Rule 206(4) under the Investment Advisers Act of 1940 prohibits investment advisers from making false or misleading statements to their current or prospective investors. In July 2007, the SEC adopted a new version of this rule that does not require scienter on the part of the adviser – meaning that instead of having to prove that an advisor intended to deceive its investors, the SEC is now working on the assumption that “negligence suffices for liability”.
Recent administrative actions by the SEC have shown that this distinction is not mere semantics, and that the SEC intends to monitor not just the information the investment advisors sends to it, but also communications between advisors and their investors. In fact, according to a DLA Piper client alert, the SEC has said that it will contact investors directly to obtain these communications.
“Because of the environment that we're in, you're seeing zero tolerance by the SEC for any misrepresentations, intentional or otherwise, between the investment advisor and his investor base”
The changes show a shift in the SEC's interpretation of fiduciary duty. Before, the SEC concerned itself with communications between the fund and the advisor. Now, there appears to be a real duty between the advisor and the ultimate investors in the fund.
A major driver of the change was the outcome of the decision by the DC Circuit Court of Appeals in favor of Philip Goldstein, a principle of an investment advisory firm who challenged the SEC's equating the term “client” with “investor” in order to force hedge funds to register as investment advisors. The Rule 206(4) change was seen as a way to ensure that the SEC could still protect the end investors in private funds managed by investment advisors – whether registered or unregistered.
The recent offenders
On 2 March, the SEC issued a cease-and-desist order against investment advisor MAG Capital for taking warrants from three hedge funds it advises without compensating the funds. The SEC had met with the firm's principal, David Firestone, to discuss the “warrant-taking in the PIPEs transactions and lack of adequate disclosure to the Funds' investors”, the SEC said in the order. After this discussion Firestone revised the PPMs of several funds to state that “in connection with financing a Portfolio Company, the Partnership and the General Partner may receive warrants to purchase common stock of the Portfolio Company”.
But the SEC felt MAG still wasn't being transparent enough. “This revised July 2006 disclosure, however, still failed to alert the Funds that the warrants that MAG took were being paid for by the Funds and that MAG was not compensating the Funds for these warrants,” the SEC said.
In another instance, the SEC charged MedCap Management & Research with “portfolio pumping”, or making large purchases at the end of the quarter of thinly traded stocks which the fund was already heavily invested in, in order to inflate their price. Last October MedCap paid the SEC $170,633, without admitting or denying the charges. Its principle, Charles Frederick Toney, has been barred from acting as an investment advisor for one year.
Danger zones
In the post-Madoff era, the SEC is cracking down on investor protection measures, and private equity funds and hedge funds alike need to tread carefully in their communications with investors.
“Because of the environment that we're in, you're seeing zero tolerance by the SEC for any misrepresentations, intentional or otherwise, between the investment advisor and his investor base,” says Perrie Weiner, co-chair of law firm DLA Piper's securities litigation group. The most common areas where these “miscommunications” can occur are: methodologies for valuation and fund performance, the advisor's description of its investment strategy and allocations, and the advisor's description of its internal systems and processes.
Valuation is the stickiest of these, because with the types of illiquid, long term assets that private equity funds tend to hold, valuation methods vary considerably, even among third-party auditors. And when an investor loses more money than he expected, the first thing he's going to scrutinise is how the assets were valued up until exit.
The best defence here is consistency, Weiner says. “If the method of valuation is spelled out, and/or the approach to valuation remains consistent, that puts the investment advisor in a safer position because he can say ‘We haven't changed the method, it's been applied consistently over time, and so you really have no basis to complain.’ But if you're an investment advisor who has changed his methodology, but you have not informed your investors of that change in methodology, that could create issues,” he says.
Anything in a fund's marketing materials could also be subject to heightened scrutiny as well, says Howard Caro, a partner in Hogan & Hartson's securities litigation practice.
“Let's say the SEC does an investigation and finds that Fund A didn't have a particularly robust compliance programme,” Caro says. “That in and of itself obviously isn't fraud or negligent representation, it's just internal conduct. But if the advisor is telling investors in its PPMs that one of the reasons they should invest their money with that advisor is because it's got this incredible compliance programme, that's not true. In the old days, that communication would not have been subject to SEC enforcement, but now it theoretically could be. The SEC is saying that it should be.”
Similarly, advisors had better adhere to whatever investment restrictions they agreed to with their LPs.
“In the post-Madoff era, if the operable agreements spell out a specific investment strategy, including a diversification of investments or a concentration or lack of concentration, what will happen is, when investors lose money, they're going to have their lawyers scrutinise the operable agreements to see if what the investment advisors have done in fact is consistent with what the agreements say. If it is not, they will exploit the discrepancy to their advantage and try to assert a client,” says Weiner.
What to expect
How exactly SEC enforcement of this new rule will play out depends on a number of factors. The political climate will be important: how much additional scrutiny of private investment funds will the government demand, in the wake of the alleged frauds carried out by Bernie Madoff and Allen Stanford? Then again, the SEC has a lot on its plate right now, so it might not have the resources to seriously ramp up its investigations of fund communications.
“I think the way it will play out is that when the SEC has a hook to go after a particular investment advisor, they're going to use this rule to broaden the scope of the conduct that they're looking at,” Caro says. “I'm not sure the Commission has the resources right now to go after funds to get information from their investors without an independent reason to investigate.”
He says he could, however, see the SEC requesting information from investment advisors who invest in particular industries or geographies that have been particularly hit by the economic downturn.
Registered investment advisors – which may soon include all private funds if the US Treasury has its way – should carefully review all of their communications, and make sure that they're doing everything they've agreed to do, and documenting their thought processes wherever possible.
“I'd have [advisors] carefully review their agreements vis-à-vis their investors to make sure their strategy is consistent with what they have said their strategy is, and make sure they are careful in their communications with their investors,” Weiner says. “In terms of valuation, they should pursue a consistent methodology, especially when it comes to hard to value illiquid securities, and in this environment they should take a reasonably conservative approach.”
The new regime
The revised Rule 206(4)-8, released in August 2007
§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. 80b6(4)) for any investment adviser to a pooled investment vehicle to:
(1) Make any untrue statement of a 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)).
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