From: John L. Petersen
For over 25 years, members of this firm have focused on helping small companies satisfy their growth capital requirements. While we have served as issuer's counsel in a few IPOs, the bulk of our work has involved the documentation of private placement transactions. Initially, our work focused on oil and gas development partnerships. Beginning in the mid-80s we diversified into publicly traded venture capital funds and conventional securities offerings for small companies in a variety of industries.
We do not and have never represented any hedge fund sponsors.
When Regulation D was first adopted by the Commission in 1982, we strongly supported the creation of a bright line standard that would allow an issuer to readily determine whether a particular investor was suitable for a particular investment. The fundamental premise of Rule 506 of Regulation D, that an individual with a net worth in excess of $1 million or an annual income in excess of $200,000 was presumptively able to protect his own interests, was sound. The existence of a bright line standard eliminated substantially all of the subjectivity that used to be associated with private placements and made it simple for securities practitioners to provide useful guidance to their clients. In a field where a solid background in lore was an essential prerequisite to an understanding of regulatory requirements, Regulation D was a long-awaited breath of fresh air.
Over the last 10 years, we have been participants in a number of continuing education seminars where members of the Commission's staff have expressed the unofficial view that the old quantitative measures of Regulation D were badly in need of adjustment to reflect the impact of intervening inflation and the organic growth in the pool of people who are merely upper middle-class, but nonetheless qualify as accredited investors. Since there is no question that today's dollar only has half the purchasing power of a 1982 dollar, the view that the quantitative limits ought to be revised upward made a lot of sense. Accordingly, we have been advising clients for several years that while a $1 million dollar net worth was sufficient to satisfy the accredited investor definition of Regulation D, the safer course of action would be to reject borderline purchasers and focus on potential investors whose net worth was significantly greater than $1 million.
We cannot support the Commission's proposal to leave the accredited investor standard at $1 million for traditional private placements by small companies while requiring hedge fund investors to meet a higher standard. The reasons for our disagreement with the proposal follow:
First, we believe the proposal does not strike a reasonable balance between the relative risk of the two classes of investments. While our firm does not represent hedge funds, we have had significant dealings with hedge fund managers that have evaluated and occasionally invested in private placements offered by our clients. In every case, the hedge fund manager was far more diligent and demanding than the most astute individual accredited investor. The hedge fund managers invariably conducted a first rate due diligence investigation; worked with experienced and knowledgeable lawyers and financial advisors; and aggressively negotiated the most minute deal terms. The end result was that client offerings that included hedge fund investors were invariably better deals for investors than "friends and family" private placements where our client established the transaction terms without the counter-balance of a seasoned professional investor on the other side.
Every private placement entails a substantial risk that an investor will lose all of his money. But if one rationally compares the relative risk of a $250,000 investment in an oil well or a new technology company with the risk of a $250,000 investment in a professionally managed fund that provides investment diversification across a broad range of investment alternatives, I have to believe the relative risk of the hedge fund investment is objectively lower.
Second, we believe the use of "total net worth" to identify accredited investors for conventional offerings and the use of "investment net worth" to identify accredited hedge fund investors adds an unwarranted layer of complexity to a simple bright line standard and raises the bar far higher than good policy dictates. We remember all too well the arguments that used to arise before Regulation D about vacation homes, collectors cars, art and antiques. The decisions were never simple and the clients invariably thought their counsel's advice was arbitrary.
We believe it would be a travesty to turn the clock back 25 years and return to a regime where the subjective judgement of a professional was substituted for a bright line regulatory standard.
It is difficult to argue that the quantitative measures of Regulation D should not be adjusted upwards to account for intervening inflation. There is a lot of truth in the assertion that what was rich 25 years ago is merely upper middle class today. But a reasonable effort to raise the bar for all who offer private placement investments should not be used as an excuse to re-establish an inherently subjective investor evaluation process that was repudiated by the Commission 25 years ago. We have been down that road before and it didn't function well.
We would fully support an increase in the quantitative accredited investor standards based on demonstrable intervening inflation, but we believe it is extraordinarily bad policy to set a more difficult, onerous and subjective standard for professionally managed investments.
John L. Petersen, partner