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.
Hedge Funds
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.