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News October 11, 2004 Issue

Talking About Your Stock Picks: What Advisers Can and Can’t Do

Hereís a practical guide to understanding what an adviser can say about its stock (or for that matter, bond) picks, to whom, and in what context.

First, a bit of background, which weíll try to make as painless as possible: The Advisers Act advertising rule, Rule 206(4)-1, makes it a fraudulent practice for SEC-registered advisers to "directly or indirectly" publish or distribute any advertisement that refers, "directly or indirectly," to the adviserís "past specific recommendations" that "were or would have been profitable to any person." For purposes of the rule, an ad is any written communication addressed to more than one person that offers any advisory service or analysis concerning securities. The definition of advertisement also picks up radio and TV ads.

The upshot: if you recommended that clients buy XYZ stock, and that turned out to be a good move, the rule generally prohibits you from talking about it in your ads (even if the ads donít actually mention that XYZ turned out to be profitable). However, there are two key exceptions to this general rule.

The first is in the rule itself. The rule states that an adviserís ad can talk about past profitable recommendations, provided that the ad contains a list of all of the adviserís recommendations (both good and bad) within the past twelve months. The ad must include the name of each past profitable security recommended and the date and nature of the recommendation (buy, sell or hold), as well as the market price at the time of the recommendation, the price at which the recommendation was to be acted upon, and the current market price of each security ("as of the most recent practicable date"). The ad also must contain a cautionary legend (specified in the rule) to the effect that the reader should not assume that the adviserís future recommendations will be profitable. The SEC staff has interpreted this provision as prohibiting a partial list: an ad must either list all of the stock picks for the past 12 months, or none at all (but can offer to provide the list).

Because of the burden of compiling the required information, keeping it updated, and squeezing it all into the ad, most advisers forgo this option. Listing the minutiae of the past yearís stock picks is not the sort of thing that gets marketing people excited. Moreover, as Stradley Ronon partner Larry Stadulis pointed out, from the adviserís perspective, disclosing all this information "may provide unwanted insights concerning the adviserís investment decision-making process."

The second key exception was provided in the 1998 Franklin Management no-action letter, which allowed an adviser to discuss past recommendations in its quarterly reports that were selected using objective, non-performance based criteria (for example, largest dollar amount of purchases or sales, or largest positions). The staff explained that the discussion of such recommendations would not "raise the dangers" that the advertising rule was meant to prevent. The letter imposes a number of conditions (see list, below).

Letís consider a number of commonly-asked questions about advertisements:

Does the ruleís reference to past recommendations that "were or would have been profitable to any person" mean that ads can talk about an adviserís unprofitable picks?

Yes. The prohibition on past specific recommendations "does not prohibit an adviser from distributing advertisements that identify and discuss the adviserís unprofitable recommendations," said the SEC staff in the Franklin letter. In other words, you can talk about your losing stock picks as much as you want (but, of course, you might not want to).

Can ads talk about your "current," rather than "past" recommendations?

Yes, but be careful. While the SEC staff, in the Franklin letter, said that an ad "that lists only the current recommendations of an adviser" would not be subject to the prohibition on past specific recommendations, it went on to note the challenges in determining whether a recommendation is "current" or "past." That, said the staff, will pretty much depend on the facts and circumstances as of the time that the ad is distributed. An ad containing only current recommendations at the time it was created would violate the rule if the ad was distributed after the adviser stopped recommending any of the securities mentioned in the ad. Put another way: Letís say you prepare an ad today that contains only the recommendations you are currently making: stocks A, B, and C. If next week you stop recommending C, you have to stop distributing the ad. So, as a practical matter, if you do attempt to advertise only current recommendations, think twice before printing them up in glossy brochures. And consider whether the incentive to continue recommending a particular stock in order to get the firmís moneyís worth from the marketing materials could create a conflict requiring disclosure.

One other thing to keep in mind when considering whether to advertise "current" recommendations: In the Franklin letter, the SEC staff noted that if an ad indicated that any of the "current" recommendations listed also had been recommended in the past, the ad could violate the rule.

Can ads talk about your "general," rather than "specific" recommendations?

Yes. Here, however, the question is what is "general" enough. Investment Counsel Association of America general counsel Karen Barr noted that many practitioners take the view that "if you talk about industry sectors, you are okay, as long as you donít get into discussing specific issuers."

Of course, if a communication is not an "advertisement" in the first place, the prohibition on past specific recommendations does not apply:

Are individualized, tailored communications, such as an e-mail or phone call, advertisements?

Under the rule, oral or written one-on-one communications, such as an in-person meeting, a telephone conversation, or a personal letter or e-mail written specifically to one individual (whether a client, a prospect, or a consultant) are not advertisements. However, if you use the same e-mail text, the same form letter, or the same phone script to contact more than one person, youíve got an advertisement. In a 2004 interpretative letter to the ICAA, the SEC staff indicated that a "series of communications" can constitute an advertisement, given the facts and circumstances.

