Maintaining Compliance Amidst Regulatory Chaos FINANCIAL PLANNING ASSOCIATION

Maintaining Compliance Amidst Regulatory Chaos FINANCIAL PLANNING ASSOCIATION Philadelphia Tri-State Conference Radnor, Pennsylvania November 17, 2005 www. marketcounsel. com 201. 836. 2700 Brian S. Hamburger, Esq. MANAGING DIRECTOR

The Adviser’s Advisor Opportunity for Independent Investment Advisors U. S. Households with > $5 MM in Investable Assets 41% 30% Use of full service broker as a primary advisor Of those that use an independent financial advisor: 65% intentionally avoid advisors affiliated with a brokerage, bank, insurance or mutual fund company. 50% choose them for their independent advice. 2001 2004 Source: Spectrem Group, 2003 2

Broker-Dealer Exception 3 The Adviser’s Advisor

Broker-Dealer Exception FIRM Merrill Lynch Smith Barney Edward Jones UBS Morgan Stanley American Express Wachovia A. G. Edwards Advest AIG / Sun. America AXA Bank of America CSFB Deutsche Bank JP Morgan. Chase Legg Mason LPL Oppenheimer Ryan Beck Vanguard Wells Fargo 4 The Adviser’s Advisor REGISTERED REP TITLE Financial Adviser Financial Consultant Investment Representative Financial Advisor Personal Financial Advisor Financial Consultant Financial Adviser Investment Adviser Investment Manager Financial Adviser Private Adviser Investment Adviser Financial Adviser Wealth Manager Financial Adviser Investment Adviser Focus Adviser Investment Manager Financial Consultant

Broker-Dealer Exception The Adviser’s Advisor Final Rule Adopted in April 2005 A BD providing investment advice to customers would be excluded from the definition of investment adviser regardless of the form that its compensation takes, as long as: º the advice is provided on a nondiscretionary basis; º the advice is solely incidental to the brokerage services; and º the broker-dealer discloses to its customers that their accounts are brokerage accounts. 5

Broker-Dealer Exception The Adviser’s Advisor Not solely incidental: º Relationship includes discretionary authority; º There is a separate fee or contracts for advisory services; or º Financial planning services. 6

Broker-Dealer Exception The Adviser’s Advisor Form of disclosure: Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time. Any questions? º The firm must also identify an appropriate person at the firm with whom the customer can discuss differences between brokerage and advisory accounts. 7

Wrap Fee Programs The Adviser’s Advisor Investment advisers that sponsor wrap fee programs must deliver a brochure meeting the requirements of Schedule H of Form ADV in lieu of their Form ADV Part II or equivalent disclosure document. A wrap program is defined as “a program under which any client is charged a specified fee or fees not based directly upon transactions in a client's account for investment advisory services (which may include portfolio management or advice concerning the selection of other investment advisers) and execution of client transactions. ” 8

Hedge Fund Manager Registration 9 The Adviser’s Advisor

Hedge Fund Manager Registration The Adviser’s Advisor New rule removes the “look through” provision. ” The rule requires advisers to “private funds” to register with the SEC by February 1, 2006, if the funds that the adviser manages: º have fifteen or more investors; and º greater than $30 million in assets. Otherwise, funds may need to register with the state. A “private fund” is one that: º would be subject to regulation under the Investment Company Act of 1940 but for the exception provided in either section 3(c)(1) or section 3(c)(7); º permits investors to redeem their interests in the fund (i. e. , sell them back to the fund) within two years of purchasing them; and º relies on the ongoing investment advisory skills, ability or expertise of the investment adviser. 10

Registration is Just a Commodity The Adviser’s Advisor Commodity Trading Advisor (CTA) º “any person who, for compensation or profit, engages in the business of advising others, either directly or through publications, writings or electronic media, as to the advisability of buying or selling commodity futures or option contracts. ” CTA must register with the Commodity Futures Trading Commission (CFTC) and become a member of the industry self-regulatory organization, the National Futures Association (NFA). Individuals with certain responsibilities must also register (generally as principals or associated persons) and must meet certain qualifications (generally passing the Series 3 examination). De minimis exemptions º provided advice to 15 or fewer persons during the past 12 months; and º does not generally hold himself out to the public as a commodities advisor. 11

