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Regulatory Update 2010
- Post-Madoff Enforcement- Dodd-Frank & the New
Regulators- Compliance 2.0
Todd Cipperman, Esq.December 1, 2010
Nothing herein should be construed as legal advice. This presentation may constitute an advertisement under U.S. law.Cipperman Compliance Services is not a law firm and does not render legal advice.
Dodd-Frank The Players
– RIA registration and supervision– Registration of municipal advisers and solicitors
The Markets– Derivatives– Short-sale reporting and regulation– Money market funds
The Process– Proxy vote reporting– Shareholder nominations
Distribution– Accredited investor defn
Enforcement and Litigation– Whistleblowers– Private rights of action
New Registrants Private fund sponsors (>$150 Million)
– Private Equity firms• Venture Capital exemption limited• Based on committed capital• Market valuations
– Hedge Fund sponsors– “ADV lite” for VC and small fund advisers
Multi-family offices SRO for Advisers? Remove BD exemption from Advisers
Act? State vs. Federal regulation
Private Funds: Infrastructure
Valuation– Overvaluing illiquid securities in side pockets (SEC v.
Mannion et. al.)• Internal valuations were lower• Methodology differed from PPM
– BDC investments overvalued (SEC v. Brantley Capital)• Impacted fee calculation • Affected financials, Board reports, SEC filings
– Over-paying for MBS to maintain values (SEC v. ICP Asset Mgt)
Long and short in same securities (In re Carlson Capital)– Rule 105: access to information
LP has right to list of other LPs (Parkcentral v. Brown)– LPA could have prohibited
Processing clerk made unauthorized trades (SEC v. Kass)
Private Funds: Conflicts of Interest
Cherry-picking for personal account (In re Dawson)– Irrelevant that Manager reimbursed fund or that clients
didn’t express concern Undisclosed payments to key BDC employee (In
re Douglas and Moore) Collusion between PE fund manager and
underlying companies to ensure committed capital (SEC v. Onyx Capital)– Money funneled back to manager– Fraudulent statements to pension plan investors
Hedge fund manager created fake administrator and auditor (SEC v. Finvest)– Delivered performance information and financials
Insider trading Galleon Dozens of cases against hedge fund
managers Mutual fund manager tipped family
members to sell his fund (In re Baldt)– Muni market declining– Knew about redemptions
Fund exec sold fund shares after learning about re-pricing (SEC v. Marquardt)
Derivatives Proposed anti-fraud rule for swaps Swaps reporting to SDRs Alternative uptick rule for shorts Funds must review derivatives disclosure CorpFin letter re: repos and securities
lending– More MD&A disclosure
Leveraged ETFs– IM Staff won’t approve ETFs that use
derivatives
Boards Can’t delegate review of affiliated
transactions under 17e-1, 17a-7, 10f-3 (IDC Letter)– CCO is a service provider, not a substitute
12b-1 proposal Jones v. Harris and its progeny
– Review of mutual fund fees New rule for money market funds Evaluate 12b-1 fees based on whether
services were reasonable in relation to fees (In re American Mutual Funds)– Board process
Compliance Programs Failing to follow your own procedures (In re Buckingham)
– Wall between BD research for nonpublic info– Creating records upon SEC exam request
Template compliance manual (In re Sierra Financial)– P/P not tailored to business– No annual review– Investing in controlled entities
BD CCOs – failing to stop use of personal e-mail account used in stock
manipulation scheme (In re Campanella)• Recklessness = intent
– Failing to supervise re variable annuity recs (In re Prime Capital)
• Authority to impose discipline– Failure to supervise brokers who churned (Westpark Capital)
SEC to leverage compliance pros (Schapiro speech)– Duty to investors– CCO’s job to ensure compliance with securities laws
Operations Ignoring back-office ops (In re Busacca)
– Cutting corners and costs– BD Pres focusing on sales, not ops
Books and Records– Storage facility destroyed records for
nonpayment of fees (SEC v. Envision) Status questions
– Function, not title triggers licensing reqs (JP Morgan Securities)
• Investment banker that supervised municipal dealer
– 28(e) research provider is not investment adviser (BNY ConvergEx)
Custody IM Staff interps
