Practical Guide to the Application of the Marketing Rule to Private Fund Placement Agents

Contents

• Introduction
• Marketing Rule Compliance Checklist for Agreements with Private Fund Placement Agents
• Testimonial & Endorsement Requirements for the Offering of Interests in a Private Fund By Placement Agent Type
• Application of the Marketing Rule to Placement Agents of Private Funds
  1. Background
     1. Testimonials and Endorsements
     2. Adoption and Entanglement
  2. Requirements Relating Generally to the Marketing Rule (Including the General Prohibitions)
  3. Requirements under the Testimonial and Endorsement Framework
     1. Clear and Prominent Disclosures
     2. Additional Disclosures
     3. Written Agreement
     4. Oversight
     5. Disqualification
  4. Recordkeeping
  5. Extraterritorial Application
• Endnotes

Introduction

This article focuses on how the new Rule 206(4)-1 (the “Marketing Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”) affects the relationships between investment advisers registered with the U.S. Securities and Exchange Commission (the “SEC” or “Commission”) and placement agents for private funds, including the contractual agreements.

This article first presents a checklist for agreements with placement agents for private funds to support the private fund adviser’s compliance with the Marketing Rule and a chart of the applicability of the “testimonial” and “endorsement” requirements for the offering of interests in a private fund broken down by placement agent type.

The article then presents a longer discussion of each of the relevant requirements under the Marketing Rule for placement agents of private funds.

Marketing Rule Compliance Checklist for Agreements with Private Fund Placement Agents

Note: This chart does not apply to affiliated persons of the private fund adviser (including affiliated placement agents) if the affiliation is readily apparent to or is disclosed to the investor at the time of the communication.

Testimonial & Endorsement Requirements for the Offering of Interests in a Private Fund By Placement Agent Type

Application of the Marketing Rule to Placement Agents of Private Funds

(1) Background

The Marketing Rule smashes together concepts under the old Rule 206(4)-1 (the “Advertising Rule”) and the old Rule 206(4)-3 (the “Cash Solicitation Rule”) and then expands on those concepts to areas that were previously not governed by those rules, including, in particular, the solicitation of investors in private funds.

The Marketing Rule introduces a new “testimonial” and “endorsement” framework that encompasses a range of activities, including, among other things, the solicitation of investors into private funds by placement agents. The terms “testimonial” and “endorsement” go far beyond their commonly understood definitions to cover a potentially very large universe of communications by the placement agent with investors. Further, by defining an “advertisement” to include a paid “testimonial” or “endorsement,” all of the requirements of the Marketing Rule (including the general prohibitions) apply to those communications and not just the specific requirements with respect to “testimonial” and “endorsement.”

In addition, the new “adoption” and “entanglement” framework will affect which communications by placement agents (including material disseminated by placement agents) are considered “advertisements” of the private fund adviser itself.

Finally, the Marketing Rule imposes substantial oversight and recordkeeping obligations on the investment adviser with respect the placement agent’s communications that are “testimonials,” “endorsements” or otherwise “advertisements.”

(a) Testimonials and Endorsements

The Marketing Rule introduces and expands on two important types of communications: “testimonials” and “endorsements.”

The content of a “testimonial” or an “endorsement” is not limited to those concerning the investment adviser but also includes those concerning supervised persons of the investment adviser.

The definition of “testimonial” and “endorsement” also include statements regarding an adviser’s (or supervised person’s) qualities, expertise or capabilities in other contexts if an investor would likely perceive them as relevant to the adviser’s investment advisory services. The SEC stated that this could include statements regarding trustworthiness, diligence or judgment.

The Marketing Rule does not include a definition of “solicit” or “refer” but in other contexts, the SEC has interpreted “solicit” very broadly.¹

Communications including Testimonials and Endorsements where there is compensation are captured by the Marketing Rule in two ways: (i) such communications are themselves “advertisements” under the Marketing Rule (and subject to all of the requirements of the Marketing Rule) and (ii) such communications are subject to specific requirements relating to disclosure, oversight and disqualification. We expand on these concepts with respect to placement agents for private funds below.

(b) Adoption and Entanglement

In addition, communications by placement agents may be captured as “indirect” advertisements of the SEC-registered adviser under the “adoption” and “entanglement” theory. Any third-party materials that meet either the “adoption” or “entanglement” standard would result in the adviser being liable for such third-party content under the Marketing Rule to the same extent as the adviser’s own content.

