Regulatory Update 2010 PostMadoff Enforcement DoddFrank the New

Regulatory Update 2010 - Post-Madoff Enforcement - Dodd-Frank & the New Regulators - Compliance 2. 0 Todd Cipperman, Esq. December 1, 2010 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.

Dodd-Frank ¨ The Players – RIA registration and supervision – Registration of municipal advisers and solicitors ¨ The Markets – Derivatives – Short-sale reporting and regulation – Money market funds ¨ The Process – Proxy vote reporting – Shareholder nominations ¨ Distribution – Accredited investor defn ¨ Enforcement and Litigation – Whistleblowers – Private rights of action

The Players

New Registrants ¨ Private fund sponsors (>$150 Million) – Private Equity firms • Venture Capital exemption limited • Based on committed capital • Market valuations – Hedge Fund sponsors – “ADV lite” for VC and small fund advisers ¨ Multi-family offices ¨ SRO for Advisers? ¨ Remove BD exemption from Advisers Act? ¨ State vs. Federal regulation

Private Funds: Infrastructure ¨ Valuation – Overvaluing illiquid securities in side pockets (SEC v. Mannion et. al. ) • Internal valuations were lower • Methodology differed from PPM – BDC investments overvalued (SEC v. Brantley Capital) • Impacted fee calculation • Affected financials, Board reports, SEC filings – Over-paying for MBS to maintain values (SEC v. ICP Asset Mgt) ¨ Long and short in same securities (In re Carlson Capital) – Rule 105: access to information ¨ LP has right to list of other LPs (Parkcentral v. Brown) – LPA could have prohibited ¨ Processing clerk made unauthorized trades (SEC v. Kass)

Private Funds: Conflicts of Interest ¨ Cherry-picking for personal account (In re Dawson) – Irrelevant that Manager reimbursed fund or that clients didn’t express concern ¨ Undisclosed payments to key BDC employee (In re Douglas and Moore) ¨ Collusion between PE fund manager and underlying companies to ensure committed capital (SEC v. Onyx Capital) – Money funneled back to manager – Fraudulent statements to pension plan investors ¨ Hedge fund manager created fake administrator and auditor (SEC v. Finvest) – Delivered performance information and financials

The Markets

Insider trading ¨ Galleon ¨ Dozens of cases against hedge fund managers ¨ Mutual fund manager tipped family members to sell his fund (In re Baldt) – Muni market declining – Knew about redemptions ¨ Fund exec sold fund shares after learning about re-pricing (SEC v. Marquardt)

Derivatives ¨ Proposed anti-fraud rule for swaps ¨ Swaps reporting to SDRs ¨ Alternative uptick rule for shorts ¨ Funds must review derivatives disclosure ¨ Corp. Fin letter re: repos and securities lending – More MD&A disclosure ¨ Leveraged ETFs – IM Staff won’t approve ETFs that use derivatives

The Process

Boards ¨ Can’t delegate review of affiliated transactions under 17 e-1, 17 a-7, 10 f-3 (IDC Letter) – CCO is a service provider, not a substitute ¨ 12 b-1 proposal ¨ Jones v. Harris and its progeny – Review of mutual fund fees ¨ New rule for money market funds ¨ Evaluate 12 b-1 fees based on whether services were reasonable in relation to fees (In re American Mutual Funds) – Board process

Compliance Programs ¨ Failing to follow your own procedures (In re Buckingham) – Wall between BD research for nonpublic info – Creating records upon SEC exam request ¨ Template compliance manual (In re Sierra Financial) – P/P not tailored to business – No annual review – Investing in controlled entities ¨ BD CCOs – failing to stop use of personal e-mail account used in stock manipulation scheme (In re Campanella) • Recklessness = intent – Failing to supervise re variable annuity recs (In re Prime Capital) • Authority to impose discipline – Failure to supervise brokers who churned (Westpark Capital) ¨ SEC to leverage compliance pros (Schapiro speech) – Duty to investors – CCO’s job to ensure compliance with securities laws

Operations ¨ Ignoring back-office ops (In re Busacca) – Cutting corners and costs – BD Pres focusing on sales, not ops ¨ Books and Records – Storage facility destroyed records for nonpayment of fees (SEC v. Envision) ¨ Status questions – Function, not title triggers licensing reqs (JP Morgan Securities) • Investment banker that supervised municipal dealer – 28(e) research provider is not investment adviser (BNY Converg. Ex)

