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

N1_ANDERSON (DO NOT DELETE) 12/27/2016 2:01 PM

735

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. ECONOMIC DOWNTURNS AND SUBSEQUENT REGULATIONS ......... 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.

_ANDERSON

736 IOWA LAW REVIEW [Vol. 102:735

B. INVESTOR ELIGIBILITY: DEFINING “SOPHISTICATED” ................. 742

1. Accredited Investor Standard ....................................... 743

2. Qualified Purchaser Standard ...................................... 744

C. EXPANDING “SOPHISTICATED” ................................................. 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. “SOPHISTICATED”: THEORY VERSUS REALITY............................ 751

B. IGNORING INCENTIVES IN EXISTING REGULATORY FRAMEWORK

AND PROPOSALS ...................................................................... 753

1. Inadequacy of the JOBS Act and the Knowledgeable

Employee Rule .............................................................. 753

2. Inadequacy of Current Proposals ................................. 754

C. HOW MISALIGNED INCENTIVES HURT THE ECONOMY ................ 755

IV. EXPANDING “SOPHISTICATED” UNDER THE QUALIFIED PURCHASER

STANDARD ..................................................................................... 756

A. LONG- AND SHORT-TERM SOLUTIONS ....................................... 756

B. CONSIDERING COUNTERARGUMENTS ........................................ 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.