Tag: Marketing Rule

SEC Brings AI Washing Cases

Back in December, Chair Gensler gave a speech to an AI Summit and warned about companies overstating their use artificial intelligence tools. From there, you can see the SEC approaching the concerns as part of fundraising fraud and marketing fraud. Chair Gensler probably knew that the Securities and Exchange Commission was actively working on two enforcement cases that got announced this week.

  • “the first investment adviser to convert personal data into a renewable source of investable capital”
  • “uses machine learning to analyze the collective data shared by its members to make intelligent investment decisions”
  • “turns your data into an unfair investing advantage”
  • “put[s] collective data to work to make our artificial intelligence smarter so it can predict which companies and trends are about to make it big and invest in them before everyone else”
  • “expert AI driven forecasts”
  • “first regulated AI financial advisor”
  • “the models are outperforming IMF forecasts by 34%, and the platform keeps improving”

These are quotes from the marketing materials for Delphia (USA) Inc. or Global Predictions Inc.

Section (a)(2) of the Marketing Rule says that an advertisement may not:

(2) Include a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate upon demand by the Commission;

When asked by SEC examiners to substantiate those claims.

They could not. These appear to be the first cases by the SEC against investment advisers for AI-washing. And two of the few cases under the Marketing Rule.

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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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    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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    Investment Adviser Marketing Rule Finally Published

    After sitting in limbo for three months, the Securities and Exchange Commission finally published the Investment Adviser Marketing Rule in the Federal Register on March 5, 2021. That makes the effective date May 4, 2021 and the compliance date 18 months after that (October November 4, 2022).

    So far I’ve not heard any information on why the extended delay. There were rumors of changes to the rule under the new Chair of the SEC. There were rumors of combing the publication with the rescission of some of the 50 years worth of no-action letters and other guidance. The rumors were apparently not true.

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