The JOBS Act directs the SEC to eliminate the prohibition on general solicitations for securities offerings under Rule 506. Once the prohibition is eliminated, many advisers to hedge funds and private equity groups may engage in some sort of advertising when placing fund securities.
Advertising by registered investment advisers is subject to Section 206 of the Investment Advisers Act. Under paragraph (4) of Section 206, the SEC has authority to adopt rules defining acts, practices, and courses of business that are fraudulent, deceptive, or manipulative. Pursuant to this authority, the SEC adopted Rule 206(4)-1, which defines the use of certain specific types of advertisements by advisers as fraudulent, deceptive, or manipulative. Although the rule does not specifically prohibit an adviser from using actual results, or prescribe the manner of advertising these results, paragraph (5) of the rule makes it a fraudulent, deceptive, or manipulative act for any investment adviser to distribute, directly or indirectly, any advertisement that contains any untrue statement of a material fact or that is otherwise false or misleading.
The SEC takes the position that, as a general matter, whether any advertisement is false or misleading will depend on the particular facts and circumstances surrounding its use including:
- the form as well as the content of the advertisement,
- the implications or inferences arising out of the advertisement in its total context, and
- the sophistication of the prospective client.
In the Clover Capital Management, Inc. no action letter, the SEC staff outlined certain advertising practices the staff believes are inappropriate. The list is not intended to address all advertising practices prohibited by Rule 206(4)-1(a)(5) and does not create a “safe harbor” that may be relied upon by an adviser as an exclusive list of the factors that must be considered in determining the type of disclosure necessary when advertising actual results.
Some of the practices the staff deems inappropriate include:
- Using 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;
- Suggesting or making claims about the potential for profit without also disclosing the possibility of loss;
- Compares actual results to an index without disclosing all material facts relevant to the comparison;
- Failing 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);
- Failing 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.
Sometimes fund advisers want to highlight a past specific portfolio company or trading strategy that was highly profitable. The SEC often looks askance at this sort of advertising.
According to the SEC, when it adopted rule 206(4)-1 under the Advisers Act, it stated that advertisements containing past specific recommendations were inherently misleading because “by their very nature they emphasize the comments and the activities favorable to the investment adviser and ignore those which were unfavorable.” The primary concern underlying the prohibition against advertisements containing past specific recommendations is that an adviser could “cherry pick” its profitable recommendations and omit the unprofitable ones. Under those circumstances, an advertisement could fraudulently or deceptively imply that the recommendations listed, and their profitability, are representative of the experience of the adviser’s clients, according to the SEC.
The SEC set forth some of its thoughts in this area in the The TCW Group, Inc. no action letter. There the SEC granted no-action relief to with respect to advertising that presented no fewer than five holdings that contributed most positively to a representative account’s performance and an equal number of holdings that contributed most negatively to the representative account’s performance. So apparently the idea is you have to present the best and the worst.
Performance of Prior Funds
Fund founders sometime wish to present their experience at a prior employer. The SEC staff has taken the position that it may be misleading for an adviser to advertise the performance results of accounts managed at an employee’s prior place of employment when the employee had been one of several persons responsible for selecting the securities for those accounts.
In the Horizon Asset Management, LLC no action letter, the SEC outlined factors when an investment adviser may use an advertisement that includes prior performance results of accounts managed by a predecessor entity:
- the person or persons who manage accounts at the adviser were also those primarily responsible for achieving the prior performance results,
- the accounts managed at the predecessor entity are so similar to the accounts currently under management that the performance results would provide relevant information to prospective clients,
- all accounts that were managed in a substantially similar manner are advertised unless the exclusion of any such account would not result in materially higher performance,
- the advertisement is consistent with staff interpretations with respect to the advertisement of performance results, and
- the advertisement includes all relevant disclosures, including that the performance results were from accounts managed at another entity.
Reports to Investors
Private equity sponsors and hedge funds also report regularly to their clients. In those circumstances, the Investment Counsel Association of America, Inc. no action letter suggests such reports are not advertisements. In that no-action letter the SEC staff stated that a written communication by an investment adviser to its existing clients generally would not be an advertisement within the meaning of rule 206(4)-1(b) merely because it discusses the adviser’s past specific recommendations concerning securities that are or were recently held by each of those clients. In general, the staff continued, written communications by advisers to their existing clients about the performance of the securities in their accounts are not offers of investment advisory services but are part of the adviser’s advisory services. If, however, the context in which the past specific recommendations are presented by the investment adviser to an existing client suggests that a purpose of the communication is to offer advisory services, the SEC staff stated it would conclude that the communication was an advertisement.
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