August 22, 2007
Hedge Fund Alert
An update on trends and developments affecting the hedge fund industry from Goodwin Procter LLP
The SEC has adopted a new anti‑fraud rule directed primarily at advisers of private investment funds. The impetus for the new rule was the June 2006 decision of the U.S. Court of Appeals for the District of Columbia (the "Goldstein decision") striking down Rule 203(b)(3)-2 under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), which required many hedge fund managers to register with the SEC as investment advisers. (See Goodwin Procter's June 26, 2006 Hedge Fund Alert, " U.S. Court of Appeals Vacates Hedge Fund Adviser Registration Rule But Withholds Mandate.") The new rule, which was adopted in the same form as originally proposed, is effective September 10, 2007. The rule highlights the SEC's ongoing emphasis on policing the activities of advisers and managers of hedge funds and other private investment funds.
The new rule signals that the SEC continues to focus intently on the fund activities of both registered and unregistered investment advisers, in particular with respect to their unregistered funds. The SEC has commented that the new rule does not expand the responsibilities of, or standards applicable to, advisers under the Advisers Act. It is, however, an indicator of the SEC's enforcement intentions, and advisers should review their compliance programs, particularly as they relate to communication and other interaction with current and prospective fund investors, in light of the new rule.
The SEC adopted the new anti-fraud rule in part to remove any doubt raised by the Goldstein decision about its ability to bring enforcement actions under the Advisers Act against an adviser to a hedge fund or other pooled investment vehicle based on allegations that the adviser defrauded the pool's investors or prospective investors. The new rule is very broad in scope and presents many issues that fund advisers should consider (or revisit) in view of the SEC's continuing focus on regulation of private investment vehicles and their managers, including the following:
Types of Advisers
Unlike the rules previously adopted under Section 206 of the Advisers Act, the new anti-fraud rule applies to any manager or adviser of a "pooled investment vehicle" that is an "investment adviser" under the Advisers Act, including unregistered advisers and advisers registered only with state regulatory authorities.
Types of Funds
The "pooled investment vehicles" subject to the new anti-fraud rule are funds of any strategy, structure or jurisdiction that are "investment companies" under Section 3(a) of the Investment Company Act of 1940, as amended (the "1940 Act"), or rely on the exclusions in Section 3(c)(1) or (7) of the 1940 Act. The release adopting the rule (the "Adopting Release") specifically contemplates the rule's application to advisers to hedge funds, private equity funds, venture capital funds and other types of privately offered pools that invest in securities and rely on the aforementioned exclusions, as well as to advisers with respect to mutual funds and other registered investment companies they advise. The Adopting Release provides the following examples of topics on which advisers might make statements that run afoul of the new rule:
Applies with Respect to Potential Investors
The new rule applies to statements made not only to investors, but also to potential investors in, for example:
Fraud Whether or Not Related to a Securities Transaction
The new rule prohibits material misstatements or omissions to investors, using language similar to that of existing anti-fraud Rule 10b-5 under the Securities Exchange Act of 1934, as amended. Unlike Rule 10b-5, however, the new rule applies to untrue statements made outside of the context of a securities transaction, i.e., they need not be made "in connection with" the purchase or sale of a security to fall within the new rule's scope. For example, the new rule would cover account statements and reports provided to investors at times when a fund is not offering, selling or redeeming securities.
Conduct Other Than Statements
The new rule includes a more general prohibition on acting in a manner that is "fraudulent, deceptive or manipulative" with respect to any investor or prospective investor, even if the conduct does not involve any "statements."
The Adopting Release reiterates that the new rule encompasses negligent conduct and that the SEC need not make the more difficult finding that a fund adviser or manager made a misstatement knowingly or with scienter, as required under Rule 10b-5.
Registered Investment Companies
The scope of the new rule is broader than that of Section 34(b) under the 1940 Act which applies a similar anti‑fraud standard to documents required under the 1940 Act to be filed with the SEC, transmitted or kept as records. Accordingly, advisers to registered investment companies will want to ensure that communications and other interactions with shareholders and potential shareholders that fall outside Section 34(b) are subject to controls and procedures designed to ensure compliance with the new rule's standards.
No New Fiduciary Duty
The Adopting Release expressly states that the new rule does not create a fiduciary duty under the Advisers Act not otherwise imposed by law and does not alter any duty or obligation an adviser has under the Advisers Act or any other law or regulation. The Adopting Release also observes that even before the Goldstein decision "advisers to pooled investment vehicles operated with the understanding that the Advisers Act prohibited the conduct that [the new anti‑fraud rule] prohibits, [and therefore,] advisers that are attentive to their traditional compliance responsibilities will not need to alter their business practices or take any additional steps and incur new costs as a result of this rule's adoption." However, the Adopting Release also notes that the rule would permit the SEC to bring an enforcement action against an investment adviser that violates a fiduciary duty imposed by other law where the violation falls within the categories of fraud the new rule prohibits. As an example of this kind of violation, the Adopting Release cites the situation where an adviser negligently or deliberately fails to make a material disclosure to a fund investor where the adviser is subject to a duty under another law to make that disclosure.
No Private Right of Action
The Adopting Release states that the new anti-fraud rule does not create a private right of action against fund advisers. This limits enforcement of the new rule to the SEC (which may act through the administrative process or the courts to seek injunctions, civil penalties, disgorgement of profits and other sanctions) and does not create a new avenue for shareholder litigation. The Adopting Release does not discuss how the SEC staff would gather evidence to pursue enforcement actions against unregistered advisers under the new rule without the benefit of the recordkeeping requirements and inspection powers to which registered advisers are subject under the Advisers Act.
