Investment Adviser Advertising

For the uninitiated, the SEC’s complex rules can have unintended consequences.

THE SEC REGULATES THE ADVERTISEMENTS investment advisers create to promote their services under rule 206(4)-1 of the Investment Adviser Act of 1940. The goal is to prevent advertisements that are false and misleading.

RULE 206(4)-1(a) INCLUDES FIVE RESTRICTIONS advisers must follow. They can overcome two of these restrictions by including mandated disclosures. CPAs working with these rules should understand how they define the terms advertisement and misleading .

A SPECIFIC PROHIBITION BARS an investment adviser from using testimonials of any kind. The SEC considers them inherently misleading because they highlight favorable client experiences while ignoring unfavorable ones.

ANOTHER PROHIBITION PREVENTS AN ADVISER from advertising past specific recommendations unless it fully discloses all recommendations for at least the past year. An adviser can advertise past profitable recommendations if the advertisement meets specific disclosure and legend requirements. The rules seek to prevent an adviser from advertising only profitable recommendations.

SEC RULES ALSO RESTRICT AN ADVISER from advertising any chart, graph, formula or other device consumers can use when making investment decisions unless the advertisement also discloses the device’s limitations and difficulties in using it. Violations typically occur when an ad claims market-timing formulas can dictate when to buy and sell securities.

AN ADVERTISEMENT CANNOT CONTAIN ANY UNTRUE statement of material fact or a statement that is otherwise false or misleading. Because of the broad construction of this catchall provision, the SEC uses it to supplement other parts of the rule.

BRIAN CARROLL, CPA, is special counsel to the U.S. Securities and Exchange Commission in Philadelphia. He is an adjunct professor at Rutgers University School of Law in Camden, New Jersey.

The U.S. Securities and Exchange Commission disclaims responsibility for any private publication or statement of any commission employee or commissioner. This article expresses the author’s views and does not necessarily reflect those of the commission, the commissioners, or other members of the staff.

n the competitive field of investment advisory services, effective advertising can make the difference between an adviser’s success or failure. Government agencies, including the SEC, heavily regulate the form and content of investment adviser advertising. Financial services professionals may be subject to periodic checks through on-site SEC examinations of advertising and other compliance issues. (See “ When the SEC Knocks…, JofA , Aug.02, page 35.)

CPAs in at least three areas have a clear stake in ensuring accurate investment adviser advertising. Those who formally offer advisory services as registered investment advisers are directly subject to SEC regulation: Running afoul of the commission’s advertising rules may result in costly and embarrassing legal problems. CPAs who rely on advertisements when counseling clients on selecting an investment adviser should be aware of certain “red flags” signaling potentially false advertising. And practitioners who offer attestation services to investment advisers aimed at verifying advertised investment performance must have a solid understanding of the SEC’s approach to regulating investment adviser advertising.

This article explains key prohibitions against false and misleading advertising by explaining how the SEC applies rule 206(4)-1, Advertisements by Investment Advisers, of the Investment Adviser Act of 1940. CPAs can review this cornerstone of the regulatory scheme and other SEC rules governing investment advisers at the SEC Web site, . CPAs should be aware the act reaches beyond SEC-registered advisers to encompass all those who meet the definition of an investment adviser and are not excepted. (See “SEC Jurisdiction Over Investment Advice,” JofA , Aug.01, page 32.) By understanding this rule, CPAs will be better prepared to avoid violating it themselves, help clients select an investment adviser and offer attestation services to investment advisers.

Rule 206(4)-1(a) includes limitations on advertising. The rule bars advertisements that directly or indirectly

Refer to testimonials.

Refer to past investment recommendations unless specified disclosures appear.

Still a Problem

According to SEC Speaks , an annual resource book on SEC activities, for the past three years one of the most common fraud-related problems the SEC examination staff has referred to the Division of Enforcement fro investigation has been misleading performance advertising by investment advisers.

Source: SEC, .

Represent reliance on a graph, chart, formula or device to determine investment strategy unless the advertisement discloses its limitations and difficulties.

