Trillium

On April 17, 2024, the Securities and Exchange Commission (“SEC”) Division of Examinations released its most recent Risk Alert focusing on the Marketing Rule (Rule 206(4)-1).

Buckle in because the Risk Alert is robust and extracting the pieces that apply to private equity funds can get lost amongst some of the more fundamental information.

Key Takeaway(s): Two things stick out to me. First, as is to be expected, the SEC has progressed from looking at whether advisers have policies and procedures (as was the case with the SEC’s Risk Alerts in September 2022 and June 2023) to reviewing the substantive provisions of advisers’ policies and procedures for compliance with rules. Second, this newest Risk Alert is meaty, wide-ranging and, in certain places, highly specific. There is a lot of information and guidance to take in from the Risk Alert. Advisers should use the Risk Alert as a checklist of sorts to assess compliance with multiple Advisers Act Rules and the Marketing Rule related implications. 

The Risk Alert is broken down into two sections – Compliance Rule, Books and Records and Form ADV violations and deficiencies specifically related to the Marketing Rule.

Compliance Rule, Books and Records Rule and Form ADV

Compliance Rule (Rule 206(4)-7)

At the outset, the SEC noted most advisers have:

1. Adopted policies and procedures to comply with the Marketing Rule.
2. Provided training to staff on the adviser’s policies and procedures.
3. Established processes for reviewing advertisements.
4. Implemented pre-approval requirements for advertisements (despite not being required by the Marketing Rule).

All good things, right? Right. However, the SEC proceeds to point out a plethora of areas where advisers’ policies and procedures “were not reasonably designed or implemented to address compliance with the Marketing Rule” and therefore in violation of Rule 206(4)-7, including policies and procedures that:

1. Consisted only of general descriptions and expectations related to the Marketing Rule.
2. Did not address applicable marketing channels utilized by the advisers, such as websites and social media.
3. Were informal rather than in writing.
4. Were incomplete, not updated, or partially updated for certain applicable marketing topics.
5. Were not tailored to address advisers’ specific advertisements (e.g., policies and procedures to address the General Prohibitions, and advertising requirements for testimonials, endorsements, and third-party ratings utilized by advisers in advertisements).
6. Did not adequately address the preservation and maintenance of advertisements and related documents, such as copies of any questionnaires or surveys used in the preparation of a third-party rating (in the event the adviser has received such documents) included or appearing in any advertisement.
7. Were updated to reflect the Marketing Rule but were not implemented. For example, policies that required net of fees performance to be included with any performance advertisement where those same advisers included only gross performance in advertisements.

Books & Records Rule (Rule 204-2)

As above, the SEC noted advisers had mostly updated their policies and procedures to reflect Marketing Rule-related books and records maintenance and preservation requirements. The deficiencies the SEC noted with advisers’ books and records practices were:

1. Advisers completed questionnaires or surveys used in the preparation of a third-party rating but did not maintain a copy of such questionnaires.
2. Advisers did not maintain copies of information posted to social media.
3. Advisers did not maintain documentation to support performance claims included in advertisements.

In practice, social media posts are difficult to retain so I expect more advisers to use screenshots to accompany any materials used for pre-approval processes. I am a bit surprised at the inclusion of the third deficiency. The SEC required substantiation of performance information before the Marketing Rule’s adoption. I am surprised the SEC did not cite a common deficiency related to substantiation of non-performance claims since it is not common practice to retain records to substantiate every claim in marketing materials. 

Form ADV

By now, every adviser has completed at least one Form ADV annual update under the Marketing Rule. Not surprisingly then, the SEC found most advisers had updated both Part 1A, Item 5.L and Part 2A, Item 14 with disclosures related to advertising. 

Part 1A. Item 5.L

The SEC found that the disclosures made by advisers were not always accurate. Specifically, the SEC stated advisers failed to disclose firm advertisements contained the following elements.

1. Third-party ratings, when their websites included third-party ratings or social media posts that touted the firms as being ranked in certain third-party ratings.
2. Performance results, when performance results were included in their marketing materials.
3. Hypothetical performance, when hypothetical performance was included in advertisements.

My position from the beginning has been there is no harm in answering affirmatively to all of the Item 5.L questions. It provides advisers with maximum flexibility to use the various components in Item 5.L in advertisements while avoiding mistakenly using an advertisement with undisclosed features, or the need to submit an other-than-annual amendment prior to using an advertisement.

Part 2A, Item 14

The SEC highlighted findings where advisers were using old or outdated language in Item 14 relating to cash solicitation arrangements. This must have been low-hanging fruit for the SEC staff given the Cash Solicitation Rule was replaced.

