On August 9, 2007, the SEC published in the Federal Register its final rule prohibiting advisers to hedge funds, private equity funds, and other pooled investment vehicles from making false or misleading statements to investors or prospective investors in pooled investment vehicles, or otherwise defrauding such investors or prospective investors (72 Fed. Reg. 44,756 (Aug. 9, 2007)). New rule 206(4)-8 (the “Rule”) under the Investment Advisers Act of 1940 (the “Act”) is effective September 10, 2007, and it prohibits advisers from making false or misleading statements to existing investors in account statements, or to prospective investors in private placement memoranda, offering circulars, responses to “requests for proposals,” electronic solicitations, and/or personal meetings arranged through capital introduction services.
The Rule will apply to both registered and unregistered investment advisers who advise pooled investment vehicles. A “pooled investment vehicle” is defined as any investment company defined in section 3(a) of the Investment Company Act, and any privately offered pooled investment vehicle excluded from the definition of investment company by virtue of section 3(c)(1) or 3(c)(7) of the Investment Company Act. Accordingly, 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 registered investment companies, will be subject to the Rule. Significantly, a violation of the Rule does not require knowing, deliberate or intentional (scienter) fraudulent conduct. Instead, the SEC indicated that the Rule will be enforced under a negligence standard.
The Rule was adopted as a result of the opinion issued in Goldstein v. SEC (451 F.3d. 873 (D.C. Cir. 2006), which concluded that for purposes of sections 206(1) and (2) of the Advisers Act, a “client” of an investment adviser managing a pool is the pool itself, not an investor in the pool. As a result of this determination, it was unclear whether the SEC could continue to rely on sections 206(1) and (2) of the Advisers Act to bring enforcement actions in situations where investors in a pool were defrauded by an investment adviser to that pool.
The Rule does not create a new fiduciary duty under the Act, and does not create a new private right of action. Instead, the Rule prohibits advisers from making materially false or misleading statements regarding (i) investment strategies the pooled investment vehicle will pursue; (ii) the experience and credentials of the adviser (or its associated persons); (iii) the risks associated with an investment in the pool; (iv) the performance of the pool or other funds advised by the adviser; (v) the valuation of the pool or investor accounts in it; and (vi) practices the adviser follows in the operation of its advisory business (i.e. how the adviser allocates investment opportunities). Although it has been suggested that the application of the Rule to advisers to registered investment companies would be burdensome and would require advisers to conduct an extensive review of all communications with clients, the SEC indicated that advisers who are attentive to their traditional compliance responsibilities would not need to alter their business practices or take additional steps and incur new costs as a result of the Rule’s adoption.
In practice, the Rule reminds advisers of registered and non-registered pooled investment vehicles that they must continue to be vigilant to ensure the accuracy and veracity of the information they communicate to existing and potential investors. Advisers should review, verify and monitor all communications with investors to confirm the accuracy of all representations.