IA Watch/Assette: Advertising & Marketing Compliance Webinar on 1/26/16

• Richard Kerr, Partner, K&L Gates

• Asher Ailey, CCO, SouthernSun Asset Management

• Amy Jones, Founder/Principal, Guardian Performance Solutions

Amy Jones Founder/Principal, Guardian Performance Solutions

Richard Kerr Partner, K&L Gates

Sponsored by:

Asher AileyCCO, SouthernSunAsset Management

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Agenda• An intro: The often-blurred lines drawn by the SEC

– Current state of advertising and marketing rules – New tripwires for social media and the rule on testimonials– Recent enforcement actions and what they tell us

• Compliance – The CCO’s role in overseeing firm marketing and advertisements – The potential for violations when using predecessor data – How the SEC focuses on marketing/performance during exams

• Best practices – Performance advertising hot topics – How the Global Investment Performance Standards (GIPS) add another layer of work and

compliance – Tips to avoid inconsistencies between marketing and regulatory reporting

• Risk Management in Advertising and Marketing Materials– How to mitigate risks when marketing materials are coming from a number of sources – Ways automation can minimize marketing operational, regulatory and reputational risks

The Often Blurred Lines Drawn by the SEC

Current State of Advertising and Marketing Rules

What is an Investment Adviser Advertisement?

• “Any written communication addressed to more than one person” that offers investment advisory services related to securities

• Includes communications designed to maintain existing clients or solicit new clients

• Includes electronic and broadcast advertisements

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Advertising and Marketing Rules

• Section 206 (general antifraud provision of Advisers Act)

• Rule 206(4)-1 (SEC advertising rule)– Prohibits an investment adviser from using an

advertisement that contains an untrue statement of material fact or that is otherwise false or misleading

• No-Action Letters• Enforced through SEC inspections and enforcement

actions• Disclosure rules not calculation rules

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Investment Adviser Advertisements

• Specific prohibitions applicable to Registered Advisers:– Testimonials

• Third Party Reports• Partial Client Lists • Ratings

– Charts/Formulas– Free Services

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Investment Adviser Advertisements

• Past Specific Recommendations– Rule 206(4)-1(a)(2)

• Provide full list• Provide certain information• Include a legend

– Franklin No-Action Letter• Criteria• References to performance• Books and records• Legend

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Investment Adviser Advertisements

• TCW Group No-Action Letter– Selection of holdings– Time period– Consistency– Minimum number of holdings– Inclusion of all necessary information– Disclosures– Recordkeeping

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No Action Letters

• Clover Capital: advertisement containing performance information is misleading if – the advertisement implies, or if a reader would infer from

it, – something about an investment adviser’s competence or

potential investment results – that would be unwarranted if the reader knew all the facts

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Clover Capital Requirements

• Model & Actual Performance– Not disclosing the effect of material market or economic conditions– Not presenting net-of-fees performance, except under certain circumstances

• Advisory fees• Other expenses that a client would have paid or actually paid

– Failing to disclose whether and to what extent the results reflect reinvestment of dividends and other earnings

– Claiming the potential for profit without disclosing the possibility for loss– Comparing results to an index without disclosing material factors relevant to

the comparison– Failing to disclose material conditions, objectives or investment strategies used

to obtain the performance

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Clover Capital Requirements

• Model Performance– Failing to disclose:

• The inherent limitations in model results• Material changes in the model versus actual performance• Differences between the model and adviser’s actual strategy• Adviser’s client results were materially different from model

results

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Investment Performance Presentations

• Actual Performance Results– Must include performance of all accounts

managed to same style or strategy unless disclose that the:

• Results relate only to a select group of clients• Basis on which the selection was made, and • Effect of this practice on the results portrayed.

