Financial Services Alert - April 30, 2013 April 30, 2013
In This Issue

The EU AIFM Directive for Private Investment Fund Managers – Breakfast Seminars in NYC (May 9) and Boston (May 10)

Goodwin Procter attorneys Glynn Barwick, Tom Beaudoin, Elizabeth Fries and John Ferguson will be hosting a breakfast presentation and discussion on how the uniform, minimum requirements for the marketing and operation of alternative investment funds within the European Economic Area (EEA) under the European Union's Alternative Investment Fund Managers (AIFM) Directive will apply to non-European fund managers marketing to EEA investors when they become effective July 22, 2013 (subject to any extensions that may be granted, e.g., the UK proposal to provide a one-year extension to Non-EEA managers as discussed here).  The seminar will focus specifically on the requirements applicable to non-European managers of venture capital funds, private equity funds, real estate funds and hedge funds.  Topics include:

  • Marketing a fund to a person within the EEA
  • Updated disclosure and reporting requirements
  • Investments in EEA large private companies
  • Impacts of non-compliance

If you are interested in attending this event, which will be held in the Goodwin Procter’s New York office (May 9) and Boston office (May 10), please contact us here for more information.

The EU AIFMD Directive for Private Fund Managers – UK Proposes to Postpone Compliance for Non-EU Managers Until July 22, 2014

The United Kingdom’s Treasury has confirmed in a Q&A document that it proposes to amend UK law to permit non-European managers to benefit from the one year transitional provision in the European Union's Alternative Investment Fund Managers (AIFM) Directive that is currently available to European managers.  This proposal would postpone from July 22, 2013 to July 22, 2014 the date by which non-European managers must comply with the marketing requirements set out in the directive.  This would allow non-European managers to continue promoting funds to UK investors as they do currently, without complying with the directive’s registration and information disclosure requirements.

This postponement will be more meaningful if it is also adopted by other EU member states.  The Alert will report on further developments in due course.

Goodwin Procter Alert: Senior SEC Lawyer Remarks Indicate Continued Focus on Private Fund Adviser Activities and Broker-Dealer Registration Issues

Goodwin Procter’s Private Investment Funds Practice and Hedge Funds Practice issued a Client Alert that discusses a recent speech in which the Chief Counsel of the SEC’s Division of Trading and Markets expressed concern about the potential implications from a broker-dealer registration perspective of: (i) the use and compensation of employees of private fund advisers or managers to market interests in the funds that they advise or manage, and (ii) the receipt of compensation from portfolio companies by advisers or managers of private investment funds for “investment banking” or other activities relating to securities transactions.

Basel Committee Seeks Comments on Proposal to Require Recognition of Cost of Credit Protection

In March 2013 the Basel Committee on Banking Supervision (the “Basel Committee”) released for public comment a Consultative Document addressing recognition of the cost of credit protection purchased.  In some circumstances, the risk based capital rules permit banking organizations to recognize the mitigating effect of credit protection for purposes of determining the amount of risk weighted assets of a particular on-or off-balance sheet exposure.  The risk based capital rules applicable to most banking organizations in the United States, and which are based upon Basel I, permit banking organizations to recognize a guarantee provided by the central government of an OECD-based country, a U.S. government agency or government sponsored entity, a state or local government of an OECD-based country, a U.S. depository institution, or a foreign bank in an OECD-based country by substituting the risk weight applicable to the guarantor for the risk weight that would otherwise be assigned to the exposure to the extent of the guarantee.  Similarly, large banking organizations that use the Basel II advanced approaches rule for calculating risk based assets may recognize the mitigating effect of credit protection obtained by an eligible credit protection provider or through an eligible credit derivative for purposes of determining the amount of risk weighted assets generated by a particular wholesale or securitization exposure in certain circumstances.

In the Consultative Document, the Basel Committee expressed concern that the current Basel II rules may create an opportunity for capital arbitrage where there is a delay in recognizing the cost of the protection in earnings (i.e., where there is no upfront credit protection payment or the cost of credit protection is payable over time) and the banking organization receives an immediate benefit in the form of a lower risk weight on the exposure.  The Basel Committee noted that arbitrage may be particularly likely to occur in the context of securitization transactions where the difference in risk weight before and after buying protection can be quite large.

