Part I of this article appeared in the May, 2007 issue of The Metropolitan Corporate Counsel. After the decision in Goldstein v. U.S. Securities and Exchange Commission, 451 F.3d 873, Fed. Sec. L.Rep. (CCH) P93890 (D.C. Cir. 2006) wherein the U.S. Court of Appeals overturned the Hedge Fund Adviser Registration Rule, the SEC has proposed a new anti-fraud rule under the Advisers Act to protect investors from unscrupulous advisers. The rule would apply to all investment advisers regardless of their registration status. Part II discusses proposed changes to the definition of "accredited investor" with respect to natural persons who invest in certain privately offered funds.
Proposed Amendments To The Accredited Investor Criteria Under The '33 Act
In 1982, the SEC adopted a non exclusive safe harbor, in the form of Regulation D, with respect to offerings relying on the 4(2) private offering exemption. Regulation D provided a definition for the term "accredited investor." There have been no changes to that definition since 1982. In the SEC Release of the proposed rule, the SEC observed that inflation and rising real estate prices over the past 25 years have contributed to the increase in the number of accredited investors from 1.87% of U.S. households to 8.47% of U.S. households (according to the SEC's Office of Economic Analysis estimate). The SEC stated that this increase and the greater complexity of hedge funds since 1982 justified the proposed revisions to the suitability criteria. The SEC estimated that the number of U.S. households that would qualify as accredited investors under the proposed rule is 1.3%.
The SEC has proposed new Rules 216 and 509 under the '33 Act. These rules would require a natural person investing in a private investment fund that relies on the 3(c)(1) exemption from the '40 Act and Regulation D or 4(6)1 under the '33 Act, to be both an "accredited investor"2 under the existing standards and to own at least $2.5 million in "investments" on the date of investment.3 The value of personal residences and real estate used in connection with a trade or business would not be treated as contributing to an accredited natural person's qualifying assets. As a result, many current investors in 3(c)(1) funds would no longer be "accredited investors."
Because the proposed rules contain no grandfather provision for an individual who currently owns interests in a 3(c)(1) fund, such individual might be precluded from investing additional capital in a fund in which the individual already has an investment, if such fund admits only accredited investors. Moreover, to the extent that a 3(c)(1) fund subjects its investors to capital calls, without a grandfather provision for current investors, a conflict might arise between the new rule and any such existing 3(c)(1) fund's operative agreements if an insufficient number of non-accredited investor slots were available.
As under the current rules, a fund would be able to continue to rely on the provisions of Regulation D under the '33 Act and permit the sale of securities in any offering to up to 35 non-accredited investors, provided that certain conditions are satisfied.4 If the fund, however, did not permit sales to non-accredited investors or had already sold to 35 non-accredited investors in a continuous offering, no additional sales could be made to natural persons who do not meet the new accreditation standard.
The proposed rules would not apply to any fund relying on 3(c)(7) of the '40 Act, which requires investors to meet the higher investor thresholds noted above. Interestingly, the rules as proposed do not include a carve-out for "knowledgeable employees" as exists in Rule 3c-5 under the '40 Act.5 As a result, a knowledgeable employee could invest in a 3(c)(7) fund by meeting the current "accredited investor" criteria, whereas the same person would have to have $2.5 million in investments to invest in an employer's 3(c)(1) fund. Although, as the SEC notes, there are various ways that employees can have exposure to their employers' hedge funds, in many cases such choices may not be practical or available.
The proposed rule specifically excludes "venture capital funds"6 from the new accreditation standard for natural persons. The SEC Release noted that venture capital funds generally provide capital and, unlike hedge funds, hands-on managerial assistance to small businesses.
The SEC suggested in the Release that competition among 3(c)(1) funds for accredited natural person subscribers may lower fees, which would benefit investors. The SEC acknowledged, however, that current accredited investors would have fewer investment options.
The proposed $2.5 million threshold would be adjusted for inflation based on the Personal Consumption Expenditures Chain-Type Price Index7 on April 1, 2012, and every five years thereafter.
Comments Requested And Received
The SEC solicited comment on a number of issues concerning the antifraud and accredited natural person proposals, including:
(1) whether the antifraud proposal should apply to additional or fewer types of funds;
(2) whether the new investor threshold is appropriate;
(3) whether a "grandfathering" provision should be added so that persons currently invested in 3(c)(1) funds could make additional investments;
(4) whether the exemption for and definition of venture capital funds is appropriate; and
(5) whether some type of exemption to allow "knowledgeable employees" to invest in 3(c)(1) funds should be included.
