Selected Marketing Issues for Investment
Advisers and Private Funds
Marketing in the alternative asset space is subject to significant regulatory constraints and is therefore rife with risk. When examining marketing efforts undertaken by a private fund adviser, it is critical to determine (i) such adviser’s registration status in respect of the Securities and Exchange Commission (the “SEC”) and the Commodity Futures Trading Commission (the “CFTC”) and (ii) what is being marketed: the investment adviser itself or a private fund to which it provides services. I. Investment Adviser Issues
Section 206 (“Section 206”) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”) governs advertising by both investment advisers registered with the Securities and Exchange Commission (the “SEC”) and unregistered investment advisers. Section 206 generally prohibits any investment adviser from directly or indirectly employing any device, scheme, or artifice to defraud any client or prospective client and from engaging in any act, practice, or course of business that is fraudulent, deceptive, or manipulative.
General
Rule 206(4)-1 of the Advisers Act (the “Advertising Rule”) governs registered investment advisers and sets forth certain advertising activities that are deemed violative of Section 206. The
Advertising Rule defines
“advertisement” generally as any written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television that offers, (i) any analysis, report, or publication concerning securities, or which is to be used in making any determination as to when to buy or sell any security, or which security to buy or sell; or (ii) any graph, chart, formula, or other device to be used in making any determination as to when to buy or sell any security, or which security to buy or sell; or (iii) any other investment advisory service with regard to securities.
While the Advertising Rule technically applies only to registered investment advisers, unregistered investment advisers should nonetheless view the Advertising Rule as applicable to their own conduct as it provides guidance as to when Section 206 (which applies to both registered and unregistered investment adviser) may be violated.
Further, behavior that would otherwise violate the Advertising Rule (and other advertising rules) could be deemed a violation of Advisers Act Rule 206(4)-8, an anti-fraud rule applicable to registered and unregistered private fund managers. The Advertising Rule enumerates the following as activity that is violative of Section 206.
1. Using testimonials. Given that testimonials generally are utilized only with respect to clients describing favorable experiences with an investment adviser, the use of testimonials is akin to “cherry picking” (discussed below); it gives an unbalanced view of the investment adviser. Testimonials, however, can be differentiated from real, unbiased third-party reports (i.e., reprints of articles), which are not necessarily prohibited. Furthermore, circulating a partial list of an adviser’s clients in an advertisement could be deemed a violation of the Advisers Act’s prohibition on the use of testimonials.
2. Refers, directly or indirectly, to past specific profitable recommendations unless all recommendations made by the investment adviser within at least the previous year are set out. This provision is meant to prevent the adviser from “cherry picking,” i.e., identifying only successful trades. This prohibition does not apply where the advertisement includes (or offers to furnish) a list of all recommendations made by the adviser that includes (i) the name of each security recommended; (ii) the date and nature of each recommendation (e.g., whether to buy, sell or hold); (iii) the market price at the time of the recommendation; (iv) the price of the
security when the recommendation was to be acted upon; (v) the market price of each such security at the most recent practicable date; and (vi) a disclaimer regarding the profitability of recommendations in the future, which must appear on the first page of the list in a print or type as large as the largest print or type used in the text, and must state the following: “It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.”
Based on SEC no-action letters issued in 1998 and 2008, respectively, the SEC permits an adviser to discuss some, but not all, of its investment recommendations where such list is compiled using objective, non-performance based criteria (e.g., a listing of the adviser’s largest holdings) or, where performance-based criteria is used, but such list is selected using objective and mechanical methodology, consistently applied to every investment holding, that includes an equal number of holdings that contributed most positively and negatively to the representative performance during the period referenced. Where an adviser elects to use objective, non-performance based data to select securities for reports, it must ensure that (i) such criteria is consistently applied, (ii) the resulting reports do not discuss realized or unrealized profits or loss; (iii) the reports include cautionary disclosures; and (iv) it maintains records regarding all recommendations and the selection criteria used to select the securities in the reports.
Finally, note that in a letter to the Investment Counsel Association of America, Inc., the SEC staff stated that a registered investment adviser responding to an unsolicited request by a client, prospective client, or consultant for specific information about the adviser’s past specific recommendation would not be prohibited to do so by the Advertising Rule provided that the adviser did not directly or indirectly solicit the client, prospective client, or consultant to make the request.
