On December 27, 2006, the SEC proposed two new sets of rules aimed principally at hedge funds and their managers. First, the SEC proposed a broad anti-fraud rule applicable to investment advisers (whether registered with the SEC or not) of “pooled investment vehicles.” The second set of rule proposals would require natural persons investing in certain 3(c)(1) funds to have “investments” (as defined in the proposed rules) of at least $2.5 million at the time of investment (effectively replacing the current “accredited investor” standard for funds relying on 3(c)(1)).
Proposed Anti-Fraud Rule
Proposed Rule 206(4)-8 under the Investment Advisers Act of 1940 (the “Advisers Act”) provides that it shall constitute a fraudulent, deceptive, or manipulative act, practice, or course of business for an investment adviser to a “pooled investment vehicle” to make any untrue statement of a material fact or to omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading, to any investor in the pooled investment vehicle or otherwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle. The proposal defines a pooled investment vehicle as any investment company, 3(c)(1) fund or 3(c)(7) fund.
While the language in the proposed anti-fraud rule is very similar to that in Rule 10b-5 under the Securities Exchange Act of 1934 (which is also applicable to offerings of hedge funds), there are a few notable differences. In particular, Rule 10b-5 applies only to fraudulent statements made in connection with the purchase and sale of a security. The proposed rule would apply to statements made in an offering memorandum as well as in investor letters, account statements, requests for proposals and other communications, whether such statements are made to prospects or existing investors and regardless of whether a fund is currently offering its securities. Additionally, unlike with Rule 10b-5, a violation of the proposed rule would not require that an investment adviser has knowledge that a statement is false or misleading or that an action is fraudulent, deceptive or manipulative. Consistent with Federal court precedent, there would be no private right of action under the proposed rule.
Proposed Investor Suitability Increase
The SEC’s second proposal would add a new suitability standard that natural persons would need to meet in order to invest in a 3(c)(1) fund (other than a venture capital fund, as discussed below). 3(c)(1) funds are typically sold in reliance upon Rule 506 under Regulation D of the Securities Act of 1933. Rule 506 allows sales to 35 nonaccredited investors and an unlimited number of accredited investors. The SEC’s proposal would provide that, in connection with an investment in a 3(c)(1) fund, a natural person would need to meet the definition of an “accredited natural person” in order to be considered an accredited investor for purposes of Rule 506. Under the proposal, 3(c)(1) funds would continue to be able to accept investments from 35 persons that do not meet the new accredited investor definition. However, most 3(c)(1) funds do not accept non-accredited investors.
An accredited natural person is defined in the proposal as an accredited investor that owns (individually, or jointly with that person’s spouse) not less than $2.5 million (as adjusted for inflation) in investments. The definition of “investments” for purposes of the proposal is similar to that used to determine whether a person is a qualified purchaser for purposes of investing in a 3(c)(7) fund. In addition to securities, the definition includes real estate, commodity interests and physical commodities, financial contracts and cash and cash equivalents, provided such assets are held for investment purposes. The proposal specifically excludes from the definition of investments real estate used by a prospective accredited natural person or a related person for personal purposes (such as a residence) or for business purposes (unless such person’s primary business is investing, trading or developing real estate). The proposal would adjust the $2.5 million threshold for inflation, based upon the Department of Commerce’s Personal Consumption Expenditures Chain-Type Index, on April 1, 2012 and on the first day of each subsequent 5-year period. If an individual is making an investment in a 3(c)(1) fund, only half of the value of any investments jointly held with a spouse would be included (if the investment is being made jointly, the entire value would be included).
Because investor suitability is measured at the time of investment, existing 3(c)(1) investors that do not meet the accredited natural person definition would not need to withdraw from a fund. However, the proposal does not provide any “grandfathering” provisions that would allow such investors to contribute additional capital.
Importantly, the proposal does not contain any exceptions for knowledgeable employees of a fund’s manager. Because of this, unless the final rules contain such an exception, fund managers will need to consider whether to allow employees that do not meet the accredited natural person definition to invest as non-accredited investors, unless such managers run parallel 3(c)(7) funds in which employees can invest (knowledgeable employees that do not otherwise meet the qualified purchaser definition are permitted to invest in 3(c)(7) funds). The SEC has solicited comments on whether it should include a knowledgeable employee exception.
The SEC’s proposal also applies to private equity funds. However, the proposal provides an exemption for “venture capital funds.” The proposal defines venture capital funds by reference to the definition of business development companies in section 202(a)(22) of the Advisers Act (generally a domestic fund that invests at least 60% of its assets in small domestic issuers). The SEC’s stated reason for excluding venture funds from the proposal is their importance to the capital markets.
Request for Comments
Comments on the SEC’s proposed rules are due by March 9, 2007. Given the impact that the proposed “accredited natural person” rules will have on the hedge fund industry, you may want to consider submitting comments on the proposed rules to the SEC. If you have any questions about these proposed rules or would like our help in formulating a comment letter, please call your regular Investment Management Group contact.