Winter 2013

COVERED IN THIS UPDATE Page No CFTC Registration for Single 1 INVESTMENT MANAGEMENT REPORT Family Offices and Business Development Companies

SEC Charges Former Fund 2 NO CFTC REGISTRATION FOR SINGLE And, CFTC Rule 4.5 provides an Directors with Failure to Satisfy Statutory Fair FAMILY OFFICES AND BUSINESS exclusion from registration for mutual Valuation Obligations DEVELOPMENT COMPANIES funds and certain other “otherwise regulated persons.” Nonetheless, SEC To Resume Granting 4 In December 2012 the Division of Swap Conditional Exemptive Relief Rule 4.13 did not make express Dealer and Intermediary Oversight of for Certain ETFs whether it exempted single family the U.S. Commodity Futures Trading FINRA Enforcement Cases 4 offices, nor did Rule 4.5 make express Commission (the “CFTC”) issued no- Underscore Import of Prospectus whether it excluded BDCs, from the Delivery Rules action relief providing assurances to CFTC’s registration requirements. single family offices1 and business Collaboration and Other 5 development companies (“BDCs”) Single Family Offices SEC Priorities for 2013 employing derivatives strategies that SEC Extends “Lost Shareholder” 7 Prior to February 24, 2012, when the they would not be required to register Rule to Broker/Dealers and CFTC announced various changes Paying Agents as commodity pool operators under to its registration regime, advisers the Part 4 of the CFTC’s Regulations.2 Recent SEC Enforcement Actions 8 to private funds excepted from SEC As amended by Section 721(a) of the registration also were exempt from Ins and Outs at the SEC 10 Dodd-Frank Wall Street Reform and CFTC registration Rule 4.13(a)(4). CCO Corner – Regulatory and 11 Consumer Protection Act (the “Dodd- Single family offices also historically Other Compliance Concerns Frank Act”), the Commodity Exchange relied on Rule 4.13(a)(4) to avoid Act defines a commodity pool operator PERKINS COIE’S INVESTMENT registering with the CFTC. In advance MANAGEMENT GROUP as any person who solicits, accepts of the December 31, 2012 effective or receives property for the purpose date of the CFTC’s rescission of Rule Martin E. Lybecker, Partner of trading in commodity interests, 202.434.1674 4.13(a)(4), the PIC requested relief including futures, options and swaps. [email protected] from the CFTC on the grounds “that Perkins Coie represented the Private Mary C. (Molly) Moynihan, Partner family offices are not operations of Investor Coalition (“PIC”), in its request 202.654.6254 the type and nature that warrant [email protected] for no-action relief for single family regulatory oversight by” the CFTC. offices from the CFTC. Karl Ege, Senior Counsel The PIC, a national organization 206.359.6189 of family offices that successfully Commodity pool operators are [email protected] generally required to register with the 1 Single family offices are professional entities Nicholas C. Milano, Senior Counsel CTFC. However, CFTC Rule 4.13 provides that exclusively serve and are wholly owned 202.654.6271 and controlled by members of one family and an exemption from registration for [email protected] provide investment advisory and related wealth “the operators of family, club and management services to the members of that family. Gwendolyn A. Williamson, Counsel 2 small pools…and pools that have The No-Action Letter regarding single family offices 202.654.6399 is CFTC Letter No. 12-37, Nov. 29, 2102 and the No- [email protected] limited futures activity or that restrict Action Letter regarding BDCs is CFTC Letter No. 12-40, participation to sophisticated persons.” Dec. 4, 2102. 1 urged the SEC to exclude single Business Development Companies any non-hedge commodity interest family offices from the registration positions do not exceed 5% of BDCs are treated somewhat uniquely requirements of the Investment the liquidation value of the BDC’s under the federal securities laws. Advisers Act of 1940 (the “Advisers total portfolio; or (ii) the aggregate Unlike mutual funds that are registered notional value of the BDC’s non- Act”), similarly urged the CFTC as investment companies under the hedge commodity interest positions that “because a family office is Investment Company Act of 1940 does not exceed 100% of the comprised of participants with close (the “Investment Company Act”), liquidation value of the BDC’s relationships, and there is a direct and distinct from private funds that total portfolio; and relationship between the clients and are excluded from the definition the adviser, such relationships greatly  the BDC perfects its claim to the of investment company under the reduce the need for the customer relief by filing a notice with the CFTC Investment Company Act, BDCs are protections available pursuant to pursuant to the instructions outlined investment companies that may Part 4 of the [CFTC’s] Regulations.” in the no-action letter. become exempt from registration by filing a notice of election to be In taking its no-action position, In offering no-action relief to single treated as a BDC under Section 54 the CFTC focused on the regulated family offices, the CFTC staff noted of the Investment Company Act. nature of BDCs and their similarity the significant amount of time and Accordingly, BDC’s do not fit squarely to mutual funds that are exempt effort spent by the SEC in working into the language of CFTC Rule 4.5, from CFTC registration under Rule 4.5. with the PIC to finalize Rule 202(a)(11) which excludes “an investment “Many BDCs have external advisers (G)-1, which exempts family offices company registered as such under the and, like advisers to [mutual funds], from registration under the Advisers Investment Company Act” from the such external advisers to BDCs must Act. The CFTC, the staff wrote, requirement to register with the CFTC register with the SEC,” the CFTC “observes that the fundamental that would otherwise apply. staff wrote, adding that BDCs, like issue of the appropriate application mutual funds are subject to periodic of investor protection standards as BDCs operate in substantially the examination by the SEC. The CFTC also required by each respective agency’s same manner as registered investment reasoned that the additional investor regulations is substantially similar companies, a fact the CFTC staff protection of CFTC registration was in the issue at hand…[and] placing highlighted in its no-action letter not necessary given that “almost all both agencies on equal footing with assuring BDCs that the CFTC would BDCs are listed for trading on national respect to the application of investor not require registration as a commodity securities exchanges and, thus, are protections relevant to this issue pool operator as long as the following subject to exchange rules governing will facilitate compliance with both conditions are met: listed companies…must comply with regulatory regimes.” the disclosure and other requirements the BDC has elected to be treated of the Securities Exchange Act of Single family offices intending to rely as a BDC under Section 54 of the on the CFTC’s no-action letter should Investment Company Act and 1934…[and] must comply with the full note the conditions established by the continues to be regulated as a panoply of regulations and corporate CFTC, namely that in order to rely on BDC by the SEC; governance guidelines required under the letter a single family office must: the Sarbanes-Oxley Act of 2002.”  the BDC has not and will not market itself to the public “as or  perfect its claim to the relief by filing SEC CHARGES FORMER FUND in a commodity pool or otherwise a notice with the CFTC pursuant to DIRECTORS WITH FAILURE the instructions outlined in the as or in a vehicle for trading in the TO SATISFY STATUTORY FAIR no-action letter; and commodity futures, commodity options or swaps markets;” VALUATION OBLIGATIONS  confirm by March 31, 2013 that it is,

