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Regulatory Overview. Todd Cipperman, Esq. Cipperman & Company September 25, 2007. Overview. SEC Examinations and Compliance 22c-2 12b-1 Revenue Sharing Valuation Soft Dollars Best Execution Disclosure Other Insider Trading Hedge Funds Market Timing Advisers/Broker-Dealers.

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Regulatory Overview

Todd Cipperman, Esq.

Cipperman & Company

September 25, 2007

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  • SEC Examinations and Compliance

  • 22c-2

  • 12b-1

  • Revenue Sharing

  • Valuation

  • Soft Dollars

  • Best Execution

  • Disclosure

  • Other

    • Insider Trading

    • Hedge Funds

    • Market Timing

    • Advisers/Broker-Dealers

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SEC Exams: NYRO Examination Request List

  • Comprehensive: Due Diligence List/Audit

  • Requires specific data formats

  • Focus on individuals: Who is responsible?

  • Work Papers: output from daily work flow

  • RFI: Disclosure, Portfolio Mgt, Brokerage, Trade Allocation, Conflicts, Valuation, Custody, Marketing, Data Protection, Compliance Program, BCP, Service Providers, Pooled Products

  • Compliance: current inventory of risks; exception reports; annual review

  • Roadmap for compliance program

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Compliance Priorities

  • OCIE Compliance Alert re common deficiencies: performance advertising, “as-of” trading, overcharging SMA accounts

  • Advisor Regulation (Donohue): e-mail retention, ADV Part II, Merrill Rule, accredited investor defn

  • Broker-Dealer Exams (Gadziala): branch supervision, hedge fund sales practices, data security, net capital, best execution, AML, books/records

  • NASD Exams (Errico): branch supervision, AML, new product sales, hedge fund suitability, BCP, non-cash compensation

  • State Regulators esp. Massachusetts and New York

    • Hedge fund hotels

    • Sufficiency of disclosure

    • Sales practices (cold calling)

  • GAO Report: SEC should require submission of compliance reviews to better segment firms into risk categories

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In re CapitalWorks and Correnti

  • 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

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  • SEC to ICI: Funds can’t use shareholder data for marketing

    • Regulation S-P limits use of personal information

    • Who owns shareholder data?

    • Intermediary Agts

  • ICI letter to intermediaries “reminding” them of rule requirements and deadlines

    • Market Power and Intermediaries

  • Relief to foreign intermediaries from delivering government issued identification

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  • SEC considering 12b-1 rescission (roundtable in June)

    • Cox: a substitute for front-end loads

    • Tax on current shareholders without benefit

    • Drag on performance

  • ICI: 12b-1 fees are good

    • pay for advice, administrative support, and recordkeeping

    • help smaller funds

  • Who will compensate the broker-dealers?

  • Back to front-end loads?

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Revenue Sharing

  • In re Morgan Stanley: must disclose receipt of revenue

  • Directed Brokerage – See In re John Hancock (not enough Board disclosure of conflict of interest)

  • No private right of action against fund advisors (See In Re Franklin Mutual Funds)

    • Who benefits from “shelf-space” arrangements?

  • Wells settlement: detailed Prospectus and SAI disclosure including names of firms and amounts

  • NASD Non-Cash Compensation Rules: NASD fined 3 mutual fund distributors for entertaining third party reps who sold funds

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  • Focus of sweeps: See NYRO Exam Request

  • Sub-Prime contagion

  • In re Allied Capital: Private Equity Firm BDC did not value portfolio companies as required by ASR 118

    • Valuation committee was not independent

    • No books and records

  • SEC v. Sentinel: Run on the cash manager during the sub-prime liquidity crisis

    • Commingling and leveraging client assets

    • Misrepresentations about leverage and valuation

  • IOSCO valuation principles: documentation, consistency, independent review, vendor due diligence, transparency

  • Responsibility for valuation

    • In re McCurdy: concurring audit partner knew financials were incorrect

    • In re Seghers: delivering inflated valuations to administrator

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Soft Dollars

  • 2006 Interpretive Release

    • Narrowed scope to advice, analysis, reports

    • Computer hardware out

    • Clear allocation of mixed use items

    • Defines “effecting a trade”

  • Cox has suggested outlawing soft dollars

  • SEC guidance re when a research provider can avoid BD registration: create a pool of credits and avoid linkage

  • Goldman XPRESS No-Action Letter: Money Manager must determine value of research

  • In re Schulze: Provide enforcement order to investors and prospective investors (the “Scarlet Letter” approach)

    • Shell “research” company to pay for non-28(e) expenses e.g. salary, rent, health insurance

  • Remaining issue: What is within 28(e) after last year’s guidance

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Best Execution

  • See Soft Dollars

  • 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

  • Can a firm ever trade through an affiliate?

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  • Donohue calls for electronic 2-page profile

    • Prospectus/SAI available on internet

    • Tagged data would allow easier access to information

    • Will SEC exempt issuers from liability?

  • XBRL initiative: tagging data for access

    • Who benefits: shareholders, advisors, plaintiffs’ lawyers?

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Hedge Funds, Insider Trading

  • Insider Trading: SEC focus esp. w/ hedge funds

    • PIPEs

    • UBS/Morgan Stanley ring

    • Safeguards: SEC v. Suman: E-Mail Administrator bought target company stock ahead of tender offer

  • Hedge Funds

    • Clawbacks in bankruptcy: redemption proceeds, margin payments, service provider payments

    • Risk Disclosure - SEC v. Wood River et. al.: failure to disclose overly concentrated position in EndWave stock

    • Proposed definition of “accredited natural person” ($2.5 Million in assets exclusive of real estate)

    • Hedge Fund Hotels: really soft dollar cases in disguise

    • Short sales: covering with public offering allocations

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Market Timing, Advisers/Broker-Dealers

  • Market Timing

    • Fair Fund distributions continue at slow pace

    • In re Byck et. al: Using Fund/SERV to late trade for hedge fund clients

  • Advisers/Broker-Dealers

    • Anti-fraud rule applicable to unregistered advisers

    • Merrill Rule etc.: discretionary BDs must become RIAs

    • Reverse Churning: need to monitor accounts

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Final (Discomforting) Thoughts

  • SEC exams have become increasingly comprehensive and forensic; everything is a “priority”

  • Post-Spitzer SEC remains aggressive

  • Regulation through enforcement action

  • Focus on personal liability

  • State regulators very active

  • How will fund companies compensate distribution channels?

  • Lacking clear guidance on valuation, best execution and soft dollars

  • Cox wants to outlaw 12b-1 and soft dollars

  • Donohue wants to re-structure disclosure (again)

  • Bad actors with technology have increased systemic risk

  • What will happen when data starts flying on October 16?

  • New sheriffs in town in 2009?

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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 three core areas - Distribution, Technology and Fund Formation:

Distribution: Broker-Dealer Regulatory Matters, Dealer, Solicitation, and Referral Agreements, Asset-Gathering Strategies and Structures, Wrap Programs, Marketing Materials

Technology: Licensors and Licensees, Installed and ASP, Portfolio Management Systems, Trading Utilities and Platforms, Compliance Tools

Fund Formation: Hedge Funds, Fund-of-Funds, Institutional Products, ETFs, Variable Insurance Products, Cash Sweep Vehicles

150 S. Warner Road, Suite 140, King of Prussia, PA 19406, 610.687.5320, [email protected],