Registration of Private Fund Managers –Implementing a Compliance Program

Mayer Brown is a global legal services organization comprising legal practices that are separate entities ("Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP, a limited liability partnership established in the United States;Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; and JSM, a Hong Kong partnership, and its associated entities in Asia. The Mayer Brown Practices are known as Mayer Brown JSM in Asia.

Part II-2: Marketing, Advertising and DistributionCompliance

Michael R. ButowskyMichele L. GibbonsOlga A. Loy

November 19, 2009

Topics to Cover

• Advertising Regulation andGuidelines

– Advisers Act Rules

– Common Examples andDisclaimers

• Private PlacementCompliance

– Regulation D

– Internet Use

– Marketing GuidelinesDisclaimers

– Common Deficiencies– Marketing Guidelines

• Issuer’s Exemption

• Placement Agents

• Pay to Play and PlacementAgent Bans

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Fiduciary Duty of Investment Advisers

• Section 206 of the Investment Advisers Act generallyprohibits an investment adviser from engaging infraudulent, deceptive or manipulative activities.

• An adviser’s fiduciary duties mandate a higher standard ofconduct for advertisements.conduct for advertisements.

• Advertisements must be truthful, balanced accurate andnot misleading.

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Fund Anti-Fraud RuleRule 206(4)-8 of the Advisers Act

• Applies to all communications provided in connectionwith the fund.

• Applies to registered and unregistered advisers

• Applies to registered and unregistered funds

• All communications to the investors or potential investorsmust be truthful, balanced accurate and not misleading.

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What is an “Advertisement”?

• An “Advertisement” includes:

– any written communication addressed to more than oneperson;

– any notice or announcement in any publication, or by radio ortelevision which offers any analysis, report, or publicationregarding securities; orregarding securities; or

– any graph, chart, formula or other device for making securitiesdecisions, or any other investment advisory services regardingsecurities.

• An adviser’s “advertisement” involves an offer of advisoryservices or products of the adviser.

• This broad definition generally encompasses materialsdesigned to maintain existing clients or solicit new clients.

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Common Marketing Materials

• Pitchbooks

• Fact Sheets

• Newsletters/MarketCommentaries

• Emails to Clients

• Brochures

• White Papers

• Speeches• Websites

• Reports to Databases

• Conference Materials

• Consultant Materials

• Speeches

• Interviews

• Questionnaires from ratingservices and consultants

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Less Common Marketing Materials

• Paid advertising inperiodicals

• Press releases

• TV, radio or otherbroadcasts

• Interview or marketingscripts

• Blogs, podcasts, webcasts

• Sponsorship adsbroadcasts

• Mass mailings

• Audio or videopresentations

• Banner ads

• Search engine ads

• Social networking posts

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The “Advertising Rule”Rule 206(4)-1 of the Investment Advisers Act

• No testimonials

• Limitations regarding past specific recommendations

• Limited value of charts, graphs, formulas or othermaterials

• No untrue statements of material facts or statements thatare otherwise false or misleading

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Use of Testimonials Prohibited

• A “Testimonial” is defined as a statement by a former orpresent advisory client which endorses the adviser orrefers to the client’s favorable investment experience withthe adviser.

• An adviser is prohibited from using advertisements which• An adviser is prohibited from using advertisements whichdirectly or indirectly refer to a testimonial regarding itsadvice and other services.

– Common examples: Article reprints, press releases, brochures,webcasts, suggestive graphics, referral letters.

– Exceptions: unbiased third party reports and certain partial listsof clients.

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Testimonials - Partial Client Lists

• Representative Client List

Arizona StateRetirement System

Corporations Public Funds Endowments &Foundations

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Testimonials - Partial Client Lists

• Representative Client List

Arizona StateRetirement System

Corporations Public Funds Endowments &Foundations

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The representative clients were selected based on _______________, the selectionof clients was not based on performance criteria. It is not known whether the listedclients approve or disapprove of the XYZ Portfolio or the advisory services provided.

References to “Past Specific Recommendations” areprohibited

• An adviser is generally prohibited from usingadvertisements that refer directly or indirectly to “pastspecific recommendations”.

• A “past specific recommendation” is a past profitabletrade, transaction or advice.trade, transaction or advice.

• Common Examples:

– Case Studies

– Representative investments

– Client Newsletters and Market Commentary

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Past Specific Recommendation – General Exception toprevent “cherry-picking”

• Exception: the advertisement including past specificrecommendations must list ALL recommendations madewithin at least the prior one-year period.

• The list of all holdings must include:

– Name of each security;– Name of each security;– Date and nature of each recommendation;– Price at which the recommendation was to be acted upon; and– Most recent price of the security.

• The first page of the list must state: “It should not beassumed that recommendations made in the future willbe profitable or will equal the performance of thesecurities in this list.”

