On December 27, the SEC released the text of its proposed new rules that would impact advisers to hedge funds and other pooled investment vehicles. The SEC originally voted to propose the new rules on December 13. As described more fully below, the proposed new rules would prohibit advisers to pooled investment vehicles from making false or misleading statements or otherwise defrauding investors or prospective investors in those vehicles. The proposed new rules also would revise the definition of accredited investor as it relates to natural persons investing in a pooled investment vehicles relying on Section 3(c)(1) of the Investment Company Act. See Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited Investors in Certain Private Investment Vehicles, Securities Act Release No. 8766 (Dec. 27, 2006), available at: http://www.sec.gov/rules/proposed/2006/33-8766.pdf.
A. New Antifraud Rule under the Investment Advisers Act
The SEC proposed new Rule 206(4)-8, an anti-fraud rule adopted under Section 206(4), that would prohibit investment advisers to investment companies and other pooled investment vehicles from (1) making false or misleading statements to investors in those vehicles, or (2) otherwise defrauding investors in those vehicles. The proposed rule would apply to both existing and prospective investors, and would, for example, prohibit false and misleading statements in account statements provided to existing investors, as well as in private placement memoranda and responses to requests for proposals provided to prospective investors. The proposed rule also would apply to both registered and unregistered advisers.
In addition, the proposed rule would apply to investors in investment companies, as well as pooled investment vehicles excluded from the definition of an investment company under Section 3(a) of the Investment Company Act by reason of either Section 3(c)(1) or 3(c)(7). The proposed rule would not distinguish among different types of pooled investment vehicles regardless of a vehicle’s investment strategy, structure or lock-up period. Thus, the proposed rule would apply to advisers to hedge funds, private equity funds, venture capital funds and other types of pooled investment vehicles, along with investment companies that are offered to the public (although most communications with investors in publicly offered investment companies are covered by Section 34(b) of the Investment Company Act).
The proposed rule also would apply to fraud whether or not it occurs in connection with the offer, sale or redemption of a pooled investment vehicle’s interests, unlike Rule 10b-5 under the Exchange Act. Accordingly, the proposed rule would prohibit a wide range of false or misleading statements in a variety of contexts. The SEC noted that it has previously found examples of false or misleading statements in connection with misrepresentations regarding a vehicle’s investment strategies, the experience and credentials of the adviser and its personnel, risks associated with an investment in the vehicle, the performance of the vehicle, the valuation of the vehicle’s assets, and practices the adviser follows in managing the vehicle such as how the adviser allocates investment opportunities. The proposed rule also would prohibit more broadly deceptive conduct that may not involve any statements. In addition, the SEC would not need to demonstrate that an adviser acted with scienter to establish a violation of the proposed rule. The proposed rule, however, would not create a private cause of action against an adviser. Nor would the proposed rule create a fiduciary duty to investors or prospective investors in the vehicle not otherwise imposed by law or otherwise alter any duty or obligation an adviser has under the Advisers Act or any other federal or state law.
B. Modifications to the Accredited Investor Standard
The SEC also proposed two new rules under the Securities Act, Rules 509 and 216, as well as minor conforming rule amendments. The proposed rules would define a new category of accredited investor (referred to as an “accredited natural person”) which would apply to offers and sales of securities issued by certain pooled investment vehicles relying on Section 3(c)(1) of the Investment Company Act (“3(c)(1) Pools”) to accredited investors under Regulation D and Section 4(6). As explained below, an “accredited natural person” would be required to satisfy both (1) the current income or net worth test specified in Rule 501(a) or Rule 215 and (2) and own at least $2.5 million in investments at the time of purchasing securities issued by a 3(c)(1) Pool. The proposed rules, however, would not apply to pooled investment vehicles relying on Section 3(c)(7). All other provisions of Regulation D, and Sections 4(6) and 2(a)(15) and Rule 215 would remain unchanged and continue to apply to the offer and sale of securities issued by private investment vehicles.
