Hedge Fund Marketing Issues: Finders, Cap Intro, and Beyond
As SEC examiners begin making their way into hedge fund shops over the next year, itís likely that advertising issues will be front and center on their radar screens. Hereís a quick overview of some of the unique regulatory issues surrounding the marketing of hedge funds.
Do finders need to be registered as broker-dealers?
If your hedge fund uses one or more third-party marketers, or "finders," to refer potential investors to your fund, chances are youíve wondered whether they need to be registered as broker-dealers with the SEC.
The law here is murky. However, if you ask an experienced securities lawyer at a major law firm, he probably will advise you that the safest course of action is to use finders that are registered broker-dealers. But not all lawyers take that position. In a comment letter on a possible "private placement broker-dealer" registration category (more on that below), Hugh Makens, a partner at Warner Norcross, a Michigan law firm, warned that some lawyers have been willing to "ignore SEC no-action letters and federal and state enforcement actions" and provide a favorable opinion on the question of whether finders have to register as broker-dealers. He indicated that this sometimes occurs when a client "forum shops" after experienced securities counsel declines to provide comfort. "Generally," said Makens, "these attorneys providing questionable opinions are solo or small firm practitioners with very limited securities experience and either no appreciation for the complexity of the analysis or a willingness to render opinions to accommodate a client."
What does the law have to say about finders?
Section 3(a)(4) of the Exchange Act broadly defines a "broker" as any person engaged in the business of effecting transactions in securities for the account of others. Thereís a lot of law and lore surrounding that definition. Of particular interest, however, is the SECís position, stated in a variety of contexts, that receipt of transaction-based compensation, involvement in the negotiation of the transaction, and regular participation are key factors that indicate that a person is acting as a broker-dealer.
Although not the most authoritative source, the SECís Division of Market Regulationís "Guide to Broker-Dealer Registration," last published in August 2004, lays out the law fairly clearly: The guide states that finders that referral investors to hedge funds "may" need to register as a broker, depending on certain factors:
Does the finder participate in important parts of the securities transaction, including solicitation, negotiation, or execution of the transaction?
Does the finderís compensation for participation in the transaction depend upon, or is it related to, the outcome or size of the transaction or deal?
Does the finder receive trailing commissions? Does the finder receive any other transaction-related compensation?
Is the finder otherwise engaged in the business of effecting or facilitating securities transactions?
Does the finder handle the securities or funds of others in connection with securities transactions?
A "yes" answer to any of these questions indicates that the finder may need to register as a broker.
More officially, the SEC staffís September 2003 hedge fund study, "Implications of the Growth of Hedge Funds," stated that consultants that market hedge fund interests "may be acting as a broker and be required to register with the Commission as such." The report stated that "regularity of participation" in securities transactions is "primary indicia" of being engaged in the business of effecting securities transactions, and therefore being a broker. It also added that a person may be found to be acting as a broker if he participates in securities transactions "at key points in the chain of distribution." Like the Market Reg. registration guide, the report listed the following "key factors" that indicate that a person may be acting as a broker:
solicitation of investors to purchase securities;
involvement in negotiations between the issuer and the investor; and
receipt of transaction-related compensation.
Ominously, the report warned that it is not necessary to prove scienter (knowledge) to establish a violation of Section 15(a)(1) (the section that makes it unlawful to act as an unregistered broker-dealer).
Looking at the factors that go into determining broker-dealer status, it would seem that many finders are caught under the compensation prong ó if a finder is compensated for referring investors to a hedge fund on the basis of the amount invested in the fund (either as a percentage of the amount invested or as a percentage of the amount of the fees generated by the investment), the compensation would appear to "depend upon, or be related to, the outcome or size of the transaction or deal." In fact, to avoid broker-dealer status, some finders structure their compensation as a flat, per capita fee per investor (i.e., $5,000 for every person that ultimately invests in the fund, regardless of the amount of the investment). However, as Purrington Moody partner David Moody pointed out, this could still be construed as a "success fee" that constitutes transaction-related compensation. "The only completely safe way is to pay compensation that is not contingent upon success, which most funds are not interested in doing," he said.
Whatever you do, donít be fooled into thinking that just because the hedge fund securities at issue are exempt from registration under Reg. D, the person who sells them is automatically exempt from broker-dealer registration. As the Market Reg. guide noted, a security sold in a transaction that is exempt from registration under the 1933 Act is not necessarily an "exempted security" for Exchange Act purposes. "For example, a person who sells securities that are exempt from registration under Regulation D of the 1933 Act must nevertheless register as a broker-dealer," said the staff (assuming the person otherwise meets the definition of broker-dealer, of course). "In other words," continued the staff, "Ďplacement agentsí are not exempt from broker-dealer registration." The SEC said essentially the same thing in its 2000 interpretive release, "Use of Electronic Media" (see text accompanying footnote 94).