I hold seminars for prospects. When I get up in front of a room, is what I say an "advertisement"?

Under the literal reading of the rule, no. In the ICAA letter, the staff said that while the rule applies to announcements in publications and to radio and television broadcasts, it "does not apply to any other oral communications." Having said that, the staff would likely view any script prepared for the seminar as an advertisement.

What if a prospect, client, or consultant asks for some of my past recommendations?

A written communication that merely responds to an unsolicited request by a client, prospective client, or consultant for specific information about the adviserís past recommendations would not be an advertisement ó even if the consultant was requesting the information on behalf of multiple clients or if the adviser provided the information to multiple consultants (see the 2004 ICAA letter). However, in taking this position, the SEC staff emphasized that the request truly must be unsolicited: the adviser must not have directly or indirectly solicited the consultant to make the request. So no dropping hints along the lines of, "Wouldnít you like to know what weíve bought for our clients?" And no advertisements that indicate that your firm would be willing to provide past specific recommendations on request.

(Incidentally, in a footnote to the ICAA letter, the SEC staff said that this position also applies to testimonials. So if a client, prospect, or consultant asks you for a testimonial, you can provide it, provided that you did not directly or indirectly solicit the request.)

What about quarterly letters and other written communications sent to my existing clients?

The general rule here is that you can discuss your clientsí holdings, or recent holdings, in a written communication sent to multiple clients, as long as the purpose of the communication is to explain the performance of the clientsí investments, rather than to promote your services.

In the ICAA letter, the staff reasoned that when an adviser discusses the performance of the securities in clientsí accounts, the adviser really isnít offering advisory services in a promotional sense ó it is actually providing them. So a communication to existing clients that discusses past recommendations would not be an advertisement, unless the context in which the recommendations are presented suggests that the purpose of the communication was to offer advisory services. The staff said that a letter to clients that discusses past recommendations of securities "not held or not recently held by some of the clients to whom the letter was directed would suggest that a purpose of the communication was to promote the advisory services of the adviser" and may be viewed as an advertisement.

A few other things to keep in mind:

  • Make sure your client communications are not inadvertently circulated to prospects (if you want to give clients an idea of what they will receive, you should turn your account statements or quarterly letter into an obviously generic piece: blank out any specific names and clearly and prominently mark the document as a sample).
  • Make sure the client letters (and all communications, for that matter) are fair, balanced, and do not misrepresent facts.
  • Remember that client communications are subject to retention under the Advisers Act recordkeeping rule (Rule 204-2(a)(7)).

What about distributing reprints of articles in which we talk about our past stock picks?

The SEC staff has taken the position that including a reprint of an unbiased, third-party article that refers to the adviserís past specific recommendations would not run afoul of the advertising rule (see the 1988 no-action letter to Kurtz Capital Management). However, make sure that the article is fair and accurate, suggested Adviser Compliance Associates consultant Barry Schwartz. He recommends that advisers review the article for any inaccuracies. If you find any, consider whether they can be corrected with accompanying disclosure, or whether the ad should not be distributed. Similarly, if the article contains performance information, consider whether it can be updated through accompanying disclosure, or whether the article should not be used.

One last point: regardless of its status as an advertisement or its compliance with the square corners of any exception or staff position, the SEC can still fault any communication if it contains any untrue statement of material fact or is otherwise false or misleading. When evaluating a communication, keep in mind the form and content, the implications or inferences it creates, and the sophistication of the persons who will receive it (on this last point, the most conservative approach is to assume that an unsophisticated retail investor will be receiving the communication).

The Franklin Management letter conditions:

  • Use objective, non-performance based criteria to select the securities that will be listed and discussed (i.e., the largest purchases and sales by dollar size during the applicable period, the largest positions held during the period, or by alphabetical or other rotational basis.)
  • Use the same selection criteria each period.
  • Do not discuss, directly or indirectly, the amount of the profits or losses, realized or unrealized, of any of the specific securities.
  • Maintain the records and, upon request, make them available for inspection by the SEC staff.
  • Do not discuss the amount or profit or loss of any particular security.
  • Include a cautionary statement along the following lines:

The information provided in this report should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an accountís portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed do not represent an accountís entire portfolio and in the aggregate may represent only a small percentage of an accountís portfolio holdings.

It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

  • Maintain, and make available to the SEC staff upon request, records that evidence: the complete list of all securities recommended by the adviser in the proceeding year for the specific investment category covered by each communication, for each recommendation, the information that would be required under the Advisers Act advertising rule (name, date, nature of the recommendation, market price at time of recommendation, price when acted on, etc.), and a record of the criteria used to select the specific securities listed in each report.