On Dec. 27, 2006, the SEC issued a Release that proposes to address "two areas of particular concern" relating to hedge funds and other pooled investment vehicles, "with a view to strengthening protections for investors." First, the SEC is proposing a new antifraud rule under the Investment Advisers Act of 1940 ("Advisers Act"). Proposed new rule 206(4)-8 would prohibit advisers to investment companies and other pooled investment vehicles from making false or misleading statements to, or otherwise defrauding, investors in those pools (and prospective investors). Second, the SEC is proposing to revise the requirements for determining whether an individual is eligible to invest in certain pooled investment vehicles. Proposed new rules 216 and 509 under the Securities Act of 1933 ("Securities Act") would revise the definition of "accredited investor" (which certain privately offered investment pools—"private pools"—use in determining whether an individual is eligible to invest in the pool) to create a new category of accredited investor called "accredited natural person." This is "designed to help ensure that investors in these types of funds are capable of evaluating and bearing the risks of their investments."
The SEC is requesting that comments on the proposals be submitted no later than March 9, 2007.
In 2004, the SEC adopted a rule that would have required certain hedge fund advisers to register under the Advisers Act by creating a new definition of who must be counted as a "client" of an adviser for purposes of the exemption from registration in section 203(b)(3) of the Advisers Act. The rule was challenged in court, and the Court of Appeals for the D.C. Circuit vacated the rule. Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006). In addressing the scope of the section 203(b)(3) exemption and the meaning of "client" as used in that section, the court expressed the view that, for purposes of sections 206(1) and (2) of the Advisers Act, the "client" of an investment adviser managing a pool is the pool itself, not the investors in the pool. As the SEC stated in the Release, the court's opinion "created uncertainties regarding obligations that investment advisers to pools have to the pools' investors." Although sections 206(1) and (2) contain broad anti-fraud language, they speak only in terms of conduct aimed at "any client or prospective client." Thus, the opinion "created some uncertainty regarding the application of sections 206(1) and 206(2) of the Advisers Act in certain cases where investors in a pool are defrauded by an investment adviser."
Proposed Rule 206(4)-8 - Pooled Investment Vehicles
Section 206(4) of the Advisers Act provides that it is unlawful for investment advisers to "engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative" and that "[t]he Commission shall, for purposes of [paragraph 206(4)] by rules and regulations define, and prescribe means reasonably designed to prevent, such acts, practices and courses of business as are fraudulent, deceptive, or manipulative. Thus, section 206(4) is broader in scope than sections 206(1) and (2) and is not limited to conduct aimed at clients or prospective clients. Moreover, the Release states that the Goldstein decision did not call into question the SEC's authority to adopt rules under section 206(4) to protect investors in pooled investment vehicles: "This section permits us to adopt rules proscribing fraudulent conduct that is potentially harmful to the growing number of investors who directly or indirectly invest in hedge funds and other types of pooled investment vehicles."
Proposed Rule 206(4)-8 is brief and to the point, providing that: It shall constitute a fraudulent, deceptive, or manipulative act, practice, or course of business within the meaning of section 206(4) of the Advisers Act for any investment adviser to a "pooled investment vehicle" to:
- (1) Make any untrue statement of a material fact or to omit to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle; or
- (2) 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.
For purposes of this section "pooled investment vehicle" would be defined to mean "any investment company as defined in section 3(a) of the Investment Company Act of 1940 ["ICA"] or any company that would be an investment company under section 3(a) of that Act but for the exclusion provided from that definition by either section 3(c)(1) or section 3(c)(7) of that Act."
Some Points to Note:
Unlike other rules adopted by the SEC under 206(4), the proposed rule would apply to any investment adviser to a pooled investment vehicle, including advisers that are not registered or required to be registered under the Advisers Act.
The proposed rule would not distinguish among types of pooled investment vehicles and is designed to protect investors both in investment companies and in pools that are excluded from the definition of investment company by reason of either section 3(c)(1) or 3(c)(7) of the ICA. Thus, the new antifraud rule would apply to all advisers with respect to all pooled investment vehicles that they advise, such as hedge funds, private equity funds, venture capital funds, and other types of privately offered pools that invest in securities, regardless of the investment strategy they employ, or the structure of the pooled investment vehicle.
