The New Hedge Fund Adviser Anti-Fraud Rule

August 17, 2007

The Securities and Exchange Commission (“SEC”) released new Rule 206(4)-8 under the Investment Advisers Act of 1940 (the “Advisers Act”) on August 3, 2007 and it was published in the Federal Register on August 9, 2007.  Once the new rule becomes effective on September 10, 2007, broad anti-fraud proscriptions will be applied to the relationship between investment advisers, both registered and unregistered, and the investors in the hedge funds they advise. 

Generally, the new rule prohibits an adviser to a hedge fund from making false or misleading statements to investors or prospective investors in the hedge fund and from otherwise defrauding them.  This is similar to Rule 10b-5 under the Securities Exchange Act of 1934, as well as other existing anti-fraud provisions of the securities laws.  In many cases, conduct deemed fraudulent under Rule 206(4)-8 will also be deemed fraudulent under one or more of such other provisions.  At the same time, and as we discuss below, conduct not fraudulent under existing SEC anti-fraud rules may be deemed fraudulent under Rule 206(4)-8. In contrast to existing anti-fraud laws applicable to hedge fund managers, the intent of the new rule is to capture fraud not just at the point of sale or when an offer of hedge fund interests is being made. but continuously at all stages of an advisory relationship.

The central elements of the new rule are that

• an adviser’s duty to refrain from fraudulent conduct extends to the ultimate investors in hedge funds and other “pooled investment vehicles” to which it provides investment advice, not merely to the pooled vehicles themselves as discrete entities (although the term includes even mutual funds and other registered investment companies, for ease of reference all pooled investment vehicles covered by the new rule will be referred to herein simply as “Funds”);

• the SEC has the authority to bring enforcement actions under the Advisers Act against advisers who violate the rule, including advisers that are not registered with the SEC;

• an adviser’s material statement, omission or other action with respect to any investor or prospective investor in a Fund, even if unintentional, can be deemed fraudulent; and

• a fraudulent act of an investment advisor relative to a Fund’s investors committed at any time, not merely an act in connection with the offering, sale or disposition of a security, may be actionable under the new rule. 

Under Rule 206(4)-8, all investors in Funds advised by an investment adviser are protected against fraudulent statements and other fraudulent behavior by the adviser, whether or not the investment adviser is involved in managing the Fund that is its advisory client.

Background

In July 2004, the SEC proposed Rule 203(b)(3)-2 (the “Hedge Fund Rule”), requiring, among other things, registration of many unregistered domestic hedge fund managers.  The Hedge Fund Rule sought to count hedge fund investors as “clients” in order to circumvent the fewer than 15-client registration exemption that permitted many hedge fund managers to avoid registering as investment advisers under the Advisers Act.  That exemption permitted even managers of very large hedge funds to avoid registration because each hedge fund was considered to be a single client; i.e., the number of investors participating in each hedge fund was disregarded.  The Hedge Fund Rule sought a corrective, by “looking through” the hedge funds, to count all direct and indirect investors as clients. Investment adviser registration became mandatory for many advisers because the Hedge Fund Rule required each investor in a hedge fund to be counted as a client.  Among the stated purposes of the Hedge Fund Rule were the necessity to collect better data on and monitor hedge funds and screen investors and advisers alike.  A corollary effect of the Hedge Fund Rule imposed higher net worth standards for new investors in hedge funds operated by formerly unregistered advisers.  See our Hedge Fund & Investment Managers Advisory, dated January 4, 2005, entitled “Hedge Fund Adviser Registration Proposal Adopted.”

On June 23, 2006, the U.S. Court of Appeals for the D.C. Circuit determined that the SEC lacked the authority to issue the Hedge Fund Rule.  In Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), the Court struck down the Hedge Fund Rule in its entirety, finding it to be “arbitrary”, and stated that the hallmark of an adviser’s obligations under the Advisers Act is “the fund’s performance, not each individual investor’s financial condition.” To the Court, that standard was inconsistent with the Hedge Fund Rule and its mandate that the fiduciary obligations of advisers had not changed (despite the obligation to “look through” to investors in the hedge funds that were the clients).  The Court also placed in doubt the SEC’s ability to rely on Sections 206(1) and (2) of the Advisers Act, the general anti-fraud provisions upon which the SEC had previously relied to bring enforcement actions when investors in a hedge fund were defrauded by false and misleading statements made by its investment adviser.  Following the ruling, in testimony before Congress SEC Chairman Christopher Cox addressed the need to regulate hedge funds in the wake of uncertainty from the Goldstein decision and promised SEC intervention to fill “the gaping hole that the Goldstein decision…left” by addressing the SEC’s ability to “look through” directly to hedge fund investors and investors in “funds of hedge funds” in order to apply SEC rules concerning fraud. 

