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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. 

Signal Provider Used Misleading Hypothetical, Backtested Performance

An index signal provider, who also managed assets, agreed to a fine, censure and an outside compliance consultant for utilizing misleading hypothetical backtested performance information.  The SEC alleges that the calculations of the hypothetical, backtested performance for one of its core strategies deviated significantly from the live data, failed to conform to the firm’s model rules, and utilized an unavailable commodity index.  The SEC also faults the firm for failing to properly supervise a third-party index provider hired to create the backtested performance.  The SEC charges violations of the Advisers Act’s antifraud provisions (206(2)), advertising rule (206(4)-1(a)(5)), and compliance rule (206(4)-7). 

This case against an index provider adds fuel to the fire started by Investment Management Director Dalia Blass who last year questioned whether index providers should be exempt from investment adviser registration.  Also, as we have said before, do not use hypothetical, backtested performance information in marketing and advertising. 

FINRA Allows Limited Use of Pre-Inception Index Performance Data with Intermediaries

FINRA has issued an interpretive letter allowing a broker-dealer to use pre-inception index performance data to market index-based registered funds to institutional investors including intermediaries.  To use pre-inception data, the index must be developed according to “pre-defined rules that cannot be altered” except under extraordinary conditions, and the member firm may only disseminate the data to institutional investors including intermediaries that will not use the information with their retail clients.  FINRA imposes several conditions including (i) the data includes no less than 10 years of performance information, (ii) the material shows the impact of the deduction of fees and expenses, (iii) the material includes actual fund performance, and (iv) the firm includes extensive disclosure including the reasons why the data would have differed from actual performance during the period.  FINRA previously allowed pre-inception performance data to institutional investors other than intermediaries with the same conditions.

The change here is allowing broker-dealers to provide the information to intermediary financial advisers and putting the burden on the intermediaries to prevent use directly with their retail clients.    Regardless, we recommend against using hypothetical backtested performance data because of SEC concerns as well as the significant regulatory and disclosure limitations. 

Robo Falsely Compared Performance with Other Robos

The SEC fined and censured a now-defunct robo-adviser for disseminating misleading marketing information that purported to show outperformance versus competitors.  The SEC asserts that the respondent understated the performance of competitor robo-advisers by using only publicly available information and failing to account for actual weightings.  The SEC faults the firm for publishing information without the documents or data to support its performance claims.  The SEC also maintains that the firm inflated its own performance by cherry-picking certain clients and time periods.  The SEC faults the firm for failing to have policies and procedures requiring the review of marketing materials in part because the Chief Compliance Officer was not aware that social media posts constituted marketing materials under the Advisers Act. 

We hate (HATE!) the concept of using a competitor’s name and/or information in marketing and advertising.  You are inviting your competitor to prove you wrong and thereby call you out on a regulatory violation. 

Robo-Adviser Charged with Multiple Compliance Breakdowns

 

 

The SEC censured and fined a robo-adviser for several compliance violations related to client account management and marketing.  The SEC alleges that software programming errors caused the respondent’s failure to execute tax loss harvesting without violating the wash sale rules, contrary to marketing materials.  The SEC also asserts that the firm retweeted client testimonials and other positive tweets made by those with an economic interest including employees, investors, and paid tweeters.  Additionally, the SEC maintains that the firm failed to provide the necessary disclosure to clients about payments to bloggers to refer the clients to the respondent.  The SEC charges the firm with failing to implement a reasonable compliance program in addition to violations of the antifraud rules and the recordkeeping rules.

 We think robo-advisers provide innovative services to under-served retail clients.  Regardless, as registered investment advisers, robos must conform to the heavily-regulated environment in which they operate.  Some of these alleged violations could have been easily avoided with an industry-standard compliance program.  We recommend reviewing the SEC’s previously issued regulatory compliance guidance to robo-advisers

SEC Re-Considering Adviser Marketing and Advertising Rules

The SEC’s 2019 regulatory agenda includes amendments to adviser marketing rules.  The SEC will consider Rule 206(4)-1, the general advertising rule that prohibits fraudulent statements and specifically limits testimonials, past specific recommendations, and “black box” claims.  The SEC will also re-visit Rule 206(4)-3, which regulates the payment of cash solicitation fees to third parties.  Last year, the SEC took action on 23 of the 26 rules on its regulatory agenda.