To address this concern, the Consultative Document sets forth a proposal under which banking organizations would be required to recognize the present value of material credit protection costs in an appropriately conservative manner if such costs have not already been recognized in earnings or otherwise reflected in the amount of common Tier 1 equity.  The present value of such costs would be treated as an exposure with a 1250% risk weight.  Credit protection costs would be considered material when the risk-weight on the exposure would be greater than 150% in the absence of credit protection, though the proposal outlined in the Consultative Document would reserve the right for national supervisors to require recognition of credit protection costs even when an exposure would attract a lower risk-weight.  The Consultative Paper raises several issues for national supervisors to consider, including the appropriate discount rate that should be applied to determine present value and whether and how spread income should be taken into account when determining present value.

The Basel Committee is requesting comments on the proposal outlined in the Consultative Document by June 21, 2013.  Even if adopted by the Basel Committee, the proposal would still need to be adopted and implemented by national supervisors before it would have any effect.  As a result, it is not clear whether or how the proposal outlined in the Consultative Document would be implemented in the United States and, if implemented, whether it would affect only advanced approaches banks or would apply more generally.  Banking organizations that use credit default swaps or that engage in synthetic securitization may wish to evaluate the potential implications of this proposal on their reports to bank regulators concerning capital adequacy.

OCC and FDIC Issue Proposed Guidance and FRB Issues Statement on Deposit Advance Loan Products

The OCC and the FDIC have each issued proposed guidance, and the FRB has issued a written statement highlighting concerns with deposit advance loan products (‘the “Guidance”) (Available here is the OCC version of the Guidance, and available here is the FDIC version of the Guidance.) The Guidance reflects a report by the Consumer Financial Protection Bureau (“CFPB”) regarding the use of payday loans and deposit advances in which the CFPB concluded that the products present an elevated risk both to financial institutions and their customers.  While none of the OCC, FDIC or FRB (collectively, the “Agencies”) has issued new rules for the offering of deposit advances, the Guidance defines this elevated risk as including both safety and soundness supervisory risks and litigation and reputational risks.  The Guidance presents a two-sided message to banking organizations:  on the one hand, it amounts to an unambiguous admonishment to financial institutions that offer deposit advance loans that such products must be monitored carefully, while on the other it encourages financial institutions to continue “to respond to customers’ small-dollar credit needs.”  At the very least, institutions that offer deposit advance products should be aware of their increasing profile in the minds of regulators and the evolving legal and regulatory landscape.

Deposit advances are a type of short-term, small dollar loan product offered to a bank’s existing customers whose deposit accounts reflect recurring direct deposits.  The product permits a customer to take out a loan against future deposits, typically paychecks, which is then repaid automatically when the next direct deposit enters the account.  Reflecting the findings of the CFPB’s report, the Agencies each note that, similar to payday loans, deposit advances bear a number of high-risk features, including high fees, very short, lump sum repayments often in advance of the customer’s other bills, and are routinely offered without due regard to the “fundamental and prudent banking practices” necessary to determine the customer’s ability to repay the loan while meeting other necessary financial obligations.

The Guidance suggests that deposit advance loan products may bring a greater potential for harm to consumers while also presenting institutions with elevated safety and soundness, legal compliance, and consumer protection risks.  The Agencies identify several categories of risk:

Credit Risk. The Guidance concludes that borrowers who obtain deposit advance loans “may have cash flow difficulties” or “insufficient credit histories that limit other borrowing options.”  The measure of credit risk posed by such borrowers is amplified by repeated or continuous provisions of credit to high-risk individuals.  The OCC’s Guidance in particular notes that higher capital requirements will generally apply to loan portfolios that exhibit higher-risk characteristics, thereby potentially increasing the cost to an institution of offering deposit advance loans.

Legal Risk. Each of the Agencies identify increased risks of consumer class action litigation and regulatory enforcement actions associated with deposit advance lending products.

Third-Party Risk. The Agencies are aware that a number of institutions rely upon third-party service providers to administer deposit advance products.  As with other aspects of their operations, financial institutions remain responsible and liable for compliance with all laws and regulations applicable to their activities, including those administered by third parties.

