Educate on the importance of robust disclosures as an investor complaint leads to SEC charges.
My name is Steve Hart, and I am a contributing journalist for Compliance Mitigation. I am a Partner at Conformity 360, a compliance consulting firm, serving as the resident subject matter-expert in buy-side Compliance. Prior to joining Conformity360, I was Chief Compliance Officer (“CCO”) for the prestigious firm Allen & Company, and prior to that, served as the Global Chief Administrative Officer for Compliance at BlackRock, the world’s largest asset management company. I hold an Investment Adviser Core Certification, an M.S. in Banking and Financial Services from Boston University and a B.A. in Political Science from the University of Pennsylvania.
Having worked as the CCO for RIAs, I have been through numerous regulatory audits and examinations. Experience gives me insight into how the SEC conducts investigations and attempts to obtain enforcement actions.
After completing this case study, the participants will be able to:
- Define the meaning of valuation.
- Explain how SEC regulators expect RIAs to value portfolio assets.
- Understand what prompts the SEC to bring enforcement actions against RIAs concerning disclosures in marketing.
- Explain “Risk Alerts” that lead to SEC enforcement actions.
- Define the meaning of back-testing.
Disclosures, Valuation, OCIE Risk Alert, Performance, Back-Testing, Marketing
RIAs oversee investments for clients. To attract investment capital, the RIAs create marketing materials to help investors understand how the firm manages assets. Depending on the type of firm, those assets may include stocks, bonds, cash, gold, real estate, or currencies. Investors rely upon marketing materials to make decisions on whether to transact business with the RIA; investors have a right to expect accurate information on valuations. According to the SEC, many RIAs mislead investors.
In July 2020, the SEC obtained a final judgment of approximately $30 million against Navellier & Associates, an RIA. The SEC alleged that Navellier used false and misleading marketing practices. According to the SEC, marketing materials deceived investors, in violation of the Investment Advisers Act of 1940.
The SEC enforcement actions against Navellier & Associates represents a growing trend of SEC investigations and enforcement actions against RIAs. The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert. The Risk Alert identifies “inaccurate valuations” as a recurrent violation by RIAs in regulatory audits / examinations.
An “investment portfolio” represents the total assets owned by firms that manage private equity, venture capital, hedge funds, or funds for institutional investors. Portfolio assets may be in the form of securities (such as stocks and bonds), businesses, real property, or other illiquid assets. A portfolio valuation means “establishing the value of each asset owned by the investment fund or entity, providing a total asset value for all investment holdings—both liquid and illiquid.”
Government agencies are becoming more aggressive with their investigations. Expect to see the Department of Justice take an interest in prosecuting people that deceive investors. The SEC’s more aggressive pursuit of RIAs that publish deceptive marketing materials will lead to more prosecutions for white-collar crime. Under the current laws, business leaders may face penalties for the work that a marketing team does, if the government shows that the leader either knew or should have known of wrongdoing. With a growing spate of enforcement action by regulators, we can expect more people to face charges for white-collar crimes.
The Advertising Rule under the Investment Advisers Act of 1940 prohibits “an adviser, directly or indirectly, from publishing, circulating, or distributing any advertisement that contains any untrue statement of material fact, or that is otherwise false or misleading.” Recent enforcement actions by the SEC highlight the importance of adequate Valuation practices and adequate disclosures pertaining to the Marketing of performance of a RIA’s portfolio holdings.
In December 2020, the SEC finalizes reforms under the Investment Advisers Act of 1940 to modernize rules that govern RIA’s advertisements. The amendments create a single rule that replaces the current advertising rule. The final rule is designed to comprehensively and efficiently regulate investment advisers’ marketing communications.
The technology used for communications advances, and the expectations of investors seeking advisory services changes, and the profiles of the investment advisory industry diversifies. The new marketing rule recognizes these changes and the SEC’s experience administering the current rules. The reforms “will allow RIAs to provide investors with useful information as they choose among investment advisers and advisory services, subject to conditions that are reasonably designed to prevent fraud.”
In August 2017, an investor filed a civil complaint with the SEC. The investor had an account with Navellier & Associates, an RIA. According to the investor’s complaint, Navellier created marketing materials that deceived investors, with inaccurate information on asset valuations. The complaint prompted the SEC to launch an investigation into the marketing practices of Navellier. Litigation followed for three years. In June 2020, the SEC obtained an enforcement action against Navellier & Associates, and its founder; the penalty associated with the action approximated $30 million. The findings held that Navellier & Associates used inappropriate “back-testing” to artificially inflate the investment strategy’s performance.
This case study profiles the Valuation, Marketing and Disclosure practices of Navellier & Associates, an RIA with the SEC. In June 2020, the SEC obtains an enforcement against Navellier & Associates, and its founder. The enforcement and related penalties resulted from a 2017 civil complaint, which alleged that Navellier & Associates had defrauded one or more of its investors.
According to the 2017 complaint, Navellier & Associates provides materially false and misleading track-record information for an investment strategy. Following the investigation into the complaint, the SEC alleged that for over a year, Navellier & Associates distributed misleading marketing materials. Those materials claimed that one of Navellier’s investment strategies tracked real-time investment decisions that significantly outperformed the S&P 500 Index between 2001 and 2008. Navellier & Associates’ marketing materials also declared that its performance was not “back-tested.” The SEC deemed both statements by the RIA conclusively false—the investment strategy in question did not exist between 2001 to 2008 and Navellier did indeed back-test to artificially inflate its investment strategy’s performance.
Government regulators find back-testing problematic because it does not necessarily reflect accurate results. Managers who present back-tested performance “can use the benefit of hindsight to create misleading marketing materials that suggest that the manager made profitable investment decisions in the past when they might not have without the benefit of hindsight.”
In February 2020, the SEC’s enforcement action against Navellier & Associates claiming that the firm violated Sections 206(1) and 206(2) of the Advisers Act of 1940 is successful. Section 206 contains the anti-fraud provisions of the Investment Advisers Act of 1940. Navellier & Associates relied upon deceptive marketing materials to deceive investors as to performance valuation. As a result, Navellier & Associates faced a $30 million penalty.
The SEC strongly advocates the proper use of prior performance by RIAs. RIAs must take care when using back-tested or other forms of hypothetical performance, as well as projected performance. The SEC monitors such performance in examinations and will expect clear disclosures about how the performance actually played out including the calculation methodology.
RIAs must also monitor and review existing Marketing materials and disclosures to ensure that information is not presented in a manner to elicit from an investor, either directly or indirectly, an improper inference relating to prior, current, or projected investment performance.
The use of back-tested performance must be accompanied by clear explanation and disclosures about its assumptions and limitations. Back-testing is the “application of a quantitative model to historical market data to generate hypothetical performance during a prior period.”
Review Compliance manuals to confirm policies exist to prevent disclosing inaccurate or misleading performance information. Maintain documentation for all calculation methodologies. Documentation is particularly important for back-tested and hypothetical performance, as well as fair market Valuations. Disclose the RIA’s role with respect to given investment strategies, and the performance of the investment strategy. Carefully review statements in marketing materials to confirm their accuracy reflecting proper Valuation practices. When addressing investment strategies in Marketing materials, confirm their consistency with the RIA’s performance being marketed.