© Copyright 2017 by K&L Gates LLP. All rights reserved.

Sonia R. Gioseffi, Partner, K&L Gates LLP J. Matthew Mangan, Partner, K&L Gates LLP

SEC Examinations and Enforcement

2017 WEST COAST INVESTMENT MANAGEMENT CONFERENCE

OVERVIEW OF PRESENTATION SEC Priorities and Trends

Examinations Priorities and Guidance

Selected Investment Adviser Enforcement Actions

Cybersecurity Developments

Cryptocurrency

What’s ahead for 2018?

SEC Priorities and Trends

SEC TRANSITION ISSUES SEC leadership is new and not operating at full strength

New Chairman Clayton and SEC Enforcement Co-Director Steven Peikin appointed

Two open Commission seats with nominations pending Senate

Terms of the remaining Commissioners expiring soon Stein in 2017 and Piwowar in 2018

Themes of jobs growth, capital formation and avoiding controversy

Day-to-day business of enforcement and examinations continue A shifting of examination staff has taken place

Investment adviser examinations are rising

EXAMINATION AND ENFORCEMENT RESOURCES

More Exams: Office of Compliance Inspections and Examinations (OCIE) conducted

more than 2400 exams in 2016, a 20% increase over FY 2015 and the highest number of exams in the preceding seven years.

Expectation is another 20% increase in FY 2017, and 5% increase in FY 2018.

Fewer Broken Windows: Broken Windows strategy is on the wane; expect fewer cases focused

on minor infractions. Enforcement staff could shrink by 7% in 2017-18 through natural

attrition, according to Steve Peikin, the Co-Director of Enforcement. Focus to shift to retail fraud and cyber deficiencies/fraud Retail fraud “makes me sick” – SEC Chair Clayton

Examination Priorities and Guidance

2017 OCIE EXAMINATION PRIORITIES OCIE announced its intent to focus efforts on (1) examining matters of

importance to retail investors, (2) targeting risks specific to elderly and retiring investors, and (3) assessing market-wide risks

To protect retail investors, OCIE will monitor electronically delivered investment advice, examine wrap fee programs for consistency with advisers’ fiduciary duties, review ETFs for compliance with all regulatory requirements, monitor newly registered advisers, study circumstances surrounding recidivists and employers that hire them, analyze multi-branch advisers for risks associated with providing advisory services from multiple locations, and track instances of conflicts of interest

To protect senior investors and retirement investments, OCIE will continue its ReTIRE initiative to protect investors with retirement accounts, monitor public pension advisers, and identify potential financial exploitation of seniors

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2017 OCIE EXAMINATION PRIORITIES Never-Before Examined Investment Advisers Continued Risk-Based Selections; Continued and better use of data Continued risk-based exams on cybersecurity compliance procedures and

controls, including testing the implementation of those procedures and controls

Private fund advisers remain a focus area focusing on conflicts of interest and disclosure of conflicts as well as actions that appear to benefit the adviser at the expense of investors. Conflicts Fees and Allocations of Expenses Trade Allocations Custody Valuation Insider Trading

RISK ALERTS Risk Alert: The Five Most Frequent Compliance Topics Identified in OCIE Examinations of

Investment Advisers (Feb. 7, 2017)

Identified most frequent topics regarding investment advisers in deficiency letters as (1) Compliance Rule, (2) inadequacies in required filings, (3) Custody Rule, (4) Code of Ethics Rule, (5) Books and Records Rule

Typical problems with Compliance Rule included use of “off-the-shelf” compliance manuals that did not reflect advisers’ individualized business practices; and the failure to conduct annual reviews or adequately review the effectiveness of policies and procedures within these reviews

Common inadequacies in regulatory filings included inaccurate disclosures on Form ADV Part 1A and in Form ADV Part 2A brochures, untimely amendments of Forms ADV, and incorrect or untimely filings of Form PF and Form D

Advisers’ problems with Custody Rule compliance included failing to identify custody when advisers had online access to client accounts with access to withdraw, had powers of attorney authorizing them to withdraw, or served as trustees of clients’ trusts or general partners of client PIVs

