On November 4, 2022 – exactly three years after amended Rule 206(4)-1 (the Marketing Rule) was first issued in proposed form1 – compliance with the new rule becomes mandatory for all registered investment advisers (RIAs) and will impact virtually all CLOs. In a recent risk alert, the staff of the Securities and Exchange Commission (SEC or Commission) warned that upcoming examinations will focus on Marketing Rule compliance and urged RIAs to adapt their policies and procedures accordingly. While the industry has been given a long transition period in which to prepare for the new rule's requirements, the broad reach of the amended rule has seemingly taken the CLO market by surprise.

"Advertisements" under the Marketing Rule include not only traditional advertising but also compensated third-party solicitations, including solicitations of prospective investors in private funds, notwithstanding that private fund solicitations are concurrently addressed by broker-dealer regulation and have historically been excluded from separate Advisers Act regulation of solicitations. "Private funds" for this purpose include any issuer that relies on the Section 3(c)(1) or Section 3(c)(7) exception under the Investment Company Act of 1940 (the ICA) and therefore include not only most hedge funds and private equity funds but also many structured finance vehicles, including virtually all CLOs.

This client alert focuses on the Marketing Rule as it applies to the relationship between collateral managers and the placement agents or arrangers they engage to market CLOs to prospective investors. The solicitation activities of a CLO arranger will constitute "advertising" under the Marketing Rule if the arranger is engaged by a collateral manager that is an RIA, as nearly all CLO collateral managers are, to market a CLO that relies on ICA Section 3(c)(7), as nearly all CLOs do. Compliance with the Marketing Rule is not as onerous as it may first appear, however, and once the elements are understood, collateral managers and arrangers can work together to develop and implement appropriate practices before the mandatory compliance date.

I. When is an Arranger Communication an "Advertisement"?

The SEC adopted a two-prong definition of "advertisement" to regulate the advertising and marketing practices of investment advisers under a single rule.

The first prong of the advertisement definition2 captures certain communications by the adviser itself – "[a]ny direct or indirect communication an investment adviser makes to more than one person ... that offers the investment adviser's investment advisory services with regard to securities to prospective clients or investors in a private fund advised by the investment adviser," subject to certain exceptions – and generally corresponds in scope to the prior advertisement definition.

The second prong of the definition3 captures certain third-party communications – any "endorsement or testimonial" for which an investment adviser provides compensation, directly or indirectly. In relevant part, the second prong covers compensated "endorsements," which include solicitations and referrals, as discussed below.

A. Scope of "Endorsement"

Endorsement means any statement by a person other than a current client or investor in a private fund advised by the investment adviser that:

  1. Indicates approval, support, or recommendation of the investment adviser or its supervised persons or describes that person's experience with the investment adviser or its supervised persons;
  2. Directly or indirectly solicits any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the investment adviser; or
  3. Refers any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the investment adviser.

Historically, third-party solicitations and referrals were regulated under a separate Advisers Act rule, the cash solicitation rule, but only as applied to direct client solicitations. Based on the 2006 D.C. Circuit Court holding that the "client" of a private fund manager is generally the private fund itself and not the investors in the fund, 4 the SEC staff took the position that the cash solicitation rule did not apply to solicitations of private fund investors.5 The explicit inclusion of private fund investors in the new definition reverses this interpretation.

No exception for oral or one-on-one communications

The first prong of the advertisement definition (capturing certain direct and indirect communications by the adviser itself) generally excludes one-on-one communications and "extemporaneous, live, oral communications," in order avoid an undue compliance burden on advisers and a chilling effect on their communications with investors.6 The second prong of the definition, which the Commission views as traditional solicitation activity, does not exclude oral or one-on-one communications. Indeed, the Commission states in the Adopting Release, "[t]hese types of communications are precisely what the second prong of the definition seeks to address."7

Therefore, any form of statement by an arranger to a prospective investor, including statements made in person or in a call or email, may potentially be an endorsement, if it is considered a solicitation or referral to invest in CLO securities or indicates approval, support, or recommendation of the collateral manager or its personnel.

Qualified exception for OMs and PPMs

Based on commentary in the Adopting Release relating to private placement memoranda for private funds,8 as well as the explicit exclusion from both prongs of the advertisement definition for certain "information contained in a statutory or regulatory notice filing, or other required communication,"9 an arranger's dissemination of an offering memorandum (OM) or similar offering document should not be considered an endorsement to the extent the content includes a description of the material terms, objectives, and risks of the notes and the CLO and other information reasonably designed to satisfy legal disclosure requirements. OM content that goes beyond the foregoing (for example, by including related performance information of other funds or accounts managed by the collateral manager)10 may constitute an endorsement and an advertisement. The Adopting Release also notes that "pitch books or other materials accompanying PPMs could fall within the definition of advertisement."11

Footnotes

1. SEC Release No. IA-5407 (Nov. 4, 2019) (the Proposing Release). The Marketing Rule was issued in final form on December 22, 2020 (SEC Release IA-5653) (the Adopting Release) and went into effect on May 4, 2021. RIAs were given 18 months in which to elect to comply with the amended rule, but most have chosen to defer compliance until the November 4, 2022 mandatory compliance date.

2. Under the first prong of the definition in Rule 206(4)-1(e)(1), an "advertisement" includes:

  1. Extemporaneous, live, oral communications;
  2. Information contained in a statutory or regulatory notice, filing, or other required communication, provided that such information is reasonably designed to satisfy the requirements of such notice, filing, or other required communication; or
  3. A communication that includes hypothetical performance that is provided:
    1. In response to an unsolicited request for such information from a prospective or current client or investor in a private fund advised by the investment adviser; or
    2. To a prospective or current investor in a private fund advised by the investment adviser in a one-on-one communication;

3. An "advertisement" under the second prong of the definition includes:

  1. Any endorsement or testimonial for which an investment adviser provides compensation, directly or indirectly, but does not include any information contained in a statutory or regulatory notice, filing, or other required communication, provided that such information is reasonably designed to satisfy the requirements of such notice, filing, or other required communication.

"Testimonial" and "endorsement" are defined similarly and generally include solicitations, referrals, and certain other statements; such statements are "testimonials" if made by a current client or investor in a private fund advised by the adviser and "endorsements" if made by any other person.

4. Goldstein v. S.E.C., 451 F.3d 873 (D.C. Cir. 2006).

5. Mayer Brown LLP, SEC No-Action Letter (Jul. 28, 2008).

6. Rule 204(6)-1(e)(1)(i), quoted in note 2 above; Adopting Release at 39.

7. Adopting Release at 55.

8. Adopting Release at 62 ("We agree that information included in a PPM about the material terms, objectives, and risks of a fund offering is not an advertisement of the adviser.").

9. Rule 206(4)-1(e)(1)(i) and (ii) (An advertisement "does not include any information contained in a statutory or regulatory notice, filing, or other required communication, provided that such information is reasonably designed to satisfy the requirements of such notice, filing, or other required communication.").

10. Adopting Release at n. 194 ("Whether particular information included in a PPM constitutes an advertisement of the adviser depends on the relevant facts and circumstances. For example, if a PPM contained related performance information of separate accounts the adviser manages, that related performance information is likely to constitute an advertisement.").

11. Id.

To view the full article, click here

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.