SAN FRANCISCO, CA (White and Case, LLP) – One of the most important considerations for hedge fund managers when establishing or reviewing prime brokerage arrangements is the capital introductioncapability of the prime broker. Expanding the distribution for most hedge funds is often essential to their success, but as we will see, the regulatory risks associated with such �capitalintroduction� activities are substantial and growing.

Broadly, hedge funds raise capital by selling directly to investors in reliance upon the �issuer exemption� in Rule 3a4-1 under the Securities Exchange Act of 1934, or through broker dealers in third party distribution arrangements. Because hedge funds are unregistered entities, they are prohibited from making a general solicitation or making use of general advertising. It has been interpreted by the staff of the Securities and Exchange Commission (the �SEC�) that when there is a pre-existing, substantive relationship existing between an issuer or its broker-dealer and the offeree, no general solicitation is present. Accordingly, under this SEC interpretation, a broker dealer may present information about hedge funds to its existing clients with which the broker has an established relationship.

The SEC staff expressed concern about hedge fund marketing arrangements in its September 2003 Implications of Hedge Fund Growth report. The SEC staff expressed concern regarding third party marketing arrangements pursuant to which brokers identify new investors, hold seminars, and assist potential investors in understanding the products and completing the subscription documents. The SEC staff also reiterated its concern regarding the use of the internet as a tool to reach potential investors for non-public offerings, such as hedge funds. Essentially, the SEC staff position has been that there is no general solicitation if investors are solicited to purchase hedge fund interests if access to hedge fund information is available only through a password protected website, and then only 30 days after the investor is determined to be qualified. But then the NASD got involved.

In February 2003, the NASD issued a Notice to Members (�NTM 03-07�) reminding brokers of their obligations when selling hedge funds and registered closed end investment companies that invest in hedge funds, or public �funds of hedge funds.� The NASD indicated that brokers must provide balanced disclosure in promotional efforts, perform a reasonable basis suitability determination, perform customer specific suitability determinations, supervise associated persons selling hedge fund or funds of hedge funds, and train associate persons about the features, risks, and suitability of hedge funds. Although the NASD acknowledged that the risks of marketing hedge funds to �retail� investors created greater risks to the investing public, the NASD did not draw any distinctions between disclosures that might be appropriate for an institutional investor in a hedge fund and those that might be appropriate for a retail purchaser of a closed end fund of hedge funds.

In April 2003, the NASD brought an enforcement action against Altegris Investments, Inc., for �failing to disclose the risks associated with hedge funds when marketing them to investors.� The NASD determined that although the hedge fund offering documents may have contained sufficient disclosure concerning the risks associated with the hedge funds, the marketing documents failed to disclose nine specific and material risks regarding the funds marketed by Altegris. In October 2004, the NASD brought another enforcement action along the same lines against Citigroup Global Markets, Inc. In this case, Citigroup was fined and censured for disseminating inappropriate sales literature that cited a targeted rate of return without providing a sound basis for evaluating the target, the improper use of hypothetical returns in charts and graphs, and the failure to include adequate risk disclosure. The NASD found that among the risks not disclosed were that the �funds are speculative and involve a high degree of risk, that an investor could lose all or a substantial amount of his or her investment, that there is no secondary market nor is one expected to develop for the funds, that there may be restrictions on transferring fund investments, that the funds may be leveraged, that the funds� performance may be volatile, that the funds have high fees and expenses that would reduce returns and other specific risks�� If these types of disclosures sound familiar, you may have recently read a mutual fund prospectus.

So what do these recent NASD actions mean to the hedge fund community? For prime brokers that provide a capital introduction service, the implications are fairly obvious. You must determine that all of the hedge fund documents, including the marketing materials, contain all of the disclosures that the NASD has indicated in NTM 03-07 and the two above-referenced enforcement cases, are required. You must make, and document that you have made, suitability determinations, and you must train, and document that you have trained, sales personnel who are involved with marketing hedge funds and funds of hedge funds.

But the NASD does not have jurisdiction over hedge funds because, in most cases, hedge fund managers are not brokers and therefore not NASD members. Can�t touch this, right? Try again. Rule 206(4)-1 under the Investment Advisers Act of 1940 (the �Advisers Act�) makes it illegal for any investment adviser to use any advertising that is false or misleading. Because Rule 206(4)-1 is under the anti-fraud section of the Advisers Act, the SEC can bring enforcement proceedings against any hedge fund manager whether or not the manager is registered as an investment adviser. Accordingly, to the extent a hedge fund manager produces marketing materials that are later found objectionable, the SEC can proceed directly against the hedge fund manager. Capital introduction dries up quickly once the SEC brings an enforcement action.

In conclusion, given our current regulatory environment, it is time for hedge fund managers and prime brokers to review the way marketing materials are produced and disseminated. Industry participants must remember that it is not enough if the offering memorandum contains all of the material risks and disclosures, the marketing materials must also contain adequate and appropriate risk information.

Note:

White & Case LLP represents hedge fund sponsors and advisers, prime brokers, and administrators through its 38 offices in 25 countries around the world. For further information on the White & Case hedge fund practice, contact:

Jay B. Gould, Esq.
White & Case LLP
San Francisco, California 94111
415-544-1112 (O)
310-800-6500 (C)
Jgould@whitecase.com