NSCP Currents: Best Practices for Disclosure Documents
By: Nada Litwin and Jeff Blumberg
Why Create a Disclosure Document At All?
Under the federal securities laws, if an issuer (e.g., a hedge fund or a private equity fund) is offering securities solely to accredited investors (which is a common practice among private fund managers) on a private placement basis in reliance on Rule 506 adopted under Regulation D of the Securities Act of 1933, as amended, there is no explicit requirement to provide a “disclosure document” to prospective investors. So why would a private fund manager invest the time and the money to draft a disclosure document (also called an offering memorandum, a private placement memorandum or a PPM) to provide to prospective investors before investing? The simple answer is that a well-drafted disclosure document (usually with the help of outside counsel) is one of the most cost effective insurance policies a private fund manager can implement.
The basic requirement under the federal securities laws and regulations for private placements to accredited investors is that the prospective investor must receive sufficient information to make an informed decision as to whether to purchase the relevant security. The most straightforward way to ensure that a prospective investor receives this level of disclosure, and that the manager can prove that such disclosure was provided, is through the delivery of an offering memorandum. A key concern in drafting a PPM is that you should not omit any information that a reasonable person would consider relevant in making an investment decision. In the words of a former colleague, “The PPM should be the defense’s Exhibit A, not the plaintiff ’s Exhibit A.” To put this into more legalistic terminology, as a best practice, a PPM should disclose all materials facts and should not omit to disclose all materials facts necessary to make the information provided therein not misleading to the prospective investor.
What Should a PPM Include?
Given that a PPM is intended to provide disclosure of all of the material facts relating to the security being offered, a PPM should generally include, at a minimum, the following topics:
- Background Information on the General Partner and/or Investment Manager
- Investment Objective, Strategy and Limitations (if any)
- Management Fees, Incentive Compensation and other fees and expenses
- Investment, Withdrawal and Transfer Procedures and Limitations
- Risk Factors
- Conflicts of Interest
- Tax Issues
- ERISA Issues
As the key disclosure document for private fund investors, the PPM must be prepared very carefully. Most importantly, a PPM must not contain any materially misleading statements or omissions because even if a private fund and the offering of its interests are exempt from most of the substantive provisions of the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Company Act of 1940, they are still subject to the general antifraud provision of the federal and state securities laws.
Updating a PPM – Best Practices
If you have ever seen a PPM for a private fund, you will have noticed that there is usually a date on the cover of the PPM. This date is significant because the private fund and its sponsor are making a representation each time the PPM is delivered to a prospective investor that the information in the PPM is accurate as of the date on the cover. That being said, there is still a potential issue if there has been a material change relating to the private fund since the date of the PPM. If a PPM dated three years earlier includes a statement that is materially inaccurate as of the date the PPM is delivered to a prospective investor and that prospective investor does not receive supplemental disclosure of the corrected information, the private fund has violated the basic requirements under Regulation D notwithstanding the fact that the information contained in the PPM was, in fact, accurate as of the date on the cover of the PPM.
As a best practice, the sponsor of private funds should be reviewing the PPM for each private fund it manages no less frequently than annually. We commonly recommend that this review be made part of a registered investment adviser’s or registered commodity pool operator’s annual compliance review process. For sponsors that are exempt from such registrations, there should be a regular schedule on which the responsible employees take the time to review the PPM closely to ensure there have been no significant changes since the last update. While frequent updates are never a bad thing, an annual review of a PPM does not necessarily mean that the PPM needs to be updated annually – if there have been no material changes to the terms of the private fund or the ancillary regulatory disclosures included in the PPM (e.g., the tax or ERISA disclosures), then there is no obligation to update a PPM solely for the purpose of updating it.
In addition, if there are material changes to the business terms of a private fund (e.g., fees, expenses, liquidity, etc.), the PPM should be updated promptly to reflect those changes (rather than waiting until the next regular review process) and certainly prior to any new investors being accepted into the private fund under the revised terms.
With respect to existing investors and any updated PPM, a private fund manager should, at a minimum, provide existing investors with a summary of any material changes to the PPM and offer to deliver a copy of the revised PPM upon request. Obviously, many material changes will require investor consent pursuant to the fund’s governing documents, so investors would have received the relevant disclosure prior to the new terms becoming effective.
The Most Common Mistake
The most common misstep we see with respect to PPMs occurs when there are internal changes in a manager’s firm that do not otherwise require investor approval (e.g., personnel changes) or external regulatory changes that the manager believes it can include in the PPM without involving outside counsel (usually to keep costs down). The result of this mistake is that the manager ends up with a currently-dated PPM reflecting that most recent change but that does not include other changes that the manager may not have realized should be addressed. As an example, assume a manager’s portfolio management team changes and the manager updates the PPM with that information and brings the date of the PPM forward from two years ago to the current date without making any other changes. In that situation, it is likely that the PPM is now providing information that is no longer accurate – for example, the tax disclosure in the PPM will most likely be inaccurate given the changes in the tax effects of investing in a private fund over the last two years.
One alternative for addressing these situations is the “supplement” approach (commonly called “stickering” the prospectus in the retail investment management world). Rather than updating the PPM itself, a private fund manager can prepare a separate document that acts as a “supplement” to the PPM that includes the new disclosure. Under this approach, the PPM maintains its original date, but the supplement is dated currently. This avoids the necessity of making sure that the ancillary disclosure is current. In other words, the manager is representing only that the information in the supplement is accurate as of the current date, and the relevant date for the information in the PPM is still the original date of the PPM. This is not an optimal solution for two reasons – first, the manager now has to distribute an additional document as part of the offering process (making certain the supplement accompanies the original PPM can be administrative challenge) and second, there is still the potential for out-of-date information to be included in the original PPM, and that potentially leaves the manager open to claims that the disclosure a prospective investor received was insufficient or misleading. However, this approach is still better than just changing the date of the PPM without updating the ancillary disclosures.
Special Considerations for CPOs and CTAs
With respect to PPMs for commodity pools operated by registered commodity pool operators (“CPOs”) that are sold to non-QEPs1, the National Futures Association (“NFA”) (the self-regulatory organization responsible for oversight of CPOs) requires PPMs for these private funds to be updated every twelve months.2 There are also NFA rules requiring additional specific disclosure information in the PPMs for these types of funds (e.g., break-even tables, performance capsules and extensive background disclosure).
Updated PPMs that are required to be filed with the NFA may be eligible for “Instant Filing” treatment if the previously-accepted PPM is on file and has been accepted by the NFA, the updated PPM contains no material changes and the private fund manager requests Instant Filing treatment. If Instant Filing treatment is requested, the NFA will either accept the PPM or issue a notice of rejection generally within two calendar days of the filing date.
In addition to the general considerations discussed above, registered CPOs should work with outside counsel to ensure that the required CFTC legends and exemption disclosures are updated in connection with such amendments.
- A QEP (qualified eligible person) is an investor suitability standard that applies to commodity pools. See CFTC Rule 4.7 for additional information relating to QEPs and the relief available to CPOs who limit investors in a commodity pool to QEPs.
- Note that this only applies to documents dated as of 2013 or later. PPMs dated prior to 2013 will have to be updated every nine (9) months pursuant to older regulations. In addition, CPOs must also update the relevant disclosure document more often if there are any material changes that must be disclosed.
*Reprinted with the permission of The National Society of Compliance Professionals