The Adviser’s Advisor Who is Watching? Investment Advisers • SEC • State securities regulators Broker-Dealers Trust Companies • NASD • State securities regulators • Self-regulatory organizations • US Treasury Dept. • State banking regulators Insurance Agencies • State insurance commissioners • NASD? • State securities regulators? 12

The Adviser’s Advisor Who is Watching? The Split Regulatory Regime Redundant and (Sometimes) Conflicting Regulation Strategies for Dealing With Duplicative Requirements º Who do I answer to? º Don’t you guys talk to each other? SEC NASD NYSE State Securities Regs. (NASAA) ONE STOP State Banking Regs. State Bar US Treasury 13 State Insurance Comm. (NAIC) State Board of CPAs

State vs. Federal Regulation 14 The Adviser’s Advisor

State Activism 15 The Adviser’s Advisor

The Adviser’s Advisor State Activism “[The SEC] hired gnomes rather than people who could think. ” Eliot Spitzer New York Attorney General Speech to investment advisers, February 3, 2005 “I wouldn't let the SEC's lawyers do a house closing for me. ” Eliot Spitzer Newsweek April 16, 2005 16

State Activism Additionally: º Attorney General Spitzer compares his office of 15 to the thousands at the SEC. º Claims he is merely making up for the dramatic failure by the SEC to do its job, a problem, he said, persists to this day. 17 The Adviser’s Advisor

State Activism (California Privacy) Covers California clients Not just firms with a place of business, registered, or notice filed in California Not preempted by federal law CIO Magazine, Jan. 15, 2005 18 The Adviser’s Advisor

State Activism (California Privacy) The Adviser’s Advisor If a financial institution shares a customer's personal data with a non-exempt third party, it must follow strict and detailed rules. Opt-in (non-affiliate) or Opt-out (affiliate) Detailed instructions on notice to clients: º margin width (“wide margins, ample line spacing and uses boldface or italics for keywords”) º font size (“no text in the form is smaller than 10 -point type”) º number of words per sentence (“an average of 15 to 20 words”) º what needs to be on the envelope (“clearly state in 16 point boldface type ‘IMPORTANT PRIVACY CHOICES’”). 19

Is Ignorance Really Bliss? The Adviser’s Advisor Recent Corporate Corruption Trials EBBERS RIGAS, T. RIGAS, J. WAKSAL QUATTRONE STEWART KOZLOWSKI SCRUSHY * Free pending appeal. 20 World. Com 25 yrs. Adelphia 20 yrs. Adelphia 15 yrs. Imclone 7 yrs. CS First Boston 18 mos. * Omnimedia 10 mos. (incl. house arrest) Tyco Pending sentence Health. South Acquitted

Ignorantia juris non excusat The Adviser’s Advisor “Ignorance of the law excuses no man. ” – John Selden An adviser who is unaware of a law may not escape punishment for violating the law merely because they were unaware of the law. From the regulator’s standpoint, all persons are expected to be aware of all laws. 21

Compliance Program Rule of October 2004 The Adviser’s Advisor Written Policies & Procedures º º º º º 22 Portfolio management processes Trading practices Proprietary and personal trading activities Accuracy of disclosures Safeguarding client information and assets Safeguarding books and records Marketing through solicitors Valuation of client accounts Business continuity plans

Compliance Program Rule of October 2004 The Adviser’s Advisor Written Policies & Procedures º Annual review º Does not have to be a “compliance manual” Chief Compliance Officer (CCO) designation º Competent and knowledgeable regarding the Advisers Act. º Empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the firm. º Sufficient seniority and authority within the organization to compel others to adhere to the compliance policies and procedures. 23

Compliance Program Rule of October 2004 The Adviser’s Advisor Anti-Money Laundering (AML) º Suspicious Activity Report º OFAC º FATF Electronic Communications º º 24 Active Monitoring Pre-Screening of Outgoing Electronic Communications Retention of All Incoming and Outgoing E-Mail Maintaining Delete Logs

SEC Maintains Their Focus The Adviser’s Advisor “The SEC will not tolerate a perfunctory show of compliance. ” Lori Richards, Director SEC Office of Compliance Inspections and Examinations Speech to Investment Company Institute, June 28, 2004 25

