Hedge Fund Performance Advertising

Recent SEC enforcements on use of performance numbers

RICARDO DAVIDOVICH AND RICHARD STROHMENGER, HAYNES AND BOONE LLP

While performance advertising has long been a focus of the Securities and Exchange Commission, some recently settled SEC enforcement matters are a cause for concern for investment advisers that utilise advertising materials containing performance information prepared by third parties.
 
In February 2016, the SEC charged Cantella & Co., a registered investment adviser with making misstatements to its advisory clients by utilising F-Squared Investment Inc.’s inflated AlphaSector performance track record in its own advertising materials. Between October 2012 and May 2015, Cantella offered F-Squared’s AlphaSector strategy to its clients.  The SEC issued a cease and desist order against Cantella as a result of its use of F-Squared’s performance information in its advertising. AlphaSector is a sector rotation strategy based on an algorithm that yields a signal indicating whether to buy or sell certain industry ETFs that compose the industries in the S&P 500 Index. This investigation originated from an SEC administrative proceeding in December 2014 in which F-Squared admitted that its advertisements falsely claimed that the AlphaSector strategy had a performance history dating to April 2001 when, in fact, its performance history was hypothetical and derived through backtesting.

F-Squared also claimed that AlphaSector had outperformed the S&P 500 Index for several years even though that performance was substantially inflated as a result of significant calculation errors.  As a result of this investigation, F-Squared acknowledged that it violated federal securities laws and agreed to hire an independent compliance consultant. F-Squared disgorged $30 million in profits and agreed to pay a $5 million penalty to settle these charges.

In the Cantella matter, the SEC alleged that Cantella inappropriately advertised the AlphaSector strategy by using F-Squared’s hypothetical and back-tested historical performance that was substantially overstated. The SEC found that Cantella took insufficient steps to confirm the accuracy of F-Squared’s historical data and other information contained in their advertising materials and that Cantella did not obtain sufficient documentation to substantiate F-Squared’s advertising claims with respect to the AlphaSector performance. It is important to note that the SEC indicated that F-Squared described the strategy falsely to Cantella by making misrepresentations about AlphaSector’s performance. Furthermore, the SEC notes that Cantella included a general statement in its AlphaSector advertisements that third parties were the source of the performance data and that Cantella did not guarantee the accuracy of this information. However, the SEC stated that Cantella “knew or should have known that it did not have a reasonable basis to believe that AlphaSector’s advertising claims were accurate.”

Cantella knew or should have known that the purported performance of F-Squared’s AlphaSector strategy set forth in Cantella’s advertising materials was exceptional over the 2001 – 2008 period in that it significantly outperformed the S&P 500 Index and purported to involve actual results notwithstanding that the AlphaSector strategy was not launched until 2008. As a result of these findings, Cantella agreed to pay a $100,000 penalty.

Specifically, the SEC found that Cantella violated Section 206(4) and Rule 206(4)-1(a)(5) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”) by publishing, circulating and distributing advertisements that contained untrue statements of material fact. Section 206 is the Advisers Act’s anti-fraud provision and Section 206(4) states that it is unlawful for an investment adviser to, directly or indirectly, “engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative.” Advisers Act Rule 206(4)-1(a)(5) clarifies that any advertisement “which contains any untrue statement of a material fact, or which is otherwise false or misleading[,]” is deemed to constitute a fraudulent, deceptive or manipulative act, practice or course of business.

The SEC also found that Cantella violated Section 204(a) (which governs recordkeeping by investment advisers) and Rule 204-2(a)(16) of the Advisers Act by not making and keeping true, accurate and current records necessary to form the basis for or demonstrate the calculation of the performance that it circulated and distributed.

Rule 204-2(a)(16) requires an adviser to maintain “all accounts, books, internal working papers, and any other records or documents” that are necessary to “form the basis for or demonstrate the calculation of” its performance or rate of return of or securities recommendations in any notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication circulated or distributed to more than ten (10) people (other than persons connected with the investment adviser).

The Cantella matter follows another proceeding in which the SEC brought similar charges against Virtus Investment Advisers in November 2015 for using F-Squared’s false performance in its advertising materials. The SEC similarly alleged that Virtus inappropriately advertised F-Squared’s AlphaSector strategy by stating that the AlphaSector strategy had a performance history since April 2001 and that it had outperformed the S&P 500 Index in several of those years. The SEC found that Virtus failed to take appropriate measures to determine whether any of the AlphaSector signals were used in any of F-Squared’s trading decisions from April 2001 to September 2008 and that Virtus did not investigate any internal concerns regarding F-Squared’s track record and related representations. The SEC also found that Virtus did not maintain the appropriate records to support the advertised historical performance of the AlphaSector strategy.  Virtus agreed to pay a $16.5 million penalty to settle these charges.

It is no surprise that advertising deficiencies continue to be an area of focus for the SEC’s enforcement division. However, in light of the SEC’s order against Cantella and the similar charges against Virtus, it is also evident that the SEC is willing to bring charges against investment advisers who fail to conduct the appropriate due diligence on underlying performance information used in advertising materials to prospective investors. Specifically, the SEC staff has stated that it plans to continue bringing similar enforcement actions against other advisers who potentially misled investors with advertisements which include F-Squared’s false historical performance track record. It is imperative that investment advisers carefully review and analyse all information disclosed to investors and prospective investors in order to ensure compliance with the SEC’s marketing rules. Disclaiming that data comes from third party sources may not be sufficient to avoid liability.

Ricardo Davidovich is a partner and Richard Strohmenger is an associate in the New York office of Haynes and Boone.