On September 11, 2023, the SEC continued its crackdown on Registered Investment Advisers (RIAs) using hypothetical performance advertising by bringing cases against nine advisers. RIAs that advertise hypothetical performance, or plan to do so, should read these SEC enforcement actions or risk serious consequences. The cases are available here.
It is also imperative that RIAs recognize when they are advertising hypothetical performance. “Hypothetical performance” is defined as performance returns that were not actually achieved by any portfolio of the RIA.
Hypothetical performance encompasses but is not limited to:
- Returns derived from model portfolios;
- Returns calculated by backtesting a strategy using data from prior time periods when the strategy was not actually used; and
- Targeted or projected performance returns with respect to any portfolio or to the investment advisory services offered in the advertisement.
Think Long Before Advertising Hypothetical Performance
The Marketing Rule permits RIAs to advertise hypothetical performance under certain conditions. Ideally, satisfying these conditions will reduce the likelihood that the advertisements are misleading. An RIA advertising hypothetical performance is required to:
- Adopt and implement policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement;
- Provide sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating the hypothetical performance; and
- Provide (or, when the intended audience is a private fund investor, offer to provide promptly) sufficient information to enable the intended audience to understand the risks and limitations of using hypothetical performance in making investment decisions.
The rule clarifies that reasonably designed policies and procedures need not address each recipient’s particular circumstances. However, an RIA must make a reasonable judgment about the likely investment objectives and financial situation of the advertisement’s intended audience. As we’ll see with the enforcement actions below, those conditions are nearly impossible to satisfy when advertising hypothetical performance to a mass audience.
Nine More RIAs Nailed For Advertising Hypothetical Performance To The General Public
The charges brought against the nine RIAs accused them of advertising hypothetical performance to the general public on their websites without adopting and/or implementing the policies and procedures required by the Marketing Rule. The enforcement actions send a loud and clear message that hypothetical performance advertising should not be directed at a mass audience.
In a press release, Gurbir S. Grewal, Director of the SEC’s Division of Enforcement, explained why the Commission is cracking down on the use of hypothetical performance advertising in advertisements aimed at the general public. “Because of their attention-grabbing power, hypothetical performance advertisements may present an elevated risk for prospective investors whose likely financial situation and investment objectives don’t match the advertised investment strategy,” said Grewal. “It is therefore crucial that investment advisers implement policies and procedures to ensure their compliance with the rule. Until that is the case, we will remain vigilant and continue our ongoing sweep to ensure that investment advisers comply with the Marketing Rule, including the requirements for hypothetical performance advertisements.”
Without admitting or denying the SEC’s findings, the charged firms agreed to be censured and to cease and desist from violating the Marketing Rule. These RIAs also agreed that they would not advertise hypothetical performance without having the requisite policies and procedures. In addition, the RIAs agreed to pay civil penalties ranging from $50,000 to $175,000. The firms were ordered to pay $850,000 in combined penalties.
The Nine Cases Contained Similar Allegations
The first RIA charged, which is based in Houston, Texas, published communications on its public website. They fell under the definition of “advertisements,” because they offered investment advisory services with regard to securities to prospective clients and offered new investment advisory services regarding securities to current clients. The advertisements included hypothetical performance that consisted of performance derived from model portfolios. The website advertisements were disseminated to the general public rather than to a particular intended audience.
When the firm advertised hypothetical performance, the RIA failed to adopt and implement policies and procedures that were reasonably designed to ensure that the performance was relevant to the likely financial situation and investment objectives of the intended audience. Because of these failures, the RIA disseminated hypothetical performance in advertisements to a mass audience rather than presenting hypothetical performance relevant to the likely financial situation and investment objectives of the intended audience.
Two of the nine enforcement actions alleged additional violations of the Investment Advisers Act. An RIA based in San Francisco, California, was charged with failing to maintain copies of each advertisement that it disseminated as required by the Books and Records Rule. Another RIA, based in Parsippany, New Jersey, also violated the same rule by failing to keep certain true, accurate and current books and records. The SEC requested that the RIA produce a copy of each advertisement reflecting performance that it disseminated during the applicable period. The RIA was unable to produce these records, because it had failed to ensure that the advertisements had been archived by an outside service provider.
These charges follow on the heels of the SEC’s previous action against a New York-based FinTech investment adviser that used misleading hypothetical performance metrics in the firm’s advertisements. The SEC’s press release, as well as the enforcement action, can be reviewed here.
It is likely we will see more enforcement actions as the SEC’s sweep continues. The SEC’s enforcement actions have implications that go beyond advertisements on websites. Fact sheets and brochures containing hypothetical performance results that are provided to a mass audience will certainly create compliance problems for RIAs.
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.