From the April 01, 2007 issue of Futures Magazine • Subscribe!

SEC wrong on rule changes

Not since the Commodity Futures Trading Commission (CFTC) innocently asked in its prelude to studying the Commitment of Traders report last year, whether the report itself was still necessary, has a regulatory agency been deluged with such negative comments as the Securities and Exchange Commission (SEC) has with its proposed rules regarding accredited investors.

After a Federal court found that the SEC went beyond its authority with its Hedge Fund Registration rule in the Goldstein vs. SEC decision, which rejected the SEC’s rule, SEC Chairman Christopher Cox stated that the decision left a hole in its regulatory ability that needed to be filled. What they came up with was a proposed rule giving it authority to prosecute fraud (an authority they already had) and creating a new standard of accreditation called “accredited natural person.”

What the new standard basically does is raise the threshold for individuals to meet — to invest in a 3c1 exempt hedge fund — to $2.5 million in investments from $1 million of net worth, and does not allow those potential investors to use the value of their home, which they previously were able to do under the old threshold. The proposal also calls for the standard to be adjusted for inflation every five years. The SEC’s Office of Economic Analysis estimates that 1.3% of U.S. households would qualify for the accredited natural person status; 8.47% of U.S. households met the existing accredited investor threshold as of 2003.

In its proposal the SEC argues that the current accredited investor threshold, which was set to ensure, “only such persons who are capable of evaluating the merits and risks of an investment in private offerings may invest in one” was set in 1982, and that “inflation and sustained growth in wealth and income of the 1990s has boosted a substantial number of investors past that standard.”

While it seemed innocent enough — the main lobbying group for the hedge fund industry, the Managed Funds Association (MFA), had several years earlier suggested the accredited investors threshold be raised in lieu of registration — to propose raising the level for individuals to qualify as accredited investors, and thus be viewed as sophisticated investors, the proposal has been met with charges of discrimination and analogies to George Orwell’s Big Brother. Comment letters are nearly unanimously against the rule and are predominantly coming from individual investors, many of whom currently qualify as accredited investors but will not meet the accredited natural person test.

Comment letters objecting to the SEC proposals hit on certain themes, including nanny government, insulting investor intelligence, favoring the rich and challenges to the SEC’s ability and objectivity (see “Comments,” in links below).

While the MFA had supported raising the accredited investor threshold, MFA president Jack Gaine points out the proposed rule is a pretty dramatic increase. “You have to be more financially well-off to invest in a hedge fund, and by a huge margin. This is not tinkering, this is going from $1 million net worth to $2.5 million worth of investments,” Gaine says.

MFA Executive Vice President and Chief Operating Officer Lisa McGreevy, says the proposal appears to be more complicated than needed. She says the SEC could have accomplished the goal by simply adjusting the original accredited investor standard set in 1982 for inflation, as the MFA had previously suggested, or leaving the threshold as is and exclude the value of an investor’s primary residence.

The rule also makes it more difficult for knowledgeable employees of funds to invest in those funds. The SEC is soliciting comments on this but if the proposal is passed as is, these individuals would have to meet the new standard, which is ironic because knowledgeable employees of 3c7 exempt funds (available only to qualified purchasers who own $5 million in investments) would still be able to invest in those funds.

While the bulk of the comments objecting to the rule proposal had to do with the new accredited natural person threshold, many legal experts say the language in the new anti-fraud rules is open to wide interpretation.

Michael Tannenbaum, founder of Tannenbaum Helpern Syracuse & Hirschtritt, points out the proposal’s prohibition on false or misleading statements or omission of material facts by an advisor does not require proof of “scienter” (intent to defraud) by the issuer. Thus an unintentional misstatement if found material could be ruled grounds for an enforcement action.


Some things may be better left alone. While the SEC is attempting to raise the threshold for accredited investors, many responders have challenged whether there should be a threshold of any kind. They make the point that there is no threshold for many high-risk investments including individual equities and start-up businesses. And on its face, the arguments of the hundreds of responders appear to be more grounded in logic than the SEC position.

