Locke Lord QuickStudy: SEC Office of Compliance Inspections and Examinations Announces Most Frequent Advertising Rule Compliance Issues for 2017

FUNDamentals™ Series
Locke Lord LLP
September 18, 2017
The Office of Compliance Inspections and Examinations (the “OCIE”) published a Risk Alert on September 14, 2017 discussing the most frequent issues that the OCIE observed during its examinations of investment advisers with regards to Rule 206(4)-1 (the “Advertising Rule”) under the Investment Advisers Act of 1940. In particular, the Risk Alert summarized several of the key deficiencies that the OCIE most frequently encountered with regard to the SEC’s recent Touting Initiative, which focused on the adequacy of disclosures made when investment advisers identified awards, promoted rankings, or identified professional designations in their marketing materials. 

The Advertising Rule applies to all communications and publications (including most written communications, those conveyed over the radio, and those conveyed by television) which offer any analysis, report or publication concerning securities; which offer any graph, chart, formula, or other device to be used in making any determination whether to buy or sell securities; or which offer any other investment advisory service with respect to securities. The Advertising Rule deficiencies identified in the Risk Alert fell into two principal categories: (i) those related to performance reporting and (ii) those related to the touting of awards, rankings, or professional designations.

Issues Respecting the Disclosure of Performance Results: 
The Risk Alert identifies several ways in which investment advisers included misleading performance results in their advertising materials. Common faults in this regard included presenting performance results without deducting advisory fees, comparing the adviser’s results to those of a benchmark index without properly disclosing the differences between the adviser’s strategy and the benchmark index, presenting hypothetical or back tested results without adequately explaining the process by which such results were derived, and falsely claiming that performance results comply with certain voluntary performance reporting standards (such as the GIPS standards). 

The OCIE Staff also noted that some advertisements contained cherry-picked stock selection. While it is permissible for investment advisers to disclose past specific investment recommendations, there are particular requirements which must be met to ensure that such presentations are not deemed to be misleading. The OCIE reiterated that the SEC Staff has in the past provided guidance on how best to present specific past recommendations in advertisements. In particular, the TCW Group no action letter (November 7, 2008) and the Franklin Management, Inc. no action letter (December 10, 1998) deal with this issue. The TCW letter provided that the SEC Staff would not recommend enforcement action against an adviser that used past recommendations in an advertisement if it disclosed at least five of its best performing recommendations, together with an equal number of its worst performing recommendations. Likewise, the Franklin no action letter provided that the SEC Staff would not recommend enforcement action against an adviser for presenting past recommendations in marketing materials if the recommendations presented were selected using a consistently applied, objective, non-performance based selection criteria.

Finally, the OCIE noted that it observed several investment advisers which either did not have policies and procedures in place which were reasonably designed to ensure compliance with the Advertising Rule or had such policies and procedures but did not follow them. These policies and procedures should include, at a minimum, a process for the review and approval of all advertising material (or templates for recurring materials) used by an investment adviser prior to its publication. 

Issues Respecting the Disclosure of Awards, Rankings, and Professional Designations: 
The OCIE launched its Touting Initiative last year to focus on the adequacy of disclosures made by investment advisers in connection with use of awards, rankings, and professional designations in communications with clients. The OCIE noted several instances in which the presentation of awards or rankings by investment advisers could be potentially misleading to investors. These included instances in which the investment adviser submitted potentially false or misleading information on the application for such awards; instances in which the investment adviser continued to publicize awards and rankings that were no longer current; and instances in which the investment adviser did not disclose material information regarding the criteria that were examined in connection with granting an award or ranking, such as the fact that the investment adviser paid to be considered for the award or for the right to distribute the award or ranking.

The OCIE also directed particular attention to the use of professional designations by investment advisers. Investment advisers were noted to have failed to remove professional designations that have lapsed from their ADV Part 2B brochure supplements. In addition, the ADV Part 2B should make clear the minimum qualifications to obtain and maintain a given professional designation.

The full text of the OCIE’s Risk Alert can be found here

Although the above were particularly noted by the OCIE as items which were frequently found to be deficiencies during the course of their examinations, it does not represent a comprehensive list of all deficiencies noted.

As we have in the past, we will continue to monitor these issues and will provide future client updates. This QuickStudy is for guidance only and is not intended to be a substitute for specific legal advice. For more information on the matters discussed in this Locke Lord QuickStudy, please contact the authors.