Compliance In A New Regulatory Environment by chenmeixiu


									Compliance In A New Regulatory

      Joel H. Sauer
      Principal Consultant
      ACA Compliance Group

      October 20, 2009

Nothing herein should be construed as legal advice or as a legal
opinion for any particular situation. Information is provided for
general guidance and should not be substituted for formal legal
advice from an experienced securities attorney.
Table of Contents

                    • SEC Examinations

                    • Custody and Safekeeping of Assets

                    • Portfolio Mandate Compliance

                    • Marketing, Advertising and Investor

                    • Best Execution and Soft Dollars

                    • Private Fund Regulation

                    • IA-BD Harmonization

                    • Questions

SEC Examinations
Re-Energized SEC Staff

 “A strong and reinvigorated SEC will
   be on the beat like never before to
          catch wrongdoers.”
                  – Mary Schapiro, SEC Chairman

Source: Practicing Law Institute's "SEC Speaks in 2009" Program, Washington, DC, February 6, 2009.

A Tougher, No-Nonsense SEC?

“We really are now going to take a no-
 excuses approach to compliance with
    the law…firms really need to be
  ready to be examined by the SEC.”
      - Lori Richards, Director of the SEC’s Office of
         Compliance Inspections and Examinations

Source: Richards Talks Tough: SEC Examiners Will Take „No Excuses‟, ACA Insight, February 16, 2009.

Better, faster, tougher enforcement

 “The focus, as I said, is on being more
  strategic, swift, smart and successful
   in our job—protecting the investor.”
   - Robert Khuzami, SEC Director of Enforcement,
     before the Senate Banking, Housing and Urban
                  Affairs Subcommittee

Source: Testimony of Mr. Robert Khuzami, “Hearing: Strengthening the S.E.C.‟s Vital Enforcement
Responsibilities” (May 7, 2009).

     SEC’s Increasing Resources

     • Additional $20 million in additional funding approved by U.S.
       Senate for FY 2010 = 60 new investigators

     • Industry and Markets Fellows Program*
         – Staffed by industry experts to “infuse the agency with knowledge of
           complex industry practices and products”

         – Work in SEC’s Office of Risk Assessment for 2 to 4 years

         – Annual salaries will range from $108,286 to $227,300

         – Broad areas of expertise, including: trading equity and fixed-income
           securities, structured products, complex derivatives, financial analysis
           and valuation, fund management, investment banking and financial
           service operations

*Source: SEC Unveils Program to Woo Industry Experts,, May 1, 2009.

Production of Records: SEC Expectations

• OCIE working with the SEC’s Division of Enforcement to create a
  policy about when examiners will refer a delay in production or lack
  of cooperation to SEC enforcement attorneys

• “Examiners will be less tolerant of delays in the production of
  information and documents…I want examiners to have a clear
  sense of when they should refer matters to the Division of
  Enforcement staff when production of documents has not been
  timely and when we feel that firms have not been fully cooperative
  with examiners during the examination process.”
    – Lori Richards, Director of the SEC’s Office of Compliance Inspections and

Source: Richards Talks Tough: SEC Examiners Will Take „No Excuses‟, ACA Insight, February 16, 2009.

Recent SEC Examination Developments

• Interesting developments related to SEC inspections that
  have commenced within the past few months:
   Surprise examinations are back!

   Email requests span up to 2 years with no “keyword” qualifiers

   Requests for all versions of particular documents during a
    review period (e.g., Form ADV, II, Compliance Manual,

   Questions about compliance budgets and potential cost cutting

Recent SEC Examination Developments (Con’t.)

  Previous deficiency letters. Re-open those letters and your
   firm’s response and ensure that all issues have been properly

  Hedge funds, group of hedge funds, or group of investment
   companies sponsored by an adviser will be examined at the
   same time as the adviser

  Confirming client account balances directly with the custodian

Other New SEC Exam Initiatives

  – More sweep exams formulated by specialized groups within the
  – SEC internal hotline for examiners to call in the event officials at
    a firm become uncooperative or attempt to derail an inspection;
  – A new staff category (“Senior Special Examiner”) to interview
    personnel in highly technical areas;
  – A more holistic approach with better integration of the
    investment adviser and broker-dealer examination groups; and
  – A periodic review of the SEC’s own internal policies and

Restructuring and Focus of Enforcement

- Streamlined formal order process

- Formation of five specialized units within the Enforcement Division
   Asset Management, Structured Products, Municipal Securities and Public
    Pensions, Foreign Corrupt Practices, and Market Abuse

