New Definition of Accredited Investor: VC Funds Not Included

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

The definition of accredited investor is scheduled to be revised in the case of private equity and hedge funds.

The Commission was obviously frustrated by the Court of Appeals decision in Goldstein, which vacated its rule intended to regulate hedge funds as Investment Advisers under the 1940 Act. The Commission continues to feel that the investing public needs protection. Therefore, a laundry list of proposals is likely to emanate from the Staff, the first being Release No. 33-8766 (Dec. 13, 2006). The Release proposes that, in view of inflation since the "accredited investor" standard for natural persons was adopted in 1982, Rules 509 and 216 should be amended to upgrade the definition of "accredited investor" for purposes of the sale of securities by a private equity funds (which the Commission refers to as "Private Investment Pools") in reliance on Reg. D, [1] increasing the net worth test to $2.5 million in investment assets from $1 million in net worth, the current net worth test in Rule 501(a) [2] The proposal goes half way towards the $5 million test in 3(c)(7) of the Investment Company Act of 1940, for Qualified Purchasers.Personal residence is not considered an investment for this purpose, of course.

The surprisingly novel aspect of the proposed rule is that it would not apply to venture capital funds, as defined in Section 202(a)(22) of the Investment Advisers Act. the definition of Business Development Company. For venture capital funds, this will bring back a number of funds which had thought they had escaped the "significant participation" test under ERISA, and the concommitant requirement to exempt themselves as Venture Capital Operating Companies . when the 2006 Pension Protection Act took out of the equation investments by state and municipal pension funds and offshore funds . i.e., not otherwise subject to ERISA. By borrowing a definition from the Business Development Company amendments in 1980 to the Investment Company Act, the Commission reintroduces the idea of managerial assistance by the fund in order to qualify itself for exempt status . in this case incorporating the notion that, to take advantage of the old (i.e., amended) accredited investor definition, the venture fund (vide the Business Development Company) must offer managerial assistance to 60% (vs. 70% in the Investment Company Act) of its portfolio.See Release No. 33-876, fn 69.

There are additional bells and whistles, as described in a recent Shearman & Sterling memorandum. [3]

"The proposal does not grandfather natural persons who currently hold investments as accredited investors. If such an investor wishes to make future investments in private investment vehicles, even in vehicles in which such investor currently holds securities, it appears the investor will have to satisfy the new $2,500,000 threshold for accredited natural persons.

"The proposed rules also do not address whether employees of pooled investment vehicles or their managers must satisfy the new criteria for accredited natural persons. This is notwithstanding the fact that many private investment vehicles currently offer their securities to such employees who do not meet the accredited investor criteria. In the Release, the SEC recognized that these investments can currently be made, without requiring employees t be accredited natural persons, in one of four ways: (1) in reliance on Rule 506, which allows, with certain requirements, up to 35 non-accredited purchasers; (2) in an offering pursuant to Section 4(2) of the Securities Act; (3) in reliance on Rule 701 under the Securities Act, which provides a registration exemption for offers and sales of securities to certain natural persons pursuant to certain compensation arrangements; or (4) pursuant to employment contracts that are not directly subject to federal securities regulation. These four exceptions from the accredited investor standard remain undisturbed."

[1] And Section 4(6).

[2] And Rule 215, which applies to offerings which are exempt under Section 4(6), versus 4(2), of the `33 Act, applying to small issuers offering no more than $5 million of securities and not engaging in general solicitation). See "SEC Proposes New Rules" Shearman & Sterling Client Publication (Jan. 22, 2007).

"An investor who invests in a private investment vehicle solely on his or her own behalf may include only 50% of any investments held jointly with a spouse. If the investment in the private investment vehicle is made jointly with a spouse, alljoint investments may be counted toward the threshold. Any real estate that is not held for investment purposes is excluded from the calculations. This includes real estate used for personal purposes or as a place of business or held in connection with a trade or business. Investments would be valued based on their fair market value on a per-investment basis, meaning a new valuation of even highly illiquid investments is required at the time of each new investment in a 3(c)(1) issuer."

[3] Ibid .

Joseph W. Bartlett, Special Counsel,

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