“Round 2” of Marketing Rule Enforcement Actions — Focus on Hypothetical Performance

On April 12, 2024, the U.S. Securities and Exchange Commission imposed fines and other sanctions on five registered investment advisers (RIAs) for violations of the Investment Adviser Marketing Rule (Rule 206(4)-1), which has now been in effect for nearly a year and a half. All five firms agreed to settle the SEC’s charges, resulting in aggregate fines of $200,000.

Hypothetical Performance. Each of the settled cases focused on a single hypothetical performance-related deficiency. In each case, a firm published hypothetical performance on a publicly accessible website without, according to the orders, having implemented policies and procedures reasonably designed to ensure that the hypothetical performance was “relevant to the likely financial situation and investment objectives of the intended audience of the advertisement”— a key requirement of the Marketing Rule.

The focus on hypothetical performance should not come as a surprise. In the first wave of Marketing Rule enforcement actions in 2023, the SEC’s Director of Enforcement noted continued efforts by the SEC on this exact point, warning:

[H]ypothetical performance advertisements may present an elevated risk for prospective investors whose likely financial situation and investment objectives don’t match the advertised investment strategy. . . . It is therefore crucial that investment advisers implement policies and procedures to ensure their compliance with the rule. Until that is the case, we will remain vigilant and continue our ongoing sweep[.]

Other Violations. The SEC order against one of the five RIAs alleged a host of other violations, including making false and misleading statements in advisory advertisements and in a fund prospectus, advertising misleading model performance, being unable to substantiate performance shown in its advertisements, failing to enter into written agreements with compensated solicitors and failing to comply with certain recordkeeping and annual review requirements.

Penalties. The penalties for these actions were, by today’s standards, modest, with individual fines against four of the five firms ranging from $20,000 to $30,000. The fact that these firms were only alleged to have compliance shortcomings on the hypothetical performance obligations, combined with the fact that all four undertook corrective remedial action before being contacted by Enforcement staffers, contributed to the relatively low penalty amounts. The fifth firm agreed to pay a civil penalty of $100,000, reflecting the broader scope of violations and the lack of advance remediation.

Next Steps. Because these were publicly available advertisements, the lessons for managers of private funds are more thematic than directly instructive. However, for managers utilizing broader marketing efforts, ensuring Marketing Rule compliance while considering these enforcement actions may require a greater investment of time and effort.

In other words, when creating flip-books and other advertisements that contain hypothetical performance (which is quite common), investor relations and compliance personnel should consider how to document that the manager actually determined that such performance was “relevant to the likely financial situation and investment objectives” of each advertisement’s “intended audience.” The good news is that for advertisements circulated to accredited investors and qualified purchasers with whom the manager has a preexisting relationship, this should be a relatively straightforward assignment.

The outlier order against the fifth firm communicates a broader message for all RIAs, which could be summarized in two points:

• Ensure that all advisory advertisements are in compliance with the Marketing Rule's seven principles-based general prohibitions.
• Ensure that the process utilized in complying with the previous bullet is documented.