Regulatory Enforcement Update 2012 Our Take LIVE June

Regulatory & Enforcement Update 2012 “Our Take” LIVE June 19, 2012

Regulatory Focus • • • New regulations, more registrants Less focus on registered funds Hedge and Private Equity funds Enforcement of compliance programs Operational breakdowns Federal court hostility toward regulators and private plaintiffs States exerting regulatory authority Surveillance of marketing and advertising FINRA regulating distribution Third party liability 2

New Regulations 3

New Regulation: CPOs • CFTC registration for fund managers • Limited exemption – Bona fide hedging – Margin/premium < 5% or notional value < 100% – Investing in stock index futures not exempt – Not marketed as vehicle for trading futures • ICI and Chamber Sue to Stop Rules – Cost/benefit analysis – Mutual funds already highly regulated 4

New Regulation: Swaps & ABS • Swaps – SEC regulates securities-based swaps – CFTC regulates other swaps – “Insurance” defined narrowly • CFTC adopts anti-fraud rule for swaps and commodities (like 10 b-5) • SEC proposal questions 1940 Act exemption for MBS • More ABS filings and disclosure 5

New Regulation: Performance Fees & Large Traders • Increased thresholds for charging performance fees – Net worth: $1. 5 → $2 Million • Excludes personal residence – Assets with manager: $750, 000 → $1. 5 Million – Effect on private funds • Large trader filing/reporting (Rule 13 h-1; Form 13 H) – 2 Million shares or $20 Million in a day or 20/$200 Million in a month – Burden on BDs to monitor 6

New Regulation: More RIAs • Managers of private funds with > $150 AUM must register – 1400 newly registered private fund advisers (4000 total) – Approx. 1/3 of all advisers manage a private fund • Limited single family office exception – Service only family members – 10 generations of lineal descendants • Non-US advisers must register – < 15 U. S. clients & $25 Million AUM – Total private fund assets less than $150 Million • May have to file as “exempt reporting adviser” 7

New Regulation: Transition and Disclosure • Advisers with less than $100 Million must transition to states – NASAA announced coordinated review • SEC will cancel registration for insufficient assets (In re Gravity Partners) • New ADV Part 2 – Material risks for private funds – Material financial conditions – Publicly available 8

New Regulation: Who Regulates RIAs? • SEC Study on adviser exams – Insufficient resources – Self-funding, SRO, FINRA • Bachus/Mc. Carthy bill for Adviser SRO • FINRA wants an adviser SRO operated by FINRA • GAO: SEC must enhance FINRA oversight • Fiduciary standard for BDs – BD ADV – Ketchum: put client’s interests first 9

New Regulation: Whistleblowers • Whistleblower program launched – Bounty of 10%-30% of awards – Bypass internal reporting • Sullivan v. Harnisch (NYS): Compliance officer can’t sue for wrongful termination – Personal trading violations – Never claimed to be whistleblower – Equity owner in firm • Fund service providers’ employees do not get SOX whistleblower protections (Lawson and Zang v. FMR) 10

Registered Funds • Fund Adviser pays over $3. 3 Million for failing to oversee sub-adviser (In re Morgan Stanley) • ICI/IDC: risk management and compliance • Derivatives (See In re Oppenheimerfunds) • Money market fund regulation • SEC proposes red flags rule (identity theft) • CPO registration • Eighth Circuit Supports Jones (Gallus v. Ameriprise) • Global/Intl fund must invest 40% in 3 countries • SEC Chief Accountant: more AC oversight of auditors 11

Hedge and Private Equity Funds 12

Hedge and Private Equity: Registration and Disclosure • Registration of Hedge and Private Equity Managers – More than $150 Million AUM – Limited venture capital exemption – Extensive ADV disclosure • Reliance on single registration for affiliates • Form PF – File detailed info about funds managed – More info for hedge > $1. 5 Billion and PE > $2 Billion – Quarterly filings if AUM > $5 Billion – SEC says it may use data in enforcement actions • SEC seeking to fill 102 new positions focused on hedge and PE 13

Hedge and Private Equity: OCIE Lists PE Issues • Fund-raising: placement fees, side letters, performance claims, overstating fund size • Investment: allocations, insider trading, transaction fees • Management: valuation, highlighting specific investments, fees • Conflicts of interest: allocations, portfolio compliance, performance/advertising, custody • Norm Champ announces sweep of new private fund advisers 14

Hedge and Private Equity: Enforcement • PE insider trading – Using info ahead of fund (SEC v. Duffel) • Allocating investment opportunities (In re Crisp) – Personal interest in other fund • Exemptive relief application to allow coinvestments for BDC and other funds 15

Hedge and Private Equity: Hedge Funds • Side-by-side management (In re Martin Currie): Registered fund buys securities to bail out hedge fund • Marking the close (SEC v. RKC Capital Management) • Use of expert network firms • Side pockets (SEC v. Baystar) • Fabricating audit(or) (SEC v. Murray) 16

JOBS Act • Removes ban on general solicitation for private funds • 3(c)(7) funds can have 2000 investors • Should private funds register under Investment Company Act? • Boon for fund-of-funds • Awaiting SEC rules 17

Compliance and Operations 18

Compliance Programs: Enforcement Lessons • Actions against firms for weak compliance programs (In re Asset Advisors et. al. ; In re Wunderlich; In re JSK Associates; In re Alpine Woods) • Template or incomplete compliance manuals (BD WSPs) • Inadequate testing and annual reviews • No training • Inexperienced or absent CCO • No implementing procedures • Failure to properly resource • Ignoring Code of Ethics 19

