"Red herring" is a term frequently encountered in the context of investment funds. Although reference to a red herring may, in isolation, suggest an intention to mislead or divert attention from the truth, in the context of funds the term has certainly acquired a different meaning. More importantly, red herrings have become an effective means of assessing investor interest in a prospective fund prior to formal establishment. They may also reduce the level of importance sometimes afforded to certain factors in choosing an offshore location for a fund, in particular timing applicable to the formation process and the level of start-up costs which a promoter may be responsible for in the event of a delayed or non-launch of their fund. In this way, red herrings encourage fund promoters to choose the appropriate long-term domicile for their fund at the outset.
By way of background, a document pursuant to which an interest in a fund is offered to investors is usually termed a "prospectus", "offering memorandum", "offering circular", "information memorandum" or the like. This describes the interest being acquired (typically shares in a company, interests in a partnership or units in a unit trust) and the material terms of the fund. Although a prospectus may be used as a collective term it normally suggests a retail offering, and an offering memorandum, offering circular, information memorandum or the like normally suggests a private offering. The choice of term used to describe the document, and the content thereof, is typically dictated by the laws and regulations, including any stock exchange rules, applicable to the fund.
Origins of red herrings
The term red herring, as used in a financial context, appears to originate in the U.S. For instance, Dictionary.com suggests the origin of the definition is as follows: "a tentative prospectus circulated by the underwriters of a new issue of stocks or bonds that is pending approval by the U.S. Securities and Exchange Commission: so called because the front cover of such a prospectus must carry a special notice printed in red". Any similar tentative financial prospectus is also included and, indeed, in practice the term has been extrapolated to apply to the tentative prospectus, offering memorandum, offering circular, information memorandum or the like of almost any fund located anywhere.
Key information considered in deciding to form a new fund is the level of actual investor interest in the target market for the specific fund product. General market information is often insufficient. Significant legal and administrative costs will be incurred in the formation of the fund and, barring contingency fees, will be payable irrespective of the level of investment. In addition, significant time and effort will be required by the promoter, together with potential service providers, to progress a fund from initial conception through to establishment. Once established, fully documented and regulated (if required), changes to fund documents to facilitate target market demands can also be cumbersome and costly.
In practice, these timing and formation issues can be less sensitive to funds using a red herring, in particular as it allows them to assess the existence of a significant investor base and progress with the finalisation of the fund following circulation of the red herring. In this sense, a red herring can be used to provide a breather in the formation process. More importantly, the cost and timing benefits mean that choosing the most appropriate jurisdiction for fund domicile can instead focus on the credibility of the jurisdiction, nature of the laws and regulations, structural issues, availability and competence of fund service providers, investor preferences, historic connections, geographic location and convenience.
Nevertheless, both legal and regulatory issues must be considered prior to the circulation of a red herring. In all cases, appropriate legal counsel for each jurisdiction with which the proposed fund will have a connection, including the chosen domicile for the fund and each jurisdiction in which the red herring will be circulated, should be engaged to do so.
Legal issues would include potential liability for the content or circulation of a red herring. A prospectus is normally issued and circulated by a fund following establishment and approval by the board, general partner or trustee of the fund. However, proceeding by way of this route eliminates practical advantages of a red herring. Additional work will be required in order to progress to a stage where the prospectus will be formally approved, and in any event enquiries may be made by potential regulators, auditors, directors and other fund service providers as to the conduct of a fund entity during the period between initial formation (for instance, the date of incorporation of a fund company) and regulatory approval - usually in the case where this period is protracted. Careful consideration should therefore be given to the stage of fund formation at which a red herring will be issued.
Regulatory implications of a red herring are also important. Red herrings typically include comprehensive disclaimers and disclosures relating to the tentative nature of the document, the fact that the fund is not yet formally constituted and also that the red herring does not comprise an offer of the interest described on a preliminary basis therein. Nevertheless, the question as to whether a red herring is permitted (or at least not prohibited), and if so the precise wording of the disclaimers and disclosures, should be carefully considered with reference to each jurisdiction with which the proposed fund will have a connection in order to ensure that the document and circulation thereof is within applicable legal and regulatory parameters.
In short, red herrings in the funds world are far from intended to deceive. They are intended to inform, and are a pragmatic way for a fund promoter to fish for investor interest prior to full costs and time being incurred in formal establishment. Given appropriate consideration of the legal and regulatory requirements, red herrings can be used to bridge the gap between the ultimate objective of formal fund establishment and the immediate need to assess investor appetite on an informed basis.
So, let's go fishing!
This article first appeared in the autumn 2008 issue of Appleby Jersey's Finance newsletter.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.