SEC Risk Alert on the new marketing rule signaling exam sweep

Summary:

• On 9/19/2022, the United States Securities and Exchange Commission (“SEC” or “Commission”) issued a Risk Alert highlighting that the SEC’s Division of Examinations will conduct a broad review of rule compliance after implementation.
• While Risk Alerts are often considered by compliance departments, this one is especially important, as it appears to set forth the focus areas for the upcoming SEC review.

Key Components and Future Review Areas:

1. Policies and Procedures

• The Commission will test for the existence of marketing policies and procedures as required by the rule.
• The Commission appears to be signaling that it will focus at least some effort on the quality and existence of a marketing testing program.
  • Analysis:
    • While many managers have now adopted marketing policies, those policies may not provide for testing. That could be a potential hole as the staff interprets the rule.

2. Substantiation

• The new Marketing Rule requires managers to be able to substantiate key statements in their marketing materials, and the staff plans to review support for such substantiation.
• The Risk Alert suggests that managers will have to point to specific documentation supporting their claim of substantiation, including policies and procedures.
  • Analysis:
    • This focus area poses significant risk for marketing rule implementations because: (a) it is unclear which statements may require substantiation; (b) Compliance often relies on others, including Finance and Investor Relations, to keep such substantiation without proactively ensuring that the substantiation is sufficient; and (c) the Risk Alert implies a focus on policies ensuring the existence of substantiation, but most managers have not developed such policies.

3. Performance Advertising

• The Risk Alert highlights six¹ areas of performance advertising compliance that will be reviewed in the private fund context. Those areas are:
  • Requirement to present net returns each time a gross return is presented;
  • Requirement not to claim that performance is Commission-approved;
  • Requirement to comprehensively show all Related Portfolios without adding unrelated portfolios or omitting Related Portfolios;
  • Compliance with Extracted Performance requirements, including providing or offering to provide the full portfolio on request;
  • Appropriateness of any Hypothetical Portfolios as well as associated disclosure and procedures;
  • Predecessor Performance compliance, including (a) maintenance of backup to support that (i) ‘primarily responsible’ personnel are managing the fund being marketed and (ii) the fund being marketed and the ‘Predecessor Performance’ fund are being similarly managed, as well as (b) inclusion of adequate disclosures in the marketing piece.

4. Books and Records

• The SEC will review how each manager has handled the recordkeeping requirements arising from the new marketing rule, including (a) updating books and records policies and procedures; (b) updating Form ADV Item 5 (although the additional section is not required to be completed before the regular annual update in March); and (c) adding ADV disclosure, presumably in Part 2, regarding marketing and advertising practices.

¹ One additional area is presented, but it does not apply to private funds advisers (i.e., the requirement to present 1‐, 5‐, and 10‐year performance).