Hedge funds may go from soliciting individual investors behind closed doors to conducting wide advertising campaigns without restrictions under a rule proposed today by the U.S. Securities and Exchange Commission.
SEC commissioners voted 4-1 to invite public comment on a proposal for how to end decades of limits on the pursuit of investors by private funds and startups. The proposal is driven by a law that repealed a ban on pitching such investments to all but a select few investors, such as those accustomed to pumping cash into hedge funds.
“I recognize that there are very real concerns about the potential impact of lifting the ban on general solicitation,” SEC Chairman Mary Schapiro said before the vote. “While I believe it will be incredibly important for the commission to take a thorough look at the private placement market in the future, I think at this point it is appropriate that we undertake this more narrow mandate that Congress placed upon us.”
The Jumpstart Our Business Startups Act, signed into law by President Barack Obama in April, ordered an end to the ban as part of a wider effort to expand funding options for fledgling companies. The shift drew criticism from investor-protection groups and the mutual-fund industry, including the Washington-based Investment Company Institute, which have said that lifting the ban without restrictions may expose investors to misleading advertisements by some private funds.
In the past, securities laws allowed firms to market non-publicly traded securities only to so-called accredited investors with whom they have existing relationships, usually meaning frequent, wealthy investors. The solicitation rules were designed to protect retail investors from inappropriate risks.
Even as future offerings are marketed to the general public, the new rule would limit participants to those with more than $1 million in assets, excluding primary residences, or those earning more than $200,000 a year. The SEC’s proposal doesn’t include restrictions for how offers are advertised, nor does it establish a system for verifying accredited investors -- only that firms must take “reasonable steps” to check.
“This is a huge disappointment,” Barbara Roper, director of investor protection for the Washington-based Consumer Federation of America, said in a telephone interview after the meeting. “It appears that none of the investor protections that we or others have advocated are included in this proposal.”
Senator Carl Levin, a Michigan Democrat, called for such protections to be added to the rule after the comment period. “I hope the SEC will significantly improve the rule before it is put into effect,” Levin said in a statement. “These investor protections in existing law have been in place for decades, and prior revisions by the SEC led to increased fraud and were ultimately reversed by the SEC itself.”
Luis Aguilar, a Democratic SEC commissioner, cited concerns about investor vulnerability as a reason for his dissenting vote.
“The proposal would permit solicitation and advertisements via billboards, TV, the Internet, radio, and telemarketer calls, among other avenues,” Aguilar said in a statement. “Allowing such broad marketing activities under an exemption designed for ‘private’ offerings is a significant change in the securities framework that greatly increases the vulnerability of investors.”
Misleading advertisements by private funds have the potential to confuse investors and “not only to harm those investing in the advertised fund itself but also to erode investor confidence in funds and fund investing more generally,” Paul Schott Stevens, president and chief executive officer of ICI, said in a statement. The trade group represents investment companies including mutual funds with about $13 trillion in assets.
“These steps will help modernize existing securities laws in a manner that will enhance financial market transparency and investor protection, and will allow for more efficient capital formation,” Stuart Kaswell, general counsel at the Managed Funds Association, said in a statement. The Washington-based trade group represents hedge funds.
Private offerings are the No. 1 fraud or scheme leading to enforcement actions and investigations, according to the North American Securities Administrators Association. The number of cases involving these types of investments jumped to 410 last year, according to preliminary data from the organization of state securities regulators. That’s a 60 percent increase from 2010.
“Unsophisticated investors will be inundated with offers of inappropriate investments sold through misleading advertisements,” said Roper of the Consumer Federation. “Fraud will surge in a market already ripe with problems.”
The lift on the advertising ban will educate a broader group about the type of private offerings available, said Steven Nadel, a partner at the law firm of Seward & Kissel LLP in New York who specializes in hedge funds and other alternative investments.
“There’s plenty of wealthy Americans who may not be super sophisticated when it comes to investing in alternatives,” Nadel said in an interview before the meeting. “It will create more knowledge, more transparency, more understanding of the entire alternative industry.”
The SEC missed the law’s July implementation deadline, and the 30-day public comment period will delay new hedge-fund advertising practices even further.
“The 90-day deadline did not provide a realistic time frame for the drafting of a new rule, the preparation of an accompanying economic analysis, the proper review by the Commission, and an opportunity for public input,” John Nester, an SEC spokesman, said in a statement.