The Securities and Exchange Commission has adopted a new rule intended to clarify its authority to bring enforcement actions against hedge fund advisers. The SEC’s action comes in the wake of a federal appeals court decision questioning attempts by the SEC to invoke its statutory authority to control hedge funds and other pooled investment vehicles. The new rule clarifies the SEC’s intent to expand its regulation of hedge funds and similar investment types and authorizes enforcement actions against investment advisers without a showing of fraudulent intent. The new rule, while not creating any private right of action, will also apply to both registered and unregistered investment advisers.
The new rule appears to be inspired by the DC Circuit’s decision in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). The SEC has previously brought enforcement actions under section 206 of the Investment Advisers Act of 1940, 15 U.S.C. § 80-b(1), et seq., against investment advisers that the SEC alleges have defrauded investors in hedge funds or other pooled investment vehicles. The statutory provision invoked by the SEC, 15 U.S.C. § 80-b(3), by its terms does not apply to investment advisers with 15 or fewer clients.
After the near collapse of the Long Term Capital Management fund in 1998, the SEC began exploring ways to increase the regulation of hedge funds. With the fund itself considered to be the “client,” section 80-b(3) did not apply. In 1994, the SEC issued a regulation redefining the term “client” as used in section 80-b(3). Under the rule, advisers to hedge funds must register with the Commission if the funds they advise have fifteen or more “shareholders, limited partners, members, or beneficiaries.” 17 C.F.R. § 275.203(b)(3)-2. In Goldstein, an investment advisory firm and a hedge fund petitioned the court for review of an SEC order regulating hedge funds under the Investment Advisers Act of 1940. The court held that this rule, which essentially required that investors in a hedge fund be counted as clients, was invalid as conflicting with the purposes underlying the statute.
In answer to this decision, the SEC has now adopted Rule 206(4)-8, which becomes effective on September 10, 2007. In doing so, the SEC has invoked section 206(4) of the Investment Advisers Act of 1940, which specifically makes it unlawful for investment advisers to engage in any act or practice that is fraudulent or deceptive and authorizes the SEC to adopt rules that are reasonably designed to prevent fraud by advisers. This new rule allows the SEC to avoid the client limitation on which the Goldstein decision was premised.
Under new rule 206(4)-8, it is a violation for the investment advisor of any pooled investment vehicle to:
- make any untrue statement of a material fact or 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.
The new rule clarifies that the duties of investment advisers to avoid fraudulent practices extend to and include an adviser’s relationship with the ultimate investors. In responding to comments on the new rule, the SEC has stated that it intends “to prohibit all fraud on investors” in pooled investment vehicles managed by investment advisers. It should be noted that the new rule specifically applies to prospective investors as well as current investors in hedge funds and other pooled asset vehicles. The new rule also applies to registered and unregistered investment advisers. Unlike other rules, such as rule 10b-5, the SEC does not need to demonstrate that an adviser has violated rule 206(4)-8 deliberately. Instead, the rule includes negligent, reckless, or deliberately deceptive conduct. The new rule, however, does not create any private right of action.
By adopting rule 206(4)-8, the SEC has signaled its intent to increase its enforcement of the laws against hedge fund advisers and advisers to other pooled asset vehicles. The rule allows the SEC to proceed against advisers that disseminate materially false or misleading information or omit material information, with or without intent to defraud, or otherwise engage in fraudulent conduct.