The SEC recently voted unanimously to adopt new Rule 206(4)-8 under the Advisers Act. The rule generally prohibits advisers to pooled investment vehicles from making false or misleading statements to, or otherwise defrauding, investors or prospective investors in the vehicles. The SEC adopted the new rule in response to Goldstein v. SEC in which the D.C. Court of Appeals vacated the “hedge fund registration rule.” Language in the court’s decision cast some doubt on the SEC’s ability to bring enforcement actions against advisers based on their dealings with investors and potential investors in pooled investment vehicles.
In our view, new Rule 206(4)-8 merely clarifies and reinforces the SEC’s ability to pursue enforcement actions against advisers to pooled investment vehicles who engage in misleading or fraudulent conduct with respect to investors and potential investors. In addition, we believe that the rule does not create any additional regulatory exposure for advisers and should not require advisers to adopt any additional compliance policies or take other steps to ensure compliance with the rule. A copy of the final rule and the adopting release, which were issued on August 3, can be found at:
A. Overview of the New Rule
The SEC adopted new Rule 206(4)-8 as proposed. The rule applies to both registered and unregistered advisers. The rule makes it a fraudulent, deceptive or manipulative act in violation of the Advisers Act for an adviser to a pooled investment vehicle to:
- Make any untrue statement of a material fact or to omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle; or
- 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.
For purposes of the rule, a “pooled investment vehicle” includes any investment company, as defined under the Investment Company Act, and any company that would be an investment company but for the exclusions in Section 3(c)(1) or 3(c)(7) of the Investment Company Act (e.g., hedge funds, private equity funds, venture capital funds and other types of privately offered vehicles that invest in securities). The rule does not distinguish between pooled investment vehicles based on their investment strategies, type of fund, or any lock up period. Moreover, the rule is not limited to fraud in connection with the purchase or sale of interests in a pooled investment vehicle. Finally, the rule does not create a private right of action, and therefore does not alter the standard of liability to investors.
B. Points of Clarification
As noted above, we believe that new Rule 206(4)-8 does not create any additional regulatory exposure for advisers and should not require advisers to take any additional steps to comply with the new rule. The adopting release includes a discussion of the new rule with helpful information that underscores our view. Some of the more significant points addressed in the adopting release are highlighted and summarized below.
1. Rule 206(4)-8 Does Not Alter the Rule 10b-5 Standard of Liability to Investors.
Rule 206(4)-8 provides the SEC, but not investors, with the ability to take action against investment advisers. The SEC acknowledged that, unlike Rule 10b-5, new Rule 206(4)-8 does not require the SEC to demonstrate that an adviser acted with scienter. In addition, the SEC acknowledged the concerns of some commenters that a negligence standard would expand the concept of fraud beyond its original meaning. The SEC stated, however, that the language of Section 206(4), upon which the new rule is based, is not limited to knowing or deliberate conduct. Accordingly, the SEC took the position that it is authorized to prescribe conduct that goes beyond fraud – including deceptive conduct done negligently – as a means to prevent fraud. The SEC added that the new rule does not create under the Advisers Act a fiduciary duty to investors and prospective investors in a pooled investment vehicle not otherwise imposed by law, nor does it “alter any duty or obligation an adviser has under the Advisers Act, any other federal law or regulation, or any state law or regulation (including state securities laws) to investors in a pooled investment vehicle” advised by the adviser.
2. Rule 206(4)-8 Does Not Create a Private Cause of Action. The Supreme Court has held that the Advisers Act provides only a limited private cause of action, specifically a right to seek the avoidance of an adviser’s contract. See Transamerica Mortgage Advisors, Inc. v. Lewis, 44 U.S. 11 (1979). Accordingly, the SEC has specifically acknowledged that Rule 206(4)- 8 does not create a private right of action.
3. Rule 206(4)-8 Applies to All Types of Communications with Investors and Potential Investors. New Rule 206(4)-8 prohibits advisers from making materially false or misleading statements whether or not the pooled investment vehicle is offering, selling or redeeming securities. The new rule differs from Rule 10b-5 in this respect. However, similar to Rule 10b-5, Rule 206(4)-8 would prohibit, for example, false and misleading statements regarding:
- A pooled investment vehicle’s proposed investment strategies;
- The experience and credentials of the adviser (or its associated persons);
- The risks associated with an investment in the vehicle;
- The performance of the vehicle or other funds advised by the adviser;
- The valuation of the vehicle or investor accounts in it; and
- Practices the adviser follows in the operation of its advisory business (e.g., how it allocates investment opportunities).
4. Rule 206(4)-8 Applies Equally to Prospective Investors. The SEC did not limit the new rule to conduct involving only existing investors in a pooled investment vehicle. The SEC acknowledged the argument that the new rule should not apply to prospective investors because fraud does not harm investors until they actually make an investment. The SEC stated, however, that false and misleading statements and other frauds by advisers are equally objectionable when made in a effort to attract new investors. Accordingly, the SEC noted that the rule prohibits, for example, false and misleading statements made to existing investors in account statements, and to prospective investors in:
- Private placement memoranda;
- Offering circulars;
- Responses to requests for proposals;
- Electronic solicitations; and • Personal meetings arranged through capital introduction services.
5. Rule 206(4)-8 Should Not Impose Any Additional Compliance Burdens. The SEC acknowledged concerns that the new rule would create additional compliance burdens, including for example, requiring advisers to conduct extensive reviews of all communications with clients. The SEC stated, however, that advisers who are “attentive to their traditional compliance responsibilities will not need to alter their business practices or take additional steps and incur new costs as a result of this rule’s adoption.” The SEC responded similarly to concerns that the breadth of the new rule’s prohibition may have a chilling effect on investor communications.
6. Rule 206(4)-8 Does Not Define “Fraud.” The SEC did not include a definition of fraud. Rather, the SEC noted that terms used in the new rule, such as “false statements” and “omissions,” encompass a well-developed body of law and that the conduct prohibited by the new rule is sufficiently clear and well understood. The SEC also noted that any effort to identify specific forms of fraudulent conduct prohibited by the rule would raise concerns about the status of conduct not specifically identified or provide “a roadmap for those wishing to engage in fraudulent conduct.”
C. Status of Revisions to the Accredited Investor Standard
At the same time that the SEC proposed Rule 206(4)-8, the agency also proposed to revise the accredited investor standard for certain private offerings. Specifically, the SEC proposed rules that would define a new category of accredited investor (referred to as an “accredited natural person”) which would apply to offers and sale of securities by certain pooled investment vehicles relying on Section 3(c)(1) under the Investment Company Act to accredited investors under Regulation D and Section 4(6) of the Securities Act. The proposal would effectively require those investors to own at least $2.5 million in “investments.”
The SEC stated in the Rule 206(4)-8 adopting release that the agency is deferring consideration of its proposal until it has an opportunity to evaluate fully comments received on the proposal along with comments received on a separate proposal to redefine the accredited investor standard for smaller companies. The SEC voted to propose those additional amendments on May 23, 2007. More recently, the SEC proposed for comment more sweeping changes to Regulation D. The most recent proposal would, among other matters, create a new category of eligible investor that would be based on the amount of “investments” owned by the investor. The proposals also would allow limited “tombstone” advertising in connection with sales to those investors, but the limited advertising would not be available to issuers also relying on Section 3(c)(1) or 3(c)(7) of the Investment Company Act. See Revisions of Limited Offering Exemptions in Regulation D, Securities Act Release No. 8828 (Aug. 3,