Hypothetical Performance Claims Likely to Draw SEC Scrutiny
Aggressive marketing that touts historical returns on investments is one thing. But when the returns touted are hypothetical, expect the SEC to come calling.
That’s what apparently happened to a New Hampshire-based investment adviser that, along with its owner, agreed last month, as part of a settlement with the agency, to pay a $100,000 civil money penalty. Both the firm, Mackensen & Company (MCI), and its owner, Warren Mackensen, were also censured.
"Investment advisers should be very cautious when advertising performance based on a hypothetical and back-tested portfolio," said Mayer Brown partner Matthew Rossi. "The SEC is frequently suspicious of this kind of advertising. Advisers advertising performance in this way should clearly disclose that the performance results are based on retroactively applied model portfolios, and do not represent actual investment results."
This case is another example of the sensitivity attached to the issue of back-testing. In another recent case (ACA Insight, 10/12/15), two commissioners dissented from a Commission Opinion that upheld an administrative law judge ruling involving back-testing. The dissenters, commissioner Michael Piwowar and now-former commissioner Daniel Gallagher, took issue with what they said was the Opinion requiring that back-testing be based on actual data, not hypothetical assumptions.
From late 2010 into 2012, MCI sent hundreds of form letters to the trustees of trust funds held by New Hampshire municipalities, the SEC said. In New Hampshire, it is typical for municipalities to have trusts that manage funds for municipal functions, such as maintaining cemeteries. The letters, of which approximately 500 were mailed by MCI starting in 2010, were an attempt by the firm to market their advisory services to the state’s trust funds, according to the administrative order instituting the settlement.
The first page of the letter, each of which the SEC said Mackensen personally signed, typically claimed that the trust funds would have been better off if they had invested with MCI from the start. The second page, according to the agency, was entitled a "comparative performance report" and purported to match the performance of the town’s current trust fund portfolio with that of MCI’s model portfolios – and computed the gain that would have been achieved had the trust invested with MCI instead.
However, "it was not disclosed in the letter that the described performance was both hypothetical and back-tested," the SEC said. MCI, which generated the hypothetical back-tested performance using software that created a "snapshot," provided performance comparisons to prospective investors "for periods that included dates during 2010 and early 2011, even though the MCI model portfolio was not assembled until May 2011," the agency said. While some of the letters did go so far as to say that the model portfolios did not represent actual results of investing in the municipality’s city or town, it "did not disclose that the portfolios did not actually exist," the agency said.
The letters worked. MCI received about 60 calls from the municipalities, and ultimately netted an additional 20 municipal clients. Mackensen then followed up with his new clients, allegedly bringing disclosures showing that he used the software to calculate the performance shown in the letters. "However, Mackensen failed to provide those disclosures to the trustees who were his actual or potential clients, and did not discuss with them how he calculated the purported additional gain the municipality could have received by investing with MCI," the SEC said.
"This case illustrates that disclaimers that are not sufficiently detailed and/or robust will not save an adviser from an enforcement action," said Sidley Austin partner Mark Borrelli. "The adviser allegedly used a disclaimer that said that the performance did not ‘represent actual results of investing for your town or city.’ According to the SEC, though, the portfolios did not represent actual results of trading for any [emphasis Borrelli] client."
An attorney representing MCI and Mackensen did not respond to a voice mail or an email seeking comment.
Rules and compliance
Mackensen, the agency said, "failed … to review the Commission’s rule related to advertising before the letters were sent out," the agency said. "He admitted that he was not familiar with the Commission’s rule relating to investment adviser advertising." Unfortunately for him, this made no difference when it came to the administrative law judge’s decision.
In addition, the firm was found not to have written policies and procedures for performance advertising. "MCI’s compliance manual contained no substantive information on performance advertising, except to note that it was not used, which was not correct," the SEC said, adding that it was Mackensen’s responsibility to create and implement those procedures "so that its performance advertisements complied with the rules governing investment adviser advertising."
"Having no procedures whatsoever relating to performance advertising, as was allegedly the case here, makes it easy for the SEC to bring a case for violation of Rule 206(4)-7," said Borrelli.
Improper performance advertising is barred by Rule 206(4)-1(a)(5). The rule considers it fraud when an adviser directly or indirectly uses an advertisement that "contains any untrue statement of a material fact, or which is otherwise false or misleading." Rule 204-2(a)(16), part of the books and records rule, requires advisers to maintain backup documentation to substantiate performance numbers used in marketing materials. There are also a number of no-action letters that set forth what advisers should and should not do when advertising performance.
"The general rule to follow for hypothetical performance information is to avoid its use if at all possible, and, if you do use it, to be careful to label it as hypothetical and to include numerous disclaimers," said Borrelli. "Advisers need to be careful when presenting anything other than actual performance. Even presenting the performance of a model portfolio that is traded side by side with actual accounts requires appropriate disclaimers, but here the adviser allegedly recreated performance using current portfolio positions, and worse, allegedly presented performance for periods in which the model portfolio did not even exist."
Rossi noted that the Enforcement Division’s Asset Management Unit co-chief Julie Riewe announced in a February 2015 speech that "valuation and performance and the advertising of that performance" would be a top priority for 2015. As a result, he said, "we can expect to see additional enforcement actions concerning performance advertising."