The International Association of Small Broker Dealers and Advisors
1620 Eye Street, NW, Suite 210 Washington, DC 20006
202-785-8940 ext. 108

February 22, 2007

The International Association of Small Broker-dealers and Advisors submits the following comments on the above referenced proposal.The proposal expands the traditional means of determining customer financial sophistication namely net worth and investments for accredited natural persons to require $2.5 million in investment securities.We believe that better protection for investors is found in requiring the presence of a registered broker-dealer or investment advisor in such transactions.Furthermore we believe that the history of the markets since 2000 and nature of wealth in America suggest there may be additional better ways to judge sophistication.The U.S. is entering a time period of an enormous transfer of wealth and and a huge projected shortfall in savings. We believe that this proposal does not adequately consider a number of factors regarding how investments are acquired and the significant role real estate plays in wealth.Additionally it fails to address how easy it is to monetize real estate in order to diversify savings and it denigrates hedge fund investments as a method of diversifying retirement savings.We conclude by suggesting that the proposal should make it easier for small hedge fund investments and require larger hedge fund investments to be done thru advisers or brokers..

  1. Inherited assets and investments indicate nothing about sophistication. A spouse that inherits wealth from their husband or wife may be very vulnerable. Yet inherited assets make up a large percentage of current generational wealth. See Kevin Philips,The Boiling Point at p.192 for the large amount of wealth in America that is inherited. The proposal does not discuss the distinction between inherited securities and purchased securities.

  2. Financial education may be a better indicator of sophistication than net worth or investments. A finance professor or chartered financial analyst may be much more sophisticated than the wealthy widow/widower in paragraph 1.

  3. A person with a 5 million dollar house with equity that can be monetized through a reverse mortgage might be easily capable of diversifying his assets by investing $100,000 into a private investment vehicle.The release is unclear as to how to treat personal real estate that has been monetized into investment securities.Is the debt counted against the house or against the securities?From the other side, eliminating from consideration a large debt on a personal residence with no equity skews the meaningfulness of investment assets. If your housing debt is $2,000,000 and you have securities worth $2,500,000,are you suitable for hedge fund investing? In today's world one's personal residence is very much an investment . The release states that "personal or business property has little or no relationship to knowledge and financial sophistication" Surely this assumption requires some evidence but is made without any citation. Can it mean that all residential real estate investments are unsophisticated but stock purchases are.? It appears that a real estate investment in residential housing is counted as an investment but an identical house used for a personal residence is not but can be if it is monetized. Is their a bias here towards inherited stock and against real estate.?

  4. A person who has been investing in equities for 30 years might be considerably more sophisticated than a person with inherited wealth.

  5. A person with the required assets and investments arguably should not be allowed to invest an unlimited amount of funds into a private investment vehicle.

  6. A person with an investment portfolio of one stock resulting from his/her founding of a company would not necessarily be a sophisticated investor in other companies.

The subjectivity of these judgments does not allow for easy rulemaking.However it does seem that a small limited exception might be allowed for investors with education or experience or a residence or a business that suggests sophistication.That exception could be limited to $100,000 which is usually the smallest amount allowed for such funds.Such an exception might be particularly useful to small hedge funds. More importantly there is a need to rethink the definition of sophistication in today's world.It does not only come from ownership of securities investments and surely does not come from inherited investments.The best test for investments is the overall suitability test applied to broker sold investments and the fiduciary test for advisors.Therefore the best thing that can be done to protect investors is to require that all investments over $100,000 require that a registered investment advisor or broker be involved in the transaction.Perhaps those funds that have failed to register should not be allowed to sell to investors who are not advised.While the Commission may lack the authority to require hedge funds to register,it clearly has the authority to define how they are sold as private placements.

A proposal in London dealing with so called sophisticated investors generated similar concerns from the Financial Services Consumer Panel which noted that allowing investors to self identify themselves as sophisticated because of net worth could lead to mis-selling.

"HM Treasury's proposals to allow wider promotion of investment in unlisted securities could cause far more problems than it solves, said the Financial Services Consumer Panel today in its response to Treasury Consultation1.

The Consumer Panel has pointed out that the proposed changes would mean that consumers who define themselves as high net worth and sophisticated investors could invest in unlisted companies without any regulated advice, and so could lose their money and not have any comeback through the Financial Ombudsman Service or Financial Services Compensation Scheme.

Whilst there will be high net worth and sophisticated investors who are competent to take these decisions and to deal with anything which may go wrong, there are others who will not be in this position. For example, given current property values in some parts of the UK, it is quite possible for an individual inheriting his or her parents' former home to meet the definition of high net worth investor (having net assets worth at least 250,000) without acquiring any financial or investment expertise.

For a "sophisticated" investor, the Treasury's proposal to allow self-certification rather than having to go through a regulated financial adviser or firm, also opens up huge possibilities of mis-selling without any recourse to compensation. It means that a person selling an investment in an unlisted equity could at the same time persuade a person to sign a self certification form, so agreeing they were a sophisticated investor and signing away all their rights in the excitement of an "exclusive" investment opportunity. The costs to the consumer of being wrongly identified as a sophisticated investor are high. So the Panel does not believe that there is any scope for relaxing the existing requirements for certification of sophisticated investors.

The Consumer Panel points out that the consultation paper focuses on the demand from business for business angels. At no point does it consider the possible risks for consumers, or show any evidence of the demand for this from consumers. The Panel believes that the possibility of more consumers being mis-sold means that no changes should be made to the current rules on financial promotion in this area."

Ann Foster, Chairman of the Panel said:

"The consumer protection in the current financial promotion regime for investment in unlisted securities should not be watered down in this way for the benefit of the few, but to the likely detriment of many." Financial Services Consumer Panel Press Release 15 Apr 04

Peter J. Chepucavage
General Counsel
Plexus Consulting
202-785-8940 ext 108.

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