COMPLIANCE CONFERENCE - Morgan Lewis

ACA’S SPRING 2015 COMPLIANCE CONFERENCEMIAMI, FL APRIL 22-24, 2015

SEC vs GIPS®REQUIREMENTS

Steven W. StonePartner

Morgan, Lewis &

Bockius LLP

LOGOKaryn D. VincentManaging Partner

ACA Performance

Services

Bockius LLP

Agenda

• SEC regulatory framework• GIPS standards• Key SEC vs. GIPS issues• GIPS disclosure requirements in Guidance

Statements

SPRING 2015 COMPLIANCE CONFERENCE

MIAMI, FL

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Statements• Q&A

SEC Regulatory Framework

• SEC creates the rules implementing the federalsecurities laws

• Issues guidance on rules; sources include:

– Rule releases


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– Rule releases

– No-action letters and other guidance

– Enforcement actions

• Goal is to prohibit fraud through regulation

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The GIPS Standards

• The Global Investment Performance Standards (GIPS®)are a set of voluntary standards developed by CFAInstitute, in partnership with other organizationsworldwide– The GIPS standards have been adopted by over 30 local

country sponsors


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country sponsors

• Claiming compliance is voluntary, but– In the U.S., claiming compliance with the GIPS

standards is required by many clients, sponsors andconsultants

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SEC Advertising Guidance

• One rule – Rule 206(4)-1

– Falls under Advisers Act anti-fraud provision

– Anti-Fraud Catchall - No misrepresentations; noomissions of material facts; no false or misleadingstatements

– No testimonials


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– No testimonials

– Limited past specific recommendations, or “CherryPicking”

– Restrictions on graphs and charts and tools to makeinvestments decisions

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• Key No-Action Letters:

– Investment Counsel Association of America: Advertisementdefinition

– Clover Capital: Prohibited advertisements

– ICI II: One-on-one presentation of performance


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– ICI II: One-on-one presentation of performance

– JP Morgan: May advertise composite performance usingmodel fees if equal to highest fee charged

– Horizon Asset Management: Portability of performance(includes predecessor performance)

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• Key No-Action Letters:

– Cambiar: Client lists

– Franklin and The TCW Group: Past SpecificRecommendations (client letters, representative accounts,best and worst performing holdings)


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best and worst performing holdings)

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Performance Advertising - SEC

• What is an advertisement?– Rule definition: Any notice, circular, letter or other

written communication addressed to more than oneperson

– Practical definition: Any communication intended tosolicit business


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solicit business• Advertising rule falls under anti-fraud provision of

Advisers Act– SEC focus on disclosure

• Investment adviser advertising cannot be false ormisleading, must be fair and balanced

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Performance Advertising – GIPS

• The GIPS standards are focused on presentingperformance to prospective clients

• Firms must make every reasonable effort to provide acompliant presentation to all prospective clients.Firms must not choose to whom they present a


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Firms must not choose to whom they present acompliant presentation. As long as a prospective clienthas received a compliant presentation within theprevious 12 months, the firm has met this requirement

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What is a Compliant Presentation?

• A presentation for a composite that contains all theinformation required by the GIPS standards and mayalso include additional information or supplementalinformation


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information

• Typically includes a table with numerical informationand a series of disclosures

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Who is a Prospective Client?

Any person or entity that has expressed interest in one ofthe firm’s composite strategies and qualifies to invest inthe composite. Existing clients may also qualify asprospective clients for any strategy that is different fromtheir current investment strategy. Investment consultants


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their current investment strategy. Investment consultantsand other third parties are included as prospective clientsif they represent investors that qualify as prospectiveclients

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Compliant Presentations

• Common practice is to treat compliant presentations(CP) as “SEC advertisements”

– Which returns are presented

– Which disclosures are included


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– Which disclosures are included

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GIPS Advertising Guidelines

• Allow a firm to state it complies with the GIPSstandards in something other than a fully compliantpresentation

