SEC Examinations and Enforcement

Todd Cipperman, Esq.Cipperman & Company

ICI General Membership MeetingMay 7, 2009

Overview Core Initial Request List SEC Exams and Priorities Personal Liability Conflicts of Interest Liability of Fund Service Providers Marketing and Solicitation Trading Valuation Operations and Technology Funds Fees Market Meltdown Jurisdictional Issues

Core Initial Request List (OCIE)

First comprehensive (and official) effort to define what is required by 206(4)-7

Holistic approach to understanding business and compliance program

Risk assessments, testing results, remedies (work paper focus) General: sub-advisory agreements, powers of attorney, JVs, service

providers, threatened litigation Compliance Program: tests, risk inventory, internal audit plan,

supervision, valuation, customer information Testing: trade blotter, client data, brokerage, soft dollars, trade

allocation, code of ethics Specific areas: performance, marketing, solicitors, financial

records, custody, AML More information if sponsoring funds, participating in wrap,

brokerage Cf: NYRO Examination Request List

– Focus on personal responsibility– Required certain data presentation– Work papers including risk assessment– Very comprehensive: due diligence/audit

SEC Exams & Priorities Compliance Alert (OCIE, July 2008): Code of Ethics,

oversight of third party proxy voting, illiquid securities holdings, soft dollar credits, free lunch seminars

Joint exams of dual registrants (Richards speech) Expand books/records rule (Donohue speech)

– All correspondence • re: clients, advice, performance, compliance, commissions,

audits• to/from clients, regulators, marketers, BDs

– Searchable electronic records for trading data, client lists, COE violations

Joint regulatory action on spreading false rumors– Reviewing personal e-mail accounts and IMs– Internal reviews and investigations

Personal Liability of CCOs Personal liability under 206(4)-7. See In re CapitalWorks:

– First (only) case under 206(4)-7– Correnti headed Marketing and Compliance– RFP responses said that CapitalWorks never had a deficiency– SEC warned the firm to implement P/P– Firm violated 206(4)-7– Correnti personally liable as CCO for aiding/abetting

violations of 206(4)-7 Merely having P/P not sufficient. See In re Martinez: CCO did

not execute insider trading policies. Aiding/Abetting. See In re Trautman Wasserman: BD CCO

sanctioned for aiding and abetting market timing – CCO helped create multiple dummy accounts– Another example of CCO undertaking several roles– Cf. SEC v. Papa et. al.: Failure to Disclose Securities Law

Violation May not result in personal liability

Personal Liability - Defenses

CCO can’t use “following orders” defense (In re Murray)– Don’t need to know that acts were illegal, although high

standard for CCOs– But cf In re Monson: In-house lawyer not liable for drafting

late trading agreement • Responsible for drafting contracts, not regulatory

compliance• General practice background, not securities

Standard of Care for CCOs (Thomsen speech):– “egregious misconduct usually involving knowing and

intentional inaction”– “sustained attention”; good faith effort– Policies and procedures not enough

Conflicts of Interest - Compensation

Failure to disclose compensation received from recommended products (SEC v. Wealthwise)– Solicitation rule not applicable (See

Goldstein) Payments from a fund administrator (In re

AmSouth) Recommending services of affiliate (In re

Merrill Lynch)– Pension consulting and manager transition desk

Gifts received by mutual fund traders (In re DeSano et. al.)– Traders personally liable

Net trading scheme to conceal commissions (SEC v. Granite Financial Group)

Conflicts of Interest - Other

Code of Ethics. See SEC v. Donovan et. al.: Front-running by mutual fund trader in mother’s account – N.B.: firm avoided liability

Portfolio Pumping. See In re Medcap: Using offshore fund to pump securities held by affiliated hedge fund

Cherry-picking. See SEC v. Dawson: Hedge fund manager’s personal account bettered hedge fund account

Recommendations. See In re Banc of America Investment Services: Wrap sponsor recommended underperforming proprietary funds

Liability of Fund Service Providers

Adviser– Failure to conduct advertised due diligence (In re

Hennessee and Gradante)• Hedge fund-of-funds consultant• Control person personally liable

– Insider trading (SEC v. Stephanou et. al.) • No benefit to the adviser, only to the fund

– Falsifying fund records (In re Keefe)• Making up investment committee meeting minutes to

support proxy statements– Submitting false invoices (In re Murray)

• No “following orders” defense for fund executive– Closed-end fund distribution notices (In re Gabelli)

• Section 19 and Rule 19a-1 Auditor: Allowing fund sponsors to use false financials in

marketing (SEC v. Friehling & Horowitz)– Madoff auditor

Marketing and Solicitation

SEC publishes PAUSE list of unregistered solicitors– Subject of investor complaints– 2 days to respond

Liability for misrepresentations to third-party selling agents (SEC v. Ponta Negra)

Solicitors must perform some bona fide service (SEC v. Morris et. al.)– New York pay-to-play scandal

Failure to properly register as RIA/BD (SEC v. UBS)– $200 Million penalty

Mutual fund wholesaler liable for assisting market timers (In re Brugman)

Principals of fund distributor liable for prospectus disclosure (SEC v. Tambone and Hussey)– Market timing disclosure– What if distributor was unaffiliated?

