Misleading Sales Literature & The Investment Company Act of 1940

Instructor: N. Faye Angel

Faye has taught college classes in Business and Information Systems programs, and has a Ph.D. in Technical Education and an M.B.A. in Business Administration.

The Investment Company Act of 1940 was passed to provide protection for investors purchasing mutual funds. Rule 34b-1 defines regulations for misleading sales literature for securities. Learn more in this lesson.

The Investment Act of 1940

Say you've been hired as a financial manager of a casino. You want to invest $120,000 of surplus cash in mutual funds, but as this is your first big purchase, you want to be aware of any advertised falsehoods so you don't lose these funds. The focus of gathering information is the truthfulness of the sales literature, as it can be deceptive and inaccurate.

The Investment Company Act of 1940 was created to provide a level of protection for those who invest in certain investments, especially mutual funds (worth trillions of dollars) to mitigate losses of their funds. Disclosure of any issues that might be material to investment decisions is necessary to provide truthful information and a comprehensive picture.

Regulations of retail securities is the target of The Investment Act. It functions as a body of regulations for investment companies and their activities, and applies to those registered with the Securities and Exchange Commission (SEC). The Act has frequently been amended, including being reinforced with the Dodd-Frank Act in July, 2010.

Rule 34b-1: Misleading Sales Literature

Rule 34b-1 specifically addresses supplemental sales literature that is considered misleading and is disseminated to potential investors. This includes formats such as any advertisement, circular, pamphlet, form letter, or other sales literature. Misleading sales literature has been extended to include electronic media, i.e., slide shows, telemarketing scripts, and speeches.

One of the most significant rules relates to misrepresenting performance data, which relies on past or historical performance. Unfortunately, many investment companies 'hand-pick' what they advertise in their sales literature, which can result in deceptive claims. Care should be taken to provide the investor with correct information, not omit necessary facts, and avoid making false statements.

The fund offered, underwriter, or dealer of security obligations must remain in compliance with Rule 34b-1 based on the anti-fraud requirements of federal laws. The Securities Exchange Commission (SEC) enforces Rule 34b-1 under section 24(b) of the Security Exchange Act of 1934.

Legislation of Investment Company Act of 1940

In the 1930s, new securities such as mutual funds were fledgling, and with the Crash of '29, regulations were needed to protect investors and the public. The need for protection increased throughout the decades as individuals invested their money, which was pooled and invested in mutual funds.

Individuals are small investors, and often do not know where an investment company put their money. So the importance of disclosure in sales advertising is a priority and does not remain confidential.

Misleading Sales Literature Example

Let's take a look at an example of misleading sales literature with violations partially based on Rule 34b-1.

In January 2014, the SEC brought charges against Mark A. Grimaldi and Navigator Money Management (NMM) for distributing misleading, or false, sales advertising literature for their mutual funds. These included, in abridged form:

  • selectively presenting favorable performance data that didn't provide an accurate picture of the security,
  • putting out sales literature via social media and newsletters that made misleading statements on the success of its mutual funds,
  • selecting a partial period for returns (favorable to the company) to claim that its funds were ranked first out of 235, but 100 mutual funds had outperformed its securities,
  • claiming in newsletters, on its website, and in e-mails that it had received a 5-star rating from Morningstar as a money manager, but Morningstar only rates investment funds, and
  • Grimaldi making inaccurate claims that his portfolios, in the last 10 years, had doubled in comparison to the S&P 500.

Without admitting or denying these charges, Grimaldi agreed to pay a fine of $100,000 and NMM agreed to other restrictions.

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