Financial Services Alert - January 24, 2012 January 24, 2012
In This Issue

SEC Staff Provides Advisers Act Guidance on Umbrella Registration and on GPs and Other Special Purpose Entities

The staff of the SEC’s Division of Investment Management (the “Staff”) provided no-action relief that would allow affiliated advisers conducting a single advisory business to register under Investment Advisers Act of 1940 (the “Advisers Act”) by filing a single Form ADV, provided certain conditions are met.  The Staff also affirmed and elaborated on past guidance regarding whether certain special purpose entities established by registered advisers to act as general partners or managing members of the advisers’ private funds (“SPEs”) must register under the Advisers Act.

Umbrella Registration

The Staff stated that it would not recommend enforcement action against an adviser that files (or amends) a single Form ADV (the “filing adviser”) for itself and each other adviser that it controls or is under common control with (each a “relying adviser”) when the filing and relying advisers (a) individually are eligible for federal registration and (b) collectively conduct a single advisory business.  The Staff listed the following conditions under which a filing adviser and relying advisers would conduct a single advisory business within the scope of the no-action relief, absent other facts suggesting that they do not:

Nature of Clients.  The filing adviser and relying advisers’ only clients are (a) private funds (funds that rely on Section 3(c)(1) or 3(c)(7) under the Investment Company Act of 1940) and (b) separate account clients (i) that are qualified clients (as defined in Advisers Act Rule 205-3) and are otherwise eligible to invest in the private funds advised by the filing adviser or a relying adviser and (ii) whose accounts pursue investment objectives and strategies that are substantially similar or otherwise related to those private funds.

Filing Adviser Supervision and Control.  Each relying adviser, its employees and the persons acting on its behalf are treated as “associated persons” of the filing adviser under the Advisers Act.

Single Compliance Program, CCO and Code of Ethics.  The filing adviser and each relying adviser operate under a single set of written compliance policies and procedures administered by a single chief compliance officer and are subject to a single code of ethics.  (The no-action relief allows for different treatment of relying advisers depending on the jurisdictions in which they operate.)

U.S. Filing Adviser - All Clients Treated as U.S. Clients.  The filing adviser has its principal office and place of business in the United States, and all the substantive provisions of the Advisers Act apply to its and each relying adviser’s dealings with clients, regardless of whether a client or adviser is a United States person.

Application of Advisers Act – SEC Examination.  The advisory activities of each relying adviser are subject to the Advisers Act, and each relying adviser is subject to SEC examination.

Identification of Relying Advisers.  The filing adviser’s Form ADV discloses reliance on the no-action relief and separately identifies each relying adviser.

Guidance On GPs and Other SPEs

The Staff affirmed its prior guidance allowing a SPE that is established to serve as a general partner or managing member of a private fund to look to and rely on its establishing adviser’s SEC registration under certain conditions (see Section G. Question 1. in the Staff’s December 8, 2005 response to the ABA Committee on Private Investment Entities).  The specific conditions are as follows: “(i) the investment adviser to a private fund establishes the [SPE] to act as the private fund’s general partner or managing member; (ii) the [SPE’s] formation documents designate the investment adviser to manage the private fund’s assets; (iii) all of the investment advisory activities of the [SPE] are subject to the Advisers Act and the rules thereunder, and the [SPE] is subject to examination by the [SEC]; and (iv) the registered adviser subjects the [SPE], its employees and persons acting on its behalf to the registered adviser’s supervision and control and, therefore, the [SPE], all of its employees and the persons acting on its behalf are ‘persons associated with’ the registered adviser (as defined in section 202(a)(17) of the Advisers Act).”

The Staff also indicated that the guidance is not limited to the situation where an adviser established a single SPE, but could apply to allow a single registration to cover a group of SPEs and the adviser that established them.  The Staff also clarified that an SPE could rely on the prior guidance if the SPE had a director (or other person performing similar functions) who was not an “associated person” of the establishing adviser, provided that the director was independent of the adviser.

