Alert May 14, 2013

FINRA Staff Provides Guidance on Use of Pre-Inception Index Performance Data in Institutional Communications

The staff of FINRA issued an interpretive letter providing guidance (the “Guidance”) regarding the use of pre-inception index performance data (“PIP Data”) in communications regarding certain publicly traded securities structured as exchange traded notes, grantor trusts or registered investment companies (“Exchange Traded Products”) distributed solely to “institutional investors” as defined in FINRA Rule 2210(a)(4) (“Institutional Investors”).  The requesting firm markets passively managed Exchange Traded Products based on newly created indexes that have been developed according to pre-defined rules that cannot be altered except under extraordinary market, political or macroeconomic conditions.  PIP Data models the performance of such an index had it existed prior to the inception of the index.  It has been FINRA’s long-standing position that the presentation of hypothetical back-tested performance data in communications with retail investors does not comply with FINRA Rule 2210(d) and its predecessor NASD rule, and FINRA noted that this interpretation, applicable only to Institutional Communications (as defined below), does not change that position.

Institutional Investor.  FINRA Rule 2210(a)(4) defines an Institutional Investor as any: (i) bank, savings and loan association, insurance company or registered investment company, a federal or state registered investment adviser, or any other person with total assets of at least $50 million, (ii) governmental entity or subdivision thereof; (iii) certain employee benefit plans with at least 100 participants that meet the requirements of Section 403(b) or Section 457 of the Internal Revenue Code; (iv) qualified plans (or multiple qualified plans offered to the employees of the same employer), as defined in Section 3(a)(12)(C) of the Exchange Act that in the aggregate have at least 100 participants; (v) a FINRA member or registered associated person of such a member; and (vi) person acting solely on behalf of any such “institutional investor.”

Institutional Communications.  FINRA Rule 2210 subjects any written (including electronic) communication (with the exception of a member's internal communications) that is distributed or made available only to Institutional Investors  (“Institutional Communications”) to certain content and supervision standards.  Under these standards, each FINRA member firm must establish written procedures appropriate to its business, size, structure, and customers that provide for the review by an appropriately qualified registered principal of Institutional Communications used by the member and its associated persons.  These procedures must be reasonably designed to ensure that Institutional Communications comply with applicable standards (as set forth in FINRA rules), which generally require that Institutional Communications must be fair and balanced, must provide a sound basis for evaluating the facts in regard to any particular security, and may not omit material information, include false, exaggerated, or misleading statements, or misstate material fact.

Conditions to Use of PIP Data.   The Guidance states that FINRA staff believes that the use of PIP Data in Institutional Communications is not prohibited if certain conditions described in the Guidance are met.  Among these conditions are the following: (i) PIP Data may be used only to market a passively managed Exchange Traded Product; (ii) each Institutional Communication containing PIP Data must be clearly labeled “For use with institutions only, not for use with retail investors”; (iii) PIP Data may be used only if it relates to an index created according to a pre-defined set of rules that cannot be altered except under extraordinary market, political or macroeconomic conditions index (an “Underlying Index”); (iv) Institutional Communications containing PIP Data must offer to provide the rule set or methodology of the Underlying Index upon request and any electronic marketing material must include a hyperlink to such information; and (v) PIP Data will not be inconsistent with information in an Exchanged Traded Product’s prospectus (but may be used even if the prospectus contains no PIP Data).  The Guidance also sets forth certain content requirements for Institutional Communications that include PIP Data, including criteria relating to the time periods presented, the currentness of PIP Data, and the presentation of PIP Data in relation to performance data of the Exchange Traded Product.

The Guidance states that any Institutional Communication containing PIP Data must include statements advising the Institutional Investor that (i)  the Exchange Traded Product is a new product, and any performance of the Underlying Index prior to the date of inception of the index is hypothetical; (ii) the PIP Data results are based on criteria applied retroactively with the benefit of hindsight and knowledge of factors that may have positively affected its performance, and cannot account for all financial risk that may affect the actual performance of the Exchange Traded Product; and (iii) actual performance of the Exchange Traded Product may vary significantly from the PIP Data.  The Institutional Communication must also disclose (a) any known reasons, such as, assumptions regarding transaction costs, liquidity, or other market factors, why the PIP Data would have differed from actual performance during the period shown; and (b) if the sponsor of the Exchange Traded Product pays an index provider to produce the PIP Data, that arrangement and the identity of the index provider.

Whether to Use PIP Data.  The Guidance provides guidance to members regarding the factors that FINRA staff believes should be considered in determining whether the use of PIP Data is consistent with the content standards of FINRA Rule 2210.  Among other things, the Guidance notes that in determining whether the use of PIP Data in an Institutional Communication is appropriate a member must consider its suitability obligations under FINRA Rule 2111 with respect to making recommendations to Institutional Investors.  In this regard, the Guidance states that the firm must be careful to not give excess weight to PIP Data, and to the extent PIP Data informs the firm’s understanding of the security and its performance characteristics, the firm must consider the correlation between PIP Data and actual performance for similar Exchange Traded Products managed by the sponsor, investment adviser or index provider.

Additionally, the Guidance identifies the following specific factors that a member should consider in determining whether PIP Data should be used in Institutional Communications:

  1. The assumptions, rules and criteria used to create the PIP Data, in sufficient detail as to permit the firm to clearly understand how the PIP Data could be replicated, using readily-available market data;
  2. The reputation of the entity that created the PIP Data, and if the sponsor of the Exchange Traded Product paid for creation of the model, how any material conflicts of interest have been addressed or mitigated;
  3. The conditions under which the PIP Data may not be effective in predicting how the Exchange Traded Product may perform (e.g., very low or high interest rate environments);
  4. The source of the data used to produce the PIP Data;
  5. The extent to which the PIP Data has been tested under varying market conditions and scenarios, based on both an analysis of historical data and simulations or stress tests; and
  6. Any reasons why the PIP Data would have differed from actual performance of the Exchange Traded Product during the period shown (e.g., transaction costs, market liquidity).