HedgeCo.net ( West Palm Beach ) – On December 27, 2006, the SEC published two new rule proposals, a broad anti-fraud rule, and a substantial increase in the net worth standard for individuals who can invest in certain types of private funds that issue securities in reliance on the Regulation D private placement exemption under the Securities Act of 1933 (the “Securities Act”).  The SEC proposed the new anti-fraud rule as a result of the D.C. Court of Appeals decision in Goldstein v. SEC, which vacated the SEC’s hedge fund adviser registration rule.  The Goldstein decision left unclear the extent to which an adviser owes a duty to investors in a fund, as opposed to the fund itself.  Also, in order to stem the “retailization” of hedge funds, the SEC proposed to limit the availability of private funds relying on Section 3(c)(1) of the Investment Company Act of 1940 to unsophisticated retail investors. 

Proposed Rule 206(4)-8

The proposed anti-fraud rule, Rule 206(4)-8 under the Investment Advisers Act of 1940 (the Advisers Act”), would apply to all investment advisers, whether registered or unregistered.  Under proposed Rule 206(4)-8(a)(1), it would constitute a fraudulent, deceptive or manipulative act, practice or course of business with the meaning of Section 206(4) of the Advisers Act for any adviser to a ^{“}pooled investment vehicle^{”} to make any untrue statement of a material fact to any investor or prospective investor in the pooled vehicle, or to omit to state a material fact necessary in order to make the statements, in light of the circumstances under which they were made not misleading.   This is the general standard contained in Rule 10b-5 under the Securities Exchange Act of 1934.  Rule 10b-5 and other anti-fraud rules require that the actionable conduct occur  “in connection with the purchase and sale of a security.”  Rule 206(4)-8(a)(1) applies “regardless of whether the pool is offering, selling or redeeming securities” and therefore has much broader potential application.

The rule would apply to any “pooled investment vehicle,” defined to include any issuer that is an investment company or a fund that relies on either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 for its exemption from registration.  Accordingly, the proposed rule would apply to domestic and foreign advisers to hedge funds, venture capital funds, buyout funds, other private equity funds, managed CDOs and registered investment companies, but not to funds relying on other exceptions from registration under the Investment Company Act, such as real estate investment trusts and business development companies. 

Investment advisers should note that and although the proposed rule does not require scienter or knowledge by the adviser that a statement was false or misleading or that an act defrauded an investor or prospective investor in order to have liability under the rule, advisory clients would not be able to bring an action against an adviser.  Only the SEC would be able to bring an action pursuant to this rule.

The proposed rule would apply to statements made in the context of a securities offering, such as statements made in a confidential private placement memorandum or “request for proposal,” as well as to statements made in investor letters and account statements to existing investors which may not involve an offering.  The proposed rule is not limited to disclosure and would cover practices related to the valuation of a fund’s portfolio, account information provided to investors account, and the calculation of performance, among other things.

Proposed Accredited Natural Person Rules

The SEC also proposed rules that would impose new accreditation standards on investors in certain Section 3(c)(1) funds.  Funds that rely on Section 3(c)(7) would not be subject to the new rules because natural persons investing in such funds must meet the “qualified purchaser” that requires such individuals to own $5 million of investments.  Advisers to private pools marketed to U.S. investors typically rely on the safe harbor provided under Regulation D of the Securities Act for offerings to “accredited investors” not involving any general solicitation.  Regulation D’s definition of accredited investor includes natural persons with annual income in excess of $200,000 (or joint income together with such person’s spouse of $300,000) or a personal net worth (or joint net worth together with such person’s spouse) of $1 million.  Entities have separate eligibility criteria.

Proposed Rule 509 under the Securities Act would require that a natural person investing in a Section 3 (c)(1) fund (other than a venture capital fund) would only be an “accredited investor” if such investor is an “accredited natural person,” which is defined as an investor who satisfies the existing income or net worth standards and also owns $2.5 million of “investments.”

“Investments” would include most securities, commodities and cash held for investment purposes, but would exclude real estate not held for investment purposes, such as real estate used by such person or a related person as a personal residence, a place of business or in connection with a trade or business. The proposed rules further narrow the test applicable to investors in Section 3(c)(7) funds by designating that only 50 percent of the value of any investments held jointly with a spouse would count towards the $2.5 million threshold unless the investment was being made jointly, and the value of the investments would be based on their fair market value.

The SEC proposed an inflation adjustment that would result in the $2.5 million threshold being adjusted every five years based on the “Personal Consumption Chain-Type Price Index” published by the Department of Commerce.

The proposed rules would continue to permit a fund to sell securities to 35 non-accredited investors if such investors met the financial sophistication criteria of Rule 506.  However, existing accredited investors who do not meet the new standard would not be grandfathered for purposes of new investments that they make in the fund.  It is uncertain how this provision might apply to capital call requirements to which a fund investor may be subject, and the SEC is seeking comments on this point. 

Under the proposed rules, a venture capital fund would be a fund that meets the definition of a “business development company” in the Advisers Act, and would be excluded from the rules.

This definition also would not cover a fund that invests a significant portion of its assets in non-U.S. issuers or to a fund that provides venture capital to a U.S. issuer but that is organized offshore for tax, regulatory or other reasons.

The proposed rules do not provide for investments made by employees of the fund’s manager. Under the proposal, employees who do not meet the new accredited natural person standard would likely be counted against the 35 non-accredited investor limit imposed by Regulation D.  That seems to be the case even if those employees were “knowledgeable employees” for purposes of Section 3(c)(1) and Rule 3c-5 (and thus not counted against the 100 investor limit imposed by that provision) or else rely on Section 4(2) or Rule 701 under the Securities Act.

Comments should be submitted to the SEC by March 9, 2007.
 
Note:
Pillsbury Winthrop Shaw Pittman LLP represents hedge fund sponsors and advisers, prime brokers, and administrators through its 16 offices, located in global centers for capital markets, finance, energy, and technology.  For further information on the Pillsbury Winthrop Shaw Pittman LLP hedge fund practice, contact:
Jay B. Gould, Esq., Pillsbury Winthrop Shaw Pittman LLP
San Francisco, CA
415-983-1226
jay.gould@pillsburylaw.com
 
Michael G. Wu, Esq., Pillsbury Winthrop Shaw Pittman LLP
San Francisco, CA
415-983-1655
michael.wu@pillsburylaw.com