May 5, 2022
May 5, 2022
Five Articles to Help Hedge Fund Managers Comply With the New Marketing Rule
In November 2019, the SEC issued proposed changes to the advertising and cash solicitation rules to update those antiquated rules and address various concerns. In December 2020, the Commission issued a new marketing rule – Rule 206(4)‑1 under the Investment Advisers Act of 1940 (Marketing Rule) – which amends the existing advertising rule and replaces the cash solicitation rule. The Marketing Rule became effective on May 4, 2021, with an 18‑month transition period. Thus, the compliance deadline is November 4, 2022. Unsurprisingly, a recent investment management compliance testing survey found that marketing is one of the top three “hot” compliance topics for private fund advisers. In light of concerns around the Marketing Rule’s requirements – and the looming compliance date – the Hedge Fund Law Report is highlighting five articles that will help hedge fund managers meet that compliance deadline. These articles note some of the advertising-related issues that partly led to the Marketing Rule; provide an overview of the rule and its requirements; explain how the cash solicitation rule has been subsumed into the Marketing Rule; discuss the key takeaways and next steps for fund managers’ legal and compliance departments; and examine the use of predecessor performance in advertising. Next week (the week starting May 9, 2022), the HFLR will resume its normal weekly publication.
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Common Advertising-Related Compliance Issues
The SEC primarily amended the advertising rule for two reasons. First, the rule was old and outdated. For example, advertising and referral practices have evolved; the technology used for communications has advanced; and investor expectations have changed. Second, the SEC’s Division of Examinations (Examinations) has continually identified advertising-related issues when conducting exams of registered investment advisers, such as misleading performance results; cherry-picking; misleading claims of compliance with voluntary performance standards; and deficient compliance policies and procedures. In fact, in September 2017, Examinations – then known as the Office of Compliance Inspections and Examinations – issued a risk alert that discusses the six most common advertising issues identified in deficiency letters from more than 1,000 adviser examinations, as well as the results of its 2016 “Touting Initiative,” which focused on nearly 70 advisers’ use of awards, rankings, professional designations and testimonials in their marketing materials. This article summarizes the findings contained in the risk alert. See our two-part series “How Can Hedge Fund Managers Market Their Funds Using Case Studies Without Violating the Cherry Picking Rule?”: Part One (Dec. 5, 2013); and Part Two (Dec. 12, 2013).
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An Overview of the Key Elements of the Marketing Rule
On December 22, 2020, the SEC issued a 430‑page release announcing the Marketing Rule, which, in addition to amending the prior advertising rule and replacing the cash solicitation rule, amends Rule 204‑2 (the books and records rule) and Form ADV. This article reviews the key elements of the Marketing Rule of particular interest to private fund managers, including an amended definition of “advertisement”; seven principles-based prohibitions; authority to use testimonials or endorsements provided certain conditions are met; a bar on the use of third-party ratings in an advertisement, unless the adviser provides disclosures and satisfies certain criteria pertaining to the rating’s preparation; specific requirements for the use of certain types of performance results, such as gross performance and hypothetical performance; and an amended Form ADV that requires advisers to provide additional information on their marketing practices. The article also examines some concerns the SEC Commissioners have with the Marketing Rule. For a look at the originally proposed changes to the advertising rule, see our two-part series: “Expanded Definition of Advertisement” (Apr. 2, 2020); and “‘Fair and Balanced’ Standard and Performance” (Apr. 9, 2020).
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What the New Marketing Rule Means for the Old Cash Solicitation Rule
The Marketing Rule not only amends the prior advertising rule but also absorbs the cash solicitation rule (Rule 206(4)‑3 under the Investment Advisers Act of 1940). For example, the amended definition of “advertisement” has two prongs, the second of which governs the activities previously covered by the cash solicitation rule, including any endorsement or testimonial for which an adviser provides cash or non-cash compensation, directly or indirectly, such as directed brokerage; awards or other prizes; or reduced advisory fees. This guest article by Fried Frank partner Stacey Song discusses what the new Marketing Rule means for the old cash solicitation rule. Although the article analyzes the SEC’s originally proposed changes to the cash solicitation rule, many of the elements in the proposal were adopted in the final version of the Marketing Rule. Because the Marketing Rule now incorporates activities previously covered by the cash solicitation rule and expressly applies to private funds, Song warned that the new rule applies not only to private fund advertisements but also to solicitation of private fund investors – which could be a big adjustment for private fund managers. See “Five Ways to Avoid Common Violations of the Cash Solicitation Rule Identified in OCIE’s Recent Risk Alert” (Nov. 29, 2018).
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Key Takeaways and Next Steps for Legal and Compliance
In April 2018, Paul Cellupica, Deputy Director of the SEC’s Division of Investment Management, observed in a panel discussion at the National Compliance Outreach Seminar for Investment Companies and Investment Advisers that the advertising and cash solicitation rules were adopted when social media, among other things, did not exist. Now, however, many people “do not make reservations for things like vacations or restaurants without first going onto social media and researching reviews and seeing what other people had to say,” he remarked. “It’s not surprising that many people would like to do the same when it comes to researching and selecting investment advisers.” Thus, the advertising and cash solicitation rules desperately needed an update, which occurred in the form of the new Marketing Rule. This two-part series examines the Marketing Rule through the eyes of private fund managers. The first article outlines important changes made to the originally proposed amendments and provides key takeaways for private fund managers, including the fact that the Marketing Rule explicitly applies to private funds. The second article spells out the next steps for managers’ legal and compliance departments, such as becoming familiar with the new rule; assessing current marketing activities; considering additional marketing activities; and monitoring for additional guidance. See “Navigating the SEC’s New Marketing Rule” (Jul. 8, 2021). In addition, for a checklist based on the old advertising rule that CCOs can adapt for the Marketing Rule, see “A Checklist for Advisers to Ensure Compliance With the Advertising Rule” (Dec. 12, 2019).
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Use of Predecessor Performance in Marketing
The Marketing Rule includes specific requirements for certain types of performance results, including predecessor performance. For example, fund managers may not include predecessor performance in any advertising unless there is appropriate similarity with regard to the personnel and accounts at the predecessor adviser and the personnel and accounts at the advertising adviser, which must include all relevant disclosures clearly and prominently in the advertisement. Fortunately, the Marketing Rule largely codified the existing SEC staff guidance on the use of predecessor performance. Because the new rule is generally consistent with the no‑action guidance in this space, managers will not need to dramatically change their approaches with regard to the use of predecessor performance in their marketing materials. Thus, this guest article by Sean O’Brien and Sara A. Welch, partner and counsel, respectively, at O’Brien LLP, and Joel A. Blanchet, partner at Kirkland & Ellis, on the portability and protection of hedge fund investment track records remains largely relevant. The article explores the manner in which the law affects investment funds, investment adviser firms and individuals when it comes to the portability of track records and identifies steps that funds and portfolio managers can take to protect their respective rights as to those track records. For a look at the originally proposed changes regarding performance advertising, see “SEC Proposes Expanding Permissible Performance Advertising Practices With Favorable Treatment for Private Fund Managers” (Dec. 5, 2019).
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