SEC Prposes Amendments to Antifraud and Eligibility Rules for Hedge Funds
On December 27, 2006, the SEC issued a proposal to adopt two new rules relating to hedge funds and other privately offered investment pools. First, the SEC proposed to expressly extend its antifraud authority under the Investment Advisers Act of 1940 (the Advisers Act) to registered and unregistered investment advisers’ conduct relating to investors and proposed investors in pooled investment vehicles. Second, the SEC proposed to increase the eligibility requirements for natural persons to be considered “accredited investors” with regard to certain investments in hedge funds and other privately offered investment pools. Comments on the proposal are due to the SEC by March 9, 2007.
Amendments to the Antifraud Provisions of the Advisers Act
Proposed Rule 206(4)-8 under the Advisers Act would prohibit false or misleading statements of material facts and any other type of fraudulent conduct by both registered and unregistered investment advisers to current or prospective investors in a pooled investment vehicle. The prohibition would apply regardless of whether the pool was offering, selling, or redeeming securities (e.g., the proposed rule would cover statements made in account statements, private placement memoranda, offering circulars, and responses to requests for proposals). Under the proposed rule, “pooled investment vehicles” would include hedge funds, private equity funds, venture capital funds, and other types of privately offered pooled vehicles that invest in securities.
Some initial observations:
- The proposed rule does not differentiate between an adviser’s conduct as an “investment adviser” to a private investment fund from “nonadvisory” conduct undertaken by an adviser or its affiliate as a general partner or manager of a limited partnership or limited liability company. As a result, proposed Rule 206(4)-8 could potentially bring nonadvisory activities within the scope of the antifraud provisions of the Advisers Act.
- Proposed Rule 206(4)-8 would not require that the SEC demonstrate that an adviser acted with “scienter” to prove a violation of the proposed rule. The SEC release notes that the proposed rule would be adopted under Section 206(4) of the Advisers Act, which courts have held does not require a finding of scienter.
- The SEC release specifically states that proposed Rule 206(4)-8 would not provide a private cause of action and would not impose a fiduciary duty on an investment adviser to investors or prospective investors in a pooled investment vehicle that is not otherwise imposed on the investment adviser by law.
Amendments to the Definition of “Accredited Investor”
The SEC also proposed amendments to raise the eligibility standard for natural persons investing in privately offered investment pools that are excluded from the definition of “investment company” under Section 3(c)(1) of the Investment Company Act of 1940 (the 1940 Act). The SEC noted that hedge funds and other privately offered investment pools typically rely on the private offering rules under the Securities Act of 1933 (the 1933 Act) in making offers and sales of their securities. *
Under the SEC’s proposal, the private offering rules would be amended to add a new category of accredited investor, an “accredited natural person.” The term “accredited natural person” would mean any natural person who: (1) meets either the net worth test or income test under the definition of accredited investor and (2) owns at least $2.5 million in investments (this figure would be adjusted for inflation every five years). The definition of “accredited natural person” would apply only with respect to investors in “private investment vehicles,” which the proposal defines as funds excluded from the definition of investment company under Section 3(c)(1) of the 1940 Act. This definition would not include Section 3(c)(7) funds, which are subject to the higher “qualified purchaser” standard under the 1940 Act, or to venture capital funds, which would be defined to have the same meaning as “business development company” under Section 202(a)(22) of the Advisers Act.
In addition, the SEC’s proposal specifies the types of investments that may be included in determining whether a person is an accredited natural person. Under the proposal, investments generally would be valued at either their fair market value on the most recent practicable date or their cost. Any debt incurred to acquire the investments would be deducted from the valuation of the investment. In addition, when a spouse is investing separately (i.e., not jointly with his or her spouse), the investing spouse would be permitted to count only 50% of the value of jointly held or community property investments.
Some initial observations:
- The SEC is soliciting comment on whether employees of private investment vehicles (including “knowledgeable employees” as defined in Rule 3c5 under the 1940 Act) or their investment advisers should be subject to the same accredited natural person definition.
- Investors in private investment vehicles who are currently eligible as accredited investors but do not meet the accredited natural person standard would not be permitted to make additional investments in those vehicles. The SEC release does not address how such a requirement would affect investors who may be obligated to make additional investments pursuant to their capital commitments to private equity funds and nonexempt venture capital funds.
- In its release, the SEC noted the lack of public information about privately offered investment pools and expressed concern that investors may find it difficult to appreciate the unique risks of those pools. In large measure, the paucity of available information results from the restrictions under Regulation D against general solicitation and advertising. The SEC Staff’s September 2003 report on hedge funds recommended that the SEC consider eliminating the ban on general solicitation and advertising, and this proposal will offer commenters the opportunity to urge the SEC to address this issue.
- The SEC release estimates that the accredited natural person definition, if adopted as proposed, would significantly reduce the number of U.S. households that are eligible to invest in private investment vehicles. By the SEC Staff’s calculation, approximately 8.47% of U.S. households currently qualify for accredited investor status under Regulation D. The Staff estimates that this percentage would drop to approximately 1.3% with respect to investments in private investment vehicles if the accredited natural person standard is adopted.
* In particular, the SEC noted that many of these funds rely on Rule 506 of Regulation D under the 1933 Act, which allows a fund to sell its securities in a private offering to an unlimited number of “accredited investors.” Under Rule 501(a) of Regulation D, an accredited investor includes a natural person whose individual net worth, or joint net worth with the person’s spouse, exceeds $1,000,000 at the time of the purchase of securities or whose individual income exceeds $200,000 (or joint income with the person’s spouse exceeds $300,000) in each of the two most recent years and who has a reasonable expectation of reaching the same income level in the year of investment.
Investment Management FYI is a service of the Investment Management Practice Group of Morgan Lewis. If you have any questions concerning the important legal developments reflected herein, please contact any member of Morgan Lewis Investment Management Practice Group, including:
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