Failure to follow the applicable rules can turn into a public enforcement action.
Hidden among the more prominent regulatory burdens faced by registered investment advisers is a cache of nuanced guidance from the Securities and Exchange Commission on advertisements, which RIAs must heed in order to avoid a potential enforcement action. The anti-fraud provisions of the Investment Advisers Act of 1940, found in Section 206 and Rule 206(4)-1, generally prohibit advertisements that contain untrue statements of material fact or that are otherwise false or misleading. The SEC has provided specific guidance on advertising practices over several decades through rulemaking, “no-action” or interpretive letters and enforcement actions.
The SEC defines advertisement broadly; a good rule of thumb is to assume that any written materials sent to clients or potential clients are subject to the advertising rules. Rule 206 prohibits advertisements that contain “any untrue statement of a material fact” or that are “otherwise false or misleading” as a catch-all to address conduct that might not otherwise violate a specific rule. Accordingly, the SEC considers the circumstances surrounding each advertisement, including the recipient's sophistication and the inferences that might be drawn from the information presented in the advertisement.
However, RIAs cannot rely on a facts-and-circumstances approach to compliance with the Advisers Act, as the SEC has provided detailed guidance on a variety of advertising issues, including:
• Testimonials. Rule 206 prohibits an RIA from using, directly or indirectly, any testimonials regarding its advice or services. However, an advertisement can refer to commentary from third-party websites that predominantly host user opinions, experiences or findings about service providers (such as investment advisers), as long as (1) the independence of the site or the commentary is indisputable; and (2) the RIA publishes the complete unedited comments.
• Prior recommendations. RIAs are generally prohibited from presenting past investment recommendations without including all recommendations within the preceding year, plus details about the recommended securities and specific cautionary language. However, under certain conditions, an RIA may be able to present information about holdings that both positively and negatively contributed to performance (i.e., certain best and worst holdings).
• Past performance Although performance advertising is permitted, advertisements must describe all material facts and circumstances, including relevant overall market performance and the effects of reinvestment of dividends or other earnings.
• Model results. Model or hypothetical results must disclose all material circumstances, particularly any relevant assumptions and differences between the model strategy and the RIA's actual strategy. Comparisons to the performance of an index should disclose relevant distinctions, such as differences in volatility between the index and the model portfolio.
• Gross vs. net returns. Generally, RIAs should not advertise actual or hypothetical performance data that does not reflect the fees and expenses borne by clients. However, gross performance may be presented side-by-side with net results if the advertisement clearly states that the gross results do not include fees and expenses. Further, if an RIA presents results for a composite of accounts using a common strategy, model fees equal to the highest fee charged to those accounts can be used to calculate the net results.
• Backtesting. The SEC regards backtested results as suspect and requires, among other things, disclosure of the calculation methodology and the fact that the strategy was designed with the benefit of hindsight. The SEC recently clarified that backtested results must be (1) calculated based on historical information (such as inflation rates) and not assumptions and (2) fully consistent with the advertised investment strategy.
These restrictions represent only a small fraction of the relevant SEC guidance. Moreover, private fund advisers who use third party marketers to find investors must ensure that those marketers comply with Finra rules on advertising activities. RIAs should also recognize that common industry guidelines, such as the Global Investment Performance Standards, do not necessarily align in all respects with applicable legal requirements.
Each RIA must carefully review its advertising materials to ensure compliance with specific SEC mandates and to avoid distributing advertisements that contain untrue statements of material fact or are otherwise false or misleading. Failure to follow the applicable rules can turn an RIA's efforts to develop new business into a public enforcement action likely to have the opposite effect.
S. Brian Farmer chairs Hirschler Fleischer's Business Section, and leads the firm's Investment Management & Private Funds Group. Brian J. Daly is an attorney at Hirschler Fleischer. His practice focuses on investment management and mergers and acquisitions.
