Financial Services Alert - July 5, 2011

Two different judges in the same Massachusetts state court dismissed two separate class actions – each brought against an adviser to a group of closed-end funds, certain of the adviser’s affiliates and the funds’ board by holders of the funds’ common shares (and each case involving a different adviser, closed-end fund group and board), holding that those claims must be brought derivatively on the funds’ behalf rather than as direct class actions. 

In both cases, the plaintiffs complained about the decision by the funds’ board in 2008 to redeem some of the funds’ auction rate preferred stock (“ARPS”).  The complaints alleged that the ARPS represented favorable financing for the funds because, among other things, the interest rates and other costs were favorable and the financing did not have a set term that would expire, but rather was “perpetual.”  When the market for ARPS froze in 2008, the funds had to pay a penalty rate that was much higher than the rate the funds had been paying to the ARPS shareholders up to that point.  The funds therefore redeemed some of the ARPS and replaced them with other forms of debt financing.  According to the plaintiffs, this replacement of the ARPS with debt financing increased the funds’ costs and reduced the total assets of the funds.  The plaintiffs also complained that the defendants caused the funds to pay the full issue price when they re-acquired the ARPS, which price exceeded their market value.

The plaintiffs asserted three claims:  (1) breach of fiduciary duty by the funds’ trustees; (2) aiding and abetting breach of fiduciary duty by the funds’ adviser and affiliates; and (3) unjust enrichment by the adviser and affiliates through their receipt of fees from the debt financing that replaced the ARPS.

In one action, Delaware law applied.  The court held that the plaintiff’s claims on behalf of a class of the fund’s common shareholders arising from the fund’s redemption of its preferred shares allege that the fund overpaid for those redemptions, resulting in lower returns to the common shareholders, which involve an alleged injury to the fund.  The plaintiff also failed to explain how the redemptions, which decreased the number of preferred shares, could have decreased the common shareholders’ voting power.  Because the plaintiff did not allege an injury to shareholders which is distinct from the injury to the fund, the court held that the plaintiff could not bring the claims directly.  Beckham v. Keith, Jr., No. 10-3574-BLS2 (Mass. Super. Ct. Suffolk Cty., June 14, 2011).

In the other action, Massachusetts law applied.  The court held that the plaintiff has “misread a fine distinction in the law” because “[a]lleging that the common shareholders have suffered harm distinct form that of the ARPS holders does not demonstrate the propriety of a direct action” under Massachusetts law, which “requires injury separate and distinct from the Funds.”  Here, plaintiff’s alleged injury regarding the decision to change the Funds’ financing from ARPS to the replacement debt financing “is the depletion of the Funds’ assets, leaving the Funds with less cash to distribute to the common shareholders,” and therefore the common shareholders suffered injury only derivatively in proportion to their pro rata share of the Funds’ assets.”  The court noted that the plaintiff “cannot escape the plain language of his well-pleaded complaints” which allege that the replacement borrowing “was more costly for the Fund.”  Accordingly, “any recovery must go to the Fund, not directly to the common shareholders.”  The court pointed out that the plaintiff “has an ample opportunity to pursue vindication of the Funds’ rights within the bounds of the procedural rules, including a derivative action following a rejected demand on the Board.”  Manuszak v. Esty, No. 10-3456-BLS1 and Manuszak v. Esty, No. 10‑3457-BLS1 (Mass. Super. Ct., Suffolk Cty., June 20, 2011). 

Goodwin Procter LLP represented the independent trustees in the Manuszak proceeding.

The Federal Financial Institutions Examination Council (“FFIEC”) has issued supplemental guidance (the “Supplemental Guidance”) regarding internet banking customer authentication, layered security, and other controls to address what the FFIEC notes as an increasingly hostile online environment.  The Supplemental Guidance updates and reinforces the Authentication in an Internet Banking Environment guidance issued by the FFIEC in October 2005.  Examiners from the FFIEC’s member agencies will begin to formally assess financial institutions under the Supplemental Guidance in January 2012.

The FFIEC noted that the continued growth of electronic banking and greater sophistication of the associated threats have increased risks for financial institutions and their customers.  Such risks identified by the FFIEC include fraudulent methods to gain unauthorized access to customers’ online accounts and the development of complicated and automated attack tools.  The FFIEC stated that effective security is essential for financial institutions to safeguard customer information, reduce fraud stemming from the theft of sensitive customer information, and promote the legal enforceability of financial institutions’ electronic agreements and transactions.  The Supplemental Guidance does not endorse any specific security technology.

