Category: Investment Advisers Act

Anti-Fraud Provision of the Investment Advisers Act

On September 10, 2007, the SEC Adopted Rule 206(4)-8. The SEC adopted this rule in response to the decision in Goldstein v. SEC, 451 F.3rd, 873 (in which the Court of Appeals for the District of Columbia ruled that the “client” of an investment adviser was the pool itself and not an investor in the pool).

Rule 206(4)-8 makes it clear that the SEC may prohibit fraudulent conduct of an investment adviser that impacts an investor in the investment pool, regardless of whether the investment adviser has registered with the SEC.

The rule does not create a private right of action.  It only provides the SEC with the authority to enforce the rule. But the SEC does have its broad authority to impose fines, sanctions bar individuals from the securities business and to seek criminal penalties.

The rule prohibits misleading statements and deceptive conduct and is not limited to “statements.” So,  the rule is applicable to non-written misstatements or omissions. The rule would include presentations at investor meetings and phone calls.

The bad act need not be made in connection with the sale of securities. Unlike 10b-5, this rule applies to regular disclosures and investor letters.

Unlike Rule 10b-5, there is no “in connection with” requirement and the SEC would not have to prove reliance or harm by any individual in an enforcement action. Also, Rule 206(4)-8 contains no scienter requirement, unlike Rule 10b-5.  The SEC need only prove that there was a misstatement or omission of a material fact.

The challenging piece is responding to requests for information from investors. If you are providing a piece of information to one investor and not providing it to others did you “omit to state a material fact”?

Although negligent conduct is proscribed, the SEC specifically stated that the rule does not create a fiduciary duty not otherwise imposed by law. This rule should not change the way an investment advisers perform their duties.  It merely removes the doubt regarding the scope of the SEC’s authority created by Goldstein.

Red Flags in the Madoff Case

Gregory Zuckerman of the Wall Street Journal put together a story on the Multiple Red Flags in Madoff Case.

  • Steady returns  in every kind of market
  • Operated as a broker dealer with an asset management division. Why not simply act as a hedge fund and pocket big gains, rather than profit from trading commissions. “Why work your magic for pennies on the dollar?”
  • No independent custodian involved who could prove the existence of assets
  • Blatant conflict of interest with a manager using a related-party broker-dealer
  • The size of the fund was enormous compared the market in which it operated
  • Questions about where the assets were
  • Used a small auditing firm
  • Inadequate number of employees in relation to the purported size of the operation
  • Inadequate office space in relation to the purported size of the operation
  • Clients did not have electronic access to their trading files
  • Clients experienced delays in getting their money back
  • Madoff would tell you nothing about how he achieved his returns
  • Lack of transparency

See:

Researching the Federal Securities Law

sec-sealThe SEC has put together a collection of Researching the Federal Securities Laws Through the SEC Website.

This guide provides an overview of how to research the securities law through the SEC website and is provided as a service to investors and members of the public. It is neither a legal interpretation nor a statement of SEC policy. If you have questions concerning the meaning or application of a particular law or rule you should consult with an attorney who specializes in securities law. This guide does not address primary and secondary sources available in print or through other websites, other than those to which the SEC website links. The guide is organized by providing suggestions for the research of:

  • Statutes (the Securities Laws)
  • SEC Rules and Regulations
  • SEC Concept Releases
  • SEC Interpretive Releases
  • SEC Staff Interpretations

In general, you should conduct your research on the federal securities laws in the order prescribed above. This is because while the federal statutes and the SEC rules and regulations have the force of law, other SEC-issued documents vary in the degree to which they carry the force of law.

The Cumulative Effect of Gift Giving

The line between holiday gift giving and corruption is very gray. You need to be concerned that traditional holiday gifts are not actually holiday corruption bribes.

Not only should you look at an individual gift, you need to look to gifts to the organization as a whole. One excessive gift may seem over the top to the recipient. But what happens when the gift-giver does the same for many people in the organization. One gift of $100 may be a little much. But if 25 people get similar gifts from the same gift-giver, then you have a $2,500 gift issue.