– Same audit firm permissible for surprise exams– May use same independent rep for all LPs
Guidance for surprise exams– Confirm assets with clients– SEC notification and filing
Compliance guidance– Background checks– Two persons to move assets– Segregate custody duties– Reconcile account and custody statements
Audit firm liable for negligent surprise exam (In re Altschuler)– Ignored commingling– Gave notice of exam– 1.5 billable hours
Action against private fund manager (In re Sands Brothers Asset Mgt)– Auditor disclaimer– Failure to deliver financials– Incorrect ADV
Shareholders and Proxies Proxy process and reporting
– Form N-PX for executive compensation matters for 13F filers (Proposal)
– Oversight of proxy advisory firms (Schapiro speech)– SEC Concept Release: proxy plumbing
• Access to intermediary data• NOBO/OBO system• Use of technology
Shareholder Proposals– Closed-end fund must include proposal to convert to
interval fund (Swiss Helvetia Fund)• Board had already considered and rejected
– Fund must include proposal to fire adviser that overvalues ARS (Boulder Growth and Income)
– Shareholder-nominated directors (Rule)• 3% for 3 years• 1 director or 25% of Board
Disclosure: Point-of-Sale Product Disclosure
– Include brokerage costs in fund expense ratio (FASB proposal)
– IFRS– Failure to disclose that counterparty influenced
collateral pool (SEC v. Goldman Sachs)– Changing investment objectives without shareholder
approval under 13(a) (In re Charles Schwab)• Is “MBS” an industry classification?
– Misreps about RMBS delinquency data (Deutsche Bank Securities)
• FINRA action against underwriter
Adviser Disclosure– New ADV
• Personnel supplement• Financial disclosure• Publicly available
– Point-of-sale disclosure for BDs– IAR information available online
Disclosure: Ongoing Summary annual reports (Donohue speech) MD&A disclosure about short-term
borrowing Short sale reporting for 13F reporters 13F information not protected by 5th
Amendment’s “Takings” clause (In re Wynnefield)
Reg FD violation for selective disclosure to private fund manager (SEC v. Presstek)– Earnings info during blackout
Marketing: Product-specific
SEC regulation– Target Date funds proposal
• No suitability statements
– Suitability (SEC v. Life Wealth Management) – Best practices report for working with
Seniors Fund marketing
– Marketing multi-strat fund/funds as conservative and liquid (In re Greenberg)
• Concentration in two underlying funds• Suitability • See also In re S4 Capital: using unhedged options in
“absolute return” fund
– Misreps in fund fact sheets for enhanced cash fund that invested in subprime (In re Flannery and Hopkins)
• CIO and Product Manager charged
Marketing: Sales Misreps Failure to disclose that wrap program was
more costly than brokerage account (SEC v. Sage)– Moving clients to new RIA firm from BD– Misrep that clients couldn’t stay with
underlying manager Failure to disclose additional commission
comp for switching classes (In re Valentine)– Investment rationale not relevant– Prospectus disclosure not enough
Options trader barred for claiming competence (In re Jafari)– Average loss of 52%
Solicitors Public Plans
– Pay-to-play rule for public plans• May only pay registered BDs and federal RIAs• Limits on political contributions
– FINRA sweep– State laws
• CA requires solicitors to register as lobbyists– No contingent compensation for public plans
– PE Firm and Exec to pay $13.2 Million in fines for undisclosed comp to public plan solicitor (SEC v. Quadrangle; SEC v. Rattner)
• “Chooch”• Section 17(a)(2)• What about 206(4)-3?
Cap Intro– Law firms
• A “salesman’s stake” (Brumberg, Mackey & Wall)– Law firm sought no-action relief– Cf. Manatt, Phelps & Phillips: no contingent compensation
– BD registration (Donohue speech)
Broker-Dealers Sales Practices
– Segregation of BD and RIA activities (Ketchum)– Suitability: leveraged ETFs, ARS, UITs, closed-end
funds– Due diligence of private placements (Reg Notice 10-22)– Obligation to verify QIB reps (In re Merrill Lynch)– Obligation to deliver due diligence info (In re Securities
America)– Implied reps and the “shingle theory" (Capital
Management v. Bennett) Disclosure
– More disclosure in U4s and U5s• Termination details• Broker awarded $5 Million for defamatory U5 (Beck v.