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Past Specific Recommendations – Limited Exceptions

• Exception 2: Partial list using objective criteriaconsistently applied and disclosed . (For example, Top 10and Bottom 10 Holdings) Must still make complete listavailable to the SEC. (Franklin No-Action Letter)

• Exception 3: Unsolicited Client/Prospective Client• Exception 3: Unsolicited Client/Prospective ClientRequests (For example, an RFP) and Individualized ClientReports (ICAA No-Action Letter)

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Limited Value of Graphs, Charts and Formulas

• Advisers are prohibited from representing that a graph,chart, formula, or other device being offered can, by itself,guide the investor as to what securities should be boughtor sold or when to buy or sell them.

• If an advertisement uses graphs, charts, formulas or other• If an advertisement uses graphs, charts, formulas or otherdevices, the advertisement must prominently disclose thelimitations and difficulties regarding its use.

• Common Examples

– Descriptive Titles vs. Punchline Titles– Unequal Comparisons (indices)– Sources and Dates– Forecasts and Projections

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Nothing False or Misleading

• Advertisements may not contain any untrue statements ofmaterial fact or be otherwise false or misleading.

• Whether a particular advertisement is false or misleadingwill depend on the facts and circumstances, including:

– The form and content of the advertisement;– The form and content of the advertisement;

– The implications or inferences arising out of the advertisementin its total context; and

– The sophistication of the prospective client.

– SEC guidance, enforcement actions and examinations

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Disclose all Material Facts

• An advertisement is prohibited if a reader would inferfrom it, something about an adviser’s competence orabout possible future investment results that would notbe true if the advertisements had disclosed all materialfacts.

• Common examples:

– Assets under Management– Biographies– Information about Affiliates– Assumptions behind forecast and hypotheticals– Conditions have changed

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Examples

• Rapid/excessive growth in assets under management.

• We rigorously control for risk to achieve our benchmark goals

• XYZ ‘s approach is exceptional and proven successful.

• XYZ has considerable management experience and expertise.

• ______ has enabled XYZ to establish a strong investmentperformance record.

• XYZ is renowned for its distinctive investment approachcoupled with the expertise and skills of global industrialanalysts and individual portfolio managers.

• We have a history of consistent, repeatable returns

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Misleading Performance Results(Clover Capital Management, SEC No-Action Letter)

• Failing to disclose the effect of material market or economicconditions on the results portrayed.

• Failing to reflect the deduction of advisory fees, brokeragecommissions, and other expenses that a client would havepaid.

• Failing to disclose whether and to what extent the results• Failing to disclose whether and to what extent the resultsportrayed include the reinvestment of dividends and otherearnings.

• Suggesting potential profits without also disclosing all materialfactors relevant to the comparison.

• Failing to disclose any material conditions, objectives, orinvestment strategies used to obtain the performanceadvertised.

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Misleading Performance Results(Clover Capital Management, SEC No-Action Letter)

Sample Performance Disclaimer

Performance results are shown net of all fees and expenses andreflect the reinvestment of dividends and other earnings. Manyfactors affect performance including changes in marketconditions and interest rates and in response to other

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conditions and interest rates and in response to othereconomic, political, or financial developments. Pastperformance is not indicative of future results. You should notassume that investment decisions we make in the future will beprofitable or will equal the investment performance of the past.

Model or Hypothetical Performance(Clover Capital Management, SEC No-Action Letter)

• The SEC believes that the following omissions or practiceswould be misleading when using model performanceresults:

– Failing to disclose (if applicable):

• the limitations inherent in model results;• the limitations inherent in model results;

• material changes in the conditions, objectives, or investmentstrategies of the model portfolio during the period portrayed, andif so, the effect thereof;

• that some of the securities or strategies reflected in the modelportfolio do not relate, or relate only partially, to the servicescurrently offered by the adviser; and

• that the adviser’s clients actually had investment results that werematerially different from those portrayed in the model.

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Model or Hypothetical Performance(Clover Capital Management, SEC No-Action Letter)

Sample Disclaimer for Hypothetical Performance

Hypothetical or simulated performance results have certaininherent limitations. Unlike an actual performance record,simulated results do not represent actual trading. Also, since such

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simulated results do not represent actual trading. Also, since suchtrades have not been executed, the results may have under orover-compensated for the impact, in any, of certain marketfactors, such as lack of liquidity. Simulated trading programs ingeneral are also subject to the fact that they are designed withthe benefit of hindsight. No representation is being made thatany account will or is likely to achieve future profits or lossessimilar to those shown. [Disclose Assumptions]

Performance must be shown Net of Fees

• Performance results must generally be shown net ofmanagement fees, brokerage commissions and other feesand expenses.