1. “Accredited Natural Persons” and Employees
The term “accredited natural person” would include any natural person who meets the requirements specified in the current definition of accredited investor and who owns not less than $2.5 million in investments at the time of purchase of any securities issued by a 3(c)(1) Pool under Regulation D or Section 4(6). The proposed definition is intended to ensure that an investor has sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment. The SEC seeks comments on various aspects of this definition, including for example whether (1) the additional investment test is an appropriate standard to measure a person’s ability to evaluate the merits of a prospective investment; (2) the current income and net worth standards should be raised or lowered; (3) the SEC should simply increase the current income and net worth standards rather than adding the investments test; (4) $2.5 million is an appropriate level for an investments test; and (5) employees of the adviser to a 3(c)(1) Pool should be subject to the same “accredited natural person” standard.
With regard to employees of an adviser to a 3(c)(1) Pool, the SEC notes that there are private investment vehicles that currently offer and sell interests in the vehicle (or similar interests tied to the performance of the vehicle) to employees who do not meet the current accredited investor standard. The SEC cites the following four methods by which such offers and sales are made: (1) by relying on Rule 506, which allows for 35 non-accredited investors (subject to certain additional conditions and disclosure requirements); (2) by making an offering pursuant to Section 4(2); (3) by relying on Rule 701 (relating to compensatory benefit plans and contracts relating to compensation) and (4) by providing incentive compensation tied to the performance of the vehicle, including for example, an allocation of a portion of the performance fee payable by the vehicle.
The SEC requests comment on whether these methods are sufficient to permit employees who are not accredited natural persons to invest in 3(c)(1) Pools advised by their employers. Alternatively, the SEC requests comment on whether the SEC should add to the list of “accredited natural persons” certain “knowledgeable employees,” consistent with Rule 3c-5 under the Investment Company Act.
With regard to existing natural person investors, the proposed rules would provide only a limited grandfather right. An existing investor in a 3(c)(1) Pool would not be permitted to make additional investments in such 3(c)(1) Pool unless the investor meets the definition of an “accredited natural person” at the time of any additional investment.
Finally, the proposed rules would provide for inflation adjustments to the $2.5 million test. The first adjustment would occur on April 1, 2012 and also after each subsequent 5-year period.
2. “Investments” Defined
The proposed definition of “investments” is based on Rule 2a51-1 under the Investment Company Act, with certain modifications. For example, the term “investments” would incorporate only those provisions of Rule 2a51-1 relevant to natural persons. In addition, the term would treat differently investments owned jointly with a spouse or that are part of a shared community interest. Such investments could be included in their entirety only if the investment in a 3(c)(1) Pool is made jointly. Otherwise, an investor acting individually would generally only be entitled to include 50% of such investments toward the $2.5 million requirement. The term “investments” also would require that the aggregate amount of investments owned and invested on a discretionary basis by a natural person be measured at their fair market value, calculated on a per investment basis. Finally, the term “investments” would not include real estate that is used by a natural person or certain family members for personal purposes or as a place of business, or in connection with a trade or business.
3. Venture Capital Funds Excluded
In recognition of the benefit that the SEC believes venture capital funds play in the capital formation of small businesses, the proposed rules would not apply to the offer and sale of securities issued by venture capital funds. The proposed rules would define the term “venture capital fund” by reference to the definition of “business development company” in Section 202(a)(22) of the Investment Advisers Act. (See footnote 69 of the proposing release for an explanation of the Advisers Act definition of a “business development company”.) In proposing this definition, the SEC also requests comment regarding whether the SEC should instead (1) use the definition of a “business development company” found in Section 2(a)(48) of the Investment Company Act; (2) formulate a specific definition of the term “venture capital fund” and, if so, define the term by reference to investment objectives and strategies or lock-up periods; (3) expand the definition to permit investing in offshore securities or other private investment vehicles; and (4) simply not exclude venture capital funds from the application of the proposed rules.
C. Comment Period
Comments on the proposed new rules must be submitted to the SEC on or before March 9, 2007.