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Fall 2009 1
Investment Management
Update
Fall 2009
In this issue:The SEC Inspector General’s Report on the SEC’s Failures to Catch Madoff,
and the SEC’s Resulting Internal Enforcement Reforms ...................................................... 1
Weathering the Storm in a Post-Madoff World .............................................................. 1
XBRL Mandate, EDGAR Updates, and Mutual Fund Risk/Return Rule
Offer Innovative Research Tools to Investors .................................................................. 2
SEC Enforcement’s New Focus on Asset Management .................................................... 4
Kanjorski Bill to Register Advisers ................................................................................ 6
CFTC and SEC Harmonization .................................................................................. 8
SEC Staff Conditionally Allows Foreign Funds to Invest in U.S. Funds in
Excess of Anti-Pyramiding Limitations of 1940 Act ........................................................ 11
Recent IRS Guidance Clarifi es Tax Treatment of
RIC Investments in Public-Private Investment Program ..................................................... 13
Industry Events ...................................................................................................... 19Weathering the Storm in a Post-Madoff WorldBy Beth R. Kramer and
Megan B. Munafo
From the collapse of Lehman Brothers to
the devastating Ponzi scheme perpetrated
by Bernard Madoff, the fi nancial services
industry as we knew it has forever changed.
Investment advisers are doing their best
to prepare for and adapt to the evolving
nature of the industry and the repetitive
warnings issued by regulators. As the
SEC recently alerted advisers during its
2009 CCOutreach Regional Seminars,
it is important for an investment adviser,
through its Chief Compliance Offi cer and
Compliance team, to arm itself with the
knowledge to survive these “unforgiving
times” where an infraction that in the past
may have resulted in a defi ciency letter,
now, in 2009, may result in an
enforcement action.
The SEC has recently touted its plans to
strengthen and enhance its training and
expertise related to adviser examinations.
In preparation for an on-site examination
in this new regulatory environment, CCOs
The SEC Inspector General’s Report on the SEC’s Failures to Catch Madoff, and the SEC’s Resulting Internal Enforcement ReformsBy Nicholas S. Hodge, Richard A. Kirby and Melissa S. Holmes
Although reports of Bernie Madoff and his life of luxury and deception have faded from the press, the
SEC has been thrust back into the spotlight with the release on September 2, 2009 of a scathing report
(the “Report”) that details the agency’s astounding failure to uncover the largest Ponzi scheme in history.
According to the Report, issued by the SEC’s Inspector General (OIG), three SEC examinations, two
SEC investigations, six substantive complaints and two industry articles expressing doubts about Madoff’s
claimed returns should have led the SEC to discover the fraud, possibly as early as 1992. The OIG
reported that the SEC’s failure to take action in the face of multiple red fl ags presented to its staff left
even Madoff astonished that he was not caught sooner.
With the release of this Report, the SEC Chairman, Mary Schapiro, released a statement detailing
regulatory reforms that the SEC has implemented and/or is seeking to implement by rule and additional
powers through congressional action to address regulatory gaps. SEC Director of Enforcement Robert
Khuzami, in congressional testimony, then elaborated on structural and other changes to the Division’s
operational approach to investigations. The OIG followed with an announcement, on September 29,
2009, of another report identifying specifi c defi ciencies in the enforcement program and making 21
specifi c recommendations, which the Division has undertaken to implement in order to strengthen that
program and to avoid a repeat of the mistakes identifi ed by the OIG. Briefl y, these reforms focus on
(1) the vetting process for reviewing and evaluating tips and complaints; (2) increased training for the
enforcement staff; (3) providing adequate qualifi ed staff tailored to the matters at issue in a specifi c
investigation; (4) emphasizing the planning, oversight and management of the investigation process,
including the process for opening and closing of investigations; and (5) increased cooperation with the
other SEC operating divisions.
continued on page 15continued on page 17
Lawyers to the investment management industry
2 Investment Management Update
Among other revisions, including an upgrade
to the taxonomy for U.S. generally accepted
accounting principles (U.S. GAAP), EDGAR 9.16
refl ects “clarifi cations to the instructions on XBRL/
interactive data tagging.” The intricacies of the
fi nal XBRL rules, the updated EDGAR Filer Manual,
and the February 11, 2009 Interactive Data for
Mutual Fund Risk/Return Summary Rule (Mutual
Fund Risk/Return Rule) will likely be clear only
to the technologically savvy reader. The end
product of these regulatory developments,
however, has the potential to revolutionize the
way professional and individual investors interact
with the securities markets.
Since the fi nal XBRL rules release, industry
service providers—from EDGAR fi ling support
to accountants and auditors—have introduced
a variety of aids for SEC fi lers. For example,
webinars describing the principal elements of
the fi nal XBRL rules and comparing them to the
proposed rules are available online, as are
publications laying out roadmaps for initiating
XBRL compliance and working through the
updated EDGAR system. Similarly, XBRL solutions,
such as outsourcing, and comprehensive
implementation packages are available to
mandated and to voluntary XBRL fi lers.
Currently, mutual funds and other investment
companies registered under the 1940 Act are
not required to fi le using XBRL, nor are business
development companies or certain foreign private
issuers. These companies may fi le interactive
fi nancial statement information using XBRL on a
voluntary basis until otherwise notifi ed by the SEC.
Voluntary XBRL fi lers may begin and cease fi ling
in XBRL at their own discretion, but must follow
the XBRL rules applicable to mandated fi lers when
preparing and submitting fi nancial data in XBRL.
Beginning January 1, 2011, under the Mutual
Fund Risk/Return Rule, registered investment
companies will be required to use XBRL to tag the
risk and return information in their prospectuses for
periods beginning on or after January 1, 2010.
The SEC reportedly is working with XBRL U.S., the
domestic arm of XBRL International (a consortium
of representatives from the global fi nancial
reporting community), “to develop the standard
list of tags for the risk/return summary section of
mutual fund prospectuses and the schedule of
investments for investment companies.”
For companies that are not excluded from
mandatory compliance with the XBRL rules,
generally including those fi ling registration
statements under the Securities Act of 1933,
fi nancial statements and their footnotes included in
quarterly reports fi led on or after June 15, 2009
must be tagged in XBRL. These companies also
must post interactive fi nancial statements on their
website no later than the end of the calendar
year the fi nancial statements were fi led or were
required to be fi led, whichever is later, and
must keep them posted for a period of twelve
months. XBRL fi lings will be submitted as exhibits
to traditional EDGAR fi lings, which currently
are formatted in American Standard Code for
Information Interchange (ASCII) or HyperText
Markup Language (HTML). All documents fi led
with the SEC in XBRL are subject to the provisions
of the federal securities laws.
The SEC took further steps to implement its highly publicized eXtensible Business Reporting
Language (XBRL) rules, released in fi nal form last January, by releasing updated EDGAR version
(9.16) and related changes to the EDGAR Filer Manual, effective August 4, 2009. These rules
represent the latest move in the SEC’s initiative to gradually phase in use of XBRL. In the SEC’s
view, once the initiative is complete, shareholders and fi nancial advisors alike will benefi t from
the dynamic research and analysis capabilities created by the integration of XBRL into the SEC’s
corporate disclosure scheme.
XBRL Mandate, EDGAR Updates, and Mutual Fund Risk/Return Rule
Offer Innovative Research Tools to InvestorsBy Gwendolyn A. Williamson
ComplianceCorner
Fall 2009 3
Application and Import of the
XBRL Initiative. The fi nal XBRL rules and the Mutual Fund Risk/
Return Rule represent the SEC’s stated commitment
to promoting “effi cient and transparent capital
markets” and its efforts to use “developments in
technology and electronic data communication
[to facilitate] greater transparency in the form
of easier access to, and analysis of, fi nancial
reporting and disclosures.” First introduced with
a voluntary fi ler program in 2005, through
which the SEC evaluated its pros and cons,
XBRL tags and maps a company’s fi nancial data,
enabling investors to download a company’s
fi nancial information “directly into spreadsheets,
[to] analyze it using commercial off-the-shelf
software, or use it within investment models in
other software formats,” all of which allows for
the ready “comparison of fi nancial and business
performance across companies, reporting periods,
and industries.” XBRL presents “a signifi cant
opportunity to…increase the speed, accuracy,
and usability of fi nancial disclosure.” Over time,
XBRL, the Mutual Fund Risk/Return Rule, and other
technological initiatives – such as the Paperless
Proxy and Summary Prospectus Rules – also
promise to reduce costs for shareholders and to
mitigate the environmental footprint of mutual funds
and other SEC fi lers.
The realization of XBRL by the SEC places the U.S.
in step with its international peers. XBRL is currently
mandated or used voluntarily in regulatory fi ling
programs throughout Western Europe, as well as
Australia, Canada, China, India, Japan, Korea,
Singapore, and Thailand. One of the hopes
pinned on XBRL is that the information it offers
to shareholders will contribute to recovery in the
markets, given its promoted potential to restore
investor confi dence through education and greater
transparency; while perhaps overly optimistic, this
hope expresses the ambition of the architects of
XBRL.
