Regulatory Update

1. Regulatory Update Todd Cipperman, Esq. Cipperman & Company Philadelphia Compliance Roundtable December 2, 2008

2. Overview • 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

3. Core Initial Request List (OCIE) • 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 • Focus on personal responsibility • Required certain data presentation • Work papers including risk assessment • Very comprehensive: due diligence/audit

4. 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

5. Personal Liability • Personal liability under 206(4)-7. See In re CapitalWorks: • 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 • Defenses. See In re Murray: CCO can’t use “following orders” defense • 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

6. 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

7. 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

8. 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?

9. 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 • 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 • Narrowed scope to advice, analysis, reports • Computer hardware out • Clear allocation of mixed use items • Defines “effecting a trade”

10. 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

11. 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.)

12. 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

13. 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

14. 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?

15. 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

16. Final (Discomforting) Thoughts • SEC exams have become increasingly comprehensive and 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

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