Performance advertising by investment advisers is a stalwart among the issues prioritized by the US Securities and Exchange Commission Office of Compliance Inspections and Examinations (SEC OCIE) in terms of examination priorities and focus areas. Rarely does a senior SEC staff member give a speech outlining regulatory or enforcement priorities without prominently mentioning performance advertising.[1] Therefore, it should come as no surprise that SEC staff recently settled an enforcement proceeding against a registered investment adviser[2] and filed a civil complaint against its founder[3] (collectively, the Enforcement Action), each based on performance advertising issues. The purpose of this article is not to summarize the case or recite the facts, but rather to highlight some of the more meaningful guidance that those in the investment management industry can glean from the SEC’s approach and claims in this case.

There are a number of issues raised in the Enforcement Action, each of which attest to the caution with which advisers should approach the use of their advertising materials and, most importantly, the content of those materials. The issues raised in the Enforcement Action are not novel. However, as with most Enforcement Actions, they are instructive in focusing compliance efforts at advisory firms on items that the SEC feels are of import. It is this author’s belief that a careful examination of the facts of the Enforcement Action is an important method by which to learn to identify issues to test for and to examine when conducting any advisory firm’s routine review of marketing and advertising materials and annual review of the entire compliance programme. If the desire to comply is not sufficient enough impetus for a firm to pay attention to the SEC’s advertising rules and guidance, then the $35 million and the reputational damage to the firm and individuals that resulted from the Enforcement Action may provide such an impetus.

The basic facts
The basic facts,[4] as outlined in the Enforcement Action, are that the advisory firm and its president and CEO at least recklessly utilized the hypothetical and back-tested performance of an index in advertising their fund that purportedly tracked the index, while claiming that performance was achieved in actual trading. The strategy involved the application of an algorithm in creating signals to trade an ETF strategy. While the performance shown dated back to 2001, the algorithm was not even finalized until 2008. In addition, the hypothetical or back-tested performance utilized was miscalculated and grossly inflated, attracting great interest from investors, and their marketing practices did not cease even when the gross miscalculation was discovered. According to the Enforcement Action and a review of the facts described in the Enforcement Action, the advisory firm in question (i) presented hypothetical and back-tested performance while not clearly identifying it as such; (ii) claimed that hypothetical and back-tested performance was the performance actually achieved in live trading; (iii) at least recklessly, compiled and presented materially inflated performance; (iv) utilized performance not supported by adequate books and records; (v) cherry-picked periods in presenting their performance; and (vi) utilized various forms of marketing materials, each of which was fraudulent or misleading.

Presentation of hypothetical and back-tested performance not identified
Regulators have for many years looked askance at the use of hypothetical or back-tested performance. Since it is derived from the retroactive application of a model developed with the benefit of hindsight and not through prospective actual trading, invariably, hypothetical or back-tested performance will show positive and often extremely positive rates of return. Exacerbating the unreliability of this type of performance is that these results are typically tweaked until they reflect desirable results and do not reflect the pressures, costs or losses and the resulting pressures associated with actual trading. While the SEC has stopped short of prohibiting the use of hypothetical or back-tested performance, the Staff has an expectation that such performance at the very least be clearly identified as hypothetical or back-tested and that the attendant risks be described. The US Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA) have taken the proactive measure of providing commodity trading advisors and commodity pool operators specific disclosures that must accompany this type of performance, and further required that this disclosure be prominent and appear proximate to the performance that it describes.[5]

In the Enforcement Action, the Staff did not object to the use of the hypothetical or back-tested performance. Rather, this first objection was that this type of performance, which is viewed as suspect to begin with, was not properly and clearly identified, thus making it inherently misleading.

Takeaway: The process for reviewing marketing materials must be designed to elicit accurate and complete information so that appropriate disclosure is included.

Claiming hypothetical and back-tested performance was actual
The Enforcement Action indicates that not only did the adviser fail to identify the hypothetical or back-tested performance and properly describe it, the adviser actually claimed it was “not back-tested” and further claimed that it reflected the results of actual trading for the back-tested period. The adviser even went so far as to openly state these patently false claims in their marketing materials.