Gifts should not result in, or even give the perception of, a conflict of interest. An example of this would be excessive gift giving from a vendor — would you direct more business to that vendor solely because of the gifts, thereby compromising your obligations? This is the conflict that results when more than nominal gifts are given

The action by the SEC against Lazard Capital Markets LLC is an example of excessive gift-giving. The charges lump together $600,000 in entertainment expenses. But that was over a 4 year period. $125,000 per year is still too much, but illustrates the cumulative effect.

You can read more about the Lazard case:

Open Letter to CEOs of SEC-Registered Firms

sec-sealThe SEC’s Office of Compliance Inspections and Examinations has published an letter to CEOs of SEC Registered Firms about the importance of compliance programs during this time of “financial and market turmoil.”

December 2, 2008

Dear CEO of SEC-Registered Firm:

During this time of financial and market turmoil, the Office of Compliance Inspections and Examinations of the Securities and Exchange Commission reminds leaders of SEC-registered firms, including broker-dealers, investment advisers, investment companies and transfer agents, of the critical role played by your firm’s compliance programs in helping to meet your obligations under the securities laws. Your firm’s compliance function is critical to assure that your operations comply with the law and rules for industry participation and to ensure that the interests of your customers, clients and shareholders are protected. Moreover, compliance is a vital control function that helps to protect the firm from conduct that could negatively impact the firm’s business and its reputation.

While many firms are considering reductions and cost-cutting measures, we remind you of your firm’s legal obligation to maintain an adequate compliance program reasonably designed to achieve compliance with the law. As SEC Chairman Cox noted recently, “[E]xperience has taught us again and again that giving short shrift to regulatory compliance subjects a company’s investors, employees, management, directors, and every other stakeholder to unacceptable risks….[C]ompliance programs have made huge strides in recent years in becoming more formalized and more robust…. Now more than ever, companies need to take a long-term view on compliance and realize that their fiduciary responsibility requires a constant commitment to investors. That means sustaining their support for compliance during this market turmoil, and beyond it as well.” http://www.sec.gov/news/speech/2008/spch111308cc.htm

Firms must be vigilant and proactive in preventing, detecting and correcting problems that could occur. Firms should pay attention to ensuring that their interactions with investors meet high standards, that sales and trading practices are appropriate, that financial, valuation and risk controls are followed, and that all disclosure obligations are met — as well as meeting all other obligations in conformity with the securities laws.

By fulfilling their obligations, regulated firms in the financial services industry can help to restore and bolster public confidence in the fairness and integrity of our markets and market participants. Providing adequate resources to compliance programs and functions and ensuring that CCOs and compliance personnel are integrated into the activities of the firm are essential to that process.

Thank you for your focus on this important matter.

Very truly yours,

Lori A. Richards
Director

http://www.sec.gov/about/offices/ocie/ceoletter.htm

Hedge Fund Registration Act

Senator Charles Grassley of Iowa is looking to expand the registration requirements of the Investment Advisers Act. According to Jim Hamilton’s World of Securities Regulation, the Senator Will Reintroduce in 111th Congress Bill Requiring SEC Registration of Hedge Fund Advisers. The Washington Post story has Senator’s Grassley’s statement coming out of the House Oversight and Government Reform Committee hearing: Fund Chiefs Back Oversight.

The SEC issued a rule in 2004 to try to expand the registration requirement under the Investment Advisers Act by defining client to mean each of the limited partners in a private investment fund, not just the fund itself. That rule was overturned by Goldstein v. SEC which found the rule to be broader than what was authorized under the Investment Advisers Act.

See also:

Counting Clients under the Investment Advisers Act

With the demise of The Hedge Fund Rule, you can look to Rule 203(b)(3)-1 to help you figure out how to count clients.  The key part of the rule from a private investment fund perspective is (a)(2)(i):

A corporation, general partnership,limited partnership, limited liability company, trust (other than a trust referred to in paragraph (a)(1)(iv) of this section), or other legal organization (any of which are referred to hereinafter as a “legal organization”) to which you provide investment advice based on its investment objectives rather than the individual investment objectives of its shareholders, partners, limited partners, members, or beneficiaries (any of which are referred to hereinafter as an “owner”)

This rule is the opposite of The Hedge Fund Rule. Here the entity is the client, not the individuals or organizations in the entity.