While, as a legal matter, the adoption of the new anti‑fraud rule may not expand liability for registered and unregistered advisers under the Advisers Act, it does signal that the SEC is intently focused on the activities of registered and unregistered advisers with respect to their pooled vehicles, particularly those that are unregistered. In recent testimony before the Senate Committee on Banking, Housing and Urban Affairs, SEC Chairman Christopher Cox cited the SEC's adoption of the new anti‑fraud rule as evidence that the SEC has the capability to combat fraud in the hedge fund sector. In this environment, it would therefore seem prudent for each advisory organization that advises "pooled investment vehicles," particularly advisers that are not registered, to inventory the different types of communications and other interactions that the organization has, or may from time to time have, with existing investors and potential investors in its pooled vehicles to ensure that there are adequate controls in place to prevent the types of conduct the new anti‑fraud rule prohibits.
The SEC release adopting the new anti‑fraud rule is available on the SEC's website at: SEC Advisor Anti-Fraud Rule Adopting Release.
 In response to public comments seeking clarification regarding the rule's application to offshore advisers' interactions with non‑U.S. investors, the SEC release adopting the new rule indicates that the rule's adoption does not alter the SEC's jurisdictional authority.
This publication, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. Additionally, the foregoing discussion does not constitute tax advice. Any discussion of tax matters contained in this publication is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or promoting, marketing or recommending to another party any transaction or matter. ¸ 2007 Goodwin Procter LLP. All rights reserved.
Elizabeth Shea Fries, a partner in Goodwin Procter's Business Law Department and a member of its Financial Services Group, as well as chair of its Hedge Funds Practice, has particular expertise in innovative investment products, hedge funds and other alternative investments, financial services merger and acquisition transactions, fiduciary issues and compliance matters. Ms. Fries dedicates her practice to a broad range of investment management, fund, broker-dealer, banking and other financial services matters. She is experienced in the public and private offering of interests in open-end and closed-end management investment companies and other collective investment vehicles or pools, such as offshore investment funds, investment limited partnerships, private REITs, CDOs, group trusts, common and collective funds and investment trusts. Ms. Fries has substantial expertise regarding the organization and structure of numerous business and investment entities and assists clients in creating and implementing investment products and service arrangements. Ms. Fries also counsels investment advisers, investment companies, banks, insurance companies, brokers and other providers of financial services regarding complex compliance issues resulting from the operation and integration of a variety of investment businesses.
Jackson B. R. Galloway, senior counsel in Goodwin Procter's Business Law Department and a member of its Investment Management Practice, assists clients with the organization and operation of collective investment vehicles, including registered open- and closed-end investment companies, hedge funds and offshore funds. Mr. Galloway also counsels registered and unregistered investment advisory organizations regarding regulatory compliance and related matters. Mr. Galloway is an editor of the firm's weekly financial services newsletter, Financial Services Alert, and is the publication's principal contributor on developments in the investment management industry.
Rufus C. King, a partner in Goodwin Procter's Corporate and Private Equity Groups, concentrates in corporate, partnership and securities law. Mr. King represents venture capital and other private equity funds, both in fund organization and in investment transactions. He has also represented public and private high-technology companies in all aspects of corporate operation and development. Mr. King has acted as issuers' and underwriters' counsel in public offerings. Mr. King represents a wide range of venture capital and private equity funds, both in the United States and internationally.
Christopher E. Palmer is leader of the Business Law Department in Goodwin Procter's Washington, D.C. office, and is a member of the Financial Services Group. Mr. Palmer focuses his practice on securities, investment management and insurance matters. Mr. Palmer represents mutual funds, investment advisers, insurance companies and broker-dealers on the development, regulatory approval, sale and administration of a variety of investment products, including mutual funds and variable and fixed life insurance and annuity contracts. He also represents mutual fund independent directors. Mr. Palmer advises companies on securities law matters, including reporting and corporate governance matters. He also represents companies in financial services litigation, SEC inspections and enforcement actions, and before state insurance departments.
L. Kevin Sheridan, Jr., a partner in Goodwin Procter's Business Law Department, has a diverse transactional practice that includes leveraged buy-outs and other change-of-control transactions, private placements and public offerings of securities and the representation of sponsors, equity and debt participants in the origination and restructuring of structured finance transactions. Mr. Sheridan's practice also includes the representation of sponsors of private equity, real estate opportunity, debt opportunity and hedge funds on various matters, including fund formation and all other legal aspects of the management of a private investment business.
Derek N. Steingarten, an associate in Goodwin Procter's Business Law Department and a member of its Financial Services Group, focuses his practice on investment management and other financial services matters, including hedge funds, mutual funds and other investment structures, financial services merger and acquisition transactions and regulatory compliance. Mr. Steingarten has significant experience advising registered and unregistered investment advisers, banks and other institutions, as well as the independent directors of mutual funds, on a wide variety of financial services matters. He has particular expertise with public and private investment vehicles, including mutual funds, onshore and offshore hedge funds, CDOs and other structures.
Goodwin Procter LLP is one of the nation's leading law firms with more than 750 attorneys in offices in Boston, Los Angeles, New York, Palo Alto, San Diego, San Francisco, and Washington, D.C. The firm's core areas of practice are corporate, litigation and real estate, with specialized areas of focus that include financial services, private equity, technology, REITs and real estate capital markets, intellectual property and products liability.