Financial Services Alert - September 9, 2014 September 09, 2014
In This Issue

OCC Issues Final Guidelines Calling for Heightened Standards for Governance and Risk Management of Large Financial Institutions

The OCC issued final guidelines (the “Final Guidelines”) that call for strengthened governance and risk management practices at the following categories of large financial institutions with $50 billion or more in average total consolidated assets, (collectively, “Large Banks”):

  • insured national banks;
  • insured federal savings associations; and
  • insured federal branches of foreign banks.

The Final Guidelines also apply to an OCC-regulated financial institution with less than $50 billion in total assets if its parent company controls at least one other entity that is a covered entity, i.e., a Large Bank.  Furthermore, the OCC has reserved the right to apply the Final Guidelines to banks that do not meet the $50 billion threshold if the OCC determines that the bank’s operations are highly complex or otherwise present a heightened risk.  Large Banks and these smaller covered entities are collectively referred to as “Covered Banks”.

The Final Guidelines are being issued as a new Appendix D to the OCC’s safety and soundness standards that appear in part 30 of the OCC’s regulations.  Covered Banks are required under the Final Guidelines to “establish and adhere to a written risk governance framework to manage and control its risk-taking activities.”  The Final Guidelines also set forth minimum standards applicable to boards of Covered Banks regarding oversight of risk management.  Comptroller of the Currency Thomas J. Curry stated, in conjunction with the issuance of the Final Guidelines, that in the aftermath of the 2008 financial crisis, the OCC concluded “that much higher standards for risk management, internal controls, and internal audit were needed.” 

The Final Guidelines are, in most respects, similar to the proposed guidelines (the “Proposed Guidelines”) that were described in the January 28, 2014 Financial Services Alert.  The OCC, however, accepted certain of the suggested changes requested in public comment letters regarding the Proposed Guidelines.  Importantly, in response to industry comments, the OCC revised the section of the Final Guidelines regarding responsibilities of a board of directors to “avoid imposing managerial responsibilities” on board members, and thereby reduce potential legal liability for members of a Covered Bank’s board.

The Final Guidelines are being phased in with the largest Covered Banks, those with total assets of more than $750 million, being required to comply 60 days after the date the Final Guidelines are published in the Federal Register (the “Publication Date”).  Covered Banks with total assets of between $100 billion and $750 billion will be required to comply beginning six months after the Publication Date, and those with total assets between $50 billion and $100 billion will be required to comply beginning 18 months after the Publication Date.  Issuance of the Final Guidelines, as guidelines rather than as regulations, provides the OCC with supervisory flexibility.  The OCC has the discretion to determine whether it will require a Covered Bank that has failed to meet the heightened standards in the Final Guidelines to file a plan of remedial action.  In general, the Final Guidelines provide the OCC with an additional, significant and flexible supervisory tool with which to require enhanced risk management practices and governance at Covered Banks.

With respect to the responsibility of a Covered Bank’s board of directors to oversee risk management, certain of the important changes and clarifications in the Final Guidelines from the Proposed Guidelines include:

  • A statement by the OCC that, as a general matter, it intends to avoid imposing an undue operational burden on boards of directors and recognizes a board’s key strategic and oversight role with respect to the design and implementation of a Covered Bank’s risk management framework;
  • Modifications to various provisions of the Proposed Guidelines that replaced the word “ensure” with “require” to clarify that board members are not guaranteeing appropriate risk management practices, but rather that they are “actively overseeing” risk management and “requiring” the Covered Bank’s management to take steps to establish and implement appropriate risk management practices;
  • Elimination of a requirement that a Covered Bank’s board or board risk committee approve all material policies related to the Covered Bank’s risk management framework and replacement of this requirement with a less burdensome oversight standard;
  • Modification of a requirement that a Covered Bank’s audit committee review and approve all internal audit risk assessments to a requirement that the audit committee approve the internal audit charter and the audit plan and consider whether there are scope or resource limitations that may prevent the internal audit function from effectively carrying out its responsibilities;
  • Modification of a requirement that a board (or a board committee) oversee the talent development, recruitment and succession planning processes for risk management, internal audit and individuals two levels down from the Chief Executive Officer to a requirement that the board or board committee review and approve a talent management program; and
  • The board (or board committee) is required to approve significant changes to the Covered Bank’s risk management framework rather than to approve all changes to the framework.

