The hedge fund industry supports proposed SEC regulations implementing Dodd-Frank provisions designed to prevent the dilution of the qualified client standard as a result of inflation and ensure that private funds are sold only to sophisticated investors; but asked the SEC to clarify the transitional relied for 3(c)(1) funds. In a letter to the SEC, the Managed Funds Association said that Section 418 of Dodd-Frank is well designed to achieve the anti-dilution goal by requiring the SEC to adjust the dollar amount tests under Section 205 of the Advisers Act for the effects of inflation within one year of the enactment of the Dodd-Frank Act, and every five years thereafter.
The MFA supports the SEC’s proposal to implement Section 418 by increasing the assets under management threshold in Rule 205-3 to $1 million and the net worth threshold to $2 million, and by issuing an order every five years to adjust the thresholds to account for inflation. The association also agrees with the proposed exclusion of the value of a natural person’s primary residence from the determination of a person’s net worth, since this would more closely align the calculation with the definition of “accredited investor” in Rule 501 under the Securities Act and “qualified purchaser” in Section 2(a)(51) of the Investment Company Act.
Similarly, the MFA strongly supports the proposed transitional relief designed to ensure that the new threshold levels do not apply retroactively and affect an investment adviser’s existing contractual arrangements. In particular, the MFA noted that the proposal would provide relief to hedge fund and private equity fund advisers that are currently exempt from registration with the SEC and will be required to register as a result of the amendments to the Advisers Act in Title IV of the Dodd-Frank Act. In the MFA’s view, this transitional relief, which is similar to the relief that the SEC provided in connection with the hedge fund manager registration rule in 2004, is necessary to allow advisers to continue to operate their businesses without significant disruption.
However, the MFA noted that the proposed transitional relief could affect the operations of a fund that relies on Section 3(c)(1) of the Investment Company Act and invests in another 3(c)(1) fund. Section 3(c)(1) exempts from registration a fund whose securities are owned by 100 or fewer persons and that is not making a public offering. The exemption is sometimes used by well-capitalized investment pools composed of sophisticated investors, such as hedge funds and venture capital funds.
In complying with Rule 205-3, noted the MFA, a 3(c)(1) fund must look through another 3(c)(1) fund that is an equity owner of the fund to its individual investors. Under this look through analysis, reasoned the MFA, the proposed amendments could be interpreted to lead to the anomalous result that a 3(c)(1) fund in compliance with Rule 205-3 and relying on the transitional relief for one or more of its investors would be effectively precluded from purchasing interests in another 3(c)(1) fund.
Such a result would significantly disrupt the investment strategies and operations of many 3(c)(1) funds, cautioned the MFA, and would also be inconsistent with the goal of the transitional relief to apply the new thresholds prospectively. Thus, the hedge fund association urged the SEC to clarify in the final regulations that a 3(c)(1) fund will be deemed to have satisfied Rule 205-3 if an equity owner of the fund that itself is a 3(c)(1) fund is in compliance with Rule 205-3.