By Steven J. Fredman , a partner and Steven J. Spencer , an associate at the New York City-based law firm of Schulte Roth & Zabel LLP.
As hedge funds and investment advisers look to expand their operations onto the information highway, they must do so within the confines of securities statutes enacted over fifty years ago. To aid them and others in their travels, the U.S. Securities and Exchange Commission issued a series of interpretive releases and no-action letters. These pronouncements do not change the U.S. securities statutes, but shed light on how they apply to today's technological advances.
The SEC's 1995 and 1996 interpretive releases
Recognizing the potential benefits of electronic communication, the SEC issued an Interpretive Release in October 1995 entitled "Use of Electronic Media for Delivery Purposes." The 1995 release outlined the SEC's general conclusion that "the use of electronic media should be at least an equal alternative to the use of paper-based media." The most important factor in determining the sufficiency of disclosure should not be the means of delivery, but the substance of what is disclosed. Since none of the federal securities statutes specifically requires paper delivery, the SEC explained the circumstances under which electronic delivery would be appropriate.
While the 1995 release did not focus specifically on investment advisers, the guidelines it set forth for the use of electronic communications are transposed easily to the adviser context. Generally, satisfactory electronic delivery involves three factors: timely and adequate notice that the information is available, access to the information and reasonable assurance of satisfying the applicable delivery obligations. Usually notice is not an issue, since the client typically receives notice when it receives the information. If an adviser posts information on its Web site, however, it should inform the client that new or additional information is available. Otherwise, the client may not be aware that the information exists. The adviser also must give the client access to the information in a manner that is not burdensome and that enables the client to retain a permanent record. Additionally, the adviser should be reasonably confident that the client has received the information. Evidence such as an electronic mail receipt would satisfy this factor. A good practice to adopt prior to sending electronic communications to an advisory client is to obtain the client's informed consent to receive communications through a particular electronic method. Of course, if a client requests a paper copy of the information, the adviser should supply it.
In May 1996, the SEC issued a second Interpretive Release, "Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for Delivery of Information." According to the 1996 release, an investment adviser generally can use electronic media to satisfy the notification and consent solicitation requirements of the U.S. Investment Advisers Act of 1940, so long as there is notice, access and reasonable assurance of satisfying the applicable delivery obligations.
At times, an investment adviser delivers personal financial information to a client. When it does so, the investment adviser should take precautions to protect the integrity, confidentiality and security of this information, whether it delivers an electronic or paper version. For electronic transmission, the client's consent takes on increased importance. In order to maintain confidentiality, the client must be willing to accept electronic delivery of the personal financial information and have actual notice that the investment adviser will deliver it electronically.
Investment adviser record-keeping and registration issues
Electronic advertisements regarding an investment adviser's services are subject to the same concerns and prohibitions as advertisements on paper. The Advisers Act requires an investment adviser to keep records of materials that it makes available to 10 or more persons. The 1996 release clarified that the record-keeping requirements also apply to materials that the adviser makes available electronically.
A key issue for many investment advisers is retaining their exemption from registration under the Advisers Act. The Advisers Act provides that an investment adviser need not register if, among other things, it does not hold itself out to the public as an investment adviser. An investment adviser would not be eligible for this exemption if it provided public access, over the Internet or otherwise, to information about its services. As discussed below, however, an adviser could post such information on a Web site that is not publicly accessible.
Hedge fund databases on the internet
A hedge fund generally offers and sells its interests pursuant to a private placement exemption from registration under the U.S. Securities Act of 1933. This exemption requires, among other things, that the fund refrain from general solicitation or general advertising. A valid private placement also is essential if the fund is to avoid registration under the U.S. Investment Company Act of 1940. Furthermore, the exemption from registration as an investment adviser under the Advisers Act is available only to an adviser that, among other things, does not hold itself out to the public as an investment adviser. Open access through the Internet to hedge fund data obviously wouldjeopardize an adviser's ability to avoid registration under these Acts for itself and the funds that it manages.