SEC Maintains Their Focus 26 The Adviser’s Advisor

SEC Maintains Their Focus 27 The Adviser’s Advisor

NASAA Sweep The Adviser’s Advisor Nationwide sweep of investment advisers by state examiners in 26 states. 257 examinations conducted between March 2003 and May 2003. Of these exams, 200 revealed at least one deficiency. Overall, the examinations found 588 deficiencies in 15 compliance areas. 28

NASAA Sweep The Adviser’s Advisor The greatest number of deficiencies identified in the sweep involved: º registration º inaccurate disclosures on the Form ADV º failed to annually offer an updated Form ADV to clients º contracts º failed to maintain contracts º failed to disclose advisory fees º books and records º failed to maintain complaint or litigation files º financial materials º failed to prepare financial statements º failed to maintain sufficient net capital º investment activities º failed to maintain suitability information about their clients º advertising º inaccurate and misleading performance reports º inaccurate web sites º failure to maintain advertising files 29

NASAA Sweep The Adviser’s Advisor NASAA’s 10 “Best Practices” to help advisers develop compliance practices and procedures: º annually review Form ADV and Part II disclosure “brochure; ” update to reflect current and accurate information; º review and update all advisory contracts; º prepare and maintain required books and records; º maintain a surety bond, if required; º prepare and maintain client profiles; º review all advertisements, including performance advertising and web site, for accuracy; º prepare and distribute a privacy policy initially and annually; º implement appropriate custody safeguards, if applicable; º calculate and document fees correctly; and º prepare a written supervisory procedures manual relevant to the type of business. 30

What’s the Story? The Adviser’s Advisor Tell me a fact and I’ll learn it. Tell me a truth and I’ll believe it. But tell me a story and it will live in my heart forever. Ed Sabol Founder NFL Films, Inc. 31

Once Upon a Time… The Adviser’s Advisor A broker-dealer made payments to advisers from its profits on the advisers’ clients’ brokerage business. The payments did not directly benefit the advisers’ clients. Instead, the advisers used the money for their own purposes. 32

Priceless? 33 The Adviser’s Advisor

The Adviser’s Advisor Not Quite Priceless Economic Benefit Received from BD = $20, 000 Disgorgement to Clients $22, 330. 84 Civil Penalties to SEC $40, 000. 00 Independent Consultant ≈ $30, 000. 00 Remediation Measures ≈ $15, 000. 00 Legal Fees ≈ $30, 000. 00 Lost Business Due to SEC Action priceless > $137, 330. 84 34

Once Upon a Time… The Adviser’s Advisor SEC said: º “The investment advisers and their principals put their own interests ahead of their clients’ interests by accepting … compensation without full disclosure to their advisory clients. ” º "By creating these serious conflicts of interest, [the brokerdealer’s] undisclosed cash payments carried the potential to corrupt the fiduciary relationship between an investment adviser and its clients" 35

What’s Next? The Adviser’s Advisor Proposed º º º º Books & Records Rules (revised) Independent Annual Compliance Audit Cash Solicitation Rule (revised) Fidelity Bond / Minimum Financial Requirements Principal Transactions Rule (revised) Pay-to-Play Self-Regulatory Organization Imminent º Fee-based Brokerage Rule º Registration of Hedge Fund Managers º New Form ADV (beta testing began) Now º º º Hedge Fund Manager Registration E-mail Retention (through interpretation of old rules and examination) Implementation of Written Policies & Procedures Chief Compliance Officer Designation Expanded Enforcement Resources Overall Increased Presence Recently º º 36 Code of Ethics Custody Proxy Voting Principals Targeted Primarily

Government Response (cont. ) The Adviser’s Advisor State Securities Regulators NASD º Power grab with IARD Financial Crimes Enforcement Network (Fin. CEN) U. S. Treasury º Anti-Money Laundering Federal Reserve Board / Comptroller of the Currency º Disaster Recovery & Contingency Planning CFP® Board of Standards º “Fee-Only” Standards º Privacy Guidelines 37

The Adviser’s Advisor Client Liability WHAT’S UP ( )? Volume of cases are º But down in 2004 Length of time is º 2002: 12. 2 month avg. º 2003: 14. 6 month avg. º 2004: 15. 4 month avg. Total awards (claimant) are º º º 2000: $76 million 2001: $97 million 2002: $139 million 2003: $162 million 2004: $194 million source: NASD Dispute Resolution web site 38

