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Hedge Fund Regulation Redux

Ventures and Intellectual Property Group Letter

First Quarter 2007

Authors: Donna L. Brooks

As we previously reported in our Third Quarter 2006 VIP Letter, the Court of Appeals for the D.C. Circuit in Phillip Goldstein, et. al v. SEC struck down the SEC’s previous attempt to regulate hedge funds as "beyond the bounds of reasonableness." The prior "Hedge Fund Rule" would have required counting each investor in a hedge fund as a client of the investment adviser to the fund (rather than just the fund itself), necessitating the registration of many hedge fund advisers with the SEC. Undaunted by the court’s ruling, the SEC has taken a somewhat different tack and proposed new rules which would not only impact hedge funds but all pooled investment funds. The SEC has proposed an anti-fraud rule, Rule 206(4)-8, that would prohibit advisers to investment companies and other pooled investment vehicles from (i) making false or misleading statements to investors or prospective investors in those pools, or (ii) otherwise defrauding them. The SEC would enforce the rule through administrative and civil actions against advisers under Section 206(4) of the Investment Advisers Act. The rule would prohibit false or misleading statements made, for example, to existing investors in account statements as well as to prospective investors in private placement memoranda, offering circulars, or responses to "requests for proposals." The proposed rule would apply to any investment adviser to a pooled investment vehicle, including advisers that are not registered or required to be registered under the Advisers Act. The new antifraud rule would apply to all advisers regardless of the investment strategy they employ, or the structure of the type of pooled investment vehicle they manage. As a result, the rule would apply to investment advisers subject to Section 206 of the Advisers Act with respect to all pooled investment vehicles that they advise, such as hedge funds, private equity funds, venture capital funds, and other types of privately offered pools that invest in securities, as well as investment companies that are offered to the public.

The other rules that the SEC has proposed address who is an appropriate investor in a hedge fund. The currently existing exemption from securities registration that most private funds rely on in selling interests in the funds is Rule 506 under Regulation D pursuant to which sales to "accredited investors" are exempt. Among other things, "accredited investors" include a natural person whose individual net worth, or joint net worth with the person’s spouse, exceeds $1,000,000 at the time of the purchase, or whose individual income exceeds $200,000 (or joint income with the person’s spouse exceeds $300,000) in each of the two most recent years and who has a reasonable expectation of reaching the same income level in the year of investment. These dollar standards have not changed since 1982, and many more people now satisfy them in large measure due to the value of their personal residences which some would argue does not indicate any level of investment savvy when it comes to investing in securities. Adjusted for inflation, these standards would have been approximately $1.9 million (net worth), $388,000 (individual income) and $582,000 (joint income) as of July 1, 2006. The SEC has proposed Rules 509 and 216 which would define a new category of accredited investor ("accredited natural person") that would apply to offers and sales of securities issued by certain private investment vehicles pools. An "accredited natural person" would need to satisfy the traditional definition of an accredited investor, and such person must also own at least $2.5 million in investments (as adjusted every five years for inflation), which would exclude the person’s residence. These proposed rules are not intended to apply to venture capital funds by exempting from the rules "business development companies" as defined in the Advisers Act. However, this definition has been seldom equated to what the industry would characterize as venture capital funds.

Any number of the elements of the proposed rules continue to be controversial. Many have provided comment letters to the SEC in response to the many questions posed by the SEC in the proposing release. The comment period has closed, and we will have to stay tuned for the final rules and any legal challenges to them.

Donna Brooks is a partner in the Business and Finance practice.

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