Recently, the U.S. Securities and Exchange Commission (the “SEC”) announced charges against an investment adviser (the “Adviser”) for using hypothetical performance metrics in advertisements that were misleading pursuant to the anti-fraud rules under the Investment Advisers Act of 1940 (the “Advisers Act”). The SEC also charged the Adviser with multiple compliance failures that led to misleading disclosures about custody of clients’ crypto assets, the use of improper “hedge clauses” in client agreements, the unauthorized use of client signatures and the failure to adopt policies concerning crypto asset trading by employees.
This matter represents the first charges brought by the SEC for a violation of Rule 206(4)-1 under the Advisers Act (the “Marketing Rule”). The SEC’s press release on this matter noted that the SEC “amended the marketing rule to allow for the use of hypothetical performance metrics but only if advisers comply with requirements reasonably designed to prevent fraud…[t]his action serves as a warning for all advisers to ensure compliance.”
Violations of the Marketing Rule
Beginning in June 2021, the Adviser elected to comply with amendments to the Marketing Rule. However, the Adviser failed to adopt and implement written policies and procedures or adapt its practices to address these new regulatory requirements. As a result, the Adviser violated the Marketing Rule by advertising hypothetical performance without having adopted and implemented policies and procedures reasonably designed to ensure that the hypothetical performance was relevant to the likely financial situation and investment objectives of the intended audience and by failing to provide certain information underlying the hypothetical performance advertised.
From a period ranging from August 2021 to October 2022, the SEC alleged that the Adviser offered strategies to retail investors through its mobile app using misleading statements on its website regarding the hypothetical performance of its investment strategies. In particular, the Adviser claimed “annualized” performance results as high as 2,700 percent for its crypto strategy. The SEC alleged that the advertisements were misleading because they failed to include material information, for example, that the hypothetical performance projections assumed that the strategy’s performance in its first three weeks would continue for an entire year. The Adviser also did not disclose whether the hypothetical projection was net of fees and expenses. The Adviser provided certain information about the assumptions and risks of calculating the hypothetical annualized return, but such information was accessible only through links embedded in the advertisements. The SEC alleged that the Adviser’s advertisement did not present the hypothetical performance in a fair and balanced way, or in a way that was not materially misleading.
Additional Compliance Violations
In addition, the SEC’s Order alleged multiple additional compliance violations, including that the Adviser made conflicting disclosures in its wrap fee brochure; included a hedge clause in its advisory agreements that violated the Adviser’s fiduciary duty to its clients; failed to obtain client signatures prior to effecting transfers; and failed to adopt policies and procedures concerning employee personal trading.
Penalty
Without admitting or denying the SEC’s findings, the Adviser agreed to a cease-and-desist order, a censure, and to pay $192,454 in disgorgement, $7,598 in prejudgment interest, and an $850,000 civil penalty.
Conclusion
This enforcement action provides some constructive insights on how SEC examiners will likely interpret the Marketing Rule and the importance of an investment adviser’s fiduciary duties to retail clients. If you have any questions regarding this memo or the Marketing Rule, please contact your primary contact at Seward & Kissel.
