Litigated Matter — Nature of Marketing Rule Performance

Background:

• On September 3, 2024, the SEC initiated legal proceedings against a private fund investment adviser, citing multiple violations including failure to register, non-compliance with Form PF requirements, books and records infractions, dissemination of misleading statements, and breaches of the Marketing Rule.¹
• This note will focus on the alleged violations of the Marketing Rule.

Key Facts – Marketing Violations:

• Enterprise Value:
  • The investment manager promoted that the “Enterprise Value of our portfolio has increased by 691% in absolute terms and 82% on a compounded average basis from March 2018 to December 2022.” However, the manager did not retain any documentation substantiating this metric.
  •  The SEC argues that this statement contravenes Rule 206(4)-1(a)(6), which mandates that advisers cannot include or exclude performance results, or present performance time periods, in a manner that is not fair and balanced.
  • Another issue appears to be the lack of clarity on whether the enterprise value growth was presented on a net or gross basis relative to fund investments.
    • Analysis: While this statement lacks substantiation and could be construed as misleading, it is critical to note that enterprise value does not constitute “performance” in the context of SEC regulations. Enterprise value reflects the growth in a corporation’s overall value, which is distinct from the actual investment performance experienced by any particular investor. Consequently, enterprise value cannot be calculated on a gross or net basis relative to a fund’s portfolio. The SEC might have had a stronger case by focusing on the lack of substantiation for this statement rather than treating enterprise value as performance.
• Attribution of Previous Performance:
  • The manager’s marketing materials included a performance table for two companies labeled as “Principal Historical Track Record – Private Companies.” However, the principal was not involved as an investment adviser in these companies but rather served as a manager and board member. The SEC did not challenge the accuracy of the performance data but contended that the principal’s role did not align with that of an investment adviser.
  • The SEC charged this conduct as a violation of Rule 206(4)-8 – prohibition against misleading statements – instead of a violation of the marketing rule.
    • Analysis: The SEC likely refrained from citing the Marketing Rule because their core argument was that the presented performance did not belong to the principal, thus not qualifying as “predecessor performance.” However, this scenario could potentially be classified as hypothetical performance under the Marketing Rule, which might have provided a strong regulatory basis for Marketing Rule claims.

_{¹ SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. BLACK DRAGON CAPITAL, LLC et a.}