PERFORMANCE ADVERTISING UNDER THE INVESTMENT ADVISERS ACT OF 1940 JANUARY 5, 1989 Mary S. Podesta Associate Director U.S. Securities and Exchange Commission Division of Investment Management The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author's colleagues upon the staff of the Commission. The assistance of Robert E. Plaze of the Division of Management is gratefully acknowledged.
I. Advertising and the Investment Advisers Act The Commission regulates investment adviser advertising under the antifraud provision of the Investment Advisers Act of 1940 ("Advisers Act"). A. The Antifraud Provision Section 206 makes it unlawful for any investment adviser using the mails or interstate commerce to employ any device, scheme or artifice to, or engage in any transaction, practice or course of business which would act to, defraud, deceive, or manipulate any client or prospective client. Section 206(4) of the antifraud provision gives the Commission authority, by rule or regulation, to define and prescribe those acts, practices and courses of business which are fraudulent, deceptive, or manipulative and to make rules reasonably designed to prevent fraud. The antifraud provision applies to all investment advisers as defined in Section 202(a)(11) of the Advisers Act, whether or not the advisers are required to register under Section 203 of the Advisers Act. B. The Advertising Rule: Rule 206(4)-1. Rule 206(4)-1, adopted by the Commission in 1962, contains certain specific prohibitions and a general antifraud standard for adviser advertising. Specific Prohibitions 1. Testimonials cannot be used. 206(4)-1(a)(1). 2. Past specific recommendations that were profitable cannot be referred to unless an adviser includes a list of all recommendations made during the past year. 206(4)-1(a)(2). 3. An adviser cannot represent that any graph, chart, or formula can in and of itself be used to determine which securities to buy or sell. 206(4)-1(a)(3).
4. An adviser cannot advertise any report, analysis, or service as free unless it really is. 206(4)- 1(a)(4). C. General Standard An adviser cannot use any advertisement which contains any untrue statement of a material fact or which is otherwise false or misleading. 206(4)-1(a)(5). In SEC v. Capital Gains Research Bureau, Inc., the Supreme Court construed Section 206 of the Act as creating broad fiduciary duties which investment advisers owe to their clients and prospective clients. The Court said that in adopting the securities acts Congress substituted a policy of full disclosure for the rule of caveat emptor in the securities industry. Thus, the Act should be interpreted not "technically and restrictively, but flexibly to effectuate its remedial proposes." The Ninth Circuit has stated that the language of the rules under Section 206, such as Rule 206(4)-1, should be construed flexibly to effect those same remedial purposes. 1 II. Performance Advertising and Rule 206(4)-1. The Commission has regulated performance advertising of advisers primarily under the general standard of Rule 206(4)- 1(a)(5). A. Anametrics and O'Keefe The Division of Investment Management has provided general guidelines in a series of "no-action" letters. Two significant letters, often cited in subsequent letters, are Anametrics Investment Management (pub. avail. May 5, 1977) ("Anametrics") and Edward F. O'Keefe (pub. avail. March 14, 1978). The position articulated by the staff in those letters assumes that an adviser advertises performance data as an indication of his competence or the experience of his clients and that an advertisement thus implies that a prospective client may expect that competence to 1 SEC v. C.R. Richmond & Co., Inc., 565 F.2d 1101 (9th Cir. 1977).
be exercised on his behalf or that the prospective client can expect to obtain that performance if he hires the adviser. Based on this assumption, Anametrics and Edward F. O'Keefe state the general rule that: Information concerning performance is misleading if it implies something about or is likely to cause an inference to be drawn concerning, the experience of advisory clients, the possibilities of a prospective client having an investment experience similar to that which the advertisement suggests was enjoyed by the adviser's clients, or the adviser's competence, when there are additional facts known by the adviser or which he ought to know, which if also provided would cause the implication not to arise or prevent the inference from being drawn. This position is in harmony with other Commission positions on disclosure under the securities laws. For example, Rule 408 under Regulation C 2 requires that a registrant include in a prospectus not only information required by the forms adopted by the Commission, but also "such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading." Anametrics and Edward F. O'Keefe require the adviser to tell the whole story and not just selective pieces. 3 2 Securities Act Release No. 3225 (June 9, 1947). Regulation C contains rules governing the filing of disclosure documents with the Commission. 3 See also, In re Kilgore Management, Inc., Investment Advisers Act Release No. 332 (Aug. 25, 1972) (advertisement failed to point out differences between indexes compared); In re Bond Timing Services, Inc., Investment Advisers Act Release No. 920 (July 23, 1984) (advertisement omitted from performance calculation the effect of advisory, sales, and transfer fees).
B. Advertising Evaluated in the Context Surrounding Its Use Staff positions state that whether an advertisement is or is not misleading will depend on all of the particular facts including: (1) the form as well as the content of a communication, (2) the implication or inferences arising out of the communication in its total context, and (3) the sophistication of the prospective client. 4 III. Recent Developments A. Substantiation Recordkeeping Rule The Commission has recently adopted amendments to Rule 204-2, the Act's recordkeeping rule, to require an adviser to retain all advertisements and to create and retain documents necessary to substantiate any performance information contained in an advertisement. These documents must be available for Commission inspection. An adviser can substantiate the advertised performance of managed accounts by retaining all account statements, if they reflect all debits, credits, and other transactions in a client's account for the period of the statement, and all worksheets necessary to demonstrate the calculation of performance. Investment Advisers Act Rel. No. 1093 (Nov. 5, 1987) (proposing release); Investment Advisers Act Rel. No. 1135 (Aug. 17, 1988) (adopting release). B. Clover 1. Model Performance Results In Clover Capital Management, Inc. (pub. avail. Oct. 28, 1986) the staff recognized that the Advisers Act and Rule 206(4)- 1 do not expressly prohibit the use of model performance results. Unlike actual results which represent the historical performance of actual client accounts, model results simulate the results a client would have achieved by following the adviser's recommendations. The staff takes the position that the lawful use of model results depends on the facts and circumstances of the model and adequate disclosure about the model results. 4 See, e.g., Covato/Lipsitz, Inc. (pub. avail. Oct. 23, 1981) ("Covato"); Edward F. O'Keefe; Anametrics.