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Clover Capital Requirement Exceptions

• Exceptions to Net of Fees– Gross of fees performance

• Performance presented GROSS of advisory and custodial fees in one-on-one presentations

• Must always be shown after transaction costs

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Clover Capital Requirements Exceptions

• The “One-on-One” Presentation Exception to the Net of Fees Requirement– Private Meeting– Ability to ask questions and negotiate advisory fees– Must disclose:

• Advisory fees are described in the adviser’s Form ADV• A representative example showing the effect advisory fees, compounded over

years, could have on the value of a portfolio

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Investment Adviser Advertisements

• Recordkeeping– Client communications and distribution lists

• Copies of all written communication• No record of who sent to if sent to more than 10 recipients

– Advertisements and Recommendations• All advertisements sent to more than 10 recipients• Document basis of all recommendations

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Investment Adviser Advertisements

• Recordkeeping– Records to support performance calculations

• “necessary to form the basis for or demonstrate the calculation of the performance”

• Internal account statements and worksheets• Prepared contemporaneously• Third party records to substantiate claims

– Retention periods– Necessary to support performance:

• In articles• From prior firm

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New Tripwires for Social Media and the Rule on Testimonials

Increasing Use of Social Media

• Putnam Investments 2015 Social Advisor Study Findings:– 81% of financial advisors now use social media for business, up from

75% last year– 40% of advisors use four or more social networks for business, up from

25% last year– 79% of advisors acquired new business via social media, up from 66%

last year, with an average asset gain of $4.6 million from those clients– Median increase in assets gained via social media activity is $1.9

million, up from $1.2 million last year

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Firms’ Response

• 2015 Investment Management Compliance Testing Survey Findings:– 89% of firms have adopted formal written policies and

procedures to govern the use of social media by employees, up from 83% in 2013

• Additional 6% have informal policies– 47% of firms prohibit use of personal social networking

websites for business purposes, down from 49% in 2013– 70% test compliance with the firm’s social media policy, up

from 63% in 2013).• 31% test annually

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Regulators Are Paying Attention to Social Media Issues

• SEC Division of Investment Management Guidance on the Testimonial Rule and Social Media (March 2014) – http://www.sec.gov/investment/im-guidance-2014-04.pdf

• SEC Says Social Media OK for Company Announcements if Investors Are Alerted– SEC Press Release (April 2, 2013)– http://www.sec.gov/news/press/2013/2013-51.htm– SEC Report of Investigation of Netflix, Inc.

• FundersClub and AngelList SEC no-action letters (March 26, 2013)– http://www.sec.gov/divisions/marketreg/mr-noaction/2013/funders-

club-032613-15a1.pdf

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Regulators Are Paying Attention to Social Media Issues (cont.)

• SEC OCIE National Examination Risk Alert (January 4, 2012)– http://www.sec.gov/about/offices/ocie/riskalert-socialmedia.pdf

• SEC Administrative Proceeding (January 4, 2012)– In the Matter of Anthony Fields, CPA d/b/a Anthony Fields &

Associates and d/b/a Platinum Securities• FINRA Regulatory Notice 11-39 Social Media Websites and the

Use of Personal Devices for Business Communications (August 2011)

• FINRA Regulatory Notice 10-06 Social Media Websites (January 2010)

• JOBS Act

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Testimonial Rule

• Testimonial Rule prohibits an adviser from using testimonials in its advertising– Concern - an adviser would emphasize favorable testimonials and

ignore unfavorable ones, creating the misleading inference that cherry-picked testimonials are typical of the experience of the adviser’s clients

• Is a third-party post on a social media website a “testimonial” that is prohibited by Rule 206(4)-1 under the Advisers Act?– SEC staff has historically considered a “testimonial” to be any explicit

or implicit statement of a client’s experience with, or endorsement of, an adviser

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Adoption and Entanglement Theories

