Defending Against Fraud Allegations in Litigation Under Section 206 of the Investment Advisers Act

Oberheiden P.C.

Section 206 of the Investment Advisers Act of 1940 is one of the many laws the U.S. Securities and Exchange Commission (SEC) uses to combat investment fraud. Under Section 206, investment advisers can face enforcement action for engaging in various forms of prohibited conduct, with such enforcement action having the potential to lead to administrative, civil, or criminal penalties.

Similar to many of the other laws the SEC uses to combat investment fraud (i.e. Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities and Exchange Act of 1934), Section 206 of the Investment Advisers Act of 1940 is extremely broad in scope. As such, it allows the SEC to pursue charges in a wide variety of circumstances, and it won’t necessarily be clear precisely why the SEC is conducting a Section 206 investigation.

With this in mind, investment advisors that are facing investigations or litigation under Section 206 must take proactive measures to defend themselves. They must promptly engage securities litigation counsel to intervene, determine the scope and nature of the allegations at issue, and execute a targeted defense strategy.

While litigation under Section 206 can lead to significant consequences, it will be possible to achieve favorable results prior to or during trial in many cases. Potential outcomes depend not only on the facts at hand, but also the efficacy and timeliness of an investment advisor’s defenses.

What Does Section 206 Prohibit?

Before we can talk about potential defenses to allegations under Section 206 of the Investment Advisers Act of 1940, we first need to talk about what Section 206 prohibits. Under Section 206, it is unlawful for any investment advisor, “by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly,” to:

  • “(1) [E]mploy any device, scheme, or artifice to defraud any client or prospective client;
  • “(2) [E]ngage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;
  • “(3) [A]cting as principal for his own account, knowingly [] sell . . . or purchase any security from a client, or acting as broker for a person other than such client, knowingly [] 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 . . .; or
  • “(4) [E]ngage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative.”

Section 206(4) expressly leaves it to the SEC to determine what constitutes a “fraudulent, deceptive, or manipulative” course of business. In the decades since the Investment Advisers Act’s enactment, the SEC has adopted several rules defining prohibited conduct under Section 206(4). This includes rules regarding:

  • Investment advisers’ marketing practices (Rule 206(4)-1)
  • Investment advisers’ custody of clients’ funds and securities (Rule 206(4)-2)
  • Investment advisors’ provision of cash payments for client solicitations (Rule 206(4)-3)
  • Investment advisers’ political contributions (Rule 206(4)-5)
  • Investment advisers’ proxy voting (Rule 206(4)-6)
  • Investment advisers’ compliance procedures and practices (Rule 206(4)-7)
  • Investment advisers’ recommendations regarding pooled investment vehicles (Rule 206(4)-8)

Together the statutory language of Section 206 and the complex provisions of the SEC’s 206(4) Rules create an extensive list of prohibitions and a substantial compliance burden for investment advisers. Even unknowing and unintentional violations of Section 206 can lead to litigation in many cases.

For example, Section 206(2) prohibits investment advisers from “engag[ing] in” any transaction that “operates as a fraud”—it does not include or imply any element of scienter. Likewise, under advertising restrictions of Rule 206(4)-2, investment advisers can face SEC enforcement litigation for violating any of the Rule’s prohibitions regardless of whether or not the violation was knowing or intentional. The Rule simply states that an investment adviser’s advertisements “may not” (among other prohibitions):

  • “Include any untrue statement of a material fact, or omit to state a material fact necessary in order to make the statement made, in the light of the circumstances under which it was made, not misleading;
  • “Include a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate upon demand by the Commission; [or]
  • “Include information that would reasonably be likely to cause an untrue or misleading implication or inference to be drawn concerning a material fact relating to the investment adviser . . . .”

How Can Investment Advisers Defend Against Section 206 Litigation?

Given the breadth of Section 206 and Rule 206(4), defending against allegations under these sources of authority can prove challenging for investment advisers on a number of different fronts. As mentioned above, one of the first challenges in many cases is simply identifying the specific allegations at issue.

The SEC pursues cases under all four operative provisions of Section 206, and each provision encompasses its own wide range of express and implied prohibitions. Thus, knowing that you are facing allegations under Section 206(1), 206(2), 206(3), or 206(4) is not enough to make informed decisions about the type(s) of defense(s) to pursue.

With that said, there are some considerations that are generally applicable to most, if not all, types of litigation matters under Section 206 of the Investment Advisers Act of 1940. These considerations pertain to: (i) avoiding litigation under Section 206, (ii) defending against administrative and civil SEC enforcement litigation, and (iii) defending against criminal charges prosecuted by the U.S. Department of Justice (DOJ).

1. Avoiding Litigation Under Section 206

The surest way to avoid liability in Section 206 litigation is to avoid Section 206 litigation entirely. While there is no way to guarantee protection from SEC scrutiny, there are ways that investment advisers can mitigate their risk of facing litigation under Section 206.

First, investment advisers can adopt policies and procedures focused specifically on Section 206 and Rule 206(4) compliance. All investment advisory firms, regardless of size, should have a documented SEC compliance program.

This program should address the firm’s and its advisers’ statutory and regulatory obligations—including their obligations under Section 206 and Rule 206(4). By understanding their obligations, addressing these obligations proactively, and monitoring their compliance on an ongoing basis, advisory firms and advisers can make informed decisions that will significantly mitigate their risk of facing SEC scrutiny.

Second, investment advisors can take a proactive approach to responding to an SEC investigation targeting allegations under Section 206 or Rule 206(4). Even with an effective compliance program in place, advisory firms and advisers can still face SEC inquiries due to customer complaints and other issues. When these inquiries arise, intervening and working with the SEC to clearly understand the allegations at hand (and to correct any flawed assumptions or other misconceptions) greatly reduce the chances of the inquiry leading to enforcement litigation.

2. Defending Against Administrative and Civil SEC Enforcement Litigation

If the SEC’s Enforcement Division finds evidence of a violation of Section 206 during an investigation, then the Commission may choose to pursue either administrative or civil enforcement litigation. Administrative and civil enforcement proceedings can involve a broad range of issues, and they can present the risk for an equally broad range of potential consequences.

Penalties in SEC enforcement cases can include temporary or permanent injunctions (i.e. a prohibition on acting as an investment adviser), as well as monetary penalties ranging from tens of thousands to millions of dollars.

3. Defending Against Criminal Litigation Under Section 206

In cases involving apparent knowing and intentional violations of Section 206, the SEC may choose to refer the matter to the DOJ for criminal prosecution. Section 217 of the Investment Advisers Act imposes criminal fines of up to $10,000 and up to five years of federal imprisonment for each individual violation of the statute—including (but not limited to) violations of Section 206. Since Rule 206(4) defines certain prohibited conduct under Section 206, violations of the Rule can lead to criminal prosecution as well.

In administrative, civil, and criminal litigation under Section 206, asserting an effective defense often involves targeting one or more specific elements of the government’s case. Section 206 and Rule 206(4) are complex, and yet they still leave a significant amount of room for interpretation. Thus, cases under Section 206 often are not clear-cut, and advisory firms and advisers will often be able to avoid liability by demonstrating that the government is unable to fully build its case—even if they cannot affirmatively disprove the allegations against them.

Procedural and constitutional defenses will be available in some cases as well, and efficiently executing a targeted and cohesive defense strategy will allow for a favorable outcome in a broad range of scenarios.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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