Consumer Protection. As noted above, the CFPB and the Agencies identify deposit advance loans as, potentially high-risk products for consumers, citing their high fee structure and preemptive means of collection directly from deposit accounts.  Additionally, the Guidance notes that, despite their small-dollar size, deposit advance loans potentially remain subject to a broad spectrum of federal and state laws and regulations governing extensions of credit, including the Truth in Lending Act, the Electronic Fund Transfer Act, the Truth in Savings Act, the Equal Credit Opportunity Act, and others.  The Guidance also specifically references the Federal Trade Commission Act’s prohibition on “unfair or deceptive acts.”

Despite these admonitions, the Guidance neither calls for an outright ban on deposit advance loans nor does it announce the promulgation of new rules to govern their issuance.  Instead, the Guidance offers a number of specific recommendations intended to lessen the risks posed by deposit advance loans to consumers and institutions.  Among the most significant of the recommendations, financial institutions are advised to:

  1. review account histories of frequent users of the deposit advance product to ensure that the relationship is of sufficient duration to verify the regularity of a customer’s direct deposits.  The Agencies suggest  six months as a minimum time period;
  2. mandate a “cooling off period” of at least one monthly statement cycle between deposit advances; and
  3. implement an ongoing review of credit eligibility on a customer-by-customer basis at least every six months.

The Agencies also announced that supervisory examinations will bring an increased focus on compliance with consumer protection laws and adherence to safe and sound banking practices in the administration of deposit advance products.

Comments on the OCC’s Guidance and on the FDIC’s Guidance are due by May 30, 2013.

SEC Settles Administrative Proceedings Against Adviser and Top Executive Over Undocumented Block Trade Allocation Practices

The SEC settled public administrative and cease and desist proceedings against a registered investment adviser (the “Adviser”) and its majority owner, who also acted as the Adviser’s CEO, Co-CIO and CCO (the “Executive” and collectively with the Adviser, the “Respondents”) during various times between January 1, 2007 and September 3, 2009 (the “Relevant Period”).  The SEC’s findings related primarily to the Adviser’s practices regarding the allocation of block trades when participating client accounts had insufficient funds to purchase their allocation.  This article summarizes the SEC’s findings, which the Respondents neither admitted nor denied.

Background. The Adviser, an SEC-registered investment adviser, offered its clients active investment portfolio management using several model portfolios designed to meet particular investment goals.  The Adviser’s clients chose particular model portfolios based on their needs and risk tolerance and delegated to the Adviser the discretionary authority to manage their accounts.  During the Relevant Period, client accounts grew from approximately 1,000 accounts representing approximately $300 million in assets to over 7,000 accounts representing over $742 million in assets under management.

Aggregation of Client Orders in Block Trades.  In connection with the Adviser’s management of client accounts, the Adviser reserved the discretion to aggregate client orders into block trades.  The Adviser exercised this discretion by buying and selling securities for all clients assigned to a particular investment strategy in large block trades.  The Adviser would allocate shares in a block trade among clients based upon the clients’ chosen model portfolios and their account balances.

The Adviser’s trade management system was not compatible with the trading platform at the custodian for the majority of client accounts through which the Adviser executed most of the block trades on behalf of its clients.  The resulting real-time trade reconciliation issues meant that the Adviser’s traders did not possess accurate real-time information from the custodian regarding clients’ actual current account balances at the time the Adviser was making initial allocations to clients for block trades.  During the Relevant Period, due to this inaccurate information, some clients who participated in block trades did not have sufficient funds in their accounts to purchase the allocated shares, resulting in unallocated shares (a “Block Trade Surplus”).  The Adviser typically learned of the existence of a Block Trade Surplus between three and five days after the original block trade was placed.  The SEC found that, in approximately July 2007, the Executive was advised of the trade reconciliation issue.

Adviser’s Block Trade Surplus Allocation Practice.  During the Relevant Period, the Adviser followed an unwritten practice of allocating any Block Trade Surplus among those clients who fell within the same investment model portfolio and whose cash positions exceeded a previously designated cash threshold.  Client accounts purchasing securities from a Block Trade Surplus did so at the execution price for the block trade, without consideration for any change in the securities’ price in the interim.  At the end of this process, any portion of a Block Trade Surplus that remained unallocated was sold through the Adviser’s error account.