The comment period on these proposals closed on March 9, 2007. The SEC received several hundred comment letters on the proposals and has continued to post letters received since the comment closing date.8 Many individual investors expressed opposition to the proposal to increase the accredited investor suitability threshold for natural persons. Such comments ranged from claims that the proposal was an insult to their intelligence and un-American, to suggestions that individuals without $2.5 million in investments should be able to avail themselves of alternative methods of demonstrating investment acumen, such as by passing an examination specifically designed for such investors. One commenter noted that responsibility for retirement savings today generally falls to the individual and that the government should provide maximum latitude for investors. Several commenters suggested that it was unfair for only wealthy investors to have access to hedge funds and questioned the proposition that wealth is a proxy for financial sophistication. Managers of smaller hedge funds commented that they would be disproportionately affected by a higher suitability threshold.
Several letters, including some from individuals, supported the increased suitability thresholds. One such commenter suggested that hedge funds are a mere fad, although others stated that the change was appropriate given inflation. Some commenters suggested limiting the aggregate amount that an individual could invest in hedge funds to a prescribed percentage.
Many commenters took issue with the SEC's assertion that 3(c)(1) funds are inherently more risky than other forms of private investment. Several letters suggested that venture capital funds and hedge funds should not be distinguished from one another in terms of which is a more or less risky investment. Many commenters also noted that the proposed rule would add more complexity to an already complicated array of existing suitability standards.
Most, if not all, of the letters that addressed the issue commented that any final rule should provide for current investors to be "grandfathered" and for "knowledgeable employees" to be permitted to invest in their employers' 3(c)(1) funds.
The antifraud proposal generated far fewer, but nonetheless, significant comments. While supporting the SEC's general goal of eliminating fraud, several letters questioned the SEC's statutory authority to adopt the proposed rule. They observed, as discussed in Part I of this article, that Section 206(4) directs the SEC to define acts, practices and courses of business that are fraudulent, deceptive or manipulative. Proposed rule 206(4)-8(a)(2) does not include the specificity that is included in existing SEC rules adopted under Section 206(4). Identifying Supreme Court and other precedents, commenters also disagreed with the SEC's assertion that it need not demonstrate intent to deceive (i.e., scienter) in an enforcement proceeding. Finally, several commenters stated that any new anti-fraud rule should not apply to advisers to registered investment companies since existing law already adequately addresses the conduct of such advisers.1 Section 4(6) provides an issuer exemption for offers and sales of securities exclusively to accredited investors for offerings not exceeding $5 million which do not involve any general solicitation. 15 U.S.C.A. 77d(6).
2 SEC Rule 501(a) under the '33 Act currently defines an "accredited investor" in the case of a natural person to be an individual with a net worth of more than $1 million or with an income of more than $200,000 (or joint income of $300,000 for married couples) per year for the past two years and reasonably expected in the current year. "Net worth" for this definition includes the value of residences and personal assets. 17 C.F.R. 230.501(a).
3 The SEC has defined "investments" for this purpose in a manner similar to the corresponding term used in determining whether a person is a "Qualified Purchaser" for purposes of the 3(c)(7) exemption from the '40 Act, with certain modifications. The modifications reflect that this definition applies only to natural persons, and changes the treatment of property held jointly by married persons. A married person would be able to count the full value of jointly owned investments only if investing in the private fund jointly with his or her spouse; otherwise only half the value of such jointly owned investments could be included.
4 Regulation D requires additional disclosure for offerings made to non-accredited investors. While an offering not qualifying for Regulation D due to the new investor threshold might be exempt from registration as a transaction "not involving any public offering" pursuant to 4(2) of the '33 Act, the preemption of state blue sky laws (which took effect for Rule 506 Regulation D (17 C.F.R. 230.506) offerings as a result of the National Securities Markets Improvement Act of 1996 (NSMIA)), would not be available. Under NSMIA, the states are generally preempted with respect to any review and approval of private offerings, although any state in which a fund is offered or sold may still require a notice filing and the payment of fees. Without the NSMIA preemption, offering documents of a 3(c)(1) fund would be subject to review by any state in which interests of the fund are offered.
5 17 C.F.R. 270.3c-5.
6 Defined to have the same meaning as "business development companies" in 202(a)(22) of the Advisers Act, 15 U.S.C.A. 80b-2(a)(22).
7 The SEC Release notes that the Index, published by the Department of Commerce, is a widely used and broad indicator of inflation in the United States economy.
8 Comments on the proposals may be found at: www.sec.gov/comments/s7-25-06/s72506.shtml.