State that certain adviser services are free, unless true.

Contain any untrue statement of material fact or which are otherwise false or misleading.

Significantly, this rule is promulgated under section 206, the act’s antifraud provision. Violating the rule may result in civil prosecution by the SEC or criminal prosecution by the Department of Justice, or both. CPAs must view the advertising rule and its prohibitions in light of their overall fiduciary duty as an investment adviser. Under federal law the U.S. Supreme Court has held that an investment adviser owes its clients “an affirmative duty of ‘utmost good faith, and full and fair disclosure of all material facts,’ as well as an obligation ‘to employ reasonable care to avoid misleading’ clients” ( SEC v. Capital Gains Research Bureau Inc., 375 US 180, 194 (1963)). This federal fiduciary duty provides a backdrop against which the SEC can measure an investment adviser’s compliance with this rule. How the SEC applies the rule is grounded in its definition of advertisement and misleading .

Rule 206(4)-1(b) generally defines an advertisement as covering, in addition to television and radio, any written communication—including notices, circulars and letters—addressed to more than one person and any notice or other announcement appearing in any publication that offers investment advisory services with regard to securities, as well as other specified services. Although the term advertisement most obviously applies to materials intended to attract potential clients, such as newspaper and trade journal ads, press releases, Web site postings and submissions to third-party rating or reporting services, its use here extends as well to adviser newsletters, brochures, pamphlets, leaflets and reports intended primarily to retain current clients.

The key here is any “written communication addressed to more than one person.” Under this broad language, the SEC has interpreted an investment adviser’s quarterly client review letter, partially customized for each client, as constituting an advertisement. Distributing a reprinted newspaper article discussing the investment adviser also qualifies. Consistent with this expansive approach, CPAs should not interpret this element as requiring that a written communication literally be addressed to more than one person, such as including the names of at least two separate addressees, to be considered an advertisement. In this context advisers should read the rule as meaning directed to more than one person.

As discussed more fully below, the four sections of rule 206(4)-1(a)(1)-(4) establish specific restrictions on adviser advertising. The most important, however, is rule 206(4)-1(a)(5). It establishes a general prohibition against untrue, false and misleading statements in advertisements. This precept applies to all aspects of an advertisement, even if it technically complies with one of four specific restrictions. For example, an advertisement can comply with the bar on using testimonials, rule 206(4)-1(a)(1), but nevertheless still can be misleading in violation of rule 206(4)-1(a)(5) if it includes a materially false statement about the adviser’s rate of investment performance, amount of assets under management or similar material misstatement. Complying with one of the four specific restrictions is not a safe harbor. The bar against untrue, false and misleading statements applies in full measure, along with the rule’s other provisions, to an advertisement, and therefore, CPAs must consider it carefully when making decisions.

Whether a statement is untrue, false or misleading depends on the facts and circumstances. Acknowledging the inherent difficulty of determining this, the SEC has adopted a flexible approach to deciding what is misleading. Generally it will weigh some basic aspects of the advertisement at issue: “(1) the form as well as the content of the advertisement, (2) the implications or inferences arising out of the advertisement in its total context and (3) the sophistication of the prospective client” (Muller Associates (June 17, 1992) 1992 SEC No-Act LEXIS 801). A statement may be misleading when it creates a favorable impression that, when judged with a full knowledge of the facts and circumstances, is unsupported. This is most apparent when an advertisement fails to reveal a key fact that materially changes the favorable impression it conveys. For example, this would occur if an adviser advertised its investment performance but failed to reveal that the results were based on hypothetical as opposed to actual investment decisions.

The first of the four specific prohibitions bars an investment adviser from using testimonials of any kind. The SEC considers client testimonials inherently misleading because they highlight favorable experiences while ignoring unfavorable ones. In addition, testimonials communicate that all clients typically have a favorable experience, even though this may not be true. Finally, if the rules permitted testimonials, advisers might be tempted to provide extraordinary service to only a select few clients, with a view toward cultivating their endorsements for an advertisement.