It should be noted that, as in the Proposed Guidelines, the Final Guidelines state that the board of a Covered Bank should provide a “credible challenge” to management and “when necessary, oppose management’s recommendations and decisions “that could cause the [Covered Bank’s] risk profile to exceed its risk appetite or jeopardize the safety and soundness of the [Covered Bank].”

Client Alert - The Woodward Case: Guidance to Trustees on Their Duties Under the Massachusetts Prudent Investor Act

The firm’s Trusts & Estates Court Practice issued a client alert that discusses the Massachusetts Supreme Judicial Court’s recent decision in Woodward School For Girls, Inc. v. City of Quincy holding that a trustee, absent special circumstances, has a duty to invest with inflation in mind, and that while not required to follow an investment advisor’s advice, a trustee cannot, without sufficient reason, simply ignore that advice.

SEC Settles With Hedge Fund Adviser Over Trade Allocations and Disclosures Regarding Trading and Investment Strategies

The SEC settled administrative proceedings against Structured Portfolio Management, L.L.C., a hedge fund adviser (the “Adviser”), and two of its affiliated advisers, SPM Jr., L.L.C. (“Adviser A”) and SPM IV, L.L.C. (“Adviser B”), (collectively with the Adviser, the “Advisers”) over findings that the Advisers had violated the compliance program requirements of the Investment Advisers Act of 1940 (the “Advisers Act”) by failing to adopt written procedures reasonably designed to (a) detect and prevent improper trade allocations and (b) ensure the accuracy of disclosures in offering documents and marketing materials regarding fund trading and investment strategies.  This article summarizes the SEC’s findings in the settlement order (the “Order”), which the respondents have neither admitted nor denied.

Background.  The Adviser advises the Structured Servicing Holdings Master Fund, L.P. (the “Fund”).  Adviser A, which was registered with the SEC until January 2013, advised the Parmenides Master Fund, L.P. (“Fund A”).  During the relevant period, Adviser owned approximately 90% of Adviser A.  Adviser B, which was registered with the SEC until April 2009, advised the Aqueous Master Fund, L.P. (“Fund B”).  During the relevant period, the Adviser owned approximately 44% of Adviser B.

The Fund and Fund A invested in mortgage-related securities, including collateralized mortgage obligations, mortgage-backed securities (“MBS”), and interest-only bonds.  Interest rate risk for the Fund and Fund A was hedged by trading in a variety of liquid securities, including U.S. Treasury securities (“Treasuries”).  Separate portfolio managers were responsible for the Fund’s and Fund A’s core mortgage-related securities holdings while a third trader (the “Hedge Trader”) was responsible for hedging interest rate risk for both Funds.  The Adviser’s principals subsequently formed Fund B, which sought to provide excess returns by investing in a wide range of financial assets drawn principally from the U.S. residential and commercial mortgage markets, along with Treasuries and other securities.  Adviser B was created to manage Fund B, and the Hedge Trader was appointed as the Fund’s portfolio manager and trader.  Fund B received seed capital from the Fund and Fund A, which were consistently among Fund B’s largest investors.

Hedge Fund Trader Conflict.  The SEC found that the Hedge Trader was subject to a potential conflict of interest with respect to trade allocation when trading the same Treasuries for all three Funds.  When trading for the Fund and Fund A, the Hedge Trader’s main responsibility was to hedge interest rate risk.  When trading for Fund B, the Hedge Trader’s sole responsibility was to make a profit.  The Advisers recognized and disclosed this potential conflict at Fund B’s inception but did not modify or update its written policies and procedures.

