Speech by SEC Commissioner:
Remarks at the SEC Open Meeting: An Antifraud Rule For Advisers To Pooled Investment Vehicles
by
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
Washington, D.C.
July 11, 2007
Thank you, Mr. Chairman. I also thank the staff in the Division of Investment Management, Office of General Counsel, and Office of Economic Analysis for your work on this rule. I support the adoption of a rule that will make it easier for the SEC to pursue those who seek to defraud investors in pooled investment vehicles. We already have many tools that allow us to go after perpetrators of fraud, but certain types of fraud may fall beyond the reach of the existing tools. A hedge fund or private equity fund advisor that mails false account statements to its investors, for example, may be hard to reach under existing antifraud provisions, such as rule 10b-5. Therefore, I am pleased to support a rule that clarifies our authority - and our intention - to pursue this type of fraud.
The first prong of the rule prohibits misstatements and omissions. It is similar to rule 10b-5(b), but is not conditioned on a connection to the purchase or sale of securities. Thus, the fund advisor who sends out an account statement that exaggerates the investor's return would be covered by the rule. This is a reasonable step to take after the decision in Goldstein,1 which properly overturned our ill-advised hedge fund advisor registration rule. The court correctly reasoned that an advisor could face irreconcilable conflicts of interest if it owed a fiduciary duty to both a fund and to the investors in the fund. As a result, Section 206(4) is a better vehicle for us to use to pursue fraud by advisors against investors in their pools.
Unlike the first prong of the rule, the second prong does not add much to our arsenal. My sons like to play baseball and love the rendition of the old Abbott and Costello exchange, "Who's on First?" I hear it over and over at home. This rule reminds me of that skit. It is a tautology. The statute states that it is unlawful "to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative." It then directs the SEC by rule to "define, and prescribe means reasonably designed to prevent" these sorts of acts, practices, and courses of business.
The problem with our rule is that we are not defining any act, practice, or course of business and we are not prescribing any means. Instead, we are restating the statute. The rule makes it "a fraudulent, deceptive, or manipulative act, practice, or course of business" to "[o]therwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative." It is like looking up "mendacity" and being told it means "the quality or state of being mendacious." How helpful is that? It is undeniable that acts, practices, and courses of business that are fraudulent, deceptive, and manipulative are fraudulent, deceptive, and manipulative. But saying this does nothing to respond to the problem that led Congress to adopt Section 206(4) in the first place - an uncertainty, in Congress's words, about "the scope of the fraudulent and deceptive activities which are prohibited" by the general language of Section 206.2
When Congress adopted Section 206(4), the Senate Report noted that the existing general statutory prohibition against fraud had "proved incapable of covering specific evils."3 Section 206(4) was designed precisely for a time like this when, for example, we realize that statements to investors in unregistered funds may not be covered by existing rules. I cannot vote against the truism embodied in the rule, but I would have preferred a more targeted approach that better carried out the mandate given to us by Congress through Section 206(4) to adopt rules addressing specific evils. This is what we have done up until now under Section 206(4). We have adopted rules, for example, covering advertisements, custody of client funds and securities, and solicitation. It is also what we have done under Section 15(c)(2), its counterpart in the broker-dealer context. Under that section, we have adopted rules governing payments received in connection with underwritings, prospectus delivery, and credit arranged by brokers and dealers.
Now let me turn from the rule text to the release. The draft in front of me takes the position that this is a negligence-based rule. I disagree with the application of a negligence standard of conduct. It is a given that we cannot lower the mental state requirement included in the statute. The United States Court of Appeals for the D.C. Circuit, in one case, has considered the required mental state for a Section 206(4) violation.4 In that case, after engaging in only a brief analysis, the court did conclude that Section 206(4) does not require the Commission to establish scienter. It is noteworthy, however, that the court was considering the statute at a time when the Commission had adopted only very specific rules under Section 206(4). Now that we are instead adopting a general rule that restates the statute, it is useful to consider how the Supreme Court has viewed a similarly broad rule - rule 10b-5 -- and especially the terminology that is common to both. In Ernst and Ernst v. Hochfelder, the Supreme Court explained that:
"manipulative," "device," and "contrivance" [are] terms that make unmistakable a congressional intent to proscribe a type of conduct quite different from negligence. Use of the word "manipulative" is especially significant. It is and was virtually a term of art when used in connection with securities markets. It connotes intentional or willful conduct designed to deceive or defraud investors … 5
It would also be helpful to look to Section 15(c)(2), from which Section 206(4) was derived. This is an aspect that the Steadman court did not address.
The draft release includes a discussion of how using a negligence-based standard, rather than a scienter-based standard, can serve as a "means reasonably designed to prevent" fraud, which is the contemplation of the statute. But, if it were that easy, then why did not Congress just make it clear that this section was a negligence section? And, since the rationale is that the imposition of a higher standard of care - negligence instead of scienter - will lead advisors to take extra precautions to avoid committing "negligent fraud," then why stop there? Why do we not just impose a strict liability standard - the highest standard making you liable for whatever goes wrong? Under that skewed logic, won't a strict liability standard really make people take extra special care to avoid any problems whatsoever?
Of course, it would not work in the real world to require the SEC to define in advance every aspect of fraudulent conduct. That would be impossible. On the other hand, we cannot leave things so vague that it will be up to our enforcement and examination staff to identify fraudulent conduct in the field. That, again, is why Congress asked us in this section to identify and delineate problematic conduct.
I do not embrace the interpretation of the standard of care that the release claims is derived from the wording of the statute and thus our rule. My concerns, however, are somewhat alleviated by the fact that the words of our rule are within our legal authority. This allows me to vote for this rule despite my disagreement with the standard of care that is asserted in the release. Ultimately, regardless of the standard of care, the Commission is solely responsible for the enforcement of this rule. If implemented properly and reasonably, this rule will be a benefit to investors and the marketplace. If, on the other hand, we overreach and turn this rule into nothing more than a negligence-based rule designed to make a federal case out of unintentional mistakes, it will advance no one's interests, and the rule may well end up to be the subject of a legal challenge that will test the bounds, and our interpretation of Sections 206(4) and 15(c)(2).
Endnotes
http://www.sec.gov/news/speech/2007/spch071107psa.htm
