06 March 2020
Main Contributor: Elizabeth Cope, CPA, CSCP, CIPM, CEO & Lead Consultant
Review of Part 1: The Foundation
In the first article of this series, we discussed the foundational information you need to know to ensure your marketing and advertising materials are in compliance with the SEC’s rules and regulations. We helped you clearly understand:
- the SEC’s definition of an “advertisement.” What is considered an advertisement, what is not, and why this is important;
- what the Adviser’s Act prohibits; and
- where you can find the exceptions to the rules…as there are more than 14 places to look.
If you haven’t already read Part 1: The Foundation, we suggest you start here, as it will provide you with a fundamental understanding of compliant advertising before reading on.
Review of Part 2: Testimonials
This second article focused on the use of testimonials. We started with what the Advisers Act does NOT allow you to do and followed that up with the No-Action Letters and/or SEC guidance that provides you with more specific details of what you CAN do without violating the rules.
If you haven’t already read Part 2: Testimonials, you can start here.
Review of Part 3: Past Specific Recommendations
This third article focuses on the DOs and DONTs of past specific recommendations. Just like we did in the Testimonial article, we began with the Advisers Act and followed it up with the No-Action Letters that provide details of what you CAN do without violating the rules. We provided some specific examples, with the goal of you being able to better understand how to practically apply the rules within your marketing materials.
If you haven’t already read Part 3: Past Specific Recommendations, you can start here.
Part 4: Performance
Surprisingly enough, the Advisors Act, Rule 206(4)-1 actually doesn’t address performance and what is required of advisors. There is, however, a general requirement (a catchall) in the Rule that states, and I am paraphrasing, “it shall constitute a fraudulent, deceptive, or manipulative act, practice, or course of business for any adviser registered, directly or indirectly, to publish, circulate, or distribute any advertisement which contains any untrue statement of a material fact, or which is otherwise false or misleading.”
To determine whether an advertisement is false, or misleading depends on the facts and circumstances of that material, including the form and content, total context of the material presented, and the sophistication of the investor. The SEC has made it very clear in the 2020 Exam Priorities and the newly required Form CRS, as summarized in our blog posts, that higher emphasis is being placed on retail investors. When you have retail investors and/or are marketing to retail investors, additional caution should be taken in your marketing materials to ensure all material facts are being disclosed to the investors.
The current guidance we have as to what CAN and CANNOT be done when presenting performance comes from a series of no-action letters. Below is a discussion of some key No-Action Letters covering the basic requirements.
Clover – General Performance Requirements
This No-Action Letter (published in 1986) is the main source of information related to performance advertising. It breaks down the requirements when presenting actual and/or model performance and the disclosures that must be presented. In our experience, this No-Action Letter is often the source of reference for noted violations to performance reporting, a summary of which is noted below.
Requirements for Actual or Model/Hypothetical Performance
In order to NOT be false or misleading, the following must be included:
- Disclose the effect of material market or economic conditions on the results portrayed – this can be accomplished by comparing the results to a relative benchmark.
- When you are comparing against the index, disclose material factors relevant to the comparison, if any.
- Make sure the actual returns are presented NET of advisor fees, brokerage commissions or other expenses a client may incur. Gross can be included with “equal prominence” to the net, meaning same font and proximity (see below when you can present gross of fee performance only).
- Disclose whether or not the returns include the reinvestment of income.
- Make sure presentation is fair and balanced. If you present the possibility of profits, make sure you also discuss the possibility of loss.
- Disclose material conditions, objectives, and investment strategies used to obtain the performance. This is most often a composite with a description of the composite or a representative account with a description of the representative account’s objectives and strategy.
Additional Requirements for Model/Hypothetical Performance
In addition to the requirements noted above, the following additional disclosures must be provided when presenting model performance:
- Disclose that there are limitations inherent in model/hypothetical results.
- Disclose material changes in the conditions, objectives or investment strategies of the model/hypothetical portfolio during the period portrayed, if any.
- Disclose if the services and strategies presented by the model/hypothetical portfolio do not relate or relate only partially to the services currently offered, if applicable.
- Disclose if actual results are different from the model/hypothetical results, if you have actual assets managed against the model.
TIP: Keep in mind, if you are presenting model/hypothetical performance to a retail investor, the SEC is going to view it with heightened scrutiny.
Additional Best Practices for Model/Hypothetical Performance
Although not outlined in the Clover No-Action Letter or Advisors Act, there are also some best practices to employ, some of which have been recommended by the SEC during examinations and other various No-Action Letters:
- Clearly label the results as model or hypothetical – in the header.
- Do NOT link model and actual results – keep as a separate line or chart and do not link in a YTD number.
- Disclose whether the results portray model or hypothetical and include all assumptions made on the results.
- Do not say “Past performance is not a guarantee of future results,” as it implies the results may be actual.
- Model or hypothetical results should only be presented to sophisticated clients.
- Maintain sufficient records to support all calculations and assumptions.
- Have written procedures that govern the preparation, review and approval of model or hypothetical performance.
