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Shaking the Magic 8 Ball
A Biennial Retrospective on the Marketing Rule
Paul Felsch
November 29, 2024
EXECUTIVE SUMMARY
Even with its relative newness still, the Marketing Rule has received considerable commentary and attention from the SEC since its November 2022 compliance date. While this commentary and attention have been voluminous and accumulated rapidly, they also afford investment managers with ample source material for guidance on how to administer their own advertising practices and policies & procedures.
All topics within the Marketing Rule have garnered attention from the SEC to one degree or another (e.g. performance, testimonials and endorsements, third-party ratings, unsubstantiated claims, etc.). However, when looking at focuses of enforcement matters in particular, the use and dissemination of hypothetical performance (specifically on an investment manager’s public website) has represented the clear majority topic. The runner-up is investment managers being unable to substantiate a variety of claims in their advertisements.
Additionally, when examining the 27 Marketing Rule enforcement actions that have settled since November 2022, data regarding fine amounts affords investment managers with a rough but not insignificant window into how the SEC determines fines for Marketing Rule actions. The enforcement matters suggest that, subject to particular facts circumstances, an investment manager could generally expect a fine representing .01%-.04% of AUM, with fines potentially amounting to 0.2% of AUM when numerous types of Marketing Rule violations are noted in a single action.
While the data on enforcement action fines can aid investment managers and their Compliance professionals in forecasting potential risk, it is feasible to avoid such scenarios altogether through fine-tuning various practices. Such measures can include: regular reviews of public website pages, augmented policy & procedure testing, robust maintenance of records supporting claims made in advertisements, focused Form ADV reviews, use of detailed advertising review checklists, and prudent use of data.
INTRODUCTION
I’m not sure I’d call it teary eyed nostalgia or sentimentality that prompted this month’s essay (though I admit I can be prone to both). But something about this month marking the two-year anniversary of the Marketing Rule’s November 2022 compliance date seemed to make for a fitting reason to look back and explore how the Rule has played out since. It’s been an active two years, to say the least. Since the Marketing Rule took effect, the SEC has levied fines totaling nearly $4 million against 27 different firms for various violations thereof, with amounts ranging from $20,000 all the way up to $850,000, and ensnared firms ranging from $42 million to $5.2 billion in assets under management. SEC staff have also issued three formal pieces of guidance regarding the Rule in this time, and there have been various remarks from Chair Gensler himself. In many respects, with the volume of activity surrounding the Marketing Rule, and the dimensionality of it, it feels like being peppered with responses from a Magic 8 Ball, some of which may be more helpful or well-received than others.
This month’s essay is intended to take this multidimensional and rapidly accumulated body of information and consolidate and make sense of it for your use (and I hope interest). To that end, this month’s essay is structured to accomplish the following:
Share common risks, deficiencies, and violations SEC staff and the SEC have noted in the course of examining registrants and enforcing the Marketing Rule;
Identify Marketing Rule topics and conduct that appear to be points of focus in SEC enforcement actions in particular
Enable registrants to more closely approximate the amount of potential fine exposure through examining data for the 27 Marketing Rule actions that have occurred since;
Provide investment managers with more fine-tuned measures that can mitigate the risk of Marketing Rule violations.
Additionally, taking a page out of the SEC’s playbook and using a layered approach, I have also included the following appendices as helpful aids for those who may have a desire or need to delve further into some of the things touched upon in the main body of this essay:
Appendix A, which providers a refresher on the more notable aspects of the Marketing Rule;
Appendix A.1, which provides a list of types of materials that typically do and do not constitute “advertising” under the Rule;
Appendix B, which provides detailed information on the 27 Marketing Rule enforcement actions mentioned above; and
Appendix C, which provides an example of the structure and content of an advertising review checklist an investment manager could employ and repurpose across multiple Marketing Rule topics.
And so . . . shake-shake. 🎱
🎱 MAGIC 8 BALL SAYS: “MY REPLY IS NO” 🎱
COMMON RISKS, OBSERVATIONS & VIOLATIONS
Risk alerts and guidance SEC staff issued shortly after the adoption of the Marketing Rule and issued in the years since provide investment managers with a reasonably reliable roadmap for what the SEC’s areas of focus and concern are for Marketing Rule compliance. Corresponding enforcement actions since the Rule’s adoption also provide clarity and particularity regarding the types of practices investment managers should seek to avoid.
