SEC Rule 206(4)-8

Rule 206(4)-8 is commonly called the "hedge fund anti-fraud rule." The Securities and Exchange Commission (SEC) adopted this rule in July 2007 to close enforcement gaps that emerged after an important court decision. The rule creates specific anti-fraud protections for investors in pooled investment vehiclesAn investment fund that combines capital from multiple investors to purchase and manage a diversified portfolio of securities, including hedge funds and private equity funds.—funds that combine money from multiple investors—managed by investment advisers.

An investment adviser is a person or firm that provides investment advice to clients for compensation. Pooled investment vehicles include hedge funds, private equity funds, and other funds that are excluded from registering as investment companies under either Section 3(c)(1) Section 3(c)(1) Section 3(c)(1) of the Investment Company Act of 1940 exempts private funds with no more than 100 beneficial owners from registration as investment companies. This exemption allows hedge funds to operate with greater flexibility. However, it also restricts their investor base to a smaller number of participants. or Section 3(c)(7) Section 3(c)(7) Section 3(c)(7) of the Investment Company Act of 1940 exempts private funds from registration as investment companies if they limit investors exclusively to "qualified purchasers" and do not make public offerings. This allows hedge funds to accept unlimited investors who meet high wealth thresholds. of the Investment Company Act of 1940 Investment Company Act of 1940 The Investment Company Act of 1940 is a U.S. law that regulates companies whose main business involves investing in securities. Hedge funds typically use special exemptions under Sections 3(c)(1) or 3(c)(7) to avoid having to register under this law, which allows them to maintain the flexibility they need for their investment strategies and fee structures. . Section 3(c)(1) funds can have up to 100 investors, while Section 3(c)(7) funds can have unlimited "qualified purchasers Qualified purchaser Qualified purchasers are investors who meet specific wealth thresholds under the Investment Company Act of 1940. These investors are required for participation in Section 3(c)(7) funds. Generally, individuals must own at least $5 million in investments, while institutions must own at least $25 million in investments. "—typically very wealthy individuals and institutions.

In 2006, the D.C. Circuit Court of Appeals issued a decision in Goldstein v. SEC that created a significant problem for securities enforcement. The court ruled that under Sections 206(1) and (2) of the Investment Advisers Act, an investment adviser's "client" is the fund itself, not the individual investors who put money into the fund.

This interpretation created a serious enforcement gap. The SEC had historically used these sections to bring cases against fund managers who defrauded individual fund investors. Under the court's interpretation, if a fund manager lied to investors about the fund's performance or strategy, the SEC might not be able to use its traditional anti-fraud tools because the "client" was technically the fund entity, not the harmed investors.

The SEC responded by using its broad authority under Section 206(4) of the Advisers Act. This section gives the SEC power to write rules preventing fraudulent conduct. In July 2007, the SEC adopted Rule 206(4)-8. The rule directly protects investors in pooled vehicles, regardless of how courts interpret the word "client" in other contexts.

Rule 206(4)-8 operates under Section 206(4) of the Investment Advisers Act, which does not use the problematic term "clients." This gave the SEC clear authority to write a rule that directly addresses fraud affecting fund investors.

The rule applies to both registered and unregistered investment advisers who manage pooled investment vehicles. It covers any company that would be considered an investment company under federal law, as well as funds that are excluded from investment company registration under Section 3(c)(1) Section 3(c)(1) Section 3(c)(1) of the Investment Company Act of 1940 exempts private funds with no more than 100 beneficial owners from registration as investment companies. This exemption allows hedge funds to operate with greater flexibility. However, it also restricts their investor base to a smaller number of participants. or Section 3(c)(7) Section 3(c)(7) Section 3(c)(7) of the Investment Company Act of 1940 exempts private funds from registration as investment companies if they limit investors exclusively to "qualified purchasers" and do not make public offerings. This allows hedge funds to accept unlimited investors who meet high wealth thresholds. .

The rule establishes two main prohibitions. First, advisers cannot make materially false or misleading statements to any investor or prospective investor in a pooled vehicle. A "material" statement is one that a reasonable investor would consider important when making an investment decision. Second, advisers cannot engage in any other fraudulent, deceptive, or manipulative acts toward fund investors.

