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Issue 13 December 2009 Investment Management Review A Quarterly Update for the Investment Management Industry Assessing Risk • Oversight: Getting It Right with Your Service Provider • SEC v. Tambone: The First Circuit Reconsiders Primary Liability for “Implied Statements” under Rule 10b-5 • Reevaluating Mutual Fund Compliance in Today’s Market Environment • Preparing for Proposed Hedge Fund Legislation • Heightened Risk Management in the Post-Crisis World • Regulatory and Legislative Update • Toward T+1 Settlement: The History of Trade Matching in the Canadian Market Issue 13 December 2009 CONTENTS 2 Oversight: Getting It Right with Your Service Provider 8 SEC v. Tambone: The First Circuit Reconsiders Primary Liability for “Implied Statements” under Rule 10b-5 Girard Healy, Managing Director, and Mike Kerrigan, Principal, Beacon Consulting Group, discuss the opportunity to redefine and transform the oversight of outsourced functions. Joel T. Shaw, Bernstein Shur Securities and Financial Services Industry Group reviews this pending case and the possible implications for fund service providers and fund distributors. 12 Reevaluating Mutual Fund Compliance in Today’s Market Environment The Regulatory Administration Group of Citi’s Fund Services offers excerpts from the October and November issues of The Investment Lawyer where the team provides an extensive analysis of the unprecedented regulatory challenges facing compliance departments of mutual funds. 17 Preparing for Proposed Hedge Fund Legislation 22 Heightened Risk Management in the Post-Crisis World 26 Regulatory and Legislative Update 30 Toward T+1 Settlement: The History of Trade Matching in the Canadian Market Jennifer English, Senior Vice President, Regulatory and Compliance Services, Citi, and Fred Schmidt, Senior Vice President, Regulatory and Compliance Services, Citi, discuss the need for a robust compliance program in response to proposed regulation. Lawrence Komo, Asia Pacific Head of Investor Services, Citi, discusses the renewed focus on effective and robust risk management in Asia Pacific. Bruce Treff, Managing Director of Regulatory and Compliance Services, Citi, and Chuck Booth, Director, Regulatory and Compliance Services, Citi, review the third quarter’s fund regulation landscape. Ajmal Asif, Vice President Product Management, Citi, discusses the increased settlement efficiency and the reduction of operational risk through timely trade matching. Investment Management Review A Quarterly Update for the Investment Management Industry IMR UP FRONT A New Regulatory Environment for the New Year As we enter the New Year, now is an opportune time to consider the macro dynamics that our industry is facing—and will need to continue to address— as we successfully adapt to a post-Lehman, post-Madoff marketplace. By far, the most wide-ranging ramifications on our business will result from the forthcoming, though still-unspecified, changes in the regulatory and compliance environment—a theme that runs through this issue of Investment Management Review. For a comprehensive overview, Citi’s regulatory and compliance specialists have produced “Reevaluating Mutual Fund Compliance in Today’s Market Environment,” a thorough analysis of the increased oversight, additional regulation and stricter reporting requirements that lie ahead for mutual funds following the unprecedented challenges of the recent global credit crisis. Finally, Joel T. Shaw of Bernstein Shur discusses the reconsideration by the U.S. First Circuit Court of Appeals of primary liability for Implied Statements under Rule 10b-5 in “SEC v. Tambone,” and the “Regulatory & Legislative Update—3rd Quarter 2009” presents a comprehensive roundup of proposed and permanent rules specifically pertinent to the asset management industry. Oversight of a different kind is featured in “Oversight: Getting It Right with Your Service Provider,” by Girard Healy and Mike Kerrigan of Beacon Consulting Group. In fund managers’ dealings with service providers, they write, “The current market environment presents an ideal opportunity to improve oversight and to simultaneously achieve two critical goals: managing operational risk and reducing costs.” In 2010 and beyond, our industry will be broadly affected by changes in regulatory and compliance provisions to be shortly put into effect by governing bodies around the world. We are very interested in your views. To offer your comments on the new regulations or to submit ideas for future articles in Investment Management Review, please contact Denise Grant at (212) 816-2174 or via email at denise.grant@citi.com The importance of a robust risk management program is also highlighted in other articles in this edition of IMR. Among other timely points, Citi’s Lawrence Komo states in “Heightened Risk Management in the Post-Crisis World” that “In the new risk management paradigm,” which the recent global credit crisis has brought about, “innovative back- and middle-office outsourcing, backed by seamless technology platforms, can enable investment managers to make more informed and actionable decisions.” Likewise, increased operational efficiency and reduced operational risk are key goals in “Toward T+1 Settlement: The History of Trade Matching in the Canadian Market,” by Citi’s Ajmal Asif. Sincerely, Bruce Treff Managing Director of Regulatory and Compliance Services Citi For your convenience, Investment Management Review is now available online. To download current and previous issues, visit our website (https://www.citibank.com/transactionservices/home/sa/2009/imr_update/form.jsp). IMR 1 Oversight GETTING IT RIGHT WITH YOUR SERVICE PROVIDER The right level of oversight means striking a balance. Now is the time to redefine and transform the oversight of outsourced functions. The current market environment presents an ideal opportunity to improve oversight and to simultaneously achieve two critical goals: managing operational risk and reducing costs. Investment managers may be assuming unnecessary risk and/or missing out on cost savings if they have not recently reviewed and streamlined their oversight activities. IMR 2 Girard Healy Managing Director Beacon Consulting Group Mike Kerrigan Principal Beacon Consulting Group IMR 3 Investment managers may be assuming unnecessary risk Defining oversight is especially difficult in organizations and/or missing out on cost savings if they have not recently that have recently outsourced these functions as they may reviewed and streamlined their oversight activities. Many not have successfully planned the transition from “doers” opportunities exist to improve the processing environment to “reviewers” of service provider output. Oversight may for outsourced or offshored fund accounting, fund also be difficult in organizations that have a long-standing administration and middle-office functions. The issue for relationship with a service provider, as the natural many investment managers is that they may be utilizing an tendency is to grow the level of tasks performed in the oversight model that has not changed since the outsourcing name of oversight, irrespective of relative risks. Human relationship began. A lot can change over the years and factors also present barriers to effective oversight as outdated models may not be focused on the range of risks cultural resistance to change complicates the transition that the current market environment has created. from performing tasks to reviewing tasks. The recent decline in assets under management and Beacon’s experience indicates that effective associated drop in revenue have prompted investment oversight activities: managers to respond with a variety of initiatives aimed at reducing costs. Managers are merging funds, eliminating • Are risk-based; share classes, reducing staff and rationalizing their capital • Ensure accountability; spending. At the same time, operational risk and investor • Embrace comprehensive