Filers, and their accountants/auditors, will need
to be organized in approaching XBRL. Given
the complexities of the XBRL rules, such as the
annually updated XBRL taxonomy and tagging/
mapping, linkbase, extension, and instance
document requirements, mutual funds and other
companies should have a strategy for preparing
and testing the portions of their SEC fi lings that
will be submitted in XBRL.
The fi nal XBRL rules, which detail how to
execute and comply with the rules, are
available at http://www.sec.gov/rules/
fi nal/2009/33-9002/pdf, and the updated
EDGAR Filer Manual is accessible at http://
www.sec.gov/info/edgarshtml. The Mutual Fund
Risk/Return Rule and several corrections thereto
are available at http://www.sec.gov/rules/fi nal.
shtml.
4 Investment Management Update
The most important change in SEC enforcement
for the investment management community will
be the SEC’s creation last month of an “Asset
Management Unit” in its Division of Enforcement.
This will be a specialized unit that will team
attorneys and investigators at headquarters and
in SEC offi ces around the country, and that will
focus exclusively on possible violations involving
asset managers. The SEC is presently considering
candidates to head the new unit, which it has
promised will be operational within the next
couple of months.
Historically, enforcement lawyers at the SEC have
had only passing knowledge of the requirements
of the Investment Company Act of 1940 and the
investment management industry. Things will now
be different. The new Asset Management Unit
will build in-house expertise – through training
and focused experience, as well as by hiring
specialists from outside. While the new unit
will not handle every investment management
matter, it will centrally plan and execute the
bigger investigations and cases in this area, and
it will also serve as a resource for enforcement
attorneys facing investment management and
1940 Act issues in other parts of the Enforcement
Division, particularly on technical questions such
as valuation matters.
While the new unit will generate its own
investigations, it will also coordinate more closely
with its traditional sources for cases – colleagues
doing inspections in the Offi ce of Compliance
Inspections and Examinations (OCIE) and experts
in the Division of Investment Management. The
Enforcement Division has worked with OCIE
to set up an internal hotline for its examiners
to use if they feel that anyone is attempting
to intimidate them, a clear “red fl ag” in the
Enforcement Director’s view. OCIE is enrolling
staff in a certifi ed fraud examiner program, and
generally taking a more aggressive stance in its
examinations, for example by reaching out to
clients and custodians for “third-party verifi cation”
of what fi rms are saying.
The SEC Enforcement Division’s new interest in
the investment management world comes as the
Division is making fundamental changes in its
organization and procedures, with the overall
theme of empowering staff to undertake bolder
initiatives with fewer approvals. Some of the
more important changes include the following:
• Staff Authorizing Investigations: Previously,
the fi ve SEC commissioners had to vote on a
staff recommendation for a so-called “formal
order” to initiate a “formal” investigation
with subpoena power to compel testimony
and document production. Now, such
formal orders will be issued by any senior
offi cer (the top management rank) in the
Enforcement Division and without Commission
review or authorization. This will speed up
investigations by making it easy for the staff to
get subpoena power, and likely increase the
number of formal investigations. When formal
orders were issued by a vote of the fi ve SEC
commissioners, companies often felt a need
to make disclosure, and this would sometimes
result in press reports that the SEC had
“elevated” an investigation to “formal” status.
Responding to heavy criticism from the Hill and the media, the SEC is in the midst of reinventing
its enforcement program. Featured prominently in this effort are investment advisers, investment
companies, hedge funds and private equity funds. In recent Senate testimony, the SEC’s new
Enforcement Director Robert Khuzami focused Congress on his concern that asset managers
“are responsible for an ever-growing percentage of invested assets, and [that] the lines between
different entities involved in these markets are blurring and overlapping.”
SEC Enforcement’s New Focus on Asset ManagementBy Stephen J. Crimmins
The most important change in SEC enforcement will be the SEC’s creation last month of an Asset Management Unit.
Fall 2009 5
With formal orders now being issued on a
far more casual basis simply by Enforcement
Division staff members, judgments may differ
on when disclosure is required. SEC guidance
on this point would be useful.
• Tools to Encourage Cooperation: The
enforcement staff will be able to offer
new incentives for individuals and entities
to cooperate with its investigations. In a
departure from past practice, staff will now
provide informal oral “assurances” that a
person has “witness” status and that, based
on known facts and in some cases a witness
proffer, the Enforcement Division does not
intend to recommend enforcement action.
While the “witness” versus “target” distinction
has long been a part of criminal practice,
SEC attorneys previously lacked authority
to indicate a person’s status, and this often
inhibited full cooperation. There will also be
formal cooperation agreements under which
the Division will agree to bring a person
or entity’s cooperation to the Commission’s
attention in any subsequent enforcement
recommendation, and in some cases to specify
what the Division’s recommendation will be
as to the cooperator. Finally, taking another
page from criminal practice, there will be
deferred prosecution agreements under which
the Commission itself will agree not to proceed
against an individual or entity in return for an
agreement to implement specified procedures
and to waive statutes of limitation to assure
ongoing compliance.
• Determination of Penalty Amounts: The SEC
has dropped its so-called “pilot” program
that required its staff to get pre-clearance
before negotiating penalty amounts to settle
enforcement actions. Staff will now be able to
set an amount they feel appropriate under the
circumstances and then, with the defendant’s
agreement, simply present the final settlement
to the Commissioners for implementation.
• Removal of a Layer of Supervision: The
Enforcement Division is in the process of
eliminating its branch chief position. Branch
chiefs were more experienced attorneys who
typically supervised about four junior staff
members. Branch chiefs, in turn, reported to
assistant directors. Under the reorganization,
line staff will now report directly to an assistant
director, though the assistant director will now
oversee fewer people. Further to the goal
of speeding investigations, the Enforcement
Division has announced that case decisions that
previously required Deputy Director approval
will now be made by senior officers throughout
the Division; that defense lawyers can expect
to get fewer meetings with managers on
cases; and that staff memos to Commissioners
recommending enforcement actions will be
shorter and subject to fewer reviews.
• Increase in Enforcement Staff: The SEC has
“reprogrammed” funds in its current fiscal
year for a modest increase in enforcement
staff, and it expects to significantly increase
staff with more generous appropriations (and
possibly some form of self-funding) in the years
immediately ahead. This reverses a trend that
saw SEC enforcement staff decline by 10%
between 2005 and 2007.
Plainly the SEC Enforcement Division’s
heightened interest in investment management
issues, coupled with the organizational changes
designed to empower enforcement staff,
means that we have entered a period requiring
increased attention to legal requirements. As
always, the best first line of defense in dealing
with stronger enforcement will be recruiting
and retaining personnel who can competently
handle compliance issues, the establishment
and maintenance of quality policies and
procedures tailored to a particular entity’s
business and operations, and a continuing
message from management that compliance is
an organizational priority.
Mr. Crimmins spent 14 years with the SEC’s
Enforcement Division and, as Deputy Chief
Litigation Counsel, co-managed its civil litigation
program. You may reach him at stephen.
crimmins@klgates.com or 202-778-9440.
6 Investment Management Update
• Advisers to hedge funds, private equity fi rms,
and other private pools of capital would have
to register with the SEC (unless state regulated).
The legislation would eliminate the exemption
from registration under Section 203(b)(3)
of the Investment Advisers Act of 1940, as
amended, for advisers with fewer than 15
clients. It would also eliminate other exemptions
for advisers of “private funds,” including from
under the exemptions for intrastate advisers and
commodity trading advisers. “Private fund” is
defi ned in the legislation as a U.S. fund (U.S.
organized or 10% owned by U.S. persons) with
no more than 100 investors or an issuer owned
exclusively by qualifi ed persons (referencing
Sections 3(c)(1) and (7) of the Investment
Company Act of 1940, as amended). However,
advisers would not be required to register if they
are a “foreign private fund adviser,” defi ned as
having no U.S. place of business, fewer than 15
U.S. clients, and under $25 million in managed
assets attributable to U.S. clients.
• The legislation allows the SEC to defi ne the
term “venture capital fund” and to provide an
exemption from registration for an adviser to
such a fund. However, the SEC would still have
the power to require such advisers to maintain
records and provide reports to the SEC.
• The SEC would be authorized to require
registered advisers to maintain records and
make SEC fi lings concerning “private funds” that
the SEC deems appropriate to protect investors
and, in consultation with the Federal Reserve, to
assess the systemic risk these advisers present.
These records and reports “shall include” the
adviser’s amount of assets under management,
its use of leverage, its counterparty credit risk
exposures, its trading and investment positions,
and its trading practices. The SEC would be
allowed to modify reporting requirements based
on the particular types or sizes of private funds
advised, e.g.¸ by varying requirements for
hedge funds and for private equity funds.
