Managed Funds Association
Additional Comments of Managed Funds Association
U.S. Securities and Exchange Commission
Roundtable on Hedge Funds
May 14 - 15, 2003
Submitted July 7, 2003 by:
John G. Gaine
Managed Funds Association
Via Electronic Mail: email@example.com
July 7, 2003
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Re: File No. 4-476 - Additional Comments on "Hedge Fund Roundtable" by Managed Funds Association
Dear Mr. Katz:
As a follow-up to the "Hedge Fund Roundtable" held in May 2003 by the Securities and Exchange Commission ("Commission"), Managed Funds Association ("MFA") would like to take this opportunity to provide additional comments to the Commission on the hedge fund industry. I was especially honored to participate in the two-day Roundtable on behalf of MFA. We commend the efforts by the SEC to provide this excellent opportunity for hedge fund industry professionals to provide information to the Commission on the many benefits of hedge funds both to the global marketplace and to their investors. As a result of the Roundtable, we are confident that the Commission and the public are better informed about this industry. At the conclusion, of the Roundtable, Chairman Donaldson requested additional commentary about the hedge fund industry. Accordingly, MFA would like to take this opportunity to provide additional information for the Commission to review. The information attached hereto would supplement our prior submission to the Commission, sent in anticipation of the Roundtable, dated May 6, 2003.
MFA has organized its submission into three key documents for the Commission to utilize as the staff analyzes the information gathered during its fact-finding mission about the hedge fund industry and prepares its final report of recommendations to the Commission. Two of the three documents are included with this cover letter; we will submit the third document, "2003 Sound Practices for Hedge Fund Managers," for the record in the near future, as discussed below. Each of these documents addresses specific issues and concerns raised at the Roundtable.
Registration of Hedge Fund Advisers Under the Investment Advisers Act of 1940
The first document we have enclosed is MFA's "White Paper on Registration of Hedge Funds Advisers Under the Investment Advisers Act of 1940." For historical context, this paper provides an analysis of the regulatory framework governing investment advisers over the past thirty years. This paper also raises the relevant considerations for any discussion by the Commission of requiring the registration of all hedge fund managers under the Investment Advisers Act of 1940. MFA believes that the sophisticated investors that today invest in hedge funds are able to evaluate the merits of investments in such funds and, therefore, do not need the additional protection that SEC registration would provide.
Financial Eligibility Standards for Investors in Hedge Funds
The second paper, MFA's "White Paper on Increasing Financial Eligibility Standards for Investors in Hedge Funds," responds to certain concerns expressed by the Commission as to whether hedge funds are now being marketed to investors who are not sufficiently sophisticated to appreciate their risks. This issue relates to the concerns expressed both inside and outside the Commission that hedge funds in some instances might be offered to inappropriate persons. This paper summarizes the history of the current "accredited investor" standard under Regulation D. It also describes amendments to the definition of "accredited investor" that the Commission could consider if it determines that hedge funds today are, in fact, being marketed to unsuitable investors.
2003 Sound Practices for Hedge Fund Managers
Finally, the third document that will become part of this overall submission to the Commission is the "2003 Sound Practices for Hedge Fund Managers" ("Sound Practices") This document will provide what, we believe, are the "best practices" for hedge fund managers, both large and small. The Sound Practices, in the process of being finalized by MFA, will cover such topics as investor protection, risk controls, valuation as well as other topics. This document is an expansion and update of a document first published by the industry in 2000 in response to a President's Working Group report. This revision, "2003 Sound Practices for Hedge Fund Managers," as discussed with Commission staff, will be completed shortly and submitted to the Commission.
MFA is pleased to submit these documents to the Commission as it prepares its report regarding the hedge fund industry. We welcome the opportunity to discuss any of the issues raised in these materials at your convenience.
/s/ John G. Gaine
John G. Gaine
WHITE PAPER ON REGISTRATION OF HEDGE FUND ADVISERS UNDER THE INVESTMENT ADVISERS ACT OF 1940
WHITE PAPER ON INCREASING FINANCIAL ELIGIBILITY STANDARDS FOR INVESTORS IN HEDGE FUNDS
WHITE PAPER ON REGISTRATION OF HEDGE FUND ADVISERS
UNDER THE INVESTMENT ADVISERS ACT OF 1940
Submitted July 7, 2003
2025 M Street, NW, Suite 800, Washington, DC 20036
Tel.: 202.367.1140, Fax: 202.367.1140, Web: www.mfainfo.org
Table of Contents
II. Background on Hedge Funds
III. Securities Laws Exemptions for Private Transactions
IV. Hedge Fund Managers Should Not Be Subject to Mandatory Registration under the Investment Advisers Act
V. Regulatory Action to Redefine the Term "Client" is Unnecessary
At the conclusion of the recent Hedge Fund Roundtable conducted by the Securities and Exchange Commission ("Commission" or "SEC"), Chairman William H. Donaldson invited the public to submit comments on the issues raised in the Roundtable. Chairman Donaldson stated that the Commission would consider such comments, and what it had learned at the Roundtable, in considering whether any legislative or regulatory steps need be taken regarding hedge funds. The Managed Funds Association is pleased to submit these comments in response to that invitation.
We commend the Commission for undertaking its review of hedge funds. This review, when coupled with past initiatives, such as the 1999 Report of the President's Working Group on Financial Markets,1 should do much to address misconceptions about hedge funds.
In determining whether additional SEC regulation of hedge funds and their managers is needed, the core objectives of the federal securities laws -- to protect investors and assure that markets are efficient -- should be borne in mind. The federal securities laws are also crafted, however, to avoid the overbearing regulatory intrusion typical of some countries that can hamper the development and evolution of strong and healthy financial markets.2 The strength and vitality of the U.S. financial markets in comparison to those of other countries validates the balancing reflected in the federal securities regulatory framework and approach over many decades.
In light of those objectives and the balancing of interests, the federal securities laws have always recognized that private transactions between sophisticated parties should not be subject to the full panoply of regulations applicable to transactions involving unsophisticated market participants. Hedge funds and other private investment funds historically have been marketed only to sophisticated investors. Consequently, hedge funds and their managers have not been required to register under the federal securities laws.
The SEC's review, in part, has been prompted by concern about the current popularity of hedge funds and their proliferation into investment vehicles or programs that may become available to the public. We share the SEC's concern that hedge fund products not be offered to investors when such products are not appropriate for such investors. If, after its review, the SEC concludes that greater investor protection is needed to address changes in hedge fund marketing, the most obvious, simplest, and most efficient solution would be to reconsider the eligibility standards that apply to investors in private funds.