The Supplemental Guidance stresses that financial institutions should perform periodic risk assessments and adjust their customer authentication controls as appropriate in response to new threats to customers’ online accounts.  The Supplemental Guidance provides that financial institutions should implement more robust controls as the risk level of a transaction increases.  Rather than relying on a single control for authorizing high risk transactions, the Supplemental Guidance states that financial institutions should implement a layered approach to security for high-risk internet-based systems.  Layered security is defined by the Supplemental Guidance as the use of different controls at different points in a transaction process so that a weakness in one control is generally compensated for by the strength of a different control.  The Supplemental Guidance provides that such layered security programs should include, at a minimum, processes designed to detect anomalies and effectively respond to suspicious or anomalous activity and, for business accounts, enhanced controls for system administrators who are granted privileges to set up or change system configurations, such as setting access privileges and application configurations.

The Supplemental Guidance also discusses the effectiveness of certain authentication techniques.  With respect to device identification, the Supplemental Guidance provides that financial institutions should no longer consider simple device identification, as a primary control, to be an effective risk mitigation technique.  The FFIEC notes that although no device authentication method can mitigate all threats, the member agencies of the FFIEC consider complex device identification to be more secure and preferable to simple device identification.  The Supplemental Guidance also provides that financial institutions should use sophisticated challenge questions, which rely on information that is not publicly available, as an effective component of a layered security program.  Additionally, the Supplemental Guidance sets forth minimum elements that should be part of a financial institution’s customer awareness and educational efforts.

On June 22, 2011, the SEC issued an order (the “SEC Order”) settling administrative proceedings against a registered investment adviser (the “Adviser”), a registered broker‑dealer affiliate of the Adviser (the “Distributor”), the Adviser’s portfolio manager (the “Portfolio Manager”) for seven affiliated bond funds sponsored by the Adviser (the “Funds”), and the Distributor’s Controller and Head of Fund Accounting (the “Controller”).  The SEC found that between January 2007 and July 2007 (the “Relevant Period”) the daily net asset value (“NAV”) of each of the Funds, which consisted of three open‑end funds and four closed-end funds, was materially inflated as a result of fraudulent conduct relating to the pricing of securities backed by subprime mortgages (“Asset-Backed Securities”) on the part of the Adviser, the Distributor, the Portfolio Manager and the Controller (collectively, the “SEC Respondents”).  The more detailed description of these and related events in the early part of this article is a summary of the SEC’s principal findings, which the SEC Respondents neither admitted nor denied. 

Concurrently with the issuance of the SEC Order, (i) the FINRA accepted a Letter of Acceptance, Waiver and Consent (the “FINRA Letter”) from the Distributor settling proceedings regarding violations of FINRA rules arising out of the same general facts, and (ii) the Adviser, the Distributor and the Portfolio Manager entered into settlements (the “State Orders”) with state securities regulators in the states of Alabama, Kentucky, Mississippi, South Carolina and Tennessee (collectively, the “States”) based on the same general facts and related findings regarding violations of provisions of the securities laws of each of the States (the “State Securities Acts”). 

Background.  During the Relevant Period, the Adviser served as the investment adviser to each of the Funds; the Distributor served as the principal underwriter and exclusive distributor for the Funds’ shares and provided certain accounting services, including valuation services, to the Funds; the Portfolio Manager served as the Funds’ portfolio manager; and the Controller, through his oversight of the Distributor’s Fund Accounting Department (“Fund Accounting”), was responsible for oversight of the pricing of the Funds’ securities and the calculation of each Fund’s daily NAV.  Each of the Funds pursued its investment objectives in part by investing, in varying amounts, in Asset-Backed Securities, which lacked readily available market quotations, and which, in accordance with Section 2(a)(41)(B) of the Investment Company Act of 1940 (the “1940 Act”) were required to be priced using their fair value.  The Funds’ Boards of Directors (collectively, the “Board”) established pricing policies and procedures (the “Valuation Procedures”) which, among other things, delegated daily pricing of the Funds’ securities to the Distributor and required that fair valued securities be valued in “good faith” by a Valuation Committee, which was comprised of the Controller and other the Distributor personnel.  Further, the Valuation Procedures required that dealer quotes be obtained by the Distributor for certain securities that were to be fair valued, including the Asset-Backed Securities.