Visit Us 39 The Adviser’s Advisor

About the Speaker The Adviser’s Advisor Brian Hamburger is the Founder and Managing Director of Market. Counsel, a business, regulatory, and compliance consulting firm for entrepreneurial investment advisory firms nationwide. Brian is also the Managing Member of the Hamburger Law Firm, an affiliated boutique law firm providing the securities industry with unparalleled legal counsel. Market. Counsel and the Hamburger Law Firm are the result of an incessant entrepreneurial spirit and genuine desire to provide an unexpected level of value and service that Brian has nurtured since he was a child. Together, the consulting and law firms represent a robust combination of preeminent counsel and uncompromising service in the securities industry. Previously, Mr. Hamburger was an attorney with the securities practice group of a large New Jersey law firm. While there, he practiced in the area of securities law, concentrating in investment adviser and broker-dealer registration and compliance matters as well as broker transition and practice management issues. Prior to that post, Brian served as a law clerk in the Enforcement Division of the U. S. Securities & Exchange Commission. He was also a judicial intern at the U. S. District Court for the Southern District of Florida and then, the State of Florida Third District Court of Appeal. Earlier, Brian was the Chief Compliance Officer of an SEC-registered investment adviser. Brian’s involvement in the securities industry started when he was a teen. Since then, he has been involved in a myriad of areas within the industry, posting a rich diversity of experiences with investment adviser and financial planning firms. Mr. Hamburger is admitted to the bars of New Jersey, New York, Pennsylvania, the District of Columbia, as well as the U. S. Supreme Court and the U. S. District Court for the District of New Jersey. He is a member of the American Bar Association (Business Law Section) and other bar associations; the Securities Industry Association, Compliance & Legal Division; National Society of Compliance Professionals; Financial Planning Association; and Society of Financial Service Professionals. Brian has been appointed to the American Bar Association’s Committees on Federal Regulation of Securities; State Regulation of Securities; and Professional Conduct; and is a Platinum and Gold Key Member of the New York Chapter of the Investment Management Consultants Association and New Jersey Financial Planning Association, respectively. He has also heeded the call of the Certified Financial Planner Board of Standards to sit on various task forces. Brian has been called on as a frequent lecturer to local and national groups in the securities, accounting, insurance and financial planning professions including training state examiners on the intricacies of Form ADV and client contracts. Mr. Hamburger proudly sits on several boards of directors and advisory boards. He maintains his NASD securities licenses (Series 7, 63 and 65), is a member of the NASD Dispute Resolution Board of Arbitrators and serves as an arbitrator for the New York Stock Exchange. His biography has been included in Marquis Who’s Who in the World, Marquis Who’s Who in America, Marquis Who's Who in American Law, Strathmore's Who Registry, International Who's Who of Professionals, Who's Who Among Students in American Universities & Colleges, and Who's Who Among American Law Students. A graduate of Quinnipiac College, Mr. Hamburger received his B. S. with the school's first dual major in Economics and Financial Management. He went on to earn his Juris Doctor from the University of Miami School of Law where he was the recipient of a Dean’s Service Scholarship and the President's Pinnacle Award for his role as Editor-in-Chief of the Res Ipsa Loquitur, the Bi-Weekly Journal of the University of Miami School of Law. Brian was recently awarded the Certified Regulatory and Compliance Professional (CRCP) designation by the Wharton School and the NASD Institute after completing his residency at the Wharton School of the University of Pennsylvania. Brian lives with his wife, Kari, and their children, Ella, Jacob, and Sidney in northern New Jersey. 40

Maintaining Compliance Amidst Regulatory Chaos © 2005 Market. Counsel, LLC. All rights reserved. No portion of this presentation may be reproduced without the express written consent of the author. Market. Counsel is a consulting firm, is not affiliated with any government entity, and does not render legal or investment advice. Market. Counsel is affiliated with the Hamburger Law Firm. www. marketcounsel. com 201. 836. 2700 SPEAKER Brian S. Hamburger, Esq. CO-AUTHOR Daniel A. Bernstein, Esq.