planning and communication; scrutiny has increased. Market volatility, increased trading volumes and added investment complexity have presented technology and operational challenges to many overburdened investment support areas. and • Utilize skilled professionals. Risk Now is the time to redefine and transform the level of Oversight activities should be designed and applied based oversight of outsourced functions. The current market on a comprehensive, process-based risk assessment. As environment presents an ideal opportunity to improve described in more detail below, a process-based approach oversight and simultaneously achieve two critical goals: ensures that risks, beginning with trade support and managing operational risk and reducing costs. ending with financial reporting, are identified and mitigated throughout the investment life cycle. The recommended approach includes an analysis of risk by activity and Oversight It is estimated that 85% of fund managers have outsourced some or all of their fund accounting, fund administration or middle-office activities. Even though these functions are outsourced, investment managers retain a shared a review of service provider capabilities. A risk-based approach will reduce unnecessary duplication of service provider activities and ensure that analytical reviews of higher-risk transactions are performed by investment manager personnel. responsibility and liability for ensuring that routine tasks are performed accurately and in accordance with regulatory and industry standards. This objective is usually achieved Accountability via an oversight role. The ideal oversight model achieves the Assumption of responsibility by the investment manager efficiencies, scalability and cost savings that led to the initial and service provider is an important element of oversight decision to outsource these functions, without increasing activities. Without accountability, the risk-based approach operational risk. The right level of oversight means striking a to oversight described above cannot work. There needs balance between completely shadowing the service provider to be commitment on both sides that agreed-upon and inattentive acceptance of anything and everything the procedures and controls will be followed. Investment service provider delivers. For most investment managers, defining that balance is more art than science. IMR 4 managers and service providers frequently speak about In a challenging economic climate, retaining experienced creating true partnerships, but few things create a true professionals for oversight can improve the oversight partnership and define accountability more effectively process and accelerate decision-making when complex issues than a comprehensive service level agreement (SLA). An need to be resolved. outsourcing relationship is a long-term proposition and approaching it as a partnership yields far more benefits for firms that view it as such over firms that view it as purely a scorekeeping exercise. One-sided SLAs typically result in a scorekeeping exercise — an SLA that obligates both sides creates a true partnership. Getting Oversight Right Defining the investment manager’s oversight model requires more analysis than simply saying, “If we performed the task using ten people, then it should only take three to review it.” Defining oversight is a continuous cycle of risk and Planning and Communication activity analysis, implementation, planning and monitoring. (See accompanying illustration.) The objective is that the Planning and communication are critical to the expertise and time devoted to an oversight activity is performance of successful oversight. The investment commensurate with the risk. manager should ensure that the service provider is aware of operational changes, new technology, new products, The risk and activity analysis entails identifying operational portfolio strategy changes and major transactions risk points and understanding exactly how the investment well before they occur. A best practice is to convene manager’s oversight personnel are spending their time. weekly update calls with the service provider to track To facilitate the analysis, the investment manager should issues and monitor resolutions. Report cards that detail identify all functional areas as for which oversight activities key performance indicators should also be part of the are performed and utilize a matrix to assist in the evaluation. communication process. Significant transactions should be treated like special projects and include a comprehensive Beacon recommends that investment managers evaluate project plan with milestones and assigned responsibilities. the risks at the detailed activity level and assign a risk rating Postmortems are also an important element of ensuring of high, medium or low. Using the matrix, the investment successful oversight. manager can also specify the roles of the service provider or the investment manager. Typical roles are “perform,” “review,” “provide” or “joint responsibility.” The matrix can be Utilization of Skilled Professionals The investment manager should perform its oversight activities with knowledgeable industry personnel who are experienced in performing the analytical reviews required to maintain a successful oversight model. These individuals must understand and resolve complex fund accounting and administration issues brought to their attention by the service providers. The oversight professional staff should consist of a mixture of individuals with deep technical knowledge as well as experienced generalists who understand the downstream ramifications of issues across all functions. For instance, professionals who understand and can communicate the impact to the tax function of an issue identified during the financial reporting processes designed to evaluate the entire enterprise or be customized on a fund-by-fund basis. The assessment process should identify material risks as well as evaluate instances where nonmaterial risks can become material when aggregated. The risks and activity analysis should be preceded by an evaluation of unique fund characteristics and internal capabilities, as well as external factors. The assessment should take into account the complexity of each fund’s strategy and product mix, trade volumes and historical issues. The level of assigned risk is also dependent on the strengths and weaknesses of the service provider. The investment manager must have a thorough understanding of the service would be beneficial. IMR 5 provider’s strengths and weaknesses in both technology and personnel. The investment manager can leverage reports such as a SAS 70 and, if available, internal audit reports to expedite the review. Lack of knowledge of the service provider’s capabilities could unintentionally direct oversight activities to low-risk areas. To become familiar with a service provider’s processes, controls, cutoff times and technology capabilities, a site visit to the service provider is recommended. Detailed knowledge of the service provider will direct where the manager’s oversight activities should be focused. For example, transactions or activities that are manually uploaded from the service provider’s ancillary systems to its core systems should receive a higher degree of oversight than those that are processed straight through. A complete inventory of available reporting from the service provider should be created. The reports should be analyzed for adequacy in helping the manager meet its oversight role. Reporting gaps • Achieves flexibility and scalability while maintaining a risk-based approach • Speeds operational oversight of new and complex products • Supports growth strategies The investment manager’s oversight policies and procedures should be documented to ensure adherence to oversight activities. The procedures should specify the party responsible for the tasks as well as the frequency with which they should be performed. The procedures should identify