Published on:

Performance Fantasies Lead to SEC Enforcement Action


Written by:  Jay B. Gould

On June 21, 2013, the Securities and Exchange Commission (“SEC”) entered a cease and desist order (technically called an “Order Instituting Administrative and Cease-and-Desist Proceeding”) against the former President of Stanford Capital Management, Jason A. D’Amato.  You may read the full SEC Order here.  Because this case is part of the broader case of former knight turned Ponzi purveyor, Allen Stanford, it would be easy to dismiss this order as an outlier and not readily applicable to other investment advisers and fund managers.  That would be a mistake.  The D’Amato Order provides useful insight into the SEC’s concerns with the use and misuse of hypothetical and back tested performance information as well as certain compliance failings that all fund manager should understand and appreciate.

To briefly summarize the facts, in 2000, Stanford began offering a mutual fund allocation program to its advisory clients.  D’Amato was hired in 2003 as an assistant analyst to track performance and create personalized pitchbooks for use by Stanford financial advisers in one-on-one presentations with prospective clients.  D’Amato calculated the performance returns for each strategy by back testing then existing allocations in each strategy against historical market data for the previous five years (i.e., if a client held a particular allocation of mutual funds from 2000 through September 2004, the pitchbook showed how it would have performed).  The pitch materials all contained charts showing the performance of each strategy dating back to 2000 with charts variously labeled “Hypothetical Performance,” “Hypothetical Historical Performance,” or “Model Performance.”  Amazingly enough, the back tested performance outperformed the index as well as actual performance in every strategy and, in some cases, by substantial margins.  In fact, the numbers were so skewed that the financial advisers who had to use these materials in front of prospective clients began complaining to Stanford management because none of their clients had ever achieved the returns disclosed on the performance charts.  So, Stanford hired an outside consultant to come in and verify the numbers, or not. 

For at least 2005 and 2006, the consultant concluded that: (i) actual returns earned by Stanford clients were, in most cases, hundreds of basis points lower than the returns published in the pitchbooks; and (ii) D’Amato and his team of analysts did not keep sufficient records to show contemporaneous changes in each of the Stanford strategies prior to 2005, so the consultant could not verify the advertised performance numbers before 2005.  But no problem, even though performance data for 2000 through 2004 could not be verified, Stanford management chose to continue using those figures in the pitchbooks using terms like “historical performance” to describe numbers for which no backup existed.  Additionally, the unaudited and unverified “data” was blended with other audited and composite data from different time periods and then published alongside actual performance.  You might think that crafting appropriate disclosures or disclaimers that would make this potpourri of numbers understandable to clients would be difficult or even impossible.  Apparently, so did Stanford because they decided not to include any.    

During this time, D’Amato began holding himself out to coworkers, clients, prospective clients, financial advisers, and others as a Chartered Financial Analyst (“CFA”).  Sadly, D’Amato was not, and had never been, a CFA and, in fact, he had failed the CFA Level I exam the first and only time that he took it.  Not to be deterred by minor details, D’Amato used the CFA designation in his e-mail signature block on thousands of e-mails and on his business cards.  He also fabricated an e-mail that he purportedly received from the CFA Institute that congratulated him on passing the Level III CFA exam and on achieving charterholder status.  D’Amato then passed that e-mail to Stanford’s human resources department, which in turn passed it along to Stanford’s compliance department which in turn threw him a party, or at least did not verify the authenticity of the “CFA” e-mail.  And what does this behavior get you in the near term?  Sir Allen Stanford was so impressed by how carefully D’Amato polished up the handle, that he was promoted to President of the Stanford investment adviser.  Simply by using totally bogus performance numbers and misrepresenting his qualifications and background, D’Amato increased assets under management from less that $10 million in 2004 to over $1.2 billion by the end of 2008, generating $25 million in management fees in 2007 and 2008.  And then Sir Allen’s Ponzi scheme came crashing down, taking D’Amato in its wake.

For fund managers and investment advisers, there are a number of takeaways from the D’Amato case.  First, when back tested or hypothetical “performance” is used in marketing materials, full and accurate disclosure must be made to investors and potential investors.  The methodology used must be sound and records must be kept.  Similarly, with respect to actual performance, calculations must be accurate and verifiable and must be presented in a context that does not make otherwise accurate information misleading in any material way.  Fund managers, in particular, should not dismiss the D’Amato case because it occurred in the context of mutual funds and more “retail” type investors.  The SEC and state regulators are willing to go back and look at past marketing presentations for inflated or inaccurate claims, all of which are required to kept as part of an adviser’s books and records.

For compliance personnel, remember, you have personal liability under Rule 206(4)-7 under the Investment Advisers Act of 1940 for the proper administration of the firm’s compliance policies and procedures.  Verifying past educational accomplishments, and confirming duties, titles, and responsibilities at former employers of advisory personnel is a basic function of the compliance role.  Even if the employee is the president of the organization, and especially if this particular executive officer ordered or condoned the use of misleading marketing materials after other employees complained about them.

The consequences to D’Amato for his role in this scheme is also worth noting.  D’Amato was fined $50,000, but more importantly, he was barred from the industry for five years and must apply to the SEC for the ability to associate with an investment adviser, broker dealer or any other regulated entity at the conclusion of that bar, should he believe that he has a future in the securities business.