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Many RIAs have some version of a “refer-a-friend” program, ranging from requests for introductions to website forms where clients can submit contact information for a friend, family member, or colleague. These programs raise an interesting question under the Marketing Rule:
Does the resulting referral constitute an “advertisement” and is it subject to the disclosure obligations and other Marketing Rule requirements for testimonials and endorsements? In other words, does a referral from an existing client trigger similar obligations as a referral from a paid solicitor?
To give the most lawyerly possible answer, it depends. More specifically, it depends on whether the client making the referral is compensated.
Defining “Advertisement”
As a foundational point, the Marketing Rule concerns itself with “Advertisements,” which is a defined term under the rule. If a particular communication is not an Advertisement, then the general anti-fraud principles underlying the securities laws certainly apply, but the Marketing Rule does not. See, for example, page 36 of the Adopting Release.
So, let's begin by considering how the Marketing Rule defines the term. The definition of “Advertisement” is often described as having two prongs. Put more simply, the word Advertisement essentially has two separate definitions under the Marketing Rule.
Under the first prong, Rule 206(4)-1(e)(1)(i), an Advertisement is any direct or indirect communication an investment advisor makes “to more than one person” that offers the advisor’s services. A communication to a single person is generally outside this prong unless it includes hypothetical performance.
Under the second prong, Rule 206(4)-1(e)(1)(ii), an Advertisement is “[a]ny endorsement or testimonial for which an investment adviser provides compensation, directly or indirectly.”
Distinguishing Between Compensated & Uncompensated Testimonials
As the SEC explains in the Adopting Release, a compensated testimonial or endorsement falls within the second prong of the definition of Advertisement regardless of whether it is made to one person or many, but “an uncompensated testimonial or endorsement would have to meet the elements of prong one in order to be considered an ‘advertisement.’”
To be sure, a client referral fits within the rule’s definition of a Testimonial under Rule 206(4)-1(e)(17), which includes a statement by a current client that “refers any current or prospective client or investor to be a client of . . . the investment adviser.” In other words, the fact that a client is simply referring a friend does not take the communication outside the definition of Testimonial.
But is that Testimonial an Advertisement? The answer depends on whether the promoter is compensated.
Compensated Referrals
If an advisor compensates a client for making a referral, then the referral falls squarely within the second prong of the definition of Advertisement: It's a testimonial for which the advisor provides compensation.
The Adopting Release makes clear that compensation is interpreted broadly and can include cash or non-cash compensation. The Release specifically discusses refer-a-friend programs that involve fee waivers, and says that the Marketing Rule applies to such arrangements and the fee waiver constitutes compensation.
As a clear Advertisement, a compensated referral must satisfy the Marketing Rule’s conditions for testimonials and endorsements under Rule 206(4)-1(b)(4), including the applicable disclosure, oversight, and written contract requirements. The only footnote is that, if compensation is "de minimis" (defined as $1,000 or less during the past 12 months), then certain of these requirements are removed — but others still apply.
Uncompensated Referrals
The analysis is different when the client receives no compensation at all. An uncompensated referral does not fall within the second prong of the definition of Advertisement because that prong expressly requires compensation. As the SEC explains in the Adopting Release, “an uncompensated testimonial or endorsement would have to meet the elements of prong one in order to be considered an ‘advertisement.’”
That first prong generally contemplates a communication to more than one person that offers the advisor's services. A typical one-to-one referral does not qualify: A client who sends an individual email introducing the advisor to a friend is communicating to one person — there is no communication to “more than one person.” Moreover, merely submitting a friend's name through the advisor's refer-a-friend web page seems even further from an advertisement, as the only communication is between the client and the advisor.
Simply put, the first prong of the definition of Advertisement does not apply, because there is no communication to more than one person advertising the advisor's services. Additionally, the second prong of the definition does not apply because the testimonial is uncompensated.
The result is somewhat counterintuitive but follows directly from the structure of the rule: An uncompensated one-to-one referral is a Testimonial, but it is not an Advertisement. And since it is not an Advertisement, the Marketing Rule does not apply and the Marketing Rule's requirements for working with Promoters are not triggered.
The Adopting Release
This distinction between paid and unpaid refer-a-friend programs can get obscured because the SEC discusses these programs several times in the Marketing Rule Adopting Release (to be precise, the words "refer-a-friend" appear 11 times in the Adopting Release — I counted). But most of that discussion concerns compensated programs. The SEC expressly declined to create any kind of exemption for compensated refer-a-friend arrangements, but it notes that many such programs would qualify for the de minimis compensation exemption mentioned above. However, that means they are still subject to certain Marketing Rule requirements, unlike uncompensated referrals, which are not Advertisements at all.
A Caveat
Readers should note that this analysis applies to an ordinary individual referral, in which a client sends an individualized email to a friend or family member making an introduction to the advisor. It likewise applies to a client submitting a colleague's contact information through the advisor's refer-a-friend web page.
By contrast, if an advisor provides clients with standardized promotional materials for mass distribution, republishes client recommendations in their own marketing (even if the clients are unpaid), or otherwise turns the testimonial into a communication to more than one person, the analysis immediately changes. Then, the communication may very well be an advertisement.
The analysis also becomes more complicated if a client shares hypothetical performance in the communication, even if it is only delivered to one person. The Marketing Rule expressly reaches both direct and indirect advisor communications, so a message conveyed by a client could still be considered a communication of the advisor.
Conclusion
With all that said, for the typical uncompensated refer-a-friend program, a plain reading of the Marketing Rule provides the answer. Where there is no communication to more than one person (and no hypothetical performance), there is no Advertisement under the first prong of the definition. Where there is no compensation, there is no Advertisement under the second prong of the definition. And without an Advertisement, the Marketing Rule’s requirements for working with Promoters do not apply.
Read more by Isaac Mamaysky here:
Isaac Mamaysky is the cofounder and COO of QuantStreet Capital, a New York-based RIA that focuses on systematic asset allocation and offers both model portfolios and a platform for other advisors to grow their business.
In addition, Isaac is a partner at Potomac Law Group PLLC, where he founded the firm’s Investment Advisers & Asset Managers practice. He writes the RIA Law Blog and welcomes readers to connect with him on LinkedIn.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.