Timothy M. Simons, CFA, CFP, CIPM, CSCP
Senior Managing Member
Focus 1 Associates LLC
September 29, 2017
September 14, OCIE issued a Risk Alert
On September 14, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert, “The Most Frequent Advertising Rule Compliance Issues Identified in OCIE Examinations of Investment Advisers.” I have read many deficiency letters from most of the SEC Regional Offices, and I think that in this Risk Alert, the SEC did identify the most common advertising deficiencies, probably over the last 30 years. Some of us remember when the SEC Division of Investment Management (“IM”), issued a no-action letter publicly available on October 28, 1986 to Clover Capital Management Inc. (“Clover”) (which just happens to be my favorite no-action letter of all time, and probably the no-action letter most often identified in deficiency letters, even today). Footnote 11 in the Risk Alert provides a link to Clover, but there is also a no-action letter to the Investment Company Institute publicly available on September 23, 1988 that directly addresses one of the identified deficiencies.
Prior to the Clover letter, very few Investment Advisers (“IAs”) advertised performance, but the Clover letter outlined IM’s concerns regarding the presentation of performance. Actually, Clover was asking for permission to use model performance with disclosures they felt appropriate and in line with the Advisers Act Rule 206(4)-1(a)(5), prohibiting any advertisement, “Which contains any untrue statement of a material fact, or which is otherwise false or misleading.” IM staff responded with a list of eleven items that would violate that Rule:
Model and Actual Results
- (1) Fails to disclose the effect of material market or economic conditions on the results portrayed;
- (2) Includes model or actual results that do not reflect the deduction of advisory fees and any other expenses that a client would have paid or actually paid;
- (3) Fails to disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;
- (4) Suggests or makes claims about the potential for profit without also disclosing the possibility of loss;
- (5) Compares model or actual results to an index without disclosing all material facts relevant to the comparison;
- (7) Fails to disclose prominently the limitations inherent in model results, particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser’s decision-making, if the adviser were actually managing clients’ money;
- (6) Fails to disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed;
- (8) Fails to disclose, if applicable, that the conditions, objectives, or investment strategies of the model portfolio changed materially during the time period portrayed in the advertisement, and if so, the effect of any such change on the results portrayed;
- (9) Fails to disclose, if applicable, that any of the securities contained in, or the investment strategies followed with respect to, the model portfolio do not relate, or only partially relate, to the type of advisory services currently offered by the adviser;
- (11) Fails to disclose prominently, if applicable, that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material.
The Risk Alert
The Risk Alert identifies the five most frequent deficiencies that OCIE has identified as failures to comply with the Advertising Rule, and in particular, paragraph 206(4)-1(a)(5):
- Misleading Performance Results
OCIE staff has observed adviser advertisements that staff believe:
- Contained misleading performance results.
- Presented performance results that did not deduct advisory fees.
- Compared results to a benchmark but did not include disclosures about the limitations inherent in such comparisons, including instances where, for example, an advertisement did not disclose that the advertised strategy materially differed from the composition of the benchmark to which it was compared.
- Contained hypothetical and back-tested performance results, but did not explain how these returns were derived and did not include other potentially material information regarding the performance results.
- Misleading One-on-One Presentations
- Advertised performance results (gross of fees) in certain one-on-one presentations, but did not include potentially relevant disclosures.
- Did not disclose that the advertised performance results did not reflect the deduction of advisory fees and that client returns would be reduced by such fees and other expenses.
OCIE staff has observed advertisements that staff believe contain misleading information in one-on-one presentations that:
- Misleading Performance Results
- (10) Fails to disclose, if applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model;
- Misleading Claim of Compliance with Voluntary Performance Standards (typically GIPS)
- Claimed that their advertised performance results complied with a certain voluntary performance standard, when it was not clear to staff that the performance results in fact adhered to the performance standard’s guidelines.
OCIE staff has observed advertisements that staff believe contain misleading claims of compliance with voluntary performance standards that:
- Cherry-Picked Profitable Stock Selections
- Included only profitable stock selections or recommendations in presentations, client newsletters, or on their websites, without meeting the conditions set forth in Subsection (a)(2) of the Advertising Rule.
OCIE staff has observed advertisements that staff believe contain cherry-picked stock selections that:
- Misleading Selection of Recommendations
- Disclosed past specific investment recommendations that may have been misleading because they included only certain, and not all, recommendations, in order to illustrate a particular investment strategy, and they did not meet the conditions set forth in Subsection (a)(2) of the Advertising Rule.
- Did not satisfy the representations upon which IM staff based certain no-action assurances as provided in the TCW Group and Franklin no-action letters.
OCIE staff has observed advertisements that staff believe contain misleading selections of investment recommendations that:
Like Clover, the TCW Group and Franklin no-action letters assured that the SEC would not take action if certain criteria were met, typically around disclosure.
ICI No-action Letter
Referenced above, was in response to a request to present gross-only performance in a one-on-one presentation, which the SEC would allow, upon the adviser providing at the same time to each client in writing:
- (1) Disclosure that the performance figures do not reflect the deduction of investment advisory fees;
- (2) Disclosure that the client’s return will be reduced by the advisory fees and any other expenses it may incur in the management of its investment advisory account;
- (3) Disclosure that the investment advisory fees are described in Part II of the adviser’s Form ADV; and
- (4) A representative example (e.g., a table, chart, graph, or narrative), which shows the effect an investment advisory fee, compounded over a period of years, could have on the total value of a client’s portfolio.
What I find particularly interesting/concerning is that Clover and the ICI no-action letters are identified (with links) under Information for Newly Registered Investment Advisers on the SEC’s website at: https://www.sec.gov/divisions/investment/advoverview.htm
And still the SEC examination staff sees the same advertising deficiencies over and over and over for more than 30 years.
A final note, I have seen indications that the SEC is considering a return to conducting some routine examinations on an unannounced basis. The SEC has continued to conduct unannounced examinations for cause, but unannounced routine examinations were dropped in the late 1980s to early 1990s, when the request list went from one page to eleven and eventually almost thirty pages, because examiners were sitting around waiting for registrants to pull together the information. I can only assume that the current surge in unannounced exams will be focused on specific high-risk areas, otherwise the number of exams conducted will shrink rather than grow.