SEC Charges Investment Manager and Former CEO with Making False Performance Claims
Commentary by Steven Lofchie
The SEC settled charges against the investment management firm F-Squared for defrauding investors through false performance advertising about its flagship exchange-traded-fund ("ETF") index product. Separately, the SEC charged the firm's co-founder and former CEO with making false and misleading statements to investors.
According to the SEC's order, F-Squared created an ETF sector strategy called "AlphaSector" using an algorithm, obtained from a third-party data provider, that provided signals indicating when to buy or sell an investment within the sector. The SEC alleged that while marketing AlphaSector, F-Squared falsely advertised a successful seven-year track record for the investment strategy based on the actual performance of real investments for real clients. In reality, the algorithm was not in existence during the seven years of purported performance success. The data used in F-Squared's advertising actually was derived through "backtesting" (i.e., the application of a quantitative model to historical market data to generate a hypothetical performance during a prior period). However, F-Squared specifically advertised the investment strategy as "not backtested."
Separately, the SEC alleged that the hypothetical data contained a substantial performance calculation error that inflated the results by approximately 350 percent. The SEC alleged that, even though a firm analyst notified the CEO of the error, F-Squared continued to advertise the inflated data for the next five years, and falsely stated that AlphaSector significantly outperformed the S&P 500 from April 2001 to September 2008.
F-Squared acknowledged that its conduct violated federal securities laws, and agreed to cease and desist from committing or causing violations of these provisions. F-Squared agreed to retain an independent compliance consultant and pay disgorgement of $30 million and a penalty of $5 million.
See: SEC Order against F-Squared; SEC Complaint against Former CEO; SEC Press Release.
Commentary
This settlement is important for several reasons. Most notably, the penalty is significant ($35 million), the firm admitted wrongdoing, and the firm's CEO was personally charged. More broadly, a number of compliance lessons may be learned from this settlement with respect to the presentation of past performance information:
- Where firms obtain past performance data from third parties, they should take appropriate steps to confirm whether the data reflects actual or hypothetical performance. Similarly, firms should respond to red flags (e.g., lack of supporting documentation) that raise doubts as to whether "actual" trade data does, in fact, reflect actual performance. Firms should confirm the accuracy of assumptions and calculations based on underlying performance data and promptly address any errors they discover.
- Generic disclaimers (e.g., that a marketing presentation does not reflect actual trading of a client account) will not cure otherwise misleading information. Firms may wish to look at Appendix 1 of the SEC order, which contains some of the slides that the SEC found to be misleading.
- Firms should check whether their compliance policies and procedures address the presentation of past performance information adequately, including through appropriate review procedures.
- The SEC may charge relevant personnel, including senior officers, that it believes were involved in preparing, or ratifying the use of, misleading marketing material.