• Advertising Guidelines do not replace the GIPSstandards


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standards

• Complying with the GIPS Advertising Guidelines isvoluntary

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GIPS Advertising Guidelines

• In an advertisement, a firm has three options

– Include an ad prepared in accordance with theGIPS Advertising Guidelines

– Include a compliant presentation


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– Include a compliant presentation

– Do not mention the GIPS standards

• Regardless of the option selected in anyadvertisements, the firm still has the compliantpresentation delivery obligation

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Applicability

• Applies to prospects and clients

• Disclosure and content may varybased on the audience; moreleeway with “sophisticated”clients

• Use of composite performance

• Use of composite performance isrequired

• Only obligation is to make everyreasonable effort to provide a CPto all prospective clients

– And to ongoing prospective

SEC GIPS standards


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• Use of composite performance

– Few rules, though changingcomposite may signal cherrypicking

– SEC interested in compositemaintenance controls

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– And to ongoing prospectiveclients at least once every 12months

• Not required to provide a CP tocurrent clients

– Current clients can qualify asprospective clients for adifferent strategy

Net vs. Gross Returns

• Net required inadvertisements

• Gross ok alongside net withequal prominence

• Gross ok in one-on-onepresentations - private

SEC• Either gross or net returns may

be presented in CPs– Gross is recommended to

allow for better comparabilitybetween firms

• But must also comply with any

GIPS standards


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presentations - privatemeeting with sophisticatedprospect (including groups) -opportunity to ask questions

• If using gross only, needdisclosure about the effect offees on performance

• But must also comply with anyapplicable laws and regulationsregarding the calculations andpresentation of performance

• Therefore common practice is toinclude both gross and netreturns in CPs

Net Returns

• May deduct actual advisory feepaid by client, or adviser’shighest standard fee

• Disclose basis used to deductfee

SEC• If use model fees, net returns

must be lower than net returnscalculated using actual fees

• Common practice is to usemodel fees– Deduct 1/12th of the highest

GIPS standards


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– Deduct 1/12th of the highesttier of the applicable feeschedule from the monthlygross composite return

• Must disclose if net returns arecalculated using actual or modelfees, and if performance fees arereflected in the net returns

Timeliness of Returns

• Can’t be false ormisleading

• Use current returns

• Can’t cherry pick

SEC

• Only annual returns must beincluded in CPs

• Must update CPs at leastannually

GIPS standards


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• Can’t cherry pick

• No hard and fast rules –tread carefully

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annually− May update more

frequently• No guidance as to how soon

after year end/other periodend new returns must beincluded

Composite vs. Fund Returns

• No hard and fast rules, butantifraud focus on cherrypicking

• While compositeperformance provides more

SEC

• Must determine if marketinga fund or composite strategy

• If marketing a fund, providefund information

GIPS standards


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performance provides moreflexibility, may show fundperformance so long asprospect is eligible to invest

• Need thoughtful / requireddisclosures

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fund information• If marketing a composite

strategy, must provide theappropriate composite’s CP

AUM/Firm Assets

• Form ADV Part 1: RegulatoryAUM (RAUM)

• May use another reasonablemethod for other uses (includingADV Part 2A); may differ fromRAUM

• Must disclose total firm assets as ofeach annual period end

• Total firm assets includes:− All portfolios for which the firm has

conditional or unconditional tradingauthority

− Discretionary and non-discretionary

GIPS standardsSEC


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RAUM

• Discretionary v. non-discretionary assets

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− Discretionary and non-discretionaryportfolios

− Fee-paying and non-fee-paying portfolios

• Total firm assets excludes− Portfolios without trading authority− Model portfolios

• Must not double count assets

Disclosures – RAUM

• Securities Portfolios: mustinclude

– Family or proprietaryaccounts

– No-fee accounts

ADV Part 1 (RAUM)

• Securities Portfolios: mayinclude− Family or proprietary

accounts

Prior ADV Part 1 AUM


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– No-fee accounts

– Foreign accounts

• Cannot deductindebtedness/liabilities

• Continuous and regularsupervisory and managementservices

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− No-fee accountsAccounts of non-US persons