Therefore, any materials distributed by the placement agents (or information contained in such materials) with respect to which the adviser was “entangled” would be “advertisements” of the adviser. In addition, any materials prepared by the placement agents (or information contained in such materials) that are “adopted” by the adviser would also be “advertisements” of the adviser.

(2) Requirements Relating Generally to the Marketing Rule (Including the General Prohibitions)

All paid Testimonials and Endorsements are themselves Advertisements and are subject to all of the Marketing Rule, including the general prohibitions. In addition, unpaid Testimonials and Endorsements that are Advertisements of the adviser (e.g., because they meet either the “adoption” or “entanglement” standard) are also subject to all of the Marketing Rule, including the general prohibitions.

This means that:

• A Testimonial and Endorsement cannot be false or misleading, whether by (i) including an untrue statement of a material fact, (ii) omitting a material fact, (iii) being likely to cause an untrue or misleading implication or inference concerning a material fact, or (iv) otherwise being materially misleading;
• The adviser must have a reasonable basis for believing it can substantiate any material statement of fact in a Testimonial and Endorsement; and
• The Testimonial and Endorsement must present in a fair and balanced manner (i) any potential benefits with the associated material risks and limitations, (ii) any specific investment advice, and (iii) any performance results.²

Therefore, the SEC has stated that an adviser may not use a promoter’s testimonial or endorsement that the adviser knows or reasonably should know to be fraudulent, misleading, or untrue. 

The SEC also highlighted there may be material facts concerning the client or investor relationship that need to be disclosed to make a Testimonial not misleading. Specifically, the SEC highlighted that, if a testimonial is made by a former client or investor from a long time ago, then the testimonial should include disclosure on that time period. The same concern could exist for a client or investor who is very recent and, in turn, only has a very short experience with the investment adviser.

Note: This means that there may be additional disclosure requirements beyond the specific disclosures required under the Testimonial and Endorsement framework discussed below.

In addition, the SEC is concerned with the potential “cherry picking” of Testimonials and Endorsements. The SEC stated an adviser needs to consider “the context and totality of information presented such that it would not reasonably be likely to cause any misleading implication or inference.” The SEC stated that the Marketing Rule does not require an equal number of positive and negative Testimonials. However, the SEC also stated that general disclaimer language would not be sufficient — for example, one could not simply add a footnote stating “these results may not be typical of all investors.” The SEC suggests that one approach would be to include a disclaimer that the Testimonial was not representative and then provide a link (or other means of accessing) all or a representative sample of the testimonials about the adviser. The assumption behind this SEC suggestion is that there exists a representative sample of Testimonials about the adviser (and also a mechanism to determine that the sample is representative).

One must assume this “cherry picking” concern with respect to the identity of the promoter does not apply with respect to a placement agent, since the context of a placement agent engagement would suggest that the opinions of a placement agent are not representative of the opinions of all placement agents.

Furthermore, the investment adviser will need to be able to substantiate any material statements of fact made in a Testimonial or Endorsement — i.e., any material statement of fact by a promoter will require that the adviser be able to substantiate their statement.

Finally, these Testimonials and Endorsement need to satisfy the specific requirements under the Marketing Rule relating to (i) third-party ratings and (ii) performance presentation. The specific elements of those requirements is beyond the scope of this article. However, placement agents should be careful about referencing third party ratings, rankings or rewards or in displaying or communicating any performance information without the approval of the applicable private fund adviser.

(3) Requirements under the Testimonial and Endorsement Framework 

In addition to the general prohibitions discussed above, any Testimonials and Endorsements (including solicitations), including both paid and unpaid, are required to be subject to the following specific requirements (with certain exceptions): (i) certain “clear and prominent” disclosures, (ii) certain additional disclosures concerning compensation and conflicts of interest, (iii) a written agreement, (iv) oversight and (v) disqualification.

(a) Clear and Prominent Disclosures

• That the Testimonial was given by a current investor, or the Endorsement was given by a person that is not a current investor, as applicable;
• Whether any compensation (i.e., cash, non-cash, or any economic benefit) was provided for the Testimonial or Endorsement, as applicable; and
• A brief statement of any material conflicts of interest on the part of the person giving the Testimonial or Endorsement resulting from the investment adviser’s relationship with the person.