and at all times thereafter continue either (i) the BDC’s commodity On December 10, 2012, the SEC interest trading is for bona fide to be, a single family office within the instituted administrative proceedings hedging purposes and the aggregate meaning and intent of Rule 202(a)(11) against the directors of five registered initial margin and premiums for (G)-1 under the Advisers Act. mutual funds. Each of the funds

Perkins Coie llp www.perkinscoie.com 2 primarily invested in below-investment evaluate the appropriateness of for which market quotations are not grade, collateralized debt obligations any methodology, nor was there a readily available be valued at fair value for which market quotations were not mechanism to identify and review as determined in good faith by a fund’s readily available. The charges stem securities whose prices had not board of directors. The SEC has stated from the alleged failure of the directors changed in some time. that “directors must determine the over an eight-month period in 2007 method of arriving at the fair value of Allegations Regarding Actual to adopt and implement meaningful each such security” and “continuously Valuation Practices valuation procedures and provide review the appropriateness of the proper oversight, resulting in material In its order, the SEC alleged that method used in valuing each issue misstatements of the funds’ NAVs. between January 2007 and of security” in the fund’s portfolio. Fund boards and their valuation August 2007: committees, as well as fund CCOs, The SEC alleged that the defendant  fund accounting routinely allowed the should heed the lessons of these cases. directors failed to meet their fair funds’ portfolio managers to set prices valuation responsibilities because, Fund Valuation Procedures for securities without any explanation among other things: (i) the directors of the basis for such prices and did so Each of the funds had in place did not know and did not inquire in a way that postponed the degree valuation procedures for pricing what methodology was used to of decline in the NAVs of the funds; securities, and each fund’s board value particular securities or types of directors had delegated pricing no reasonable analytical method, of securities; (ii) the directors never responsibilities to the fund’s such as a pricing model or cash established guidelines for the use investment adviser. The funds’ flow analysis, was used to make of price confirmations, including procedures for fair-valued securities fair value determinations; frequency or selection of broker/dealers, nor did they require identification required that they be valued “in  the price of a security was typically of those securities for which no good faith” by the adviser’s valuation not changed from its purchase price confirmations had been obtained committee, which was composed of unless a sale or price confirmation for a period of time; (iii) reports representatives of fund accounting and showed a variance greater than 5%; the adviser. The valuation procedures provided to the directors did not meet  price confirmations were sought listed various factors the committee the requirements of the valuation for as few as 10% of the funds’ was to consider in making value procedures and the directors did not fair-valued securities and were not determinations and required certain request the required information. obtained in a timely manner for the written documentation and reports In particular, the directors’ review of prices they were meant to confirm; to the funds’ directors concerning valuations was limited because reports the value determinations made.  fund accounting was not required to given the directors did not include identify or explain instances where certain information about fair-valued According to the SEC, other than the price confirmations were ignored or securities in the funds’ portfolios that list of factors, which the SEC noted overridden; and had not been sold, when less than 25% were taken nearly verbatim from of the funds’ fair-valued securities were the valuation committee tasked with SEC Accounting Series Release No. sold during the first six months of 2007. overseeing the fair valuation process 118, the funds’ valuation procedures “As a result of the directors’ causing the typically did no more than compare funds to fail to adopt and implement “provided no meaningful methodology sales prices to previously determined or other specific direction on how to fair values on a monthly basis and reasonable procedures, the NAVs of the make fair value determinations for failed to perform any additional funds were materially misstated.” specific portfolio assets.” Citing as analysis to confirm the fair values examples, the SEC noted there was of securities that had not been sold A public hearing on the matter is no guidance on how the factors or confirmed. scheduled to occur on April 2, 2013 should be interpreted or weighed, before an administrative law judge what methodology should be used SEC Charges who will issue an initial decision. for each type of security or how to Section 2(a)(41)(B) of the Investment Company Act requires that securities