What about the so-called "finderís exemption" from broker-dealer registration, created by a host of no-action letters interpreting the broker-dealer definition? That exemption, weíre told, applies where the finder is doing nothing more than handing a hedge fund manager a list of names and saying, "Here, go call them." In fact, the letters describe the role of a true-blue finder as almost "clerical or ministerial" in nature. In practice, it seems that most hedge fund finders are too involved in discussions with the potential clients to qualify under the finder exemption.
What about the October 1994 Dana Investment Advisors letter, where a state hospital association got no-action assurance from Market Reg. that it did not have to register as a broker-dealer prior to introducing the associationís members to an adviser that had set up a 3(c)(1) fund specifically designed for the associationís members?
At least one lawyer IM Insight spoke with distinguished that letter on the scope of the associationís activities, which were limited by the referral agreement between the manager and the association. For example, the referral agreement prohibited the association from discussing the advantages or disadvantages or value of any investments, including the hedge fund, with the potential investors. The lawyer pointed out that the context ó a membership organization telling its members about a hedge fund set up just for them ó is a bit different from the typical hedge fund finder scenario.
So thatís the law.
But then thereís reality.
That friendly, perpetually-tanned guy who knows everybody (you know the one) is simply not going to go out and register as a broker-dealer and comply with the SECís net capital rule and heaven knows what else, just because you want to pay him for referrals based on a percentage of the assets he brings in. (However, he might be willing to sit for the Series 7 and affiliate with an already-registered broker-dealer).
In any event, the issue of unregistered finders is being played out in the context of the SECís Advisory Committee on Smaller Public Companies. For years, the American Bar Associationís Task Force on Private Placement Broker-Dealers has been urging the SEC to create a "broker-lite" registration category for finders. Just three weeks ago, three members of that Task Force, including investment management lawyer Faith Colish, who sits on the boards of several Neuberger Berman funds, sent the SEC a letter analogizing the current state of affairs to the days of the Prohibition. Finders that are not registered as broker-dealers are "in a situation similar to that of our parents and grandparents who were social drinkers during Prohibition," said the letterís authors. "They were, and a large majority of the unlicensed [finders] are, violating laws which are over-broad and largely ignored because of the need of the community to act in disregard of those laws."
Are there risks to utilizing an unregistered finder? While there have been numerous SEC enforcement cases involving unregistered finders, all appear to involve fraudulent activities, such as ponzi schemes or prime bank schemes. There do not seem to have been any SEC enforcement proceedings against finders strictly on the basis of not being registered as a broker-dealer. Moreover, there do not appear to be any cases against hedge fund managers for utilizing unregistered finders.
There is a complication for hedge funds that sell to California investors (or are based in California): As a result of a law passed last year, California investors are now authorized to sue for rescission of any securities purchased through an unregistered broker-dealer. The statute of limitations is five years, or two years from discovery of the facts by the investor, whichever is first. While the California law technically applies only to unlicensed broker-dealers, at least some lawyers view it as implicitly applying to issuers. Given that the goals of the amendment are to deter private placements that improperly involve unlicensed finders and, in the case of rescission, to return the parties to their original positions, "it is foreseeable that a right of rescission might be implied against issuers," said the law firm of Morrison & Forester in a July 2005 client memo. "This is in part due to the fact that in most private placements finders do not actually buy or sell securities, thus making an implied right against issuers seem necessary to give this new law Ďteethí." If thatís right, and the right of rescission could go against the fund, the downside to a fund that sells to California investors via an unregistered finder could be huge.
Do finders need to be treated as solicitors?
Some have argued that finders should be treated like cash solicitors, under Advisers Act Rule 206(4)-3. While only registered advisers are subject to the requirements of the cash solicitation rule, even some unregistered hedge fund managers have jumped through the ruleís hoops, as a voluntary best practice.
The analysis of whether a hedge fund finder is acting as a solicitor would seem to be analytically separate from the question of whether the finder is a broker-dealer. In practice, however, the solicitation question is often reached when it is determined that broker-dealer registration is out of the question. "If the finder canít register as a broker-dealer," the thinking seems to go, "then letís at least treat it as a solicitor."
"There is an argument" that a third-party marketer can be paid as a solicitor for hedge fund assets, "depending on a very factual analysis," said Dechert partner David Vaughan. If, for example, a marketer promotes separate accounts as a solicitor, but the manager also offers hedge funds, said Vaughan, it is "probably reasonable that you should not deny [the marketer] their fees" just because a referred client ended up in a hedge fund.