Acting Contrary to Public Disclosures.   The SEC found that during the Relevant Period, the Distributor did not price the Funds’ securities in accordance with the Valuation Procedures and that the valuation process set forth in the Funds’ documents filed with the SEC (the “SEC Documents”), including each Fund’s prospectus, differed significantly from the process described in the Valuation Procedures.  The SEC Documents stated that the fair value of securities would be determined by the Adviser’s valuation committee using procedures adopted by the Funds; however, this responsibility was delegated to the Distributor, which primarily staffed the Valuation Committee.  The Distributor and the Valuation Committee failed to comply with the Valuation Procedures in several ways, including: (i) pricing decisions were made by lower level employees in Fund Accounting who did not have the training or qualifications to make fair value pricing determinations; (ii) Fund Accounting relied on “price adjustments” provided by the Portfolio Manager without obtaining any basis for or documentation supporting the price adjustments or applying the factors set forth in the Valuation Procedures; (iii) the Distributor gave the Portfolio Manager discretion beyond the parameters of the Valuation Procedures in validating the prices of portfolio securities by allowing him to determine which broker‑dealer price confirmations (“Dealer Quotes”) to use, without obtaining supporting documentation; and (iv) neither the Valuation Committee nor the Distributor ensured that the fair value prices assigned to many of the portfolio securities were periodically re‑evaluated, allowing portfolio securities to be carried at stale values for many months at a time.  Further, the Adviser adopted its own procedures to determine the actual fair value of portfolio securities and to “validate” those values “periodically.” Among other things, those procedures provided that “[q]uarterly reports listing all securities held by the Funds that were fair valued during the quarter under review, along with explanatory notes for the fair values assigned to the securities, shall be presented to the Board for its review.”  The Adviser failed to fully implement this provision of its policy. 

The SEC found that the Controller either knew or was reckless in not knowing, of the deficiencies in the implementation of the Valuation Procedures and failed to remedy them or otherwise ensure that fair-valued securities were accurately priced and the Funds’ NAVs were accurately calculated.  Among other things, the Controller was aware of each of the deviations from the Valuation Procedures set forth above, and that the only pricing test regularly applied by the Valuation Committee was the “look back” test, which compared the sales price of any security sold by a Fund to the valuation of that security used in the NAV calculation for the five business days preceding the sale.  The Controller nevertheless signed the Funds’ annual and semi-annual financial reports on Forms N-CSR, filed with the SEC, including certifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002.

On this basis, the SEC found that the Distributor failed to employ reasonable procedures to price the Funds’ portfolio securities and, as a result of that failure, did not calculate accurate NAVs for the Funds.  In addition, the Distributor published daily NAVs for the Funds which it could not know were accurate and sold and redeemed shares based on those NAVs.

Fraudulent Manipulation of the Funds’ Securities Prices.   The Portfolio Manager actively screened and influenced Dealer Quotes received during the Relevant Period from one broker‑dealer (the “Submitting Firm”) by pressuring the Submitting Firm to in certain cases to (1) refrain from providing Dealer Quotes that reflected actual bid prices, and (2) provide interim Dealer Quotes that did not reflect fair value to enable the Portfolio Manager to avoid marking down securities to fair value in one adjustment.  In each case the Portfolio Manager was aware that the securities in question would ultimately be required to be marked down over time.  The Portfolio Manager did not disclose to Fund Accounting or the Funds’ Boards that he had received Dealer Quotes from the Submitting Firm which were lower than the current valuations recorded by the Funds, and that the Submitting Firm had refrained from submitting Dealer Quotes to Fund Accounting or had submitted quotes at higher prices than it had originally planned.  The Portfolio Manager also did not disclose that he caused the Submitting Firm to alter or withhold Dealer Quotes.  Additionally, in certain instances the Portfolio Manager provided “price adjustments” for securities that were above the Dealer Quote received from the Submitting Firm in violation of the Valuation Procedures.  The SEC Order also found that during the Relevant Period the Portfolio Manager withheld from Fund Accounting material information regarding a substantial decrease in value of an Asset-Backed Security held in the Funds in breach of his fiduciary duty as portfolio manager of the Funds.

