ARTICLE I - INVESTMENT ADVISER FRAUD

This article is first of four articles that review investment adviser regulation and the significant issues presented by the statutes and rules, as well as makes recommendations to bring the law more in line with the fiduciary and professional responsibilities which is at the core of investment adviser regulation.

With the new hedge fund adviser rule (SEC Rule 203(b)(3)-2) under the Investment Advisers Act of 1940 ["1940 Act"] requiring 1940 Act registration for a greater number of investment advisers by reason of a "look through" the private equity fund to determine how many clients the hedge fund adviser really serves; greater focus should made upon the 1940 Act anti-fraud provision and the SEC rules in order to keep clients from going astray. The new transparency is not only to identify how many clients the adviser serves but opens up investment advisers to the SEC inspection process and in consequence greater liability exposure to regulators and private investors as well. This new exposure should raise the conscious level of investment advisers, especially the newly registered hedge fund advisers and their lawyers. A "minefield" is presented by Section 206 of the 1940 Act, the anti-fraud provision, and the rules thereunder. Review of the statutory provision and applicable rules not only should suggest more care and better practices for advisers to follow in order to avoid problems, but the need for a more intelligible legislative and regulatory framework suited to investment advisers and the clients they serve.

Statute and Rules
Section 206 sets forth the fundamental prohibitions that are essential to keep in mind with the 1940 Act registration and filing requirements. Section 206(1) [15 U.S.C. §806-b-6 (2005)] prohibits the adviser from "employ(ing) any device, scheme or artifice to defraud any client or prospective client". This language is identical to Section 17(a)(1) of the Securities Act of 1933 and requires scienter i.e. intent to deceive or extreme recklessness. Section 206(3) states two fundamental prohibitions for an investment adviser who is "acting as a principal for his own account, knowingly to sell any security to or purchase any security from a client; or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction". This section is a clear language prohibition that gives educative notice that investment advisers should not be on the other side of a transaction where they are a principal or acting in a representative capacity for another person without disclosure and consent. Not only does this provision make clear as to what has to be disclosed, but informs that the broker or dealer not acting as an investment adviser in the transaction is not covered by the prohibition. Even though the firm may be registered under the 1940 Act as well as the Securities Exchange Act of 1934 ("1934 Act"), as long as it is providing pure brokerage services such as market-making activities, this 1940 Act provision does not apply.

The "slippery slope" starts to set in with respect to Sections 206(2) and 206(4). These two subparagraphs of the anti-fraud provision are significant to pay attention to because of the three tier penalty provisions. Section 206(2) prohibits the adviser from ". . . [engaging] in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client " (emphasis added). It is an oxymoron, but this is the species non-scienter fraud, because scienter is not an essential element. Section 206(4) is clear in that the language prohibits the adviser from ". . . [engaging] in any act, practice, or course of business which is fraudulent, deceptive, or manipulative" (emphasis added). What is very tricky is Congress’ mandate to the Commission that it "shall, for the purposes of this paragraph (4) by rules and regulations define, and prescribe means reasonably designed to prevent such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative". (Emphasis Added). The plain meaning of this provision is that not only is Congress outlawing fraud with its traditional and essential element of intent or recklessness, but it is requiring the Commission in its rule making capacity to give educative notice to the regulated community as to what is or is not fraud under the statute.

There has been a conspicuous absence of civil litigation of this statutory anti-fraud provision due to the absence of a private right of action other than a statutory right of recission. One only has to compare Section 10(b) and Rule 10b-5 litigation under the 1934 Act and Section 206 and the rules thereunder to confirm the validity of this conclusion. It should be noted in this regard the right to rescind under Section 215 is accorded along with the restitution of fees and costs, but not a right to recover market losses.

Both the Courts and the SEC have from the context of litigation and rule making identified and prohibited a wide range of investment adviser fraud. Activities such as "scalping" or getting ahead of the client’s trades for the purposes of getting a better price on the adviser’s personal trades; misuse of material inside information; late trading and market timing, and fraudulent advertising are the basic kinds of Investment Adviser Fraud one sees in the cases. Most likely because there is an absence of an implied right of action and there is a greater dependency on regulators rather than private litigants to enforce the 1940 Act, aiding and abetting as well as primary violations are outlawed. Actual economic injury is also not an essential element for violating Section 206 of 1940 Act.