We do not believe, however, that mandatory registration of all hedge fund managers under the Investment Advisers Act of 1940 is merited. Sophisticated investors that today invest in hedge funds are able to evaluate the merits of investments in such funds and therefore do not need the additional protection that registration would provide. Moreover, hedge fund managers are already subject to appropriate regulatory requirements and there are additional safeguards covering the activities of hedge funds to the extent that they interact with regulated third parties such as registered broker-dealers and banks. In addition, mandatory registration of managers of hedge funds would divert precious Commission resources from the areas of the securities markets that traditionally have been the focus of the SEC's efforts -- the retail markets. Finally, mandatory registration of hedge fund managers under the Investment Advisers Act might create unnecessary regulatory burdens, impede entrepreneurial efforts, drive some managers offshore, and inhibit an industry that until now has been characterized by its diversity and innovation.
II. Background on Hedge Funds
The term "hedge fund" is not defined in the federal securities laws. It is used, however, to describe a diverse set of investment strategies employed by a variety of institutional investors.3 Generally these investors take the form of limited partnerships or limited liability companies or, in some cases, offshore corporations, the investors in which are wealthy and sophisticated -- both natural persons and institutions.4
Hedge funds avail themselves of certain limited exemptions and exclusions from registration requirements of the federal securities laws. In this regard, hedge funds are no different from leveraged buyout, venture capital, private equity, oil and gas, and real estate funds. Under the Securities Act of 1933, the equity interests in such funds are securities and must be registered unless an exemption is available. Such funds usually rely on the exemption from registration for transactions not involving a public offering under Section 4(2) of the Securities Act and Rule 506 of Regulation D thereunder. Rule 506 is a nonexclusive safe harbor that permits private placements to an unlimited number of accredited investors, and no more than 35 nonaccredited investors.5
Under the Investment Company Act of 1940, any company that is engaged primarily in investing in securities must register as an investment company, unless an exemption or exclusion is available. Hedge funds and other private funds rely on two exclusions. Section 3(c)(1) of the Investment Company Act provides an exception from the definition of investment company for funds with no more than 100 beneficial owners that have not made and do not propose to make a public offering. Section 3(c)(7) of the Investment Company Act excepts funds whose securities are owned exclusively by "qualified purchasers" and that do not make a public offering.6
The manager of a hedge fund generally will come within the definition of an "investment adviser" in the Investment Advisers Act. Some hedge fund managers register as investment advisers. Other investment advisers do not register, in reliance on the exemption from registration under Section 203(b)(3) for advisers that have fewer than fifteen advisory clients (counting each fund, and not each investors therein, as a client), do not hold themselves out to the public as investment advisers, and do not act as advisers to any registered investment companies.
As the President's Working Group Report noted, hedge funds employ a variety of investment styles. Some use quantitative techniques; others use more subjective analysis. They also vary in their use of different types of financial instruments, with some investing primarily in equity or fixed income securities, and others using derivatives to a large degree.7 Some hedge funds use leverage; others do not. The managers of hedge funds typically receive advisory fees that include a component that depends on the investment performance experienced by the funds.
The President's Working Group Report noted that hedge funds can provide benefits to financial markets, by providing liquidity and making those markets more efficient:
Hedge funds and other investors with high tolerance for risk play an important supporting role in the financial system in which various risks have been distributed across a broad spectrum of tradable financial instruments. With financial intermediation increasingly taking place in the capital markets instead of banking markets, prices play a larger role in the allocation of capital and risk. In this world, investors such as hedge funds that undertake a combination of long and short positions across markets help maintain the relative prices of related financial instruments.8
Hedge funds also are sources of financial innovation.9
III. Securities Laws Exemptions for Private Transactions
From their inception, the federal securities laws have carved out exemptions from regulation for private transactions and the parties to those transactions.10 Public offerings, as distinguished from "private offerings," proved to be the basic policy distinction on which Congress relied in delineating the scope of the Securities Act. As James Landis, one of the principal drafters of that Act and the second Chairman of the Commission, later put it, "the sale of an issue of securities to insurance companies or to a limited group of experienced investors was certainly not a matter of concern to the federal government."11 This policy distinction, valid then and valid now, exists in nearly every federal regulatory scheme that has been created since then.
Accordingly, when Congress enacted the Securities Act in 1933, it exempted from registration those "[t]ransactions by an issuer not with or through an underwriter and not involving any public offering."12 Seven years later, when Congress enacted the Investment Company Act and the Investment Advisers Act, it created exceptions from the registration requirements for pooled investment vehicles and investment managers that engaged solely in non-public activities. Under the Investment Company Act, Congress excepted investment funds that did not make any public offering of their securities and had no more than 100 investors.13 Under the Investment Advisers Act, Congress established a parallel exemption for those investment advisers that do not hold themselves out to the public as investment advisers and have fewer than 15 clients.14
A few years ago, Congress expanded the exceptions available for private investment companies. Congress did this in response to a 1992 report of the Commission's Division of Investment Management that recommended the adoption of a new exception for private funds that are sold exclusively to "qualified purchasers,"15 whether or not they have more than 100 investors. The Division reasoned that "[f]or issuers whose securities are owned exclusively by sophisticated investors, the * * * 100 investor limit [is] not supported by sufficient public policy concerns. The new exception would be premised on the theory that `qualified purchasers' do not need the Act's protections because they are able to monitor such matters as management fees, transactions with affiliates, corporate governance, and leverage."16
In 1996, Congress enacted the National Securities Markets Improvement Act ("NSMIA"),17 which included the new exception for qualified purchaser funds.18 As the Senate report on the legislation explained:
The qualified purchaser pool reflects the Committee's recognition that financially sophisticated investors are in a position to appreciate the risks associated with investment pools that do not have the Investment Company Act's protections. Generally, these investors can evaluate on their own behalf matters such as the level of a fund's management fees, governance provisions, transactions with affiliates, investment risk, leverage, and redemption rights.19
In sum, for more than 70 years, Congress and the SEC have recognized that private investment funds and their managers need not be required to register under the Securities Act, the Investment Company Act, and the Investment Advisers Act.
IV. Hedge Fund Managers Should Not Be Subject to Mandatory Registration Under the Investment Advisers Act
We believe that mandatory registration of all hedge fund managers under the Investment Advisers Act is not warranted. We base our conclusion on the sophistication of hedge fund investors and related industry sound practices, the existing regulatory requirements applicable to hedge fund managers (including indirect regulation through dealings with other securities market participants), the diversion of Commission resources that would result from a mandatory registration requirement, and the potential regulatory burdens that might inhibit an innovative and creative industry.
As discussed above in Section II, by law hedge funds may only offer their securities privately and, with very limited exceptions, to investors who meet certain objective tests designed to establish their financial sophistication. Moreover, in recent years sophisticated institutional investors have come to play a larger and larger role in the hedge fund market.20 These investors have only a limited expectation of governmental protection, and instead employ their financial sophistication to evaluate the merits of any particular investment, including investments in private funds.21
The organizational, contractual, and offering documents of hedge funds typically contain provisions whose level of detail ultimately serves to protect the interests of investors in those funds. These documents address matters such as the calculation of the manager's advisory fee, the methodology to be employed in valuing the fund's assets, the availability of the fund's books and records for investor scrutiny, the disclosure of potential conflicts of interest between the manager and the fund, withdrawal and redemption provisions, investor voting rights, and reporting requirements. Investors generally are required to represent that they and their advisers have read and understood the relevant documents before investing in a fund.
