The Securities and Exchange Commission (the “SEC”) on Aug. 3, 2007, issued a release (the “Adopting Release”) adopting the new investment adviser anti-fraud rule it had proposed on Dec. 27, 2006. Rule 206(4)-8 (the “Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”) makes it a fraudulent, deceptive or manipulative act, practice or course of business within the meaning of Section 206(4) of the Advisers Act for an investment adviser of a “pooled investment vehicle”: (a) to make any false or misleading statements or to omit any material fact to an investor or prospective investor in a pooled investment vehicle; or (b) to otherwise engage in any fraudulent, deceptive or manipulative act with respect to an investor or prospective investor in the pooled investment vehicle.

The Rule applies to investment advisers to “pooled investment vehicles,” which are defi ned by the Rule to include “investment companies” as defi ned in Section 3(a) of the Investment Company Act of 1940 (the “1940 Act”) and those investment pools, including many hedge funds, private equity funds, and venture capital funds, that rely on an exclusion from the defi nition of an investment company contained in either Section 3(c)(1) or Section 3(c)(7) of the 1940 Act. The Rule became effective as of Sept. 10, 2007.

The impetus for the Rule was the June 2006 decision of the U.S. Court of Appeals for the D.C. Circuit in Goldstein v. SEC, which overturned the SEC’s hedge fund adviser registration rule. In the view of the SEC, the Goldstein decision “created some uncertainty” as to whether Sections 206(1) and 206(2) of the Advisers Act (which make it unlawful to defraud clients and prospective clients) apply to the defrauding of investors in pooled investment vehicles because the court in Goldstein interpreted the term “client” to mean the pool itself and not the investors in the pool. Rule 206(4)-8 provides that investors and prospective investors in a pooled investment vehicle may not be defrauded.

The Adopting Release specifi es that:

  • The Rule applies to both registered and unregistered investment advisers.
  • There is no scienter requirement under the new Rule 206(4)-8. The SEC need only show negligent—not intentional— misconduct.
  • The Rule is not limited to situations “in connection with the purchase or sale of a security.” The pooled investment vehicle need not be offering, selling or redeeming securities to trigger a violation of the Rule. • The Rule applies both to current and prospective investors.
  • Only the SEC may enforce the Rule; there is no private right of action. 
  • The Rule applies to conduct, not just statements. For example, collecting fees that an adviser is not entitled to might be the basis for a fraud claim under the Rule.

Practical Implications of the Rule

The Adopting Release, and public statements by SEC commissioners and staff, indicate some areas where the impact of the Rule is likely to be felt:

Investor Communications.As noted above, the Rule is not limited to situations “in connection with the purchase or sale of securities.” Therefore, all investor communications are subject to the Rule. SEC staff have, in particular, noted that there may be situations where account statements and shareholder reports misrepresent the value of assets or the performance of a fund. The SEC also noted other topics that may be misrepresented by advisers in violation of the Rule, including the nature of the investment strategies that a vehicle intends to pursue, the credentials of the adviser’s key personnel and the risks associated with investing in the vehicle.

  • Marketing Materials. The Rule applies to marketing materials, whether or not the recipient of the materials ever becomes an investor. In addition, the absence of a scienter requirement means that unintentional errors in a pitchbook might be the subject of a fraud allegation under the Rule. 
  • Side Letters. The failure to disclose a side letter to all investors may be the subject of a fraud allegation under the Rule. While acknowledging that the analysis will depend heavily on the particular facts and circumstances at issue, the SEC staff indicated that if there is a contractual or legal obligation to disclose a side letter, then failure to do so would be fraud under the Rule.

The manner in which the SEC’s enforcement and examination divisions will apply the new anti-fraud Rule remains to be seen. The SEC can be expected to carefully review side letters, offering memoranda, ADV disclosures, and due diligence questionnaire responses for compliance with the Rule. Advisers to pooled investment vehicles should evaluate their compliance programs—particularly in connection with communications and operating procedures—in light of the new Rule