Wealth and Knowledge: Strengthening the Economy by Expanding the Qualified Purchaser 'Sophisticated' Standard Under the Investment Company Act of 1940

• Author: Eveyln S. Anderson
• Position: J.D. Candidate, The University of Iowa College of Law, 2017; B.A., Grinnell College, 2012
• Pages: 735-760

Wealth and Knowledge: Strengthening the Economy by Expanding the Qualified Purchaser “Sophisticated” Standard Under the Investment Company Act of 1940 Evelyn S. Anderson * ABSTRACT: This Note traces the government’s effort to balance the need for investments with the need for regulating the economy. Regulations of the financial industry, largely in response to economic crises such as the Great Depression and the 2008 recession, have focused on limiting investments deemed too risky for the general public to “sophisticated” investors. Struggling to define “sophisticated,” Congress and the SEC opted for criteria based on the investor’s net worth with narrow exceptions for highly knowledgeable but lower-net-worth individuals. Recent legislation and interpretation of that legislation have expanded these narrow exceptions, suggesting the trend is moving towards investor eligibility criteria based on sophistication measures beyond net-worth. This change is a positive one for investors, businesses, and the economy as a whole. However, the benefits of the current efforts to expand the definition of “sophisticated” cannot be realized because legislative incentives for investment managers continue to limit investment opportunities to only the very rich without regard for knowledge or expertise. This Note proposes that Congress should expand the Qualified Purchaser standard under the Investment Company Act of 1940 to allow sophisticated but lower-net-worth individuals to invest in hedge funds. I. INTRODUCTION ............................................................................. 736 II. HEDGE FUNDS: A REGULATORY FRAMEWORK ............................... 739 A. E CONOMIC D OWNTURNS AND S UBSEQUENT R EGULATIONS ......... 741 * J.D. Candidate, The University of Iowa College of Law, 2017; B.A., Grinnell College, 2012. Thank you to Julie Coleman, Zack Shankman, Brett Rogers, and Mike Hankin at Brown Advisory for sparking my interest in this topic and giving me the opportunity to develop my understanding of finance and corporate law. Thank you also to my friends and editors on the Iowa Law Review for their help with this Note. 736 IOWA LAW REVIEW [Vol. 102:735 B. I NVESTOR E LIGIBILITY : D EFINING “S OPHISTICATED ” ................. 742 1. Accredited Investor Standard ....................................... 743 2. Qualified Purchaser Standard ...................................... 744 C. E XPANDING “S OPHISTICATED ” ................................................. 746 1. The Knowledgeable Employee Rule and Qualified Purchasers ...................................................................... 747 2. The JOBS Act and Accredited Investors ...................... 748 III. FAILING TO DEFINE AND IMPLEMENT A WORKABLE DEFINITION OF “SOPHISTICATED” .......................................................................... 750 A. “S OPHISTICATED ”: T HEORY V ERSUS R EALITY ............................ 751 B. I GNORING I NCENTIVES IN E XISTING R EGULATORY F RAMEWORK AND P ROPOSALS ...................................................................... 753 1. Inadequacy of the JOBS Act and the Knowledgeable Employee Rule .............................................................. 753 2. Inadequacy of Current Proposals ................................. 754 C. H OW M ISALIGNED I NCENTIVES H URT THE E CONOMY ................ 755 IV. EXPANDING “SOPHISTICATED” UNDER THE QUALIFIED PURCHASER STANDARD ..................................................................................... 756 A. L ONG - AND S HORT -T ERM S OLUTIONS ....................................... 756 B. C ONSIDERING C OUNTERARGUMENTS ........................................ 758 V. CONCLUSION ................................................................................ 759 I. INTRODUCTION Fear surrounding economic downturns is not a recent phenomenon. After the stock market crash, or “Black Tuesday,” that propelled the United States into the Great Depression in 1929, The New York Times reported, “[s]tock prices virtually collapsed yesterday,” and called the crash “the most disastrous in Wall Street’s history.” 1 Almost 79 years later, in 2008, a headline in The New York Times proclaimed, “For Stocks, Worst Single-Day Drop in Two Decades.” 2 As is typical in moments of fear and panic, the American public searched for answers that might explain the losses that left many without jobs or opportunities. The American government, seeking to alleviate such fears, 1. Stocks Collapse in 16,410,030-Share Day, but Rally at Close Cheers Brokers; Bankers Optimistic, to Continue Aid , N.Y. TIMES: ON THIS DAY (Oct. 29, 1999), http://www.nytimes.com/learning/ general/onthisday/991029onthisday_big.html (last visited Oct. 12, 2016). 