February 20, 2005

Alternative investments
Be careful with unregulated products

Recent troubles at Portus Alternative Asset Management will probably scare some investors entirely from this less candid group of products. However, what it should do is remind us that such unregulated products require very careful and diligent evaluation before recommending them to clients.

Internal affairs

Portus' BancNote Trust product is now frozen as the Ontario Securities Commission attempts to make sense of its structure and trace its flow of funds. Initially, the OSC's concerns centered around sales practices and documentation.

There is much debate about whether investor money is safe, but at this point, it's nothing more than a debate. Portus maintains that the note held by the trust will make investors whole if held for the full five year term. Supporting that assertion is this OSC press release which states, in part:

"As a result of the Temporary Order [to stop trading], the notes are protected. At maturity the notes will have a value of at least the principal invested by the clients. The Temporary Order also precludes immediate withdrawals which could result in the preferential treatment of some clients to the detriment of others."

The Order stated that Portus did not fulfill conditions of its registration with respect to record keeping and client statements. As a result, the firm may neither trade nor accept sales or redemption orders until mid-May. There are, however, some (related) fundamental issues not adequately addressed thus far in the media coverage.

Unregulated investments

Mutual fund prospectuses are initially submitted to the securities commission for review. Often the commission will send it back requesting more information, or clarity on specific issues. Once resolved, the commission approves the prospectus - though they never endorse any product. With products like Portus, neither the product nor the offering memorandum is reviewed or approved by a regulatory body.

There is a reason why such investments are set aside for so-called 'accredited' or wealthy investors. It's because they either know enough to be more careful, or have enough money to hire a qualified expert.

No doubt many advisors and investors automatically assume that an offering document that looks so official has been reviewed or approved by a regulator - but that's not the case. Advisors are expected to know this - which leads to another issue.

The devil is in the details

While I never witnessed a sales presentation for Portus, I'm told (and it is reported) that BancNote Trust was promoted as an investment that is guaranteed by a bank. But a simple read of the offering memorandum reveals that investors were not buying a guaranteed investment.

Right near the beginning of the document, the Trust's strategy is noted as (with my emphasis added):

"To achieve its investment objective, the Trust will enter into one or more agreements with the Banks to purchase the Bank Notes. The Bank Notes *may* be structured in such a way that the principal amount is fully protected at Maturity and the positive return (if any) on the Bank Notes will be linked to the performance of the Reference Portfolio.

Alternatively, the Bank Notes *may* assume the legal obligation of delivering to the Trust on the Maturity Date an amount sufficient for the Principal Protection, and the Trust assumes the obligation to return to Unitholders at Maturity both the principal amount and the positive return (if any) of the Reference Portfolio."

Not only is the guarantor not mentioned anywhere by name, but the above excerpt simply says that trust will buy notes that "may" provide principal protection. A skeptic could interpret that as "may not" also. Now, all might be fine with Portus' client money. I don't know. But a number of points in the offering memorandum should have at least sparked additional questions.

A lack of regulation simply means that there is no standard regarding what needs to be included in the offering document and how it is to be worded. Mutual fund prospectuses, on the other hand, are convenient that way. We know exactly what's included and where to find it because there are regulations governing such details. Not so with unregulated instruments - which means that a high level of scrutiny is required.

False comfort

The OSC also announced that its probe will widen to investigate the referring advisors and their sponsoring dealer firms. But the portfolio management agreement that should have accompanied the offering memorandum (and account application) contains an interesting clause regarding the liability of dealers and advisors. In part, it states:

"The investor acknowledges that the dealer or agent referring the investor to Portus will have no involvement in the investment of the investor's money in the Account, and that the dealer or agent will not have any liability whatsoever for, and will not in any way or for any reason be obliged to compensate the investor for, and the investor agrees not to be involved in any litigation against the dealer or agent for, any losses in the Account however caused."

I'm no lawyer and, hence, cannot comment on the strength of such a clause. However, basic contract law says that parties may not agree to terms that are against the law. Hence, if any party was found to have breached its standard of care to individual investors, this clause may not protect an advisor or his dealer. Ironically, however, it may have provided greater comfort to the advisors that entrusted more than $700 million of their clients' money to this now besieged hedge fund company.