Category: Marketing Rule

The One With Performance an Acre Apart from Reality

Reviewing the actions filed against other fund managers by the Securities and Exchange Commission helps me see what the SEC thinks are bad actions. When I started reading the case against Twenty Acre Capital I was hoping to gain some insight into the Marketing Rule.

Twenty Acre is a registered investment adviser and advises a private fund. Twenty Acre presented performance returns, as one does, in the marketing materials for the fund. The Marketing Rule applies. [Advisers Act Rule 206(4)-1 Release No. IA-5653 (Dec. 22, 2020) (effective May 4, 2021)]

The Marketing Rule prohibits and adviser from publishing an advertisement that would

“(1) Include any untrue statement of a material fact, or omit to state a material fact necessary in order to make the statement made, in the light of the circumstances under which it was made, not misleading; … or Include or exclude performance results, or present performance time periods, in a manner that is not fair and balanced.”

See Advisers Act Rule 206(4)-1(a)

Twenty Acre published “performance returns that were experienced by a single limited partner that had invested in the Fund at inception and was eligible for all Fund investments.” That sounded like this might be an insightful look at performance advertising. This one investor’s performance differed from the Fund’s overall performance because some IPO investments the Fund had made were credited to the investor’s capital account in greater proportion than other investors’ capital accounts. The investors that didn’t get the IPO investments were restricted by FINRA Rules 5130 and 5131.

Twenty Acre didn’t note that the performance presented was just for the one investor and not the fund as a whole. Of course, that seems like a mistake. But an enforcement action seemed like a lot for failing to footnote.

Then I read the difference and spit coffee all over my computer screen. The one investor achieved a 44.8% net performance in 2021. [Fantastic return!] Comparatively, the fund as a whole achieved a -5.7% return. [That is not fantastic.]

Okay, so that was more than not including a footnote. That’s a $100,000 fine.

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Initial Observations Regarding Advisers Act Marketing Rule Compliance

With the issuance of the Marketing Rule for Investment Advisers (Rule 206(4)-1) decades of interpretations and guidance were wiped out. We’ve been waiting to see what falls under those seven general prohibitions in the Marketing Rule. We’ve been thirsting for more guidance.

We’ve gotten some additional clarification on the performance aspects of marketing. We know we can’t put hypothetical performance on a website. We know the net and gross returns have to be calculated in the same manner. (see FAQ 4).

The Division of Examinations released a Risk Alert with the Initial Observations Regarding Advisers Act Marketing Rule Compliance that provides some of that additional guidance of what not to do. It’s mostly a hit list of what not do.

  1. Don’t claim that your investment processes were validated by professional institutions when they were not.
  2. Don’t state that you considered certain risk tolerances when recommending investment strategies when all clients were placed into the same strategy without consideration of risk tolerances.
  3. Don’t reference a formalized securities screening processes that did not actually exist.
  4. Don’t describe yourself as a “private fund adviser” when you don’t actually advise any private funds.
  5. Don’t say that you received awards that you didn’t actually receive.
  6. Don’t say you are different from other advisers because you act in the “best interest of clients”. (Without disclosing that all investment advisers have a fiduciary duty to act in their clients’ best interests.)
  7. Don’t say that were “seen on” national media, without disclosing that the “appearances” were in fact paid advertisements.
  8. Don’t include the Securities and Exchange Commission logo on your website.
  9. Don’t claim that you achieved above average performance results without disclosing that you did not yet have clients or performance track records.
  10. Don’t print disclosures in an unreadable font on websites or in videos.
  11. Don’t use outdated market data information.
  12. Don’t market performance of only realized investment information in the total net return figure and exclude unrealized investments.

These dozen are just some of the anecdotes mentioned in the Risk Alert. Most of these are very obvious failures.

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A Reminder that Hypothetical Performance Does Not Belong on Your Website

The Securities and Exchange Commission brought actions five investment advisory firms for violations of the Marketing Rule. The firms posted advertisements that included hypothetical performance on their websites.

