Financial Services Alert - December 30, 2008

The FRB approved GMAC’s application to become a bank holding company (“BHC”) by converting its industrial loan company to a “bank” for purposes of the Bank Holding Company Act (the “BHC Act”).  In evaluating the proposal, the FRB had to consider “a number of unique issues,” including the historical relation of GMAC to General Motors Corporation (“GM”), and the current majority ownership of GMAC by entities controlled by or affiliated with Cerberus Capital Management L.P. (“Cerberus”).  Neither GM nor Cerberus is able to comply (or presumably wanted to make the changes necessary to comply) with the nonbanking activity restrictions of the BHC Act.

Control Issues.  To address concerns it could control GMAC for purposes of the BHC Act (and thus itself be deemed a BHC), GM committed that before consummation of the proposal it would reduce its ownership in GMAC to less than 10 percent of GMAC’s voting and total equity interests.  The remainder currently held by GM would be transferred to a trust with a trustee acceptable to the FRB and the Treasury.  The trustee would be independent of GM and would dispose of the GMAC equity interests within three years.  Until full divestiture by the trust occurs, GM will be considered an affiliate of GMAC for purposes of Sections 23A and 23B of the Federal Reserve Act, and GMAC would revise its agreements to remove limits on its ability to provide financing to parties other than GM.

As to Cerberus, to avoid BHC concerns the Cerberus funds would distribute a significant portion of their stakes in GMAC to their investors, which are sophisticated and independent of Cerberus.  Cerberus and its related parties would not own more than 14.9% of the total voting interests or 33% of the total equity of GMAC (consistent with the FRB guidance on minority investment described in the Alert dated September 23, 2008).  Moreover, Cerberus employees and consultants would no longer provide services to or act as dual employees of GMAC, and neither Cerberus nor any affiliated entity would have any advisory relationship with GMAC or any investor regarding the vote or sale of shares, or the management policies, of GMAC.

Capital Issues.  The FRB approval also addressed the capital position of GMAC.  In approving the proposal, the FRB noted GMAC’s successful efforts to raise additional capital, and commitments it made to maintain significant capital in the future.  The FRB also considered that GM, which would continue to be a major business partner of GMAC, had received credit from the Treasury to improve its viability.  After the FRB approval, the federal government announced that it would make available a total of $6 billion to GMAC, in the form of a $5 billion investment in GMAC and a loan of $1 billion to GM which GM will then invest in GMAC.

At a recent Investment Company Institute conference, Lori A. Richards, Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), described measures being discussed at OCIE to incorporate surveillance of registered advisers and mutual funds into OCIE’s risk-based oversight program.  Although the precise details of such a program were not made clear, it appears that the type of surveillance Ms. Richards envisions would entail adviser and mutual fund registrants making available to the SEC staff a broader and more timely range of information in an XML-tagged or other type of structured format designed to facilitate analysis by the SEC staff.  Ms. Richards observed that current filings made by mutual funds are in an unstructured, text-based format, lack certain portfolio-level identifying information and are not timely enough to provide the data needed for a robust surveillance program.  (As an alternative to the filing of surveillance information with the SEC, Ms. Richards indicated that OCIE was also considering an approach under which funds would post the required information in tagged or structured format to a secure space in their information technology environment which the SEC staff could access to both view and download the information.  The SEC staff would use web-crawler type technology to regularly access funds’ posted information.)  Ms. Richards identified as possible goals of a surveillance system detecting indications of issues like mispricing, liquidity concerns, lack of diversification and deviation from stated investment objectives.  For money market funds, it might also be used to identity funds that hold securities of troubled issuers and those that may be at risk of “breaking the dollar”. 

The types of data that might be requested for the surveillance system could include the following:  net asset value, shadow pricing for  money market funds, total net assets and shares outstanding, percentage of the portfolio priced using fair value, percentage of a portfolio that is illiquid, share class descriptions and the primary investment objective or style of the fund; and might also include specific information concerning portfolio securities held by a fund.  For advisers, this data might include the identity of the audit firm used by the adviser, and the custodian of client assets.  Another element of the surveillance program might be a requirement that regulated firms provide the SEC with information concerning any serious violations, or indicia of violations, as mandated by other regulators in the U.S. and abroad. 

