SEC Proposes Limitations On Hedge And Private Equity Funds’ Money-Raising Activities

January 2007

The United States Securities and Exchange Commission (SEC) proposed new rules designed to limit investors who could participate in hedge funds and other pooled investment vehicles such as private equity funds. The new proposals respond to the ruling in Goldstein v. SEC (451 F.3d 873, D.C. Cir. 2006), which struck down the SEC's hedge fund manager registration rule. Recognizing that there is more than one way to accomplish its objectives, the SEC proposed a new antifraud rule and an amendment to Regulation D under the Securities Act of 1933 to increase the net worth requirement to meet the definition of an "accredited investor."

The Goldstein Court determined that the "client" of an investment adviser managing a hedge fund is the fund itself, not the fund's investors.  The Court's ruling raised the question of whether the antifraud provisions of Sections 206(1) and 206(2) of the Investment Advisers Act of 1940 apply to hedge fund investors.  In response, proposed Rule 206(4)-8 would forbid federally registered, state-registered, and unregistered investment advisers to make material misstatements and omissions, or to engage in any other act that is fraudulent, deceptive, or manipulative with any investor or prospective investor.

The SEC also proposes to amend Regulation D under the Securities Act of 1933 to set a higher requirement for investors who buy shares of private investment vehicles.  Regulation D provides a safe harbor for private placements to an unlimited number of accredited investors, plus up to 35 non-accredited but sophisticated investors. Hedge funds have typically relied on Regulation D in selling their securities.  In addition to the existing standard (described in the next paragraph), proposed Rules 509 and 216 will require an accredited natural person to own not less than $2.5 million in investments.  For this purpose, “investments” excludes real estate not held for investment purposes, such as one’s home(s) or real estate used in connection with a trade or business. This $2.5 million threshold will be adjusted for inflation every five years.

Currently, under Regulation D, Rule 501(a), an "accredited investor" is a natural person whose (i) net worth exceeds $1 million at the time of purchase, OR (ii) 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 current year. These standards were adopted in 1982. Except for the addition of the $300,000 joint income standard in 1988, these rules have not been revised since their original adoption.

Because of inflation, and in particular inflation in the value of personal residences, the SEC estimates that approximately 8.5% of households qualified for accredited investor status in 2003. The new standards would lower this to 1.3% of U.S. households.  This percentage is roughly equal to the estimated 1.9% of U.S. households that qualified for accredited investor status in 1982.

Because the proposed rules apply to offers, redemptions, and ongoing communications such as account statements, there is no “grandfathering” of existing funds and holdings. Although investors who don’t meet the new requirements may continue to hold their existing investments, these investors could not make new purchases.

Non-accredited natural persons could still purchase under the provision for up to 35 non-accredited investors, although many issuers refuse to allow any non-accredited investors. More importantly, the 35 person limitation is too small to raise substantial amounts of money, particularly when one considers that the non-accredited investors are not as wealthy and cannot individually commit substantial sums.

The SEC specifically stated that the proposed rule does not provide a private cause of action, does not impose a fiduciary duty on an investment advisor that does not already exist, and does not require scienter on the part of the advisor to cause a violation.

The new rules will have a substantial impact on the use of hedge funds and private equity funds that rely on non-institutional sources to raise money.

Fulcrum Inquiry is a licensed CPA firm that performs financial investigations and business appraisals.