Perkins Coie llp www.perkinscoie.com 3 SEC TO RESUME GRANTING to, and effectively permitting the settlement. In practice, broker/ CONDITIONAL EXEMPTIVE RELIEF registration of, non-leveraged actively dealers must provide a prospectus FOR CERTAIN ETFS managed ETFs intending to invest in to a customer within three days of his derivatives. (See, e.g., IC Release No. or her investment in a mutual fund. Nearly three years after announcing 30350, Jan. 15, 2013). And while the order In several of the enforcement actions, that it had indefinitely deferred itself does not specifically mention the prospectuses were delivered more consideration of exemptive applications use of derivatives, the ETF’s exemptive than a year after the transactions made by actively managed ETFs with application, which was amended in question. significant investments in derivatives, following Director Champ’s December the SEC announced in December 6, 2012 speech, contains the explicit In the FINRA enforcement actions, that it would begin considering and representations referred to in the the defendant broker/dealer firms were approving exemptive requests under speech. For the time being, this seems charged with failing to comply with the Investment Company Act by to be the magic language for actively prospectus delivery rules and failing non-leveraged actively managed ETFs managed ETFs seeking exemptive relief. to establish and maintain adequate investing in derivatives. supervisory systems and written procedures reasonably designed to FINRA ENFORCEMENT CASES Speaking at the ALI CLE 2012 monitor and ensure compliance with UNDERSCORE IMPORT OF Conference on Investment the rules. These lapses, FINRA said, Adviser Regulation, Norm Champ, PROSPECTUS DELIVERY RULES were violations of the federal securities Director of the Division of Investment During the fourth quarter of 2012, laws and also breaches of the FINRA Management, said the Division FINRA settled five enforcement Manual. NASD Conduct Rules 3010(a)(1) would consider exemptive requests cases against well-known broker/dealer and (b)(1) require that member under the Investment Company firms for failing to properly deliver broker/dealer firms must have in Act relating to actively-managed prospectuses to mutual fund place a working and enforced written ETFs that make use of derivatives investors. The enforcement actions, system to supervise the activities provided the request included two which included financial penalties, of each registered representative, specific representations: come as a strong reminder that even registered principal, and other that the ETF’s board periodically in the modern scheme of automated associated person that is reasonably will review and approve the ETF’s trading and online brokerage designed to achieve compliance use of derivatives and how the ETF’s services, the prospectus delivery with applicable securities laws investment adviser assesses and rules established by Congress and regulation. FINRA asserted manages risk with respect to the 80 years ago are as applicable that the firms’ failures were also in ETF’s use of derivatives; and as ever. contravention of FINRA Rule 2010, which requires that each member that the ETF’s disclosure of its use of Section 5(b)(2) of the Securities Act of derivatives in its offering documents firm “in the conduct of its business, and periodic reports is consistent 1933 (the “Securities Act”) sets forth shall observe high standards of with relevant Commission and the primary prospectus delivery rule, commercial honor and just and staff guidance. requiring that every sale of a security equitable principles of trade.” be preceded or accompanied by a Director Champ cautioned that the prospectus that complies with Section The broker/dealer firms in each of the Division would continue its ongoing 10(a) of the Securities Act. In addition, FINRA cases relied on a service provider review of the use of derivatives by Rule 10b-10 and Rule 15c6-1(a) under to carry out delivery of prospectuses funds. The SEC’s moratorium on the Securities Exchange Act of 1934 to clients. In the settlement orders, leveraged actively managed ETFs (the “Exchange Act”) together require FINRA made clear that broker/ remains in place. that broker/dealers provide transaction dealers could not avoid responsibility confirmation statements – which must for prospectus delivery compliance In early January, the SEC issued include certain disclosures included by delegating the task to a third the first of what is sure to be many in a prospectus – to their customers party. Broker/dealers must, FINRA, orders affording exemptive relief within three days of the transaction explained, have written supervisory

Perkins Coie llp www.perkinscoie.com 4 procedures that call for review of and overseeing the compliance of Champ told the group that REG and service providers’ performance of its service providers with prospectus the five examiners within the Division their prospectus delivery obligations. delivery requirements. of Investment Management would And, simply having the procedures on coordinate closely with the SEC’s the books is not enough, as several FINRA brought the five enforcement Office of Compliance Inspections and of the firms that settled with FINRA actions in connection with its review Examinations (“OCIE”). He said that had written supervisory procedures of mutual fund prospectus delivery while OCIE’s on-site presence exams that FINRA found to be inadequate. during the period from January 1, primarily targeted large adviser and For example, simply asking registered 2009 to June 30, 2011. The actions broker/dealer firms with systemic risk representatives “annually to confirm involved over 100,000 mutual fund factors, REG would begin visiting firms his or her understanding of [the firm’s] transactions, and follow similar cases of all types and sizes. requirements regarding mutual fund in 2011 where FINRA fined Wells Fargo prospectus delivery, and accept[ing] Advisors, LLC $1 million “for its failure Director Champ noted that REG’s the representative’s response,” was to deliver prospectuses in a timely main goal was to better leverage deemed insufficient by FINRA under manner…and for delays in reporting the information and data generated NASD Conduct Rules 3010(a)(1) and material information about its by OCIE. For example, Champ (b)(1). Other specific failures cited by current and former representatives” explained, members of the Investment FINRA include improper householding and fined TD Ameritrade $100,000 Management Division staff would in connection with the annual delivery in connection with charges that “in be asked to accompany OCIE staff of mutual fund prospectuses and not 4 percent to 5 percent of the mutual on presence exams so that the regularly updating and monitoring the fund transactions the firm conducted, Investment Management staff could prospectus mailing list maintained by customers were not timely receiving get both a “snapshot” view of individual a third party vendor. prospectuses.” The fines agreed to as firms and a bird’s eye view of industry- part of the five settlements reached wide risks and themes. In addition, In several of the cases, broker/ in late 2012 range from $40,000 Champ said that he would work to dealers pointed the finger at mutual to $400,000. establish a formalized communication funds and their advisers, asserting system between the Division of that “the primary cause of the late COLLABORATION AND OTHER SEC Investment Management, OCIE and deliveries was the failure of certain PRIORITIES FOR 2013 the other divisions of the SEC. mutual fund companies to maintain adequate supplies of paper copies Investment Management Priorities Champ also spoke to the backlog of approximately 60 “shelf projects” of prospectuses.” FINRA, however, Norm Champ, Director of the SEC’s at the SEC, including the Rule 12b-1 countered that the broker/dealers Division of Investment Management, reform proposed in 2010. He said that should have “taken actions to ensure laid out his priorities for 2013 at the list had been pared down to the that all of its customers were receiving the November 2012 meeting of the following eight top projects: prospectuses on time,” for instance, Business Law Section of the American by taking advantage of the “print Bar Association and at the February a review of the Investment Advisers on demand” capability offered by 2013 meeting of the Corporation, Act of 1940 in light of the new private prospectus delivery service providers. Finance and Securities Law Section adviser registrations; This service, FINRA pointed out, of the District of Columbia Bar. a rethinking of reporting on would allow a firm to comply with One focus for the year will be on Form N-SAR; prospectus delivery rules by obtaining the new Investment Management an electronic copy of the prospectus exemptive and/or no-action relief Risk and Examination Group (“REG”), for certain types of derivative from the fund company and then which Director Champ said will printing hard copies to send to instruments, with a focus on monitor industry risk in quantitative disclosure regarding leverage; customers. A mutual fund’s compliance and qualitative terms and also a potential rule exempting certain program should also include a process address specific investment products, categories of ETFs; for monitoring and ensuring the sales practices and firms. Director adequacy of prospectus inventory