Trading Compliance Procedures.  The Advisers followed a single set of compliance policies and procedures (the “Compliance Manual”), which was created in consultation with an external consultant.  The Compliance Manual stated that Advisers’ traders would seek to allocate trades “in a fair and equitable manner in light of the investment objectives and strategies of [the Advisers’] funds and other factors.”  The trade confirmation procedures in the Compliance Manual required a trader executing a trade to complete a trade blotter identifying, among other things: (i) the name of the Fund purchasing or selling the security; (ii) a description of the security traded; (iii) the amount of securities traded; (iv) the price at which the trade was executed; and (v) the counterparty.  On a daily basis, a member of the operations staff was required to review and enter the blotter information into the Advisers’ proprietary trade management system.  The SEC found that (a) after the creation of Fund B, the Advisers did not institute any additional procedures to confirm that traders identified at the time of trade the Fund for which the securities were traded, and (b) trade blotters were provided to, or collected by, the Advisers’ operations department on a sporadic basis throughout the day without any way of determining when the trader had identified the Fund for which the securities were traded in relation to when the trade was executed.

Trade Allocation Concerns.  In August 2006, based on reviews of trading data, concerns were raised internally at the Advisers as to whether Fund B was receiving more favorable prices than the Fund and Fund A when all three were trading the same Treasury security on the same day.  As a consequence, the Hedge Trader was allowed to trade only for Fund B for a period of six months.  In January 2007, in conjunction with allowing the Hedge Trader to resume trading for all three Funds, the Advisers instructed traders to provide trade blotters to the operations department more frequently throughout the day and assigned a junior compliance officer to ensure that trade blotters were provided in a timely manner, but the Advisers did not amend their written policies and procedures to address the potential for conflicts.

The SEC faulted these remedial measures on several scores:

“[T]he oral instructions regarding the trade blotters were not accompanied by anything in writing and no additional guidance was provided to the traders or to the junior compliance officer.  For example, while traders were required to provide blotters to the operations department more frequently, there was no written guidance concerning when the blotter needed to be provided in relation to when the trade was placed.  Further, [the Advisers] did not provide the junior compliance officer with any written procedures to ensure that blotters were provided in a timely manner.  In November 2008, while the junior compliance officer was on vacation and there was no one assigned to carry out those responsibilities, [the Advisers] raised concerns that traders were not properly allocating their trades by fund at the time of execution.”

Trade allocation concerns were subsequently raised by an independent firm during the Advisers’ annual compliance review in November 2008, and again internally in January 2009 on the basis of a statistical analysis showing that Fund B’s trading performance from September 2007 through January 2009 was aberrational.  A subsequent review of trade allocations by outside counsel was inconclusive.  In March 2009, Fund B was closed.

The SEC found that while the Advisers’ compliance manual “required traders to identify the fund for which the securities were being traded upon execution, this requirement alone was not sufficient for preventing improper trade allocations,” and that “[d]espite being aware of concerns about improper trade allocations, [the Advisers] failed to adopt and implement written policies and procedures reasonably designed to prevent improper trade allocations.”

Inadequate Procedures for Disclosure Review.  The SEC found that as a result of not adopting and implementing compliance policies and procedures reasonably designed to prevent inaccurate investor disclosures, the Advisers did not adequately review Fund B’s offering documents and other investor disclosures on a regular basis to determine whether they were inaccurate.  Fund B’s private placement memorandum disclosed that it would invest primarily in MBS, including Fannie Maes and Freddie Macs, but that it also might invest in Treasuries and other liquid securities.  From Fund B’s inception in February 2006 until mid‑2007, it traded highly liquid MBS and Treasuries as set forth in its offering documents.  Over time, however, Fund B stopped trading MBS and began almost exclusively to day-trade Treasuries from September 2007 through February 2009, Fund B made only two trades that were not in Treasuries.

Violations.  The SEC found that the Advisers violated the compliance program requirements of Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder by failing to implement written policies and procedures reasonably designed to prevent (1) improper trade allocations and (2) inaccurate disclosures in offering and marketing materials.

Sanctions and Remedial Measures.  In addition to a cease-and-desist order and censure, the Advisers agreed jointly and severally to pay a civil penalty of $300,000.  The Adviser also agreed to (a) engage a compliance consultant to make recommendations with respect to its policies and procedures designed to prevent and detect improper trade allocations and inaccurate investor disclosures and (b) send a copy of the Order to its advisory clients and private fund investors within twenty days of the Order’s entry and promptly revise its Form ADV to reflect the Order.

Structured Portfolio Management, L.L.C., SPM Jr., L.L.C., and SPM IV, L.L.C., SEC Release No. IA-3906 (Aug. 28, 2014).

