NASD Review of Hedge Fund Advertising Results in Formal Action
In January 2003, NASD’s Advertising Regulation Department contacted 64 NASD member firms to determine their level of compliance with the NASD and SEC rules that govern advertisements and sales literature for hedge funds and funds of hedge funds. Twenty-five firms responded that they had not used such communications during the subject time period. Thirty-nine firms responded with submissions of over 1000 communications including Web pages, brochures, electronic newsletters, seminar materials, and form letters. Certain items raised serious compliance concerns in the areas of risk disclosure, accuracy of language, and presentation of performance data. NASD staff provided written commentary to all 39 firms that responded with material.
In connection with this review, NASD recently announced that it had censured and fined a firm $175,000 for distributing sales literature regarding specific hedge funds that violated NASD advertising rules. In addition to the censure and fine, the firm has undertaken to file prior to use, for a period of six months, all sales literature and advertisements. NASD also censured and fined the firm’s Chief Compliance Officer $20,000 for failing to adequately supervise the firm’s advertising practices. (See Altegris Investments, Inc., Letter of Acceptance, Waiver and Consent, No. CAF030015.)
NASD found that the member firm distributed 26 pieces of hedge fund sales literature that failed to include important disclosures regarding specific risks of investing in hedge funds. The sales literature also made unbalanced presentations about the particular hedge funds being offered that failed to provide investors with a sound basis for evaluating whether to invest in the funds. NASD Conduct Rule 2210 requires that members’ communications provide a sound basis for evaluating the facts with respect to any product or service discussed. The rule also prohibits exaggerated, unwarranted or misleading statements or claims, unwarranted forecasts, or projections of future performance.
Two of the items were research reports on specific hedge funds written by a registered representative at another member firm. These research reports contained exaggerated and unwarranted statements and claims. For example:
The second research report made the following unwarranted 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."
The second research report inaccurately stated that the hedge fund was "subject to NASD inspection" and that "the NASD will audit the fund as well." The research report went on to say, "For some, this layer of regulatory oversight is comforting." The statement was false since NASD does not and will not audit the hedge fund.
In addition, certain sales literature presented hypothetical results for specific hedge funds that either had limited operating history or no operating history. Finally, the firm failed to timely file 12 pieces of sales literature for public direct participation programs with NASD’s Advertising Regulation Department as required by Rule 2210.
In its review of members’ hedge fund communications, NASD has noted the following general areas of concern:
Communications regarding hedge funds and funds of hedge funds must adequately disclose the risks associated with these products. Presentations must address the risks associated with hedge funds in general as well as the specific risks associated the fund being offered including, but not limited to, the risks associated with a fund’s structure, investment strategies, portfolio securities, tax treatment, etc. Importantly, marketing material must stand on its own merits. Members should not rely on delivery of an offering document to remedy the omission of risk disclosure in communications with the public.
Misleading or Exaggerated Language
Some communications for specific funds have misstated those funds’ investment objectives. For example, some sales literature has stated that a fund’s objective is to produce a steady or predictable return when, in fact, the fund’s prospectus does not disclose such an objective. In general, sales material for a specific offering should reflect the disclosure contained in the offering document.
Members should also avoid language that states or implies hedge funds or funds of hedge funds are appropriate for all investors or should be part of all investors’ portfolios. Similarly, members must avoid language that embellishes the investment adviser’s capabilities.
NASD has noted that some marketing materials contain language that states or implies an investor can expect a specific rate of return from investing in a fund. Such projections or predictions of investment results are prohibited. Members should be very cautious about forward-looking statements with respect to securities investments.
Members should restrict discussions of performance results to actual performance of the fund being promoted. Communications must not attribute the performance of another product to a new fund that has either a limited operating history or no operating history.
Some hedge funds offered by members are exempt from registration under the Securities Act of 1933. In most instances, as stated in SEC Rule 502(c), such privately placed funds may not be offered or sold by any form of general solicitation or general advertising, including, but not limited to, the following:
Any questions regarding compliance with NASD advertising rules regarding hedge fund communications with the public may be directed to the Advertising Regulation Department at (240) 386-4500.