The U.S. Circuit Court of Appeals for the District of Columbia recently denied a petition to review an order of the Securities Exchange Commission (“SEC”) imposing sanctions against Raymond J. Lucia and investment adviser Raymond J. Lucia Companies, Inc. (“Lucia Companies”) for violations of the Investment Advisers Act of 1940 and the advertising rule thereunder, Rule 206(4)-1. In denying the motion, the DC Circuit affirmed the SEC’s broadened views on the use of back-tested performance in marketing and advertising materials.
As discussed previously, this case involves the improper use by an investment adviser of back-tested performance data in retirement-planning seminars. Raymond J. Lucia, and Lucia Companies allegedly used a hypothetical inflation rate that was lower than actual historical rates to make their performance results more favorable. In addition, the performance data allegedly failed to reflect the deduction of advisory fees and was not calculated in a manner fully consistent with the advertised investment strategy. As a result, the SEC barred Raymond J. Lucia from the securities industry and imposed civil penalties of $300,000.
In appealing the SEC’s order, the petitioners argued that the SEC’s entire case against them was based on the premise that they misled investors by describing their investment strategy performance data as “back-tested” when at the time there was no settled meaning of the term “back-tested.” Petitioners argued that the term “back-tested” did not necessarily imply that the analysis would only use historical data, and that the SEC’s position that performance data labeled “back-tested” must be historically accurate and cannot contain any assumptions was a new position. The petitioners argued that they were free to use a mixture of historical data and assumptions in data that was labeled as “backtested.” The petitioners also pointed to disclaimers accompanying their performance data which disclosed that their particular “back-tested” data included some hypothetical assumptions.
The D.C. Circuit Court of Appeals disagreed, finding that the SEC properly found the petitioners’ presentations to be materially misleading. Firstly, the investment strategy performance data was labeled as “back-tested” when it relied on hypothetical assumptions regarding inflation rate and the rates of return of certain investments. In addition, the performance data was not fully consistent with the advertised investment strategy as it did not implement the key feature described by the petitioners in other parts of the advertising as “rebucketizing,” or shifting assets from riskiest buckets of assets to safer buckets of assets once safer buckets of assets were spent.
The Court agreed with the SEC that the term “back-test” typically refers to the use of historical, not assumed, data. In addition, here petitioners had not only used the term to describe their performance data, but had also illustrated how their investment strategy would have performed in different historical time frames had investors used their investment strategy. Thus, even though the presentation contained disclaimers that some assumptions were being used in the “back-tested” data, it did not alter the overall impression that the data was fully “back-tested.” Ultimately the Court agreed with the SEC that these actions were materially misleading to investors.
Lastly, the petitioners argued that the sanction of a lifetime industry bar was extreme. The SEC found that such a bar was in the public interest and necessary to protect the trading public from further harm given petitioners’ egregious and recurrent misconduct. The D.C. Circuit Court of Appeals agreed with the SEC, finding that petitioners had repeatedly violated their fiduciary duty and made these misstatements at dozens of seminars. In addition, such behavior could be expected in the future given petitioners’ failure to recognize the wrongful nature of their conduct. Therefore, the Court upheld the SEC’s lifetime industry bar sanction and denied the petition for review.
This case demonstrates that the SEC has expanded its views on the use of back-tested performance in marketing and advertising materials by adding additional parameters not seen in prior SEC enforcement actions involving back-tested performance data such as In re Schield Management Company, In re Meridian Investment Management Corp., In re LBS Capital Management, Inc., and In re Patricia Owen-Michel. The term “back-tested” will generally be implied to mean that the performance data was calculated using actual historical data, without any hypothetical assumptions. General disclaimers of hypothetical assumptions will not alter this overall impression, particularly when coupled with historical illustrations of how the investment strategy would have performed in different time periods. Lastly, back-tested performance data should be calculated in a manner fully consistent with the advertised investment strategy.
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