Investment Management Law

SEC Charges Sponsor of Feeder Fund that Invested in Ponzi Scheme

Todd Cipperman — Thu, 24 May 2012 10:55:45 GMT

The SEC has filed suit against two individuals that sponsored a feeder fund into a Ponzi scheme. The SEC alleges that the defendants knew or reckless in not knowing that the legal settlements purchased by the fund did not exist. The SEC charges that the defendants did not follow procedures described in the PPM including obtaining underlying documentation and engaging a third-party verifier. The SEC charges violations of the various securities anti-fraud laws and regulations.

OUR TAKE: The issue of interest here is how far does third party liability attach when investing in Ponzi schemes. In this case, the SEC suggests that feeder fund sponsors have an affirmative duty to ensure the validity of underlying securities.

http://sec.gov/litigation/complaints/2012/comp-pr2012-100.pdf

FINRA Says that Brokers Must Put Clients’ Interests First

Todd Cipperman — Wed, 23 May 2012 12:58:42 GMT

FINRA recently issued suitability guidance stating: “The suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his other interests ahead of the customer’s interests.” Continuing, FINRA explained that examples of a broker placing his/her interests ahead of clients include a motivation to receive larger commissions or recommending proprietary or new issues to keep a job. Similarly, in a recent speech, FINRA CEO and Chairman Richard Ketchum said that it was adapting its regulatory focus to ensuring that brokers “identify conflicts and place…customers’ interests before” the firm’s. Ketchum continued by stating that a financial adviser “should be able to write down on a single page why this investment is in the best interests of your client.” Moreover, said Mr. Ketchum: “This does not have to wait until you find out the details of any fiduciary rulemaking the SEC may make. Being able to articulate why an investment is in the best interests of your client is fundamental to what the securities industry must be about if it is to deserve the trust of investors. The time to do it is now.”

OUR TAKE: Apparently, FINRA is imposing the fiduciary standard by administrative fiat without SEC rulemaking and without a rule proposal with industry input. This is a sea change for brokers. Under the more traditional suitability standard, a broker’s reasons for recommending a security should not be relevant so long as the recommendation is suitable.

http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p126431.pdf www.finra.org/Newsroom/Speeches/Ketchum/P126481

Khuzami Defends and Explains SEC’s Settlement Practices

Todd Cipperman — Mon, 21 May 2012 11:34:51 GMT

In testimony before the House Committee on Financial Services, SEC Enforcement Director Robert Khuzami defended his Division’s settlement policies. Mr. Khuzami explained the benefits of swift settlements over lengthy litigation including the risks that the SEC could lose at trial or win a lesser penalty. He also noted that the median time for disposition of civil cases in federal courts ranges from 19 to 44 months. Regardless, he explained, the SEC has prevailed in 84% of trials since the beginning of 2010. Mr. Khuzami also defended the SEC’s practice of allowing “neither-admit-nor-deny” settlements as necessary especially where respondents must consider private litigation implications. However, we think Mr. Khuzami did announce that the SEC would no longer allow “neither-admit-nor-deny” settlements where there is a parallel criminal proceeding.

OUR TAKE: Prohibiting or limiting “neither-admit-nor-deny” settlements would significantly handcuff both the SEC and respondents and force them into high-stakes and costly litigation. Many respondents, when faced with an SEC action, want to end the case quickly. However, it may make sense to force litigation where the SEC has to prove its case to an unpredictable judge or jury and may have to wait several years for an outcome.

http://sec.gov/news/testimony/2012/ts051712rk.htm

Best of the Web - May 2012

Todd Cipperman — Fri, 18 May 2012 11:24:14 GMT

As a new feature for our loyal and long-suffering OUR TAKE readers, we bring you the “Best of the Web.” During our daily review of all matters regulatory, we sometimes come across publicly-available pieces from our clients, partners, competitors, and friends that we think are extremely helpful and well done. Usually, these articles provide in-depth analysis far greater than we can offer in the short-form format that you receive from us every morning. Sometimes, these industry players address issues well outside our expertise and experience. We offer these articles and links in no particular order. We hope you find these gems as valuable as we did.