The Dana Investment Advisor letter also dealt with the question of whether the hospital association should register as a solicitor. Although Market Reg. said that the hospital association did not have to register as a broker-dealer, the IM staff indicated that it should be treated as a cash solicitor. The referral arrangement, said the staff, raised "precisely the type of concerns" that the cash solicitation rule was designed to address. The hospital association "has an interest in the successful distribution of the Partnership, and notice of that interest, together with sufficient information to evaluate the interest, should be given to the [potential investors] at the time they are solicited."
Of course, regardless of whether a decision is made to comply with the cash solicitation rule, advisers should consider what conflicts of interest arise when a finder is paid to market a fund, and how those conflicts should be disclosed to current and potential investors. Funds should consider whether and how to disclose the terms of their finderís compensation, as well as any conflicts of interest surrounding the referral arrangement. For example, in its hedge fund report, the SEC staff noted that a conflict arises when the solicitor is also an investor in the hedge fund.
What regulatory concerns are raised by participating in cap intro events?
The good news for hedge fund managers: capital introduction events seem to raise more compliance concerns for the prime brokers that sponsor them than the hedge funds that participate in them.
A cap intro event is typically a seminar sponsored by a fundís prime broker that brings investors and hedge fund personnel together in a networking situation. As Michael Rogers, associate general counsel of Bank of America Securities put it at last monthís SIA hedge fund conference, cap intro is "setting up events." In fact, he said, "you could argue that itís party planning, to some extent." The SECís Hedge Fund report noted that some prime brokers describe cap intro events as akin to a "dating service."
Of course, prime brokers do not sponsor cap intro events out of the goodness of their hearts. Typically, the understanding is that the hedge fund being helped by the prime broker will turn around and send brokerage back through the prime broker. That, of course, leads to a host of conflicts for the hedge fund manager in the allocation of brokerage. For example, managers should consider whether commissions of the fund, an asset of the fundís shareholders, should be used to pay for cap intro and other services that benefit the hedge fund manager. As Rogers put it, "old investors donít care if there are additional investors."
And, as Goodwin Procter partner Victoria Schonfeld pointed out, cap intro services are outside the scope of Section 28(e). While hedge funds are free to operate outside the safe harbor (assuming that pension plan investments havenít caused the fund to be deemed plan assets under ERISA), funds should be careful to provide clear disclosure that they are operating outside 28(e) and how, exactly, they will be using commissions. For example, said Schonfeld, the manager "would need explicit disclosure that cap intro is a factor in brokerage allocation."
Prime brokers face their own conflicts, as well. As Commissioner Annette Nazareth noted in a July speech (delivered when she was still Market Reg. director), prime brokers benefit from the growth of hedge funds that they recommend ó a fact that "is likely not known by the prospective investor."
There are also questions about the role of prime brokers that host the cap intro events. When they identify potential investors and invite them to hear about a particular hedge fund, are they making recommendations? Providing advice? The SECís Hedge Fund report noted that some in the industry have asserted that cap intro services do not rise to the level of acting as a broker or investment adviser. However, said the staff, "we question whether this conclusion is accurate in all circumstances." The report urged SEC examiners "to be vigilant" when examining cap intro services to determine whether prime brokers are complying with all applicable regulatory requirements.
Hereís the basic issue: if a broker goes to a customer and say, "I think this is an interesting product for you," under NASD rules, that may be a recommendation, regardless of whether or not the broker-dealer is actually saying "I recommend this product." Even if a customer is told to go look at an investment and make up his own mind, that broker could be viewed as having made an "implied recommendation," explained Schulte Roth partner Paul Roth at the SIA hedge fund conference. "Is it an implicit introduction when you invite the people into a room to meet with hedge fund managers for whom they happen to do prime brokerage?" asked Roth. "I myself think that as long as that is limited to 3(c)(7) investors itís not a major issue" for the brokerage community, although he noted that the issue has received "a lot of attention" from regulators. Roth indicated that there is not yet a clear answer to the question: "Itís like the guy in Peanutsô where thereís a lot of dust in the air but nothing is ever settled," he said.
In her July 2005 speech, however, Nazareth noted that "making capital introductions may appear as if the prime broker is recommending the hedge fund to the potential investor when it, in fact, is not."
In any event, thereís a definite trend towards limiting cap intro events to 3(c)(7) investors. Rogers noted that as a result of regulatory and press scrutiny on cap intro events over the past year, cap intro has increasingly been viewed as a "wholesale, not a retail, business," he said. Investors that attend such events, he said, now must meet higher eligibility standards. "A lot" of the prime brokers that hold cap intro events now require attendees to meet the qualified purchaser standard, he said. And some do not allow individual investors to attend. "Youíre talking about $25 million investors," he said. "Youíre not dealing with moms and pops." While cap intro has always been viewed as a non-retail activity, Rogers added, limiting it to those who meet the qualified purchaser threshold and not allowing individuals to attend "makes it clear" that firms are "taking this to a very sophisticated level."
