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Broker Should Have Disclosed Investment Product Red Flags


An unregistered broker agreed to pay $600,000 to settle charges that he sold third party investments without disclosing numerous red flags and negative facts to potential investors.  According to the SEC, the respondent painted an overly rosy picture of the investments (ultimately Ponzi schemes) and the sponsor by highlighting consistent rates of return and a personal business relationship.  However, the respondent did not disclose that the sponsor had previous issues with the SEC, multiple failed investments schemes, and financial problems.  The SEC argues that once the respondent described the investments in a positive way, he “was under a duty to make materially fair and complete disclosure rather than presenting only a one-sided and unbalanced view of the investment.”  The SEC charges the unregistered broker with violating the antifraud provisions of the Securities Act.

When selling investment products, you cannot merely disclose the good facts.  In this case, the respondent may not (or may) have known the investments were Ponzi schemes, but he did have enough facts to suspect and should have warned potential investors. 

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.

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. 

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.

Adviser Inflated AUM and Touted Fake Returns

An investment adviser has been censured, fined, and barred from the industry for making misleading marketing representations.  The adviser used emails to claim inflated assets under management and tout a non-existent quantitative trading model and historical performance.  The adviser furthered his fraud by putting the fake product and returns on a hedge fund database that was accessed by potential investors.

OUR TAKE: The SEC has warned that it would bring cases against advisers for misleading marketing claims.  Firms should also note that the use of third party databases constitutes marketing subject to the Advisers Act’s anti-fraud rules.