NASD Alerts Members to Heightened Due Diligence Responsibilities for Hedge Funds and Funds of Hedge Funds

he NASD recently reviewed member firms that sell hedge funds and funds of hedge funds. It is concerned, especially with sales to retail customers. In Notice to Members 03-07, the NASD states that it "believes that members should take into account the fact that hedge fund investing historically has been available only to high net worth individual investors and institutions and consider whether the fact that certain hedge funds are now available to a broader segment of investors may itself be a red flag that casts doubt on the desirability and suitability of such funds to retail investors." Offering funds of hedge funds, instead of hedge funds, matters not, according to the NASD, because while funds of hedge funds offer diversification, they still present the same concerns as investments in hedge funds directly.

Accordingly, NTM 03-07 reminds members (and their reps) of numerous obligations, including the duty to: 1) ensure that sales promotions provide balanced disclosures of risk and return; 2) perform due diligence to determine that the hedge fund or fund of hedge funds is suitable for any customer; and 3) perform a customer-specific suitability determination. Let's examine each of those reminders.

First, regarding sales promotions, there must be a "fair presentation of the risks and potential disadvantages of hedge fund investing." NTM 03-07 points out that while providing a prospectus or other disclosure document is required, that does not satisfy the duty to provide balanced sales materials and oral presentations. Instead, members (and their reps) must disclose (as applicable) that hedge funds and funds of hedge funds:

Often engage in leveraging and other speculative investment practices that may increase the risk of loss;
Can be highly illiquid;
Are not required to provide periodic pricing or valuation information to investors;
May involve complex tax structures and delays in distributing important tax information;
Are not subject to the same regulatory requirement as mutual funds; and
Often charge high fees.

Likewise, member firms (and their reps) should describe accurately and not exaggerate claims that the hedge funds offer superior management with more investment flexibility, protect against declining markets, or offer better returns due to the imposition of performance-based fees.

Additional information regarding the risks of investing in hedge funds or funds that invest in hedge funds is available. The SEC has published, "Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds," available at www.sec.gov/answers/hedge.htm. Likewise, the NASD has published an Investor Alert entitled, "Funds of Hedge Funds - Higher Costs and Risks for Higher Potential Returns," available at www.nasd.com/investor/alerts/alert_hedgefunds.htm.

Second, regarding product due diligence, NTM 03-07 requires a "heightened responsibility" to investigate, and "substantial due diligence" to perform. Before making a recommendation to any customer, member firms must do at least the following:

Investigate the background of the hedge fund manager;
Review the offering memorandum;
Review the subscription agreements;
Examine references; and
Examine the relative performance of the fund.

Third, regarding customer-specific suitability, the NASD makes clear that evidence of a customer's wealth is not an indicator of suitability, and wealth does not provide a basis for recommending risky investments. NTM 03-07 reminds member firms (and their reps) that they must perform the standard suitability analysis. They must examine the customer's financial status, tax status, investment objectives and any other relevant information to determine suitability before making a recommendation. Furthermore, the notice states that a member's acting as a placement agent still may bring the firm within the definition of "recommendation", citing NTM 96-60, because the firm brought the specific hedge fund or fund of hedge funds to the attention of the customer.

Reps, know these responsibilities before recommending hedge funds or funds of hedge funds to your retail customers.