The Securities and Exchange Commission held an open meeting on December 13, 2006, to consider, among other things, certain regulatory changes affecting investments in hedge funds and also affecting mutual fund governance.
Hedge Funds
The continuing focus on regulatory changes affecting the hedge fund industry follows the decision this past summer of the U.S. Court of Appeals in Phillip Goldstein, et al. v. SEC, which overturned the SEC’s 2004 rule requiring many advisers to hedge funds to count investors in the funds for purposes of determining if registration as an investment adviser is required.
At the meeting, the SEC Commissioners unanimously approved a proposed rule to apply an "enhanced accredited investor" standard for individuals that invest in certain privately offered funds which rely on the Section 3(c)(1) exemption from registration under the Investment Company Act of 1940. The Staff of the SEC noted that the enhanced accredited investor standard would not apply to individual investors in venture capital funds in light of the critical role such funds play in the initial capitalization of small business in the United States. There were no further comments as to whether other types of privately offered funds would be excluded from the enhanced standards.
The enhanced accredited investor standard will require individuals to be both "accredited investors" under the existing standards and own not less than $2.5 million in investments (as currently defined in the Investment Company Act for purposes of the Section 3(c)(7) exemption) on the date an investment is made. The current accredited investor standards, which were adopted in 1982, require an individual to have a net worth, or joint net worth with his or her spouse, in excess of $1 million or have income in excess of $200,000 in each of the past two years, or joint income with his or her spouse of more than $300,000 in each of those years, and a reasonable expectation to reach the same income levels in the current year. The proposed rules do not affect these amounts, but the staff of the SEC noted increases in these amounts are being considered. An individual investing jointly with his or her spouse may count investments held jointly to meet the $2.5 million investment requirement. If the enhanced accredited investor standard becomes effective, it would apply to all future investments by an ADMDOCS/191826.1 individual in certain 3(c)(1) funds, even if such investor had invested in the fund prior to the effectiveness of the rule. The proposed rule also provides for an inflation adjustment on April 1, 2012 and every five years thereafter.
The Commissioners also unanimously approved a proposed rule under Section 206(4) of the Investment Advisers Act of 1940 to prohibit a registered or unregistered investment adviser from making false or misleading statements to investors in any pooled investment vehicles it manages, including hedge funds. This new anti-fraud rule would have the effect of looking through a fund to its investors (reversing a side-effect of the Goldstein decision). The new antifraud rule would not provide individual investors with a private right of action against advisers that engage in fraudulent behavior.
Following the release of the proposed rules, the public will be afforded an opportunity to comment before the rules become effective.
Mutual Fund Governance
The SEC also unanimously decided to reopen the comment period regarding the proposed adoption of two key mutual fund governance provisions. In 2004, the SEC adopted rule amendments that conditioned reliance on commonly used exemptions under the Investment Company Act of 1940 upon compliance with a number of governance requirements, including, among others, requirements that a mutual fund’s board have no fewer than 75 percent independent directors (two-thirds, if the board has only three members) and that the board have an independent chair. These two requirements proved quite controversial and were the subject of a court challenge by the U.S. Chamber of Commerce. In April 2006 the U.S. Court of Appeals for the District of Columbia Circuit determined that the SEC had violated the Administrative Procedure Act in adopting the requirements by relying on information outside its rulemaking record without affording an opportunity for public comment. The Court vacated the requirements, but allowed the SEC to reopen the rulemaking record for comment.
In June 2006, the SEC requested additional comments on both the 75 percent independent director requirement and the independent chair requirement. In the release requesting comments, the SEC particularly sought comments on the costs associated with the two requirements, but also asked for suggestions for additional provisions designed to achieve the protection of funds and fund shareholders. In connection with reopening the comment period, we understand that the SEC decided to publish economic analyses of mutual fund governance and independence issues by the SEC Office of Economic Analysis.
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