By Hannah M. Terhune © 2008
Raising Capital and Internet Offers
What good is the best performance record around if few people know about it? Marketing and promotion are vital for a private fund to succeed. However, unlike other businesses significant restrictions exist for private funds. Only registered, listed funds (e.g., mutual funds) may market themselves to the general public. Non-registered, private funds must market themselves and their performance records in a discreet, nonpublic manner.
Private offerings (funds) in virtually all countries are exempt from registration requirements. In nearly all countries exempt funds are subject to limits on the manner of offering; the number and types of purchasers and offerees; the resale of the purchased securities; and in many cases the amount of money raised during a specific time period.
What Creates Illegal Offers?
Marketing to the general public is not allowed for private funds. The general public is everyone in the world except people and institutions you have established a pre-existing relationship. Promoting a private fund in a public chat room or other public forum is a public communication and illegal in most countries.
Quantitative traders aside, fund managers and their investment advisers may well be the most technologically competent players in the fund industry. Once a private fund is established the question arises about use of the Internet to attract investors. Marketing your fund through a website is viewed as an offer to the general public if anyone can access the message. It is possible to avoid an illegal offer when your fund has a secure website allowing password protected access to clients or pre-qualified prospects.
Many countries do not treat information presented on a website as an offer unless it contains both detailed information and a means to subscribe (e.g. a subscription agreement). Other countries treat less detailed information as an offer but do not consider the offer to be made unless the information on the website is targeted at their residents. There are some countries that consider an offer of sale made simply if any information is viewable by their residents. Countries in the latter group are not likely to target the issuer for enforcement activity unless there is evidence that the offer is targeted at their residents in some way. Countries concerned with Internet offerings and enforcement also show interest in the elements of push-pull marketing and volition. If a viewer "pulls" the information from the Internet, the information may not constitute an offer. If the information were "pushed" at the viewer (e.g., through e-mail) the information would treated as an offer.
U.S. Private Funds
In the United States, use of the Internet raises tough issues for funds. Absent special safeguards the SEC views information about a fund spread over the Internet as general advertising and solicitation, which is problematic from a legal standpoint as the Securities Act of 1933 prohibits any form of general solicitation or general advertising on behalf of a private fund. When selling a private fund through the Internet, good planning is needed to avoid legal headaches. Under very limited circumstances the SEC permits a password protected website to provide information about a fund. At a minimum, fund web sites need to ensure fund information is available only to pre-qualified accredited investors and password protected. Self-certification by potential investors of their status as an accredited investor is not allowed; rather, fund managers must evaluate and screen prospects through questionnaires and in-depth phone calls. The private fund's name cannot be disclosed except in materials that can be accessed only by pre-qualified accredited investors through a password. Finally, pre-qualified accredited investors should not be allowed to invest in the fund until 30 days has passed since they were qualified.
Private Investment Advisers
The Investment Advisers Act of 1940 exempts from registration any investment adviser who during the course of the preceding 12 months has had fewer than 15 clients and who does not holds himself out generally to the public as an investment adviser. The SEC interprets "holding out" broadly. The private adviser cannot use business cards or let it be known generally by word of mouth or otherwise that he is available to provide investment advice or accept new clients.
Hedge Fund Databases
There are many websites today that allow accredited investors to scan, monitor and contact the managers of the funds listed. These sites and services have proven to be an effective way for fund managers to obtain investors and prospects. The SEC has advised that a private investment adviser posting information about a private fund on a restricted access web site is not holding itself out generally to the public. Procedures must be in place to limit access to web site information to accredited investors. Private fund managers can post information related to a private fund but cannot offer other services or products on the site. Internet to provide information about an adviser's services would be holding out.
Procedures for Internet Offering
SEC guidance indicates the following criteria are necessary to ensure the mere posting of information on a website is not a public advertisement: the website is run by a broker registered with the FINRA or affiliated with such a registered broker; the website requires a password to gain access; requires the broker to have a pre-existing, substantive relationship with the prospective investor; and the website requires the person signing up for access to the service be qualified as an accredited investor.
Create a Paper Trail
Use questionnaires to establish or determine preexisting relationship, accredited investor status, sophistication, business experience, and/or prior investment with issuer. Questionnaires are helpful in terms of proving general marketing did not take place. SEC guidance indicates that a pre-existing, substantive relationship with the prospective investor can be established through a purchaser questionnaire providing sufficient information to evaluate the offeree's sophistication as an investor and financial situation. You must maintain adequate records of the number and names of the persons contacted in connection with your offering and of the nature and extent of your relationships with them. The goal here is to be ready to demonstrate that a solicitation was controlled, private, and not indiscriminate.
Fund marketing has evolved into an industry of its own. Registered brokers are entitled to distribute private fund information to their own customers even though the fund itself has no pre-existing relationship with the broker's customers. Different rules apply to brokers and for that reason many funds attempt to raise capital with their assistance. Brokers enter into selling agreements with fund managers to find investors for their funds. Brokers work with fund managers on strategy and market positioning. Brokers can identify prospective investors, arrange meetings to pre-qualify prospective investors in terms of overall suitability, accompany managers to investor presentations, prepare marketing materials, follow up with prospective investors, and act as client liaison throughout the investment period. For these services a broker may demand 20% of all fees. The SEC takes the position that the relationship between an intermediary (e.g., broker/dealer, lawyer, or accountant) and the intermediary's client can take the place of the issuer/investor relationship. If you are considering whether to sign a selling agreement there are a variety of issues to consider. The most important issue for sales in the U.S. market is whether the placement agent is licensed as a broker with the SEC and in the various states in which it intends to solicit investors. The placement agent will be selling securities (your fund) and getting paid and needs to have a license. The reason you can sell interests in your own fund without a sales license to investors is because you are covered by issuer exemption. Note that your staff cannot receive separate compensation for their sales efforts under the issuer exemption.
If you use a broker to market and distribute your fund, you should obtain investors certifications to make sure that they qualify for investment in your fund and that statements in the subscription agreement are in fact accurate.
Restrict Delivery of Offering Documents
Procedures such as those outlined by the SEC should be established to limit delivery of the memorandum to persons who are qualified to invest in your fund. Either one person or a limited number of persons should control access to your fund's offering documents and keep records as to who has received a copy of the offering documents. Release of the offering documents should require the approval of some person or persons who has made a solid inquiry as to the prospective offeree.
The Bottom Line
While in some ways it is good that no specific criteria exist as to what constitutes marketing to the general public and an illegal offer, fund promoters must make sure their marketing activities do not rise to the level of a public offer. In just about any country, the best way to raise capital for your fund is to build on existing relationships. Use direct personal contact to identify prospective purchasers or to establish preexisting business relationships in the legal sense. A preexisting relationship is not an absolute requirement especially in situations where only a very small number of persons will be solicited. In larger offerings, however, if there is a preexisting relationship it is less likely that the larger numbers of offerees will result in unlawful public solicitation and illegal offer. The preexisting relationship can exist with either the issuer or its professional intermediary.
By Hannah M. Terhune,
Attorney © 2008
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