On December 27, 2006, the Securities and Exchange Commission (the “Commission”) issued a release proposing new rules under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) as part of their continued effort to safeguard investors in “pooled investment vehicles.” The proposed rules would (1) prevent advisors, both registered and unregistered, from defrauding prospective and current investors in hedge funds and other pooled investment vehicles and (2) amend the current definition of accredited investors as it pertains to natural persons that elect to invest in specific privately offered investment pools.
Comments to the proposed anti-fraud and accredited investor rules (the “Proposed Rules”) must be received by the Commission on or before March 19, 2007.
Proposed Rule 206(4)-8 under the Advisers Act: Investor Anti-Fraud Protection
In SEC v. Goldstein, the Court of Appeals for the D.C. Circuit vacated the Commission’s 2004 rule requiring certain hedge fund advisers to register under the Advisers Act. In reaching its decision, the court found that, for purposes of Sections 206(1) and 206(2) of the Advisers Act, the client of an investment adviser to a pooled investment vehicle is the investment pool itself and not the individual investors in the pool.
This ruling called into question the applicability of these sections to cases where an investment adviser defrauds investors in a pooled investment vehicle. The ruling, however, did not call into question the Commission’s authority to protect investors in pooled investment vehicles under Section 206(4) of the Advisers Act. The Commission has proposed new Rule 206(4)-8 pursuant to the broad authority granted by Section 206(4) to prevent fraudulent conduct.
Proposed Rule 206(4)-8
Proposed Rule 206(4)-8 would prohibit an adviser to a “pooled investment vehicle,” with respect to any investor or prospective investor in that pool, (1) to make any untrue statement of a material fact or omit to state a material fact; or (2) to otherwise engage in any act, practice, or course of business that is fraudulent, deceptive or manipulative. Unlike existing anti-fraud rules promulgated by the Commission, such as Rule 10b-5 under the Securities Exchange Act of 1934, as amended, proposed Rule 206(4)-8 is not restricted to fraudulent activity that occurs during the offer, sale, or redemption of a security and is not predicated upon whether the adviser acted with scienter. In the proposing release, the Commission stated that the broad scope of the rule was intended to combat many of the common forms of false or misleading statements that are typically made to investors, such as those regarding the investment strategies pursued by the pooled investment vehicle, the experience and credentials of the adviser, the risks associated with an investment in the pool, the performance of the pool or other funds advised by the adviser, the valuation of the pool or investor accounts in it, and practices the adviser follows in the operation of its advisory business such as how the adviser allocates investment opportunities.
In contrast to other rules adopted under Section 206(4), proposed Rule 206(4)-8 would apply to all advisers whether or not they are registered with the Commission. Additionally, proposed Rule 206(4)-8 extends to investors and prospective investors in “pooled investment vehicles,” which is defined to include any investment company as defined in Section 3(a) of the Investment Company Act of 1940, as amended, (the “1940 Act”) and any investment pool that is excluded from the definition of an investment company by reason of either Section 3(c)(1) (“Section 3(c)(1) funds”) or Section 3(c)(7) (“Section 3(c)(7) funds”) of the 1940 Act. Moreover, the proposed rule does not differentiate between private funds on the basis of their investment strategy or structure. The Commission noted that defrauding investors in hedge funds, private equity funds, venture capital funds or any other type of private fund is equally unacceptable. The proposed rule, however, does not create a private cause of action against advisers nor does it create a fiduciary duty to investors or prospective investors not otherwise required by law.
Proposed Rules 509 and 216 under the Advisers Act: Private Offering Rules
Section 4(2) of the Securities Act of 1933, as amended (the “1933 Act”) exempts privately offered investment pools from the registration and prospectus delivery requirements imposed by the 1933 Act when offered in the United States to investors that are capable of evaluating the merits of such investment and bearing any associated economic risk. Regulation D under the 1933 Act specifically establishes “safe harbor” criteria for issuers to objectively utilize this exemption. Rule 506 of Regulation D provides privately offered investment pools the opportunity to sell their securities to an unlimited number of “accredited investors” without registration under the 1933 Act (unless subject to any other restriction). Rule 501(a) of Regulation D defines the term “accredited investor” as including a natural person (1) whose individual net worth, or joint net worth with the person’s spouse, exceeds $1,000,000 at the time of purchase; or (2) whose individual income has exceeded $200,000 in the two most recent years or whose joint income with their spouse has exceeded $300,000 in each of those years and has a reasonable expectation of reaching the same level of income in the current year. Similarly, an exemption also exists pursuant to Section 4(6) of the 1933 Act for privately offered investment pools that are offered solely to accredited investors and in which the aggregate offering price of the pool’s securities does not exceed $5,000,000.
