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SEC Changes Accredited Investor Definition Again PDF Print E-mail

SEC Changes Accredited Investor Definition Again

By David Mainzer

January 2012

Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which was passed in July, 2010, required the Securities and Exchange Commission (the “SEC”) to change the definition of who is an “accredited investor” for the purposes of Regulation D (“Reg. D”) under the Securities Act of 1933 (the “Securities Act”).  Within the investment management industry, the primary effect of this provision was to require hedge funds, private equity funds and venture capital funds (collectively, “Private Funds”) to change their fund offering process to ensure that new investors satisfy the changed definition.

Prior to the passage of the Dodd-Frank Act, the accredited investor definition included as accredited investors “any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000.”  Section 413(a) of the Dodd-Frank Act effectively changed this definition to exclude the value of a person’s primary residence from their net worth in making the determination of whether their net worth exceeds $1 million.  Shortly thereafter, the SEC issued guidance to allow investors to disregard any mortgage debt secured by their primary residence, unless the amount of the mortgage debt exceeds the fair market value of the primary residence.  If the amount of the mortgage debt exceeds the fair market value of the primary residence, then the prospective investor is required to deduct the amount of such excess from their net worth in determining whether they are an accredited investor.

Effective on February 27, 2012, the SEC has made a further refinement to this set of rules.  The change creates a second level of inquiry regarding mortgage debt secured by a potential investor’s primary residence.  The effect of this is that any increase in primary residence mortgage debt incurred within 60 days prior to the determination of whether someone is an accredited investor (e.g. within 60 days prior to their completion of the subscription documents for a private fund) will also now be deducted from a person’s net worth for the purposes of the accredited investor definition, unless the increase was in connection with the acquisition of the primary residence.  This is the case regardless of whether the then increased amount of debt exceeds the value of the residence.

One interesting effect of these provisions is that a person may be able to invest in a private fund one day, but then not able to invest in a private fund the next day simply because they bought a new house or refinanced their mortgage.  In the adopting release, SEC notes the concern that, without this new rule, investors “…may be incentivized (or urged by unscrupulous sales people) to take on debt secured by their homes for the purpose of qualifying as accredited investors and participating in investments without the protection to which they are entitled.”  Implicit in this line of regulation seems to be the assumption that people who have equity in their home are less able look after their own interests than people of equal means who pay rent.

The SEC has also adopted a grandfathering provision for certain investors that had existing rights to purchase securities on July 20, 2010.

Private Funds relying on Reg. D will generally need to ensure that investors that are natural persons meet the accredited investor definition as it has been changed.  This will typically require updating the investor questionnaire portion of the fund’s subscription documents and the permitted investors section of the fund’s private placement memorandum.

As the accredited investor definition is only relevant at the time an investor invests in a fund, Private Funds will generally not need to determine if their existing investors remain accredited investors after the change.  However, as it is possible that an existing investor will no longer be an accredited investor, Private Funds should ensure that existing investors complete a new investor questionnaire before accepting additional investments in the fund.  Private Funds that rely on Securities Act exemptions other than Reg. D (for example, offshore funds relying on Regulation S under the Securities Act) should not be affected by this change.

©2012 Spolin Silverman Cohen & Bosserman LLP (“SSC&B”).  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and SSC&B makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and SSC&B.
 
SEC Increases Qualified Client Thresholds PDF Print E-mail

By David Mainzer

August 2011

On July 12, 2011, the Securities and Exchange Commission (the “SEC”) adjusted Rule 205-3 under the Investment Advisers Act of 1940 (the “Advisers Act”) to increase the dollar amount thresholds necessary for a person to qualify as a “qualified client.”  These adjustments will become effective on September 19, 2011.  Rule 205-3 is an SEC rule that allows investment advisers to charge their clients performance based fees, which are otherwise prohibited by Section 205(a)(1) of the Advisers Act.  For hedge funds and other funds, investors in the fund must be qualified clients in order for the fund to be able to pay performance fees to the investment adviser.

