Year: 2011

Performance Results in Fund Brochures

Section 206 of the Investment Advisers Act prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent, deceptive or manipulative.

The first item on the list of fraudulent, deceptive or manipulative practices is testimonials, which I wrote about earlier.

The second item in the advertising rule is prohibition on using past performance in an advertisement, subject to some qualification:

206(4)-1(a)(2): Which refers, directly or indirectly, to past specific recommendations of such investment adviser which were or would have been profitable to any person:

Provided, however, That this shall not prohibit an advertisement which sets out or offers to furnish a list of all recommendations made by such investment adviser within the immediately preceding period of not less than one year if such advertisement, and such list if it is furnished separately:

(i) State the name of each such security recommended, the date and nature of each such recommendation (e.g., whether to buy, sell or hold), the market price at that time, the price at which the recommendation was to be acted upon, and the market price of each such security as of the most recent practicable date, and

(ii) contain the following cautionary legend on the first page thereof in print or type as large as the largest print or type used in the body or text thereof: “it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list”

Of course, all advertising is still subject to the prohibition on advertising that is otherwise false or misleading in Rule 206(4)-1(a)(5).The SEC has adopted a facts-and-circumstances test to determine whether the use of performance results is false or misleading.

[W]e believe the use of model or actual results in an advertisement would be false or misleading under Rule 206(4)-1(a)(5) if it implies, or a reader would infer from it, something about the adviser’s competence or about future investment results that would not be true had the advertisement included all material facts. Any adviser using such an advertisement must ensure that the advertisement discloses all material facts concerning the model or actual results so as to avoid these unwarranted implications or inferences. Because of the factual nature of the determination, the staff, as a matter of policy, does not review any specific advertisements. Clover Capital Management, Inc. 1986 No Action Letter

A facts-and-circumstances test is not one that helps a compliance officer sleep at night. That means judgment calls and disagreements with management on what can be included and how it can be included.

There are many SEC no action letters out setting some lines in the sand. A 1986 No Action Letter to Clover Management lays out a series practices that are bad for disclosing model and actual results:

(1) Fails to disclose the effect of material market or economic conditions on the results portrayed (e.g., an advertisement stating that the accounts of the adviser’s clients appreciated in the value 25% without disclosing that the market generally appreciated 40% during the same period);

(2) Includes model or actual results that do not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid;

(3) Fails to disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;

(4) Suggests or makes claims about the potential for profit without also disclosing the possibility of loss;

(5) Compares model or actual results to an index without disclosing all material facts relevant to the comparison (e.g. an advertisement that compares model results to an index without disclosing that the volatility of the index is materially different from that of the model portfolio);

(6) Fails to disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed (e.g., the model portfolio contains equity stocks that are managed with a view towards capital appreciation);

(7) Fails to disclose prominently the limitations inherent in model results, particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser’s decision-making if the adviser were actually managing clients’ money;

(8) Fails to disclose, if applicable, that the conditions, objectives, or investment strategies of the model portfolio changed materially during the time period portrayed in the advertisement and, if so, the effect of any such change on the results portrayed;

(9) Fails to disclose, if applicable, that any of the securities contained in, or the investment strategies followed with respect to, the model portfolio do not relate, or only partially relate, to the type of advisory services currently offered by the adviser (e.g., the model includes some types of securities that the adviser no longer recommends for its clients);

(10) Fails to disclose, if applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model;

(11) [for actual results] Fails to disclose prominently, if applicable, that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material.

The other important thing to keep in mind when deciding to use performance results is that you must keep all of the accounts, books, internal working papers and other records necessary to demonstrate the calculation of the performance results. SEC Rule 204-2(a)(16)

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Ratings and Fund Managers

Investment advisers, and therefore fund managers once they register as investment advisers, are limited in how they advertise. Section 206 of the Investment Advisers Act already prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent deceptive or manipulative.

The first item on the list of restrictions is testimonials. This prohibition reflects the concern that the experience of one customer is not necessarily typical of the experience for all customers.

To some extent this also covers third party ratings since they are relying on the testimonials of clients. If you have a good rating you may want to include that rating as part of your fundraising materials. That means you are indirectly including a testimonial in your advertising and are staring squarely at the prohibitions in the advertising rule.