Certain hedge funds, like other securities market participants, have from time to time been subject to fraudulent activities, with the perpetrators being prosecuted by governmental authorities. As CFTC Commissioner Lukken recently explained, however, many cases of reported hedge fund fraud do not involve true hedge fund managers, but rather "individuals who commit fraud by marketing themselves as hedge fund managers and bucketing the profits for themselves."22 Accordingly, we do not believe that allegations of hedge fund fraud would justify mandatory registration of all hedge fund managers.
Moreover, a significant percentage of hedge fund managers choose to register under the Investment Advisers Act, because they wish to manage assets for more than fourteen hedge funds or advisory clients, because they wish to hold themselves out publicly as investment advisers or because they believe such registration is attractive to their clients or investors in their funds. Therefore, a sophisticated investor that wishes to invest in a hedge fund managed by a registered manager has many options.23
Moreover, the private sector, in response to the Long-Term Capital Management situation, has published a variety of reports providing guidance on best practices by hedge fund managers. In direct response to the suggestion of the President's Working Group, in 1999 hedge funds submitted a sound practices guide entitled "Sound Practices for Hedge Fund Managers" to the President's Working Group. The Counterparty Risk Management Policy Group, a group of twelve of the world's largest commercial and investment banks, issued a report in 1999 entitled "Improving Counterparty Risk Management Practices," which set forth twenty recommendations to enhance strong practices and counterparty credit and market risk management.24 The International Swaps and Derivatives Association issued its own recommendations for improving collateral management practices.25 The Institute for International Finance, a global association of financial institutions, formed a special task force on risk assessment in 1998 to examine the lessons learned from emerging markets crises in 1997 and 1998.26
Much of the discussion regarding hedge funds and their managers appears to assume that they are not subject to any governmental oversight, but that is a misconception. Hedge funds and their managers, even those that are exempted or excepted from regulation under the Investment Company Act and the Investment Advisers Act, are subject to a variety of other regulatory requirements.
Hedge funds and their managers, regardless of whether they are registered, are subject to the broad antifraud provisions of the Securities Act, the Securities Exchange Act of 1934, and the Investment Advisers Act itself, which prohibit fraud in connection with the offer, sale, and purchase of securities, in connection with trading securities, and in connection with advisory relationships. Hedge funds and their managers, like other market participants, are prohibited from engaging in activities such as market manipulation and insider trading that could undermine market integrity and efficiency.
Hedge funds and their managers, like other investors, must comply with the reporting requirements of the Securities Exchange Act, which are designed to increase market transparency. The Securities Exchange Act requires any hedge fund or hedge fund manager who directly or indirectly acquires more than 5% of the shares of a registered security to file a report with the SEC within 10 days of such acquisition.27 It also requires institutional investment managers, including hedge fund managers, that exercise discretion over accounts holding more than on $100 million in exchange-traded and NASDAQ-quoted securities on the last trading day of any month of any calendar year to provide a quarterly report on the securities in the portfolio, the names of the companies, and the number of shares or principal amounts.28 In addition, any hedge fund that owns 10% or more of a registered security must file reports on Forms 3, 4, and 5 and comply with the restrictions on short-swing profits.29
Over the past year, the Treasury Department proposed two rules that would require certain hedge funds and investment advisers, including unregistered hedge fund managers, to establish anti-money laundering programs. In particular, the proposals would require investment advisers to develop written anti-money laundering policies and procedures, designate a person or persons to be responsible for anti-money laundering compliance, train appropriate employees with regard to money laundering, and periodically audit or test the functioning of their anti-money laundering compliance efforts. These rules would require hedge funds and their managers to file notices with the Treasury Department containing specified information. In addition, unregistered hedge fund managers would be required to screen investors in certain types of pooled investment vehicles and make their anti-money laundering programs available for Treasury Department or SEC inspection. These proposals are still pending.
In addition, some hedge funds and their managers are subject to registration requirements under other regulatory regimes. Some hedge funds, or their managers, engage in activities that require them to register as broker-dealers under the Securities Exchange Act, and thus become subject to the regulatory requirements of the SEC and securities self-regulatory organizations. Under the Commodity Exchange Act, to the extent that a hedge fund with U.S. investors trades futures and options contracts on a futures exchange, that fund is considered to be a commodity pool and the operator of the pool is subject to regulation as a commodity pool operator ("CPO"). A hedge fund manager that provides advice to a hedge fund regarding such futures and options contracts may also become subject to regulation as a commodity trading advisor ("CTA"). CPOs and CTAs are subject to registration, recordkeeping, and reporting requirements and fraud prohibitions under the Commodity Exchange Act and the regulations of the CFTC and National Futures Association.30 If hedge funds are significant traders in the futures markets, they also become subject to the CFTC's large trader reporting system, which requires the reporting of certain information on exchange-traded contracts to the CFTC for purposes of market surveillance. Further the U.S. Treasury Department monitors participants in the foreign-exchange markets, requiring weekly and monthly reports for certain large participants and imposes reporting requirements on entities, including hedge funds, that have large positions in to-be-issued or recently-issued U.S. Treasury securities. Finally, some hedge fund managers are registered as investment advisers with one or more state securities regulators or with non-U.S. regulatory authorities.
Hedge funds and their managers are subject to indirect regulation, through their dealings with other securities market participants. Financial institutions, namely, broker-dealers and commercial banks, which serve as creditors of, counterparties to, or placement agents for hedge funds, are subject to regulation by the securities and banking regulators. Regulations that serve to limit the risk that such entities take or the credit that these institutions provide serve as an indirect form of regulation of hedge funds. On the securities side, broker-dealers are subject to net capital and margin rules. Under the net capital rules, a broker-dealer must deduct from net worth 100% of the value of loans that are not fully collateralized by liquid securities, which serves to limit broker-dealers' exposure to credit risk.31 The margin rules require customers to provide collateral based on the market risk of the position.32 On the banking side, regulators promote sound risk management practices by banks through on-site reviews, examinations, and the issuing of supervisory guidance.33
All federal agencies face constrained resources, and the SEC is no exception. Given its resources, the SEC historically has done a remarkable job of policing the market in the interests of investors. The SEC would acknowledge, however, that it has all it can do to keep up with the activities of currently registered entities and their impact on retail investors. In fact, the bifurcated system of state and federal jurisdiction over investment advisers established as part of NSMIA in 1996, resulted, at least in part, from the realization that the SEC did not have the resources to effectively regulate all of the federally registered investment advisers.34 Expanding the SEC's jurisdiction to protect the wealthy and sophisticated would divert SEC resources from the agency's traditional focus: protecting retail investors.
