Advertising Rule Violations: OCIE Lets Advisers Know Which Get Cited Most
Advisers now have even less of an excuse for violations of Rule 206(4)-1, the Advertising Rule, than they did before. With the Office of Compliance Inspections and Examinations’ issuance of a risk alert listing the most frequent Advertising Rule compliance issues identified during examinations, the agency is leaving little doubt as to what may constitute a violation.
The Risk Alert, issued September 14, lists the top nine such violations. Its findings are based on compliance issues identified in more than 1,000 examinations in 2016, as well as nearly 70 examinations conducted under OCIE’s "touting initiative," which focused on advisers’ use of accolades, that same year.
"This is the SEC staff saying, ‘This stuff is important to us, so pay attention,’" said Dechert partner Michael Sherman. "The staff continues to be concerned about marketing."
The Risk Alert "should be taken seriously by registered investment advisers," said K&L Gates partner Michael Caccese. "Advertisements and the presentation of performance are always listed as one of the top violations that the SEC staff publishes every year. Now, the staff is pointing out to advisers the recurring violations that they have seen and identified in exam deficiency letters to over 1,000 advisers."
"All advisers should take the Risk Alert to heart and review their advertisements, representations, performance presentations, and compliance polices and controls," he said. "After issuing this Risk Alert, OCIE may be less willing to include an Advertising Rule violation in a deficiency letter and more willing to pass it on to the Enforcement Division on the theory that ‘I told you so and you did not listen.’"
Morgan Lewis partner Jennifer Klass suggested that advisory firm compliance departments can use the Risk Alert to "arm internal compliance professionals when talking to marketing and business colleagues. Compliance staff can show the Alert to those in marketing and business to demonstrate the seriousness with which the SEC views these issues."
In addition, she said, the Risk Alert "provides a good excuse for advisers to look at their policies and procedures for reviewing advertising materials to be sure that the review process is working as intended, and as a checklist to sample existing materials."
The Advertising Rule prohibits an adviser, directly or indirectly, from publishing, circulating or distributing any advertisement that contains any untrue statement of material fact, or that is otherwise false or misleading. It also includes four specific prohibitions:
Testimonials are not allowed to be used if they related to the adviser or any advice, analysis, report or other services rendered by the adviser;
Past specific recommendations of the adviser that were or would have been profitable to any person are not allowed;
Graphs, charts, formulas or other devices may not be used if the advertisement claims that they by themselves can be used to determine whether to buy or sell a security; and
"Free" reports, analyses or services may not be used as part of advertising unless they are entirely free and without any condition or obligation, directly or indirectly.
In addition, the SEC staff has, over the years, issued advertising guidance, and "principles are often discussed in Commission opinions, court decisions and Commission orders in settled enforcement proceedings and in no-action letters and guidance updates issued by the . . . Division of Investment Management," the Risk Alert says. Examiners will match adviser advertising against not only the formal Advertising Rule, but against the additional material, as well.
In fact, said Sherman, much of what the SEC and its staff says is permissible or impermissible can be found not in the Advertising Rule, but in guidance and no-action letters, as the examples listed in this Risk Alert make clear (see below).
Advertising Rule violations observed
Following is a list of the most frequent deficiencies examiners identified in regard to the Advertising Rule, along with some examples, as listed in the Risk Alert. OCIE does not offer any thoughts as to the order in which they are listed in the Risk Alert. They are presented here in the order in which they are listed in the Risk Alert.
Misleading performance results. As an example, the Risk Alert states that "staff observed advisers that presented performance results without deducting advisory fees." As such, this would be a violation of the Rule, according to the October 1986 Clover Capital Management no-action letter, in which Division of Investment Management staff stated that results that do not reflect the deduction of advisory fees, brokerage or other commissions, as well as any other expenses that a client would have paid, may be misleading. "Staff also observed adviser advertisements that compared results to a benchmark but did not include disclosures about the limitations inherent in such comparisons," the Alert states. Such limitations may include instances where an advertisement "did not disclose that the advertised strategy materially differed from the composition of the benchmark to which it was compared," OCIE said. Finally, the Alert notes that advertisements containing hypothetical and back-tested performance results without explaining how those returns were derived and not including other potentially material information regarding the performance results, is a violation, and noted its February 2017 settlement with Jeffrey Slocum & Associates (ACA Insight, 3/20/17) as an example.