Overall
In September 2022, two months before the Marketing Rule’s compliance date, SEC staff issued a risk alert identifying those aspects of the Rule it would be paying particular attention to when examining registrants. In June 2023, SEC staff issued another risk alert identifying and reinforcing areas of examination focus. These focal points are consistent with the topics the SEC took time to note specifically in its press release accompanying the adoption of the Marketing Rule (a summary of which I have selected for inclusion in Appendix A for those who may be in need of a quick refresher on the Rule). Subsequent to these two examination alerts, SEC staff also shared observations regarding common deficiencies found while examining investment managers’ marketing and advertising practices. And of course, a number of enforcement matters, as mentioned at the outset of this essay, have occurred as well. The table below is meant to highlight and summarize (though still comprehensively) particular advertising practices various investment managers have employed that SEC staff and the SEC have determined to be problematic or violative of the provisions of the Marketing Rule.
TABLE 1: EXAMPLE MARKETING RULE DEFICIENCIES & VIOLATIONS
Policies & Procedures | → Consisted only of general descriptions and expectations related to the Marketing Rule → Did not address applicable marketing channels utilized by the investment managers, such as websites and social media → Were informal rather than in writing - Were incomplete, not updated, or partially updated for certain applicable marketing topics → Were not tailored to address investment managers’ specific advertisements (e.g., policies and procedures to address the General Prohibitions, and advertising requirements for testimonials, endorsements, and third-party ratings utilized by investment managers in advertisements) → Did not adequately address the preservation and maintenance of advertisements and related documents, such as copies of any questionnaires or surveys used in the preparation of a third-party rating (in the event the investment manager has received such documents) included or appearing in any advertisement |
Books & Records | → Completed questionnaires or surveys used in the preparation of a third-party rating but did not maintain a copy of such questionnaires → Did not maintain copies of information posted to social media → Did not maintain documentation to support performance claims included in advertisements |
Endorsements | → Stated investment managers were “seen on” national media, implying appearances in national news media, without disclosing that the “appearances” were in fact paid advertisements → Included images of celebrities in marketing materials in a manner that implied the celebrities endorsed the firms when such celebrities did not endorse the firms |
Substantiation | → Represented that “[i]n the latest measure, the models are outperforming IMF forecasts by 34%, and the platform keeps improving” but was unable to produce records substantiating the claim → Disseminated advertisement in which it claimed principal “had been named one of the top wealth managers by the readers of San Diego Magazine for 14 consecutive years” without being able to substantiate that material statement of fact |
Untrue Statements or Omissions or Otherwise Misleading | → Stated that the investment managers were “free of all conflicts,” when actual conflicts existed → Stated material facts about the investment managers’ businesses that were inaccurate, including: → Described material facts about advisory services or products offered that were inaccurate, including → Publicized the receipt of certain awards or accolades that were not received → Statements that investment managers were different from other investment managers because they acted in the “best interest of clients,” without disclosing that all investment managers have a fiduciary duty to act in their clients’ best interests → Recommended certain investments (e.g., on podcasts or websites) without disclosing the conflicts of interest attributed to the compensation paid to or received by the investment managers for such recommendations → Cited SEC registration beyond factual statements as to investment managers’ registration status in a way to imply that SEC registration was representative of a particular level of skill or ability, or that the SEC had either approved or passed upon the investment managers’ business practices → Included SEC logo on their websites with the purpose of implying that the websites or the investment managers had been approved or endorsed by the SEC → Presenting disclosures on websites or videos in fonts or sizes that were unreadable |
Performance | → Advertised cumulative profits that the investment managers believed were not achievable or were impossible to achieve without unlimited money to invest → Presented performance information that did not provide adequate disclosure regarding the share classes included in the performance returns → Used lower fees in calculations for net of fees performance returns than were offered to the intended audience → Omitted material information regarding fees and expenses used in calculating returns → Advertised hypothetical performance on public website without adopting and implementing policies and procedures reasonably designed to ensure that the hypothetical performance was relevant to the likely financial situation and investment objectives of the intended audience → Did not disclose the time period or did not disclose whether the returns were calculated for the same time period as additional performance information included in the same advertisement → Included or excluded certain performance results in manners that were not fair and balanced, such as advertisements that included the performance of only realized investment information in the total net return figure and excluded unrealized investments → Advertised models would have outperformed a “Global 60/40 Benchmark” for the years 2015 through 2022, which predated the investment manager’s founding |
