The SEC has proposed rules that raise the hurdle investors must meet in order to enter the world of hedge funds. The proposed rules also seek to create a new anti-fraud provision under the Investment Advisers Act of 1940, which would apply to managers/investment advisers to pooled investment vehicles. These proposed rules were presented by the SEC during an Open Meeting which took place on Wednesday, December 14,2006.

The presentation of these new proposed hedge fund rules has been eagerly anticipated, and expected, after the D.C. Circuit Court Decision, Goldstein v. SEC, struck down a rule earlier this year which would have required most hedge fund managers to register with the SEC.

In the wake of the Goldstein decision, it was widely believed that the SEC would not move to appeal this decision. Rather, it was expected that the SEC would move quickly to develop new proposed rules to address certain concerns about the hedge fund industry. Specifically, subsequent to the Goldstein decision SEC Chairman Cox warned that hedge funds were too risky for “mom and pop” type investors and commented that the increasing use of hedge funds by so-called retail investors carried with it the potential for retail exposure to hedge fund risk.

The two (2) new proposed hedge fund rules the SEC has presented for comment are as follows: 

    An anti-fraud provision under the Advisers Act of 1940 which would make it a fraudulent, deceptive or manipulative act, practice or course of business for an investment adviser to a pooled investment vehicle to make false or misleading statements or to otherwise defraud investors or prospective investors in that pool. The rule would apply to all investment advisers to pooled investment vehicles, regardless of whether the adviser is registered under the Act. Under the proposed rule, a pooled investment vehicle would include any investment company and any company that would be an investment company but for the exclusions in section 3c-1 or 3c-7 of the Investment Company Act of 1940.

Commentary during the SEC Open Meeting confirmed that this proposed anti-fraud rule will not give rise to private right of action

The proposed rule does not seek to impose any specific disclosure obligations upon investment advisers to pooled investment vehicles.

    The second proposed rule involves amendments to private offering rules under the Securities Act of 1933 which would define a new category of accredited investor that would apply to offers and sales of securities issued by hedge funds and other private investment pools to natural persons, but would not apply to venture capital funds. The proposed definition would include any natural person who meets either the net worth test or income test specified in Rule 501(A) or rule 215 (i.e., the current Accredited Investor test) AND owns at least $2.5 million in investable assets, as to be defined in the proposed rules. 

How will this proposed rule affect those investors who are already invested in hedge funds and will there be a “grandfather clause” provision? Based upon commentary provided during the SEC Open Meeting, the new test is meant to apply at the time an investor makes an investment in a pooled investment vehicle. Accordingly, investors who are already invested in private/hedge funds will not necessarily be affected, but may be affected to the extent they wish to make additional contributions to their existing hedge funds or any others. Thus, there appears to be a somewhat limited “grandfather clause” in the new proposed rule.   

The proposals will be published in the Federal Register and open to public comments over a sixty (60) day-period before a final policy is adopted.   

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