3. Represents, directly or indirectly, that any graph, chart, formula, or other device being offered can, in and of itself, be used to determine which securities to buy or sell, or when to buy or sell them; or an advertisement which represents, directly or indirectly, that any graph, chart, formula, or other device being offered will assist any person in making his own decisions as to which securities to buy, sell, or when to buy or sell them, without prominently disclosing in such advertisement the limitations thereof and the difficulties with respect to its use. 4. Represents that a report, analysis, or other service will be provided free of charge unless such items are provided entirely free without any conditions or obligations.
5. Makes any untrue statement of a material fact or which is otherwise false or misleading.
Performance Advertising
The SEC views performance advertising in the context of subparagraph (a)(5) of the Advertising Rule whereby such advertisement must not contain an
untrue statement of a material fact, or be otherwise false or misleading. Again, while this provision and its interpretations technically only govern SEC registered investment advisers, they should be followed by unregistered investment advisers as a matter of best practices in light of the fact that otherwise violative conduct, but for an adviser’s unregistered status, could be deemed a violation of the anti-fraud provisions of Advisers Act Rule 206(4)-8. The SEC has imposed certain restrictions on performance advertising (e.g., advertising performance generated while at a previous employer, using net versus gross returns, using model or hypothetical returns, comparing returns to the performance of an index, etc.). The SEC staff’s positions on these items can be found in various no-action letters. The starting point for any analysis with respect to performance advertising is the Clover Capital Management, Inc. no-action letter (“Clover”).
In Clover, the SEC took the opportunity to set forth certain advertising practices it believes are inappropriate with respect to advisers who advertise model or actual results. In the SEC’s view, the Advertising Rule prohibits an advertisement that:
Model and Actual Results
1. Fails to disclose the effect of material market or economic conditions on the results portrayed (e.g., an advertisement stating that the accounts of the adviser’s clients appreciated in value 25% without disclosing that the market generally appreciated 40% during the same period);
2. Includes model or actual results that do not reflect the deduction of advisory fees, brokerage, or other commissions, and any other expenses that a client would have paid or actually paid;
3. Fails to disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;
4. Suggests or makes claims about the potential for profit without also disclosing the possibility of loss;
5. Compares model or actual results to an index without disclosing all material facts relevant to the comparison (e.g., an advertisement that compares model results to an index without disclosing that the volatility of the index is materially different from that of the model portfolio);
6. Fails to disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed (e.g., the model portfolio contains equity stocks that are managed with a view towards capital appreciation);
Model Results
7. Fails to disclose prominently the limitations inherent in model results, particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser’s decision-making if the adviser were actually managing clients’ money;
8. Fails to disclose, if applicable, that the conditions, objectives, or investment strategies of the model portfolio changed materially during the time period portrayed in the advertisement and, if so, the effect of any such change on the results portrayed;
9. Fails to disclose, if applicable, that any of the securities contained in, or the investment strategies followed with respect to, the model portfolio do not relate, or only partially relate, to the type of advisory services currently offered by the adviser (e.g., the model includes some types of securities that the adviser no longer recommends for its clients); 10. Fails to disclose, if applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model; or
Actual Results
11. Fails to disclose prominently, if applicable, that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material.
Other important no-action letters sent by the SEC include: (a) a letter sent to the Investment Company Institute reaffirming that performance results must be net of fees, but indicating that custodial fees do not have to be deducted from such performance results; (b) another letter sent to the Investment Company Institute stating that an adviser may use gross performance results in one-on-one presentations to wealthy individuals, pension funds, universities,
and other institutions if the adviser, at the same time, provides in writing (1) disclosure that the performance results do not reflect the deduction of investment advisory fees, (2) disclosure that the client’s return will be reduced by the advisory fees and other expenses it may incur as a client, (3) disclosure that the adviser’s advisory fees are described in Part 2 of the adviser’s Form ADV, and (4) a representative example (in the form of a table, chart, graph, or narrative) showing the effect of compounded advisory fees, over a period of years, on the value of a client’s portfolio); and (c) a letter sent to the Investment Counsel Association of America, Inc. in which the SEC stated that a written communication sent by a registered investment adviser only to its existing clients generally would not be an advertisement within the meaning of Rule 206(4)-1(b) of the Advisers Act merely because it discusses the adviser’s past specific recommendations concerning securities that are or were recently held by each of those clients provided that such communications are not designed to offer advisory services.
