What is the Status of Refer-a-Friend Programs Under the Marketing Rule?

Many RIAs have some version of a “refer-a-friend” program, including requests for introductions and webpages on which clients can submit contact information for a friend, family member, or colleague. This raises 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 some communication is not an Advertisement, then the general anti-fraud principles underlying the securities laws certainly apply, but the Marketing Rule does not. See, e.g., Footnote 98 to 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, an Advertisement is any direct or indirect communication an investment adviser makes “to more than one person” that offers the adviser’s services. A communication to a single person is generally outside this prong unless it includes hypothetical performance. Rule 206(4)-1(e)(1)(i).

Under the second prong, an Advertisement is “[a]ny endorsement or testimonial for which an investment adviser provides compensation, directly or indirectly.” Rule 206(4)-1(e)(1)(ii).

Distinguishing Between Compensated and Uncompensated Testimonials

As the SEC explains in the Adopting Release to the Marketing Rule, 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.’” Adopting Release.

To be sure, a client referral fits within the rule’s definition of a Testimonial, 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." Rule 206(4)-1(e)(17).  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 adviser 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 adviser provides compensation.

The Adopting Release makes clear that compensation is interpreted broadly and can include cash or non-cash compensation. Adopting Release. 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, 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.  Rule 206(4)-1(b)(4). 

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.’” Adopting Release.

That first prong generally contemplates a communication to more than one person that offers the adviser's services. A typical one-to-one referral does not qualify: A client who sends an individual email introducing the adviser to a friend is communicating to one person -- there is no communication to “more than one person.” Moreover, merely submitting a friend's name on the adviser's refer-a-friend webpage seems even further from an advertisement, as the only communication is between the client and adviser.

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 adviser's services, and 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 some 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. But 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 adviser. It likewise applies to a client submitting a colleague's contact information on the adviser's refer-a-friend webpage.

By contrast, if an adviser provides clients with standardized promotional materials for mass distribution, republishes client recommendations in its own marketing (even if they are unpaid), or otherwise turns the testimonial into a communication to more than one person, then the analysis immediately changes and the communication may very well be an advertisement. Likewise, the analysis also becomes more complicated if a client shares hypothetical performance in the communication, even if it is only to one person. The Marketing Rule expressly reaches both direct and indirect adviser communications, so just because a message is conveyed by a client does not mean it is not a communication of the adviser.

Conclusion

And 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 compensation, there is no Advertisement under the second prong of the definition. 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. And without an Advertisement, the Marketing Rule’s requirements for working with Promoters do not apply.