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The Friday List: The 10 Most Significant Changes in the Proposed Adviser Advertising Rule

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

Earlier this week, the SEC proposed a new investment adviser advertising rule that would dramatically alter current adviser marketing practices.  Proposed Rule 206(4)-1 changes the definition of “advertising,” applies different standards to retail-directed advertisements, allows testimonials, and requires a responsible employee to review and approve all materials.  The Release is over 500 pages, so we offer a summary of the most significant changes in the proposed rule.  Please note, however, that this proposal still has to go through a lengthy comment process before the law actually changes.

The 10 Most Significant Changes in the Proposed Adviser Advertising Rule

  1. Expanded Definition of “Advertisement”. The proposed rule applies to “any communication, disseminated by any means.”  This definition includes all digital and social media communications.
  2. Includes Private Funds. The definition of “advertisement” includes communications intended to obtain investors for a pooled investment vehicle (other than a registered fund) advised by the investment adviser.
  3. Gross Performance Allowed. The proposed rule allows the use of gross performance for non-retail accounts if the adviser includes the fees and expenses that would be deducted to determine net performance.
  4. Performance Periods. Retail advertisements (see below) must include one, five, and ten-year (or life if shorter) performance numbers.
  5. Extracted Performance Restricted. A presentation of a subset of portfolio performance must include (or offer to provide) the results of all portfolio investments.
  6. Higher Standards for Retail Advertisements. A retail advertisement is a communication directed to anybody other than a qualified purchaser (Investment Company Act Section 2(a)(51)) and a knowledgeable employee (Investment Company Act Rule 3c-5). For example, an adviser can only show gross performance if it also shows net performance.
  7. Practically Outlaws Hypothetical Performance. The disclosure requirements for the use of hypothetical performance are so stringent that the rule essentially outlaws the use of such information.
  8. Testimonials Permitted. For the first time, advisers could use client testimonials so long as significant disclosure is included.  This will facilitate social media comments and likes.
  9. Designated Reviewer. A designated employee (presumably the Chief Compliance Officer) must review and approve all advertisements.
  10. Compliance and Recordkeeping. The new rule requires advisers to enhance policies and procedures to ensure the accuracy of any marketing claims, comply with the new Rule’s requirements, and maintain supporting documentation.

SEC Proposes New Investment Adviser Advertising Rule

 

The SEC has proposed a new investment adviser advertising rule that broadens the definition of “advertising,” more specifically regulates performance information, and allows certain testimonials and endorsements.  Revised Rule 206(4)-1 would broadly include any communication distributed by any means that promotes advisory services or a pooled fund and prohibits any misleading or unsubstantiated statements.  The new rule would also require all retail-directed advertisements to include one, five and ten-year periods when presenting performance information.  Advisers would also be able to use testimonials so long as the adviser fully discloses whether the person is a client and whether compensation has been provided.  The new rule would also require approval in writing by a designated employee before dissemination.  The SEC said it may rescind current no-action letters.  The SEC also proposed a new solicitation rule that would require additional disclosure about the solicitor but eliminate the current rule’s requirement to collect client acknowledgements.  Both rules require at least a 60-day comment period.

We like that the SEC has modernized certain areas (e.g. testimonials) and has clarified how to present performance information.  We believe that clearer rules help compliance professionals and reduce the likelihood of enforcement cases resulting from subjective standards. 

Rich College Student Misleads Outside Investors with Faulty Valuations

 

The SEC charged a private fund manager and its principals with using a non-standard valuation model to value structured notes, thereby inflating fund performance and fees.  The main principal launched his firm out of his college dorm room initially to invest his family’s fortune but ultimately marketed his fund to third-party investors.  Rather than value the underlying structured note investments pursuant to “fair value” as required by ASC 820, the firm used a proprietary valuation model that deviated significantly from industry norms, thereby inflating returns and fees.  The SEC asserts that the respondents lied to investors, the auditor, and the SEC staff about its valuation practices.  The SEC cites multiple violations of the Securities Act, the Exchange Act and the Advisers Act.

Although ASC 820 leaves some discretion to management, the inputs cannot consistently juice valuations and returns and must have some market-based support.  The SEC could preempt these types of practices by publishing more specific valuation guidance as previously promised

Adviser Recklessly Promised Investors that Third Party Capital was Coming

 

The principal of an adviser formed to manage private funds was barred from the industry and fined for misleading clients by touting a promised capital infusion.  According to the SEC, the respondent recklessly believed that a third party would invest a large amount of capital, thereby allowing the fund to expand investment activities.  Although the third party had executed a non-binding letter of intent, the transaction was never consummated.  Nevertheless, the respondent continued to promise investors that it had hundreds of millions in committed capital.  The SEC also charges the respondent with a series of related misrepresentations as well as lying on Form ADV and illegally registering with the SEC.

Don’t make promises based on a promise.  It appears that the respondent genuinely believed the money was coming, but, unfortunately, the third party never legally committed.  As the old saying goes, “If wishes were fishes, we’d all have a fry.”