Investment Adviser Anti-Fraud Rules
SEC Rule 206(3) addresses agency cross-transactions for advisory clients. An "agency cross transaction for an advisory client" is "a transaction in which a person acts as an investment advisor . . . or acts, as broker for both such advisory client and for another person on the other side of the transaction". This type of transaction is deemed non-fraudulent if the following conditions occur: (1) the advisory client has "prospectively" executed an authorization to the adviser to effect agency cross transactions after full disclosure of the potential conflicts and the remuneration; (2) written confirmation takes place and includes if the client requests, the date and time of the transaction and the source and amount of the remuneration; (3) no party including the investment advisor is participating in a distribution or in connection with a sale in a tender offer; (4) there is an annual written summary of such transactions that identifies the total number of transactions and the remuneration received or to be received; (5) there is a conspicuous written statement in the confirmation that the written authorization for such "cross-agency transactions" may on written notice be revoked; and (6) the investment adviser cannot recommend the same transaction to both buyer and seller. The rule does not diminish the adviser’s obligations under Section (1) and (2) of 206 or its obligation of best price execution for the particular transaction. This rule is textually clear and gives advisers educative notice of what they can and cannot do and is an appropriate implementation of subparagraph (3) of the statutory provision.

Rule 206(4)-1(a) is the advertising rule. An advertisement includes any notice, circular, letter or other written communications addressed to more than one person or an announcement on radio or television that is to be used to buy or sell a security or provide other investment advisory services. Specifically the rule prohibits testimonials of any kind, representations that refer to prior past specific recommendations that were profitable, use of graphs or charts without disclosing the limitations and difficulties with respect to its use or statements that any report or analysis is being furnished free of charge when this is not so and "which contains any untrue statement of a material fact or which is otherwise false or misleading".

Rule 206(4)-2 declares in respect to custody or possession of client’s funds or securities that the adviser will have engaged in fraud, deception, or manipulation unless the adviser (1) segregates with written identification the securities of each client, (2) deposits clients funds in a bank account containing only client funds with a separate record showing the name and address of the bank, the dates and amounts of deposit and withdrawals and the exact amount of the interest of each and every client, (3) notifies the client in writing of where the funds are maintained and any change of status, (4) sends at least every quarter an itemized statement showing the funds and securities in the adviser’s custody or possession and any account debits, credits, and transactions for the period, and (5) without prior notice at least once every calendar year an independent public accountant shall verify and then certify after the examination as to the details regarding the adviser’s custody and possession of client funds and securities. The rule does not apply to registered broker-dealers or exchange members that are subject to the 1934 Act and its rules.

Rule 206(4) relates to cash payments for client solicitations. The rule is detailed as to when and how solicitation activities have to occur. The adviser has to be registered as a 1940 Act Investment Adviser, the solicitor cannot have been subject to criminal conviction or disciplined by the SEC for conduct involving violations of Section 206(1), (5), or (6) or Section 203(e), and not subject to any order or judgment for violation of Section 206(4). The fee can only be paid pursuant to a written agreement to which the advisor is a party, which agreement has to be kept by the adviser. The fee has to be paid to the solicitor only for the provision of impersonal services. If the solicitor is an affiliate of the advisor i.e. partner, officer, director or employer, this fact has to be disclosed at the time of solicitation or referral.

There are other conditions that have to be met in respect to solicitation activities. There must be a written agreement describing the solicitation activities to be engaged in; an undertaking by the solicitor that he will be subject to the provisions and rules of the1940 Act; and the solicitor must acknowledge he will act consistent with advisers instructions. At time of the solicitation, if compensation is paid, the solicitor must provide the client with the Adviser’s written disclosure statement pursuant to Rule 204-3 ("the brochure rule"), and at the time of entering the investment advisory contract there must be "a signed and dated acknowledgment of receipt of the investment adviser’s written disclosure statement and the solicitor’s written disclosure document" by the client. The solicitor’s disclosure document must contain the solicitor’s name; the investment advisers name; the nature of the relationship of the solicitor to the adviser; disclosure that the solicitor is being paid; the cost of obtaining the client’s and the prospective adviser fee, and the differential of any amount charged to the clients by virtue of the adviser’s and solicitor’s compensation arrangement. Further nothing in the rule excuses any person from their fiduciary duties and other legal obligations.

