In late December 2006, the Securities and Exchange Commission (SEC) proposed new rules that would impact certain hedge funds and their investment advisers.1 The rules, proposed under the Investment Advisers Act of 19402 and the Securities Act of 1933,3 are part of the SEC's response to the June 2006 decision by the United States Court of Appeals for the District of Columbia Circuit in Goldstein v. U.S. Securities and Exchange Commission.4 Goldstein had its roots in the SEC's adoption, in 2004, of a controversial rule5 under the Advisers Act which was intended to require registration of most advisers to hedge funds offered in the United States. That rule was invalidated by the court in Goldstein and the SEC went back to the drawing board. In the wake of Goldstein, the SEC undertook to review its approach to overseeing the activities of hedge funds and their advisers. The proposed rules are the result of that review.
Some Hedge Fund Basics
The Investment Company Act of 1940. Because hedge funds trade securities, they would generally be subject to registration with the SEC under the Investment Company Act of 19406 but for exceptions that exist in that act for privately offered entities. Hedge funds generally rely on either 3(c)(1) or 3(c)(7)7 to avoid registration under the '40 Act. Both exceptions require that the fund be privately offered. In practical terms, a 3(c)(1) fund may have up to 100 owners who are "accredited investors" as that term is defined in Regulation D under the '33 Act. Up to 35 non-accredited investors may be among the 100 owners in a 3(c)(1) fund.8 A domestic 3(c)(7) fund, in practical terms, may have up to 499 owners who are "accredited investors" and, in addition, "qualified purchasers," as that term is defined in the '40 Act.9
The Securities Act of 1933. The interest in a hedge fund, whether a limited partnership interest, limited liability company interest or share of corporate stock is a "security" for purposes of the '33 Act. In order to avoid the registration requirements of the '33 Act with respect to the sale of their securities, hedge funds generally rely on the private offering exemption in 4(2)10 of that act and on the safe harbor contained in Regulation D promulgated thereunder.11 Section 4(2) exempts from registration securities sold without any "public offering." As a practical matter, this means that there can be no mass mailings about the fund, no meetings with prospective investors that have been solicited by a mass mailing, and no communication (electronic or otherwise) that could be viewed as a general solicitation or advertisement.
The Rule Proposals
The SEC has proposed a new anti-fraud rule under the Advisers Act, which would apply to all investment advisers regardless of their registration status. The effect of the proposed anti-fraud rule would be to permit the SEC to bring enforcement actions against advisers that violate the rule. While investors in hedge funds would not have a private right of action under the new rule, they have, of course, a common law right to sue their hedge fund advisers for fraud.12 As a general matter, the proposed anti-fraud rule should not be problematic for any adviser that is following a "best practices" approach to its business. As discussed below, however, parts of the rule as proposed could make it more likely that practices thought to be acceptable under certain circumstances could be deemed inappropriate in hindsight (because of changing disclosure standards, for example). Thus, advisers could find themselves having to defend practices that were undertaken with an understanding that such practices were acceptable.
The SEC has also proposed new rules and rule amendments under the '33 Act that would raise the suitability threshold for natural persons who wish to invest in certain hedge funds. A two-step suitability analysis would apply with respect to natural persons in hedge fund offerings that rely on 3(c)(1) of the '40 Act. In order for an individual to qualify as an accredited investor for a 3(c)(1) offering, he would be required to satisfy the traditional Regulation D criteria and, in addition, would need to have $2.5 million in "investments" as defined in the proposed rule. This stricter standard would effectively preclude many individuals from investing in certain hedge funds because, among other reasons, personal residences would be excluded from the term "investments." A similar two-step analysis applies to 3(c)(7) funds (except that investors must have either $5 million or $25 million in investments, as noted above).
Proposed Anti-Fraud Rule 206(4)-8 Under The Advisers Act
Section 206(4) of the Advisers Act13 generally prohibits an investment adviser from engaging in any act, practice or course of business which is fraudulent, deceptive or manipulative. Section 206(4) directs the SEC to use its rulemaking authority to define fraudulent, deceptive and manipulative acts, practices and courses of business, and to prescribe means reasonably designed to prevent such activities. The hedge fund adviser registration rule invalidated by Goldstein required an investment adviser to certain private funds to consider the underlying investors of the fund as clients for certain purposes.14 The Goldstein decision cast doubt on the applicability of the anti-fraud provisions in the Advisers Act to underlying investors in a fund. Sections 206(1) and 206(2) of the Advisers Act15 refer specifically to clients and prospective clients. To the extent that investors in funds are not considered to be clients of the adviser, these sections do not apply to the relationship between the adviser and the investors. The SEC is proposing new anti-fraud Rule 206(4)-8, which would explicitly prohibit certain activities with respect to the underlying investors or prospective investors in pooled investment vehicles. Proposed Rule 206(4)-8 would apply to all investment advisers to pooled investment vehicles, regardless of whether the adviser is registered under the Advisers Act. A "pooled investment vehicle" for purposes of this proposed rule would include any registered investment company and any company that would be an investment company but for the exclusion provided by 3(c)(1) or 3(c)(7) of the '40 Act.