Brian Ruane, executive vice-president of The Bank of New York, also noted a recent trend towards requiring attendees at a cap intro event to certify that they met the appropriate criteria. "In more recent times, certainly in the past year," he said, "you would be asked to sign a declaration before you go into the room, which is something that years back wasnít as common." Rogers noted that his firm has used an online click-thru certification, which he said makes the certification process a little easier. "Basically, you are working yourself out of any kind of allegation that you are doing a retail activity," said Ruane, also speaking at the SIA conference. The goal is to demonstrate that the cap intro event is an activity among "consenting, sophisticated parties."
Schonfeld agreed that limiting cap intro events to 3(c)(7) investors ("at a minimum") that are not individual investors is a smart idea. She also suggested that prime brokers include "very clear" disclosure in the invitation to a cap intro event and elsewhere that the invitation is not a recommendation of the particular fund.
During his remarks, Rogers noted that as a result of prime brokersí concerns about private litigation, "thereís been a trend among the prime brokers to eliminate performance information entirely from the actual presentations that might take place." Moreover, he added, performance is not included in any of the information given out directly in the context of the event. The intent, he explained, is to separate the information and have managers themselves give out their performance information. He also described a "reverse inquiry" where investors receive performance information only if they affirmatively ask for it, and where it is provided outside the conference context. The goal, he said, is that when people get up and speak at a cap intro event, "they donít get up and say ĎIíve been up 1000 percentí and they have a chart that just shows a straight line up."
Roger advised brokers to "stick with the concept of what Ďintroducing meansí," as opposed to marketing the fund. "The concept of introducing is that you are bring together investors, its networking . . . itís allowing them to get together," he said. By eliminating the performance discussion, a prime broker can say that investors, on the basis of a cap intro event alone, are not going to be able to make a decision to invest. "You ask anybody, theyíll say ĎIím not investing unless I know the performanceí," unless, he added, the fund in question is a start-up.
Mayer Brown partner Michael Butowsky agreed, noting that brokers, from a liability point of view, have been concerned that by republishing performance information obtained from hedge funds, they were therefore taking responsibility for the accuracy of the numbers, "regardless of the disclaimers they put in."
That, in turn, gets into the issue of what information is available at cap intro events, who is responsible for confirming its accuracy, and who is responsible for delivering it. For example, prime brokers may ask the hedge fund manager to deliver their conflicts disclosure.
Cap intro may raise other conflict issues as well. For example, what if a hedge fund introduced by a prime broker is subsequently sold to advisory accounts managed by the prime brokerís advisory affiliate? At a minimum, disclosures may be required, depending on the prime brokerís role and compensation. If the accounts buying the fund are subject to ERISA, there should be a careful analysis to determine whether the transaction is prohibited or whether fees must be rebated or credited to avoid double-dipping.
All issues to discuss with your favorite lawyer.
What about other types of hedge fund marketing?
Section 3(c)(1) and 3(c)(7) each require that there is no public offering of the fundís shares. Consequently, hedge funds must be privately offered with no general solicitation. That means that hedge funds, and persons acting on their behalf, cannot contact investors via:
articles, notices or other communications published in a newspapers or magazines;
"cold" mass mailings;
TV or radio broadcasts;
publicly-available web-sites (i.e., not password protected);
e-mail messages sent to a large number of previously unknown persons; and
seminars where the participants have been invited via a general solicitation.
According to the SEC, "information contained in newsletters, press articles and even institutional reporting services about a specific hedge fund raises concerns about whether the hedge fund is engaged in a general solicitation or general advertising if that information is provided by the hedge fundís adviser or at their behest."
However, the SEC has long taken the position that a general solicitation is not present when there is a pre-existing, substantive relationship between a hedge fund (or its broker-dealer) and the person being solicited. For hedge funds, the relationship must be established 30 days before the investor can make an investment.
How does this work in practice? As Alan Beller, director of the SECís Division of Corporation Finance famously put it during the SECís Hedge Fund Roundtable, "You canít put up a billboard on Times Square and say, ĎWe have a new hedge fund, but please understand that unless you are an accredited investor, donít callí."
And, if your firm gets a list of 100 accredited investors from a list broker, that wonít work either. "Neither the manager or its agent has a pre-existing relationship of the nature that the SEC expects in a private placement," said Dechert counsel Brian Vargo.
Also keep in mind that once you post something on the Internet, itís public, unless the site is password protected. The SEC and staff have issued guidance on the ways in which the Internet can be used in private offerings, such as the IPONet and Lamp no-action letters. Make sure to read them: a few years ago, the SEC went out of its way to warn that some industry participants were not following the staffís guidance.
Also of note: the SEC staff recently has suggested that a "public offer, private sale" be permitted in the context of Section 3(c)(7) funds.