The Adviser did not categorize Block Trade Surpluses as trade errors, but treated them as administrative errors.  If Block Trade Surpluses had been labeled as trade errors, the Adviser’s compliance procedures required the Adviser to document them as such and perform a profit and loss analysis for the trade.  The Adviser’s written policy also required it to make any client whole if any trade error resulted in a loss to the client.

In over 400 instances during the Relevant Period, the Adviser allocated Block Trade Surpluses to clients other than those originally intended to receive the shares.  The SEC found that these clients suffered approximately $20,183 in losses as a direct result of those allocations.

Annual Compliance Review and Books and Records Violations.  The SEC found that, the Respondents failed to conduct on a timely basis the 2007 review of the Adviser’s compliance policies and procedures.  The SEC also found that the Adviser did not maintain complete and accurate records concerning its trading practices or the allocation of Block Trade Surpluses: the SEC determined that neither the Adviser’s trade allocation spreadsheet, nor its trading records contained complete records of allocation of Block Trade Surpluses, and that no formal records of these allocations were kept or maintained.

SEC Examination and Enforcement Referral.  The SEC’s examination staff conducted an examination of the Adviser in 2009 and alerted it to deficiencies regarding its compliance program, including: the Adviser’s failure to follow its stated policies and procedures in its compliance manual; the Adviser’s failure to maintain adequate records of its trading; and the Adviser’s failure to timely conduct a required annual compliance review.  The SEC’s examination staff referred the matter to enforcement staff for further investigation and enforcement staff determined that the Adviser’s deficiencies continued after the examination period.

Remedial Efforts.  In determining to accept the Offers of Settlement, the SEC considered the cooperation afforded the SEC staff and the following remedial acts undertaken by the Adviser: (1) the Adviser changed its primary custodian in 2008 and upgraded its trading platform in 2009 (effectively eliminating its trade reconciliation issues by September 2009); (2) the Respondents hired a compliance consultant to perform the 2007 and 2008 annual compliance reviews and to evaluate and give guidance regarding the Adviser’s compliance practices and procedures; (3) the Adviser currently has a third party compliance consultant serving as its Chief Compliance Officer; and (4) the Adviser hired an independent accountant to analyze the impact of the Adviser’s reallocation process on its clients.

Violations.  The SEC found that the Adviser willfully violated:

  • Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, which requires, among other things, that a registered investment adviser (a) implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules and (b) review at least annually its written policies and procedures and the effectiveness of their implementation; and
  • Section 204 of the Advisers Act and Rule 204-2(a)(3) thereunder which requires, among other things, that a registered investment adviser make and keep true, accurate and current records relating to its business including: a memorandum of each order given by the investment adviser for the purchase or sale of any security; of any instruction received by the investment adviser from the client concerning the purchase, sale, receipt or delivery of any particular security, and of any modification or cancellation of any such order or instruction.

The SEC also found that the Executive, in his roles as CEO, CCO and Co-CIO, willfully aided and abetted and caused the Adviser’s violations of Sections 204 and 206(4) of the Advisers Act and Rules 204-2(a)(3) and 206(4)-7 thereunder.

Sanctions. In addition to censure and a cease-and-desist order, (i) the Adviser agreed to disgorge $20,183 (the approximate amount of client losses determined by the SEC), plus prejudgment interest, and pay a civil penalty in the amount of $100,000 and (ii) the Executive agreed to pay a civil penalty in the amount of $25,000.

In the Matter of Foxhall Capital Management, Inc. and Paul G. Dietrich, SEC Release No. IA-3590 (April 19, 2013).

Rollout of New Online Form 13F Delayed Until At Least May 20

The staff of the SEC’s Division of Investment Management announced that mandatory filing of Form 13F using the EDGAR XML Technical Specification, previously scheduled to begin April 29, 2013, will now commence no sooner than May 20, 2013.  The SEC staff will publish another notice once the rollout date is confirmed.  The new filing requirement does not affect Form 13F or its instructions.