Definition of Firm

• No requirement to disclose

• SEC requires disclaimer inForm ADV 2A if say, “GetRich Advisers, Inc. is an SEC-registered adviser…”

SEC• Must disclose the definition of the

firm in CPs• Becoming more common to

include the SEC disclaimer in CPsand other marketing materials thatmention SEC registration

GIPS standards


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• Disclaimer: SEC registrationdoes not imply a certain level ofskill or training

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mention SEC registration

Supplemental Information

• GIPS term

• If included in marketingmaterials, all SEC guidanceapplies

SEC

• Supplemental information is anyperformance or performance-relatedinformation included as part of a CPthat supplements or enhances therequired and/or recommendedprovisions of the GIPS standards

GIPS standards


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provisions of the GIPS standards

• Must not contradict or conflict withthe GIPS standards

• Must be clearly labeled andidentified as supplemental to aspecific CP

Representative Accounts

• Can raise past specificrecommendation issues

• TCW Group no-actionletter

• No “cherry picking”– Equal number of holdings (at

SEC

• Considered supplementalinformation

• Subject only to therequirement to not present

GIPS standards


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– Equal number of holdings (atleast 5) on each side, plusweight and % contribution

– Objective methodology andconsistent presentation acrossperiods

– Equal prominence

• Disclosures

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requirement to not presentperformance orperformance-relatedinformation that is false ormisleading

Recordkeeping Requirements

• Performance: mustmaintain info to supportperformance calculationsforever

• Other records: varies,generally 5 years for

SEC• Must maintain records to

support all informationincluded in compliantpresentation, includingsupplemental information

• Once information is deleted

GIPS standards


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generally 5 years foradvisers, 6 years for mutualfunds

• Custody statements

– If receive, need to keep

– Paper vs. electronic

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• Once information is deletedfrom a CP, no longer requiredto maintain those records

• But SEC requirements trumpGIPS requirements

Policies and Procedures

• Firms required to adopt andimplement policies andprocedures reasonably designedto prevent violations ofapplicable rules

• Key: policies need to be

SEC

• Firms must document all of theirpolicies and procedures used inestablishing and maintainingcompliance with the GIPSstandards

• Includes ensuring the existence and

GIPS standards


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• Key: policies need to becustomized around firm’s actualbusiness practices

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• Includes ensuring the existence andownership of client assets

• Must apply them consistently

Error Correction - SEC

• No official rule – fiduciary responsibilities and anti-fraudexpectations apply

• Traditional SEC focus on error correction directed towardsinvestment and trading errors


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• In performance advertising context, SEC focus is on anti-fraudprinciples

• Client reporting and disclosure obligations need to be assessed

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Error Correction - GIPS

• Obligation is to provide a CP to all prospective clients:assumption is that the information included in the CP is correct

• Firms must establish an error correction policy to address howto handle errors in CPs and other directly-related materials(e.g., the list of composite descriptions)


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(e.g., the list of composite descriptions)

• Does not apply to other marketing materials, includingadvertisements in which the firm claims compliance followingthe GIPS Advertising Guidelines

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Error Correction

• Duty to discloserestatement? Consider:

– Fiduciary duty

– Anti-fraud provisions

• Self-reporting

SEC

• Material errors must bedisclosed in the corrected CPfor at least 12 months

• Corrected CP (with materialerror disclosure) must be

GIPS standards


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• Self-reportingconsiderations

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error disclosure) must beprovided to all prospectiveclients that received theerroneous CP

Portability

• General principle: Investmentperformance is earned by a firm,not an individual

• Allowable under certain conditions

• Cannot be misleading

SEC• General principle: same as

SEC• Very strict requirements for

being able to port acomposite’s track record froma prior firm and link it to

GIPS standards


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• May encounter record ownershipissues

• Horizon Asset Management no-action letter

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a prior firm and link it toperformance at the new firm

