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SEC Weighs Up Sophisticated Investors’ Sophistication

Can sophisticated investors make their own decisions? The SEC is not so sure.

As the Securities and Exchange Commission prepares to permit hedge funds and other private partnerships to advertise, the trade group that looks out for the interests of hedge funds has asked the regulator to spell out exactly what they must do to verify whether investors are accredited after the rules in the Jump Start Our Business Start-ups Act (JOBS Act) are finalized.

The Hedge Fund Association wants the SEC to eliminate managers’ legal liability if they follow certain procedures or standards such as receiving a signed subscription agreement from an investor who “unequivocally affirms” that he or she is an accredited investor. If the SEC implements a stiffer requirement, it could create administrative burdens for hedge funds and other private partnerships and defeat the purpose of the Act — to create jobs, the HFA asserts.

Under recently updated rules, most investors can only invest in hedge funds if they are accredited: that is, if the person or couple’s joint net worth exceeds $1 million, excluding the value of their primary residence, or if an individual’s income has exceeded $200,000 in each of the two most recent years — or joint income with a spouse exceeded $300,000 for those years — with a reasonable expectation of the same income level in the current year.

In its August 29 proposal, the SEC said it would be “impractical and potentially ineffective” to require that hedge funds use specific verification methods in light of the numerous ways in which a purchaser can qualify as an accredited investor.

The SEC did concede that it was concerned that specific rules related to verification could become overly burdensome. A set of steps may not apply in all circumstances and in some circumstances may not actually verify accredited investor status.

The HFA says it is happy with the SEC’s first draft, but it just wants the regulator to spell out this view more specifically so there is no ambiguity and the onus is clearly not on the hedge fund firm to verify that the investor told the truth.

“If they certify they are accredited and lie, there is no reason we should take the risk,” says HFA board member George Schultze of Schultze Asset Management. And he argues that going through the time-consuming and painstaking process of verifying and looking at tax returns and getting sworn statements from lawyers and accountants would undermine the entire purpose of the Act — which is to create jobs.

“The purpose of the law is to create jobs by simplifying the process to get investors,” he says. “Otherwise, it would be one step forward and three steps backward.”

Interestingly, the SEC is seemingly taking the opposite approach of Department of Homeland Security and U.S. Immigration and Customs Enforcement, which enforce immigration laws by aggressively targeting employers as to whether or not they verify the employee’s legal status.

Schultze, however, says you can’t compare verifying legal residency and citizen status with whether someone is an accredited investor. He says the SEC’s rule is designed more to protect the investor from fraud. 

“Sophisticated investors can make their own decisions,” he adds.

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