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SEC Adopts Antifraud Rule for Hedge Fund Advisers

The SEC yesterday adopted an antifraud rule under the Investment Advisers Act to prohibit advisers to certain pooled investment vehicles, including hedge funds, from making false or misleading statements to defraud investors or prospective investors. New rule 206(4)-8 clarifies the SEC's ability to bring enforcement actions against investment advisers in response to uncertainties raised by the court of appeals decision in Goldstein v. SEC (451 F.3d 873 (D.C. Cir. 2006)). SEC Chairman Christopher Cox noted that the court, while raising those uncertainties, also offered the SEC a way to proceed under its rulemaking authority.

In the Goldstein decision, the court held that, for purposes of sections 206(1) and (2), the client of the investment adviser managing the pool was the pool itself, and not the investors in the pool. The court did not question the SEC's authority to adopt rules under section 206(4) to protect investors in pooled investment vehicles. Section 206(4) permits the SEC to adopt rules proscribing fraudulent conduct that may be harmful to investors who directly or indirectly invest in hedge funds and other types of pooled investment vehicles.

Robert Plaze, an associate director in the Division of Investment Management, explained that the prohibited conduct does not have to be in connection with the purchase or sale of a security. The staff chose not to outline specific conduct that is prohibited out of concern that it would provide a roadmap to evade the rule. He noted that the language in the new rule is almost identical to the SEC's other antifraud rules. The rule will apply to all investment advisers of pooled investment vehicles, regardless of whether the adviser is registered with the SEC.

The rule does not impose a new obligation on an adviser to a pooled investment vehicle, Plaze added. Law abiding advisers will not have to alter their current business practices to comply.

Cox noted that the draft of the final rule states that the rule will not alter the SEC's jurisdiction outside of the U.S. Plaze cited the staff position in Unibanco (Uniao de Bancos de Brasileiros S.A., SEC No-Action Letters Ind. & Summaries (WSB) #072792007 (July 28, 1992)) in which it concluded that the substantive provisions of the Investment Advisers Act will not apply with respect to a foreign registered adviser's non-U.S. clients. Plaze later added that, in his travels abroad, he has discovered that lawyers all know the Unibanco interpretation.

Cox asked Plaze to describe the kinds of misconduct at which the new rule is aimed. Plaze said, for example, the rule would address the distribution of false account statements or taking an investor's money without investing it, neither of which is misconduct in connection with the purchase or sale of securities. There is nothing in the rule that is inconsistent with the court's decision in Goldstein, he advised.

Commissioner Paul Atkins asked whether side letters would have to be disclosed. Plaze said they would have to be disclosed if the failure to do so would be deemed fraudulent. It is a "facts and circumstances" situation, he said. As for who would be deemed a potential investor, Plaze said it is those that the adviser solicits or to whom it distributes materials.

Commissioner Roel Campos, telephoning in from South Africa, said the timing of the rule could not be more appropriate given the rapid developments and changes in the hedge fund market and the major market force it represents.

The rule, which was adopted substantially as proposed, will take effect 30 days after publication in the Federal Register.