- Increased scrutiny of tolling agreements

- Elimination of branch chiefs

- Creation of an Office of Market Intelligence

Recent Exam Priorities
• Custody of client assets
• Personal trading by advisory staff (especially trades in private funds
  managed by the adviser)
• Valuation and liquidity issues
• Portfolio risk monitoring
• Disparate treatment of investors
• Sales of structured products by broker-dealers and advisers
• Controls and processes at recently merged or acquired firms, both advisers
  and broker-dealers
• Money market funds
• Short selling and compliance with Regulation SHO

Custody and Safekeeping of
Client Assets
Custody and Safekeeping of Fund Assets
Current Custody Rule under Advisers
• Qualified Custodian
• Notice to Clients
• Quarterly Account Statements to
• Private Fund Exception to Reporting
  – GAAP audit requirement
  – Distributed within 120 days to all
    investors/shareholders (180 for fund-of-
  – Unqualified opinion

 SEC Director on Custody Focus

  “Examiners are going to be out in force looking at
    your controls over custody…Don‟t wait for us to
     do it. Do it now…We will want to tie the firm‟s
      records and the firm‟s account statements to
   customers back up to independent custodian … so
   we will be spending an enormous amount of time
      really confirming the existence of client and
                    customer assets.”
                        – Lori Richards, OCIE Director

Source: Richards Talks Tough: SEC Examiners Will Take „No Excuses’ and SEC Sweeps on Custody, ACA
Insight, February 16, 2009.

     Simply “Verify”

         “…to a greater extent, examinations of
          advisers and broker-dealers include a
        verification of the assets held…I like to say
          that our philosophy here isn‟t so much
          Ronald Reagan‟s „trust but verify,‟ but
                      simply „verify.’”

Source: Lori Richards, Director, SEC’s Office of Compliance Inspections and Examinations,
Strengthening Examination Oversight: Changes to Regulatory Examinations, June 17, 2009 at

Proposed Changes to Custody Rule (May 2009)

• Major proposed changes:
  – Surprise audit by independent accountant for any adviser with
    custody, even if only because of ability to deduct fees; private
    funds also subject to surprise audit

  – Written opinion from independent accountant regarding adviser’s
    internal controls related to custody

  – Disclose the name of independent accountant conducting surprise
    audit (for hedge funds, the accountant conducting the GAAP
    financial audit) on Form ADV Part 1

  – If custodian is adviser or affiliate, independent accountant must be
    PCAOB-registered and internal control report required (SAS 70,
    Level II)

SEC Focus on Auditor Relationships
• SEC examiners have asked advisers to sign an authorization
  requesting work papers from their Fund’s auditor
• SEC staff requesting meetings/discussions with a fund’s auditor
  with respect to various issues (e.g., clawbacks related to Madoff
• What due diligence did the adviser perform on the auditor for its
  funds? What documentation was maintained?
• Is the auditor registered with the PCAOB?
• Do the auditor or its personnel have any investments in the funds or
  with the adviser?
• Does the adviser or the auditor send audited financial statements
  and K-1s to investors?

Additional Custody Considerations

• SEC staff “down-the-chain” custody requests – contacting clients
  and investors to verify account balances (FoF – capital account
  balances, cash flows and all holdings of the fund)

• Liquidation audits – can a manager forgo a final audit due to
  expense considerations?

• “Due inquiry” requirement – what about clients that do not want to
  get “copies” of account statements (e.g., foreign clients)?

• Exception from qualified custodian requirement for certain
  privately offered securities – bank debt, trade claims and other
  investments subject to this provision?

Portfolio Mandate Compliance
     SEC Focus on Portfolio Mandate Compliance

      “Advisers simply cannot tell investors
        they are going to do one thing with
          their funds and then not follow
           through on those promises.”
       - Linda Chatman Thomsen, former Director of the
           SEC’s Enforcement Division, July 30, 2008

Source: SEC Charges Mutual Fund Manager for Violating Socially Responsible Investment Restrictions, SEC Press
Release No. 2008-157, July 30, 2008.

Recent Portfolio Mandate Case Studies

• In the Matter of Hennessee Group LLC and Charles J. Gradante, Advisers
  Act Release No. 2871, April 22, 2009
   – In the course of soliciting clients, Hennessee Group…made numerous
     representations concerning the quality and rigor of its due diligence process for
     evaluating hedge funds.

• New York Law School v. Ascot Partners, L.P., J. Ezra Merkin and BDO
  Seidman LLP, December 16, 2008.
   – “…neither the Offering Memorandum nor any other offering material used in
     soliciting investment in Ascot ever disclosed that virtually all of Ascot‟s assets
     were invested with Madoff, BMIC or other Madoff controlled entities.”

