Though long-established hedge fund managers are likely to be familiar with US advertising rules The Hedge Fund Journal sometimes gets queries from newer and smaller managers. Lawyers Dechert LLP recently held a refresher seminar entitled ‘US Advertising Rules for Investment Advisers’ for their clients, and separately provided THFJ with a briefing on the topic from which we extract some high level takeaways. The apparently widespread misconception that hedge funds could not advertise prior to the JOBS Act being signed into law in April 2012 may have arisen from very few hedge funds having ever advertised (pre or post JOBS Act) in the common parlance sense of the word. The JOBS Act opens the door to ‘general solicitation’, and ‘general advertising’ but “it is subject to uncertainty so most managers prefer to rely on the Rule 506(b) Reg D private placement exemption from registering securities with the SEC,” says Karen L. Anderberg, Financial Services Partner at Dechert LLP. She is of the opinion that the SEC advertising rules under the Investment Advisers Act of 1940 will anyway still apply to managers offering funds via the 506(c) exemption from registration under the Securities Act of 1933, which was introduced in 2014.
Even within the same country, the USA, different regulators babble in many tongues and Dechert’s briefing only considered SEC guidance for investment advisers and private funds, and not SEC rules applying to US registered ‘40 Act mutual funds, nor FINRA’s rules for broker dealers selling funds, nor CFTC/NFA guidance for CTAs and CPOs (any of which may also apply to managers registered with multiple regulators – Dechert runs separate events to update clients on these). Some of the guidance on advertising could also apply to advisers who are not registered with any regulator, as it comes under the more general umbrella of anti-fraud provisions. These are found in Section 206 of the Investment Advisers Act of 1940, which intends to safeguard against fraudulent, deceptive or manipulative conduct. So, investment managers that are not fully SEC-registered such as “exempt reporting advisers – including many UK hedge fund managers – can still be covered by the anti-fraud rules even if they are not covered by the full substantive provisions of US law” stresses Anderberg.
‘Advertising’ has an expansive meaning according to US regulators: any written or electronic communication to more than one person offering investment advisory services; any media mention of the same, or any factsheets, newsletters, websites, emails and communication via social media such as Facebook, LinkedIn and Twitter can all be covered, explains Dechert LLP Associate Laurel C. Neale.
Carve outs from ‘advertising’ definition
“Oral communication with clients or potential clients that is not broadcast, one-on-one communication to a single client or potential client, written responses to unsolicited requests, or written communication to existing clients, can be exceptions,” Neale adds.
A wrinkle though is that the same information communicated to multiple individuals might be viewed as an advertisement, but newsletters to existing investors about the product they are invested in, generally should not be.
Anderberg details two exemptions that are of special relevance to publications such as The Hedge Fund Journal. “Reprints of media articles can avoid being seen as advertising, if they are from a bona fide, unbiased, third party source; contain no testimonials and avoid statements endorsing the firm. Performance awards are also permitted, so long as the awards are independent and based on a fair and large sample of potential winners.”
But the breadth of the advertising definition means few advisers seem likely to sidestep it entirely, (unless they market funds, such as a UCITS, that are not sold in the US and indeed some hedge fund managers do eschew US clients). The onus is on hedge fund managers to be conversant with the SEC advertising rules, because, unlike some other regulators, the SEC does not pre-approve advertising, but might disapprove of it after it is released, possibly during a site visit or other inspection.
Indeed, advertising has nearly always belonged to the top five or 10 of OCIE’s priorities set out in its annual letter and speeches. The number of enforcement actions around advertising seems relatively low, at between two and six per year, but this greatly understates the SEC’s degree of scrutiny of advertising because not all rules breaches lead to enforcement actions. Explains Anderberg: “Only about 10% of firms get inspected each year, but about 85% get a deficiency letter and then 5% get referred for enforcement.” Thus it is extremely common to receive a deficiency letter and indeed “large allocators may request sight of any deficiency letters as part of their due diligence process,” Anderberg sees. After the SEC issues a deficiency letter, managers have 30 days to respond, and hopefully rectify the deficiencies, and the SEC does circle back later on to check compliance. If firms fail to correct matters the issue is more likely to reach enforcement. Dechert “regularly debriefs funds on inspections, to alert them to common deficiencies as compliance is so complicated,” says Neale.
Recent enforcement actions have included two where, inter alia, model returns were shown as actual returns. US mutual fund sub-advisor F Squared Investments was presenting hypothetical backtest as actual performance and even in the context of this ‘model’ performance a calculation error inflated performance massively. In 2014 a $35 million fine was imposed and actions were subsequently brought against other managers using F Squared as sub-adviser who themselves presented the faulty performance data. In the Bennet Group case, model performance allowed a small firm to obtain a number five ranking in a Barrons award and use this in advertisements, which also exaggerated the size of the firm, resulting in a 2015 enforcement action. These two cases seem egregious but in the Trust and Investment Advisers Inc case, an action was brought, inter alia, for what may be a common oversight: using a benchmark that omits to include reinvestment of dividend income. Anecdotally, it is not unusual for benchmarks to be ‘price only’ as opposed to ‘total return’ equity indices as most equity indices that populate media headlines are ‘price only’.