Unregistered Adviser Barred From Industry for Marketing Misrepresentations

 

The SEC fined an unregistered investment adviser and barred its principal from the industry for making false representations in marketing materials primarily to professional athletes.  The SEC asserts that the adviser, which terminated its SEC registration in 2008 but continued to market its investment advisory services through 2018, baldly lied about its assets under management, clients, management, and employees.  The firm emailed its misleading brochure to over 80 prospects over a 12-month period and included a cover email that also included significant misrepresentations.  The SEC alleges violations of the Advisers Act’s antifraud rules.

Just because you do not register with the SEC does not mean that you are exempt from its antifraud rules.  Section 206 applies to any statement made by an investment adviser, whether registered or unregistered, that could defraud any client or prospective client.

Name-Dropping in Offering Materials Leads to Securities Fraud Charges

The Canadian-based principal of a company formed to invest in blockchain companies and digital assets was fined and censured by the SEC for making misrepresentations while soliciting capital. According to the SEC, the respondents used slide decks and other materials that falsely claimed that four prominent blockchain individuals served as advisors to the company. The respondents boasted “access to, and unparalleled relationships with, opinion-makers, the best entrepreneurs, and the highest profile figures in the blockchain community.” The SEC maintains that these false statements helped raise $16 Million in a convertible debenture offering. The Ontario Securities Commission imposed an additional $520,000 fine following a court order whereby the principal agreed to forego his $2 Million interest in the company.

Didn’t know that name-dropping could result in securities fraud? Any misstatement arguably relied upon by investors could give rise to Section 17(a)(2) charges of offering securities by means of an untrue statement of a material fact.

Fund Manager Barred for Lying About Investment Strategy

A private fund manager was barred from the industry for misleading potential investors about the success of his trading strategy.  The respondent claimed to invest in a diversified portfolio of publicly-traded securities with a proprietary algorithm to limit downside risk.  Instead, he pursued a highly risky unhedged options strategy that wiped out the fund’s assets.  The SEC alleges that the respondent hid his losses by sending out false account statements and tax forms.  The SEC charged the state-registered adviser with securities fraud.  The parties agreed to additional proceedings to determine penalties and disgorgement. 

This case should be read by any potential client/investor enticed by a too-good-to-be-true investment pitch.  It is unfortunate when legitimate investment managers have to compete for business against wrongdoers who outright lie about their performance. 

Large Bank Lied about Hedge Fund Due Diligence Process

The SEC fined a large commercial bank for failing to disclose that it only recommended hedge funds that paid a portion of the management fee back to the bank.  The bank marketed a robust due diligence process conducted by a purportedly independent, in-house research group performing a multi-step due diligence process to select hedge funds from an “extremely large universe.”  In fact, the bank only recommended hedge funds that paid back management fees that it called “retrocessions.”  Although the bank disclosed that it might receive revenue sharing and the amount actually received from each hedge fund, the actual due diligence process did not comport with marketing promises.  The bank, which is not a registered adviser or broker-dealer, was charged with violating the Securities Act’s anti-fraud provisions (17(a)(2)).

Check the marketing team’s enthusiasm at the door.  The SEC doesn’t allow firms an exception from the securities laws for product hype, regardless of how clients/investors may perceive the statements.  Rather than caveat emptor (buyer beware), caveat venditor (seller beware) governs sales of securities products.  

Day Trader Lied About Track Record

The SEC charged an unregistered day trader for lying about his trading success and misappropriating client funds. The defendant convinced clients to hire him by asserting that that he had done very well as a day trader over several years and then promised over 50% annualized returns.  Once retained, the trader did very poorly and siphoned client assets for personal expenses.  According to the SEC, he then concealed his misconduct by delivering false account statements and implementing a microcap wash sale scheme.  The defendant also faces criminal charges brought by the U.S. Attorney’s Office for the Eastern District of New York.

Lying about your investment track record constitutes securities fraud, subjecting you to civil and criminal penalties.  Do not make performance claims unless you can affirmatively support your claims with hard data. 

SEC’s Blass Announces Plans to Modernize Adviser Marketing Rules

The SEC’s Investment Management Division Director, Dalia Blass, anticipates that the Division will soon recommend changes to the adviser marketing and solicitation rules.  In her annual speech to the Investment Company Institute membership, Ms. Blass also announced initiatives for a summary shareholder report, updates to the valuation guidance, modernization of the offering rules for business development companies and closed-end funds, and changes to the rules for funds’ use of derivatives.  Additionally, Ms. Blass wants the Division to finalize the proposed ETF and fund-of-funds rules.  She has also asked the staff to begin an outreach to small and mid-sized fund sponsors about regulatory barriers.  She announced that the Division is considering the formation of an asset management advisory committee to solicit diverse viewpoints on critical issues.

We applaud the reinvigorated Investment Management Division for tackling some of the thornier problems that have faced the industry for many years.  For instance, the marketing rules haven’t changed for decades despite revolutionary change in the financial services industry.