Buyer Beware: The Use of Hypothetical Performance
Main Contributor: Elizabeth Cope, CPA, CSCP, CIPM, CEO & Lead Consultant
With the New Marketing Rule’s effective day behind us, the SEC has wasted no time examining advisory firms for compliance with the new requirements. We have seen it in our clients’ exams with a focus on substantiating material statements of fact, testimonials and endorsements, and performance reporting.
Most recently, on September 11, 2023, to be exact, the SEC brought to enforcement nine different advisory firms for their violation of the New Marketing Rule’s requirements around the use of hypothetical performance. These firms had to pay civil penalties ranging from $50,000 to $175,000.
Further, on August 21, 2023, another enforcement case was brought against a FinTech firm for using hypothetical performance that was misleading, causing a cease-and-desist order, $192,454 in disgorgement, and another $850,000 in civil penalties. As with many enforcement cases, this one brought up several other issues the SEC had with the Firm’s practices.
In this article, we will cover the requirements for presenting hypothetical performance and lessons we can learn from these enforcement cases in an effort to avoid violating the rule, should your firm decide to present hypothetical performance.
Refresher on the Requirements
If you are going to use hypothetical performance in your marketing, you must comply with the following requirements:
Adopt 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.
Sufficiently disclose to the intended audience information on the criteria and assumptions made in calculating the hypothetical performance.
Sufficiently disclose to the intended audience information on the risks and limitations of using hypothetical performance when making investment decisions.
Present the performance Net of Fees
Since it is hypothetical performance and not based on actual client accounts, you will most likely be using a model fee, so make sure that the model fee is the highest fee that you expect the intended audience to pay.
Do not make statements that the calculation or performance has been approved by the Commission.
Comply with the seven General Prohibitions.
Lessons from the Enforcement Cases
In all instances of the enforcement cases from September 11, 2023, all nine advisers advertised their hypothetical performance to mass audiences on their website, so they were unable to comply with the first requirement noted above. It’s clear that advisers need to be able to obtain basic financial information from prospective clients in order to substantiate that the hypothetical performance being presented is relevant to their likely financial situation and investment objectives, which cannot be achieved when presenting on public websites and social media platforms. SCS recommends that hypothetical performance only be provided in a setting where the adviser has a relationship with the prospective client and can reasonably document their adherence to the requirement that it’s relevant for that investor’s likely financial situation and investment objectives.
For the FinTech firm from the August 21, 2023, enforcement case, the findings were specifically around misleading representations being made on the firm’s advertising by not including details on how the returns were calculated and that they were in fact hypothetical. Further, they didn’t disclose the risks and limitations.
Other Nuances to Consider
Hypothetical performance is defined as performance results that were not actually achieved by any portfolio of the investment adviser and explicitly includes model, back-tested, and target or projected returns. Firms don’t always recognize targeted returns as hypothetical – so please keep that in mind when reviewing your materials to ensure compliance with the requirements noted above.
In the Rule’s release, the SEC does clarify that providing an Index for comparative purposes would not be scoped in as hypothetical unless it was presented as performance that could be achieved by the portfolio.
Don’t forget that with all advertisements firms must comply with the seven general prohibitions. For example, if the adviser has actual performance that is managed similarly to the hypothetical performance but is choosing to not provide the actual performance because the results are not as good, then this could very easily violate one or more of those general prohibitions.
Conclusion
With the enforcement actions coming quickly off the heels of the effective date of the New Marketing Rule and the SEC’s process of enveloping several advisers into one enforcement it’s clear that this is a hot and sensitive topic with the staff. As quoted by the staff in the press release “…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.”
If your firm allows the use of hypothetical performance, make sure you have robust policies on the use, clear disclosures, and adequate training with the appropriate staff to ensure your firm’s full compliance with the stated requirements.