Regulatory & Enforcement Update

ICI General Membership Meeting

May 1, 2013

Recent Activity

• SEC Enforcement focus on compliance programs• Mutual fund directors’ liability• Expensive disclosure cases• CPO/CTA registration and compliance• Misleading marketing (not just performance)• Focus on Private Equity • FINRA active

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Compliance: SEC Positions• Record number of enforcement actions; focus on

compliance programs• di Florio tells firms to strengthen conflicts of interest

practices: sales practices, outside business activities, wrap programs, side-by-side management, affiliations, valuation practices

• Aguilar: protect investors• Walter: problems with small firms• IM Division focusing on “strategically important

advisors”

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Compliance Programs• Firm must hire outside provider to fix compliance program (In re IMC

Asset Management)

– Not just testing

– 2 incumbent employees with little compliance experience

– WSPs rather than compliance manual

– No evidence of compliance reviews conducted

– No underlying violation

• BD WSPs ≠ RIA compliance manual (In re Evens Barthelemy)

• P/P should have required 2 signatures to move client funds (SEC v. Resources Planning Group)

• Failure to verify pitchbook valuations (In re Oppenheimer Asset Management)

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Compliance Rules

• Reg S-ID: Identity Theft Red Flags Rule– Transaction accounts– Board approval

• Custody rule violations in 1/3 of exams

• Regulation SCI (IT)

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Compliance and Operations• Trading through affiliated BD (In re Tilden Loucks & Woodnorth)

– Conflict disclosed

– Higher commission rates

– Principals benefitted

• Failure to disclose deteriorating financial condition (SEC v. Aletheia Research)

– Item 18 of Form ADV

– Factors: significant litigation, creditor liens, a rapid decline in AUM, negative shareholder equity, and/or material operating losses

• MBS trader lied about mark-ups and counterparties (SEC v. Litvak)

– TARP funds involved

– Criminal prosecution

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Mutual Funds: Directors• SEC sues independent directors for failing to oversee fair

valuation (In re Alderman et. al.)• Scrutiny of sub-adviser fees (Kasilag v. Hartford)

– Split of fees between adviser and sub-advisers– Comparable funds (Vanguard comparison)

• Federal court says that directors not independent (PRSSA Welfare Plan v. UBS)– Fund sponsor so pervasive in local market– Placement agent in past deal– Puerto Rico exempt from ICA

• Fund sponsor suing directors in class action (Third Avenue v. Reserve)

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Mutual Funds• SEC must file enforcement actions within 5

years of conduct, not discovery (Gabelli v. SEC)

• Filing of social media content– Fund performance

– Investment merits

• Derivatives: Hedging vs. speculation– Notional amount > value of underlying

securities (In re Top Fund Management)

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Disclosure

• Failure to disclose impact of derivatives strategy (In re Claymore Advisors)– Trying to juice returns with put options and short

variance swaps rather than covered calls– $45 Million in fines, etc.

• Prospectus did not adequately describe minimum benefit feature (In re Mass Mutual Life)– $1.625 MM fine– Section 34(b) of Investment Company Act

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CFTC and NFA• Court upholds CPO registration for registered funds

(ICI v. CFTC)– Deference to administrative agencies– Considered costs/benefits: protection of

markets/public; market efficiency, competitiveness and financial integrity; price discovery; risk management; and the public interest

• Fund managers must ensure sub-advisers are properly registered– FCMs also have obligation

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Marketing• May use social media to disseminate information (Netflix)• Compensating unregistered solicitors (In re Ranieri

Partners)• Using software to pass off hypothetical backtested

performance (In re New England Investment and Retirement Group)

• Misleading website claims (B&T Securities)• Inflating AUM (In re Tandon)• Misleading about co-investing (In re Aladdin Capital)• Misleading GIPS performance claims (In re ZPR Investment

Management)

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Private Funds• SEC launches Private Equity Initiative: identify higher risk firms

– Karpati: more enforcement cases against private equity firms

• Valuation– FAS 157 (In re KCAP Financial)– Audit firm liability (In re Aesoph and Bennett)

• Cross-trading between funds (SEC v. Commonwealth Advisors)• Preferential redemption rights to large investor (SEC v. New Stream

Capital)• SEC regulating pre-Dodd Frank conduct (In re Lawton)

• Portfolio companies controlled by affiliated fund• Form PF (21 pages of FAQs)• BD registration for salespeople

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FINRA• Focusing on high-yield products: BDCs, CMBS, high-

yield debt, structured products, exchange-traded funds and notes, closed-end funds, and variable annuities

• Will take adviser arbitrations• Rule 8210 gives FINRA broad authority to obtain

documents– Outside business activities– Possession, custody, or control– Includes info about unregulated third parties (In re Goldstein)

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Lessons

• Get a professional compliance program• Re-examine independent directors• Refresh disclosure documents• Review marketing materials like a regulator• Implement CPO/CTA compliance• Prepare for private equity exams/enforcement• Don’t forget FINRA (and states)

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