Rule 206(4)-4 addresses financial and disciplinary information that advisers must disclose to prospective and actual clients. The information is deemed material for a period of ten (10) years from the event that required disclosure. Essentially material information in the context is as follows: (a) a financial condition of the adviser that impairs his ability to meet commitments to the client, and (b) "a legal or disciplinary event that is material to an evaluation of the adviser’s integrity or ability to meet contractual commitments to clients". The latter obviously includes a conviction for fraud, false statements, or omissions, wrongful taking of property, bribery, forgery, counterfeiting or extortion, violations of an investment related statute or regulations; the fact that the person was enjoined temporarily or permanently from engaging in an investment related activity; that the person was subject to SEC, state or self-regulatory organization administrative proceedings where there was a finding that the disciplined person caused an investment-related business to lose its license; and was suspended or barred from association with an investment related business.

Fiduciary Status
What complicates interpretation and application of Section 206 and the above cited SEC Rules is the fiduciary and professional status of 1940 Act Investment Advisers. This is, however, sound public policy since investment advisers should act in accord with the highest standards of conduct. In advising clients or advocating for a more intelligible and improved legislative and regulatory framework, this more elevated status should always be considered. The fiduciary status of Investment Advisers is well settled.
In SEC v. Capital Gains Research Bureau, Inc. et al., the SEC sought injunctive relief against a registered investment adviser who did not disclose to his clients his practice of purchasing securities for his own account shortly before recommending to the clients that very security for long-term investment and then immediately selling for its own account the shares at a profit upon the rise in the market price following the recommendation. The SEC alleged violations of Section 206(2) as the practice was deemed to ... "[operate] as a fraud or deceit upon any client or prospective client". The District Court and the Second Circuit denied the SEC its relief because "fraud" and "deceit" in its "technical sense" required both an intent to injure the clients and actual monetary loss. The Supreme Court reversed because the 1940 Act was enacted so the "highest ethical standards prevail" and as a result neither intent nor economic injury are now considered to be an essential element.

Prior to the enactment of the 1940 Act, and after an exhaustive study, the Commission issued a report that the Supreme Court heavily relied upon in rendering its opinion. The Court observed,

"The report reflects the attitude . . . that investment advisers could not completely perform their basic function - furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments - unless all conflicts of interest between the investment counsel and the client were removed. The report stressed that affiliations by investment advisers with investment bankers, or corporations might be an impediment to a disinterested objective, or critical attitude toward an investment by clients.

This concern was not limited to deliberate or conscious impediments to objectivity. Both the advisers and the Commission were well aware that whenever advice to a client might result in financial benefit to the adviser - other than the fee for his advice that advice to a client might in some way be tinged with that pecuniary interest [whether consciously or] subconsciously motivated . . . [The] commission staff . . . suggested that a significant part of the problem was not the existence of a deliberate intent to obtain a financial advantage but rather the existence subconsciously [of] a prejudice in favor of one's own financial interests."
Further the Court in resolving the issue of intent and whether the investment adviser's status necessitated dispensing with that element, reviewed the legislative history. On that basis also, the Court held:

". . . The Investment Advisers Act of 1940 thus reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship, as well as a congressional mandate to eliminate, or at least to expose all conflicts of interest which might incline an investment adviser - consciously or unconsciously - to render advice which was not disinterested. It would defeat the manifest purpose of the Investment Advisers Act of 1940 for us to hold, therefore, that Congress is empowering the Courts to enjoin any practice which operates as a fraud or deceit intended to require proof of intent to injure and actual injury to clients."

Standard setting and the prevention of possible harm to investors is the core concern of the statute and that is why fiduciary responsibilities, more than anything, govern and should govern the conduct of investment advisers.

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