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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. 

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. 

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.

Asset Manager Fined $1.9 Million over Hypothetical Back-Tested Performance

 

 

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).

Large Asset Manager Pays $97 Million for Over-Relying on Faulty Quant Models

 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.

SEC Charges Violations of Testimonial Rule

 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.