SEC Staff Grants No-Action Relief for Advisory Fee Rebate

The staff of the SEC’s Division of Investment Management (the “Staff”) granted no-action relief with respect to the rebate of advisory fees by Amerivest Investment Management, LLC (the “Adviser”) to eligible clients for which it implements third-party model portfolios of mutual funds and ETFs (the “Program”) when the performance composite for the applicable model portfolio experiences two consecutive discrete calendar quarters of negative performance (before advisory fees) during a twelve-month period.

The Program.  The Program consists of the Adviser’s implementation of asset allocation models and corresponding mutual fund and exchange-traded fund (ETF) investment recommendations provided by Morningstar Associates, LLC (“Morningstar”), which serves as investment adviser and independent consultant to the Adviser with respect to the Program, but does not enter into an investment advisory agreement with the Adviser’s clients.  The Adviser deviates from Morningstar’s recommendations solely: (i) for non-investment and non-performance related reasons such as tax considerations  (e.g., the tax ramifications of substituting one ETF for another) or reasonable client restrictions; or (ii) to the extent required by its fiduciary duty to clients.  The Adviser maintains a record of each deviation and the reason for it. 

The Rebate.  If the model portfolio in which an eligible client is invested experiences two consecutive discrete calendar quarters of negative performance (before advisory fees) during a twelve-month period (“Term”), the Adviser will automatically rebate the client’s advisory fees for the Program for those two quarters.  A client will not have to elect to receive a rebate, or request a rebate.  Performance for each calendar quarter is measured independently.  The Adviser may extend the Term for additional twelve-month periods or discontinue the rebate arrangement following notice to clients (as discussed below).  There will be no “catch up” or other provision allowing the Adviser to recapture foregone fees through future appreciation.  The Adviser may not deviate from or otherwise seek to influence Morningstar’s recommendations for the purpose of avoiding a rebate, and the mere fact that the Adviser deviates from or declines to implement a recommendation from Morningstar will not – in and of itself – make a client ineligible for a rebate.  There will be no arrangement or understanding between the Adviser and Morningstar or any of their principals under which Morningstar’s compensation or continued engagement may be affected by whether the Adviser pays a rebate to Program participants.

Client Eligibility.  The Adviser will implement the rebate arrangement for (i) all new discretionary client accounts, and (ii) all existing discretionary client accounts with a new deposit of $25,000 or higher, provided that the new deposit represents net new assets to the Adviser.  To be eligible for the rebate, an account must participate in the Program for a minimum of two consecutive calendar quarters during the Term, and during such participation the client must not withdraw more than the required deposit of $25,000 to remain eligible for subsequent quarters.  Except for enforcing the eligibility requirements, the Adviser will not take any action for the purpose of negating or compromising a client’s eligibility for the rebate, including, without limitation, any action that would result in a client no longer participating in the Program.

Disclosure to Clients.  The Adviser will fully and clearly disclose the rules governing eligibility for the advisory fee rebate and the methodology for calculating model portfolio performance (together, the “Rebate Terms”) to all clients participating in the Program.  The Adviser must provide clients notice of any change in the Rebate Terms that will disadvantage them and may not implement such a change prior to the commencement of the next subsequent Term.  The Adviser will provide ninety days advance written notice to clients if it elects to extend the Term for additional twelve-month periods or discontinue the rebate arrangement.

Relief.  Section 205(a)(1) of the Investment Advisers Act of 1940 generally prohibits registered investment advisers from entering into, extending, renewing or performing any investment advisory contract that provides for compensation to the investment adviser on the basis of a share of capital gains or capital appreciation in a client’s account or any portion thereof.  In Investment Advisers Act Release No. 721 (May 16, 1980), the Staff stated that the concerns animating the performance fee ban “are as apposite to advisory fees which are contingent upon an advisory account obtaining a certain level of performance as they are to fees which vary directly with capital gains or appreciation.”  In granting relief for the Adviser’s proposed fee rebate, the Staff cited numerous aspects of the proposed rebate arrangement, but referred particularly to the role of Morningstar in selecting securities and making asset allocation recommendations and the limited discretion the Adviser would have to deviate from such recommendations as helping to “alleviate the concerns that form the basis of Section 205(a)(1).” 

