hedge LAW REPORT fund law and regulation Social Media Understanding the Regulatory Regime Governing the Use of Social Media by Managers and Broker-Dealers By Ricardo W. Davidovich and Karina Bjelland Social media [1] has been increasingly adopted, if not embraced, by businesses, including investment advisers (such as hedge fund managers) and broker-dealers (which may be affiliates of certain hedge fund managers). The question that arises is how does social media fit into the regulatory regime governing investment advisers and broker-dealers? The question is increasingly important in light of both the forthcoming rulemaking by the Securities and Exchange Commission (SEC) pursuant to the Jumpstart Our Business Startup Act (JOBS Act) as well as the SEC s recent release of a National Examination Risk Alert entitled Investment Adviser Use of Social Media (Alert). The Financial Industry Regulatory Authority, Inc. (FINRA) has also issued regulatory notices within the last two years providing guidance on the use of social media by broker-dealers. This article summarizes the relevant regulatory guidance from the federal securities laws, the JOBS Act, the Alert and the FINRA rules and notices to members. General Overview The Investment Advisers Act of 1940, as amended (Advisers Act), currently does not contain a specific rule governing the use of social media; this does not, however, mean that social media is not regulated. Social media usage instead needs to be examined in light of existing SEC rules and regulations. The following sections of the Advisers Act, for example, should be considered when an advisory firm utilizes, or allows its investment adviser personnel to utilize, social media: Section 206 Prohibited Transactions by Investment Advisers (generally referred to as the Advisers Act s anti-fraud provision). Rule 206(4)-8 Pooled Investment Vehicles (generally referred to as the hedge fund anti-fraud rule, which notably does not require wrongful intent as most anti-fraud rules do, but instead can be triggered by negligence). Rule 204-2 Books and Records to be Maintained by Investment Advisers (self-explanatory). Rule 206(4)-7 Compliance Procedures and Practices (the rule which requires SEC registered investment advisers to maintain certain written policies and procedures). Rule 206(4)-1 Advertisements by Investment Advisers (the rule governing how SEC registered investment advisers may advertise). In addition, to the extent an investment adviser advises any private pooled investment vehicles (e.g., hedge funds), the securities of such vehicles are most likely offered pursuant to one of the rules under Regulation D of the Securities Act of 1933, as amended (Securities Act). Additionally, these private pooled investment vehicles typically rely on an exclusion from registration as an investment company found in either Section 3(c)(1) of the Investment Company Act of 1940, as amended (Company Act) or Section 3(c)(7) of the Company Act. These provisions provide certain safe 2013 The Law Report. All rights reserved.
harbors and exemptions from SEC registration (as described below) and contain prohibitions on general advertising, general solicitations and public offerings. While restrictions on general advertising and solicitations will be removed shortly (as discussed below), they are applicable as of the date of this article. Just as the Advisers Act does not contain any specific rules pertaining to the use of social media by investment advisers, there are no FINRA rules that specifically govern the use of social media by broker-dealers. However, FINRA has issued guidance regarding the application of certain existing rules with respect to communications conducted through social media. Broker-dealers need to be aware of FINRA rules and regulations which may be applicable to the use of social media. These rules include the following: [2] NASD Rule 2210 Communications with the Public. NASD Rule 2310 Recommendations to Customers (Suitability). FINRA Notice to Members 11-02 provides guidance on whether a particular communication could be viewed as a recommendation for purposes of this rule. NASD Rule 3010 Supervision. FINRA Rule 4511 (effective December 5, 2011) includes the recordkeeping requirements of predecessors NASD Rule 3110(a) and NYSE Rule 440, and clarifies that firms are obligated to: (1) make and preserve books and records as required under the rules of FINRA, the applicable Securities Exchange Act of 1934 as amended (Exchange Act) rules, and (2) preserve the books and records required to be made pursuant to the FINRA rules in a format and media that complies with Exchange Act Rule 17a-4. FINRA Rule 4511 also requires firms to preserve FINRA books and records for which there is no specified retention period under FINRA rules or SEC rules for a period of at least six years. As a result, social media must be used in compliance with current applicable rules and regulations. For example, an investment adviser must undertake an analysis to ensure that a social media posting (1) contains all material information so that it is not misleading or deceptive, (2) is consistent with the adviser s compliance procedures, (3) is properly captured and maintained with the adviser s books and records (to the extent the content of the posting constitutes a record required to be maintained pursuant to rule 204-2 of the Advisers Act), (4) complies with all of the SEC s rules and directives governing advertising by investment advisers, and (5) does not violate any prohibitions on general advertising, general solicitations or public offerings applicable to any private funds advised by the investment adviser. For brokerdealers, a similar review should be conducted to ensure that a business-related social media posting (1) contains all material information so that it is not misleading or deceptive, (2) is consistent with the broker-dealer s policies and procedures, (3) is maintained within the broker-dealer s books and records as required by Rules 17a-3 and 17a-4 under the Exchange Act and FINRA Rule 4511, and (4) complies with NASD Rule 2210 governing communications with the public. Broker-dealers should also review NASD Rule 2310 in connection with social media postings that could potentially be considered recommendations. Further, broker-dealers are required to adequately supervise associated persons use of social media in accordance with their adopted policies and procedures. 2013 The Law Report. All rights reserved. 2