• The SEC would have the power to require
advisers to provide to investors, prospective
investors, counterparties and creditors, such
disclosures concerning their private funds as the
SEC deems appropriate.
Declaring that “we need to ensure that everyone who swims in our capital markets has an
annual pool pass,” the Chairman of the House Financial Services Subcommittee on Capital
Markets, Representative Paul E. Kanjorski (D-PA), has introduced legislation to require the
registration of all domestic investment advisers. The legislation, called the Private Fund
Investment Advisers Registration Act, has the following principal features:
• The SEC would be authorized to conduct
periodic, special and other examinations
of private fund advisers. Where the SEC
determined that the materials it obtains were
necessary to assess the systemic risk presented
by a private fund, the SEC would have to make
them available to the Federal Reserve and other
regulators with systemic risk responsibilities.
The legislation would eliminate the provision
in Section 210(c) of the Advisers Act that
prevents the SEC from obtaining, outside of the
enforcement context, the identity, investments, or
affairs of any client of an investment adviser.
• The legislation provides that the SEC may
determine not to disclose certain information it
obtains concerning private funds, but stipulates
that the SEC may not withhold such information
from Congress, from a federal agency or an
SRO acting within its scope of responsibility, or
in response to a federal court order in a case
fi led by the SEC or the Justice Department.
The latter provision raises the prospect that
defendants in SEC civil enforcement cases
may be able to obtain court discovery orders
for otherwise confi dential information, but
subject to court-imposed limitations on use of
such information.
Kanjorski Bill to Register AdvisersBy Stephen J. Crimmins
Advisers to hedge funds, private equity fi rms, and other private pools of capital would have to register with the SEC
Fall 2009 7
At the same time, Chairman Kanjorski introduced
two related pieces of legislation. The fi rst, the
Investor Protection Act, would double the SEC’s
budget over fi ve years and give the SEC new
enforcement powers. The Act would also subject
broker-dealers to the same fi duciary duty to their
customers as investment advisers, create an
expanded whistleblower bounty program, allow
the SEC to forbid mandatory arbitration clauses,
and authorize the PCAOB to examine auditors
of broker-dealers even if they are not public
companies. It would also direct a
“comprehensive study of the entire securities
industry by a high caliber body” to identify and
implement further reforms.
The other legislation proposed by Chairman
Kanjorski, the Federal Insurance Offi ce Act,
would develop expertise at the federal level
concerning insurance products, assess and
mitigate systemic risks from such products, and
coordinate with foreign insurance regulators.
The new Federal Insurance Offi ce would be part
of the Treasury Department.
The SEC would have the power to require advisers to provide to investors, prospective investors, counterparties and creditors, such disclosures concerning their private funds as the SEC deems appropriate.
For several decades, the K&L Gates Investment Management practice has been ranked in the top tier
of investment management practices, providing premier legal counsel to the investment company
industry. We have over 100 lawyers practicing in 14 offi ces across three continents who provide
services to the registered fund industry.
We represent clients in connection with the full range of investment company industry products and
activities, including all types of open-end and closed-end investment companies, exchange-traded
funds, funds-of-funds, funds-of-hedge funds, variable insurance products, and unit investment trusts.
Our clients run from start-up managers and specialized fi rms to some of the largest fund managers
in the world. As the industry has developed, grown and innovated, our lawyers have been at the
forefront of those developments.
From creation and registration with the SEC, to distribution, day-to-day compliance, sale, merger and
consolidation of funds, K&L Gates is well-versed in all legal issues relating to registered funds, as well
as all aspects of operations.
Practice HighlightRegistered Investment Companies Practice
8 Investment Management Update
CFTC and SEC HarmonizationBy Molly Moynihan
On October 16, 2009, the SEC and the CFTC released the Joint Report of the SEC and the
CFTC on Harmonization of Regulation. The Report contains 20 recommendations, including
proposals to:
• impose a uniform fi duciary duty on
intermediaries who provide similar services for
futures or securities,
• grant the SEC specifi c statutory authority for
aiding and abetting under the Securities Act and
the Investment Company Act,
• enhance customer protection and the authority to
deal with insider and disruptive trading,
• address portfolio margin accounts, and
• expedite judicial review of jurisdictional disputes.
In addition, the Report recommends creation of
a Joint Advisory Committee and a Joint Agency
Enforcement Task Force, and contains various
proposals for sharing and joint training of staff.
The Report is broken down into two main sections.
The fi rst is a lengthy review of CFTC and SEC
regulatory approaches, focusing on eight areas
of concern: (i) product listing and approval;
(ii) exchange/clearinghouse rule changes; (iii)
risk-based portfolio margining and bankruptcy/
insolvency regimes; (iv) linked national market
and common clearing contrasted with separate
markets and exchange-directed clearing; (v)
market manipulation and insider trading; (vi)
customer protection standards applicable to
fi nancial advisers; (vii) regulatory compliance by
dual registrants; and (viii) cross-border regulatory
matters. The second section provides 20 specifi c
recommendations, divided into four categories:
Markets, Financial Intermediaries, Enforcement and
Operational Coordination. The recommendations
include 12 recommendations that would require
legislative action and 8 actions that the agencies
could take themselves.
In preparation for the Report, the two agencies
conducted extensive inter-agency discussions and
held their fi rst ever joint meeting on September
2-3, 2009 to address harmonization of regulation.
While the Report contains a number of concrete
proposals, most of these will require new
legislation, and other important issues were left on
the table, suggesting that true harmonization is still
very much a work in progress.
This article briefl y summarizes the recommendations
and related areas of concern identifi ed in the Report.
Uniform Fiduciary StandardThe Report recommends legislation to impose
a uniform fi duciary duty on intermediaries who
provide similar investment advisory services
regarding futures or securities. The agencies
recommend that a consistent standard apply to
any commodity trading advisor (CTA), futures
commission merchant (FCM), introducing broker
(IB), broker-dealer, or investment adviser who
provides similar investment advisory services. The
recommendation is consistent with other legislative
efforts to establish a uniform standard of conduct
for broker-dealers and investment advisers,
including Title IX of the Administration’s fi nancial
regulatory reform legislation.
Aiding and AbettingThe CFTC already has specifi c statutory
enforcement authority for aiding and abetting any
violation of the Commodity Exchange Act (CEA)
or CFTC rules or regulations. The Report proposes
legislation to grant the SEC specifi c statutory
authority for aiding and abetting under the
Securities Act and the Investment Company Act,
which would make those statutes consistent with
the Securities Exchange Act and the Investment
Advisers Act.
The Report contains a raft of proposals to enhance cooperation and coordination between the two agencies.
Fall 2009 9
basis of material non-public information from any
governmental authority, for example, misuse of
material non-public information from the Treasury
Department, the Department of Agriculture and the
Federal Reserve.
Portfolio MarginingA major area of concern identified during the
public hearings relates to portfolio margining.
Currently, futures positions may not be included in
a securities customer portfolio margining account.
Many market participants have argued that the
CFTC and SEC should resolve the issue of whether
and how futures should be included in a portfolio
margin account, and generally permit customers
to margin all related instruments in one account.
It is thought that the ability to margin all related
instruments in one account would allow customers
to better manage risk and capital efficiencies
across their entire portfolio.
In response, the Report recommends legislation
to facilitate the holding of (i) futures products in
an SRO securities portfolio margin account and
(ii) securities options, securities futures products,
and certain other securities derivatives in a
futures portfolio margin account. The Report also
suggests that the two agencies review their existing
customer protection, margin and any other relevant
regulations to determine whether any rule changes
or exemptive relief would be necessary to achieve
the full benefits of risk-based portfolio margining.
Finally, the Report suggests that the agencies
explore, with input from experts, the industry,
and the public, whether further modifications
to portfolio margining, including adoption of a
one-account model that would accommodate all
financial instruments and all broker-dealers and
FCMs, would be in the public interest.
Rule Changes and Introduction
of New ProductsCurrently, if a financial product has attributes of
both securities and commodities, introduction
of the product can face significant delays
while regulators determine whether the product
should be regulated by the SEC or the CFTC.
Market Manipulation and
Disruptive Trading Both the CEA and the Securities Exchange Act
prohibit market manipulation. However, the
different nature of the securities and futures markets
and their regulatory regimes has resulted in two
very different approaches to the issue. In cases
involving securities, manipulation usually involves
false statements or a “pump and dump” scheme
to manipulate price for trading advantage.
Commodities cases, on the other hand, typically
involve the use of market power to force the short
side of a transaction to deal with the long side on
terms created by the long side.
Because of the different nature of the markets,
different approaches may be inevitable. However,
the Report notes that certain practices are so
disruptive to trading in the futures market that they
should be presumptively prohibited. Accordingly,
the Report recommends legislation to enhance
the CFTC’s enforcement authorities with respect to
disruptive practices that undermine market integrity
and the price formation process in the futures
markets, although these “disruptive practices” are
not specified.
