In June 2006, the US Federal Court of Appeals for the District of Columbia struck down the SEC’s hedge fund registration rule in its ruling in Phillip Goldstein, et. al. v. Securities and Exchange Commission, on the basis that the SEC exceeded the scope of its legislative authority in implementing certain aspects of the rule. Before being overturned by the Court of Appeals, the hedge fund registration rule, which was issued under the US Investment Advisers Act of 1940 (the Advisers Act) and came into effect on 1 February 2006, required most hedge fund managers, including non-US hedge fund managers, that had more than 15 US investors in their funds to register with the SEC. In August 2006, the SEC announced that it would not appeal the Court’s decision.
In December 2006, the SEC issued two sets of proposed rules designed to protect hedge fund investors and enhance its ability to bring enforcement actions against hedge fund managers. If implemented, these rules would increase the net worth requirements for individual investors in hedge funds that rely on the exemption from registration with the SEC provided by Section 3(c)(1) of the US Investment Company Act of 1940 (1940 Act) and would expand the anti-fraud provisions of the Advisers Act to cover investors in hedge funds.
Proposed Rules 509 and 216 under the US Securities Act of 1933 (1933 Act) would raise the ‘accredited investor’ standard for individuals who invest in 3(c)(1) funds (other than venture capital funds) to $2.5 million in investments. In order to rely on a Section 3(c)(1) exemption from registration under the 1940 Act, a fund must be privately offered to investors. In most cases, funds rely on the safe harbour provided by Regulation D under the 1933 Act when conducting their private offerings. One of the criteria for a Regulation D private placement is for the offering to be made primarily to ‘accredited investors.’ Under the current definition of ‘accredited investor,’ natural persons must either have an annual salary of $200,000 ($300,000 with spouse) for the past two years and a reasonable expectation that his or her salary will remain above this threshold, or $1 million in net worth, including the value of any real estate owned by the individual.
The SEC has taken the view that the ‘accredited investor’ standard, which was put in place in the early 1980s based upon income standards at the time, is no longer adequate to protect individual investors in 3(c)(1) funds. Under the proposed rules, in addition to the current income or net worth requirement for ‘accredited investors,’ individual investors in 3(c)(1) funds would need to own at least $2.5 million in investments. The proposed rules do not include any ‘grandfathering’ provision and if adopted as currently drafted, would require 3(c)(1) funds to evict individual investors who did not meet the higher ‘accredited investor’ standard.
Proposed Rule 206(4)-8 under the Advisers Act would expand the protections of the anti-fraud provisions of the Advisers Act to cover investors in investment pools, such as hedge funds and private equity funds. The anti-fraud provisions of the Advisers Act apply to both registered and unregistered investment advisers, including non-US managers to the extent that they have US investors in their funds.
Traditionally, the SEC has relied on the anti-fraud provisions of the Advisers Act, among other things, to bring enforcement actions against registered and unregistered investment advisers for defrauding investors in investment pools such as hedge funds.
The Court of Appeals ruling in Goldstein, which found that the SEC did not have the authority to expand the definition of ‘client’ as used in the Advisers Act to include investors in private funds, has called into question whether the SEC can continue to rely upon the anti-fraud provisions of the Advisers Act to protect investors in investment pools. To address this concern, the SEC has proposed Rule 206(4)-8 under the Advisers Act, which would make it unlawful for both registered and unregistered investment advisers to make false or misleading statements of material facts to investors in investment pools or to otherwise defraud investors in investment pools.
The SEC has brought a number of enforcement actions against hedge fund managers for insider trading over the past few years and continues to make investigating insider trading by hedge funds a priority. Many of these enforcement activities focus on trading relating to PIPE (private investment in public equities) transactions. Recent activity indicates that the SEC is also focusing on service providers to hedge funds, such as Wall Street consulting firms and brokerage firms.
One of the most publicised cases of insider trading by a hedge fund manager in connection with a PIPE transaction involved Hilary Shane. In May 2005, the SEC filed a civil enforcement action against Shane alleging that she engaged in short selling shares of CompuDyne based upon material non-public information of an upcoming PIPE offering. According to the SEC, Shane, who had purchased unregistered shares of CompuDyne for herself and the hedge fund she managed through a PIPE transaction, engaged in short selling the publicly listed shares of CompuDyne before the announcement of the PIPE transaction with the expectation that the value of the shares would decline upon the announcement of the PIPE offering. Shane settled with both the SEC and NASD for more than $1.2 million without admitting or denying the allegations against her and was banned from the brokerage industry for life. In September 2006, the SEC filed criminal charges against Shane for which she entered a plea of ‘not guilty.’
Recently, both the SEC and the New York Attorney General’s Office have started to separately investigate whether Wall Street consulting firms, such as Gerson Lehrman Group and Vista Research, are facilitating the transfer of insider information to their clients, many of which are hedge funds. These firms connect their clients with industry insiders to assist their clients with gathering information on particular industries and perhaps companies. The regulators appear to be concerned that the information being passed on to the consulting firms’ clients may constitute material non-public information and that hedge funds and others may be trading on this information.
Finally, in what may be the biggest case of insider trading on Wall Street since the 1980s, at the beginning of March 2007, the SEC announced criminal and civil actions against 11 people, 2 hedge funds and a proprietary trading firm for insider trading. The SEC has alleged that the insider trading scheme involved insiders at UBS and Morgan Stanley who passed on insider information to a number of individuals, who then traded on this information on behalf of themselves and their clients, including hedge funds.
While hedge funds remain largely unregulated in the United States, the SEC continues to increase its scrutiny of hedge funds and their trading practices. The SEC’s proposed rules, while modest, are intended to address the SEC’s most pressing concerns regarding the protection of investors in hedge funds. In addition, the SEC’s recent enforcement activities and investigations into the trading practices of hedge funds demonstrate the Commission’s increased focus on policing potential market abuses by hedge fund managers.