Misrepresentations to Investors and the Board.   By including a signed letter to investors reporting on the Funds’ performance “based on net asset value” in each of the Funds’ annual and semi-annual reports filed with the SEC on Forms N-CSR during the Relevant Period, the Portfolio Manager made fraudulent misrepresentations, including omissions of material facts, to the Funds’ investors concerning the Funds’ performance.  By virtue of the Portfolio Manager’s manipulation of the NAV of the Funds’ and the valuation of certain securities, the Portfolio Manager, and through him the Adviser, were aware that the performance of the Funds was materially misstated.  Additionally, the Adviser, through the Portfolio Manager, also defrauded the Funds by providing a quarterly valuation packet reflecting inflated prices for certain securities to the Board, failing to disclose to the Board information indicating that the Funds’ NAVs were inflated, and that the Portfolio Manager was actively screening and influencing Dealer Quotes and providing Fund Accounting with unsubstantiated price adjustments.  In addition, the SEC Documents incorrectly described the Adviser as responsible for fair valuation of the Funds’ portfolio securities, when, in fact, as discussed above, the Valuation Procedures delegated such responsibility to the Distributor, which was actually performing the valuation function for the Funds.

Violations.  As a result, the SEC found violations of the following provisions of the federal securities laws:

• The SEC found that the Adviser willfully violated, and the Portfolio Manager willfully aided, abetted and caused violations of, Section 206(4) of the Investment Advisers Act of 1940 (the “Advisers Act”) and Rule 206(4)‑7 thereunder (which, respectively, (a) prohibit fraudulent, deceptive or manipulative practices or courses of business by an investment adviser, and (b) require an investment adviser to adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and the rules thereunder by its supervised persons);
• The SEC found that the Adviser willfully violated, and the Portfolio Manager willfully aided and abetted and caused violations of, Sections 206(1) and 206(2) of the Advisers Act (which prohibit fraudulent conduct by an investment adviser);
• The SEC found that the Adviser and Portfolio Manager willfully violated, and the Distributor willfully aided, abetted and caused violations of, Section 34(b) of the 1940 Act (which prohibits untrue statements of material fact or omissions to state facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, in any registration statement, report or other document filed pursuant to the 1940 Act or the keeping of which is required pursuant to Section 31(a) of the 1940 Act);
• The SEC found that the Distributor willfully violated, and the Adviser, Portfolio Manager and Controller willfully aided, abetted and caused violations of, Rule 22c-1 under the 1940 Act, (which makes it unlawful for an open-end fund to sell, redeem, or repurchase such securities except at prices based on current net asset value); and
• The SEC found that the Adviser, Distributor, Portfolio Manager and Controller willfully aided, abetted and caused violations of Rule 38a-1 under the 1940 Act, (which requires that a registered investment company adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws, including policies and procedures that provide for oversight of compliance by the investment company’s investment adviser).

Undertakings and Penalties.  In determining to accept the offer of settlement, the SEC considered certain undertakings agreed to by the SEC Respondents, including agreements from each of the Adviser and the Distributor: (i) to refrain from being involved in, or responsible for, recommending to, or determining on behalf of, a registered investment company’s board of directors or trustees or such company’s valuation committee, the value of any portfolio security for which market quotations are not readily available, and (ii) to cooperate fully with the SEC in any and all investigations, litigations or other proceedings relating to or arising from the matters described in the SEC Order or otherwise involving valuation of, the securities of the Funds.  Among other penalties, the SEC Order requires: the Adviser and the Distributor to collectively pay $100 million in disgorgement, interest, and penalties to a fund established for the benefit of the Funds’ investors (the “Fair Fund”), (ii) the Portfolio Manager and Controller to pay civil penalties of $250,000 and $50,000, respectively, to the Fair Fund, (iii) the Portfolio Manager to be barred from future participation in any securities business, and (iv) the Controller to be suspended from participation in any securities business for one year and barred from appearing or practicing before the SEC as an accountant. 

