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Banking and Finance

Ratings and Fund Managers

Investment advisers, and therefore fund managers once they register as investment advisers, are limited in how they advertise. Section 206 of the Investment Advisers Act already prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent deceptive or manipulative.

The first item on the list of restrictions is testimonials. This prohibition reflects the concern that the experience of one customer is not necessarily typical of the experience for all customers.

To some extent this also covers third party ratings since they are relying on the testimonials of clients. If you have a good rating you may want to include that rating as part of your fundraising materials. That means you are indirectly including a testimonial in your advertising and are staring squarely at the prohibitions in the advertising rule.

However, the SEC has recognized that the distribution of unbiased third-party ratings may not be fraudulent. In a 1982 No Action Letter to New York Investors Group, Inc., the SEC allowed the investment adviser to include an article from a financial publication that "lauds the Company/ and or the Company president's success in picking stocks that do well under both favorable and unfavorable market conditions."

The SEC ruled that "an article by an unbiased-third party concerning an investment adviser's performance, however, is not a testimonial unless it includes a statement of a customer's experience or endorsement. " While clarifying that the article is not a testimonial, it is still an advertisement.

The more detailed discussion about the use of ratings is in a 1998 No Action Letter to DALBAR, Inc. The company conducted a survey to measure the effectiveness of investment advisers and their representatives.  Based on the survey, DALBAR would assign a numerical ranking. Since the investment adviser was paying for the survey, presumably they would want to publish a good result to attract more clients. That means the ratings would be part of an advertisement.

The SEC said that the DALBAR rating is a testimonial because the rating carries an implicit statement of clients' experiences. The DALBAR rating is testimonial, made indirectly.

But the SEC turns around and and blesses the DALBAR rating, granting the sought after "we would not recommend enforcement action." The SEC lists these factors:

  • DALBAR rating does not emphasize the favorable client responses or ignore the unfavorable responses.
  • The rating represents all or a statistically significant sample of an adviser's clients.
  • The client questionnaire has not been prepared to produce any pre-determined results.
  • The client questionnaire makes it easy for a client to give negative or positive responses.
  • DALBAR does not perform any subjective analysis of the survey results, but merely assigns numerical ratings after averaging client responses.
  • DALBAR is not affiliated with any advisers.
  • DALBAR charges a uniform fee, paid in advance.
  • Survey results clearly identify the percentage of survey participants who received each designation and the total number of survey participants.

While the SEC blesses the DALBAR rating system, they took the opportunity to point out that an adviser's use of the rating in their advertisement materials could still be a violation of Section 206(4) and Rule 206(4)-1(a)(5). The SEC provided some guidance that advisers should consider when using a DALBAR or similar rating:

1. Whether the advertisement discloses the criteria on which the rating was based;

2. Whether an adviser or IAR advertises any favorable rating without disclosing any facts that the adviser or IAR knows would call into question the validity of the rating or the appropriateness of advertising the rating (e.g., the adviser or IAR knows that it has been the subject of numerous client complaints relating to the rating category or in areas not included in the survey);

3. Whether an adviser or IAR advertises any favorable rating without also disclosing any unfavorable rating of the adviser or IAR (or the adviser that employs the IAR);

4. Whether the advertisement states or implies that an adviser or IAR was the top-rated adviser or IAR in a category when it was not rated first in that category;

5. Whether, in disclosing an adviser's or IAR's rating or designation , the advertisement clearly and prominently discloses the category for which the rating was calculated or designation determined, the number of advisers or IARs surveyed in that category, and the percentage of advisers or IARs that received that rating or designation;

6. Whether the advertisement discloses that the rating may not be representative of any one client's experience because the rating reflects an average of all, or a sample of all, of the experiences of the adviser's or IAR's clients;

7. Whether the advertisement discloses that the rating is not indicative of the adviser's or IAR's future performance; and

8. Whether the advertisement discloses prominently who created and conducted the survey, and that advisers and IARs paid a fee to participate in the survey.

If you are using third-party ratings as part of your fundraising materials, DALBAR presents you with a laundry list of things you can and cannot do with those ratings.

For additional commentary on developments in compliance and ethics, visit Compliance Building, a blog hosted by Doug Cornelius.

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