Exceptions from this requirement are available for:

1. Affiliates, partners, officers, directors or employees of the adviser or the affiliates if affiliation is clear (e.g., same or similar name or same brand) or expressly stated; and
2. SEC-registered broker-dealers if the Testimonial or Endorsement is in accordance with “Regulation Best Interest” (Rule 15l-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

These disclosures are expected to be succinct but still “promote their salience and impact.”

For an oral Testimonial or Endorsement, these disclosures should be provided at the same time as it is disseminated.

While the assessment of whether a person is a “current” investor or not is technically based on the person’s status as of the dissemination of the Testimonial or Endorsement, the SEC stated that a former investor may be considered a “current” investor for purposes of this requirement depending on the facts and circumstances, particularly if the communication reflects the investor’s recent prior experience. Furthermore, as noted above, the SEC also suggested that the period of time since the person has been an investor may be a material fact that needs to be disclosed. Therefore, in certain circumstances, it may be advisable to include the relevant time period that the person was an investor (or similar information) connected with the clear and prominent disclosures discussed herein.

Another consideration for a placement agent would be not just whether the placement agent itself is, or has been, an investor in any private fund advised by the private fund adviser but also whether any of its employees (particularly, any of the employees who are making the communications containing the Testimonial or Endorsement) is, or has been, an investor in any private fund advised by the private fund adviser.

Finally, it should be noted that there is no requirement that the person’s name be disclosed in connection with the Testimonial or Endorsement. However, withholding the name cannot be used in a fashion that might make the Testimonial or Endorsement misleading under the general prohibitions of the Marketing Rule. Therefore, a placement agent would not necessarily need to share the name of which employees are “current” investors, unless the facts and circumstances of the solicitation dictate otherwise.

(b) Additional Disclosures

The adviser must provide additional disclosures with respect to:

• The material terms of any compensation agreement (including a description of the compensation); and
• A description of any material conflicts of interest on the part of the person giving the Testimonial or Endorsement.

(i) Disclosure on Material Terms of Compensation

With respect to the compensation, the following rules apply:

• Covers both direct and indirect compensation (e.g., compensation is paid to an affiliate or employer);
• Disclose if the promoter’s expenses are reimbursed by the adviser;
• If a specific amount of cash compensation is paid, then the specific amount must be disclosed;
• If the compensation is based on a percentage and/or a time period, then such percentage and/or time period must be disclosed;
• If the investor would pay increased advisory fees and the amount of the increased fees is known or could be reasonably obtained, the amount of such increased fees must be disclosed;
• If there is a directed brokerage arrangement, then the material terms of this arrangement (including brief description of the compensation) must be disclosed, including the range of commissions that the firm charges for investors directed to it by the adviser and, if applicable, any associated thresholds must be disclosed;
• If the value of the non-cash compensation is readily ascertainable, then the amount of such value must be disclosed; and
• If the compensation is payable upon dissemination or deferred or contingent on a future event (e.g., an investor’s continuation or renewal of its advisory relationship, agreement or investment), then such terms must be disclosed.

Terms of the compensation that are immaterial do not need to be disclosed including (a) detailed information on the calculation of the compensation, (b) compensation arrangement for services or other items other than for the promoter’s testimonial or endorsement, and (c) compensation arrangements for other promoters.

(ii) Disclosure on Material Conflicts of Interest

The SEC is looking primarily for an “explicit disclosure that the promoter, due to such compensation, has an incentive to recommend the adviser, resulting in a material conflict of interest” — i.e., the disclosure should include this as a plain statement (“[Placement Agent] has received compensation from [Investment Adviser] and, therefore, has a conflict of interest with respect to marketing an investment in [Fund] because it has an incentive to market [Fund] as a result of this compensation.”).

An adviser should also consider whether there are any other material conflicts of interest that could affect the credibility of the Testimonial or Endorsement. For example, these could include conflicts associated with proprietary products, payments from third parties, and compensation arrangements. The materiality standard is met if an investor would consider a particular conflict of interest with respect to a promoter to be material to his or her decision to investment in the private fund of the adviser.

(4) Recordkeeping

An investment adviser is required to maintain records of all Advertisements that they disseminate. This means that each communication of a promoter that is a paid Testimonial or Endorsement (which each are Advertisements) must be maintained as a record by the investment adviser. For an oral Advertisement, the investment adviser must maintain either (i) a recording or (ii) a copy of any written or recorded materials used by the person in connection with the oral Advertisement, including the required disclosures (including copies of such disclosures if provided separately).

