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SEC Examinations and Enforcement. Todd Cipperman, Esq. Cipperman & Company ICI General Membership Meeting May 7, 2009. Overview. Core Initial Request List SEC Exams and Priorities Personal Liability Conflicts of Interest Liability of Fund Service Providers Marketing and Solicitation

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sec examinations and enforcement

SEC Examinations and Enforcement

Todd Cipperman, Esq.

Cipperman & Company

ICI General Membership Meeting

May 7, 2009

  • Core Initial Request List
  • SEC Exams and Priorities
  • Personal Liability
  • Conflicts of Interest
  • Liability of Fund Service Providers
  • Marketing and Solicitation
  • Trading
  • Valuation
  • Operations and Technology
  • Funds Fees
  • Market Meltdown
  • Jurisdictional Issues
core initial request list ocie
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
sec exams priorities
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 of ccos
Personal Liability of CCOs
  • 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
    • Cf. SEC v. Papa et. al.: Failure to Disclose Securities Law Violation May not result in personal liability
personal liability defenses
Personal Liability - Defenses
  • CCO can’t use “following orders” defense (In re Murray)
    • 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
conflicts of interest compensation
Conflicts of Interest - 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)
  • Recommending services of affiliate (In re Merrill Lynch)
    • Pension consulting and manager transition desk
  • Gifts received by mutual fund traders (In re DeSano et. al.)
    • Traders personally liable
  • Net trading scheme to conceal commissions (SEC v. Granite Financial Group)
conflicts of interest other
Conflicts of Interest - Other
  • 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
liability of fund service providers
Liability of Fund Service Providers
  • Adviser
    • Failure to conduct advertised due diligence (In re Hennessee and Gradante)
      • Hedge fund-of-funds consultant
      • Control person personally liable
    • Insider trading (SEC v. Stephanouet. al.)
      • No benefit to the adviser, only to the fund
    • Falsifying fund records (In re Keefe)
      • Making up investment committee meeting minutes to support proxy statements
    • Submitting false invoices (In re Murray)
      • No “following orders” defense for fund executive
    • Closed-end fund distribution notices (In re Gabelli)
      • Section 19 and Rule 19a-1
  • Auditor: Allowing fund sponsors to use false financials in marketing (SEC v. Friehling & Horowitz)
    • Madoff auditor
marketing and solicitation
Marketing and Solicitation
  • SEC publishes PAUSE list of unregistered solicitors
    • Subject of investor complaints
    • 2 days to respond
  • Liability for misrepresentations to third-party selling agents (SEC v. Ponta Negra)
  • Solicitors must perform some bona fide service (SEC v. Morris et. al.)
    • New York pay-to-play scandal
  • Failure to properly register as RIA/BD (SEC v. UBS)
    • $200 Million penalty
  • Mutual fund wholesaler liable for assisting market timers (In re Brugman)
  • Principals of fund distributor liable for prospectus disclosure (SEC v. Tambone and Hussey)
    • Market timing disclosure
    • What if distributor was unaffiliated?
  • 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”
  • 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
  • Collusion with pricing vendor (SEC v. Lee et. al.)
  • 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
operations and technology
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
  • 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.)
fund fees
Fund Fees
  • 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
  • Eighth Circuit holds that fund fees should be compared against institutional fees (Gallus et. al. v. Ameriprise)
  • Cox attacks 12b-1 fees (Cox speech)
    • Call distribution fees “loads” or “sales charges”
    • Who will compensate distribution? Back to front-end loads?
market meltdown
Market Meltdown
  • Schapiro suggests that SEC may require third party compliance reviews (speech to Council of Institutional Investors)
  • Gohlke says that SEC will contact investors and other third parties to verify assets (letter to MFA)
  • SEC raises maximum monetary policy by 12%
  • SEC calling for more resources
  • Lori Richards warns CEOs not to cut compliance
jurisdictional issues
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
  • SEC can act as prosecutor in federal case and adjudicator in SEC action (In re Vancook)
  • Adviser lacks standing to sue on behalf of clients (Huff Asset Management v. Deloitte & Touche)
  • State enforcement cases
    • consequential damages in ARS cases
    • Madoff feeder funds
  • New York State announces intent to regulate CDS as insurance
final discomforting thoughts
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
  • Awaiting new regulatory initiatives

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,,