Resource constraints are not the only reason the SEC should eschew mandatory registration of hedge fund managers. As the President's Working Group recognized, it would be difficult to limit any changes solely to hedge fund advisers. From a regulatory perspective, a hedge fund is defined more by what it is not -- it is not a registered investment company -- than by what it is. Thus, depending on the precise nature of any revisions to the law, the term hedge fund could include venture capital funds and private equity funds, as well as other vehicles that rely on exceptions from the definition of investment company in the Investment Company Act. Also, SEC regulation of hedge fund managers could create a "moral hazard" risk, by creating an expectation among private investors and securities markets that the agency will be able to ensure or protect against any difficulties in the operations of hedge funds.
Most hedge funds have begun as entrepreneurial efforts by individuals who put their own careers and capital on the line to start a business. Many hedge fund managers start hedge funds as second careers after successful careers in the brokerage or mutual fund industries because they believe that they may develop more successful businesses outside of the highly regulated environment of brokerage firms, banks, and mutual funds. The success and market performance of the hedge fund industry bears testament to the validity of this premise. Requiring across-the-board Investment Advisers Act registration and imposing one-size-fits-all regulatory oversight might unduly constrain these entrepreneurial efforts.
Although the Investment Advisers Act may contain fewer detailed prescriptions on its registrants than the Investment Company Act, the regulatory burdens it imposes are not insignificant. In addition to the specific statutory requirements, the staff of the SEC has imposed a variety of additional requirements on investment advisers.35 The imposition of this regulatory scheme on hedge fund managers could impair their ability to implement the innovative and fast-paced investment strategies, which have contributed to the success of the hedge fund industry and overall market efficiency. Instead, many hedge fund managers might become homogenized and bureaucratic - managing their businesses to meet SEC staff expectations rather than in the entrepreneurial and innovative manner that hedge fund managers and sophisticated investors have found to be beneficial. Registration might have similar effects on managers of venture capital, leveraged buyout, and other private funds.36
Many have suggested that across-the-board regulation of hedge fund managers could cause those managers that wish to retain the flexibility necessary to implement innovative investment strategies to move offshore and away from the SEC's jurisdiction.37 Driving hedge fund managers offshore merely makes existing regulation less effective.38 As Chairman Greenspan put it:
[M]ost hedge funds are only a short step from cyberspace. Any direct US regulations restricting their flexibility will doubtless induce the more aggressive funds to emigrate from under our jurisdiction. The best we can do in my judgment is what we do today: regulate them indirectly through the regulation of the source of their funds. We are thus able to monitor far better hedge funds' activity, especially as they influence US financial markets. If the funds move abroad, our oversight will diminish.39
V. Regulatory Action to Redefine the Term "Client" is Unnecessary
Some have suggested that the SEC could redefine the term "client" to include each investor in a hedge fund organized as a partnership or limited liability company, and thereby require all hedge fund managers to register under the Investment Advisers Act. Such an action, however, would be inconsistent with long-standing SEC practice and with the plain meaning of the term "client". Moreover, it would capture managers of venture capital funds, private equity funds, real estate funds, family partnerships, and other entities that rely on Section 3(c)(1) to raise capital through private placements.
In applying the fifteen-client limit, the SEC historically has interpreted the "client" of a manager of a private fund to be the fund, and not the individual investors in the fund. This is consistent with the operational reality of private funds, because each private fund manager invests in keeping with the investment guidelines applicable to the particular fund, rather than the financial objectives of each fund investor. This interpretation of the Investment Advisers Act also has been recognized implicitly and approved by Congress, in amendments to the Investment Company Act and Investment Advisers Act in 1980 and 1996.
The SEC first acknowledged nearly forty years ago that for client counting purposes a fund, and not its equity owners, is an adviser's client. As originally enacted, the Investment Advisers Act exempted any investment adviser who had fewer than fifteen clients and did not hold itself out to the public as an adviser, even if the adviser was an adviser to a registered investment company. In a 1966 report entitled "Public Policy Implications of Investment Company Growth," the SEC recommended that the law be changed to require that all investment advisers to registered investment companies register under the Investment Advisers Act. In doing so, the SEC did not find that each shareholder of an investment company was a client of the investment adviser. Rather, it recommended that Congress amend the Investment Advisers Act to remove the exemption for advisers who served as advisers to registered investment companies.
Since that time, the SEC has continued to recognize that where an adviser tailors its advice to the investment objectives of a fund, it is the fund itself and not its investors that should be deemed its client. In 1980, as part of the Small Business Investment Incentive Act of 1980, Congress took the same approach toward business development companies, amending the Investment Advisers Act to make clear that a business development company, rather than its individual investors, would count as the adviser's client. In 1985, the Commission proposed and adopted Rule 203(b)(3)-1, which codified these positions for funds organized as limited partnerships. As part of its effort to implement provisions of NSMIA in 1997, the Commission amended Rule 203(b)(3)-1 in order to broaden its scope and apply its client counting standard to other forms of business organization, including corporations, general partnerships, limited liability companies, and trusts.
Not only is the SEC's client counting interpretation long-standing, it is also consistent with the use of the term "client" in other regulatory contexts under the Investment Advisers Act. For example, the SEC has long held that an adviser violates the Investment Advisers Act when it makes or recommends investments that are unsuitable for its clients. In doing so, it has never suggested that the manager of a private fund -- or a registered investment company -- must determine what investments are suitable for the individual investors in that pooled vehicle. Given this history and the plain meaning of "client," the SEC should not repeal or amend its rule on client counting to compel private fund managers to register under the Investment Advisers Act.
The Managed Funds Association appreciates this opportunity to comment on the potential regulation of hedge funds and their managers. We would be pleased to provide additional information or respond to questions from the Commission or its staff.
ENDNOTES FOR WHITE PAPER ON REGISTRATION OF HEDGE FUND
ADVISERS UNDER THE INVESTMENT ADVISERS ACT OF 1940
1 The President's Working Group consists of the Secretary of the Treasury and the Chairs of the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. The President's Working Group Report issued in 1999 was entitled "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management." It was undertaken to analyze the lessons learned from the difficulties encountered by Long-Term Capital Management in the face of events in the global financial markets in the summer and fall of 1998 and to analyze what, if anything, should be done differently as to the regulation of hedge funds to mitigate systemic risk.
2 Federal securities regulators historically have weighed potential costs, burdens, and impediments of regulations against their potential benefits in evaluating whether regulation is appropriate. Such an analysis is required explicitly under many of the federal securities laws. See, e.g., Investment Advisers Act § 202(c) ("Whenever pursuant to this title the Commission is engaged in rulemaking and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission should also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.")
3 The President's Working Group Report summarizes the varieties and operations of hedge funds at pp. 1-10. See also Brandon Becker and Colleen Doherty-Minicozzi, Hedge Funds in Global Financial Markets (Feb. 2000), at <http://www.wilmer.com> at 3-16.
4 According to the President's Working Group Report, institutional investors increasingly are investing in hedge funds. President's Working Group Report at 14.