Discussion

Rule 206(4)-8 [1] is designed broadly to define the making of materially false or misleading statements as a fraudulent, deceptive or manipulative practice, and to prohibit other practices that defraud or deceive Fund investors.  The SEC deliberately avoided any attempt to describe the type of fraudulent conduct to be proscribed because its intent is to capture and prohibit any type of fraudulent conduct that could be harmful to persons who invest or even attempt to invest, directly or indirectly, in Funds.  Unlike Sections 206(1) and (2) of the Advisers Act, which are limited in their application to investment advisory clients or prospective clients, Section 206(4) of the Advisers Act generally permits the SEC “to define, and prescribe means reasonably designed to prevent, fraud by advisers.” Rule 206(4)-8 was promulgated under Section 206(4) to avoid the limitations of Sections 206(1) and (2).

Unlike other rules promulgated under Section 206(4) of the Advisers Act, the new rule’s application is not limited to advisers registered under the Advisers Act.  The only determining factor is whether the investment adviser’s activities are directed at or on behalf of a Fund.  As a result, Rule 206(4)-8 will apply to unregistered investments advisers as well as registered advisers, both domestic and offshore (albeit that with respect to offshore advisers, the fraudulent conduct must be directed at protected individuals in the United States).  Rule 206(4)-8 will also apply irrespective of an investment adviser’s role in the management of the Funds to which it renders investment advice. 

Rule 206(4)-8 also does not distinguish between Funds that are registered under the Investment Company Act of 1940 (the “Investment Company Act”) and those that are exempt from registration.  The term “pooled investment vehicles” is specifically designed to include those Funds excluded from registration as investment companies pursuant to Sections 3(c)(1) and 3(c)(7) of the Investment Company Act.  Generally, Section 3(c)(1) excludes investment funds whose securities have been privately offered and have 100 or fewer beneficial owners and Section 3(c)(7) excludes investment funds whose securities have been privately offered exclusively to “qualified purchasers.” These are the exclusions generally relied upon by hedge funds to avoid registration as investment companies.  However, Rule 206(4)-8 will also apply to, among others, advisers to private equity, venture capital and buyout funds, which also generally rely on those exclusions, as well as to advisers to mutual funds and other registered investment companies.  Advisers to pooled investment vehicles entitled to other exemptions from registration under the Investment Company Act, such as REITs, will be exempt from the application of Rule 206(4)-8. 

In contrast to similarly worded anti-fraud rules, the intent of Rule 206(4)-8 is to capture fraud, not merely after the damage is realized, such as at the point of sale, but in its incipient stages.  By including prospective investors in the protected class, the SEC’s goal is to cause investment advisers to focus on their anti-fraud efforts at an earlier stage.  However, the application of Rule 206(4)-8 is not limited to fraud in connection with the purchase or sale of a security.  It applies continuously to any actions an adviser takes in respect of a Fund.  While false or misleading statements contained in offering materials are covered under Rule 206(4)-8, as are statements appearing in responses to requests for proposals, in electronic solicitations and in one-on-one presentations to prospective investors, so too are statements wholly unrelated to marketing efforts.  Moreover, false or misleading statements addressed to investors or prospective investors can violate the new rule, even if no one is induced to act on such statements and even if they were not false or misleading when first made.

Advisers should be mindful of some of the materials that are relevant to the application of Rule 206(4)-8, in which potentially fraudulent and misleading statements might be found, for they extend beyond those materials which already may be covered under other anti-fraud rules.  Thus, in addition to private placement memoranda, prospectuses, offering circulars and other marketing materials, any of the following may be sources of fraudulent misrepresentations:

• Correspondence with investors,
• Account statements, including fee calculations, and
• Periodic and routine reports to investors.

As a consequence, Rule 206(4)-8 may be deemed to address fraud in connection with the holding of securities.  Fund professionals should carefully review and consider all their communications to investors and prospective investors, including any material that is publicly accessible via the Internet or otherwise to look for statements that are or have become inaccurate or misleading or that omit material information.

The SEC stated in the release adopting Rule 206(4)-8 (Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles, Investment Advisers Act Release No. 2628, July 11, 2007 [72 Federal Register, 44756 (Aug. 9, 2007)]) (the “Release”) that it did not intend for the new rule to expand an investment adviser’s duties.  “[P]rior to Goldstein, advisers operated with the understanding that the Advisers Act prohibited the same conduct that would be prohibited by the rule. Accordingly, we do not believe that advisers to pooled investment vehicles attentive to their traditional compliance responsibilities will need to take steps or alter their business practices in such a way that will require them to incur new or additional costs as a result of the adoption of the rule.” As the SEC sees it, Goldstein relieved investment advisers of a duty to which they thought they were subject but weren’t; a duty that Rule 206(4)-8 merely re-imposes. It can certainly be argued, though, that the new rule goes beyond the reasonable prior expectations of unregistered hedge fund managers.  In any event, this aspect of Rule 206(4)-8 will likely cause advisers, especially unregistered advisers, to pay greater attention to detail than in the past when communications are directed to existing Fund investors.

Among the kinds of disclosures cited by the SEC as potential sources of materially false or misleading statements are those pertaining to portfolio valuations, investment strategies that a Fund will pursue, the experience and credentials of the adviser and its key personnel, risk factor discussions, the performance of any portfolio managed by the adviser, portfolio valuations and operational matters such as the allocation of investment opportunities.  Thus, a discussion with existing investors of potential new directions in investment strategies or a gilded presentation of the credentials of the adviser or its personnel (even if the misrepresentation was unknown when published) can potentially violate Rule 206(4)-8.  Additionally, merely circulating an erroneous draft letter or inadvertently circulating a document such as a portfolio manager’s C.V., or an old report that is no longer accurate (even if correct when originally prepared) may constitute a violation. 