Clearly, one need not read the Enforcement Action to learn that lying in advertising or marketing materials is something that is frowned upon. However, there is a greater lesson that is implicit in the Enforcement Action. Having a system of checks and balances in place in the process of the review of marketing materials is a vital aspect of the compliance process. In the Enforcement Action, it is not clear that compliance or marketing personnel of the adviser actually knew the performance results were not actual. The only thing that is clear is that this fact was known by the president/CEO and an analyst.

Perhaps an occurrence such as this can be prevented by including additional and appropriate personnel in the review of marketing materials before those materials can be used. For example, if certain materials include a performance track record, then the person who compiled the track record should be required to approve that track record in writing during the process of reviewing the marketing materials including that track record. Of course, a crucial component is to train marketing and accounting personnel as to issues that they need to identify during such a review, including noting that performance is hypothetical or back-tested or pro forma, gross, etc. If the analyst who compiled the track record that was the subject of the Enforcement Action had been included in the process of approving the use of that track record and had been properly educated to identify these types of issues, then compliance and marketing personnel would have been aware of the problem and presumably acted appropriately. Indeed, if this performance had been flagged as hypothetical or back-tested the first time it was used, then a compliance person would know to look for this issue in future materials.

Takeaway: The process for reviewing marketing materials must require the appropriate personnel to sign off on information they compiled or provided. Those personnel must be educated as to which specific issues must be identified during the review process.

Materially inflated performance
Rarely, if ever, does one see a performance advertisement from an adviser that includes hypothetical or back-tested performance that is negative. If it was negative, the adviser would change its system in order to make it positive. Just the fact that the advertised performance is positive should not be a red flag to compliance. However, in the Enforcement Action, the performance was not just positive. It was positive in the extreme, claiming to outperform the S&P 500 Index by a large margin. In fact, due to a mistake by the analyst that calculated the track record, the results were inflated by approximately 350%. Extreme outperformance against the index to which it is being compared is the type of red flag that should at least raise a question during a compliance review of marketing materials.

The SEC alleged that the analyst who calculated the back-tested performance “inadvertently applied the buy/sell signals to the week preceding any ETF price change that the signals were based on. The mistake carried the model portfolio’s back-tested buy and sell decisions back in time one week, enabling the model to buy an ETF just before the price rose and sell an ETF just before the price fell.”[6] However, this mistake was then exacerbated and became fraud when the analyst explained the error to the president/CEO but the firm did not cease using that track record. Instead, the firm continued to use the inflated track record. That turned a mistake into something far worse.

As a compliance lesson, there are at least two things that could have been done differently and would have prevented problems. First, just as the SEC and CFTC focus on aberrational performance and conduct inquiries when they identify those that substantially outperform their peers or relevant indices,[7] compliance personnel should also inquire with appropriate personnel when the issue appears. When compliance personnel notice comparisons that reflect an aberration, as they should during the review of marketing materials showing extreme outperformance compared to an index or peers, the compliance person should make inquiries of appropriate personnel. In the case of the Enforcement Action, that would include having a discussion with the analyst and perhaps uncovering the mistake sooner, and preventing that mistake from later becoming a deliberate misleading. Second, when implementing a new process or new investment programme that is reliant upon data being entered properly, one important safeguard that should be instituted is to have a way of independently testing whether the data was entered properly. In the Enforcement Action, there should have been a second set of eyes independently testing that data was properly entered and applied. This principle was one of those issues underlying a past SEC enforcement action as well.[8]

Finally, of course, once a problem is discovered, it is an adviser’s obligation to stop using the false track record and to take corrective action. The president/CEO knowingly made false statements all along. However, it is important to train all personnel that if there is an issue with a track record (or some other material compliance matter) that person has an obligation to inform compliance personnel so that compliance personnel can ensure it is dealt with appropriately. In the Enforcement Action, they did cease using the track record at some point after they had knowingly used the false record for years. They explained this by further misleading investors without actually informing them that they had been misled.

Takeaway: Aside from including appropriate personnel in the marketing materials review process and educating them as to what material issues to flag, personnel must know that compliance must be made aware of issues so that compliance can ensure issues are not ignored or exacerbated.

Performance not supported by books and records
Paragraph (a)(16) of Rule 204-2 under the US Investment Advisers Act of 1940, as amended, provides that an investment adviser is required to keep records necessary to back up the calculation of its performance. Clearly, in the Enforcement Actions, the firm could not have had such books and records to support its track record, as the track record was not the result of actual trading.

