New Marketing Rule FAQ

The Division of Examinations has been taking a close look at investment adviser marketing since the Marketing Rule rule compliance deadline last fall. We’re getting dribbles of updates as a result of those exams, with the SEC just starting to point out things it hasn’t liked in exams.

The first was extracted performance from a private fund in January 2023.

“[A]n adviser may not show gross performance of one investment or a group of investments without also showing the net performance of that single investment or group of investments, respectively.”

The latest FAQ focuses on the calculation of net and gross performance.

Q: Must gross and net performance shown in an advertisement always be calculated using the same methodology and over the same time period?

Yes, is the answer. The extra point made in the answer is taking into account the use of a subscription credit facility when calculating returns. If you exclude the use of the facility in one calculation you have to exclude it in the other calculation. And vice versa.

The FAQ goes on to make another point about calculating new IRR when a fund uses a credit facility.

“[A]n adviser would violate the general prohibitions (e.g., Rule 206(4)-1(a)(1) and Rule 206(4)-1(a)(6)) if it showed only Net IRR that includes the impact of fund-level subscription facilities without including either (i) comparable performance (e.g., Net IRR without the impact of fund-level subscription facilities) or (ii) appropriate disclosures describing the impact of such subscription facilities on the net performance shown.”

The new Private Fund Quarterly Reporting Rule also requires calculation of returns with and without the use of the credit facility. (Assuming the rule is not vacated by the courts after the recent hearing.) Add in this FAQ and I see the SEC having a very negative view on private fund’s use of credit facilities.

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What We’ve Learned About Marketing Hypothetical Performance

When the Securities and Exchange Commission enacted the Investment Adviser Marketing Rule at the end of 2020, it threw out decades of cobbled together opinions, no action letters, and informal guidance. In the 18 months it took to reach the compliance date, the SEC offered little in the way of additional guidance. The SEC made it very clear that it would be taking a closer look at investment advisers’ marketing practices shortly after the compliance date a year. There have been signs that the examiners have been doing just that.

Enforcement has begun. The SEC announced action against nine firms for improper use of hypothetical performance.

(8) Hypothetical performance means performance results that were not actually achieved by any portfolio of the investment adviser.
(i) Hypothetical performance includes, but is not limited to:
(A) Performance derived from model portfolios;
(B) Performance that is backtested by the application of a strategy to data from prior time periods when the strategy was not actually used during those time periods…

Each of the nine firms published hypothetical performance on its website. Under 206(4)-1(d)6, an investment adviser can’t use hypothetical performance in an advertisement unless the firm:

(i) Adopts and implements policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement;

(ii) Provides sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance; and

(iii) Provides (or, if the intended audience is an investor in a private fund, provides, or offers to provide promptly) sufficient information to enable the intended audience to understand the risks and limitations of using such hypothetical performance in making investment decisions; ….

In the adopting release for the Marketing Rule at page 220, the SEC points out that hypothetical performance should not be used in mass advertising:

We believe that advisers generally would not be able to include hypothetical performance in advertisements directed to a mass audience or intended for general circulation. In that case, because the advertisement would be available to mass audiences, an adviser generally could not form any expectations about their financial situation or investment objectives.

There is no higher form of general circulation than using a public webpage to broadcast hypothetical performance. There is also the additional challenge of meeting the record-keeping requirements of the Marketing Rule for a website. To of the firms failed to have tools in place to archive their websites.

The lesson learned from these nine cases is don’t put hypothetical performance on your firm’s website.

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The One with the Failure to Disclose Fees

The private fund industry is plagued with bad actors who don’t disclose fees and affiliate relationships. That has directly lead to the new reporting rule issued by the SEC for private fund advisers. The latest firm to get caught is the Prime Group, based in Saratoga Springs, New York. Prime’s business is investing in self-storage properties.

Prime is not registered with the Securities and Exchange Commission as an investment adviser. The new private fund reforms will only be partially applicable. Prime has at least two investment funds according to the SEC order. I assume they fall outside the definition of a “Private Fund” because Prime is relying on the c(5) exemption or claiming that the fund doesn’t invest in securities.

Prime also has an affiliate real estate brokerage firm owned by Prime’s CEO. Prime had employees and independent contractors that sourced acquisitions. When a fund bought one of these sourced acquisitions, it paid a brokerage fee to the affiliate. This arrangement is, of course, very usual and legal. According to the SEC Order, the majority of Fund II’s transactions paid a brokerage fee to the affiliate.