Testimonials | → Included testimonials from clients of a third-party product on the investment managers’ websites without any disclosures explaining the context of the testimonials, implying that the testimonials were about the investment managers’ services rather than the third-party product |
Third-Party Ratings | → Materials Implied investment managers were the sole top recipients of certain awards when the awards went to multiple recipients or the investment managers were not the top recipients → Materials indicated investment managers were highly rated by various organizations without disclosing that the methodologies for such ratings were based primarily or solely on factors that were not related to the quality of investment advice, such as assets under management, the number of clients, or that investment manager personnel nominated fellow employees for such awards |
Form ADV | → Reported on Form ADV, Part 1A, that investment managers’ advertisements did not include: |
Enforcement Matters
While the foregoing table is meant to summarize observations and findings the SEC and SEC staff have made across a variety of aspects of the Marketing Rule, when looking at practices that resulted in enforcement actions, a more precise picture comes into focus. In evaluating the 27 Marketing Rule enforcement actions, the aspect of the Rule the SEC most commonly addresses and notes is use of hypothetical performance (in particular on websites). As seen in the below chart, hypothetical performance appeared, exclusively or in part, in 16 out the 27 actions. The next closest topic was unsubstantiated, followed by a relatively close cluster of others.
Accordingly, when using hypothetical performance in advertising materials (particularly on websites), investment managers should be acutely aware the level of scrutiny it has received from the SEC thus far. Additionally, managers should also be sure that any claims made in their advertising materials can be reasonably substantiated. Last, managers should also be acutely aware of information posted on their websites generally, as many of the problematic practices the SEC cites in these actions are website-based. Appendix B provides additional detail regarding the particular facts and circumstances underlying each of these 27 actions.
🎱 MAGIC 8 BALL SAYS: “YOU MAY RELY ON IT” . . . SORT OF 🎱
WHAT THE FINE DATA SAYS
In examining the fine amounts in the 27 enforcement actions and certain factors in relation thereto, a somewhat consistent pattern and forecasting mechanism emerges. While it should not be taken as an absolute, this pattern and mechanism can allow investment managers and their Compliance personnel to assess what their financial exposure would potentially be in light of any problematic practices they may be employing. It can also serve as an advocacy tool should an investment manager ever find itself in the unfortunate situation of settlement discussions with the SEC.
Fines as Percentage of AUM
As mentioned in the Introduction of this essay, for the 27 enforcement matters, the fine and registrant sizes vary to a fair degree. Fines range from $20,000 all the way up to $850,000, and ensnared firms ranging from $42 million to $5.2 billion in assets under management. Viewed through the lens of fines as a percentage of assets under management, the range includes fines as low as .01% of assets under management, up to .20% of assets under management. Notwithstanding this superficial disparateness, a closer look at the data, as the below table that shows the fine amounts in percentages of assets, suggests a greater degree of consistency:
Global Predictions did not have any regulatory assets under management given the nature of its business. Therefore, ascribing a fine as a percentage of its assets was not mathematically possible.
When unpacking these figures, a few notable aspects can be observed. Notwithstanding the range(s) mentioned previously, the mode fine (i.e. the fine amount that appears most often in the series) is .01% of assets under management (representing 10 out of the 27 actions). The average fine amount correlates to a .04% of assets under management, and the median fine amount correlates to .02% of assets. If an investment manager wished to roughly predict what their financial exposure may be in connection with potentially problematic advertising practices, one could conceivably forecast something in the .01%-.04% range, recognizing that .2% is still a possibility.
Fines as a Percentage of AUM & Number of Violation Types
An investment manager, however, does not need to necessarily settle for this type of crude forecasting pattern and mechanism. In fact, given some of the apparent outliers in the above table, it begs the question what may be driving those fines that represent a greater percentage of assets. While it is difficult to calculate the number of different violations in the actions given the SEC often notes conduct that merely serves as example of problematic practices, one is able to at least count the number of different aspects of the Marketing Rule the actions cover. As such, I decided to ask whether the number of different types of violations could possibly account for those fines that fall above the mode, median, and average figures noted above. The following graph depicts the intersection of these two factors (i.e. percentage of assets under management and number of violation types):
Unpacking the above graph, it seems an investment manager could potentially forecast that, if the manager only has one type of problematic Marketing Rule practice, its fine amount would likely correlate to .01%-.02% of their assets, and that as the number of different types of violations increases, so does the percentage amount of assets under management for the fine. By what factor, exactly, is more challenging to pinpoint. As the above graph illustrates, as the number of violation types increases beyond two, there does not appear to be the same relatively consistent degree of correlation between number of violation types and percentage of fine amounts as there appears when number of violation types are two are less.