The Final 408(b)(2) Regulation: Impact on Investment Managers (Drinker Biddle)

http://www.drinkerbiddle.com/files/Publication/f65a1caa-223b-4b31-b9aa-45461ed4badb/Presentation/PublicationAttachment/d7ef8a09-ca3b-4552-8d41-4c71b6152ac6/TheFinal408(b)(2)Regulation.pdf

2011 Year in Review: Selected Federal Securities Litigation Developments (Morgan Lewis)

http://www.morganlewis.com/pubs/LIT_2011YrReviewSelectedFederalSecuritiesLitDevelopments_13feb12.pdf

U.S. JOBS Act Remakes the Standards for Offerings of Hedge Funds and Private Equity Funds (Dechert)

http://www.dechert.com/files/Publication/af8642e0-e42b-416b-8f03-01618113736d/Presentation/PublicationAttachment/a396c42c-777c-47f8-b84e-1511d9244b99/FS_9_04-12_JOBS_Act_Remakes_the_Standards_for_Offerings.pdf

New Guidance on Confidentiality Agreements (Ropes & Gray)

http://www.ropesgray.com/files/Publication/d9e30e43-f8a3-4203-a67f-643ff81520f8/Presentation/PublicationAttachment/c89abc9c-d4b6-49ed-9be7-6781f02687a8/20120515_PE_Alert.pdf

Board Oversight of Strategic Risk (King & Spalding)

http://www.kslaw.com/imageserver/KSPublic/library/publication/LDNViewPoints_Issue13.pdf

So You Think Your Marketing Practices Are Compliant? (Stark & Stark)

http://www.njlawblog.com/TDG%20-%20IMCA%20Monitor%20-%206.07.pdf

Brochure Delivery Rule - Important Reminder (FrontLine Compliance)

http://www.frontlinecompliance.com/compliancealert/compliance_alert_4-12-12.html

Fair Valuation– Does Management Know Enough About the Process? (BBD)

http://www.bbdcpa.com/blog/fair-valuation%E2%80%93-does-management-know-enough-about-the-process/

NYS’s Highest Court Rules that Compliance Officers Can’t Sue for Wrongful Termination

Todd Cipperman — Thu, 17 May 2012 11:32:46 GMT

The New York Court of Appeals (the state’s highest appellate court) has ruled that compliance officers do not have a cause of action for wrongful termination when fired for raising compliance issues. The Court refused to find an exception to the state’s at-will employment doctrine. The case involved a hedge fund manager’s compliance officer who claimed retaliatory termination when he raised personal trading violations by the firm’s majority owner. The plaintiff argued that the nature of a compliance officer’s job requires protection against termination where he/she merely performed the duties inherent in the position. The Court determined that the plaintiff was not entitled to Dodd-Frank whistleblower protection because the plaintiff never claimed to be a whistleblower “i.e. told the SEC or anyone else” about the alleged misconduct. A vigorous dissent argued that an exception from the at-will doctrine was legally justified, asserting: “The message that will be taken from the majority's decision is self-evident: if compliance officers (and others similarly situated) wish to keep their jobs, they should keep their heads down and ignore good-faith suspicions or evidence they may have that their employers have engaged in illegal and unethical behavior, even where such violations could cause or have caused staggering losses to their employers' clients.”

OUR TAKE: We are not employment lawyers, so we will not opine on whether the Court properly applied New York State’s at-will doctrine. From a securities law perspective (at least in New York State), it appears that a compliance officer can only seek the protections of Dodd-Frank’s anti-retaliation protections if he/she claims to be a whistleblower and reports the violation to the SEC. This is completely untenable, as the dissent argued.

Sullivan v. Harnisch

OCIE’s Deputy Director Announces Exam Sweep of Private Fund Advisers

Todd Cipperman — Wed, 16 May 2012 11:07:43 GMT

Norm Champ, the Deputy Director of the SEC’s Office of Compliance Inspections and Examinations, announced that OCIE will conduct “a coordinated series of examinations of a significant percentage” of new private fund adviser registrants. OCIE will then publish “a series of ‘after action’ reports” reporting findings. Mr. Champ highlighted 10 “takeaways” for new private fund advisers: conduct compliance reviews, prepare for Form PF reporting, identify firm risks, ensure employees understand their obligations, verify client assets at third parties, identify and eliminate conflicts of interest, ensure accurate disclosure in marketing and advertising, ensure portfolio management compliance, address customer complaints, and check IT security.

OUR TAKE: Mr. Champ does not speak often, so firms should listen carefully when he does. He is giving private fund advisers very clear guidance about the SEC’s focus. And, if you believe that the OCIE will only use the private fund adviser sweep exams to publish findings, you really should speak with somebody who has actually lived through an SEC exam.

http://www.sec.gov/news/speech/2012/spch051112nc.htm

SEC Sues to Obtain Audit Work Papers from Chinese Firm

Todd Cipperman — Tue, 15 May 2012 11:01:55 GMT

The SEC has instituted administrative proceedings against a foreign accounting firm that has refused to produce its work papers in response to a request related to an investigation into potential accounting fraud. The respondent claims that applicable Chinese law prohibits delivery of the work papers. The SEC charges that the audit firm must produce the work papers pursuant to Section 106(b) of the Sarbanes-Oxley Act.