The JOBS Act On April 5, 2012, President Obama signed into law the JOBS Act, a bill intended to promote economic growth by facilitating easier access to capital through a less burdensome regulatory framework. Among other things, the JOBS Act instructs the SEC to revise Regulation D and Rule 144A of the Securities Act to eliminate the prohibitions against general solicitations and general advertising for offerings made in accordance with Rules 506 and 144A of the Securities Act. [3] The Securities Act requires that any offer to sell securities be registered with the SEC unless the offer is exempt from such registration requirements. Section 4(2) of the Securities Act provides an exemption from such registration for transactions by an issuer not involving any public offering. Rule 506 of Regulation D is a Section 4(2) safe harbor and provides that where an offering does not include more than thirty-five (35) non-accredited investors (and an unlimited number of accredited investors [4] ), and where there has been no general solicitation or general advertising, the transaction will be deemed to not involve a public offering, as described in Section 4(2), and therefore will be exempt from registration under the Securities Act, regardless of the offering s dollar amount. While neither general solicitation nor general advertising are defined, Rule 502(c)(1)-(2) provides a nonexhaustive list of items falling under these prohibitions, which include [a]ny advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and [a]ny seminar or meeting whose attendees have been invited by any general solicitation or general advertising. In a series of noaction letters, the SEC has interpreted the general solicitation and general advertising prohibition to require a fund to have a pre-existing relationship with potential investors prior to contacting them regarding the subject offering. [5] The JOBS Act revises Rule 506 and eliminates the prohibition on general solicitation and general advertising in Regulation D offerings involving only accredited investors. Where nonaccredited investors are included, the prohibitions remain in effect. This is a significant change to the existing regulatory structure. Because general solicitation and general advertising will now be permitted in Rule 506 offerings made exclusively to accredited investors, the demonstration of a pre-existing relationship becomes irrelevant in these transactions. While Rule 506 provides a safe harbor for issuers relying on the exemption from registration provided by Section 4(2) of the Securities Act, revision to the safe harbor also impacts funds that depend on exemptions provided by other statutory authority. Of particular note are private funds that rely on the exemptions from registration as an investment company, which are provided by definitional exclusions set forth in Sections 3(c)(1) and 3(c)(7) of the Company Act. To obtain registration relief under either Section 3(c)(1) or 3(c)(7), the issuer must not presently propose to make a public offering of its securities, which is potentially at odds with the modified Rule 506 that allows for general solicitation and advertising. The JOBS Act anticipates this potential inconsistency and provides that offers and sales exempt under Rule 506 shall not be deemed public offerings under the federal securities laws as a result of general advertising or general solicitation. The JOBS Act, therefore, seems to grant Section 3(c)(1) and 3(c) (7) private funds the ability to engage in general solicitation and advertising, provided the securities of the private funds are offered only to accredited investors under Rule 506. As a result, many hedge fund managers may turn to social media as a means to market their hedge funds. It should be noted that the SEC, the primary regulator of investment advisers and hedge funds, has expressed its opposition to these regulatory relaxations. Accordingly, the SEC will likely subject any advertising, particularly through a public medium such as 2013 The Law Report. All rights reserved. 3
social media, to significant scrutiny. As noted above, any advertisement conducted by an investment adviser on behalf of a Section 3(c)(1) or 3(c)(7) fund will still need to comply with the Advisers Act. Broker-dealers that participate in Rule 506 offerings should review general solicitation materials to ensure the materials are in compliance with FINRA requirements governing communications with the public. General solicitation materials, including material distributed through social media, may be considered sales literature or advertisements under NASD Rule 2210. Broker-dealers will also need to ensure that their conduct complies with the recordkeeping standards set forth in Rule 2210. NASD Rule 2310 should also be reviewed in connection with the general solicitation materials in order to assess whether the materials could be considered a recommendation under NASD Rule 2310. If a communication to a customer(s) is deemed a recommendation, Rule 2310 requires the broker-dealer to have reasonable grounds for believing that the recommendation is suitable for the customer(s). NASD Notice to Member 01-23 (Online Suitability) provides some guidance on when an online communication falls within the definition of recommendation under Rule 2310. The Alert In the Alert, issued January 4, 2012, the staff of the SEC s Office of Compliance Inspections and Examinations (Staff) [6] defines social media as follows: Social media is an umbrella term that encompasses various activities that integrate technology, social interaction and content creation. Social media may use many technologies, including, but not limited to, blogs, microblogs, wikis, photos and video sharing, podcasts, social networking, and virtual worlds. The