However, the SEC has recognized that the distribution of unbiased third-party ratings may not be fraudulent. In a 1982 No Action Letter to New York Investors Group, Inc., the SEC allowed the investment adviser to include an article from a financial publication that “lauds the Company/ and or the Company president’s success in picking stocks that do well under both favorable and unfavorable market conditions.”

The SEC ruled that “an article by an unbiased-third party concerning an investment adviser’s performance, however, is not a testimonial unless it includes a statement of a customer’s experience or endorsement. ” While clarifying that the article is not a testimonial, it is still an advertisement.

The more detailed discussion about the use of ratings is in a 1998 No Action Letter to DALBAR, Inc. The company conducted a survey to measure the effectiveness of investment advisers and their representatives.  Based on the survey, DALBAR would assign a numerical ranking. Since the investment adviser was paying for the survey, presumably they would want to publish a good result to attract more clients. That means the ratings would be part of an advertisement.

The SEC said that the DALBAR rating is a testimonial because the rating carries an implicit statement of clients’ experiences. The DALBAR rating is testimonial, made indirectly.

But the SEC turns around and and blesses the DALBAR rating, granting the sought after “we would not recommend enforcement action.” The SEC lists these factors:

  • DALBAR rating does not emphasize the favorable client responses or ignore the unfavorable responses.
  • The rating represents all or a statistically significant sample of an adviser’s clients.
  • The client questionnaire has not been prepared to produce any pre-determined results.
  • The client questionnaire makes it easy for a client to give negative or positive responses.
  • DALBAR does not perform any subjective analysis of the survey results, but merely assigns numerical ratings after averaging client responses.
  • DALBAR is not affiliated with any advisers.
  • DALBAR charges a uniform fee, paid in advance.
  • Survey results clearly identify the percentage of survey participants who received each designation and the total number of survey participants.

While the SEC blesses the DALBAR rating system, they took the opportunity to point out that an adviser’s use of the rating in their advertisement materials could still be a violation of Section 206(4) and Rule 206(4)-1(a)(5). The SEC provided some guidance that advisers should consider when using a DALBAR or similar rating:

1. Whether the advertisement discloses the criteria on which the rating was based;

2. Whether an adviser or IAR advertises any favorable rating without disclosing any facts that the adviser or IAR knows would call into question the validity of the rating or the appropriateness of advertising the rating (e.g., the adviser or IAR knows that it has been the subject of numerous client complaints relating to the rating category or in areas not included in the survey);

3. Whether an adviser or IAR advertises any favorable rating without also disclosing any unfavorable rating of the adviser or IAR (or the adviser that employs the IAR);

4. Whether the advertisement states or implies that an adviser or IAR was the top-rated adviser or IAR in a category when it was not rated first in that category;

5. Whether, in disclosing an adviser’s or IAR’s rating or designation , the advertisement clearly and prominently discloses the category for which the rating was calculated or designation determined, the number of advisers or IARs surveyed in that category, and the percentage of advisers or IARs that received that rating or designation;

6. Whether the advertisement discloses that the rating may not be representative of any one client’s experience because the rating reflects an average of all, or a sample of all, of the experiences of the adviser’s or IAR’s clients;

7. Whether the advertisement discloses that the rating is not indicative of the adviser’s or IAR’s future performance; and

8. Whether the advertisement discloses prominently who created and conducted the survey, and that advisers and IARs paid a fee to participate in the survey.

If you are using third-party ratings as part of your fundraising materials, DALBAR presents you with a laundry list of things you can and cannot do with those ratings.
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Client Lists and Private Fund Managers

Section 206 of the Investment Advisers Act prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent deceptive or manipulative.

The first item on the list of restrictions is testimonials. This prohibition reflects the concern that the experience of one customer is not necessarily typical of the experience for all customers.

Merely including a list of client names is not a testimonial, but could still be considered fraudulent. You can see that in the example of Reservoir Capital Management. Reservoir provided prospective clients a client list, which Reservoir described as “representative,” that consisted of the names of eight institutional investors. In the SEC’s view this created the impression that a substantial portion of Reservoir’s client base was institutional clients. The truth was that no more than fifteen percent of Reservoir’s assets under management were assets of institutional clients.

A list of all clients would unlikely to be considered a testimonial in violation of the rule. Once you start producing a partial list, the SEC gets considered that the inclusion or exclusion of clients on the list could be fraudulent or manipulative.

