The SEC found that a registered investment adviser that operates as a “manager of managers” misstated a sub-adviser’s investment performance in communications with its clients, potential clients and the SEC. According to the SEC, these misstatements occurred despite warnings from FINRA that the use of back-tested investment performance in mutual fund advertisements was misleading and concerns about the sub-adviser’s track record that were raised by other market participants.
The SEC found that the adviser published the inflated, hypothetical and back-tested performance record of a sub-adviser in regulatory filings, mutual fund advertisements and client presentations over a period of more than four years.
The SEC also found that the adviser failed to adopt and implement written compliance policies reasonably designed to prevent violations of the Advisers Act and related rules. In particular, although the adviser’s policies addressed its obligations with respect to advertising performance of its client accounts, those policies did not address the accuracy of third-party-produced performance information or third-party marketing materials or provide a means of reporting and assessing concerns raised about the accuracy of statements in such marketing materials.
Notably, these issues arose although the adviser initially “expressed skepticism” about the sub-adviser’s track record. The SEC said that the adviser continued to refer to the incorrect numbers despite several red flags. For example, the adviser allegedly was aware of warnings from other market participants to the adviser’s wholesalers that the track record reflected back-tested results rather than performance of “live” assets. A data provider that attempted to recreate the advertised track record also raised concerns. The SEC found that, although the adviser raised questions with the sub-adviser about these concerns, it failed to follow up on its own questions.
The adviser retained an independent compliance consultant to review its compliance policies and procedures and settled the SEC’s charges without admitting or denying the findings. The adviser must disgorge fees of $13.4 million plus prejudgment interest of $1.1 million and incurred a civil money penalty of $2 million.
Our take. The SEC recognized that the adviser asked questions of the sub-adviser and its principal and, in certain instances, was misled. This, together with a decision to proactively retain a compliance consultant, probably helped to reduce the firm’s penalty. Nevertheless, the adviser’s failure to adequately follow up on its concerns – and to implement a compliance program tailored to its business as a manager of managers – resulted in a failure of its compliance infrastructure that the SEC found actionable. Advisers need to ensure that their compliance programs provide adequate oversight of service providers – including sub-advisers – and that the compliance program includes a means of verifying that concerns about compliance matters are raised and addressed appropriately.