Section 206 - Anti-fraud
Due to the recent charges brought against Investment Advisers by the SEC, I thought I would do a short review on Section 206 of the Investment Advisers Act of 1940 ("IAA").
Pursuant to Section 2(a)(11) of the IAA, an investment adviser is any person who: (1) for compensation; (2) engages in the business of advising others; (3) as to the value of securities. An investment adviser is a fiduciary, has a higher level of responsibility with regard to their clients, and owes certain duties to its clients with regards to its practices. See SEC v. Capital Gains. A fiduciary has a legal obligation to act in its client's best interest and owes its clients a duty of undivided loyalty & utmost good faith. Specifically, an investment adviser has the obligation to disclose conflicts of interests or material information and to employ reasonable care to avoid misleading its clients. Further, through the fiduciaries duty of loyalty, a fiduciary must present investment opportunities to its client first, treat all clients equally (for example, through aggregation/allocation), and see best execution for its clients. Material information, with regard to disclosure under the IAA, is information that would be significant and affect an investor's decision to continue its services with the adviser.
Fiduciary obligations are effectively enforced through Section 206 of the IAA. Section 206 of the IAA contains the anti-fraud provisions relating to investment advisers. Specifically, section 206 states, "It shall be unlawful for any investment adviser, by use of mails or any means or instrumentality of interstate commerce, directly or indirectly, to employ any device, scheme, or artifice to defraud any client or prospective client." Section 206(1) of the IAA is scienter based fraud.
Section 206(2) of the IAA states, "It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client." Section 206(2) of the IAA is non-scienter based fraud. Intent is not necessary for the SEC to bring an enforcement action under section 206(2) of the IAA. It is important to note that if a person fits into an exclusion under section 202 of the IAA, the antifraud provisions of the IAA do not apply. However, if the person fits into an exemption in section 2033 of the IAA, the anti-fraud provisions do apply.
IAA Section 206(3) states, "It shall be unlawful for any investment adviser ... acting as 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." While still dealing with truthfulness of the adviser, 206(3) is a much more stringent in what it is trying to prevent as opposed to section 206(1) and (2) anti-fraud.
There are also several other rules under the IAA that may apply. For example, Rule 206(4)-7 mandates that an investment adviser must have written policies and procedures reasonably designed to prevent violations, conduct annual reviews of the adequacy of such procedures, and designate a CCO. Rule 206(4)-8 under the IAA mandates that investment advisers to pooled investment vehicles must not make any untrue statement of a material fact to any investor or prospective investor in the pooled investment vehicle or otherwise engage in
any act, practice, or course of business that is fraudulent with respect to any investor or prospective investor in that pooled investment vehicle.
As any securities practitioner will know Section 10(b) and Rule 10(b)-5 of the Securities Exchange Act, it is important to note the anti-fraud provisions that apply to investment advisers. A later post will detail the rules under the IAA. As a practitioner is is important to realize that a 206(1) violation holds a much heavier weight than a 206(2) violation due to the scienter requirement.
IAA Section 206(3) states, "It shall be unlawful for any investment adviser ... acting as 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." While still dealing with truthfulness of the adviser, 206(3) is a much more stringent in what it is trying to prevent as opposed to section 206(1) and (2) anti-fraud.
There are also several other rules under the IAA that may apply. For example, Rule 206(4)-7 mandates that an investment adviser must have written policies and procedures reasonably designed to prevent violations, conduct annual reviews of the adequacy of such procedures, and designate a CCO. Rule 206(4)-8 under the IAA mandates that investment advisers to pooled investment vehicles must not make any untrue statement of a material fact to any investor or prospective investor in the pooled investment vehicle or otherwise engage in
any act, practice, or course of business that is fraudulent with respect to any investor or prospective investor in that pooled investment vehicle.
As any securities practitioner will know Section 10(b) and Rule 10(b)-5 of the Securities Exchange Act, it is important to note the anti-fraud provisions that apply to investment advisers. A later post will detail the rules under the IAA. As a practitioner is is important to realize that a 206(1) violation holds a much heavier weight than a 206(2) violation due to the scienter requirement.
