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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