The SEC offered some additional guidance on including a partial list of clients in a 1993 No Action Letter to Denver Investment Adviser Associates. They came up with three conditions that need to be satisfied:

1. You can’t use performance based criteria in determining which clients to include in the list

2. The client list has a disclaimer similar to this: “It is not known whether the listed clients approve or disapprove of the adviser or the advisory services provided.

3. The client list includes a statement disclosing the objective criteria used to determine which clients to include in the list.

For a fund manager, the funds are the clients. However, I could easily see how this limitation could be taken the next step to investors in the funds.

Also keep in mind that the fact that a particular customer or consumer is a client could be considers nonpublic personal information, making it subject to Regulation S-P. Several states prohibit an investment adviser from disclosing a client’s identity
without consent.

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Patriots’ Day and Compliance

Patriots’ Day is a Massachusetts holiday honoring the anniversary of the Battles of Lexington and Concord, the first battles of the Revolutionary War. Since Maine was once part of Massachusetts, it is also a holiday in Maine. Although they switch the possessive to Patriot’s Day.

That means Paul Revere and William Dawes mount their horses to re-create the warning: “The British are coming!” That means battle re-enactments in Lexington. That means the Boston Marathon passes through. That means a Red Sox home game.

That means a holiday for me from thinking too much about compliance.

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Image of the Minuteman Statue in Lexington Massachusetts is by Daderot
CC BY-SA 3.0

Free Will and Compliance

“Human Irony” from Saturday Morning Breakfast Cereal

Heisenberg Uncertainty: Published by Werner Heisenberg in 1927, the principle implies that it is impossible to determine simultaneously both the position and the momentum of an electron or any other particle with any great degree of accuracy or certainty.

Intent and the Advertising Rule for Investment Advisers

In it’s prohibition against fraud, deceit and manipulation, Section 206 of the Investment Advisers Act is strict. There is no requirement of intent. You can argue that you didn’t mean to mean to commit fraud. That may affect whether you get referred to enforcement instead of merely getting hit with a deficiency letter or an injunction.

Under common law there us generally some requirement of intent. That is not so true under securities laws.

In SEC v. Capital Gains Research, Inc. 375 U.S. 180 (1963) (.pdf 16 pages), the Supreme Court allowed an injunction without a finding of intent to commit fraud.

The foregoing analysis of the judicial treatment of common-law fraud reinforces our conclusion that Congress, in empowering the courts to enjoin any practice which operates “as a fraud or deceit” upon a client, did not intend to require proof of intent to injure and actual injury to the client. Congress intended the Investment Advisers Act of 1940 to be construed like other securities legislation “enacted for the purpose of avoiding frauds,” not technically and restrictively, but flexibly to effectuate its remedial purposes.

The limitations in Rule 206(4)-1 on investment adviser advertising approach the communication from the view of a client or prospective client, not the adviser. The limitations are designed to prevent an adviser from doing things that could be perceived as fraudulent even if the adviser is acting with good intent.

The use of testimonials and ratings are an example of this. More on that subject later.

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Is it an Advertisement?

Section 206 of the Investment Advisers Act prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent deceptive or manipulative.

So what is an advertisement for purposes of the rule 206(4)-1:

“[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.”

That is a very broad definition.

The first thing I notice is that it must be in written. So oral communications do not fall within the definition. A speaking engagement would not be an advertisement for purposes of this rule. However, the Powerpoint presentation would be, especially if it’s handed out or otherwise made available.

The second is that it must be a “communication addressed to more than one person.” So one-on-one communications should fall outside the limitations of this rule.

A reply for a request for information is generally not an advertisement. In the 1984 SEC Letter to the Investment Counsel Association of America, Inc. they pointed out that an unsolicited request by a client, prospective client or consultant for specific information is not an advertisement.

Thus, for example, if a consultant specifically requests an investment adviser to provide it with written information about the adviser’s past specific recommendations, the adviser’s mere communication of that information in writing to the consultant would not, by itself, be an “advertisement” within the meaning of the rule and would not be prohibited by rule 206(4)-1(a)(2) under the Act, so long as the adviser did not directly or indirectly solicit the consultant to make the request. We also would reach the same conclusion if the adviser provided the same information to (a) one consultant that was requesting the information on behalf of several clients or (b) several consultants, so long as the adviser was providing the information in response to a specific, unsolicited request for information about the adviser’s past specific recommendations.