Patchwork quilt of rules
To stay compliant, investment advisers need to heed a broad swathe of rules. Though social media has been subject to new guidance, much of the advertising guidance dates back to the 1980s and 1990s and has not been superseded by the JOBS Act. No single rulebook or central code of conduct exists but rather multiple sources of guidance include a fragmented patchwork of SEC No Action Letters (NALs), responses to queries, speeches, risk alerts, enforcement actions and other utterances from the SEC stretching back over decades.
There are a handful of areas with clear cut prohibitions, Neale sets out. Managers should not suggest that being a registered investment adviser (RIA) implies any endorsement by a US government agency (including the SEC), but can provide a generic statement on being registered. With few exceptions, client testimonials are forbidden and are broadly defined to include any client statement. Any free good or service offered must come without any strings attached in terms of obligations to use other services. And a catch all provision is that no untrue, false, or misleading statement can be made.
Websites are viewed as an advertisement, so should ideally be screened for a US audience – with any performance data sitting behind password protection. “Both website content – and anything referenced or linked to it – must be compliant with US rules and this for instance means that links to articles containing testimonials are off limits,” Anderberg warns.
Policing social media
Guidance from OCIE in 2012 establishes that in social media (Facebook, LinkedIn, Twitter) clicking “like” can be deemed an endorsement or testimonial. Neale suggests a remedy here is that LinkedIn allows users to withhold ‘endorsements’ from public view; any testimonials written on an advisers’ own social media page should be deleted. Retweeting is more complicated. Neale goes on: “Retweets of an article by an unbiased third party in the media need not be a concern, but if the tweet itself contains a summary or excerpt of that content then the tweet could separately get caught in the net of ‘advertising’.” Additionally it is not possible to control the ultimate destination of a chain of retweeting. Even if an asset manager tries to stop US persons following them on Twitter, retweets could still result in US persons having sight of a tweet that may contain links to a website, which could be seen as advertising. “You can have a closed twitter distribution list, but cannot control somebody in your network retweeting,” stresses Neale. If a fund only markets into the US based on the private placement rules, the manager should be careful to avoid naming the fund or performance in the tweet, though links to a password protected page could be acceptable, Anderberg has found.
Case studies and performance advertising
Special guidance applying to performance advertising dates back to No Action Letters from the 1980s and 1990s. Past Specific Recommendations are generally not permitted due to concerns about ‘cherry picking’ or selective disclosure of superior examples of performance. There are some exemptions but they are often unworkable, Anderberg has found. “Listing all recommendations made in a year with exact buy prices, sell prices, and dates is not realistic,” she explains, as this could lead to a copious amount of data retrieval and text. Some other exemptions seem more practical. If advisers pick a particular criterion, they could show the top five and bottom five investments, for instance. Context matters so “past specific recommendations can also be used to illustrate how a particular investment strategy works, perhaps by explaining a focus on particular sectors oron certain types of corporate events,” Anderberg elaborates. Example holdings can also be shown in literature that is only sent on request on a particular fund.
Moving from the performance of individual investments to that of a whole fund, “advertising need not disclose performance but if it does, the information must be compliant,” says Anderberg. As aforementioned, SEC enforcement action has focused on performance advertising, and post-Madoff the SEC now has a team of quantitative staff who try to identify unusually and improbably positive performance information. But “the primary source of guidance is still a 30 year-old No Action Letter called the 1986 Clover Capital Letter, which provides a non-exhaustive ‘laundry list,’” notes Neale. We touch on a few examples here. Historical, hypothetical, ‘model’ or back-tested performance can be shown but must be clearly labelled as such, properly disclaimed and kept separate from actual performance. There is scope for managers to try and pick more flattering benchmarks, so the NAL requires managers to justify the relevance and reason for their benchmark choice, and explain how the performance of the fund and index may differ (e.g., with respect to volatility). Selective disclosure of performance relating to limited time periods or client groups is also off limits. If outperformance relates mainly to certain unusual events such as one or two IPOs, that should be disclosed as well. “Performance should generally be shown net of fees, though gross performance can be displayed alongside net performance so long as both are given equal prominence and appropriate disclosures are made. Gross performance should not however be disclosed in isolation, with some exceptions such as one on one meetings with sophisticated investors,” Anderberg details.
Portability from previous firms is also subject to special guidance and ‘portable track record’ is another casually used term that has a special meaning for regulators. “The same individuals must have been primarily responsible for performance, running similar enough accounts, and including performance for all relevant accounts managed in the same manner (unless there is a reason to exclude them),” says Anderberg. Additionally managers should keep back up records and have the prior firm’s permission to use the data!
The CFA Institute’s GIPS (Global Investment Performance Standards) are widely observed in the US and in some areas seem to overlap with regulatory guidance. Claiming compliance with GIPS imposes additional obligations and indeed an SEC action has been brought against an adviser for misrepresenting compliance with the GIPS (ZPR Investment Management in 2014). “If an adviser claims that information presented is GIPS compliant, the SEC enforcement staff will expect that to be the case,” Neale observes.
Record keeping applies to registered advisers, Neale points out. Advertisements sent to 10 or more recipients should be retained, as should records behind performance calculations. The lookback period is five years from the end of the fiscal year in which the advertisement was last used, so most advisers keep records for six years. Records should be kept at offices for the first two years and can be kept off site (as long as easily accessible) after that.