SEC Issues Marketing Rule Risk Alert

By Craig Moreshead, Managing Director,

The SEC published a Risk Alert on December 16th titled “Additional Observations Regarding Advisers’ Compliance with the Adviser’s Act Marketing Rule” (the “Alert”).  The Alert focuses on two specific sections of the Marketing Rule: i) the disclosure and oversight requirements under the Testimonials and Endorsements provision and ii) the due diligence and disclosure requirements under the Third-Party Ratings provision.  This article discusses the concerns and common deficiencies raised by the SEC in the Alert relating to testimonials, endorsements and third-party ratings.

Testimonials and Endorsements

Untimely Disclosures.  Under the Marketing Rule required disclosures pertaining to testimonials and endorsements must be provided “at the time the testimonial or endorsement is disseminated”.  According to the Alert the most common deficiency observed by examiners regarding testimonials and endorsements is the failure to provide required disclosures at the time the testimonial or endorsement is disseminated.  These non-compliant testimonials and endorsements were often presented on advisers’ websites, including d/b/a websites of the advisers’ supervised persons.  Compliance deficiencies were also observed related to utilization of lead generation firms, social media influencers, adviser referral networks, and “refer-a-friend” programs. 

Failure to Provide Clear and Prominent Disclosures.  The Marketing Rule requires that certain disclosures must be provided “clearly and prominently”.  The “clear and prominent” standard requires that disclosures be included within the testimonial or endorsement itself.  Examiners observed advertisements that used hyperlinked disclosures rather than including the required “clear and prominent” disclosures within the testimonial or endorsement.  Examiners observed other advertisements where required disclosures were in a smaller or lighter font than the testimonials or endorsements to which they were related. 

Disclosure of Compensation Arrangements.  Under the Marketing Rule compensated testimonials or endorsements must disclose the fact that compensation was paid, the material terms of the compensation arrangement with a description of the compensation that was paid or to be paid.  If a specific amount of cash compensation is paid the advertisement should disclose that amount, and if the compensation takes the form of a percentage of the total advisory fee over a period of time the advertisement should disclose the percentage and time period.  Examiners observed advisers that provided compensation in the form of gift cards to clients to write reviews on third-party websites, but failed to ensure compliance with the disclosure requirements for paid testimonials.  Other advertisements included generic disclosures about compensation arrangements but omitted material information about the compensation terms of referral payments. 

Failures Related to Affiliated Promoters.  A testimonial or endorsement by an affiliated promoter is exempt from certain disclosure and written agreement requirements under the Marketing Rule as long as the affiliation is readily apparent to or disclosed to the client or investor at the time the testimonial or endorsement is disseminated.  Examiners have observed advertisements that failed to disclose material conflicts resulting from promoters having financial interests in the promoted advisers, including clients of advisers who were also investors in the promoted advisers or who were principals or officers of other advisory firms with sub-advisory or other business arrangements with the promoted advisers.  In addition, while affiliations were often disclosed when the prospective clients or investors were introduced to the advisers, the affiliation was not readily apparent or disclosed at the time the testimonial or endorsement was disseminated.  

Third-Party Ratings

Inadequate Due Diligence.  When advertising a third-party rating or award, an adviser must have a reasonable basis for believing that a 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.  Typical due diligence approaches include i) reviewing of publicly disclosed information about third-party questionnaire or survey methodologies, ii) obtaining the questionnaires or surveys utilized in the preparation of the rating, or iii) seeking representations from the third-party rating agencies regarding how the questionnaires/surveys were designed and administered.  Examiners have found that many advisers conduct insufficient due diligence and therefore lack sufficient information to form the reasonable basis required under the Marketing Rule.  Examiners also found that many advisers had developed inadequate policies, procedures and controls to satisfy the due diligence requirement.  

Lack of Required Disclosures.  The Marketing Rule requires clear and prominent disclosures of i) the date on which the rating was given and the period of time upon which the rating was based; ii) the identity of the third party that created and tabulated the rating; and (iii) if applicable, that compensation has been provided directly or indirectly by the adviser in connection with obtaining or using the third-party rating.  In order to be clear and prominent, the disclosures must be at least as prominent as the third-party rating.  Examiners found advertisements that included links to third-party websites containing ratings of the adviser where neither the advertisement nor the third-party website included the required disclosures.  Some advertisements failed to reference a date on which the rating was given or a period of time upon which the rating was based.  Other advertisements included third-party rating logos that did not clearly identify the third-party rating agency.  The Alert also highlighted several circumstances where advisers failed to clearly disclose compensation that was paid, including payments for the use of logos or reprints, payments for priority placement or enhanced exposure, and payments for referrals through the rating agency’s webpage.  Some advertisements also violated the clear and prominent requirement in using smaller font or placing the disclosures at the bottom of website pages away from the actual ratings.