Deficiencies with respect to Code of Ethics Rule included failing to identify all access persons for the purpose of reviewing personal securities transactions, failing to specify the review of the holdings and transactions reports within codes of ethics, and failing to describe codes of ethics in Part 2A of Form ADVs

Shortcomings with respect to Books and Records Rules included failing to maintain all records required by the rule, committing errors in documents like fee schedules and client records, and failing to identify inconsistencies in recordkeeping, which resulted in contradictory information being held in separate records 9

RISK ALERTS Risk Alert: The Most Frequent Advertising Rule Compliance Issues Identified in OCIE

Examinations of Investment Advisers (Sept. 15, 2017)

OCIE listed compliance issues under Advisers Act Rule 206(4)-1 (“Advertising Rule”), which prohibits advisers from distributing advertisements that contain untrue or misleading statements of material fact

Advisers presented misleading performance results and engaged in misleading one-on-one presentations; e.g., failing to deduct advisory fees when discussing performance results

Advisers have erroneously claimed to be in compliance with certain voluntary performance standards (GIPS)

Advisers appeared to have cherry-picked profitable stock selections

Advisers have utilized advertisements that contain misleading selections of investment recommendations in ways that violated subsection (a)(2) of the Advertising Rule

Advisers have disseminated advertisements containing potentially misleading use of third-party rankings, awards, professional designations, and testimonials

Advisers did not appear to have appropriate policies and procedures designed to prevent violations of the Advertising Rule

In response to OCIE assessments, advisers that were deemed to be in violation of the Rule elected to edit out misleading language in advertising materials or add appropriate disclosures to remedy any ambiguity 10

RISK ALERTS Risk Alert: Multi-Branch Adviser Initiative (Dec. 12, 2016)

OCIE announced the Multi-Branch Adviser Initiative focused on advisers that offer services from multiple locations, specifically their compliance programs for remote locations and the role of compliance personnel in these offices

Examinations will focus on advisers’ programs under the Compliance Rule, specifically the implementation of polices at both main and branch offices, the supervision structure for branch offices, the empowerment of compliance personnel in branch offices, and the accuracy of branch offices’ filings

Examinations will also focus on investment recommendations from branch offices, specifically the process by which advice is formulated at branch offices and the policies and procedures designed to supervise this process for risks like conflicts of interest

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Selected SEC Investment Adviser Enforcement Actions

2017 ENFORCEMENT CONSIDERATIONS Plain vanilla fraud, Ponzi schemes, insider trading and fewer

“broken windows” cases

Approval of Enforcement Division Co-Head required for initiation of Formal Orders of Investigation, reversing 2009 delegation to lower senior staff

Supreme Court ruling that 5-year Statute of Limitations applies to disgorgement actions (SEC v. Kokesh)

Cooperation credit still seen and touted as a factor in settlements

Formation of Retail Strategy Task Force and Cyber Unit

2017 ENFORCEMENT CONSIDERATIONS Preference for litigated administrative proceedings on the wane?

Whistleblowers still rewarded and employment agreements scrutinized for anti-retaliation and “pre-taliation” language

Fewer settled actions involving admissions

Fiduciary duties of advisers and conflicts of interest remain key

Clayton’s focus on individual culpability rather than corporate liability

2017 ENFORCEMENT CONSIDERATIONS Recent enforcement actions continue to highlight themes from 2015 and

2016, including: Conflicts of Interest Fees and allocation of Expenses Insider Trading Trade Allocations Best Execution Valuation of Securities Custody Rule Violations

INSIDER TRADING Deerfield Management Company, Advisers Act Rel. No. 4749 (Aug. 21, 2017)

Hedge fund adviser allegedly failed to tailor policies regarding the misuse of MNPI to account for risks posed by engaging research firms and political intelligence analysts; SEC found inadequate training and improper and inadequate reliance on research firms’ MNPI policies and procedures

Adviser’s analysts traded on MNPI obtained from a government employee

See SEC v. Blaszczack, et al., No. 17-cv-03919 (S.D.N.Y. filed May 24, 2017)

