SEC Targets Advisers for Misleading Investors, Advertising Missteps, and Violations of Reg. S-ID: Lessons Learned from Recent SEC and FINRA Cases for October 2018


$1.9 million lesson on Back-Testing Performance:  To be or not to be, that is the question  . . . The Securities and Exchange Commission (“SEC”) slammed Massachusetts Financial Services (“MFS”) with a $1.9 million fine for not disclosing that a hypothetical performance chart included in institutional marketing materials, specifically a pitchbook, RFPs and a white paper, included back-tested information.  MFS created its quantitative desk in 2000. However, the performance chart included quantitative performance back to 1995. “Specifically, the quantitative ratings for the period 1995-2000 for all stocks and for the period 2000-2003 for some stocks were the result of the retroactive application of MFS’s quantitative model.”  The SEC stated “[b]ack-tested performance attempts to illustrate how a portfolio would have performed during a certain historical period if the portfolio had been in existence during that time. Back-tested performance carries the risk that the performance depicted is not due to successful predictive modeling.” The chart and statements regarding the performance records were found to be materially false and misleading because they were not based on original research and the firm did not disclose that the back-tested performance significantly improved the hypothetical performance.

Not surprisingly, MFS was cited for inadequate policies and procedures for reviewing the marketing materials.  The internal breakdowns included miscommunication between portfolio management and compliance and the use of multiple compliance personnel, based on audience, to review the materials who did not have all the facts related to the history of the portfolios.

Or take arms against a sea of troubles. . . Using back-tested performance in marketing materials is a high-risk activity, whether a firm is dealing with sophisticated institutional investors or retail clients.  The SEC views this type of information as inherently suspect, requiring copious disclosure. However, if a firm chooses to use back-tested performance, it’s critical that the materials receive continuous scrutiny such as including experienced compliance personnel in the review process, requiring the portfolio manager to sign off on the disclosures, and verifying the performance record by a third party.  Contributed by Senior Compliance Consultant, Heather D. Augustine

Private Fund Adviser Fined $200,000 for Withholding Information in Buy-Out Offer.  This case illustrates the perils of engaging in principal transactions.  The SEC fined an investment adviser and one of its principals $200,000 for failing to disclose a potential increase in fund assets when making a buy-out offer.  This story starts out with some limited partners asking for a way to exit a 17-year old fund, the VS&A Communications Partners III, L.P. (the “Fund”).  The Fund’s investment committee decided to dissolve the Fund through a distribution-in-kind.  A principal of the Fund, Jeffrey Stevenson, apparently still believed in the remaining portfolio companies and offered to buy the limited partners’ interests for cash equal to 100 percent of Fund’s audited net asset value as of December 31, 2014.  The majority of the limited partners accepted this offer in April 2015.  In early May 2015, the Fund’s investment committee learned that the two remaining portfolio companies had done well in the first quarter, indicating, at least preliminarily, a material increase in the Fund’s net asset value.  VSS Fund Management LLC (“Fund Adviser”), the Fund’s adviser, rescinded the offer for the distribution in-kind and told the limited partners that it would keep the Fund open for those who wanted to remain invested.  Those who wanted out of the Fund could accept the offer from Stevenson to purchase their interests on the same terms as previously provided. About 80 percent of the limited partners decided to take the cash.

The SEC found that the Fund Adviser and Stevenson misled the limited partners since they failed to disclose the Fund’s potential increase in net asset value.  These omissions were violations of Section 206(4) of the Advisers Act and Rule 206(4)-8, which prohibit advisers from engaging in fraudulent, deceptive or manipulative behavior.  The lesson learned in this case is that an adviser can never have too much disclosure when engaging in a transaction with investors.  Even if the Fund Adviser had doubts about the increase in net asset value, it should disclose the information to the investors to ensure fairness.  Contributed by Jaqueline M. Hummel, Partner and Managing Director

Putting the Cart Before the Horse:  Transamerica Sells Quant Funds with Untested Model and SEC Blames Management.   In this series of three cases, the SEC charged four Transamerica entities and two principals with misleading investors about a quantitative model being used to manage assets, resulting the firms having to distribute $97.6 million to affected investors.  Apparently, the model developed by an inexperienced junior analyst “contained numerous errors, and did not work as promised,” according to the SEC’s press release.   This case is eerily reminiscent of the Axa Rosenberg Group case back in 2011. Both cases involve a quantitative model used to manage client assets.  In the Axa Rosenberg case, an error was discovered in the model two years after it was introduced.  Management was informed and the error was fixed, but the firm made no public disclosure and clients lost money.  In the Transamerica case, the administrative order asserts that AEGON USA Investment Management, LLC (“AIUM”) put a newly minted MBA in charge of developing a quantitative model that was used in some mutual funds and other investment products, all without testing the model.  Internal audit identified issues with the model early on, but the investment products were launched anyway, with the promise that the firm would develop a model validation policy in short order.

