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Client Advisory - SEC Proposes New Anti-Fraud Rule and New Accredited Investor Definition for Private Investment Vehicles

Edwards Angell Palmer & Dodge LLP
January 1, 2007

SEC Proposes New Anti-Fraud Rule and New Accredited Investor Definition for Private Investment Vehicles
By Matthew C. Dallett, John C. Molloy, Jr. and Stephen M. Muniz

The SEC recently proposed new rules and amendments to existing rules that are important to hedge funds, private equity funds, venture capital funds and their advisers.[1]   A new anti-fraud rule under the Investment Advisers Act of 1940 (“Advisers Act”) would apply to all advisers, whether registered or not.  In addition, new rules and amendments under the Securities Act of 1933 (the “Securities Act”) would significantly reduce the pool of potential natural person investors for 3(c)(1) funds[2] by raising the financial qualifications required. 

New Anti-Fraud Rule
Proposed Rule 206(4)-8 would prohibit false or misleading statements made to, or fraud on, any investor or prospective investor in a fund.   The rule would, for example, prohibit materially false or misleading statements in offering material or investor reports regarding investment strategies, the credentials of the adviser, the risks associated with an investment, historical performance, valuations of a fund’s assets or an investor’s interest therein, and the operational practices of the adviser (including how the adviser allocates investment opportunities).[3]   Significantly, it could be used after an offering if the fund is not in fact managed consistently with the offering disclosures.

The proposed rule would apply to both SEC-registered and unregistered advisers.  It is designed to address uncertainties created by the recent Goldstein decision[4] regarding duties advisers have to investors and prospective investors in the funds they manage.  The Goldstein court held that, for purposes of Sections 206(1) and (2),[5] the general anti-fraud provisions of the Advisers Act, the client of an adviser is the fund and not the fund’s individual investors.   Proposed Rule 206(4)-8 is designed to remedy this perceived gap in anti-fraud protection.  The proposed rule would not create a private right of action; i.e., it could only serve as a basis for action by the SEC, not for investor lawsuits.

New Accredited Investor Standard for Regulation D Offerings by Certain 3(c)(1) Funds

A series of proposed rules and amendments to existing rules under the Securities Act would increase the financial qualification requirements of natural person accredited investors that invest in 3(c)(1) funds.    If adopted as proposed, in order for a 3(c)(1) fund to rely on Regulation D under the Securities Act, it could only accept natural persons as investors who satisfy the traditional “accredited investor” requirements and own at least $2.5 million in investments. 

Substantially all securities offerings by private funds to U.S. investors are effected under the safe harbor of Regulation D.   Generally, in order to rely on Regulation D, no more than 35 offerees may be other than accredited investors.  The term “accredited investor,” which is defined in rules 215 and 501 under the Securities Act, generally requires that a natural person have an individual or joint net worth with spouse of $1 million, or have individual net income that exceeds $200,000 (or have joint income with his or her spouse exceeds $300,000) in each of the two most recent years and have a reasonable expectation of reaching the same level in the year of investment.  As originally adopted in 1982, these standards were designed to limit private offerings to only those persons the SEC believed were capable of evaluating the merits and risks associated with the securities being offered.  The SEC’s proposing release notes that the standards have not been adjusted for inflation or the dramatic rise in residential real estate values, which may be included in determining net assets, since 1982.  The release also notes that, while just 1.87% of U.S. households qualified as “accredited investors” under this definition in 1982, 8.7% of U.S. households qualified in 2003. 

Based on these factors, the SEC believes that offerees of 3(c)(1) funds presently are not sufficiently protected.   The SEC has proposed new rules and amendments that would require a two-step approval process similar to that used by 3(c)(7) funds (i.e., confirmation of  “accredited” status followed by confirmation of “qualified purchaser” status).  Investors who satisfy the traditional accredited investor requirements and own at least $2.5 million in investments would be called “accredited natural persons.”   The definition of “investments,” as used in the new rules, is similar (with some exceptions) to the definition of “investments” in Rule 2a51-1 under the 1940 Act for purposes of determining whether a person is a “qualified purchaser” under Section 3(c)(7) of the 1940 Act.  For example, real estate not held as an investment (e.g., real estate used for personal purposes or in connection with a trade or business) may not be counted. 

Other Matters
Venture capital funds generally would not be covered by the proposed rules, so their investors would not need to satisfy the “accredited natural person” standard.  

The $2.5 million accredited natural person threshold would be adjusted for inflation every five years. 

Current investors in funds who did not meet the new accredited natural person standard would not be grandfathered and would be unable to make additional investments in such funds.   

The SEC noted in the release that many advisory employees who currently invest in funds managed by their employers would not meet the new standard and solicits comments whether a “knowledgeable employee” standard similar to that which applies for 3(c)(7) funds should be added.

SEC Comments
The SEC has solicited comments on the proposed rules, which may be submitted until March 9, 2007.  The final rules would be adopted after the agency has considered the comments.  If you would like assistance in submitting a comment to the SEC, or you have any questions regarding the matters discussed in this memorandum, please contact the Edwards Angell Palmer & Dodge LLP attorney responsible for your affairs, or one of the following members of the Investment Management Practice Group:

Matthew C. Dallett

John C. Molloy

Stephen M. Muniz


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[1] Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited Investors in Certain Private Investment Vehicles, Release No. 33-8766, Dec. 27, 2006.

[2] A “3(c)(1) fund” is exempt from registration as an investment company under Section 3(c)(1) of the Investment Company Act of 1940 (“1940 Act”), i.e., it has 100 or fewer investors and does not make a public offering of securities.  A “3(c)(7) fund” is exempt from registration under Section 3(c)(7) of the 1940 Act based on the financial qualifications of its investors.

[3] Unlike SEC Rule 10b-5, proposed Rule 206(4)-8 would not be limited to fraud in connection with the purchase or sale of a security, but could also be used by the SEC when the facts of the case do not involve the purchase or sale of a securities.

[4] Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006).

[5] Section 206 provides that “[i]t shall be unlawful for any investment adviser [whether or not registered with the SEC], by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly—1. to employ any device, scheme, or artifice to defraud any client or prospective client; 2. to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client….”

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