• In the Matter of Pax World Management Corp., Advisers Act Release No.
  2761, July 30, 2008.
   – Sanctioned for not following stated social screens
   – Note: no harm alleged

It’s More Than Just the PPM and IMA…

• Private Offering Memorandum (PPM)

• Investment Management Agreement (IMA)

• Flipbooks

• Due Diligence Questionnaires

• Responses to RFPs

• One-on-One Presentations

• Annual Client or Investor Meeting Materials

• Verbal Representations

Advertising, Marketing and
Investor Relations
Regulatory Focus on Advertising and
Performance and Investor Relations
• Are the materials accurate and

• Performance track records

• Composite construction

• Assets under management

• Pay-to-play and client/investor
  solicitation arrangements

• Selective disclosure

• Increasing use of social media
  (Facebook, LinkedIn, Twitter)

 SEC Focus on Performance Claims

  “Given the conflicts of interest in this area — the fact
    that advisory fees may be pegged on performance,
    the marketing significance of performance claims,
         and the simple fact that there is a natural
   disinclination to deliver bad news to clients — this is
   an area where CCOs and compliance personnel will
               want to focus their attention.”

     – Lori Richards, Director of the SEC’s Office of Compliance
                   Inspections and Examinations

Source: Compliance in Today‟s Environment: Step Up to the Challenge, Speech by SEC Staff, March 12, 2009.


• New York AG (Cuomo) investigation

• Morris/Loglisci Indictment

• Individual State Laws

• SEC Rule Proposal – Political Contributions
  by Investment Advisers (Aug. 3, 2009)
    – Prohibit adviser from providing advisory
      services for compensation to a
      government client for 2 years after the
      adviser/employees made contributions to
      elected officials or candidates

Selective Disclosure

• Are those in pooled vehicles (private funds or mutual funds) treated
  equally with regard to the disclosure of important information
  about the fund?

• In the Matter of Evergreen Investment Management Company, LLC
  and Evergreen Investment Services, Inc., Advisers Act Release No.
  2888, June 8, 2009.
  – “talking points…intended to be shared with any Ultra Fund shareholder
    or registered representative who made an incoming call to any of the
    Evergreen Distributor‟s wholesalers to discuss the Fund‟s recent NAV

  – “Evergreen Adviser willfully violated Section 204A of the Advisers
    Act…Evergreen Adviser disclosed material, non-public information
    about the Ultra Fund to an affiliate…”

Regulatory Focus on Electronic Communications

• Emails and instant messages

• Internet websites

• Social networking sites (MySpace,
  Facebook, LinkedIn)

• Wikipedia

• You Tube

• Blogs

• Chat Rooms

• Twitter

Asset Managers and Social Networking Sites

• TIAA-CREF has gone where
  other asset management firms
  fear to tread and launched a
  Facebook page. New York-
  based TIAA-CREF is using
  Facebook to communicate with
  its 3.6 million clients.

• Accomplished with input from
  the firm’s compliance, legal
  and technology divisions.

Source: TIAA-CREF, Vanguard Launch Facebook Pages,, May 29, 2009.

 Investor Focus on Best Practices
     “Hedge fund managers should voluntarily provide
    sufficient transparency to enable investors to comply
   with the PWG Investors‟ Committee‟s principles and best
            practices…TRS has adopted the recent
       recommendations established by the President‟s
      Working Group. Thus far, 35 of our 44 hedge fund
   relationships have stated that they are fully compliant.
    The majority of the remainder has indicated that they
   will be appropriately compliant no later than year end”
                      [Emphasis Added]
      – Brit Harris, CIO of Teacher Retirement System of Texas
Source: Perspectives of Hedge Fund Registration, Capital Markets Subcommittee of the U.S House of
Representatives Financial Services Committee Hearing, May 7, 2009.

SEC Deficiency Letter on Specific
 “The examination revealed that Page 8 of the Annual
    Investor Meeting Presentation contained a list of
 investments representing a cross section of the types of
   deals undertaken by XYZ. The methodology used to
  select such investments does not appear to have been
  done using objective non-performance based criteria.
 Accordingly, XYZ should cease from advertising in this
     manner going forward and re-issue a corrected
  presentation to current investors and inform the staff
     of the steps it intends to take with respect to this
                matter” [Emphasis Added].

Eight Questions You Should Always Ask!
(A Common Sense Checklist)
 • Is it the whole truth?

 • Will your audience understand what you are saying?

 • Is the presentation misleading?

 • Can you back it up?

 • Have you checked the facts?

 • Have you made promises you can’t keep?

 • Are charts and graphs clearly labeled?

 • Has the compliance team reviewed and approved the final

Best Execution and Soft
Best Execution

• What does best execution mean

  – Fund of funds managers?