In brief, Section 3(c)(1) excludes from the definition of investment company an issuer the securities (other than shortterm paper) of which are "beneficially owned" by not more than 100 persons and that is not making or proposing to make a public offering of its securities.
In brief, Section 3(c)(7) excludes from the definition of investment company an issuer the outstanding securities of which are owned primarily by persons who, at the time of acquisition of such securities, are "qualified purchasers," and that is not making or proposing to make a public offering of its securities. "Qualified purchaser" is defined in section 2(a)(51) of the ICA generally to include a natural person (or a company owned by two or more related natural persons) who owns not less than $5,000,000 in investments; a person, acting for its own account or accounts of other qualified purchasers, who owns and invests on a discretionary basis, not less than $25,000,000; and a trust whose trustee, and each of its settlors, is a qualified purchaser.
Proposed rule 206(4)-8 would not be limited to fraud in connection with the purchase and sale of a security; that is, it would prohibit advisers to pooled investment vehicles from making any materially false or misleading statements to investors in the pool regardless of whether the pool is offering, selling, or redeeming securities.
The SEC would not need to demonstrate that an adviser violating rule 206(4)-8 acted with scienter.
There would be no private cause of action against an adviser under the proposed rule.
Proposed rule 206(4)-8 would not create a fiduciary duty to investors or prospective investors in the pooled investment vehicle not otherwise imposed by law. Nor would the rule alter any duty or obligation an adviser has under the Advisers Act, any other federal law or regulation, or any state law or regulation (including state securities laws) to investors in a pooled investment vehicle it advises.
"Accredited Natural Person" Proposal
The thrust of this proposal is to add an additional criterion to the definition of "accredited investor" to further qualify a "natural person" for investment in a "private investment vehicle" (i.e., any issuer, other than a "venture capital fund," that would be an investment company as defined in section 3(a) of the ICA but for the exclusion provided for in section 3(c)(1) of the ICA; or a "3(c)(1) Pool"). Thus, in addition to meeting existing standards for either net worth or income, a natural person would have to own at least $2.5 million in "investments" in order to be allowed to invest in a "private investment vehicle." A person meeting all relevant qualifications would be defined as an "accredited natural person."
Private offerings of securities issued by investment pools are made without compliance with the registration and prospectus delivery requirements of section 5 of the Securities Act, in reliance on the private offering exemption provided by section 4(2) or section 4(6) of the Securities Act, or in compliance with certain related rules. Regulation D under the Securities Act establishes a non-exclusive "safe harbor" for the section 4(2) private offering exemption, and Rule 506 of Regulation D is the provision that privately offered investment pools typically rely on in making offers and sales of their securities. An issuer may sell its securities under rule 506 to an unlimited number of "accredited investors" without registration under the Securities Act (unless the issuer is subject to another restriction).
Rule 501(a) of Regulation D defines the term "accredited investor" to include (among others) a natural person whose individual net worth (or joint net worth with the person's spouse) exceeds $1 million at the time of the purchase, or whose individual income exceeds $200,000 (or joint income with the person's spouse exceeds $300,000) in each of the two most recent years and who has a reasonable expectation of reaching the same income level in the year of investment.
Section 4(6) of the Securities Act provides an additional issuer exemption for offers and sales of securities to "accredited investors" if the issuer offers no more than $5 million of securities and does not
engage in a general solicitation. Section 2(a)(15)(i) of the Securities Act establishes a statutory definition of the term "accredited investor," as used in section 4(6), that includes certain institutions. Section 2(a)(15)(ii) gives the SEC statutory authority to adopt rules to further define any person (including any natural person) as an accredited investor. The definition of accredited investor for purposes of section 4(6) is contained partly in section 2(a)(15)(i) and partly in rule 215 under the Securities Act, which contains the categories of accredited investors adopted by the SEC. Taken together, the accredited investor categories under section 4(6) are the same as under Regulation D.
