Before the 1934 baseball season, St. Louis Cardinals’ pitcher, Dizzy Dean, was asked how many games he and his brother, Paul “Daffy” Dean, would win that year. In response to the question, Dizzy said that he and his brother, who were considered the nucleus of the pitching team, would win 45 games that season for the Cardinals. Dizzy Dean was quoted as saying, “It ain’t bragging if you can back it up.” As it turned out, the Dean brothers won 49 games that year and led the Cardinals to a championship.
When it comes to RIA advertisements, advertising rules prohibit bragging. Every statement must be backed up with substantive evidence. A firm may not use glowing adjectives to describe itself unless there is hard evidence proving these descriptions are accurate and truthful. The marketing propaganda we see in general advertising is inappropriate for RIAs.
Just as investment advisors have different business models, they also have very different perspectives on advertising. Some RIAs view advertising as unnecessary, relying on word of mouth to build their client base, while other investment advisors spend a significant amount of time engaged in advertising and marketing. Almost all RIAs have websites, and some advertise on billboards and benches, all of which are subject to advertising regulations.
Noncompliant advertisements can lead to problems. Section 206 contains the anti-fraud provision of the statute, and ensures that RIAs’ advertising and marketing practices are consistent with the fiduciary duty owed to clients and prospective clients. Section 206 enjoins an RIA from employing any device, scheme, or artifice, which defrauds any client or prospective client. An RIA may not engage in any transaction, practice, or course of business that operates fraudulently upon any client or prospective client.
As we have stressed on several occasions, violations of Section 206 of the Investment Advisers Act are viewed as the most serious transgressions committed by an RIA. Rule 206(4)-1 under the Act, as well as various no-action letters, show RIAs how to advertise honestly. State-registered investment advisors are usually bound by similar rules.
Rule 206(4)-1 Prohibitions
There are five prohibitions found in Rule 206(4)-1, and each is intended to stop false or misleading advertising and marketing practices.
- Rule 206(4)-1(a)(1) forbids the use of testimonials, whether express or implied. The SEC does not permit them, because testimonials imply that every client had a positive experience with the RIA. This prohibition often comes as a surprise to IARs who used to be registered representatives, because brokers are permitted to use testimonials subject to certain restrictions.
- Rule 206(4)-1(a)(2) restricts advertisements from referring to specific recommendations made by an RIA, which were or would have been profitable to any person. This does not stop an RIA from advertising or offering a list of all recommendations made during the immediately-preceding period of not less than one year. If the list is furnished separately, it must comply with very specific regulatory requirements.
- Rule 206(4)-1(a)(3) precludes references to a graph, chart, formula, or other device that can be used by itself to make investment decisions, unless the advertisement prominently discloses the limitations of this approach. For example, an RIA may not use an advertisement touting a market-timing formula without disclosing its limitations.
- Rule 206(4)-1(a)(4) prevents an RIA from using an advertisement offering a free report, analysis, or other service, unless it will, in fact, be furnished entirely free and without obligation.
- Rule 206(4)-1(a)(5) prohibits the use of an advertisement containing any untrue statement of a material fact or that is otherwise false or misleading.
Rule 206(4)-1(a)(5) is a catch-all provision that can be rather subjective. Whether an ad is misleading often depends upon the person reading it. Furthermore, an examiner’s opinion, like a baseball umpire’s, is usually the last word when evaluating whether an ad violates Rule 206(4)-1.
Determining whether an advertisement is false or misleading depends upon the facts and circumstances surrounding its use, including the:
- form and content of the ad;
- implications or inferences arising out of the ad’s content; and
- sophistication of the prospective client.
Many state advertising regulations are modeled after Rule 206(4)-1 or have been incorporated by reference. The definition of an advertisement, however, may be slightly different.
Definition of Advertisement
Rule 206(4)-1(b) under the Investment Advisers Act of 1940 defines “advertisement” as any:
“notice, circular, letter or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television, which offers (1) any analysis, report, or publication concerning securities, or which is to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (2) any graph, chart, formula, or other device to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (3) any other investment advisory service with regard to securities.”
In the context of the SEC rule, written communication to one person is not an advertisement. Generally, if the same or similar communication is directed toward more than one person, it is viewed as an advertisement. Some state rules define advertisements as communication to more than five persons or utilize a different threshold in their definition. Certain states require that all advertisements be submitted to securities regulators before being used. The SEC rule does not impose this requirement.
An SEC-registered investment advisory firm is not required to retain advertisements unless they are sent to ten or more individuals. Nevertheless, an RIA should create an advertising file including all advertisements, even those that were sent to just a handful of potential clients.
Securities regulators view performance advertising suspiciously. They recognize that prospective clients will often hire an RIA based on the firm’s returns. Unfortunately, performance data advertised by RIAs is not always reliable.
Performance advertising does not always take the form of a chart or graph, and in fact, a statement referring to the RIA’s track record might be construed as performance advertising. Similarly, stating that the firm beat the Dow or some other benchmark might be viewed as performance advertising.
