Financial Services Alert - October 19, 2010

On October 8, 2010, the FDIC Board of Directors issued a proposed rule (the “Proposed Rule”) to clarify how it would treat certain creditors in liquidations of non-banks.  The FDIC was granted the power to liquidate nonbank financial institutions designated as “Covered Financial Companies” under Title II of The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”).  The FDIC’s new Title II powers to act as receiver apply to financial companies whose failure and subsequent liquidation under the Bankruptcy Code or alternative insolvency procedures would pose a significant risk to the stability of the United States financial system (a “Covered Financial Institution”).  The receivership and liquidation authority granted to the FDIC has been widely analogized to the FDIC’s receivership authority to resolve the affairs of failed banks.  Pursuant to the Act, the FDIC was granted the authority to make additional payments to creditors of a Covered Financial Institution, regardless of the priority of such creditor, if such payments would: (i) maximize the value of the assets or the present value return of such assets, (ii) initiate and/or continue operations essential to the receivership or any bridge financial company established by the FDIC in connection with the receivership, or (iii) reduce losses from any sales or disposition of the assets.

The FDIC was granted broad authority to treat creditors with similar priority disparately.  The Proposed Rule addresses only the treatment of creditors in a failed financial firm and was proposed to provide clarity and certainty as to how key elements of the FDIC’s resolution authority will be implemented.  The Proposed Rule establishes several bright line rules regarding the distribution of any additional payments from a failed institution to its creditors.  These include:

• Holders of long-term senior debt (defined in the Proposed Rule as senior debt with a term of more than 360 days), subordinated debt and equity interests in Covered Financial Institutions are barred from receiving additional payments that would result in such holders recovering more than other creditors entitled to the same priority of payments under the law;
• No creditor may receive additional payment from a Covered Financial Institution unless the FDIC Board determines by recorded vote that the payments meet the statutory requirements;
• Any payment to any creditor would be subject to recoupment if recoveries were insufficient to repay temporary government liquidity support provided as part of the FDIC’s orderly wind-down of the Covered Financial Institutions, unless such additional payments were made to initiate and/or continue operations essential to the receivership or any bridge financial company;
• Recoupment must occur prior to the imposition of a general assessment on industry to cover the shortfall.  The intent of the recoupment rules is to prevent taxpayer money from covering losses associated with the failure of a Covered Financial Institution;
• Secured creditors are only protected to the extent of the fair value of their collateral.  If a secured creditor is undersecured, the unsecured portion of its claim will receive the same treatment as other unsecured creditors.  Secured obligations collateralized with United States government securities are exempt from this rule and such securities will be valued at par.

In addition to these key priority rules, the FDIC’s Proposed Rule also addresses several other discrete areas, including provisions:

• Giving the FDIC receiver authority to continue operations by making additional payments to pay for basic services provided by employees and third parties, such as information technology, building maintenance and other services necessary to maintain the Covered Financial Institution as it is wound down;
• Clarifying how damages will be measured with respect to contingent claims by defining that a claim will be contingent if the future event creating the contingency: (i) cannot occur by the mere passage of time, (ii) is not under the control of either the Covered Financial Institution or the party to whom the obligation is owed, and (iii) has not occurred as of the date of the appointment of the receiver;
• Clarifying that the remaining value of any liquidated subsidiary of a Covered Financial Institution that is an insurance company will be paid in accordance with the priorities provided in Title II of the Act, as is currently the case in other types of FDIC receiverships.  The net effect of this provisions is that the shareholders of a Covered Financial Institution that is an insurance company will be at the last to receive any value from any subsidiary;
• Establishing rules for determining the compensation of employees of Covered Financial Institutions who would continue in a bridge institution, including that any employee who would continue shall be paid in accordance with existing personal services agreements, including collective bargaining agreements, and such amounts would be entitled to administrative priority in the receivership of the Covered Financial Institution.  This provision will not apply to agreements with senior executives or directors of the failed institution; 
• No party acquiring a Covered Financial Institution will be bound by any personal services agreement unless it expressly assumes such agreement.

The Chairperson of the FDIC, Sheila Bair, stressed that the policy goal of the Proposed Rule is to establish that shareholders and unsecured creditors, rather than taxpayers, are at risk upon the failure of a Covered Financial Institution.  The FDIC stated that it is seeking to ensure that even those creditors eligible for additional payments are likely to suffer a diminished recovery for their claim by setting a difficult standard for the receipt of additional payments.  Commentators have noted that the most significant departure from established insolvency rules is that the collateral of a secured lender is valued at fair value, reducing the claim value of a secured creditor.  Under the Bankruptcy Code, secured creditors may file claims for the amount lent to the debtor. 

The FDIC has proposed two separate requests for comment.  The first request seeks comment on specific issues related to creditor claims under the Proposed Rule and the FDIC will accept comments on this first request that are submitted by November 18, 2010.  The second request for comment asks for comment on broader questions that will inform the FDIC’s future rulemaking on the issue of orderly liquidations under the Act and the FDIC will accept comments on its second request until January 18, 2011. 