Testimonials include a statement of the client’s positive experience with the adviser or an endorsement. An adviser placing an advertisement in a newspaper with photos of clients accompanied by statements claiming the adviser helped them meet their financial goals obviously would violate the rule. Similarly, using written client statements as part of an advertisement also would be a violation. More subtle, circulating a reprinted copy of a newspaper article that quoted an adviser’s client’s favorable experience also would violate the regulations. Unlike other parts of the rule, this section does not provide for any disclosures that, when accompanying a testimonial, would make it acceptable to use the testimonial.

Significantly, advertising a partial list of clients does not fall within the testimonial bar. The SEC allows this form of advertising, when a prospective client requests it, if the adviser selects clients for the list based on an objective criterion (such as the largest dollar amount of purchases or sales of securities in managed accounts in a particular category) that does not include investment performance; the criterion is disclosed; and a disclaimer stating “it is not known whether the listed clients approve or disapprove of the adviser or advisory services” appears (Cambira Investors Inc. (Aug. 28, 1997) 1997 SEC No-Act, LEXIS 833).

CPAs , Standards and Guidance
Many CPAs provide attestation services to investment advisers in engagements to determine whether they have met the Association for Investment Management and Research performance presentation standards (AIMR-PPS). One of AICPA Statement of Position 01-4’s most significant contributions to the process—as prepared by the AICPA investment performance statistics task force—is its guidance on how CPAs should approach this type of engagement under the principles established in Chapter 1, Attest Engagements, of Statement on Standards for Attestation Engagements no. 10, Attestation Standards: Revisions and Recodifications.

The SOP gives CPAs direction on the engagement’s planning and objectives, establishing an understanding with the client, obtaining sufficient evidence, the representation letter and reporting. Recently, AIMR substantially revised its PPS as part of a standards globalization program. Currently, an adviser may seek a firmwide verification of compliance (level 1) and, in addition, an examination of the performance results of any specific composite of client accounts. For more information about AIMR and its performance presentation standards, go to .

The second prohibition prevents an adviser from advertising past, specific investment recommendations that were or would have been profitable, unless the ad fully discloses all recommendations for at least the past year (including the security recommended; the date, price and nature of the recommendation (buy, sell or hold); the price triggering the recommendation; and most recent price) and includes a mandated cautionary legend. An adviser can advertise past profitable recommendations by meeting the disclosure and legend requirements. This provision seeks to prevent an adviser from “cherry-picking” past recommendations by advertising only the profitable ones.

Although the rule addresses past but not current recommendations, an adviser must tread lightly. Whether a recommendation was made in the past or is current depends on the facts and circumstances—particularly how much time has passed. What the adviser considers a current recommendation when it creates an advertisement may have become a past recommendation by the time the ad appears in print. If an adviser says it also made a current recommendation at some time in the past, such a claim might constitute a “past recommendation” under the rule.

The language of the rule permits an adviser to meet the detailed disclosure and legend requirements by offering in the advertisement to furnish this information separately, apart from the advertisement. However, this approach doesn’t always work. In a no-action letter, the SEC staff did not allow an adviser to reprint a newspaper article listing past, profitable recommendations even though the adviser offered to furnish the mandated disclosure and legend information separate from the article.

Under certain circumstances an adviser may forgo having to meet the disclosure and legend requirements of the past, specific recommendations rule and provide only a partial list of past recommendations. For example, when an adviser had made more than 500 recommendations during the past year, rendering it impractical to list all of the required disclosure information, the SEC staff allowed the adviser to list only those recommendations that met an objective, non-performance-based criterion consistently applied, without mentioning the amount of profits or losses the listed securities generated. The adviser had to maintain records of the information required under the rule for SEC examination.

The third provision generally restricts an adviser from advertising any graph, chart, formula or other device that consumers can use to determine when to make investment decisions, unless it prominently discloses the device’s limitations and difficulties in its use. A violation of this provision typically occurs when an advertisement claims that market-timing formulas can profitably dictate when and what securities to buy and sell without disclosing any limitations or difficulties. For example, an adviser violated the provision by advertising a market-timing formula without disclosing its limitations or that it might not always work. Similarly, an adviser committed a violation by suggesting in its ad the potential for profits without acknowledging the possibility of loss.