The proposed rule would make it a fraudulent, deceptive or manipulative act, practice or course of business in violation of 206(4) of the Advisers Act for an investment adviser to a pooled investment vehicle to make false or misleading statements or to otherwise defraud investors or prospective investors in that pool. The SEC noted that, unlike Rule 10b-5 under the Securities Exchange Act of 1934,16 which prohibits materially untrue or misleading statements in connection with the purchase or sale of any security , proposed Rule 206(4)-8 would prohibit advisers to pooled investment vehicles from making materially false or misleading statements to any investor or prospective investor in the pool regardless of whether the pool is offering, selling or redeeming its securities.
By way of example, the SEC Release states that the proposed rule would prohibit materially false or misleading statements regarding
investment strategies the pooled investment vehicle will pursue (including strategies the adviser may pursue for the pool in the future),
the experience and credentials of the adviser (or its associated persons),
the risks associated with an investment in the pool,
the performance of the pool or other funds advised by the adviser,
the valuation of the pool or investor accounts in it, and
practices the adviser follows in the operation of its advisory business, such as how the adviser allocates investment opportunities.
The SEC is also proposing, in Rule 206(4)-8(a)(2), to prohibit other fraudulent, deceptive or manipulative acts or practices with respect to investors or prospective investors in pooled investment vehicles by advisers to such vehicles that may not involve "statements." That part of the proposed rule basically repeats the statutory provision in 206(4) without providing any additional guidance. In effect, it states that engaging in a fraudulent, deceptive or manipulative act or practice with respect to an investor or prospective investor is fraudulent, deceptive and/or manipulative. This portion of the rule would be more useful if it identified particular acts and practices that are prohibited or restricted because they are deemed to be, or are likely to lead to, fraud: otherwise, investment advisers may learn only through enforcement actions that certain acts and practices are regarded by the SEC staff as fraudulent.17
Based on a 1992 decision by the United States Court of Appeals for the District of Columbia Circuit, the SEC believes that it need not demonstrate in an enforcement proceeding that an adviser acted with scienter (i.e., an intent to deceive, manipulate, or defraud) in order to establish a violation of Rule 206(4)-8.18
This article will be continued in the June issue of The Metropolitan Corporate Counsel.1 Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited Investors in Certain Private Investment Vehicles, Release No. 33-8766; IA-2576: File No. S7-25-06, 2006 WL 3814994 (Dec. 27, 2006).
2 15 U.S.C.A. 80b-1 et seq. (Advisers Act).
3 15 U.S.C.A. 77a et seq. ('33 Act).
4 Goldstein v. S.E.C., 451 F.3d 873, Fed. Sec. L. Rep. (CCH) P 93890 (D.C. Cir. 2006). See also Willkie Farr & Gallagher LLP Client Memorandum, "U.S. Court of Appeals Overturns Hedge Fund Adviser Registration Rule" (June 23, 2006), available at http://www.willkie.com/firm/pubs.aspx.
5 The rule was adopted over the dissent of two of the five SEC Commissioners.
6 15 U.S.C.A. 80a-1 et seq. ('40 Act).
7 15 U.S.C.A. 80a-3(c)(1), 80a-3(c)(7).
8 A 3(c)(1) fund may have more than 35 non-accredited investors in the aggregate if it conducts separate offerings and certain conditions are satisfied.
9 Generally, individuals or family companies with a $5 million investment portfolio or institutions with a $25 million investment portfolio. 15 U.S.C.A. 80a-2(a)(51)(A).
10 15 U.S.C.A. 77d(2).
11 17 C.F.R. 230.501 et seq.
12 The Supreme Court has held that a limited private right of action exists under the Advisers Act to void an advisory contract, but that the act provides no other private rights of action. Transamerica Mortg. Advisors, Inc. (TAMA) v. Lewis, 444 U.S. 11, 100 S. Ct. 242, 62 L. Ed. 2d 146, Fed. Sec. L. Rep. (CCH) P 97163 (1979).
13 15 U.S.C.A. 80b-6(4).
14 See Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. 2333, 84 S.E.C. Docket 1032, 2004 WL 2785492 (Dec. 2, 2004).
15 15 U.S.C.A. 80b-6(1), 80b-6(2).
16 17 C.F.R. 240.10b-5.
17 The recent press reports about the investigation by the Massachusetts Secretary of State into the practice of investment banks providing office space and other assistance to start-up hedge fund advisers may illustrate this point. Several investment banks have provided various services, including introduction of prospective investors, to fledging hedge fund advisers over the past several years. The extent of the Massachusetts investigation is not yet known, but assessing in hindsight whether disclosure about the conflicts of interest attendant to such practices was appropriate may well involve a great deal of subjectivity.
18 S.E.C. v. Steadman, 967 F.2d 636, Fed. Sec. L. Rep. (CCH) P 96843 (D.C. Cir. 1992).
Rita M. Molesworth is a Partner in the Corporate and Financial Services Department of Willkie Farr & Gallagher in New York and is a member of the firm's Asset Management, Regulatory and Capital Markets Practice Group. This article was originally published in the January 2007 edition of Futures & Derivatives Law Report - the Journal on the Law of Investment & Risk Management Products (Thomson/West Vol. 27 No. 1). 2007 Thomson West. Reprinted with permission.