Currently, SEC Rule 205-3(d)(1)(i) and (ii) provides that individuals and companies are qualified clients if either (a) they have $750,000 under the management of the investment adviser immediately after entering into the investment management agreement providing for the performance fees or (b) the investment adviser reasonably believes that they have a net worth (for a natural person, this includes assets jointly held with a spouse) of more than $1.5 million immediately prior to entering into the investment management agreement providing for the performance fees.

The changes made by the SEC will increase these amounts, such that individuals and companies will be qualified clients if either (a) they have $1 million under the management of the investment adviser immediately after entering into the investment management agreement providing for the performance fees or (b) the investment adviser reasonably believes that they have a net worth (for a natural person, this includes assets jointly held with a spouse) of more than $2 million immediately prior to  entering into the investment management agreement providing for the performance fees.

The SEC has also proposed changes to the qualified client definition that, among other things, would (a) increase the foregoing dollar amounts every five years to reflect inflation and (b) exclude the value of a natural person’s primary residence in determining whether they meet these thresholds.  The SEC is still considering these further changes.

Investment advisers will be required to update their compliance policies and procedures, by September 19, 2011, to ensure compliance with the changed rule.  For managers of hedge funds and other private funds, this will generally require updates to the funds’ subscription documents and private placement memoranda.

©2011 Spolin Silverman Cohen & Bosserman LLP (“SSC&B”).  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and SSC&B makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and SSC&B.
 
New FINRA Rule 5131(b) Requires Changes to Hedge Fund IPO Procedures PDF Print E-mail

By David Mainzer

July 2011

On September 26, 2011, the new FINRA Rule 5131(b) will come into effect.  FINRA Rule 5131(b) seeks to stop an underwriting practice called “spinning,” by generally prohibiting underwriters from allocating shares of an initial public offering of an equity securities (an “IPO”) to any hedge fund or other account in which executive officers or directors of certain public or non-public companies, or persons that are materially supported by these executive officers or directors, have a beneficial interest of greater than 25%.

Managers of hedge funds that intend to invest in IPOs will therefore be required to certify to the underwriters that their hedge funds are not prohibited accounts under FINRA Rule 5131(b).  This requirement is similar to the certifications that are currently required under FINRA Rule 5130.

In order to make the required certifications under FINRA Rule 5131(b), we expect that hedge funds will generally need to determine which of their investors are executive officers or directors of public or non-public companies, or persons that are materially supported by such executive officers or directors.   This will typically require (1) updating the investor questionnaire portion of the hedge fund’s subscription documents, to add a certification as to the investor’s status under FINRA Rule 5131(b), and (2) circulating an annual questionnaire to investors to update this certification.

With the September 26 deadline fast approaching, we recommend that hedge fund managers begin addressing these changes as soon as possible.



©2011 Spolin Silverman Cohen & Bosserman LLP (“SSC&B”).  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and SSC&B makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and SSC&B.
 
SEC Extends Registration Deadline for Hedge Fund and Private Equity Fund Managers PDF Print E-mail

By David Mainzer

June 2011

Managers of hedge funds and private equity funds currently are not required to register with the SEC as investment advisers if they come within the "private adviser exemption" from registration. The private adviser exemption is generally available to investment managers with fewer than 15 clients (each fund is typically treated as one client) that do not hold themselves out to the public. This is set to change pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, which eliminated the private adviser exemption effective July 21, 2011. As a result, a significant number of investment managers of hedge funds and private equity funds (i.e. those with fewer than 15 clients and $150 million or more in assets under management) will be required to register as investment advisers with the Securities and Exchange Commission (the "SEC").

With the July deadline approaching, on June 22, 2011, the SEC sensibly adopted a "transitional exemption" to allow the affected hedge fund and private equity fund managers sufficient time to register as investment advisers and put in place the necessary compliance infrastructure. As a result, hedge fund and private equity fund managers that have $150 million or more in assets under management, and currently come within the private adviser exemption, will have until March 30, 2012 to register as investment advisers with the SEC.

 

©2011 Spolin Silverman Cohen & Bosserman LLP ("SSC&B"). All Rights Reserved. Attorney Advertisement. This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation. This document may not be accurate, complete or up to date, based on the facts applicable to you, and SSC&B makes no representation or warranty that it is. Receipt or use of this article does not create any attorney-client relationship between the user and SSC&B.
 