Performance advertising should comply with guidance found in the Clover Capital no-action letter. Although no-action letters from the SEC do not have the force of law, they help explain the Commission’s interpretation of rules and regulations. RIAs who adhere to advice in these no-action letters will be in a good position if challenged by examiners during an audit.
Clover Capital stands for the proposition that all performance results must be presented on a net-of-fees basis. Nothing stops an RIA from presenting results on a gross-of-fees and net-of-fees basis, as long as those returns are presented in equally prominent type. In other words, an RIA should not bury its net-of-fees results in a footnote or in some other obscure place.
Generally, reports to clients are not advertisements. Some advisors, however, show samples of these reports with names redacted to prospective clients, and at that point, the reports become advertisements. The advisor commonly chooses a report with the highest return as a sample, and the RIA is likely to be accused of cherry-picking a report showing the firm in the most favorable light.
A one-on-one presentation is technically not an advertisement. If that same presentation is used to court more than one client, however, it is likely to be viewed as an advertisement.
In distinguishing advertising from ordinary communications, it is helpful to look at a few examples. A letter or email to clients to allay their fears about the debt ceiling crisis, or the Standard and Poor’s downgrade of United States debt, is likely to be an example of ordinary communication, not an advertisement. However, if an RIA’s letter or email suggests that now is a good time to invest more money or offers additional advisory services, there is little doubt that it is an advertisement. Furthermore, if the communication encourages a client to tell his or her friends about the RIA, it is an advertisement.
Advertising Books and Records
Advertisements utilized by RIAs must be retained for five years. All versions of a firm’s website must also be kept for five years, and RIAs must retain emails meeting the definition of advertisement in their advertising file. As we saw in Client Communication and Miscommunication, certain emails must be retained as part of an RIA’s books and records obligation.
Books and records issues also arise when IARs use their smart phones to communicate with current and prospective clients. It is imperative that these communications are captured on the firm’s server and retained in accordance with books and records requirements. As we will see in Use and Misuse of Social Media, RIAs using social media to market their services must archive and review those communications.
As noted above, performance advertising attracts regulatory scrutiny. Securities regulators look closely at how performance results are calculated. The Books and Records Rule requires RIAs to retain all accounts, books, internal working papers, and any other records or documents necessary in calculating the performance or rate of return of any or all managed accounts or securities recommended in any notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication that the firm circulates or distributes, directly or indirectly, to ten or more persons.
When advertising their services, investment advisors are usually marketing themselves. In many cases, the intent of their advertisements is to demonstrate the advisor has considerable investment and financial expertise. To achieve that goal, it is common for IARs to list their designations and educational credentials in advertisements. Designations and educational credentials show that IARs are dedicated to their profession, and are extremely useful for investors attempting to choose an advisory firm.
Although designations are indicative of an IAR’s competence and professionalism, they can also be misleading to an unsophisticated investor. Securities regulators scrutinize these designations, especially if they might be misleading to a senior investor.
In Part 2B of Form ADV, IARs are permitted to list their designations. They are not required, however, to disclose them. If they do, IARs must provide sufficient information for clients to understand the nature of the designations. Part 2B requires that brochure supplements explain the qualifications required to earn and retain a designation. While some designations require mandatory completion of rigorous exams, as well as having worked in a particular field for several years, others can be obtained with little effort and payment of a fee. In some cases, financial professionals are using a self-conferred designation.
Many of these designation issues arise in the context of the so-called “free-lunch seminars” that securities regulators routinely scrutinize. Regulators are worried that senior citizens are being sold unsuitable investments at these seminars by individuals who purportedly have special qualifications to help older investors. A study conducted by FINRA found that roughly 25 percent of senior investors were told by financial professionals that they had received special training to give advice to seniors. These assertions influenced the investor’s willingness to listen to the person’s advice.
In a publication entitled “Senior” Specialists and Advisors: What You Should Know About Professional Designations, the SEC warns investors that some professional designations represent legitimate expertise, while others are a marketing tool. Some designations are a little bit of both. The SEC advised investors that:
“Some financial professionals use designations that imply that they are experts at helping seniors with financial issues. Many seniors, however, don’t understand the sets of initials that may follow the names of these financial professionals or the meaning of the titles - such as “senior specialist” or “retirement advisor”—they use to market themselves.
The education, experience, and other requirements for receiving and maintaining a “senior” designation vary greatly. In some cases, a financial professional may need to study and pass several rigorous exams—after working in a designated field for several years—to receive a particular designation. In other cases, it may be relatively easy in terms of time and effort to receive a “senior” designation, even for an individual with no relevant experience.”
The online version of this publication (www.sec.gov/investor/pubs/senior-profdes.htm) provides a link to FINRA’s website. Investors can look up the meaning of a designation and what requirements must be satisfied to earn it. FINRA does not, however, approve or endorse any particular professional designation.
Compliance examiners worry most about senior designations and titles awarded for little or no effort. Nevertheless, IARs and registered representatives should be cautious in how they describe all of their credentials. An improperly-used designation may raise issues with securities regulators.