Perkins Coie llp www.perkinscoie.com 5 valuation guidance for fund boards those inherent to the previously private equity products, “especially of directors; unregulated private adviser and into the valuation of illiquid assets books and records reform; private equity segment of the industry. and the operations of portfolio “We want to understand the structure companies;” and conflicts of interest working with the Financial Stability of the industry, the customs and leading to “misappropriation, Oversight Council to use the data practices, the incentives that exist for deal cherry picking and other provided by private advisers on Form managers, and trends and risks that forms of misconduct.” PF to monitor systemic risks; and could enable us to more effectively variable annuities reform. spot or investigate fraud,” Karpati said. Karpati also spoke about AMU’s Private Equity Initiative (“PEI”), While Champ emphasized that To that end, Karpati explained that the announced in December 2012, Rule 12b-1 reform and related revenue AMU was working to create certain which he explained was a joint sharing concerns were not on his list data-based and quantitative method- project of the Division of Risk, of eight projects, he noted that the based “risk analytic initiatives” Strategy and Financial Innovation, Division of Investment Management that would allow the Division of the Division of Investment was continuing to gather data on Enforcement to “proactively detect Management and OCIE to identify Rule 12b-1 fees and practices. fraud and identify other problematic private equity advisers that are Director Champ reported that efforts industry practices.” at higher risk for certain specific to harmonize the standard of care fraudulent behavior. In particular, Like Champ, Karpati also highlighted applicable to advisers and broker/ he said that the PEI sought to identify plans to foster cross-pollination dealers in connection with the study “zombie managers” with relatively among the SEC’s various divisions. required by Section 913 of the Dodd- illiquid private equity holdings and “One significant area of collaboration Frank Act were and ongoing priority an inability to raise new funds to is with our National Exam Program,” for the Division. Current SEC Chairman establish additional investment Karpati said, where “AMU personnel Elisse Walter echoed Director Champ’s vehicles to manage. “Since zombie have helped train examiners and statements in mid-February 2013 when managers are unable to raise new have accompanied them on she testified to the Senate Backing capital,” Karpati said, “their incentives exams of private equity managers. Committee that the SEC expected may shift from maintaining good In return, the National Exam to act on the proposal to expand the relations with their investors to Program (“NEP”) has enhanced our fiduciary standard “in the next month maximizing their own revenue understanding of the private equity or two.” Chairman Walter reportedly using the assets that they have.” industry with observations and noted that the SEC Commissioners Thus in investigating private funds insights from examinations….We also were generally supportive of and advisers targeted by the PEI, frequently engage with our Division of establishing a unified fiduciary Karpati said, the AMU would, Investment Management colleagues standard for investment advisers among other issues, “look for on the legal aspects of private equity. and broker/dealers. misappropriation from portfolio IM staff assists us in addressing companies, fraudulent valuations, Enforcement Priorities complex legal and contractual issues lies told about the portfolio in that crop up in our investigations.” Bruce Karpati, Chief of the Division order to cause investors to grant extensions, unusual fees, [and] of Enforcement’s Asset Management Karpati noted that as AMU honed principal transactions.” Unit (“AMU”), speaking at the Private its skills, private equity might Equity International Conference increasingly be in the SEC’s spotlight. In late February 2013, the SEC in New York on January 23, 2013, Among other things, Karpati said published its list of NEP priorities for echoed Champ’s statements about that AMU’s primary concerns about 2013.3 As Carlo V. di Florio, Director of the SEC’s efforts to strengthen practices in the current private OCIE reported, the NEP’s “market-wide expertise on understanding equity industry center on fundraising risks related to the investment and capital overhang; the lack of 3 The full list of OCIE priorities for 2012 is available at management industry, particularly transparency surrounding many http://www.sec.gov/news/press/2013/2013-26.htm.

Perkins Coie llp www.perkinscoie.com 6 priorities include fraud detection and 12b-1 compliance and revenue sharing. regarding the standards of conduct prevention, corporate governance and OCIE will look at “the wide variety of and other obligations of broker- enterprise risk management, conflicts payments made by advisers and funds dealers and investment advisers.” of interest, and technology controls.” to distributors and intermediaries, The SEC intends to use the comments the adequacy of disclosure made to and information it receives to OCIE’s 2013 priorities for its fund boards about these payments, “inform [its] consideration of investment adviser/investment and boards’ oversight of the same. alternative standards of conduct company examination These payments go by many names for broker-dealers and investment program include: and are purportedly made for a variety advisers when providing personalized of services, most commonly revenue investment advice about securities  the safety of client assets sharing, sub-TA, shareholder servicing, to retail customers….and of potential and compliance with custody and conference support.” harmonization of certain other requirements under Advisers Act aspects of the regulation of broker- Rule 206(4)-2; Broker/Dealer Priorities dealers and investment advisers.”  conflicts of interest related to As the SEC works to respond to the Comments are due to the SEC 120 days compensation arrangements such findings of the study of advisers and from publication of the release in the as “undisclosed fee or solicitation broker/dealers that was required by Federal Register – approximately arrangements, referral arrangements Section 913 of the Dodd-Frank Act, July 1, 2013. (particularly to affiliated entities), which recommended that the SEC and receipt of payment for services propose and adopt “a uniform fiduciary SEC EXTENDS “LOST SHAREHOLDER” allegedly provided to third parties;” standard of conduct for broker/dealers RULE TO BROKER/DEALERS AND and investment advisers when they  marketing and performance PAYING AGENTS advertising, which OCIE characterizes provide personalized investment advice According to research conducted by as “an inherently high-risk area due to about securities to retail investors,” the Investment Company Institute, the highly competitive nature of the it will also coordinate with FINRA to approximately 80% of current mutual investment management industry;” hold a National Compliance Outreach Program for Broker/Dealers. The event, fund shareholders are invested