Insider Trading The securities laws contain strong prohibitions
against corporate insider trading on the basis of
material, non-public information, which do not
have a counterpart under the CEA. The CEA
only prohibits insider trading on single stock
futures, primarily because the concept of an
“insider” (with its attendant fiduciary obligations)
is not typically applicable to futures instruments,
such as commodities, and because it is expected
that end users will hedge in the futures markets
on the basis of information known only to the
user. However, the commodities laws do contain
prohibitions against misusing information, for
example by entering into proprietary trades based
on information about a customer’s order.
In an incremental approach to expanding insider
trading prohibitions under the CEA, the Report
recommends legislation to amend the CEA to make
unlawful the misappropriation and trading on the
The Report recommends legislation that would
provide a process for expedited judicial review
of jurisdictional matters regarding new products.
Specifically, the legislation would establish and
clarify: (i) legal certainty with respect to the
agencies’ authority over products exempted by the
other agency; and (ii) a review process to ensure
that any jurisdictional dispute is resolved by the
agencies against a firm time line. Notably, the
two agencies did not propose that another
financial regulator, such as the Treasury,
adjudicate such disputes.
A central source of competitive inequality
between the two regulatory regimes is thought to
arise from the fundamentally different operating
principles guiding the SEC and CFTC. The
CFTC has operated under a “principles-based”
regulatory approach for the exchanges and
clearing organizations under its jurisdiction.
The governing statute of the CFTC, the CEA,
sets forth separate sets of “core principles” for
exchanges and clearing organizations. While
all futures exchanges and clearing organizations
must adhere to the core principles applicable
to them, they are given considerable discretion
in determining how they will do so. In addition,
the CFTC sets regulatory objectives for regulated
entities. SROs may establish or change their own
rules by certifying to the CFTC that the new rule
complies with the CEA. In contrast, where the SEC
is involved, SROs are subject to a “rules-based”
regulatory approach, under which each new or
amended SRO rule must be approved by the SEC.
The Report recommends legislation to enhance
CFTC authority over exchange and clearinghouse
compliance with the CEA, asserting that the
CFTC currently lacks sufficient authority to ensure
that exchanges and clearinghouses it regulates
are operating within the principles, rules and
regulations established under the CEA, are able
to adapt to market conditions and international
standards, and protect the public. The Report
recommends that the CEA be amended to provide
the CFTC with clear authority with respect to
exchange and clearinghouse rules that the CFTC
determines are necessary to comply with the CEA.
10 Investment Management Update
Investor Protection IssuesThe Report contains recommendations linked to
investor protection covering conflicts of interest,
restitution and whistleblower protections. The
Report recommends legislation to authorize the
CFTC to require FCMs and IBs to implement
conflict of interest procedures that would separate
the activities of persons in a firm engaged in
research or analysis of commodity prices from
those involved in trading or clearing activities.
The CFTC currently has express authority to seek
restitution for investor losses in administrative
proceedings. The Report recommends legislation to
clarify that restitution in CFTC enforcement actions
is defined in terms of the losses sustained by
persons as a result of the unlawful conduct.
The recommendations do not deal directly with the
key concerns of differing treatment of segregation
of assets and insolvency.
Recordkeeping and
Disclosure Issues The Report contains three recommendations
aimed at harmonizing recordkeeping and
disclosure requirements.
First, it recommends that the SEC and the
CFTC undertake to align their record retention
requirements for intermediaries by harmonizing
the length of time records are required to be
maintained. The Report envisages that the general
CFTC record retention standard of five years may
be adopted by both agencies.
Second, the Report recommends that the agencies
undertake to provide greater consistency in their
customer risk disclosure documents. Specifically, the
SEC indicated that it may consider amending the
requirements for the Options Disclosure Document
(ODD). One panelist complained that the ODD can
exceed 100 pages, and should be more like the
futures disclosure of two or
three pages.
Third, the Report recommends that the CFTC and
the SEC review regulatory requirements applicable
to investment advisers and CTAs/commodity pool
operators (CPOs) with respect to private funds
to eliminate, as appropriate, any inconsistent
or conflicting provisions regarding: (i) the use
of performance track records; (ii) requirements
applicable to investor reports (including the
financial statements often used by registered
investment advisers to comply with the Investment
Advisers Act custody rule and the financial
statements delivered to investors by CPOs); and
(iii) recordkeeping requirements.
Cross-Border IssuesThe Report recommends that the SEC review its
approach to cross-border access to determine
whether greater efficiencies could be achieved
with respect to cross-border transactions in
securities which would be consistent with the
protection of investors and the public interest.
The Report also recommends legislation to
empower the CFTC to require any foreign board
of trade that seeks to provide direct access to
members or other participants located in the
United States to register with the CFTC. When
appropriate, the Report suggests relying on the
applicable foreign regulator to avoid duplicative
regulation.
Coordination between
the Two AgenciesFinally, the Report contains a raft of proposals to
enhance cooperation and coordination between
the two agencies. These include:
• A Joint Advisory Committee to identify emerging
regulatory risks and assess and quantify their
implications for investors and other market
participants, and provide recommendations for
solutions.
• A Joint Agency Enforcement Task Force
to harness synergies from shared market
surveillance data, improve market oversight,
enhance enforcement, relieve duplicative
regulatory burdens, and oversee temporary
details of personnel.
• A joint cross-agency training program for staff
that would focus on enforcement matters.
• A program for the regular sharing of staff
through detailed assignments.
• A Joint Information Technology Task Force to
pursue linking publicly filed information on
CFTC and SEC regulated persons to create a
comprehensive, consolidated database.
Overall, the Report represents a serious effort to
meet the challenges posed by harmonization.
Chairman Gensler has repeatedly expressed
his commitment to the process and the need to
lower risk throughout the system and increase
transparency. Chairman Schapiro has been
somewhat more muted than Chairman Gensler,
perhaps because the SEC is the dominant
regulator. Now that the agencies have spoken,
continued progress towards harmonization will
require both coordinated rule-making by the two
agencies as well as legislative changes that
will require cooperation between the two major
committees in Congress that govern securities
and commodities.
The Report contains recommendations linked to investor protection covering conflicts of interest, restitution and whistleblower protections.
Fall 2009 11
SEC Staff Conditionally Allows Foreign Funds to Invest in U.S. Funds in Excess of Anti-Pyramiding Limitations of 1940 ActBy Gwendolyn A. Williamson
The SEC staff has broken new ground by allowing foreign investment companies (Foreign
Funds) to buy up to three percent of the voting securities of domestic registered investment
companies (U.S. Funds) without complying with the anti-pyramiding limitations of Section 12(d)
(1)(A)(ii) and (iii) of the 1940 Act. In a recent no-action letter, the staff determined that the
restrictions of Section 12(d)(1)(A)(ii) and (iii)—which generally prevent an investment company
from investing more than fi ve percent of its total assets in any one investment company and from
investing more than ten percent of its total assets in investment companies in the aggregate –
would not apply to Foreign Funds under certain circumstances. The no-action request was made
on behalf of U.S. Funds seeking to provide investors of Foreign Funds access to a diversifi ed
fund portfolio by supplementing or replacing direct investments in U.S. securities markets. The
request letter is available on the SEC’s website, www.sec.gov, under the Division of Investment
Management’s link to its staff no-action and interpretive letters.
Considering the legislative history of Section 12(d)
(1), the SEC staff wrote that Congress aimed to
curtail, among other practices, “pyramiding of
voting control in the hands of persons that owned
only a nominal stake in an acquired company…
and the ability of the acquiring company to
exercise undue infl uence over the adviser of the
acquired company through the threat of large-
scale redemptions and the concomitant loss of
advisory fees.” The SEC staff reasoned that as
long as a Foreign Fund limits its holdings to no
more than three percent of the voting securities of
a U.S. Fund, as required by Section 12(d)(1)(A)(i),
removing the fi ve and ten percent limitations
of Section 12(d)(1)(A)(ii) and (iii) would not subject
U.S. shareholders to the risks envisioned by Congress.
The SEC staff also seemed to be persuaded that
there is no need to apply the federal securities
laws for the protection of foreign investors in these
circumstances. While noting that Section 12(d)(1)
refl ects Congressional concern that shareholders
could be negatively affected by duplicative fees
and unnecessarily complex investment strategies
and/or portfolio composition, the staff response
seemed to recognize that Congress had little
regulatory interest in protecting Foreign Funds and
their shareholders from such abuses.
The SEC staff’s assurance of no action under the
facts and representations presented in the Foreign
Fund request letter also was based on adherence
to the following conditions:
• Compliance with the restrictions of Section 12(d)
(1)(A)(i) of the 1940 Act. Foreign Funds may
not purchase more than three percent of a U.S.