the specific review procedures, include reasonableness tests and specify levels of materiality that may require additional research or coordination with the service provider (e.g., pricing, income and expenses). Functional job descriptions for oversight personnel should be developed to ensure that key functions are performed and evaluate their oversight capabilities. and related enhancements should be coordinated with the service provider. The investment manager should take the lead in communication and planning with the service provider. The Next, it is critical that investment managers understand exactly where their personnel are spending their time. The same matrix that is used to assess risk should also be utilized to measure time spent on activities by the manager’s investment manager is driving the business and the service provider needs to be privy to upcoming strategic decisions and operational changes that may impact its ability to deliver quality services. personnel. An SLA should be revised or initiated with the service Upon completion of the risk assessment steps, the manager can overlay the risk profile against time spent. This analysis is the best way to make adjustments and redirect oversight activities to high-risk areas. An additional benefit from this approach is that it may be helpful in allocating technology spending, especially where low-risk, manual processes are consuming a significant amount of time. provider. Industry-standard SLAs typically include a list of service requirements and identify the responsible party and time frames by which the requirement must be met. The SLA should include obligations by both parties especially where the service provider’s compliance with the SLA is dependent on action by the investment manager. For example, the SLA might stipulate that the service provider will book all trades on trade date, provided trades Once the oversight roles are determined, implementation activities can begin with the development of an oversight are sent by the manager at the agreed-upon frequency and prior to the cutoff time. model. An operating model defines the scope of functions performed by the firm and outlines how the oversight processes would be logically organized into work groups to deliver effective oversight. The ideal oversight model has the following characteristics: The process described above is a continuous process. New risks are identified on almost a daily basis. The investment manager’s oversight regimen should be structured so that it can quickly anticipate risks and provide effective oversight of new products. IMR 6 Conclusion The appropriate levels and depth of oversight activities should be designed and applied based on a comprehensive, process-based risk assessment. A continuous assessment process ensures that oversight activities can be directed to significant risk areas. Understanding the details of the service provider’s processes and controls is an integral part of the assessment process. Developing good relationships with service providers is important, as well as agreeing on a mutual service level agreement. Applying a risk-based approach is critical. Any other approach to oversight is likely to result in a significant amount of ineffective, but well-intended, activities performed in the name of oversight and ultimately will conjure the story of the policeman who one night spotted a man in the road on his hands and knees looking for something. “What are you doing?” asked the officer. “I dropped a nickel a mile down the road,” said the man. “Then why are you looking for it here?” asked the officer. “Because the lighting is better here,” said the man. How Many? No examination of service provider oversight would be complete without answering the question: “How many professionals does it take to perform adequate oversight?” There is not a formulaic answer. The keys to the right level of oversight lie in the investment manager’s capacity to move from performing core tasks to a culture of performing analytical reviews, the capabilities of the service provider, the experience of the investment manager’s staff and the volume and complexity of the funds. Interestingly, Beacon Consulting Group recently completed a benchmarking study that compares the relative performance of the financial reporting process using in-house staff versus outsourcing the process. The firms that outsourced the financial reporting process utilized two-thirds fewer staff than those preparing the financial reports in-house. Getting Oversight Right Is a Continuous Process • • • • • Service Level Agreements Key Performance Indicators Deadlines Reporting Sanctions • Changes in Product, Strategy • Project Orientation • Communicate Monitoring Planning Risk & Activity Analysis • Activity-Oriented View • Time Allocation • Understand Service Provider Capabilities and Technology Implementation • Operating Model • Policies and Procedures • Job Descriptions IMR 7 Joel T. Shaw Bernstein Shur Securities and Financial Services Industry Group SEC v. Tambone: The First Circuit Reconsiders Primary Liability for “Implied Statements” under Rule 10b-5 A Slippery Slope On the morning of October 6, 2009, the First Circuit Court of Appeals heard oral arguments pursuant to a rehearing en banc in Securities and Exchange Commission v. Tambone, et al., U.S. Court of Appeals, First Circuit (Dec. 3, 2008). In what is expected to be its final word in the case, the First Circuit will either maintain the status quo with respect to the conduct for which a defendant may be held primarily liable under Rule 10b-5, as promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or expand it to include the novel concept of “implied statements.” Tambone is simply the latest in a line of cases that applies, directly or indirectly, to the investment management industry and threatens to shift the liability standards applied to fund service providers and, at a minimum, raise the level of due diligence required of fund distributors with respect to statements made in a fund prospectus. Although the essential Tambone holding arguably applies only to fund distributors, the question remains to be answered: Is the First Circuit on the precipice of a slippery slope that will capture a broader range of market participants? IMR 8 A Brief History 17(a)(2) of the Securities Act of 1933, as amended (the “Securities Act”) and Section 10(b) of the Exchange Act and Between 1998 and 2003, James R. Tambone and Robert Hussey were each employed as senior executives of the principal underwriter and distributor for the Columbia family of mutual funds. In these capacities, they were responsible for selling the securities and for disseminating informational materials, including prospectuses, to investors and potential investors. Although occasionally Rule 10b-5 promulgated thereunder. The SEC subsequently entered into a $140 million settlement agreement with Columbia Management Advisors, Inc., Columbia Funds Distributors, Inc., and three former employees. Hussey and Tambone were not party to the settlement and, instead, moved to dismiss the SEC claims against them. involved in revising draft documents, neither defendant was responsible for creating the original content. During the same time period, the Columbia funds adopted various The District Court Dismisses disclosure statements for inclusion in the prospectuses On two occasions, first in January 2006 and again in regarding “market timing” activities. The Securities and December 2006, the District Court for the District of Exchange Commission (“SEC”) later alleged that Hussey Massachusetts agreed with Hussey and Tambone and co-led a working group, which recommended that all of dismissed the SEC complaint and amended complaint. the Columbia funds adopt a consistent position against Addressing the question of primary liability, the court held market timing. The SEC further alleged that Hussey and that to be liable under Section 10(b) of the Exchange Act Tambone each reviewed