The SEC points out that websites are available to the general public and not “presenting hypothetical performance relevant to the likely financial situation and investment objectives of the intended audience.” Of course, a firm’s website and the materials posted to it are going to be considered advertisements for advisory services.

As a reminder, Advisers Act Rule 206(4)-1(e)(1) defines hypothetical performance as performance results that were not actually achieved by any portfolio of the investment adviser and includes, but is not limited to:

  • Performance derived from model portfolios;
  • Performance that is backtested by the application of a strategy to data from prior time periods when the strategy was not actually used during those time periods; and
  • Targeted or projected performance returns with respect to any portfolio or to the investment advisory services with regard to securities offered in the advertisement.

One thing I found curious about four of the five actions is that those four removed the advertisements containing hypothetical performance on June 8, 2023 before being contacted by SEC staff. What happened on that date to these four?

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New Marketing Rule FAQ

The Division of Examinations has been taking a close look at investment adviser marketing since the Marketing Rule rule compliance deadline last fall. We’re getting dribbles of updates as a result of those exams, with the SEC just starting to point out things it hasn’t liked in exams.

The first was extracted performance from a private fund in January 2023.

“[A]n adviser may not show gross performance of one investment or a group of investments without also showing the net performance of that single investment or group of investments, respectively.”

The latest FAQ focuses on the calculation of net and gross performance.

Q: Must gross and net performance shown in an advertisement always be calculated using the same methodology and over the same time period?

Yes, is the answer. The extra point made in the answer is taking into account the use of a subscription credit facility when calculating returns. If you exclude the use of the facility in one calculation you have to exclude it in the other calculation. And vice versa.

The FAQ goes on to make another point about calculating new IRR when a fund uses a credit facility.

“[A]n adviser would violate the general prohibitions (e.g., Rule 206(4)-1(a)(1) and Rule 206(4)-1(a)(6)) if it showed only Net IRR that includes the impact of fund-level subscription facilities without including either (i) comparable performance (e.g., Net IRR without the impact of fund-level subscription facilities) or (ii) appropriate disclosures describing the impact of such subscription facilities on the net performance shown.”

The new Private Fund Quarterly Reporting Rule also requires calculation of returns with and without the use of the credit facility. (Assuming the rule is not vacated by the courts after the recent hearing.) Add in this FAQ and I see the SEC having a very negative view on private fund’s use of credit facilities.

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What We’ve Learned About Marketing Hypothetical Performance

When the Securities and Exchange Commission enacted the Investment Adviser Marketing Rule at the end of 2020, it threw out decades of cobbled together opinions, no action letters, and informal guidance. In the 18 months it took to reach the compliance date, the SEC offered little in the way of additional guidance. The SEC made it very clear that it would be taking a closer look at investment advisers’ marketing practices shortly after the compliance date a year. There have been signs that the examiners have been doing just that.

Enforcement has begun. The SEC announced action against nine firms for improper use of hypothetical performance.

(8) Hypothetical performance means performance results that were not actually achieved by any portfolio of the investment adviser.
(i) Hypothetical performance includes, but is not limited to:
(A) Performance derived from model portfolios;
(B) Performance that is backtested by the application of a strategy to data from prior time periods when the strategy was not actually used during those time periods…

Each of the nine firms published hypothetical performance on its website. Under 206(4)-1(d)6, an investment adviser can’t use hypothetical performance in an advertisement unless the firm:

(i) Adopts and implements policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement;

(ii) Provides sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance; and

(iii) Provides (or, if the intended audience is an investor in a private fund, provides, or offers to provide promptly) sufficient information to enable the intended audience to understand the risks and limitations of using such hypothetical performance in making investment decisions; ….

In the adopting release for the Marketing Rule at page 220, the SEC points out that hypothetical performance should not be used in mass advertising:

We believe that advisers generally would not be able to include hypothetical performance in advertisements directed to a mass audience or intended for general circulation. In that case, because the advertisement would be available to mass audiences, an adviser generally could not form any expectations about their financial situation or investment objectives.

