Since the adoption of the Investment Advisers Act of 1940, advertising, the referral process and the investment advisory industry as a whole have evolved drastically. A degree of modernization was necessary due to the advancement of technology and the changing expectations of those seeking advisory services.
On December 22, 2020, the Securities and Exchange Commission (SEC) adopted amendments to the rules under the Investment Advisers Act of 1940 pertaining to advertisements and referrals.
This is exciting news for advisors as the reforms make it easier to provide current and potential investors with useful information (subject to conditions) that could help them stand out from their peers.
Before the adoption of these amendments, using testimonials and endorsements in any capacity had been nearly impossible. Many advisors saw this as an unfair regulatory prohibition because genuine, positive testimonials could have helped them attract new clients. These amendments create new and exciting opportunities for advisors to use testimonials and endorsements to their advantage. They also provide some clarity surrounding third-party ratings.
With the help of an expert guest, Max Schatzow from the law firm of Stark & Stark, PC and host of the blog AdviserCounsel, we’ve laid out information below regarding the new rules, and how they will affect testimonials, endorsements and third-party ratings.
When will these amendments become effective?
These amendments are set to become effective 60 days after the rule is published in the Federal Register, which as of January 20, 2021 still has not happened. There will also be an eighteen-month transition period between the effective date of the rule and the compliance date.
Under the new rule, there are seven general prohibitions that are designed to prevent false or misleading marketing practices. Those seven prohibitions apply to all traditional advertisements and extend to testimonials and endorsements where an adviser has provided direct or indirect compensation. The discussion that follows is limited by these general principles.
What is considered a testimonial?
Under the new rule, a testimonial is defined as “any statement by a current client or investor in a private fund advised by the investment adviser:
- About the client or investor’s experience with the investment adviser or its supervised persons;
- That directly or indirectly solicits any current or prospective client or investor to be a client of, or an investor in a private fund advised by the investment adviser; or
- That refers to any current or prospective client or investor to be a client of, or an investor in a private fund advised by the investment adviser.”
What is considered an endorsement?
An “endorsement” under the new rule is defined as “any statement by a person other than a current client or investor in a private fund advised by the investment adviser that:
- Indicates approval, support, or recommendation of the investment adviser or its supervised persons or describes that person’s experience with the investment adviser or its supervised persons;
- Directly or indirectly solicits any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the investment adviser; or
- 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.”
How can an advisor use a testimonial?
According to the new rule, an advertisement may not include any testimonial or endorsement, and an adviser may not provide compensation, directly or indirectly, for a testimonial or endorsement, unless the investment adviser generally complies with three conditions. There are certain exemptions, which reduce the burden on some, but not all of the three conditions.
The Three Conditions
1. Mandatory Disclosure. An investment adviser must “disclose, or reasonably believe that the person giving the testimonial or endorsement discloses, the following at the time the testimonial or endorsement is disseminated:
- Clearly and prominently:
- That the testimonial was given by a current client or investor, and the endorsement was given by a person other than a current client or investor, as applicable;
- That cash or non-cash compensation was provided for the testimonial or endorsement, if applicable; and
- A brief statement of any material conflicts of interest on the part of the person giving the testimonial or endorsement resulting from the investment adviser’s relationship with such person.
- The material terms of any compensation arrangement, including a description of the compensation provided or to be provided, directly or indirectly, to the person for the testimonial or endorsement; and
- A description of any material conflicts of interest on the part of the person giving the testimonial or endorsement resulting from the investment adviser’s relationship with such person and/or any compensation arrangement.
- These are collectively referred to as the “Disclosure Requirements”.
2. Oversight Requirement. An investment adviser must maintain a “reasonable basis” for “believing that the testimonial or endorsement complies with the requirements of [the three conditions] (the “Oversight Requirement”). An adviser must also maintain “a written agreement with any person giving a testimonial or endorsement that describes the scope of the agreed-upon activities and the terms of compensation for those activities. (the “Written Agreement Requirement”).
3. Disqualifying Provision. Under the new rule, an investment adviser cannot compensate a person in any manner for a testimonial or endorsement if they know or should know with the exercise of reasonable care that the person providing the testimonial or endorsement is an “ineligible person” when it is disseminated. There is a grandfathering provision in the rule that might provide some relief to “ineligible persons” assuming they were not disqualified under the prior cash solicitation rule (Rule 206(4)-3).
Exemptions from the Conditions
There are a few instances where all of the conditions referenced above are not required for compliance with the rule. Each of these situations is discussed below:
1. Free and De Minimis Testimonials and Endorsements. In cases where an adviser disseminates an advertisement containing a testimonial or endorsement for no compensation or $1,000 or less (or the equivalent in non-cash compensation) during the preceding 12 months, the parties do not need to enter into a written agreement outlining the scope of services and the terms of compensation and the person receiving compensation could be an “ineligible person”. Put another way, the adviser must still perform the Oversight Requirement, but is excused from the Written Agreement Requirement and could pay an “ineligible person”.
2. Payments to Employees and Related Persons. A testimonial or endorsement by an investment adviser’s “partners, officers, directors, or employees, or a person that controls, is controlled by, or is under common control with the investment adviser, or is a partner, officer, director or employee of such a person” is excused from the Disclosure Requirements and the Written Agreement Requirement, “provided that the affiliation between the investment adviser and such person is readily apparent to or is disclosed to the client or investor at the time the testimonial or endorsement is disseminated and the investment adviser documents such person’s status at the time the testimonial or endorsement is disseminated.”
3. Certain Exceptions for Broker-Dealers. For broker-dealers registered with the SEC, they are excused from the Disclosure Requirements if the testimonial or endorsement is a recommendation subject to Regulation Best Interest. In addition, there are exceptions from certain disclosure requirements if the recipient of the testimonial or endorsement is not a retail customer (as defined by Regulation Best Interest). Lastly, they are excused from the disqualification provisions so long as they aren’t subject to the statutory disqualification provisions under section 3(a)(39) of the Securities Exchange Act of 1934.
What is considered a third-party rating?
Under the new rule, a “third-party rating” is “a rating or ranking of an investment adviser provided by a person who is not a related person (as defined in the Form ADV Glossary of Terms), and such person provides such ratings or rankings in the ordinary course of its business.”
An investment adviser may not include any third-party rating in an advertisement unless they meet two conditions. The first condition is that the investment adviser must maintain a reasonable basis for “believing that any questionnaire or survey used in the preparation of the third-party rating is structured to make it equally easy for a participant to provide favorable and unfavorable responses, and is not designed or prepared to produce any predetermined result.” The second condition requires that an investment adviser “clearly and prominently” disclose or that the rating itself “clearly and prominently” discloses i) the date the rating was given and time period on which the rating was based, ii) the third party that created and tabulated the rating, and iii) whether any compensation was provided directly or indirectly to obtain or use the rating.
This analysis of the Investment Advisers Act of 1940 amendments was provided by Max Schatzow. You can find him on his website, AdviserCounsel, and Twitter. This material is provided for your convenience and does not constitute legal advice or create an attorney-client relationship. Attorney Advertising.
White Glove is ready to help you navigate and explore the opportunities created by these amendments. We’re constantly evolving and learning because we’re committed to providing our clients with cutting edge technology, services and information.
Don’t hesitate to contact us regarding these new rules or our wide array of done-for-you products and advisor resources.