Related Proceedings - FINRA

This section describes the principal findings in the FINRA Letter, which the Distributor neither admitted nor denied.  The FINRA Letter states that during the Relevant Period, the Distributor, which is a broker‑dealer registered with the SEC and a member of FINRA, sold shares of one of the Funds (the “Bond Fund”) using false and misleading materials in violation of NASD Rules 2110, 2210 and 3010.  During the Relevant Period the Distributor served as the principal underwriter of the Funds, exclusive distributor for the Funds’ shares and provided certain accounting services, including valuation services, to the Funds. 

The FINRA Letter states that during the Relevant Period, (1) the Bond Fund was heavily invested in risky structured products, including Asset-Backed Securities, and that these investments caused the Bond Fund to experience serious turmoil in early 2007; (2)misleading sales materials that were not fair and balanced and portrayed the Bond Fund as relatively low risk, led the Distributor’s brokers to make material misrepresentations to investors regarding the Bond Fund, which was marketed as a relatively safe and conservative fixed income mutual fund investment when, in fact, it was exposed to undisclosed risks associated with its investment in Asset-Backed Securities and subordinated tranches of other structured products; (3) despite the negative impact on the Bond Fund in early 2007 of the turmoil in the mortgage-backed securities market, the Distributor failed to disclose in any of its 2007 sales material that a substantial portion of the Bond Fund’s portfolio was acutely affected by then-current economic conditions; (4) the Distributor provided incomplete internal guidance on the Bond Fund, which ineffectively conveyed the Bond Fund’s risk profile and caused asset allocation models to give the Bond Fund greater weight in conservative portfolios than aggressive portfolios; and (5) the Distributor failed to establish, maintain and enforce a complete internal guidance system, including written supervisory procedures, reasonably designed to achieve compliance with federal securities laws and FINRA rules.

The FINRA Letter identifies the following violations:  (i) the Bond Fund’s marketing materials violated NASD Conduct Rules 2110, 2110(d) and 2210 because they failed to provide a sound basis to evaluate the Bond Fund, lacked a fair and balanced presentation, and made exaggerated claims; (ii) the Distributor violated NASD Conduct Rules 2110 and 2210(c) by failing to file with FINRA during the Relevant Period updated Bond Fund profiles that were made available to the Bond Fund’s investors; (iii) the Distributor violated NASD Conduct Rules 3010(a), 3010(b) and 2110 when failing to establish, maintain and enforce an adequate supervisory system reasonably designed to comply with NASD Rules.

In the FINRA Letter, the Distributor agreed to the aggregate $200 million penalty payable to the Fair Fund, and a similar fund established pursuant to the State Orders.  The Distributor also agreed to retain an independent compliance consultant to perform periodic reviews and provide certain employee training.

Related Proceedings - States

The State Orders settled related proceedings against the Adviser, the Distributor and the Portfolio Manager for violations of the State Securities Acts.  In addition to being registered with the SEC as a broker-dealer and being a member of FINRA, the Distributor is registered as a broker‑dealer with each of the States.  The Adviser is registered as an investment adviser with the SEC and makes notice filings, but is not registered, with the States.

In broad terms, the State Orders found that during the Relevant Period each of the Adviser and the Distributor violated the relevant provisions of the State Securities Acts by: (1) making material omissions and misrepresentations in marketing materials related to the Funds; (2) failing to reasonably supervise their agents, employees and other associated persons; (3) failing to make suitable recommendations concerning purchase and concentration of the Funds in customer accounts; (4) failing to enforce supervisory procedures; (5) failing to review correspondence and marketing materials used by associated persons to sell the Funds; (6) failing to make suitable recommendations concerning purchase and concentration of the Funds in investor accounts; and (7) making material omissions and misrepresentations in the SEC Documents.

The State Orders also found that during the Relevant Period, the Portfolio Manager violated the relevant provisions of the State Securities Acts by: (1) failing to retain documentation relating to Funds’ securities pricing, (2) failing to adequately disclose or adequately describe the Funds’ risk profile(s), (3) failing to reasonably the Distributor’s mischaracterization of down turning market’s effect on Funds as “buying opportunit[ies].”

