Investment Fund Regulation: How Legal Counsel Reduces Liability Risk

Under the Investment Advisers Act of 1940, any person providing investment advice for compensation above the registration threshold must register on Form ADV and comply with the Fiduciary Duty and Section 206 anti-fraud provisions of the investment fund compliance framework. Capital markets and investment management counsel can advise on Section 203(b) exemptions and how to structure investment advisory services arrangements that satisfy SEC requirements.

The Fiduciary Duty consists of a Duty of Care requiring advice in the client's best interest and a Duty of Loyalty requiring disclosure of all material conflicts, and a breach of either prong can give rise to SEC enforcement or a breach of fiduciary duty civil claim. Fiduciary services counsel can document compliance to defeat both SEC and private enforcement.

A publicly offered fund must file a Form N-1A, prepare a prospectus satisfying Section 10(a) of the securities act, and a material omission creates strict Section 11 liability for the fund and its directors. Capital markets securities and sec-regulations counsel can structure Disclosure documents to minimize Section 11 exposure, and securities regulations counsel can defend omission claims by demonstrating immateriality.

The table below compares the regulatory requirements, investor eligibility, and legal risk profiles for publicly offered funds and private investment funds.

The Duty of Suitability under FINRA Rule 2111 requires fund distributors to have a reasonable basis that the recommended fund suits the investor, and a distributor who sells a high-risk fund without adequate Disclosure violates the standard. Securities litigation and securities frauds counsel can document FINRA Rule 2111 compliance, and securities fraud class action defense counsel can manage parallel investor class actions.

The following checklist identifies the legal compliance items fund operators must review to identify fraud risk exposures and Internal Control deficiencies.

• Conflict of interest management: Verify that the Internal Control system discloses every material conflict in the Form ADV Part 2, because undisclosed conflicts are the most common basis for breach of fiduciary duty claims.
• AML compliance: Confirm a written aml compliance program meeting Bank Secrecy Act requirements, because AML deficiencies frequently accompany financial fraud investigations.
• Performance fee disclosure: Verify that performance fees are consistent with the offering documents, because fee discrepancies satisfy the materiality element of a securities frauds claim.
• Periodic report accuracy: Confirm that each investor report accurately reflects the fund's net asset value, because material misstatements constitute securities fraud under Rule 10b-5, and corporate compliance counsel should review each report.

Under SEC Rule 206(4)-7, every registered investment adviser must adopt written compliance policies designed to prevent Advisers Act violations, designate a chief compliance officer, and conduct an annual review, and a fund manager who self-detects violations through its compliance program occupies a stronger legal position than one whose violations are detected by the SEC. Corporate compliance and sec-compliance counsel can design the program and produce Internal Control documentation that courts treat as evidence of good faith.

When sec-enforcement or sec-investigations are initiated, federal criminal defense counsel can manage document production, sentencing advocacy counsel documents the pre-offense compliance program to reduce the guideline range, and class action litigation defense counsel coordinates parallel investor class actions.