Recordkeeping
Rule 204-2 of the Advisers Act sets forth the books and records required to be maintained by registered investment advisers. Rule 204-2(a)(11) covers communications and requires a registered investment adviser to maintain copies of each notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication that such investment adviser circulates or distributes, directly or indirectly, to ten (10) or more persons (other than persons connected with such
registered investment adviser), and if such document recommends the purchase or sale of a specific security and does not state the reasons for such recommendation, a memorandum of the registered investment adviser indicating the reasons therefor.
With respect to performance advertising, a registered investment adviser must maintain a record of all performance advertisements and the supporting documentation thereof. Specifically, Rule 204-2(a)(16) requires a registered investment adviser to maintain all accounts, books, internal working papers, and any other records or documents that are necessary to form the basis for, or demonstrate the calculation of, the performance or rate of return of any or all managed accounts or securities recommendations referred to in any notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication that the registered investment adviser circulates or distributes, directly or indirectly, to ten (10) or more persons (other than persons connected with such investment adviser); provided, however, that, with respect to the performance of managed accounts, the retention of all account statements, if they reflect all debits, credits, and other transactions in a client’s account for the period of the statement, and all worksheets necessary to demonstrate the calculation of the performance or rate of return of all managed accounts shall be deemed to satisfy the requirements of this paragraph.
In general, Rule 204-2 requires registered investment advisers to maintain its books and records for five
(5) years (two (2) years onsite, three (3) years offsite). With respect to books and records requirement discussed herein, such books and records must be maintained for five (5) years from the end of the fiscal year during which the investment adviser last published or otherwise disseminated, directly or indirectly, the notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication.
II. CFTC Issues
To the extent an investment adviser is registered with the CFTC as a commodity pool operator (“CPO”) and/or a commodity trading advisor (“CTA”), it is also subject to various rules promulgated by the CFTC pursuant to the Commodity Exchange Act, an amended (the "CEA").
In general, a CPO/CTA is subject to CFTC Rule 4.41. CFTC Rule 4.41 generally prohibits a CPO, a CTA or any principal thereof from advertising in a manner which employs any device, scheme or artifice to defraud any client or prospective client or involves any transaction, practice or course of business which operates as a fraud or deceit upon any client or any prospective client. Furthermore, Rule 4.41 contains specific language that must be used if simulated or hypothetical results are presented. Finally, Rule 4.41 indicates that advertisements include “any publication, distribution or broadcast of any report, letter, circular, memorandum, publication, writing, advertisement or other literature or advice, including the texts of standardized oral presentations and of radio, television, seminar or
similar mass media presentations.” It should be noted that Rule 4.41 applies regardless of whether the CPO or CTA is exempt from registration with the CFTC under the CEA. As such, advisers that are exempt from registration pursuant to CFTC Rules 4.13 (with respect to CPOs) and 4.14 (with respect to CTAs) must still comply with Rule 4.41.
Furthermore, to the extent the CPO/CTA is a member of the National Futures Association, which is a condition of CFTC registration, it is also subject to the NFA Compliance Rules. NFA
Compliance Rule 2-29
“Communications With The Public and Promotional Material” among other things, contains a general prohibition against any communication with the public which operates as a fraud or deceit; employs or is part of a high pressure approach; or makes any statement that futures trading is appropriate for all persons. Rule 2-29 also contains specific prohibitions including, without limitation, on promotional material which maintains the possibility of profit unless accompanied by an equally prominent statement of the risk of loss, or includes any reference to actual past trading profits without mentioning that past results are not necessarily indicative of future returns. Rule 2-29 is comprehensive (more so than CFTC Rule 4.41) and must be considered any time a registered CPO or CTA advertises.
III.Private Fund Issues
As discussed below, there are significant restrictions on a private fund’s ability to advertise. Note that when an investment
adviser whose only services are to private funds (i.e., it does not offer managed accounts) advertises, it could be deemed that such adviser is in fact advertising its private fund(s).