Violation of IAA Section 204A, $3.9 million penalty, $714,110 in disgorgement

Alan M. Stark, Exchange Act Rel. No. 81523 (Sept. 5, 2017)

Attorney for adviser allegedly traded on MNPI acquired through privileged communications about filings of beneficial owner reports

Violations of ‘34 Act Section 10(b) and Rule 10b-5, professional practice suspension; $7,608 penalty, $7,608 in disgorgement

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CHERRY PICKING SEC v. Strategic Capital Management and Michael J. Breton,

Lit. Rel. No. 23867 (June 23, 2017)

Adviser placed trades through master brokerage account and owner allegedly allocated profitable trades to himself and unprofitable trades to clients; trades were made on earnings announcement dates, allocations were made afterward

Violations of ‘34 Act Section 10(b) and Rule 10b-5 and IAA Sections 206(1) and (2), owner banned from industry, monetary sanctions to be determined; prison and penalty in corresponding criminal case

Howarth Financial Services and Gary S. Howarth, Advisers Act Rel. No. 4768 (Sept. 12, 2017)

Adviser and owner purchased securities through omnibus account, then allegedly delayed allocation until after determining intraday performance; owner also allegedly sold client securities and waited to see if price increased or decreased, allocating losses to clients and allocating profitable repurchases to himself

Violations of ‘34 Act Section 10(b) and Rule 10b-5 and IAA Sections 206(1) and (2), owner banned from industry, $160,000 penalty, $38,172 in disgorgement

EXPENSE ALLOCATION Potomac Asset Management Company, Inc., Advisers Act Rel. No. 4766

(September 11, 2017)

Private equity fund manager alleged to have improperly allocated fees and expenses to two funds

The Manager provided services to a portfolio company that generated $2.2 million in charges, and improperly charged a fund for these expenses instead of the portfolio company. The Manager also failed to apply a contractually required Management Fee offset of the $2.2 million fee

The Manager used fund assets to pay adviser-related expenses that were not authorized in the governing documents or disclosed to investors, including: office rent, operational expenses and regulatory costs from an SEC exam and investigation

The Manager inappropriately passed the expenses of a team member through to the funds as a “third-party consultant” expense

Financials did not disclose related party relationships, violating GAAP and the Custody Rule

The manager voluntarily reimbursed the funds for the management fees that were not offset; civil penalty of $300,000

EXPENSE ALLOCATION (CONT.)

Platinum Equity Advisors, LLC, Advisers Act Rel. No. 4772 (September 21, 2017)

Private equity fund manager that managed three main funds from 2004 to 2015. These funds invested approximately $5.3 billion in 85 companies during this period

A separate co-investment vehicle invested in each portfolio company at an amount equal to a percentage determined annually

The LPAs of the funds specified that the funds paid the expenses of their operations

The SEC alleged that the funds paid all broken-deal expenses, opposed to paying a portion of these expenses based on the co-investment percentage

The manager did not adopt policies or procedures governing its broken deal expense allocation practices

Disgorgement of over $1.9 million and $1.5 million civil penalty

PAY-TO-PLAY VIOLATIONS SEC settled with 10 investment advisory firms in January 2017 for pay to

play violations of Rule 206(4)-5

Minor violations but strict liability

Small political contribution amounts

In some, the covered associate had obtained a return of the contribution

9 of the 10 settlements had contributions by 1 covered associate

“Tainted” government entities were current investors in funds of the advisers and the advisers continued to receive management fees from such investors

Sanctions ranged from $35,000 to $100,000 in penalties together with cease and desist orders

CHIEF COMPLIANCE OFFICER LIABILITY The SEC’s position is unchanged; no new pronouncements and few actions

Prior speeches contained common themes:

SEC is not targeting CCOs

CCOs who perform their responsibilities “diligently” need not fear enforcement

SEC actions against CCOs tend to involve compliance officers who:

Affirmatively participated in the underlying misconduct,

Helped mislead regulators,

Wear multiple hats including as CCO while engaging in misconduct, or

Had clear responsibility to implement compliance programs and wholly failed to carry out that responsibility

