Transcript CIPPERMAN & COMPANY - Cipperman Compliance Services, LLC

Regulatory Update
Todd Cipperman, Esq.
Cipperman & Company
Philadelphia Compliance Roundtable
December 2, 2008
Overview
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Core Initial Request List
SEC Exams and Priorities
Personal Liability
Conflicts of Interest
Marketing and Solicitation
Customer Data
Trading
Valuation
Operations and Technology
ERISA Developments
Funds and ETFs
Financial Crisis 2008
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
 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
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CCO helped create multiple dummy accounts
Another example of CCO undertaking several roles
 Defenses. See In re Murray: CCO can’t use “following orders” defense
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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):
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“egregious misconduct usually involving knowing and intentional inaction”
“sustained attention”; good faith effort
Policies and procedures not enough
Conflicts of Interest
 Receipt of 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)
 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
Marketing and Solicitation
 Past specific recommendations (TCW NAL)
– 5 most positive and negative contributors
– Weighted performance
– Mathematical tool
 Unregistered fund mangers need not comply with solicitation rule (Mayer
Brown NAL)
– Anti-fraud rules?
 Intermediaries need not review mutual fund sales literature (FINRA
proposal)
– Obtain FINRA review letter
– No changes to material
 SEC publishes PAUSE list of unregistered solicitors
– Subject of investor complaints
– 2 days to respond
Customer Data
 Selling customer data to insurance agents as
sales leads (SEC v. Mondschein)
– BD referral arrangements
– Conflict of interest not disclosed
 Rep transition programs (In re Next Financial)
– Pre-populating customer database
– Whose client is it, anyway?
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
 FASB staff guidance on 157
– Inactive market: widening of bid/ask spreads, decrease in trading volume,
stale prices, wide price variations
– May use unobservable inputs (e.g. management assumptions about discount
rates, cash flows, etc.)
 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
 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
 IOSCO valuation principles: documentation, consistency, independent
review, vendor due diligence, transparency
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
 Collusion with pricing service (SEC v. Lee et. al.)
 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.)
ERISA Developments
 New proxy voting guidelines (DoL Interpretive
Bulletin)
– “economic value of the plan’s investment”
– no legislative, regulatory, or public policy issues
– Fund managers can require benefit plans to adopt fund’s
proxy voting guidelines (sub-docs)
 Cross-trading permitted
– Policies/procedures to ensure fair and equitable
allocations
– 17a-7 pricing
Funds and ETFs
 Exemptive order allows ETF of ETFs (iShares Trust)
 New ETF rule allowing plain vanilla ETFs without exemptive relief
 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
 Cox attacks 12b-1 fees (Cox speech)
– Call distribution fees “loads” or “sales charges”
– Who will compensate distribution? Back to front-end loads?
 New summary prospectus for mutual funds by 2010 (SEC rule)
– Full prospectus on line and available for delivery
 SEC reviewing web sites (Donohue speech)
– Consistency with regulatory filings
– Financial statements, fund holdings
 XBRL and the Mutual Fund Reader
Financial Crisis 2008
 Schapiro calls for systemic regulation
– Similar to banking and insurance
– The Paulson plan
– Regulate unregulated markets (e.g. CDS)
– Product agnostic
 Merging of SEC and CFTC, etc.
 Short-selling ban
– Is short selling bad? (SEC: efficient price discovery,
mitigating bubbles, liquidity, hedging, limiting upward
manipulation)
 Reporting of short positions
– Public information subject to FOIA requests?
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
 States seeking consequential damages in ARS cases
– Unable to access funds
– Not just rescission
 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
Distribution and disclosure uncertain
Complete regulatory overhaul
New sheriffs in town in 2009
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