• Unless it is a friendlyacquisition, portability testsprobably will not be met

GIPS Disclosure Requirements inGuidance Statements

Calculation Methodology (Jan. 1, 2011)

• Changes in methodology discloseablewithout regard to materiality

• Treatment of withholding taxes if material

• Policies on valuation, calculation ofperformance and preparation of compliantpresentations available on request (vsadditional information)

Error Correction (Jan. 1, 2011)

• Disclosure of errors – for 12 monthsfollowing correction

• Policies and Procedures on errorcorrection (including errors involvingmissing disclosures)

Performance Portability (Jan. 1, 2011)

• Disclose if ported performance is linked


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additional information)

Composite Definition (Jan. 1, 2011)

• Disclose minimum asset level forinclusion in composite and any changes

• Disclose composite creation date and anyredefinition of composite (and date,description and reason)

• Disclose if ported performance is linked

• Disclose use of sub-advisors and relevantperiods

• Disclose key changes (i.e., changes ofcontrol, key people)

Recordkeeping (Jan. 1, 2011)

• Disclose use of performance despiteunavoidable destruction of backup &reasons why records unavailable


Definition of the Firm (Jan. 1, 2011)

• Disclose definition of Firm

• If multiple subsumed entities, must list

• Date, reasons and description of anyredefinition

• Use of sub-advisers

Fees (Jan. 1, 2011)

Treatment of Carve-Outs (Jan. 1, 2011)

• Disclose percent of composite assetscarved out

Wrap Fee/SMA Portfolios (Jan. 1, 2011)

• Composite with SMA and non-SMAaccounts with additional disclosure

• Disclose that SMA performance includes


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Fees (Jan. 1, 2011)

• Disclose applicable fee schedule

• With gross, whether any fees or expenses(other than trading costs) are deducted

• With net, what fees are netted, if model oractual fees are used, if returns are net anyperformance fees

• Bundled fees

• Disclose that SMA performance includespre-SMA performance (and periods)

• Gross/Net information

• Sponsor specific – if gross, must sayinternal use

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Alternative Investment Strategies and Structures (Oct. 1, 2012)

• Evaluate “need for increased disclosure” of complex strategies

• With new strategy with no appropriate composite, disclose that firm does not currently managethe specific strategy

• Disclose if composite’s valuation hierarchy materially differs from GIPS Valuation Principles

• Disclose use of subjective unobservable inputs for valuing investments if material


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• Disclose use of subjective unobservable inputs for valuing investments if material

• Disclose if pricing has been performed internally

• Disclose if firm opts out of monthly valuations

• For composites with investments that do not lend themselves to monthly valuations and inwhich the underlying fund is open to client cash flows only on a less frequent (e.g., quarterly)basis, disclose that the three-year annualized ex-post standard deviation is not presented for thecomposite (and benchmark if applicable) because monthly returns for the composite(benchmark) are not available

• Disclose if using estimates to fair value and percentage of assets valued using estimates


Alternative Investment Strategies and Structures (Oct. 1, 2012)

• Disclose if a portfolio or fund in the composite creates a side pocket

• Disclose “all significant events” (e.g., events related market, composite or the firm”)

• Disclose “presence, use, and extent of leverage, derivatives, and/or short positions, if material,including a description of the frequency of use and characteristics of the instruments sufficientto identify risks”


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to identify risks”

• Disclose if illiquid securities are a significant part of the strategy or if there is a strategic intentto invest in illiquid investments

• Disclose the benchmark description

• If firm determines that no appropriate benchmark exists, disclose why none is presented

• If firm uses a custom benchmark or combination of benchmarks, disclose the benchmarkcomponents, weights, and rebalancing process

• Disclose if firm presents portfolio or composite performance eliminating “cross-investments”

Questions

Contact information

Steven W. StoneMorgan, Lewis & Bockius [email protected]


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[email protected]

Karyn D. Vincent, CFA, CIPMACA Performance Services503-288-2704, ext. [email protected]

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COMPLIANCE CONFERENCE - Morgan Lewis