Walking A Fine Line

Advertising prohibitions can snare the unwary

Suppose your firm is brainstorming ways to market itself to stand out from the pack. One investment adviser has a brilliant idea: a professionally produced video introducing potential clients to firm members with clips of happy, satisfied clients praising the firm’s great service.

However, there is a problem. If the tape actually is produced and distributed, the firm would violate the Securities and Exchange Commission’s (SEC) Investment Advisers Act of 1940 (Advisers Act). What makes the tape so effective from a marketing perspective makes the video noncompliant: the happy, satisfied clients.

Marketing services without overstepping Advisers Act compliance boundaries is a difficult task for investment advisers. The Advisers Act has strict rules for investment adviser advertising—basically any communication addressed to more than one person (see “Advertise Meants“)—including a specific prohibition on the use of testimonials of any kind. A testimonial is any statement of a customer’s experience regarding the advisory services provided by an adviser or a client’s endorsement of the adviser’s services. Unlike other SEC rules, there are no disclosures that, when accompanying a testimonial, would make it acceptable. Broker/dealers who are not also investment advisers can use testimonials, but investment advisers are strictly prohibited from doing so, says Nancy Lininger, founder/consultant for The Consortium in Camarillo, California.

Testimonials are banned because the SEC considers them inherently misleading in that they highlight favorable client experiences and ignore unfavorable ones. The whole point of the prohibition is that an adviser is likely to cherry-pick only happy clients, says Barry Schwartz, a partner in Adviser Compliance Associates, LLC, in Washington. The SEC also has made it clear that it believes that, if testimonials were permitted, advisers would cultivate endorsements by providing extraordinary service to a select few clients.

Knowing what is and is not a testimonial can be tricky. Plain vanilla testimonials—where clients rave about an adviser in a print or television advertisement—are easy to understand and avoid. It’s the indirect or less subtle forms of testimonials that tend to trip up advisers.

For example, statements attesting to an adviser’s character, even if the person making the statement is not a current or former client, are testimonials. In fact, the SEC staff ruled that a statement from an adviser’s minister stating that the adviser is of high moral character may not be used in the adviser’s advertising, despite the fact that the minister is not a client of the adviser. Similarly, not using actual clients but hiring actors and models to portray “satisfied customers” in advertising and other marketing materials is prohibited, says Lininger.

Listing clients or stating that client references will be provided on request in marketing materials can be violations of the Advisers Act. Even using third-party ratings of investment advisers in advertisements is not permitted in certain circumstances.

Even more subtle, sending current or potential clients a reprinted copy of a newspaper article quoting an adviser’s client’s favorable experience violates the rule.

Even prospecting techniques should be scrutinized. One of Lininger’s clients produced a letter with glowing reviews of the adviser and which invited his clients to send the letter to prospective clients. Lininger called the SEC for input and the SEC indicated that, because the adviser drafted the letter and encouraged clients to send it to other potential clients, it could be viewed as a prohibited testimonial.

Testimony “Null”

Conversely, the SEC has indicated that certain types of communications are not testimonials. In certain circumstances, the SEC permits advisers to use partial client lists. Partial client lists in advertising are permissible if the adviser selects clients for the list based on objective criteria other than investment performance: for example, selecting clients to list based on the largest dollar amount of purchases or sales of securities in managed accounts or providing a list of ERISA plan clients. Advisers are not, however, allowed to list only satisfied clients in advertising, or leave off a list a client who otherwise would meet the objective criteria, says Lininger.

Of course, she adds, advisers also cannot publish the name of a client without permission, so clients who otherwise meet the objective criteria can be left off a list if they do not provide permission. Advisers also must state that it is not known whether the listed clients approve or disapprove of the adviser or advisory services.

Advisers also can use third-party ratings if client sampling is an insignificant part of the ranking, with certain disclosures. However, advisers cannot just disclose the rating, says Schwartz; information must also be disclosed that includes the scope and number of investment advisers surveyed, as well as statements that past performance does not indicate future performance and whether or not the firm paid a fee. Furthermore, in a 1982 no action letter, the SEC stated that an adviser could send an article written by an unbiased third party concerning the adviser’s performance, as long as the article does not include client testimonials.

A recent ruling settled a particularly troubling issue for advisers working with ERISA plans, says Schwartz. ERISA-plan requests for proposals (RFPs) generally ask advisers to provide references. The SEC, however, previously took the position that providing references is a form of testimonial prohibited under the Advisers Act. Thus, advisers that provided references violated the Advisers Act, but advisers that did not provide references often were put at a competitive disadvantage. A 2004 SEC no action letter now allows advisers to provide client references in response to an unsolicited request by a client, prospective client, or consultant, says Schwartz. This was the first time the SEC ruled that providing references is not necessarily prohibited if requested by a client or prospective client, says Schwartz.