In that same letter, the SEC pointed out that a communication to existing investors is generally not an advertisement. “In general, written communications by advisers to their existing clients about the performance of the securities in their accounts are not offers of investment advisory services but are part of the adviser’s advisory services. ”

Keep in mind that even if the communications falls outside the definition of “advertisement” and the limitations of Rule 206(4)-1, it is still subject to the anti-fraud provision of Section 206.

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Image is A & P (Great Atlantic & Pacific Tea Co.), 246 Third Avenue, Manhattan.. Abbott, Berenice — Photographer. March 16, 1936 made available to the public by the New York Public Library

Marketing Limitations on Private Funds

As a private fund manager registering as an investment adviser, you get new limitations on how you market and sell interests in your funds.

It all starts with Section 206 of the Investment Advisers Act:

It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly–

1. to employ any device, scheme, or artifice to defraud any client or prospective client;
2. to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;
…
4. to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative. The Commission shall, for the purposes of this paragraph (4) by rules and regulations define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.

In case you didn’t notice, that provision is applicable to all investment advisers, not just registered investment advisers. Since this law was enacted in 1940, it has always been illegal for a private fund manager to engage in fraud, deception or manipulation.

Once you register with the SEC as an investment adviser, the new marketing rules that come into place are in Rule 206(4)-1. That rule lays out five things than an investment adviser can not do with an advertisement:

1.  Refer, directly or indirectly, to any testimonial of any kind concerning the investment adviser or concerning any advice, analysis, report or other service rendered by such investment
adviser; or

2.  Refer, directly or indirectly, to past specific recommendations of such investment adviser which were or would have been profitable to any person: Provided, however, That this shall not prohibit an advertisement which sets out or offers to furnish a list of all recommendations made by such investment adviser within the immediately preceding period of not less than one year if such advertisement, and such list if it is furnished separately: (i) State the name of each such security recommended, the date and nature of each such recommendation (e.g., whether to buy, sell or hold), the market price at that time, the price at which the recommendation was to be acted upon, and the market price of each such security as of the most recent practicable date, and (ii) contain the following cautionary legend on the first page thereof in print or type as large as the largest print or type used in the body or text thereof: “it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list”; or

3.  Represent, directly or indirectly, that any graph, chart, formula or other device being offered can in and of itself be used to determine which securities to buy or sell, or when to buy or sell them; or which represents directly or indirectly, that any graph, chart, formula or other device being offered will assist any person in making his own decisions as to which securities to buy, sell, or when to buy or sell them, without prominently disclosing in such advertisement the limitations thereof and the difficulties with respect to its use; or

4.  Contain any statement to the effect that any report, analysis, or other service will be furnished free or without charge, unless such report, analysis or other service actually is or will be furnished entirely free and without any condition or obligation, directly or indirectly; or

5. Contain any untrue statement of a material fact, or which is otherwise false or misleading.

More about some of these later.
Image is Apples and Oranges by Jeremy / http://creativecommons.org/licenses/by-nc-sa/2.0/

Possible Extension to Registration for Private Fund Managers

Dodd-Frank put enormous pressure on the Securities and Exchange Commission to create dozens of new rules. Tile IV of the law, the Private Fund Investment Advisers Registration Act of 2010, shifts thousands of mid-sized investment advisers from federal to state registration. It also repeals the private adviser exemption, causing most private fund managers to register with the SEC.

Section 419 of Dodd-Frank pegs the transition period at one year. That means there is July 21, 2011 registration deadline. The SEC may be bending on that deadline for the registration of private fund advisers.

In an April 8, 2011 letter to the president of the North American Securities Administrators Association, the SEC indicated it may try to push back that July 21 deadline to the first quarter of 2012.

The letter states that the SEC intends to have the necessary rulemaking done by July 21. Of course, that means the subjects of the rules need to get in line. Since there is only three months until that deadline, the clock is ticking very loudly.

The SEC also needs to get the computer systems in place. Once the rules and forms are finished, they need to update the Investment Adviser Registration Depository System. Back in November, the SEC proposed big changes to the Part 1 of Form ADV to address these new registration and reporting requirements. The final form has not been released. I thought the release may have been because they were re-programming IARD to deal with the new form, allowing them to release the final Form ADV and the registration at the same time. According to this letter, that is not the case. The SEC does not expect IARD to be re-programmed until the end of 2011.