 conflicts of interest related to which is scheduled for April 9, 2013 in through a financial intermediary such the allocation of investment Washington, D.C., is being sponsored as a broker/dealer or transfer agent. opportunities among funds and by OCIE and the SEC’s Division of Congress recognized this trend in other products managed by an Trading and Markets as well as FINRA. drafting Title IX of the Dodd-Frank investment adviser; and The conference, says Director di Florio, Act and under Section 929W added 4  fund governance – “the staff will is intended to “support and enhance a new sub-section to Section 17A confirm that advisers are making the compliance and risk management of the Exchange Act that directed the full and accurate disclosures to fund functions of firms” by providing SEC to (i) expand Rule 17Ad-17 so that boards and that fund directors are “a forum for open discussions about the requirement to search for “lost conducting reasonable reviews of effective compliance practices for securityholders” applied to broker/ such information in connection with broker/dealers… on topics of interest dealers as well as transfer agents and contract approvals, oversight of service to compliance, risk, and audit officers (ii) add a requirement that “paying providers, valuation of fund assets, and of large broker/dealers with multiple agents” notify “unresponsive payees” assessment of expenses or viability.” and complex business lines.” in writing that a check sent to them has not been cashed. On January 16, 2013, OCIE reports that during 2013 it On March 1, 2013, the SEC released the SEC adopted final rule amendments will also focus on leverage, liquidity, an information request asking the implementing the Section 929W valuation, compliance and issues industry for “quantitative data and directive. Fund boards and CCOs should associated with hedge funds’ and economic analysis relating to the mutual funds’ investments in benefits and costs that could result 4 Section 17A(g) of the Exchange Act is entitled “alternative investment companies,” from various alternative approaches “Due Diligence for the Delivery of Dividends, as well as matters related to Rule Interest, and Other Valuable Property Rights.”

Perkins Coie llp www.perkinscoie.com 7 be aware of these rules, which are  includes a de minimus exclusion for revenue sharing agreements and summarized below, and take account of uncashed checks of less than $25. other conflicts of interests to mutual them in developing and implementing  does not apply if a broker/dealer fund shareholders. According to the their financial intermediary compliance or transfer agent has an agreement SEC, the adviser received revenue oversight programs. with the “lost shareholder” that sharing payments from certain broker/ unclaimed checks will be deposited dealers in connection with certain In addition to extending “lost directly into his or her account. funds that the adviser recommended shareholder” obligations to broker/ to its clients, and did not disclose that dealer firms, Rule 17Ad-17, as amended:  has no impact on state “the agreement created incentives escheatment laws. for [the adviser] to favor a particular  requires broker/dealers and transfer category of mutual funds over other agents “to exercise reasonable care In the final rule release (Release No. investments.” The SEC determined that to ascertain the correct addresses of 34-68668), the SEC explained that the receipt of the compensation without ‘lost securityholders,’...and to conduct loss of contact between a financial related conflicts of interest disclosure certain database searches for them.” intermediary and its customers can be harmful to investors “because violated Section 206(2) and 207 of

 defines a “lost securityholder” to they no longer receive corporate the Advisers Act which, respectively, mean: (i) a shareholder to whom a communications or the interest and prohibit an investment adviser from broker/dealer or transfer agent has dividend payments to which they may “engaging in any transaction, practice, sent an item of correspondence, be entitled.” Such loss of contact has or course of business which operates addressed to the shareholder’s various causes, the SEC said, but most as a fraud or deceit upon any client or address of record, that has been frequently results from: “failure of a prospective client” and from willfully returned as undeliverable, provided securityholder to notify the transfer making “any untrue statement of a that if the intermediary re-sends agent of his correct address after material fact.” The defendant advisory the correspondence within one relocating…[or] failure of the estate firm agreed to pay a $1.1 million fine month, the shareholder will not of a deceased securityholder to notify to settle the charges, which also be deemed “lost” until such re-sent the [intermediary] of the death of included allegations that (i) the adviser correspondence is returned the securityholder and the name and violated Section 15(c) of the Investment as undeliverable; (ii) a shareholder address of the trustee/administrator Company Act by providing misleading for whom a broker/dealer or for the estate.” fee information to the board of trustees transfer agent has not received of a mutual fund for which the firm new address information; and/or Along with the Rule 17Ad-17 was to serve as a sub-adviser and (iii) an “unresponsive payee” in that amendments, the SEC also adopted (ii) violated various provisions of the a check sent to the shareholder new technical Rule 15b1-6 under the Advisers Act by voting client proxies was not cashed “before the earlier Exchange Act, “which will provide in a favor or a proposal in which of the paying agent’s sending the ongoing notice to brokers and dealers a related person of the firm had a next regularly scheduled check of their obligations under Rule 17Ad-17.” financial interest. or the elapsing of six months after the sending of the not yet The compliance date for amended The Portland adviser’s case may be negotiated check.” Rule 17Ad-17 is January 23, 2014. a harbinger of similar enforcement actions to come as the Division of  defines “paying agent” to “include Enforcement’s Asset Management Unit, any issuer, transfer agent, broker, RECENT SEC together with the SEC’s San Francisco dealer, investment adviser, indenture ENFORCEMENT ACTIONS Regional Office, has commenced trustee, custodian, or any other Failure to Disclose Revenue an enforcement and examination person that accepts payments from Sharing Tantamount to Fraud initiative to uncover “arrangements an issuer of securities and distributes where advisers receive undisclosed the payments to the holders of The SEC recently settled charges compensation and conceal conflicts the security.” against an investment adviser based in Portland, OR for failing to disclose of interest from investors.”

