Transcript CIPPERMAN & COMPANY

SEC Examinations and
Enforcement
Todd Cipperman, Esq.
Cipperman & Company
ICI General Membership Meeting
May 7, 2009
Overview
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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)
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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
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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:
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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
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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
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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
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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, [email protected], www.cipperman.com