Who needs the most protection from financial predators? Millionaires probably aren't the first group to come to mind -- but they're the beneficiaries of a recent SEC ruling, designed to safeguard investors with a net worth between $1 million and $2.5 million. Unfortunately, some investors see the new rules as more of a limitation.
By raising the minimum assets required to buy into certain types of alternative investment vehicles from $1 million to $2.5 million, the SEC hopes to ensure that those vehicles are only used by customers who can afford to get advice from professionals before they invest. This move may protect people who choose not to make inquiries or perform due diligence before they invest, but it also bars better-informed but less wealthy investors who from making these decisions for themselves.
The accredited investor standard
The SEC generally acts to protect investors by enforcing laws that require companies to disclose information about securities they intend to offer to the public. The documents that companies make available to prospective investors in an IPO are reviewed and approved by the SEC. Whenever you invest in a mutual fund, the prospectus you receive includes SEC-mandated information. The quarterly reports upon which stock analysts rely to confirm their own findings and conclusions are also an SEC requirement.
But some types of securities aren't subject to the same level of SEC regulation. Exceptions to securities laws' disclosure rules include investments offered solely to accredited investors. In order to qualify as an accredited investor under the old rules, an individual needed either a minimum net worth of $1 million, or ongoing income of at least $200,000 per year. As long as an investment firm accepts only accredited investors as clients, it can generally avoid SEC registration requirements -- and all the regulation that comes with them.
Hedge funds and other private investments
The SEC took action amid an explosion in the number of investment firms targeting these accredited investors. The Hedge Fund Association estimates that there are now about 9,000 hedge funds, with total assets of at least $1.1 trillion. Meanwhile, private equity firms have become increasingly active in mergers and acquisitions, proposing deals to buy Harrah's (NYSE: HET ) , Triad Hospitals (NYSE: TRI ) , and Equity Office Properties (NYSE: EOP ) , among many others.
The SEC is concerned that the lack of reliable information and disclosure about alternative investment firms not subject to SEC regulation makes investors vulnerable to fraud. Inflation, rising real estate prices, and buoyant financial markets have also substantially swelled the ranks of accredited investors under the old standard since 1982, when the $1 million limit was last revised. Having tried and failed to implement rules specifically regulating hedge funds, the SEC's latest rule change will reduce the number of people from whom alternative investment firms could solicit money.
Rather than simply raising the net worth requirement, the new rules require that accredited investors have $2.5 million or more in investments. Most notably, the value of an investor's personal residence no longer counts here, although real estate held for investment purposes still qualifies.
It's likely that these rule changes will create strong feelings on both sides of the issue. There's real concern that alternative investment firms operate in a regulatory vacuum, which lets them employ strategies that only the most sophisticated investors can truly understand. Clearly, the SEC believes that it can't ensure the security of investors and their money without additional regulation of alternative investment vehicles.
On the other hand, many investors feel that limiting access to such investments leaves only unsatisfactory alternatives; after all, the majority of actively managed mutual funds often fail to even match their targeted benchmarks. Furthermore, at some point, investors must take responsibility for their own actions. Many are offended at the idea that they need to be protected from themselves.
Regardless of how this issue plays out, expect continuing friction between the SEC and the hedge-fund industry. In the meantime, if you want to use alternative investments, you'd best get started toward the new $2.5 million mark.
Hedge your bets with further Foolishness:
If you're not rich enough to qualify for "accredited investor" status, you could probably use a little more help with your investments. At Motley Fool Green Light, the Fool's personal finance service, you'll learn tips for saving more, spending less, and investing more profitably. Take a look with our free 30-day trial.