Interpretive Letter to Michael D. Udoff, Securities Industry Association
October 2, 2003
Vice President and Associate General Counsel
Securities Industry Association
120 Broadway
New York, NY 10271-0080
Dear Mr. Udoff:
This is in response to your letter dated August 6, 2003 in which you seek interpretative guidance pertaining to the sale of hedge funds and funds of hedge funds. We have structured our interpretative guidance in a question and response format, similar to the manner in which your letter was drafted.
1. Notice to Members 03-07 and Reasonable-Basis Suitability
Question: Notice to Members 03-07 ("NASD Reminds Members of Obligations When Selling Hedge Funds," February 2003) states that a member recommending a hedge fund "must have a belief that the product is suitable for any investor" (described in the NtM as "reasonable-basis suitability"). The NtM further states that the member may discharge this suitability obligation by "conducting due diligence with respect to the hedge fund, or in the case of a fund of hedge funds, with respect to the underlying hedge funds."
When recommending a fund of hedge funds, must a member conduct due diligence of the hedge funds in which the fund of hedge funds invests or intends to invest?
Response:
Notice to Members 03-07 was published in February 2003 to draw members' attention to their sales practice obligations in connection with the sale of hedge funds and funds of hedge funds. The NtM focused on five areas: (1) providing balanced disclosure in promotional efforts; (2) performing a reasonable-basis suitability determination; (3) performing a customer-specific suitability determination; (4) supervising associated persons selling hedge funds and funds of hedge funds; and (5) training associated persons regarding the features, risks, and suitability of hedge funds.
The reasonable-basis suitability obligation addresses a member's obligation, in connection with a security it recommends, to have a belief that the security is suitable for any investor. NASD explained that members discharge this obligation 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 offering memorandum, reviewing the subscription agreements, examining references, and examining the relative performance of the fund. NtM 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 a fund of hedge funds. The analysis of whether due diligence may be required at each or some of the underlying funds is fact-specific, and would depend on the information and findings at the fund of hedge funds. When a member's due diligence on a fund of hedge funds establishes a sufficient basis to evaluate the merits and risks of the investment, then generally, for regulatory purposes, no further due diligence into the underlying funds would be required.
2. Notice to Members 03-07 and its Footnote 4 Regarding Recommendations
Question: Footnote 4 to NtM 03-07, citing to Notice to Members 96-60 (Sept. 1996), states that "acting as a placement agent may still bring a member within the term 'recommendation' ... In particular, a transaction will be considered to be recommended when the member or its associated person brings a specific security to the attention of a customer through any means, including, but not limited to, direct telephone communication, the delivery of promotional material through the mail, or the transmission of electronic materials ... Bringing a hedge fund to the attention of a customer therefore may constitute a recommendation."
Is the footnote intended to change existing NASD guidance as to what constitutes a recommendation for purposes of NASD rules generally and/or for purposes of delineating a member's responsibilities regarding hedge funds and funds of hedge funds?
Response:
No. Footnote 4 is not intended to alter existing NASD guidance as to what constitutes a recommendation. Rather, footnote 4 was intended to illustrate the fact that even a member that only acts as a "placement agent" can be deemed to have made a recommendation.
For guidance on the factors relevant in determining whether a specific communication may be a recommendation, members should refer to the analysis applied in the policy statement set out in Notice to Members 01-23. This NtM, which is also referenced in footnote 5 of NtM 03-07, sets forth guidelines to assist members in evaluating whether a particular communication could be viewed as a recommendation, thereby triggering application of the suitability rule.
NtM 01-23 provides "general principles for member firms to use in determining whether a particular communication could be deemed a 'recommendation,'" noting that "the 'facts and circumstances' determination of whether a communication is a 'recommendation' requires an analysis of the content, context, and presentation of the particular communication or set of communications." The NtM adds:
The determination of whether a 'recommendation' has been made, moreover, is an objective rather than a subjective inquiry. An important factor in this regard is whether – given its content, context, and manner of presentation – a particular communication from a broker/dealer to a customer reasonably would be viewed as a 'call to action,' or suggestion that the customer engage in a securities transaction. Members should bear in mind that an analysis of the content, context, and manner of presentation of a communication requires examination of the underlying substantive information transmitted to the customer and consideration of any other facts and circumstances, such as any accompanying explanatory message from the broker/dealer. Another principle that members should keep in mind is that, in general, the more individually tailored the communication to a specific customer or a targeted group of customers about a security or group of securities, the greater likelihood that the communication may be viewed as a 'recommendation.' (footnotes omitted).