OUR TAKE: This action shows that the SEC will enforce U.S. securities laws against non-U.S. entities involved with U.S. issuers. One key issue is whether Chinese law really prohibits delivery of the work papers. If so, it seems somewhat unproductive to institute enforcement proceedings.

http://www.sec.gov/litigation/admin/2012/34-66948.pdf

SEC Moves against Former Detroit Mayor and Investment Adviser for Kickbacks

Todd Cipperman — Mon, 14 May 2012 11:45:26 GMT

The SEC has filed a suit against an investment adviser, it principal, and two former public officials charging violation of the securities laws in connection with an influence peddling scheme. The SEC alleges that the adviser provided lavish gifts to Detroit’s then Mayor and Treasurer to win advisory business from certain public pension plans. The SEC noted that the alleged transactions violated a Michigan anti-corruption law and charged violations of Sections 17 and 10 of the 1933 Act and the anti-fraud provision of the Advisers Act.

OUR TAKE: We are unsure how the SEC has jurisdiction to enforce state anti-corruption laws. We certainly understand the Advisers Act anti-fraud charges against the adviser and its principal, but we don’t see the SEC’s jurisdiction over the city officials. We also think that charging this group with securities fraud in connection with the sale of securities is a legal reach. Isn’t this a job for the Michigan State Attorney General?

http://www.sec.gov/litigation/complaints/2012/comp-pr2012-88.pdf

Side-by-Side Management Leads to Charges against Fund Manager

Todd Cipperman — Fri, 11 May 2012 11:05:26 GMT

An investment manager to a registered fund and a hedge fund agreed to pay over $8 Million in penalties and reimburse fund losses and return management fees for using the registered fund to bail out the hedge fund. According to the SEC, the fund manager directed the registered closed-end fund to make an ill-advised investment in a private Chinese company solely for the purpose of stemming a liquidity crisis impacting its hedge fund. The SEC alleges that the manager and the Chinese company created the transaction whereby the Chinese company would use the proceeds from the investment to redeem certain bonds that the hedge fund held. The SEC charges that the respondent misled the registered fund’s board and its outside counsel by failing to disclose the purpose of the transaction and the Chinese company’s use of proceeds. The SEC also contends that the firm did not properly follow its valuation procedures. Additionally, the SEC charges that the firm had an inadequate compliance program that failed to implement relevant policies and procedures to avoid conflicts of interest.

OUR TAKE: Side-by-side management whereby a manager invests multiple clients/funds in the same securities creates significant conflicts of interest. To avoid these types of regulatory issues, firms must implement heightened policies and procedures and ensure full disclosure to boards.

http://sec.gov/litigation/admin/2012/ia-3404.pdf

Todd Cipperman Presents "Our Take" at ICI General Membership Meeting

Todd Cipperman — Wed, 09 May 2012 12:14:57 GMT

Todd Cipperman will present "Our Take" on recent regulatory and enforcement developments at the ICI General Membership Meeting in Washington today at 6:15. Todd will offer some big picture themes and offer his unique opinions and predictions on the regulatory environment. If you plan to attend the conference, please stop by for a lively discussion. If you can't make it, you can see the presentation by clicking on the attached link.

ICI GMM Presentation

Private Investment Firm Seeks Time to Divest to Avoid Registration

Todd Cipperman — Tue, 08 May 2012 11:57:05 GMT

A private investment firm has filed an exemptive application to avoid investment company registration as it transitions to comply with the applicable exemptions. The applicant, which generally invests for the purpose of managing and holding operating companies, inadvertently came under the Investment Company Act because investor redemptions resulting from the financial crisis caused the company to hold more than 45% of its assets or derive more than 45% of its net income from non-majority owned operating companies. The application asserts that the firm is taking ongoing affirmative steps to bring bad assets below the 45% threshold but needs more time to complete all the necessary transactions. The exemptive application would provide relief for up to a year.

