Proposed New SEC Anti-Fraud Rule for Hedge Funds and Advisors

In this issue, Mike Piazza, partner in Dorsey & Whitney’s Southern California office, draws attention to the SEC’s proposed anti-fraud rule. Proposed Rule 206(4)-8 will apply to hedge funds and their advisors. It will impact on anyone with financial or business interests linked to hedge funds that have any link to the United States. The proposed rule has drawn a significant amount of negative comment but it is likely that it will become a reality before the end of 2007.
In the next issue, we will be including two articles.

Simon Scales, TNT’s Deputy Director of Global Security & Compliance Manager will look at the prevention of fraud and corruption from an in-house perspective. TNT, a leading global express and mail business has taken a lead within the field of fraud and corruption prevention. Their Security and Compliance functions have provided and conducted professional investigations of incidents concerning suspected fraud and corruption, and, some time ago, embedded procedures for dealing with whistleblowers. A great deal of emphasis has been placed on developing proactive anti-fraud and corruption measures as a way of improving integrity for all stakeholders. TNT carries out “healthchecks” of its business units aimed at identifying, analysing and dealing with the “red-flags” of fraud and corruption. In parallel with these measures, the TNT Integrity Program was developed by TNT Group Integrity, in conjunction with other key departments including Security & Compliance and Corporate Audit. Their Integrity Program provides anti-fraud and corruption training for employees. “Prevention is better than cure,” says Simon, and “it’s about doing the right things as well as doing things right”.

In addition, Peter Law from A&L Goodbody will be reviewing the new laws targeting money laundering in the European Union. The laws will place a limit on the amount of undeclared cash (including bankers drafts and cheques) that can be carried either into or out of the EU. It is hoped that the limits will help to stem the flow of criminally-acquired cash or money used for criminal purposes.

If you are interested in writing an article for a future edition of the Anti-Fraud Network newsletter, please contact us at info@antifraudnetwork.com

Nick Burkill

In the United States today, there is a growing demand for some form of government regulation over hedge funds (an oft-misused term that has come to mean to many Americans various types of private equity funds, many of which bear no relation to the traditional definition of a “hedge fund.”) Be that as it may, the recent failure of Amaranth, a hedge fund that focused on natural gas trades, has reignited a debate last heard loudly in the United States in the wake of the Long Term Capital Management failure in the 1990s. The genesis of the politicians’ and regulators’ concern is the growing concentration of investment funds in seemingly fewer hands. With estimates that over US$1.2 trillion is currently invested in hedge funds, concerns about the lack of regulation over and transparency of hedge funds has risen. Add to this scenario an upcoming Presidential campaign, and one can well understand that the political urge to bring about new regulation is palpable.

As a result, in December 2006, the United States Securities and Exchange Commission (SEC) released proposed new rules that would govern hedge funds and, specifically, the advisors that guide those funds. Some of the new regulations propose to change the definition of an accredited investor to limit those that can invest in hedge funds. Other proposed rules focused on the role of the advisor to the fund. Most importantly for those involved in the prevention, investigation and cessation of fraud, the SEC proposes a new anti-fraud rule that would be applicable to hedge fund advisors.
The anti-fraud hedge fund advisor rule, named Rule 206(4)-8 by the Commission, is allegedly targeted to address a gap in the SEC’s current regulatory authority. The gap was created one year ago by the District of Columbia Court of Appeals when that Court vacated and ruled null and void the SEC’s rule that had just taken effect in February of 2006 requiring certain hedge fund advisors to register with the Commission as Investment Advisors under the 1940 Investment Advisors Act. (Goldstein v Securities and Exchange Commission, 451 F.3d 873 [D.C. Cir. 2006]).

Goldstein may well prove to be but a pyrrhic victory for the hedge fund industry in the United States, and may indeed result in greater regulation of (or at least attempts to regulate) hedge funds and their advisors than the relatively innocuous registration rule that is now gone by the wayside.

Take the newly proposed antifraud rule as an example. Proposed Rule 206(4)-8 would prohibit advisors from (i) making false or misleading statements to investors in pooled investment vehicles, or (ii) otherwise defraud those investors; but significantly, the rule would extend to potential investors as well as existing clients. This is because the SEC has made clear that the proposed rule would apply not only to clients of the funds but also prospective clients of the funds (just as Rules 206(1) and (2) of the Investment Advisors Act apply to existing and prospective clients of Investment Advisors).
This aspect of the proposed rule drew a significant amount of comment, and the comments appear to predominantly be negative.

As the letter from the Securities Industry and Financial Markets
Association summed up the concerns:

First, the proposed rule fails to differentiate the roles played by an investment adviser qua investment adviser to a private fund, and the separate and distinct role the adviser (or any associated persons) may play as the managing member or general partner of the fund. In the context of fraud liability, we are concerned that the proposed rule might be read as attributing to an investment adviser communications made by a private fund (or its other service providers) to current or prospective investors on the theory – rejected by the D.C. Circuit – that those prospective or current investors are clients for purposes of the Advisers Act . . . Second, we question the need for the proposed rule to create a new antifraud standard without scienter or intent as an essential element. Increasing, and we think legitimate, focus is being placed upon the adverse impact upon the competitiveness of U.S. financial markets of our broad and yet amorphous standards for fraud liability. We are concerned that global money managers may increasingly eschew accepting U.S. natural persons as clients if they perceive applicable enforcement and liability standards to be vaguely defined and detached from traditional concepts of intent. Global public offerings have increasingly excluded U.S. persons because of concerns about the U.S. regulatory environment. We therefore urge the Commission to reconsider creating a new standard for fraud liability without the traditional concept of intent as an essential element.

Other comment letters echoed the concern that the new regulation would further hinder America’s competitiveness in worldwide capital markets. This is an area hotly debated inside and outside Washington, D.C. these days, recently receiving front page attention in the wake of a report issued jointly by Mayor Michael Bloomberg and United States Senator Charles Schumer on the decreasing competitiveness of New York City as an international capital market center (and the role of excess government regulation in that decrease as a result of Sarbanes-Oxley compliance costs, etc.)
Some parts of the proposed hedge fund advisor antifraud rule have garnered some support, including the fact that it expressly refuses to create a private cause of action (preventing a wave of new private securities litigation), and it also does not create a new fiduciary duty specifically applicable to the hedge fund advisors subject to the regulation. Nevertheless, the overall industry reaction to the proposed antifraud rule has been negative.

In sum, there seems little doubt that before the close of 2007 the SEC will authorize a new antifraud rule applicable to hedge fund advisors. The question remains how far the new rule will go and whether (and how quickly) it will be challenged in the courts à la Goldstein. Stay tuned.

Mike Piazza is a Partner in Dorsey & Whitney’s Trial, Regulatory and Technology practice group. He is also a member of the firm’s Securities and Financial Institutions Litigation practice group. Prior to joining Dorsey, he was the Regional Trial Counsel for the Los Angeles office of the United States Securities and Exchange Commission. Mike’s practice focuses on securities, intellectual property, and complex commercial litigation. Contact Details: Tel: +1 949 932 3614 Email: piazza.mike@dorsey.com