"Mad Men" Era Advertising Rule Changes Proposed

The SEC Advertising Rule hasn’t been amended since 1961 – a time before widespread use of desktop computers, cell phones, social media or even websites.  In this episode, Part 1 of 2, Oyster Associate Director Bill Reilly and Senior Consultant Michelle Craft discuss the proposed changes in detail and what firms should be thinking about when assessing their advertising materials. 

CRC-Oyster: Compliance Risk Concepts / Oyster Consulting

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Molly Bryson 0:08

Hello everyone. I'm Molly Bryson , your host for today's podcast, Part 1 of a two-part series talking about the SEC's proposed advertising rule changes. Today we're discussing the difference between the current rule and proposed changes. Next week, in Part 2, we will talk about pertinent enforcement cases and the impact of Reg BI on marketing and advertising. I'm joined today by Oyster Associate Director, Bill Rielly and Senior Consultant Michelle Craft. Bill's been with Oyster for seven years. Prior to that, Bill was a state of Florida regulator for 30 years. He has deep experience with broker dealer and investment advisor compliance programs and frequently acts as an expert witness. M ichelle Craft has been with Oyster for eight years and in the financial services industry for 24 years. She has held various roles from Registration Analyst to Chief Compliance Officer for regional and national broker dealers as well as investment advisors. So let's get started. Bill, could you start us off?

Bill Reilly 1:04

The current SEC Rule 206 of the Investment Adviser Act defines an advertisement as: any notice, circular, letter or written communication addressed to more than one person; or any notice or other announcement in any publication by radio or television, which offers any analysis, report, publication, concerning securities or which is to be used i n making any determination as to whether or not to buy/sell any security, or w hat security to buy or sell; any graph, chart, formula, or other device to be used in making any determination as to when to buy or sell a security; or which security to buy or sell. And lastly, any other investment advisory services with regard to securities. Now, one of the things that's important to point out here is that there is an industry standard for advertisements. And that standard is that an advertisement may not contain any untrue statement of material fact or which is otherwise false or misleading. In essence, all advertisements must be fair and balanced.

Michelle Craft 2:11

That's correct. So on November 4th of 2019 the SEC did publish , the proposed changes to the advertising rule. This is going to be the largest change in the advertising rules, or any change to the advertising roles since 1961. We discussed here internally that many of the people who are currently in the financial securities industry weren't even born when this rule was originally written. So this is a big change. It helps to address the technology advances that we've had over the years and how the industry as a whole has evolved since 1961. So one of the biggest changes is the actual definition of advertisement. So it's now going to be more broadly defined as any communication that's disseminated by any means, by or on behalf of an investment advisor, that offers or promotes investment advisory services or that seeks to obtain or retain advisory clients or investors, in a pooled investment vehicle that's advised by the advisor . Now, there are a couple exclusions to the definition when we talk about any communication disseminated by any means. They do specifically exclude from the definition of advertisement oral communications that are not broadcasted, responses to certain unsolicited requests for specified information, any other sales material , that may be within the scope of another commission rule and any information that is contained in a statutory or regulatory notice or filing or other communication. And that would include things like the ADV Part 2 brochure because that's a regulatory filing, well, required filing or notice that would not fall under the definition of an advertisement. Now, under the proposed rules, the general prohibitions do remain the same. So you can't make any false or misleading statements, omissions of material fact. You can't have any unsubstantiated claims. You have to provide a balanced presentation. You can't talk about the benefits and not also talk about the risks, including or excluding any performance results or other performance information or time periods in a manner that is not, again, balanced or fair; and any other information that they would otherwise deem to be materially misleading. It seems like basic common sense, but ultimately those are the general prohibitions. I think something that we'd like to do is kind of look at the risk alert that was issued back in 2017 by the SEC that really targeted what were the areas of advertising that were most frequently identified as ad visers v iolating the advertising rules an d k ind of co mparing c ontrast how the proposed rules are being addressed. So when we look at what the violations were in the past and what the issues were that were as a result of the former advertising rule, and then kind of looking forward at how the proposed ru le i s intending to address some of those areas. So I'm going to toss it back to Bill to kind of kick us off on some of the different areas that we want to address: current role versus proposed role.

Bill Reilly 5:59

Yes. Thank you Michelle . And one of the things that, again, I'm going to talk about is the current rule, and we'll talk about their proposals and we'll move forward from there. But one of the first areas that was discussed in the 2017 risk alert, was advertising concerns that the Commission had regarding Registered Investment Advisors presenting performance results without deducting advisory fees. And, of course, the regulation requires that the performance results must be net of fees. Another area that the SEC talked about was that the Registered Investment Advisors compared results for a benchmark but did not include disclosures regarding the limitations of such comparisons. An example of that is the advertised strategy material different from that of the benchmark. It's very important to make sure that all of that information is included and analyzed. And one other, one last area under the current rules for a misleading performance results is that the advisor included hypothetical and backtested performance results without explaining how these returns were derived. Again, one of the things that we've talked about are full and fair disclosure - disclosure of the good, disclosure of positive and disclosure of the risks. In many of these situations, these performance results did not present both sides of the equation.