OUR TAKE: This is a strategy that other private equity firms with a small number of long-term holdings may wish to consider to avoid registration and regulation. Such a firm may also be able to avoid Advisers Act registration.

http://www.sec.gov/rules/ic/2012/ic-30056.pdf

FINRA Focuses on Holding Periods in Suitability Actions

Todd Cipperman — Mon, 07 May 2012 11:22:46 GMT

FINRA fined four large brokerage firms a total of $9.1 Million for making unsuitable sales of leveraged and inverse exchange-traded funds. FINRA charged that the firms did not have a reasonable basis for recommending the securities because of their volatility over longer holding periods, especially for conservative and older investors. FINRA also charged that the firms did not adequately supervise selling reps who did not sufficiently understand the risks of the products.

OUR TAKE: The notable element of these actions is FINRA’s focus on holding periods as a factor in a suitability analysis. Brokers, in theory, do not have an ongoing responsibility to advise clients about when to sell securities, only to ensure that the security is suitable at the time of purchase. By requiring a consideration of holding periods, FINRA is imposing a backdoor fiduciary standard. As time progresses, a previous suitable recommendation could become unsuitable as markets change.

http://www.finra.org/Newsroom/NewsReleases/2012/P126123

Top 5 Regulatory Alerts for April 2012

Todd Cipperman — Fri, 04 May 2012 11:46:29 GMT

Here are our top 5 Regulatory Alerts for April. You can read further at blog.cipperman.com.

Bachus and McCarthy Introduce Bipartisan Bill to Establish Adviser SRO (4/26/12)
SEC/CFTC Adopt Final Swap Rules Exempting Most Swap Users (4/19/12)
ICI and Chamber Sue CFTC to Stop Registration Rule (4/18/12)
Fund Manager to Pay $4.3 Million for Marketing Back-Tested Hypothetical Performance (4/23/12)
SEC Sues Public Plan Placement Agent for Falsifying Disclosure Docs (4/24/12)

Hedge Fund Manager Charged with Marking the Close

Todd Cipperman — Thu, 03 May 2012 11:10:18 GMT

The SEC initiated a lawsuit against a hedge fund manager that it alleges artificially inflated the fund’s NAV by marking the close on the fund’s largest holding and directing the fund’s administrator. The SEC claims that the fund, contrary to its marketing materials, invested approximately half of its assets in one security. The SEC further charges that the defendant marked the close of the security by placing a significant number of buy orders on behalf of the fund and the defendant’s separate account clients at the end of the last trading of the month. This practice artificially raised the price of the security for purposes of calculating assets, performance, and fees. When marking the close ceased working, the defendant instructed its third party administrator to use a higher price on the basis that the market price was not accurate. The third party administrator did ultimately demand a rationale for using a different price, but the security had already begun a significant market decline. The SEC charges various violations of the antifraud provisions of the 1934 Act and the Advisers Act.

OUR TAKE: The lesson here is that a fund with a third party administrator is better than one without one, but a third party administrator does not insure safety from manipulative practices.

http://sec.gov/litigation/complaints/2012/comp22353.pdf

Fund Sponsor to Pay $26 Million for Concealing Proprietary Trading and Deteriorating Secondary Market

Todd Cipperman — Wed, 02 May 2012 11:18:25 GMT

A large broker-dealer agreed to pay over $26 Million to settle charges that it misrepresented and manipulated the secondary market for affiliated closed-end funds. The SEC charges that the respondent effectively controlled the secondary market and consistently provided prices that exceeded the funds’ net asset values. When the secondary market started to decline in 2008, the firm attempted to reduce its own inventory (in response to demand from its Chief Risk Officer) by selling at prices below orders placed by its customers. According to the SEC, the firm, based in Puerto Rico, held 49% of total retail brokerage assets in Puerto Rico and heavily sold the closed-end funds, comprised of Puerto Rico municipal bonds, to retail investors. The SEC also charged the firm’s office head and trading desk head.

OUR TAKE: Firms can’t favor their own trading desks over their own clients. We suspect the respondent would have suffered an action for not adequately disclosing the limited and failing secondary market. What really led to the huge penalties was proprietary trading on information not disclosed to clients and to the detriment of clients trying to unload the same securities.

http://www.sec.gov/litigation/admin/2012/33-9318.pdf http://www.sec.gov/litigation/admin/2012/33-9317.pdf

FINRA Will Implement New System for Public Offering Reviews

Todd Cipperman — Tue, 01 May 2012 12:54:47 GMT

FINRA has announced that it will implement a new filing system to replace the COBRADesk for public offerings required to be filed under Rule 5110. The Rule requires the filing of offering documents and FINRA approval before commencing a public offering. Although the Rule does not apply to open-end funds or private funds, it does apply to publicly-offered closed-end funds and BDCs. According to FINRA, the new system will include an online filing cabinet including a keyword search function and an historical listing of documents. The new system goes into effect on June 20.