CFTC Proposes Additional Registration Requirements for Hedge Fund Managers PDF Print E-mail

By David Mainzer

February 2011

This month, the Commodity Futures Trading Commission (the “CFTC”) announced that it is considering requiring a significant number of currently exempt hedge fund managers that trade in futures and commodity option products regulated by the CFTC to become “dual registrants.”   Dual registrants are required to register both as an investment adviser, with the Securities and Exchange Commission (the “SEC”), and as a commodity pool operator (a “CPO”), with the National Futures Association (the “NFA”).  The CFTC would accomplish this by eliminating two exemptions from the CPO registration requirements that are commonly used by hedge funds.

The following is a summary of certain parts of the proposed changes.  Note that these changes have not been enacted and the CFTC has not published a proposed timetable for their implementation.

CPO Exemptions

Currently, hedge fund managers may be exempt from registration as a CPO under one of two widely used exemptions: (a) the “limited trading exemption” under CFTC Rule 4.13(a)(3), which exempts managers of hedge funds that, among other things, limit the margin premiums required to establish the futures and commodity option positions to 5% of the fund’s net asset value; or (b) the “sophisticated investor exemption” under CFTC Rule 4.13(a)(4), which exempts managers of hedge funds that, among other things, require that each natural person investor in the hedge fund is a “qualified eligible person.”

As a result of the elimination of these two exemptions, many hedge fund managers that trade futures or commodity options, but are not currently required to be registered as CPOs, will be required either to register with the NFA as a CPO or else cease trading in these kinds of investments.

CTA Exemption

In addition to registration as a CPO, the manager of a hedge fund that trades in futures and commodity options is also subject to registration as commodity trading advisor (“CTA”) unless it comes within one of the exemptions from CTA registration.  Hedge fund managers that are exempt from CPO registration under the limited trading exemption and/or the sophisticated investor exemption are currently exempt from registering as CTAs under CFTC Rule 4.14(a)(8).  As a result, we expect that many hedge fund managers that are required to register as CPOs, because of the elimination of these two exemptions, will also be required to register as CTAs.

NFA Registration

Registration with the NFA (as a CPO and/or a CTA) is generally more time consuming and expensive than SEC registration as an investment adviser.  Hedge fund managers that register with the NFA are required to file Form 7-R for the manager and Form 8-R for each principal and associated person, and certain of the manager’s principals and other associated persons are required to pass the FINRA Series 3 examination.  The registration process can take 3 to 4 months.

Once registered as a CPO, the hedge fund manager becomes subject to the disclosure and reporting obligations in Part 4 of the CFTC Rules.  These include requirements that specific provisions must be included in the fund’s private placement memorandum, or otherwise disclosed to each investor, and acknowledged in writing by the investor.  The disclosure document must be filed with the CFTC and must be updated not less that once every nine months.  In addition, the CPO must provide specified annual reporting to investors and is subject to NFA/CFTC recordkeeping and regulatory examination requirements.

The CFTC is also currently proposing additional reporting requirements for CPOs that are dual registrants.  This is expected to include information about the hedge fund, including assets under management, use of leverage, counterparty exposure and trading and investment positions.  These requirements would be satisfied by filing Form PF with the SEC, with Part 1 due on an annual basis from CPOs with less than $1 billion under management, and Part 1 and 2 due on a quarterly basis from CPOs with more than $1 billion under management.

Conclusion

The CFTC has proposed to eliminate the limited trading exemption and the sophisticated investor exemption to CPO the registration requirements.  As a result, many hedge funds that trade futures or commodity options would be required to either register with the NFA as a CPO or else cease trading in these kinds of investments.  The CFTC has stated that the additional registration requirements are designed to limit regulatory arbitrage and increase transparency.  We expect that the elimination of these exemptions will, if enacted, aggravate the current increase in regulatory and compliance costs already impacting hedge funds.

 

©2011 Spolin Silverman Cohen & Bosserman LLP (“SSC&B”).  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and SSC&B makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and SSC&B.
 
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