The question is what compliance procedure should have been in place that could have prevented this track record from being used. On this, there are two parts of a typical compliance programme that should prevent such a problem from arising. As described above, an integral part of the marketing materials review process should be requiring accounting or other appropriate personnel to sign off on the track record being used. That sign-off indicates that the person has properly calculated and checked the track record for accuracy. In the Enforcement Action, if the analyst had been asked to approve the use of the track record during the course of the marketing materials review process, the analyst should have discovered the improper use of the track record.

However, this would not have identified the lack of books and records issue. An integral part of any compliance programme is educating and properly explaining, often repeatedly, what is required of the personnel responsible for implementing that part of the compliance programme. This training must take place, as there is no substitute. Accounting or other appropriate personnel must be trained to understand what books and records they are expected to have in order to back up the claimed performance. Had this training been provided to the analyst, the analyst would have understood that he did not have the necessary back-up and, therefore, could not sign off on the track record during the marketing materials review process.

Takeaway: There is no substitute for adequately training personnel to competently perform their compliance functions. Each person in the marketing materials review process must know and understand what it is he or she is responsible for.

Any type of communication is problematic when it’s fraudulent
Many securities law practitioners have spent time determining whether a particular communication falls within the definition of “advertisement” under Section 206 of the Advisers Act and the rules thereunder governing advertisements. Whether or not particular materials constitute an advertisement can be a determining factor as to whether various rules under the Advisers Act governing advertisements will apply.

However, whether or not a particular marketing piece constitutes an advertisement, the Enforcement Action can be read as a reminder that all communications are subject to the general anti-fraud provisions of Section 206 of the Advisers Act. Put more simply, you can’t lie and mislead, no matter what the context or medium. The various media used by the firm in the Enforcement Action included emails, letters, investor letters, PowerPoint presentations, websites, marketing materials prepared by third parties based upon materials provided by the firm, marketing materials prepared by third parties based upon interviews with firm personnel, articles by third parties, article reprints, oral statements and others. The Enforcement Action stands for the principle that a statement is just as false and misleading no matter where or in what form it appears.

Takeaway: Every type of material used in marketing must be carefully considered. Personnel must be trained in what they can say, not just in what they write.

Conclusion
The recent Enforcement Action focused on various core principles of marketing and advertising compliance. These are not new principles and are not principles that should take any firm by surprise. Firms should actively take steps to educate personnel regarding what is permitted and prohibited in marketing materials and must put in place procedures to mitigate the chance of prohibited activities occurring. Enforcement actions are instructive. Firms should actively take that instruction. Finally, it is important to note that the SEC did not allege that investors lost money as a result of the misrepresentations in these cases. The point was not to recover money lost by misled investors. Rather, the Enforcement Action reflects the priority placed by the Staff on enforcing its investor protection rules.

Steven M. Felsenthal is general counsel and chief compliance officer of Millburn Ridgefield Corporation, a CTA. Prior to joining Millburn in January 2004, Felsenthal was a senior associate in the investment management group at Schulte Roth & Zabel LLP.

Footnotes

1. For example, see “Spreading Sunshine in Private Equity,” Andrew J. Bowden, Director, SEC Office of Compliance Inspections and Examinations, May 6, 2014 (available at http://www.sec.gov/News/Speech/DetailSpeech/1370541735361#.VNjHai4kp2A)
2. Available at http://www.sec.gov/litigation/admin/2014/ia-3988.pdf.
3. Available at http://www.sec.gov/litigation/complaints/2014/comp-pr2014-289.pdf.
4. These facts are based upon the SEC claims in the Enforcement Actions. As with any Enforcement Action, even those that are settled, the parties that were the subject of the Enforcement Actions may very well have defenses or mitigating factors. However, the purpose of this article is to examine what actions in these Enforcement Actions the SEC found objectionable and other items that the author believes a compliance-oriented firm should think about. Therefore, these basic facts are those the SEC purports to have occurred.
5. See CFTC Regulation 4.41(b) and NFA Compliance Rule 2-29(c).
6. See http://www.sec.gov/news/pressrelease/2014-289.html#.VNjVMy4kp2A.
7. See http://www.sec.gov/news/press/2011/2011-252.htm.
8. See http://www.sec.gov/litigation/admin/2011/33-9181.pdf.