5 "Accredited investor" is defined in Regulation D to include any savings and loan association; any broker-dealer; any employee benefit plan with total assets of more than $5 million; any private business development company; any organization, corporation, trust, or partnership not formed for the specific purpose of acquiring securities offered with total assets of more than $5 million; any natural person with individual net worth, or joint net worth with that person's spouse, of $1 million; any natural person with individual income of more than $200,000 in each of the two most recent years or joint income with that person's spouse of more than $300,000 in those years, and a reasonable expectation of reaching the same income level in the current year; and any entity in which all the equity owners are accredited investors.
6 Qualified purchasers include any individual owning $5 million in investments (including joint investments with that individual's spouse), certain family-owned companies with at least $5 million in investments, trusts that are established and funded by qualified purchasers if investment decisions are made by a qualified purchaser, and any person who, acting for its own account or the account of other qualified purchasers, in the aggregate owns and invests on a discretionary basis at least $25 million in investments. In addition to qualified purchasers, "knowledgeable employees" may invest in § 3(c)(7) funds, under Rule 3c-5.
7 President's Working Group Report at 2-3.
8 Id. at A-6.
9 Id. at 2. For additional discussion of the ways in which hedge funds are beneficial to financial markets, see the Association's comments for the Hedge Funds Roundtable (May 6, 2003) at 6-10.
10 Franklin Roosevelt's 1932 campaign platform included the notion of "advocat[ing] protection of the investing public by requiring to be filed with the government and carried in advertisements of all offerings of foreign and domestic stocks and bonds true information as to bonuses, commissions, principal invested, and interests of the sellers" (emphasis added). Why the Federal Securities Act Was Passed, 13 Cong. Dig. 130, 131 (1934).
11 Landis, The Legislative History of the Securities Act, 28 Geo. Wash. L. Rev. 29, 37 (1959).
12 See Securities Act § 4(1) (1933). The modern private placement exemption is found in § 4(2) of the Securities Act and exempts from registration "transactions by an issuer not involving any public offering."
13 See Investment Company Act § 3(c)(1).
14 See Investment Advisers Act § 203(b)(3).
15 A "qualified purchaser" is defined in § 2(a)(51)(A) of the Investment Company Act. See supra note 6.
16 SEC, Division of Investment Management, Protecting Investors: A Half Century of Investment Company Regulation 104-05 (1992).
17 P. L. No. 104-290, 110 Stat. 3416, 3432-33 (1996).
18 See Investment Company Act § 3(c)(7).
19 S. Rep. No. 104-293, at 10 (1996). See also H. R. Rep. No. 104-622, at 18 (1996):
The legislation also provides a new exception from the definition of "investment company" to permit investment pools that sell their securities only to "qualified purchasers" who are deemed to be sophisticated investors to sell to an unlimited number of these investors. These pools, which include not only hedge funds but also financing vehicles such as venture capital funds that provide capital directly to start-up companies or businesses, currently operate pursuant to an exception in the Investment Company Act that limits the number of investors that can invest in these pools. Although there is no exact accounting of the total number and size of these private investment partnerships, estimates indicate that the total number may be as high as 3,000, with assets estimated between $75 and $160 billion. The Committee recognizes the important role that these pools can play in facilitating capital formation for U.S. companies. The Committee expects that the legislation will significantly reduce regulatory restrictions that have affected these pools, and will remove incentives that have caused some Americans to invest in unregulated offshore markets.
20 See President's Working Group Report at 14.
22 CFTC Commissioner Walt Lukken, Remarks before the New York State Bar Association (May 20, 2003) (in explaining that "these people are fraudsters and have little to do with the concerns surrounding the legitimate hedge fund industry," the Commissioner explained that "[f]rom a regulatory standpoint, this behavior is not a hedge fund problem, per se - it is essentially an issue of fraud"). See also, Statement of Patrick McCarty, General Counsel, CFTC, SEC Hedge Fund Roundtable ("Our -- I guess combined SEC and CFTC enforcement actions total somewhere around 3,300 over the last five years and I believe the total number of cases -- enforcement cases brought in that 5-year period against entities who are saying that they're hedge funds is about 80. So it's somewhere on the order of magnitude of about 2 percent of all cases, maybe 3.")
23 For instance, some hedge fund managers choose to register under the Investment Advisers Act in order to have a significant percentage of their funds' assets represented by investments from pension plans. If private pension plans invest in a hedge fund, the hedge fund will be subject to Department of Labor regulations concerning plan assets under the Employee Retirement Income Security Act of 1974, as amended, unless an exception is available. The only exception that will be available for an unregistered hedge fund, as a practical matter, is if the hedge fund has pension plan participation that is not "significant." Plan participation is considered not to be "significant" only if both private and public, and both domestic and foreign, benefit plans as a group constitute less than 25% in interest of the hedge fund's investors, excluding for these purposes any investment by the hedge fund manager and its affiliates.
24 See SEC Welcomes Counterparty Risk Management Policy Group Report, Press Release 99-68, June 21, 1999, available at <www.sec.gov/news/press/pressarchive/1999/99-68.txt>.
25 International Swaps and Derivatives Association, Inc., ISDA 1999 Collateral Review, 1999.
26 Institute of International Finance, Inc., Report of the Task Force on Risk Assessment: Recent Experiences, Lessons, and Recommendations, March 1999 ("Risk Assessment Report").
27 Securities Exchange Act § 13(d) and Rule 13d-1 thereunder. Rule 13d-1 permits hedge funds that are registered broker-dealers to file beyond the 10-day period under § 13(g) of the Securities Exchange Act, in some circumstances.
28 Securities Exchange Act § 13(f) and Rule 13f-1 thereunder.
29 Securities Exchange Act §§ 16(a), (b) and Rule 16a-3 thereunder.
30 In March 2003, the CFTC proposed new exemptions from CPO registration that would exempt many managers of hedge funds from registration, provided the hedge fund manager met certain requirements as to books and records retention and financial statements. See Additional Registration and Other Regulatory Relief for Commodity Pool Operators and Commodity Trading Advisers, 68 Fed. Reg. 12622 (Mar. 17, 2003). This proposal is still pending.
31 Exchange Act Rule 15c3-1.
32 The Board of Governors of the Federal Reserve System administers margin rules; the SEC enforces them.
33 See, e.g., Bank Lending to and Other Transactions with Hedge Funds: Before the Subcommittee on Financial Institutions and Consumer Credit of the House Committee on Banking & Financial Services, 106th Cong. (1999) ("March 1999 Hearings") (statement of Laurence H. Meyer, Board of Governors, Federal Reserve System ("Meyer statement")).
34 See S. Rep. No. 104-193, at 3 (1996) (citing testimony by SEC Chairman Arthur Levitt that the SEC inspections had become so infrequent that small advisers were inspected, on average, once every 44 years).
