The New Testimonial Rule

The SEC has recently published the new Investment Adviser Marketing Rule in the federal register. The effective date of the new legislation will be May 4th, 2021, with a compliance date set for eighteen months following the effective date of the rules. Any advertisements disseminated on or after the compliance date by advisers registered, or required to be registered with the Commission will be subject to the new marketing rule. 

"Much to the surprise of many, it appears as if the Securities Exchange Commission (SEC) has recognized the changing landscape of the investment advisory industry."

I guess that with time, examination findings became increasingly difficult to translate into viable options for firms to implement as practical changes to their supervisory practices. The permeation of technology in the industry coupled with the idea that existing and prospective clients may be able to benefit from gaining information about advisers and the services they offer led to the “investor protection” element of the decision. Much to the surprise of many, it appears as if the Securities Exchange Commission (SEC) has recognized the changing landscape of the investment advisory industry.

Firm Implementation Best Practices

The final rule will permit advertisements of investment advisers to include testimonials and endorsements. However, advisers aren’t completely free to run wild with third-party ratings and client feedback. There will be required disclosures and new practices to be implemented for oversight and ongoing supervision. What’s the path of least resistance to implementing policies and procedures?

Here are 5 items for firms to consider when making adjustments to their compliance programs in response to the new rule.

Establish a “reasonable basis” for believing the adviser complies with regulatory requirements.

For many, this part of the supervisory process will not change. Even before the change to the testimonial rule, firms were advised to ensure that nothing in their marketing and advertising materials could be construed as “materially misleading”. It would stand to reason that the same principle applies here, even if the information being disseminated is provided by way of a testimonial. 

Create and document a policy regarding compensation for testimonials.

Under the new regulations, the SEC establishes a de minimis compensation exemption for testimonials and endorsements. After considering comments and various thresholds, the SEC decided to set the de minimis threshold amount to $1,000. “Accordingly, the disqualification provisions will not apply if an investment adviser provides compensation to a promoter of a total of $1,000 or less (or the equivalent value in non-cash compensation) during the preceding twelve months”. Many firms will be interested in offering gift cards and small niceties to incentivize clients to leave reviews. Creating a policy, along with ongoing supervisory procedures before the effective date of the rule will make this process more transparent and organized.  Also, please keep in mind that advisers who enter into compensation arrangements in exchange for testimonials or endorsements above the de minimis threshold must have a written agreement in place. 

Consider testimonials and solicitation arrangements to be two sides of the same coin.

The definitions of testimonials and endorsement under the new rule also include solicitation and referral arrangements.  From a logical perspective, it makes sense to view the act of referring a client to another adviser as an endorsement of that adviser’s services. Tangentially, the expanded definition of advertisement created by the updated marketing rule provides a third “prong” for creating ongoing supervisory procedures. Most specifically, the new definition includes not only communications made directly by the adviser but also marketing materials that the adviser provides to others, (such as solicitors), to disseminate on their behalf. 

Maintain control of the mediums of dissemination.

One concept that the SEC was careful to highlight in commentary surrounding the new rule was the concept of “entanglement”. This term describes the idea that an adviser that endorses, approves of, incorporates, or involves itself in the preparation of information created by a third-party, has “adopted” this information, and may be held liable for the content under the marketing rule. This concept is most relevant when advisers hyperlink third-party content through their website, without adequate review of the content, and proactive policies and procedures that will prevent the adoption of fraudulent and deceptive, or materially misleading content.

Changes to Form ADV

The next few months will be filled with comments and questions from advisers and compliance professionals who are trying to make sure we are properly advising on how to update the ADV for various changes to the rule. Fortunately, the SEC Release allows adequate time for firms to update their compliance documents, stating that “each adviser is only responsible for filing an amended form that includes responses to the amended questions in Item 5 in its next annual updating amendment that is filed after the eighteen-month transition period.” In addition to potential updates firms may need to make to their written supervisory procedures, a new subsection for “Marketing Activities” will be added to Item 5 of Form ADV Part 1A requiring information about an adviser’s use of testimonials in advertisements. Interestingly enough, the SEC through its Economic Analysis estimates the cost and burden from ADV Amendments to increase by approximately 0.5 hours per adviser. 

Many industry professionals feel this change was long overdue. I consider myself among them. However, I also understand that with additional rights, comes added responsibilities. So, I remain cautiously optimistic about this change. In other words, I think I’ll wait until the examination findings and deficiency letters begin to emerge before tossing confetti and drinking champagne.

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