More broadly, the consumer group maintains that the SEC’s failure to request comment on alternative regulatory approaches is a violation of both the standard imposed by the DC Circuit in its decision on the proxy access case and the Commission’s own guidelines for economic analysis, which suggests that a rule adopted pursuant to this proposing release would be highly vulnerable to legal challenge. In the view of the Federation, it also sends the disturbing message that the Commission believes rules such as this that roll back long-standing investor protections do not have to meet the same rigorous standard for economic analysis that it applies to rules to strengthen investor protections, such as those it is required to adopt under the Dodd-Frank Act.
The Federation also asked the SEC to address the potential for misleading advertising by hedge funds and private equity funds, either by precluding them from claiming the exemption from the general solicitation and advertising ban or, imposing new regulatory requirements on any such solicitation or advertising practices. It was only after the JOBS Act was adopted, noted the group, that significant attention was paid to the fact that hedge funds and private equity funds with no claims to job creation would also be able to take advantage of the relaxed solicitation and advertising constraints, absent action by the Commission to restrict their ability to claim the exemption. The group emphasized that the potential for the new rule to permit unlimited and unregulated advertising by private funds raises significant issues that deserve far greater attention than they have been given in the proposal.
Citing a 2003 SEC staff report, the group noted that the SEC has itself recognized that hedge fund trading raises special concerns and that hedge funds pose heightened risks for investors. Among other things, the Commission has found that hedge funds have incentives to inaccurately value their assets and that they have a record of inadequately disclosing the layering of fees in funds of hedge fund structures. The Commission has also acknowledged that hedge fund and other private fund investors may not have access to the kind of information provided through the system of securities registration and therefore may find it difficult to appreciate the unique risks of these pools, including those with respect to undisclosed conflicts of interest, complex fee structures and the higher risk that may accompany such pools’ anticipated returns.
In light of these concerns, the consumer group said that it is not enough to rely on antifraud rules to protect investors from these risks. Ideally, the Commission should simply prohibit funds that rely on the exemptions under Section 3(c)(1) and (7) of the Investment Company Act from engaging in general solicitation and advertising. The group reasoned that such a ban would be completely consistent with the JOBS Act’s focus on promoting capital formation for small start-ups.
Short of an outright prohibition on general solicitation and advertising by private funds, the group continued, the Commission should adopt clear standards for the reporting of performance and fees by private funds, and delay their eligibility from engaging in general solicitation and advertising until such time as those standards are in place. If the SEC still decides to allow hedge fund and other private fund advertisements, they should be required to carry a clear, prominent warning that they are not mutual funds and carry special risks in order to reduce the potential for investor confusion.
Verification of Accredited Status
In lifting the ban on general solicitation in Rule 506 offerings, noted the group, the JOBS Act requires the Commission to identify methods issuers must adopt constituting reasonable steps to verify the accredited status of all investors in the offering. This is in direct contrast to the JOBS Act standard for Rule 144A offerings, which requires only that the issuer have a reasonable belief that all investors are Qualified Institutional Buyers.
According to the Federation, the Commission’s proposed approach regarding verification of accredited investor status fails to satisfy the statute by failing to specify any methods for verification, thereby indirectly reaffirming the reasonable belief standard the statute intended to replace. Instead of specifying reasonable steps that issuers must follow, noted the consumer group, the SEC proposes to rely on an after-the-fact determination of whether the steps taken were in fact reasonable, an approach that will be difficult to enforce.
Thus, the Federation urged the SEC to withdraw this rule proposal and conduct a meaningful economic analysis that carefully weighs the risks to investors and alternative regulatory approaches to minimize those risks, and to issue a new proposal that incorporates and requests comments on those alternatives. The current proposed approach offers the worst of both worlds, said the consumer group, inadequate investor protection and insufficient clarity for issuers. In the group’s view, the Commission needs to start from scratch to adopt clear standards governing verification of accredited investor status.
As part of that revised approach, it must eliminate the indirect incorporation of a reasonable belief standard that is in direct conflict with the statutory mandate that all investors in offerings sold through general solicitation and advertising be accredited investors and that the Commission specify methods issuers must follow to ensure that this is the case.