SEC Adopts New Antifraud Provision Under the Investment Advisers Act of 1940

The SEC recently adopted a new antifraud provision under the Investment Advisers Act of 1940, 15 U.S.C. § 80(b), that becomes effective September 10, 2007. 

The new rule, 17 CFR 275.206(4)-8, prohibits advisers to pooled investment vehicles from making false or misleading statements to or otherwise defrauding investors or prospective investors in pooled investment vehicles.  The SEC adopted this rule in response to the decision in Goldstein v. SEC, 451 F.3rd, 873 (D.C. Cir. 2006) in which the Court of Appeals for the District of Columbia ruled that the "client" of an investment adviser was the pool itself and not an investor in the pool.  New Rule 206(4)-8 makes it clear that the SEC may prohibit conduct of an investment adviser that impacts the investor in the pool. 

The rule does not create a private right of action.  It only provides the SEC with the authority to enforce the rule.  The rule applies to both registered and unregistered investment advisers.  In other words, it applies to advisers of hedge funds, private equity funds and venture capital funds as well as mutual funds. 

The rule prohibits misleading statements and deceptive conduct that may not include statements.  The rule prohibits fraud on potential investors, including those that do not make an investment.  Unlike Rule 10b-5, there is no "in connection with" requirement and the SEC would not have to prove reliance or harm by any individual in an enforcement action.

Also, unlike Rule 10b-5, new Rule 206(4)-8 contains no scienter requirement.  It applies to negligent misrepresentations and conduct that is negligently deceptive.  Although negligent conduct is proscribed, the SEC specifically stated in its release (No. IA-2628) that the rule does not create a fiduciary duty not otherwise imposed by law. 

This rule should not change the way that investment advisers perform their duties.  It merely removes the doubt regarding the scope of the SEC's authority created by Goldstein.  The text of the new rule is set forth below:

Rule 206(4)-8 Pooled Investment Vehicles. 

(a)        Prohibition.  It shall constitute a fraudulent, deceptive, or manipulative act, practice, or course of business within the meaning of Section 206(4) of the Act, 15 U.S.C. § 80b-6(4), for any investment adviser to a pooled investment vehicle to:

(1) make any untrue statement of material fact or to omit to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle; or

(2) 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. 

(b)        Definition.  For purposes of this section "pooled investment vehicle" means any investment company as defined in section 3(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(a)) or any company that would be an investment company under section 3(a) of that Act but for the exclusion provided from that definition by either section 3(c)(1) or section 3(c)(7) of that Act (15 U.S.C. 80a-3(c)(1) or (7)).