At an open meeting on December 13th, the Securities and Exchange Commission (the “SEC” or “Commission”) took various actions, including proposing new rules related to hedge fund advisers and bank dealer activities, and reopening the comment period on the Commission’s proposed mutual fund governance rule. The hedge fund proposals would prohibit investment advisers to hedge funds or other pooled investment vehicles, such as private equity funds, from defrauding investors in these pools, regardless of whether the adviser is registered or not. The proposals would also amend the definition of “accredited investor” to the extent it applies to natural persons who invest in hedge funds or other pooled investment vehicles, excluding venture capital funds.
The SEC also voted to propose jointly, with the Board of Governors of the Federal Reserve System (the “Board”), Regulation R (“Reg R”), which will address the partial exemption of banks from the definition of “broker” under the Securities Exchange Act of 1934 as amended (the “Exchange Act”) and pursuant to the Gramm-Leach-Bliley Act of 1999 (the “GLB Act”). Reg R would define key terms under the GLB Act, and would create new exemptions for banks from the definition of “broker.” The Commission also proposed SEC specific rules and extended the temporary exemption of banks from the definition of “broker” until July 2, 2007. The Board will consider the joint proposal at its December 18, 2006 meeting, at which time the text of the proposed Reg R will be available. The text of the proposed rules is not yet available. The descriptions provided in this special alert are partially based on statements made by the commissioners and staff at the open meeting. The proposed rules are expected to be publicly available shortly, at which time we will prepare a more comprehensive advisory discussing the proposals.
Hedge Fund Regulation
On June 23, 2006, the U.S. Court of Appeals for the District of Columbia Circuit struck down a rule adopted by the SEC that required most hedge fund advisers to register with the Commission. That rule redefined the term “client” for purposes of the adviser registration de minimus exception. In light of the invalidation of that rule, the SEC has proposed a new, two-pronged approach to protecting investors in hedge funds and other pooled investment vehicles.
Anti Fraud Provision Under the Iinvestment Advisers Act
The SEC proposed a new rule under Section 206(4) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”) that would clarify that it is a fraudulent, deceptive, or manipulative act, practice, or course of business for an investment adviser to a pooled investment vehicle to make false or misleading statements or to otherwise defraud investors or prospective investors in that pool. The rule would apply to all investment advisers to pooled investment vehicles, regardless of whether the adviser is registered under the Advisers Act. Under the proposed rule, a pooled investment vehicle would include any investment company and any company that would be an investment company but for the exclusions in sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, as amended (the “1940 Act”). Most hedge funds are not registered under the 1940 Act pursuant to these exclusions.
Accredited Investor Definition Under the Securities Act
The proposal would also amend the private offering rules in Regulation D promulgated under the Securities Act of 1933, as amended (the “Securities Act”). The proposal would create a new and more restrictive category of accredited investor that would apply to the offer and sale of securities issued by hedge funds and other private investment pools relying on the Section 3(c)(1) exclusion, except venture capital funds. The proposed definition would require a natural person to:
- Meet the current accredited investor requirements (either the net worth test or income test specified in Rule 501(a) or Rule 215, as applicable), and
- Own at least $2.5 million in investments, as that term is currently defined in rules under the 1940 Act for purposes of the Section 3(c)(7) exception. The definition of “investments” explicitly excludes the value of an investor’s home.
The new accredited investor standard will not impact investment pools relying on the 3(c)(7) exclusion. Additionally, the SEC rejected applying the new accredited investor standard to individuals that invest in venture capital funds because of the perceived importance such funds serve in raising capital for small businesses.
This proposal attempts to address the rapid increase in hedge fund investment by limiting the potential pool of hedge fund investors. According to SEC economists, these new requirements will reduce the pool of accredited investors by 88 percent. The proposal also would make the required income and investment levels for accredited investors self-adjusting annually, in order to account for inflation.
Bank Broker Activities
As part of several reforms in 1999 that generally expanded the securities-related activities of banks, section 201 of the GLB Act removed the broad exemption that banks had enjoyed from the definition of “broker” in the Exchange Act and replaced it with a set of narrower exceptions. The SEC and the federal banking agencies have battled over the implementation of this new definition ever since without final resolution. Section 101 of the Financial Institutions Regulatory Relief Act of 2006 directed the SEC and the Board jointly to issue a proposed new rule within 180 days – i.e., by April 11, 2007. The new proposal is in response to that statutory mandate.
Reg R proposes bank exceptions from the definition of “broker” in the areas of third-party brokerage (“networking”), trust and fiduciary activities, sweep accounts and safekeeping and custody.
- Networking Exception - would allow banks to refer bank customers to broker-dealers in exchange for a share of the commissions earned from the customers’ accounts.
- Trust and Fiduciary Activities Exception - would permit a bank to effect securities transactions in a trustee or fiduciary capacity if it is “chiefly compensated” for those transactions, consistent with fiduciary principles and standards, on the basis of specifically enumerated types of fees. The proposed rules would define methodologies for determining if a bank is “chiefly compensated” within the terms of this exception.
- Sweep Accounts Exception - would permit a bank to sweep deposits into no-load, money market funds. The proposed rules would define terms used in the sweep accounts exception, and would provide banks with a conditional exemption for transactions in money market funds that are not no-load as well as for transactions that are not sweeps.
- Safekeeping and Custody Exception - would permit banks to perform specified services in connection with safekeeping and custody of securities, and would allow securities transactions on an accommodation basis. Specified services would include taking orders for securities transactions from employee benefit plan accounts and individual retirement and similar accounts for which the bank acts as a custodian, as well as from other safekeeping and custody accounts on an accommodation basis.
The SEC also extended the existing temporary exemption of banks from the definition of “broker” until July 2, 2007. If Reg R is adopted, banks will have a transitional 18-month exemption until the first day of their first fiscal year commencing after June 30, 2008 to be in compliance with its provisions.
Independently of the joint SEC-Board Reg R proposal, the SEC also reproposed an exemption from the definition of “dealer” for banks’ conduit securities lending activities, a conditional exemption from the definition of “dealer” for banks’ riskless principal Regulation S transactions, and proposed certain technical amendments to various rules to ensure internal consistency.