February 20, 2007
Nancy M. Morris, Secretary
Securities and Exchange Commission
100F. Street, NW
Re: File Number S7-25-06
I thank you for the opportunity to comment on proposed new rules 216 and 509 encompassed in file number S7-25-06.
The Securities and Exchange Commission (the Commission) states early in the proposal that the goal of the rule changes is strengthening protections for investors in hedge funds and other pooled investment vehicles. The Commission states further that redefining those individuals eligible to invest in such pools is the method to strengthen those protections. While the goal is consistent with the purpose of the Commission, the method seems to be lacking in any true strengthening of protections. The sought after protections are limited only to exclusion and in no manner attempt to address any perceived core inadequacies in the entities the Commission seeks to protect investors from.
The Commission further asserts in the section III .A, that the pooled investments have become increasingly complex, that they use complicated investment strategies and there is minimal information available about them in the public domain. Additionally, the Commission states as reasoning for these rule changes that investors do not have access to the kind of information provided through the Commissions system of securities registration and therefore investors may find it difficult to understand the risks these investment pools may pose. I respectfully disagree with the Commissions arguments used as the very foundation for the rule changes.
The Commission casts an unreasonably wide net by including all hedge funds in this proposal. While there are a number of funds with high degrees of complicated strategies and fee structures, the Commission implies that this is the norm. I disagree with this inference and know that a large number of hedge funds limit their investment strategies and fee structures to those that are easily understandable to all investors. It also appears that the Commission is holding the lack of information in the public domain against these pooled investment vehicles, when it is the current regulatory system that makes these funds operate as they do for fear of running afoul of the general solicitation rules. In any event what is available in the public domain is not representative of the information that is made available to prospective investors in these funds. Lengthy disclosure documents that repetitively and exhaustively lay out the investment risks and fee structures are presented to any investor prior to their putting any money at risk.
Regardless of the current disclosures provided, the Commission alludes to the fact that one way to achieve the desired protection in its broader discussion of pooled investment vehicles is the increase of information available to potential investors. Yet while the Commission touches on this potential avenue the proposed rule changes do nothing to alleviate this perceived weakness. Instead the Commission has chosen to exclude a large number of intelligent, yet only modestly wealthy individuals from having the option to diversify their portfolios utilizing pooled investment vehicles. Many of these individuals understand that hedge funds can reduce the volatility of their investment portfolio particularly during a bear market. Choosing exclusion over disclosure avoids entirely the potential issues at hand. Additionally, the Commission gives no weight to the changing talents of investors in their jurisdiction. We are truly in the information age and the availability of information is not comparable to 1982, when the initial accredited investor rules were enacted. To merely adjust rules for inflation that may have been appropriate in 1982 without considering the larger changes to the overall sophistication of investors and their ability to access information is a travesty. During Chairman Bernankes testimony to Congress the issue of wealth distribution in America was explored and it was noted that 31% of American families with incomes under $35,000 were involved in investing. This clearly indicates that more individuals are comfortable with investing now than at any other time in American history. This trend will only continue as fewer individuals rely on pensions for their retirement and instead rely on self directed pension plans such as IRAs and 401(k)s. Choosing exclusion over information ignores this trend and simply limits the investment choices for the public the Commission is charged to protect.
The industry has already begun to move in the direction of providing investors with even more information needed to make an informed investment decision. Firms such as Moodys, Standard and Poors and Amber have been issuing fund ratings similar to those used in the mutual fund industry. The Commission makes no mention of such advancements that are occurring. Any changes to the regulatory environment should attempt to further this movement.
The Commission is undoubtedly aware that a small number of hedge funds hold a large portion of the assets, colloquially the 90/10 rule. The proposal states that the Commission is aware that individuals have indirect investment in pooled investments through pensions and other methods, but that their investment risk is mitigated by the administration by plan fiduciaries and registered investment professionals. Yet the fund failures that are well publicized and the funds with the greatest potential for market disruption are the ones that include investors advised by such fiduciaries and professionals. The funds managing multi billion dollar portfolios do not get there by taking investments from high net worth individuals that would be impacted by the new definition of natural person. The investor slots in these funds are far too valuable to be occupied be such relatively small investors. Therefore the Commissions proposals will not affect 90% or more of the assets invested in these products. This seems to be a poor application of risk management and a poor allocation of the scarce resources of the Commission. So the proposed rule changes will not impact the vast majority of assets and investors invested in hedge funds but instead will impact smaller funds, where the risks are not nearly as large. The proposed rules create larger barriers to entry for the entrepreneur and small business owners without a corresponding level of protection to the public.
Obviously, I feel the Commission is moving in the wrong direction. Instead of excluding the smaller yet sophisticated investor I believe the Commission should move towards the disclosure of more useful information to investors. This would need to be done in a way that would not compromise the investment managers need to protect proprietary information regarding their investing processes. I would also like to comment further on slight adjustments to the proposed rules that would alleviate some of the barriers they may create for entrepreneurial investment managers.
The proposed rules will have their greatest impact during the initial formation of new funds. Therefore, there should be some means for funds to have a limited number of natural persons who do not meet the proposed definition of accredited natural person similar in thought to the ability of funds to accept 35 non-accredited investors. However, a slight change would need to be made so that no additional disclosure requirements would be required for funds taking this route. Allowing for 20 natural persons to invest before the accredited natural person rules apply would help alleviate this problem.
Secondly, I do not see any sound reason to not continue to allow for knowledgeable employees to invest in the funds that they help to manage. The Commission has stated that one reason for the proposed rule changes is the lack of information to make informed decisions. Who will have more information and understanding of the fund than the knowledgeable employees? Additionally, investors look at the level of principal, affiliate and employee investing in the funds they manage as a positive factor that indicates belief in the strategies they are engaging in.
Furthermore, with regard to current investors who would no longer meet the increased standard I believe it is necessary to grandfather them. These investors should be allowed to not only maintain their investment but also add to that investment in the future.
In conclusion, I believe that the Commission needs to be aware of the indirect consequences these proposals may have on the markets and other stakeholders in this industry. As stated above, these proposals will only affect the smaller funds. A number of these funds made a conscious decision that they would not become multi-billion dollar funds, as they invest in areas of the market that would not be attractive to the largest of funds. Restricting these funds will reduce liquidity in these markets and lead to greater inefficiencies. Restricting investors access to investment strategies they would otherwise invest in will reduce the number of small businesses and cause job displacement for some immeasurable amount of employees. There will surely be impacts to the industry and the markets as a whole that are not contemplated or quantifiable and that will lead to financial losses by choosing exclusion over information.
I thank you for your consideration of my comments.
Kirby Richards, CPA