Michelle Craft 7:22

Okay. So again, when we think about what the proposed rule states, they've kind of broken it down into a couple of categories. You h ave some performance information in general - they have defined there are certain prohibitions or would be certain prohibitions. Number one, gross performance results. Unless it is provided with a schedule of fees and expenses deducted to calculate net performance, you cannot use gross performance, unless you are providing that schedule of fees and expenses deducted to calculate net performance. Where before you basically were told that you could only do net performance, now th ey're s aying that you can potentially provide gross performance, but only if it is n't a ccompanied by that schedule of fees and expenses that would allow someone to calculate the net performance. In addition, no statement that the calculation or presentation of performance results have been approved or reviewed by the Commission. We keep in mind that there are many places where the Commission does not , not allow us to make a statement that it has been reviewed, approved, or endorsed by the commission. Think about your Form ADV Part 2 disclosures. That is a statement that you have to make in your ADV. If you state that you are a Registered Investment Advisor, you must make the statement that the Commission has not reviewed or approved, and is not endorsing your Registered Investment Advisor. In addition, performance results with fewer then all of your portfolios was substantially different investment policies, objectives or strategies as those being offered or promoted in the advertisement, with a limited number of exceptions, would also be prohibited. Performance results of a subset of investments that were extracted from a portfolio, unless it provides or offers to provide, promptly the performance reviews of all investments in that portfolio would also be prohibited. When we think about hypothetical performance, unless the advisor has adopted and implemented policies and procedures that are designed to ensure that the performance is relevant to the financial situation and the investment objective of the recipient, and the advisor provided certain information underlying the hypothetical performance. So again, the hypothetical performance has to be relevant and it has to describe why it is relevant to the information that you're providing. If it's an advertisement that's targeted towards a retail audience, additional protections would also be provided. They wouldn't require that the presentation, the net of fees alongside any growth performance. So again, we talked about the general prohibitions that gross performance would not be allowed, unless you provided a schedule of fees and expenses that would give you the ability to deduct and calculate the net performance. If it's targeted towards a retail audience, you would be required to present net of fees along with any presentation, gross of performance. Requiring that the presentation of any performance results in any portfolio or certain composition aggregations for the one-year, five-year and 10-year period. So they've gotten very specific in that you have to provide it for specific time periods as well. And again, that is for advertisements targeted to retail investors.

Bill Reilly 11:30

Okay, well let's, let's talk for a few minutes about some other provisions that were, that are in these release . And one of them is cherry picking of profitable stocks elections under the proposal. Now, one of the things that all of us are familiar with are cherry picking. It's the generally used in review of client accounts, and it's placing favorable transactions into certain preferred accounts. So that itself is a general definition cherry picking. But in the definition of cherry picking of their profitable selections under the proposed rule, in a lot of situations the RIAs included only profitable stock selections in their recommendations and presentations, client newsletters, on their website. And the a dvisor f ailed to furnish a list of all recommendations made by such investment advisors during the proceeding year. I n essence, what w e're talking about here is taking the good information, highlighting that and not presenting a balanced approach by providing the not so favorable r ecommendation. So a very, very serious problem there. The next section we want to talk about is misleading selection or recommendations. And what the Commission found is that advisors disclose past specific recommendations that may have been misleading because they included only certain and not all recommendations in order to i llustrate an investment strategy. Again, one of the things is that all advertisements must be fair and balanced and when you're not providing the positive information and either not providing or downplaying the "not so positive" or negative aspect of the recommendations, the Commission is going to come in and question those activities. And also the OCIE staff observed that advertisements may not have been consistent with these representations. A good example of this is disclosing that specific recommendations did not represent all securities purchased, sold or recommended to clients during that period, and discussing an advertisement t o profits realized by specific recommendations. Again, fair and balanced advertisement disclosed the positive information, but also it's necessary to provide the downside and the risks associated with any type of recommendations. The next area that we want to talk about, is compliance policies and procedures. Just like a lot of other areas, the Commission requires firms to have policies and procedures relating to advertisements. One of the things that the Commission found is that advisors did not have or did not implement policies and procedures concerning the following issues. First issue: the process for reviewing and approving advertising materials prior to their publication or dissemination. Many firms will have a pre-approval policy in place. The next one was, when using composites d etermined i n the parameters for which accounts were included or excluded from performance calculations. I think in many situations there was positive information presented at the expense of some negative information. And the last is confirming the accuracy o f performance results i n compliance with the advertising r ules. Now, w e're going to turn it back to Michelle. She's g oing t o address a little bit about the policies and procedures under the proposed regulation.

