In a September risk alert, the SEC’s Division of Examinations put investment advisers on notice to review their written policies and procedures for the new marketing rule before the November 4, 2022, compliance deadline. This served as more than encouragement, as the examinations staff advised that they will be conducting “a number of specific national initiatives” to ensure compliance with the new rule. As discussed in Bates’ previous post on compliance preparation for the marketing rule, there’s a lot to review because the new marketing rule consolidates previous SEC guidance, no-action letters, and exam findings on questions concerning recommendations, testimonials, and the presentation of performance metrics. Here’s the latest on what the SEC wants you to know.
Specifically, the Division of Examinations alerted the industry that the scope of its initial examination efforts will prioritize four areas: (1) policies and procedures; (2) the “substantiation requirement;” (3) books and records requirements; and (4) the “performance advertising” requirement and related prohibitions. These four areas are not surprising, and the staff provided some useful guidance around the first three areas:
One area where additional guidance from the SEC would have been helpful is performance advertising. The alert discusses what the examination staff plans to review in this area, but an “FAQ” with proactive guidance from the Division of Investment Management would likely have been more helpful. Left to fend for themselves, firms are well advised to consider the general prohibitions of the new marketing rule when disclosing performance, and to take a conservative approach. General prohibitions include:
A particular area of concern regarding the disclosure of past performance involves well-accepted practices for private equity firms in this area. These firms usually present fund returns without deducting fees and expenses. As of November 4, 2022, private equity firms must disclose returns net of expenses. While this may seem straightforward, the nature of the deals involved in this area, and the valuation of such deals, involves a great deal of judgment when determining the past performance to be disclosed. For example, unrealized investments require private equity managers to estimate their allocation of deal profits before they know with some level of precision how much they will in fact earn. Further complicating the effort is the fact that the SEC did not provide specific guidance on how to address such circumstances, leaving firms to make their best determination on proper disclosure.
In terms of where the SEC may be headed next, the Division of Examinations and Division of Enforcement’s “playbook” for Reg BI for the brokerage industry may provide some guidance. With regard to Reg BI, then as now, the Division of Examinations issued a risk alert prior to the Reg BI compliance deadline. It then conducted initial examinations that purportedly focused on gathering information and intelligence for the SEC regarding compliance with Reg BI, with more in-depth examination following. If a similar approach is taken here, we can expect a first wave of new marketing rule examinations, followed by more in-depth and potentially aggressive later round examinations, and we believe it is prudent to be prepared for potential first wave examinations. The key will then be to follow developments coming from the first wave of examinations to enhance and improve policies and procedures in order to avoid referrals to the Division of Enforcement for investigations of violations of the new marketing rule.
Foley partners Jim Lundy and Peter Fetzer published the above article in the Investment Adviser Association’s IAA Today online newsletter. It is reprinted here by permission and can be accessed at https://investmentadviser.org/iaatoday/iaa-voices/new-marketing-rule-initial-exam-expectations/. (Subscription may be required.)