What Prime did wrong was sell interests in the fund without disclosing the payment of brokerage fees to the affiliate. There was some disclosure, but not enough. From the Fund II Limited Partnership Agreement:

“The General Partner may, from time to time, engage any person to render services to the Fund on such terms and for such compensation as the General Partner may determine, including attorneys, investment consultants, brokers, independent auditors and printers. Person so engaged may be Affiliates of the General Partner or employees of Related Persons.”

The SEC stated that “from time to time” failed to reflect that most of the transactions involved payment of the brokerage fee. This sounds a bit like the SEC’s attack on the use of “may” in disclosures.

The PPM for Fund II disclosed other affiliate fees, a 1% acquisition fee charged on all transactions and 5% property management fee paid to an affiliate, but failed to disclose the brokerage fee. It obviously would have been better practice to disclose the fee. It is common to pay a brokerage fee on transactions, although it usually paid by the seller, not the buyer. In my opinion if this is all the disclosures, it is potentially misleading.

The SEC dug further into Prime’s own DDQ and specific DDQs from some investors:

“Do you use the service of a broker to source deals?”
“Prime has not and does not use a broker; all sourcing is done internally.

“[Disclose]any fees, including consulting fees, paid to any affiliated group or person.”
“NA.”

Any other fees?
“Individual deal team members, unaffiliated with Prime Group Holdings or the fund manager, receive a brokerage fee of 1% to 3% of net purchase price.”

Unfortunately, Prime took a perfectly usual and legal fee and got itself in trouble by not disclosing it.

The twist, at least for a compliance geek, is that the SEC charge was not under the Investment Advisers Act. It was under Section 17(a)(2) of the Securities Act.

(a) It shall be unlawful for any person in the offer or sale of any securities … directly or indirectly—

(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.”

Since Prime was not registered as an investment adviser and the fund was not a private fund, there is a strong argument that there was no investment advice about securities and therefore the activity falls outside the scope of the anti-fraud provisions of the Investment Advisers Act. But the interests in Prime’s funds are securities, so the Securities Act does apply to the sale of those interests. So the SEC relied on the anti-fraud provisions of the Securities Act.

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Abusing Hypothetical Performance Under the New Marketing Rule

“These charges mark the first violation of the SEC’s amended marketing rule” according to the SEC press release.

Really, when use marketing collateral that your strategy has a 2700% return, you are going to catch the attention of the regulators. Titan Global Capital Management USA LLC, a New York-based FinTech investment adviser, used this hypothetical performance in its advertisements. Plus this was for a crypto strategy, so it’s even more suspect. I assume this lead the Securities and Exchange Commission to take a closer look at Titan Global and find a host of other problems.

The SEC Order provides great insight into what the SEC thinks about compliance with the Marketing Rule as a registered investment adviser. There has been a great deal of mumbling in the compliance world about the lack of guidance from the SEC on how to comply with the general provisions. The SEC annulled decades of guidance on how to be complaint with advertising. The one substantive FAQ about net performance for a single investment in a fund didn’t come out until four months after the compliance deadline.

So how did Titan Global achieve this 2700% return? They took their strategy and ran it for three weeks against price changes, with no actual money invested. During those three weeks, the strategy yielded a 21% return. Titan Global extrapolated that being able to achieve that return for a whole year and came up with a 2700% annualized return.

Titan Global is registered with the SEC as an investment adviser and put a marketing policy in place in June 2021 to comply with the Marketing Rule. There is no question about jurisdiction or applicability of the rule.

A list of the errors cited by the SEC:

  1. Titan Global failed to adopt and implement any policies or procedures reasonably designed to ensure that the hypothetical performance metrics included in its advertisements complied with the Marketing Rule.
  2. The hypothetical performance results were materially misleading. (Advisers Act section 2026(2)
  3. Titan Global failed to present material criteria used and assumptions made in calculating its hypothetical performance projection, including sufficient information to appreciate the significant risks and limitations associated with this hypothetical performance projection.
  4. Titan Global’s target audience was retail investors which requires heightened disclosure.
  5. Titan Global did not disclose in the advertisements that the 2,700 percent annualized return was based on a purely hypothetical account in which no actual trading had occurred.
  6. Titan Global failed to disclose that the annualized return had been extrapolated from a period of only three weeks.
  7. Titan Global failed to disclose Titan’s views as to the likelihood that this three week performance could continue for an entire year.
  8. Titan Global did not disclose whether the hypothetical projection was net of fees and expenses.
  9. Titan Global did provided information about the assumptions it used to calculate the hypothetical annualized return, and risks, as clearly and prominently as the highlighted 2,700 percent annualized return.
  10. The disclosures failed to disclose the significant risks associated with the strategy.

