Gide Loyrette Nouel (Paris) and Gide Loyrette Nouel (NY), respectively
In December 2006, the US Securities and Exchange Commission (the SEC) proposed (i) new anti-fraud rules for investment advisers and (ii) a new standard for the definition of accredited investors. The SEC released these two newly proposed rules to the public for comments. The deadline for the public to submit comments on those two rules ended on 9 March 2007. The 600 comment letters sent to the SEC represent an extraordinarily high number for such technical issues and is a further indication that hedge funds have, in fact, in the public mind become an alternative to traditional investments. On 11 July 2007, the SEC voted to adopt the proposed anti-fraud provisions only.
The New Anti-Fraud Rule
The new rule will make it 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 to, or otherwise to mislead, investors or prospective investors in that pool. The rule will apply to all investment advisers to pooled investment vehicles, regardless of whether the adviser is registered or not under the Advisers Act. Under the new rule, a pooled investment vehicle will 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. No scienter requirement has been provided for in this rule to trigger the adviser’s liability. The new rule does not grant any private right of action.
In other words, the new rule will apply to all pooled investment vehicles, including hedge funds, private equity funds, venture capital, as well as mutual funds and business development companies.
The proposed rule came in the aftermath of the Goldstein decision . In this decision, the US Court of Appeals of D.C. overturned the new rule adopted by the SEC in 2004, requiring most hedge funds managers to register with the SEC. Under the Investment Advisers Act, managers with fifteen or more clients during the preceding twelve months and with more than US $30 million in assets under management are required to register with the SEC unless, among others, the adviser has fewer than fifteen clients. This exemption has been relied on by hedge fund managers to avoid federal registration. However, in 2004, the SEC decided that hedge fund managers were required to “look through” the fund and to count each of their beneficial owners as a client for the purpose of determining whether the manager has fewer than fifteen clients. This new rule was vacated in the Goldstein decision as the court in this case interpreted the term “client” to mean the fund itself and not the investors in the fund.
Most comments have supported these anti-fraud rules. A commonly shared view, however, was that the proposed rule was too broadly drafted and did not circumscribe the definition of fraud. Most commentators have also contested the lack of scienter requirement to establish the liability of the adviser. Some commentators have also suggested that the registered investment companies of Section 3(a) of the Investment Company Act, should be excluded from the scope of the proposed rule 206(4)-8, as the registered investment companies are already covered by a broad range of antifraud rules.
The Accredited Natural Person Rule
Unlike the anti-fraud rules, the accredited natural person standard came under strong criticism, especially among those who qualify under the current rules but would not be eligible to invest in hedge funds under the enhanced standard.
The current definition of an accredited investor under the Securities Act includes a natural person; provided that this person has a net worth of US$1 million or US$ 200,000 in income in the last two years, or US$300,000 in joint income with a spouse in the last two years ((Rule 501(a) and Rule 215 of the Securities Act)).
The new proposed category of accredited natural person, supplements the above test. An accredited natural person would be defined as any natural person who meets the above net worth/income test and who, in addition, owns at least US$2.5 million in qualifying investments. This new standard is intended to apply only to investors investing in private investment vehicles, other than certain venture capital funds, including hedge funds, that rely on the exclusion from the definition of an investment company under Section 3(c)(1) of the Investment Company Act.
The main criticism with respect to this new standard is the lack of correlation between the additional US$2.5 million threshold and a higher sophistication on the part of the investors. Small investors have also complained about the unfair and discriminatory effect of such a new standard. Others have also pointed out that increasing the protection of unsophisticated investors by raising the financial minimum wealth level, does not address the real issue, i.e the growth of hedge funds and it is likely to impair new funds formation and fund raising by smaller investors. Other commentators have criticised the limitation of the proposed new definition to hedge funds only. Some have also questioned the proposed exceptions to this new rule, such as venture capital fund exclusion from the definition of private investment vehicles, based on the assertion that these funds play an important role in the capital formation process for small businesses. Again, those against the exception have argued that investment in venture capital may be as risky as investments in hedge funds and that hedges funds are as valuable a source of capital as venture capital. Many have expressed the view that the SEC should provide exceptions from the accredited natural person status for employees of fund’s managers, who are often sophisticated enough to evaluate the risks of investing in private investment pools. Another concern is the absence of grandfathering rules for current investors. According to the proposed rule, these investors will be prevented from making further investments if they do not meet the US$2.5 million test. The comment letters also call for an alternative to the proposed new standard for accredited investors to avoid the needless complexity of this supplemental test.
The strong reactions to the new standard show that many investors do not wish their access to hedge funds to be limited and that there is no such strong case, on the investors’ side, for increased regulatory protection of their interests.
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