2. Vikas Bajaj & Michael M. Grynbaum, For Stocks, Worst Single-Day Drop in Two Decades , N.Y. TIMES (Sept. 29, 2008), http://www.nytimes.com/2008/09/30/business/30markets.html. 2017] WEALTH AND KNOWLEDGE 737 implemented measures to regulate the financial industry and reinstill the public with faith in the economy. 3 Both the Great Depression and the 2008 crash were largely the result of speculation and unsound investment advice, leaving much of the general public blindsided by severe losses. 4 The government reacted by regulating certain investments deemed too risky for the general public and limited those who could invest to only the “sophisticated.” 5 Congress and the Securities and Exchange Commission (“SEC”) decided that hedge funds—greatly leveraged, high-risk, high-reward investment opportunities available to only the very rich that are subject to minimal regulations 6 —were too risky for the average investor. 7 Only “sophisticated investors,” reasoned the government, are able to appreciate the risk involved and can more freely invest in hedge funds. As a proxy for “sophistication,” an individual was “sophisticated” if she was wealthy—an Accredited Investor 8 or Qualified Purchaser, 9 depending on the type of hedge fund. The government and the public largely blamed hedge funds for the 2008 collapse. 10 Even before the crash, there was significant criticism surrounding 3. See JOSEPH WILLIAM SINGER, NO FREEDOM WITHOUT REGULATION: THE HIDDEN LESSON OF THE SUBPRIME CRISIS 59 (2015) (describing the need for regulations following the financial crisis in 2008 as driven by the lessons “that people can be fooled into taking on financial burdens that they cannot bear and that these arrangements have the potential to undermine economic prosperity for all of us[,] . . . that when we begin to gamble on the infrastructure of economic life, we pose undue risks to ourselves and our neighbors[,] [a]nd . . . that markets will better reflect our preferences if we enact laws that ensure that we get what we bargain for”). 4. See Steve Denning, Lest We Forget: Why We Had a Financial Crisis , FORBES (Nov. 22, 2011, 11:28 AM), http://www.forbes.com/sites/stevedenning/2011/11/22/5086 (describing role of subprime mortgages in the financial crisis as advertised and sold to consumers as high-yield investments without disclosure of risks, which allowed mortgage originators to bundle mortgages and “relax underwriting standards, abdicating traditional lending metrics such as income, credit rating, debt-service history and loan-to-value[,]” which led to huge defaults in mortgages and ultimately an economic collapse). 5. See infra Part II.B. 6. U.S. SEC. & EXCH. COMM’N, IMPLICATIONS OF THE GROWTH OF HEDGE FUNDS 3 (2003), http://www.sec.gov/news/studies/hedgefunds0903.pdf (describing hedge funds as “an entity that holds a pool of securities and perhaps other assets, whose interests are not sold in a registered public offering and which is not registered as an investment company under the Investment Company Act”). 7. The regulations following the Great Depression did not specifically target hedge funds, because the first hedge fund did not appear until 1949. However, the regulations following both the crash of 1929 and 2008 sought to address the highly speculative, leveraged, and overall risky investment strategies that led to severe losses. See James E. McWhinney, A Brief History of the Hedge Fund , INVESTOPEDIA, http://www.investopedia.com/articles/mutualfund/05/hedgefundhist.asp (last visited Oct. 12, 2016). 8. See infra Part II.B.1. 9. See infra Part II.B.2. 10. See Hedge Funds Took a Serious Hit in 2008 , CBS NEWS (Jan. 12, 2009, 7:14 PM), http:// www.cbsnews.com/news/hedge-funds-took-a-serious-hit-in-2008 (describing the hedge fund industry as characterized by greed and overconfidence and “[u]sing sophisticated trading models,” promising to make “wealthy people wealthier with eye-popping returns that carried seemingly 738 IOWA LAW REVIEW [Vol. 102:735 hedge funds, leading one famous hedge fund manager, Mario Gabelli, to write in 2000: “[M]ost folks would characterize [a hedge fund] as a highly speculative vehicle for unwitting fat cats and careless financial institutions to lose their shirts.” 11 However, the bad rap hedge funds have endured is misplaced, 12 as hedge funds are not actually as risky as the post-2008 headlines would lead the public to believe. 13 Rather, hedge funds provide benefits to the investor that an ordinary mutual fund or stock investment cannot—they allow diversification in an investor’s portfolio 14 , which provides a safeguard against risk, and they provide absolute returns, 15 allowing the investor a better chance to profit. 16 Both Congress and the SEC seem to recognize that the risks of hedge funds have been overstated as they have recently expanded access to hedge funds to knowledgeable but lower-net-worth individuals. 17 Investments are necessary for the success of an economy, and placing severe limits on access to that market risks harming small business. This is especially true because private, small businesses make up the bulk of most hedge fund portfolios. 18 moderate risk” before being “[b]lind-sided” by their failure and the market...