SEC Rule for Investment Advisers on Shaky Ground in Atkins Era

As the Securities and Exchange Commission continues reversing course on past positions, investment advisers might be particularly interested in potential changes to a rule that prohibits advisers from defrauding investors in funds.

This rule, Advisers Act Rule 206(4)-8, has become a mainstay of the SEC’s registered and private fund enforcement program since its adoption in 2007. It has relied on the rule to bring enforcement actions addressing a broad swath of conduct by investment advisers, most often involving undisclosed conflicts and fee and expense abuses.

But its enforcement might be ripe for reassessment with SEC Chairman Paul Atkins’ return to the agency.

When the rule was adopted, Atkins—a commissioner at the time—unsuccessfully argued that advisers should be charged under the rule only when the SEC could show intentional or reckless misconduct. Instead, the rule imposed a mere negligence standard.

During the last administration, more than 100 enforcement actions were brought alleging a violation of the rule with most requiring only negligence. While very, very early days, since Atkins came on board in late April, he has yet to bring an enforcement action alleging a negligence-based violation of the rule.

With Atkins at the helm, advisers to funds should closely watch to see if the SEC raises the bar in enforcing this key rule.

Background of Rule

Rule 206(4)-8 was born in the defeat of an earlier rule that sought to include underlying investors in funds as advisory clients.

In Goldstein v. SEC, the US Court of Appeals for the DC Circuit struck down that prior rule in 2006, stressing that an investment adviser’s client is the fund that it advises and generally not the underlying investors in that fund.

The SEC responded in 2007 by adopting Rule 206(4)-8 to clarify, in light of Goldstein, its ability to bring enforcement actions under the Advisers Act against investment advisers who defraud investors or prospective investors in a fund or other pooled investment vehicle.

It asserted that negligence was enough to establish a violation and, in practice, the SEC has required only a showing of negligence to bring an enforcement action.

But Atkins, when he was a commissioner, took a different view on the required mental state.

Atkins’ Objections

Relying on two key principles, he argued that the SEC needed to show intentional or reckless misconduct to establish a violation.

He said he didn’t believe that the negligence standard was consistent with the SEC’s authority under Section 206(4), the statutory provision used to adopt the rule. Section 206(4) authorizes the SEC to adopt rules to prohibit investment advisers from engaging in conduct that is fraudulent, deceptive, or manipulative.

Atkins at the time focused on the word “manipulative” and cited US Supreme Court cases to emphasize that one must act deliberately to be manipulative. He concluded that the SEC didn’t have the authority to promulgate rules that undercut this intentionality threshold.

Atkins also argued as a commissioner that the SEC should require intentional or reckless misconduct as a policy matter—even if it had statutory authority to adopt the rule with a negligence standard.

He explained his view that arbitrarily selecting a higher standard of care (such as requiring only a showing of negligence) “just to be on the safe side” has the potential to misdirect enforcement and inspection resources and to chill well-intentioned advisers from serving their investors.

Takeaways for Advisers

The last several months have seen substantial recalibration and policy reversal at the SEC. All the pieces are there for the SEC to reevaluate its approach to enforcement of Rule 206(4)-8.

When an adviser’s course of conduct operates as a fraud on both the fund and its investors, investment advisers are likely to see little relief from a change in position on the rule because other provisions applicable to fraud on the fund have a clear negligence standard.

However, in instances where the relevant conduct is merely negligent and involves purported misstatements or other conduct involving a small number of investors in a fund, the SEC may be less likely to seek to enforce the rule.

As a result, the SEC’s approach to Rule 206(4)-8, particularly in the context of private funds offered exclusively to well-resourced, sophisticated investors, will be an important space to watch.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Adam Aderton, Justin Browder, Anne Choe, and Michael Osnato are partners at Simpson Thacher. Aderton and Osnato were senior officials in the SEC’s enforcement division.

Simpson Thacher associate Anna Goodnight and former summer associate Timothy Silva contributed to this article.

Author Information

Write for Us: Author Guidelines