OCIE Publishes Risk Alert on Most Frequent Advertising Rule Compliance Issues Found During Examinations
The Office of Compliance Inspections and Examinations (OCIE) of the U.S. Securities and Exchange Commission (SEC) issued a National Exam Program Risk Alert on September 14, 2017 (Risk Alert). The Risk Alert highlights advertising-related compliance issues “most frequently identified in deficiency letters recently sent to SEC-registered investment advisers” (advisers) from a sample of over 1,000 examinations and of nearly 70 examinations of advisers’ “use of accolades in their marketing materials” in 2016 (Touting Initiative). The deficiencies or weaknesses concerned requirements of rule 206(4)-1 (Advertising Rule) under the Investment Advisers Act of 1940 (Advisers Act).1 The Risk Alert encourages advisers to review their compliance programs – and specifically, their advertisements – for compliance with the Advertising Rule, the anti-fraud protections of section 206 and their fiduciary duties to investors.
In his first public speech as Chairman of the SEC, Jay Clayton discussed eight principles of his leadership, including an endorsement of the SEC’s historic approach to regulation. In his remarks, the Chairman stated that “[d]isclosure and materiality have been at the heart of the SEC’s regulatory approach for over eighty years. As my colleague, Commissioner Michael Piwowar, recently said, ‘Unlike merit-based regimes, our system of disclosure comports well with American traditions ... By arming investors with information, they can evaluate and make investment decisions that support more accurate valuations of securities and a more efficient allocation of capital.’”2 The Advertising Rule and principles discussed in the Risk Alert are examples of the SEC’s attempts to “ar[m] investors with information [so that] they can evaluate and make investment decisions.”
The Advertising Rule prohibits advisers that are registered or required to be registered from distributing any advertisement that contains an untrue statement of a material fact, or which is otherwise false or misleading.3 The Advertising Rule also includes four specific prohibitions, which are related to: (1) testimonials as to client experience with the adviser or other services rendered; (2) past specific recommendations in an improper format or without a legend; (3) the use of devices, graphs, charts or formulas, without disclosing the limits thereof; and (4) offering purportedly free services, reports or analyses.4 Under the Advertising Rule, the definition of “advertisement” is broad and includes any “written communication addressed to more than one person” and any other public announcement, where such communication (i.e., notice, circular or letter) offers: (i) any advice (i.e., analysis, report or publication) concerning securities, or which is to be used to determine what to buy or sell, or when; (ii) any formula or device (i.e., graph or chart) to be used in making such determinations; or (iii) any other investment advisory service with regard to securities.5
In addition to the Advertising Rule, which has not been substantively amended since its adoption in 1961,6 a patchwork of guidance exists across enforcement orders, no-action letters and Division of Investment Management (Division) guidance updates. This patchwork has grown as industry practices have changed.
The Risk Alert identifies the most frequent issues seen in examinations, and provides a summary of the OCIE staff’s observations from the Touting Initiative.
Most Frequent Advertising Rule Compliance Issues
The OCIE staff identified the following deficiencies in advertisements:
- Misleading Performance Results. As examples of presentations the OCIE staff believed to be misleading, the Risk Alert cites:
- Presentation of returns without deduction of related fees or expenses (e.g., advisory fees, brokerage or other commissions, any other client-paid expenses) that would be, or actually were paid.
- Presentation of benchmarks without adequate disclosure as to the inherent limitations of such comparisons (e.g., disclosure that the composition of the benchmark materially differed from the advertised strategy).
- Presentation of hypothetical and back-tested returns without adequate disclosure (e.g., missing explanations of how performance was derived and “other potentially material information”).
- Misleading One-on-One Presentations. As examples of presentations the OCIE staff believed to be misleading, the Risk Alert cites:
- Returns expressed “gross of fees” without disclosure consistent with existing no-action relief.7
- Returns that did not reflect the deduction of advisory fees, without disclosure of this practice or an explanation that advisory fees and other expenses would reduce returns.
- Misleading Claim of Compliance with Voluntary Performance Standards. The Risk Alert cites the following as an example of claims the OCIE staff believed to be misleading:
- Materials claiming compliance with certain performance reporting standards (e.g., the Global Investment Performance Standards (GIPS®)) in instances where it was not clear that returns followed the relevant standard’s guidelines.
- Cherry-Picked Profitable Stock Selections. As an example of a recommendation the OCIE staff believed to be cherry-picked, the Risk Alert cites:
- Displays of profitable investment selections or recommendations without complying with the Advertising Rule (i.e., without supplying or offering a list of all recommendations made during the preceding year, along with specific disclosures identifying the security and inclusion of a cautionary legend).
- Misleading Selection of Recommendations. The Risk Alert cites the following as examples of recommendations the OCIE staff believed to be misleading:
- Recommendations not in compliance with the Advertising Rule as noted in the preceding heading (i.e., without supplying or offering a list of all recommendations made during the preceding year, along with specific disclosures identifying the security and inclusion of a cautionary legend).
- Recommendations not presented consistently with prior Division guidance in no-action letters (i.e., advisers showing only the top performers without an equal number of worst performers alongside specific representations;8 advisers showing past specific recommendations without disclosing that not all recommendations were provided; and advisers discussing profits realized only by specific recommendations9).
- Compliance Policies and Procedures. The Risk Alert cites as examples the failure to have, or implement, compliance policies and procedures regarding:
- Review and approval of advertising materials prior to publication or dissemination.
- Determination of parameters for including or excluding accounts from composites.
- Confirmation of accuracy of returns in compliance with the Adverting Rule.
Summary of Observations from Touting Initiative
This initiative examined marketing materials that included awards, rankings and professional designations (collectively, accolades), and considered the appropriateness of related disclosures. In the Risk Alert, the OCIE staff made the following observations:
- Misleading Use of Third Party Rankings or Awards. As examples of presentations the OCIE staff believed were potentially misleading due to the omission of material information, the Risk Alert cites accolades:
- Obtained through the adviser’s submission of an application containing “potentially false or misleading information.”
- Containing references to outdated rankings or evaluations potentially misrepresenting the adviser’s current standing (i.e., rankings “several years” old).
- Used without disclosure as to the relevant selection criteria.
- Misleading Use of Professional Designations. The Risk Alert cites as examples of potentially false or misleading advertisements and disclosures in Part 2B of Form ADV:
- References to lapsed professional designations.
- Failures to explain minimum qualifications to achieve a designation.
- Potentially prohibited testimonials and endorsements used or re-printed in marketing materials, including the firm website and social media.
Implications for Advisers
Investment advisers should consider reviewing their advertisements for consistency with their obligations under the Advisers Act and to identify potential deficiencies, including particularly the issues identified in the Risk Alert. Additionally, the Risk Alert notes remedial measures taken by advisers, which include removal of misleading language from advertisements and the addition of disclosures to prevent misleading advertisements. The Risk Alert also should serve as a reminder that getting the details right is essential to a well-designed compliance program.