• Advisers may show performance both net of fees andgross of fees as long as both are displayed with equalgross of fees as long as both are displayed with equalprominence and fully disclosed.

• Model fees (average, highest, etc.) may be used for thecalculation if actual fees are disclosed.

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Net of Fees – One-on-One Presentations(ICI SEC No-Action Letter)

• Exception for one-on-one presentations to certainwealthy clients (accredited investors).

– One-on-one presentation of a private and confidential naturewhere client may ask questions about fees.

– Requires additional disclosures, including a table, chart, or– Requires additional disclosures, including a table, chart, orgraph showing the compounding effect fees will have onperformance over time.

– Material should disclose that it may be used for “one-on-onepresentations only”.

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Comparisons to Benchmarks

• Define the Index.

• Describe how index is computed.

• Describe differences between index and the account thatis being compared.

• Describe factors that effect the index differently (e.g.,volatility).

• Describe the limitations of using an index as acomparison.

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Comparisons to Benchmarks

Sample Benchmark Disclaimer

Benchmarks are provided for illustrative purposes only.Comparisons to benchmarks have limitations because benchmarkshave volatility and other material characteristics that may differfrom the portfolio. Also, performance results for benchmarks do

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from the portfolio. Also, performance results for benchmarks donot reflect payment of investment management/incentive fees andother fund expenses. Because of these differences, benchmarksshould not be relied upon as an accurate measure of comparison.

Selection of Accounts

• In connection with the use of actual performance results,the SEC has stated that if performance results are only fora selected group of accounts, failure to disclose the basison which the selection was made and the effect of thispractice on the results portrayed would be misleading.

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Recordkeeping Requirements

• Advisers must keep all advertisements and all recordsused to verify accuracy of performance, including:

– Account statements

– Brokerage statements

– Custodial accounts– Custodial accounts

• All source materials should be maintained.

• Must be kept for 5 years after last use.

• Includes websites and other media (including speeches,scripts and social networking postings).

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Common Adviser Marketing and AdvertisingDeficiencies

• Inaccurate or misleading performance returns

• Failure to show performance net of fees

• Failure to disclose whether income and dividends werereflected

• Representing model or back-tested performance as actualperformance

• Failure to include necessary elements to preventmisleading advertisements

• Cherry-picking composites

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Common Adviser Marketing and AdvertisingDeficiencies

• Comparing performance to inappropriate indices

• Inaccurate assets under management

• False AIMR-PPS/GIPs claims

• Past specific recommendations• Past specific recommendations

• Testimonials

• Aggressive teaser language

• Inadequate disclaimers

• Lack of or ineffective polices

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Private Placement CompliancePrivate Placement Compliance

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Securities Act of 1933 (the “Securities Act”)

• Every offering of securities within the US jurisdiction mustbe registered or exempt from registration under theSecurities Act of 1933.

• Registration under the Securities Act is a lengthy andexpensive process and exposes issuers to significantexpensive process and exposes issuers to significantliability for any misleading statements in the registrationprocess.

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Regulation D – Rule 506 Safe Harbor:

1. Sales to “Accredited Investors”

2. Limited marketing efforts – no general solicitation orgeneral advertising activities

– Pre-existing Substantive Relationship

– Number of Prospective Investors– Number of Prospective Investors

– Manner of Offerings

3. No re-sales

4. Form D

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Accredited Investor Standard

• Reasonable belief standard

• Knowledgeable and sophisticated

• Rule 501 Definition:

– Institutional investors (banks, brokers, insurance companies,investment companies, SBIC, BDC)investment companies, SBIC, BDC)

– Individuals – individual net worth over $1 million (or incometest)

– Entities – total assets over $5 million

– Issuer - officers and directors of the issuer or GP of the issuer

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No General Solicitations or Advertising

What is a General Solicitation?

2 Tests – (1) Relationship and (2) Means of Communication

Relationship test - show that the issuer has a “pre-existingsubstantive relationship” with the offeree. Options include:substantive relationship” with the offeree. Options include:

1. Prior investment or business dealings

2. Investor questionnaire and evaluation (30 days)

3. Prior substantive relationship with an intermediary

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Use of Intermediaries –Bridging Substantive Pre-existing Relationships

• Broker-dealers

• Capital Introduction Groups

• “Finders”

• Consultants• Consultants

• Third Party Websites

• Other investors and business associates (?)

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Means of Communication

Communication Test – Is it an “offer”?

• An “offer” is anything that may induce a potential investorto inquire about a particular security or transaction

• Specificity of information - The more specific, the morelikely it is an “offer”likely it is an “offer”

• Restrict use of the fund’s name, strategy, terms andperformance

• Restrict information to controlled environments with“pre-qualified” investors

• Restrict information to small number of investors

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Press and the Media

• Tombstone Ads

• Unsolicited articles

• Interviews, quotes and approved articles

• Speaking engagements – who is the audience?• Speaking engagements – who is the audience?

