The holidays provide the opportunity for us take a step back from the routine, remind ourselves of our priorities, and gain fresh perspective. Instead of being forced back to work and feeling completely apprehensive about returning to our professional duties, we can actually view the process with an appreciation for renewed perspective.
As 2011 commences and the effects of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) are being felt more and more, we believe this is a suitable time to revisit a few quandaries. We will do this over the next several communiqués. Today we want to iron out some of the confusion surrounding the applicability of Securities and Exchange Commission (“SEC”) related regulations to private fund presentations, partner letters, and other materials. Specifically, we want to consider Rule 206(4)-1 (“the Advertising Rule”), under the Investment Advisers Act of 1940 (“Advisers Act”) and associated guidance.
The Advertising Rule is a tricky one to raise with private fund managers given that private funds are prohibited from advertising and hence, the Advertising Rule should not be applicable. Generally speaking, if private fund advisers do not want to register their private funds, they cannot make a general solicitation or advertise. It seems pretty black and white, so why raise the topic? Investment advisers, whether registered with the SEC or not, are subject to the anti-fraud provisions of the Advisers Act. It is important to understand that the application of the anti-fraud provisions is dependent on the specific facts and circumstances. Section 206 of the Advisers Act specifically prohibits investment advisers from engaging in fraudulent, deceptive or manipulative activities. By extension, the materials created and disseminated by investment advisers, even if only related to unregistered funds and are for use only by sophisticated investors, are subject to these anti-fraud provisions.
The Advertising Rule was created to address prohibited advertising activities by registered advisers pursuant to the anti-fraud provisions. These prohibitions are very broad. Private fund managers would be well served to gain an understanding of these prohibitions as they would be better equipped to comply with the anti-fraud provisions. To clarify, this would be a best practice as opposed to hard fast rule applicable to private fund managers.
While private fund materials, such as due diligence questionnaires and letters to investors, may not necessarily be deemed “advertisements” as defined in the Advertising Rule, they share many of the characteristics of investment adviser advertisements such as presenting performance and commentary regarding an adviser’s investment strategies. Thus, by applying SEC guidance to these materials, an adviser is following what the SEC has previously indicated will likely not violate the anti-fraud provisions.
The SEC Advertising Rule is relatively short with little detail. The SEC has issued further guidance regarding the Advertising Rule in the form of no-action letters which can be seen as a type of safety net for advisers. A no-action letter is the SEC’s response to an investment adviser’s (or some other interested party’s) formal written request to the SEC requesting the SEC’s feedback and whether or not the SEC would take issue with certain specific activities the investment adviser lists in its request. The SEC would generally respond with a detailed answer, specific to the facts and circumstances presented. If the SEC provides feedback that the agency would not take issue with the facts and circumstances presented, other advisers may engage in similar activities relying on the “no-action letter” requested by the original firm.
Specific Prohibitions and Limitations
Advertisements include any written communication addressed to more than one person that offers any analysis, report, or publication regarding securities or any graph, chart, formula or other device for making securities decisions, or any other investment advisory services regarding securities. An advertisement involves an offer of advisory services or products of the adviser. Note that the definition does not distinguish between prospective and existing clients. As mentioned above, the advertising rule has relatively few prohibitions. Among the prohibitions and limitations are those with respect to testimonials, past specific recommendations and, any untrue statements of material facts or statements that are otherwise false or misleading. It is important to understand that failing to make adequate disclosure is considered manipulative and misleading.
One of the most confounding restrictions under the Advertising Rule is that regarding past specific recommendations. The SEC’s intent is to prevent advisers from “cherry picking” favorable investments and using them to represent the adviser’s investment expertise or what a client may experience. Thus, registered advisers are prohibited from providing past specific recommendations related to transactions or advice made by the investment adviser that was or would have been profitable. Examples of past specific recommendations include mentioning specific securities in commentary to clients and using a representative investment in a standard presentation to illustrate an investment strategy. The SEC has provided limited no-action relief with respect to materials that include references to securities selected through consistently-applied, non-performance based criteria, such as top 10 holdings lists. Another exception is unsolicited requests, such as from prospective clients through requests for proposals or reports made to clients that are individualized or customized. As mentioned above, private fund materials may not necessarily be deemed advertisements. However, again we return to an adviser’s responsibility to create and disseminate materials that do not violate the anti-fraud provisions of the Advisers Act. An adviser may forego mentioning past specific recommendations or apply the exceptions mentioned above, among others. An adviser may also want to contact its attorneys or compliance consultants regarding these exceptions as well as the appropriate disclosure to include when discussing specific investments in private fund materials.
The broadest prohibition in the advertising rule is that regarding making any untrue statements of material facts or statements that are otherwise false or misleading (or failing to make adequate disclosure). We have already discussed some of the applicability of this provision to private fund materials. The Clover no-action letter provides guidance regarding the use of performance in advertisements and disclosure that should be included so the materials do not violate the advertising rule and anti-fraud provisions. Using the disclosures provided in the Clover letter is a good first step when it comes to preparing private fund materials. An adviser should also consider other disclosures appropriate to the material(s). One size fits all disclosure is not a solution except for universally applicable disclosure such as mentioning that “Past performance is no guarantee of future results.”
An Intertwined Relationship
In short, whether or not a private fund’s materials are investment adviser advertisements is not really the primary consideration. First, the materials should be prepared with a view to not violating the Advisers Act’s anti-fraud provisions to which all advisers, registered or not, are subject. Second, one should recognize that advisers and the private funds they manage are in an intertwined relationship. Registered advisers are subject to the Advertising Rule. The requirements of the rule and SEC guidance flows through to private fund materials not only as a means to protect the adviser, but also as a best practice to provide accurate, meaningful information to investors and potential investors.