The SEC s Latest Hedge Fund Rulemaking: More Than 600 Comment Letters Later

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1 Asset Management Group Alert April 27, 2007 The SEC s Latest Hedge Fund Rulemaking: More Than 600 Comment Letters Later SEC Chairman Christopher Cox reacted quickly to last summer s Goldstein decision by the Court of Appeals for the District of Columbia, which overturned the efforts of the Securities and Exchange Commission to compel hedge fund managers to register with the SEC as investment advisers. 1 Just over a month later, Cox was before a U.S. Senate panel calling the result a regulatory gaping hole that demanded emergency rulemaking. 2 By year s end, in December 2006, the SEC had proposed two new rules aimed principally at hedge funds one an antifraud rule for pooled investment vehicles under the U.S. Investment Advisers Act of 1940, and the other a rule representing a higher accredited investor standard under Regulation D. 3 These rules generated remarkable interest during the public comment period (which formally ended last month although incoming letters are still being posted to the SEC website). In fact, the over 600 letters received to date dwarfs the nearly 200 such letters drawn by the original hedge fund manager registration rule that was invalidated under Goldstein. 4 The range of interests represented is especially noteworthy, with hundreds of small investors speaking up side by side with hedge fund managers, industry trade groups, representatives of state governments and others Goldstein v. Securities and Exchange Commission, 451 F3d 873 (D.C. Cir. 2006). 2 Testimony of SEC Chairman Christopher Cox Concerning the Regulation of Hedge Funds Before the U.S. Senate Committee on Banking, Housing and Urban Affairs (July 25, 2006) at Taken as a whole and especially when tallying the views of small investors on the proposed changes to Regulation D the comment letters offer a picture of broad-based industry and public concern with the proposed rulemaking. That said, there were supportive comments as well, especially in respect of the broader purposes of the proposed rules. Our summary of the comments follows. Given the nature of any summary, however, we necessarily cannot capture the full diversity or nuance of the views offered and 3 Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited Investors in Certain Private Investment Vehicles, Release No (Dec. 27, 2006) at A Jan. 22, 2007 Shearman & Sterling Asset Management Group Alert more fully summarizes this release and the proposed rules. That Alert is available at 4 At the time of publication of this Alert, Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited Investors in Certain Private Investment Vehicles had received 604 comment letters ( Registration Under the Advisers Act of Certain Hedge Fund Advisers, Release No. IA-2266 (July 20, 2004) received 187 comment letters ( NYDOCS02/

2 2 encourage readers interested in more detail to either contact us or to refer to the public posting of the comment letters, all of which are available on the SEC website at Proposed New Antifraud Rule Proposed Rule 206(4)-8 under the Advisers Act would apply a regulatory antifraud standard to any investment adviser (registered or unregistered) providing advice to pooled investment vehicles. As described in the SEC s proposing release, this rule is intended to reassert the SEC s enforcement authority after the Goldstein decision. Commenters who expressed their support for the proposal generally view it as an appropriate and necessary regulatory response to the growth of the hedge fund industry. Aspects of the proposed antifraud rule, however, drew strong criticism, typically along one or more of the following lines: the ABA committee and the ICI suggest, in effect, that the reach of the proposed rule (especially its second paragraph) is so broad that it may fail to provide the statutorily required definition of conduct to which the SEC objects. Many other commenters expressed the same view, although more prosaically, limiting their complaints to calling the rule sweeping, unclear, undefined, amorphous and so on rather than potentially invalid. In the same vein, another aspect of the proposed rule that triggered heavy comment was the absence of a point-ofsale disclosure fraud requirement. Unlike Rule 10b-5 under the U.S. Securities Exchange Act of 1934 (on which parts of the text of the proposed rule were modeled), the proposal does not require that the prohibited conduct be tied to the sale of securities in the pooled vehicle. As an example of how broad this makes the proposed provision be, it would protect prospective investors from fraudulent statements even if they never actually invest in the fund. Why so broadly phrased? Perhaps the most common complaint about the proposed rule goes to its scope. In fact, prominent letters call overbreadth a basis to question the very validity of the Commission s rulemaking. Both the Committee on Federal Securities Regulation of the American Bar Association (ABA) and the Investment Company Institute (ICI) take this tack, with the ICI stating plainly in its letter: We believe the generality of the rule raises the strong possibility that it is susceptible to being overturned upon challenge in the courts. 5 By way of background, the proposed rule would be adopted under Section 206(4) of the U.S. Investment Advisers Act of 1940, which: (i) prohibits investment advisers from engaging in any act, practice, or course of business, which is fraudulent, deceptive, or manipulative and (ii) authorizes the SEC to adopt rules to define prohibited acts, practices, and courses of business. Both 5 The Investment Company Institute Letter, March 9, 2007, p. 4. Why no scienter requirement? Others writing in response to this proposed rule objected to the lack of a scienter requirement. In doing so, these commenters generally cited case law or other precedents that indicate that a culpable mental state e.g., intent or recklessness should be required for Section 206(4) liability. Commenters also pointed to scienter requirements in Rule 10b-5 and other prominent securities fraud laws. Why apply the rule to advisers to registered investment companies? Because the proposed rule would apply to investment advisers of all pooled vehicles investing in securities, some took issue with what they perceive as the unnecessary burden the rule would place in the context of registered investment companies. Pointing out that registered investment companies already are subject to a considerable body of law, including antifraud rules, these commenters believe that adding another conduct standard for their investment advisers especially one that may be illdefined is both unnecessary and confusing.