- For Hypothetical, we suggest the following additional disclosures, at a minimum:
- the back tested performance was derived from the retroactive application of a model with the benefit of hindsight. (e.g., the adviser only began to offer the given service after the performance period depicted by the advertisement).
- whether the trading strategies retroactively applied were not available during the periods presented.
Keep in mind, that this list in not exhaustive. There may be additional disclosures warranted, that in their absence, deem the presentation false or misleading. We understand that it is frustrating to not have a black and white list of what needs to be included. We suggest obtaining a clear understanding from the team forming the results and stepping in the shoes of an investor to determine what additional disclosures may be warranted. We always suggest erring on the side of caution with model/hypothetical performance.
ICI – Presenting Gross Performance
The SEC has generally taken the view that presenting performance without the reduction of fees is misleading because it doesn’t provide the investors actual experience they would have with that advisor. In the 1988 ICI No-Action Letter, the SEC permitted the advisor to present performance gross of fees only, as long as the following criteria were met:
- Only provide in a one-on-one setting to wealthy clients, in which the participant(s) have the opportunity to ask questions about the fees.
- Disclose that the performance results do not reflect the deduction of investment advisory fees.
- Disclose that the advisory fees are described in your Part 2A or reference if they are included in the existing presentation.
- Disclose that the client’s return will be reduced by the advisor fees and other expenses the clients may incur.
- Include a representative example showing the effect of compounding advisory fees over a period greater than one year. Example: the effect of investment management fees on the total value of a client’s portfolio assuming (a) quarterly fee assessment, (b) $1,000,000 investment, (c) portfolio return of 8% a year, (d) 1% annual investment advisory fee would be $10,416 in the first year, and cumulative effects of $59,816 over five years and $143,430 over 10 years.
Tip: Even if you have gross on one page and the net returns on another page, in our experience the SEC has not viewed that to be equal prominence and has required the aforementioned disclosures on the same page that includes the gross returns.
JP Morgan – Model Fees
Often times advisors want to use a model fee when calculating the net returns for a presentation. The JP Morgan Investment Management No-Action Letter published in 1996 allows this for advisors, as long as the model fee used is not lower than the actual fee clients may incur. In addition, the presentation must fully disclose the use of a model fee. The most common example we see is the use of the highest management fee.
Various – Prior Firm Performance
There are multiple no-action letters that address the requirements for firms who market performance that was obtained while at a prior firm (often referred to as portability). This performance can be presented, if the follow criteria are being met:
- The person(s) who managed the previous accounts were and still are primarily responsible for achieving the results
- The strategy managed at the predecessor firm are similar to the ones managed at the current firm so that it would be relevant to a prospect
- Substantially all of the accounts managed at the predecessor firm are included in the results of the prior firm (unless the exclusion of an account(s) would not result in materially higher performance
- The advertisement is consistent with the Clover No Action Letter (mentioned above)
- The advertisement clearly discloses that the returns were obtained from a prior firm
- Make certain you have the records from the prior firm to substantiate the performance being presented and to support that “substantially” all of the accounts are included
This can be a complicated matter that may require additional thought and discussion to make certain the presentation is not misleading.
TIP: GIPS also addresses the issue of portability and for a firm that claims compliance with GIPS, those specific requirements must also be met.
Record Keeping Requirements
You must retain all records used to substantiate performance provided to any ONE person for as long as that performance is being presented and then an additional five years following the fiscal year-end of its use. This can be satisfied with custodial statements, system generated reports, invoices, and worksheets used to calculate performance. Keep this in mind when working through system conversions and/or record destruction.
Global Investment Performance Standards
Given the lack of requirements provided by the SEC and state regulatory agencies on marketing performance, a set of voluntary standards were adopted by the investment community to address requirements and standards, referred to as the Global Investment Performance Standards (or “GIPS”). PRO TIP: It’s not pronounced “JIPS”. Firms that elect to claim compliance with GIPS have their own set of requirements regarding performance composites, calculations and disclosures. While the SEC does not directly enforce GIPS, the staff will scrutinize presentations, composite membership, and performance calculations of firms with claims of GIPS compliance. If you inaccurately claimed GIPS compliance, the staff will make note of it in the form of a deficiency letter. Because GIPS can be complicated and fact specific, we always recommend the use of a third-party verifier or consultant.
TIP: You are not “compliant with GIPS” once you are verified by a third-party verifier. In fact, being verified isn’t a requirement, nor can you claim your performance is audited. You merely “claim compliance with GIPS”. You must also notify the CFA Institute of your GIPS claim annually.
Even though the SEC does not currently address requirements for performance in the Advisors Act, it is generally covered by the statement that presentations cannot be false and misleading. It’s important, when presenting performance, that compliance reviews and approves all marketing pieces for all required disclosures noted above.
As usual, there is always a gray area. It’s good to have policies in place for the review and approval of all marketing materials, including your website and social media platforms.
As with all areas of compliance, sometimes unique circumstances come up around marketing and advertising. If you have a unique situation, or if, after reading this, you have any questions or concerns and would like a sounding board, email us or give us a call (541) 227-2336. We are always happy to help!