However, emphasizes Schwartz, the request must be “unsolicited.” Advisers cannot put something in an advertisement or marketing materials that says, in effect, “references will be provided upon request.” That line, says Schwartz, will still violate the Advisers Act.

Advisers, say experts, have gotten savvy regarding testimonials. It is now well understood that statements from clients are not allowed, and it is unusual to see an adviser use a direct testimonial, says Thomas Giachetti, a shareholder in the Lawrenceville, New Jersey, law firm of Stark & Stark. For example, advisers pretty much understand now that placing an advertisement in a newspaper with photos of clients accompanied by statements claiming the adviser helped them meet their financial goals obviously violates the rule. Similarly, using written client statements as part of an advertisement also would be a violation.

Still, the testimonial rule is an easy one to trip over, and many advisers still do. “Most investment advisers understand that there is a prohibition, but don’t understand the extent of the prohibition,” says Schwartz. One very common mistake Schwartz sees is listing the names of prominent clients in marketing materials without disclosing the criteria used to pick clients to list.

Advisers also err in the use of indirect testimonials, which also are prohibited. For example, says Schwartz, he often sees statements in clients’ marketing materials such as “Our clients chose us as their investment adviser because we are X.” Advisers, he says, often do not realize that innocuous statements like that run afoul of the rules. Anything that indirectly puts words in clients’ mouths is prohibited. Schwartz recently reviewed a client’s brochure that stated, “These individuals tell us that what we offer is exactly what they’ve been searching for-services that not only increase their net worth, but also give them time to enjoy it.” While not a classic testimonial, the statement does purport to convey what clients think, explains Schwartz, so it is an indirect testimonial and prohibited. Advisers need to be cautious about puffery and overstatements as well, says Giachetti.

In addition, advisers frequently trip up when giving interviews on either TV or for publication, says Lininger, particularly if the adviser later uses it for marketing purposes. For example, she says, if a magazine conducts an interview of the adviser and several of the advisers’ clients who comment favorably on the adviser’s services, and then the adviser gives reprints to clients, the rules have been violated.

Advisers also believe that, if they are not advertising their investment advisory services, they can use testimonials, which is incorrect, says Lininger-for example, if an adviser is also a consultant advertising its pension consulting services. “The SEC takes the position that testimonials cannot be used for any offered services, not just investment advisory services,” says Lininger.

It is necessary for investment advisers to understand the scope of the testimonial rule, says Giachetti, because the SEC also has gotten savvy about marketing materials. The SEC has become very aggressive during exams with regard to reviewing marketing materials, he says, scrutinizing for indirect testimonials. Advisers need to be cognizant of the nuances, says Giachetti.

Advertise Meants

The expansive definition of advertising in the Investment Advisers Act of 1940 includes any written communication (including e-mail) sent to more than one person, as well as anything used to attract potential clients on or in television, radio, billboards, newspapers, Web sites, blogs, magazines, trade journals, or press releases. Any notice or other announcement appearing in any publication that offers investment advisory services with regard to securities, as well as other specified services, is advertising, as is any newsletter, brochure, pamphlet, leaflet, or report sent to current clients. “Advertising” also includes submissions to third-party rating or reporting services.

Fee-only advisers and those registered only as investment advisers have to comply only with the SEC and/or state rules, and do not have to comply with rules of the National Association of Securities Dealers (NASD).

The NASD requires broker/dealers to submit various types of advertising and sales literature to it for comments in advance. Anything discussing mutual funds, collateralized mortgage obligations, variable products, unit investment trusts, limited partnerships, or government securities must be submitted.

Registered representatives must have all advertising and sales literature approved by their compliance departments or an authorized office of supervisory jurisdiction. Registered representatives who also are registered investment advisers with either the SEC or the state must comply with both SEC/state and NASD rules for advertising. Any registered representative who is also a registered investment adviser must reference the broker/dealer affiliation.

Registered representatives who want to use testimonials for their non-RIA activities must state four things: the testimonial is not representative of the experience of other clients; the testimonial is not indicative of future performance or success; if more than a nominal sum is paid for the testimonial, disclosure that it was a paid testimonial; if the testimonial refers to a technical aspect of investing, the person making the testimonial is an expert.