For a private investment fund, the limited partnership is the client, not the invidiual limited partners.

Counting Clients under the Investment Advisers Act – The Demise of the Hedge Fund Rule

Section 203(b) lays out the exceptions to registration under the Investment Advisers Act. Section 203(b)(3) exempts you if during the previous 12 months (i) you have fewer than 15 clients and (ii) you do not hold yourself out as an investment adviser.

For private investment funds, the general partner is generally considered an investment adviser [See: Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 1977) , overruled in part on other grounds by Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11 (1979)]

In the private investment world, as long as you had fewer than 15 funds and did not hold yourself out as an investment adviser you did not have to register.  The question is what was a fund/client for the purposes of the Investment Company Act?

With the demise of Long Term Capital, the SEC was interested in regulating hedge funds. In 2004 the SEC passed the Hedge Fund Rule which tried to expand the scope of the Investment Advisers Act by defining “client” under Section 203(b)(3). The rule specified that for “[f]or purposes of section 203(b)(3) of the [Advisers] Act (15 U.S.C. § 80b-3(b)(3)), you must count as clients the shareholders, limited partners, members, or beneficiaries . . . of [the] fund.” § 275.203(b)(3)-2(a). Effectively, the SEC tried to shift the definition from the fund up to the investors in the fund.

This Hedge Fund Rule was overturned by the United States Court of Appeals for the District of Columbia Circuit in the appelate case of Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).

“An investor in a private fund may benefit from the adviser’s advice (or he may suffer from it) but he does not receive the advice directly. He invests a portion of his assets in the fund. The fund manager – the adviser – controls the disposition of the pool of capital in the fund. The adviser does not tell the investor how to spend his money; the investor made that decision when he  invested in the fund. Having bought into the fund, the investor fades into the background; his role is completely passive. If the person or entity controlling the fund is not an “investment adviser” to each individual investor, then a fortiori each investor cannot be a “client” of that person or entity.”

Code of Ethics for Investment Advisers

Rule 204A-1 under the Advisers Act requires investment advisers to adopt a code of ethics. Adoption means establish, maintian and enforcing a written code. At a minimum, the code must include:

(1) A standard (or standards) of business conduct that you require of your supervised persons, which standard must reflect your fiduciary obligations and those of your supervised persons;

(2) Provisions requiring your supervised persons to comply with applicable Federal securities laws;

(3) Provisions that require all of your access persons to report, and you to review, their personal securities transactions and holdings periodically as provided below;

(4) Provisions requiring supervised persons to report any violations of your code of ethics promptly to your chief compliance officer or, provided your chief compliance officer also receives reports of all violations, to other persons you designate in your code of ethics; and

(5) Provisions requiring you to provide each of your supervised persons with a copy of your code of ethics and any amendments, and requiring your supervised persons to provide you with a written acknowledgment of their receipt of the code and any amendments.

17 CFR § 275.204A-1  Investment adviser codes of ethics

Information for Newly-Registered Investment Advisers

The Staff of the Securities and Exchange Commission’s Division of Investment Management and Office of Compliance Inspections and Examinations put together an information overview for Newly-Registered Investment Advisers.

It is intended to assist newly-registered investment advisers in understanding their compliance obligations with respect to these provisions. This information sheet also provides information about the resources available to investment advisers from the SEC to help advisers understand and comply with these laws and rules.

As an adviser registered with the SEC, you have an obligation to comply with all of the applicable provisions of the Advisers Act and the rules that have been adopted by the SEC. This information sheet does not provide a complete description of all of the obligations of SEC-registered advisers under the law. To access the Advisers Act and rules and other information, visit the SEC’s website at www.sec.gov (the Advisers Act and rules are available at http://www.sec.gov/divisions/investment.shtml).