Investment Management
OCTOBER 2003
NASD Issues Interpretive Advice to Members Concerning
the Sale of Hedge Funds
The National Association of Securities Dealers
(“NASD”) has issued an interpretive letter to the
Securities Industry Association (the “Letter”)
pertaining to the sale of hedge funds and funds of
hedge funds. The Letter clarifies that reasonablebasis suitability determinations by members of the
NASD (“NASD Members”) in connection with the
sale of a fund of hedge funds generally need not
extend to suitability determinations regarding the
underlying funds. The Letter also announces that no
NASD Member may publish or distribute advertising
and sales literature relating to hedge funds that
include related performance information, with one
limited exception. The Letter also addresses other
recent issues relating to hedge funds.
REASONABLE BASIS SUITABILITY REGARDING
FUNDS OF HEDGE FUNDS
Language contained in Notice to Members 03-07,
“NASD Reminds Members of Obligations When
Selling Hedge Funds,” issued in February 2003 (the
“Notice”), created questions regarding the duties of
NASD Members when making reasonable basis
suitability determinations in the recommendation of
funds of hedge funds. The reasonable-basis
suitability obligation requires an NASD Member to
have a belief that a recommended security is a
suitable investment for any investor, and is distinct
from a determination of suitability for a particular
investor. NASD Members typically discharge this
obligation in the sale of hedge funds by conducting
due diligence with respect to the security being
recommended, including but not limited to,
investigating the background of the hedge fund
manager, reviewing the fund’s offering memorandum
and subscription agreements, examining references,
and examining the relative performance of the fund.
The Letter clarifies that Notice to Members 03-07
was not intended to suggest, in the case of a fund of
hedge funds, that such due diligence must be
performed at each of the underlying funds in the fund
of hedge funds. The Letter clarifies that whether
such due diligence may be required would depend on
the information and the findings regarding the fund
of hedge funds and its manager. Accordingly, when
an NASD Member’s due diligence on a fund of
hedge funds establishes a sufficient basis to evaluate
the merits and risks of the investment, generally, for
regulatory purposes, no further due diligence into the
underlying funds is required.
RELATED PERFORMANCE IN HEDGE FUND
MARKETING MATERIALS
NASD Rule 2210, which governs advertising and
sales literature, generally requires that all NASD
Member communications with the public be fair,
balanced and not misleading. The NASD has had
outstanding since 1998 proposed amendments to
NASD Rule 2210 that, once effective, would permit
certain related performance information in mutual
fund and variable product sales material. The NASD
states that it intends to consider whether its current
proposal should be amended to permit related
performance information for hedge fund sales
material. 1 Until such time, however, the NASD has
announced in its guidance that related performance
information (e.g., including the record of another
fund managed by the same manager as the
recommended fund or including underlying fund
performance in fund of hedge fund marketing
materials) is not permitted for inclusion in hedge
fund sales material.2 Sales material published or
The staff of the Securities and Exchange Commission expressly permits mutual funds and investment advisers to use
related performance information subject to certain limitations.
1
Kirkpatrick & Lockhart LLP
distributed by an NASD Member is subject to NASD
Rule 2210, even if a non-member such as a hedge
fund manager prepared the material.
The Letter states that the term “related performance
information” includes the performance of other,
separate investment companies, funds, portfolios,
accounts or composites managed by the same
investment adviser, sub-investment adviser, or
portfolio manager that manages the hedge fund that
the NASD Member is promoting. Of potential
concern for hedge funds and funds of hedge funds is
that the related performance information excluded
from hedge fund advertising and sales literature used
by NASD Members includes (i) the performance of
so-called “clone” funds
(e.g., onshore and offshore funds run on a side by
side basis) and other similarly managed accounts and
funds, (ii) the performance of funds’ accounts that
preceded and were converted into the hedge fund in
the advertising or sales literature, and
(iii) composites of other similarly managed funds,
accounts or portfolios. In this regard, the interpretive
guidance prohibits related performance information
in advertising and sales literature commonly used
when selling hedge fund interests. Additionally, the
interpretive guidance prohibits the use of
hypothetical or back-tested performance that does
not reflect the actual performance of the hedge fund
(e.g., model portfolio performance based on the
underlying funds that comprise the portfolio of a
fund of funds) and the separate performance of the
underlying funds in a fund of funds’ portfolio. The
NASD’s sole noted exception is that the related
performance prohibition generally would not include
the performance of a master fund of which a hedge
fund is a feeder fund, to the extent that it reflects the
performance of the same portfolio of securities in
which the hedge fund’s assets are invested.
It is our understanding that the NASD does not
consider a private offering memorandum to be
advertising or sales literature. Therefore, hedge
funds and funds of hedge funds may wish to consider
whether to include related performance information
in such a document, rather than in other materials.