Compliance Programs: SEC Focus • CCO charged with primary liability – Failure to supervise (In re Manual Lopez-Tarre) – Failure to file SARs (In re Pagliarini) • Compliance failures leading to underlying violations – Misleading statements about principals investing in funds (In re Quantek) • IAA Study shows compliance burden – More work, fewer resources – 5% of revenues; 1 basis point 20

Operations • Firm fined $200 Million because it hid errors in quant model (In re AXA Rosenberg) • Fund sponsor pays $300 Million for mis-pricing subprime bonds (In re Morgan Keegan) – Allowing PM to override broker quotes • Unreasonable fair valuation (In re Bunzel) • Receiving kickbacks from prop trading firm to aggregate trades (In re Pegasus) • Lying about use of org expenses to Board, administrator, investors (SEC v. Juno Mother Earth Asset Mgt) • OCIE Risk Alert on Unauthorized Trading • New Series 99 for Ops Professionals 21

Federal Court Hostility 22

Federal Court Hostility • Proxy access rule vacated (Business Roundtable v. SEC; D. C. Cir. ) – Effect on efficiency, competition, and capital formation; empirical benefits • Fund Adviser not liable for prospectus disclosure (Janus v. First Derivative Traders; U. S. Supreme Court) – Cf. In re Oppenheimer Funds: adviser has regulatory responsibility for prospectus statements 23

Federal Court Hostility • Class action plaintiffs foreclosed because NAV was correct (Yu v. State Street; S. D. N. Y. ) – No loss causation despite weak disclosure • FINRA can’t sue to enforce fines (Fiero v. FINRA; 2 nd Cir) – FINRA is a membership organization 24

Federal Court Hostility • No private right of action under fund compliance rule (Smith v. Oppenheimer. Funds Distributor; S. D. N. Y. ) • Fund-of-fund investors can’t sue underlying funds (Curran v. Principal Management; S. D. Iowa) • Offshore hedge fund can’t sue CDO sponsor (Basis Yield v. Goldman Sachs; S. D. N. Y. ) – Failed to prove U. S. sales activities 25

State Regulation & Enforcement • NASAA Announces State Enforcement Stats – 51% increase in enforcement actions – 200% increase in funds returned – > 7000 investigations; > 3000 actions • NASAA lists deficiencies in coordinated IA exams – Form ADV, suitability docs, safeguarding client records, supervision, advertising • Failing to register in Mass. (In re Eagle Trades and Osirix FX) – rescission 26

State Regulation & Enforcement • Registration of private fund managers – Mass. exempts only 3(c)(7) funds and 3(c)(1) funds for qualified clients • NASAA model custody rule requires delivery of account statements even if fund is audited • NASAA President vows to defend states’ authority, criticizes NSMIA • NASAA wants renewed power to review private placements 27

Marketing and Advertising 28

Marketing and Advertising: Regulation • Pay-to-Play rule implementation – FINRA fines firm for MSRB violations (Southwest Securities) – SEC Sues Detroit city officials (SEC v. Kilpatrick) – Solicitor payment prohibition postponed • Social Media – OCIE Risk Alert/FINRA guidance – Content not media is what’s relevant – Supervision and retention – SEC sweep (includes personal use) • FINRA rule re point-of-sale disclosure for mutual fund revenue sharing 29

Marketing and Advertising: Enforcement • Lying about SEC deficiencies in RFPs (In re Aletheia) • Claiming eligibility to register with SEC (In re Delta Global Advisors) – Didn’t really manage UITs – Several cases where advisors inflated AUM • Exaggerating background (SEC v. Hicks) – Quant model developed at Harvard • Back-Tested Hypothetical performance (In re GMB Capital Management) • Falsifying solicitor disclosures (SEC v. ARVCO) • Overvaluing equity in sale to client (In re Oxford Investment Partners) 30

FINRA Regulates Distribution • New content standards as of February 2013 • FINRA sanctions 8 firms for insufficient private placement due diligence (In re Next Financial et. al. ) – Need on-site visits – Document due diligence – Review financials and red flags • Fund wholesaler fined because marketing materials were misleading (In re Wells Fargo Investment Securities) • European bank pays $7 Million for failing to register as BD (In re Banco Espirito Santo) 31

FINRA Regulates Distribution • FINRA charges BD for not second-guessing NAVs (David Lerner & Associates) – Declining real estate market • Late prospectus delivery (Wells Fargo Advisors) • FINRA proposes rule to file PPMs (5123) – Content requirements (use of proceeds, offering expenses, solicitor compensation) 32

Third Party Liability • Audit firms – Clean audit opinion violated Martin Act (Cuomo v. Ernst & Young) – Failing to verify assets caused securities fraud (In re Sofo) – PCAOB considers mandatory auditor rotation – Only PCAOB firms avoid surprise custody audits • Collateral manager sued for allowing hedge fund to participate (SEC v. Steffelin) • Failure to oversee due diligence vendor (In re Calhoun Asset Management) • Independent directors too close to management (SEC v. Krantz) 33

Predictions 34

Predictions for 2012 • • • PE and Hedge fund firms will ignore compliance obligations SEC will give new registrants a grace period Non-U. S. fund sponsors ignore registration requirements FINRA will win jurisdiction over (retail) advisors Mary Schapiro will resign after election More SEC cases that firms don’t qualify States will begin interstate exam cooperation Whistleblower program will be a non-issue More compliance program cases Expanding third party liability 35

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