CHIEF COMPLIANCE OFFICER LIABILITY Susan M. Diamond, Advisers Act Rel. No. 4619 (Jan. 19, 2017)

CCO of private fund adviser (an ERA) allegedly filed Forms ADV with false statements that financial statements were audited and would be distributed;

Violation of IAA Section 207 (material misstatements in a report filed with the SEC); nine month industry suspension; permanent bar from acting as a partner, officer, branch manager, or director, or in a compliance capacity for advisers; $15,000 penalty

David I. Osunkwo, Advisers Act Rel. No. 4745 (Aug. 15, 2017)

Outsourced CCO failed to file timely and accurate Forms ADV and amendments; filings overstated AUM and total number of client accounts; allegedly relied on and failed to verify of CIO’s inaccurate statements

Violations of IAA Sections 204 and 207, $30,000 penalty, and 12 month industry suspension

Firms sanctioned for recordkeeping and filing violations

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John W. Rafal, Admin. Proc. File No. 3-17760 (Jan. 9 2017); Peter Hershman, Esq., Admin. Proc. File No. 3-17761 (Jan. 9 2017); Essex Financial Services, Inc., Admin. Proc. File No. 3-17762 (Jan. 9, 2017)

Adviser’s President and CEO admitted to fraudulently circumvented rule regarding payments for client solicitations by paying attorney for client referral without notifying client of arrangement and resulting conflict of interest

President sent emails to other clients, falsely claiming that he was not being investigated for a securities violation. He also made false statements in testimony to the SEC regarding solicitation arrangement. He was barred from the industry and ordered to pay $275,000 fine and disgorgement of $275,000

Attorney barred from the industry and ordered to pay $37,500 penalty and disgorgement of $49,000

SEC considered adviser’s remedial measures of increasing compliance department staffing, reporting solicitation arrangement, promptly removing President from his position and subjecting him to internal investigation, and ultimately discharging him. Adviser also promptly informed the SEC of President’s false emails and compelled him to issue retractions. SEC ordered adviser ordered to pay disgorgement of $170,000

FAILURE TO DISCLOSE CONFLICTS

SHARE CLASS CONFLICTS Envoy Advisory, Inc., Advisers Act Rel. No. 4764 (Sept. 8, 2017)

Adviser firm recommended Class A mutual fund shares when less expensive share classes available; firm received approximately $24,000 in 12b-1 fees; firm’s disclosures did not adequately inform clients of conflict of interest created by its recommendation to purchase Class A shares

Firm violated Advisers Act Sections 206(2), 206(4), and 207

SEC issued cease and desist order and ordered disgorgement of approximately $24,000

SEC took note of the firm’s cooperation and remedial efforts, including engaging a compliance consultant

DISTRIBUTION-IN-GUISE Calvert Investment Distributors Inc. and Calvert Investment Management, Inc.,

Admin. Proc. File No. 3-17016 (May 2, 2017)

Adviser and broker-dealer affiliate negligently caused its advised open-end investment companies to pay nearly $13 million for distribution and marketing of fund shares outside of a Rule 12b-1 plan. As a result, funds’ prospectuses contained material misstatements regarding distribution-related services, and also, funds incurred expenses for sub-transfer agent services beyond applicable expense limits

Violation of Advisers Act Section 206(2) and Investment Company Act Sections 12(b) and 34(b)

SEC issued cease and desist order and imposed disgorgement and interest of over $21.6 million, plus a reduced penalty of $1 million

SEC reduced the monetary penalty due to the funds’ self-reporting of the improper fee payments, significant cooperation, and prompt remediation through shareholder distribution

DISTRIBUTION-IN-GUISE (CONT.)

