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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. 

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. 

Marketplace Lender Fined $3 Million for Overstating Returns Due to Coding Errors


A marketplace lender agreed to pay a $3 Million fine for overstating returns because of coding errors.  The SEC asserts that the firm’s legacy coding omitted charged-off loans from historical performance calculations once the charged-off loans were sold to a third party.  According to the SEC, the firm knew as far back as 2014 that its legacy code had significant issues but failed to fix the code affecting the return calculations.  The firm used the inflated returns in client reporting and marketing. 

As firms implement FinTech and RegTech, they cannot simply set it and forget it.  Compliance, operations, and IT personnel must work together in real time to ensure that systems reflect current regulatory requirements.  Technology is a great tool, but it is not the complete answer to regulatory compliance. 

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. 

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. 

BDC Censured for Mischaracterizing Distributions as Income Rather than Return of Capital

 The SEC censured a business development company for overstating its income as a payment of dividends rather than a return of capital and thereby violating several reporting rules.   The BDC included all payments received from underlying asset management subsidiaries as dividends even though a significant portion of the distributions should have been deemed returns of capital.  According to the SEC, the firm failed to offset taxable and accumulated net operating losses.  The SEC asserts that the mischaracterization was material because tax-basis distributable income is a significant metric used by analysts and investors to evaluate BDCs.  The BDC restated its financial statements and reported a material weakness in its financial control infrastructure.

The BDC should be thankful it didn’t get fined.  Although the SEC alleged facts suggesting that the firm should have known about the mischaracterization, an allegation that the firm intentionally juiced reported returns would have resulted in much more significant penalties. 

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).

Target Performance Statements Cost Firm, CFO and Sales Chief

 A public company, its CFO, and its SVP of Sales were censured and fined nearly $2 Million for providing misleading revenue guidance in a press release, during analyst calls, and on Form 8-Ks.  The SEC accuses the respondents of providing inflated forward-looking revenue targets when they knew, or should have known, that such targets would not be achieved.  According to the SEC, the respondents knew that the sales pipeline was weaker than expected and that the company pulled revenue into a prior year period.  When the company revised the revenue target down later in the quarter, the stock price fell more than 33%.

OUR TAKE: The lesson here for fund managers is to avoid forward-looking or target performance projections.  If the rosy predictions ultimately fall short, the SEC will retrospectively review all internal communications and activities for any information that might have suggested lower numbers.  We recommend discussing performance through the lens of the rear-view mirror rather than the windshield.

 

SEC Proposes New Fund Research Reports

The SEC has proposed a new rule that would allow third party broker-dealers to publish research reports about registered investment companies without having to comply with current performance presentation requirements.  Proposed Rule 139b would allow a broker-dealer that is not affiliated with the fund’s adviser to publish research reports that meet certain presentation requirements even where the broker-dealer participates in the offering.  A similar safe harbor already exists for other issuers.  The SEC seeks comment about whether performance information should be required to comply with Rule 482’s performance presentation requirements currently applicable to fund advertising.

OUR TAKE: We would go a step further and rewrite Rule 482 to allow more flexibility for all fund materials.  Then, the SEC would not have to wrestle with whether to allow different types of fund reports depending on the preparer, which could result in more confusion.

http://www.sec.gov/rules/proposed/2018/33-10498.pdf

Performance Track Record No-Action Letter Will Help Adviser M&A

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.

https://www.sec.gov/divisions/investment/noaction/2018/southstatebank050818.htm