35 See, e.g., Interagency Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System, Exchange Act Release No. 47638 (Apr. 8, 2003) (requiring that registered investment advisers, regardless of their size or business, have disaster recovery plans).
36 See, e.g., SOMETHING VENTURED: VCs Sweat Possible Hedge Fund Rules, W. St. J. Online (June 11, 2003).
37 See, e.g., March 1999 Hearings (Meyer statement).
38 See, e.g., President's Working Group Report at 42; March 1999 Hearings (Meyer statement).
39 See, e.g., March 1999 Hearings 23 (statement of William J. McDonough, President of the Federal Reserve Bank of New York and Chairman of the Basel Committee on Banking Supervision) ("I do not believe that it would be easy to develop a workable approach to the direct oversight of hedge funds. The reality is that imposing direct regulation on hedge fund entities that are chartered in the major industrialized countries would likely result in the movement of all operations offshore. Direct regulation of hedge funds would require a high level of coordination involving the political, legislative, and judicial bodies of many countries. . . ."); President's Working Group Over-The-Counter Derivatives and Hedge Funds Study Before the Senate Committee on Agriculture, Nutrition & Forestry, 105th Cong. -- (1998) (statement of James E. Newsome, Commissioner, CFTC) ("There are many who doubt the utility of traditional, direct regulation of hedge funds. Indeed, as I have stated, I believe that heavy-handed regulation will certainly drive business off the shores of the United States.")
WHITE PAPER ON INCREASING FINANCIAL ELIGIBILITY
STANDARDS FOR INVESTORS IN HEDGE FUNDS
Submitted July 7, 2003
2025 M Street, NW, Suite 800, Washington, DC 20036
Tel.: 202.367.1140, Fax: 202.367.1140, Web: www.mfainfo.org
Table of Contents
II. A Brief History of the Accredited Investor Standard
B. Rule 146
E. Regulation D
Appendix A -- Text of Amendments to Definition of Accredited Investor
Appendix B -- Effects of Inflation Over Time
At the conclusion of the Hedge Fund Roundtable, Securities and Exchange Commission ("SEC" or "Commission") Chairman Donaldson invited the public to submit comments on the issues raised in the Roundtable discussions. Chairman Donaldson stated that the Commission would review such comments, and what it had learned at the Roundtable, in considering whether any legislative or regulatory steps need be taken regarding hedge funds. Managed Funds Association is pleased to submit this paper in response to the Chairman's concerns related to `retailization' of hedge funds.
The Commission's review, in part, apparently has been prompted by concern about the current popularity of hedge funds and whether they are now marketed to investors who are not sufficiently sophisticated to appreciate their risks. We understand the Commission's concern that hedge fund products should be offered only to investors for whom such products are appropriate. Given that evaluating investments in pooled investment products such as hedge funds requires a significant degree of investment sophistication, if the Commission concludes that hedge funds are being marketed to investors who lack the requisite financial sophistication, it may wish to consider amending the definition of "accredited investor" as to issuers relying on one of the exceptions in the Investment Company Act of 1940 for private funds.
This White Paper briefly summarizes the history of the accredited investor standard and how it applies to hedge fund offerings. It also describes amendments to the definition of accredited investor that the Commission could consider, if it determines that hedge funds today are being marketed to investors who may not fully appreciate their risks.
II. A Brief History of the Accredited Investor Standard
Congress recognized in passing the very first of the federal securities laws, the Securities Act of 1933 (the "Securities Act"), that registration of a security is a long and expensive process, and that in some circumstances the costs of compliance with registration greatly exceeded any public benefit. Thus, exemptions from the burdens of registration were written into the Securities Act as originally enacted in 1933.1
Although the Securities Act expressly exempts transactions that do not involve a "public offering," it does not define "public offering." As early as 1935, the General Counsel of the SEC issued an opinion describing four factors to consider when determining whether an offering was private or public.2 The enumerated factors were the number of offerees, the relationship of the offerees to the issuer, the number of units offered and the manner of the offering.3 However, in 1953, the United States Supreme Court rejected the number of offerees as dispositive and focused instead on the nature of the offerees.4 In SEC v. Ralston Purina & Co., the Court decided that an offering of stock by company to its employees-regardless of how many employees received the offer-was a public offering because some of the employees needed the protection of the Securities Act.5 Following the Ralston decision, uncertainty prevailed. As a result, for twenty years, the private capital markets were of little use to the U.S. economy, issuers or investors.
In response, the SEC in 1974 adopted Rule 146 as a "safe harbor" for private placements. The express purpose of Rule 146 was to provide objective standards for reliance upon the private placement exemption so as to permit issuers to make effective use of these markets. The Rule 146 requirements included limits on the manner of offering and the number of purchasers, minimum qualifications of offerees, offerees' access to certain information, and reporting to the SEC.6 Rule 146 served its purpose: private issuances increased dramatically as a result of the safe harbor it created.
Although the safe harbor approach of Rule 146 to private placements greatly increased private issuances (to as much as $4.2 billion in a single year), the Rule itself was widely criticized as imposing overly severe restrictions for an offering to qualify under the safe harbor which the Rule established. Rule 146 required issuers to have the equivalent of a crystal ball because they had to determine subjectively the sophistication of each offeree and each purchaser. This presented the issuers with continuing uncertainty as to whether the issues qualified for the exemptions under Rule 146.
During the late 1970's, the Commission became increasingly concerned that its disclosure rules and regulations were having a disproportionately large inhibiting effect on small businesses' ability to raise funds. In 1978, the Commission held public meetings in several cities to determine if the burdens imposed on small businesses could be alleviated, consistent with the protection of investors. The fruit of these discussions was Rule 242.
Rule 242 allowed certain corporate issuers to offer and sell up to $2 million per issue of their securities to an unlimited number of accredited persons and up to 35 other purchasers without registering those securities under Section 5 of the Securities Act. Rule 242 generally defined accredited person to include (i) any bank, insurance company, employee benefit plan, investment company, small business investment company, (ii) any person who purchased $100,000 or more of securities, and (iii) any director or executive officer of the issuer.7
Rule 242 was the first use of the term "accredited" in the securities area.8 The Commission considered such "accredited persons" to be less reliant on its investor-protecting rules. Consequently, the disclosure and other requirements under Rule 242 were less stringent (or eliminated entirely) for such investors. If the only purchasers of a securities issuance were accredited purchasers, the Rule had no disclosure requirement, reflecting the Commission's long-held belief that accredited purchasers are in a position to ask for and obtain whatever information they believe is relevant.9
Rule 242 was intended to minimize the uncertainty associated with the existing exemptive provisions, through the use of easily applied, bright line rules. Where Rule 146 was objective with regard to the amount of capital that could be raised, it was nonetheless subjective regarding the types of individuals who could invest. Rule 242 provided objective requirements which were less burdensome to issuers.