Fund’s outstanding voting securities.
• Agreement to not offer or sell securities in the
U.S. or to any U.S. Person. In order to rely
on the no-action letter, an acquiring Foreign
Fund could not offer or sell its securities to U.S.
Persons as defi ned in Rule 902(k) of Regulation
S under the Securities Act of 1933. This group
generally includes individuals residing in the
U.S., partnerships and corporations organized
in the U.S., trusts and estates administered by
U.S. Persons, agencies and branches of foreign
governments located in the U.S., accounts
held for the benefi t of a U.S. Person or by
a fi duciary residing in the U.S., and foreign
partnerships and corporations formed by a U.S.
Person for the purpose of investing in securities
not registered under the Securities Act, unless
organized by accredited investors who are not
individuals, trusts, or estates.
The no-action relief provided by the SEC staff has the potential to attract foreign investors to U.S. Funds.
12 Investment Management Update
• Commitment to transacting offshore. Each
transaction made in reliance on the no-action
letter must be consistent with the defi nition of
“offshore transactions” set forth in Rule 902(h)
of Regulation S: an offer or sale of securities
occurs offshore if (1) the offer is not made to a
person in the U.S., and (2) either (A) the buyer
is not in the U.S. when the purchase order is
placed, or the seller reasonably believes the
buyer is outside the U.S. at that time, or (B) the
transaction is carried out through an established
foreign exchange located outside the U.S. or
through a designated offshore securities market,
and the seller does not know that the transaction
has been prearranged with a U.S. buyer.
• Compliance with the restrictions of Section 12(d)
(1)(B) of the 1940 Act. Each U.S. Fund involved
in a transaction relying on the no-action letter
must adhere to the requirements of Section 12(d)
(1)(B), which generally prohibits any registered
open-end investment company, its principal
underwriter, and any registered broker/dealer
from knowingly selling securities if the sale
would cause more than three percent of its
outstanding voting securities to be acquired
or more than ten percent of its securities to be
owned by other investment companies in
the aggregate.
Implications for U.S. Funds. The no-action relief
provided by the SEC staff has the potential to
attract foreign investors to U.S. Funds. Especially
in light of the economic turmoil of the last year, this
should come as good news for funds interested
in securing new foreign investments or increasing
the investments of existing foreign investors. It
also creates new opportunities for Foreign Funds,
expanding their ability to invest in the U.S. mutual
fund market.
Any U.S. Fund issuing shares to a Foreign Fund
in reliance on the no-action letter should consider
whether its compliance program under Rule
38a-1 requires modifi cation to ensure compliance
with the conditions imposed by the SEC staff. In
addition, a U.S. Fund’s board and management
would be wise to keep an eye to the possibility
that funds and shareholders could be impacted, in
ways both previously addressed and unforeseen,
by the augmented ability of Foreign Funds to
acquire U.S. Fund shares.
The SEC staff also seemed to be persuaded that there is no need to apply the federal securities laws for the protection of foreign investors in these circumstances.
Fall 2009 13
TaxUpdate
The IRS has recently issued two pieces of guidance clarifying the tax treatment of investments by regulated
investment companies (“RICs”) in public-private investment partnerships (“PPIPs”).
Recent IRS Guidance Clarifi es Tax Treatment of RIC Investments in Public-Private Investment ProgramBy Thomas F. Joyce and Roger S. Wise
Background on PPIPsThe public-private investment program is one of the
initiatives implemented by the Treasury Department
as part of its Financial Stability Plan in connection
with the Emergency Economic Stabilization Act of
2008 (the “EESA”). Under the Legacy Securities
Program (initiated under authority of the EESA), the
Treasury Department will invest in PPIPs—generally
in the form of debt and equity—alongside private
investors. These partnerships will purchase “Legacy
Securities,” which are certain eligible commercial
mortgage-backed securities and certain eligible
non-agency residential mortgage-backed securities
issued prior to 2009 that were originally rated
AAA. The rationale for the program is that these
securities, though trading at reduced prices, could
ultimately perform.
Each PPIP is generally structured in the same
manner, with Treasury investing directly, and
private investors investing through one or more
feeder funds. Some of these feeder funds are RICs.
Income and Assets TestsA fund must satisfy an annual income test and
quarterly asset diversifi cation tests in order to
qualify for treatment as a RIC under the Internal
Revenue Code of 1986, as amended (“Code”).
The Code already makes clear that a RIC may
“look through” a partnership in which it invests
for purposes of satisfying the income test. Thus, if
a RIC invests in a partnership, the RIC may treat
the items of income included in its allocable share
of partnership’s income as “good” income under
these tests to the extent that those items would have
so qualifi ed if the RIC had earned that income
directly. However, there is no explicit statutory
support for asset diversifi cation “look through.”
Revenue Procedure 2009-42, 2009-40 I.R.B.
459, issued on September 9, 2009, permits a
RIC to “look through” to the underlying assets of
a PPIP in which it invests for purposes of satisfying
the quarterly asset diversifi cation tests set forth in
section 851(b)(3) of the Code.
Earlier guidance issued by the IRS had generally
permitted RICs that invest in partnerships to rely on
a similar “look through” approach for purposes of
the quarterly asset diversifi cation tests. However,
that guidance imposed a number of conditions,
including, among other items, a requirement
that the RIC’s allocable share of each item of
the partnership’s income, gain, loss, deduction
and credit be proportionate to its ownership
interest therein. However, Revenue Procedure
2009-42 imposes no such restrictions on the
partnership allocations, and one can surmise that
it was issued, in part, to allow the “look through”
approach described above despite the fact that
the RIC invests in a PPIP that provides for special
allocations to certain partners. (The capital
structure and operating rules of a PPIP may make
special allocations unavoidable, and any special
allocation must be agreed to by the Treasury
Department in its capacity as an investor.) Thus,
while the Revenue Procedure’s conclusion is an
important, and likely justifi able, departure from
historical agency practice in light of the current
extraordinary economic circumstances, it probably
should not be read as relaxing or liberalizing the
theoretical underpinnings that informed the IRS’s
traditional, conservative position on this question.
Investors in partnerships outside the PPIP context or
PPIP investors that do not fi t the mold of Revenue
The rationale for the program is that these securities, though trading at reduced prices, could ultimately perform.
14 Investment Management Update
Procedure 2009-42—to fi t within the scope of the
Revenue Procedure, a RIC must invest at least 70%
of its original assets (including seed capital and
net proceeds from an initial public offering) as a
partner in one or more PPIPs—the limitations of the
IRS’s historical guidance on these issues will need
to be kept in mind.
Taxable Mortgage PoolsA real estate mortgage investment conduit
(“REMIC”) is a special vehicle under the Code
for the issuance of mortgage-backed securities.
To ensure that multi-tranche offerings of mortgage-
backed securities are done only through REMICs,
the Code provides that an entity, or a portion of
an entity, that primarily holds mortgages secured
by real property and issues debt with more than
one maturity tied to those mortgages (a “taxable
mortgage pool” or “TMP”) will be treated as a
corporation if it does not elect REMIC status. That
is, the TMP rules essentially force securitization
vehicles to elect REMIC status by subjecting them
to a corporate-level tax if they do not.
A PPIP could meet the defi nition of a TMP because
it will hold mortgages secured by real property.
The PPIP will issue one tranche of debt to the
Treasury Department under the public-private
investment program, and may issue additional
tranches of debt–perhaps also to the Treasury
Department under other programs established
pursuant to the stimulus bill. Treating such a PPIP as
a TMP–taxable as a corporation–would defeat (or
impede) the purpose of the program.
Revenue Procedure 2009-38, 2009-37 I.R.B.
362, issued on August 27, 2009, provides that
a PPIP will not be treated as a TMP so long as it
holds Legacy Securities and the U.S. Government
owns a “signifi cant equity interest” in the fund.
Although signifi cant equity interest is not defi ned, it
seems reasonable to presume that the 50% equity
interest that is typical for PPIPs would suffi ce. This
guidance also applies to other entities (i.e., feeder
funds), and portions thereof, that invest substantially
all of their assets in a qualifying PPIP.
Revenue Procedure 2009-38 is somewhat unusual
in that it is more of a “no-action” letter than a
statement of the IRS’s interpretation of the law. In
the Revenue Procedure, the IRS merely states that
it will not assert that a PPIP or related entity is
a TMP.
the Revenue Procedure’s conclusion... probably should not be read as relaxing or liberalizing the theoretical underpinnings that informed the IRS’s traditional, conservative position
Fall 2009 15
of Madoff’s business, Madoff’s strategy, basic
custody issues, or equity and options trading.
