Advertising Rule Reform: What to Expect
Reform of Rule 206(4)-1, the Advertising Rule, has long been a goal of many in the investment advisory community. With the new SEC chair, Jay Clayton, now indicating that he too would like to see some long-term agency rules revisited, it is beginning to look like 2018 may be the year when the Advertising Rule is brought in line with the realities of today’s business world.
The Rule was adopted in 1962, the advertising era depicted by Don Draper and his colleagues on the television series about the advertising industry, Mad Men. Methods of mass communication then were primarily print, movies and the three broadcast networks. No one had yet conceived of email or social media. In terms of the securities business, "the focus of the SEC at that time was mostly retail with non-discretionary managers," said Dechert partner Michael Sherman. "Today it is almost entirely a different advisory landscape."
Clayton, in a July 2017 New York City speech, said that "the Commission should review its rules retrospectively. We should listen to investors and others about where rules are, or are not, functioning as intended. We cannot be shy about being introspective and self-critical." During his April 2017 confirmation hearings, he testified that he has a problem with "unnecessarily complex" regulations and that, "to the extent possible, reducing complexity, clarity, are very important. If people know the rules, they can operate more efficiently."
When will any revisions occur? There’s nothing certain, but probably not until next year, according to K&L Gates partner Michael Caccese. For one thing, the SEC did not list amendments to Advisers Act marketing rules under its short-term regulatory flexibility agenda, but under its long-term list, both published this past December. In addition, he said, "what the agency will probably do is send out a request for comments, or ask a prominent association, such as the Investment Adviser Association, to do so, as part of an effort to determine the changes advisers and others would like to see," he said. "They will then review those before deciding what course to take," a process that he said would take more than a year.
The IAA, in May of last year, sent a letter to Clayton, urging him to look at several existing rules, the Advertising Rule among them. "We would like him to take a fresh look at the way some of the rules are working and see if we can make some improvements to their effectiveness and to the efficiency of the regulatory regime," IAA president and chief executive officer Karen Barr said about the letter at the time (ACA Insight, 6/19/17).
"Technology has removed traditional barriers to obtaining information," the IAA said in an article in its February 2018 newsletter, "The internet, the use of social media, and other modern achievements in communications have led to the significant proliferation of the availability of information. Investors can now access and assimilate a vast trove of information into their decisionmaking process."
Mobile devices have changed the way by which investors read and respond to marketing and disclosures, the association said. "The SEC should carefully consider the role technology plays in how investors communicate and obtain information today and into the future."
Bringing the Advertising Rule up to date "is not an easy question," said Sherman. "It’s easy enough to say that advisers need more freedom than the current Rule provides, and that’s true. But it should be a measured process, making sure that the unsophisticated are protected, that bad information is not presented to anyone, but allowing sophisticated people to get the information they need."
That the SEC is now, under Clayton, finally willing to look at the Rule with an eye toward revision and greater flexibility "is an extremely positive development," said Morgan Lewis partner Jennifer Klass.
The main concerns about the Advertising Rule appear to fall around four of its five main prohibitions involving a "fraudulent, deceptive or manipulative act, practice or course of business." Stated in brief, advisers are prohibited from publishing, circulating or distributing an advertisement that:
Makes use of past specific recommendations that were profitable to any person;
States that a graph, chart, formula or other device can, by itself, be used to make investment decision, without also prominently disclosing the limitations of doing so; and
Offers a report, analysis or other service "free or without charge," when in fact there may be some condition or obligation attached to it.
The bans on testimonials and past specific recommendations have been the most problematic, said Klass.
The IAA, in its May letter to Clayton, suggested that violations of these prohibitions should not be considered, by themselves, as fraud. "We suggest, at a minimum, that the specific prohibitions in the Rule not be considered per se fraudulent – something that the SEC staff implicitly has recognized through their many no-action letters," the association said. "The general anti-fraud section of the Advisers Act and ‘catch-all’ provision included in the Rule itself, which clearly apply to all disclosures and statements made by investment advisers in advertisements, effectively prohibit misleading advertising practices and protect investors."
One option, said Sherman, is that the SEC could create a prudential regime by simply eliminating all four of these prohibitions, as false or misleading advertisements would already be covered by the fifth prohibition, which, according to the Rule, outlaws any advertisement that "contains any untrue statement of a material fact, or which is otherwise false or misleading." In addition, he noted, Advisers Act Sections 206 (1) and (2), which prohibit fraud, can be used when false or misleading advertisements come into play. A general advertising anti-fraud rule could simply state, "You can put out any advertising that is not false or misleading," he said.