drafts of and offered comments to and Section 17(a) of the Securities Act, the defendant must the proposed disclosures. By 2001, all of the prospectuses have personally made either an allegedly untrue statement in the Columbia funds family did in fact reflect a consistent or a material omission. Because neither defendant was strict prohibition on market-timing activities. responsible for creating the original content in the Columbia funds’ prospectuses, in the eyes of the district court, “[t]he Notwithstanding the disclosure statements, the SEC major flaw with the SEC’s complaint was then, and continues subsequently determined that, during the approximately to be, a failure to attribute misleading statements to either five-year period between 1998 and 2003, nearly $2.5 billion Tambone or Hussey.” of transactions were executed pursuant to market-timing arrangements in the Columbia funds family with certain preferred customers. The SEC claimed to have identified The First Circuit Reverses multiple market-timing arrangements that Hussey and Tambone allegedly either affirmatively approved or knowingly allowed each in violation of the strict prohibition disclosures contained in the Columbia funds’ prospectuses. On December 3, 2008, a three-judge panel of the First Circuit Court of Appeals unceremoniously reversed the holding of the district court, concluding that Hussey and Tambone could be held primarily liable for using false or misleading prospectuses to sell mutual fund shares under both Section The SEC Acts 17(a)(2) and Rule 10b-5. In reaching its decision, the First Based on its investigation of the above-described conduct respect to primary liability in at least two respects. Circuit panel challenged the current jurisprudence with in the Columbia funds family, the SEC initiated an enforcement action in 2005, alleging various violations Section 17(a)(2) provides, in relevant part, that “[i]t shall be of the anti-fraud provisions of the federal securities laws, unlawful for any person in the offer or sale of any securities including, but not limited to, primary violations of Section … by the use of any means or instruments of transportation IMR 9 or communication in interstate commerce or by the use of The First Circuit was persuaded by the SEC’s argument the mails, directly or indirectly, to obtain money or property that, as senior executives of the primary underwriter for by means of any untrue statement of a material fact or any the Columbia funds, they each had a legal duty to confirm omission to state a material fact necessary in order to make the accuracy and completeness of the prospectuses that the statements made, in light of the circumstances under they were responsible for distributing. In light of this duty, which they were made, not misleading.” It is well settled that the defendants made “implied statements” of their own Section 17(a)(2) applies only to sellers of securities, and was to potential investors within the meaning of Rule 10b-5(b) thought to be well settled, at least to Hussey and Tambone, that they had a reasonable basis to believe the information that, for primary liability to attach, the untrue statement in the prospectuses was truthful and complete. Having or omission must be directly made by or attributable to the decided that an “implied statement” was the functional defendant. The First Circuit, however, adopted a compelling equivalent of a “made statement,” the First Circuit argument by the SEC that the wording of the statute “by concluded that the SEC sufficiently alleged that both means of any untrue statement” (emphasis added) does not Hussey and Tambone made statements to investors about require the seller to have actually uttered a word, provided the market-timing practices of Columbia funds when they that an untrue statement made by someone was used by knew, or were reckless in not knowing, that the disclosure the seller in connection with the transaction. In doing so, statements in the prospectuses were false. The issue of breaking from prior precedent, the First Circuit recognized the primary liability attaching under Rule 10b-5(b) based on an potential implication of its holding that Section 17(a) captures implied statement theory is now subject to the rehearing a broader scope of conduct than Section 10(b) and Rule 10b-5. en banc in the First Circuit. The panel’s ruling with respect to the Section 17(a)(2) claim withstood the defendants’ motion for rehearing and for now is the law of the case and the law of the First Circuit. Although certain commentators have accepted, albeit grudgingly, the Tambone decision as a logical interpretation of Section 17(a), others, including Judge Selya in dissent, accused the court of nothing short of a judicial rewriting of Rule 10b-5. Rule 10b-5(b) provides that “[i]t shall be unlawful for any person, directly or indirectly, to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.” Contrary to Section 17(a)(2), based on the plain language of the rule, there was no reasonable dispute that the SEC must allege and prove that Hussey and Tambone actually made an untrue statement of material fact. Consequently, the issue became how broadly could the SEC convince the First Circuit to construe the concept of making a statement? Unfortunately for Hussey and Tambone, thus far, that answer appears to be very broadly. IMR 10 The New Landscape If allowed to stand, the First Circuit panel’s decision in Tambone is feared to be the precipitating factor for one of any number of unintended (or intended) consequences. Most notable among these is the blurring of the line between primary and secondary liability that the Supreme Court attempted to carefully delineate in Central Bank of Denver v. First Interstate Bank of Denver, U.S. Supreme Court (1994). Following that seminal case, secondary liability—more commonly known as “aiding and abetting”— can no longer be the legal and factual basis for Rule 10b-5 liability in private rights of action. With so much at stake for industry participants, an entire body of law has developed around this critical line of demarcation. To further aid in determining the outer limits of primary liability, courts of appeals generally have either followed a “bright-line” test (as relied on by the district court) or a “substantial participation” test. By declining to follow either of the existing methods in favor of a third “implied statement” test, correlate to the legal duty giving rise to the implied which seemingly has the potential to characterize a much statements triggering the potential applicability of Rule broader array of conduct as “primary,” the First Circuit has 10b-5(b). As the legal duty increases and becomes more introduced yet another theory of primary liability under Rule fundamental to the fair and efficient operation of the 10b-5 to an existing split in the circuits. There is a growing securities markets, the due diligence required to satisfy belief that the Supreme Court will take its next opportunity such duty should increase in a corresponding manner. to settle the law. Consequently, market participants should be asking themselves the following questions: By virtue of our Until the Supreme Court intervenes, however, without a actions in the chain of distribution, do we have a legal duty clear dividing line it may be virtually impossible to assess to investors? What is the nature of our legal duty? Are we the magnitude of the risk of private litigation associated taking appropriate steps to satisfy our legal duty, including, with certain conduct in the securities industry by concluding without limitation, conducting appropriate due diligence that it is either primary and within the reach of Rule with respect to offering materials prepared by others? 10b-5, or secondary and outside the reach of Rule 10b-5. And most importantly, can we document those steps in the If the essential elements of the Tambone decision are event of a claim by the SEC or by a private litigant? reaffirmed by the full First Circuit, the immediate question should be “How far-reaching are the effects on all market participants?