Regulatory & Enforcement Update ICI General Membership Meeting

May 1, 2013

Recent Activity

• SEC Enforcement focus on compliance programs • Mutual fund directors’ liability • Expensive disclosure cases • CPO/CTA registration and compliance • Misleading marketing (not just performance) • Focus on Private Equity • FINRA active 2

Compliance: SEC Positions

• Record number of enforcement actions; focus on compliance programs • di Florio tells firms to strengthen conflicts of interest practices: sales practices, outside business activities, wrap programs, side-by-side management, affiliations, valuation practices • Aguilar: protect investors • Walter: problems with small firms • IM Division focusing on “strategically important advisors” 3

Compliance Programs

• • • • Firm must hire outside provider to fix compliance program (

In re IMC Asset Management

) – Not just testing – 2 incumbent employees with little compliance experience – WSPs rather than compliance manual – No evidence of compliance reviews conducted – No underlying violation BD WSPs ≠ RIA compliance manual (

In re Evens Barthelemy

) P/P should have required 2 signatures to move client funds (

SEC v. Resources Planning Group

) Failure to verify pitchbook valuations (

In re Oppenheimer Asset Management

) 4

Compliance Rules • Reg S-ID: Identity Theft Red Flags Rule

– Transaction accounts – Board approval

• Custody rule violations in 1/3 of exams • Regulation SCI (IT)

5

Compliance and Operations

• • • Trading through affiliated BD (

In re Tilden Loucks & Woodnorth

) – Conflict disclosed – Higher commission rates – Principals benefitted Failure to disclose deteriorating financial condition (

SEC v. Aletheia Research

) – Item 18 of Form ADV – Factors: significant litigation, creditor liens, a rapid decline in AUM, negative shareholder equity, and/or material operating losses MBS trader lied about mark-ups and counterparties (

SEC v. Litvak

) – TARP funds involved – Criminal prosecution 6

Mutual Funds: Directors

• SEC sues independent directors for failing to oversee fair valuation (

In re Alderman et. al.

) • Scrutiny of sub-adviser fees (

Kasilag v. Hartford

) – Split of fees between adviser and sub-advisers – Comparable funds (Vanguard comparison) • Federal court says that directors not independent (

PRSSA Welfare Plan v. UBS

) – Fund sponsor so pervasive in local market – Placement agent in past deal – Puerto Rico exempt from ICA • Fund sponsor suing directors in class action (

Third Avenue v. Reserve

) 7

Mutual Funds

• SEC must file enforcement actions within 5 years of conduct, not discovery (

Gabelli v. SEC

) • Filing of social media content – Fund performance – Investment merits • Derivatives: Hedging vs. speculation – Notional amount > value of underlying securities (

In re Top Fund Management

) 8

Disclosure

• Failure to disclose impact of derivatives strategy (

In re Claymore Advisors

) – Trying to juice returns with put options and short variance swaps rather than covered calls – $45 Million in fines, etc.

• Prospectus did not adequately describe minimum benefit feature (

In re Mass Mutual Life

) – $1.625 MM fine – Section 34(b) of Investment Company Act 9

CFTC and NFA

• Court upholds CPO registration for registered funds (

ICI v. CFTC

) – Deference to administrative agencies – Considered costs/benefits: protection of markets/public; market efficiency, competitiveness and financial integrity; price discovery; risk management; and the public interest • Fund managers must ensure sub-advisers are properly registered – FCMs also have obligation 10

Marketing

• May use social media to disseminate information (Netflix) • Compensating unregistered solicitors (

In re Ranieri Partners

) • Using software to pass off hypothetical backtested performance (

In re New England Investment and Retirement Group

) • Misleading website claims (

B&T Securities

) • Inflating AUM (

In re Tandon

) • Misleading about co-investing (

In re Aladdin Capital

) • Misleading GIPS performance claims (

In re ZPR Investment Management

) 11

Private Funds

• SEC launches Private Equity Initiative: identify higher risk firms – Karpati: more enforcement cases against private equity firms • Valuation – FAS 157 (

In re KCAP Financial

) – Audit firm liability (

In re Aesoph and Bennett

) • Cross-trading between funds (

SEC v. Commonwealth Advisors

) • Preferential redemption rights to large investor (

SEC v. New Stream Capital

) • SEC regulating pre-Dodd Frank conduct (

In re Lawton

) • Portfolio companies controlled by affiliated fund • Form PF (21 pages of FAQs) • BD registration for salespeople 12

FINRA

• Focusing on high-yield products: BDCs, CMBS, high yield debt, structured products, exchange-traded funds and notes, closed-end funds, and variable annuities • Will take adviser arbitrations • Rule 8210 gives FINRA broad authority to obtain documents – Outside business activities – Possession, custody, or control – Includes info about unregulated third parties (

In re Goldstein

) 13

Lessons

• Get a professional compliance program • Re-examine independent directors • Refresh disclosure documents • Review marketing materials like a regulator • Implement CPO/CTA compliance • Prepare for private equity exams/enforcement • Don’t forget FINRA (and states) 14

CCS provides compliance services to registered funds and money managers. CCS leverages the experience of a multi-disciplinary team and takes full accountability for its advice and services.

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