Amerivest Investment Management, LLC, SEC No-Action Letter (publ. avail. Aug. 19, 2014).

ISS Introduces Equity Plan Data Verification Web Site for U.S. Companies

As a supplement to its existing QuickScore data verification portal, ISS has announced a new Equity Plan Data Verification portal.  Equity Plan Data Verification will provide eligible companies with an opportunity to preview, and if necessary request that ISS update, the data upon which the ISS voting recommendation on an equity plan proposal will be based.  Participation in Equity Plan Data Verification is optional, but many companies will want to take advantage of this new process to ensure that ISS is using the most timely and accurate data in its proxy research analysis and recommendations.

Eligibility for Equity Plan Data Verification will at least initially be limited to U.S. companies and companies that are otherwise covered under ISS’s U.S. policy.  The company must have a new or revised equity plan proposal on the ballot for a stockholder meeting.  The process will not be available for cash and bonus plan data points.  The Equity Plan Data Verification process will be available to companies that file definitive proxy materials (a) after September 8th, 2014 and (b) at least thirty (30) days in advance of the date of the meeting at which stockholders will vote on the equity plan.

In most cases, ISS expects that the two business day period for companies to utilize the Equity Plan Data Verification process will begin within 12 business days after the company files its definitive proxy materials, although exact dates cannot be given in advance and may vary.  After ISS has collected equity plan data from the company’s definitive proxy materials and other SEC filings, ISS will notify the company’s registered contact(s) by email on the morning on which the company’s data verification window will open, prior to the time the window opens. 

When the data verification window opens, the company’s data will be available from 9:00 a.m. ET on the first business day until at 9:00 p.m. ET on the following business day.  The company can review and verify the data and/or request that ISS modify the data during this two business day window.  ISS generally expects that it will respond to companies that submit a data update response to ISS within five business days.  Notification of ISS’s review of the company’s data verification submission will be sent by email to the company contact(s) who entered their contact information on the response form and submitted the data verification request.  Note that if multiple users submitted separate data verification requests (for example, dealing with different parts of the data), users will receive results of ISS’s review only for the items that were submitted by that user.  The results of ISS’s review and responses to all company submissions will also be available to all users on the ISS Equity Plan Data Verification web site.

ISS will also make final proxy research analysis available for any company for which ISS publishes proxy research analysis, whether or not the company has an equity plan proposal on the ballot.  Company contacts registered on the Equity Plan Data Verification web site will receive an email alert when ISS publishes its final proxy analysis, and can access the report through ISS’s separate Governance Analytics web site using their Equity Plan Data Verification login.

Companies that wish to participate in the Equity Plan Data Verification process must register using the web form on the ISS web site.  Company contacts will receive login details within five to seven business days after registering, and will also receive emails when a submission is received by ISS and again when ISS has reviewed the submission.  In addition, ISS will send email notices when the two business day period for company review begins and when ISS has responded to a company’s data verification submission.  Multiple company employees may register, but ISS does not permit compensation consultants or other advisers (including outside counsel) to register or use company login credentials.

Companies that are interested in learning more about the Equity Plan Data Verification process and definitions of data points to be collected by ISS can view and download ISS FAQ, which includes the list of questions that are included in Equity Plan Data Verification process, on the ISS web site at  There is also a link to the registration web form available on that web page.

Expanded Financial Services Alert to Debut Next Week

Beginning next week, Goodwin Procter’s weekly Financial Services Alert will have a new look, a new name and expanded national and international coverage.  The new publication will be called the Financial Services Weekly News Roundup, and will provide headlines and brief summaries of legislative, regulatory, judicial, and industry developments of note with links to primary sources.  We will continue to distribute more detailed analyses of financial industry news and trends through regular and timely client alerts, and of course, are always pleased to respond to requests for more information on any particular topic of interest.

Goodwin Procter has a long history of serving the financial services industry, and has been reporting on legal and regulatory developments for more than 15 years.  We look forward to continuing to keep you informed and updated.  We hope you find the new format, which was based in part on reader feedback, easier to use and share and, as always, we welcome your suggestions on ways we can further improve the publication.