On September 14, 2017, the Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) issued a National Exam Program Risk Alert related to Rule 206(4)-1 under the Investment Advisers Act of 1940 (the “Advertising Rule”). The alert outlined the compliance issues most commonly noted by the SEC’s examination staff. Below are some of the issues specifically highlighted in the alert.
- Misleading performance results without sufficient disclosure to explain the methodology used to calculate the performance data that is shown
- Misleading one-on-one presentations
- Misleading responses to due diligence requests
- Cherry-picked profitable portfolio company transactions
- Misleading selection of past specific recommendations
- Compliance policies and procedures
- Misleading use of third-party rankings or awards
A recently settled enforcement action re-emphasizes the importance of this alert. In April 2020, the SEC instituted a cease and desist order against a U.S. private fund manager for:
- Misrepresentation of investment performance and omitted disclosure information, and
- Failure to implement its policies and procedures concerning statements about investment performance in its marketing materials.
- Principals of the firm managed a Legacy Portfolio which included three types of investments: direct drilling investments (DDIs), private equity investments, and private fund investments. DDI’s formed the vast majority of investments in this portfolio, both in number and in size.
- The firm used this Legacy Portfolio’s “track record” while marketing for a fund’s capital raising efforts. This firm also showed the investment performance of early stage DDIs in the Legacy Portfolio.
- Marketing materials stated the fund would only invest in DDIs, private equity investments, and midstream assets, either directly or through a private equity investment.
- With respect to DDIs, the marketing materials provided that the fund’s focus would be on early stage and development stage DDIs. These materials also stated that investments in other private funds would not be part of the investment strategy.
- Misrepresentation of investment performance and omitted disclosure information
- When calculating the track record, the adviser categorized a private fund investment that had strong, positive performance as an early stage DDI. This investment did not meet the marketing materials’ definition of a DDI. The marketing materials, however, omitted the information related to this.
- The inclusion of the private fund’s performance as an early stage DDI investment improved the track record for DDIs and early stage DDIs. At the time of the creation of the marketing materials, the private fund had a return on investment of 10.9x. The other early stage DDIs in the Legacy Portfolio had a much lower return on investment.
- Failure to implement policies and procedures concerning statements about investment performance in marketing materials
- The adviser’s compliance manual included policies and procedures that prohibited the adviser and its employees from publishing, circulating, or distributing any advertisement that contained any untrue statement or omission of a material fact, or that was otherwise false or misleading. The manual also had policies and procedures prohibiting the use of investment performance results in marketing materials that were false or misleading, including any misleading depictions of investment performance in both form and content leading to direct or indirect implications or inferences arising out of the context of the marketing materials.
- The adviser failed to implement its policies and procedures in its compliance manual concerning the use of investment performance results in marketing materials, thus rendering them to be misleading when a private fund investment was categorized as an early stage DDI in the track record. The adviser also omitted information concerning the role of the private fund’s third-party adviser and why the private fund investment’s structure differed from other DDIs in the track record.
Sanctions Imposed by the SEC
- Cease and desist order
- Respondent was censured
- Respondent is ordered to pay a civil monetary penalty in the amount of $1,000,000 to the SEC
How ACA Can Help
ACA offers Focused Performance Reviews to assist firms in validating investment performance and the supporting books and records. The Focused Performance Review includes a review of the appropriateness of the construction of the track record, calculation methodologies underlying investment performance, adequacy of controls around the creation and review of investment performance, and the completeness of accompanying disclosures. The Focused Performance Review helps firms prepare for regulatory scrutiny by strengthening the tools used to demonstrate global capabilities across strategies and the controls in place to govern how performance is produced.
For More Information
If you have questions about the SEC’s recent performance-related enforcement cases, or would like more information on ACA's Focused Performance Reviews, please contact Shivani Choudhary.