Of course, there are other imperfections and unexplainable points in the above data that should prompt an investment manager to proceed with caution when attempting to forecast potential financial exposure relative to their advertising practices, at least when they believe they may have potential issues with more than two topics. First, in the Trowbridge matter, Trowbridge only had one type of violation – hypothetical performance – and the fact pattern is virtually identical to the McElhenny, Linden, and Elm matters. And yet, Trowbridge’s fine represented .14% of its assets under management, whereas the other registrants’ fines represented .01%-.02%. The Banorte and BTS matters also have a similarly perplexing complexion. Three, the severity of the violation, the SEC’s perceived degree of an importance of a particular topic, and any number of other qualitative factors can undermine reliable forecasting. For example, in the Delphia matter, there was only one type of violation – AI washing – but it resulted in a fine amount correlating to .12% of assets under management. Presumably this is due to AI washing being a particularly passionate topic for Chair Gensler, who on numerous occasions has remarked how seriously the SEC will treat the topic. Whether and/or when the SEC or SEC staff decide to place similar levels of importance on other topics is of course inherently unpredictable. And last, 27 actions is not necessarily a statistically significant sample size, particularly when within those actions the type of conduct focused on by the SEC is predominantly hypothetical performance, potentially making how the SEC may handle other violation types less certain.
Notwithstanding these and other challenges in this data, the data observations do not seem entirely useless. First, there does appear to be a relatively confined range of fine percentages (.01%-.2%) amid a notable range of number of violation categories (ranging all the way up to one manager experiencing seven different violation types in a single action, six of which related to the Marketing Rule). Two, for the majority of actions (albeit a simple 18 out of 27), the SEC only found one type of problematic practice relative to the Marketing Rule, and only three of those actions (Trowbridge, Banorte, and BTS) represent outliers relative to their fine amounts correlating to percentage of assets. For those three outlier actions, it is notable that they occurred in September 2023, which represented the SEC’s first true wave of Marketing Rule enforcement actions. This could suggest the SEC itself may have still been in the process of creating a reasonably consistent approach to determining fine amounts. And three, part of what can account for different fine percentages notwithstanding seemingly similar conduct and practices is a manager’s ability to negotiate with SEC. On this end, the data and observations noted in the above graph can equip a manager with information that could prove beneficial should a manager ever find themselves in enforcement settlement discussions with the SEC.
🎱 MAGIC 8 BALL SAYS: “CONCENTRATE AND ASK AGAIN” 🎱
FINE TUNING MITIGATING MEASURES
With the information made available regarding how the SEC and SEC staff approach administering the Marketing Rule, a number of refined measures emerge for investment managers to employ. These measures could potentially reduce the risk of Marketing Rule violations and corresponding regulatory exposure.
Between the three risk alerts the SEC has published since the Marketing Rule’s adoption, various statements by the SEC Chair, and the 27 enforcement actions that have occurred since the Rule’s compliance date, there is an ample body of “lessons learned” that should guide investment managers in how they implement and administer the Rule in their own shops. These alerts, statements, and actions speak to “lessons learned” more at the thematic level. However, the below is meant to identify more fine-tuned, practical measures investment managers can employ to increase their chances of compliance with the Rule and reduce potential regulatory vulnerability in light of the recent landscape.
Fine-tuned Mitigating Measures
Augmented Policy & Procedure Testing
Do not wait until the annual 206(4)-7 Compliance review to test the adequacy of design and operating effectiveness of policies & procedures. Instead, consider treating the Marketing Rule as a higher risk Compliance program topic and testing corresponding policies & procedures, or at least certain provisions therein, on a more frequent basis, such as semi-annually, quarterly, or even monthly depending on how much advertising content your firm produces.