2004 Personal Financial
Planning Conference
January 5–7
Mandalay Bay Hotel, Las Vegas

Free optional sessions on Sunday, January 4, 2004. Keynote and featured speakers include John C. Bogle, founder of the Vanguard Group Inc. and president of Bogle Financial Markets Research Center; George F. Will, Pulitzer Prize-winning newspaper columnist and contributing editor of Newsweek magazine; and Marvin Zonis, noted economist and professor at the University of Chicago Graduate School of Business. For more information or to register go to .

The fourth provision prohibits an advertisement from stating that any advisory service is offered free of charge, unless it actually is free. Although this may seem self-evident, many businesses subject to less government regulation routinely offer a “free” product or service if the consumer purchases another product or service. An adviser’s advertisement would violate this provision if it offered a “free” service, but conditioned its being free on the purchase of the adviser’s services.

Because of its reach, this fifth provision permeates the adviser advertising regulatory scheme. It prohibits an advertisement that “contains any untrue statement of material fact, or which is otherwise false or misleading.” Obviously, the application of this provision is limited only by the imagination of the person who seeks to create a materially misleading advertisement. Some examples of the most common violations include overstating the amount of assets under the adviser’s management; misrepresenting the educational background and work experience of adviser personnel; overstating the longevity of the advisory firm; failing to disclose the adviser based its investment performance on hypothetical, not actual, investments; misrepresenting that an adviser’s performance results are audited or calculated in compliance with an industry-wide standard; misrepresenting the length of investment performance history and failing to appropriately position key disclosures appearing in the advertisement.

Because of the provision’s broad construction, the SEC uses it to supplement other parts of the rule. For example, an adviser committed a violation when it included in its promotional materials a copy of a newspaper article quoting the adviser’s president and CEO making a misleading statement. (In effect the adviser claimed to have increased its clients’ capital tenfold over the past 10 years.) Though this self-laudatory statement may or may not have qualified as a testimonial under rule 206(4)-1(a)(1), it was clearly misleading because the adviser’s average client investment performance during the 10 years was 50%. The statement was misleading because it suggested the tenfold return was typical when in fact returns were lower.

Similarly, an adviser who claimed to rely on a computer model to determine investment strategy failed to disclose the other factors it relied on in the decision-making process such as stock-market chart patterns, Federal Reserve policies, interest rates, analysis of international conflicts and even astrology. Though arguably these factors may have been limitations of an investment device under rule 206(4)-1(a)(3), failing to disclose them rendered the claim misleading.

Finally, this catchall provision is one of the main sources of authority for regulating advertised investment performance or rate of return. An adviser’s main selling point is its success in selecting client investments that produce a favorable rate of return, consistent with the client’s investment objectives and risk tolerance. Because this is the primary reason someone retains an adviser, it may pressure an adviser to inflate its advertised investment performance. In contrast, an adviser may be less likely to inflate in an advertisement the performance of an individual portfolio the client could easily verify.


CPAs and all others registered as investment advisers must use rule 206(4)-1, Advertisements by Investment Advisers, of the Investment Adviser Act to guide them in developing advertisements for their advisory practices.

The term advertisement goes beyond television and radio to include virtually all written material that is intended to attract potential clients including newspaper advertisements, press releases, Internet postings and submissions to third-party rating services.

Rule 206(4)-1(a) includes five restrictions on advertising that advisers must follow. Violating these rules can result in civil prosecution by the SEC or criminal prosecution by the Justice Department. Rule 206(4)-1(a)(5) establishes a general prohibition against untrue, false and misleading statements in advertisements.

Many advisers may wish to voluntarily comply with the performance presentation standards established by the Association for Investment Management and Research.

