Regulatory Update 2010 - Post-Madoff Enforcement - Dodd-Frank & the New Regulators - Compliance 2.0

1. 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.

2. 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

3. The Players

4. 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

5. 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)

6. 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

7. The Markets

8. 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)

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

10. The Process

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

12. 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

13. 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 ConvergEx)

14. 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

15. Shareholders and Proxies • Proxy process and reporting • Form N-PX for executive compensation matters for 13F 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

16. Distribution

17. 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

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

19. 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 S4 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

20. 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%

21. 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)

22. 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 U4s and U5s • Termination details • Broker awarded $5 Million for defamatory U5 (Beck v. SunTrust) • Politics not sales practices • FINRA considering broker-dealer ADV • More information required in BD applications (Reg Notice 10-01)

23. 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 (NtM 10-06) • Market participation • Naked access • Inadequate customer ID (In re Pinnacle) • CDS market manipulation (Phoenix Derivatives) • Best execution should include multiple venues (Ketchum)

24. Litigation And Enforcement

25. 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. DoL) • $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

26. 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 (9th Cir))

27. 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/DoJ argue that advisers liable for fund prospectuses (Janus v. First Derivative Traders) • Civil and criminal penalties

28. 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 (3rd Cir)) • No “fraud created the market” theory • Law firm in securities offering (PIMCO v. Mayer Brown (2nd 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

29. 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 FreedomTree) • 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

30. Jurisdictional Battles: FDIC and DoL • 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. DoL • New disclosure about plan and investment options • More transparency • Expanded definition of “Fiduciary” • More than just providing “regular advice” • RIAs • DoL sues Madoff feeders (Solis v. Beacon et. al.) • Feeder managers were fiduciaries • Jurisdictional issues

31. 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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