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.
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 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.
The SEC fined a large asset manager $1.9 Million for failing to fully disclose that it used hypothetical back-tested performance data in advertisements. The SEC asserts that the respondent claimed that it could prove back to 1995 that its stock strategy combining fundamental and quantitative research outperformed either approach alone. Although the firm labeled such research as “hypothetical,” the SEC faults the firm for failing to disclose that its research was based on back-tested quantitative ratings for a time period before it generated its own quantitative models or research. Using the longer period helped boost the claimed outperformance. The outperformance data was used in marketing to institutional investors, RFP responses, and a white paper. The SEC also criticizes the compliance program because compliance personnel that reviewed the materials were not informed that the materials included back-tested data.
OUR TAKE: Do not market hypothetical, backtested performance. No amount of disclosure can ever insulate you from the SEC’s retrospective criticisms and analysis that you cherry-picked time periods or data. Also, compli-pros should note that marketing materials delivered solely to institutional investors are subject to the same rules as more widely-distributed marketing materials (with a few exceptions such as allowing presentation of gross performance together with net performance).
A large asset manager agreed to pay over $97 Million in disgorgement, fines and interest for over-relying and marketing faulty quantitative models and other portfolio management missteps. The SEC maintains that the respondents rolled out registered funds and separate accounts based on un-tested quantitative models created by an inexperienced research analysist. When the models failed to work as described to the Board and investors, the respondents discontinued their use without explanation or disclosure. The SEC also accuses the firm of declaring dividends without proper disclosure of the percentage attributable to return of capital and for using third party performance data without verification. The SEC charges violations of the anti-fraud rules, the compliance rule, and Section 15(c) of the Investment Company Act for lying to the funds’ Board.
OUR TAKE: This case reads like a cautionary tale for large firms trying to quickly roll out a product. It appears that the portfolio management, marketing, legal, operations, and legal functions worked in silos, and, as a result, failed to properly vet or describe the products. We recommend that firms create a cross-functional product assessment team that can ask the hard questions before launching a product.
The SEC settled five enforcement actions against two investment advisers, three investment adviser representatives, and the principal of a third party marketing firm for utilizing the internet to disseminate unlawful client testimonials. Three of the actions involved a testimonial program sold by the third party marketing firm that solicited client testimonials for publication on social media websites. Clients lauded the subject firms for service, returns, knowledge, and market access. One of the firms sought positive reviews on Yelp that it would endorse. One of the firms posted client videos on YouTube. The SEC charged the principal of the third party marketing firm with causing his client’s violations. The testimonial rule (206(4)-1(a)(1)) prohibits advertisements that refer to any testimonial about advice, analysis, or services.
OUR TAKE: Last September, OCIE warned advisers against misleading marketing practices. It’s hard to believe that advisers could violate the testimonial rule, a clear prohibition that has been in effect for decades. If you don’t know the rules, hire a compli-pro to ensure you don’t violate the black letter rules.
The staff of the Division of Investment Management has granted no action relief to allow a merged subsidiary to continue to use its performance track record. The SEC noted that the internal reorganization described would result in a newly-created division utilizing the same investment personnel and processes. The applicant, which merged the former separate entity into another investment adviser subsidiary, distinguished the reorganization from the Great Lakes no action letter, where the SEC came to a different conclusion because the new investment committee had personnel changes.
OUR TAKE: This letter will help investment adviser roll-ups by private equity firms and other strategic buyers by allowing internal corporate structuring freedom without fear of losing performance track records.
The SEC’s Office of Compliance Inspections and Examinations has issued a Risk Alert citing common investment adviser marketing and advertising compliance issues. OCIE, drawing on over 1000 examinations and its recent “Touting Initiative,” cited several deficiencies: (i) misleading performance results including failure to present performance net of fees, comparisons to inapplicable benchmarks, and hypothetical/back-tested performance, (ii) misleading claims about compliance with voluntary performance standards (i.e. CFA Institute), and (iii) cherry-picked performance and misleading presentations of past specific recommendations. The SEC also criticized advertising that cited third party awards or rankings without proper explanation. The SEC urges advisers to “assess the full scope of their advertisements and consider whether those advertisements are consistent with the Advertising Rule, the prohibitions of Section 206, and their fiduciary duties, and review the adequacy and effectiveness of their compliance programs.”
OUR TAKE: OCIE generally issues these types of Risk Alerts in advance of bringing enforcement actions. Although the SEC has not generally brought enforcement cases solely on the basis of misleading performance claims, this Risk Alert may signal a change in enforcement policy.
The SEC censured and fined an investment consultant and its principal $700,000 for lying about gifts received from recommended investment managers and performance information. The respondent’s marketing material claimed that neither the firm nor its principals took “so much as a nickel” from any investment manager. However, the firm’s Code of Ethics permitted gifts over $100 with pre-approval and under $100 without. The SEC asserts that personnel in the firm received tickets to the Masters Golf Tournament and other smaller gifts over a 4-year period, even where such gifts violated the Code of Ethics but the firm never imposed discipline. The SEC also accuses the firm of marketing hypothetical and back-tested performance without sufficient disclosure or backup.
OUR TAKE: Code of Ethics violations are an oft-cited SEC deficiency and should be remedied upon discovery (see Common OCIE Deficiencies). However, this firm compounded the problem by boasting about its Code of Ethics compliance in marketing materials. We do not recommend claiming 100% compliance with any rule as part of a marketing campaign.