“ For underwriters, including any fund advisers with affiliated distributors, the short answer is that they will fall squarely within the crosshairs of the SEC, as well as private litigants, for any material misstatements or omissions in the offering materials that they distribute, regardless of where the ultimate responsibility for drafting the documents lies. Because the SEC, unlike private litigants, still has an action for “aiding and abetting” in its arsenal, it is the potential explosion of private liability that is most concerning to the securities industry. Underwriters in particular need to be prepared for the possibility of a significantly increased due diligence burden, with an eye toward defending claims based on material misstatements attributable to the issuer. For others the answer will be less obvious. However, for those market participants engaged in the chain of distribution, no due diligence with respect to offering materials will never be the correct approach. Based on the And Now We Wait The First Circuit panel’s “implied statement” theory in Tambone indisputably captures a broader scope of conduct subject to primary liability under Rule 10b-5 than exists under current law. It is too soon to predict, however, how far beyond underwriters the bounds of primary liability could stretch under this new theory. If preserved in its final decision, the court’s intense focus on the “essential role” of the defendants as principal underwriters and the legal duty that entails should temper the fear of a true slippery slope that will inextricably blur the line between primary and secondary liability under Rule 10b-5. Ultimately, resolution of the appropriate manner to determine the outer limits of primary liability appears to be on a one-way track back to the Supreme Court. Until then, the industry will wait and watch with keen interest for the decision of the full First Circuit in Tambone. existing Tambone decision, it is reasonable to conclude that the appropriate level of due diligence should at least IMR 11 Reevaluating Mutual Fund Compliance in Today’s Market Environment In its October and November issues, The Investment Lawyer published an extensive analysis, written by regulatory and compliance specialists in Citi Fund Services, of the unprecedented challenges—increased oversight, additional regulation, greater frequency of SEC examinations and enforcement actions, stricter reporting requirements, etc.—faced by compliance departments of mutual funds. Below are excerpts from that two-part article; if you’d like the complete article please contact Maureen Hicks at maureen.hicks@citi.com. IMR 12 The effects of the recent economic crisis on the financial services industry have been profound and widespread. Banks have failed, storied institutions have collapsed or been bailed out, financial scandals have been exposed and the precipitous decline in the markets has severely reduced the fortunes of individual investors and institutions alike. Although nearly every financial institution in the country has been affected by the crisis, the mutual fund industry has been hit especially hard with tumbling stock prices and increased redemptions causing mutual fund assets to drop at one point by a staggering $2.5 trillion. This extraordinary drop in fund assets ultimately reduced revenues for many mutual fund sponsors, leading to reductions in staff and other resources throughout the industry. The crisis has created a unique set of challenges for many mutual fund compliance departments. With the unprecedented intervention by the federal government in the financial services sector, compliance departments have had to navigate through some unfamiliar waters. The recent spike in examinations and enforcement actions by the Securities and Exchange Commission (SEC) has made these waters increasingly unfriendly. In addition, the number of mergers, acquisitions and consolidations in the financial services industry resulting from the crisis has created a more complex web of affiliates. As a result, some compliance departments have had to spend extraordinary amounts of time evaluating recent industry changes to ascertain new affiliations and to monitor for prohibited affiliated transactions. These factors, coupled with the recent significant reduction in revenues, have left many compliance departments in the unenviable position of being asked to accomplish more with fewer resources. IMR 13 In an effort to prevent cuts in compliance resulting “the need for interim reviews in response to significant from the crisis, the SEC staff has stressed the need for compliance events, changes in business arrangements compliance programs that are more robust than the current and regulatory developments” should be considered. industry standard. With mutual funds suffering prolonged In light of the current market environment, along with negative performance periods, the pressure to turn around the fast-changing business and regulatory landscape, performance results has only intensified, leading to increased compliance departments should strongly consider, if they potential for noncompliant or unethical behavior. As a result, are not doing so already, performing one or more interim now more than ever, the SEC considers the compliance reviews of their funds’ compliance program. function as being essential to mutual fund operations. In fact, the SEC staff has directed mutual funds to view their In performing a review of compliance programs, the SEC compliance departments as vital to their survival and to fund staff has advocated that compliance departments conduct them accordingly. comprehensive “risk assessments” to identify risks that may affect their funds. In fact, one of the items the SEC Given such a mandate, this article contends now is the time staff routinely requests to review during fund examinations for mutual funds to perform a comprehensive review of their are documents evidencing that a risk assessment has compliance programs to ensure they adequately deal with the compliance risks that have surfaced, or received extra attention, as a result of the recent market turmoil. been performed. A risk assessment is a process by which a compliance department analyzes a fund’s operations and identifies issues, conflicts and other problems that are unique to that particular fund, including a careful review of the fund’s vulnerabilities. When identifying potential risks, Time to Reevaluate Risks compliance departments should also think “outside the Pursuant to Rule 38a-1 under the Investment Company Act their funds. In addition to identifying compliance risks, a 1940 Act, as amended (the 1940 Act), mutual funds are risk assessment also includes assigning levels of risk and required to maintain written policies and procedures that identifying solutions. The greater the risk in an area, the are reasonably designed to prevent, detect and correct more compliance departments should focus on compliance violations of securities laws by the fund, as well as provide in that area. As new risks are identified, new controls oversight of the compliance efforts of the fund’s service should be implemented to reduce or eliminate such risks. providers through which the fund conducts its business (that As compliance programs have evolved, many compliance is, adviser, transfer agent, distributor and administrator). departments are conducting risk assessments on a In addition, Rule 38a-1 requires funds to determine quarterly basis, and even more frequently for higher-risk the adequacy of their policies and procedures, and the areas of a fund’s operations. And although not required, effectiveness of their implementation, as well as those of many chief compliance officers are now providing copies of their service providers, on at least an annual basis. Although risk assessment reports to the boards of their funds