Focus On Registered Investment Advisers, Not Exempt Reporting Advisers

The Staff focused its guidance exclusively on advisers that are subject to the registration requirements of the Advisers Act, and did not address advisers that qualify as exempt reporting advisers (“ERAs”) under the Advisers Act.  In general, ERAs are qualified advisers that manage exclusively venture capital funds or that have less than $150 million in assets under management in the United States exclusively in private funds.  It is possible (but not assured) that the Staff will adopt more relaxed guidelines for determining when affiliated ERAs may be covered by a single (partial) Form ADV.  For more information about ERAs, please see the June 30, 2011 Goodwin Procter Alert.

FDIC Proposes Rule Requiring Annual Stress Tests of State Nonmember Banks and FDIC-Supervised State Savings Associations with More Than $10 Billion in Assets

The FDIC has issued a notice of proposed rule making (the “Proposal”) that would require state nonmember banks and FDIC-supervised state savings associations with over $10 billion in assets to conduct annual stress tests, report the results to the FDIC, and make the results available to the public.  The proposal would implement section 165(i)(2) of the Dodd-Frank Act by imposing requirements substantively equivalent to the FRB regulation imposing stress tests on bank holding companies with over $50 billion in assets, issued in November 2011 and discussed in the December 6, 2011 Financial Services Alert.

The Proposal defines a stress test as a “process to assess the potential impact on a covered bank of economic and financial conditions on the consolidated earnings, losses and capital of the covered bank over a set planning horizon, taking into account the current condition of the covered bank and its risks, exposures, strategies, and activities.”  The FDIC noted that the Proposal focuses on capital adequacy, and not other aspects of financial condition, and that as of September 30, 2011, there were 23 state banks with assets exceeding $10 billion.

Under the Proposal, in November of each year, the FDIC would provide to each bank subject to the annual stress test requirement at least three scenarios, including baseline, adverse and severely adverse scenarios, that the bank must use to conduct its stress test.  The bank would then, using data as of September 30th of that year, assess the potential impact of each of the scenarios on the bank’s earnings, capital and other related items over the following nine quarters, considering all relevant exposures and activities.  The bank would be required to report its results to the FDIC by the following January 5th, including qualitative information describing the test, methodologies and assumptions employed and the types of risks assessed, and quantitative information such as pro forma capital levels and ratios, the estimated impact upon on certain financial measures and potential capital distributions over the nine quarter period.  The FDIC would then review the report, and recommend any changes to the bank’s capital structure that the FDIC deems appropriate.  Finally, the bank would be required to publish the results within 90 days of its report to the FDIC, and the Proposal states that publication on the bank’s website would be sufficient.

The FDIC is specifically requesting comments with respect to the anticipated costs of complying with the Proposal, the proposed method and contents of the public disclosure, any challenges to the proposed steps and time frames, specific alternatives that would fulfill the statutory requirement for stress tests and whether immediate effectiveness would provide a bank with sufficient time to prepare for its first stress test.  Comments on the Proposal are due March 17, 2012.

FDIC Board Approves Final Rule Requiring Insured Depository Institutions with $50 Billion or More of Total Assets to Submit Resolution Plans to FDIC

The Board of Directors of the FDIC approved a final rule (the “Final Rule”) requiring insured depository institutions with $50 billion or more in total assets (“Covered Banks”) to submit to the FDIC periodic contingency plans concerning the Covered Bank’s resolution in the event of its failure (a “Resolution Plan”).  The Resolution Plans are intended to help the FDIC resolve a Covered Bank in a manner that would allow depositors to gain access to their insured deposits within one business day of the date of failure (or two business days if the failure occurs on a day other than a Friday) and that minimizes the losses realized by the Covered Bank’s creditors.  The Final Rule replaces an interim final rule adopted by the FDIC in September 2011 and described briefly in the September 20, 2011 Financial Services Alert.  The Final Rule complements the separate joint rulemaking by the FRB and the FDIC, described in the September 20, 2011 Financial Services Alert, that requires certain systemically important nonbank financial companies and bank holding companies to prepare resolution plans, referred to as “living wills,” that address the resolution of these entities under the federal Bankruptcy Code.  The FDIC said that currently 37 depository institutions are Covered Banks.  The Final Rule becomes effective on April 1, 2012.