Periodic Website Reviews
As a sub-part of an investment manager’s 206(4)-7 testing, consider regularly reviewing websites to ensure there is no content that violates their policies & procedures or the Marketing Rule. Given how much website content featured in the 27 enforcement matters, this seems highly advisable. Website content in particular may also be appropriate for a stricter pre-approval requirement by Compliance, as opposed to sample-based, retroactive back-testing of advertisements.
Books & Records and Substantiation
Verify books & records policies & procedures require not just the retention of all advertisements for the Marketing Rule’s retention period, but also that evidence substantiating claims and statements made in such advertisements also be retained. Verifying whether claims and statements can be substantiated, and if applicable, evidenced, should also be a sub-party of an investment manager’s 206(4)-7 testing.
Use of Detailed Review Checklists
For each aspect of the Marketing Rule that would be applicable to an investment manager’s own marketing practices, create a checklist to guide reviewers through their review of materials. That way, reviewers will be able to easily and confidently verify whether certain types of marketing pieces (e.g. performance, testimonials, third party ratings, etc.) satisfy all of the applicable elements of the Marketing Rule. Appendix C provides an example of what such a checklist could look like for a selected Marketing Rule topic. Even with various advertising review technologies on the market, such technologies can often be limited on finer points of the Marketing Rule.
Focused Form ADV Reviews
As part of the annual Form ADV update, pay particular attention to the sections pertaining to the Marketing Rule that seek information on marketing practices. Ensure statements in the Form ADV are consistent with actual marketing practices of the manager.
Prudent Use of Data
Subject to the cautionary notes mentioned previously, consider comparing any testing observations to the findings and fine data in the 27 enforcement actions that have occurred to-date. Such comparisons could afford managers a sense of what their regulatory exposure might be as a result of any deficient practices detected in their own testing and can help them prioritize and redirect resources to self-cure accordingly. Such data can also be used by an investment manager’s Compliance professionals to advocate to and educate management on any control changes or resource needs that may be warranted.
🎱 MAGIC 8 BALL SAYS: “SIGNS POINT TO YES” 🎱
PARTING THOUGHTS
As I similarly remarked in an essay examining the SEC’s electronic communications enforcement actions, one could spend the better part of a year analyzing the more microscopic nature of all of Marketing Rule enforcement matters, and also look at them from different angles than what I have done. Additionally, and as I’ve also commented before, as with any set of data, there are outliers in what I’ve examined that serve as counterpoints to the general themes and trends I’ve noted, or that at least continue to confound and puzzle. However, I do think there is some degree of consistency to it that can be used by investment managers to have some sense of what their ultimate financial risk could be for Marketing Rule violations, which is a particularly useful tool to have for Compliance professionals within organizations. The data can also aid a manager in ensuring a fair and equitable settlement with the SEC should a manager ever find itself in such crosshairs. Hopefully, however, that doesn’t come to pass, and given the abundance of examples of problematic practices that are publicly available, avoidance seems feasible (particularly with the change in the POTUS administration). Of course, when humans are involved – with their beliefs and motivations and other attributes – one can never be absolutely certain.
Thinking about the future, I very much welcome others looking at the data discussed in this essay and advancing and evolving any other potential use it may have. I also think it may be worth our industry inquiring with SEC staff regarding what to expect from a Marketing Rule enforcement perspective in light of the new POTUS administration. We could even press for an explanation of rationales for fine amounts – and in contexts beyond the Marketing Rule. In fielding those types of questions, I think SEC staff responses have been relatively consistent over time, and perhaps the Magic 8 Ball may sum them up best: “Reply hazy, try again.”
Well, maybe we should.
Thanks for reading.
BIBLIOGRAPHY
“Examinations Focused on Additional Areas of the Investment manager Marketing Rule,” https://www.sec.gov/files/risk-alert-marketing-rule-announcement-phase-3-060823.pdf, June 8, 2023.
“Examinations Focused on the New Investment manager Marketing Rule,” https://www.sec.gov/files/exams-risk-alert-marketing-rule.pdf, September 19, 2022.
Gensler, Gary. https://www.sec.gov/newsroom/speeches-statements/sec-chair-gary-gensler-ai-washing, March 18, 2024.
Gensler, Gary. https://www.sec.gov/about/office-hours-gary-gensler-ai-washing, October 16, 2024.
“Initial Observations Regarding Investment managers Act Marketing Rule Compliance,” https://www.sec.gov/files/exams-risk-alert-marketing-observation-2024.pdf, April 17, 2024.
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