2014 • Volume 37 • Number 1

Private Investment Companies in the Wake of the Financial Crisis: Rethinking the Effectiveness of the Sophisticated Investor Exemption

Cary Martin

As was appropriately observed amid the Great Depression, the performance of securities markets affects economic activity. Indeed, since millions of individuals and enterprises rely on the markets as a fundamental source of capital, economic turmoil is often intensified by severe market volatility and other related harms. To mitigate these harms, Congress passed the federal securities laws to ensure the safety and reliability of the public capital markets. The Securities and Exchange Commission (“SEC”) is the regulatory body that is charged with implementing these laws and it fulfills this obligation by actively pursuing its mission to protect investors, maintain fair, efficient, and competitive markets, and facilitate capital formation. While considerable disagreement exists with respect to the policies and mechanisms utilized by the SEC, the proper implementation of its mission is absolutely necessary because the markets are inextricably linked to the health of the national economy.

However, securities transactions that are considered ‘‘private’ are not subject to extensive federal oversight based on the assumption that they do not affect the broader national economy. These transactions include those that are restricted to sophisticated investors, which are statutorily defined as institutional or high net-worth individuals who can presumably use their resources to protect themselves from undue risk. Yet, many private investment companies that rely on the sophisticated investor exemption to avoid substantial regulation are avid participants in the public capital markets. This has blurred the distinction between public and private vehicles. Moreover, these vehicles are also capable of creating negative externalities that adversely affect unsuspecting third parties as well as the national economy. For example, the hedge fund industry, which may account for nearly half of the daily trading volume on the New York and London stock exchanges, and can ‘move markets’ through its speculative trading activities, was entirely exempt from SEC oversight because these vehicles are restricted to sophisticated investors. Accordingly, this Article argues that the sophisticated investor exemption is no longer a reliable mechanism for separating private and public investment companies. This Article broadens this analysis by examining the extent to which the sophisticated investor exemption has undermined the SEC’s ability to fulfill its mission to protect the public capital markets, and whether this failure has left the general public inadequately protected. This analysis is both necessary and timely because it could help ensure that the new regulations promulgated under the Dodd-Frank Act are closely tailored to the problems that the previous regulatory approach created. 

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