SEC Settles Enforcement Proceeding over Registered Investment Adviser’s Failure to Comply with Mutual Fund Pricing Procedures

The SEC settled an enforcement action against a registered investment adviser (the “Adviser”) based on the Adviser’s failure to cause certain fixed-income securities purchased in June 2008 by mutual funds it managed (the “Funds”) to be valued in accordance with the funds’ fair valuation procedures.  The fixed-income securities in question (the “Securities”) were primarily non-agency mortgage-backed securities, but also included asset-backed securities and collateralized debt obligations.  This article provides a summary of the SEC’s principal findings in the settlement, which the Adviser neither admitted nor denied. 

The Funds’ Valuation Policies and Procedures.  The boards of the Funds established valuation policies and procedures that in relevant part used prices provided by broker-dealers and designated third-party pricing vendors (collectively “Pricing Sources”).  These procedures required that a security be valued at its trade price for up to five business days if there was a difference of three percent or more between the security’s trade price and the valuation provided by a Pricing Source.  During the five day period, the Adviser’s valuation committee could direct that the valuation provided by the Pricing Source be used if deemed appropriate.  If no decision was made by the fifth day, the committee was required to make a valuation determination.  The Adviser’s compliance procedures included automated price checks that tested for these variances and when they were detected, generated Price Tolerance Reports, which were provided to the Adviser’s compliance department.  In the event of a three percent or greater variance, the procedures called for the Adviser to issue a price challenge to the Pricing Source requesting a justification for the variance.

Adviser’s Practices.  The SEC found that in June 2008, shortly after the securities were purchased, the quotations received for the Securities from broker-dealer Pricing Sources were more than 100% higher than the Securities’ trade prices and, in some cases, were more than 1,000% higher.  The prices received from third-party pricing vendor Pricing Sources were similarly in excess of the Securities’ trade prices.

Given the large variance between trade prices and prices from Pricing Sources, Price Tolerance Reports were generated for almost all of the Securities.  The Securities were not, however, valued at their trade prices during the succeeding five business days, and the Adviser did not issue price challenges to the Pricing Sources for a majority of the Securities that appeared on the Price Tolerance Reports.  In addition, the Adviser did not follow up with challenged Pricing Sources or make fair value determinations at the conclusion of the five-day periods.  The Adviser’s valuation committee ultimately elected to fair value the Securities at the midpoint between their trade prices and the prices received from the Pricing Sources until the committee received responses to the price challenges.  Price challenges were not issued for a majority of the Securities until July 1, 2008, and were never issued for some Securities.  As a consequence of the foregoing, the NAVs of the Funds were misstated between one cent and ten cents per share for several days in June 2008.

Violations.  Due to the practices noted above, the SEC found that by misstating their NAVs and executing transactions in redeemable securities at prices not based on current net asset values, the Funds violated Rule 22c-1 under the Investment Company Act, which prohibits a registered investment company from selling, redeeming, or repurchasing any redeemable security it has issued except at a price based on that security’s current net asset value.  Additionally, the SEC found that the funds’ failure to adequately implement their pricing procedures violated Rule 38a‑1 under the Investment Company Act relating to compliance programs for registered investment companies.  The SEC found that the Adviser willfully aided and abetted and caused each of the foregoing violations by the Funds.

Sanctions.  Under the terms of the settlement, among other sanctions, the Adviser agreed to pay a civil penalty of $300,000.

SEC Requests Public Comment to Assist Study on Investor Financial Literacy

In connection with preparing a study regarding financial literacy among investors as mandated by the Dodd-Frank Act, the SEC issued a request for public comment on the following topics specified in the Act:

  • methods to improve the timing, content, and format of disclosures to investors with respect to financial intermediaries, investment products, and investment services;
  • the most useful and understandable relevant information that retail investors need to make informed financial decisions before engaging a financial intermediary or purchasing an investment product or service that is typically sold to retail investors, including shares of registered open-end investment companies (“mutual funds”); and
  • methods to increase the transparency of expenses and conflicts of interest in transactions involving investment services and products, including shares of mutual funds.

Comments are due no later than 60 days after the request is published in the Federal Register.