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SEC's Custody, Ad Rule Updates Nearing the Finish Line

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Two major rules are being overhauled by the Securities and Exchange Commission — the Custody and Advertising rules — and are nearing the finish line.

Each year, the Investment Adviser Association and National Regulatory Services provide a snapshot of the registered investment advisor universe via their Evolution Revolution report. As part of the report, IAA and NRS provide updates on critical rulemakings.

“We understand that there’s now a dedicated team in the Division of Investment Management that’s actively working to update” the custody rule, Karen Barr, president and CEO of IAA, told me during a recent Human Capital podcast. “We recommended a complete review and rethink of the rule.”

(See related: SEC to Vote on Long-Awaited Advertising Rule Changes Next Week

As the IAA/NRS report states, the regulatory framework under the Advisers Act Custody Rule “is overly complex, unduly burdensome, and has caused unnecessary confusion for advisors.”

Barr told me she expects the SEC to release its proposed changes to the Custody rule in the first quarter. The SEC’s Division of Investment Management is considering recommending that the Commission propose amendments to existing rules and/or propose new rules under the Investment Advisers Act of 1940 to improve and modernize the regulations around the custody of funds or investments of clients by advisors, the report explains.

“The common sense use of the word ‘custody’ is not matching up to how the SEC defines it,” Barr told me. “There are a lot of instances where the SEC is using the rule to try to get at identity theft rather than using identity theft rules. There are a lot of different ways that the SEC could make this rule more common sense and easier to apply in practice.”

SEC Plans

The SEC’s regulatory agenda said the agency planned to recommend adopting amendments to the advertising and solicitation rules for RIAs in October. That didn’t happen. Butthe SEC said it would vote Dec. 16 on the rules.

The Division of Investment Management plans to recommend that the commission adopt amendments to rules 206(4)-1 and 206(4)-3 under the Investment Advisers Act of 1940 regarding marketing communications and practices by investment advisors.

While the Evolution Revolution report found that advisors with at least one social media platform or website continued to increase, going to 12,047 in 2020 from 11,538 in 2019, the advertising rule has hampered advisors’ use of social media to attract clients.

“Almost all social media posts are subject to the SEC’s stringent” advertising rule, which hasn’t been materially changed since being adopted in 1961, the report states.

As it stands now, the advertising rule prohibits or restricts client testimonials, references to past specific profitable investment recommendations, and portfolio performance without substantial disclosure, according to IAA.

The confusion surrounding the custody rule stems from the fact that while advisors, in general, are prohibited from having physical custody of client assets, the IAA report explains, “advisors are also deemed to have custody under certain other circumstances. Many of the questions in Form ADV relate to advisors that are deemed to have custody, although to complicate matters further, advisors that are deemed to have custody for certain types of reasons (such as the ability to deduct fees) are not required to answer certain custody questions on Form ADV.”

Further confusion has ensued since the SEC staff released an Inadvertent Custody Guidance Update. This indicates that an advisor may have “inadvertent custody” if the client’s custody agreement contains broad authority for the advisor to instruct the custodian, even where the advisor is not a party to the custody agreement and that authority is inconsistent with the advisor’s agreement with the client, the IAA report states.

Also, the guidance “calls into question the industry’s understanding of the authorized trading exception to the Custody Rule, which has significant implications for instruments that are not processed or do not settle on a ‘delivery versus payment’ basis (non-DVP).”

Dalia Blass, head of the IM Division, stated at IAA’s compliance event in early March, that the agency was still digesting the comments that have come in regarding the definition of advertising — the scope — and “the compliance review aspect of the proposal” as well as “where those two areas can present potential problems.”

The comment period on the ad rule proposal ended Feb. 10.

Blass explained that the proposal affects “a diverse community” of investment advisors and their advertising and solicitation duties, along with retail and institutional investors as clients as well as private funds and robo-advisors.

Putting the advertising rule changes together “was not an easy task,” Blass said. “It was one of the harder proposals for us to bring together,” considering the rule predated the internet as well as other market and technology developments.

IAA’s report states that the current regulatory framework governing advertising by investment advisors “is unnecessarily complex, overly broad in reach, unduly prescriptive, and involves a complex maze of enforcement actions and several decades’ worth of SEC staff no-action letters and interpretive releases that are difficult to decipher and apply to evolving circumstances.”

The Advertising rule “prohibits or restricts client testimonials, references to past specific profitable investment recommendations, and portfolio performance without substantial disclosure.”

Applying the Advertising rule “to traditional media is already a challenge, let alone to interactive environments,” the report states.

The proposed rule would move advertising compliance “from a rules-based model to a risk-based (or principles-based) model, under which an advisor would be required to develop and enforce policies and procedures to prevent its advertisements from being false or misleading,” the IAA report states.

If adopted, the risk-based approach “could make social media more attractive for advisors, although the proposed rule also includes onerous requirements for the review and presentation” of ads.

RIAs’ Social Media Use in 2020

As the IAA/NRS report found last year, LinkedIn is the preferred social media site for advisors, with over 44% of all advisors (5,976) reporting at least one LinkedIn page — a 16% increase since 2019, the Evolution Revolution report found.

While LinkedIn typically is considered a business and professional networking platform, it does offer marketing and advertising services, the report notes.

Consumer-oriented services such as Facebook and Twitter “are by far the next most popular platforms” among advisors, with Facebook claiming 2,869 advisor users (up 15% from 2019) and Twitter being used by 2,593 advisors (up 10% from 2019).

“While these increases are more modest than those seen in 2019, the fact that users are steadily increasing every year indicates that firms, while still generally reluctant, are starting to embrace social media as a necessary element of their marketing strategies, despite the compliance challenges they present,” the report notes.

Other social media platforms used by advisors include YouTube (830, up 20% since 2019), Instagram (639, up 45%), Vimeo (84, up 25%), and SoundCloud (77, up 17%).

Top States for Advisors

As to where advisors are headquartered, the IAA/NRS report found that New York still holds the most, with 2,512 advisory firms in 2020, up from 2,449 in 2019. California comes in second, with 1,630 firms versus 1,585 in 2019. Texas has 767 firms, up from 713, while Massachusetts comes in fourth at 604 firms, up from 592 last year.

Coming in fifth and sixth are Illinois, with 601 firms, up from 586 in 2019 and Florida, with 567 firms, up from 509 last year.

Washington Bureau Chief Melanie Waddell can be reached at [email protected].


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