Under the State Orders, among other penalties and undertakings, (i) the Adviser and the Distributor will collectively pay $100 million to a fund established for the benefit of the Funds’ investors (the “State Fund”), (ii) the Portfolio Manager will $250,000 to the State Fund, and the (iii) the Adviser and Distributor will provide mandatory and comprehensive training related to each of their products and offerings sold or recommended to clients to their respective investment advisers and registered agents for the next three (3) years, and (iv) the Adviser and Distributor are each prohibited from creating, offering or selling any proprietary funds for a period of two years.

The SEC issued a proposal to amend the broker-dealer financial reporting rule (Rule 17a‑5 under the Securities and Exchange Act of 1934 (the “1934 Act”)), including requirements for compliance and exemption reports and a related accountant’s examination report, and a new “Form Custody” to be filed by broker‑dealers.  The amendments would facilitate the ability of the PCAOB to implement oversight of independent public accountants of broker‑dealers as required by the Dodd-Frank Act, require the filing of new reports and forms to enable the SEC and designated examining authorities (“DEAs”) to more closely examine compliance with financial responsibility rules, place additional responsibilities on independent public accountants to immediately report material non-compliance with financial responsibility rules discovered during the course of audits, and require broker‑dealers that either clear transactions or carry customer accounts to consent to allowing the SEC and DEAs to have access to independent public accountants to discuss their findings with respect to annual audits of the broker-dealers and to review audit documentation.

Compliance Report.  Under the proposed amendments to Rule 17a-5, each carrying broker-dealer would be required annually to file a Compliance Report containing the following statements and information:

• That the broker-dealer has established and maintained a system of internal control to provide the broker-dealer with reasonable assurance that any instances of material non‑compliance with Rule 15c3-1 under the 1934 Act (the Net Capital Rule), Rule 15c3-3 under the 1934 Act (the Customer Protection Rule), Rule 17a‑13 under the 1934 Act (Quarterly Security Counts) or the applicable rules of the broker-dealer’s DEA requiring account statements to be sent to customers of the broker-dealer (“Account Statement Rule” and together, the “Financial Responsibility Rules”) will be prevented on a timely basis;
• Whether the broker-dealer was in compliance in all material respects with the Financial Responsibility Rules as of its fiscal year-end;
• Whether the information used to assert compliance with the Financial Responsibility Rules was derived from the books and records of the broker-dealer;
• Whether internal control over compliance with the Financial Responsibility Rules was effective during the most recent fiscal years such that there were no instances of material weakness; and
• A description of each identified instance of material non-compliance and each identified material weakness in internal control over compliance with the specified rules.

The SEC proposes to replace the term “material inadequacies” currently used in Rule 17a-5 with “material non-compliance.”  The SEC notes that it is not proposing that broker-dealers make an assertion in the Compliance Report relating to effectiveness of internal control over financial reporting.

Examination Report.  The SEC proposes to require each carrying broker-dealer to engage an independent public accountant to examine the broker-dealer’s assertions in the Compliance Report and issue an Examination Report to be filed by the accountant with the SEC.  The examination and resulting Examination Report would replace the existing practice that results in the accountant issuing a report based on a “study.”  The proposed amendments and requirements relating to the Examination Report would result in the following fundamental changes to broker-dealer audits:

• Broker-dealer examinations would be performed in accordance with PCAOB standards, rather than GAAS, consistent with the Dodd-Frank Act;
• In connection with their engagement, independent public accountants would be required to provide an opinion concerning the broker-dealer’s compliance, and internal control over compliance, with key regulatory requirements; and
• The Examination Report, as it applies to internal control over compliance, would cover the full fiscal year instead of relating to the effectiveness of controls only at year-end.

The SEC believes that one benefit of the new compliance examination and report requirements is that a broker-dealer that acts as a qualified custodian for itself when acting as an investment adviser or for its related investment advisers under Rule 206(4)-2 under the Investment Advisers Act (the “IA Custody Rule”) would be able to use the Examination Report to satisfy the reporting requirements under both Rule 17a-5 and the IA Custody Rule.

Notification by Accountants.  The proposed amendments would require that an independent public accountant notify the SEC within one business day if the accountant determines during the course of an examination that an instance of “material non-compliance” exists with respect to any of the Financial Responsibility Rules.  This would replace the current requirement that an accountant call to the attention of a broker-dealer’s chief financial officer any material inadequacy, and that the chief financial officer then notify the SEC and the broker-dealer’s DEA.

