by contributors Howard J. Beber and Gregory A. Dodge, Proskauer | Published November 30, 2011 at 3:01 PM
The Dodd-Frank Wall Street Reform and Consumer Protection Act eliminates the "private adviser" exemption in the Investment Advisers Act of 1940, a statutory exemption historically relied upon by advisers to private investment funds to remain exempt from registration with the Securities and Exchange Commission. As a result, many advisers to private investment funds will be required to register with the SEC following a transition period ending on March 30, 2012. Registered investment advisers are subject to many SEC rules and restrictions concerning advertising and marketing practices. Several of the restrictions applicable to common marketing practices of investment advisers are discussed below.
The Investment Advisers Act defines "advertisement" as any written communication addressed to more than one person that offers any investment advisory services with regard to securities. Through a series of no-action letters and enforcement actions, the SEC staff has interpreted the definition of "advertisement" broadly to generally encompass any materials designed to maintain existing clients or solicit new clients, including an investment adviser's website.
The SEC broadly regulates investment adviser advertising under the general anti-fraud provisions of the Investment Advisers Act. Under the anti-fraud provisions, it is unlawful for investment advisers to engage in manipulative, fraudulent or deceptive activities. Violations do not require intentional or deliberate conduct; an adviser can be found to have violated the anti-fraud rules if it merely "engages" in deceptive conduct, even unintentionally.
There is no explicit prohibition in the Investment Advisers Act on the use of performance data in advertising material. However, the SEC has set forth a number of practices that it considers to be intrinsically false or misleading, including, without limitation, failing to reflect the deduction of fees, brokerage commissions and other expenses that a fund or client account paid (that is, the "net of fees" requirement), failing to disclose whether and to what extent the results portrayed reflect the reinvestment of dividends or proceeds, comparing results to an index without disclosing all material factors relevant to the comparison and disclosing performance results for a select group of funds or client accounts without disclosing the basis on which the selection was made and the effect of this practice on the results portrayed (if material).
The SEC staff has stated that registered advisers may only disclose performance results on a "net of fees" basis. Accordingly, a private equity fund adviser that wishes to disclose performance must first deduct all investment advisory fees, carried interest, brokerage commissions (if any) and other expenses and transaction costs that the applicable fund or account paid.
Nevertheless, the SEC staff stated that an adviser may distribute advertising materials containing both gross and net performance numbers so long as both sets of numbers are presented in an equally conspicuous manner and the advertising materials contain certain disclosures. In addition, the SEC staff has stated that it does not object to an adviser using gross performance results in one-on-one presentations to wealthy individuals and institutions in limited circumstances and by including a number of comprehensive disclosures.
The SEC has stated that performance of funds or accounts managed at a predecessor adviser or an adviser at which investment personnel previously managed accounts can be used by a successor adviser only if the investment personnel at the successor adviser were primarily responsible for achieving the prior performance results and no other person played a significant role in achieving that prior performance. In addition, such investment personnel must be primarily responsible for achieving the performance at the successor adviser.
The accounts managed at the prior adviser must be sufficiently similar such that the comparison is meaningful and relevant to investors. The adviser must include the performance of all accounts managed in a substantially similar manner at the prior adviser (unless the exclusion would not result in materially higher performance) and must disclose that the performance results were achieved at the prior adviser. It is important to note that the successor adviser must have access to all documents that are necessary to form the basis for or demonstrate the calculation of the performance of the relevant funds or accounts at the prior adviser.
Registered advisers are prohibited from using advertisements that refer directly or indirectly to an adviser's past specific investment recommendations that were, or would have been, profitable unless certain conditions are met. The rationale of the rule is to avoid "cherry picking" by the adviser (that is, mentioning profitable recommendations, but omitting unprofitable recommendations). To the extent that an adviser's advertising materials highlight the success or performance metrics of specific investments (such as case studies or liquidity events), the inclusion of such information could be problematic.
In order to use past recommendations in marketing materials, the advertisement must include a complete list of all recommendations made by the adviser within the immediately preceding period of not less than one year and certain disclosures, including the name, purchase price and current market value of the investment, as well as a cautionary legend stating that it should not be assumed that recommendations made in the future will be profitable. In recognition of the practical difficulty and questionable value of furnishing clients and investors with extensive lists of all investment recommendations, the SEC staff has permitted advisers to provide information about a limited number of investment recommendations that are selected using objective, nonperformance based criteria (such as the adviser's 10 largest commitments) so long as the adviser does not discuss profitability.
Advisers also are prohibited from referring to a testimonial concerning the adviser. "Testimonial" has generally been understood to include any favorable statement of a client's or investor's experience with, or endorsement of, the adviser. Nevertheless, the SEC staff has permitted the use of bona fide, unbiased third-party articles or reports about the adviser so long as the articles or reports do not include a statement regarding a client's or investor's endorsement or experience with the adviser.
The SEC staff has cautioned that reprints of such third-party reports remain subject to the general prohibition against false or misleading advertisements. The SEC staff has also permitted advisers to include partial client lists in advertisements, so long as the adviser does not use performance-based data to determine which clients to include and discloses the objective criteria used to compile the list and that it is not known whether the listed clients approve or disapprove of the adviser or its services.
Advisers should also keep in mind that the use of social media by the adviser (or the use of social media by employees of the adviser) may have regulatory implications, as endorsements or other positive references by clients or investors made publicly available via social media outlets such as Facebook, LinkedIn or Twitter could be viewed as testimonials by the SEC.
Advisers are generally required to retain a copy of any advertisement for not less than five years from the end of the fiscal year in which the advertisement was last published or otherwise disseminated, with the records maintained in an appropriate office of the adviser for the first two years. If an advertisement contains performance data, an adviser must keep true, accurate and current records of any documents that are necessary to demonstrate the calculation of the performance for a minimum of five years after the last advertising material that includes the relevant performance is disseminated.
For example, if a 2011 private placement memorandum includes performance information for a 1995 vintage year fund, supporting documentation for the 1995 fund performance calculations must be kept until the end of 2016. Appropriate records reflecting performance of accounts from a prior adviser must be kept if the performance of such accounts is included in the successor adviser's current advertising materials.
Newly registered advisers that are required to register with the SEC pursuant to the elimination of the "private adviser" exemption may continue to use performance information relating to the period prior to registration without being subject to the record-keeping requirements for that time period. However, to the extent that a newly registered adviser preserved such performance information even though it was not required to, the adviser must continue to preserve its records.