Under Rule 206(4)-1(a)(1) of the Investment Advisers Act of 1940, it is a fraudulent, deceptive or manipulative act for an investment advisor to “directly or indirectly” publish, circulate or distribute any advertisement that “refers, directly or indirectly, to any testimonial of any kind concerning the investment advisor or concerning any advice, analysis, report or other service rendered by such investment advisor [emphasis added].”
While this rule does not define the term “testimonial,” the Securities and Exchange Commission consistently interprets it to include a statement by a current or former client that either endorses the advisor or refers to a favorable investment experience with the advisor. An “indirect testimonial” would include an investment advisor publishing a favorable statement or endorsement attributed to its client (e.g., “our clients tell us that we are the best investment advisors in the business.”).
Based on the SEC's broad interpretation of the word “testimonial” and the drafting of the rule itself, the ban on testimonial advertising has been extended not only to indirect testimonials, but to testimonial statements that have practically nothing to do with investment-related activities.
Why Testimonials Are Prohibited
According to the 1961 Adopting Release to Rule 206(4)-1, the rule contemplates that “advisors are professionals and should adhere to a stricter standard of conduct than that applicable to merchants; securities are ‘intricate merchandise’; and clients or prospective clients of investment advisors are frequently unskilled and unsophisticated in investment matters.”
Simply put, the SEC determined over 50 years ago that investment advisory clients are incapable of critically evaluating testimonials applied to investment advisors, even though they may be capable of evaluating testimonials proffered by merchants in practically any other industry. Apparently, the SEC has not changed this attitude since that time.
Nonetheless, testimonials are prohibited because from the SEC's perspective they are likely to create a deceptive or mistaken impression that all of the advisor's clients or investors typically experience the same favorable results as the person providing the testimonial, and testimonials emphasize favorable experiences and do not account for unfavorable experiences.
Testimonials Only Prohibited in Ads
Critically, the prohibition against testimonials is limited to their use in an advisor's advertisements. Rule 206(4)-1(b) currently defines an 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, that offers any analysis, report or publication concerning securities or that 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 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 any other investment advisory service with regard to securities.”
Given this limited definition of advertisement, one would reasonably assume that a client testimonial stating absolutely nothing about an investment advisor's advisory services would fall outside the scope of the prohibition. For example, it would seem reasonable that clients’ statements about an investment advisor representative having general industry knowledge or high moral character would not violate the ban on testimonials, since they do not seem to involve any analysis, advice or service related to securities. However, there are published no-action letters and SEC releases that challenge this assumption and evince the SEC's intent to prohibit practically any testimonial advertisements that even mention an investment advisor.
Examples of SEC Interpretation
In the SEC's 1995 no-action letter regarding Gallagher and Associates Ltd., an investment advisor providing only financial planning services sought no-action relief relative to publishing comments from his clients about his “religious affiliation or general moral character; community service; trustworthiness and ethical character; diligence and attention to details; ability to listen and be sensitive to client needs; knowledge of investing, insurance and tax strategies (but never with reference to attained return on investment); and prudence and judgment.”
The SEC denied no-action relief based on the fact that the rule prohibits the use of testimonials “of any kind.” This denial ignores the concept that such statements fall outside the ambit of Rule 206(4)-1(b)'s definition of advertisement since they barely relate (if they relate at all) to advice regarding securities or investment advisory services.
To the SEC's credit, perhaps the trigger point was the proposed statements about this investment advisor's “knowledge of investing,” since that could potentially involve “any other investment advisory service with regard to securities.” However, the published no-action letter simply concludes with little explanation that the proposed use would constitute an impermissible testimonial.
In a CIGNA Securities no-action letter, the SEC denied no-action relief for the proposed use of written statements from financial planning (and not investment management) clients “to the effect that such persons are, in fact, satisfied clients.” The requesting party stressed that the underlying purpose of 206(4)-1 is to address the “basic concern and potential abuse” relating “to the manner in which traditional investment advisors portray and advertise their track records.” The requesting party further argued that “Rule 206(4)-1, which was adopted to deal with potential abuses by traditional investment advisors, should not be applied in a mechanical fashion to a fundamentally different kind of activity [i.e., financial planning] that does not involve the same potential abuse.” Once again, the SEC ignored these key distinctions and simply determined that the proposed statements would constitute impermissible testimonials.
Following this logic, Advisers Act Release No. 1490, issued in May 1995 against Louis Corujo, establishes that from the SEC's perspective, signed quotes from satisfied financial seminar participants that described how the seminar benefited the participants also constitutes the use of testimonials. Again, the link between such signed quotes and the definition of advertisement is questionable at best, especially considering that it would be practically impossible to provide individualized investment advice in that setting. However, the SEC clearly reads the testimonial prohibition broadly enough to encompass these quotes as well.
In light of the above, investment advisors should think twice before publishing any advertisement that could potentially constitute a testimonial advertisement in the mind of the strictest possible regulator applying the broadest possible definitions. In all likelihood, such statements should be avoided at all costs.
--- Read "Where FINRA, SEC and NASAA Are Really Focusing This Year" on ThinkAdvisor.