Exemption Report.  A non-carrying broker-dealer claiming an exemption from Rule 15c3‑3 would be required to file an annual Exemption Report containing an assertion by the broker-dealer that it is exempt from the provisions of Rule 15c3-3 because it meets one or more of the conditions set forth in paragraph (k) of that rule with respect to all of its business activities.  The non-carrying broker-dealer would also be required to engage an independent public accountant to review the assertion in the Exemption Report and prepare a report based on that review and in accordance with standards of the PCAOB.  If the independent public accountant is aware of any material modifications that should be made to the assertion contained in the Exemption Report, the accountant would be required to disclose them in its report.

Change in Applicable Audit Standards.  The SEC is proposing to require that the audit of the Financial Report (currently required), the examination of the Compliance Report and the review of the Exemption Report be performed pursuant to standards established by the PCAOB.  This is being done pursuant to the authority provided by the Dodd-Frank Act to the PCAOB, subject to SEC approval, to establish auditing and related attestation, quality control, ethics and independence standards to be used by registered public accounting firms with respect to the preparation and issuance of audit reports to be included in broker-dealer filings with the SEC.

Filing SIPC Reports with the SIPC.  The SEC proposes to shift the responsibility for creating and revising reports required under SIPA and would require that the reports be filed with the SIPC. 

Access to Audit Documentation.  To facilitate the examination of a broker-dealer that clears transactions or carries customer accounts (a “clearing broker-dealer”), the SEC is proposing that each clearing broker-dealer be required to consent to permitting its independent public accountant to make available to the SEC and DEA examination staff the audit documentation associated with its annual audit reports required under Rule 17a-5 and to discuss findings related to the audit reports with the SEC and DEA examination staff.  The current notice pursuant to Rule 17a-5(f)(2) would be amended to require that the notice filed by each clearing broker-dealer include a representation that the broker-dealer agrees to allow representatives of the SEC and DEA to review the audit documentation associated with the accountant’s reports, and to permit the accountant to discuss with those representatives the findings associated with the reports.

Form Custody.  The SEC is proposing a new form to be filed by broker-dealers – Form Custody – which is designed to elicit information concerning whether a broker‑dealer maintains custody of customer and non-customer assets and, if so, how such assets are maintained. Form Custody would be required to be filed with the broker‑dealer’s quarterly FOCUS Report.  Information required to be provided on Form Custody would include the following:

• Whether the broker-dealer introduces customer accounts to another broker‑dealer on a fully-disclosed basis and the names of each such broker‑dealer;
• Whether the broker-dealer introduces customer accounts to another broker‑dealer on an omnibus basis and the names of each such broker‑dealer;
• How and where the broker-dealer holds cash and securities;
• Whether the broker-dealer carries customer accounts for another broker‑dealer on a fully disclosed or omnibus basis, and information about the reporting broker-dealer’s custodial responsibilities with respect to accounts held for the benefit of other broker‑dealers;
• Whether the broker-dealer sends transaction confirmations to customers and other accountholders;
• Whether the broker-dealer sends account statements directly to customers and other accountholders;
• Whether the broker-dealer provides customers and other accountholders with electronic access to information about the securities and cash positions in their accounts;
• Whether the broker-dealer operates as an investment adviser and, if so, information relating to its custody arrangements for customers; and
• Whether the broker-dealer is an affiliate of an investment adviser and, if so, information concerning whether the broker-dealer has custody of client assets of an affiliated investment adviser and the approximate dollar market value of the assets.

Technical Changes; Comment Period. The SEC has also proposed clean-up and technical amendments to Rule 17a-5, including the removal of a now-obsolete provision relating to year 2000 (Y2K) preparations.  Comments on the proposal are due no later than August 26, 2011.

Goodwin Procter issued a detailed client alert discussing the consequences of recently adopted SEC rules under the Investment Advisers Act of 1940 for a wide range of U.S. and non-U.S. investment advisers, particularly managers of hedge, venture capital, private equity, real estate and other privately offered funds.

The Office of Management and Budget approved the final versions of the Treasury Department’s Form SLT and its instructions.  Form SLT is designed to gather information on long-term U.S. securities held by foreign residents and long-term foreign securities held by U.S. residents.  The first report on Form SLT for the period ending September 30, 2011 is due no later than October 23, 2011.  More information regarding Form SLT will be included in an upcoming issue of the Alert.