In 1980, as part of the Small Business Investment Incentive Act, Congress added Section 4(6) to the Securities Act. Section 4(6) provides an exemption from the registration requirements of the Securities Act for offers and sales of securities by an issuer to accredited investors if the aggregate amount of securities offered is $5 million or less and if there is no public solicitation.10
Congress defined "accredited investor" for purposes of Section 4(6) to be:
(i) a bank... an insurance company... an investment company or a business development company... a Small Business Investment Company... or an employee benefit plan...; or
(ii) any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies as an accredited investor under rules and regulations which the Commission shall prescribe.11
Congress implemented these changes essentially to help small businesses raise capital. The House Report on the legislation explained:
A vigorous and effective program of investor protection, together with disclosure requirements designed to result in an informed securities market, help to create the kind of investor confidence necessary to successful capital-raising by American businesses.... No such system of regulation is without cost, however. The committee is well aware of the slowing of the flow of capital to American enterprise, particularly to smaller, growing businesses, that has occurred in recent years. The importance of these businesses to the American economic system in terms of innovation, productivity, increased competition and the jobs they create is, of course, critical. Hence, the need to reverse this downward trend is of compelling public concern. Without doubt, the slowdown that has occurred is the product of many economic forces...[b]ut no undue cost should be shielded from scrutiny. As but one means of dealing with the more general problem, this bill seeks specifically to reduce some of the costs of government regulation imposed on the capital-raising process, to the extent that it can be done without sacrificing necessary investor protection.12
In enacting Section 4(6), Congress struck a balance between investor protection and burdens on capital raising and found that balance through recourse to the accredited investor standard.
In response to Congress' actions, in 1981, the Commission proposed Regulation D to replace the existing private and limited offering exemptions contained in Rules 146, 240, and 242. The Commission's intent was to have a more coherent pattern of exemptive relief, particularly as it related to the capital formation needs of small business. The Commission also intended Regulation D to simplify and clarify existing exemptions and to expand their availability by eliminating any unnecessary restrictions that those rules and regulations place on issuers.13
Throughout the adoption process, the Commission was continually concerned about the effect of its rules on small businesses' ability to raise capital. Toward that end, the Commission collected information about the number of purchasers and dollar amount of their purchases by category to enable the Commission to determine whether the expanded concept of "accredited investor" was useful. The Commission specifically asked for comments as to whether accredited investors as defined in Proposed Rule 501(a), including the new categories of accredited investors, could sufficiently fend for themselves. The overwhelming response was positive.
Regulation D, as initially adopted in 1982, was comprised of six rules, designated 501 through 506. Rule 501 included the Commission's definition of "accredited investor." Rule 505 replaced Rule 242 and continued to permit sales to an unlimited number of accredited investors and up to 35 non-accredited investors. Rule 506 replaced Rule 146 and incorporated the accredited investor standard into Rule 506 rather than continue the subjective determination required under Rule 146.14 Regulation D is based on the recognition that there are situations in which there may be no need for the registration provision of the Securities Act or in which the public benefits of registration may be too remote to require expensive and time consuming compliance.
Rule 501(a)'s definition of "accredited investor" was an expansion of the term "accredited person" present in Rule 242. This definition applies both to Section 4(6) of the Securities Act and to Regulation D. Accredited investors include:
Regulation D has unquestionably achieved its goals, even from its adoption. A study sponsored by the Commission to examine the general operation of Regulation D in its first year concluded that Regulation D was being used primarily by small issuers and that the expanded accredited investor concept allowed issuers to raise significant amounts of capital.16 In addition, there was no indication that Regulation D offerings replaced private placements to large institutional investors under Section 4(2) of the Securities Act. Moreover, the study concluded that accredited investors were provided disclosure which was similar to what the Commission mandated for non-accredited investors.17
Shortly after adoption of Regulation D, the SEC staff, in a series of no-action letters, confirmed that hedge funds and other private investment funds that made offerings of securities under Rule 506 could rely on Section 3(c)(1) under the Investment Company Act, assuming they had no more than 100 investors.18 Accordingly, hedge funds that rely on Section 3(c)(1) may offer their securities to natural persons with a net worth of $1 million or income of $200,000.
Given, however, the Commission's recent expressed concerns about the "retailization" of hedge funds, we understand that the Commission may wish to revisit whether it is appropriate for hedge funds to be sold to natural persons who fall within today's definition of accredited investor. In this regard, historically the Commission and Congress have believed that pooled investment vehicles present certain regulatory issues that differ from those of other companies. For that reason, the Investment Company Act of 1940 imposes a comprehensive regulatory structure on pooled investment vehicles that are sold to the public.19
If the Commission concludes that "retailization" merits regulatory action, it could consider amending Rule 501's definition of accredited investor to increase the standards of financial eligibility for natural persons investing in pooled investment vehicles. For example, the Commission could increase the $1 million net worth threshold to $2 million, the $200,000 annual income threshold to $400,000, and the $300,000 annual joint income threshold to $500,000. It also could consider amending Rules 505 and 506 so that no investors who were not accredited could invest in hedge funds and similar pooled investment vehicles.
As shown in Appendix A, such amendments could be drafted to limit their effect to hedge funds and similar issuers relying on Section 3(c)(1) of the Investment Company Act.20 In this way, the changes would not adversely affect other types of issuers, such as small businesses, who rely on Regulation D for much of their capital raising activities. These changes, however, would affect the ability of other entities that rely on Section 3(c)(1) to raise capital through private placements. We acknowledge that the Commission will weigh carefully the competing public policy implications of increasing the financial eligibility standards for all Section 3(c)(1) issuers.
These changes would also align these thresholds with the effects of inflation, as demonstrated by the Consumer Price Index since these thresholds were adopted. (Appendix B summarizes the relevant changes in the Consumer Price Index and the Employment Cost Index.)
Finally, if the Commission decides to amend Rule 501's definition of accredited investor to increase the standards, it also should consider adopting a rule allowing certain knowledgeable fund employees to be included. While such individuals would not necessarily meet higher net worth and income standards, their position inside the fund (or its manager) provides them with financial sophistication, knowledge, and experience in financial matters. The Commission adopted a similar rule, Rule 3c-5, under the Investment Company Act in 1997. (Proposed rule language is shown in Appendix A.)
Managed Funds Association appreciates this opportunity to provide this White Paper. We would be pleased to provide additional information or respond to questions from the Commission or its staff.
Text of Amendments to Regulation D
1. Amendment to Rule 501(a) under the Securities Act of 1933, pursuant to Sections 19(a), 19(c), 3(b), 4(2), and 4(6) of the Securities Act of 1933
New Paragraph (a)(9):
(9) For purposes of this paragraph (a), where the issuer would be an investment company but for the exception provided for in section 3(c)(1) of the Investment Company Act of 1940, then: subparagraph (a)(5) shall include a natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $2,000,000; subparagraph (a)(6) shall include any natural person who had an individual income in excess of $400,000 in each of the two most recent years or joint income with that person's spouse in excess of $500,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year; and subparagraph (a)(8) shall include any entity in which all of the equity owners are accredited investors as redefined in this subparagraph (a)(9).
