By JAMES R. HEDGES, IV, PARTNER, AND CHARLOTTE LUER, PARTNER, LJH FINANCIAL MARKETING STRATEGIES, AND LUCINDA O. MCCONATHY, PARTNER, AND PATRICIA C. O’PREY, PARTNER, RICHARDS KIBBE & ORBE LLP
Marketing a hedge fund involves a myriad of considerations, including compliance not only with the regulatory requirements and restrictions of the jurisdiction in which the hedge fund is domiciled, but also the requirements and restrictions of each jurisdiction in which the fund’s target investors live. Here, we address the status of hedge fund regulation in the United States, with a particular focus on its implication for hedge fund marketing efforts.
Regulation of Hedge Fund Marketing
In order to avoid the requirement to register their securities under the Securities Act of 1933, hedge funds must be sold via a private placement. In most instances, as stated in SEC Rule 502(c), such privately placed funds may not be offered or sold “by any form of ‘general solicitation’ or ‘general advertising,’” including, but not limited to, the following:
- Any advertisement, article, notice, or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; or
- Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising
Limited by these restrictions, hedge funds may wonder how to market their funds. Below, we offer some suggestions based on prior SEC statements and based on guidance provided by the NASD (now FINRA, the Financial Industry Regulatory Authority) to its members in setting forth guidelines for marketing hedge funds.
Limited Audience for Solicitations
First and foremost, although the SEC has not defined the terms “general solicitation” and “general advertising,” it is clear that solicitations provided to a general audience will run afoul of Rule 502(c). Indeed, the SEC has indicated that it believes the following actions violate Rule 502(c):
- Mass mailings;
- Speaking to the media referencing an investment currently offered or contemplated, particularly where the discussion is an attempt to “condition the market” by making reference to the success or attractive return of previous investments; and
- Print, radio and television advertisements or solicitations regarding funding or investment matters. Accordingly, hedge funds should limit the audience from which they solicit investments, preferably to individuals or entities with which they have a pre-existing relationship. Even in the potentially fruitful situation of participating in an investment forum, hedge fund advisers should take care that the attendees are limited to accredited investors and, preferably, to investors with whom the advisers have a pre-existing relationship.
FINRA Guidelines Regarding the Content of Solicitations
In 2003, FINRA studied hedge fund marketing materials and then issued guidance for member firms in the form of a member update regarding the marketing of hedge funds by its members. FINRA maintains this general guidance today. Although this guidance does not apply directly to hedge funds, it provides a useful framework for hedge fund marketing materials. In reviewing member marketing of hedge funds, FINRA found that some examples of hedge fund sales literature included “unbalanced presentations about the particular hedge funds being offered” and, therefore, failed “to provide investors with a sound basis for evaluating whether to invest in the funds.”
NASD Member Update October 9, 2003, NASD Review of Hedge Fund Advertising Results in Formal Action. FINRA’s review identified four general areas of concern in hedge fund advertising: (i) risk disclosure; (ii) misleading and exaggerated language; (iii) performance; and (iv) general solicitations. We address these areas below.
According to the guidance, hedge fund promotional materials must be a balanced, fair presentation of the risks and potential disadvantages of hedge fund investing. Communications regarding hedge funds and funds of hedge funds must adequately disclose the risks associated with these products. Presentations must address the risks associated with hedge funds in general, as well as the specific risks associated with the fund being offered including, but not limited to, the risks associated with a fund’s structure, investment strategies, portfolio securities, tax treatment, etc. For example, members must balance sales material or oral presentations that promote the advantages of hedge fund investing with full disclosure of the risks that hedge funds present, including the fact that hedge
- Often engage in leverage and other speculative investment practices that may increase the risk of investment loss;
- Can be highly illiquid;
- Are not required to provide periodic pricing or valuation information to investors;
- May involve complex tax structures and delays in distributing important tax information;
- Are not subject to the same regulatory requirements as mutual funds; and
- Often charge high fees
NASD Notice to Members 03-07, NASD Reminds Members of Obligations When Selling Hedge Funds. In addition, it may also be advisable to highlight to potential investors the fact that a hedge fund investment may not be suitable for all investors and, in particular, to suggest that it is suitable only for the most sophisticated investors. Indeed, some FINRA comments have called for disclosure of accredited investor requirements in hedge fund marketing materials.
Hedge fund managers should restrict discussions of performance results to actual performance of the fund being promoted. FINRA has noted that some marketing materials contain language that states or implies that an investor can expect a specific rate of return from investing in a fund. Such projections or predictions of investment results are prohibited. Generally, funds should be very cautious about forward-looking statements with respect to securities investments. Moreover, where a fund has experienced a period of extraordinary performance, disclosure of the reasons for extraordinary market performance, and the fact that such performance may not be repeated in the future, is advisable.
