Advertising and Sales Literature Rules: SEC and FINRA Guidelines

8.5.3 Advertising and Sales Literature Rules

In the highly regulated world of securities, advertising and sales literature play a crucial role in how investment products, particularly mutual funds, are presented to potential investors. Both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have established stringent rules to ensure that advertising is fair, balanced, and not misleading. This section provides an in-depth exploration of these rules, focusing on the requirements for performance presentation and risk disclosure.

Understanding SEC and FINRA Rules

SEC Rules on Advertising

The SEC’s primary concern with advertising and sales literature is to prevent misrepresentation and ensure that investors receive accurate and complete information. Under the Investment Company Act of 1940, the SEC has established rules that guide how mutual funds and other investment companies can advertise their products.

Key SEC Guidelines:

• Truthfulness and Accuracy: All statements in advertisements must be truthful and not misleading. This includes avoiding exaggerated claims about performance or benefits.

• Performance Data: When performance data is presented, it must be based on historical data and clearly indicate that past performance does not guarantee future results.

• Risk Disclosure: Advertisements must disclose the risks associated with the investment. This includes potential loss of principal and market volatility.

• Balanced Presentation: Any discussion of the benefits of an investment must be balanced with an equally prominent discussion of the risks.

FINRA Rules on Advertising

FINRA Rule 2210 governs communications with the public, including advertising and sales literature. This rule categorizes communications into three types: retail communications, correspondence, and institutional communications, each with specific requirements.

Key FINRA Guidelines:

• Approval and Recordkeeping: Retail communications must be approved by a registered principal before use. Firms must maintain records of all communications for at least three years.

• Content Standards: Communications must be fair and balanced, providing a sound basis for evaluating the facts. They must not omit material information or make exaggerated claims.

• Performance Presentation: Any performance data must be accompanied by a statement that past performance is not indicative of future results. It should also disclose the source and date of the data.

• Risk Disclosure: Similar to the SEC, FINRA requires that any discussion of potential returns is accompanied by a discussion of the risks.

Requirements for Performance Presentation

Performance presentation is a critical aspect of advertising in the securities industry. Both the SEC and FINRA have specific requirements to ensure that performance data is presented in a manner that is not misleading.

Historical Performance Data

When presenting historical performance data, firms must ensure that:

• Time Periods: The performance data covers at least the most recent one, five, and ten-year periods, or since inception if the fund is less than ten years old.

• Standardized Format: Performance data must be presented in a standardized format to allow for easy comparison between different funds.

• Net of Fees: Performance figures must be shown net of fees and expenses to give a true picture of the returns an investor would have received.

Hypothetical Performance

Hypothetical performance data, which projects future returns based on past data, is subject to strict scrutiny:

• Assumptions Disclosure: All assumptions used in the hypothetical scenarios must be disclosed.

• No Guarantees: It must be clear that hypothetical performance is not a guarantee of future results.

Risk Disclosure Requirements

Risk disclosure is a fundamental requirement in all advertising and sales literature. Investors must be made aware of the potential risks involved in any investment.

Key Risk Factors

• Market Risk: The potential for investment losses due to market fluctuations.

• Interest Rate Risk: The risk that changes in interest rates will affect the value of investments.

• Credit Risk: The risk that an issuer will default on its obligations.

• Liquidity Risk: The risk that an investor will not be able to sell an investment quickly at its fair market value.

Prominent Placement

Risk disclosures must be prominently placed within the advertisement. They should not be hidden in footnotes or in small print. The language used should be clear and understandable to the average investor.

Examples of Compliant and Non-Compliant Advertisements

To illustrate the application of these rules, let’s consider some examples of compliant and non-compliant advertisements.

Compliant Advertisement Example

Compliant Advertisement:

• Headline: “Invest in Our High-Performing Mutual Fund”
• Body: “Our mutual fund has delivered a 10% annual return over the past five years. However, past performance is not indicative of future results. Investing in mutual funds involves risks, including the potential loss of principal. Please read the prospectus carefully before investing.”
• Risk Disclosure: “Market and interest rate risks may affect the value of your investment. Consult with your financial advisor to understand all risks.”

This advertisement is compliant because it provides balanced information about past performance and risks, includes a disclaimer about past performance, and encourages the reader to consult additional resources.

Non-Compliant Advertisement Example

Non-Compliant Advertisement:

• Headline: “Guaranteed High Returns with No Risk!”
• Body: “Our mutual fund guarantees high returns with no risk involved. Invest now to secure your financial future.”
• Risk Disclosure: Hidden in small print at the bottom of the page.

This advertisement is non-compliant because it makes misleading guarantees, fails to provide balanced information, and hides the risk disclosure.

Glossary

• Misrepresentation: Providing false or misleading statements in advertising or sales literature. This includes exaggerating performance results or downplaying risks.

Best Practices for Compliance

To ensure compliance with SEC and FINRA rules, firms should adopt the following best practices:

• Regular Training: Conduct regular training sessions for all employees involved in creating or approving advertisements.

• Internal Review Processes: Establish robust internal review processes to ensure all advertisements meet regulatory requirements before they are published.

• Use of Disclaimers: Always include appropriate disclaimers regarding past performance and potential risks.

• Clear and Balanced Information: Ensure that all advertisements provide clear, balanced, and truthful information.

Common Pitfalls and Challenges

• Overstating Performance: Avoid the temptation to overstate performance figures to attract investors. Always present performance data accurately and in context.

• Inadequate Risk Disclosure: Ensure that risk disclosures are clear, prominent, and easy to understand.

• Failure to Update Information: Regularly update advertisements to reflect the most current data and regulatory changes.

Real-World Applications and Regulatory Scenarios

In practice, compliance with advertising rules is critical to maintaining trust and avoiding regulatory penalties. Consider the following real-world scenarios:

• Case Study: A mutual fund company was fined for using outdated performance data in its advertisements, which misled investors about the fund’s current performance. The firm failed to update its marketing materials regularly, resulting in non-compliance with SEC rules.

• Scenario: A brokerage firm received a warning from FINRA for not having a registered principal approve its retail communications. This oversight could have led to the distribution of misleading information to investors.

Conclusion

Understanding and adhering to SEC and FINRA rules on advertising and sales literature is essential for any firm operating in the securities industry. By ensuring that all communications are truthful, balanced, and compliant, firms can protect themselves from regulatory action and build trust with investors.

Additional Resources

For further exploration of advertising and sales literature rules, consider the following resources:

• SEC’s Investment Company Act of 1940
• FINRA Rule 2210: Communications with the Public
• SEC’s Guide to Mutual Fund Investing

Series 7 Exam Practice Questions: Advertising and Sales Literature Rules