William Blair & Company, Admin. Proc. File No. 3-17960 (May 1, 2017)

Adviser and broker-dealer affiliate negligently used mutual fund assets to pay for distribution and marketing of fund shares outside of a written, board-approved Rule 12b-1 plan, and sub-TA services in excess of board-approved limits; payments totaled approximately $1.25 million and rendered disclosures concerning payments for distribution and sub-TA services inaccurate

Findings that William Blair failed to fully disclose to the funds’ board that it (and not a third-party service provider) would retain a fee for providing shareholder administration services to the funds under its shareholder administration services agreement

SEC found William Blair to have violated Advisers Act Section 206(2) and Investment Company Act Section 34(b), and to have caused the funds to violate Investment Company Act Section 12(b) and Rule 12b-1

SEC imposed cease and desist order and $4.5 million penalty, taking into consideration credit for remediation and cooperation

After being informed by OCIE that it would conduct an examination into payments to financial intermediaries, William Blair self-investigated and detected the violations, and remediated by promptly notifying the fund Board, reimbursing the funds with interest, and supplementing its practices of providing oversight of payments to financial intermediaries

NEGLIGENT OVERCHARGING Citigroup Global Markets, Inc., Advisers Act Rel. No. 4626 (Jan. 26, 2017)

Between 2000 and 2015, CGMI overcharged approximately $18 million in advisory fees. Overcharging occurred due to procedural flaw relating to how fee rates were entered into computer system. CGMI also failed to maintain and preserve certain books and records regarding advisory contracts

SEC issued cease and desist order and imposed $14.3 million penalty and $3.2 million in disgorgement.

Morgan Stanley Smith Barney, LLC, Advisers Act Rel. No. 4607 (Jan. 13, 2017)

Between 2002 and 2016, MSSB inadvertently overcharged approximately $16 MM in advisory fees primarily due to numerous errors in its billing systems. MSSB also failed to maintain and preserve certain books and records regarding advisory contracts

SEC issued cease and desist order and imposed $13 million penalty

Cybersecurity Developments

CYBERSECURITY ISSUES Risk Alert: Observations from Cybersecurity Examinations

Generally, firms had enhanced cybersecurity measures and functioned with heightened cybersecurity awareness

Issues:

Policies and procedures were not reasonably tailored

Firms did not appear to adhere to or enforce policies and procedures or did not reflect actual practices

Firms should establish and maintain robust cybersecurity policies:

Maintain a complete inventory of data and information regarding each service provider and vendor

Adopt comprehensive cybersecurity-related instructions that cover penetration tests, security monitoring, system auditing, access rights, and reporting of breaches

Consistently test for data integrity and vulnerabilities

Disseminate “acceptable use” policies to employees and strictly enforce access controls.

Mandatory information security training, monitor attendance, and take appropriate punitive action against noncompliance

SEC hacked

Announced that EDGAR was hacked in 2016

SEC acknowledged the hacking “may have provided the basis for illicit gain through trading”

NEW CYBER ENFORCEMENT UNIT Focus is on cyber-related misconduct:

Hacking

Market manipulation schemes involving false information spread through electronic and social media

Violations involving distributed ledger technology and ICOs

Misconduct using the dark web

Intrusions into retail brokerage accounts

Cryptocurrency

FRAUD ENFORCEMENT ACTIONS AND WARNINGS

SEC Investor Alert: “Innovations and new technologies are often used by fraudsters to perpetrate fraudulent investment schemes”

General “fraudy-fraud” enforcement actions

SEC v. Recoin Group Foundation, LLC (Sept. 29, 2017)

Sold investors digital tokens, purportedly backed by real estate and diamonds, in two separate ICOs

SEC alleged that neither the digital tokens nor the alleged backing of real estate and diamonds existed, and as such, false statements were made in connection with the offering

SEC also alleged that these were illegal securities offerings for which no registration was filed and as to which no exemption from registration was available

THE DAO: CRYPTOCURRENCIES MAY BE SECURITIES

Investigation report and no formal finding, not an enforcement action – but a warning

Announcement that cryptocurrencies may be securities and therefore subject to the securities laws

DAO tokens constituted an “investment contract”

Howey Test – a “security” includes an investment of money in a common enterprise with a reasonable expectation of profit to be derived from the entrepreneurial or managerial efforts of others

“I have yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security” - SEC Chair Clayton

WHAT’S AHEAD FOR 2018

Questions?