SEC hits hedge fund regulatory hurdle

WASHINGTON — A proposal to provide tougher qualification standards for investing in hedge funds and other alternative investments has proved to be so controversial that the Securities and Exchange Commission may have to alter the plan or scrap it altogether. That is the assessment of industry observers about the proposal, which was first introduced in December by the SEC. The SEC last week approved another part of the proposed regulation clarifying its anti-fraud authority over all pooled-investment funds, including hedge funds, private-equity funds and mutual funds. However, the agency indefinitely delayed action on the part of that original proposal that would raise wealth qualifications for private-investment pools. “The commission recognized that the proposal raised a broader question of what standard investors need to be eligible for other types of alternative investments,” said Barry Barbash, a partner in the Washington and New York offices of New York law firm Willkie Farr & Gallagher LLP. The proposal made in December would require “accredited investors” in private-investment pools to have at least $2.5 million in assets, excluding the value of their primary residence. Currently, those investors need $1 million in assets, including the value of their home, to invest in private pools. The $1 million standard has stood since 1982. The proposal would make millions of investors ineligible to continue investing in such areas as real estate, and oil and gas limited partnerships, in addition to hedge funds. “What’s happened is, the commission recognized that the undertaking needs to be broader,” said Mr. Barbash, who represents hedge funds and who was director of the SEC’s division of investment management from 1993 to 1998. He predicted that the SEC will now look at wealth qualifications for other types of pooled investments. That worries financial advisers who deal with individual investors. These advisers currently use hedge funds and other alternative investments to diversify their clients’ assets and provide better returns than mutual funds. Under the proposal, “the vast majority of our clients would be unable to purchase private securities,” said Brian Dietz, a principal of Portland (Maine) Financial Planning Group LLC. “You’re shutting down all kinds of perfectly appropriate types of investments for accredited investors,” he said. Investments in real estate and energy limited partnerships in recent years have provided high returns that are not correlated with market downturns, Mr. Dietz said. The minimum-threshold plan has apparently enraged some investors, who earlier this year wrote letters to the SEC arguing that setting such a high bar would deprive them of investment opportunities. SEC officials would not comment on what they plan to do with the proposal, which received hundreds of comments in opposition. Industry officials, meanwhile, watching the progress of the proposal, believe that the high level of dissent surrounding it — which came primarily from hedge fund investors, operators of smaller hedge funds and financial advisers who work with retail customers — will mean that the SEC is going to have to start anew. “They might re-propose it,” predicted Karen Barr, general counsel for the Investment Adviser Association in Washington, which represents SEC-registered advisers, some of whom advise hedge funds. More than 1,900 investment advisers to hedge funds are registered with the SEC, but not all hedge fund advisers are required to be registered. The SEC usually proceeds from a proposal to finalizing a rule, as it did last week with the anti-fraud part of the December proposal. A re-proposal is done only on occasions where the agency is having difficulty achieving enough agreement to craft a rule. The key issue, Ms. Barr said, is harmonizing the different qualifications SEC regulations require for investments in high-end securities. There are at least six current qualification standards, she said. The proposal made in December, raising qualifications for private investments to $2.5 million in net assets, would add yet another definition for “accredited natural persons.” “What they’re considering doing is looking at harmonizing at least some of these standards instead of having all these fragmented definitions,” Ms. Barr said. The IAA has proposed that the standards used to determine whether a person can invest in private-investment pools should be the same as the “qualified client” definition used to determine whether an adviser can charge performance fees, as most hedge fund managers do. “The SEC perhaps has realized maybe the more appropriate approach would be to rethink the accredited-investor criteria across the board for all private investments, and not single out hedge funds,” said Mitch Nichter, a partner in the San Francisco office of Los Angeles law firm Paul Hastings Janofsky & Walker LLP. He represents hedge funds and investment management companies. Other industry officials are predicting that the accredited-investor proposal may die altogether. “We think it’s going to be scrapped,” said one hedge fund industry official, who asked not to be identified. Advisers whose businesses would be affected by the proposed rule would likely welcome such an occurrence. “My concern initially was, they were targeting hedge funds, but the way the standard looked, it was going to be for everything that required accreditation,” said John Schooler, president of WFP Securities Corp., a San Diego company that operates a registered investment advisory firm and a broker-dealer that uses real estate, and oil and gas drilling partnerships, as investments. “There are all these things out there to help regular investors who are high net worth,” he said. If the proposal were finalized as a regulation, “they would lose the ability to do those kinds of investments,” Mr. Schooler said. “It would be a real shame.”