To provide guidance, the staff set forth its views on certain practices it believed inappropriate concerning model and actual results. With respect to model results, in the staff's view an advertisement would violate Rule 206(4)-1(a)(5) if it: (a) Fails to disclose prominently the limitations inherent in model results, 5 particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser's decision-making if the adviser were actually managing clients' money; (b) Fails to disclose, if applicable, that the conditions, objectives, or investment strategies of the model portfolio changed materially during the time period portrayed; (c) Fails to disclose, if applicable, that any of the securities contained in, or the investment strategies followed with respect to, the model portfolio do not relate, or only partially relate, to the type of advisory services currently offered by the adviser (e.g., the model includes some types of securities that the adviser no longer recommends for its clients); 6 and (d) Fails to disclose, if applicable, that the adviser's clients had investment results materially different from the results portrayed in the model. 5 With respect to model results, the staff recognized that advisers may wish to advertise model results derived from model portfolios that differ in form and structure from that presented by the facts in Clover. The staff stated that to the extent it is more difficult to verify or objectively test the criteria underlying the model portfolio in question, the disclosure obligation of the adviser would correspondingly increase. 6 See, e.g., Covato.
2. Actual Performance Results With respect to actual results, the staff stated its views that an advertisement would violate Rule 206(4)-1(a)(5) if it: Fails to disclose prominently, if applicable, that the results portrayed relate only to a select group of the adviser's clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material. 7 3. Actual and Model Results With respect to both model and actual results the staff stated Rule 206(4)-1(a)(5) would prohibit an advertisement that: (a) Fails to disclose the effect of material market or economic conditions on the results portrayed (e.g., an advertisement stating that the accounts of the adviser's clients appreciated in value 25% without disclosing that the market generally appreciated 40% during the same period); 8 (b) Includes model or actual results that do not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid; (c) Fails to disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings; (d) Suggests or makes claims about the potential for profit without also disclosing the possibility of loss; 9 7 See, e.g., O'Keefe. 8 See, e.g., Anametrics. 9 See, e.g., Anametrics; Multinational Investment, Inc. (pub. avail. Sept. 17, 1977).
(e) Compares model or actual results to an index without disclosing all material facts relevant to the comparison (e.g., an advertisement that compares model results to an index without disclosing that the volatility of the index is materially different from that of the model portfolio); 10 and (f) Fails to disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed (e.g., the model portfolio contains equity stocks that are managed with a view towards capital appreciation). C. Post-Clover Developments The position in Clover that advisory fees, commissions and other expenses must be deducted from performance results (i.e. that results must be presented on a net rather than a gross basis) has been controversial. While advisers generally have shown performance net of commissions they typically have not shown it net of advisory fees. The rationale for the staff position is that the presentation of gross results does not show the impact of fees on performance or the compounding effect on performance of not deducting the fees. When the staff reaffirmed its position in a letter to the Investment Company Institute, 11 that organization and other industry groups filed a formal petition for rulemaking stating that the position should be taken, if at all, through rulemaking. 12 10 See, e.g., Anametrics; Multinational Investments, Inc. (pub. avail. Sept. 17, 1977). 11 Investment Company Institute (pub. avail. Aug. 24, 1987). This letter, however, clarified Clover in one respect. The staff stated its view that adviser performance advertising could be presented without reflecting custodian fees paid to a bank or other organization for safekeeping client funds and securities. 12 The petition was filed by the Investment Company Institute, Financial Analysts Federation, Institute of Chartered Financial Analysts, and Investment Counsel
Subsequent dialogue between the staff and the industry resulted in a modification of the Clover position for the use of advertisements containing performance figures in private presentations to prospective clients. 1. Factual Context Investment Company Institute (pub. avail. Sept. 23, 1988) concerned two types of one-on-one presentations. One is the type advisers often make to prospective clients such as wealthy individuals, pension plans or other institutions with sufficient assets to justify the cost of this type of presentation. While the oral presentations may be individualized, advisers typically use the same standard performance charts and graphs in making all the presentations. Thus, the performance charts would be subject to Rule 206(4)-1. 13 The other type of presentation is made by consultants, hired by clients to monitor adviser performance, based on performance data supplied by the adviser. 2. Staff Position The staff modified Clover to permit the use of gross performance results in one-on-one presentations provided the adviser furnishes to the client in writing at the time of the presentation: (a) Disclosure that the performance figures do not reflect the deduction of investment advisory fees; (b) Disclosure that the client's return will be reduced by the advisory fees and any other expenses it may incur in the management of its investment advisory account; Association. A similar rule petition was filed by the Securities Industry Association. The first rule petition was withdrawn following the staff's modification discussed below of the Clover position for certain private presentations. 13 Rule 206(4)-1(b) defines an advertisement to include any notice, circular, letter or other written communication addressed to more than one person which offers any investment advisory service regarding securities.
(c) Disclosure that the investment advisory fees are described in Part II of the adviser's Form ADV; and (d) A representative example (e.g., a table, chart, graph, or narrative), which shows the effect an investment advisory fee, compounded over a period of years, could have on the total value of a client's portfolio. This position also permits advisers to provide performance data to consultants on a gross basis provided the adviser instructs the consultant to give the performance data only on a one-on-one basis and the consultant provides the disclosure in (a) through (d) above.