Perkins Coie llp www.perkinscoie.com 8 Deviation from Fund Policies into Risky Sections 206(1), 206(2) and 206(4) but if their registration statement Derivatives Results in Heavy Sanctions of the Advisers Act and Rule 206(4)- disclosed the risks of such losses, In late December 2012, the SEC settled 8(a) thereunder; Section 17(a)(3) of their advisers were generally protected with an Arizona-based mutual fund the Securities Act; Section 10(b) of from liability. But, the advisers and portfolio manager for a number of the Exchange Act and Rule 10b-5 portfolio managers involved in the violations of the federal securities laws thereunder; and Sections 34(b) and SEC settlement failed to properly related to the manager’s deviation from 13(a)(3) of the Investment Company disclose the significant risks associated a fund’s stated investment objective Act. He was accordingly subject to a with the new derivatives strategies and strategies. As the settlement order number of sanctions, including a non- they began employing in April 2007. details, the fund’s prospectus and SAI permanent bar from the investment The registration statement in effect for characterized the fund as pursuing an management industry. the fund during the period in question equity strategy of “investing, under did not disclose the implementation In a similar case also settled in late normal market conditions, at least 80% of the new strategies – writing December 2012, two Midwestern of its total assets in common stocks and out-of-the-money put options and investment advisers and their portfolio securities immediately convertible into shorting variance swaps – as principal managers were charged with failing common stocks,” with an objective of investment strategies nor did it “to adequately inform investors about seeking long-term capital appreciation. describe the substantial risks to the the fund’s risky derivative strategies The fund’s use of derivatives was fund of using these types of derivatives, that contributed to its collapse during restricted and its prospectus “made no particularly given the high percentage the financial crisis.” The close-end fund mention of options trading and none of fund assets that were being devoted at issue in the case had a principal of the principal risks involved options.” to them by the fund’s portfolio investment strategy of investing in Moreover, the management discussion managers. The strategies, the SEC equity securities and writing covered included in the fund’s annual report found, became an integral part of call options on a substantial portion of to shareholders during the period in how the fund’s portfolio managers those equities. The fund’s registration question stated that options would sought to achieve its investment statement disclosed this strategy as be used only as part of a hedging objective. Still, the fund’s reports to well as the fact that the fund intended program with “the potential to greatly shareholders from the period did not to utilize a variety of derivative reduce market risk.” The fund’s portfolio address written put options or variance strategies generally, including put and manager, however, “pursued a strategy swaps. Rather the shareholder reports call options, futures contracts, swaps, of buying options for speculative asserted that the fund’s covered call caps, floors and collars. During the one purposes contrary to [the fund’s] strategy “had the potential to protect and a half year period leading up to stated investment policy that was the fund in a downward trending the 2008 financial crisis, however, the changeable by shareholder vote” market.” As the SEC explained in one fund’s advisers “implemented two new in that it was a fundamental of the settlement orders, the fund’s derivative strategies to supplement the investment policy. His investments in advisers “never disclosed that put fund’s existing covered call investment options during the period in question options and variance swaps were strategy,” both of which “exposed the ranged from 21% to 75% of the fund’s primary drivers of fund performance, fund to substantial losses in the event total assets, in clear violation of the or that the use of those products might of a steep market decline or spikes in fund’s 80% equity investment policy. alter the fund’s risk profile by exposing market volatility.” Such declines and the fund to significant losses.” Over the course of five quarters, volatility, of course, materialized in the the portfolio manager’s activities fall of 2008 and the fund realized a loss One adviser involved in the case resulted in $3.7 million in losses for of approximately $45 million (or 45% of agreed to settle with the SEC for a the fund (roughly 70% of its total its net assets). It was liquidated in 2009 fine of approximately $2 million for assets) and its eventual liquidation after losing $70 million total (72% of its willful violations of Section 34(b) and dissolution. The SEC found the net assets). of the Investment Company Act portfolio manager’s behavior to be and Section 206(4) of the Advisers Many funds suffered such losses willfully fraudulent and violative of: Act and Rule 206(4)-8 thereunder. during the 2008 financial collapse,

Perkins Coie llp www.perkinscoie.com 9 The other adviser charged by the late 2012. Director Cross was a part announced his departure effective SEC agreed to reimburse $45 million of Chairman Schapiro’s senior December 31, 2012. Mr. Cahn was to shareholders impacted during the leadership team. replaced by Chairman Walter with period in question. That adviser was Geoffrey F. Aronow, a private attorney. charged with willfully violating Section Robert Khuzami, who served as Mr. Aronow previously served as the 34(b) of the Investment Company Act the Director of the SEC’s Division Director of the Division of Enforcement and causing violations of Rule 8b-16 of Enforcement for four years, at the CFTC. thereunder. The fund’s two portfolio announced in early January 2013 managers during the period were each that he would step down. During David Grim, a long-time SEC staffer, alleged by the SEC to have violated Director Khuzami’s tenure, the SEC was appointed Deputy Director of Section 10(b) of the Exchange Act and tried over 150 cases tied to the the SEC’s Division of Investment Rule 10b-5 thereunder; Section 206(4) financial crisis, including those related Management on Jan. 15, 2013. As the of the Advisers Act and Rule 206(4)- to the federal insider trading probe, SEC reported, “Mr. Grim has worked in 8 thereunder; and Section 34(b) of and prosecuted more than 700 the division for 17 years, most recently the Investment Company Act Rule enforcement actions in each of 2011 as Assistant Chief Counsel in its Office 8b-16 thereunder. A public hearing to and 2012. Director Khuzami endorsed of Chief Counsel, and has received determine the sanctions against the his deputy, George S. Canellos to take several awards for his legal and portfolio managers will be held during his position, and the SEC formally managerial work.” the first quarter of 2013. named Canellos as Acting Director of the Enforcement Division effective February 8, 2013. Canellos has served as INS AND OUTS AT THE SEC the Deputy Director of the Division of In November 2012, Mary L. Schapiro, Enforcement since June 2012, and was announced her resignation as previously the Director of the SEC’s Chairman of the SEC, effective New York Regional Office. David P. December 14, 2012. Schapiro served Bergers, former Director of the SEC’s at the SEC for nearly four years during Boston Regional Office, has been a period of substantial regulatory named Acting Deputy Director of the overhaul, including the enactment Enforcement Division, also effective and implementation of the Dodd-Frank February 8, 2013. Act following the 2008 economic crisis. Schapiro’s departure followed the Robert W. Cook, Director of the Division summer 2012 resignations of Ricardo of Trading and Markets at the SEC, Delfin, one of her closest advisors, and announced his intention to leave Robert Plaze, Deputy Director of the the agency in late 2012. During his Division of Investment Management. three years at the SEC, Cook oversaw President Obama designated Elisse B. the implementation of significant Walter, an existing SEC Commissioner, rulemaking and other responsibilities to temporarily serve in Schapiro’s place. assigned to the Division of Trading and In late January 2013, the President Markets under the Dodd-Frank Act nominated Mary Jo White, a private and the Jumpstart Our Business attorney, to serve as the permanent Startups (“JOBS”) Act. John Ramsay, SEC Chair. Chairman Walter will the current Deputy Director of the continue to serve until Ms. White is Division of Trading and Markets, has confirmed by the Senate. been named to serve as the Acting Director of the Division. Meredith B. Cross announced her resignation as Director of the SEC’s Mark D. Cahn, who served as General Division of Corporation Finance in Counsel at the SEC for two years,

