31 August 2021
Main Contributor: Elizabeth Cope, CPA, CSCP, CIPM CEO & Lead Consultant
This is the third article in our series to breakdown the updated Marketing Rule. If you have not been following us, we highly suggest you start with the first in our series, The Definition of an Advertisement, where we summarized the amended Marketing Rule’s definitions of an advertisement; specifically the elements covered under Prong 1 and Prong 2 of the definition. We follow this with part two of our series, which focuses on the General Prohibitions and what they mean in practice for our registered investment adviser audience.
Sometimes when we discuss the future, we have to focus on elements of the past. In this instance, focusing on the past will provide context for the changes that relate specifically to testimonials and endorsements. For those of you who are new to the industry and just jumping right into the new Marketing Rule, this reflection will help provide context for the Rule’s requirements.
Under the old Advertising Rule, the SEC identified several prohibited activities, one of which was the use of testimonials. Under the new Marketing Rule, the SEC will now allow advisors to utilize testimonials and endorsements as long as specific requirements are being met (which we will discuss herein). Another important fact to note is that the original Solicitation Rule will no longer exist and will now be wrapped up and replaced under this section of the new Marketing Rule. The term solicitor will also disappear, now referred to as promoters. Clear as mud? Kidding aside, lets dig a litter deeper into the four main requirements. This section of the new Marketing Rule is very technical, so give yourself some grace as you tackle the new requirements.
Also, as a quick reminder, here are the definitions of both a testimonial and endorsement.
Testimonial means 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 any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the investment adviser.
Endorsement means 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.
First Requirement: Follow the General Prohibitions
When including testimonials and endorsements in your firm’s advertising, you still have to make sure they are subject to the general prohibitions. You can circle back to our second article to remind yourself of the seven (7) general prohibitions. To simplify it, you want to make sure that your advertisements are not false or misleading.
Second Requirement: Include the Required Disclosures
Any advertisement that includes a testimonial or endorsement must be accompanied by specific disclosures that are “clear and prominent,” unless there is an exemption.
For a Testimonial
Disclose that it was given by a current client or private fund investor.
For an Endorsement
Disclose that it was given by a person other than a current client or private fund investor.
For Both Testimonials and Endorsements
- Disclose, as applicable, that cash or non-cash compensation was provided.
- Example: “This is a paid for advertisement” or clearly label it as a paid testimonial or endorsement.
- Include a brief statement of any material conflicts of interest on the part of the person who was giving the testimonial or endorsement. This includes:
- The material terms of any compensation arrangement, describing the compensation provided.
- If a specific amount is paid > this amount must be disclosed.
- If reimbursing expenses is part of the compensation > this payment amount must be disclosed.
- If the compensation is a percentage of the advisory fee > this percentage must be disclosed.
- If non-cash compensation value can be ascertained > this amount must be disclosed.
- If there is a contingency to the compensation for trailing fees, such as continuation or renewal of the advisory agreement > this fact must be disclosed.
- If compensation is in the form of directing brokerage to a broker-dealer for the endorsement > this fact must be disclosed.
- Description of any other material conflicts of interest. Materiality is subjective and dependent upon whether the fact would have impact on the prospective client or investors’ decision to choose you as their investment advisor.
Clearly and Prominently
The disclosure requirements must be:
- provided within the testimonial or endorsement.
- in close proximity of the testimonial or endorsement, so they can be read at the same time.
Since the disclosures must be provided within the testimonial and endorsement, the SEC has clarified they are not expected to be lengthy; they should be concise and to the point. If there are additional disclosures that are relevant, those can be hyperlinked or referred to another location.
In the case of an oral endorsement or testimonial (example would be a promoter having a discussing with a potential client), the disclosures must be provided at the time of the endorsement or testimonial and should be provided in writing.
These disclosures can be provided by you or by a promoter providing the testimonial or endorsement, as long as you have a reasonable basis that the promoter is actually providing them. You could obtain a reasonable basis by providing the required disclosures to the promoter and then follow up, either verbally or through a certification process, whereby the promoter attests in writing on a periodic basis that they are in fact providing the disclosures. When a written agreement is required, you should include provisions requiring the promoter deliver the required disclosures at the time of the endorsement or testimonial.
Third Requirement: Oversight and Compliance
All testimonials and endorsements, whether compensated or not, will be subject to your firm’s oversight and compliance supervision. You will be required to:
- Have a reasonable basis for believing that any testimonial or endorsement complies with the requirements of the rule.
- Have a written agreement with any person (aside from certain affiliates as discussed below) giving a compensated testimonial or endorsement, if the compensation is greater than $1,000 over the preceding 12-months.
The rule did not explicitly define how advisors will need to obtain a reasonable basis for compliance with the rule. It will be based on the facts and circumstances, ensuring this element is incorporated into your policies and documented, then reviewing the process as part of your annual review. Some examples provided by the SEC in the adopting release of the rule include:
- Inquiring investors solicited to assess whether the promoter complied with the rule by providing them the required disclosures.