as part only an annual review is required, the SEC has stated that of their annual 38a-1 report. IMR 14 box” and assess new areas that could significantly impact Compliance programs should be in a state of constant improvement, continuing to identify and address new and emerging risks, as well as changes in the dynamics Maintaining Requisite Compliance Resources associated with existing risk areas. Due to the market It has been over five years since the adoption of Rule 38a-1 events of the past year, a thorough and careful review and mutual fund compliance programs continue to evolve as by compliance departments of such risks is necessary to compliance departments constantly seek the best methods assure that compliance programs are “square on” today’s to improve their programs. The recent economic crisis has compliance risks. In fact, even the SEC’s own risked-based made this process more challenging because of the new and examination program will focus on areas that are emerging risks that have been identified. In addition to the particularly critical in today’s market environment. Several seven SEC-identified areas of risk listed at left, others have of the areas that SEC examiners will be focusing on affect been brought to light. Many mutual funds have also identified mutual funds and their service providers, and include, emerging risks in the areas of business recovery, safety of among other things: customer assets, securities lending, use of pricing agents 1. Valuation; and proxy voting, to name a few. Consequently, maintaining an effective compliance program in today’s market and 2. Money market funds; regulatory environment requires significant resources. As 3. Controls over nonpublic information, personal trading compliance departments perform risk assessments of their and codes of ethics; 4. Best execution; compliance programs, whether or not to cut back on such resources during these difficult economic times should be given careful thought and consideration. If the SEC staff 5. Anti-money laundering; finds a violation of securities laws caused by the absence of 6. Safety of customer information; and compliance, then a fund and its adviser could face significant 7. Disclosure. The compliance and regulatory experts at Citi Fund Services have examined each of these focal points identified by the SEC and have suggested ways that mutual fund firms and their compliance professionals can help ensure appropriate oversight and adherence. The full, troubles—as well as even greater costs trying to repair the damage done. While a reduction in compliance resources may be unavoidable for some funds, these funds should focus first on retaining the most trained and experienced compliance personnel to help avoid any compliance problems. As the SEC staff has stated, now is not the time to ignore compliance. two-part article that appeared in The Investment Lawyer’s October and November issues, “Reevaluating Mutual Fund Compliance in Today’s Market Environment,” can be downloaded from Citi’s website at (insert URL). IMR 15 IMR 16 PREPARING FOR Proposed Hedge Fund Legislation By Jennifer English Senior Vice President, Regulatory and Compliance Services, Citi By Fred Schmidt Senior Vice President, Regulatory and Compliance Services, Citi IMR 17 Proposed Federal legislation and regulation will have a significant impact on the hedge fund industry. It is clear that due to recent scandals and increasing enforcement action, the industry will be subject to much greater focus and scrutiny regardless of what actual proposals become law. Throughout the industry, there have been calls from investors and regulators to enhance internal controls, compliance and risk management. The focus on improved corporate governance will lead to the development of more robust compliance programs, which should evidence greater transparency. For those hedge fund managers or investment advisers that are already registered with the Securities and Exchange Commission (SEC), there will be a need to enhance existing compliance programs. For those who are currently unregistered, there will be greater expectations to be met regardless of the final decision on any registration requirements. Much of the controls, reporting and transparencies of registered funds would be realized by requiring the registration of investment advisers of hedge funds, and satisfying the requirements of the Investment Advisers Act of 1940 (the “Advisers Act”). Every investment adviser registered with the SEC must to serve as chief compliance officer (CCO) to administer and adopt and implement written compliance policies and implement the compliance program and (c) evidence of an procedures and develop a compliance program. Specifically, annual review to determine the adequacy of the compliance Rule 206(4)-7 under the Advisers Act requires (a) an policies and procedures and the effectiveness of their investment adviser to adopt and implement written implementation. The objective of a well-designed compliance compliance policies and procedures reasonably designed to program is to prevent violations from occurring, detect prevent violations of the Advisers Act (and rules thereunder) violations that have occurred and correct promptly any by the investment adviser or any of its supervised persons, violations of the Advisers Act that have occurred. (b) the designation and appointment of a qualified individual Throughout the industry, there have been calls from investors and regulators to enhance internal controls, compliance and risk management. IMR 18 Major Aspects of Developing and Maintaining a Compliance Program The following key areas of compliance oversight have While Rule 206(4)-7 does not enumerate specific elements unregistered funds: been identified by the SEC for registered investment advisers and may be applicable to investment advisers of that investment advisers must include in their compliance policies and procedures, investment advisers have been • Portfolio Management instructed to identify conflicts and other compliance • Trading Practices factors creating risk exposure for the firm and its clients in light of the firm’s particular operations and then design • Accuracy of Disclosures compliance policies and procedures that address those • Safeguarding of Client Assets risks. The SEC listed issues an investment adviser’s • Creation and Maintenance of Records compliance policies and procedures, at a minimum, should address (to the extent that they are relevant to • Solicitation Arrangements that investment adviser) in the adopting release for Rule • Valuation of Client Holdings 206(4)-7. Additional guidance has been provided via • Privacy Protection forums, correspondence and public speeches. • Business Continuity When developing a compliance program, the following • Pricing of Portfolio Securities steps may be appropriate: • Identification of Affiliated Persons • Develop a checklist of applicable Federal Securities Laws • Protection of Nonpublic Information • Document controls of the investment adviser and its • Fund Governance Standards service providers that support compliance with those rules and regulations • Map the controls to the rules and regulations and determine existing control weaknesses and gaps • Test and report on the effectiveness of the controls, and update the risk assessment, based on the likelihood and impact of a failure or occurrence, and compliance history • Perform ongoing reviews to monitor changes to the • Anti-Money Laundering Policy Development and Oversight • Personal Trading and Code of Ethics Review and Reporting • Use of Leverage • Counterparty Credit Risk • Performance Calculations control environment through internal best practices and • Regulatory Disclosure and Filings regular participation in industry committees • Brokerage Allocation • Develop methods for monitoring new industry developments, rule proposals, final rules and regulatory • Investor Transactions and Recordkeeping • Soft Dollars guidance • Develop standard review procedures and documentation for procedure changes IMR 19 During the past year, the SEC has provided guidance and accounts to generate soft-dollar credits rather than discussed the examination process and focus areas. In seeking best execution and misrepresenting investment order to thoroughly evaluate a compliance program’s performance of a fund to enhance its position in the effectiveness, examiners need to obtain sufficient competitive marketplace. Investment advisers may information about the structure of an investment adviser’s also have risks and conflicts of interest that are unique organization and operations to (i) understand the risks and as a result of the firm’s organizational arrangements, conflicts of interest present at the firm and the policies affiliations, business partners, diversity of client base, and procedures implemented to address such risks and conflicts, (ii) determine the ability of the compliance program to prevent, detect and correct compliance problems and (iii) evaluate the reasonableness of the firm’s compliance monitoring processes and the remedial actions implemented by the firm once problems have been identified. products and services offered to clients, geographical locations and personnel. To implement a compliance program reasonably designed to prevent violations of the Advisers Act and rules thereunder, each investment adviser should identify the risks and conflicts of interest that are relevant to its business. Examiners also evaluate the frequency, severity and nature of the problems identified by an investment adviser’s compliance program. Investment advisers with effective Portfolio management covers a broad array of advisory activities. It includes the allocation of investment compliance programs will generally have fewer compliance opportunities among clients, the consistency of portfolios breaches, problems that are not as egregious, fewer with clients’ investment objectives, disclosures to client repetitive compliance problems, issues identified on a timely and consistency of operations with applicable regulatory basis and problems that are promptly corrected. requirements and the firm’s code of ethics. Because of their importance, these areas are typically reviewed during Investment advisers are exposed to numerous risks and all examinations. Risks in the area of portfolio management conflicts of interest that can result in harm to investors and are greatly dependent on an investment adviser’s may cause a firm to deviate from regulatory requirements. operations, services, affiliations and the specificity of Many risks and conflicts of interest are common among guidelines and restrictions clients place on the firm firms. Examples of such risks and problems include portfolio regarding their individualized services. Also relevant is how managers making decisions that are contrary to a client’s the firm handles its receipt of nonpublic information, and investment objectives, traders placing orders for clients’ how the firm maintains the confidentiality of information regarding its clients. IMR 20 An investment adviser may choose to engage service providers to perform a number of important services for advisory clients, including management or contractual responsibilities. Service providers often serve as administrator, pricing agent, proxy voting agent and/ or fund accountant. These service providers may: provide inancial reporting, tax and regulatory services; create and maintain required books and records; value portfolio securities and accounts; prepare regulatory ilings; calculate client account expenses; vote client proxies; and monitor arrangements with other service providers. However, when a service provider is utilized, the investment adviser still retains its fiduciary responsibilities for the delegated services. As a result, investment advisers should review each service provider’s overall compliance program and should ensure that service providers are complying with the applicable compliance policies and procedures of the investment adviser. In summary, management support at the top fosters a strong compliance environment and sends a strong message when regulators examine an investment adviser. Compliance programs should be approached with a Portfolio management covers a broad array of advisory activities. It includes the allocation of investment opportunities among clients, the consistency of portfolios with clients’ investment objectives, disclosures to client and consistency of operations with applicable regulatory requirements and the firm’s code of ethics. “what-if” mentality, looking for issues that may not have previously occurred, but could in the future. Ideally, a compliance program will be evergreen in nature, and updated and enhanced as needed. IMR 21 Navigating in a new environment: HEIGHTENED RISK MANAGEMENT In the Post-Crisis World By Lawrence Komo Asia Pacific Head of Investor Services, GTS, Citi IMR 22 The global financial crisis has been a wake-up call for the global investment management industry. Irrespective of geographic location, the turbulent market environment has impacted the entire investment management industry and has drawn into sharp relief the cornerstone role played by risk. Discussions with investment managers indicate the morphing of risk management strategies to the next level as a consequence of the financial crisis and events including the Lehman Brothers’ collapse. A renewed focus on effective and robust risk management structure capable of withstanding external and internal shocks is sweeping the investment management industry in Asia Pacific. For investment managers across the region, a robust risk management framework provides the base foundation to meet business objectives. However, a risk management framework that comprehensively covers the pre- and post-trade environment does come at a cost for investment managers. As capital deployment remains tight and the objective for investment managers remains skewed toward generating returns, custodians have seen their role in providing effective and scalable risk management solutions evolve significantly since the onset of the financial crisis. The Risk Management Fallout Significant capital investment and a high level of technological and operational support is often necessary to drive market expansion, product innovation or improved client service. Unfortunately, as a consequence, the premium placed on risk management by investment managers across the region proved to be inadequate to cope with the global financial turmoil. Risk management strategies across credit risk, operational risk and liquidity risk were woefully inadequate, prompting a sea change in both opinion and strategy execution. As a result, for investment managers severely burned by the financial crisis, risk management is now front-and-center of concerns. In other words, the market conditions since late 2008 have drawn attention to capital preservation, which relies heavily on risk management techniques throughout the trade and settlement cycles. IMR 23 According to a recent study by the IBM Institute of Business Value, which surveyed global investment industry participants, transparency has emerged as the largest concern in today’s financial architecture. Approximately 35% of respondents listed transparency as the major focus required to reconstruct the global financial infrastructure, while a further 15% earmarked enhanced security as the primary concern going forward. The New Risk Management Value Proposition Although the future of the global investment management space remains unclear at this stage, it is widely accepted that market volatility will remain a fact of life for investment managers for some time to come. As the most recent financial crisis has shown the industry, market volatility can be extreme when it occurs and when risk The same selection of investment management participants also painted a bleak picture of current risk management