Staff indicates that SEC registered investment advisers using social media should, pursuant to Advisers Act Rule 206(4)-7, adopt (and periodically review the effectiveness of) policies and procedures regarding social media. [7] The Staff specifically states that the use of social media by registered investment advisers has been a matter of interest to the Staff, which recently identified registered investment advisers of varying sizes and strategies to evaluate whether their use of social media complied with the federal securities laws. In its observations following these examinations, the Staff noted that while many investment advisers have procedures that apply to advertisements, client communications or electronic communications, these policies often do not specifically include social media. Further, the Staff noted that many compliance procedures did not specify the types of social networking that are permitted or prohibited by the adviser and did not address the use of social media by solicitors. The Staff provided a non-exhaustive list of factors that an investment adviser should consider when evaluating the effectiveness of its compliance programs relating to the use of social media: Usage Guidelines Consider whether to create firm usage guidelines that provide guidance on appropriate and inappropriate use of social media. Are there to be restrictions? Will there be a list of approved social media sites? Content Standards What information might implicate or perhaps undermine the firm s fiduciary duty or other regulatory issues (e.g., content that contains investment recommendations, investment performance, etc.). Should the firm impose content restrictions? Monitoring How and at what frequency is the firm going to monitor the use of social media? For example, 2013 The Law Report. All rights reserved. 4
if the information posted is such that rapid and broad use by others is reasonably anticipated, an after-thefact correction of inaccurate information may not be reasonable under the circumstances. Approval of Content Should the firm s policy require pre-approval rather than after-the-fact review? Who are the persons at the firm authorized to permit the posting or provide a correction? Firm Resources What resources can or should the firm devote to monitoring social media usage? A firm may consider using sampling, spot checking, or lexicon-based or other search methodologies, or a combination of methodologies, to monitor social media use and content. Criteria of Approving Participation The firm s compliance procedures may consider, without limitation, the reputation of the site, the site s privacy policy, the ability to remove third-party posts, controls on anonymous posting and the advertising practices of any social media site. Training Consider requiring training on social media usage in the context of the SEC rules and guidance and the firm s internal policies. Certification Perhaps the policy should require a certification from employees that they understand the social media policies and that they are in compliance with such policies Functionality Consideration might be given to the functionality of social media upgrades, modifications, etc. Personal and Professional Sites The policy might consider whether the firm can conduct firm business on an otherwise personal social media site. Should there be a specific set of rules to address what can be said on sites not operated, supervised or sponsored by the firm? While a firm may determine that it is appropriate to permit business card information on a specific personal site or third-party site, it may choose to prohibit conducting firm business on that site. Information Security A firm may consider whether permitting access to social media sites poses any information security risks. Protecting information and information systems from unauthorized access, use, disclosure, disruption, modification, perusal, inspection, recording or destruction is an important risk faced by all firms. Although hacking and other breaches of information security can be posed in multiple ways, use of social media, especially thirdparty social media sites, may pose elevated risks. Firms may consider adopting compliance policies and procedures to create appropriate firewalls between sensitive customer information, as well as the firm s own proprietary information, and any social media site to the extent that the firm permits access to such sites. Enterprise Wide Sites An adviser that is part of a larger financial services or other corporate enterprise may consider whether to create usage guidelines reasonably designed to prevent the advertising practices of a firmwide social media site from violations of the Advisers Act. Testimonials; Postings by Third Parties While the term testimonial is not defined in Advisers Act Rule 206(4)-1(a)(1), the SEC staff has interpreted that term to include a statement of a client s experience with, or endorsement of, an investment adviser. [8] The Alert notes that in the social media context, a testimonial can include the mere pressing of the like button or the thumbs up button 2013 The Law Report. All rights reserved. 5
on a website. As such, firms that allow for third parties to post information on their social media sites should consider having policies concerning third-party postings, including testimonials, to avoid violations of federal securities laws. Recordkeeping Responsibilities Advisers Act rule 204-2 requires SEC registered investment advisers to maintain specific books and records for specific periods (generally five years). The rule does not distinguish between media: any communication could be subject to the rule depending on its content. As such, firms should consider their record retention policies to ensure that they address social media. In the Alert, the Staff recommends that investment advisers adopt compliance procedures that address the following factors relating to the recordkeeping and production requirements of required records generated by social media communications: determining, among other things, whether each social media communication used is a required