On December 27, 2006, the SEC proposed rules that would create a new category of “accredited investor” and substantially reduce the universe of investors who may invest in hedge funds and other private pooled investment vehicles (“private funds”). The proposed rules also would prohibit investment advisers from engaging in false or misleading conduct with regard to investors in private funds.
If adopted in their current form, the proposed rules will have far reaching effects on registered and unregistered investment advisers and private funds. We will keep you apprised of any final rules that the SEC may adopt.
New Category of “Accredited Investor”
The SEC has become increasingly concerned by the growing access of investors to hedge funds. The SEC’s Office of Economic Analysis (“OEA”) estimates that in 1982, when the SEC first adopted the definition of an “accredited investor,” approximately 1.87% of U.S. households qualified for accredited investor status. According to OEA estimates, approximately 8.47% of U.S. households qualified as accredited by 2003.
As proposed, Rules 509 and 216 under the Securities Act of 1933 (the “Securities Act”) would address the SEC’s concern by creating a new category of accredited investor known as an “accredited natural person.” An accredited natural person would be defined as any natural person who (i) is an “accredited investor” under the current definition provided in Rule 501(a) of Regulation D of the Securities Act and (ii) owns at least $2.5 million of “investments,” as defined in the Investment Company Act of 1940 (the “1940 Act”). Consistent with current requirements under Regulation D, eligibility for the new category would be determined by the issuer at the time of investment.
Under the proposed rules, any natural person who purchases securities of a private fund that is deemed to be a “private investment vehicle” must satisfy the new accredited natural person test. A private investment vehicle would be defined as an issuer that would be an investment company but for the registration exemption provided by Section 3(c)(1) of the 1940 Act (the “100 beneficial owners” exemption). Private funds that rely on registration exemptions provided by other sections of the 1940 Act (e.g., private equity funds that rely on the Section 3(c)(7) exemption) would not be deemed to be private investment vehicles and their investors would not be required to meet the accredited natural person test. The proposed rules would also automatically adjust the $2.5 million investment requirement upwards for inflation on April 1, 2012 and every five years thereafter.
It is important to note that the proposed rules do not contain a “grandfather” clause for existing investors in private investment vehicles. This means that investors that do not satisfy the new accredited natural person test would not be able to make future investments in funds in which they are currently invested.
The proposed rules would, if adopted, significantly reduce the pool of potential investors for many small or mid-sized hedge funds and private equity funds that rely on the Section 3(c)(1) exemption. In addition, the new $2.5 million investment requirement may, as a practical matter, require private investment vehicles to reevaluate the nature and scope of the information in their standard investor questionnaires and other due diligence that they require from a potential investor in order to establish a reasonable belief that the investor meets the accredited natural person test.
New Anti-Fraud Rule
Sections 206(1) and 206(2) of the Investment Advisers Act of 1940 (the “Advisers Act”) prohibit investment advisers from engaging in a variety of fraudulent conduct with regard to advisory clients. However, the recent court decision in Goldstein v. SEC (which struck down the SEC’s prior interpretation of “client” for purposes of the Advisers Act) has created uncertainty regarding the extent to which these two sections might apply to investment advisers that defraud investors in private funds.
As proposed, Rule 206(4)-8 under the Advisers Act would eliminate this uncertainty by clearly prohibiting both registered and unregistered investment advisers to private funds from (i) making false or misleading statements to existing or prospective investors in private funds or (ii) otherwise defrauding such investors.
The practical effect of the proposed rule would be to prohibit investment advisers from making false or misrepresenting statements in private placement memoranda, offering circulars, requests for proposals and other communications regarding such things as investment experience or credentials of a portfolio manager or the performance, valuation, investment strategies or risks about a private fund.
The proposed rule would not distinguish between different types of private funds and would apply to hedge funds, private equity funds, venture capital funds and other investment companies that qualify for the exemptions under either Section 3(c)(1) or 3(c)(7) of the 1940 Act. In addition, Rule 206(4)-8 would not be limited to fraud in connection with the purchase and sale of a security by investors in a private fund, and the SEC would not be required to prove “scienter” (or intent to commit a fraud) when bringing enforcement actions against investment advisers under the rule.
Managers of small or mid-sized hedge funds or private equity funds who are contemplating forming a new fund in the future or raising additional capital from existing fund investors must carefully consider the possible effect of the proposed rules on their ability to raise capital from individual investors.
In addition, registered and unregistered investment advisers should carefully examine all disclosures and other communications made to existing and prospective investors in private funds in light of the proposed anti-fraud rule under the Advisers Act.
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This Client Alert is intended to inform readers of recent developments in the field of securities and corporate finance law. It should not be considered as providing conclusive answers to specific legal problems.