United States: SEC Proposes New Anti-Fraud Rules For Private Funds

Agency Also Seeks to Raise Minimum Investor Qualifications for Smaller Funds

On December 27, 2006, the SEC released proposed rules directed at advisers of private investment funds. The SEC has proposed these rules in the wake of the June 2006 decision of the U.S. Court of Appeals for the District of Columbia (the "Goldstein decision") striking down Rule 203(b)(3)-2 under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), which required many hedge fund managers to register with the SEC as investment advisers. (See Goodwin Procter’s June 26, 2006 Hedge Fund Alert, ("U.S. Court of Appeals Vacates Hedge Fund Adviser Registration Rule But Withholds Mandate.") The SEC’s new rule proposals highlight the SEC’s continued focus on regulating the activities of advisers and managers of hedge funds and other private investment funds and have the potential to shrink the pool of eligible investors in certain of such funds, such as venture capital funds and buyout funds.

The first SEC proposal targets the statements and actions of advisers (both registered and unregistered) with respect to investors and prospective investors in funds managed by them. This rule is intended to clarify the SEC’s general anti-fraud enforcement powers under the Advisers Act. The second proposal modifies Regulation D under the Securities Act of 1933, as amended (the "Securities Act"),¹ which covers private placements, by raising the minimum standard for individual "accredited investors" in certain private funds to persons who have at least $2.5 million in qualifying "investments." The SEC is seeking comments on many aspects of these proposed rules. Comments are due by March 9, 2007.

The SEC has indicated that it proposed the new anti-fraud rule in part to remove any doubt raised by the Goldstein decision about its ability to bring enforcement actions under the Advisers Act against an adviser or manager of a hedge fund or other pooled investment vehicle who is alleged to have defrauded investors or prospective investors. The new rule is very broad in scope and presents many issues that fund advisers should consider in view of the SEC’s continued focus on regulation of private investment vehicles and their managers, including the following:

• Unlike the current rules adopted under Section 206(4) of the Adviser Act, the new anti-fraud rule would apply to any manager or adviser of a "pooled investment vehicle" that is an "investment adviser" under the Advisers Act, including unregistered advisers and advisers registered only with state regulatory authorities. In addition, the rule would apply to statements made to prospective investors as well as actual investors in a fund.
• "Pooled investment vehicles" subject to the proposed anti-fraud rule include funds of any strategy, structure or jurisdiction that are "investment companies" under Section 3(a) of the Investment Company Act of 1940, as amended (the "Investment Company Act"), but that rely on the exclusion of Section 3(c)(1) or (7) of such Act.²
• The proposed rule prohibits material misstatements or omissions to investors, using language similar to that of existing anti-fraud Rule 10b-5 under the Securities Exchange Act of 1934, as amended. Unlike Rule 10b-5, however, the proposed rule would apply to untrue statements made outside of the context of a securities transaction. For example, the proposed rule would cover regular reports to investors, as well as formal and informal offering documents. Moreover, under the proposed rule, the SEC has indicated that it need not prove that a fund adviser or manager made a misstatement knowingly or with scienter, as in a Rule 10b-5 case, and has suggested that a violation could rest on a finding of "simple negligence." Indeed, the SEC has specifically stated that "the effect of this provision of the rule would be to prohibit, for example, materially false or misleading statements regarding investment strategies the pooled investment vehicle will pursue (including strategies the adviser may pursue for the pool in the future), the experience and credentials of the adviser (or its associated persons), the risks associated with an investment in the pool, the performance of the pool or other funds advised by the adviser, the valuation of the pool or the investor accounts in it, and practices the adviser follows in the operation of its advisory business such as how the adviser allocates investment opportunities."

• The proposed rule includes a more general prohibition on acting in a manner that is "fraudulent, deceptive or manipulative" with respect to any investor or prospective investor, even if the conduct does not involve any "statements." Accordingly, if the proposed rule is adopted, advisers may wish to revisit the policies and procedures they implement to ensure truthfulness and prevent fraud generally.
• The SEC has stated that the proposed anti-fraud rule would not create a private right of action against fund advisers and would not create any fiduciary duty not imposed by law, or alter any other duty an adviser has to investors in a pooled investment vehicle. This would limit enforcement of the new anti-fraud rule to the SEC (which may impose administrative orders, civil penalties, disgorgement of profits and other penalties) without creating a new avenue for direct lawsuits by investors. The proposed rule does not indicate how the SEC staff would gather evidence to pursue enforcement actions against unregistered advisers.

