SEC Hedge Fund Proposed Rule Release re Fraud and Accredited Investors

The SEC has released its full text (click to get it and likely an accompanying headache) on the proposed hedge fund rules regarding fraud and changes to accredited investor standards. The accredited investor standards change is likely to draw most of the attention - although there is kind of a nasty non-scienter catch (you don't have to "know" you are misleading investors) to the anti-fraud rules.

In case you've been on Mars lately (or have better things to do) the accredited investor standard is to be lifted from $1M in net worth (including home equity) or $200K income ($300K with spouse) as specified to adding an additional (sorry if I am being redundant but not if the SEC is) requirement of $2.5M in net worth exclusive of home equity.

In turn (using somewhat dated numbers) this-  per the SEC - will reduce the % of the US population qualifying as accredited investors from 8.4% of US households to 1.3% of US households.

The chief persons likely to quake in their boots at the new accredited investor rules are entrepreneurial (read "small") hedge funds who fear that they won't be able to recruit new investors meeting the much elevated $2.5 M net worth (ex home equity) standards of the new rules. Worse, for funds relying on the accredited investor standards, their old accredited investors might not be able to invest more capital in the funds if the investors don't meet the new accredited investor standards. Apparently, the rules at least are not retroactive, so old investors who don't meet the new standards don't have to be ignominiously booted out of such funds as being mere millionaires.

Before full panic sets in perhaps a few calming  (and hopefully relatively user friendly) if admittedly preliminary thoughts are in order.

1. The new rules are not final. There is to be an extensive public comment period lasting until March 9, 2007. It would be surprising if those comments did not result in at least some changes to the proposed rules - hopefully with some "relief" to entrepreneurial advisers. The SEC, for example, seems open in the name of an exclusion for "venture capital" funds to giving a "pass" from the new accredited investor standards to funds that will lock up investor capital for a stated minimum period (e.g. 2 years).

2. Provided heightened disclosure and other requirements of Reg D are met, hedge funds are still going to be able to accept up to 35 non-accredited investors (i.e. persons who don't have to meet for federal standards any minimum net worth or minimum income requirements) and still be within the non-registration safe harbor of Reg D.

3. For the truly bold funds (which often equates to the truly small) a reliance on the Section 4(2) (non-public offerings) registration exemption of the US Securities Act without the comfort of the safe harbor of Reg D may be a "risk" worth taking. For such funds, provided state law registration exemptions can at least arguably be obtained in the states where their individual investors reside, the $2.5M federal minimum net worth standard will not be a show stopper.

Stay tuned as there will be more - much more - on this forthcoming from all quarters. However, for now, I would not proclaim the small hedge fund dead.

Happy 2007.