This section of the rule, however, does not lay down any requirements for the key building blocks of advertised investment performance: portfolio composite construction (deciding the criteria for grouping client portfolios with similar investment objectives to calculate an overall rate of return), calculation methodology (time-weighted-return method, total return, average annual return or internal rate of return) and presentation (results net or gross of adviser fees) and disclosures. CPAs may find direct SEC guidance on many, but not all, of these issues in a series of no-action letters from the SEC Division of Investment Management. (See “ Calculating Investment Performance. ”)

To enhance their credibility and marketability with potential institutional clients and others, many advisers have voluntarily complied with the Association for Investment Management and Research performance presentation standards (AIMR-PPS). AIMR is a leading investment management professional and standards-setting organization. The AIMR-PPS provide comprehensive direction for, among other things, composite construction, calculation methodology, reporting and presentation and disclosures. The SEC does not mandate compliance with AIMR-PPS, but an adviser falsely claiming to comply could very well be making a misleading statement. In response to the rapid growth of CPAs’ auditing for compliance with these standards, AICPA Statement of Position 01-4, Reporting Pursuant to the Association for Investment Management and Research Performance Presentation Standards, provides guidance to CPAs engaged to examine and report on an adviser’s compliance with AIMR-PPS. (See “ CPAs, Standards and Guidance .” )

Investment advisers occupy a position of trust. They are legally bound to uphold their obligations as a fiduciary, which include complying with SEC regulations governing adviser advertising. To fulfill these responsibilities, an adviser should consult with legal counsel or an experienced compliance professional before advertising. For the uninitiated, the flexibility and complexity of this regulatory scheme can sometimes result in unintended and adverse consequences.

Calculating Investment Performance
A n adviser may advertise investment performance as either the performance of actual portfolios it manages or of a model portfolio that has no assets but is managed as though it does and may mimic an actual portfolio’s investment strategy. Through a series of no-action letters—which the SEC Division of Investment Management usually issues when it determines an adviser’s suggested course of conduct will result in the Division of Enforcement’s taking “no action” against that adviser—guidance has evolved for complying with these calculation, disclosure and presentation requirements. The seminal no-action letter addressing the basic aspects of both actual and model performance is Clover Capital Management Inc. (Oct. 28, 1986) 1986 SEC No-Act LEXIS 2883. It interprets rule 206(4)-1(a)(5) as prohibiting an advertisement that

Fails to disclose the effects of material market or economic conditions on the results portrayed.

Includes model or actual results that do not reflect the deduction of advisory fees, brokerage or other commissions and any other expenses a client would have paid or actually paid.

Fails to disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings.

Suggests or makes claims about the potential for profit without also disclosing the possibility of loss.

Compares model or actual results to an index without disclosing all material facts relevant to the comparison.

Fails to disclose any material conditions, objectives or investment strategies used to obtain the results portrayed.

n Fails to disclose prominently the limitations inherent in model results, particularly the fact that such results do not represent actual trading and they may not reflect the impact material economic and market factors might have had on the adviser’s decision making if the adviser was actually managing client money.

Fails to disclose, if applicable, that the conditions, objectives or investment strategies of the model portfolio changed materially during the time period portrayed in the advertisement and, if so, the effect of any such change on the results portrayed.

Fails to disclose, if applicable, that any of the securities contained in, or the investment strategies followed with respect to, the model portfolio do not relate or only partially relate to the type of advisory services the adviser currently offers.

Fails to disclose, if applicable, that the adviser’s clients had investment results materially different from those portrayed in the model.

Fails to disclose prominently, if applicable, that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made and the effect of this practice on the results portrayed, if material.

This list is not intended to be all-inclusive or to provide a safe harbor. Moreover, subsequent no-action letters have further addressed issues this list raised. Because of the complexity of this area and the fact that false performance advertising is the most common basis for Division of Enforcement actions, CPAs who are advisers should seek the counsel of an experienced attorney or compliance professional before advertising investment performance.


CPEOs provide peace of mind around payroll services

The creation of these new IRS-certified service providers for small businesses clarifies some issues around traditional professional employer organizations.


8 sentences to help you master subject-verb agreement

When professionals prepare written material for readers inside their organization or outside, they should make sure that no errors distract from the message they need to convey. Take this short quiz for practice in subject-verb agreement.