The New SEC Marketing Rule Part 2 – What are Testimonials and Endorsements?

May 3, 2022

The New Marketing Rule Part 2 – What are Testimonials and Endorsements?

What happened?

On December 22, 2020, the U.S. Securities and Exchange Commission (SEC) passed amendments to the advertising and cash solicitation rules, along with updates to other requirements for registered investment advisers. The formerly separated rules are now combined under the new Marketing Rule, Rule 206(4)-1 of the Advisers Act, made effective May 4, 2021, with a compliance date of November 4, 2022.

With six months until the compliance date for the new Marketing Rule, our Flash Reports will cover areas RIAs will need to consider as they update their compliance program for the new regulation. This Flash Report is the second in that series. See part one here.

One of the reasons the SEC gave for proposing amendments to the rule was to provide certain restrictions and conditions on testimonials and endorsements. Prong Two of the new definition of advertisement covers promotion by third parties in the form of testimonials and endorsements.

The Scope of Prong Two includes any endorsement or testimonial for which an investment adviser provides compensation, directly or indirectly. The cash solicitation rule is subsumed into this prong as solicitations or paid referrals would be compensated endorsements.

• Testimonial – Any statement by a current client or private fund investor about that client or investor’s experience with the investment adviser or its supervised persons.
• Endorsement – Any statement by a person other than a current client or private fund investor that indicates approval, support or recommendation of the investment adviser or its supervised persons.
• Examples include:
  • Opinions or statements about the investment advisory expertise or capabilities of the adviser or its supervised persons;
  • Statements about an adviser or its supervised person’s qualities (e.g., trustworthiness, diligence, or judgment);
  • Statements on the expertise or capabilities of an adviser or its supervised persons in other contexts, that suggest those qualities, capabilities, or expertise are relevant to the advertised investment advisory services.
  • Solicitation activities – Could be by a firm that solicits for an adviser, such as a broker-dealer or a bank, and by individuals soliciting at such firms, such as bank representatives or an individual registered representative of a broker-dealer.
    • Statements that directly or indirectly solicit any client or private fund investor to become a client of, or investor in a private fund advised by, the investment adviser; and
    • Referrals of any client or investor to become a client of, or investor in a private fund advised by, the investment adviser.
• Compensation – Both cash and non-cash compensation can incentivize third-party communication. Thus, any form of direct or indirect compensation for a testimonial or endorsement triggers a Prong Two advertisement. Compensation may or may not be contingent on communication leading to new clients or investors. Examples of compensation triggering the rule include:
  • Cash Compensation:
    • Fees based on a percentage of assets under management or amounts invested
    • Flat fees, hourly fees or retainers
    • Reduced or waived fees
    • Rewards for communication, referral or solicitation activities
    • Any other form of cash compensation
  • Non-cash Compensation:
    • Sales awards or other prizes
    • Gifts
    • Entertainment, such as outings, tours or other forms of entertainment
• · Lead Generation Firms and Referral Networks – Because these entities typically offer to match an investor with one or more advisers compensating the entity to participate in the services, these entities are typically soliciting, referring or otherwise promoting the adviser’s services or qualifications. This promotion will likely meet the definition of endorsement under Prong Two. However, selling an adviser a list containing names of prospective investors would not, without more activity, meet the definition because the seller is not indicating approval, support, or recommendation of the adviser or describing its experience with the adviser.

Compensated testimonials or endorsements are ads regardless of whether the communication is to one or more persons and regardless of the medium of communication. Uncompensated testimonials or endorsements are ads only where the adviser entangles itself with the communication or adopts the communication.

Adoption and Entanglement – Third-party communication, such as testimonials and endorsements, may be attributable to an adviser as an advertisement depending on the facts and circumstances. Distributing information generated by a third party or having a third party include information about an adviser’s investment advisory services in the third party’s materials can qualify:

• Adoption occurs when the adviser explicitly or implicitly endorses or approves of third-party information after its publication.
  • If an adviser incorporates information from a third party into its performance advertising, that information is adopted and will be attributed to the adviser as a Prong One advertisement.
  • Uncompensated third-party information, if adopted, is attributable to the adviser, and the adviser is liable for such information under the new Marketing Rule.
• Entanglement occurs when the adviser has involved itself in a third party’s preparation of information.
  • Advisers linking to third-party content on the adviser’s own website or contributing to third-party websites could be entanglement.
  • Suppressing or editing negative social media comments and/or promoting positive comments would also be entanglement.

Adoption and Entanglement are how uncompensated testimonials and endorsements can become ads and still require disclosures under the new Marketing Rule. Trainings are necessary to safeguard the use of third-party content in your marketing materials.

What does this mean for me?Although relief from certain restrictions are offered by the new rule, significant compliance and operational oversight will be needed to ensure all the new requirements are fulfilled.

Fairview will continue to update you with in-depth information about the impact of these changes and how your firm may be affected. Future Flash Reports will outline the restrictions and requirements necessary to make use of testimonials and endorsements under the new Marketing Rule. Our next Flash Report in this series will discuss the general prohibitions under the new Marketing Rule.

Fairview Investment Services provides ongoing, full-service compliance support for investment advisers, including comprehensive marketing and advertising review. Contact Fairview Investment Services for additional information about maintaining your compliance program in an ever-changing regulatory environment.