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September 15, 2023

SEC Sweep of RIAs: Market Hypothetical Performance With Due Care

Advisory

Earlier this week, the Division of Enforcement at the U.S. Securities and Exchange Commission (SEC) announced settled charges against nine registered investment advisers (RIA) for advertising hypothetical fund performance to the general public without properly adopting or implementing 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,” as required by the Marketing Rule (Rule 206(4)-1 of the Investment Advisers Act of 1940 (Advisers Act)). The Marketing Rule, which was adopted in December 2020 and went into effect on November 4, 2022, requires RIAs who use hypothetical fund performance in advertising materials to have a documented reasonable basis for believing the RIA will be able to substantiate material statements of fact and requirements for performance in advertising, testimonials, endorsements, and third-party ratings.

Marketing Rule Violations

The recently announced settled charges arise out of an ongoing sweep investigation of advisers’ compliance with the Marketing Rule, an issue the SEC’s Division of Examinations previously highlighted as a high priority when it announced its 2023 exam priorities, which we discussed earlier this year. While none of the RIAs who reached settlements with the SEC admitted fault, the settled charges found that each of the nine named RIAs violated the Marketing Rule by failing to adopt or implement policies and procedures reasonably designed to ensure that the advertised hypothetical performance was relevant to the likely financial situation and investment objectives of the intended audience. Specifically, the settled charges find that the RIAs disseminated advertisements that:

  • Included hypothetical performance that consisted of performance derived from model portfolios
  • Included hypothetical performance that consisted of performance derived from model portfolios and performance that was back tested by the application of a strategy to data from prior time periods when the strategy was not actually used
  • Were targeted to the general public rather than to a particular intended audience

In addition, two RIAs were also found to have violated Section 204(a) of the Advisers Act because they failed to “keep a copy” of each advertisement reflecting hypothetical performance that they disseminated via their website.

As a result of this conduct, the RIAs each agreed to pay civil penalties that ranged from $50,000 to $175,000. In addition, each RIA agreed that within 30 days of the settled order, to the extent the RIA wanted to continue to advertise hypothetical performance, the RIA would undertake to review its policies and procedures and ensure they are reasonably designed to ensure that any advertised hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement. Moreover, each RIA also agreed that within 40 days of the settled order, the RIA would certify its review of its Marketing Rule policies and procedures by providing written evidence of compliance in the form of a narrative and exhibits sufficient to demonstrate compliance.

Conclusion

Given that the Marketing Rule has been in effect for less than a year, it is notable that the SEC has already announced settlements with findings related to failures to comply with the rule. This enforcement activity shows that the SEC does not intend to provide the investment management industry with a de facto grace period to adapt to the new rules. It also emphasizes the SEC’s assertion that the use of hypothetical returns is an area of particular focus.

The enforcement activity is intended to remind RIAs to: (1) ensure that their compliance manuals and training programs cover the Marketing Rule, (2) review all marketing materials that they currently use (even if prepared before the effective date of the Marketing Rule) to confirm that they comply with the requirements of the rule, including but not limited to the rules related to use of hypothetical returns information, and (3) confirm that their client referral and placement agent relationships comply with the requirements of the new rule. RIAs should take special care, in the above and generally, with any potential use of hypothetical returns information in any advertising materials.

Arnold & Porter’s Financial Services, Investment Management, and Securities Enforcement & Litigation practices have been actively monitoring and advising in this area. Please reach out to any of the authors or your regular Arnold & Porter contact to discuss how to stay ahead of this fast-moving landscape.

© Arnold & Porter Kaye Scholer LLP 2023 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.