Misleading Presentation of Model Results Leads to SEC Fraud Charges

May 9, 2012 § Leave a comment

The Securities and Exchange Commission has charged a father-and-son duo of hedge fund managers with securities fraud stemming from claims about their investment strategy and past performance. According to the SEC’s order, Gabriel and Marco Bitran raised millions of dollars for their hedge funds through, among other things, very successful performance track records based on actual trades from 1998 to the inception of their hedge funds. In fact, those track records were based on hypothetical historical investments. In settling the SEC action, the Bitrans and their fund management entities agreed to pay disgorgement of $4.3 million, other monetary penalties and be barred from the securities industry.

The SEC has long viewed presentation of model or backtested results with a wary eye. Under Rule 206(4)-1, investment advisers (both registered and exempt advisers) may not present advertisements that contain untrue statement or that are otherwise false and misleading. While model results are not per se misleading (though this was formerly the SEC’s position), the SEC believes investors and clients should know whether an adviser has actually produced the results claimed or if they are merely hypothetical.

In its Clover Capital Management no-action letter, the SEC set forth a number of advertising practices–with respect to both actual and model results–that it believes are inappropriate. The list is not exhaustive nor does it provide a safe harbor but it does provide helpful guidance when advertising performance results. In the SEC staff’s view, the following practices are prohibited:

When presenting either model or actual results:

  • Failing to disclose the effect of material market or economic conditions on the results presented (for example, advertising that the adviser’s accounts increased 25% without disclosing that the broader market increased by 40% during the same period);
  • Including results that do not reflect the deduction of advisory fees and other expenses a client would have paid or actually paid;
  • Failing to disclose whether and to what extent the results reflect reinvestment of dividends and other earnings;
  • Suggesting the potential for profit without also disclosing the possibility of loss;
  • Comparing results to an index without disclosing all material facts relevant to the comparison (for example, failing to disclose differences in volatility between the results presented and the index used for comparison);
  • Failing to disclose any material conditions, objectives, or investment strategies used to obtain the results presented.
When presenting model results:
  • Failing to prominently disclose the limitations inherent in model results;
  • Failing to disclose if the conditions, objectives, or investment strategies materially changed during the time period presented and, if so, the effect;
  • Failing to disclose whether some of securities or strategies in the model results do not relate or only partially relate to the services currently offered by the adviser;
  • Failing to disclose if the adviser’s clients had actual results that materially differed from the model results.

The prohibitions in the Clover Capital no-action letter provide only a partial list of advertising practices that the SEC staff believes to be in violation of Rule 206(4)-1. Every adviser presenting model or actual results has an affirmative duty to ensure that its advertisements are not false or misleading.

Enactment of the JOBS Act means that, sometime this summer, private fund managers will have increased freedom to advertise their funds and their results. The JOBS Act’s repeal the ban on general solicitation and advertising was not popular at the SEC and two SEC Commissioners spoke out against the act. Presentation of model and actual performance results has been, and will continue to be, an area of intense scrutiny from both SEC and state regulators.

Sources:

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Jack G. Martel is the author of Investment Adviser Law Blog which is devoted to providing information and discussion of interest to investment advisers, private fund managers and others in the financial management industry. Jack is a partner in Ragghianti | Freitas LLP. He has over fifteen years experience in general business and securities transactions with a focus on assisting investment advisers, fund sponsors and managers in all manner of legal, regulatory and compliance issues. Jack can be reached at 415.453.9433.

 

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