Regulatory Update 2009

Todd Cipperman, Esq.

Kreischer Miller Annual Investment Industry UpdateDecember 9, 2009

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.

Overview Madoff SEC Enforcement Regulatory “Reform” Pay-to-Play and Solicitors Conflicts of Interest Insider Trading Personal Liability Compliance Programs Valuation Proxy Voting Privacy Hedge Funds Mutual Funds

Madoff Complicit actors

– IT pros (SEC v. O’Hara and Perez)• Programs to produce false reports• SEC must prove knowledge for aiding/abetting• What are the “ill-gotten gains”?

– Solicitor (SEC v. Cohmad Securities)• Solicitor liable for aiding/abetting advisor’s failure to disclose

solicitation payments under Rule 206(4)-3 • See also In re Cohmad Securities: Mass. revokes BD registration before

hearing after defendants invoked 5th Amendment rights– Audit Firm: allowed use of financials (SEC v. Friehling and

Horowitz)– Manager of feeder funds (In re Fairfield Greenwich (Mass.))

• Failure to conduct due diligence described in offering docs• Blaming the victim?

Sweep exams: affiliate-held assets, smooth/large returns, unknown auditors

OCIE will contact clients to verify assets Proposal to require surprise exams to verify assets

– Invoice clients for fees

SEC Enforcement Schapiro stresses Enforcement and new toughness

– Bob Khuzami – former prosecutor– Increased enforcement activity through 9/30

• 448 vs. 181 enforcement cases• $1.8 BN v. $865 MM in disgorgements/penalties

Prosecutorial tactics– Enforcement may open cases without full Commission

approval– Enforcement has power to issue subpoenas without approval– Use of plea deals in exchange for cooperation– Taping telephone conversations

5 new specialized enforcement units including Asset Management Unit

SEC increases maximum enforcement penalties SEC gets bigger budget SEC may consider administrative action while pursuing

civil action i.e. acting as prosecutor and judge (In re Vancook)

Regulatory “Reform” Expand SEC authority: fiduciary standard, point-of-sale

disclosure, compensation practices Proposals to register hedge fund advisers and disclose hedge

fund info– Impact on state regulators– <15 clients?– Venture capital?

Regulation of derivatives SEC/CFTC harmonization: fiduciary standard, point-of-sale

disclosure, performance reporting for CTAs and FCMs (or one regulator?)

Fiduciary standard for brokers (Who will be the regulator?) Protecting and rewarding whistleblowers Schapiro wants 40 Act for ABS More disclosure for target date funds Summary prospectus for variable insurance products Cf. American Equity v. SEC: SEC prohibited from regulating

equity indexed annuities

Pay-to-Play and Solicitors Public Plans and Rule 206(4)-3 New York Common Fund

– Code of Conduct/Proposed legislation: No solicitors, campaign contribution restrictions, disclosure, certifications, etc.

– 4 private equity firms returned $4.5 Million in fees– SEC suit (SEC v. Morris et. al.)

• Money manager paid solicitors that didn’t perform services; Solicitors aided and abetted

• Note: Rule 206(4)-3 does not require the performance of services, only disclosure

SEC Proposal– No solicitors for public plans, government employee retirement plans,

529 plans– No campaign contributions to pols in position to influence the selection

of the adviser State Codes of Conduct (e.g. Illinois requires extensive disclosure

of anybody bidding on a state contract worth more than $50,000) BD pays $75 Million/forfeits $647 in swap fees for failing to

disclose payments made to locally connected firms to win muni business (In re JP Morgan Securities)– Recipients performed no services– Disclosure may not have made a difference

SEC Claims that wholesaling and marketing support create obligation to register as BD (SEC v. Big Apple Consulting)– Respondent took below-market stock as compensation

Conflicts of Interest Wrap Programs: Wrap sponsor fined/censured for

recommending money managers that didn’t go through due diligence process (In re Morgan Stanley)– Kickbacks via brokerage commissions and referred clients

Commission Recapture: Advisor (to fund) ordered to pay over $34 Million because affiliated broker took 80% of recapture program (In re Value Line)– CEO and CCO also fined and censured– SEC charges that BD must provide some execution,

clearing or settlement function Net Trading: Hedge fund traders used net trading to

conceal higher commission and personal benefits (SEC v. Travis)

Pension Consulting: Pension consultant recommended affiliate directed brokerage and transition management programs (In re Merrill Lynch)

Disclosure, Disclosure, Disclosure

Insider Trading Hedge Funds: Hedge fund portfolio manager (SEC v.

Stephanou) received tips from investment banker– Benefiting fund investors; See Galleon case

Derivatives: Bond trader tipped hedge fund portfolio manager about bond issues that would impact CDS (SEC v. Rorech and Negrin)– Trader earned more commissions; manager earned more fees

Private Equity: CFO of private equity firm (SEC v. Tang)– Firm would acquire, knew negative info– Firm not charged: notified blackout periods and trading restrictions

Regulation FD: Reg FD violated for negative info delivered to analysts (In re Black)– No personal benefit to CFO– Reg FD as tipper enforcement tool– Note: SEC FD Interps allow some guidance

Open questions:– Who has a duty?– What is the benefit accruing to the wrongdoer?

