Over the past few years property developers have increasingly relied upon wholesale financing to fund their business activities. Traditionally, developers attract investors willing to provide capital in exchange for a fixed return paid quarterly. These finance companies and their limited partnership equivalents specifically target wholesale investors who are eligible to invest in unregulated, wholesale funds which do not require regulated disclosure. The Financial Markets Authority (FMA) has recently taken a closer look at the wholesale investing sector and in particular the level of risk investors are exposed to.
In October 2021 the FMA issued property development company Du Val a direction order in respect of its Mortgage Fund Limited Partnership (MFLP). The FMA noted that statements made by Du Val in its advertising contravened fair dealing provisions in the Financial Markets Conduct Act (FMCA) and created an impression that property development was low risk. The FMA argued that in fact property development was inherently risky and could not be represented as low risk in Du Val’s advertising.
Du Val appealed against this direction order with a judgement being released last week. This case is of note as it clarified some aspects of the wholesale investor regime.
Not all wholesale investors are equal
When advertising a financial product the High Court accepted, that a fund must not engage in conduct which is misleading or is likely to mislead in relation to the supply of financial products.
Du Val submitted the FMA erred in law by not accepting that wholesale investors were inherently more sophisticated than retail investors and investors who had qualified as wholesale investors but who were not considered sophisticated should be excluded as outliers. The FMA countered that not all wholesale investors are necessarily sophisticated and that it was within its rights to consider unsophisticated wholesale investors when assessing whether an advertisement was misleading.
The Court agreed with the FMA and ruled that as a matter of law, not all wholesale investors were inherently sophisticated and that different wholesale investors possessed varying degrees of sophistication. The High Court also agreed with the FMA that ill-equipped wholesale investors could not be excluded when assessing whether an advertisement was likely to mislead or contravene fair dealing.
The Court also appeared to accept that widespread advertising, such as through social media, could encourage investors to complete a wholesale certification or eligible investor certificate despite being inexperienced. The Court ruled that subsequent disclosure of additional detailed or corrective material would not be sufficient to cure its initial advertisements. Du Val could not rely on the material set out in its information memorandum to correct its initially misleading and deceptive advertising.
Can retained profit be considered a fee?
The FMA also argued that because the general partner took all additional profits above and beyond the 10% return promised to its investors, it was in fact charging a performance-based fee. The Court noted that the FMA was entitled to adopt a broad interpretation of the word ‘fees’ and take the position that because MFLP retained any profit above the promised 10% return, the limited partnership could not be considered “fees free”. The Court also noted that it appeared the FMA was concerned about a lack of clarity around the general partner receiving a benefit in respect of the operation of the fund.
Key learnings
This ruling has significant implications for fund structures and advertising. First, when preparing advertisements, the fund should consider the type of investors who meet the criteria for wholesale investors and may be exposed to the advertising. Care should be taken so the advertisement caters for all types of wholesale investors and not necessarily just sophisticated investors. Furthermore, if funds choose to advertise their products widely, they should pay close attention to each certification or exclusion relied upon to make sure that each investor meets the standard required to be considered wholesale. Secondly, funds should carefully consider any claims made in the advertising and whether they truly reflect the substances of the investment.
Next steps
This judgement reflects the recent trend of a more muscular FMA which is keen to take a closer look at the wholesale investing space. New and old players alike should take this opportunity to review their advertising, exclusion review process and fund structure.
Lane Neave has a dedicated financial markets team who are able to assist with any queries related to wholesale investing, fund structure and advertising.