The net worth and income standards of the current definition of “accredited investor” were adopted in 1982 in the belief that an investor able to satisfy these requirements would be able to evaluate the merits and bear the risks of an investment in a private offering. However, due to inflation and an increase in overall investor wealth since these standards were first implemented, the Commission believes that certain forms of private pooled investments have become available to a far broader demographic than initially envisioned and that the accredited investor standard is no longer a sufficient hurdle to ensure that private offerings of certain pooled vehicles are only made to sophisticated investors. While investors that intend to purchase interests in Section 3(c)(7) funds must satisfy both the definition of an accredited investor under Regulation D and the definition of a qualified purchaser under the 1940 Act, investors in Section 3(c)(1) funds must qualify as accredited investors only. Accordingly, deficiencies in the definition of accredited investor may not necessarily result in sophisticated investors acquiring interest in Section 3(c)(7) funds, but would likely result in Section 3(c)(1) funds becoming increasingly available to a wider array of investors than was initially contemplated when the safe harbor provision of Rule 506 was drafted in 1982. To address this problem, the Commission has proposed the new rules in an effort to abate the large influx of investors that could potentially qualify to invest in a private investment company without possessing the sophistication necessary to evaluate the merits or bear the risk of such an investment.
Proposed Rules under 509 and 216
Proposed Rules 509 and 216 revise the definition of accredited investor as it pertains to natural persons, creating a new category of accredited investor, the “accredited natural person,” which relates strictly to investments by natural persons in “private investment vehicles.” Under the proposed rules, a “private investment vehicle” is defined as any issuer that would be an investment company but for the exclusion provided by Section 3(c)(1) of the 1940 Act (the term private investment vehicle, however, does not include venture capital funds, as discussed in more detail below). Specifically, proposed Rule 509 would apply the accredited natural person standard to offerings of private investment vehicles made in reliance on Regulation D while proposed Rule 216 would apply the accredited natural person standard to offerings by private investment vehicles relying on Section 4(6) of the 1933 Act.
To qualify under the proposed accredited natural person standard, a natural person must (1) satisfy the current definition of an accredited investor and (2) own at least $2.5 million in “investments” (as valued at the time of purchase), exclusive of primary residences or real estate held in connection with a trade or business.
The term “investments,” as defined by the proposed rules, is similar to the definition utilized for qualified purchasers in Rule 2a51-1 under the 1940 Act, but differs in that it does not permit an individual, acting on his or her own behalf (and not jointly with a spouse), to include all property that he or she owns jointly or as part of shared community interest. Instead, when a natural person acts solely on his or her own behalf, he or she may include only 50 percent of any investments that are held either jointly with a spouse or in which the natural person shares a community property or similar shared ownership interest with a spouse.
The aggregate value of such investments is calculated based upon their fair market value. As proposed, the dollar amount of investments would be adjusted for inflation first on April 1, 2012, and then every five years thereafter.
In addition, proposed Rules 509 and 216 would not “grandfather” current investors. Thus, under the proposed rules, certain current investors would not be able to make additional purchases in private investment vehicles in which they are already invested.
Venture Capital Funds
The proposed accredited investor rules apply to those investors that seek to invest in Section 3(c)(1) funds, however, these rules would exclude “venture capital funds” that meet the definition of a business development company under Section 202(a)(22) of the Advisers Act. This exclusion was proposed because of the importance, in the Commission’s view, that venture capital funds and business development companies play in the capital formation of small businesses.
The Commission is soliciting comment as to whether employees of either a private investment pool or its investment adviser who wish to invest in the pool should be required to satisfy the proposed accredited natural person standard. Current methods that are typically used to offer securities in an investment pool to non-accredited employees include:
• making an offer in reliance upon Rule 506 under the 1933 Act (which permits 35 non-accredited purchasers);
• making an offer pursuant to Section 4(2) of the 1933 Act;
• making an offer in reliance upon Rule 701 under the 1933 Act (which provides an exemption from registration for offers and sales of securities to certain natural persons pursuant to certain compensatory benefit plans and contracts relating to compensation); and
• providing equity incentive compensation through contractual arrangements in employment agreements.
The Commission is seeking comment as to whether these methods are sufficient and whether the list of accredited natural persons should include certain “knowledgeable employees” consistent with the concept of “knowledgeable employees” eligible to invest in private investment pools in accordance with Rule 3c-5 under the 1940 Act.
The Proposed Rules signal that, even in light of the recent Goldstein decision, the Commission intends to uphold its commitment to protect investors in privately offered investment pools. While the Goldstein decision may have impeded the Commission’s ability to oversee the rapidly expanding private fund business, the Proposed Rules attempt to lessen the impact of the court’s decision by re-granting the Commission certain oversight authority and minimizing the proliferation of private funds by elevating the qualification standards for investors. It is important to note that the proposed rule release solicits comment in a variety of areas and thus the Proposed Rules may be altered, perhaps significantly, prior to enactment.