Personal Liability Aiding and abetting employer’s misconduct

– CCO aided and abetted principals’ misuse of funds (SEC v. Duffy)• Bookkeeper who wired funds, documented transfers• CCO benefitted through salary and bonus

– In-house lawyers at Enron fined for not disclosing related party transactions in proxy statement (SEC v. Mintz and Rogers)

– President and GC of fund admin company charged with aiding/abetting for concealing payment to clients in exchange for Board recommendations (In re Huber and In re Hurley (Bisys))

• SEC alleges personal benefit was bonus– Portfolio manager falsified investment committee notes provided in

response to SEC exam request (In re Keefe)• Anti-fraud liability for all books and records

Primary liability– Financial adviser jailed for selling tax shelters (U.S. v. Coplan)– Mutual fund wholesaler arranges market timing (In re Brugman)

• Use of 10b-5 even though respondent didn’t sell securities Participation in unlawful activity (and personal

benefit)

Personal Liability Privilege: Corporate officer can’t claim privilege for

statements made to lawyers conducting internal investigation (U.S. v. Ruehle (stock-options backdating))– Communication to audit firm broke privilege – Resulted in criminal indictment

No personal liability– SEC v. Papa: Individuals not liable for failing to disclose as-of

transactions • No ongoing obligation• No “contemporaneous assurance” to hide fraud• Low-level employees with no personal benefit?

– U.S. v. Cioffi and Tannin: Hedge fund managers not guilty of criminal fraud because prosecution couldn’t prove they intentionally misled investors

• SEC has lower burden of proof in civil actions Insurance: Corporation cannot claim under D&O policy

for acts of officers (Medical Mutual Ins. v. Indian Harbor Ins. (disability disc.)– D&O protects individuals not companies– Importance of E&O policies

Compliance Programs IDC Task Force

– Importance of an independent CCO; benefits of outsourcing– 5 elements: tone at the top, collaborative, customized,

transparency/communication, good people/resources SEC Statements

– SEC considers requiring third-party compliance reviews of big firms

– Schapiro wants CCOs to lead enterprise risk management CCO liability

– In re Bauman: CCO failed to implement Reg S-P P/P • Personal records sitting in Rep’s trash • Firm had no P/P to safeguard customer info

– In re CentreInvest: CCO banned for referring business to controlling foreign affiliate that was not registered

• Active participation in the securities law violations SEC v. Envision: Firm violated 206(4)-7 by thwarting

CCO’s efforts to stop overcharging

Valuation Fair Valuation Guidance

– SEC Declares to Congress that fair value accounting did not cause financial crisis

– Bibliography of SEC Fair Valuation guidance (Division of Investment Management)

– ASU 2009-12: Fund-of-funds cannot simply rely on provided NAVs• Must add disclosure re redemption restrictions and fair value inputs

– FASB proposals• disclose changes to Level 3 inputs• Movement away from strict mark-to-market

– Include only Impairment in earnings– 8 factors to determine whether market is inactive

Fair Valuation Cases– Money Market Fund manager sued because it falsely assured the Board

and investors that fund would maintain $1.00 NAV (SEC v. Reserve Management)

• Respondent told investment bankers that buyers would not have to stand behind credit support agreement

– Mutual fund manager agreed to pay $40 Million for withholding pricing information from Valuation Committee (In re Evergreen)

– Importance of a process and transparency

Proxy Voting Adviser fined for failing to disclose pro-

union polices to win Taft-Hartley biz (In re Intech)

SEC allows exclusion of union proposal re succession planning (American Capital NAL)– Proposal related to ordinary business

operations SEC requires funds to include shareholder

nominees Counting broker non-votes for quorum

(NYSE proposal)

Privacy Regulation S-AM: limits on customer

solicitation RIA/BD firm failed to implement anti-virus

software for contractors (In re Commonwealth Equity)– Hacker obtained customer info– IT Dept knew of the problem

Model privacy notice issued by 8 regulators– Two forms: opt-out and no opt-out– Safe harbor

Hedge Funds Concealing bad performance

– SEC v. Paramount Partners: SEC uses Rule 206(4)-8 to close unregistered hedge fund adviser that provided misleading account and performance information

– SEC v. Ponta Negra: Hedge fund/principals doctored prime brokerage statements in response to asset verification due diligence performed by third party selling agent

Concealing compensation: Hedge fund manager took warrants (PIPE deals) from funds as compensation (In re M.A.G. Capital)

Hedge Fund Distributors– Hedge fund consultant fined for failing to conduct its own advertised due diligence

and investing in Bayou (In re Hennessee)• No review of portfolio; No contact with auditor• What is an advisor’s duty of diligence?• Cf. South Cherry Street v. Hennessee: Defendant not liable for securities fraud

because no actual knowledge of fraud even though due diligence may have revealed fraud

– Class action filed against RIA for failing to perform due diligence on PPM statements (Toomey v. Summit Retirement Advisors)

• Claim that RIA is “seller” of securities• No special compensation i.e. commissions

– Feeder fund that invests in commodity pool must register as CPO (CFTC v. Equity Financial Group)

• Focus on solicitation of funds to invest in commodities– Large firm agrees to pay $200 Million for failing to register as RIA or BD even though

it solicited and maintained US clients (SEC v. UBS)

Mutual Funds Money Market Funds

– Credit ratings for underlying paper– $1.00 NAV– Weekly reporting if NAV drops below $.9975– Reporting of holdings– Minimum liquid assets– Shortened WAM

Adviser Fees– Fund manager pays over $6 Million for charging high fees

because of principal guarantee feature (In re New York Life)

• Disclosure docs said shareholders received principal guarantee feature at no additional cost

• Brought as a disclosure case, not a fiduciary duty case– Standard of care in reviewing fund fees (Jones v. Harris

Associates, Gallus v. Ameriprise) More regulation of fund use of derivatives (Donohue

speech)

Final (Discomforting) Thoughts

Madoff: Bad facts make bad law A prosecutorial SEC Insider trading construed broadly Focus on personal liability More regulation of public plans Solicitors need to perform services Disclosure cures many problems but not all

conflicts Need more valuation guidance Proxy voting and Privacy remain hot topics Adviser due diligence obligations Money market funds New regulatory regime in 2010

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