The SEC sums this all up by saying Titan Global’s “advertisement did not present the hypothetical projected performance in a fair and balanced way, or in a way that was not materially misleading.”

I don’t think there is much argument with that summary. This is not a marginal case. I think this advertising would have been found to be misleading under the old Advertising Rule. This part of the SEC Order just uses some of the new language in the Marketing Rule to frame the violation.

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New Risk Alert on the Marketing Rule

The Division of Examination released a risk alert on additional areas of emphasis during examinations focused on the new Marketing Rule (Rule 206(4)1): Examinations Focused on Additional Areas of the Adviser Marketing Rule. This is identified as a follow up to the September 19, 2022, Risk Alert describing the initial areas of review related to examining advisers for compliance with the Marketing Rule: Examinations Focused on the New Investment Adviser Marketing Rule.

The new areas of focus are:

  1. Testimonials and Endorsements
  2. Third-Party Ratings
  3. Form ADV

Testimonials and Endorsements

The focus seems to be just on the key compliance areas. You need to make sure you have good disclosures about whether the person is an actual client/investor, whether the person is compensated and any material conflicts of interest.

I’m seeing placement agents struggling with how to disclose their role in the marketing and fundraising. They all have good disclosures and procedures. I assume there will some move towards standardization in the industry.

Third-Party Ratings

Compliance needs to keep a close eye on these and the substance behind them. The Risk Alert makes it clear that the SEC wants the time frame to be clear, who did the rating and whether there was any compensation.

An interesting note is that the SEC wants to see that the:

“adviser has a reasonable basis for believing that such questionnaire or survey 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.”

Form ADV

The SEC wants to make sure you are checking the right boxes in the new Form ADV questions regarding marketing. Not much substance here, just easy for the SEC to review and grade. I assume the examiners have seen a bunch of advisers who checked the wrong boxes.

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Back from a hiatus on the blog. I thought it prudent to shut down during an examination. The end result was just fine. Exams are just nerve-wracking.

A New Marketing Rule FAQ

It’s been two months and the SEC finally issued a substantive FAQ on the Marketing Rule for investment advisers. https://www.sec.gov/investment/marketing-faq

Gross and Net Performance

Q. When an adviser displays the gross performance of one investment (e.g., a case study) or a group of investments from a private fund, must the adviser show the net performance of the single investment and the group of investments?

A. Yes. The staff believes that displaying the performance of one investment or a group of investments in a private fund is an example of extracted performance under the new marketing rule.[1] Because the extracted performance provision was intended, in part, to address the risk that advisers would present misleadingly selective profitable performance with the benefit of hindsight, the staff believes the provision should be read to apply to a subset of investments (i.e., one or more). Accordingly, an adviser may not show gross performance of one investment or a group of investments without also showing the net performance of that single investment or group of investments, respectively.[2] In addition, the adviser must satisfy the other tailored disclosure requirements as well as the general prohibitions, including the general prohibition against specific investment advice not presented in a fair and balanced manner, when showing extracted performance.[3]

This has been an issue that private equity fund managers have been trying to clarity on for over a year. There has been conflicting advice from consultants and lawyers about the best way to deal with case studies that highlight the type of investing and managing by the private equity fund manager.

I think showing the net overall returns for the fund is more important that coming up with some jiggered calculation of net return for a single investment. But the SEC clearly thinks the opposite.

This will impact many fund managers who took the opposite advice from the SEC position. Marketing materials will need to be revised. Policies and procedures will need to be re-written. A formula for estimating net returns for an individual investment will need to be created.

Happy Marketing Rule Day

The new Marketing Rule for Registered Investment Advisers takes effect today. (Nov 4) Hopefully you’ve got your policies and procedures in place and operational, if the rule applies to you.

Many were hoping for some clarifications and updates. Only two questions were ever answered.

  1. An adviser may choose to comply with the amended marketing rule in its entirety any time starting on the effective date, May 4th, 2021. Until an adviser transitions to the amended marketing rule, the adviser would continue to comply with the previous advertising and cash solicitation rules and look to the staff’s positions under those rules. The staff believes an adviser may not cease complying with the previous advertising rule and instead comply with the amended marketing rule but still rely on the previous cash solicitation rule.
  2. The staff would not object if you are unable to calculate your one-, five-, and ten-year performance data in accordance with rule 206(4)-1(d)(2) immediately following a calendar year-end and you use performance information that is at least as current as the interim performance information in an advertisement until you can comply with the calendar year-end requirement. 

There are several unanswered questions out there. I’ve seen two floating around with lots of discussion these last few weeks.

