Tag: Advertising

Fees and Performance Results for Advisers and 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 fraudulent, deceptive or manipulative practices is testimonials, which I wrote about earlier. The second item in the advertising rule is a prohibition on using past performance in an advertisement, subject to some limitations. I also wrote about that last week.

One of the controversial standards when using performance results is that they must be shown net of fees.

In a 1986 No Action Letter to Clover Management the SEC said it was their view that “Rule 206(4)-1(a)(5) prohibits an advertisement that: … (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; ”

Can you just include a description of your fees? No.

[B]ecause advertisements typically present adviser performance results over a number of
years, narrative disclosure of the existence and range of advisory fees, in our view, would
not be an adequate substitute for deducting advisory fees because of the compounding
effect on performance figures that occurs if advisory fees are not deducted. In our view it is
inappropriate to require a reader to calculate the compounding effect of the undeducted
expenses on the advertised performance figures. Investment Company Institute No Action Letter (1987)

But you can include gross returns, as long as they are side-by-side with net of fees results. See Association of Investment Management and Research (1996). Both the net and gross performance figures need to be presented in an equally prominent manner. The “advertisement” must contain sufficient disclosure to ensure that the performance figures are not misleading. For example, when showing a performance figure gross of fees there should be a disclaimer that the figures do not reflect the payment of investment advisory fees and other expenses.

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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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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

Advertising Limitations for Investment Advisers on Social Networking Sites

While FINRA has a very strict limitation on advertisements focusing on procedures, investment advisers have a principles driven approach to limitations on advertising.

To start, an advertisement is any communication addressed to more than one person that offers (1) analysis concerning a security, (2) any information to used in making a determination to buy to sell a security, or (3) any investment advisory service with regard to securities. That means bulk emails, television ads, radio ads, websites, and social networking sites are advertisements. If you label yourself as an investment adviser in your Facebook profile, Twitter profile, or blog information, those sites are advertisements. Even if you use them solely for personal purposes, they may be considered an advertisement if you mention securities or offer your services.

Given the broad definition of advertisement, you should just assume that your activity on a social networking site is an advertisement.

Let’s focus on the things you can’t do in an advertisement and then come back to how they affect an investment adviser’s use of the internet and social networking sites. These all come from the general prohibition on fraud under Section 206 of the Investment Advisers Act.

First, you can’t have “any testimonial of any kind concerning the investment adviser or concerning any advice, analysis, report or other service rendered by such investment adviser.” That means no recommendations on LinkedIn or other social networking site. That means you would need to moderate your blog comments and delete any that seem like a testimonial or recommendation.

Second, you can’t refer to past specific recommendations of securities. However, you can separately provide a separate detailed list of all past recommendations over at least the past year, with name of the security, the date recommended, and the price at which it was recommended. You also need to include a legend that past performance is not an indication of future performance. That means you can’t advertise your past success. Effectively, you can’t cherry-pick your best performing securities recommendations. You also need to disclose all material facts necessary to avoid unwarranted inference.

Third, you can’t advertise a graph, chart, formula, or other device for use in determining which securities to buy or sell or when to do so.

Fourth, you can’t offer any report, analysis, or other service for free, unless it is actually entirely free and without any condition or obligation.

Fifth, your advertisement can’t have any untrue statement or material fact or otherwise be false or misleading.

In looking at these principles, you can’t communicate something on a web 2.0 site that you could not put in a newspaper advertisement.

There has not been any additional guidance from the SEC on the use of Web 2.0 by investment advisers.  In a speech last week, Mary Schapiro said that the SEC “hasn’t come to a resolution on the new technology.” That alone may shy investment advisers away from using web 2.0 and social networking sites.

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