Perkins Coie llp www.perkinscoie.com 10 CCO Corner

black and white categorizations of who it was launching a two-year “initiative is and who is not a supervisor as well to conduct focused, risk-based as what a supervisor is expected to do.” examinations of investment advisers to private funds that recently registered An October 2012 FINRA settlement with the Commission (“Presence provides a concrete example of Exams”).” The announcement was when failure to supervise liability REGULATORY AND OTHER communicated through a letter will attach to a CCO.5 The former CCO COMPLIANCE CONCERNS distributed to senior executives of of a brokerage firm was responsible for private advisers that were required to Failure to Supervise Liability supervising the firm’s president and for register with the SEC in connection reviewing the firm’s transaction for any with the amendments to Section 203 Commissioner Daniel M. Gallagher, irregular activity, including potentially of the Advisers Act required by the speaking at the National Society of suspicious trades. The CCO did not Dodd-Frank Act. The Presence Exams Compliance Professionals National identify or otherwise act upon a large are intended to assess whether these Meeting in October 2012, reminded number of red flags that, had they been newly registered advisers are operating compliance officers that the Advisers investigated, would have revealed that in a manner that is consistent with the Act authorizes sanctions against the firm’s president was engaged in federal securities laws. compliance officers of investment an intricate cherry-picking scheme in advisers for failing to reasonably which he reallocated trades for his own OCIE will conduct the Presence Exams supervise an employee or other profit. The former CCO was found by in three primary phases. During the associated person of the adviser, FINRA to have failed to supervise the first phase, in which OCIE will endeavor if that person commits a violation firm’s president, and was suspended to reach out to private adviser CCOs of the federal securities laws and he from serving in any capacity at a FINRA other senior executives, OCIE’s stated or she was subject to the compliance member firm for a period three months. goal is “to inform newly registered officer’s supervision. This failure to firms about their obligations under the supervise liability has the potential to Private Adviser Presence Exams Advisers Act and related rules.” To this make compliance officers responsible The SEC’s Office of Compliance end, OCIE “has published compliance for the illegal activity of other people Inspections and Examinations outreach materials, staff letters, and is a hazy area of the law. As such, (“OCIE”) is charged with protecting risk alerts, special studies, speeches, Commissioner Gallagher explained the investing public by conducting and other documents” through the that “in recognition of the complexity exams and inspections of SEC- SEC website and will hold regional of the subject and the resulting need registered entities, including meetings and national seminars as for flexibility…we should be cognizant investment advisers, investment part of the SEC’s Compliance Outreach of the limitations of establishing a companies, broker/dealers, transfer Program, which is designed to provide rigid set of expectations based on agents, and exchanges. In October a forum for CCOs to discuss compliance bright-line rules.” He did offer some 2012, OCIE announced that as part issues with the SEC staff and learn guidance, however, noting that of its National Exam Program (“NEP”), about effective compliance practices. “optimal supervision requires a framework that encourages in-house The second phase, in which OCIE will legal and compliance officers to depart, 5 FINRA Letter of Acceptance, Waiver and Consent review the business and operations of when necessary, from the safety of No. 2010024116901.

Perkins Coie llp www.perkinscoie.com 11 CCO Corner private advisers selected for an exam, CCOs at all registered investment that the adviser uses “to identify, will require much more action on advisers should review their firm’s mitigate, and manage certain the part of private adviser CCOs. policies and procedures to ensure conflicts of interest within [the firm]. During the examination phase, that they cover the “higher-risk” Some areas of the conflicts OCIE will visit private advisers’ topics identified by OCIE. of interest that NEP staff will offices and will request records review include: allocation of relating to the adviser’s “higher-risk  One focus of the Presence Exams investments, fees, and expenses; areas,” including marketing, portfolio will be on truth in advertising. sources of revenue; payments made management, conflicts of interest, “NEP staff will review marketing by private funds to advisers and safety of client assets and valuation. materials to evaluate whether the related persons; employees’ outside As the introductory letter issued by investment adviser has made false business activities and personal OCIE explains, “after the completion of or misleading statements about its securities trading; and transactions the on-site portion of the examination, business or performance record; by advisers with affiliated parties.” made any untrue statement of a NEP staff may send [the adviser] a  The Presence Exams will inquire about material fact; omitted material letter indicating that the examination private advisers’ custody practices in facts; made any statement that is has concluded without findings or a keeping with the enhanced items on otherwise misleading; or engaged letter that describes the deficiencies Form ADV regarding safekeeping of in any manipulative, fraudulent, identified and asks [the] firm to client assets. “NEP staff will review or deceptive activities.” undertake corrective action. If serious advisers’ compliance with the relevant deficiencies are found, in addition to  Not surprisingly, the Presence provisions of the Advisers Act and sending an examination summary Exams will also focus on portfolio related rules that are designed to letter, NEP staff may refer the problems management and conflicts of interest. prevent the loss or theft of client to the Division of Enforcement, Advisers have an obligation to act in assets. When obtained, NEP staff also or to a self-regulatory organization, the best interests of their clients and will review independent audits of state regulatory agency, or other “to identify, mitigate, and disclose any private funds for consistency with regulator for possible action.” material conflict of interest. NEP staff the Advisers Act custody rule.” will review and evaluate investment  And, as the SEC is generally focused Once the intensive examination advisers’ portfolio decision-making on valuation matters, the Presence phase of the Presence Exams project practices, including the allocation Exams will address private advisers’ is complete, OCIE plans to report its of investment opportunities and valuation policies and procedures. findings and observations to the SEC whether advisers’ practices are “NEP staff will review advisers’ and the public, which “may include consistent with disclosures provided valuation policies and procedures, common practices identified in the to investors.” higher-risk focus areas, industry trends, including their methodology for fair and significant issues.” The goal of the  As with traditional exams of valuing illiquid or difficult to value reporting, OCIE has stated, will be registered advisers, with the instruments. NEP staff also will “to encourage firms to review Presence Exams OCIE will look at review advisers’ procedures for compliance in these areas and to private advisers’ compliance controls. calculating management and promote improvements in investment Each on-site exam will include a performance fees, and allocation adviser compliance programs.” review of the procedures and controls of expenses to private funds.”