Examiners from the SEC’s Offi ce of Compliance
Inspections and Examinations (“OCIE”) testifi ed
that many of them were not familiar with securities
laws, that they had no training, and that they
focused on front-running because that was
their area of expertise. Accordingly, the Report
concluded that, although Madoff provided evasive
and inconsistent answers during questioning, the
SEC staff did not appreciate that he never gave a
logical explanation for his infl ated claimed returns
and accepted his claim that they were due to his
“gut feel” for the market.
The Report identifi es a series of problems with
bureaucracy and administration at the SEC.
Despite the seriousness of complaints, the SEC
was slow in responding, delaying nine months
from the receipt of one complaint before initiating
an inquiry. Because one complainant stated
that he had withdrawn his money from Madoff,
no review or analysis of the complaint was
deemed necessary. Although questions were still
unanswered following an SEC examination of
Madoff in 2004, the examiners responsible for
that examination were shifted to different projects.
There was so little sharing of information between
SEC offi ces that examiners from one SEC offi ce
learned from Madoff himself that a parallel “for
cause” examination was being conducted by
another offi ce of the SEC.
Litany of SEC Failures According to the Report, the SEC failed to
investigate credible complaints adequately, did not
suffi ciently prepare for examinations, conducted
examinations that were too narrow in scope,
and staffed examinations with inexperienced or
inappropriate personnel. SEC staff also did not
follow up on contradictory statements made by
Madoff, did not obtain third-party verifi cation
of Madoff’s trading, and did not understand
Madoff’s strategy or operations. The Report also
faults bureaucratic hurdles and lack of information
sharing between SEC offi ces and divisions.
More particularly, “perhaps the most egregious
failure” of the SEC’s investigations, according
to the OIG, was the failure to obtain third-party
verifi cation of Madoff’s trading. The Report noted
that the SEC failed to follow up on reports that
were inconsistent with Madoff’s claims. More than
once, a fi nancial institution that Madoff claimed
to use for trading responded that Madoff had
conducted no transactions for the relevant time
period, but the SEC did nothing in response. Over
the years, the SEC staff drafted several requests
for information from third parties that were never
sent; SEC examiners accepted copies of third-party
records from Madoff himself; and SEC examiners
declined to seek trade data from the NASD or
audit trail data because it would have taken “a
ton of time” to review. Even Madoff thought the
jig was up when the SEC asked for his Depository
Trust Company account number in 2006; to his
surprise, the SEC never contacted DTC to verify
his trading.
The Report also faults the staffi ng and scope of
SEC inquiries. The SEC staff was so focused on
front-running, investment adviser registration and
the adequacy of disclosures, according to the
Report, that they were oblivious to the fraud in front
of them. Examination teams were inexperienced
and simply did not comprehend the fundamentals
continued from page 1
The SEC Inspector General’s Report on the SEC’s Failures to Catch Madoff, and the SEC’s Resulting Internal Enforcement Reforms
The Report also noted a number of ways in which
the failure to catch Madoff was infl uenced by
human bias, including Madoff’s stature within
the investment community. Madoff determined
which of his employees were interviewed by SEC
examiners, pushed the examiners to fi nish their
investigation, and intimidated junior examiners
by name-dropping higher-ups at the SEC. Though
they caught Madoff lying, SEC examiners simply
accepted Madoff’s answers to their questions,
including his assertion that he did not take a
performance fee from his funds because he was
“not greedy.” Personal feelings also played a
role - because a branch chief personally disliked
Harry Markopolos, an independent fi nancial
fraud analyst and a persistent and compelling
complainant, he “declined to even pick up the
‘several inch thick fi le folder’ on Madoff that
Markopolos offered” and ignored Markopolos’
offers of additional evidence.
The Report also concluded that the SEC staff failed
to appreciate the signifi cance of numerous red
fl ags, including Madoff’s extreme secrecy, unusual
fee structure, and consistent, nonvolatile returns
despite his unremarkable trading strategy. Madoff’s
returns did not correlate to the overall equity
markets in over ten years, his strategy was not
duplicable by anyone else, and the staff ignored
evidence that his auditor was a related party. The
volume of options Madoff was trading was not
visible in the marketplace, and it was impossible
for Madoff to have found a counterparty to handle
the volume of his ostensible options trading, but the
SEC staff was not sophisticated enough to detect
this and ignored repeated complaints and tips
urging the SEC to focus on these issues. Finally,
Madoff’s incomplete or contradictory responses to
SEC inquiries and behavior during investigations
SEC examiners declined to seek trade data from the NASD or audit trail data because it would have taken “a ton of time” to review.
16 Investment Management Update
should have caused the SEC staff to push harder;
instead, it simply backed off.
The Chairman’s Statement The day the Report was released, Chairman
Schapiro released a statement detailing the
measures the SEC had already taken in the
aftermath of the Madoff catastrophe. Chairman
Schapiro noted that the SEC has proposed new
rules to safeguard investors’ assets and to require
surprise audits and has pushed for legislation
to compensate whistleblowers. Additional
changes were further detailed in the testimony
of Robert Khuzami before the Senate a week
later, such as improving the handling of tips,
putting experienced people on the ground, hiring
people with certain skills, increasing training, and
requesting more resources.
The SEC Response The SEC Director of Enforcement testified before
the U.S. Senate Committee on Banking, Housing
and Urban Affairs on September 10, 2009
with a number of responses to the Report. At the
administrative and structural level, the SEC plans
to reduce management by 40% so that more
senior-level employees can participate hands-on
in investigations. A chief operating officer will
transfer administrative and infrastructure tasks to
operations personnel and away from investigative
personnel. The SEC is also conducting internal
reviews with the goal of eliminating bureaucratic
processes and maximizing resources.
Enforcement Response The Enforcement Division is creating five
specialized units: (1) Asset Management, which
will focus on investment advisers, hedge funds,
and private equity funds (see SEC Enforcement’s
New Focus on Asset Management, also in
this newsletter); (2) Market Abuse, focusing on
large-scale abuses and manipulation schemes;
(3) Structured and New Products, specializing in
complex derivatives and financial products; (4)
Foreign Corrupt Practices Act; and (5) Municipal
Securities and Public Pension, aimed at abuses
such as pay-to-play schemes. In addition, an
Office of Market Intelligence will be created
within the Enforcement Division to improve the
handling of tips and complaints.
OCIE Response OCIE is now emphasizing fraud detection in
addition to identifying violations of securities laws.
It hopes to fill new “Senior Specialized Examiner”
positions with professionals having experience
in areas such as valuation, sales and forensic
accounting. Going forward, OCIE will primarily
conduct risk-targeted “sweep” examinations
staffed with multi-disciplinary teams, including
teams comprised of both broker-dealer and
investment management staff for examinations of
entities that engage in both functions.
Finally, the SEC is augmenting its staff, seeking
personnel with practical trading and market
skills and training existing personnel in forensic
technology, investigating financial fraud, market
manipulation, Ponzi schemes and offering frauds,
and developing coordination among SEC offices.
Accordingly, the SEC is seeking more funding
from Congress, as the number of entities subject
to its oversight and examination has grown
much faster than the number of staff available to
examine them.
The OIG Reform
Recommendations The implementation of the recommendations of the
OIG will augment the structural reforms identified
by the SEC Enforcement Director. A major focus
of these reforms is the process by which the
SEC will review and vet tips, complaints and
referrals. The new Office of Market Intelligence
will coordinate this process. Enhanced training for
law enforcement staff is being given a renewed
priority. Another focus of the reforms is the method
by which the SEC Enforcement Division staffs,
plans and supervises investigations. A much more
rigorous and systematized process of planning
review and oversight is to be undertaken to keep
investigations on task and staffed with adequate
expertise to address the issues uncovered.
Likewise, the SEC is implementing a more rigorous
process for review of the opening and closing of
investigations.
Fall 2009 17
continued from page 1
Weathering the Storm in a Post-Madoff World
must identify and assess the risk of their firms and
evaluate their policies and procedures in order
to mitigate specific risks associated with their
advisory business. Despite the SEC’s current focus
on “cause” examinations of investment advisers,
firms should be vigilant and prepared for “routine”
examinations to continue. Historically, SEC exams
have primarily focused on the effectiveness of
adviser compliance programs. Now, five years
after the adoption of the Compliance Rule, the
SEC, expecting a “fully-operational, effective,
compliant compliance program” and is both
making significant changes to investment adviser
examinations and turning its attention to other
areas in an effort to enhance investor protection.
As part of the 2009 CCOutreach Regional
Seminars, the SEC staff cautioned investment
advisers that the following areas, among others,
will likely be the focus of on-site examinations:
• portfolio management;
• outsourcing services;
• safeguarding client funds and securities;
• performance claims; and
• valuation.
Portfolio Management Although a broad range of advisory activities
will continue to be reviewed, the following
areas will be of specific importance to the SEC
staff during examinations: (i) the allocation
of investment opportunities among clients; (ii)
consistent adherence to client objectives and
restrictions; (iii) appropriate, “meaningful” client
disclosure regarding adviser practices; (iv) the
consistency of business operations with regulatory
requirements; and (v) the adviser’s code of ethics.