• Under FINRA guidance, third-party content is generally not attributed to the firm, unless the firm:– “Adopts” it by explicitly or implicitly endorsing or approving the

content (depending on context, could be ‘Like’ or ‘retweet’); or– Is “entangled” with the content by involving itself in the preparation of

the content (e.g., firm pays for an industry study)• SEC has employed adoption and entanglement theories in the

context of an adviser’s responsibility for third-party information that is hyperlinked to its website– The adviser would be responsible for the content on the website and

the website’s compliance with the advertising rules under the Advisers Act

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SEC Guidance on the Testimonial Rule and Social Media (March 2014)

• Genuine third-party social media commentary can be useful to investors• An adviser that maintains or links to a social media site that contains

public commentary (including client commentary) would not be in violation of the Testimonial Rule if:– The social media site provides independent content– There is no material connection to the independent site that could jeopardize

its independence or the independence of the commentary posted on the site– The content is complete - all testimonial commentary from the site is included

(subject to the site’s content guidelines)– No modification of content

• Impermissible testimonial depends on the facts and circumstances

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SEC Guidance on the Testimonial Rule and Social Media (cont)

• Entanglement and adoption may implicate the testimonial rule

• Placing advertisements on the third party site does not jeopardize the site’s independence

• List of contacts or “friends” on the social media website of an adviser or its personnel not an impermissible testimonial, even if the list is a partial client list– May still be a misleading advertisement

• May provide links to third party sites – See Us On

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Disclaimers

• Firm is not affiliated with [name of third-party social media site]. Use at your own risk.

• Firm is not responsible for and does not endorse any content, advertising, advice, opinions, recommendations or other information from third parties, including the social media site.

• Opinions, comments expressed by [friends or followers] are those of the persons submitting them and do not represent the views of the firm or its management.

• We do not endorse or approve content submitted by third parties, or endorse individuals or organizations, by using any features on this site.

• Read the [name of third-party social media site] terms of service and privacy policy, as they apply to your communications throughout our [page/account].

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Recent Enforcement Actions and What They Tell Us

The Lucia Matter

• SEC found: – Lucia had used performance data labeled as back-tested

data that was:• based on certain assumptions rather than historical rates of

inflation and rates of return• did not deduct advisory fees or clarify that they were not

accounted for• failed to calculate the data in a manner that fully followed the

investment strategy. – Methodology produced significantly better performance

than would have resulted had the data been based on the historical rates

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The Lucia Matter

• SEC found:– Lucia at least acted recklessly in sharing and not properly explaining

the performance data presented– Use of performance data that was improperly labeled as back-tested

was in violation of Rule 206(4)-1(a)(5)

• Penalties:– Revoked Lucia’s and its principal’s investment adviser registration– Barred Lucia from associating with an investment adviser, broker, or

dealer– Imposed civil penalties of $250,000 on Lucia and $50,000 on its

principal

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The Lucia Matter

• New expectations that back-tested data must be:– Based on actual historical data rather than assumptions– Calculated in a manner fully consistent with the

investment strategy that the back-tested data is used to advertise

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The F-Squared Matter

• SEC alleged:– Advertised a successful seven-year track record for the

investment strategy based on the actual performance of real investments for real clients

• Reality: Algorithm was not even in existence during the seven year period

– Used back-testing while specifically advertising the investment strategy as “not back-tested”

– Calculation error inflated results by ~350%

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The F-Squared Matter

• SEC determined:– Violated Sections 204, 206(1), 206(2), 206(4), and 207 of

the Investment Advisers Act of 1940 and Rules 204-2(a)(16), 206(4)-1(a)(5), 206(4)-7, and 206(4)-8

– Aided and abetted and caused certain mutual funds sub-advised by F-Squared to violation Section 34(b) of the Investment Company Act of 1940

• Disgorgement of $30 million and penalty of $5 million

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The Virtus Matter

• SEC alleged:– Failed to properly verify several false statements made by

sub-advisor F-Squared Investments, Inc.– Made corresponding false statements in advertising– Failed to investigate several signs that data was false or

misleading– As result, made false or misleading statements to board of

directors of its mutual funds, to potential clients, and in its promotional materials