Custody ¨ IM Staff interps – Same audit firm permissible for surprise exams – May use same independent rep for all LPs ¨ Guidance for surprise exams – Confirm assets with clients – SEC notification and filing ¨ Compliance guidance – Background checks – Two persons to move assets – Segregate custody duties – Reconcile account and custody statements ¨ Audit firm liable for negligent surprise exam (In re Altschuler) – Ignored commingling – Gave notice of exam – 1. 5 billable hours ¨ Action against private fund manager (In re Sands Brothers Asset Mgt) – Auditor disclaimer – Failure to deliver financials – Incorrect ADV

Shareholders and Proxies ¨ Proxy process and reporting – Form N-PX for executive compensation matters for 13 F filers (Proposal) – Oversight of proxy advisory firms (Schapiro speech) – SEC Concept Release: proxy plumbing • Access to intermediary data • NOBO/OBO system • Use of technology ¨ Shareholder Proposals – Closed-end fund must include proposal to convert to interval fund (Swiss Helvetia Fund) • Board had already considered and rejected – Fund must include proposal to fire adviser that overvalues ARS (Boulder Growth and Income) – Shareholder-nominated directors (Rule) • 3% for 3 years • 1 director or 25% of Board

Distribution

Disclosure: Point-of-Sale ¨ Product Disclosure – Include brokerage costs in fund expense ratio (FASB proposal) – IFRS – Failure to disclose that counterparty influenced collateral pool (SEC v. Goldman Sachs) – Changing investment objectives without shareholder approval under 13(a) (In re Charles Schwab) • Is “MBS” an industry classification? – Misreps about RMBS delinquency data (Deutsche Bank Securities) • FINRA action against underwriter ¨ Adviser Disclosure – New ADV • Personnel supplement • Financial disclosure • Publicly available – Point-of-sale disclosure for BDs – IAR information available online

Disclosure: Ongoing ¨ Summary annual reports (Donohue speech) ¨ MD&A disclosure about short-term borrowing ¨ Short sale reporting for 13 F reporters ¨ 13 F information not protected by 5 th Amendment’s “Takings” clause (In re Wynnefield) ¨ Reg FD violation for selective disclosure to private fund manager (SEC v. Presstek) – Earnings info during blackout

Marketing: Product-specific ¨ SEC regulation – Target Date funds proposal • No suitability statements – Suitability (SEC v. Life Wealth Management) – Best practices report for working with Seniors ¨ Fund marketing – Marketing multi-strat fund/funds as conservative and liquid (In re Greenberg) • Concentration in two underlying funds • Suitability • See also In re S 4 Capital: using unhedged options in “absolute return” fund – Misreps in fund fact sheets for enhanced cash fund that invested in subprime (In re Flannery and Hopkins) • CIO and Product Manager charged

Marketing: Sales Misreps ¨ Failure to disclose that wrap program was more costly than brokerage account (SEC v. Sage) – Moving clients to new RIA firm from BD – Misrep that clients couldn’t stay with underlying manager ¨ Failure to disclose additional commission comp for switching classes (In re Valentine) – Investment rationale not relevant – Prospectus disclosure not enough ¨ Options trader barred for claiming competence (In re Jafari) – Average loss of 52%

Solicitors ¨ Public Plans – Pay-to-play rule for public plans • May only pay registered BDs and federal RIAs • Limits on political contributions – FINRA sweep – State laws • CA requires solicitors to register as lobbyists – No contingent compensation for public plans – PE Firm and Exec to pay $13. 2 Million in fines for undisclosed comp to public plan solicitor (SEC v. Quadrangle; SEC v. Rattner) • “Chooch” • Section 17(a)(2) • What about 206(4)-3? ¨ Cap Intro – Law firms • A “salesman’s stake” (Brumberg, Mackey & Wall) – Law firm sought no-action relief – Cf. Manatt, Phelps & Phillips: no contingent compensation – BD registration (Donohue speech)

Broker-Dealers ¨ Sales Practices – – – Segregation of BD and RIA activities (Ketchum) Suitability: leveraged ETFs, ARS, UITs, closed-end funds Due diligence of private placements (Reg Notice 10 -22) Obligation to verify QIB reps (In re Merrill Lynch) Obligation to deliver due diligence info (In re Securities America) Implied reps and the “shingle theory" (Capital Management v. Bennett) ¨ Disclosure – More disclosure in U 4 s and U 5 s • Termination details • Broker awarded $5 Million for defamatory U 5 (Beck v. Sun. Trust) – Politics not sales practices – FINRA considering broker-dealer ADV – More information required in BD applications (Reg Notice 10 -01)

