The Securities and Exchange Commission has proposed new rules to expand its oversight of hedge funds and other pooled investment vehicles. The rules would prohibit advisers from making false or misleading statements or defrauding investors in those funds, and would raise the bar for investments in certain private funds. These proposed rules represent the second attempt to regulate hedge fund advisers, after a federal court of appeals invalidated rules that expanded the Commission’s power to regulate those advisers.
As hedge fund assets surged toward the $1 trillion mark, the Commission expressed concern that its knowledge of these private investment pools was “woefully inadequate.” After conducting a series of “sweep” examinations and holding a roundtable, the Commission found that more and more institutions, pension funds and smaller investors were investing in hedge funds, a phenomenon it termed “retailization.”
Moreover, the Commission noted an increase in the number of fraud cases involving hedge funds. These factors, it decided, merited increased oversight of hedge fund advisers. Hedge fund advisers with fewer than 15 clients need not register with the Commission. A single hedge fund counts as one client, even though the fund may consist of many investors and hundreds of millions of dollars of assets. Unregistered advisers are exempt from the substantive provisions of the Investment Advisers Act of 1940, although they are subject to its anti-fraud rules. More important, the Commission lacks the authority to conduct routine examinations of unregistered advisers.
At a highly contentious open meeting in 2004, the Commission required advisers to count individual owners of “private funds” as “clients” for purposes of determining whether or not the advisers must register with the Commission.
“Private funds” included companies that would be required to register under the Investment Company Act of 1940 but for an exemption provided by section 3(c)(1) (funds with fewer than 100 beneficial owners) or section 3(c)(7) (funds that limit investments to “qualified purchasers”). A “look-through” to the individual owners did not apply to funds that imposed a “lock up” of two years and one day. The rule excluded most private equity and venture capital funds from the look-through.
The Commission said that registration of hedge fund advisers created many benefits. For example, it would help the Commission gather much needed information about hedge funds, deter fraud, bar unfit persons from the industry, require more compliance controls and limit “retailization.”
Critics of the rule, however, claimed that the Commission exceeded its authority, and that existing rules were adequate to address the Commission’s concerns. Critics also claimed that extending U.S. securities laws to non- U.S. advisers of funds with U.S. investors would create a chilling effect.
Almost immediately, a lawsuit challenged the Commission’s authority to regulate hedge fund advisers. In Goldstein v. SEC, the Court of Appeals for the D.C. Circuit, in 2006, threw out the hedge fund adviser registration rule, holding that funds themselves were an adviser’s “clients,” not the investors in those funds.1 The decision was notable because it narrowly construed the term “client” as used in the Advisers Act and gave little deference to the Commission’s view that an expansive definition was necessary.
The Court’s action created somewhat of a regulatory vacuum, because it also eliminated some safe harbors that many newly-registered hedge fund advisers had relied upon. Those advisers suddenly found themselves potentially in violation of other rules.
The Commission’s staff initially addressed the fallout from the Goldstein decision “no-action” interpretive guidance in August 2006. The guidance confirmed that:
- The substantive provisions of the Advisers Act do not apply to non-US advisers with respect to offshore funds and other offshore clients to the extent previously stated. Offshore advisers, of course, must comply with the Advisers Act and related rules with respect to its current and prospective US clients.
- The staff would not recommend enforcement action against registered advisers that failed to comply with various requirements if they relied on the rules that the Goldstein court vacated, involving, among other things, custody; performance-based compensation; and books and records.
- The staff would not recommend enforcement action against advisers that registered as a result of its rule and then withdrew their registration not later than February 1, 2007 because they were exempt, even though they held themselves out to the public and/or had more than 14 clients while registered.
Rule-making: anti-fraud provisions
The Commission said that the Goldstein opinion “created some uncertainty regarding the application” of the Advisers Act’s antifraud rules when advisers defraud investors in private investment pools. Citing its authority under Section 206-4 of the Advisers Act, 2 the Commission, as a way to prevent fraud, proposed new rule 206(4)-8, which would prohibit advisers to investment companies and other pooled investment vehicles from:
- making false or misleading statements to investors in those funds, or
- otherwise defrauding them.
Who would the rules protect?
The rules would apply to both existing clients and prospective clients. Thus, for example, the rules would prohibit false or misleading statements contained in account statements and to prospective investors in private placement memoranda, offering circulars, or responses to “requests for proposals.”
What kind of pooled investment vehicles would the rules cover?
The rules would apply to both registered investment companies (e.g., mutual closed-end funds), and other pooled investment vehicles that are excluded from the definition of investment company under sections 3(c)(1) or 3(c)(7) of the Investment Company Act. They would apply to private funds, including hedge funds, private equity funds, venture capital funds, and other types of funds that invest in securities, regardless of their investment strategies. The rules would not apply to funds relying on other exemptions, such as real estate investment trusts.
Would the rules apply to unregistered advisers and non-U.S. advisers?
Unlike existing rules adopted under Section 206, the new rules would apply to both registered and unregistered advisers. They would apply to non-U.S. advisers of these pooled investment vehicles.
What is the nature of the prohibition?
