Advertising Rule Compliance Issues Most Frequently Identified by the SEC in Investment Adviser Exams
Client Alerts | October 31, 2017 | Hedge Funds
On September 14, 2017, the staff of the Office of Compliance Inspections and Examinations (“OCIE“) of the Securities and Exchange Commission (the “SEC“) issued a risk alert (the “Risk Alert“) regarding the most frequently identified compliance issues related to SEC-registered investment adviser (“RIA“) compliance with Rule 206(4)-1 (the “Advertising Rule“) under the Investment Advisers Act of 1940, as amended, and the rules and regulations promulgated thereunder (the “Advisers Act“). The Advertising Rule generally prohibits RIAs from directly or indirectly publishing, circulating or distributing any advertisement that contains any untrue statement of material fact, or is otherwise false or misleading. The Risk Alert includes observations by the OCIE staff from its examination “touting initiative” that focused on RIAs use of accolades in their marketing materials. Below is a summary of the nine compliance issues discussed in the Risk Alert.
Most Frequent Advertising Rule Compliance Issues
According to the Risk Alert, the nine areas where the OCIE staff most frequently identified compliance issues and examination deficiencies concerning the Advertising Rule include:
• Misleading Performance Results, including (i) the presentation of gross performance results (without deducting advisory fees), (ii) comparing performance results to benchmarks without disclosure that explains the limitations of such comparisons, and (iii) using hypothetical and back-tested performance results without appropriate explanations and disclosures.
• Misleading One-on-One Presentations, including the use of performance results without adequate disclosure that actual performance would reflect deductions for fees and expenses.
• Misleading Claim of Compliance With Voluntary Performance Standards, including making such claims without any evidence provided to the SEC that the RIA was actually in compliance with such standards.
• Cherry-Picked Profitable Stock Selection, typically only using profitable stock selections in advertisements.
• Misleading Selection of Recommendations, including (i) disclosing only certain and not all recommendations, (ii) disclosing only profitable recommendations and not an equivalent number of non-profitable recommendations (such as showing the five best recommendations without showing the five worst recommendations) and (iii) disclosing a subset of recommendations (such as in connection with a specific strategy or other consistently-applied, objective and non-performance-based selection criteria) without disclosing that the subset does not represent all securities purchased, sold or recommended and/or including a discussion of the profits realized by the specific recommendations in the advertisement.
• Lack of Compliance Policies and Procedures Reasonably Designed to Prevent Advertising Rule Violations, including RIAs failing to establish policies and procedures for reviewing and approving advertising material prior to publication or dissemination, establishing parameters for performance composites, and or confirming accuracy of performance results.
• Misleading Use of Third Party Rankings or Awards, including references to third-party awards and/or rankings that were (i) obtained based on potentially false or misleading information in the relevant applications, (ii) stale or based on stale information, or (iii) that did not disclose the relevant selection criteria or that a fee was paid to participate in or distribute the results of the survey.
• Misleading Use of Professional Designation, including references to professional designations that (i) have lapsed or (ii) did not explain the minimum qualifications to attain such designation.
• Use of Testimonials Client Endorsements, including the use of testimonials, which are generally prohibited under the Advertising Rule, on firm websites, in social media and/or in reprints of third-party articles distributed by the RIA or used in presentations in a prohibited manner.
RIAs should carefully review their advertisements and consider whether there are any potential issues in light of the Risk Alert guidance and for compliance with the Advertising Rule generally. RIAs should also review and evaluate their compliance policies and procedures to ensure that they are reasonably designed to comply with the Advertising Rule.
 “The Most Frequent Advertising Rule Compliance Issues Identified in OCIE Examinations of Investment Advisers,” National Exam Program Risk Alert, Volume VI, Issue 6 (September 14, 2017), available at: https://www.sec.gov/files/risk-alert-advertising.pdf.
 Under the Advertising Rule, advertisements are defined broadly to include “any notice, circular, letter or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television, which offers (1) any analysis, report, or publication concerning securities, or which is to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (2) any graph, chart, formula, or other device to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (3) any other investment advisory service with regard to securities.” With such a broad definition, materials such as electronic newsletters and websites are included as advertisements along with traditional pitch books and investor presentations.
 See Advisers Act Rule 206(4)-1(a). The Advertising Rule generally further prohibits advertisements that (i) refer, directly or indirectly, to any testimonial concerning the RIA or any advice, analysis, report or other service rendered by the RIA, (ii) contain past specific recommendations of the RIA that were or would have been profitable to any person, unless certain conditions are met, (iii) claim that any graph, chart, formula or other device can by itself determine whether to buy or sell a security, without including certain disclaimers, or (iv) offer purportedly free reports, analyses or services, unless such report, analysis or service actually is or will be furnished entirely free and without any condition or obligation, directly or indirectly.