Advertising a fund’s performance is a key aspect of soliciting new investors. Among the myriad considerations investors take into account when determining whether to invest with a hedge fund, performance is routinely cited as one of the most unambiguous key factors influencing both the initial decision to invest and the decision to remain in a hedge fund. Performance reporting, however—a potential minefield of regulatory nuances that can flummox even the most thorough of hedge fund compliance programs—is not as straightforward, which the Securities and Exchange Commission has spilled considerable ink in releases, guidance and enforcement actions emphasizing. Recently, the SEC’s Office of Compliance Inspections and Examinations released a Risk Alert that provides insight into the most frequent advertising violations OCIE staff encounter. This article summarizes that Risk Alert’s findings.
The Advertising Rule
OCIE’s most recent Risk Alert focuses on compliance issues related to Rule 206(4)-1 of the Investment Advisers Act of 1940, more commonly referred to as the Advertising Rule. The issues OCIE highlighted were gleaned from deficiency letters sent to RIAs and an exam initiative focused on the use of what the SEC termed accolades, or touting, in firms’ marketing materials and provide valuable lessons for registered investment advisers, including hedge funds.
Generally, the Advertising Rule prohibits an adviser from, directly or indirectly, publishing, circulating or distributing any advertisement that contains any untrue statement of material fact or that is otherwise false or misleading. The Rule further prohibits four specific actions: advertisements that refer, directly or indirectly, to any testimonial concerning the adviser or any advice, analysis, report or other service rendered by the adviser; advertising past specific recommendations of the adviser that were or would have been profitable to any person; claiming that any graph, chart, formula or other device can by itself determine whether to buy or sell a security; or advertisements that offer purportedly free reports, analyses or services.
The Rule defines advertisements as: “[A]ny notice, circular, letter or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television, which offers (1) any analysis, report or publication concerning securities, or which is to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (2) any graph, chart, formula or other device to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (3) any other investment advisory service with regard to securities.”
Advertising guidelines are also discussed in court decisions, various opinions, orders, no-action letters and guidance updates issued by the SEC which have, among other things, increased the breadth of media subject to the Rule to include electronic media or “other non-traditional styles of presentation.”
Most Frequent Performance Advertising Compliance Issues
The Risk Alert highlights a broad range of advertising functions in which OCIE observed compliance issues across the advisers examined. Specifically, OCIE observed that misleading performance results touted performance figures that failed to deduct advisory fees; used a benchmark without disclosing the limitations of such comparisons, such as when the strategy differed materially from the composition of the benchmark; or included back-tested or hypothetical performance results without adequately explaining how they were derived.
In one-on-one presentations, OCIE observed that firms failed to disclose performance results gross of fees, as opposed to net of fees. Advisers also touted compliance to voluntary performance standards, without clarifying whether they actually adhered to those standards’ guidelines. Firms also provided “cherry-picked” stock selections in presentations and newsletters, and on websites, without meeting the conditions for doing so prescribed by the Advertising Rule. Furthermore, OCIE staff noted that advisers advertisements to various constituencies, including consultants, current investors and prospective investors, disclosed past recommendations that did not meet conditions set out in the TCW Group and Franklin no-action letters. In the TCW Group case, Division of Investment Management staff determined that a firm could tout its five best holdings if it displayed with equal prominence an equal number of the worst performing holdings. In the Franklin case, the IM staff allowed for presenting past recommendations so long as they were selected for presentation using “objective, non-performance based selection criteria” and certain disclosures were made.
As is often the case, the issues OCIE noted at firms came down to insufficient policies and procedures around the problem area. Examiners said that “advisers did not have, or did not implement, policies and procedures pertaining to the following issues: the process for reviewing and approving advertising materials prior to their publication or dissemination; when using composites, determining the parameters for which accounts were included or excluded from performance calculations; and confirming the accuracy of performance results in compliance with the Advertising Rule.”
OCIE launched the Touting Initiative in 2016 to examine firms’ disclosures around aspects of marketing materials that sought to leverage awards, ranking lists and/or professional designations—something the staff said it encountered “regularly.” Among the deficiencies OCIE staff found were use of third-party rankings or awards that were misleading because they omitted key facts about the rankings or award, such as that they included outdated rankings, awards that had been earned due to the submission of potentially false information, or that the adviser paid a fee for inclusion in the relevant surveys or distribution of the survey’s results.
OCIE staff also found questionable uses of professional designations—such as designations that had lapsed, or failed to adequately explain their minimum qualifications—and prohibited testimonials.