In connection with its annual internal review, a
CCO should randomly sample client contracts to
test whether the adviser is adhering to specific
client prohibitions (e.g., prohibition on purchasing
“sin” stocks) and has adequate policies,
procedures and controls in place designed to
comply with specific client guidelines. The CCO
may also consider assessing whether accurate
and complete disclosures were made regarding,
among other areas: (i) conflicts of interest created
by business arrangements or affiliations; (ii)
compensation arrangements with solicitors and
service providers; (iii) fees paid by clients to the
firm and affiliates and the services provided; and
(iv) use of client commissions to pay for products
and services. It is also important for CCOs to
confirm that all disclosure documents are delivered
to clients and filings are made with the SEC in a
timely manner.
Outsourcing Services Investment advisers may engage third-party
service providers to perform various services
for their clients. Pursuant to its fiduciary duty to
investors, an adviser must supervise its service
providers, including sub-advisers, administrators,
proxy voting agents, and transfer agents. At least
annually, the CCO must confirm that the policies
and procedures of each service provider are
adequate in relation to the services performed
for its advisory clients, including any mutual fund
it may advise. As a general matter, this oversight
requires initial and on-going due diligence by
the CCO and compliance team (e.g., on-site
visits). Where possible, the CCO should perform
forensic back-testing as a check on the service
provider, particularly an affiliated entity (e.g.,
affiliated sub-adviser). During its annual review,
the CCO should assess whether the adviser is
properly disclosing its use of third-party service
providers, including whether it uses affiliated
service providers, and applicable fees charged
for such services.
Safeguarding Client Funds
and Securities Although custody has been a focus area of
the SEC for some time, the Madoff fraud re-
emphasized the importance of safeguarding
client assets. At a minimum, CCOs should confirm
that the adviser has: (i) policies and procedures
created to safeguard clients’ funds and securities
and protocols for dealing with a third-party
custodian; and (ii) security measures designed
to protect confidential personal information and
to prevent unauthorized use of such information.
In an effort to independently verify investor
assets, SEC examiners may contact other service
providers and counterparties and are likely to
contact clients directly to confirm consistency
of capital account balances. Because SEC
examiners are likely to perform certain custodial
checks during an examination, the CCO should
consider taking similar steps to confirm that
advisory clients’ assets are safe, including: (i)
obtaining statements from the custodian; (ii)
comparing custodial statements with advisory
records; (iii) reviewing its reconciliation process;
(iv) taking additional steps to confirm assets when
custody is with the adviser or an affiliate; and (v)
reviewing account statements sent by the adviser.
As the SEC has emphasized, the CCO should be
aware that conflicts of interest and/or potential
“red flags” may exist in circumstances where the
adviser and the qualified custodian are affiliated,
the adviser is in a difficult financial situation, client
funds are held at a foreign financial institution,
advisers charge performance fees or the adviser
hires an inexperienced auditor to perform audits
or surprise verifications. In light of the massive
Ponzi schemes that emerged over the last year,
SEC examiners will likely assess whether there
are adequate controls in place to prevent the
falsification of account statements to clients.
Despite the SEC’s current focus on “cause” examinations of investment advisers, firms should be vigilant and prepared for “routine” examinations to continue.
18 Investment Management Update
Performance ClaimsUnder the Investment Advisers Act of 1940,
as amended, an adviser is prohibited from
employing or engaging in fraudulent, deceptive
or manipulative activities, including through the
use of its advertising and marketing materials.
An adviser should make performance claims in
marketing materials subject to the verifi cation of
computation of returns, criteria for including/
excluding accounts, proper maintenance of
required books and records, and process for
ensuring clear, accurate disclosure. During its
annual review, the CCO should review its policies
and procedures and confi rm that the adviser’s
performance claims are accurate and consistent
and that proper disclosures are included. CCOs
should periodically test disclosures between
various types of adviser advertising, including the
fi rm’s website, pitch books and other advertising
materials. If GIPS-compliance is asserted, the
CCO must confi rm that the fi rm’s composite
performance claims are consistent with GIPS
standards. In addition, it is important for CCOs
to periodically random sample recordkeeping
practices to confi rm that all documents necessary
to substantiate advertised performance are
maintained in the appropriate manner.
ValuationAdvisers should have adequate policies and
procedures, internal controls and verifi cation
processes in place to detect situations where
market values materially deviate from values
used to price client portfolios. Because of the
potential confl ict of interest in valuing a client’s
portfolio, investment advisers must be cautious
not to overvalue client portfolios thereby creating
higher advisory fees and performance fees that
are paid to the adviser. Examiners will seek to
confi rm that advisers have taken reasonable steps
to determine market valuation where there are
pricing inaccuracies that come to the adviser’s
attention. The SEC recommends forensic testing to
analyze whether the adviser’s valuation policies
and procedures are adequate. In light of current
market volatility and liquidity issues, as part of
the annual review the CCO should review its
current procedures and consider: (i) evaluating
and verifying the accuracy of prices; (ii) reviewing
exception reports; (iii) conducting internal audits
and reviewing related reports; (iv) completing self-
assessments; and (v) documenting and maintaining
all quotes received from third-party sources.
Despite the state of the economy, investment
advisers must remain focused on compliance
and investor protection. In fact, the SEC staff has
emphasized how critical the roles of the CCO
and compliance personnel are in creating a
“culture of compliance” and cautioned advisers
against making resource reductions to compliance
programs that could undercut their effectiveness.
With the number of enforcement actions on
the rise and the SEC’s active role as “investor
advocate,” it is in the adviser’s best interest to
maintain a vigilant CCO and compliance team.
As 2009 comes to a close, and in anticipation
of next year’s annual internal review, the CCO
should thoroughly review its compliance program,
mapping the fi rm’s potential compliance risks in
light of the past year’s events and any changes
to its advisory business. As part of its review,
the CCO should pay particular attention to
information contained in past defi ciency letters
and responses, current regional SEC request
letters, and the SEC exam focus areas discussed
above. If these steps are taken, the CCO
will be in a better position to demonstrate the
dynamic nature of its compliance program and its
preparation to weather any storm that 2010 has
in store for the fi nancial industry.
Fall 2009 19
Stephen J. Crimmins: Understanding the New SEC Enforcement Program, Financial Research Associates, October 20, 2009, Webinar
Elaine A. Lindenmayer and Mark D. Perlow: Regulatory Development Impacting Hedge Fund and the Investment Management Industry, 100 Women in Hedge Funds, October 28, 2009, San Francisco, CA
Michael S. Caccese: Understanding Disclosure: Form ADV, Performance and Advertising, NRS, November 4, 2009, Las Vegas, NV
Michael S. Caccese: Investment Adviser Advertising and Marketing; Crisis Management and Internal Investigations, NRS 24th Annual Fall Investment Adviser and Broker-Dealer Compliance Conference, November 5 and 6, 2009, Las Vegas, NV
Daniel F. C. Crowley: The Obama Administration’s Impact on Private Equity, CLE International Private Equity and Mezzanine Finance Conference, November 6, 2009, Charlotte, NC
Paulita Pike: Director Oversight of Compliance and Risk Management, Investment Company Directors Conference, Independent Directors Council, November 11-13, 2009, Amelia Island, FL
Robert J. Zutz: Judicial and Regulatory Developments, Independent Directors Council, November 17, 2009, Fort Worth, TX
Robert A. Wittie: Securities Lending, Mutual Fund Directors Forum and KPMG, November 18, 2009, Webinar
David Dickstein: Investment Adviser Association Compliance Workshop, December 1, 2009, Los Angeles, CA
Kay Gordon and Philip Morgan: Renewable Energy Funds – New Frontiers for the Funds Industry, Celesq®, December 3, 2009, Webinar
Diane E. Ambler: Mutual Funds Under New Administration: Litigation and Regulation, Boston University School of Law, December 4, 2009, Boston, MA
Paulita Pike and Paul Dykstra: Mutual Fund Directors Institute, Mutual Fund Directors Forum, January 26-28, 2010, Coral Gables, FL
Alan P. Goldberg: Risk Management for Mid-Size Firms, Investment Adviser Association/ACA Insight 2010 Investment Adviser Compliance Forum, February 25, 2010, Arlington, VA
Fall 2009 Fall 2009 Fall 2009 Fall 2009 Fall 2009 Fall 2009 Fall 2009 Fall 2009 Fall 2009 Fall 2009 Fall 2009 Fall 2009 Fall 2009 19191919Fall 2009 19191919
Please visit www.klgates.com for more information on the following upcoming investment management events in which K&L Gates attorneys will be participating:
Please join us for our 2009 Investment Management Training SeminarsAt these seminars, lawyers from our Investment Management practice will discuss a broad range of topics and practical issues. Each program will feature a “Hot Topics” panel discussing current issues con-fronting the investment management industry
To register for these seminars, please go to www.klgates.com/events.
