SEC Announces the First Enforcement Action under the New Marketing Rule

The U.S. Securities and Exchange Commission (the “SEC”) announced on August 21, 2023 that it has settled with a FinTech registered investment adviser (the “Adviser”) that offers multiple investment strategies, including a crypto strategy, through its mobile app, for more than $1 million to resolve allegations that it, among other things, advertised misleading hypothetical performance projections in its marketing materials. Beginning June 2021, the Adviser elected to comply with the new marketing rule, which became effective on May 4, 2021 but had a compliance date of November 4, 2022. The Adviser’s advertisements, which were directed at retail investors and available on its website, were found to be misleading because they lacked material information and “painted a misleading picture of certain of its strategies.” The SEC also found that the Adviser failed to adopt and implement policies and procedures regarding hypothetical performance that are required under the rule. This settlement is the first enforcement action alleging violations of the SEC’s recently amended marketing rule (the “Marketing Rule”).

 

This enforcement action should serve as a reminder to investment advisers to (i) adopt and implement policies and procedures with respect to compliance with the Marketing Rule (including with respect to hypothetical performance), (ii) review their disclosures (including with respect to the criteria, assumptions, risks and limitations of hypothetical performance and with respect to the use of “layered” disclosure), and (iii) review any hedge clause used in any investment advisory agreement or governing agreement of a private fund, particularly with respect to retail investors.

 

The Violations

• Misleading Statements regarding Hypothetical Performance. The SEC found that the written marketing materials dealing with the hypothetical performance of the Adviser Crypto, an active crypto strategy offered to retail investors, did not include material information, including criteria used and assumptions made in calculating its hypothetical performance projection and how the annualized return was calculated. The marketing materials also failed to provide information about the risks and limitations of using this hypothetical performance in making investment decisions. Specifically, the Adviser projected a 2,700% annualized return based on only three weeks of historical performance of 21% growth every 3 weeks, assuming such performance would continue for an entire year. The SEC also noted that the advertisement did not disclose whether the hypothetical projection was net of fees and expenses.
• Insufficient Disclosures leading to, and within, Embedded Links. While the Marketing Rule adopting release allows for layered disclosure,^[1] the SEC found that the embedded links that provided additional information about the assumptions used to calculate the hypothetical performance and the attendant risks were not “as clear and prominent” as the highlighted 2,700% annualized return. The SEC noted that advertisement itself did not include any information to alert retail investors of the necessity of clicking the embedded links to view such additional material information. The SEC also found that the disclosures within the embedded links were too general in nature, and failed to provide “vital information about the criteria, assumptions, risks and limitations of the hypothetical performance” in the advertisement and only had minimal generic disclosures within the same hyperlinks. For example, the SEC noted that the disclosures failed to sufficiently provide information about the significant risks associated with the hypothetical annualized return calculation, including the unlikelihood of a continued growth trajectory of 21% every 3 weeks for an entire year. By failing to present “material criteria used and assumptions made in calculating its hypothetical performance projection,” the Adviser did not give sufficient information on the attendant risk of hypothetical performance to the retail investors it was advertising to or alert them to the necessity of clicking on the hyperlinks.
• Disclosure Failures related to Custody of Crypto Assets. The SEC also found that the Adviser made “conflicting and misleading disclosures” to investors about the custody of crypto assets. Specifically, on the Adviser’s website, the Adviser disclosed that crypto assets execution and custody were provided by a clearing firm and its affiliate. However, in contravention to this disclosure, the Adviser’s wrap fee brochure stated that the clearing firm affiliate “does not custody crypto assets, but instead relies on unaffiliated third parties to provide custody of crypto assets.” The SEC noted that not only the disclosure was misleading, but adviser also failed to disclose the actual custodians of its clients’ crypto assets. The SEC, however, notably did not allege a violation of the Custody Rule (Rule 206(4)-2 under the Advisers Act).
• Hedge Clause in Violation of The Adviser’s Fiduciary Duties. The SEC found that the Adviser’s investment advisory agreements contained a hedge clause that appeared to have disclaimed its fiduciary duty and improperly attempted to “relieve the Adviser from liability for conduct as to which the client has a non-waivable cause of action.” While the SEC did not specify the portion(s) of the language it found to be problematic, the hedge clause appeared to mislead the Adviser’s clients into waiving the Adviser’s “duty of care” to, among other things, provide advice that is in the best interest of the client or duty to “provide advice and monitoring over the course of the relationship.”^[2] The Commission Interpretation Regarding Standard of Conduct for Investment Advisers, IA Rel. No. 5248 (June 5, 2019) (the “Fiduciary Duty Guidance”) provides that in order to provide advice that is in the best interest of the client, an adviser must 1) make a reasonably inquiry into a client’s objectives and 2) have a reasonable belief that advice is in the best interest of the client.^[3] The Fiduciary Duty Guidance also obligates an adviser to monitor, which generally “extends to all personalized advice it provides to the client, including, for example, in an ongoing relationship, an evaluation of whether a client’s account or program type…continues to be in the client’s best interest.”

The hedge clause, among other things, appeared to waive any obligations related to obtaining “true, accurate, complete, and current information or to update information or any misrepresentations or omissions made by [the client]” or for “any damages or losses that were reasonably foreseeable” by the Adviser, which would effectively disclaim such fiduciary duties.

• Compliance Policies and Procedures Failures. The SEC found the two following violations under the category of “compliance policies and procedures” failures:
  • Safety of Client Assets-related Compliance Failures. According to the SEC, for more than three years, the Adviser had access and ability to transfer client funds by applying an electronic signature of the client to letters of authorization, IRA distribution forms, and other client account-related forms, rather than requesting, obtaining, and verifying client signatures prior to the transfer. Notably, upon discovery, the Adviser implemented two corrective actions: 1) the Adviser retained an independent auditing firm to investigate the practice, where such auditor did not find any evidence of any authorized asset transfers or other account-related actions for which clients’ electronic signatures were applied, and 2) the Adviser voluntarily self-reported this violation to the Commission Staff. The corrective actions notwithstanding, the SEC appears to have focused on the long-standing nature and prevalence (more than 3,000 letters of authorization) in its rationale to include this violation in the order.
  • Code of Ethics-related Compliance Failures. While the Adviser’s wrap fee brochure stated that it had adopted personal securities and crypto asset trading procedures, the SEC found that the Adviser failed to adopt and implement such procedures for crypto assets.

Takeaways and Next Steps

It is worth noting that the facts of this case would have provided sufficient grounds for an enforcement action under the old Advertising Rule and the anti-fraud provisions (including Rule 206(4)-8). Additionally, it is important to view the SEC’s perspectives within the context of retail investors, which is a term highlighted 8 times in the order. Still, as the SEC’s first enforcement settlement alleging a violation of the new Marketing Rule, this case provides additional color on the SEC’s focus on advisers’ level of disclosure, as well as the prominence of such disclosure, with respect to their presentation of hypothetical performance. The chief of the Enforcement Division’s Complex Financial Instruments Unit, stated that the action should “serve as a warning for all advisers to ensure compliance” with the new marketing rule. Along with the June 8, 2023 Risk Alert: Examinations Focused on Additional Areas of the Adviser Marketing Rule we expect the SEC staff’s focus on adviser’s compliance with the Marketing Rule to continue. 

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^[1] See the Marketing Rule adopting release at n.241.
^[2] See the Commission Interpretation Regarding Standard of Conduct for Investment Advisers, IA Rel. No. 5248 (June 5, 2019) (the “Fiduciary Duty Guidance”). 
^[3] Id. at pp.12-18.