For a more detailed description of Title II of the Act, its scope and its anticipated impact on financial institutions, please see the July 28, 2010 Special Edition of the Alert. 

The Department of Labor (the “DOL”) issued final regulations under Sections 404(a) and 404(c) of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  The regulations set forth fiduciary requirements regarding disclosures to participants in participant-directed individual account plans (e.g., most so-called 401(k) plans).  The DOL originally proposed similar regulations in July 2008.  The final regulations are applicable for plan years starting on or after November 1, 2011, and will be discussed in greater detail in a future issue of the Alert.

As required under Section 409 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the SEC proposed Rule 202(a)(11)(G)-1 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).  The proposed rule would create a new exclusion from the definition of “investment adviser” for “family offices” that largely codifies prior SEC exemptive relief in this area, and would implement related grandfathering provisions.  Comments on the proposal are due on or before November 18, 2010. 

Background – Dodd-Frank Act’s Removal of the Private Adviser Exemption and Effect on Family Offices.  Family offices are entities established by wealthy families to manage their wealth and to provide other services, financial and otherwise, for family members.  Family offices and their employees may be compensated for their services.  If those services include providing advice about securities, the entities and the individuals who provide the advice may be subject to the Advisers Act, and required to register, absent an exemption or exclusion.  Many family offices rely on the “private adviser” exemption in Section 203(b)(3) available to an investment adviser that, during the preceding twelve months, has had fewer than fifteen clients, and neither holds itself out generally to the public as an investment adviser nor acts as an investment adviser to a registered investment company.  The SEC has also provided exemptive relief on a case-by-case basis to family offices that provide advisory services to more than fifteen persons.  The Dodd-Frank Act removes the private adviser exemption, effective July 21, 2011, but also adds a new exclusion from the definition of “investment adviser” in the Advisers Act for a “family office.”  The proposed rule is the result of an accompanying direction in the Act that the SEC define the term “family office” by rulemaking.

Definition of Family Office.  Proposed Rule 202(a)(11)(G)-1 would define “family office” as a company (including its directors, partners, trustees and employees acting within the scope of their position or employment) that (a) has no clients other than “family clients” (with some allowance for situations resulting from the death of a family member); (b) is wholly owned and controlled by family members; and (c) does not hold itself out to the public as an investment adviser.

“Family client” would be defined to include any (1) “family member”; (2) key employee (as defined in the rule); (3) charitable foundation, charitable organization or charitable trust established and funded exclusively by one or more family members or former family members; (4) trust or estate for the sole benefit of family clients; (5) corporate or similar entity wholly owned or controlled and operated for the sole benefit of family clients; and (6) former family members under limited conditions for existing investments or commitments.

“Family Members” would include: 

• the founders of a family office, their lineal descendants (including by adoption and stepchildren) and the spouses or spousal equivalents of those lineal descendants;
• the parents of the founders; and
• the siblings of the founders, the siblings’ spouses or spousal equivalents, their lineal descendants (including by adoption and stepchildren) and those lineal descendants’ spouses or spousal equivalents.

Adopting the definition of that term as used in the SEC’s auditor independence rules, “spousal equivalent” would mean a cohabitant occupying a relationship generally equivalent to that of a spouse.  The proposing release points out that it has not previously provided exemptive relief for a family office whose clients included stepchildren or spousal equivalents, and seeks comment on those elements of the proposed rule.  The proposing release indicates that in conjunction with this rulemaking the SEC does not intend to rescind the exemptive relief it has previously provided to family offices, on the grounds that the relief provided by the proposed rule is substantially similar to the relief previously given.

Grandfathering.  The proposed rule includes a grandfathering clause that would allow persons to rely on the proposed “family office” exclusion, provided that (a) they were not registered or required to be registered as investment advisers with the SEC on January 1, 2010 and (b) they would meet the conditions of the proposed rule but for the fact that they provide advice to specified types of clients, and were engaged in doing so prior to January 1, 2010.  (The Dodd-Frank Act provides that a family office that relies on this grandfathering provision is nevertheless subject to the anti‑fraud provisions of paragraphs (1), (2) and (4) of Section 206 of the Advisers Act.)

On October 5, 2010, President Obama signed into law Senate Bill 3717 (“S. 3717”), which removed the heightened confidentiality provisions recently added to the federal securities laws by Section 929I of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  Section 929I exempted the SEC from being compelled to disclose records or other information obtained from its regulated entities in response to Freedom of Information Act (“FOIA”) requests and subpoenas served on the SEC if the information was produced to the SEC in connection with the SEC’s  “surveillance, risk assessments, or other regulatory and oversight activities” outlined in the Securities Exchange Act of 1934 (the “1934 Act”), the Investment Advisers Act of 1940 (the “Advisers Act”), and the Investment Company Act of 1940 (the “1940 Act”).  In the 1940 Act, these new provisions replaced the more modest protections of Section 31(c) which provided that the SEC, “shall not be compelled to disclose any internal compliance or audit records, or information contained therein, provided to the [SEC] under this section” by a registered investment company.  (No comparable provisions were displaced from the 1934 Act or Advisers Act by Section 929I.)