With respect to status as "investment companies," most private pools rely on an exclusion from the definition of investment company provided by section 3(c)(1) or section 3(c)(7) of the ICA, both of which are also premised on the absence of a public offering. 3(c)(1) Pools may have no more than 100 beneficial owners, regardless of whether they are "accredited investors" under rule 501(a). The Release reviews the reasons for the SEC's belief that certain investor protections "may be lacking with respect to 3(c)(1) Pools." It also notes in this regard that these protections already exist for private pools that rely on the exclusion provided by ICA section 3(c)(7) ("3(c)(7) Pools"). Natural persons who invest in such pools are required to own $5 million in certain investments at the time of their investment in the pool. In addition, for a 3(c)(7) Pool to rely on the safe harbor from Securities Act registration provided by Regulation D, the pool must limit the sale of its securities to qualified purchasers who also meet the definition of "accredited investor."
The SEC describes 3(c)(7) Pools as being subject to a "two-step" approach that is designed to provide assurance that an investor "has a level of knowledge and financial sophistication and the ability to bear the economic risk of the investment in such pools, as demonstrated by the investor's investment experience and also, for natural persons, that person's net worth or income … We believe that such a two-step approach may provide important, additional investor protections to natural persons who invest in certain 3(c)(1) Pools. Accordingly, … the proposed rules governing investments in such pools incorporate that approach."
The SEC is proposing two rules under the Securities Act, containing the same substantive provisions. As proposed, rules 509 and 216 would define a new category of accredited investor ("accredited natural person") that would apply to offers and sales of securities issued by certain 3(c)(1) Pools (defined in the proposed rules as "private investment vehicles") to accredited investors under Regulation D and section 4(6), respectively.
The term "accredited natural person" would mean any natural person who meets either the current net worth or income test specified in rule 501(a) or rule 215, as applicable, and who also owns at least $2.5 million in "investments," as defined in the proposed rules. The term would apply for purposes of determining whether a person is an accredited investor at the time of that person's purchase of an interest in a "private investment vehicle." Under the proposals, the $2.5 million amount would be adjusted for inflation in a specified manner April 1, 2012, and every five years thereafter.
As noted, the term "private investment vehicle" would encompass all 3(c)(1) Pools, except "venture capital funds," which the proposals define to have the same meaning as the definition of "business development company" in section 202(a)(22) of the Advisers Act. Note that term business development company is also defined, although somewhat differently, in section 2(a)(48) of the ICA, and the SEC is seeking comment on whether one definition would be more appropriate than the other.
The proposed rules would define "investments" to generally include "securities" as well as the following assets that are held for "investment purposes": real estate; "commodity interests" and "physical commodities" (as defined in the rules); certain "financial contracts" that may not be "securities"; and certain cash and cash equivalent items. The rules include proposed guidance on whether holdings of real estate and other assets would be for investment purposes. They would also mandate that investments generally be valued at their "fair market value on the most recent practicable date or their cost, " and that the amount of any outstanding indebtedness incurred for the purpose of acquiring investments be deducted from the value of the investments.
The proposals would specify that, in determining whether a natural person is an accredited natural person, there may be included in the amount of such person's investments any investments held individually, and 50 percent of any investments (1) held jointly with such person's spouse, and (2) in which such person shares with such person's spouse a community property or similar shared ownership interest. In determining whether spouses who are making a joint investment in a private investment vehicle are accredited natural persons, there may be included in the amount of each spouse's investments any investments owned by the other spouse (whether or not such investments are held jointly).
Some Points to Note:
Except as modified by the application of the proposed definition of accredited natural person, all other provisions of Regulation D, and sections 4(6) and 2(a)(15) and rule 215, would continue to apply to the offer and sale of securities issued by private investment vehicles. Thus, as proposed, the rules would alter the criteria for investments by natural persons described in rule 501(a)(4) and rule 215(d) (e.g., directors and executive officers of the issuer).
The proposed rules would not grandfather current accredited investors who would not meet the new accredited natural person standard so that they could make future investments in private investment pools, even those in which they currently are invested. The proposed rules would apply solely to the offer and sale of securities issued by private investment vehicles, as defined in the proposed rules. Thus, these proposed rules would not apply to offers and sales of securities issued by private funds not meeting the proposed definition of the term private investment vehicle, including venture capital funds and 3(c)(7) Pools.
The treatment in the proposed rules of investments a natural person may own jointly with a spouse or that are part of a shared community interest is different from the treatment of such investments under ICA rule 2a51-1. In the context of 3(c)(7) Pools, Rule 2a51-1 permits all of such investments to be included in the determination of whether a natural person is a qualified purchaser.