Published by Securities Law 360
Controversy continues to swirl around the Securities and Exchange Commission's new proposed rules affecting pooled investment funds, including hedge funds.
Among other things, the rules, proposed in late 2006, are designed to provide broader protection for investors by updating the definition of "accredited investor" with respect to individuals investing in pooled investment vehicles that are exempt from registration because they have 100 or fewer total investors.
The proposed changes to the definition of "accredited investor" involve the creation of a new category of accredited investor-the "accredited natural person." An accredited natural person would include any individual who:
--Either has a net worth, individually or jointly with a spouse, of more than $1 million, or had an individual income in excess of $200,000 in each of the two most recent years ($300,000 if jointly with a spouse) and has a reasonable expectation of reaching the same income level in the current year. This portion of the proposed definition is the current definition of "accredited investor," which has been in place, unchanged, since 1982.
--Owns at least $2.5 million in investments at the time of investing in the pooled investment vehicle.
In addition, existing individual investors in a pooled investment vehicle would only be given limited "grandfather" rights if they do not meet the $2.5 million in investments test.
These investors would be grandfathered with respect to their existing investments, but would be required to meet the full "accredited natural person" test, including the $2.5 million test, before making any additional investments.
Finally, many assets would not be counted toward the $2.5 million requirement, including real estate owned by a prospective investor that is used by him or her or certain family members for personal or business use. If the investor is investing individually, but owns other investments jointly with his or her spouse, only 50 percent of the value of those joint investments may be counted toward the requirement.
The SEC proposed these rules out of concern that some investors in pooled investment vehicles are not adequately sophisticated and do not have enough financial experience to determine whether an investment is appropriate for them.
However, some experts estimate that the addition of the $2.5 million requirement could reduce the number of individuals qualifying as "accredited investors" by as much as 88%, which would necessarily make it much more difficult for pooled funds to raise money from non-institutional investors.
As evidenced by the already lively debate over the proposed rules during the ongoing comment period which ends on March 9, 2007, the proposed rules are proving to be very controversial, particularly in the middle market.
The SEC has specifically solicited comments on whether the $2.5 million requirement is too low, too high, or even appropriate at all. It is possible that the SEC could opt to simply increase the current net worth/income tests, or to include the new "investments" test but at a lower threshold.
Because the accredited investor test has not changed in 25 years, and because of the current pressures on the SEC to get its arms around the growing hedge fund industry, it is very likely that the rulemaking process will result in a final rule based at least in some measure on the proposed rule.
The largest hedge funds and their investors will pay little or no attention to these changes: they deal with investments from only the very wealthiest.
However, many smaller fund managers and their investors are troubled by the proposed requirements. They point to the investments test as an overly crude process for winnowing out inappropriate investors.
Ultimately, the choice of a proper rule must follow from a proper public policy. What is the purpose to be served? Who needs the protections of the securities laws when it comes to hedge fund and private equity fund investing?
If the point is to distinguish between those who can absorb investment losses and those who cannot, a more tailored approach (and one that provides greater investing freedom) would limit private fund investments to a percentage of the investor's assets. One advantage to such an approach would be to allow some exposure to hedge funds and other private funds by persons other than the most wealthy.
If, on the other hand, the key observation is that private fund investing is more challenging than, say, mutual fund investing, then the goal might be to limit investments in accordance with investor sophistication and experience.
Of course, it is difficult to craft a rule that both achieves this goal and is also practical to implement and enforce. The SEC's bright-line approach with its proposed rule is easy to apply, but is wide open to the criticism that it excludes too many sophisticated investors and includes too many investors who know nothing or close to nothing about private fund investing.
Addressing Fraud Concerns
In addition to redefining who can and cannot invest in pooled vehicles, the SEC's proposed rules would also tighten standards for fraud, prohibiting registered and unregistered advisers from defrauding existing and prospective investors in all types of investment companies and pooled funds.
It would also clarify that advisers may not defraud either their clients (the pooled funds) or the investors in those pooled funds, even though they are arguably not technically clients of the investment adviser.
Furthermore, the rules would apply to fraud regardless of whether it occurs in connection with the offer, sale or redemption of a security. For example, misleading information on an account statement would violate the proposed rule, even though the statement was not given to an investor in connection with his or her purchase of the pooled fund's securities.
However, under the new rule, only the federal government, not any individual investor, would be eligible to sue the adviser.
Under this new regulatory framework, the SEC proposes to significantly increase the scope of its authority over investment advisers, particularly with respect to unregistered investment advisers and the types of people to whom investment advisers owe duties.
However, the anti-fraud portion of the proposed rules is not likely to stir up much controversy, since they proscribe activity that virtually everyone agrees constitutes wrongdoing.
The impetus for the rules was the recent Goldstein case handed down from a federal appellate court, which cast some doubt on the SEC's authority over private placements of securities by private funds. These proposed rules attempt to close some of these perceived loopholes.
By Aaron S. Kase and Stephanie J. Nyman, Levenfeld Pearlstein LLC Aaron Kase is a partner in the corporate practice group, and leads the securities service group at Levenfeld Pearlstein LLC. He represents clients in securities regulatory, syndicated equity finance and corporate governance and disclosure matters, including organization and operation of hedge funds and private equity funds, private and public offerings of equity and debt securities and the formation and administration of limited liability companies, limited partnerships, and joint ventures. Stephanie Nyman is an attorney in the corporate practice group and the securities service group at Levenfeld Pearlstein LLC. In addition to general corporate and securities matters, she focuses her practice on securities law issues unique to broker-dealers and investment advisers. "