Presumably, this rulemaking review has arisen from last year’s sweep whereby OCIE reported widespread marketing violations including misleading performance claims, cherry-picking results, the use of past specific recommendations, and improper claims of GIPS compliance.  The rules haven’t really changed much in several decades, so a re-boot makes some sense.  We recommend that the SEC consider specific standards rather than relying on a general anti-fraud rule. 

SEC Allows Broker-Dealer Fund Research Reports

 The SEC has adopted a new rule allowing third party broker-dealers to publish mutual fund research reports, so long as the reports include standardized performance information.  The new rule (139b) provides that a research report prepared by a broker-dealer unaffiliated with the mutual fund manager or sponsor will not result in an unregistered offering, and the research report will not constitute a prospectus.  The rule requires several conditions including: (i) the subject fund must have met all reporting requirements during the prior 12 months, (ii) the fund must have a net asset value of at least $75 Million, and (iii) any performance information must comply with Rule 482, which requires performance information to be presented in a standardized format.  The SEC initially proposed the rule in May.

The only controversy here is whether performance information should need to comply with Rule 482.  To keep performance information consistent probably makes life simpler for investors, broker-dealers, and the staff at the SEC and FINRA.  Regardless, we still believe that the SEC should take a fresh look at Rule 482 given the proliferation of investment products beyond open end funds investing in publicly-traded securities. 

The Friday List: 10 Adviser Marketing Practices to Avoid

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.

Last year, the SEC’s Office of Compliance Inspections and Examinations issued a Risk Alert warning advisers to review their marketing and advertising practices.  More recently, OCIE alerted advisers to widespread noncompliance with the solicitation rule.  Meanwhile, the Enforcement Division has brought several actions alleging that adviser marketing practices violated applicable law.   With this increased scrutiny, advisers should re-assess the following marketing practices to avoid material exam deficiencies or enforcement actions:

 

10 Adviser Marketing Practices to Avoid

  1. Hypothetical Back-Tested Performance.  The SEC has consistently targeted the use of hypothetical, backtested performance, and the Enforcement Division has brought numerous cases.
  2. Gross Performance.  Although firms can present gross performance in a few limited situations, most should firms should always present performance information net of fees.
  3. Misrepresenting Investment Strategy.  Sales personnel should not make representations about investment products that are inconsistent with disclosure documents.
  4. Receiving Revenue Sharing.  The SEC will heavily scrutinize undisclosed revenue sharing that incent advisers to sell certain products.
  5. Faulty GIPS Compliance.  Claiming compliance with GIPS (CFA Institute) performance standards but failing to actually comply with those standards will draw the ire of the regulators.
  6. Cherry-Picking Performance.  The SEC will challenge firms that only show good performance of certain past specific recommendations.
  7. Testimonials.  Rule 206(4)-1(a)(1) specifically prohibits the use of testimonials. Yet, too-clever advisers keep trying to use them, resulting in enforcement actions.
  8. Lying about Credentials.  Don’t present credentials that are inconsistent with your actual work experience in an effort to market greater expertise.  
  9. Inflating AUM.  Avoid using unverifiable assets under management totals in marketing materials or on Form ADV.
  10. Claiming Clean Compliance.  When asked in an RFP to describe compliance deficiencies identified during exams, do not ignore the question or say “none” unless it’s true.

SEC Warns Advisers about Solicitation Rule Violations

 

The staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) has issued a risk alert about widespread noncompliance with the solicitation rule (206(4)-3).  Reviewing examination deficiency letters for the last 3 years, the staff found that firms frequently failed to (i) ensure that third party solicitors provided or obtained adequate client disclosure statements; (ii) execute required agreements with third party solicitors; and (iii) conduct adequate due diligence to determine whether solicitors complied with agreements.  The staff also expressed concern about conflicts of interests whereby advisers received client referrals in exchange for recommending service providers.  The staff encourages advisers to “review their practices, policies, and procedures.”

This heightened review of solicitation rule compliance is consistent with OCIE’s broader concerns about adviser marketing practices.  The SEC has increased scrutiny in related areas such as the use of backtested performance, testimonials, and revenue sharing.  Also, last year, OCIE issued a comprehensive Risk Alert admonishing advisers to review their marketing and advertising compliance procedures.