A decision clarifies the advertising regime for wholesale offers

In recent years, real estate developers have increasingly relied on wholesale financing to fund their business operations. 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 that do not require regulated disclosure. The Financial Markets Authority (FMA) recently took a closer look at the wholesale investment industry and in particular the level of risk to which investors are exposed.

In October 2021, the FMA issued real estate development company Du Val an instruction order regarding its Mortgage Fund Limited Partnership (MFLP). The FMA noted that statements made by Du Val in its advertisement violated the fair use provisions of the Financial Markets Conduct Act (FMCA) and gave the impression that the real estate development was low risk. The FMA argued that, in fact, property development was inherently risky and could not be portrayed as low risk in Du Val’s advertising.

Du Val appealed this instruction order and a judgment was rendered last week. This case is noteworthy because it clarified some aspects of the wholesale investor regime.

Not all wholesale investors are equal

When advertising a financial product, the High Court has accepted that a fund must not engage in misleading or misleading behavior in relation to the provision of financial products.

Du Val argued that the FMA erred in law by not accepting that wholesale investors were inherently more sophisticated than retail investors and investors who qualified as wholesale investors but 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 held that as a matter of law, not all wholesale investors are inherently sophisticated and that different wholesale investors possess varying degrees of sophistication. The High Court also agreed with the FMA that ill-equipped wholesale investors could not be excluded when it came to assessing whether an advertisement was likely to mislead or breach fair use.

The Court also seemed to accept that widespread advertising, for example via social media, may encourage investors to complete a wholesale certification or qualifying investor certificate despite their inexperience. The Court ruled that subsequent disclosure of further detailed or corrective material would not be sufficient to remedy its initial advertisements. Du Val could not rely on the elements contained in its information note to correct its initially misleading and misleading advertising.

Can retained earnings be considered an expense?

The FMA also argued that because the general partner was taking any incremental profits beyond the 10% return promised to its investors, it was actually charging a performance-based commission. The Court noted that the FMA was entitled to adopt a broad interpretation of the word “expense” and to take the position that because MFLP retained any profit above the promised 10% return, the limited partnership could not be considered “free of charge”. The Court also noted that it appeared the FMA was concerned about a lack of clarity regarding which general partner receives a benefit in relation to the operation of the fund.

Main lessons

This decision has important implications for fund structures and advertising. First, when preparing advertisements, the fund should consider the type of investors who meet the wholesale investor criteria and may be exposed to advertising. Care should be taken to ensure that advertising is aimed at all types of wholesale investors and not necessarily only sophisticated investors. Additionally, if funds choose to advertise their products extensively, they should pay close attention to each certification or exclusion invoked to ensure that each investor meets the standard required to be considered a wholesaler. Second, funds should carefully consider all claims made in the advertisement and determine whether they truly reflect the substance of the investment.

Next steps

This judgment reflects the recent trend of a more muscular FMA wanting to take a closer look at the wholesale investment space. New and returning players should take this opportunity to review their advertising, exclusion review process and funding structure.

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