A private fund is established as some form of legal entity. U.S.-domiciled private funds are typically established as limited partnerships or limited-liability companies. Offshore private funds are typically established as corporations. The interests in these vehicles are securities under the U.S. securities laws. Section 5 (“Section 5”) of the Securities Act of 1933, as amended (the “Securities Act”) prohibits an issuer from offering its securities without first filing a registration statement. As such, unless a registration statement is first filed with the SEC, it is unlawful, directly or indirectly, to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to sell a security (e.g., an interest in a private fund) unless an exemption from such requirement is available. A private fund has the burden of proving the availability of an exemption from registration. The purchaser of a security sold in violation of the registration requirements (i.e., there was neither a registration nor a valid exemption) has the right to rescind its purchase and obtain the amount of their investment plus interest. Two exemptions a fund may rely on are Section 4(a)(2) (“Section 4(a)(2)”) and Regulation D (“Regulation D”) of the Securities Act.
Section 4(a)(2) and Regulation D
Section 4(a)(2) provides an exemption from registration for “transactions by an
issuer not involving any public offering.” While its language is brief, Section 4(a)(2) has resulted in substantial confusion and case law varies from jurisdiction to jurisdiction. The problem with Section 4(a)(2) is that the information provided by the issuer to each investor to allow such investor to properly evaluate the investment has to be tailored to each such investor’s individual level of sophistication. The uncertainty surrounding Section 4(a)(2) makes it difficult to rely on directly. Conversely, Regulation D, generally referred to as the private placement exemption, has very specific requirements. Regulation D is comprised of Rules 501-508. Rule 506 of Regulation D (“Rule 506”), the Section 4(a)(2) safe harbor generally relied on by private funds selling their interests in the U.S., specifically states that if certain conditions of Rule 506 are satisfied with respect to an offer and sale of a security, such offer and sale shall be deemed to be a transaction not involving a public offering within the meaning of Section 4(a)(2) and therefore will be exempt from registration under the Securities Act, regardless of the offering’s dollar amount. It should be noted that Regulation D is a safe harbor and not a law. Where an issuer stays within the confines of Regulation D, it will be exempt from Section 5’s registration requirements. Failure to remain within such confines is not, in itself, a violation, but rather a source of uncertainty regarding an issuer’s registration obligations.
Rule 506 formerly included prohibitions on general solicitation and general advertising. However, pursuant to the
Jumpstart our Business Startups Act (the “JOBS Act”), which was signed into law on April 5, 2012, the SEC amended Rule 506 to add subpart (c), which eliminates the prohibition on general solicitation and general advertising for Regulation D offerings made in accordance with Rule 506(c) where (i) all purchasers of securities are accredited investors; (ii) the issuer has taken reasonable steps to verify that the purchasers of the securities are accredited investors; and (iii) all terms and conditions of Rules 501, 502(a) and 503 are satisfied. The SEC’s amendments with respect to the JOBS Act pertain only to Rule 506(c) and not Section 4(a)(2) offerings in general. As such, issuers relying on Section 4(a)(2) outside of Rule 506(c) (e.g. Rule 506(b)) will still be restricted in their ability to publicly communicate with potential investors.
The Rule 506(c) Verification Requirement The SEC expects an issuer to objectively determine the reasonableness of its verification steps by considering the context of the particular facts and circumstances of each purchaser and each transaction. To assist issuers in making such determination (which determination should be adequately documented and a record thereof retained), Rule 506(c) provides a short list of factors that should be considered, including (i) the nature of the purchaser and type of accredited investor that the purchaser claims to be, (ii) the amount and type of information the issuer has about the purchaser, and (iii) the nature and terms of the offering. Rule 506(c) also provides a non-exclusive list of methods that issuers may use to verify a potential natural person investor’s accredited investor status, including:
(i) with respect to income, any IRS form (e.g., Schedule K-1 and Forms W-2, 100, 1065 and 1040) that reports the purchaser’s income for the two (2) most recent years, provided such documentation is accompanied by a written representation from the purchaser that he/she has a reasonable expectation of reaching the necessary income level for the current year;
(ii) with respect to net worth, bank statements, brokerage statements and other statements of assets dated within the prior three (3) months, accompanied by a recently generated consumer report and a written representation from the purchaser that all liabilities necessary to make the net worth determination are disclosed;
(iii) written confirmation from either a broker-dealer, an SEC-registered investment adviser, or a licensed and duly-registered attorney or certified public accountant, which confirmation will provide that such person or entity has taken reasonable steps within the prior three (3) months to verify the purchaser’s accredited investor status; or
(iv) with respect to any natural person who invested in an issuer’s Rule 506(b) offering as an accredited investor prior to September 22, 2013, and remains an investor of the issuer, the issuer is deemed to satisfy the verification requirements of Rule 506(c) in regards to any such person by obtaining a certification by such person at the
time of sale that he/she qualifies as an accredited investor.