Noting that implementing a surveillance program might require rulemaking by the SEC, and possibly legislation, Ms. Richards invited the fund industry to work together with the SEC staff to explore the ideas she had presented.  As readers are aware, the SEC is in the process of reconsidering its rules regarding recordkeeping by advisers and registered funds, partially in response to complaints from the industry regarding the SEC staff’s requests for a variety of documents and communications in electronic format during the sweep examinations related to market timing/late trading and revenue sharing.  Since then, the SEC staff has become accustomed to requesting and receiving information from the fund industry in electronic format, most recently in sweep examinations of money market funds in which the SEC staff received in electronic format structured schedules of portfolio holdings from all money market funds as of a single date.  Given recent criticism of SEC oversight prompted by the Madoff investigation and the fact that the SEC’s adviser and fund recordkeeping rules are designed to facilitate inspection and examination by the SEC staff, it would not be surprising if a surveillance program along the lines described by Ms. Richards were a part of the SEC’s recordkeeping modernization initiative.

The FDIC issued a research report (the “Report”) entitled “The Changing Liquidity Landscape” in the FDIC’s Winter 2008 issue of Supervisory Insights.  The Report states that recent disruptions in the credit and capital markets have increased the liquidity management challenges for banking institutions and demonstrated the need for a banking institution to have in place an effective liquidity management plan.  The Report stresses that in the current financial environment, liquidity shortfalls can develop far more rapidly than has historically been the case.

The Report notes that over time, in an effort to increase earnings, banks have moved to an asset structure more heavily weighted to profitable, but less liquid asset classes (such as acquisition, development and construction loans).  At the same time, banks have increased their use of off-balance sheet and liability-based liquidity strategies.  This combination of a less liquid asset mix and liability-based liquidity strategies has led to increased liquidity risks for banks.  Accordingly, it has become critical that a bank have in place an effective Contingency Funding Plan (“CFP”) that addresses, among other things: (1) cash flow mismatches; (2) target amounts of unpledged liquid reserves; (3) asset class concentrations; (4) funding concentrations, e.g., concentrations of deposits with a few large depositors, a family group or deposit brokers; and (5) contingent liability metrics, including amounts of unfunded loan commitments and lines of credit.

The Report states that CFPs should identify and assess possible liquidity-challenging events and should describe the tools that management intends to use to monitor these issues, including stress testing.  Among other things, the Report states that a CFP should assess the adequacy of contingent funding sources, e.g., back-up lines of credit, Federal Home Loan Bank funding and brokered deposit arrangements.  The Report stresses that management should understand the various legal, financial and logistical constraints, such as notice periods, collateral requirements or net worth requirements that could prevent a bank from using a source of contingent funding.  The Report notes that current liquidity runs are not usually characterized by lines of depositors assembled around a branch waiting to withdraw deposits.  Rather, current potential signals of a liquidity run, states the Report, can be: (a) an upward spike in electronic transfers such as ATM withdrawals or wire transfers; (b) public depositors that start requiring increased collateral pledges; (c) movements of deposits to banks that are perceived as “safer”; (d) a significant number of large certificate of deposit holders who are willing to absorb early withdrawal fees to access their funds; and (e) a large number of uninsured depositors rapidly withdrawing funds.

As discussed in the November 4, 2008 Alert, beginning January 1, 2009 all applications for orders under any section of the Investment Company Act of 1940, as amended (the “1940 Act”), and all filings pursuant to Regulation E under the Securities Act of 1933, as amended, made by small business investment companies and business development companies, must be submitted to the SEC electronically.  The new electronic filing requirements will apply to newly filed applications for orders under the 1940 Act and to amendments to applications previously filed in paper form.

Massachusetts has issued comprehensive data security regulations that are scheduled to go into effect on May 1, 2009.  They apply to any business in possession of personal information of Massachusetts residents, whether or not that business maintains a presence in the state.  The first of their kind in the country, these rules apply regardless of industry or the number of Massachusetts residents whose data is involved.  These regulations impose very detailed data security and system requirements to protect personal information and may require renegotiation of relationships with vendors to obtain written certifications about vendor practices and personal information.

Goodwin Procter invites you to attend a free webinar on the new Massachusetts Data Security Regulations on January 15, 2009 from 12:30-2:00 EST.  This webinar will address the practical implications of these regulations for businesses nationwide.  Attorneys from Goodwin Procter’s Privacy & Data Security Practice will examine the scope and requirements of the new rules; analyze the interrelationship between the Massachusetts rules and other information security requirements; explore best practices for information security policy development and implementation; and share views on current trends in this area, including other states that may be considering similar legislation.