Proposed Antifraud and Accreditation Rules for Pooled Investment Vehicles

The Securities and Exchange Commission (the "SEC") has proposed two new rules regarding hedge funds and other pooled investment vehicles. This article summarizes the rules proposed in SEC Release No. 33-8766, dated December 27, 2006 (the "Release"). The first proposed rule broadens the SEC's antifraud authority under the Investment Advisers Act of 1940 (the "Advisers Act") by prohibiting advisers of pooled investment vehicles from defrauding investors or prospective investors. The second proposed rule supplements the definition of "accredited investor" under the Securities Act of 1933 (the "Securities Act") with respect to the sale of interests in certain hedge funds and pooled investment vehicles.

ANTIFRAUD

Following the recent Goldstein v. Securities and Exchange Commission court decision, the obligations of investment advisers to fund investors and the SEC's ability to bring actions against advisers engaged in fraudulent activity directed at fund investors are uncertain. Sections 206(1) and 206(2) of the Advisers Act generally prohibit advisers from defrauding clients and prospective clients. In the Goldstein decision, the court stated that in the private investment fund context, the adviser's only "client" for these purposes was the fund itself, and not investors in the fund. This interpretation of "client" leaves uncertain the application of Sections 206(1) and 206(2) to advisers that defraud fund investors. Before Goldstein, the SEC had taken the position that for certain purposes, fund investors were "clients" of the adviser.

Proposed Rule 206(4)-8

In response to the Goldstein decision, the SEC has proposed Rule 206(4)-8. Proposed Rule 206(4)-8 would prohibit advisers from engaging in certain fraudulent activity against both investors and prospective investors in most hedge funds and pooled investment vehicles. In the Release, the SEC stated that the proposed rule would not, however, create a fiduciary duty to investors or prospective investors that is not otherwise imposed by law.

Among other requirements, the proposed rule prohibits false or misleading statements of material facts by investment advisers. Because the rule would apply to both investors and prospective investors, the rule would prohibit false or misleading statements made in account statements, private offering documents, and responses to "requests for proposals." This provision of the proposed rule is not limited to fraud that occurs in connection with purchases and sales of securities; it prohibits advisers from making fraudulent statements to investors, regardless of the context. The proposed rule effectively prohibits false statements regarding investment objectives, credentials of the adviser, risk disclosures, performance, valuation, and allocation of investment opportunities. The proposed rule also makes it a fraudulent act for an investment adviser to "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," and more broadly prohibits fraudulent acts that do not necessarily involve statements.

Application

The antifraud provisions of the proposed rule would apply to all investment advisers to pooled vehicles, regardless of whether the advisers are registered or required to be registered under the Advisers Act. Also, the proposed rule would apply to most hedge funds and pooled investment vehicles; the rule would apply to mutual funds and pools that are excluded from the definition of "investment company" under either Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (the "Company Act"). The proposed rule does not apply to companies that qualify for other exclusions from the definition of "investment company" under the Company Act.

In the Release, the SEC states that it would not be required to show that the adviser acted with scienter in connection with a violation of the antifraud provisions of the proposed rule. The proposed rule does not provide fund investors with any private cause of action against the adviser.

ACCREDITATION

The term "accredited investor" is defined in the Securities Act under Rule 501(a) of Regulation D as a natural person whose individual net worth, or joint net worth with the person's spouse, exceeds $1,000,000 at the time of purchasing securities, or whose individual income exceeds $200,000 (or joint income with the person's spouse exceeds $300,000) in the most recent two years and who has a reasonable expectation of reaching the same income level in the year of investment.

Proposed Rule 509

Proposed Rule 509 would define a new category of accredited investor ("accredited natural person") that would apply to offers and sales of securities to individual investors by certain hedge funds excluded from the definition of "investment company" under Section 3(c)(1) of the Company Act. "Accredited natural person" would mean any natural person who meets the net worth test or income test under Rule 501(a) and who owns at least $2,500,000 in investments at the time of purchasing securities (this amount to be adjusted every five years for inflation). The proposed rule does not include a grandfather provision; current accredited investors that do not meet the new accredited natural person standard would not be able to make additional investments in private pools, even pools in which they are presently invested. The SEC has requested comments about whether certain "knowledgeable employees," as defined in Rule 3c-5 of the Company Act, should be included under the proposed rule as accredited natural persons.

Definition of Investments

In determining whether an investor owns at least $2,500,000 in investments, the value of a person's personal real estate or place of business, or real estate held in connection with a trade or business, is not included. Additionally, a person making an investment on the person's own behalf (rather than jointly with a spouse), may only include 50 percent of such person's jointly owned or community property investments. If spouses make a joint investment in a hedge fund, the full amount of all of their investments would be included for determining accreditation. The value of a natural person's investments is calculated on a per investment basis.

Application

The proposed rule applies only to "private investment vehicles." This term is defined in the proposed rule to include funds that rely on the exclusion from the definition of "investment company" under Section 3(c)(1) of the Company Act. Funds that rely on 3(c)(7) of the Company Act are not included in the definition of "private investment vehicles," because sales of securities issued by those funds are subject to higher "qualified purchaser" standards. Also, the proposed rule does not apply to venture capital funds; the proposed rule defines "venture capital fund" to have the same meaning as the definition of "business development company" in Section 202(a)(22) of the Advisers Act. The SEC is seeking comments as to whether the definition of "venture capital fund" should instead mean 3(c)(1) funds that include a specific holding period for redemptions.

Comments on the proposed rules must be received by the SEC on or before March 9, 2007. Following the comment period, the SEC will adopt final rules, at which point the date for compliance with the rules will be established.

This article should not be construed as imparting any legal advice. The content of this article is meant to provide a general guide to the topic.