Finance Regulation Bill Changes Accredited Investor Rules

Congress changed the rule that determines who can invest in hedge funds and other similar funds.

One of the many overlooked features of the Financial Regulation (FinReg) bill signed last Wednesday by President Obama includes a change to the definition of “accredited investor.”

The accredited investor net worth threshold for natural persons is $1 million. However, going forward, this no longer includes the value of the investor’s primary residence. Until now, this feature enabled many otherwise middle-class people to qualify for hedge funds in recent years due to the soaring rise in home values.

The bill does not change the annual income test, however. The current requirement is $200,000 of income for an individual, or $300,000 for a couple, in each of the two most recent years, and are reasonably expected to earn at least the same in the current year.

One year after the bill is enacted the SEC can review the definition of “accredited investor” as applied to natural persons, and propose to change the definition. However, it cannot modify the net worth threshold.

After four years and then at least every four years, the SEC would be required to review the entire definition of “accredited investor” as applied to natural persons, and would be authorized to modify the definition “as appropriate for the protection of investors, in the public interest, and in light of the economy,” provided that any net worth threshold for natural persons must exceed $1 million, excluding the value of an investor’s primary residence, according to law firm Davis Polk & Wardell.

The bill also requires the SEC to adjust for inflation, within one year after enactment and every five years thereafter, the assets under management and net worth tests for determining a client’s status as a “qualified client” to whom an investment adviser may charge a performance fee under Rule 205-3 under the Advisers Act.

“Heightened ‘accredited investor’ and ‘qualified client’ standards would shrink the pool of investors eligible to invest in funds,” David Polk states in a Client Alert.

Good. It is about time.

The new net worth rule is a long time coming. It will most likely lessen the potential pool of investors for those small, puny fledgling hedge funds with little track record that are not required to register even under the FinReg bill because they have less than $150 million in assets.

The larger, well known names require minimum investments that most people with the minimum net worth thresholds were unable to come up with. Now, I would like the SEC to define a “sophisticated investor” using criteria other than income or net worth — like their ability to understand the risk they are taking.

As I like to say: Investing in hedge funds in effect requires someone to give a substantial amount of money to a stranger who is not registered by the SEC to invest their hard earned money under the stipulation that the manager will not provide much detailed information about how — and how well — they invest the money and the customer can’t ask too many questions.

Sounds wacky on paper, which is why there must be a little more regulation and higher standards for individuals to qualify.