Michelle Craft 14:52

Thanks Bill. So under the proposed rule, similar for those of you that are FINRA registered firms or dual-registered firms, FINRA has said for a long time that you had to have pre-review and approval of communications with the public or advertising; that they had to be reviewed by a designated principal prior to the distribution or dissemination of any advertising material. The proposed rule follows suit with that and is going to require Registered Investment Advisors to have an internal pre-use review and approval process. All communications, all advertisements would have to be previously reviewed and approved by the designated employee. So, unlike on the FINRA side , you would have a series 24, Series 910 principal that would be responsible for reviewing and approving advertisements or communications with the public prior to dissemination. They don't have that same designation of the individual on the Registered Investment Advisory side, but nonetheless the firm will need to designate a individual that is responsible for reviewing and approving prior to dissemination of any advertisement . Now, there are a couple of exceptions to when it will not be subject to that prior review and approval standard. That is for communications that are disseminated solely to one individual or household, or single investor in a pooled investment vehicle, or in the case that it's a live oral communication, that's broadcasted on the radio, television, the internet or, or some other similar medium. And obviously, because it's broadcasted live, it can't be reviewed and approved prior to dissemination. So those would be the only two instances. Moving forward, if the proposed rule was approved as currently written , you would not need prior review and approval of an advertisement.

Bill Reilly 17:30

Okay. Let's go back and talk about the current rule and the misleading use of third party rankings or awards. A Couple of things that the Commission found during their reviews was that advisers advertised accolades that have been obtained by submitting potentially false or misleading information. The applications for such accolades that advisors published were marketing materials that referenced outdated rankings, advertisements that refer to the IRAs' high rankings, and various publications were issued several years prior where the rankings were no longer applicable. It's very important that information that is provided to clients is current as opposed to, in some situations, it's indicated from information that may have been several years old . Also , advisers published potentially misleading advertisements that did not disclose irrelevant selection criteria for the awards or rankings, o r who conducted the survey. Again, f air, balanced, and transparent are general observations that are made about advertising. And lastly, the Commission found that IAs failed to disclose the fact that they had paid a fee to participate. The Commission found that investment advisors failed to disclose the fact that they had paid a fee to participate in or distribute the results of the survey. Anytime we're talking about monies or services being paid or exchanged, it's important for that information to be, to be disclosed. And in many situations, the payment of these monies and so forth might actually even be discouraged from being utilized in this use of their party rankings. Michelle....

Michelle Craft 19:20

So under the proposed rules, they will allow the use of third party rankings. They are going to require that there be specified disclosures and there has to be certain criteria included in those disclosures when pertaining to the preparation of the rating or ranking or accolade. So, similar to what Bill was just mentioning, all of those little highlighted areas that the SEC picked apart, those are the specific disclosures that you're going to need to include. So they're going to allow them, you need to state whether or not you were paid a fee or that you paid a fee to circulate the survey. You need to substantiate what was the criteria for earning the accolade, what is the calculation and or methodology for the rating being granted. So now all of that information is clearly spelled out in the proposed rule - that you have to clearly define how did you obtain it, what was the criteria for obtaining it? What is the methodology of any rating that's being used? And if you've earned an award or you have paid any money to circulate the results of that survey, all of that information has to be there.

Bill Reilly 20:48

And the last area that we're going to talk about under the 2017 release is dealing with testimonials. One of the things that the Commission found is that Registered Investment Advisors presented statements of clients attesting to the RIA's services or endorsing the RIA, that may be prohibited under the testimonials. And what we're talking about here are client endorsements published on websites, social media pages, reprints or third party articles, or pitch books. I think this is one area that is going to be a major change on the proposed rules that Michelle's going to talk about in a second, that will allow certain types of testimonials to be provided by Registered Investment Advisors. So Michelle, why don't you talk about that?

Michelle Craft 21:37

Yes, that is correct. So again, this is another one of those areas where the SEC has looked at FINRA rules. So FINRA would allow a broker-dealer to post a testimonial or to have an endorsement posted on a public website or on a social media page. The one caveat to the FINRA rule is that if you p aid the individual for the testimonial for it to make any kind of endorsement, that information has to be disclosed. So under t he proposed SEC advertising rules, this w ill follow suit. They are g oing t o allow testimonials; however, it is going to be subject to those specified disclosures, including whether the person that is giving the testimonial or the endorsement is a client and whether or not compensation had been provided by or on behalf of the a dvisor for that testimonial and or endorsement. And again, I think as Bill mentioned, one of the biggest areas we expect this to be impacted on is... as we know, advisors are using LinkedIn. LinkedIn has that section out there where you can endorse and/or provide some sort of recommendation, based on the services that you've received from that advisor. That's an area that many firms have just completely said, "You need to turn that off on your LinkedIn account so that someone can't inadvertently put information out there that would be in violation of the rule." So that is an area I think that wi ll h ave a potentially large impact for some firms if they allow people to turn that function back on. They can have their clients now provide a testimony, a testimonial, and or endorsement out on LinkedIn. They'll still want to monitor, obviously, what is being posted there, and they may choose to still not allow it. But certainly under the proposed rule, if it is approved as written, it would allow for testimonials.

Molly Bryson 23:56

Thanks Michelle and Bill. Well, I think we covered a great deal about the differences between the current advertising rule and the proposed changes. Be sure to tune in next week as we talk about SEC enforcement actions and how Reg BI will impact marketing and advertising. I think a lot of people are going to be very busy in the upcoming months. If you have any questions about anything we've discussed today or if you have a topic you'd like to hear in a future Oyster Stew podcast, please feel free to call us at (804) 965-5400 or visit us at www.oysterllc.com

Oyster 24:34

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