In a May 1997 no-action letter to Lamp Technologies, Inc. and a follow-up letter in May 1998, the SEC's staff addressed the manner in which a hedge fund could post information about itself and its adviser on the Internet through a database operated by a third party without the fund or its adviser having to register under the Securities Act, Company Act or Advisers Act. Lamp proposed to operate a database that would include the offering memoranda, performance data and contact information for the participating funds. To protect the private placement exemptions, Lamp stated that it would limit access to its Web site to financially sophisticated, accredited investment and financial professionals. These professionals would pre-qualify for password-protected access to the site by completing a questionnaire that would identify them as accredited investors under the Securities Act. The questionnaire would be generic, and would not refer to any particular fund on the Web site. To prevent a subscriber from joining the service so as to invest in a particular fund, subscribers would have to agree to wait 30 days after qualification to invest in any fund that they were not already invested in, being solicited to invest in or actively considering investing in. By allowing only sophisticated professionals that affirmed their accredited investor status to access the site, requiring the use of a password and imposing a 30-day waiting period, Lamp Technologies provided the staff with a sufficient basis to conclude that no registration would be required of funds participating in the database*.
U.S. and non-U.S. fund web sites
The Lamp Technologies no-action letters gave comfort to hedge funds and investment advisers listing information on the Web sites of unrelated third parties, but did not specifically address how a hedge fund could operate its own Web site without affecting its private placement status. A U.S. hedge fund should password-protect its Web site, limiting access to existing investors and pre-qualified prospective investors. The fund's general partner should reasonably believe that each prospective investor has the requisite legal qualifications and financial sophistication to invest in the fund. Moreover, the general partner should have a relationship with the potential investor, either directly or through a third party, upon which the general partner can judge each prospective investor's eligibility. To avoid questions of enforceability in particular jurisdictions, a fund should require that investors submit their subscription documents in hard copy rather than electronically. Furthermore, requiring an investor to sign its name manually to a subscription agreement may simply be a good practice because it forces the investor to think more closely about what it is signing.
When administering its Web site, a fund must be wary of stale and potentially inaccurate information that viewers may mistakenly assume is current. The fund should update its site periodically and should provide the date that it posted the information. It also should consider posting a disclaimer stating that the information provided is accurate only as of the date that it was posted, and that the fund does not undertake to update the information.
Non-U.S. funds and non-U.S. investment advisers face slightly different concerns under U.S. law when they establish Web sites than do U.S. based funds and advisers. Non-U.S. funds must be concerned with whether the offering and solicitation materials that they post on their Web sites are targeted to the U.S. In March 1998, the SEC issued an Interpretive Release entitled "Statement of the Commission Regarding Use of Internet Web Sites to Offer Securities, Solicit Securities Transactions or Advertise Investment Services Offshore." In the 1998 release, the SEC explained the circumstances under which it would consider the posting of offering or solicitation materials on the Internet not to be targeted to the U.S. and therefore not covered by the registration requirements of the U.S. securities laws.
To prevent targeting the U.S. with their offers and solicitations, non-U.S. funds should implement measures that are reasonably designed to guard against selling or providing services to U.S. persons. Whether they have successfully implemented such measures depends on the surrounding facts and circumstances. While non-U.S. funds need not password-protect their Web sites, they should include a prominent disclaimer clearly stating that the offer is directed only into countries outside of the U.S. or only into specified, non-U.S. jurisdictions. They also should obtain each prospective investor's mailing address and telephone number prior to sale in order to confirm that the investor is not a U.S. person. As an added precaution, they should look for certain red flags that an investor is really a U.S. person. For example, an investor may wire funds from a U.S. bank account, provide a U.S. taxpayer identification number or otherwise indicate that, notwithstanding the information it provided to the fund, it is a U.S. person.
The same general considerations apply to an investment adviser for a non-U.S. fund. Unless access to the Web site is limited, an unregistered investment adviser would be susceptible to claims that it must register because it is holding itself out publicly in the U.S. as an investment adviser.
Over the past several years, the SEC has made the Internet a less treacherous road to travel. While open issues remain, hedge funds and investment advisers now have a great deal of guidance as to when and how they may communicate via electronic means. By following the SEC's general guidance, they should continue to thrive in the Internet age.
* While not discussed in the Lamp Technologies letter, the general partner of a hedge fund would be wise to develop a relationship with a prospective investor that obtained information about the hedge fund through a database before the general partner sends subscription documents to that investor.