Misleading one-on-one presentations. "Staff observed advisers that advertised performance results (gross of fees) in certain one-on-one presentations, but did not include potentially relevant disclosures," the Alert says. Doing so may be a violation of the Rule, according to the September 1988 Investment Company Institute no-action letter, in which Investment Management staff indicated that performance results presented on a gross basis in a one-on-one presentation with certain disclosures may not be misleading. Also, the Alert says, some one-on-one presentations that are subject to the Advertising Rule did not disclose that the advertised performance results did not reflect deduction of advisory fees and that client returns would be reduced by such fees and other expenses. It tied this to its May 2015 settlement with Trust & Investment Advisors (ACA Insight, 6/8/15).
Misleading claim of compliance with voluntary performance standards. "A common example of a voluntary performance standard is the Global Investment Performances Standards (GIPS)," OCIE noted, adding that, in addition to voluntary performance standard violations it found, the Commission, in an October 2015 Opinion, found investment adviser ZPR Investment Management in violation of Rule 206(4)-1(a)(5) for having falsely claimed in an advertisement that it complied with GIPS.
Cherry-picked profitable stock selections. "Staff observed advisers that included only profitable stock selections or recommendations in presentations, client newsletters, or on their web sites, without meeting the conditions set forth in Subsection (a)(2) of the Advertising Rule," the Risk Alert says. Subsection (a)(2) is the part of the Advertising Rule that generally prohibits an adviser from advertising past specific recommendations of the adviser that were or would have been profitable to any person.
Misleading selection of recommendations. "Staff observed advisers that disclosed past specific investment recommendations that may have been misleading because they included only certain, and not all, recommendations, in order to illustrate a particular investment strategy, and they did not meet the conditions set forth in Subsection (a)(2) of the Advertising Rule," the Risk Alert says. Further, the Alert states, they did not satisfy the representations that the Investment Management staff, in two no-action letters, said were necessary to avoid enforcement actions. One of those two no-action letters was the November 2008 TCW Group no-action letter, in which Investment Management staff said it would not take enforcement action against an adviser if it listed an equal number of both the best and the worst performing holdings in regard to a particular investment strategy. The other was the December 1998 Franklin Management no-action letter, in which the staff said it would not pursue enforcement action if an adviser that used past specific recommendations selected those recommendations using consistently applied, objective, non-performance based selection criteria, provided that certain representations were made.
Compliance policies and procedures. "OCIE staff observed advisers that did not appear to have compliance policies and procedures reasonably designed to prevent deficient advertising practices," the Risk Alert says, which would be a violation of Rule 206(4)-7, the Compliance Program Rule. As examples, it notes that examiners found advisers that did not have, or did not implement, policies and procedures for a number of issues, including a process for reviewing and approving advertising materials prior to their publication or dissemination; determining the parameters for which accounts were included or excluded from performance calculations when using composites; and confirming the accuracy of performance results.
Misleading use of third-party rankings or awards. This observation was one of those derived from OCIE’s touting initiative, involving advisers’ use of accolades in their marketing materials. Among the problems examiners found were accolades obtained by submitting potentially false or misleading information in the applications for such accolades; advertisements that referred to advisers receiving high rankings in various publications issued several years prior, and no longer applicable; and failure to disclose the relevant selection criteria for the awards or rankings, who created and conducted the survey, or whether the advisers paid a fee to participate in or distribute the results of the survey. The Risk Alert references the March 1998 DALBAR no-action letter, which it said includes factors that advisers should consider when determining whether an advertisement containing a third-party rating is false or misleading.
Misleading use of professional designations. Another observation from the touting initiative, examiners here observed advertisements and disclosures made in advisers’ Form ADV Part 2B brochure supplements that the Alert says "contained potentially false or misleading references to employee professional designations, such as, for example, references to professional designations that have lapsed or that did not explain the minimum qualifications required to attain such designations."
Testimonials. "OCIE staff observed advisers that had published statements of clients attesting to their services or otherwise endorsing the adviser that may be prohibited testimonials," the Alert says. As examples, it specified client endorsements published in firm websites, social media pages, reprints of third-party articles, or pitch books.