United States: Investment Advisers Act Update: SEC Issues Final Rule Prohibiting Fraud By Advisers To Certain Pooled Investment Vehicles*

The SEC has published the final release adopting as originally proposed a new antifraud rule under the Investment Advisers Act (the "Advisers Act") that prohibits fraud on investors in pooled investment vehicles.¹ The new rule — Rule 206(4)-8 — prohibits advisers to pooled investment vehicles from (i) making false or misleading statements to investors or prospective investors in those pooled vehicles, or (ii) otherwise defrauding those investors or prospective investors through improper conduct.

The rule will be enforced by the SEC through civil and administrative enforcement actions against advisers who violate the rule. The new rule goes into effect on September 10, 2007.

The rule was adopted in response to the opinion of the Court of Appeals for the District of Columbia Circuit in Goldstein v. U.S. Securities and Exchange Commission² that, for purposes of Sections 206(1) and (2) of the Advisers Act, the "client" of the investment adviser was the pool itself and not the individual investors in the pool. As a result, the Goldstein decision created some uncertainty regarding whether the SEC could continue to bring enforcement actions where investors in a pool are defrauded by the pool’s investment adviser. The new rule, however, clarifies that an adviser’s duty to refrain from fraudulent conduct extends to the individual investors in the pool, and thus the SEC can assert antifraud jurisdiction over advisers directly where the SEC failed to impose jurisdiction through registration.

A. Scope of Coverage

The scope of the rule is modeled after Sections 206(1) and (2) of the Advisers Act, which makes it unlawful for advisers to commit fraud upon clients or prospective clients. As such, the rule operates as a general antifraud rule prohibiting all fraud on investors in pooled investment vehicles, and is applicable to both registered and unregistered investment advisers. Pooled investment vehicles, in general, include any investment company defined in Section 3(a) of the Investment Company Act of 1940 (e.g., mutual fund) and any privately offered pools of fewer than 100 persons or owned by qualified purchasers (e.g., hedge funds, private equity funds, and venture capital funds).

B. Prohibition on False or Misleading Statements

Rule 206(4)-8(a)(1) prohibits advisers to pooled investment vehicles from making any materially false or misleading statements to investors or prospective investors in the pooled vehicle regardless of whether the pool is offering, selling, or redeeming securities. For example, the new 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.

C. Prohibition of Other Fraudulent Conduct

Rule 206(4)-8(a)(2) prohibits advisers to pooled investment vehicles from engaging in any act, practice, or course of business (i.e., conduct) that is fraudulent, deceptive or manipulative with respect to any investor or prospective investor in the pooled vehicle. This provision was designed to apply more broadly to deceptive conduct that may not involve statements.

D. No Scienter Requirement

Notwithstanding Commissioner Paul Atkins’ opinion that a finding of scienter should be required as part of establishing a violation under the rule,³ the Adopting Release reiterates that the SEC is not required to demonstrate that an adviser violating the new rule acted with scienter. This is consistent with the U.S. Supreme Court’s view of Section 17(a) of the Securities Act of 1933, which contains similar provisions. Thus, the rule covers statements and conduct that amount to no more than negligence and were not intended to deceive or mislead.

In light of the broad reach of the rule, it may become necessary for advisers to conduct more extensive reviews of all communications with investors and prospective investors to ensure that such communications do not contain untrue or misleading statements, as well as to review existing policies and procedures designed to prevent fraudulent conduct in its broadest sense.

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