An investment adviser is also required to maintain the following records relating to an Advertisement: (i) documentation substantiating material statements of facts, (ii) documentation of the due diligence relating to third-party ratings, rankings or awards (e.g., a copy of the underlying questionnaire or survey), (iii) documentation relating to performance presentations, and (iv) documentation of the “intended audience” if the Advertisement includes hypothetical performance.³

The Recordkeeping Rule requires that certain books and records (including copies of Advertisements or the disclosures with respect to oral Advertisements) are required to be maintained and preserved in “an easily accessible place” for five years and for the first two years also in an “appropriate office of the investment adviser.” This means, for example, that copies of the Advertisements maintained solely at the office of a placement agent may not satisfy the Recordkeeping Rule — i.e., a private fund adviser may not be able to rely on the recordkeeping of the placement agent to satisfy the adviser’s obligations under the Recordkeeping Rule.

The question that will arise is how a placement agent should transfer these records (particularly, e-mails, text messages, etc.) to the investment adviser for their records. Most investment advisers satisfy the requirements to maintain certain e-mails (or similar communications) that might fall within certain categories of the Recordkeeping Rule by capturing all of the e-mails within the requirements of the Recordkeeping Rule. However, this approach also captures many e-mails that do not fall within the requirements of the Recordkeeping Rule. Unaffiliated broker-dealers or placement agents are unlikely to be willing to take such an approach with respect to the e-mails (or other communications) that might be Advertisements under the Marketing Rule, so there will need to be a different approach to sorting out such e-mails. The SEC has permitted the storage of required records (including e-mails) at cloud storage or with a third-party vendor if the adviser can promptly produce records in accordance with the Recordkeeping Rule. Depending on future SEC staff guidance, it may be possible that the investment adviser and placement agent may be able to organize, for example, restricted access to the service provider who stores the e-mail or other communications of the placement agent in a manner that complies with the Recordkeeping Rule.

Finally, this recordkeeping requirement means that any communication by a placement agent or its personnel must be using methods that permits the records retention. Similar to the existing issues faced by broker-dealers and investment advisers under the Advisers Act and the Exchange Act, the investment adviser must ensure that the placement agent is not communicating “advertisements” through methods that do not permit the retention of the record of that communication.⁴ To this end, SEC-registered broker-dealers and SEC-registered investment advisers who are subject to substantially similar recordkeeping requirement will be familiar with these types of policies on limiting the form of communications. However, non-U.S. placement agents may not face similar requirements under their applicable non-U.S. law and so may not have the internal compliance structure necessary to comply with these requirements.

(5) Extraterritorial Application

The SEC has confirmed that many of the substantive provisions of the Advisers Act (including the Marketing Rule) do not apply to an SEC-registered investment adviser whose principal place of business is outside of the United States (a “non-U.S. SEC-registered investment adviser”) with respect to their clients who are not U.S. persons (“non-U.S. clients”), including funds organized outside of the United States (“non-U.S. funds”) with U.S. investors. This means that a placement agent engaged by a non-U.S. SEC-registered investment adviser with respect to its non-U.S. funds may not be required to comply with the requirements of the Marketing Rule described herein. However, any such non-U.S. SEC-registered investment adviser would need to include appropriate disclosure on the fact that the Advisers Act does not apply with respect to any reference or disclosure to its SEC registration status. Non-U.S. private fund advisers should consider reviewing their fund documentation and other materials to add this disclosure if they are interested in avoiding the requirements of the Marketing Rule.

However, this extraterritorial limitation does not apply to:

• A U.S. SEC-registered investment adviser, regardless of whether the U.S. or non-U.S. placement agent is soliciting for a U.S. or non-U.S. fund; and
• A U.S. private fund, regardless of whether the U.S. or non-U.S. placement agent is soliciting for (i) the U.S. private fund itself, (ii) a U.S. or non-U.S. feeder fund of the U.S. private fund, or (iii) other U.S. or non-U.S. vehicle that is “formed for the purpose” of investing, directly or indirectly, in a U.S. private fund.