OUR TAKE: Let’s hope the new system expedites FINRA review, which has become a significant issue for publicly-offered closed-end funds.

http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p126121.pdf

SEC’s Corp Fin Suggests Disclosure Relevant for Closed-End and Private Equity Funds

Todd Cipperman — Mon, 30 Apr 2012 11:40:27 GMT

The SEC’s Division of Corporation Finance has issued a disclosure letter for structured note offerings, which may be relevant for closed-end funds and private equity funds. The letter requires prominent disclosure about differences between a security’s offering price and the issuer’s estimate of fair value. The staff also requests disclosure about different uses of value on account statements or repurchase offers. The letter also requests disclosure about limitations on secondary market liquidity and the use of hypothetical historical price information.

OUR TAKE: Although Corp Fin does not regulate advisers and funds, it often serves as a standard-setter for disclosure required by the Division of Investment Management.

http://www.sec.gov/divisions/corpfin/guidance/structurednote0412.htm

SEC Asserts Jurisdiction Over UK- Based Securities Fraud

Todd Cipperman — Fri, 27 Apr 2012 10:49:31 GMT

The SEC has filed a securities fraud suit against two UK residents that operated an internet-based stock-touting scheme. The SEC charges that the two brothers sold subscriptions to a newsletter that described recommendations made by a stock-picking robot. The SEC alleges that the newsletter touted stocks that the brothers were hired to tout. Although it appears that the activities occurred outside the U.S., the SEC asserts jurisdiction because the defendants’ conduct “had a foreseeable substantial effect” within the U.S.

OUR TAKE: This case will test the SEC’s extra-territorial reach. Should a national regulator (in any country) have the ability to pursue enforcement litigation with respect to internet-based activity originating outside its national boundaries?

http://www.sec.gov/litigation/complaints/2012/comp-pr2012-72.pdf

Bachus and McCarthy Introduce Bipartisan Bill to Establish Adviser SRO

Todd Cipperman — Thu, 26 Apr 2012 11:20:41 GMT

Congressmen Bachus (R-AL) and McCarthy (D-NY) introduced the Investment Adviser Oversight Act of 2012, which provides for the creation of a self-regulatory organization for most investment advisers. Excluded from SRO supervision (and subject to direct SEC supervision) would be investment company sponsors, private fund managers, and advisers to qualified purchasers. The SEC would supervise the SRO and retain policy-making responsibilities. Before the Committee yesterday, SEC Chairman Mary Schapiro testified that the SEC examined only 8% of registered investment advisers in 2011 and that the SEC has never examined 40% of investment advisers. FINRA supports the legislation, but NASAA (the association of state regulators) opposes it.

OUR TAKE: We generally oppose the idea of an adviser SRO and the separation of regulation depending on whether a firm manages funds or separate accounts. However, nobody has elected or appointed us. It appears that both political parties, SEC Chairman Schapiro, and FINRA support the SRO concept, and NASAA and the industry have come out against. You do the math.

http://financialservices.house.gov/UploadedFiles/l2458.pdf http://www.finra.org/Newsroom/NewsReleases/2012/P126079 http://www.nasaa.org/12469/nasaa-statement-on-investment-adviser-oversight-act-introduction/ http://www.sec.gov/news/testimony/2012/ts042512mls.htm

SEC Allows Previously Barred Supervisor to Head Equity Sales

Todd Cipperman — Wed, 25 Apr 2012 10:59:51 GMT

The SEC granted the application filed by FINRA to allow a previously disqualified person to serve as a large firm’s Head of Equity Sales and re-engage as a supervisor, subject to significant compliance requirements. Pursuant to a 2005 Order, the individual was barred from serving in a supervisory capacity and paid a $120,000 fine for failing to supervise a person that published fraudulent research reports. The SEC allowed re-instatement as a supervising principal based on rigorous compliance requirements including: (1) weekly management meetings with his direct supervisor that are documented and retained; (2) twice monthly meetings with a dedicated senior compliance officer; (3) periodic calls with the person’s direct reports and the dedicated compliance officer; (4) quarterly compliance training; and (5) compliance review of all correspondence.

OUR TAKE: The remedial actions taken by the firm offer a useful roadmap for firms wishing to engage a person with a previous regulatory blemish.

http://www.sec.gov/rules/other/2012/34-66844.pdf