management is concerned, traditional risk management techniques tend to fall short. platforms and devices. According to the IBM Institute of Business Value, the same respondents rated their ability to manage systemic risk and manage associated risks with new products and markets as key priorities, but also recognized weak proficiency in executing as inhibiting their plans. For investment managers, selecting an effective partner who can implement risk management solutions is key to their ability to function in the most effective and efficient manner. While mitigation solutions remain important to any outsourced risk management relationship between an This data does have defined implications for custodian banks. In this environment, the traditional boundaries between investment managers and their service providers—be investment manager and a custodian, there are clearly new variables required to enhance transparency and rebuild lost confidence in processes. they custodians, fund accountants, middle-office service providers—have blurred. Clearly, the cost and effectiveness of providing robust risk management solutions correlates directly to a custodian’s Clearly, to achieve effective and efficient risk management, the ability of the entire investment management industry as a whole, including internal and external service providers, to function together as a seamless unit is key. This is in stark contrast to the previous model, which functioned as technology platform and ongoing investments to this platform. To foster transparency and enhance security, technology must seamlessly serve investment managers and integrate both the pre- and post-trade space to provide optimal risk management. a random summation of what may be perfectly functioning individual units. As the concept of engaging the best solutions provider grows in acceptance in Asia Pacific, the risk management focus clearly plays to the advantage of proactive and innovative custodians, with the resources and the experience of packing an effective solution to the client rather than individual product silos. In the new risk management paradigm, the true value of technology is discovered in consideration of the new premium being placed by custodians that provide these outsourced services. For example, backed by seamless technology platforms, innovative back- and middle-office outsourcing can enable investment managers to make more informed and actionable decisions. IMR 24 From where we stand, the role to be played by integrated Clearly, investment management firms across Asia Pacific, solutions in managing risks relies on closer interaction with in their various business objectives, require innovative investment managers. This is particularly true when unique solutions straddling the investment life cycle from concerns over transparency and security throughout the presettlement to post-settlement. However, a unique pre- and post-settlement cycle for each client are fully understanding and trusted adviser approach is required to considered. Investment managers clearly require their cater to each individual investment manager and take into custodians to have a complete view of their footprint, levels account their unique characteristics. of automation, processes, investments and future ambitions to provide value-added risk management solutions. By working closely with investment managers and combining our comprehensive service platforms, we are able to Citi has proactively addressed this evolution in the market. help them achieve optimal risk management solutions. As investment managers look to outsource more risk Partnering with Citi provides investment managers access management processes and focus on core competencies in to market-leading technology, the most adaptable service light of the new economic paradigm, personalized service platforms and the comfort of the most personalized services provides greater peace of mind. to drive business growth while ensuring effective risk management. In other words, through a “client solutioning” approach, solutions provided by custodians like Citi are evolving and becoming less commoditized. Custodians like Citi use a partnership and adviser approach to work with investment managers to decide what processes they want simplified and eliminated, what technology platforms can be integrated and what risk management strategies can be added to enhance existing processes and support future expansion plans. This is truly where value is being added in the new environment, where clients are turning, allowing them to focus on core competencies. The risk issues highlighted by the financial crises will not disappear, but the responses to and strategies to manage the same are continually evolving. The fallout of the crisis has prompted many investment managers to reevaluate their approach to risk management with a greater focus on transparency and security. Increasingly, to achieve these goals without sacrificing the primary objective of generating investment returns, investment managers see custodian-provided partner-based and integrated solutions as the answer to address risk management concerns. IMR 25 BE ADVISED: STRICTER REGULATIONS AHEAD Financial reform continued to be the hot topic of the quarter. While most unregistered investment advisers have begrudgingly accepted that they will be required to register with a regulatory agency, most likely the SEC in some form or fashion, they are still lobbying for relief from some of the more onerous proposals being suggested. IMR 26 By Bruce Treff Managing Director of Regulatory and Compliance Services, Citi By Chuck Booth Director of Regulatory and Compliance Services, Citi Regulatory and Legislative Update— Third Quarter 2009 Most of us watching the debate and following it on a regular basis believe it will be a two- to three-year process for the legislative and regulatory changes to become fully finalized and implemented. However, 2010 promises to be a lively year for the unregistered world and will almost certainly set the tone for many years to come. All of this attention to hedge funds and unregistered advisers would seem to likely result in a slowdown in regulatory activity on the registered side of the house. Not true. The SEC, FinCEN, state securities offices, the IRS and other regulators have seemed to excel in their ability to sustain multiple agendas in their rule-making and rule-proposal efforts this past quarter. IMR 27 Finalization of rule proposals and permanent rules to replace The amendments also removed references to NRSROs prior temporary and interim rules seemed to be at the in Rules 5b-3 and 10f-3 under the ICA. The reference in forefront of most regulatory activity in the third quarter. Rule 5b-3 changed the conditions that allow a mutual Of most significance, the SEC replaced temporary portfolio- fund to look through to the collateral of a repurchase holding reporting requirements under the U.S. Treasury’s agreement, replacing it with a requirement for a fund’s money market fund Guarantee Program by adopting Rule Board (or its delegate) to determine if the collateral is 30(b)1-6T under the Investment Company Act of 1940 (the liquid and presented minimal credit risk. The amendment “ICA”) on September 18. The rule was effective immediately to the definition of “Eligible Municipal Securities” in Rule and requires that money market funds with market-based 10f-3 replaced the reference to NRSROs with a reference net asset values below $0.9975 report portfolio-holdings to securities that are: (i) sufficiently liquid to be sold at information to the SEC on a weekly basis. The rule is set to or near their carrying value within a reasonably short expire on September 17, 2010, but, given the industry support period of time; and (ii) subject to moderate credit risks for the new rule, it is likely that the reporting requirement (minimal credit risks for payers with less than three years will be included when the amendments to Rule 2a-7 of operations.