11th Circuit Rejects SEC Finding That Misstatements Are Material Despite Disclaimers

“Sunlight is said to be the best of disinfectants” according to Justice Lewis Brandeis. That theme has long been one of the pillars of federal securities regulation. The point was recently emphasized in an action involving an investment adviser who made misleading statements but in one instance was saved from his error by timely and specific risk disclosures. ZPR Investment Management Inc. v. SEC, No. 16-153263 (11th Cir. Decided June 30, 2017).

Registered investment adviser ZPR Investment was founded by its now president and sole shareholder, Respondent Max Zavanelli in 1994. To enhance the reputation of his firm, Mr. Zavanelli had it adopt the Global Investment Performance Standards or GIPS. Adoption of the voluntary standards assures investors that the presentation of investment performance is based on full disclosure under specified requirements that permit an “apples to apples” comparison among firms. This is because those permitted to claim GIPS compliance must comply with specific standards of disclosure regarding performance and advertising. The former specifies how the firm must calculate and present its performance metrics. The latter requires the firm to disclose specific information about the firm –period to date performance results and either 1, 3 and 5 year cumulative annualized composite returns or five years of annual composite returns.

Beginning in early 2008 the adviser placed advertisements in financial magazines claiming to be GIPS compliant. Consultant Ashland Partners & Company LLP was hired to assure compliance. These claims were considered important by Mr. Zavanelli in marketing institutional clients. More advertisements claiming GIPS compliance were taken out in the fall of 2008.

While those published in the spring of 2008 were in fact GIPS complaint, those in the fall were not. If the fall ads had been GIPS complaint they would have shown that the firm’s performance lagged behind its benchmark index by as much as 10%. Ashland had reviewed and approved the ads for the early part of the year but not those for the fall. Mr. Zavanelli dismissed concerns raised by the firm’s operations manager about the failure of the fall ads to meet the compliance standards by noting that the disclosures in the fall ads were for a longer period that specified by the GIPS standard. That longer period showed the firm outperforming its benchmark index.

Mr. Zavanelli also published a newsletter. In the April and December 2009 editions he wrote that the firm was GIPS compliant. Although Ashland had reviewed with him the requirements for compliance, neither edition of the newsletter met the standards. The December edition contained disclaimers, however. Those stated in part that the “investment report you are reading is not GIPS compliant. It was never intended to be nor can it be. . . Our report remains not GIPS compliant.”

Following an inspection, in early 2010 the SEC staff informed the adviser in a letter that while its December 2008 advertisement claimed GIPS compliance, it was not. The staff sent a second letter in August noting that an investigation was being conducted. Despite these letters in furnishing Morningstar information in August 1010 and later in March 1011 for reports a firm employee responded “no” to a question about whether the adviser was under investigation. The firm continued to publish ads in early 2011 claiming GIPS compliance when it was not, despite assurances to the SEC staff that it would make sure all ads were in fact compliant.

The Commission instituted an administrative proceeding against the firm and its founder, charging violations of Advisers Act Sections 206(1),(2) and (4). Ultimately the Commission concluded that the firm had violated each of the Sections based on the fall 2008 and spring 2011 magazine adds, the 2009 newsletters and the 2011 Morningstar report. It also found that the firm violated Advisers Act Sections 206(2) and (4) as to the 2010 Morningstar report. Mr. Zavanelli was determined to be liable for all of the misrepresentations regarding GIPS compliance in violation of Advisers Act Sections 206(1) and (2) and for aiding and abetting the violations by the firm. The agency found him not liable for the misrepresentations in the Morningstar reports which had been made to the reporting agency by an employee of the adviser. The Commission imposed a cease and desist order on both Respondents, an industry bar on Mr. Zavanelli, and a civil penalty of $575,000 on him and $250,000 on the firm.

In considering the Petition for Review sought by the Adviser and its founder, the Eleventh Circuit granted in part and denied in part. Specifically, the Court vacated the violations and monetary sanctions regarding the December 2009 news letter but affirmed the other violations and sanctions in the Commission’s order.

The Adviser and its Founder challenge the Commission’s findings on two points. First, they argued that any misstatements were not material in view of the total mix of information available. Second, they claim that the findings of scienter were not supported by substantial evidence.

The question of materiality is determined at the time of the alleged misstatement, the Circuit Court noted. In this case, with one exception, there can be no doubt that the misstatements regarding compliance with the GIPS standards were material. Compliance with those standards is important to the reasonable investor as the Commission found. The point is bolstered by Mr. Zavanelli who had concluded that GIPS compliance would enhance the firm’s marketing, particularly with institutional investors. This is because compliance with GIPS gave potential investors a ready frame of reference to do an “apples to apples” comparison among advisers. Representing that the information furnished was GIPS compliant when in fact it was not directly undercut the very purpose of the standards. The discrepancy here is “something a reasonable investor would consider important,” the Court concluded (internal quotations omitted).

Petitioners’ claims that the information was later furnished to the investors and that it was available on the adviser’s website do not change the misleading nature of the statements. When potential investors read the statements the later supplied information was not available; there was no cross-reference to the website. The “problems caused by a false ad cannot be cured by passing along corrected information to the very customers the company attracted through the misinformation in the first place,” according to the Circuit Court. Indeed, the “mere availability” of accurate information does not negate inaccurate statements.

The December 2009 newsletter is different. There on the page after the misleading statement investors were specifically told that the report was not GIPS compliant. The disclaimer went on to note that the report was never intended to be GIPS compliant. This rendered the initial false claim immaterial. While general cautionary language or boiler plate would not suffice, in this instance the disclaimer was clear and unequivocal, addressing the exact question of GIPS compliance. Accordingly, the Court reversed the Commission’s determination on this point.

Finally, the Court rejected the claim that substantial evidence did not support the Commission’s findings regarding scienter. The evidence demonstrates that as to the ads and news letters the adviser and its founder were aware of the misstatements and permitted them to stand. This is highlighted by the fact that in one instance different metrics were used other than those permitted by GIPS specifically to conceal an unfavorable trend. Accordingly, the Court rejected this claim as it did Petitioners’ other contentions.

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