These steps do not constitute a verification safe harbor. Certain of these steps may be inappropriate or unnecessary in light of the facts and circumstances of a particular transaction or where such issuer has reason to believe that the verifications provided therein may be inaccurate or incomplete. As such, an issuer should use a reasonableness standard in assessing the adequacy of its verification procedures. Before commencing a Rule 506(c) offering, investment advisers that transact in commodity interests should consider their registration status with the CFTC. The availability of certain relief from the requirement to register with the CFTC as a CPO and/or CTA (e.g., CFTC Rule 4.13(a)(3)) is conditioned on the requirement that interests in the commodity pool are not marketed to the public. Therefore, absent any future guidance from the CFTC, the availability of relief from CFTC registration is currently incompatible with an offering conducted pursuant to 506(c) and involving general solicitation and general advertising.
Rule 506(b).
For issuers who would like to (i) avoid Rule 506(c)’s requirement to take reasonable steps to verify a purchaser’s accredited investor status or (ii) place securities with certain non-accredited investors, former Rule 506 (recodified as Rule 506(b)) continues to be available and enables such issuers to sell privately to up to thirty-five (35) non-accredited investors (and an unlimited number of accredited investors) who meet the Rule 506(b) sophistication requirements. Such Rule
506(b) offerings remain subject to the prohibition on general solicitation and general advertising. As such, avoiding general solicitation and general advertising in a Rule 506(b) offering is paramount to ensuring that the offering is properly exempt from the registration requirements of Section 5.
While neither “general solicitation” nor “general advertising” are defined in Regulation D, Rule 502(c)(1)-(2) provides a non-exhaustive list of items falling under these prohibitions, which include “[a]ny advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and [a]ny seminar or meeting whose attendees have been invited by any general solicitation or general advertising.” In a series of no-action letters, the SEC has indicated that a general solicitation and general advertising does not occur when an issuer (e.g., a fund) has a pre-existing, substantive relationship with potential investors prior to contacting them regarding the subject offering. The pre-existing relationship must be established at a time prior to the commencement of the private offering or, in the case of a private fund, generally thirty (30) days before the investor can make an investment. As such, it is critical that no marketing be engaged in with respect to a prospective investor unless a substantive relationship has been formed with such prospective investor at least thirty (30) days before the solicitation effort. Initial contacts with unknown prospects should be limited to qualifying the prospect. It should be noted that having a pre-existing, substantive relationship is not the only way to avoid a general solicitation. The presence or
absence of a general solicitation depends on the facts and circumstances of each particular case.
Investment Company Act
In order to avoid registration as an investment company (e.g., a mutual fund) under the Company Act, a private fund based in the U.S. or marketing to U.S. investors must qualify for an exemption from the definition of “investment company,” which is contained in Section 3(a) of the Company Act. The most commonly used exemptions are contained in Sections 3(c)(1) (the “100 investor” exemption) and 3(c)(7) (the “qualified purchaser” exemption) of the Company Act. If a fund does not qualify for either of these exemptions, or any other exemption, it must register as an investment company under the Company Act. Such registration results in significant regulations, fees, and scrutiny.
Section 3(c) begins by indicating that each of the entities in the subsections that follow Section 3(c) (i.e., subsections (1)-(14)) will not be considered investment companies within the meaning of the Company Act.
