SEC Marketing Rule

The U.S. Securities and Exchange Commission (SEC) adopted amendments to the SEC marketing rule 206 (4)-1 that affect investment advisor advertising, marketing activities, and the use of testimonials in marketing materials effective December 22, 2020.

Section 206 of the Advisers Act is meant to prohibit investment advisors from engaging in any fraudulent, deceptive, or manipulative conduct. Rule 206(4)-1 helps to regulate marketing practices to help reduce instances of market manipulation aimed at protecting investors.

Initially, the Investment Advisers Act of 1940 provided governing guidelines for professional advisors. After 60 years, the SEC has published a modernized and consolidated regulatory update in a single rule that redefines advertising. The amendments create a single rule that replaces the current advertising and cash solicitation rules. The final rule is designed to comprehensively and efficiently regulate investment advisers’ marketing communications.

Definition of An Advertisement

The amended definition of “advertisement” contains two prongs: one that captures communications traditionally covered by the advertising rule and another that governs solicitation activities previously covered by the cash solicitation rule. 

• First, the definition includes any direct or indirect communication an investment adviser makes that: (i) offers the investment adviser’s investment advisory services with regard to securities to prospective clients or private fund investors, or (ii) offers new investment advisory services with regard to securities to current clients or private fund investors. The first prong of the definition excludes most one-on-one communications and contains certain other exclusions.

• 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).

Hypothetical Performance

The new marketing rule intends to address instances when communication includes hypothetical information to solicit business from existing or prospective clients. In other words, advisors must be careful in the way they offer examples of imagined portfolio performance over the years.

• Exceptions from this rule could include live, off-the-cuff discussions and one-on-one communications that don’t include hypothetical performance discussions. Marketing rules also don’t apply to account statements, educational materials, and regulatory filings. Hypothetical performance statements are acceptable if they are in response to unsolicited requests asking for this kind of information.

• Most importantly, if you do use any hypotheticals, they need to be very plainly explained as such. The intended audience should clearly understand the risks and limitations of hypothetical performance so they can make an informed investment decision.

• Among private fund advisers, it is common to include certain figures that are now classified as “hypothetical” performance, such as return targets or projections and/or composites of extracted performance. This use of “hypothetical” performance figures now requires specific written policies and procedures, the absence of which could lead to deficiency findings in an SEC exam.

General Prohibitions

The marketing rule will prohibit the following advertising practices:

• Making an untrue statement of a material fact, or omitting a material fact necessary to make the statement made, in light of the circumstances under which it was made, not misleading

• Making 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 Commission

• Including 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

• Discussing any potential benefits without providing fair and balanced treatment of any associated material risks or limitations

• Referencing specific investment advice provided by the adviser that is not presented in a fair and balanced manner

• Including or excluding performance results, or presenting performance time periods, in a manner that is not fair and balanced

• Including information that is otherwise materially misleading

• Gross only performance, unless the advertisement also presents net performance. However, advisers are left to determine how to calculate such net performance. Gross performance is no longer acceptable, unless the net performance is also presented within the same time period and follows all stipulations of the rule. Additionally, returns should be shown as net of advisory fees. Regardless of the approach selected, advisers must provide full disclosure of the calculation methodology, the underlying assumptions used and any known shortcomings.

• Any performance results, unless they are provided for specific time periods in most circumstances. Timelines for the presentation of performance are standardized, with 1-year, 5-year, and 10-year return periods. If those time periods aren’t available, advisors must also show performance results of the total portfolio from the portfolio’s inception. The rule specifically outlines “anti-cherry-picking provisions,” which prohibits the selection of date ranges that offer the most favorable numbers while omitting unfavorable ones.

• Any statement that the Commission has approved or reviewed any calculation or presentation of performance results

• Performance results from fewer than all portfolios with substantially similar investment policies, objectives, and strategies as those being offered in the advertisement, with limited exceptions

• Performance results of a subset of investments extracted from a portfolio, unless the advertisement provides, or offers to provide promptly, the performance results of the total portfolio

• A new adviser firm seeking to market using prior-firm investment performance must also have access to the back-up records that are necessary to substantiate such performance.  Advisors must maintain records of all advertisements. Adequate books will track things like compensation for testimonials or performance reports used in ads. Working papers or other documents may be required to demonstrate how the rate of return was calculated for performance advertising. Advisors should also keep records of testimonials or endorsements including non-cash compensation provided to investors

Testimonials and Endorsements

The marketing rule prohibits the use of testimonials and endorsements in an advertisement, unless the adviser satisfies certain disclosure, oversight, and disqualification provisions:

• Disclosure - Advertisements must clearly and prominently disclose whether the person giving the testimonial or endorsement (the “promoter”) is a client and whether the promoter is compensated. Additional disclosures are required regarding compensation and conflicts of interest. There are exceptions from the disclosure requirements for SEC-registered broker-dealers under certain circumstances. The rule will eliminate the current rule’s requirement that the adviser obtain from each investor acknowledgements of receipt of the disclosures.

• Oversight and Written Agreement - An adviser that uses testimonials or endorsements in an advertisement must oversee compliance with the marketing rule. An adviser also must enter into a written agreement with promoters, except where the promoter is an affiliate of the adviser or the promoter receives de minimis compensation (i.e., $1,000 or less, or the equivalent value in non-cash compensation, during the preceding twelve months).

• Disqualification - The rule prohibits certain “bad actors” from acting as promoters, subject to exceptions where other disqualification provisions apply. 

Third-Party Ratings

The rule prohibits the use of third-party ratings in an advertisement, unless the adviser provides disclosures and satisfies certain criteria pertaining to the preparation of the rating.

The following documents were created to help firms understand the US SEC Marketing Rule as it relates to the GIPS Standards, all provided by the CFA Institute:

Reconciling the GIPS Standards and the SEC Marketing Rule

This white paper addresses the differences between the Global Investment Performance Standards (GIPS®) and the Securities and Exchange Commission (“SEC” or the “Commission”) Marketing Rule (“Marketing Rule”). The United States Investment Performance Council (“USIPC”), the US Sponsor of the GIPS standards, worked together with CFA Institute staff to create this white paper.

Sector and Contribution Model Net Performance

Sample worksheet providing calculations on sector performance and contribution to return on a Net basis.

Investment-level Net TWR Calculation

Sample worksheet providing calculation to assist firms with calculating Net performance of a single investment using time-weighted returns.