On August 3, 2007, the Securities and Exchange Commission (the “SEC”) published the release (“Release”) adopting Rule 206(4)-8 (the “Rule”) under the Investment Advisers Act of 1940, as amended (“Advisers Act”).1 The Rule prohibits investment advisers from (1) making any false or misleading statements to investors or prospective investors of pooled investment vehicles they advise, or (2) engaging in fraudulent conduct involving these investors. The Release also clarifies that an investment adviser’s duty to refrain from fraudulent conduct under the federal securities laws extends to the relationship with the ultimate investors and that the SEC may bring enforcement actions under the Advisers Act against investment advisers who defraud investors or prospective investors in pooled investment vehicles. The Rule will become effective 30 days after publication in the Federal Register.
The SEC proposed the Rule on December 16, 2006, in response to the Goldstein v. SEC opinion by the U.S. Court of Appeals for the D.C. Circuit,2 which created uncertainty regarding the obligations that investment advisers to pooled investment vehicles have to the pools’ investors. In that decision, the court expressed the view that, for purposes of Sections 206(1) and 206(2) of the Advisers Act, the “client” of an investment adviser managing a pool is the pool itself, not the investors in the pool. As a result, the opinion created some uncertainty regarding the application of Sections 206(1) and 206(2) of the Advisers Act in certain cases where investors in a pool are defrauded by an investment adviser.
Unlike Sections 206(1) and 206(2) of the Advisers Act, Section 206(4) is not limited to conduct aimed at clients or prospective clients of investment advisers.3 Section 206(4) allows the SEC to adopt rules proscribing fraudulent conduct that is potentially harmful to investors who directly or indirectly invest in hedge funds and other types of pooled investment vehicles. Accordingly, the SEC adopted the Rule under this authority.
The Rule prohibits an adviser to pooled investment vehicles from (i) making false or misleading statements to investors or prospective investors in pooled investment vehicles or (ii) otherwise defrauding these investors or prospective investors. The SEC will enforce the Rule through civil and administrative enforcement actions.
The Rule applies to both registered and unregistered investment advisers and to any pooled investment vehicle they advise. “Pooled investment vehicle” is defined as any investment company defined in Section 3(a) of the Investment Company Act of 1940, as amended (“1940 Act”), and any privately offered pooled investment vehicle that is excluded from the definition of investment company by reason of either Section 3(c)(1) or 3(c)(7) of the 1940 Act. As a result, the Rule applies to advisers to hedge funds, private equity funds, venture capital funds, and other types of privately offered pools that invest in securities, as well as advisers to investment companies that are registered with the SEC. The SEC asserts in the Release that the Rule should not require investment advisers to take significant compliance steps or incur large costs because prior to the Goldstein opinion, advisers to pooled investment vehicles operated with the understanding that the Advisers Act prohibited the conduct that the Rule now prohibits.
Rule 206(4)-8(a)(1) prohibits any investment adviser to a pooled investment vehicle from making any untrue statement of a material fact to any investor or prospective investor in the pooled investment vehicle, or omitting to state a material fact necessary in order to make the statements made to any investor or prospective investor in the pooled investment vehicle, in the light of the circumstances under which they were made, not misleading. Unlike other anti-fraud provisions of the federal securities laws (e.g., Rule 10b-5 under the Securities Exchange Act of 1934, as amended) that focus on securities transactions, the Rule is not limited to fraud in connection with the purchase and sale of a security. Accordingly, the Rule prohibits advisers to pooled investment vehicles from making any materially false or misleading statements to investors in the pool regardless of whether the pool is offering, selling, or redeeming securities.
Importantly, the Rule does not require the SEC to demonstrate that an adviser violating the Rule acted with scienter. The Release notes that a violation of the Rule could rest on simple negligence. However, the Release also states that the Rule does not create a fiduciary duty under the Advisers Act to investors or prospective investors in a pooled investment vehicle that is not otherwise imposed by law. Nor does the Rule 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 it advises.4 In addition, the SEC asserts in the Release that the Rule does not provide a private cause of action against an adviser.
Examples of Prohibited Conduct
The Rule prohibits false or misleading statements that are made, for example, to existing investors in account statements as well as to prospective investors in private placement memoranda, offering circulars, or responses to “requests for proposals,” electronic solicitations, and personal meetings arranged through capital introduction services. Among other things, the Rule prohibits materially false or misleading statements regarding:
- Investment strategies the pooled investment vehicle will pursue;
- The experience and credentials of the adviser (or its associated persons);
- The risks associated with an investment in the pool;
- The performance of the pool or other funds advised by the adviser;
- The valuation of the pool or investor accounts in it; and
- Practices the adviser follows in the operation of its advisory business such as how the adviser allocates investment opportunities.