There is no higher form of general circulation than using a public webpage to broadcast hypothetical performance. There is also the additional challenge of meeting the record-keeping requirements of the Marketing Rule for a website. To of the firms failed to have tools in place to archive their websites.

The lesson learned from these nine cases is don’t put hypothetical performance on your firm’s website.

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Abusing Hypothetical Performance Under the New Marketing Rule

“These charges mark the first violation of the SEC’s amended marketing rule” according to the SEC press release.

Really, when use marketing collateral that your strategy has a 2700% return, you are going to catch the attention of the regulators. Titan Global Capital Management USA LLC, a New York-based FinTech investment adviser, used this hypothetical performance in its advertisements. Plus this was for a crypto strategy, so it’s even more suspect. I assume this lead the Securities and Exchange Commission to take a closer look at Titan Global and find a host of other problems.

The SEC Order provides great insight into what the SEC thinks about compliance with the Marketing Rule as a registered investment adviser. There has been a great deal of mumbling in the compliance world about the lack of guidance from the SEC on how to comply with the general provisions. The SEC annulled decades of guidance on how to be complaint with advertising. The one substantive FAQ about net performance for a single investment in a fund didn’t come out until four months after the compliance deadline.

So how did Titan Global achieve this 2700% return? They took their strategy and ran it for three weeks against price changes, with no actual money invested. During those three weeks, the strategy yielded a 21% return. Titan Global extrapolated that being able to achieve that return for a whole year and came up with a 2700% annualized return.

Titan Global is registered with the SEC as an investment adviser and put a marketing policy in place in June 2021 to comply with the Marketing Rule. There is no question about jurisdiction or applicability of the rule.

A list of the errors cited by the SEC:

  1. Titan Global failed to adopt and implement any policies or procedures reasonably designed to ensure that the hypothetical performance metrics included in its advertisements complied with the Marketing Rule.
  2. The hypothetical performance results were materially misleading. (Advisers Act section 2026(2)
  3. Titan Global failed to present material criteria used and assumptions made in calculating its hypothetical performance projection, including sufficient information to appreciate the significant risks and limitations associated with this hypothetical performance projection.
  4. Titan Global’s target audience was retail investors which requires heightened disclosure.
  5. Titan Global did not disclose in the advertisements that the 2,700 percent annualized return was based on a purely hypothetical account in which no actual trading had occurred.
  6. Titan Global failed to disclose that the annualized return had been extrapolated from a period of only three weeks.
  7. Titan Global failed to disclose Titan’s views as to the likelihood that this three week performance could continue for an entire year.
  8. Titan Global did not disclose whether the hypothetical projection was net of fees and expenses.
  9. Titan Global did provided information about the assumptions it used to calculate the hypothetical annualized return, and risks, as clearly and prominently as the highlighted 2,700 percent annualized return.
  10. The disclosures failed to disclose the significant risks associated with the strategy.

The SEC sums this all up by saying Titan Global’s “advertisement did not present the hypothetical projected performance in a fair and balanced way, or in a way that was not materially misleading.”

I don’t think there is much argument with that summary. This is not a marginal case. I think this advertising would have been found to be misleading under the old Advertising Rule. This part of the SEC Order just uses some of the new language in the Marketing Rule to frame the violation.

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New Risk Alert on the Marketing Rule

The Division of Examination released a risk alert on additional areas of emphasis during examinations focused on the new Marketing Rule (Rule 206(4)1): Examinations Focused on Additional Areas of the Adviser Marketing Rule. This is identified as a follow up to the September 19, 2022, Risk Alert describing the initial areas of review related to examining advisers for compliance with the Marketing Rule: Examinations Focused on the New Investment Adviser Marketing Rule.

The new areas of focus are:

  1. Testimonials and Endorsements
  2. Third-Party Ratings
  3. Form ADV

Testimonials and Endorsements

The focus seems to be just on the key compliance areas. You need to make sure you have good disclosures about whether the person is an actual client/investor, whether the person is compensated and any material conflicts of interest.

