Q:

I provide performance reports on the accounts of some of my selected clients to prospective clients. Any information by which a client could be identified is redacted from the performance reports. When I mentioned this to a rep who works at another firm, he told me that it isn't ethical to show the results of selected accounts. I've got to show results from all accounts, assuming they're all scrubbed for identifying information. Is what I'm doing appropriate or not? If not, why not?

A:

Your conduct could be considered fraudulent and misleading: It may violate NASD rules, federal securities regulations [specifically Rule 10b-5], almost certainly your firm's compliance rules, and it potentially subjects you and your firm to civil action, regulatory fines and suspension.

By selecting to include performance information from certain accounts in your report, you create an incomplete — and thus misleading — picture of the total performance of all accounts you advise, control, manage or oversee. Further, you don't say whether the performance reports apply to accounts over which you exercise discretion, whether the account owners have any say in the investment decisions, and whether all accounts engage in transactions at the same time. You also fail to mention whether the performance reported on the different accounts covers identical periods, and whether these numbers have been audited by an independent entity. A strong argument can be made that the absence of any combination of the above factors renders the reports false, misleading and inaccurate.

The starting point for analysis is to define your conduct. By sending “performance reports” to prospective clients, you have engaged in “communications with the public,” governed by NASD Rule 2210. Among the things that qualify as “communications with the public” in Section 2210a is “sales literature,” or any written or electronic communication other than an advertisement, independently prepared reprint, institutional-sales material and correspondence that is generally distributed, or made generally available to customers or the public, including performance reports or summaries.

You mention that you only send performance reports representing the accounts of “select clients.” I interpret this to mean only those accounts with positive results. A reasonable interpretation is that you're using the performance of these accounts to imply that similar future results are likely. Paragraph (d)(2)(N) of the Rule cited above states investment results cannot be predicted or projected. And investment performance illustrations may not imply that gain, or income realized in the past, will be repeated in the future. As a registered broker/dealer and member of the NASD, your firm and you, its registered representative, are subject to all of the requirements in NASD Conduct Rules, including the prohibition on predictions provided in NASD Conduct Rule 2210(d)(2)(N). A strong case can be made that your conduct violates Rule 2210.

Further, if you haven't received written approval prior to sending the performance reports, your conduct may place your firm in violation of its supervisory requirements. In addition, most NASD member firms have compliance manuals that prohibit advisors from distributing their own sales or marketing materials. You'd be well advised to discuss this issue with your compliance principal. I'm confident he'll find sending “performance reports” impermissible.
Jeffrey S. Feinberg
Bernstein Nackman & Feinberg LLP
New York, NY
(212) 748-4800

jfeinberg@bnfcounsel.com

A:

Registered rep marketing efforts are always fraught with pitfalls. Our questioner has, unfortunately, demonstrated this fact to us the hard way, and learned a lesson from a competing rep in the process. The questioner describes his efforts to market to prospective clients by preparing performance reports using results from selected clients, rather than all clients. These performance reports are meant to demonstrate to potential clients that the rep is “doing the right thing” for his or her current clients, and will do the same thing for you — that is, obtain great results. No doubt, these performance reports would show results from the clients who have accounts with positive gains.

Nonetheless, in preparing these performance reports, the rep takes great pains not to disclose any client-identifying information for fear of violating one of the myriad of privacy regulations. (By the way, I have always wondered about these privacy regulations because, to me, it seems it wouldn't make sense for any rep to disclose such client information anyway. Other reps would just try to steal the clients from them!)

The problem is, consider a scenario where a prospective investor relies on the incomplete information in the performance report when deciding to open an account with the rep. Later, let's say the client loses money in his or her account, and discovers (through arbitration proceedings, or, worse, a FINRA or SEC investigation) that the performance report offered by the rep only contained select information. The client will, of course, not be pleased, and will seek to recover losses from the rep. As described above, there is also a possibility that FINRA or the SEC may investigate the use of incomplete performance reports. The rep, most assuredly, does not want to be involved in such an investigation.

There are two additional considerations that must be made when a rep is preparing and using these kinds of performance reports for marketing purposes. For one, even before distributing complete performance reports, the rep should indicate — in proper type, and in an easy to find place — that the reports are based on past performance, and not indicative of future results. Similarly, the rep should be aware that any communication with a client, or potential client, must be vetted and approved by the compliance department at the rep's firm before it is distributed to the public. If the compliance department approves the performance report, the rep will be on solid ground if anyone should question its contents.

In sum, all is not lost. The rep may still use these performance reports to solicit new clients, provided the rep uses all of his or her clients' results, discloses that such information is not reflective of future results, and obtains approval from his or her firm.
Ernest E. Badway
Saiber Schlesinger Satz & Goldstein, LLC
New York City
212-461-2323

eeb@saiber.com

Encounter a situation at work that makes you uncomfortable? Hesitant to change firms because you're unclear how your clients could be affected? Don't fret. Send your questions to Registered Rep. Contributing Editor Ann Therese Palmer at at.palmer@penton.com. Then look for an answer in a future Ethical Rep column. Anonymity guaranteed.
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at.palmer@penton.com