“An important objective of any financial regulator in protecting investors is to ferret out bad actors and foster the provision of information necessary to make informed investment decisions. Capital formation—a core SEC mission and one that is vital to our economy—cannot flourish in an environment rife with fraud and deceit. At the same time, any investment involves risk and we must avoid paternalistic regulation that presumes the government knows best. Or, as Judge Sporkin put it, ’We must permit access to the market place for new and budding enterprises with the minimum restraints. Whatever new forms of regulation are considered, they must be examined in the context of an evolving society designed to be driven by the innovation of the private sector and not an impediment to it. We must make sure that the creativity of our brilliant scientists and entrepreneurs is not stifled by suffocating regulation.’”
This statement, given by SEC Acting Chair Mark Uyeda, highlights the Securities and Exchange Commission’s (SEC) movement away from what some refer to as “regulation by enforcement.” Both he and SEC Commissioner Hester Peirce have recently made statements acknowledging the SEC’s continued focus on investor protection, while also citing their desire for a more proportionate approach to regulation.
Given this shift in focus and our expectations regarding how the SEC will focus enforcement in the coming years, it’s a sensible time for a quick brush up on Section 206 of the Investment Advisers Act of 1940 (the “Advisers Act”).
Section 206 of the Advisers Act is commonly cited by the SEC, both in examinations and when taking enforcement actions against non-compliant firms. In the rule, you’ll find mandates on protecting investors’ interests while avoiding deceitful or fraudulent practices — making it an especially important section to familiarize (and refamiliarize) yourself with on a regular basis.
What Does Section 206 Cover?
Section 206 is the anti-fraud provision of the Advisers Act.
Here are the specific subsections found under Section 206 that pertain to all SEC-registered investment advisers:
- Section 206(1): Advisers are prohibited from employing “any device, scheme, or artifice to defraud any client or prospective client.”
- Section 206(2): Advisers are prohibited from engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.”
- Section 206(3): Advisers must have a client’s consent in writing before buying or selling a security to or from the client. [However, this does not apply to “any transaction with a customer of a broker or dealer if such broker or dealer is not acting as an investment adviser in relation to such transaction.”]
- Section 206(4): This final section remains broad, stating that advisers are prohibited from engaging “in any act, practice, or course of business which is fraudulent, deceptive, or manipulative.”
Notably, Rule 206(4)-1 (advertising rule) and 206(4)-3 (cash solicitation rule) under the original Section 206(4) were replaced in 2021 with a singular ruling commonly referred to as the new Marketing Rule. In addition, Rule 206(4)-5 is commonly referred to as the Pay-to-Play Rule, which restricts political contributions made by investment advisers and their associates to certain government officials and entities.
Who Does Section 206 Apply To?
Section 206 applies to all SEC-registered investment advisers, including private equity fund advisers and hedge fund advisers. In addition, investment advisers who are exempt from registering with the SEC under Section 203(b) of the Advisers Act are still subject to the anti-fraud provisions outlined in Section 206.
If you are registered with state regulators, you are generally subject to your state(s)’ regulations rather than the SEC’s. However, many state regulations closely resemble the SEC’s guidance, and it’s possible you will be responsible for complying with a state regulatory framework very similar to that found in Section 206 of the Advisers Act.
How Can Advisers Comply?
Section 206 incorporates multiple prohibitions against fraud and protecting your clients’ interests. Your firm’s compliance program should incorporate specific policies, procedures, and checks to ensure you’re operating compliantly with each aspect of Section 206. At a high level, you can protect yourself and your firm from potential violations or penalties by maintaining your fiduciary duty and avoiding conflicts of interests (or disclosing and mitigating conflicts as they arise).
As a reminder, an adviser’s fiduciary duty includes two specific elements: a duty of care and a duty of loyalty.
- Duty of care: Offering investment advice that’s in your client’s best interests based on the client’s objectives, including executing client transactions to the best of your ability.
- Duty of loyalty: Always putting your client’s interests above your own and making full and fair disclosure of all conflicts of interest which might incline the adviser to render advice that is not disinterested.
What Complications Arise from Trying to Comply with Section 206?
As the SEC continuously monitors evolving trends or potential threats to investor well-being (such as cybersecurity, digital advertising, etc.), it generally releases guidance interpreting its existing regulations (such as firms’ Section 206 obligations) and may even make changes to the Advisers Act.
As an adviser, it can be challenging keeping up with changes to existing regulatory interpretations. Yet, missing critical updates can lead to violations, fines, and damage to your professional reputation.
Keeping your compliance program up to date with evolving regulations can be especially difficult for firms without dedicated compliance teams. Leverage the insights of our COMPLY Expert Consulting professionals, who can help you confidently navigate new rules, amendments, risk alerts, policy statements, and more.
Book a demo today to learn more about our COMPLY Expert Consulting services.