The above aside, however, Sherman said that he does not believe that it is likely that the Commission will make wholesale changes of this kind, but may instead tackle the problem in other ways. An alternative would be for the SEC to bifurcate the Rule, leaving it as it is for advertisements to retail clients, but providing greater flexibility for institutional clients, as they tend to be more sophisticated, he said.
"Consumers today are accustomed to conducting research on the internet, creating and evaluating user reviews, and sharing views publicly," the IAA said. "The ban on testimonials is particularly dated in this regard, in effect, thwarting common uses of social media. For example, based on staff interpretations, it is questionable whether members of the public can ‘like’ an adviser’s online posts or endorse a skill on LinkedIn without running afoul of the Rule. This stance materially impedes investment advisers’ marketing activities and does not reflect investor expectations."
Testimonials, in and of themselves, are not necessarily false or misleading, and that to label all of them that way by banning them simply does not make sense, said Sherman.
The main reason that the prohibition is problematic is that the SEC has taken a very broad view on just what testimonials are, said Klass. "The testimonial ban has made it difficult for new advisers to promote their services when competing against existing firms. If they don’t eliminate the prohibition, they should at least narrow the concept of what a testimonial is to the investment advice provided and to the performance of the adviser."
Past specific recommendations
"The past specific recommendation ban highlights another unfortunate consequence of the Advertising Rule – it restricts the ability of an investment adviser to provide complete and accurate information to investors that may be useful in making decisions," the IAA said. "Investors would like more current and relevant information than their advisers are currently permitted to provide. For example, investors could benefit greatly from specific examples demonstrating how an adviser’s investment process or philosophy has been put to work by the adviser’s personnel in managing actual accounts. This is particularly acute in the private equity context, where case studies are extremely useful in explaining the adviser’s services and approach and do not necessarily include performance information."
The SEC’s main concern here is related to "cherry-picking," Klass said, in the sense that the agency does not want advisers offering testimonials that only state positive things, and thereby potentially not offering a full portrait of the advisory firm.
She suggested that the SEC eliminate some of the more specific requirements associated with this prohibition, such as the adviser having to provide a list of all recommendations made by the adviser over the immediately preceding year. In addition, she said, the agency could build some flexibility here by codifying certain elements of the positions taken by the SEC staff in two no-action letters: the Franklin Management no-action letter and The TCW Group no-action letter.
In the December 1998 Franklin Management no-action letter, the agency staff took the position that quarterly reports that identified some, but not all, securities that were bought, sold or held for advisory accounts within a particular investment category could be sent to existing and prospective clients if certain conditions were met. Among these conditions was that the securities in the reports must be selected using objective, non-performance criteria, Klass said.
In the November 2008 TCW Group no-action letter, the SEC staff said that as long as an objective, non-discretionary, unbiased and mechanical methodology was used to select holdings, that the performance of these holdings could be discussed in a presentation. Other criteria must also apply, including that the calculation methodology must apply to all holdings in the representative account that contributed to the account’s performance.
"The TCW letter does not go so far as to permit investment advisers to show the actual performance or discuss the absolute profitability of particular holdings," said Klass. "However, it does seem to validate, or at least move closer than prior SEC interpretive guidance, to the long-standing industry view that the identification and discussion of partial lists of portfolio holdings should not be prohibited if the holdings are selected on an objective basis . . . and are presented in a fair and balanced manner."
What is an advertisement?
Another area of the Rule that might be looked at is its definition of what constitutes an advertisement. As currently written the definition says, in part, that an advertisement is "any notice, circular, letter or other written communication addressed to more than one person."
The SEC should "clarify just what an advertisement is," said Klass. In particular, she suggested that it state whether or not information addressed to just one client counts as an advertisement," and end any confusion over "gray areas resulting from somewhat-customized communications."
Customized presentations are also a problem, said Sherman. "Presentations are often designed for interactions with one person at a time. The Rule, as currently written, has the habit of reducing the amount of information that can be used for decisionmaking. A true one-on-one presentation should not, in my view, be regulated under the same rule that applies to general advertising to retail clients. These are sophisticated audiences."