While the thrust of NtM 01-23 was the application of the suitability rule to online communications, member firms may rely on the general principles stated therein to determine the application of the suitability rule in the context of the sale of hedge funds and funds of hedge funds, including application of the various examples concerning what constitutes and does not constitute a recommendation.
3. NASD News Release Regarding the Altegris Enforcement Action
Question: In a news release dated April 22, 2003, the NASD announced that it had fined Altegris Investments, Inc. for failing to disclose adequately the risks of investing in hedge funds. Among other things, the news release identified a list of nine hedge fund risks that Altegris had failed to disclose in its sales literature, although "some or all of these risks may have been described in the [hedge fund] offering documents."
Was the release intended to indicate that lists of risk factors must be included on each piece of hedge fund sales literature used by a member?
Response:
No. NASD's advertising rule, Rule 2210(d)(1), requires that each piece of sales material "be based on principles of fair dealing and good faith and should provide a sound basis for evaluating the facts in regard to any particular security . . . discussed . . . ." In addition, "[n]o material fact or qualification may be omitted if the omission, in light of the context of the material presented, would cause the communication to be misleading." Moreover, each piece of sales material used by a member must independently comply with the rules' standards. Thus, members must include only those disclosures that are necessary to ensure that each piece of sales material is fair and balanced.
4. Related Performance in Hedge Fund Marketing Materials
Question: During the course of our discussions regarding the marketing materials at issue in Altegris, you indicated that the NASD is reviewing the inclusion of "related performance" information in hedge fund marketing materials used by members. You also acknowledged that related performance (for example, 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 commonly used by hedge fund managers.
What standards apply to the inclusion of related performance information in marketing materials relating to hedge funds used by members to recommend such funds?
Response:
Sales material published or distributed by an NASD member is subject to Rule 2210, even if a non-member such as a hedge fund manager prepared it. Under Rule 2210, no member may publish or distribute sales material for a hedge fund that presents related performance information.1
In 1998, NASD proposed amendments to our advertising rule that would permit related performance information in mutual fund and variable product sales material. These amendments have not yet become effective; thus, NASD does not permit the use of most forms of related performance information in mutual fund and variable product sales material.
In light of the fact that we have proposed rules in the area of related performance, we do not believe that it would be appropriate to exempt or otherwise interpret NASD rules to permit related performance information for hedge fund sales material. We note that NASD staff also has declined to permit use of related performance information even in those areas for which our pending rule proposal would apply – mutual fund and variable product sales material.
Our interpretative position, however, is not intended to foreclose the possibility of using related performance for hedge funds in the future. We believe the appropriate venue to consider the use of related performance information for hedge fund sales material is in connection with our pending rule proposal. Accordingly, we intend to consider whether our current proposal should be amended to permit related performance information for hedge fund sales material.
We hope the foregoing responds to your questions. As we have said before, we appreciate the SIA's efforts in assembling a group of industry experts to engage us in a discussion of the application of NASD rules to broker/dealers selling interests in hedge funds. If there are any further questions, please do not hesitate to contact us at NASD.
Sincerely,
Gary L. Goldsholle
1 For purposes of this letter, the term "related performance information" includes the performance of other, separate investment companies, funds, portfolios, accounts or composites thereof managed by the same investment adviser, sub-investment adviser, or portfolio manager that manages the hedge fund that the member is promoting. This term includes the performance of so-called "clone" funds and other similarly managed accounts and funds, the performance of funds or accounts that preceded and were converted into the advertised hedge fund, and composites of other similarly managed funds, accounts or portfolios. However, the term generally would not include the performance of a master fund of which a hedge fund is a feeder, to the extent that it reflects the performance of the same portfolio of securities in which the hedge fund's assets are invested. In addition, members must not use any hypothetical or backtested performance that does not reflect the actual performance of the hedge fund.
Under our longstanding position, members may publish or distribute sales material for a public commodity pool that presents the same related performance information that appears in the pool's offering document as prescribed by the Commodity Futures Trading Commission.