Broker-Dealers con’t ¨ Operations and Infrastructure – Liquidity risk management (Reg. Notice 10 -57) • No excuses for loss of funding – – – Licensing of Ops personnel (Proposal) E-Mail retention (Piper Jaffray) Expansion of TRACE Protection of customer information from hacker (D. A. Davidson) Insufficient resources devoted to AML (Penson and Pinnacle) Social Networking (Nt. M 10 -06) ¨ Market participation – Naked access • Inadequate customer ID (In re Pinnacle) – CDS market manipulation (Phoenix Derivatives) – Best execution should include multiple venues (Ketchum)

Litigation And Enforcement

Enforcement Power ¨ New Whistleblower rule – 30%, $1 Million – Not required to use company procedure – Employment law implications ¨ SEC Argues that SOX protects third-party whistleblowers (Klopfenstein v. Do. L) ¨ $1 Million bounty awarded to insider trading informant (SEC v. Pequot) – Ex-wife of tipper who misled SEC ¨ Asset Management Unit – Specific initiatives (Bond Fund, Problem Adviser, Mutual Fund Fees) ¨ Virginia Financial and Securities Fraud Task Force – Ability to bring criminal charges ¨ Enforcement will offer cooperation agreements ¨ Increased enforcement activity (2009) – 496 vs. 233 investigations – $2. 09 BN v. $774 MM in disgorgements – $345 MM vs. $256 MM penalties

Private Rights of Action ¨ Extending “conduct and effects” test to non- US transactions ¨ Must show stock price movement for “fraud -on-the-market” theory in class action (Berks County ERF v. First American (SDNY)) ¨ No private right of action under Section 13(a) (Northstar v. Schwab (9 th Cir))

Who’s liable? (aka Madoff con’t) ¨ Liable – Adviser that suspected Madoff fraud (Cuomo v. Ivy – – – Asset Management (NYS)) Custodian for Madoff feeders (Pitkin v. Westport National Bank (CT)) RIA for failing to conduct proper due diligence of Ponzi scheme (In re Yosemite) Fund manager for blindly relying on performance information provided by sub-adviser (SEC v. Moody) Fund accounting head for allowing PM price overrides (In re Morgan Asset Mgt et al) SEC/Do. J argue that advisers liable for fund prospectuses (Janus v. First Derivative Traders) • Civil and criminal penalties

Who’s liable? (aka Madoff con’t) ¨ Not Liable – Auditor of Madoff feeder (CRT v. BDO Seidman (NYS)) – Auditor or any other service provider with interest in the offering (Malack v. BDO Seidman (3 rd Cir)) • No “fraud created the market” theory – Law firm in securities offering (PIMCO v. Mayer Brown (2 nd Cir)) • May only apply to private rights of action – Lender to ponzi scheme not liable to Receiver (Marion v. TDI) – BD GC for failure to supervise (In re Urban) • Not a supervising principal • Reported issues

Jurisdictional Battles: FINRA and NASAA ¨ SEC v. FINRA – Ketchum Wants SRO for RIAs; SEC launches study to determine if it should eliminate broker exemption from Advisers Act – FINRA assumes enforcement for NYSE ¨ SEC v. NASAA – SEC action against adviser had <$25 Million AUM (In re Freedom. Tree) – SEC suit against state-registered adviser for PPM fraud uncovered by FINRA (SEC v. Vallett) – State regulatory standards • SEC standard • NASAA resource – 1940 Act trumps MD takeover statute (Boulder Total Return Fund) – DF moves mid-sized advisers ($25 -$100 AUM) to states • Must have examination program • >4000 advisers • New quasi-SRO? – Deference to arbitration awards (Wiederhorn v. Merkin (NYS)) • Large award for investors in Madoff feeder

Jurisdictional Battles: FDIC and Do. L ¨ SEC v. FDIC – Collective funds • Funds did not disclose subprime investments and leverage (In re State Street) – SEC fraud case • Donohue questions rationale for 1940 Act exemption ¨ SEC v. Do. L – New disclosure about plan and investment options • More transparency – Expanded definition of “Fiduciary” • More than just providing “regular advice” • RIAs – Do. L sues Madoff feeders (Solis v. Beacon et. al. ) • Feeder managers were fiduciaries • Jurisdictional issues

Final Thoughts ¨ Dodd-Frank changes everything ¨ Nothing left unregulated ¨ Private funds business will segment ¨ Zero tolerance for insider trading ¨ Derivatives less available ¨ Need for professional compliance and ops ¨ More transparency in disclosure, sales and marketing ¨ More (costly) enforcement actions ¨ Jurisdictional battles = more regulators

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