  – Private equity/venture capital

• Functions of best execution

Soft Dollars

• Soft Dollar Aggregators

• Sharing of Credits

• Protecting Credits against Broker-Dealer

• Transfers of Credits/Unused Credits

Private Fund Regulation
Private Fund Regulation

•   Hedge fund manager registration is near certain

•   Informational data collection on funds (e.g., assets under

•   The Private Fund Investment Advisers Registration Act of 2009
    would require the SEC to collect information on:
     –   Assets under management

     –   Leverage (including off-balance-sheet leverage)

     –   Counterparty credit risk exposures

     –   Trading and investment positions

     –   Trading practices

     –   Any other information determined necessary after consultation with the Fed

Private Fund Regulation

•   Provides an exemption for advisers to venture capital funds, but
    not private equity

•   Timeframe – Congressional action likely before year-end with
    SEC implementation in mid-late 2010

•   Potential impact on other advisers:

     – Elimination of “private adviser” exemption

     – Extension of reporting requirements

Investment Adviser –
Broker-Dealer Harmonization
Finding, Redefining and Refining the Fiduciary

  A fiduciary duty has two parts:

     – Duty of Loyalty =   Duty to put your clients’ interests before
                           your own and to disclose all conflicts of

     – Duty of Care    =   Duty to devote reasonable care and
                           diligence to handling your clients’ business.

     The current debate is primarily about the Duty of Loyalty.

Finding, Redefining and Refining the Fiduciary

“Historically, broker-dealers that simply effected
 transactions as directed by their clients generally
 would not be fiduciaries and had duties focusing
 on the transaction service they provided. As
 broker-dealers increasingly provide advice to
 their clients, the higher standards and fiduciary
 duties of advisers should also be applied to these

           - SEC Commissioner Luis Aquilar - January 10, 2009 speech to
             the North American Securities Administrators Association

Finding, Redefining and Refining the Fiduciary

“Rather than perpetuating an obsolete regulatory
 regime, SIFMA recommends the adoption of a
 „universal standard of care‟ that avoids the use of
 labels that tend to confuse the investing public,
 and expresses, in plain English, the fundamental
 principles of fair dealing that individual investors
 can expect from all of their financial services

           - SIFMA President Timothy Ryan, Jr. - March 10, 2009 testimony
             before the Senate Banking Committee

Finding, Redefining and Refining the Fiduciary

  Expose or Eliminate? – Areas of Potential Impact
     – Principal and agency cross trades – Will Rule 206(3)-3T become permanent or
       will its application be broadened or narrowed for different situations?
     – Sale of proprietary products and services – What additional disclosures will be
       required for brokers selling proprietary products and services? Will some
       proprietary sales be restricted or prohibited?
     – Suitability – Will brokers (and advisers) be required to recommend the “most”
       suitable product or service?
     – Commission levels – Will broker-dealers create additional commission levels for
       different levels of service? Will broker-dealers be required or pushed to adopt level
       compensation policies?
     – Fee-based vs. Transaction-based – Will brokers (and advisers) be required to
       assess whether fee-based or transaction based services are more appropriate for
       their clients?
     – Research – NASD Rule 2711 could be a model for implementing a general broker-
       dealer or universal fiduciary duty.

SRO for Investment Advisers

“I also believe that all financial professionals
 should be required to be members of one or more
 self-regulatory organizations ("SROs") that are
 empowered with both enforcement and standard-
 setting authority and are subject to the oversight
 of the Commission.”

         - SEC Commissioner Elisse Walter – May 5, 2009 speech to
           the Mutual Fund Directors Forum

SRO for Investment Advisers – Continued Opposition

“There is no existing adviser membership organization that
 polices conduct. In short, it would be outsourcing a
 regulatory obligation rather than building on an existing
 structure. I personally believe that the SEC should not
 outsource its mission. It is the only entity with experience
 overseeing investment advisers, an industry governed by
 the Advisers Act, which is based on a principles-based
 regime. By contrast, broker-dealer SROs primarily regulate
 through the use of very detailed, specific sets of rules and
 are not well versed in the oversight of principles-based

          - SEC Commissioner Luis Aquilar – May 7, 2009 speech to
            the Investment Advisers Association

Investor Protection Act of 2009

•   Applies Advisers Act fiduciary duty to broker-dealers providing
    investment advice to retail customers

•   Requires the SEC to adopt rules defining this fiduciary duty (to
    retail customers) to require broker-dealers and investment
    advisers to act in the best interest of the customer without regard
    to their own financial or other interests

•   Defines “retail customer” as an individual who
     –   Receives personalized investment advice from the broker-dealer

     –   Uses such advice primarily for personal, family, or household purposes

Investor Protection Act of 2009

•   Requires the SEC to facilitate the provision of simple and clear
    disclosures to investors regarding the terms of their relationships
    with broker-dealers and investment advisers

•   Requires the SEC to examine conflicts of interest and
    compensation schemes for financial intermediaries and empowers
    the agency to adopt rules regulating these areas

•   Requires harmonization of enforcement options and remedies

•   Permits the SEC to collect fees from investment advisers to cover
    the costs of the examination program – fees may be based on
    multiple measures of “risk” of the adviser


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