The SEC also found advisers inaccurately indicating that no referral arrangements existed, and advisers omitting material terms and compensation of referral arrangements that were in place.

If you have not already updated Item 14 in Part 2A to remove references to the Cash Solicitation Rule and disclosed testimonial and endorsement relationships, now is the time to do so.

Observations from Compliance with the Marketing Rule’s General Prohibitions

Over half of the Risk Alert is devoted to Marketing Rule deficiencies observed by the SEC. The SEC provides specific examples for each high-level deficiency, some of which may be applicable to private equity firms but many of the examples are not. I would encourage people to spend time reading all the examples in the Risk Alert.  I intend to highlight only private equity specific examples and I reordered them from the Risk Alert based on the applicability to private equity managers. The deficiencies noted by the SEC are:

1. References to specific investment advice that were not presented in a fair and balanced manner

The SEC shined a spotlight on advertisements that included only the most profitable investments or specifically excluded certain investments without providing sufficient information and context to evaluate the rationale, such as investments that were written off as a loss or were lower performing investments. The SEC also observed advisers had not established criteria in their policies and procedures to ensure references to specific investment advice shown in advertisements were provided in a fair and balanced manner.

Case studies and investment examples are squarely in the cross hairs here. Unless private equity firms intend to include all investments as examples (which is easier for some than others), advisers will need to establish criteria for selecting case studies to ensure that prior investments are being shown in a fair and balanced manner and not simply highlighting successful deals.

2. Inclusion or exclusion of performance results or time periods in manners that were not fair and balanced

The SEC found advisers using advertisements that included or excluded certain performance results or presented performance time periods in a manner that was not fair and balanced. For example:

• Advertisements that did not disclose the time period or did not disclose whether the returns were calculated for the same time period as additional performance information included in the same advertisement.
• Advertisements that included or excluded certain performance results in manners that were not fair and balanced, such as advertisements that included the performance of only realized investment information in the total net return figure and excluded unrealized investments.

3. Fair and balanced treatment of material risks or limitations.

The SEC found advertisements that included statements about the potential benefits connected with the advisers’ services or methods of operation that did not appear to provide fair and balanced treatment of any material risks or material limitations associated with the potential benefits.

Pretty straightforward. The SEC seems to no longer consider the audience of an advertisement as important to the disclosures required. I’ve started adding high-level, general risks of private equity investing and the sponsor’s strategy to marketing materials to create the balance the SEC appears to require.

4. Untrue statements of material fact and unsubstantiated statements of material fact. 

Making false statements is clearly a violation (it was under the previous Advertising Rule as well). The SEC pointed out “[i]n some cases the advisers acknowledged that the statements of material fact were likely untrue after being unable to substantiate the statements upon demand.” As pointed out above, the SEC expects firms to be able to substantiate all statements of material fact and have support for those statements (See “Books & Records section above). This represents a new, more aggressive approach to the review of advertisements by the SEC in my view.

5. Omission of material facts or misleading inference.

The SEC provides numerous examples of omitting material facts or making misleading inferences in the Risk Alert. Of the examples provided, many are retail-esque (e.g. misleading celebrity endorsements, public advertising). Private equity fund managers should focus more on the performance-related examples such as:

• Advertisements using third-party ratings implying they were the sole recipient of an award that went to multiple firms or indicating an adviser was highly rated by an organization without disclosing the methodology of the ranking.
• Benchmarks comparisons without defining the benchmark and the difference between a benchmark and actual investing.
• Using outdated market data.
• Using lower fees in calculations for net of fees performance returns than were offered to the intended audience.
• Omitting material information regarding fees and expenses used in calculating returns.

6. Advertisements that were otherwise materially misleading. 

Finally, last but not least, the SEC observed advertisements that appeared to otherwise be materially misleading, such as presenting disclosures in an unreadable font on websites or in videos.

How Trillium Can Help

Testing and Surveillance: A key component of Trillium’s ongoing compliance support is reviewing your firm’s practices in key risk areas against policies and procedures and disclosures. The ability to identify and rectify problematic areas, prior to an examination, is integral in preventing potentially significant time and expense later on.

Compliance Program Development: Trillium helps you put in place policies and procedures that work for your firm. Developing and applying consistent policies and procedures is paramount to fulfilling a firm’s regulatory obligations and fiduciary duty.

Marketing Material Review and Process:  Marketing material review and commentary is included as part of Trillium’s comprehensive ongoing compliance support. Trillium also helps clients design and implement marketing material review processes through the use of technology to ensure proper records are created and maintained.