On August 9, 2016, a federal appeals court upheld the SEC’s 2015 decision in In the Matter of Raymond J. Lucia Companies, Inc., in which an adviser and its owner (collectively, “Lucia”) were found to have violated anti-fraud provisions of the Advisers Act, as well as Rule 206(4)-1 under the Advisers Act (the “Advertising Rule”), in advertisements that presented hypothetical (“back-tested”) performance information.
The Advertising Rule prohibits any “advertisement,” as defined under the Rule, that contains any “untrue statement of a material fact” or that “is otherwise false or misleading.” Advertising using back-tested performance information – theoretical performance resulting from applying a specific investment strategy, such as a quantitative or formula-based strategy, to historical financial data – is not per se fraudulent. However, there are a number of requirements that an adviser must satisfy when advertising back-tested performance to avoid violating the anti-fraud provisions of the Advisers Act and the Advertising Rule.
In its decision, the SEC found that Lucia, in advertisements at seminars conducted to sell prospective clients on its investment strategy, made fraudulent misstatements of material fact and omissions of material fact necessary to make statements made not misleading. These misstatements included misrepresentations regarding the back-tests it had performed to prove that Lucia’s investment strategy would have resulted in advantageous investment outcomes during difficult market periods. The SEC found that the back-tests were misleading because, among other reasons, Lucia did not sufficiently disclose to prospective clients that the back-tests used an assumed rate of inflation and an assumed rate of return on a class of investments that were not the actual historical rates. In addition, the SEC found that the back-tests did not actually follow the strategy being promoted by Lucia. Thus, the advertised performance did not, as claimed, show what would have happened if an investor had employed Lucia’s investment strategy during the back-test periods. Instead, the advertised performance was materially overstated.
The SEC found that Lucia violated anti-fraud provisions of the Advisers Act and the Advertising Rule. The SEC ordered the Lucia adviser to pay a civil penalty of $250,000, and Lucia’s owner to pay a civil penalty of $50,000. In addition, Lucia’s owner was barred from the industry.