Perkins Coie llp www.perkinscoie.com 12 CCO Corner

Since OCIE’s announcement, was especially important because who has some understanding of private advisers have reported that certain long held industry practices – compliance issues to help review and the examination phase of the such as “the offering of co-investment implement some of these procedures… Presence Exam initiative is underway. opportunities only to certain favored CCOs should be part of the firm’s In addition to the topics referenced in clients” – may be viewed as putting important decision making processes OCIE’s October 2012 letter, NEP staff the adviser’s interests ahead of and should act as investor advocates,” has also asked for information about: investor interests in violation of including by making sure that the Advisers Act. valuations are fairly represented and

 distribution fees and alternative that investors are accurately informed investment companies; As such, Karpati said, many private of the status of their investment.”  “selling away” by adviser advisers need to make efforts to brokerage affiliates; better establish and implement Karpati urged private advisers to tailored compliance policies and embrace their regulated and/or  risk assessment methods; procedures and to integrate registered status and “be alert and  oversight of third party compliance risk into their overall risk prepared for exam inquiries. It is service providers; management processes. Private adviser important to be cooperative with exam firms, just like investment management staff while an examination takes place.  audited financial statements shops that have been registered It is also important to implement any for the past three years; with the SEC for many years, must necessary corrective steps if the SEC  limited partnership and operating ensure that their “CCOs and other risk staff identifies deficiencies or possible agreements; and managers are able to proactively spot violations.” Taking these steps, Karpati and correct situations where conflicts said, would “help the examination  carried interest and claw backs of interest may arise.” Indeed, speaking process to proceed more efficiently and paid by private funds. at the February 2013 meeting of the reduce the likelihood of more formal Andrew J. Bowden, Deputy Director Corporation, Finance and Securities inquiries” in the future. of OCIE, has stated that in addition Law Section of the District of Columbia to NEP staff, enforcement attorneys Bar, Director of the SEC’s Division Private advisers who have been and economic advisers may visit of Investment Management, operating as unregistered advisers adviser offices in connection with Norm Champ, reported that the should understand that their existing the Presence Exams. primary issues arising from the NEP policies and procedures may not presence exams that OCIE had reported conform with the expectations of Bruce Karpati, Chief of the Division to his Division involved conflicts of examination staff on such matters as: of Enforcement’s Asset Management interest inherent to the way private investor letters and offering documents Unit, speaking at the Private Equity advisers operated prior to being that provide past specific performance International Conference in New York required to register with the SEC. information but do not list all prior on January 23, 2013, offered advice investments; treatment of soft dollars to the CCOs of private adviser firms Karpati also noted, “given the and research; record-keeping; and in approaching life as a regulated transactional focus of most private custody relationships. entities. Karpati emphasized that the equity shops, it may make sense to oversight role of a private adviser CCO assign an experienced deal professional

Perkins Coie llp www.perkinscoie.com 13 CCO Corner

Mutual Fund Distribution and shelf space, sub-transfer agency,  Any attribution analysis performed Sub-Transfer Agency Arrangements shareholder servicing, marketing on fund flows. support, 12b-1 plans, or exposure to a The SEC has embarked on a targeted  Board materials and minutes related third party’s sales force or customers.” examination sweep of mutual fund to fund distribution during the distribution arrangements “with a  The purpose of the compensation examination period. view towards ensuring that, as broker/ payable under each third party  Revenue sharing payments made dealers experience declining revenue agreement, the basis for each by the funds’ principal underwriter, streams, they not look to increase category of compensation and presented by sales channel in dollars their sub-TA fees to compensate them the total amount paid to the and in basis points. for distribution expenses.” The sweep financial intermediary during the comes approximately two years after examination period.  Omnibus and network fees paid by the SEC’s stymied Rule 12b-1 reform the fund and its principal underwriter,  Methods for tracking third party proposal and as the mutual fund presented by sales channel in dollars intermediary remuneration. industry begins tackling transparency and in basis points.  Any analysis conducted as part of and other issues related to oversight  Expense allocations by fund and by the negotiation process with third of financial intermediaries selling and share class for sub-accounting fees, party intermediaries and a list of servicing fund shares through omnibus Rule 12b-1 fees, management fees, intermediary firms considered but platforms. Mutual fund CCOs should and redemption fees paid pursuant rejected as distribution partners. be aware of the operational areas to Rule 22c-2 under the Investment identified in the distribution sweep  The disclosed Rule 12b-1 fee Company Act. exam and make sure that their funds percentage applicable to each  Policies and procedures regarding can produce the information requested. distribution arrangement and any Rule 22c-2 compliance, breakpoint As evidenced by exam letters received changes thereto; the dollar value of discounts and anti-money laundering. from OCIE’s Denver and Boston regional that percentage for each year; and a offices, among other information, detailed accounting of the amount  With respect to omnibus accounts the sweep exam solicits the following actually expended each year. invested in a fund: all contracts documentation going back as far as between the fund’s principal  All policies and procedures related to October 2009: underwriter and the relevant third party distributor remuneration. financial intermediary; all compliance  All agreements with third party  The most recent risk ratings for each exception reports related to Rule financial intermediaries – such as third party involved with distributor 22c-2 compliance generated during broker/dealers, financial planners, remuneration; the most recent the examination period; all requests insurance agents, retirement planners, “Contract Analysis” and “Market for underlying beneficial shareholder and investment advisers – regarding Analysis” performed by the firm’s investor information related to “a relationship that attracts assets finance department surrounding Rule 22c-2 compliance made during to the fund,” pursuant to which the distributor remuneration; and any the examination period; and any fund pays any form of remuneration. internal audit report related to warnings, restrictions, or bans A relationship that attracts assets distributor remuneration for the issued to shareholders during to a fund could be in any form, funds’ principal underwriter or any the review period. including “arrangements involving of its affiliates. sales, distribution, directed brokerage,

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