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The Virtus Matter

• SEC determined:– Willful violations of Sections 204, 206(2), and 206(4) of the

Advisers Act and Rules 206(4)-1(a)(5), 206(4)-7, 206(4)-8, and 204-2(a)(16) thereunder

– Actions (and failures to act) on part of Virtus caused certain registered investment companies to violate Section 34(b) of the Investment Company Act of 1940

• Virtus censured and fined $16.5 million• Reminder: Investment adviser is ultimately responsible

for verifying the accuracy of any performance data presented in its advertisement

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The Alpha Fiduciary Matter

• SEC alleged:– Failure to disclose that performance contained in

advertisements was hypothetical rather than actual• Some advertising materials suggested performance represented

actual returns– Advertised performance included examples of favorable

investment decisions without offering to provide all investment decisions

– Performance included past-specific recommendations without disclosing all recommendations

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The Alpha Fiduciary Matter

• SEC determined:– Violations of Sections 206(2), and 206(4) of the Advisers Act

and Rules 206(4)-1(a)(2) & (5), and 206(4)-7 thereunder• Penalties:

– Alpha Fiduciary, its president and its former business development director were censured

– Alpha Fiduciary and its president were jointly and severally fined $250,000

– Must disclose matter to investors and engage compliance consultant

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The Bennett Matter (Ongoing)

• SEC alleged:– Overstated assets by at least $1.5 billion to ranking service, on radio,

and in other advertisements• Magazine used information for rankings of financial advisors• Bennett Group then promoted rankings and repeated the

misrepresentations contained in magazine– Claimed returns placed them in “top 1%” of firms

• Did not disclose returns were those of model portfolio– Failed to adopt and implement policies related to calculation and

advertisement of assets managed and of investment returns– Made false statements during investigation to cover-up

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The Bennett Matter (Ongoing)

• SEC alleged (among other violations):– Violations of Sections 206(1) and 206(2) of the

Advisers Act– Violations of Section 206(4) of the Advisers Act

and Rule 206(4)-1(a)(5) thereunder– Violations of, Section 206(4) of the Advisers Act

and Rule 206(4)-7 thereunder

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What do these recent actions tell us?

• Hypothetical or back-tested performance data should not be based on assumptions when actual historical data is available;

• Investment advisers should maintain adequate backup for performance claims made in their advertisements, including claims based on information provided by third parties;

• Disclosure that performance data is hypothetical or back-tested should be complete and prominently displayed with the performance data; and

• The prohibition on past specific recommendations in advertising material contained in Section 206(4)-1(a)(5) of the Advisers Act, as modified by SEC guidance, continues to be an important investor protection tool the violation of which is subject to SEC enforcement.

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The CCO and Advertising / Marketing

Understand firm marketing objectives:• Marketing campaigns (targeted or ongoing)• Client types (public pensions, retail / HNW) • Jurisdictional Focus (US or non-US)• Product Types (mutual fund, SMA)

Understand firm marketing methods:

• One on one presentations

• Cold calling / mass distribution

• Reverse solicitation

Understand firm marketing content:• Usage of model performance / charts / formula

• Usage of client lists

• Usage of third party data

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The CCO and Advertising / MarketingDesign and implement appropriate policies and procedures– Define advertisements (helpful to provide examples of non-advertisements)– Implement a compliance review, prior to the release of advertisements, if possible– Outline training program– Implement procedures related to speaking publicly and interaction with media

Basis for compliance review– Ensure information is no misleading or inaccurate– Ensure there are no testimonials, unsupported claims or instances of cherry-picking– Ensure complete disclosure of the information being presented and jurisdictional specific disclosures are made– Ensure performance data is being generated or pulled from appropriate sources

Centralized process– If possible, centralize marketing content approval process with one or a few members of marketing team to gain efficiency – Use checklist, if possible, for advertising production and compliance reviews

Training– Procedural training– Regulatory context– Use real examples!