Obviously, this letter merely indicates that at least one person inside the SEC thinks the deadline could be extended. That is a long way from actually extending the deadline. I still have a question about whether the SEC can extend the deadline without some sort of legislative action.

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Compliance Bits and Pieces – UK Bribery Act Edition

With the recent release of the Guidance under the UK Bribery Act, I decided to pull together some other stories:

Howard Sklar decided to start from the back of the guidance and give his thoughts on the case studies:

From Securities Docket, Avoiding Prosecution Under the UK Bribery Act-Playing Offense and Defense, including Vivian Robinson, Q.C. discussing the position of the UK’s Serious fraud office.

Bribery Act in force from July 1: Ken Clarke’s statement in full from Bribery Act .com

“Today I have announced that the Bribery Act will enter into force on July 1st, replacing and bringing together the current bribery laws which date back to 1889.  I am also publishing guidance to businesses about how they can reduce their exposure to bribery and understand the Act.  This guidance is available on the Ministry of Justice’s website here http://www.justice.gov.uk/guidance/bribery.htm

UK Bribery Act guidelines: has the lobbying worked? By Helen Parry, senior regulatory intelligence expert, Complinet

Seemingly unnerved at the anti- Bribery Act lobby’s dire predictions of British corporations losing out to competitors hailing from jurisdictions with a more relaxed approach to such matters, the Ministry of Justice appears to have taken heed. This is clearly demonstrated by the reassuring, empathetic and positively emollient tone employed in the revised version of the guidance for companies issued last week, particularly when sensitive issues such as facilitation payments and corporate hospitality are being addressed. This change of heart can be clearly discerned by comparing the original and revised versions of the case study on facilitation payments featured in the guidance documents.

UK Bribery Act guidance fails to clarify compliance issues by Mark Sands on Risk.net

New guidance from the Ministry of Justice and the Serious Fraud Office (SFO) on the UK’s Bribery Act does not clear up issues of prosecutorial discretion, according to first responses to the papers.

The papers are designed to clarify both the way in which the new bribery laws will be enforced and the appropriate procedures that firms can put in place to make sure they are not liable. However, sources have responded by saying that, while the guidance does help in some areas, it also muddies the waters.

“I think the issue is that this new guidance doesn’t have force of law, so it’s up to the SFO and the courts to decide to prosecute,” says one source at a UK consultancy. They say although Kenneth Clark, in his role as the UK’s secretary of state for the Ministry of Justice, is required to provide guidance to firms, it is not absolute. “You could actually do everything it says and still be prosecuted. Because it’s not prescriptive guidance, it won’t give you the silver bullet,” they say.

Don’t get hysterical – taking an extra biscuit won’t get you arrested under the Bribery Act by Andrew Clark in the Guardian

Rather like the All Blacks performing the haka, a full-scale tantrum by Britain’s business elite can be majestic in its fury. So it was difficult to ignore the histrionic reaction afforded to Jack Straw’s Bribery Act, which got royal assent in the dying days of the Labour government.

The act, intended to update a patchwork of anti-corruption legislation dating back to 1906, clamps down on backhanders, sweeteners and brown envelopes lubricating the progress of transactions and is largely aimed at British companies operating overseas.

Good Act, Deplorable Guidance from Transparency International

Corruption matters to the UK Government. Taking a strong anti-corruption stance should allow the UK to speak with authority at times when it matters, such as in Afghanistan and in the Arab Spring. The new Government is a year old, and has yet to set out its anti-corruption strategy. Judged by its deplorable approach to the Bribery Act, it has made a very poor start.

Life After Guidance: No Change by Michael Volkov in the FCPA Blog

What now? Companies need to review existing anti-corruption programs and make sure U.K. compliance is covered. Because one fact has always been certain: No one wants to become known as the first defendant in a prosecution under the Bribery Act.

‘Questionable Guidance’ From Justice Secretary by Bill Waite in the FCPA Blog

The recent friction between the SFO and Lord Justice Thomas and Mr Justice Bean suggest to me at least that the judiciary will remain staunchly independent in this area and reject guidance where they consider that it conflicts with the statute.