The Nebraska Department of Banking and Finance, Bureau of Securities, has issued an interpretive opinion regarding the use of designations and certifications in advertising by IARs and agents of broker-dealers. Nebraska asserts that using a certification or designation on business cards, stationery, and in advertisements, creates the impression that the IAR or registered representative has special qualifications in a certain area of finance or financial planning. This state is especially concerned about designations and certifications, which incorrectly imply expertise in addressing the financial needs of senior citizens.
In accordance with Interpretive Opinion No. 26, IARs and registered reps may only use designations approved by the Commissioner. They risk fines or suspension for using unapproved designations. All certifications and designations that are acceptable for use in Nebraska at this time are listed in the opinion. The list is revised regularly and additional designations will be approved. The interpretive opinion and the list can be found at: http://www.ndbf.org/.
Similarly, a Massachusetts regulation forbids the use of a credential or professional designation indicating or implying that the agent of a broker-dealer is trained or certified to help senior investors, unless it has been accredited by an organization recognized by the Secretary of the Commonwealth. The regulation defines “senior investor” as a person who is age 65 or older.
In October and November, 2008, Alabama and California joined a growing number of states adopting regulations based on NASAA’s model rule relating to use of senior certifications and professional designations. Many other states have followed suit and adopted similar regulations to protect senior investors.
Other Compliance Issues Arising from Designations
It is not just designations targeted toward senior investors which cause problems for an RIA and IAR. While securities regulators have turned their attention in recent years to senior designations, examiners have always been on the lookout for questionable credentials. Examiners will scour a firm’s marketing materials and website determining if references to credentials or designations are questionable.
Using the acronym, RIA, can cause trouble for an advisory firm. Placing RIA after an advisor’s name insinuates that a designation was awarded. Similarly, it is inappropriate to utilize IAR in a manner that appears to be a designation. An RIA may not state or imply on its website that the firm is sponsored, approved, or recommended by the SEC or state regulators.
The issue of credentials and designations may arise in a different context. Suppose an IAR has graduated from law school but never passed the bar. An examiner may object to the IAR’s use of the Juris Doctor (JD) designation after his or her name. An examiner may be concerned that clients will infer that the IAR is a licensed attorney in that particular jurisdiction and might be misled. There have also been questions raised about the use of the Certified Public Accountant (CPA) designation by IARs. It may be misleading for IARs to use the CPA designation unless they have an active license, which requires them to take continuing education courses. An examiner may expect the advisory firm’s marketing materials to reflect that the IAR’s CPA license is inactive.
The Big Picture
Whether a letter or email is an advertisement or not, an RIA should be certain that it is not misleading in any way. Deciding whether an item is an advertisement or not is very important from a books and records perspective. Firms retain advertisements in a separate file than client communications. Most RIAs have a policy and procedure, requiring submission of an advertisement to the firm’s CCO before it is utilized. This pre-approval is not usually required with routine client communications, although CCOs are required to supervise them.
Website content should also be approved before it is posted. Policies and procedures should require that website content be reviewed on an ongoing basis ensuring that statements have not become stale and misleading. For example, an RIA referring to its assets under management on the firm’s website must keep those figures up to date. In addition, some advisory websites refer to IARs no longer with the firm or investment strategies no longer being utilized.
It is not just an issue of which designation is being used by an advisor. Regulators will look at the context in which the designation is used. Using a questionable designation at a “free lunch” seminar where high-commission products are sold exacerbates potential compliance problems. Regulators get a negative impression if the invitation and ads for a seminar contain too much hype, along with references to a misleading designation. Furthermore, when a questionable senior designation is used to influence the sale of an unsuitable product to an elderly investor, it might create a perfect storm for compliance problems.
A designation will be particularly offensive to a securities regulator if an IAR or registered representative embellishes the requirements for earning it. One firm referred to a certain senior designation as having a “rigorous” academic program to qualify. In fact, the academic requirements for obtaining the designation were far less than rigorous.
Designations, certifications, qualifications, and experience have always been, and will continue to be, extremely important in attracting clients to an advisory firm. IARs and registered reps should not hesitate to use those credentials when communicating with potential clients, as long as they represent meaningful achievement and are not misleading.
RIAs should also exercise caution when advertising third-party ratings and awards. It is imperative that they disclose the criteria on which the ratings and awards were based and must provide a number of other disclosures. A full examination of these issues can be found in my book, Growing within the Lines: The Investment Adviser’s Advertising and Marketing Compliance Guide, which was also published by The National Underwriter Company/Summit Business Media.
At a seminar for RIAs in October 2011, a Pennsylvania compliance examiner said that he will sometimes look at RIA advertisements to determine which firms to examine. If an advertisement is misleading or promises too much, the RIA may become the subject of an examination. Therefore, the advertisement created to attract clients may also be attracting regulatory attention.
Social media used by RIAs and IARs is also likely to attract regulatory scrutiny. As RIAs build their brands on the Internet, it will be obvious to regulators if advisors are making inconsistent and potentially misleading statements.