The first sentence of Section 3(c)(1) indicates that its exemption is available to:
any issuer whose
outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons and which is
not making and does not
presently propose to make a public offering of its securities. [Italics added]
The first sentence of Section 3(c)(7) indicates that its exemption is available to:
any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is
not making and does not at that time propose to make a public offering of such securities. [Italics added]
The absence of a public offering is a critical element to qualifying for the exemptions contained in Sections 3(c)(1) and 3(c)(7). To satisfy such element, a fund may want to rely on Section 4(a)(2). As discussed above, given the lack of certainty surrounding how to make a 4(a)(2) offering, a private fund would generally make an offering pursuant to Regulation D of the Securities Act, specifically Rule 506. New Section 4(b) provides that offers and sales exempt under Rule 506 shall not be deemed public offerings under the federal securities laws as a result of general solicitation. As such, provided that an adviser meets all the requirements of Rule 506(c), it may engage in general solicitation without precluding the availability of the Sections 3(c)(1) and 3(c)(7) exemptions. However, we note that any advertisement conducted by an investment adviser on behalf of a 3(c)(1) or 3(c)(7) fund will still need to fully
comply with the Advisers Act, as discussed in Part I.
In considering what an adviser is marketing, and therefore the regulatory confines of such marketing, the adviser needs to consider the services it provides. While the Advisers Act allows registered investment advisers to advertise, as discussed above, if an adviser would like to advertise its services, but the only services it provides are serving as an investment adviser to private funds (i.e., it does not provide managed account services), it is likely that the investment adviser’s advertisement would be deemed to really be an advertisement for its private funds. As a result, the private fund could be deemed to have made a general solicitation or engaged in general advertising, which determination implicates such private fund’s reliance on the Section 4(a)(2) safe harbor and potentially exposes it to rescission liability. In cases where a private fund is relying on Rule 506(b), the attribution of the investment advisor’s advertising efforts to the private fund is fatal to its reliance on Rule 506(b). With respect to private funds relying on Rule 506(c), investment advisors should conform their policies and procedures to the requirements of Rule 506(c) before commencing their advertising efforts. IV. Broker-Dealer Issues
The SEC has recently increased its focus on broker-dealer issues relating to private funds and their managers. Section 15(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) requires a person who is engaged in the business of executing securities
transactions for the account of others to be registered with the SEC as a broker-dealer. Under Section 3(a)(4) of the Exchange Act, the term “broker” means any person engaged in the business of effecting transactions in securities for the account of others. Under Section 3(a)(5) of the Exchange Act, the term “dealer” means any person engaged in the business of buying and selling securities for such person’s own account through a broker or otherwise. Broker-dealer concerns relating to private funds have become an increasing area of focus for the SEC, primarily with respect to sales of private fund interests made by certain people.
The manner in which sales of private funds interests are marketed could expose a private fund’s manager to broker-dealer regulations. Often times, a fund manager pays its personnel transaction-based compensation for selling interests in a fund or has personnel whose only or primary functions are to sell interests in the fund. The test for whether broker-dealer registration is required is broad and dependent on various activities a person performs in one or more securities transactions. Some examples of activities or factors that might require private fund adviser personnel to register as a broker-dealer include (i) marketing securities (shares or interest in a private fund) to investors; (ii) soliciting or negotiating securities transactions; or (iii) handling customer funds and securities. The importance of each of these activities is heightened where there is compensation that depends on the outcome or size of the securities transaction, i.e., transaction-based compensation, also referred to as a “salesman’s stake” in a securities
transaction. The SEC and SEC staff have long viewed receipt of transaction-based compensation as a hallmark of being a broker (although it must be noted that one can be acting as broker-dealer without receiving transaction-based compensation). Private fund adviser should think through the adviser’s marketing activities, particularly how it goes about obtaining new investors and retaining existing investors, and whether such marketing and sales activities would trigger broker-dealer registration obligations.