Importantly, the SEC made clear that advisers can violate this rule even without intending to commit fraud. Negligent conduct that results in fraud or deception is enough to establish a violation. This "negligence" standard is lower than the "scienterA legal standard requiring proof that a defendant acted with intent to deceive, manipulate, or defraud, representing a higher threshold than negligence in securities fraud cases." requirement in many other securities fraud cases, where the government must prove the defendant acted with intent to deceive or with reckless disregard for the truth.

Rule 206(4)-8 functions as a broad, catch-all provision. Rather than listing specific prohibited activities, the rule relies on established legal principles about what constitutes fraud, deception, and manipulation under federal securities laws. This flexibility allows the SEC to address new forms of misconduct as they develop.

The rule applies whether or not securities are being offered, sold, or redeemed. It covers false or misleading statements about investment strategies, the adviser's experience and qualifications, investment risks, fund performance, asset valuations, and how the adviser allocates investment opportunities among different clients.

The prohibited conduct extends beyond statements made during securities transactions. Any fraudulent behavior that affects fund investors falls within the rule's scope. For example, if an adviser secretly diverts fund assets for personal use, this would violate Rule 206(4)-8 even if no statements were made to investors about the diversion.

The SEC has used Rule 206(4)-8 in a wide variety of enforcement cases. Advisers have been charged for failing to offset consulting fees as required by fund documents, causing funds to overpay for services. The rule has addressed situations where advisers negotiated fees from portfolio companies without disclosing these arrangements to fund investors before they committed capital.

Common violations include misappropriating fund assets, investing fund capital in ways that contradict offering documents, repeatedly misleading investors about investment positions, and filing false registration forms with regulators. The SEC has also applied the rule to cases involving undisclosed conflicts of interest and misleading disclosures about fund redemption proceduresThe specific processes and requirements established by a fund for investors to withdraw their capital, including redemption frequency, notice periods, and any applicable gates or restrictions..

The rule remained a cornerstone of SEC enforcement through the regulatory changes of 2024-2025. Recent enforcement actions applied Rule 206(4)-8 to cases involving failures to safeguard investor assets and undisclosed conflicts of interest, particularly as private fundAn investment fund that is not registered with the SEC and is typically limited to accredited or qualified investors, including hedge funds, private equity funds, and other alternative investment vehicles. assets under management expanded substantially over the past decade.

Rule 206(4)-8 operates within the comprehensive anti-fraud framework of Section 206 of the Investment Advisers Act. Section 206 broadly prohibits investment advisers from using deceptive devices against clients, engaging in transactions that operate as fraud, and engaging in fraudulent, deceptive, or manipulative conduct. However, Sections 206(1) and (2) apply specifically to "clients," while Rule 206(4)-8 extends protections to all investors in pooled vehicles regardless of the client relationship.

The rule differs from other regulations under Section 206(4) in important ways. Rule 206(4)-1 addresses marketing and advertising fraud by registered advisers. Rule 206(4)-7 SEC Rule 206(4)-7 Rule 206(4)-7 (the Compliance Rule) under the Investment Advisers Act requires registered investment advisers, including hedge fund managers, to adopt and implement written compliance policies and procedures and designate a chief compliance officer. requires registered advisers to implement compliance policies and procedures designed to prevent violations of the Advisers Act. Rule 206(4)-8 uniquely targets conduct by advisers to pooled investment vehicles and applies to both registered and unregistered advisers.

This broad application has made Rule 206(4)-8 one of the SEC's most frequently used enforcement tools in private fund matters. The rule covers both advisers who must register with the SEC and those who are exempt from registration, creating uniform anti-fraud protections across the industry.

One important limitation is that Rule 206(4)-8 does not create a private right of actionA legal doctrine that allows private individuals or entities to bring civil lawsuits directly under a statute to seek damages or injunctive relief for violations, as distinguished from enforcement authority granted exclusively to government agencies.. Only the SEC can bring enforcement proceedings under the rule. Private investors cannot sue directly under this provision, though they may pursue remedies under other federal and state laws or common law theories such as breach of fiduciary dutyLegal obligation to act in the best interests of another party, requiring utmost good faith and loyalty. or common law fraud.