SEC Proposes New Antifraud Rule and Revised Accredited Investor Standards for Hedge Funds

December 13, 2006

At its meeting on December 13, the Securities and Exchange Commission voted to propose a new antifraud rule under Section 206 of the Investment Advisers Act of 1940 (the “Advisers Act”) and revisions to the criteria under the Securities Act of 1933 (the “Securities Act”) for natural persons to be considered “accredited investors” for purposes of investing in certain privately offered investment vehicles. The text of the rule proposals are not yet available.

The SEC proposed a new rule to address certain effects of the decision by the U.S. Court of Appeals for the District of Columbia Circuit in Goldstein v. SEC, where the Court overturned rules adopted by the SEC in 2004 that had required advisers to hedge funds and other pooled investment vehicles to register with the SEC. In response to the holding in Goldstein that the antifraud provisions of Sections 206(1) and 206(2) of the Advisers Act apply only to “clients” of advisers, such as hedge funds, but not to investors in the funds, the proposed new rule under Section 206(4) of the Advisers Act would prohibit advisers to hedge funds and other pooled investment vehicles from defrauding investors in such vehicles. The SEC also proposed two new rules under the Securities Act that would modify the definition of “accredited investor” as it relates to investors in unregistered pooled investment vehicles in order to adjust for inflation and the significant expansion of the number and size of hedge funds in the markets.

The proposals are as follows:

  • New hedge fund antifraud rule. Under the proposed antifraud rule, it would constitute a fraudulent, deceptive and manipulative act, practice or course of business for an investment adviser to a pooled investment vehicle, whether the adviser is registered or not, to make any untrue statement of a material fact to an investor or prospective investor in the pooled investment vehicle, or to omit to state a material fact necessary in order to make the statements made to any investor or prospective investor in the pooled investment vehicle, in light of the circumstances under which they were made, not misleading, or 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. The proposed rule applies to pooled investment vehicle advisers regardless of the investment strategy they employ on behalf of their clients or the type of pooled investment vehicle they manage.

  • Revised “accredited investor” standard. The proposed new rules relate solely to hedge funds and other private investment funds that rely on Section 3(c)(1) of the Investment Company Act of 1940 (the “Investment Company Act”) to make private offerings by relying on Section 4(6) or Regulation D under the Securities Act. Due to the increases in individual net income and the exponential increase in the value of individual residences since 1982, the SEC is concerned that, under the current definition of “accredited investor” which is linked solely to income or net worth, investors may be deemed qualified to invest in hedge funds and other private investment funds relying on Section 3(c)(1) for reasons unrelated to their financial knowledge or sophistication. The proposed new rules thus aim to enhance the “accredited investor” criteria for individuals investing in private investment funds relying on Section 3(c)(1). In particular, the proposed rule will state that only a natural person who meets the current “accredited investor” standard, and who, in addition, owns, individually or jointly with the person’s spouse, $2.5 million or more in certain investments could invest in a hedge fund relying on Section 3(c)(1). The recommended standards would apply at the time of purchase of shares of a hedge fund, and would not apply to investments in certain venture capital funds that assist in capital formation of small U.S. businesses. The SEC did not specify the type of investments that could be included to meet the $2.5 million test.

The SEC’s press release describing the proposals can be viewed at the following link:

Please feel free to contact any of your regular contacts at the firm or any of our partners and counsel listed under Private Equity or under Capital Markets in the “Our Practice” section of our website if you have any questions.