Mike McD comment: With the passage of the JOBS (Jumpstart Our Business Startups) Act, the regulatory environment for hedge funds and other private investment managers is about to change dramatically.
I sat down with Kevin Cott, Esq. – An expert on securities law, and our legal counsel, to find out exactly how this new act will affect the industry.
In the interview that follows, we discuss the JOBS act implications for the marketing and promoting hedge funds, presentation of performance metrics, and creative avenues for managers to raise AUM (assets under management).
The situation is rapidly evolving, and it will be important for managers to stay on top of new developments. This is true whether you are a hedge fund manager, a RIA or private investment manager, or if you are a trader considering opening your own shop.
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MIKE: We’ve seen a lot of press regarding the JOBS Act and the affect it will have on hedge fund managers. Can you give us a quick overview of what has happened so far, and how the Act will affect hedge fund managers going forward?
KEVIN: Sure… On April 5th, President Obama signed the JOBS Act, which effectively removes the general solicitation and general advertising prohibition for “rule 506 exempt private offerings.” This is the regulatory framework that most hedge funds operate under.
Previously, if you were doing a rule 506 offering, you could not engage in any act of general advertising or general solicitation. Because of the restrictions, hedge fund managers could only discuss their fund with a very close and restricted group of potential investors.
Under the regulations, managers could only raise capital within a very close circle of friends, family, and professional contacts with whom they have an existing relationship. This made it very difficult for new managers to build their business and raise enough capital to reach critical mass.
With the new regulations under the JOBS act, these restrictions on capital raising will be rendered obsolete. Private fund managers will have a broad array of capital raising options that were previously not given to them.
Essentially, managers will be able to engage in advertising, media broadcasts, public websites, interviews, social media, email campaigns, and any number of other marketing strategies to generate interest in their fund.
MIKE: So it sounds like the majority of restrictions will be lifted… Does this mean that hedge funds will be able to publicize track records? I know that up to this point, any presentation of historical returns or a track record could be considered a solicitation.
KEVIN: Yes, that’s correct. The key is that the JOBS Act essentially eliminates the former “rule 506” restriction on how managers can market and sell their fund. They are still subject to general anti-fraud rules under the securities act and the exchange act.
Managers still cannot engage in anything that would be deemed manipulative or deceptive advertising. Just like any other business, they are prohibited from making untrue statements of material facts.
They will also be subject to specific performance advertising rules.
So specifically for investment advisers, there is already a stream of “no action” letters which are based on the “Clover Capital SEC no action letter.” These guidelines would still apply to applicable managers.
Under these guidelines, there are very specific ways that investment managers need to structure and word performance advertising. For example:
- The effect of material market or economic conditions must be disclosed.
- Managers cannot use “cherry picking” when presenting returns.
- Results must show the deduction of fees and expenses.
- Managers cannot make claims about profits without also disclosing the possibility of loss.
So all of these guidelines would still apply, but the key is that managers will have the ability to disclose the information in a public setting instead of just through one-on-one presentations.
MIKE: So for new and even existing hedge fund managers, I guess there will be a significant ramp-up in terms of presenting this information. Now that they are able to disclose historical information, there is a need to determine how to format and present returns.
KEVIN: Right… Hedge fund managers used to be restricted to basic power point presentations and tear sheets, and now they have a more expanded arena in which they can present. But there is a challenge in figuring out how to advertise in a legally compliant way and make sure that they are not opening themselves up to additional liability…
MIKE: So do you expect to be working with some of your hedge fund clients to help them design advertising material – or working with managers in reviewing promotion ideas?
KEVIN: I think the big initiative is going to be the use of public websites in addition to other public advertising avenues. Managers will want to take advantage of the opportunity to reach a broad audience, but will need to be careful in how the fund or trading program is presented.
Formerly, any fund information offered on the web was done through the General Partner (or management company) of the fund. So the web address would be under the name of the management company and information for the fund would have to be password protected.
Typically there would be a legal disclaimer for the management company, but now if the fund is going to be able to market itself, there will need to be legal disclaimers on all of the fund websites. There is going to be a significantly larger amount of marketing material that needs to be appropriately drafted and appropriately legally disclaimed.
So although the JOBS Act will create a much more open environment for marketing hedge funds, there are a lot of compliance issues that will also need to be addressed.
MIKE: I have to ask, do you think we’ll start to see World Series and Super Bowl commercials for hedge funds? Will “Paulson & Co.” begin sponsoring major sporting events?