record, and, if so, the applicable retention period for such record, and the accessibility of the record; maintaining social media communications in electronic or paper format (e.g., screen print or pdf of social media page, if practical); conducting employee training programs to educate advisory personnel regarding the SEC s recordkeeping provisions; arranging and indexing social media communications that are required records and keeping the records in an electronic format to promote easy location, access and retrieval of a particular record; periodic test checking (using key word searches or otherwise) to ascertain whether employees are complying with the compliance policies and procedures (e.g., whether employees are improperly destroying required records); and using third parties to keep records consistent with the recordkeeping requirements. FINRA Regulatory Notices Although there are no specific rules governing social media for broker-dealers, FINRA has issued Regulatory Notices that provide guidance relating to the use of social media. Regulatory Notice 10-06 provides guidance relating to the use of social media websites such as blogs and social networking sites. The notice covers a firm s recordkeeping responsibilities, suitability responsibilities, supervision of social media sites and third-party posts. Regulatory Notice 11-39 provides additional guidance on these issues, as well as discussions concerning the following topics: links to third-party sites, data feeds and social media use on personal devices. Recordkeeping If a broker-dealer permits its registered representatives to exchange business communications using social media sites, the broker-dealer must ensure that it can capture records of those communications and monitor them effectively. This applies to messages sent directly to specific clients or potential clients, and to posts made on social media sites that are not directed at anyone specifically, such as a Facebook wall post. Every firm that communicates through social media, or permits its associated persons to communicate through these sites, must ensure that it can retain records of these communications as required by Rules 17a-3 and 17a-4 of the Exchange Act and FINRA Rule 4511. It is up to the firm to ensure that the technology it chooses to use to retain these communications complies with the books and records rules. 2013 The Law Report. All rights reserved. 6
If a firm permits its associated persons to use personal communication devices such as personal cellular phones for business communications, the firm must be able to retain, retrieve and supervise the business communications sent using the device. This includes business-related communications sent through social media applications on the device. Some firms that are not able to acquire this type of record retention and monitoring technology (perhaps because of budgetary constraints) may create a policy that prohibits their associated persons from posting business related content to social media sites or using those platforms to communicate with clients. Suitability Broker-dealers should remind associated individuals to be cognizant of whom they have made posts available to. For example, the firm should consider whether the communication was sent to one individual, or a larger audience. The audience is an important factor in a firm s review process for potential suitability concerns. The issue is whether online communications could fall within the definition of a recommendation pursuant to Rule 2310. Rule 2310 requires a broker-dealer to determine that a recommendation is suitable for every investor to whom it is made. This can become an issue when individuals post recommendations that are viewable by a large audience. Communications that trigger the FINRA suitability rule could create liability for the firm or individual. These communications must also include the appropriate disclosures. Additionally, a firm might consider prohibiting all communications that recommended a specific investment product unless a registered principal has previously approved the content. As social media is rapidly expanding and the technology to capture content is constantly evolving, it can be difficult to monitor all of these posts and communications. Alternatively, a firm might consider creating a database of previously approved materials that associated individuals can access and use. Interactive Forums Participation in interactive electronic forums falls within the definition of public appearance under Rule 2210. Interactive electronic forums include chat rooms and public seminars. Although this guidance has been around for a decade, this is an important issue to bring up because there are now chat rooms and other interactive forums available on many social media sites such as Facebook and Google+. Other examples of interactive forums on social media include interactive posts on Twitter and Facebook. These forums are subject to the content requirements of Rule 2210. Supervision If broker-dealers are going to permit the use of social media sites for business purposes, they need to ensure that they can effectively supervise their associated persons participation in the same manner that they would supervise other activity. When developing written supervisory procedures, firms should keep this in mind and tailor the social media procedures to their business. Firms must supervise both static content on social media sites and interactive communications that relate to firm business. Static content on social media sites (such as user profiles) can be considered advertising and should be reviewed by a firm prior to posting if an associated individual is using the social media account to conduct business. Although firms are not required to have a registered principal approve interactive forum communications prior to use, firms 2013 The Law Report. All rights reserved. 7