SunTrust)– Politics not sales practices
– FINRA considering broker-dealer ADV– More information required in BD applications (Reg
Notice 10-01)
Broker-Dealers con’t Operations and Infrastructure
– Liquidity risk management (Reg. Notice 10-57)• No excuses for loss of funding
– Licensing of Ops personnel (Proposal)– E-Mail retention (Piper Jaffray)– Expansion of TRACE– Protection of customer information from hacker (D.A.
Davidson) – Insufficient resources devoted to AML (Penson and
Pinnacle)– Social Networking (NtM 10-06)
Market participation– Naked access
• Inadequate customer ID (In re Pinnacle)– CDS market manipulation (Phoenix Derivatives)– Best execution should include multiple venues (Ketchum)
Enforcement Power New Whistleblower rule
– 30%, $1 Million– Not required to use company procedure– Employment law implications
SEC Argues that SOX protects third-party whistleblowers (Klopfenstein v. DoL)
$1 Million bounty awarded to insider trading informant (SEC v. Pequot)– Ex-wife of tipper who misled SEC
Asset Management Unit– Specific initiatives (Bond Fund, Problem Adviser, Mutual
Fund Fees) Virginia Financial and Securities Fraud Task Force
– Ability to bring criminal charges Enforcement will offer cooperation agreements Increased enforcement activity (2009)
– 496 vs. 233 investigations– $2.09 BN v. $774 MM in disgorgements – $345 MM vs. $256 MM penalties
Private Rights of Action
Extending “conduct and effects” test to non-US transactions
Must show stock price movement for “fraud-on-the-market” theory in class action (Berks County ERF v. First American (SDNY))
No private right of action under Section 13(a) (Northstar v. Schwab (9th Cir))
Who’s liable? (aka Madoff con’t)
Liable– Adviser that suspected Madoff fraud (Cuomo
v. Ivy Asset Management (NYS))– Custodian for Madoff feeders (Pitkin v.
Westport National Bank (CT))– RIA for failing to conduct proper due diligence
of Ponzi scheme (In re Yosemite)– Fund manager for blindly relying on
performance information provided by sub-adviser (SEC v. Moody)
– Fund accounting head for allowing PM price overrides (In re Morgan Asset Mgt et al)
– SEC/DoJ argue that advisers liable for fund prospectuses (Janus v. First Derivative Traders)
• Civil and criminal penalties
Who’s liable? (aka Madoff con’t)
Not Liable– Auditor of Madoff feeder (CRT v. BDO
Seidman (NYS))– Auditor or any other service provider with
interest in the offering (Malack v. BDO Seidman (3rd Cir))
• No “fraud created the market” theory
– Law firm in securities offering (PIMCO v. Mayer Brown (2nd Cir))
• May only apply to private rights of action
– Lender to ponzi scheme not liable to Receiver (Marion v. TDI)
– BD GC for failure to supervise (In re Urban)• Not a supervising principal• Reported issues
Jurisdictional Battles: FINRA and NASAA
SEC v. FINRA– Ketchum Wants SRO for RIAs; SEC launches study to
determine if it should eliminate broker exemption from Advisers Act
– FINRA assumes enforcement for NYSE SEC v. NASAA
– SEC action against adviser had <$25 Million AUM (In re FreedomTree)
– SEC suit against state-registered adviser for PPM fraud uncovered by FINRA (SEC v. Vallett)
– State regulatory standards• SEC standard• NASAA resource
– 1940 Act trumps MD takeover statute (Boulder Total Return Fund)
– DF moves mid-sized advisers ($25-$100 AUM) to states • Must have examination program• >4000 advisers• New quasi-SRO?
– Deference to arbitration awards (Wiederhorn v. Merkin (NYS))
• Large award for investors in Madoff feeder
Jurisdictional Battles: FDIC and DoL
SEC v. FDIC– Collective funds
• Funds did not disclose subprime investments and leverage (In re State Street)
– SEC fraud case• Donohue questions rationale for 1940 Act exemption
SEC v. DoL– New disclosure about plan and investment options
• More transparency– Expanded definition of “Fiduciary”
• More than just providing “regular advice”• RIAs
– DoL sues Madoff feeders (Solis v. Beacon et. al.)• Feeder managers were fiduciaries• Jurisdictional issues
Final Thoughts Dodd-Frank changes everything Nothing left unregulated Private funds business will segment Zero tolerance for insider trading Derivatives less available Need for professional compliance and
ops More transparency in disclosure, sales
and marketing More (costly) enforcement actions Jurisdictional battles = more regulators
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