This means, for example, that a non-U.S. placement agent soliciting for a non-U.S. fund (with a U.S. SEC-registered investment adviser) or a non-U.S. feeder fund of a U.S. fund under Regulation S of the Securities Act would still be subject to the requirements of the Marketing Rule. Since such non-U.S. placement agent agreements have limited provisions with respect to compliance with U.S. federal securities laws, the requirements of the Marketing Rule will create a significant change in the applicability of the U.S. securities laws to those relationships.

Endnotes

ⁱ Such conduct is any conduct that:

(A) Involves the purchase or sale of any security, the taking of a false oath, the making of a false report, bribery, perjury, burglary, any substantially equivalent activity however denominated by the laws of the relevant foreign government, or conspiracy to commit any such offense;

(B) Arises out of the conduct of the business of a broker, dealer, municipal securities dealer, investment adviser, bank, insurance company, government securities broker, government securities dealer, fiduciary, transfer agent, credit rating agency, foreign person performing a function substantially equivalent to any of the above, or entity or person required to be registered under the Commodity Exchange Act [7 U.S.C. 1 et seq.] or any substantially equivalent statute or regulation;

(C) Involves the larceny, theft, robbery, extortion, forgery, counterfeiting, fraudulent concealment, embezzlement, fraudulent conversion, or misappropriation of funds or securities or substantially equivalent activity however denominated by the laws of the relevant foreign government; or

(D) Involves the violation of section 152, 1341, 1342, or 1343 or chapter 25 or 47 of title 18, or a violation of substantially equivalent foreign statute.

ⁱⁱ Such conduct includes any conduct where the person “has willfully made or caused to be made in any application for registration or report required to be filed with the Commission under this subchapter, or in any proceeding before the Commission with respect to registration, any statement which was at the time and in the light of the circumstances under which it was made false or misleading with respect to any material fact, or has omitted to state in any such application or report any material fact which is required to be stated therein.”

ⁱⁱⁱ Such conduct is any conduct where the person “has willfully violated any provision of the Securities Act of 1933 [15 U.S.C. 77a et seq.], the Securities Exchange Act of 1934 [15 U.S.C. 78a et seq.], subchapter I of this chapter, this subchapter, the Commodity Exchange Act [7 U.S.C. 1 et seq.], or the rules or regulations under any such statutes or any rule of the Municipal Securities Rulemaking Board, or is unable to comply with any such provision.”

^iv Such conduct is any conduct where the person “has willfully aided, abetted, counseled, commanded, induced, or procured the violation by any other person of any provision of the Securities Act of 1933 [15 U.S.C. 77a et seq.], the Securities Exchange Act of 1934 [15 U.S.C. 78a et seq.], subchapter I of this chapter, this subchapter, the Commodity Exchange Act [7 U.S.C. 1 et seq.], the rules or regulations under any of such statutes, or the rules of the Municipal Securities Rulemaking Board, or has failed reasonably to supervise, with a view to preventing violations of the provisions of such statutes, rules and regulations, another person who commits such a violation, if such other person is subject to his supervision. For the purposes of this paragraph no person shall be deemed to have failed reasonably to supervise any person, if —

(A) there have been established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect, insofar as practicable, any such violation by such other person, and

(B) such person has reasonably discharged the duties and obligations incumbent upon him by reason of such procedures and system without reasonable cause to believe that such procedures and system were not being complied with.”

^v Such order is any order that “(A) bars such person from association with an entity regulated by such commission, authority, agency, or officer, or from engaging in the business of securities, insurance, banking, savings association activities, or credit union activities; or (B) constitutes a final order based on violations of any laws or regulations that prohibit fraudulent, manipulative, or deceptive conduct.”

^vi This covers any “order, judgment, or decree of any court of competent jurisdiction, including any foreign court of competent jurisdiction, from acting as an investment adviser, underwriter, broker, dealer, municipal securities dealer, government securities broker, government securities dealer, transfer agent, credit rating agency, foreign person performing a function substantially equivalent to any of the above, or entity or person required to be registered under the Commodity Exchange Act [7 U.S.C. 1 et seq.] or any substantially equivalent statute or regulation, or as an affiliated person or employee of any investment company, bank, insurance company, foreign entity substantially equivalent to any of the above, or entity or person required to be registered under the Commodity Exchange Act or any substantially equivalent statute or regulation, or from engaging in or continuing any conduct or practice in connection with any such activity, or in connection with the purchase or sale of any security.”

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