In repealing Section 929I, S. 3717 does not restore Section 31(c) of the 1940 Act; however, it does add language clarifying that FOIA Exemption 8 applies to the SEC.  Exemption 8 exempts from disclosure in response to FOIA requests, information “contained in or related to examination, operating, or condition reports prepared by, on behalf of, or for the use of an agency responsible for the regulation or supervision of financial institutions.”

The SEC issued a release formally withdrawing Rule 151A under the Securities Act of 1933.  That rule, which was designed to require registration of certain indexed annuity contracts, was vacated by the U.S. Court of Appeals for the District of Columbia circuit.  See the July 13, 2010 Alert.  The SEC stated that its action to withdraw the rule is ministerial in nature in light of the court decision.  The SEC did not withdraw Rule 12h‑7 under the Securities Exchange Act of 1934, which was adopted at the same time as Rule 151A but was not subject to court challenge.  (Rule 12h-7 was discussed in the January 13, 2009 Alert.)

To implement Section 945 and a portion of Section 932 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the SEC proposed (a) a new rule under the Securities Act of 1933 (the “1933 Act”) to require any issuer registering the offer and sale of an asset-backed security (“ABS”) to perform a review of the assets underlying the ABS; (b) amendments to Regulation AB that would require an ABS issuer to disclose the nature of that review and its findings and conclusions related to the review and the findings and conclusions of any third party engaged to review the assets underlying the ABS; and (c) a new form to be filed by the issuer or underwriter of an ABS offering providing certain disclosure relating to third-party due diligence providers.  Comments must be received on or before November 15, 2010.

The SEC adopted an interim final temporary rule for the reporting of security-based swaps entered into before July 21, 2010, the terms of which had not expired as of that date  (“pre-enactment security-based swap transactions”), designed to implement Section 766 of the Dodd‑Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  The SEC also issued an accompanying Interpretive Note to the rule that states that counterparties that may be required to report to the SEC will need to preserve information pertaining to the terms of these pre‑enactment security-based swaps. The SEC’s rule is effective upon its publication in the Federal Register and will remain in effect until the earlier of (a) the operative date for permanent recordkeeping and reporting rules for security-based swap transactions to be adopted by the SEC or (b) January 12, 2012.  The SEC is also seeking comment on the rule; comments are due no later than 60 days after the rule’s publication in Federal Register.

Pursuant to Section 729 of the Dodd-Frank Act, the CFTC adopted a corresponding interim final rule and interpretive note regarding reporting and recordkeeping related to swaps entered into before July 21, 2010, the terms of which had not expired as of that date.  The CFTC rule was effective October 14, 2010.  The CFTC is also seeking comment on its interim final rule; comments must be received no later than November 15, 2010.

For additional detail on these and other SEC and CFTC rulemaking mandates under provisions of the Dodd‑Frank Act affecting derivatives regulation, see the August 2, 2010 Special Edition of the Alert.

The Financial Crimes Enforcement Network (“FinCEN”) extended the deadline for mutual funds to comply with the so-called “Recordkeeping and Travel Rule” for funds transfers until April 10, 2011.  Under amendments from earlier this year to FinCEN’s regulations for mutual funds which were covered in the April 20, 2010 edition of the Alert, mutual funds originally would have been required to comply with the Recordkeeping and Travel Rule by January 10, 2011.  When the amendments are effective, the Recordkeeping and Travel Rule will require mutual funds to create and retain records and include certain information (such as the name and address of the transmitter, date and amount of the transmittal order, and identity of the recipient’s financial institution) in the transmittal order for wire transfers and other transmittals of funds in amounts of $3,000 or more, subject to certain exceptions.  FinCEN granted the compliance deadline extension in response to comments that mutual funds would need additional time to implement changes to their transaction reporting and recordkeeping systems to ensure compliance with these new requirements.

FinCEN, under the auspices of the Bank Secrecy Act Advisory Group, published the October 2010 edition of its SAR Activity Review.  This edition of the SAR Activity Review (the “October 2010 Review”) contains analysis of Suspicious Activity Reports (“SARs”) filed by firms in the securities and futures industries related to commercial real estate investment vehicles, such as real estate investment trusts (“REITs”) and commercial mortgage backed securities (“CMBS”). 

The October 2010 Review also provides examples of suspicious fact patterns reported in SARs involving REITs or CMBS.  Moreover, it provides an analysis of SAR filings by depository institutions whose narratives contain the terms “debt relief” and “debt settlement,” as well as an analysis of inquiries received by FinCEN’s Regulatory Helpline.