Trading Best execution analysis must consider alternative trading venues

such as algos and dark pools (Donohue speech)– Transparency, cost– Unbundling

Fund directors must consider best execution (SEC proposal)– Part of 15(c) review– Consider BDs used, allocation, commissions, venues, soft dollars, sub-adviser

trading In re Morgan Stanley: Trading system failed to ensure best

execution– Embedded mark-ups/downs– Delayed settlement– In-house system replaced commercial applications– No compliance review of in-house system

In re Folger Nolan: Use of BD affiliate to execute trades without demonstrating best execution

2006 Soft Dollar Interpretive Release– Narrowed scope to advice, analysis, reports– Computer hardware out– Clear allocation of mixed use items– Defines “effecting a trade”

Valuation Mutual fund manager should not have relied on

pricing service where he knew muni bonds were over-valued (In re Hearland Advisors)

Responsibility for valuation– In re McCurdy: concurring audit partner knew financials

were incorrect– In re Seghers: delivering inflated valuations to

administrator Collusion with pricing vendor (SEC v. Lee et. al.) Private Equity Firm BDC did not value portfolio

companies as required by ASR 118 (In re Allied Capital) – Valuation committee was not independent– No books and records

Operations and Technology

Inflating assets and performance to database services used by consultants (In re Warwick Capital)– ADV had much lower asset figures– Full SEC added more charges after appeal– Where was the data scrubbing?

Disabling trading software to allow short sales (SEC v. Beardsley)– Violations of uptick rule– Driving down price of thinly-traded stock to cover shorts

Hacker cost clients following internal audit report warned of deficiencies (In re LPL)

Portfolio Manager bypassed internal compliance re: SRI investing (In re Pax World Management)

E-Mail Administrator bought target company stock ahead of tender offer (SEC v. Suman)

Using Fund/SERV to late trade for hedge fund clients (In re Byck et. Al.)

Fund Fees Seventh Circuit rejects Gartenberg standard

in 15(c) review (Jones v. Harris Associates)– Boards should rely on the competitive

marketplace more than their own assessment of reasonableness of fees

Eighth Circuit holds that fund fees should be compared against institutional fees (Gallus et. al. v. Ameriprise)

Cox attacks 12b-1 fees (Cox speech)– Call distribution fees “loads” or “sales charges”– Who will compensate distribution? Back to front-

end loads?

Market Meltdown Schapiro suggests that SEC may require

third party compliance reviews (speech to Council of Institutional Investors)

Gohlke says that SEC will contact investors and other third parties to verify assets (letter to MFA)

SEC raises maximum monetary policy by 12%

SEC calling for more resources Lori Richards warns CEOs not to cut

compliance

Jurisdictional Issues SEC jurisdiction extends to non-US plaintiffs and non-

US defendants (Morrison v. National Australia Bank)– US conduct material to fraud’s success and forms a

substantial component of the scheme Anti-fraud rule applicable to unregistered advisers SEC can act as prosecutor in federal case and

adjudicator in SEC action (In re Vancook) Adviser lacks standing to sue on behalf of clients (Huff

Asset Management v. Deloitte & Touche) State enforcement cases

– consequential damages in ARS cases– Madoff feeder funds

New York State announces intent to regulate CDS as insurance

Final (Discomforting) Thoughts

SEC exams have become increasingly comprehensive and forensic; everything is a “priority”

Regulation through enforcement action Focus on personal liability Conflicts of interest may not necessarily be

cured with disclosure State regulators very active Lacking clear guidance on valuation Technology-savvy bad actors have increased

systemic risk Awaiting new regulatory initiatives

Cipperman & Company is a unique law firm devoted exclusively to the investment management industry. Our lawyers have spent their careers in the investment management industry, including significant experience at major industry players. Our shared heritage and experience make our lawyers unique and creative industry partners who can give you practical, real-world advice for making informed business decisions and controlling your legal risk. We have worked on a wide range of transactional and regulatory matters, but we concentrate on four core areas – Compliance, Distribution, Fund Formation, and Technology:

Compliance: Policies/Procedures, Compliance Manuals for RIAs, BDs, and Funds, Annual Reviews, Regulatory Exams, Testing

Distribution: Broker-Dealer Regulatory Matters, Dealer, Solicitation, and Referral Agreements, Asset-Gathering Strategies and Structures, Wrap Programs, Marketing Materials

Fund Formation: Hedge Funds, Fund-of-Funds, Institutional Products, ETFs, Variable Insurance Products, Cash Sweep Vehicles

Technology: Licensors and Licensees, Installed and ASP, Portfolio Management Systems, Trading Utilities and Platforms, Compliance Tools

150 S. Warner Road, Suite 140, King of Prussia, PA 19406, 610.687.5320, tcipperman@cipperman.com, www.cipperman.com