Hedge Fund Marketing: Where the NASD Stands
At last week’s Securities Industry Association hedge funds conference, Gary Goldsholle, associate general counsel at the NASD, addressed a range of hedge fund marketing issues.
Targeted returns. Early in the conference, an industry lawyer warned that after the NASD’s recent case against Citigroup, the hedge fund industry can’t use targeted returns.
Goldsholle took issue with that assessment: "That’s not what we said."
According to Goldsholle, hedge funds still can use targeted returns, provided that additional disclosures about the limits of the target are provided on the face of the document containing the targeted returns. "When you provide information on targeted returns, you need to provide some other information to the investor so they can evaluate the reasonableness of that target [and] the factors that may contribute to the ability to achieve that or those that may ultimately work against the fund’s ability to achieve that," he said. Simply saying that a fund seeks a return without providing additional information to help an investor evaluate that type of statement "is not going to fly," he said.
Ironically, an August 2002 NASD investor education piece acknowledges the fact that many hedge funds attempt to seek targeted returns: "Hedge fund managers typically seek absolute positive investment performance. This means that hedge funds target a specific range of performance, and attempt to produce targeted returns irrespective of the underlying trends of the stock market," said the NASD. "This stands in contrast to investments like mutual funds, where success or failure is often measured in terms of performance in relation to a stock index, like the Dow Jones Industrial Average."
Of course, hedge fund managers should avoid projections like those alleged in the NASD’s April 2003 case against Altegris Investments. There, the fund distributed a research report written by a registered rep at another broker dealer, who made the following projection of the hedge fund manager’s future performance: "Is he likely to continue to give us 12-14% years over the next 4-5 years? In my opinion, I think it is likely he will."
Related performance. Goldsholle referred to a letter issued earlier this fall to Collins/Bay Island Securities stating that the NASD’s position that related performance is permissible in the context of 3(c)(7) funds (as set forth in a December 2003 letter to Davis Polk) cannot be extended to 3(c)(1) funds. The letter asked whether it would be permissible to distribute related performance information to potential investors in 3(c)(1) funds who are qualified institutional buyers, (a.k.a. "QIBS") as defined in 1933 Act Rule 144A. The NASD, said Goldsholle, "said no," based on concerns that a 3(c)(1) fund can have both qualified as well as non-qualified investors. "The fact that [such a position] would permit certain types of information to be disclosed to one category of investors and not another caused concerns to us." All investors in a fund, he said, should have access to the same level of disclosure of information.
Goldsholle acknowledged that the SEC and the NASD have differing views on the use of related performance in sales materials. Although the disagreement between the regulators dates back to the issuance of several SEC no-action letters in 1997 that expanded the use of related performance information by mutual funds, it seemed to strike some in the audience as a surprise. "NASD understands that related performance information is something that investors want to see," said Goldsholle. His advice: stick it in the PPM. "We’ve never applied our advertising rule to the private placement memorandum," he said. When people come in and ask if they can use related performance for hedge funds, the NASD’s position is "Put in the PPM and you’ve got no issues whatsoever under our advertising rules." Because of that, he said that he views with "a little bit of skepticism those who say that somehow we’re denying investors access to information." The NASD, he said, is just saying that there is an "appropriate manner and form" to present related performance. He acknowledged, however, that the solution of putting related performance information in the PPM "doesn’t always work," particularly in the context of private equity funds, where funds may be marketed before there is an offering memorandum.
Benchmarks. Goldsholle noted that the NASD has not yet brought any cases involving hedge funds’ use of benchmarks, adding ominously: "I see this area as one that has potential for great problems going forward." He said that benchmarks involve three types of bias:
Selection bias, in that hedge funds are not required to report performance to the benchmark, and those that have negative performance may choose not report it.
Survivorship bias: if any funds close, their performance is not reported.
Entry bias: "some of the very best funds" represented in the benchmark are closed to new investors.
"When I see materials that contain hedge funds as an asset class," said Goldsholle, "I get concerned that there’s not the appropriate disclosures or risks of the various hedge fund indices highlighted."
Goldsholle pointed to another benchmark-related issue: "On one hand, they are marketed frequently as absolute return vehicles, and that’s certainly appropriate." On the other hand, he added, the fund’s performance is described in relationship to the S&P, which may represent "a small subset of what the hedge fund could do." He also noted that although he hasn’t seen the entire universe of hedge funds sales material, those he has seen "don’t seem to compare their performance to the hedge fund benchmarks that are used to market the product as an asset class." That, he said, struck him as a "curiosity." He added that those were his own views, and not those of anyone at the NASD besides himself.
"At the present time," he added.
Hypothetical performance. Goldsholle noted that the Citigroup case involved hypothetical fund of funds performance. "I’d like to invite people to identify a fund with hypothetical returns that actually have been negative," said Goldsholle. The problem with hypothetical performance, he said, is that "the numbers are going to be spectacular." For that reason, hypothetical returns cause "a lot of concern for us." Goldsholle said that in the Citigroup case, the fund had less than two year’s worth of operating history, and actual performance hovered around two percent per year. In contrast, the hypothetical performance was between 12 and 15 percent. He also said that there were issues with the way the hypothetical performance was constructed: according to Goldsholle, the performance included funds that may not have been in existence at the time, the fund manager had absolute discretion over what funds he could invest (instead of being constructed mechanically, with, say, ten funds with ten percent each, rebalanced every quarter). The result, "not surprisingly, produced very favorable information."
Goldsholle also criticized the presentation of the hypothetical performance, noting that it was portrayed "so as to really confuse investors" about how long the fund was in existence. He said that actual and hypothetical performance were presented in the same table, with actual returns "‘almost seamlessly" turning into hypothetical returns in the next column.
Suitability in the cap intro context. Goldsholle noted that broker-dealers face suitability obligations whenever a recommendation is being made, regardless of whether the broker-dealer is acting in a traditional sales capacity or is working in the "cap intro" context. Goldsholle noted that "firms are a little more careful now" about conducting their activities in the cap intro context so as not to be viewed as making a recommendation. However, he added, "simply calling something ‘cap intro’ is not a way of taking a firm out of this suitability requirement." Goldsholle referred to NASD Notice to Members 01-23, "Suitability Rule and Online Communications," as a source of guidance for when something is a recommendation. That NTM, he said, "is not limited only to the online space."