Marketing rule: The benefit of an ‘evidence locker’

The SEC will have answers from most advisers by April 1 about their use of the new marketing rule via several new Form ADV questions. Some believe that’s when commission exams to gauge compliance with the new rule will begin in earnest.

The SEC will have answers from most advisers about their use of the new marketing rule as firms answer new Form ADV questions by April 1. Some believe that’s when commission exams to gauge compliance with the new rule will begin in earnest.Big empty mockup Billboard along a highway with forest on background of blue sky with beautiful clouds on a bright sunny day.

The answers to the new ad questions will help the SEC “source candidates” for exams, predicts Kristin Snyder, a partner with Debevoise & Plimpton in San Francisco, who formerly served as the deputy director of the SEC’s Division of Examinations. She spoke March 16 during a webinar by affiliate title RCW, SEC Exams and the new IA Ad Rule: Compliance Guidance to Gauge if You’re Ready, available on demand for RCW subscribers here.

Be able to prove it

“I think substantiation is going to be a critical focus in upcoming SEC examinations,” said Michelle Jacko, managing partner of Jacko Law Group and CEO of Core Compliance & Legal Services in San Diego, referring to how examiners under the new rule can ask for evidence proving material claims made in adviser ads.

Firms must keep relevant records that can substantiate material ad claims. Jacko has seen an adviser who has set up a special e-mail address within the firm that was partially named “marketingbackup.”

“They’re having their investment team” taking screen shots of evidence “and sending that immediately to that e-mail account” to preserve the documentation, she reported. “Then it’s all captured in one repository.”

Steve Trigili, chief compliance officer of Red Bank, New Jersey-based Garden State Securities ($184 million in AUM), has set up an “evidence locker” to house all of the materials that would substantiate his firm’s material ad claims in one place.

SEC examiners already are asking firms to show how their compliance P&Ps have been revised to accord with the new marketing rule. That will be “low hanging fruit” for examiners should they find an adviser using outdated P&Ps, noted Snyder.

Tips for your P&Ps

Be sure the biggest changes appearing in the new marketing rule also show up in your revised P&Ps, counseled Trigili. Given that the concept of a promoter now falls within the marketing rule, maintaining P&Ps that refer to the now withdrawn cash solicitation rule may well draw an exam deficiency.

Your P&Ps also should mention the rule’s clear prohibitions, e.g., against making untrue statements and cherry-picking performance, he continued.

Jacko has noted that some advisers have failed to update “tangential policies,” e.g., revising their gifts and entertainment P&Ps given the marketing rule’s permission to gain testimonials with cash and non-cash compensation.

Your P&Ps also should outline your due diligence steps to ensure a bad actor doesn’t become or remain a promoter. If necessary, update your contracts with promoters, she encouraged.

An early deficiency

“Be careful around unpaid endorsements,” warned Darren Mooney, managing director at IQ-EQ in Boston. He noted SEC examiners issued a deficiency to an adviser recently because a portfolio company executive made a glowing assessment of its private equity fund adviser on the company’s website but neglected to disclose the obvious conflict given the executive also is an investor in the fund.

“I do think there will be a sweep” exam tied to the new marketing rule this year, offered Snyder. She referred attendees to the DOE’s risk alert last fall on the marketing rule for guidance on what examiners will focus on.

While Snyder said she doubts the SEC will release any new FAQs related to the marketing rule anytime soon, Jacko noted she heard an SEC official at a recent industry conference indicate advisers may continue to rely on some of the “no-action” letters that technically were withdrawn with the new rule.

“You could still rely on those no-action letters, almost as a safety net,” especially around the use of hypothetical performance, she said, in quoting the unidentified SEC speaker. But such ads must have “robust” disclosures, said Snyder.

Mooney alerted that advisers mustn’t forget to present performance in 1-5-10 year increments for most new ads. And realize that materials, such as emails, performance updates and written commentaries can now be seen as ads if they go to clients not currently engaged in those strategies.

Training staff

Trigili described his process for educating staff on the marketing rule. Given dwindling attention spans, he often will break up material into smaller chunks—such as one paragraph—and cut up a larger educational piece into these tiny chunks over multiple days. Be sure to test for compliance throughout the year, too, he recommended.

That FAQ

“It’s created a big, big issue,” said Mooney of the recent SEC FAQ around the use of extracted performance in ads. It creates a challenge because “there’s so many different types of fees that could be charged,” says Jacko, that it’s difficult to get confidently to net performance.

“A gross/net discount factor is I think the most popular” method that firms are using to arrive at net, Mooney continued. This involves taking the margin between gross and net performance of a portfolio that has portfolio level fees, and “applying that to any gross multiple of a particular security.”

Other methods include exposure-based allocation, which allocates those portfolio level fees based on the size of each investment in the portfolio. “And then there’s a performance-based allocation,” he said. “There’s no right way” to do this, added Mooney.

“Pick a reasonable methodology,” apply it consistently and “disclose, disclose, disclose,” said Jacko. Consider adding “no investor will ever achieve these results” in the ads given the hypothetical nature of arriving at net. And remember that you must offer to promptly deliver the total portfolio performance in these ads, she reminded.