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The CCO and Advertising / Marketing

Monitor and test compliance – Email surveillance (confirm only approved advertising materials are

utilized)– Perform reviews of records to ensure supporting data / back-up is

maintained on file– Independently review databases and public sources to ensure firm

information is accurate, not misleading and consistent with policy– Confirm firm has received written authorization from client to use client

name in advertising materials

Reporting – Escalate issues of non-compliance to senior management or head of

marketing effort

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Using Predecessor Firm DataInvestment Performance Portability • Un-Linked

• Persons responsible for performance at new firm were among those responsible at prior firm

• Accounts managed the same• Accounts selected not cherry picked• Appropriate disclosure• Supporting records

• Linked• All unlinked conditions met (outlined above) and • Solely responsible for performance at both firms (same investment decision makers)

– GIPS compliant firms• All accounts managed to the strategy (full composite) is presented• Disclosure that performance is linked• Must link if requirements are met

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Potential Violations Related to Predecessor Firm Data

• Insufficient books and recordso The firm must have records necessary to form the

basis for or demonstrate the calculation of the performance

• Relying on the prior firm to maintain books and records

• Lack of disclosure related to performance history • Presenting prior performance when not all the

portability tests are met

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Performance Advertising Hot Topics

– Net-of-fee calculations o Confirm net returns are reduced by all management fees charged to the client o If applying a model fee to arrive net-of-fees results, confirm that the fee is the highest charged

o Ensure net-of-fees performance is presented where required

– Sub-advisers performance recordo Implement due-diligence process that confirms that sub-adviser’s performance is accurateo Disclose the use of sub-advisers

– Benchmarkso Confirm performance records are compared to appropriate indices and disclose material

differences

– Model or Backtested Resultso Adequate disclosure on the same page results are presented

– Policies and procedureso Be prepared to demonstrate the firm’s processes to calculate and present performance to

prospective clients o If the firm claims GIPS compliance, then be ready to prove it – develop custom GIPS manual,

implement consistent process for maintaining compliance, and ensure distribution of GIPS-compliant presentations

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GIPS standards

• GIPS compliance is constant

• GIPS compliance is “all or nothing”

• The GIPS standards continue to evolve

• GIPS compliance impacts the entire firm

• GIPS verification ≠ GIPS compliance

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GIPS standards - Latest Updates

• Advisers to Pooled Funds stay tuned…

• Exposure draft of the Guidance Statement on Broadly Distributed Pooled Funds is expected to be released late January

• To learn more sign up for the CFA Institute webinar scheduled January 28th .

• Notification requirement to the CFA Institute

• Stay current with the latest related to the GIPS Standards [email protected]

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Testing Considerations Related to GIPS Compliance Program

• Review GIPS manual

• Ensure both policies and procedures are addressed

• Confirm it is complete – passes the weight test

• Test firm’s procedures for delivering GIPS Compliant Presentations to prospective clients

• Audit processes related to composite construction

• Review changes to composite assignment and performance outliers

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Advertising & Marketing Compliance

Quality Assurance

Policies & Procedures

Compliance Oversight

Input Data Validation

Performance and Risk Statistics Calculation

Production of Materials

Marketing Compliance

Program

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Operational Risks

• Operational risks surrounding the creation of marketing materials which can lead to regulatory or reputational issues:– Data coming from a number of sources – Incorrect performance– Human error related to manual updates– Stale data– Failing to include required disclosures

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Mitigate Risks • Ways automation can minimize marketing operational,

regulatory and reputational risks o Technology can be critical

o Implement processes where data goes straight through from source systems to the final marketing materials and client reports

o Institute controls to check for necessary disclosures, mandatory slides (e.g., GIPS-compliant presentations), and require compliance approval

o Establish a system that serves as a single source for data to be used for various communication purposes

o Trust but verify o Knowledgeable personnel involved to review the output and oversee

the process

Questions?