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From Securities Regulation Daily, October 2, 2015

Dissenting commissioners rip backtesting requirements spun 'from whole cloth,' would defer to courts on ALJ issue

By John M. Jascob, J.D., LL.M.

SEC Commissioners Daniel Gallagher and Michael Piwowar have taken the Commission to task for creating “from whole cloth” specific requirements for advertisements by advisers that include the word “backtest.” In a strong dissent to the SEC’s opinion in the action against Raymond J. Lucia Companies, Inc., the commissioners chided the majority for finding that the backtesting of the results represented in the respondents’ advertisements constituted a fraudulent practice because the backtest failed to use historical inflation rates. The dissenters also wrote, without elaborating, that the federal courts should be the ultimate arbiters of whether the administrative law judge overseeing the proceeding was appointed in a manner consistent with the Constitution (In the Matter of Raymond J. Lucia Companies, Inc., October 2, 2015).

Buckets of Money. The dissent acknowledged that the misdeeds of the respondents were well established. The respondents had pitched their investment advisory services to the public by touting a re-balancing strategy called “Buckets of Money,” which they claimed would produce superior results when compared to certain other retirement portfolio strategies in a sharp market decline, such as in 1973, or in a period of long stagnation, such as occurred between 1966 and 1982.

The Commission found, however, that the respondents: (1) did not actually use the “Buckets of Money” approach in determining the results for the 1973 and 1966 scenarios; and (2) could not even re-construct their supporting calculations with respect to the calculations for the 1973 scenario. Accordingly, the Commission upheld the ALJ’s findings that the company misled investors about its investment strategy in violation of the Advisers Act. The investment adviser registration of Raymond J. Lucia Companies was revoked, while owner Raymond J. Lucia, a 40-year veteran of the securities industry, was barred from associating with an investment adviser or broker-dealer. In addition, the Commission imposed civil penalties of $250,000 on the company and $50,000 on Lucia.

Rulemaking by opinion. If the Commission had stopped there, the dissenters stated, the opinion would have been easy to support. Instead, the Commission needlessly engaged in “rulemaking by opinion” by also finding that the respondents’ use of the word “backtest” and assumed inflation rates was misleading because the backtest failed to use actual historical rates — even though their slideshow presentation specifically disclosed the use of assumed rates for certain components. The Commission made this finding despite the lack of any statutory or regulatory definition of what constitutes a “backtest,” the dissenters noted.

In the dissenters’ view, it was appropriate to use a consistent, assumed inflation rate when comparing the results among portfolio strategies to illustrate how inflation can affect retirement savings. Moreover, they found “troubling” the majority opinion’s holding that, notwithstanding the disclosure that the scenarios were determined using an assumed three percent inflation rate, the slideshow presentation was nonetheless fraudulent because a backtest must use historical inflation rates.

Although the majority opinion emphasized the testimony of witnesses who thought that the backtests in the slideshows used actual historical inflation rates, the dissenters pointed out that the test for materiality is an objective test of the reasonable investor. Given the clear disclosure of the inflation rate assumptions in the slideshow presentation, a reasonable investor would not have believed that actual historical rates of inflation were used in the backtests, the dissenters stated.

Constitutional challenge. Much of the interest in the SEC’s enforcement action against Lucia and his company had focused on the respondents’ challenge to the Commission’s appointment of the administrative law judge overseeing the proceeding. The respondents had argued that the administrative proceeding against them was unconstitutional because the administrative law judge, Cameron Elliott, was an “inferior officer” who was not properly appointed under the Appointments Clause contained in Article II of the Constitution. The majority of commissioners flatly rejected this argument, reasoning that Elliot was an "employee," and that Article II does not apply to the SEC’s employee ALJs.

The dissenters stated that the respondents had “raised important issues” with respect to the constitutionality of Elliot’s appointment. Although noting that the Commission is free to express its views on Constitutional issues, Gallagher and Piwowar nevertheless believe it is appropriate that Article III federal judges ultimately resolve the issue. Perhaps following their own advice, however, the dissenters declined to elaborate further, leaving the constitutional battle to continue before the federal judiciary.

Companies: Raymond J. Lucia Companies, Inc.

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