President Obama recently enacted into law the Jumpstart Our Business Startups Act, or more commonly known as the JOBS Act. Its main aim is to create more jobs by making it easier for small businesses to raise capital.
While that is indeed a worthy goal, it has, however, created a loophole that hedge funds can use to gain access to less sophisticated investors.General advertising for the securities of most private offerings, including hedge funds, used to be banned by virtue of the Exchange Act of 1934. This ban is now lifted with the signing of the JOBS Act, so Hedge Funds may now solicit for investors from the general public.
A Quick Review of the Laws Governing US Hedge Funds
In theory, hedge funds should be regulated under the Investment Company Act of 1940. However, hedge funds can’t stomach the said Act’s restrictions on redemptions, leverage, and incentive compensation. So they use a loophole which is an exemption to the 1940 Act. This exemption is more commonly known as 3(c)(7), and it only applies to private offerings that allow contributions only from individuals or institutions with at least $5M in money to be managed, AKA “qualified purchasers”.
The JOBS Act makes two significant changes for hedge funds operating under 3(c)(7), and these are the following:
1. The Jobs Act increases the Exchange Act’s threshold for registering as a public company from 500 to 2,000 shareholders. The Exchange Act of 1934 requires companies with 500 or more shareholders to register and publish quarterly reports. Historically, hedge funds have not been required to publish such reports.
2. The Jobs Act removes the Exchange Act’s ban on “general advertising” for the securities of most private offerings, including hedge funds. Simply put, a 3(c)(7) hedge fund may now aim for investors from the general public through traditional media like newspaper advertising, TV, or the internet.
Potential Dangers to Unwary Investors
The JOBS Act has made the hedge fund industry very happy. The Act basically “opened up” their business for more customers, and more customers mean more money to be made. In the hedge fund business, more money with less restrictions can only lead to either fun or disaster. The real danger now lies in hedge funds that take advantage of another exemption from the 1940 Act, which is known as the 3(c)(1) exemption. This exemption allows hedge funds to accept up to 100 “accredited investors”. According to the 3(c)(1), these are individuals with incomes of $200,000 annually ($300,000 for married couples), or a net worth of at least $1m excluding their home. Take note that “accredited investors” are very different form “qualified purchasers”. By definition under the 1940 Act, “qualified purchasers” have at least $5M to invest while “accredited investors” only have to have a net worth of $1M. That may mean a lot of difference in terms of financial sophistication. “Qualified purchasers” will probably be less likely to be convinced by an advertisement, while “accredited investors” may be easily swayed by a really good ad. The danger for these “accredited investors” then comes when bad hedge funds come up with really good ads. This is because there’s no law to stop them from publishing inaccurate performance results.
Congress and the SEC’s Role
Since the SEC’s main role is to protect investors, it is now up to them (along with the blessing of Congress) to come up with solutions to the potential problems caused by the JOBS Act. A recent Financial Times article suggested updating the definition of the term “accredited investor” and establishing uniform standards for reporting performance by hedge funds. I agree that these steps can greatly improve the safety of investors with regards to the dangers resulting from the JOBS Act. But in the end, it is still up to the individual investor to protect himself. He can do that by educating himself and doing extensive research on specific investments or funds. Like Warren Buffett said, “risk comes from not knowing what you’re doing”.