The rules would prohibit advisers to pooled investment vehicles from making any untrue statement of a material fact to any investor or potential investor, or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances, not misleading. Unlike the better-known Rule 10b-5 under the Securities Exchange Act of 1934, the proposed rule would not be limited to fraud in connection with the purchase and sale of securities.
Unlike violations of Rule 10b-5, the Commission need not show that an adviser violated the rules with scienter (that is, the Commission need not show that the adviser knew that an act or omission was wrongful).
No fiduciary duty created
The rules would not create a fiduciary duty to investors or prospective investors that the law does not otherwise impose on advisers. The rules would not alter any duty or obligation of an adviser under federal or state law.
No private right of action
The rules would not create a private right of action against an adviser. That is, only the Commission could bring an action accusing an adviser of a violation.
Rule-making: private offering rules
The Commission proposed to raise the financial bar for those who would invest in certain types of private investment funds. The rules would not change the criteria for institutional 3(c)(1) fund investors, or for investors in section 3(c)(7) funds.
Securities issued by private investment pools
Issuers may offer shares of private investment pools without complying with the registration and prospectus delivery requirements of the Securities Act if they rely on one of the private offering exemptions. Section 4(2) of the Securities Act (as expanded by Regulation D) exempts from the registration requirements transactions “by an issuer not involved in a public offering.” Section 4(6) exempts issuers from the registration requirements of the Securities Act if they limit sales to accredited investors for private offerings that do not exceed $5 million.
The rules would apply to certain types of investment funds that would be investment companies but for section 3(c)(1), and that rely on either the private offering exceptions provided by Regulation D or Section 4(6) of the Securities Act. The rules refer to these types of funds as “private investment vehicles.”
Regulation D under the Securities Act provides non-exclusive safe harbor criteria for the section 4(2) exemption. Private investment pools typically rely on rule 506, which lets issuers sell securities to an unlimited number of “accredited investors” without registration under the Securities Act (and up to 35 nonaccredited investors), unless the issuer is subject to another restriction.3
Accredited investors include natural persons whose:
- individual net worth, or joint net worth together with a spouse, exceeds $1million at the time of purchase, or
- individual income exceeds $200,000 (or joint income exceeds $300,000) in each of the two most recent years and reasonably expects the same level of income in the current year.
Accredited natural person
Citing the increasing complexity of private pools, the paucity of public information about them, and the fact that it established the accredited investor standards nearly 25 years ago, the Commission proposed to raise the financial threshold for investing in private investment pools.
Rules 509 and 216 would establish a new category called the “accredited natural person” that would apply to offers and sales of securities issued by “private investment vehicles” to accredited individuals under Regulation D and section 4(6).
“Accredited natural person” would mean any natural person who meets:
- either the net worth or the income test described above, and
- who owns at least $2.5 million in investments.
What would count as investments?
The rules would base the definition of “investments” on the definition contained in section 2(a)(51) of the Investment Company Act used to determine a “qualified purchaser” of section 3(c)(7) funds. That is, “investments” would include most securities, commodities and cash held for investment purposes, and selfdirected assets held in retirement accounts.
The new rules, however, would tighten the measurement criteria beyond those that apply to “qualified purchasers.” For example:
- Married investors who want to invest in their own account may only count half of their joint assets toward the $2.5 million threshold.
- The rule would value investments at fair market value. (Qualified purchasers may value investments at the higher of fair market value or cost.)
- Real estate not held for investment purposes (e.g., a personal residence, a summer home or property used as a place of business) would not count.
- Every five years, the Commission would adjust the threshold for inflation.
The proposed rules would not grandfather current accredited investors who do not qualify as accredited natural persons. Thus, accredited investors who do not meet the higher standard could not make future investments in private investment vehicles, even those that they already own. They would not be required, however, to sell their current holdings.
Venture capital funds
The Commission would not apply the new rules to the offer and sale of securities issued by venture capital funds in recognition of the benefit that those funds play in the capital formation of small businesses.
The Commission would define venture capital funds by referring to the definition of “business development company” (BDC) under section 202(a)(22) of the Advisers Act. BDCs under the Advisers Act must invest at least 60 percent of their assets in enumerated “eligible portfolio companies” (as compared to 70 percent for other types of BDCs) and must provide managerial assistance to those companies. Advisers Act BDCs need not function as closed-end funds (as is the case with other BDCs), may purchase assets from anyone (unlike other BDCs) and are not subject to other rules that apply to traditional BDCs.
Employees of issuers
The Commission did not address whether the rules would require the fund manager’s employees to qualify as accredited natural investors, even if they are “knowledgeable employees” for purposes of section 3(c)(1) (and thus do not count to the 100 investor limit).
Issuers of private investment vehicles wishing to sell interests to employees who do not meet the standard would be required to rely on another exemption. For example, they could rely on Rule 506 of Regulation D, which lets funds sell interests to up to 35 non-accredited investors, provided they meet certain conditions.
The Commission has solicited comments on many aspects of the proposal, including whether the investment levels and manner of measuring investments are appropriate. Comments are due by March 9, 2007.