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 funds 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 Members 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 NASDs 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 funds 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 NASDs 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 NASDs 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 NASDs interpretative letter providing advice to NASD Members concerning the sale of hedge funds was issued on October 2, 2003 and can be found on NASDs 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. 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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.