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PF reforms presage accreditation battle

Expert sees regulatory jujitsu in Chairman's approach.

SEC Chairman Gary Gensler’s sweeping new private fund reform proposals have already shocked the industry. They also point to a potentially more shocking proposal yet to come: a fundamental rethinking of the meaning of “accredited investor,” according to affiliate title Regulatory Compliance Watch.

Private fund advisers all but gasped collectively when the Chairman proposed stringent new disaster-reporting requirements for registered funds, and then new compliance reporting obligations for all funds. Among other things, the new rules would ban several fee-and-expense habits in the industry. Dissenting from each, Republican Commissioner Hester Peirce said she saw “a sea change” in the way the Commission regulates private fund advisers.

The Form PF proposals, Peirce said, embody “a belief that many sophisticated institutions and high net worth individuals are not competent or assertive enough to obtain and analyze the information they need to make good investment decisions or to structure appropriately their relationships with private funds.”

“Therefore,” she added, “the Commission judges it wise to divert resources from the protection of retail investors to safeguard these wealthy investors who are represented by sophisticated, experienced investment professionals. I disagree with both assessments; these well-heeled, well-represented investors are able to fend for themselves, and our resources are better spent on retail investor protection.”

‘Fend for themselves’


The phrase “fend for themselves” is the key one in Peirce’s dissent.  The Supreme Court famously used that exact phrase in its seminal 1953 decision in SEC v. Ralston-Purina. The Commission had tried to stop Ralston from selling some $2 million in equity stock certificates to “key employees.” Regulators argued that any such special shares ought to be registered under Securities Act section 4.

Writing for the 8-0 majority, Justice Tom Clark held that, had Ralston offered these shares to every company employee, they would have had to be registered. Since they were only offered to relatively wealthy, sophisticated employees, the stocks weren’t public offerings and were therefore exempt from registration under Securities Act section 5. “An offering to those who are shown to be able to fend for themselves,” Clark wrote, “is a transaction ‘not involving any public offering.’”

That language has more-or-less protected private funds from public disclosures ever since.

‘Silver lining’

Peirce says she’s worried that Gensler’s proposals are “a meaningful recasting of the SEC’s mission.” First, because they infantilize accredited investors. Second, because they will divert regulators’ time, money, and attention to private fund investors when retail investors need the SEC the most. Third, because the proposals are “another step toward erasing any distinction afforded by the exemption from registration,” she said.

For all of that, Peirce said she hoped she glimpsed a silver lining.

“I personally have never found the sophistication narrative a compelling rationale for keeping unaccredited investors out of the private markets,” she said, “and, maybe a silver lining of today’s rules is that it signals a new belief that all investments should be open to all investors. After all, with this proposal, which affords retail-like protections to accredited investors, this Commission is publicly calling into question the rationale for dividing retail from accredited investors.”

Armed with harmony

Whatever the merits of Peirce’s claims, her logic is akin to that used by Gensler to propose his reforms in the first place, says Kurt Wolfe, a veteran securities litigator who is counsel to Quinn, Emanuel. When then-SEC Chairman Jay Clayton expanded the definition of accredited investors, lifted caps on exempt raises and otherwise tried to “harmonize” the public and private markets, Democrats and their allies howled, and promised to revisit those rules should their party win office.

So far, anyway, Gensler hasn’t moved to repeal those rules.

“He isn’t yet peeling back any of Chair Clayton’s harmonization efforts,” Wolfe says of Gensler. “He’s saying, in effect, ‘You want to harmonize public and private markets? Fine, but we’ll regulate them in harmony, too.’”

Regulatory jujitsu


Gensler is overruling his own friends to do so. After losing the harmonization vote just ahead of the 2020 election, for instance, Democratic Commissioners Allison Herren Lee and Caroline Crenshaw were emphatic that private fund advisers had gotten just about enough from the Commission. Gensler’s hand-picked director for the Division of Corporation Finance, Erik Gerding, called Clayton’s harmonization efforts “a radical rule change”. His now-senior adviser, Barbara Roper, called the proposals “the most radical agenda to expand the private markets that we’ve seen”.

Wolfe says he sees a kind of regulatory jujitsu at work here, and not just with private fund advisers. “Gary Gensler was certainly under pressure to scrap Reg BI and impose a fiduciary rule on broker-dealers,” Wolfe says. “Instead, he’s kept Reg BI but his exam staff is casting an increasingly critical eye over firms’ Reg BI compliance, and we should expect to see robust enforcement in the space. It may be the ultimate lesson in being careful what you wish for.”

That’s not the only way Gensler is calling Peirce’s hand. Among his top priorities are a new definition of accredited investor. Lee and Crenshaw, among others, have argued that the wealth thresholds should not only be raised, but they should also be pegged to inflation.

Ultimate irony

For former New Jersey Bureau of Securities chief Chris Gerold, there’s an irony at work in all of this. Now a partner with Lowenstein Sandler, Gerold says that until Clayton expanded the definition of accredited investors, Washington had paid little notice of it since the early days of the Reagan Era. One thing that meant was the long slow tide of inflation dragged in thousands, perhaps millions, of ordinary investors who may have had the money but may not have had the sophistication to handle their accreditation, Gerold says.

Something like one out of every 10 American homes now has an accredited investor in it. The average age of such people is between 60 and 65 years old. It’s precisely the population of people the public disclosure acts and rules were supposed to protect. In other words, Gerold says, Washington’s laissez faire attitude toward the meaning of accredited investors is now, in effect, being used as evidence against laissez faire arguments for private fund disclosures.

“If the definition of accredited investor had just kept up with inflation,” Gerold says, “we probably wouldn’t be here right now.”

That may be so, but in any case, the next regulatory battle over accredited investors is already taking shape. And, as we’ve already seen this year, it’s likely to get loud.