Episode 3: Performance Advertising Issues for Investment Advisers

This week, Michelle Jacko discusses Performance Advertising issues, including reviews of key No Action letters from the SEC, and takeaways for your firm regarding what you should be aware of in your marketing materials. 


Hello, this is Michelle Jacko, CEO of Core Compliance and Legal Services, and this week, on the CCO Buzz, we will be disussing performance advertising issues. Unlike other regulations, the performance advertising rule is one sentence, and it's simply summarized as: 

"Thou shalt not do anything fraudulent, deceptive, or misleading or make omissions of material fact."

The last time that the advertising rule was updated was actually when it was promulgated in 1940.  There haven't been any updates until we received regulatory guidance in the form of either SEC no action letters or, most importantly, in the national examination program's risk alert, which was issued on September 14th, 2017. 

It's such a valuable piece of information because it provides additional guidance as to the SEC's expectations as it relates to performance advertising. 

What the national examination program's risk alert focused on were the compliance issues found based upon 1,000 routine investment adviser examinations, and 70 focused exams during the year 2016. 

Those focused exams were called the Touting Initiative. Basically, what were advisers doing in terms of making accolades in their marketing materials. The goal of releasing the risk alert was to assist firms in adopting effective policies and procedures and to provide investment advisers with reminders that they cannot distribute materials that contain untrue statements of material fact, or statements that are misleading. 

So what were some of the findings in this risk alert? 

Well, the first had to deal with misleading performance results. And what the SEC found during these examinations were that investment advisers failed to deduct advisory fees. 

So in other words, they were presenting gross of fee returns, without providing net of fee numbers. 

They also found that investment advisers were failing to disclose inherent limitations in comparing their performance to a benchmark. 

So for example, if a manager strategy differed from the S & P 500, yet the S & P 500 was identified as the benchmark, did the disclosures describe how the manager's strategy differed with the consituents of the benchmark - and often times, it did not. 

The SEC also found that advisers failed to provide adequate disclosures related to hypothetical back tested performance. It is a very difficult area. 

In fact, the guidance that is provided in the SEC no action letter, Clover Capital, specifies the type of considerations that should be included when presenting hypothetical or model performance information. 

And often times, advisers don't go far enough in providing the limitations of that presentation of numbers. So for example, not disclosing that if we actually had live investor funds, the manager could opt to manage those funds differently for those portfolios by perhaps taking it to an all cash position or being more conservative in the approach of their securities selections. 

The next area that the SEC focused on happened to be on misleading claims of compliance with GIPS. 

If an investment adviser claims compliance with GIPS, they truly need to adhere to all of the standards. Remember, that to comply with GIPS, these are voluntary guidelines. 

But, if you do state that you are compliant with GIPS, attention must be made in regards to the stringent application of those standards. 

The SEC also found that investment advisers were also cherry picking profitable stock selections, and they were only including profitable stocks in presentations, newsletters, and websites. They also saw that investment advisers were failing to offer or furnish a list setting forth all recommendations made by the investment adviser during the past year, and that would be in compliance with the SEC no action letter TCW, whereby the firm must show the 5 best performing and the 5 worst performing holdings within the stated period, or with the Franklin Management no action letter, whereby an investment adviser must offer to furnish all buy or sell recommendations for that firm for the last 12 month period.

Finally, one of the areas that the SEC focused on was compliance with policies and procedures. Firms have policies and procedures, perhaps, but they fail to have them customized, or reasonably designed to prevent deficient advertising practices. 

They may not have addressed protocols for advertising approval. They also found that policies did not discuss the parameters of inclusion or exclusion. 

Finally, firms fail to confirm performance results. 

Our takeaway from this is that investment advisers must go through their policies and procedures to ensure that they are effectively designed to prevent violations of federal securities law, in particular, Rule 206(4)-1 of the Advisers Act. 

This NEP risk alert provides a great checklist for investment advisers to go through to ensure that they've provided adequate guidance to their employees and associated persons on what they must know when presenting performance returns. 

If you have any questions or require additional information, we invite you to please contact us at area code 619.278.0020 or visit our webiste at corecls.com. 

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