One is for private equity fund managers using extracted performance in a case study for a fund. I’ve seen conflicting advice from different consultants and law firms about whether you need to generate some kind of a net return for that single investment or whether you can use the net return for the fund.

The second is whether you need to update Form ADV Part 2 Question 14 regarding placement agents or solicitors right away to comply with the Marketing Rule. The SEC has said conflicting things about this update.

The Division of Examinations has already stated it will start a sweep exam on compliance with the Marketing Rule. (See the Risk Alert) Keep an eye on your phone Monday morning.

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Withdrawal of Advertising Rule Guidance

On December 22, 2020, the Securities and Exchange Commission adopted the new Marketing Rule (amended Rule 206(4)-1) under the Investment Advisers Act that will replace both the current advertising and cash solicitation rules and will govern investment adviser marketing. Since it’s a complete re-write of investment adviser marketing, most, if not all, of the staff guidance, no-action letters and other publications are likely inapplicable. The SEC said it would be evaluating them and withdrawing them as appropriate.

The Division of Investment Management has made that announcement: Division of Investment Management Staff Statement Regarding Withdrawal and Modification of Staff Letters Related to Rulemaking on Investment Adviser Marketing (PDF)

The big ones are in there. Clover Capital Management, DALBAR, and Franklin Management. The staff also withdrew the 2014 Guidance on the Testimonial Rule and Social Media. There are over 200 items withdrawn.

What leaves me scratching my head is whether any of the past guidance was not withdrawn. Is there something still sticking around? It will take a bunch of research to figure that out. The IM Information update says that “certain” staff statements around the old advertising rule are being withdrawn. Not “all” statements. It might have been useful for the SEC to point out any guidance that was not withdrawn.

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Pre-existing, Substantive Relationship

Rule 506(b) of Regulation D provides a safe harbor for issuers to engage in private placements. Private placements undertaken pursuant to Rule 506(b) are limited by Rule 502(c) of Regulation D, which imposes as a condition on offers and sales under Rule 506(b)that “… neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising…”

The SEC Staff has issued various interpretive letters that have tried to clarify the regulation. One of those was the statement that a general solicitation is not present when there is a “pre-existing, substantive relationship” between an issuer, or its [agent], and the offerees.

The SEC has published some Q and A’s on the topic. 256.31 says “substantive” means you have sufficient information to determine the offeree is an accredited or sophisticated investor. Blast emails to unknown investors would not be substantive.

As to the “pre-existing” prong, question 256.30 says there is no minimum waiting period, but there is a waiting period. The Lamp Technologies No Action letter in 1997 said that 30 days is sufficiently long to be pre-existing. (See Footnote 6). So somewhere between 0 days and 30 days is pre-existing enough, as long as you know the potential investor is accredited, to send information on offering.

There is also the question of what amounts to an offering. If it’s at the early stages of a fund, before its formed, perhaps there is no actual security sell. It’s hypothetical information about an upcoming offering.

This all circles back to the IR people asking whether they can leave a copy of the pitchbook for a fund at the initial meeting with an investor. I think the answer is generally “no”, unless you can show that there is a pre-existing substantive relationship with the investor. An initial meeting is generally the 0-day period, unless there has been a series of discussions prior to that initial meeting.

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General Solicitation and Placement Agent Agreements

D.H. Hill Securities got hit with a FINRA penalty for violating the private placement offering rules. FINRA concluded that D.H. Hill did not have a pre-existing, substantive relationships with several investors in an offering. This was a breach of the Rule 502(c)

The key point from the settlement was that the D.H. Hill began participating in the private placement offerings before creating a substantive relationship with the individuals. The “pre-existing” standard was not there because D.H. Hill started selling to them without establishing the relationship.

FINRA cites two ways for a broker-dealer to create a pre-existing, substantive relationship:

  1. through a previous investment in securities offered through the broker-dealer
  2. through submission and approval of an investor qualification questionnaire

FINRA is making it clear that its easier to sell private placements to the existing client base than reaching out for new investors.

Question 256.29 makes this even clearer:

Question: What makes a relationship “pre-existing” for purposes of demonstrating the absence of a general solicitation under Rule 502(c)?

Answer: A “pre-existing” relationship is one that the issuer has formed with an offeree prior to the commencement of the securities offering or, alternatively, that was established through either a registered broker-dealer or investment adviser prior to the registered broker-dealer or investment adviser participation in the offering. See, e.g., the E.F. Hutton & Co. letter (Dec. 3, 1985). [August 6, 2015]

Of course, the big question is long between the initial contact and screening before a relationship becomes pre-existing?

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