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Finra's suitability rules on private funds create conflicts

Regulator's recently-adopted rules seem to directly contradict the implicit promise of privacy from SEC/CFTC rule

Jan 15, 2013 @ 12:01 am

By Kevin Duffy

Regulation, finra
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Over the last several years the entry costs for marketing alternative investments has been pushed ever higher. Now a series of somewhat conflicting regulations has pushed those costs to new heights and threatens the traditional way in which many of these investments are marketed.

The regulations at issue here are the SEC/CFTC's Rule that has been implemented pursuant to Section 404 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly known as Rule PF (and Form PF); FINRA's enhanced Rule 2111 concerning suitability; and most recently FINRA Rule 5123. Rule PF is generally viewed as demanding confidential information with the understanding by the industry that the information will be guarded by the SEC/CFTC and kept in confidence. The other rules listed above now would take the confidential information in Form PF and disclose it to the world. The clash of these regulatory mandates will noticeably change the way that hedge funds and private equity funds are marketed by broker-dealers and financial advisers. Needless to say, the interaction of these rules will also have the potential to change the landscape of regulatory investigations and arbitrations.

Rule PF AND Form PF

The SEC/CFTC, through Rule PF, requires private fund managers to disclose certain detailed data so that it may assemble information for the Financial Stability Oversight Council (FSOC) to assess whether a Funds business and/or investments pose a systematic risk to the domestic financial system. The SEC and CFTC have stated that those advisers that are determined to have systematic risk to the financial system would also be subject to oversight by the Federal Reserve Board. This information is deemed to be private by the SEC and CFTC.

Rule PF and its Form is not static one-time filing. Rather, Rule PF requires hedge fund, liquidity fund managers to make annual or quarterly filings to the SEC/CFTC concerning their investments and use of leverage or borrowed securities. Large private fund advisers, those with more than one billion in assets under management, are required to file Form PF on a quarterly basis.

Those fund managers who are registered investment advisers, which have less than one billion dollars in AUM will only have to file Form PF on an annual basis. The information required on Form PF is extensive and much would be considered proprietary. Those advisers to private funds that invest exclusively in other private funds will have limited disclosure requirements. However, all private fund advisers will be required to disclose the total and net assets under management broken out by the types of funds it advises. In addition, information about the Funds' gross and net assets, the aggregate notional value of derivative positions, location and identification of creditors to whom a fund is indebted in excess of 5% of its net asset value (“NAV”) — including broker-dealer counterparties, number of beneficial owners of each fund, the percentage ownership of the five largest shareholder, and the monthly and quarterly performance for each of the funds. Registered hedge fund managers will also be required to disclose investment strategies, percentage of portfolio based on computer driven computer trading, the identification of significant trading counterparties and the trading and clearing practices of the fund(s).

Suitability Requirements under FINRA Rules 2111 and 5135

Many hedge fund, private equity and liquidity fund investments have been introduced to potential clients by broker-dealers. Broker-dealers and their registered employees have long had an obligation to make sure that the investments that they recommended to clients are “suitable.” Investments in private funds have traditionally been vetted by a broker –dealer through due diligence questionnaires and meetings. Now however, a broker dealer and its registered representative may have the obligation to go one step further, requiring the disclosure of Form PF from any private fund marketed by the broker-dealer. This disclosure requirement is not part of Rule PF but is part of the newly enhanced suitability requirements put forth in FINRA Rule 2111.

As stated in FINRA Rule 2111, a broker-dealer and its registered representatives must “have a reasonable basis to believe that a recommended transaction of investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm] or associated person to ascertain the customer's investment profile.” The new Rule further states that a “broker must perform reasonable due diligence to understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and determine whether the investment is suitable for at least some investors.” The FAQ's section of May 12-25 FINRA Release has also specifically stated that the JOBS act does not obviate the need for a broker-dealer” “recommends” a private placement…. The suitability rule applies.”

Many times the following situation may arise: a broker–dealer, backed by a lot of money, goes to a hedge fund and offers to invest a large amount on condition that the fund advisor turn over its PF Form, thus saving the broker-dealer the costs of doing a proper “due diligence” investigation. The hedge fund wants or needs the promised investment and turns over the PF Form demanded. At that point, all of the proprietary information given supposedly in confidence to the SEC becomes public. This, of course, is in stark contrast to the stated reasons giving impetus to the enactment of Rule PF.

Most recently FINRA implemented Rule 5123 which requires that a broker-dealer that sells interests in a private placement (non-public offering) must file an offering memorandum or term sheet and all material amendments with FINRA within 15 days. True, this rule provides a series of exceptions, but most private equity and hedge funds that are marketed through broker-dealers will be subject to it. Although the rule itself is not specific as to what documents need to be filed, it is apparent that FINRA will be seeking to further member compliance with the disclosure requirements for exempt entities as set forth in the Securities Act of 1933. Some people are expecting that the disclosure in part will include a copy of the PF Form.

The Potential Conflicts

What does the passage of these rules accomplish for the average “accredited investor”? Nothing. It demonstrates merely that the regulators have not thought through the implicit promise of privacy that Rule PF and Form PF purport to give fund managers.

FINRA's recently-adopted rules seem to directly contradict the implicit promise of privacy that Rule PF promised. Instead, it will be left to future regulators, arbitration panels and the courts to decipher what constitute proper “due diligence” when marketing private funds. In the meantime, the so-called “private “ fund filings made by hedge fund and private fund managers are fair game in any due diligence investigation by a broker-dealer or its affiliated employees. Obviously this will benefit those large fund managers that maintain their own marketing departments, fund-to-fund complexes that have little proprietary information to hide and those fund managers who do not use broker dealers to raise funds. It can hurt small RIA hedge fund and private equity managers and small broker-dealers. But more importantly, it places professional investors who run these funds at a competitive disadvantage compared to those who seek to use the JOBS act as a method of raising money. This, of course, has the potential to remove those who are most critical of startup and small companies from that arena.

Kevin T. Duffy, partner, Kaufman Dolowich Voluck & Gonzo focuses his practice in securities litigation, FINRA arbitrations and private fund formation. He can be reached at kduffy@kdvglaw.com.

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