I’m seeing placement agents struggling with how to disclose their role in the marketing and fundraising. They all have good disclosures and procedures. I assume there will some move towards standardization in the industry.

Third-Party Ratings

Compliance needs to keep a close eye on these and the substance behind them. The Risk Alert makes it clear that the SEC wants the time frame to be clear, who did the rating and whether there was any compensation.

An interesting note is that the SEC wants to see that the:

“adviser has a reasonable basis for believing that such questionnaire or survey is structured to make it equally easy for a participant to provide favorable and unfavorable responses, and is not designed or prepared to produce any predetermined result.”

Form ADV

The SEC wants to make sure you are checking the right boxes in the new Form ADV questions regarding marketing. Not much substance here, just easy for the SEC to review and grade. I assume the examiners have seen a bunch of advisers who checked the wrong boxes.

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Back from a hiatus on the blog. I thought it prudent to shut down during an examination. The end result was just fine. Exams are just nerve-wracking.

A New Marketing Rule FAQ

It’s been two months and the SEC finally issued a substantive FAQ on the Marketing Rule for investment advisers. https://www.sec.gov/investment/marketing-faq

Gross and Net Performance

Q. When an adviser displays the gross performance of one investment (e.g., a case study) or a group of investments from a private fund, must the adviser show the net performance of the single investment and the group of investments?

A. Yes. The staff believes that displaying the performance of one investment or a group of investments in a private fund is an example of extracted performance under the new marketing rule.[1] Because the extracted performance provision was intended, in part, to address the risk that advisers would present misleadingly selective profitable performance with the benefit of hindsight, the staff believes the provision should be read to apply to a subset of investments (i.e., one or more). Accordingly, an adviser may not show gross performance of one investment or a group of investments without also showing the net performance of that single investment or group of investments, respectively.[2] In addition, the adviser must satisfy the other tailored disclosure requirements as well as the general prohibitions, including the general prohibition against specific investment advice not presented in a fair and balanced manner, when showing extracted performance.[3]

This has been an issue that private equity fund managers have been trying to clarity on for over a year. There has been conflicting advice from consultants and lawyers about the best way to deal with case studies that highlight the type of investing and managing by the private equity fund manager.

I think showing the net overall returns for the fund is more important that coming up with some jiggered calculation of net return for a single investment. But the SEC clearly thinks the opposite.

This will impact many fund managers who took the opposite advice from the SEC position. Marketing materials will need to be revised. Policies and procedures will need to be re-written. A formula for estimating net returns for an individual investment will need to be created.

Happy Marketing Rule Day

The new Marketing Rule for Registered Investment Advisers takes effect today. (Nov 4) Hopefully you’ve got your policies and procedures in place and operational, if the rule applies to you.

Many were hoping for some clarifications and updates. Only two questions were ever answered.

  1. An adviser may choose to comply with the amended marketing rule in its entirety any time starting on the effective date, May 4th, 2021. Until an adviser transitions to the amended marketing rule, the adviser would continue to comply with the previous advertising and cash solicitation rules and look to the staff’s positions under those rules. The staff believes an adviser may not cease complying with the previous advertising rule and instead comply with the amended marketing rule but still rely on the previous cash solicitation rule.
  2. The staff would not object if you are unable to calculate your one-, five-, and ten-year performance data in accordance with rule 206(4)-1(d)(2) immediately following a calendar year-end and you use performance information that is at least as current as the interim performance information in an advertisement until you can comply with the calendar year-end requirement. 

There are several unanswered questions out there. I’ve seen two floating around with lots of discussion these last few weeks.

One is for private equity fund managers using extracted performance in a case study for a fund. I’ve seen conflicting advice from different consultants and law firms about whether you need to generate some kind of a net return for that single investment or whether you can use the net return for the fund.

The second is whether you need to update Form ADV Part 2 Question 14 regarding placement agents or solicitors right away to comply with the Marketing Rule. The SEC has said conflicting things about this update.

The Division of Examinations has already stated it will start a sweep exam on compliance with the Marketing Rule. (See the Risk Alert) Keep an eye on your phone Monday morning.

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