KEVIN: In theory, there’s no reason they couldn’t. Of course they would have to follow all of the anti-fraud regulations, but it is certainly a possibility.
MIKE: I guess it’s probably very likely that we will see advertisements on CNBC, Bloomberg TV and other financial networks.
KEVIN: Right now we already have advertising for the management companies and for mutual funds. But the management companies can’t directly mention their funds on-air. So in the future we will probably see more specific advertising for the hedge funds themselves.
The caveat here is that the JOBS act is still pending the SEC’s final draft of the new rules. The regulations won’t actually go into effect until the SEC completes the formal process of drafting and approving the new regulations.
MIKE: So what is the timeline and the process for the proposals to actually be organized and passed into law?
KEVIN: The SEC was given 90 days to basically write rules that remove the general advertising and general solicitation prohibition. So initially that is 90 days from April 5th.
But a lot of times, these rule promulgations will get extended. So it is not guaranteed that they will have final rules within 90 days.
There are a few specific issues that will come into play. Not only is the SEC removing the general advertising prohibitions, there are also caveats to consider.
For example, the rule 506 prohibition on general advertising / solicitation will be removed provided that all investors in the fund are accredited. Formerly you could have up to 35 non-accredited investors in a hedge fund, so that is a significant change that the SEC has to draft.
There is another key concept that will need to be addressed. Essentially the management company itself will have to certify that the investor is accredited.
In the past, a manager could rely on an investor’s claim to be an accredited investor. Of course this was “within reason” – as long as a manager didn’t have a reason to doubt that the investor was truly accredited.
MIKE: But now it looks like the burden of proof will be on the manager to prove that he performed adequate due-diligence to ensure that his investors are accredited — right?
KEVIN: Correct… So these are some of the rules that the SEC will have to draft in addition to removing the prohibition on advertising. The timeline of when they actually complete these rules will be affected by how detailed the SEC is in covering some of these additional regulations being put in place.
MIKE: Do you expect that managers will now have to request pay stubs and tax returns from their prospective investors? And what about grandfather clauses? Do you expect that if someone is already running a fund which makes use of the 35 “non-accredited” slots, that they will be able to continue to operate with these investors in their fund?
KEVIN: That’s a good question… This is a big part of what the SEC will have to clarify as they draft the rules. They will have to disclose how much documentation is required, and what it means to “certify” an investor as accredited. This will be a very important area for managers to follow as the rules are clarified over the next year or two.
At this point I haven’t seen any material that actually addresses a grandfather clause, but that will be an important issue for the SEC to cover as they draft the new rules.
MIKE: Do you think there will be an opportunity for managers to choose between structures – where they can either accept 35 non-accredited subscribers and NOT advertise to the general public, or they can take advantage of the solicitation privileges and restrict their fund to only accredited investors?
KEVIN: This is another critical issue that the SEC will need to address in detail.
My general expectation, based on the way the JOBS act was written, is that managers will have the option of continuing to use the 35 non-accredited investors option, but this will need to be clarified. It all depends on the SEC’s interpretation of the JOBS act.
MIKE: What are some creative ways that a hedge fund manager might be able to use this new latitude in marketing their fund or promoting awareness of their returns, even without spending the $3.2 million dollars for a Super Bowl television ad.
KEVIN: Well, there are a tremendous number of opportunities to pursue. Managers can now speak at conferences. They can attend seminars and discuss their fund with other attendees. We will probably see managers organizing events for the specific purpose of networking and exposing potential investors to the fund.
As far as creative ways of doing this, the sky is the limit. Just like any other small business owner, hedge fund managers can now look for effective ways to reach the broadest number of customers. These could range from online seminars to in-person presentations. Marketers can choose to present to large audiences, or engage prospects individually.
Now, instead of worrying about regulatory restrictions, managers can focus on the cost benefit analysis of promotion activities and build their business much more efficiently.
MIKE: Good deal. We will be sure to stay in touch with you as these new regulations are passed into law and the grey areas are clarified.
Thanks for taking the time to chat with me today — we’ll look forward to circling back in the next few months.
Kevin Cott is the founder and principal at Cott Law Group, and specializes in advising investment managers on all aspects of the fund formation process. His practice focuses on structuring domestic and offshore funds, including traditional hedge funds, incubator funds, private equity funds, commodity pools, forex funds and separately managed account structures.
If you would like to speak with Kevin about forming a new fund, you can contact him via Kevin [at] cottlawgroup.com.
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