The SEC’s second proposal relates to the minimum qualifications that an investor in a private fund must satisfy to be treated as an "accredited investor." Under the current private placement exemption provided by Regulation D under the Securities Act, an individual generally qualifies as an "accredited investor" if he or she has a net worth in excess of $1 million or has an annual income of $200,000 in each of the two most recent years, or joint income with his or her spouse in excess of $300,000 in each of those years.³ Under the proposed rules, individual investors in a "private investment vehicle" relying on Regulation D would need to satisfy a higher "accredited natural person" standard.⁴ Key aspects of the proposed requirements include the following:

• Under the proposed rules, an "accredited natural person" is an individual who satisfies the current criteria for accredited investor status and who also owns, individually or jointly with his or her spouse, not less than $2.5 million in qualifying "investments." The proposed rule specifies the types of investments that qualify for purposes of this standard, as well as valuation and other requirements for such investments, including a requirement that a person investing alone count only 50% of the value of investments held jointly with his or her spouse.⁵ The proposed rules do not include a provision that would grandfather existing investors who do not meet the accredited natural person standard.
• As proposed, the "accredited natural person" requirement would apply to any "private investment vehicle," which is defined as a fund that is an investment company under Section 3(a) of the Investment Company Act, but that relies on the exclusion in Section 3(c)(1) applicable to funds whose securities are beneficially owned by not more than 100 persons (as determined in accordance with Section 3(c)(1) and applicable regulations). Those funds relying on the exemption in Section 3(c)(7) of the Investment Company Act already require individual investors to meet a higher standard ($5 million in "investments" as defined under Rule 2a51-1). Thus, most large private investment funds would not be affected by the proposed rules.

• The proposed rules would not apply to funds that meet the definition of "business development company" under Section 202(a)(22) of the Advisers Act. (The proposed rules refer to these funds as "venture capital funds.") In general terms, under this definition (which differs from the one under the Investment Company Act), a "business development company" is a fund that has 60% or more of its assets invested in "eligible operating companies." A company is an "eligible operating company" if it is (i) domestic, (ii) not an investment company, and (iii) does not have any class of securities listed on a national securities exchange.

• The proposed rules would not affect the ability of certain of an adviser’s key personnel to invest in a private investment vehicle under a separate accredited person category that already exists for directors and executive officers even if they do not satisfy the accredited natural person standard. However, in contrast to the requirements for funds relying on Section 3(c)(7) under the Investment Company Act, the proposed rules do include an exception that permits "knowledgeable employees" to invest notwithstanding their lack of accredited natural person status. Accordingly, fund managers that plan to establish or accept new investments in affiliate funds and employee funds may need to recalibrate their minimum investor standards if the proposed rules become effective.

The SEC’s release describing the proposed rules is available on the SEC’s website at: http://www.sec.gov/rules/proposed/2006/33-8766.pdf.

^{1 A similar proposed rule would also apply to offerings of securities under Section 4(6) of the Securities Act, which provides a private offering exemption for offerings of $5 million or less.}

2 The proposed rule would also apply with respect to funds that are, or should be, registered under the Investment Company Act even though documents regarding such funds filed with the SEC (which include most adviser communications with fund investors) are already subject to similar anti-fraud prohibitions under Section 34(b) of the Investment Company Act.

3 The private offering exemption under Section 4(6) of the 1933 Act uses a parallel standard for determining accredited investor status. The SEC’s proposal includes changes to the Section 4(6) standard that mirror those proposed under Regulation D.

4 As proposed, the new rules would not apply to private placements under the statutory provision of Section 4(2) that do not rely on Regulation D or Rule 215, although the SEC has requested comment on this approach. The proposed rules would not affect the ability of an individual to invest in an offering by a private investment vehicle as one of the 35 non-accredited investors permitted by Regulation D.

5 The investments that would qualify for consideration in determining whether an investor met the accredited natural person standard generally parallel those used in determining qualified purchaser status for funds relying on Section 3(c)(7) under the Investment Company Act except that the latter allows 100% of a joint investment with a spouse to count in determining an individual’s qualified purchaser status.

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