Take, for instance, the exemption offered to venture capital funds.

The SEC exempts venture capital funds from the new standard based on the argument they are an engine of small business growth. Well, 3c1- exempt hedge funds are small businesses too.

In fact, large hedge funds are not upset about this proposal because most of them would not be affected, their clients are qualified purchasers. Besides, if the purpose of the proposal is investor protection, which the SEC says it is, it is illogical to exempt one type of pooled investment because of its “benefit in the capital formation of small businesses.” Many responders highlighted this hypocrisy, pointing out venture capital funds are more risky and less transparent than many hedge fund strategies.

“Some very smart and sophisticated financial industry professionals consider venture capital funds to be even more volatile and harder to understand than most hedge funds… It is hard to understand how the commission can rationalize this contradiction and inconsistency,” noted one comment letter.

Phillip Goldstein, whose lawsuit struck down the hedge fund registration rule, was more direct. “[Venture capital funds] have less transparency than hedge funds and their assets are priced with more subjectivity…they offer abundant opportunity for fraud and self-dealing…excluding venture capital funds unquestionably renders the rule arbitrary and capricious.”


Many responders and interested parties also were upset with the lack of a more complete grandfather provision. Under the proposal, investors in 3c1 funds who no longer meet the standard will be able to maintain their current investments but will not be able to invest in other 3c1 funds or add to investments in funds they currently are invested in. Many of these investors (see “I am not an idiot,” below) have been investing in hedge funds for more than a decade but now they are no longer “sophisticated investors.”

If the proposal is approved, many of these investors could face being kicked out of existing. J.P. Bruynes, of Arnold & Porter LLP, says 3c1 exempt funds will consider converting to the higher, 3c7 fund standard. “Some people’s response has been to survey their investor base and see if they can’t convert their funds.” Bruynes point out if they convert to 3c7 status they would have to kick people out who are not qualified purchasers.


As of this writing, comments are still pouring in but the comment period officially ends March 9. The next step would be for SEC staff to look at the comments and provide a summary of their content and then make a recommendation for further action. The SEC could adopt the proposal as is, offer amendments or drop the proposal altogether, which would be unlikely. A spokesperson for the SEC said that if the SEC proposes material changes to the original proposal it could go back out for further comment.

How the SEC will react to the negative comments is not known. “I am not sure how much sway investor letters are going to have with them. I could easily see the commission saying, ‘we know better than they do and we are going to put this in place,’” says Jeff Blumberg, of Drinker Biddle Carton Gardner.

That is not to say there won’t be amendments. Blumberg expects some relief for knowledgeable employees and additional grandfather provisions. “They are going to add in some knowledgeable employee standards and possibly the ability for existing investors to [add to their] investments.”

Some commenters feel that without significant changes the proposal with go the way of the defunct registration rule. One noted, “The [SEC] suffered a crushing defeat in Goldstein. The proposing release suffers from many of the same infirmities. This commenter pointed out many of the inconsistencies and lapses of logic in the proposal.

For example, in an argument some logicians might find amusing, one of the justifications for the higher standard offered in the SEC proposal is that there is “minimal information available about [hedge funds] in the public domain.”

Of course, that is a direct result of the regulatory structure that prevents exempt private offerings from advertising or even holding themselves out as investment advisors.

While the SEC argues that hedge funds are more complex than ever and there is a lack of information regarding them, dozens of letters pointed out how the internet and 24-hour business channels have increased the volume of available information than existed in 1982.

Blumberg points out that, technically, the SEC is not preventing non accredited natural persons from investing in 3c1 funds, just removing the safe harbor provision under Regulation D of the Securities Act. “The SEC response could be ‘we are not telling you, you can’t, we are just saying you don’t meet the safe harbor anymore, which is affectively the same thing, but not legally the same thing,” Blumberg adds.

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