SEC Clarifies RIA Performance Advertising Obligations: The Lucia Matter

Pursuant to Section 206 of the Investment Advisers Act of 1940 (“Advisers Act”) and Rule 206(4)-1, it is considered fraud for a registered investment adviser to publish, circulate, or distribute any advertisement which contains any untrue statement of material fact or which is false or misleading. One type of advertising that has been the focus of recent regulatory activity is performance advertising.

Performance advertisements are generally used by investment advisers to portray their past performance results to prospective clients. In order to be avoid misleading the prospective client, all material facts regarding the performance data and how it was calculated must be disclosed. This includes disclosing any material market conditions, the amount of advisory fees or other expenses that were deducted, whether results portrayed include reinvested dividends and other earnings, the investment strategies which were used to obtain the results, and any other material fact which may have impacted the results in any way.

In addition, performance advertisements can also be comprised of back-tested performance data, or model performance results. These are calculated by applying current investment strategies to historical data to see how the strategy would have performed had it been used. This form of performance advertisement is generally scrutinized more closely by regulators given that the results it portrays never happened at all. In addition to the disclosures required for actual performance results, investment advisers using model performance results should also disclose that the results are model or hypothetical results, any model limitations, any material changes in the model during the period portrayed, any differences between the strategy portrayed in the model to actual services currently offered by the adviser, any materially different actual results, and any other material fact which may have impacted the results in any way.

In order to have accurate performance numbers, investment advisers commonly use the Global Investment Performance Standards (GIPS) created by the Certified Financial Analyst Institute when calculating and presenting investment performance data. Whether or not such standards are used, investment advisers should be sure to maintain sufficient records to support all performance data calculations and presentations.

The SEC has vigorously investigated and enforced Rule 206(4)-1 in regards to performance advertising, and regularly imposes sanctions when it finds misleading advertisements. Recently there have been a few SEC enforcement actions which have provided some clarification to investment advisers on what is acceptable and not acceptable when using performance advertising.

The first enforcement action involves a radio personality, Raymond J. Lucia, and his investment adviser firm, Raymond J. Lucia Companies. Lucia and his firm held seminars for prospective clients promoting his “Buckets of Money” strategy through the use of back-tested performance data. He allegedly claimed that extensive back-testing had proved that his investment strategy would provide inflation-adjusted income to retirees while simultaneously protecting and increasing their retirement savings. However, when the SEC asked to see those calculations all that Lucia Companies was allegedly able to produce were two two-page spreadsheets.

The SEC discovered that the back-tested data on these spreadsheets was not based on the historical rate of inflation, but instead allegedly used a lower hypothetical inflation rate that made the results more favorable. In addition, Lucia Companies allegedly failed to deduct advisory fees from its back-tested performance results, also leading to more favorable results. On top of that, it allegedly failed to disclose to prospective clients that advisory fees had not been deducted from its back-tested performance data. Lastly, Lucia Companies’ back-testing was allegedly not done in a manner fully consistent with the “Buckets of Money” strategy and therefore was inconsistent with the investment strategy whose results were purportedly reflected.

As a practical matter, this case demonstrated the weight the SEC places on basing back-tested performance data on actual historical data in order to ensure accuracy of results and to avoid misleading investors. In addition, the back-tested performance data should be calculated in a manner that is fully consistent with the investment strategy it is designed to advertise.

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