Ultimately AIUM stopped using the models, but failed to disclose the change in investment strategy to investors, or disclose the errors in the model.

Two members of firm management, Bradley Beman, Chief Investment Officer for AEGON USA Investment Management, LLC (“AUIM”), and Kevin Giles, AUIM’s Director of New Initiatives, were found personally liable.  These two were responsible for managing the risks associated with the model-driven strategy but apparently failed.  They were fined $75,000 and $25,000, respectively.

Despite all the media emphasis on the development of the model by an inexperienced junior analyst, the heart of the SEC’s case against Transamerica and its related entities dealt with the cover-up that took place after the issues with the model were identified. A key takeaway from this case is when advisers reserve the greatest rewards for sales and impose no consequences for failures to address risk and compliance issues; they are guaranteed to have regulatory issues.   Contributed by Jaqueline M. Hummel, Partner and Managing Director

The Weakest Link in Identity Theft:  Your Own Employees:  The case involving Voya Financial Advisors, Inc. (“VFA”), shows how vulnerable advisers can be to criminals trying to steal customer funds.  Over a six-day period in 2016, fraudsters impersonating VFA representatives were able to get VFA’s technical support staff to reset their passwords.   According to the SEC, the intruders were then able to get access to personal information of at least 5,600 of VFA’s customers and account information for three customers.  No unauthorized transfers resulted from the attack.   This is the first case the SEC has brought SEC involving Regulation S-ID, the Identity Theft Red Flags Rule.  VFA agreed to pay a $1 million fine and retain an independent compliance consultant to review its policies and procedures to ensure compliance with Regulation S-P and Regulation S-ID.

The case is a good case study showing how the intruders were able to exploit the vulnerabilities in the system.  According to the SEC order, VFA’s inadequate cybersecurity procedures resulted in not shutting off the intruders’ access to VFA’s systems quickly after the breach.  The case also illustrates that training on information protection is essential; staff should understand how to identify intruders and what steps to take to stop them.  Our advice: read the case and learn from VFA’s mistakes.  Contributed by Jaqueline M. Hummel, Partner and Managing Director

Radio Show Host gets Advisor in Hot Water for Glowing Review.  As any compliance officer can tell you, advertising for investment advisers is a tricky business.  There are, however, a couple of things that are clearly forbidden under Rule 206(4)-1, the “Advertising Rule” and the first is using a client testimonial in an advertisement. Creative Planning, Inc., and its president, Peter Mallouk, agreed to pay a $200,000 penalty to the SEC for a violation of Rule 206(4)-1(a)(1) under the Advisers Act which prohibits the use of client testimonials in advertisements.

Creative Planning, Inc. (“Creative”) advertised its services on a local radio station where the radio host would discuss the firm’s services live on the air. Creative gave the station specific instructions to use content from its compliance-approved pre-recorded spots.  One of the radio hosts became a client of Creative and began discussing his satisfaction with the service provided as part of the on-air advertisement.   Apparently, no one at Creative listened to this station or requested recordings of the live ads, so no one at the firm was aware of these ad hoc testimonials, which aired over 200 times over a two-year period.

The obvious lesson from this case is to monitor your firm’s advertisements to ensure that they are being presented in compliance with SEC regulation.  Peter Mallouk discusses what he learned from this experience — check it out hereContributed by Jaqueline M. Hummel, Partner and Managing Director

Worth Reading: 

Earning the Right to Get Swindled:  Matt Levin from Bloomberg provides a new approach for defining “accredited investor.”

Urban Meyer, Ohio State Football, and How Leaders Ignore Unethical Behavior:  David M. Meyer discusses how biases get in the way of ethical conduct.

The other side of the story:  Peter Mallouk, CEO of Creative Planning, discusses the hard lessons he learned as a result of SEC action against his firm.

Get Yer Ya Yas Out:  Thomas Fox, the Compliance Evangelist, writes a great blog post about how important it is to find compliance officers with curiosity, and encourage your staff to continuously learn and ask questions.

Five Social Media Cybersecurity Updates you Can Address Now:  Scott Kleinberg at InvestmentNews provides some simple advice on protecting your firm from cybercriminals.

Report on State of IA Industry Released:  Lorna Schnase provides her take on the report from National Regulatory Services and the Investment Advise Association.

2018 Evolution Revolution:  Check out NRS and Investment Adviser Association’s report on the state of the investment adviser profession.

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