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July 2007 www.klgates.com
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Cary J. [email protected]
Alexandra C. [email protected]
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HedgeFund/PrivateEquity/InvestmentManagementAlert
SEC Adopts Antifraud Rule 206(4)-8 for Advisers to Pooled Investment Vehicles
On July 11, 2007, the U.S. Securities and Exchange Commission (“SEC”) voted unanimously to adopt Rule 206(4)-8, an antifraud provision under the Investment Advisers Act of 1940 (“Advisers Act”). Rule 206(4)-8 will enable the SEC to bring enforcement actions against investment advisers for making false or misleading statements to, or otherwise defrauding, investors or prospective investors in pooled investment vehicles. The rule will apply to advisers not only of hedge funds, but also of private equity funds, venture capital funds and mutual funds, and will apply regardless of whether those advisers are required to be registered under the Advisers Act.
The potential application of Rule 206(4)-8 is very broad, because the rule does not require a showing of scienter (i.e., intent by the adviser to deceive, manipulate, or defraud), nor does it require a connection to a sale of securities. Examples of actions that could trigger enforcement under the rule include making false or misleading statements regarding fund performance or taking fees to which an investment adviser is not entitled, even if such actions are done only negligently and not intentionally.
The Commissioners expressed the belief that investment advisers are likely already doing what is necessary to comply with the rule, and thus the formal adoption of this rule should not require the implementation of any new business practices. As a practical matter, however, the rule could encourage even unregistered advisers to adopt policies and procedures relating to disclosure, trading and other issues meant to help defeat a claim of negligence if the adviser were to inadvertently issue any false or misleading information or engage in any activity that could potentially be deemed to be false or misleading.
When asked how the rule would affect side letters, the SEC Staff stated that it would depend on whether an external obligation to disclose side letters existed, and explained that because the rule does not create a fiduciary duty across the board, it would depend upon the facts and circumstances of the case.
Rule 206(4)-8 was proposed in December 2006 in response to legal uncertainty resulting from Goldstein v. Securities and Exchange Commission. In that case, the D.C. Circuit Court struck down a rule requiring most hedge fund advisers to register under the Advisers Act. That decision, which found that investors in hedge funds are not clients of the investment adviser of the fund, may have called into question the extent to which investors or potential investors in pooled investment vehicles would be protected by existing antifraud provisions.
Although the final language of the rule has not yet been published, the SEC stated that it was adopting the rule as it was originally proposed. The rule, which will become effective 30 days from publication in the Federal Register, does not create a private right of action against the adviser, does not create any new fiduciary duties to investors or prospective investors and does not modify other federal or state laws or regulations relating to investors in a pooled investment vehicle.
July2007|2
HedgeFund/PrivateEquity/InvestmentManagementAlert
When the new antifraud rule was originally proposed, the SEC additionally proposed the adoption of a new definition of “accredited investor” that would include natural persons who meet the current net worth or income standards specified in Rule 215 or in Rule 501(a) under the Securities Act of 1933, as applicable, and who, in addition, own at least $2.5 million in investments, as defined in the proposal. The SEC has not yet taken final action on that proposed accredited investor standard.
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