ICI Legal Forum: May 1, 2013 - Cipperman Compliance Services

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

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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 •

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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)

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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)

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Compliance and Operations •

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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

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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)

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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, highyield 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)

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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)

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