SEC hears an earful on hedge fund change
Sunday, March 11, 2007
Does wealth equal market intelligence?
Can you be middle class and financially savvy?
That's the debate raging on -- of all places -- the Securities and Exchange
Commission Web site.
In late December, the SEC proposed steeply raising the amount of assets
investors need to participate in what it calls pooled investment vehicles,
including many hedge funds.
Since 1982, to invest in these unregistered and largely unregulated
vehicles, an individual or married couple has needed at least $1 million in net
worth or a certain amount of annual income -- $200,000 in each of the past two
years for individuals or $300,000 for couples. Had those amounts been indexed
for inflation, they would have nearly doubled by now. The rule does not exclude
home equity from net worth.
Under the proposed rule, individuals or married couples would have to meet
the old standard plus a new one. They would also have to have at $2.5 million
in "investment assets" -- excluding equity in a home or business
property -- to qualify as an accredited investor eligible to participate in
many private offerings.
These rules are designed to protect unsophisticated investors from the added
economic risk of private offerings.
Any company that offers securities to the public must register them with the
SEC and provide continuing disclosures about their performance, fees,
management and other issues. There are certain exceptions to this requirement.
One is if the securities are offered to no more than 35 non-accredited
investors. Congress gave the SEC the authority to decide who qualifies as an
accredited investor.
Although the proposal was not expected to create much of a stir, the SEC had
received more than 500 responses as of Friday, the public comment deadline.
They are posted at sec.gov/comments/s7-25-06/s72506.shtml.
Almost all of the comments were critical of the new rule. An overwhelming
number came from individuals and a large number said, essentially, that being
rich doesn't make you smart.
"To discriminate based on race, creed, sex is illegal. To discriminate
based on assets should also be illegal. If you want the public to be protected
from bad investments, then a test should be implemented. ... But
to simply say that the rich are smarter than the poor is elitist propaganda.
I find it absurd that a person born into wealth, with no education or training
in investments, is considered more qualified than a college professor in
economics just because of their assets," wrote Daniel Figueroa.
Stephen Bruhn of
Bruhn told me he invests in private-placement real estate notes. He would
not qualify for these notes under the new standard. The notes pay about 15
percent interest and provide interim financing to developers of condos, town
homes and subdivisions.
Seth Stafford, a software manager from San Carlos, told the SEC, "There
is no intrinsic reason to deny access to major investment opportunities at an
arbitrary dollar net worth threshold as the world has its share of
poor-but-smart or wealthy-but-dumb investors who are ill-served by such
distinctions."
"I think a simple dollar qualification is kind of reminiscent of a poll
tax," he said. "It's kind of un-American to say you have to have this
much money in the bank to do something."
Jim Price, a retired airline pilot from
"Overall I've done better on my own than investing in hedge
funds," he told me. Nevertheless, he told the SEC, "I do agree with
the concept of limiting hedge funds to somewhat more sophisticated investors. I
would think that $1,000,000 in investment assets or $1,500,000 including home
equity would be sufficient."
Quite a few asked the SEC to make an exception for smaller investors who
work through professional financial advisers.
"It is difficult enough these days to have your money grow without this
additional interference from the Federal Government," wrote Kenneth Lagana of
Under the proposed rule, people who already invest in hedge funds or other
private offerings but would not qualify under the new rule would not have to
sell their holdings. But they couldn't add to their positions or invest in any
new private offerings.
"Some commenters asked for a broader grandfathering
clause," says Anita Krug, an attorney with Howard Rice Nemerovski
Canady Falk & Rabkin.
While hedge funds are generally considered riskier than public securities,
some people who commented pointed out that some funds pursue strategies
designed to reduce risk and cushion losses during market downturns.
The proposed rule exempted investments in venture capital funds from the new
$2.5 million requirement.
"Venture capital funds historically have provided a benefit to
Some people, including hedge fund managers, questioned that exception for
venture capital.
James Chanos, writing on behalf of the Coalition
of Private Investment Companies, said, "This rationale does not relate in
any way to the stated motivation for this proposed rule change, which is to
ensure that potential investors are able to understand and withstand the risks
of an investment. Indeed, the commission has not identified any reason to
believe that business development (venture capital) companies are any less
risky or difficult for an investor to analyze than (a hedge fund). On the
contrary, such issuers are frequently non-diversified companies that feature a
high degree of risk."
The rule also would not apply to firms that offer securities to more than
100 people. These firms already must restrict their offerings to investors that
meet even higher standards. They are typically large hedge funds that cater to
institutions and very rich individuals.
Another concern is what would happen to competition and fees. When hedge
funds start up, they typically must rely on investments from smaller investors.
Prohibiting such investors from putting money in hedge funds would erect new
barriers to entry, perhaps protecting existing firms, and their fees.
Despite all the comments, Krug says, "I think the SEC will issue a
final rule that looks fairly similar to the proposed rule."
In 1982, according to the SEC, 1.9 percent of the