Another area where private fund managers might implicate broker-dealer rules is through the use of third parties who are compensated for raising capital. In March 2013, the SEC settled separate charges with a private fund adviser and an agent thereof stemming from alleged violations of the broker-dealer registration provisions of the Exchange Act. The settlement involves Ranieri Partners LLC, a New York-based holding company of an SEC-registered investment adviser subsidiary (collectively, “Ranieri”), and relates to its employment of an unregistered broker to effect sales of its private investment funds. Ranieri specifically highlights the SEC’s willingness to hold an investment adviser accountable for a third party service provider’s failure to comply with certain securities laws that are equally applicable to the investment adviser. In January 2008, Ranieri established the first of two private investment funds (the “Selene Funds” or the “Funds”) focusing on investments in distressed residential mortgages. Shortly thereafter, Ranieri entered into a consultancy agreement (the “Agreement”) with William
Stephens (the “Finder”) to locate potential investors on behalf of the Funds. The Finder, who was not registered as a broker-dealer (or associated with a registered broker-dealer), had been the subject of a 2000 SEC enforcement action and had been barred from association with any investment adviser with a right (never exercised) to reapply for association. The Ranieri Agreement provided that the Finder’s activities, which would be coordinated by Ranieri, would be limited to contacting potential investors to arrange meetings with principals of Ranieri. The Finder would not be permitted to contact investors directly or be allowed to discuss his views with respect to the merits and strategies of the Selene Funds. Ranieri would maintain exclusive control over the distribution of the Funds’ offering documents, which would be provided along with certain other materials to the Finder, and the Finder would be prohibited from providing such documents to potential investors.
Over the subsequent three years, the Finder actively solicited investors, ultimately netting himself transaction-based compensation of approximately $3.8 million based on total commitments of $569 million, by, inter alia, engaging in discussions with, and providing offering materials to, potential investors regarding the Selene Funds’ merits, performance record and investor rosters and, on several occasions, traveling to meet with potential investors that had already been introduced to Ranieri. Significantly, during the course of his engagement, the Finder submitted various reports to Ranieri evidencing his travel and entertainment expenditures
(and which such expenses were reimbursed by Ranieri), which put Ranieri on notice of the Finder’s prohibited activity.
As a result of the foregoing actions, the SEC initiated proceedings against (i) the Finder for operating as an unregistered broker in violation of Section 15(a) of the Exchange Act, which makes it unlawful for any broker or dealer to make use of any means or instrumentality of interstate commerce to effect any transactions in, or induce or attempt to induce the purchase or sale of any security unless such person is registered with the SEC, and (ii) Ranieri for causing the Finder’s Section 15(a) violation. As noted above, the receipt of transaction-based compensation is a hallmark of being a broker and, coupled with his active solicitation efforts, it is unremarkable that the SEC pursued enforcement against the Finder. It is remarkable, however, that the SEC held Ranieri responsible for the Finder’s violative behavior (without alleging fraud by Ranieri) under the theory that Ranieri caused (i.e., aided and abetted) the Finder’s violations by failing to adequately oversee the Finder’s efforts, despite such efforts being unequivocally prohibited in the Ranieri Agreement. For private fund advisers who have depended on solicitation agreements containing explicit activity restrictions similar to those set forth in the Ranieri Agreement to avoid potential Exchange Act registration obligations (and rescission liability), the Ranieri actions serve as a reminder that private fund advisers cannot contract out of their regulatory obligations. The Ranieri case puts advisers on notice that Section 15(a)
Exchange Act liability will not necessarily be limited to those agents acting as unregistered brokers, and may also include the principals thereof.
In light of the foregoing, private fund advisers should consider the following in determining their potential Exchange Act obligations:
whether the adviser has a dedicated group of employees (regardless of how they are compensated) performing its solicitation and marketing efforts (which may indicate that the adviser is in the business of effecting transactions); whether employee(s) that solicit
investors have other responsibilities with respect to the adviser;
whether personnel soliciting on behalf of the adviser receive transaction-based compensation; and whether the adviser charges a
transaction fee in connection with the sale of its securities.
Whether a person should register as a broker-dealer is a fact-specific analysis, and the above queries, while not determinative, embody the SEC’s own general framework and represent a starting point for advisers to make their own determination.
V. Conclusion
Marketing of advisory services and private funds are highly regulated activities. Failure to comply with applicable rules and safe harbors could result in regulatory action and/or litigation and give rise to investor
rescission rights. Marketing compliance is applicable to all marketing efforts including, without limitation, mailings, presentations and generally speaking, correspondence (including email). All statements made by an adviser must be supportable and materials must be distributed in a manner that is not a general solicitation and advisers should consider whether their marketing activities implicate broker-dealer registration issues. Marketing materials
and manners of distribution should be reviewed by counsel to ensure appropriate disclaimers and disclosures are utilized. Finally, advisers to private funds should ensure that a pre-existing substantive relationship is in place before marketing is undertaken.
For more information on the topic discussed, contact Ricardo W. Davidovich at davidovich@thsh.com.