The NASD’s guidance regarding related performance
information, however, raises serious issues in the sale
of hedge funds by NASD members, as well as issues
regarding the updating of information that may be
contained in a private offering memorandum.
OTHER ISSUES
The NASD clarified that the Notice was not intended
to alter existing NASD guidance regarding what
constitutes a recommendation of a hedge fund. The
guidance explains that a footnote reference in the
Notice relating to the activities of a placement agent
was intended only to illustrate that an NASD
Member acting as a placement agent could be
deemed to make a recommendation of a hedge fund.
In addition, the NASD clarified that its April 22,
2003 news release announcing an enforcement action
against Altegris Investments, Inc. for failure to
disclose risks relating to hedge funds was not
intended to indicate that risk factors regarding a
hedge fund must be included in advertising and sales
literature.
Because the interpretive guidance is an expression of
the NASD’s views regarding the application of an
existing rule, it is effective immediately and NASD
Members that participate in the sale or distribution of
hedge fund interests should comply accordingly.
CONCLUSION
The NASD’s interpretative letter providing advice to
NASD Members concerning the sale of hedge funds
was issued on October 2, 2003 and can be found on
NASD’s website at www.nasd.com.
MICHAEL S. CACCESE
617.261.3133
mcaccese@kl.com
GEORGE J. ZORNADA
617.261.3231
gzornada@kl.com
ERICA BLAKE
617.261.3244
eblake@kl.com
The prohibition on use of related performance information applies to all advertisements, sales literature and
correspondence, which includes: (1) all material published, or designed for use in, a newspaper, magazine or other
periodical, radio, television, telephone or tape recording, videotape display, signs or billboards, motion pictures,
telephone directories (other than routine listings), electronic or other public media; (2) other written or electronic
communications distributed or made generally available to customers or the public not covered in (1) above;
(3) circulars, research reports, market letters, performance reports or summaries, form letters, telemarketing scripts,
seminar texts, and reprints or excerpts of any other advertisement, sales literature or published article; and (4) any
written or electronic communication prepared for delivery to a single current or prospective customer, and not for
dissemination to multiple customers or the general public.
2
Kirkpatrick & Lockhart LLP
2
Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States,
with more than 60 lawyers devoting all or a substantial portion of their practice to this area and its related
specialties. The American Lawyer Corporate Scorecard, published in April 2003, lists K&L as a primary legal
counsel to the investment companies, board members or advisory firms for 15 of the 25 largest mutual fund
complexes. No law firm was mentioned more frequently in the Scorecard.
We represent mutual funds, closed-end funds, insurance companies, broker-dealers, investment advisers, retirement
plans, banks and trust companies, hedge funds, offshore funds and other financial institutions. We also regularly
represent mutual fund distributors, independent directors of investment companies and service providers to the
investment management industry. In addition, we frequently serve as outside counsel to industry associations on a
variety of projects, including legislative and policy matters.
We work with clients in connection with the full range of investment company industry products and activities,
including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance
products, private and offshore investment funds and unit investment trusts. Our practice involves all aspects of the
investment company business.
We invite you to contact one of the members of the practice, listed below, for additional assistance. You may also
visit our website at www.kl.com for more information, or send general inquiries via email to
investmentmanagement@kl.com.
BOSTON
Michael S. Caccese
Philip J. Fina
Mark P. Goshko
Thomas Hickey III
Nicholas S. Hodge
617.261.3133
617.261.3156
617.261.3163
617.261.3208
617.261.3210
mcaccese@kl.com
pfina@kl.com
mgoshko@kl.com
thickey@kl.com
nhodge@kl.com
LOS ANGELES
William P. Wade
310.552.5071
wwade@kl.com
NEW YORK
Beth R. Kramer
Richard D. Marshall
Robert M. McLaughlin
Loren Schechter
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212.536.3941
212.536.3924
212.536.4008
bkramer@kl.com
rmarshall@kl.com
rmclaughlin@kl.com
lschechter@kl.com
SAN FRANCISCO
Eilleen M. Clavere
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David Mishel
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Richard M. Phillips
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eclavere@kl.com
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WASHINGTON
Clifford J. Alexander
Diane E. Ambler
Catherine S. Bardsley
Arthur J. Brown
Arthur C. Delibert
Robert C. Hacker
Benjamin J. Haskin
Kathy Kresch Ingber
Rebecca H. Laird
Thomas M. Leahey
Cary J. Meer
R. Charles Miller
Dean E. Miller
R. Darrell Mounts
C. Dirk Peterson
Alan C. Porter
Theodore L. Press
Robert H. Rosenblum
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Lynn A. Schweinfurth
Donald W. Smith
Robert A. Wittie
Robert J. Zutz
202.778.9068
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This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2003 KIRKPATRICK & LOCKHART LLP.
ALL RIGHTS RESERVED.