3 3 Proposed New Accredited Investor Standard Proposed Rules 509 and 216 under the U.S. Securities Act of 1933 would create a new category of accredited investor called the accredited natural person. Under this new standard, a person would have to meet the existing Regulation D net worth or income tests for individuals and own at least $2.5 million in qualifying investments before being deemed eligible to participate in certain hedge fund investments. The rule would apply only to investors in private investment vehicles that are excluded from the definition of an investment company under Section 3(c)(1) of the U.S. Investment Company Act of 1940 (these 3(c)(1) funds often are referred to as 100-person funds, because Section 3(c)(1) limits them to no more than 100 investors). Like the proposed antifraud rule, this proposal drew mixed reactions. Many supportive commenters agreed that the existing net worth standard in Regulation D is ripe for review, but the proposal also attracted strong criticism, as follows: Why $2.5 million? Perhaps the single most questioned aspect of the proposed rules is the new accredited investor standard s increase from $1 million to $2.5 million. Many of the letters, especially from small investors, object to wealth being the sole determining factor of eligibility. Some letters ask whether further economic analysis might arrive at a lower threshold number. Among other things, they assert that if the purpose was to update the prior net worth requirement, $2.5 million goes too far, both outpacing the effects of inflation and substantially reducing the percentage of qualifying households relative to when Regulation D was adopted in Other letters directly question the premise that an increase is even necessary. They note that the effective investor net worth requirement for investing with hedge fund managers that are registered investment advisers is already $1.5 million. 6 They also note that many 3(c)(1) funds require high minimum investments (often $500,000 or more), with the result being that these funds voluntarily have raised the bar well above the minimum required by Regulation D. Some letters express concern that the new standard would be confusing to funds and their investors, often illustrating this point by listing the many differing investor standards already in use (e.g., accredited investor, qualified client, qualified institutional buyer, qualified eligible participant and eligible contract participant). Compounding the issue of competing standards, the new standard deviates in its application from the current Regulation D net worth requirement in some significant ways, such as in cutting the amount of community property held jointly with a spouse that counts towards the qualifying investments threshold from 100% to 50%. Further, qualifying investments would now fully exclude personal real estate. Why just hedge funds? Limiting application of the proposed accredited investor standard to hedge funds is a particularly contentious issue. A number of critical letters questioned the policy basis for that approach, noting that it suggests that hedge fund investors somehow require more regulatory protection than do investors in other private placements. Quite a few observers said that almost the opposite should be considered, arguing that many hedge funds, because of diversification and other risk management policies, are inherently less risky for investors than are private placement securities issued by operating companies. 6 This derives from the qualified client standard required of clients of registered investment advisers whose advisory accounts are subject to performance fees. See Rule under the Advisers Act.