must still supervise these communications. Under NASD Rule 3010, firms must supervise the interactive forums to ensure that they do not violate the content standards of FINRA s communications rules. Firms must establish procedures that reflect how they will supervise this activity. Firms may use risk-based principles to determine how and to what extent they must review social media communications in order to conduct adequate supervision. Firms should also ensure that associated persons have the necessary training and background in order to use social media for business communications. For example, a firm may require associated persons to review, acknowledge and adhere to content guidelines when using interactive forums. Third-Party Issues If a firm is aware or has reason to believe that a third-party website contains false or misleading content, the firm should not provide a link to that site on the firm s website or through any social media sites. If a firm was to endorse third-party content on one of its own sites or pages, then this could be considered adopting the third-party content. By adopting the content, the firm is then responsible for that content under NASD Rule 2210. Also, if a firm is involved in the development of content on a third-party site, the firm could be considered to have become entangled with the thirdparty site and will also be responsible for the content of the third-party site under NASD 2210. Similar to third-party websites, which are discussed above, posts made by third parties on social media sites are only considered to be firm communications if the firm has involved itself in the preparation of the posts, or has endorsed or approved the posts. In those cases, the communications would be subject to Rule 2210. If firms utilize data feeds from outside sources on their websites, they must adopt procedures to review the data and the outside source of the data. Firms should review the vendor s procedures and calculations in order to ensure that the data is accurate and current. Inaccurate information or links should be corrected or removed in a timely manner. Ultimately, when using social media, firms and associated individuals should adhere to the same code of conduct they would abide by if they were interacting with a customer in their office or when using firm e-mail. As social media sites expand, and more individuals use these platforms to generate business, the responsibilities of broker-dealers and associated individuals will continue to evolve. Ricardo Davidovich is a partner at Tannenbaum Helpern Syracuse & Hirschtritt LLP, a full service commercial law firm with particular expertise in financial services legal matters, including hedge fund start up and regulation, SEC regulation, registrations and enforcement matters, ERISA matters, employment law, private equity and private equity transactions, tax law and regulatory matters facing family offices. This article is for educational purposes only, is not legal advice and may constitute attorney advertising in certain jurisdictions. He is reachable at (212) 508-6710 or at davidovich@thsh.com Karina Bjelland is a managing consultant in the Financial Institutions Practice at Berkeley Research Group, LLC, a leading global expert services and consulting firm that provides independent expert testimony, litigation and regulatory support, authoritative studies, strategic advice, and document and data analytics to major law firms, Fortune 500 corporations, government agencies and regulatory bodies around the world. Berkeley Research Group, LLC is not a CPA firm and does not provide audit, attest or public accounting services. The views expressed are those of the author and not intended to represent those of Berkeley Research Group or other experts at BRG. 2013 The Law Report. All rights reserved. 8
[1] The term social media refers to various web-based technologies used to turn communication into interactive dialogue. Social media is generally addressed to or available to many readers/recipients and includes, without limitation, blogs, wikis, Facebook, Twitter, and podcasts. [2] In 2007, FINRA was formed through the consolidation of the National Association of Securities Dealers, Inc. (NASD) and the member firm regulatory operations of the New York Stock Exchange (NYSE). FINRA is establishing a consolidated FINRA rulebook that will consist solely of FINRA Rules. Until the completion of the rulebook consolidation process, the FINRA rulebook includes NASD Rules and incorporated NYSE Rules, in addition to the FINRA rules that have been approved to date. [3] The JOBS Act set a deadline of July 4, 2012 for these revisions. In her June 28, 2012 testimony to the U.S. House of Representatives Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs and the Oversight and Government Reform Committee, SEC Chairman Mary Schapiro indicated that such deadline would not be met. As of date of this writing, the revisions have not yet been made. [4] Generally, accredited investors (as defined in Rule 501 of Regulation D) includes financial institutions, corporations, trusts and various other legal entities with assets in excess of $5 million, as well as natural persons that meet certain net worth or income standards. [5] See In re Kenman Corp, SEC No-Action Letter (Apr. 19, 1985). [6] The Alert is notable in that it reflects the published views of the staff of the SEC s Office of Compliance Inspections and Examinations in accordance with other SEC staff including the Division of Enforcement s Asset Management Unit and Division of Investment Management. The Alert indicates that FINRA was also consulted. [7] Note that in the Alert, the Staff refers to registered investment advisers, but many of the issues raised apply to unregistered investment advisers as well. [8] Rule 206(4)-1(a)(1) states that: [i]t shall constitute a fraudulent, deceptive, or manipulative act, practice, or course of business... for any investment adviser registered or required to be registered under [the Advisers Act], directly or indirectly, to publish, circulate, or distribute any advertisement: (1) which refers, directly or indirectly, to any testimonial of any kind concerning the investment adviser or concerning any advice, analysis, report or other service rendered by such investment adviser.... 2013 The Law Report. All rights reserved. 9