With the date for compliance with the new Investment Adviser Marketing Rule approaching, now is the time for registered investment advisers to consider how the new rule impacts many facets of their regular practices. One area that should be carefully evaluated is the use of “hypothetical performance.” The new rule expands the definition of an “advertisement” to include many one-on-one presentations that were not covered by the former advertising rule. Now, any one-on-one presentation that contains “hypothetical performance” is subject to the general anti-fraud provisions of the new rule, as well as to several specific conditions and limitations on the use of hypothetical performance.
The definition of “hypothetical performance” is “performance results that were not actually achieved by any portfolio of the investment adviser.” That definition expressly encompasses “targeted or projected performance returns.” The illustration of “targets” or “projections” in one-on-one presentations was previously covered by the general anti-fraud rules, but the new regime imposes more onerous requirements and may indeed prevent RIAs from using the types of illustrations they are currently routinely using with new clients and prospects.
A common approach to acquiring new clients involves presenting an illustration of how a proposed portfolio will perform. This is frequently done through the use of reporting software or publishing services such as Morningstar, Riskalyze, and others, although the adviser may have the ability to customize the inputs and the contents of the final report. Sometimes specific returns are projected, while at other times the projections will show a range or band of returns coupled by a specific probability range.
The SEC’s interpretive release, issued when the new rule was adopted (“Adopting Release”), makes it clear these types of illustrations – commonly established through the use of historical data and/or mathematical modeling – are “hypothetical performance” and are therefore subject to the new rule’s requirements. As the Adopting Release states, the SEC “generally would consider a target or projection to be any type of performance that an advertisement presents as results that could be achieved, are likely to be achieved, or may be achieved in the future by the investment adviser with respect to an investor.” An exclusion from the definition of hypothetical performance for “interactive analysis tools” may sometimes prevent such projections from being considered “hypothetical performance,” but in most instances projected returns do not present an opportunity for the investor to “interface directly” with the model-producing software, the report, or the model itself, and therefore this exclusion will not be available. Importantly, even if the presentation can be classified as an “interactive analysis tool,” it must still be accompanied by significant disclosures.
While the new rule makes these illustrations of projected returns subject to the seven “general prohibitions,” it also prohibits the use of hypothetical performance unless the adviser does three things: (1) Adopts and implements policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience; (2) Provides sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance; and (3) Provides sufficient information to enable the intended audience to understand the risks and limitations of using such hypothetical performance in making investment decisions.
The Adopting Release makes it clear that an adviser may not present projected performance for general distribution or to clients or prospects who lack the resources and financial expertise to evaluate and interpret the illustration. Importantly, the guidance states that it would be misleading to present projected performance to any investor who lacks the tools or data to assess the impact of assumptions made, or who is unable to subject the performance projections to additional analysis. In situations where the assumptions and methodology are complex, as is often the case, this is a high standard that will exclude the use of projections for a significant segment of retail clients.
The additional requirements of the new rule as it relates to the advertisement of “hypothetical performance” are beyond the scope of this article. Furthermore, the requirements for each proposed advertisement, and for each firm’s own policies and procedures, will vary significantly as each situation will be different. At a minimum, all RIAs should review the Adopting Release and consult with their compliance and legal advisors regarding how to comply with the requirements of the new rule.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.