Goodwin Procter’s Consumer Financial Services Practice Group issued a Special Alert concerning the FRB’s adoption of final rules implementing provisions of the Dodd-Frank Act to address debit interchange and network routing and exclusivity, among other things, and which have commonly been referred to as the Durbin rules.  As part of the final rules, the FRB adopted a per-transaction interchange cap consisting of a base component of 21 cents and a fraud loss adjustment of 5 basis points per transaction.

The SEC issued an order granting temporary relief and providing interpretive guidance designed to make clear that a substantial number of the requirements of the Securities Exchange Act of 1934 applicable to securities will not apply to security-based swaps (“SBSs”) when the revised definition of “security” under the Dodd-Frank Act goes into effect on July 16, 2011.  Although the order was effective July 1, 2011, public comment may be submitted through July 15, 2011.  The SEC also approved interim final rules providing exemptions from the Securities Act of 1933, the Trust Indenture Act of 1939 and other provisions of the federal securities laws to allow certain SBSs to continue to trade and be cleared as they have prior to the Dodd-Frank Act.  This exemptive relief will extend until the SEC adopts rules further defining “security-based swap” and “eligible contract participant.”  The interim final rules are effective upon publication in the Federal Register; comments may be submitted through August 14, 2011.  The SEC previously issued an order providing temporary exemptions from, other temporary relief from and guidance regarding, compliance dates for provisions of the Securities Exchange Act of 1934 that address and regulate SBSs as a result of the Dodd-Frank Act as discussed in the June 21, 2011 Alert.  The SEC plans additional steps related to the July 16 effective date under the Dodd‑Frank Act.

The SEC extended the expiration dates in temporary rules that provide exemptions under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Trust Indenture Act of 1939 for certain credit default swaps in order to continue facilitating the operation of one or more central counterparties for those credit default swaps as the SEC considers rulemaking that implements the clearing provisions of the Dodd-Frank Act.  The extension of the expiration dates until April 16, 2012 is effective upon publication in the Federal Register.  If the SEC adopts permanent exemptions for security-based swaps issued by certain clearing agencies before April 16, 2012, it will terminate the effectiveness of the temporary rules as part of that rulemaking.

The SEC issued an order pursuant to Section 36 of the Securities Exchange Act of 1934 (the “1934 Act”) granting a temporary, conditional exemption from the clearing agency registration requirements under Section 17A(b) of the 1934 Act for entities providing certain services for security-based swaps. This exemption will be effective until the compliance date for the final rules relating to the registration of clearing agencies that clear security-based swaps pursuant to Sections 17A(i) and (j) of the 1934 Act.

The SEC issued proposed rules that would impose certain business conduct standards upon security-based swap dealers (“SBS Dealers”) and major security-based swap participants “Major SBS Participants”) when those parties engage in security-based swap (“SBS”) transactions.  The proposed rules are designed to implement the SEC’s oversight of SBSs pursuant to the Dodd-Frank Act.  Under the proposed rules, SBS Dealers and Major SBS Participants would be required to communicate in a fair and balanced manner and make certain disclosures, including conflicts of interest and material incentives, to potential counterparties.  Additional requirements would be imposed for dealings with certain entities such as municipalities, pension plans, endowments and similar entities.  Comments on the proposed rules must be received by August 29, 2011.

The CFTC posted a discussion draft of a staff no-action letter designed to supplement previously proposed exemptive relief from certain requirements in the Commodity Exchange Act (the “CEA”) resulting from the Dodd-Frank Act that otherwise become effective on July 16, 2011 under the terms of the Act.  The proposed exemptive relief was discussed in the June 21, 2011 Alert.  The proposed no-action relief would be from (1) certain segregation requirements with respect to collateral for uncleared swaps that apply to swap dealers and major swap participants; (2) certain registration requirements that apply to a derivatives clearing organization that clears swaps; and (3) requirements applicable to swap dealers and major swap participants regarding the duties and designation of a chief compliance officer.  The proposed staff no-action letter would not limit the CFTC’s applicable anti-fraud and anti-manipulation authority.  The no‑action relief would expire upon the earlier of the effective date of rulemaking that completes the definition of relevant terms in accordance with the Dodd-Frank Act or December 31, 2011.