2. Amendment to Rule 501(e) under the Securities Act of 1933, pursuant to Sections 19(a), 19(c), 3(b), 4(2), and 4(6) of the Securities Act of 1933
New Paragraph (e)(1)(v):
(v) if the issuer would be an investment company but for the exception provided for in section 3(c)(1) of the Investment Company Act of 1940, any Knowledgeable Employee, as such term is defined in Rule 3c-5 of the Investment Company Act of 1940.
3. Amendment to Rule 505(b)(2)(ii) under the Securities Act of 1933, pursuant to Sections 19(a), 19(c), 3(b), 4(2), and 4(6) of the Securities Act of 1933
New Paragraph (b)(2)(ii):
(ii) Limitation on Number of Purchasers. There are no more than or the issuer reasonably believes that there are no more than 35 purchasers of securities from the issuer in any offering under this Rule 505; provided, however, that if the issuer would be an investment company but for the exception in section 3(c)(1) of the Investment Company Act of 1940, then there are no or the issuer reasonably believes that there are no purchasers of securities from the issuer in any offering under this Rule.
4. Amendment to Rule 506(b)(2)(i) under the Securities Act of 1933, pursuant to Sections 19(a), 19(c), 3(b), 4(2), and 4(6) of the Securities Act of 1933
New Paragraph (b)(2)(i):
(ii) Limitation on Number of Purchasers. There are no more than or the issuer reasonably believes that there are no more than 35 purchasers of securities from the issuer in any offering under this Rule 506; provided, however, that if the issuer would be an investment company but for the exception in section 3(c)(1) of the Investment Company Act of 1940, then there are no or the issuer reasonably believes that there are no purchasers of securities from the issuer in any offering under this Rule.
Effects of Inflation over Time
The accredited investor definition includes several dollar thresholds. In April, 1982, the natural person thresholds were set at a net worth of $1 million or total income of $200,000. An additional threshold was set in April of 1988 at joint total income of $300,000. The nominal value of these limits has not changed in the ensuing years, notwithstanding the effects of inflation.
The effects of inflation can be measured by the Consumer Price Index ("CPI"). The CPI measures the changes in prices of all goods and services purchased for consumption by U.S. households. The table below lists the dollar limitations of Regulation D as of the date of their enactment and today's equivalent dollar amount based on the CPI.21
Net Worth Minimum
Based on the CPI, to purchase on April 30, 2003 the same amount of goods or services that could be purchased for $5 million back on June 30, 1982, nearly $10 million would be needed. Similarly, it would require nearly $2 million to purchase what $1 million would have purchased when Regulation D was enacted. Other measures of the value of money over time also show similar results. The Employment Cost Index ("ECI") is a measure of the change in the cost of labor, free from the influence of employment shifts among occupations and industries. The table below lists the dollar limitations of Regulation D as of the date of their enactment and today's equivalent dollar amount based on the ECI.22
Net Worth Minimum
ENDNOTES FOR WHITE PAPER ON INCREASING FINANCIAL ELIGIBILITY
STANDARDS FOR INVESTORS IN HEDGE FUNDS
1 Section 3 of the Securities Act, for example, provides exemptions for government securities, national bank securities, commercial paper, securities issued by non-profit organizations, securities issued by specified building and loan associations, securities issued by a farmers' cooperative, securities issued by common carriers and certificates in bankruptcy proceedings among others. In addition, Section 4 of the Securities Act provides exemptions for transactions by any person other than an issuer, underwriter, or dealer, transactions by an issuer not with or through an underwriter and not involving any public offering, and unsolicited broker's transactions among others.
2 Securities Act Release No. 285 (Jan. 24, 1935).
4 SEC v. Ralston Purina Co., 346 U.S. 119 (1953).
5 See id. at 125.
6 Rule 146(d)(1) required that an issuer have reasonable grounds to believe and shall believe: (1) Immediately prior to making any offer, either: (i) that the offeree has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or (ii) that the offeree is a person who is able to bear the economic risks of investment; and (2) Immediately prior to making any sale, after making reasonable inquiry, either: (i) that the offeree has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or (ii) that the offeree and his offeree representative(s) together have such knowledge and experience in financial and business matters that they are capable of evaluating the merits and irks of the prospective investment and that the offeree is able to bear the economic risk of the investment.
7 The Commission believed that such an individual, by virtue of his or her position with the issuer, would have access to information necessary for him or her to make an informed investment decision about the issuer's securities.
8 Congress, by this point, was considering the Small Business Investment Incentive Act of 1979, which was enacted in 1980. That legislation defined and used the term "accredited investor." See infra note 11 and accompanying text.
9 If on the other hand, there were no more than 35 purchasers of each issue of the securities, excluding any accredited persons, then the limited disclosures specified in Rule 242(f) had to be given in writing to non-accredited purchasers of the securities during the transaction and prior to sale. Securities Act Release No. 6121 (later codified at 17 C.F.R. § 230.242(e)). In addition, if accredited purchasers were involved in the transaction as well, they were entitled to any information available to non-accredited purchasers.
10 In addition, Congress increased the Commission's authority to exempt small offerings from the registration requirements. Instead of offerings at or below $2 million, the Commission now had the authority to exempt offerings of up to $5 million under Section 3(b).
11 Securities Act § 2(15). The Section 4(6) definition was similar, but not identical to, Rule 242's "accredited person" definition. Congress omitted the $100,000 purchaser and the director and executive officer portions of the Rule 242 definition.
12 H.R. Rep. No. 96-1341, at 20 (1980).
13 See id. and supra note 6.
15 The joint-income test at the $300,000 level for accredited investor status was not added until 1988. Securities Act Release No. 6758 (March 3, 1988).
16 An Analysis of Regulation D, Fed. Sec. L. Rep. (CCH) 83,631 (May 1984).
17 Id. The study's conclusions included the following:
18 Santa Barbara Sec., SEC No-Action Letter (Mar. 8, 1983). The SEC staff will not issue no-action letters under Section 3(c)(1) unless an offering complies with Rule 506. STARS & STRIPES GNMA Funding Corp., SEC No-Action Letter (Dec. 19, 1985).
19 See also Division of Investment Management, SEC, Protecting Investors: A Half Century of Investment Company Regulation (1992) ("the Division believes the ability to evaluate on regulated investment companies requires a high degree of sophistication").
20 Because hedge funds relying on Section 3(c)(7) of the Investment Company Act may sell their securities only to "qualified purchasers", a more restrictive definition than accredited investor, it would not appear to be necessary to amend the definition of "accredited investor" for such issuers.
21 U.S. Department of Labor, Bureau of Labor Statistics, Consumer Price Index, available at ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt.
22 U.S. Department of Labor, Bureau of Labor Statistics, Employment Cost Index Data, available at ftp://ftp.bls.gov/pub/time.series/ec/ec.data.1.AllData.