• Indices and ranking agencies

• Subscription-only industry press

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Use of the Internet

• Very limited relief provided by the SEC to third partywebsite providers

• Website must pre-screen all users as accredited investorswith a questionnaire (and a 30 day waiting period)

• No self-certifications• No self-certifications

• No general solicitation to promote the website or events

• No blogs, bulletin boards, banner ads, social networking,etc.

• For offshore funds – SEC Release - “adequate measures”

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Consequences of General Solicitations

• No exemption from registration under the Securities Actor the Investment Company Act

• Disclosure liabilities under the Securities Act

• Voidability of contracts under the Investment CompanyAct (dissolution of fund) -different for offshore funds?Act (dissolution of fund) -different for offshore funds?

• Loss of state exemptions

• Potential broker liability for the sale of unregisteredsecurities

• Early problems in the offering – possible delays to “cooloff” the offering

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Marketing Private Funds – Private placementprocedures

• Pre-qualify offerees and document basis of relationship

• Control the distribution of all sales literature and offeringmaterials

• Limited use of the Fund’s name, strategy, terms andperformanceperformance

• Limit publicity (no press releases, speeches or emails)

• Control internet and electronic communications

• Provide adequate disclaimers and disclosures on fundmaterials

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Placement Agents and the Issuer’sPlacement Agents and the Issuer’sExemption

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Securities Exchange Act of 1934Broker-Dealer Registration

• Definition of a broker

• Use of an unregistered broker-dealer can result inregulatory sanctions, rescission of subscriptions and civiland criminal liability

• Brokers selling fund interests rely on exemptions under• Brokers selling fund interests rely on exemptions underthe Securities Act and Investment Company Act.

• Intent and expectation of the investors is an importantfactor

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Rule 3a4-1 Issuers Exemption/Safe Harbor

• Employees, partners, officers and directors of a privatefund may conduct sales activities without being requiredto register if their sales activities are passive in nature(part of their other activities for the fund) andcompensation is not based on the success of marketingthe fund.the fund.

– No disciplinary disqualification

– Not associated with a broker

– Only 1 “offering” every 12 months

– Issuer vs. adviser

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Solicitors Rule – Advisers Act Rule 206(4)-3

• Solicitors Rule:

– Cash solicitations may not be made to a disqualified person (found tohave violated U.S. securities laws within the last 10 years).

– Agreement must be in writing.

– Unaffiliated solicitors must obtain client acknowledgement:

• Describe the nature of the relationship with adviser;

• Disclose that the solicitor will be paid by the adviser• Disclose that the solicitor will be paid by the adviser

• Describe payment terms;

• Describe additional fees, if any, client will pay as a result of the solicitation and

• Deliver Form ADV Part II

– Non-cash disclosures.

• The Rule does not apply to solicitations for investors inprivate funds, but disclosures of conflicts still required

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Pay -to-Play and Placement Agent bans

• Proposed SEC Rule

• State Bans for State Plans

• Pension Plan Bans

• See Mayer Brown Client Alert for more information

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Please join us for the continuation of this series

• Thursday, December 3 – SEC Examinations

• Please register and submit questions

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Thank youThank youThank youThank you

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Copyright 2009 Mayer Brown LLP

IRS CIRCULAR 230 NOTICE. Any advice expressed within as to tax matters was neither written nor intended by the sender or Mayer Brown LLP to be used and cannot be used by any taxpayer forthe purpose of avoiding tax penalties that may be imposed under US tax law. If any person uses or refers to any such tax advice in promoting, marketing or recommending a partnership or otherentity, investment plan or arrangement to any taxpayer, then (i) the advice was written to support the promotion or marketing (by a person other than Mayer Brown LLP) of that transaction ormatter, and (ii) such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

Disclaimer: This Mayer Brown LLP presentation provides comments and information on legal issues and developments of interest to our clients and friends. The foregoing is not acomprehensive treatment of the subject matter covered and is not intended to provide legal advice. Participants should seek specific legal advice before taking any action with respect to thematters discussed herein.

Mayer Brown is a global legal services organization comprising legal practices that are separate entities ("Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP, a limited liability partnership established in the United States;Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; and JSM, a Hong Kong partnership, and its associated entities in Asia. The Mayer Brown Practices are known as Mayer Brown JSM in Asia.

Michael R. Butowsky, PartnerNew York+1-212-506-2512mbutowsky@mayerbrown.com

Olga A. Loy, PartnerChicago+1-312-701-8093oloy@mayerbrown.com

Mitch L. Gibbons, PartnerHouston, New York+1-713-238-2623+1-212-506-2180mgibbons@mayerbrown.com