On August 21, 2023, the SEC charged a New York-based FinTech investment adviser with using misleading hypothetical performance metrics in the firm’s advertisements. This enforcement action is particularly noteworthy, because it is the first case brought involving violations of the SEC’s Marketing Rule.
Hypothetical performance ads are subject to strict compliance requirements
For the period ranging from August 2021 to October 2022, the Registered Investment Adviser (RIA) offered multiple complex strategies to retail investors through its mobile trading application. Among other alleged violations, the RIA made misleading representations in written marketing materials that discussed the performance of the firm’s actively managed crypto investment strategy.
In the SEC’s press release, Osman Nawaz, Chief of Enforcement’s Complex Financial Instruments Unit, said, “When offering and marketing complex strategies, investment advisers must ensure the accuracy of disclosures made to existing and prospective investors.” According to Nawaz, the Marketing Rule permits the use of hypothetical performance metrics in advertisements, as long as RIAs comply with its requirements, which are designed to prevent fraud. Nawaz also emphasized that this RIA’s advertisements and disclosures painted a misleading picture of certain strategies offered by the firm.
According to the SEC’s order, the RIA made misleading statements on its website regarding hypothetical performance. The RIA advertised annualized performance results for its crypto strategy and claimed that the returns were as high as 2,700 percent. The SEC alleged that the RIA’s advertisements were misleading because they failed to include material information regarding how the annualized return was calculated.
The firm did not disclose that the advertised annualized return was derived from a purely hypothetical account in which no actual trading had occurred. Furthermore, the RIA’s 2,700 percent annualized return assumed that the strategy’s performance in its first three weeks would continue for an entire year. Based upon the performance extrapolated from a period of only three weeks, the RIA projected that its crypto strategy would continuously generate a 21 percent return every three weeks for an entire year.
RIAs must adopt specific policies and procedures before advertising hypothetical performance
Among other allegations, the SEC accused the RIA of violating the Marketing Rule by advertising hypothetical performance metrics without first adopting and implementing the required policies and procedures. An RIA advertising hypothetical performance must:
- Adopt and implement policies and procedures that are reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience for the advertisement;
- Provide sufficient information that enables the intended audience to understand the criteria used and assumptions made in calculating the hypothetical performance; and
- Provide sufficient information to enable the intended audience to understand the risks and limitations of using hypothetical performance when making investment decisions.
In this particular case, the RIA allegedly failed to supply investors with the material criteria used and assumptions made in calculating its hypothetical performance projection. RIAs must include sufficient information, so the intended audience can appreciate the significant risks and limitations connected to the firm’s hypothetical performance projection. The RIA allegedly failed to provide information in its advertisements about the risks and limitations of using this hypothetical performance when making investment decisions. The targets of this RIA’s advertisements were retail investors who are far less likely to understand the risks and limitations that arise when relying on hypothetical performance advertising.
The RIA did not provide the required information about the 21 percent return in the advertisements themselves. The only way to access this information was through links embedded in the firm’s advertisements. The embedded hyperlinks were labeled generically as “Disclosures” and “Track Record.” Investors were not alerted that they needed to click on the embedded links in order to review vital information about the criteria, assumptions, risks, and limitations of the hypothetical performance results being advertised. Even if investors clicked on the embedded links, however, they did not receive all of the necessary information regarding the assumptions used and the attendant risks.
Not surprisingly, the assumptions that the RIA used to calculate the hypothetical annualized returns and risks were not as clear and prominent as the highlighted 2,700 percent annualized results. The advertisements also did not disclose whether the hypothetical projected returns were presented net of fees and expenses.
Other compliance problems
Along with its violations of the Marketing Rule, the RIA made contradictory disclosures on its website, as well as in its wrap fee brochure, regarding how the firm’s assets were custodied. In addition, the RIA included a hedge clause in its client advisory contracts. This liability disclosure language in its hedge clause created the false impression that clients had waived causes of action against the RIA, which they were entitled to bring under state or federal law.
The SEC determined that the RIA failed to adopt policies and procedures concerning employee personal trading in crypto assets, even though it made representations to the contrary. The RIA failed to adopt policies and procedures to ensure the accuracy of its disclosures concerning its internal controls over representatives’ personal trading in crypto assets held in the strategy.
Aside from its other compliance deficiencies, the RIA failed to adopt and implement policies and procedures that were reasonably designed to ensure that clients’ signatures were obtained to authorize certain types of transactions in their accounts. The SEC’s order pointed out that the RIA self-reported its failure to ensure that client signatures were obtained for certain types of transactions in their accounts.
Takeaways
The RIA agreed to a cease-and-desist order, a censure, and to pay $192,454 in disgorgement. The RIA was also ordered to pay prejudgment interest and an $850,000 civil penalty that will be distributed to affected clients.
Enforcement actions do more than just punish firms that do not satisfy their compliance obligations. They also send a message to other RIAs that they need to bolster their compliance programs. “This action serves as a warning for all advisers to ensure compliance,” Nawaz said.
The SEC’s press release, as well as the enforcement action, can be reviewed here.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.
RIA Compliance Group, LLC – 701 SE 6th Ave, Suite 201, Delray Beach, FL 33483 – Tel: 561-600-0564 – sales@ria-compliance.com
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