Even routine document maintenance and record-keeping activities of a Fund—vital to keeping investors abreast of necessary information—can lead to violations of the new rule.  The SEC has rejected the idea that the new rule may have a chilling effect on investor communications.  Indeed, silence is not an option, as it can result in a violation if a material omission results. However, simply employing a lowest common denominator approach—disclosure designed to satisfy the most untutored of potential investors—might run afoul of confidentiality obligations or result in the disclosure of proprietary information to the detriment of the Fund, not to mention triggering an even greater burden to update all published information as facts change.  Fairly detailed warnings, in the form of legends or otherwise, that inform investors and prospective investors that material information is not being disclosed—for example, to avoid confusion—may satisfy the anti-fraud proscription. 

Rule 206(4)-8(a)(2) also provides for a catch-all proscription: “It shall constitute a fraudulent, deceptive, or manipulative act, practice, or course of business…[to]…[o]therwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative”. The stated rationale for this provision is to insure that actions other than statements or utterances are captured.  There is little in the commentary from the SEC to illustrate what type of act, practice or course of business, while not constituting a “statement,” might run afoul of this proscription.  Will, for example, the use of an investment strategy founded upon a flawed algorithm constitute fraudulent conduct under Rule 206(4)-8?  Undoubtedly, the SEC will know it when it sees it and, equally unquestionably, this will be an area of considerable consternation for advisers who may find themselves facing an SEC investigation based upon an alleged violation of Rule 206(4)-8(a)(2). 

The most controversial aspect of the new Rule, however, is the absence of scienter (the intent to deceive manipulate or defraud) as a required element of a Rule 206(4)-8 violation.  Simple negligence (e.g., unintended wording, an erroneous assumption or a prematurely released document) could be subject to the application of Rule 206(4)-8.  According to the Release, the SEC is “clearly is authorized to proscribe conduct that goes beyond mere fraud as a means reasonably designed to prevent fraud, prohibiting deceptive conduct done negligently is a way to accomplish this objective.” Small comfort though it may be, advisers (and the professionals who serve them) are not alone in being confounded by the uncertainty of fraud that can be simple negligence or of undefined acts that may be actionable under Rule 206(4)-8. SEC Commissioner Paul S. Atkins, in a strongly-worded concurrence, argued against this feature of the Rule.  Said Commissioner Atkins,

from a purely practical perspective, I dispute the regulatory approach underlying the contention that “by taking sufficient care to avoid negligent conduct, advisers will be more likely to avoid reckless deception.” By an extension of that same logic, a strict liability standard would evoke even more care by advisors. Even if the SEC is authorized to pick the standard of care that applies broadly to all “fraudulent, deceptive, or manipulative” acts and practices, arbitrarily selecting a higher standard of care “just to be on the safe side” has the potential of misdirecting enforcement and inspection resources and chilling well-intentioned advisors from serving their investors. (emphasis supplied)

Perhaps because neither knowledge nor intent is a required element of a Rule 206(4)-8 violation, the SEC determined that the covered class—investors and prospective investors—should be without the authority to bring private actions for violations.  Nevertheless, the remedies that will be available to the SEC in civil and administrative enforcement actions in reliance on the new rule will include cease and desist orders, debarment from associating with an investment adviser, application of civil fines or injunctions, and even disgorgement.  Of course, there remains the possibility that the Courts will infer the existence of a private right of action under the new rule.

In addressing the “hole” left by the Goldstein decision, the SEC has adopted a rule that circumvents the definitional hurdle that led to the Hedge Fund Rule being vacated. In the current environment, Fund managers may find themselves perplexed as to whether their conscientious practices to benefit the interests of the Fund as a whole might result in sanctions because an unintentional act directed at a prospective investor is deemed fraudulent.  Rule 206(4)-8’s proscriptions will require advisers to prepare for full-scale assessments of currently circulating and proposed materials available to the public.  Daunting as it may be, the task will be made all the more difficult by the adoption of a standard of care far different from past practice and one that may differ for a Fund’s varied constituencies.

[1] §206(4)-8 Pooled investment vehicles.

(a) Prohibition. It shall constitute a fraudulent, deceptive, or manipulative act, practice, or course of business within the meaning of section 206(4) of the Act (15 U.S.C. 80b-6(4)) for any investment adviser to a pooled investment vehicle to:

(1) Make any untrue statement of a material fact or to omit to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle; or

(2) Otherwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.

(b) Definition. For purposes of this section “pooled investment vehicle” means any investment company as defined in section 3(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(a)) or any company that would be an investment company under section 3(a) of that Act but for the exclusion provided from that definition by either section 3(c)(1) or section 3(c)(7) of that Act (15 U.S.C. 80a-3(c)(1) or (7)).

For additional information on this topic, you may contact Howard A. Neuman and Carol Spawn Desmond.