First, an advertisement will be considered an endorsement if it indicates approval, support or recommendation of the investment adviser or its supervised persons or describes his or her experience with them. The second path for an advertisement to be considered an endorsement is if it directly or indirectly solicits any current or prospective client of the investment adviser or investor of a fund the adviser advises. Thirdly, if a statement refers any current or prospective client or investor to be a client of, or an investor in a private fund advised by the investment adviser, then it is an endorsement.
There are three ways in which statements by a current client or investor in a private fund advised by the investment adviser would constitute a testimonial. First, a testimonial has been provided when a client states his/her experience with the investment adviser or its supervised persons. Second, a testimonial has been given when the client’s statement directly or indirectly solicits another to be a client of the investment adviser or invest in a private fund the adviser advises. Third, a testimonial has been provided when the current client or investor refers any client or investor to be a client of the adviser or invest in a private fund the adviser advises.
Testimonial and endorsement provisions
Since 1961, the SEC advertising rule has not permitted testimonials and endorsements. It is likely that the rule primarily stems from them SEC’s fear that advisers possess the ability to mislead investors. As access to information has advanced and technology has improved tremendously, the SEC’s fear has likely been scaled back. Today, investors can make more informed decisions compared to when they didn’t have access to certain data. Investors can easily compare companies’ growth with other companies, while access to certain public records are much more accessible, and investors’ understanding of the markets have drastically improved. Although the risk of misleading investors has decreased over the years with various rules and regulations, it still creates somewhat of a concern. To combat that fear, and others, the SEC has created provisions that must be met in order for an adviser to use testimonials or endorsements in an advertisement.
The first provision is known as the disclosure provision. Under this provision, an adviser must clearly and prominently disclose, or reasonably believe that the person giving the testimonial or endorsement discloses, whether the individual giving the testimonial or endorsement is a client of the investment adviser, and whether the individual is being compensated. This disclosure shines light on some concerns investors may have about certain adviser’s credibility. If advisers are paying individuals to bolster their performance, potential investors could become skeptical since an individual is being paid to make a statement, especially if that individual is not a client of the adviser.
The second condition requires oversight and a written agreement. This means that advisers who use testimonials and/or endorsements must ensure compliance with the marketing rule. The written agreement requirement is excluded if the person giving the testimonial or endorsement receives no compensation or total compensation of $1,000 or less during the preceding twelve months. The SEC has not established standards regarding what is sufficient to ensure that advisers are overseeing properly. However, it appears that as long as an adviser is complying with the rules, and employs some form of oversight, such as an oversight committee, the adviser will be in compliance with this provision. It is likely that industry standards will help to shape this rule after it is in place for more time and continues to be applied on a case-by-case basis.
The third provision, which is important to achieving the goal of protecting investors, is disqualification. This rule prohibits advisers to compensate a person, directly or indirectly, for a testimonial or endorsement if the adviser knows, or in the exercise should have known, that certain bad actors are ineligible to act as promoters.
It seems intuitive that for advisers should not use individuals with bad standing, particularly in the financial services space. However, when it does happen, investors are left to do their own due diligence in researching these individuals. This poses a risk that investors may not have proper access to research promoter’s records. This would have been a big issue back in 1961, as it may not have been as easy to access public records and review an individual’s criminal background.
Although there may still be other concerns regarding the use of testimonials and endorsements, I appreciated the inclusion of testimonials and endorsements in the new marketing rule. There are also other aspects of the marketing rule that have not been covered, such as exemptions, the use of certain performance information, amendments to books/records, etc. The new rule has really overgone a needed overhaul and reflects a more modernized rule to help better protect investors.