Wednesday and Thursday, November 4 and 5
Live at K&L Gates in Washington, DC and video conferenced to K&L Gates Charlotte, K&L Gates Dallas, K&L Gates Miami; K&L Gates Newark, K&L Gates New York and K&L Gates Pittsburgh
Tuesday, November 10 Live at the Palace Hotel San Francisco
Tuesday, November 17 Live at K&L Gates in Los Angeles and video conferenced to our offi ces in Orange County, San Diego, and Seattle
Thursday, November 19 Live at K&L Gates in Chicago
Friday, November 20 Live at K&L Gates in Boston
Tuesday, December 8 Live at K&L Gates in New York
Please join us for our Seminar:The Current and Future State of the Hedge Fund Industry: Business PerspectivesThursday, October 29, 2009, 4:00 p.m. to 7:00 p.m. (Eastern time) This program will be live in our New York offi ce.
This seminar will be conducted as an active dialogue among industry speakers, who will respond to ques-tions from members of K&L Gates’ New York Investment Management group concerning business, legislative and regulatory challenges hedge funds may be expected to face in 2010 and thereafter. Featured industry panelists will be Charles Clarvit (BlackRock Alternative Advisors), Jaeson Dubrovay (NEPC) and David Harmston (Albourne America).
Please join us for our Seminar More Enforcers at Your Door: preparing for and Responding to Increased Government Investiga-tions and ActionsTuesday, November 17, 2009, 1:45 to 6:15 p.m.This program will be live in our London offi ce.
K&L Gates, in partnership with the Risk Advisory Group, AlixPartners and ELD International, is pleased to invite you to this half-day conference on new trends in government enforcement. Hear fi rst hand from current and former regulators including Richard Alderman, Director, Serious Fraud Offi ce, U.K. and Richard Thornburgh, former U.S. Attorney General and K&L Gates Of Counsel in our Washington, D.C. offi ce. Obtain practical guidance from senior corporate counsel on dealing effectively with multiple regulators and participate in a hands-on workshop led by corporate counsel, consultants and practitioners to learn how your company can limit exposure to government enforcement action.
To register for this event, please go to www.klgates.com/events.
Industry Events
To learn more about our Investment Management practice, we invite you to contact one of the lawyers listed below, or visit www.klgates.com.
AustinRobert H. McCarthy, Jr. 512.482.6836 robert.mccarthy@klgates.com
BostonJoel D. Almquist 617.261.3104 joel.almquist@klgates.comMichael S. Caccese 617.261.3133 michael.caccese@klgates.comMark J. Duggan 617.261.3156 mark.duggan@klgates.comMark P. Goshko 617.261.3163 mark.goshko@klgates.comThomas A. Hickey III 617.261.3208 thomas.hickey@klgates.comNicholas S. Hodge 617.261.3210 nicholas.hodge@klgates.comPeter N. McIsaac 617.261.3225 peter.mcissac@klgates.comClair E. Pagnano 617.261.3246 clair.pagnano@klgates.comGordon F. Peery 617.261.3269 gordon.peery@klgates.com Rebecca O’Brien Radford 617.261.3244 rebecca.radford@klgates.comGeorge Zornada 617.261.3231 george.zornada@klgates.com
ChicagoCameron S. Avery 312.807.4302 cameron.avery@klgates.comPaul H. Dykstra 312.781.6029 paul.dykstra@klgates.comDavid P. Glatz 312.807.4295 david.glatz@klgates.comAlan P. Goldberg 312.807.4227 alan.goldberg@klgates.comThomas F. Joyce 312.807.4323 thomas.joyce@klgates.com D. Mark McMillan 312.807.4383 mark.mcmillan@klgates.comAnna Paglia 312.781.7163 anna.paglia@klgates.comPaulita A. Pike 312.781.6027 paulita.pike@klgates.comDavid C. Sienko 312.807.4382 david.sienko@klgates.comDonald S. Weiss 312.807.4303 donald.weiss@klgates.com
Fort Worth Scott R. Bernhart 817.347.5277 scott.bernhart@klgates.com
Hong Kong Navin K. Aggarwal +852.2230.3515 navin.aggarwal@klgates.com London Danny A. Brower +44.20.7360.8120 danny.brower@klgates.comPhilip J. Morgan +44.20.7360.8123 philip.morgan@klgates.com Los Angeles William P. Wade 310.552.5071 william.wade@klgates.com New York David Dickstein 212.536.3978 david.dickstein@klgates.comEdward G. Eisert 212.536.3905 edward.eisert@klgates.comKay A. Gordon 212.536.4038 kay.gordon@klgates.comAlan M. Hoffman 212.536.4841 alan.hoffman@klgates.comBeth R. Kramer 212.536.4024 beth.kramer@klgates.com RaleighF. Daniel Bell III 919.743.7335 dan.bell@klgates.com
San Francisco Kurt J. Decko 415.249.1053 kurt.decko@klgates.com Elaine A. Lindenmayer 415.249.1042 elaine.lindenmayer@klgates.comJ. Matthew Mangan 415.249.1046 matt.mangan@klgates.comDavid Mishel 415.249.1015 david.mishel@klgates.comMark D. Perlow 415.249.1070 mark.perlow@klgates.comRichard M. Phillips 415.249.1010 richard.phillips@klgates.com Seattle James A. Andrus 206.370.8329 james.andrus@klgates.com Taipei Christina C. Y. Yang +886.2.2175.6797 christina.yang@klgates.com Washington, D.C. Clifford J. Alexander 202.778.9068 clifford.alexander@klgates.comDiane E. Ambler 202.778.9886 diane.ambler@klgates.comMark C. Amorosi 202.778.9351 mark.amorosi@klgates.comCatherine S. Bardsley 202.778.9289 catherine.bardsley@klgates.comNdenisarya M. Bregasi 202.778.9021 ndenisarya.bregasi@klgates.com Beth Clark 202.778.9432 beth.clark@klgates.comDaniel F. C. Crowley 202.778.9447 dan.crowley@klgates.comArthur C. Delibert 202.778.9042 arthur.delibert@klgates.comStacy L. Fuller 202.778.9475 stacy.fuller@klgates.comJennifer R. Gonzalez 202.778.9286 jennifer.gonzalez@klgates.comRobert C. Hacker 202.778.9016 robert.hacker@klgates.comKathy Kresch Ingber 202.778.9015 kathy.ingber@klgates.comRebecca H. Laird 202.778.9038 rebecca.laird@klgates.comDeborah A. Linn 202.778.9874 deborah.linn@klgates.comCary J. Meer 202.778.9107 cary.meer@klgates.comMarc Mehrespand 202.778.9191 marc.mehrespand@klgates.comR. Charles Miller 202.778.9372 chuck.miller@klgates.comDean E. Miller 202.778.9371 dean.miller@klgates.comR. Darrell Mounts 202.778.9298 darrell.mounts@klgates.comMolly Moynihan 202.778.9058 molly.moynihan@klgates.comLawrence B. Patent 202.778.9219 lawrence.patent@klgates.comC. Dirk Peterson 202.778.9324 dirk.peterson@klgates.comDavid Pickle 202.778.9887 david.pickle@klgates.comAlan C. Porter 202.778.9186 alan.porter@klgates.comTheodore L. Press 202.778.9025 ted.press@klgates.comEric S. Purple 202.778.9220 eric.purple@klgates.comFrancine J. Rosenberger 202.778.9187 francine.rosenberger@klgates.comBruce A. Rosenblum 202.778.9239 bruce.rosenblum@klgates.comRobert H. Rosenblum 202.778.9464 robert.rosenblum@klgates.comWilliam A. Schmidt 202.778.9373 william.schmidt@klgates.comLori L. Schneider 202.778.9305 lori.schneider@klgates.comLynn A. Schweinfurth 202.778.9876 lynn.schweinfurth@klgates.comDonald W. Smith 202.778.9079 donald.smith@klgates.comAndras P. Teleki 202.778.9477 andras.teleki@klgates.comStacy H. Winick 202.778.9252 stacy.winick@klgates.comRoger S. Wise 202.778.9023 roger.wise@klgates.comRobert A. Wittie 202.778.9066 robert.wittie@klgates.comRobert J. Zutz 202.778.9059 robert.zutz@klgates.com
K&L Gates is a global law firm with lawyers in 33 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.
K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the United States, in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in Dubai, U.A.E., in Shanghai (K&L Gates LLP Shanghai Representative Office), and in Singapore; a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining offices in London and Paris; a Taiwan general partnership (K&L Gates) maintaining an office in Taipei; and a Hong Kong general partnership (K&L Gates, Solicitors) maintaining an office in Hong Kong. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office.
This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
©2009 K&L Gates LLP. All Rights Reserved.
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