Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News March 20, 2017 Issue

SEC Crackdown on Misleading Marketing Nets Another Adviser

Use of hypothetical and/or backtested performance results in marketing is a surefire way to draw attention from SEC staff. A new settlement with an advisory firm should serve as a potent reminder to anyone who may have forgotten.

Minneapolis-based adviser Jeffrey Slocum & Associates recently settled charges that it provided misleading marketing materials to current and prospective clients, the agency said. Specifically, the SEC alleged that the firm:

  • Disseminated marketing materials with misleading performance data, including the use of hypothetical and backtested performance figures that were not adequately disclosed as such;
  • Made misstatements in its marketing about the firm’s acceptance of gifts from investment managers; and
  • Made misstatements about its enforcement of its Code of Ethics.

In addition, Jeffrey Slocum & Associates allegedly failed to create and keep required books and records supporting its performance data, and failed to adopt and implement necessary compliance policies and procedures. The owner and president of the firm, Jeffrey Slocum, was charged in the settlement with having caused some of these violations.

The case is the latest in a series of enforcement actions involving "misleading advertisements that the SEC continues to bring against investment advisers," said K&L Gates partner Michael Caccese. "Firms need to clearly label performance that is backtested or hypothetical as such and explain the methodology used to calculate the performance."

"The SEC order also reminds the industry of the need to maintain records that support the calculation of actual, hypothetical and backtested performance, and that performance claims cannot rely on third-party data that the adviser does not maintain in its own files," he said. "Advisers need to be squeaky clean when they present performance, especially hypothetical and backtested performance, so there is no chance that the potential client is misled."

"Each one of the violations on its own doesn’t seem like it would be enforcement worthy," said ACA Compliance Group managing director Kimberly Daly. "But the collective impact of the misleading statements and the adviser’s non-compliance with its own written policies and procedures paints a pretty bleak picture. This case is a great reminder of the importance of being completely truthful and honest in communications to clients and prospective clients."

Why is the SEC so concerned about performance results that are hypothetical or backtested? The main reason is that hypothetical results show performance that does not reflect the experience of actual client portfolios.

Backtested results are also hypothetical. They occur when a particular investment strategy is applied to historical financial data in an attempt to show the performance that the strategy would have obtained if it had been implemented during the time period. The agency is concerned that unsophisticated investors will view such results as the real thing, when they in fact are not.

Marketing statements and golf tournaments

Jeffrey Slocum & Associates, which recently sold its assets and is no longer registered as an adviser, had approximately 130 clients and $123 billion in assets under management as of April 2016, according to the SEC’s administrative order. The firm provided investment consulting services, such as recommending investment managers, to institutional clients.

From at least June 2011 to October 2014, the agency said, Jeffrey Slocum & Associates disseminated marketing materials to at least 14 current or prospective clients explaining its strict practice of not accepting anything of value from investment managers. The agency quoted from the firm’s marketing materials, which allegedly stated that "’Our firm has never, not once, taken even so much as a nickel from an investment manager, under any guise.’" Marketing materials, from at least January 2012 to August 2014, according to the agency, also stated that "’Our firm actively guards against any actual or potential conflicts of interest by enforcing a strict Code of Ethics to which all employees must adhere in order to remain on our staff.’"

The advisory firm did allow employees to accept gifts worth less than $100 and, between 2011 and 2014, according to the SEC, a number of employees did. Certain gifts worth more than $100 required employees to obtain pre-approval from the firm’s chief compliance officer or general counsel.

Unfortunately, according to the agency allegations, these rules were not always followed, which left the firm in the position of making statements in its marketing materials that were not true. "In 2013, in violation of [Jeffrey Slocum & Associates’] gift policy, four … employees each accepted tickets to the Masters [Golf Tournament] valued over $100 from [an investment manager] without consulting with and obtaining pre-approval from the CCO or general counsel."

While the firm’s CCO and general counsel then proposed a response that would have required these employees to reimburse the investment manager for the full value of the tickets, Slocum, the firm owner, directed that the response be "softened," the SEC said, "and the employees were permitted to accept the gift of the tickets. The employees were not formally disciplined for their violation of the gift policy."

The agency’s position was that the statements in the marketing materials about accepting gifts "were misleading because [Jeffrey Slocum & Associates’] gift policy permitted employees to accept gifts from investment managers under certain circumstances and because [advisory firm] employees had in fact accepted tickets to the Masters Golf Tournament from an investment manager in 2012 and 2013. Further, [Jeffrey Slocum & Associates] and Slocum failed to impose any formal discipline on the employees who violated the gift policy by accepting tickets to the 2013 Masters Golf Tournament without pre-approval."

The value added chart

Advisory firm employees in June 2013 created a chart, called the "value added chart," the SEC said, that "purported to show the value added by [the adviser’s] investment manager recommendations." The chart, according to the agency, showed both absolute and risk-adjusted return measurements for at least 20 asset classes over the previous, three, five and 10 years.

However, the SEC alleged, "the performance figures were both hypothetical and backtested. They were not based on the historical performance of the holdings of any [Jeffrey Slocum & Associates] client account, nor on [the advisory firm’s] past manager recommendations to clients. Instead, they were calculated as an equally weighted composite of the past performance of investment managers that were on the approved list (the firm’s recommended investment managers) as of the date of the chart."

The chart was, after some additional updating, distributed to advisory firm consultants, who, the SEC said, "incorporated it into marketing materials, such as responses to requests for proposals and pitchbooks that they disseminated to clients or prospective clients."

Some of the firm’s employees, according to the SEC’s administrative order, considered changing the chart "to reflect the performance of all current and historical approved managers during the periods when those managers were on the approved list." But they were unable to do so, the agency said, because the firm, at the time, "did not maintain reliable data on the past composition of the approved list." In other words, the SEC said that the firm did not have the necessary records to do so.

Some employees began adding footnotes to the chart disclosing the methodology by which it was prepared. But the "vast majority" of marketing materials that included the chart did not have these footnotes, according to the agency.

"From June 2013 to August 2014, the value added chart was incorporated into at least 40 marketing documents disseminated to at least 33 different clients or prospective clients," the SEC alleged. "At least 22 clients or prospective clients received marketing materials incorporating the value added chart without any disclosure that the chart reflected backtested and hypothetical performance data. An additional nine clients or prospective clients received marketing materials incorporating the value added chart with only partial disclosures."

"It seems as though some of the employees suspected or knew that the way the firm was allegedly presenting historical performance data was not completely above board," said Daly. "Some remedial changes were implemented, but not, apparently, in a consistent manner, according to the agency. This demonstrates the importance of not only having an escalation mechanism for employees’ concerns, but also a process for adopting changes in a comprehensive and systematic manner."

Violations and penalties

As part of the settlement, Jeffrey Slocum & Associates was charged with willfully violating Advisers Act Sections 206(2) and (4), both of which prohibit fraud, as well as Rule 206(4)-1(a)(5), which outlaws advertisements containing untrue statements of a material fact, or which is otherwise false or misleading. In addition, the firm was charged with willfully violating Section 204(a) of the Advisers Act and its Rule 204-2(a)(16), part of the Books and Records Rule. Finally, the SEC charged Jeffrey Slocum & Associates with willfully violating Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule, for failing to adopt and implement written compliance policies and procedures. Slocum himself was charged with having caused his firm to violate 206(2) and(4), as well as Rule 206(4)-7.

The advisory firm was censured and ordered to pay a $300,000 fine. Slocum was ordered to pay a $100,000 fine. An attorney representing the firm did not respond to a voice mail or email seeking comment.