4 4 What about possible exceptions, such as that proposed for venture capital funds? The proposed standard does not apply to certain venture capital funds, even if organized as 3(c)(1) funds. That exception was questioned as too narrow by some and as unfair and potentially unsupportable as a matter of law by others. Those advocating for a broader venture capital fund exception than that proposed note that the present carveout would be limited to domestic U.S. vehicles investing primarily in U.S. investments. They refer to the wide variety of business models in the venture capital industry and are concerned that many venture capital funds will fall outside the proposed exception. On the other hand, those that consider it unfair to single out venture capital funds for preferential treatment challenge the principal policy justification offered for that distinction in the first place. In response to the Commission s assertion that venture capital funds should be excluded in recognition of their important role in the capital formation process for small businesses, these commenters submit that hedge funds are themselves a valuable source of capital for start-up businesses. Offering some of the strongest criticism in this area, the Managed Funds Association called the proposed exception for venture capital funds discrimination and arbitrary and capricious. 7 Looking beyond venture capital funds, commenters offered an array of other possible exceptions from the proposed standard. Other vehicles suggested as appropriate to exclude were: funds of hedge funds, small business investment companies, and registered investment companies. Finally, some commenters argued that applying the new standard to pools advised by SEC-registered investment advisers does not fully align with the regulatory purpose of the earlier rule struck down by Goldstein. They submit that if the original mission simply was to encourage registration with the Commission, then exempting registered advisers from the new standard would be an effective means of reviving that goal. Why target smaller hedge fund managers? Many letters note that the proposed standard s burdens likely will fall hardest on smaller and start-up hedge fund managers, who tend to use 3(c)(1) funds to a greater degree than their larger competitors. The potential, therefore, is that the proposed standard will have unintended anti-competitive effects, serving as a barrier to entry protecting established industry participants from rising competition. Moreover, the letters argue that limiting the sources of capital available to these types of managers may stifle innovation in the industry, to the ultimate detriment of the hedge fund investor community. What about the risk of forcing parts of the industry even further outside Regulation D? A number of letters considered the possibility that raising the accredited investor standard might result, ironically, in more, not less, hedge fund investment by non-accredited investors. They note that Regulation D already permits reliance on an exception for up to 35 nonaccredited investors and that the general private offering exception under Section 4(2) of the U.S. Securities Act of 1933 has no investor eligibility requirements. Although those alternatives to Regulation D s accredited investor requirements are relied upon infrequently today, will that continue to be the case, these commenters ask, if the proposed dramatic increase in the Regulation D standard is adopted? 8 7 The Managed Funds Association Letter, March 9, 2007, pp The Managed Funds Association went on to ask the Commission to carefully reconsider whether it has the statutory authority to treat venture capital funds differently than other 3(c)(1) funds. Id., p.6. 8 Connecticut Banking Commissioner Howard Pitkin added to that discussion by calling for a hard prohibition on non-accredited investors in hedge funds. The Connecticut Banking Commissioner Letter, March 8, 2007.

5 5 Why lock out current investors? As proposed, there would be a narrow exception from the new standard for current investors, allowing these investors to remain invested in a particular 3(c)(1) fund if they are no longer qualified under the new standard, but prohibiting them from making add-on investments (even add-on investments resulting from reinvested dividends). Many letters responded to the SEC s request for comments on this exception, with the large majority favoring a full grandfathering for current investors sufficient to allow add-on investments. These letters note that other similar changes in the past provided for grandfathering. The letters also generally pointed to the knowledge obtained by grandfathered investors through their often longstanding connection to a fund as a factor weighing in favor of treating those investors as sufficiently sophisticated for this purpose. What about employees? The new standard as proposed includes no special treatment for individuals associated with a fund or its manager on a day to day basis often colloquially referred to in the industry as knowledgeable employees. The SEC solicited comments on what standards should apply to these knowledgeable employees, and many writers took the Commission up on that invitation. Most agreed that adding a knowledgeable employee exception in the proposed rulemaking would be desirable and appropriate, commenting that fund investors strongly prefer investing in funds in which insiders have a personal stake. Many also took the opportunity to call for more expansive interpretations of current knowledgeable employee exceptions. Looking Forward The public position of the SEC and its senior staff is that the outpouring of views generated by the comment process is welcome and desirable. Off the record reports, though, suggest both surprise and dismay at the volume and tenor of the comments. These reports also indicate a strong commitment by the SEC to proceeding with the rulemaking. Indeed, one senior SEC staffer recently was quoted in the press as saying that the new accredited investor standard is all but a given. 9 Yet there is clearly room for compromise, with many commenters expressing support for the principles and goals underlying the proposed rules while criticizing their current formulations. Perhaps the only certainty in looking forward is that the tug-of-war between those favoring hedge fund regulation and those opposing it will continue regardless of whether, when or in what form the new rules are adopted. 9. Money Management Executive, Vol. XV, Issue No. 12, March 26, 2007, p. 8 (citing comments by Jennifer McHugh, Senior Adviser to the Director of SEC s Division of Investment Management). This memorandum is intended only as a general discussion of these issues. It should not be regarded as legal advice. We would be pleased to provide additional details or advice about specific situations if desired. For more information on the topics covered in this issue, please contact: Azam H. Aziz aaziz@shearman.com Nathan J. Greene ngreene@shearman.com William R. Murdie London bill.murdie@shearman.com Donna M. Parisi dparisi@shearman.com Barnabas W.B. Reynolds London barney.reynolds@shearman.com Paul S. Schreiber pschreiber@shearman.com Richard Metsch rmetsch@shearman.com Lorna X. Chen lorna.chen@shearman.com John D. Jackson john.jackson@shearman.com 599 LEXINGTON AVENUE NEW YORK NY Shearman & Sterling LLP. As used herein, Shearman & Sterling refers to Shearman & Sterling LLP, a limited liability partnership organized under the laws of the State of Delaware.