- Pre-review testimonials and endorsements or even impose limitations on the content.
The written agreement must include the following elements:
- Description of the scope of the agreed upon activities.
- The terms of the compensation for those activities.
Unlike the old solicitation rule, the promoter will no longer be required to deliver your firm’s ADV Part 2A and a separate written disclosure document at the time of solicitation. Therefore, you will no longer be required to obtain written acknowledgments from clients for the receipt of the two aforementioned documents. Instead, disclosures are required within the advertisement or to be provided by your firm. This does not absolve the adviser from providing the ADV to all new clients either prior to or at the time of entering into a contract. The SEC removed this requirement for promoters because of the delivery requirements already imposed by advisors.
Fourth Requirement: Disqualifications for Persons with Misconduct
An adviser is prohibited from compensating any person directly or indirectly for a testimonial or endorsement if the advisor knows, or has a reasonable basis to know, that they are considered to be an ineligible person.
An “ineligible person” is a person who is subject either to a disqualifying Commission action or any disqualifying event. An ineligible person includes persons associated with them. For example, if the ineligible person is a partnership, it will include all of the general partners of that partnership. However, a control affiliate can be excluded if they are involved but operate independently, for example.
Only persons exempt from this requirement (to avoid duplicate regimes) are:
- Registered broker-dealers, provided they are not subject to a statutory disqualification under the Exchange Act’s disqualification provisions.
- Covered Persons under Rule 506(d) of regulation D with respect to private offerings made under Rule 506.
A “disqualifying Commission action” is any Commission opinion or order barring, suspending, or prohibiting a person from acting in any capacity under Federal Securities laws.
A “disqualifying event” if any of the five categories of events that occurred within 10 years prior to the person disseminating an endorsement or testimonial. All five categories can be found here: Electronic Code of Federal Regulations (eCFR).
Carve-out exceptions for disqualifying events
There is a carve-out allowing advisors to compensate a promoter that is subject to certain disqualifying events. The criteria that must be met are:
- An order pursuant to section 9(c) of the Investment Company Act of 1940, OR
- A Commission opinion or order with respect to such event that is not a disqualifying Commission action; provided:
- The person is in compliance with the terms of the order or opinion, including, but not limited to, the payment of any inappropriate/unlawful profits made, prejudgment interest, civil or administrative penalties, and fines; AND
- For a period of ten years following the date of each order or opinion, the advertisement containing the testimonial or endorsement must:
- include a statement that the person providing the testimonial or endorsement is subject to a Commission order or opinion regarding one or more disciplinary action(s) AND
- include the order or opinion or a link to the order or opinion on the Commission’s website.
Under the old solicitation rule, an advisor was not allowed to compensate a solicitor for referrals if they were statutorily disqualified. Under the new rule, the form of disqualification is broader, therefore, the SEC has said that if a promoter has disqualifying provisions pre-dating the effective date of the rule (May 4, 2021), as long as it would not have disqualified them per the previous rule’s provisions, the solicitor may be compensated for referrals under this new Marketing Rule.
Knowledge or Reasonable Care
The frequency and steps taken to monitor for eligibility will vary based on the particular facts and circumstances. The key again, is for the methods and frequency to be noted in the firm’s policies and procedures, adequately documented, and then reviewed as part of the firm’s annual review.
When the promoter is a partner, officer, director, employee, or a person who controls, is controlled by, or is under common control (deemed at 25% ownership), the promoter will not be required to comply with the disclosure requirements and written agreement requirement. The relationship with the affiliate, however, must either be known or disclosed to the client at the time the testimonial or endorsement is disseminated. Determining whether the relationship is “known” to the client will depend on facts and circumstances. In addition, the advisor must document internally the status of the relationship. Advisors will still be required to meet the oversight requirement of the promoter’s activities to ensure compliance with the rule and the disqualification requirements noted above.
Di Minimis Compensation
A testimonial or endorsement that is disseminated with zero compensation, or for compensation under $1,000 within the preceding 12 months, is exempt from the written agreement requirement and the disqualification requirements noted above.
Please refer to the Exhibit below for a visual breakdown of the various exemptions to the requirements discussed herein for testimonials and endorsements.
Everyone is jumping up and down at the prospect of freely using testimonials and endorsements. While we don’t want to dampen the spirits of advisors everywhere, we do want to ensure that they understand the requirements that must be met in order to use testimonials or endorsements and remain compliant. The SEC did not allow the use of testimonials and endorsements to make the advisor’s life easier. Think again. Everything they do is to protect clients and investors, so the onus is on the advisor and CCOs everywhere to ensure that requirements are met and disclosures, albeit succinct and short, are clear and prominent.