SEC Adopts New Antifraud Rule For Investment Advisers to Pooled Investment Vehicles

On July 11, 2007, the Securities and Exchange Commission (SEC) unanimously adopted a measure designed to curb fraudulent conduct by investment advisers with respect to "pooled investment vehicles" including hedge funds, private equity funds and venture capital funds.1 On August 3, 2007, the SEC published its final release adopting new Rule 206(4)-8 under the Investment Advisers Act of 1940.2 The rule prohibits investment advisers from (1) making false or misleading statements to prospective or actual investors in pooled investment vehicles; or (2) otherwise defrauding those investors. The rule is effective thirty days after publication in the Federal Register. According to SEC Chairman Christopher Cox, this rule will provide the SEC with an important mechanism to regulate the hedge fund market in which managers trade trillions of dollars of investor assets.3

Background

Generally, advisers to pooled investment vehicles are exempt from registration under the Investment Advisers Act of 19404 (the "Act") if they have less than fifteen clients, do not offer advisory services to the general public, and do not advise registered investment companies. In 2004, the SEC sought to bring hedge fund advisers under the registration requirements by adopting a new rule (the "Hedge Fund Rule") that expanded the meaning of "client" to include "the shareholders, limited partners, members or beneficiaries" of a hedge fund. Most hedge fund advisers who had more than fifteen clients under the modified definition and did not otherwise fit within the limited exceptions to the rule were required to register. In turn, these investment advisers were required to appoint a chief compliance officer and set up a compliance program to meet the new regulatory requirements.

Goldstein Decision

An important decision of the Court of Appeals for the D.C. Circuit called into question the SEC's authority to regulate hedge fund advisers in this manner. Philip Goldstein, a principal in an investment advisory firm, challenged the Hedge Fund Rule on the grounds that equating "investor" with "client" was improper. The Court of Appeals agreed, finding that such a reading of the statutory term "client" was arbitrary and could not be justified by either the text or the history of the Act .5 Notably, the court emphasized the nature of the relationship between investment adviser and client as determinative of which parties would constitute a client. Since limited partners in hedge funds...