New funds need to be particularly cautious regarding their marketing materials because any attempts to attribute the performance of another product to a new fund that has either a limited operating history or no operating history may be misleading.
Misleading or Exaggerated Language
In its first Compliance Alert letter to the chief compliance officers of registered firms, the SEC staff stated the most common deficiency in adviser advertising was that “many” advisory firms did not include in the advertisements of their performance returns the disclosures necessary to prevent their advertising from being misleading. For example, firms did not:
- Deduct advisory fees from performance results;
- Disclose whether results reflected dividends; or
- Disclose differences with the particular index being used to benchmark performance claims.
FINRA’s Member Conduct Rule inherited from the NASD provides that no material fact or qualification may be omitted from marketing materials if the omission would cause the communication to be misleading. In the context of hedge funds, FINRA generally considers the disclosure of the inherent and particular risks of an investment, investment strategy or underlying assets, liquidity restrictions, withdrawal rights and fees and performance fees and charges to be material. Thus, performance calculations should be presented net of the fees charged. If the performance description is not calculated net of fees charged, the fees to be deducted must be disclosed, along with a disclosure that the funds’ performance would be lower if the fees were deducted.
Performance presentations should also illustrate downside volatility and should not highlight only successful investments or reporting periods with positive results. Note that providing a prospectus does not satisfy the duty to provide balanced sales materials and oral presentations. Exaggerated, unwarranted or misleading statements or claims are prohibited. Typically, the use of superlatives in the description of the fund or its performance is not advisable. The use of objective language to describe the fund’s performance is advised.
FINRA noted particular deficiencies within marketing materials:
- Make unbalanced presentations about the particular hedge funds being offered;
- Contain exaggerated, unwarranted or misleading statements or claims, unwarranted forecasts or projections of future performance;
- Refer to a hedge fund as an “ideal fund for conservative investors” when the fund had a limited operating history, was speculative and involved a high degree of risk; indicate that hedge funds are subject to regulatory oversight;
- Present hypothetical results for specific hedge funds that had limited operating history or no operating history;
- State that a fund’s objective is to produce a steady or predictable return when, in fact, the fund’s prospectus did not disclose such an objective;
- Use language that states or implies that hedge funds or funds of funds are appropriate for all investors or should be part of all investors’ portfolios: and
- State or imply that an investor can expect a specific rate of return from investing in a fund.
Best Practices Noted by the SEC
Recently, the SEC’s Office of Compliance Inspections and Examinations (OCIE) offered examples of policies and procedures in place at the firms with fewer performance advertising deficiencies. Such policies include:
- A multi-level review process among an adviser’s performance group, portfolio managers, and marketing group for the accuracy of marketing materials prior to their use;
- The creation of “tolerance reports” on a monthly basis to compare all composite accounts to their respective benchmarks, with any material discrepancies being investigated;
- A composite committee review of all accounts on at least a quarterly basis to ensure proper composite construction and maintenance; and
- The use of a second independent pricing service to periodically verify the accuracy of prices supplied by the primary pricing service, with any material discrepancies in prices being investigated.
In summary, we recommend:
- Targeting solicitations to individual potential investors or to a discrete group of accredited investors, preferably already known to the hedge fund adviser;
- Disclosing the risks and potential disadvantages of a hedge fund investment, as well as particular risks involved in investing in the particular fund at issue;
- Restricting discussions of performance to actual past performance, net of fees charged; and
- Disclosing statutory investor-eligibility requirements.
These marketing recommendations must be understood against the broader context of accelerating initiatives to regulate the hedge fund industry in the United States.
James R. Hedges, IV and Charlotte Luer are partners in LJH Financial
Marketing Strategies, a firm that provides marketing and investor
relations support to hedge funds ranging from multi-billion dollar firms
to emerging managers. They may be reached at 212.925.8703 or email
at email@example.com or firstname.lastname@example.org. The firm’s Web site is
Lucinda O. McConathy and Patricia C. O’Prey are partners in the law
firm of Richards Kibbe & Orbe LLP. They represent hedge funds,
commercial banks, investment banks, brokerage firms, and other
financial services institutions, along with individual traders and
executives, in private civil litigation and government investigations and
litigation. Ms. McConathy may be reached in RK&O’s Washington, D.C.
office at 202.261.2992 and Ms. O’Prey may be reached in RK&O’s New
York office at 212.530.1969. RK&O’s Web site is www.rkollp.com.