Financial Services Alert - August 16, 2011

The FRB issued an interim final rule (the “Rule”) that establishes FRB regulations for savings and loan holding companies (“SLHCs”) and their non-depository subsidiaries. As mandated by the Dodd-Frank Act, the FRB assumed regulatory supervision of SLHCs from the OTS on July 21, 2011. Included within the Rule is a new FRB Regulation LL, which provides rules governing SLHCs, and new FRB Regulation MM, which contains the regulatory requirements for SLHCs organized in mutual form. The FRB stated that the Rule generally involves adoption of the former OTS regulations, in some cases with only technical changes and in other cases with changes that reflect amendments made by the Dodd-Frank Act or efforts by the FRB to conform to existing regulations related to bank holding companies.  The changes made to the prior OTS regulations include the following:

• Regulation LL modifies the standards previously used by the OTS to determine when a company or person has acquired control of a savings association or savings and loan holding company for purposes of Section 10 of the Home Owners’ Loan Act of 1933, as amended (the “HOLA”), and the Change in Bank Control Act (the “CIBC Act”).  Under Part 574 of the OTS regulations, the OTS would presume that a person or company (called an “Acquiror”) would acquire control of a savings association or SLHC if, among other circumstances, the Acquiror acquired more than 10% of any class of voting securities of the savings association or SLHC and was subject to a “control factor,” such as being one of the two largest holders of any class of voting securities of the savings association or SLHC.  An Acquiror proposing to acquire an interest in a savings association or SLHC in a transaction that would cause such Acquiror to become subject to a presumption of control could rebut the presumption by making a so-called rebuttal of control filing with the OTS and executing a Rebuttal of Control Agreement, provided the transaction would not result in the Acquiror acquiring “conclusive” control under a definition set forth in the HOLA.  Under the FRB’s new Regulation LL, the FRB will use the standards set forth in its existing rules applicable to investments in banks and bank holding companies to determine whether an Acquiror has acquired control of a savings association or SLHC, including the standards set forth in its Policy Statement on Equity Investments in Banks and Bank Holding Companies.  Under these standards, an Acquiror considering an investment in a savings association or SLHC may need to consult with FRB staff and enter into passivity commitments in order to avoid a finding of control under Section 10 of the HOLA.  For example, the FRB may regard a company owning, controlling or holding with power to vote 10% or more of a class of voting securities of a savings association or SLHC as having control of the savings association or SLHC even if the company is not one of the two largest holders of such securities.

   

• With respect to the CIBC Act, Regulation LL adopts the control standards used by the FRB to administer the CIBC Act in connection with investments in banks and bank holding companies.  Under these standards, the FRB will presume that a person who acquires 10% or more of any class of voting securities of an SLHC has acquired control of the SLHC if the institution has a class of securities registered under Section 12 of the Securities Exchange Act of 1934, as amended, or if no other person will own, control or hold with power to vote a greater percentage of that class of voting securities.  Like the FRB’s regulations applicable to investments in banks and bank holding companies, the rule contemplates the possibility of rebutting this presumption.  However, the FRB has not typically permitted investors in banks and bank holding companies to rebut a presumption of control arising under the CIBC Act, and it indicated in the explanation that accompanied the Rule that it would continue that practice.  As a result, prospective investors in a savings association or SHLC may need to make a notice filing under the CIBC Act if a proposed investment would trigger a presumption of control and will no longer have the option of making a rebuttal of control submission.

   

• Section 606(b) of the Dodd-Frank Act amended the HOLA by adding financial activities permitted by Section 4(k) of the Bank Holding Company Act of 1956, as amended (the “BHC Act”) to the list of activities exempt from the limitations on activities contained in Section 10(c)(1)(B) and (C) of the HOLA.  The OTS previously permitted all SLHCs to engage in activities permitted by Section 4(k) of the BHC Act on the basis of language contained in Section 10(c)(9) of the HOLA.   The FRB has taken the position that the changes made by Section 606(b) of the Dodd-Frank Act will require all savings and loan holding companies other than those with grandfathered rights under Section 10(c)(9) of the HOLA (e.g., certain companies that were SLHCs prior to May 4, 1999 or that became an SLHC pursuant to an application pending before the OTS on or before that date) to make an effective election to be treated as a financial holding company in order to continue to engage in activities permissible for financial holding companies under Section 4(k) of the BHC Act.  These SLHCs would also need to make an effective election to be treated as a financial holding company to commence activities of a type permissible for a bank holding company under Section 4(c)(8) of the BHC Act or comply with certain other filing requirements described in the Rule.

The Rule is effective as of the date it is published in the Federal Register, but the FRB will accept comments on the Rule through October 27, 2011.

The Massachusetts Securities Division has adopted new regulations that, in effect: (i) require investment advisers to obtain certifications from consultants that are paid to assist with investment decisions; and (ii) prohibit investment advisers from receiving performance-based compensation, except from “qualified clients” (as defined in Rule 205-3 of the Investment Advisers Act of 1940).

Under the first new regulation, which becomes effective December 1, 2011, upon retaining any “Investment Consulting Service,” an investment adviser must obtain a certification from the service provider that: (A) describes the confidentiality restrictions relevant to the consultation; (B) states that the consultant will not provide certain types of confidential information to the investment adviser; and (C) is accurate at any time consultations are provided.  For these purposes, “Investment Consulting Service” refers to a consultant that assists an investment adviser with deciding whether to buy, sell, or hold positions in client accounts.  This regulation also prohibits an investment adviser from trading the securities relevant to any confidential information received from an Investment Consulting Service, until the information is made public.

Under the second new regulation, which is expected to become effective August 19, 2011 (i.e., once published in the Massachusetts Register), investment advisers are prohibited from receiving any compensation based upon capital gains or appreciation, unless such compensation is received in compliance with Rule 205-3 under the Investment Advisers Act of 1940.  As a practical matter, this means that investment advisers (regardless of whether they are registered with the Division), will only be able to receive performance-based compensation from “qualified clients” (i.e., investors which either: (i) have at least $1,000,000 under the management of the adviser; or (ii) have a net worth of at least $2,000,000).

In announcing the new regulations, the Division also stated that it is continuing to review proposed regulations regarding investment adviser registration in Massachusetts and related filing requirements.  (The proposed regulations were discussed in the April 26, 2011 Financial Services Alert.)

People’s United Bank, the nation’s largest regional bank headquartered in New England, won a key victory in a data security breach case that had been followed for two years by the national banking associations, as well as by American Banker and other industry publications.

Patco Construction Company Inc., a commercial customer of the bank, brought suit alleging that the bank was responsible when third-party cybercriminals allegedly breached Patco’s computer system, stealing passwords and challenge question answers allegedly through the use of keylogging malware, and executed a series of fraudulent withdrawals from Patco’s checking account.  Patco filed suit against People’s United in 2009, alleging negligence, breach of contract, breach of fiduciary duty, unjust enrichment and conversion.

In May 2011, Magistrate Judge John Rich recommended that the court grant People’s United’s motion for summary judgment on all six counts and deny Patco’s cross-motion for summary judgment.  In a detailed 70-page opinion, Magistrate Judge Rich found that People’s United had “demonstrated that the security procedures that it had in place as of May 2009 were commercially reasonable” under Article 4A of the UCC and that the rest of Patco’s claims were preempted.  On August 3, 2011, Judge Brock Hornby upheld the Magistrate’s recommendation. 

The SEC ruled against an equity trader (the “Appellant”) for a mutual fund adviser in its review of the appeal of an administrative law judge’s decision that the Appellant had violated Section 17(e)(1) of the Investment Company Act of 1940 (the “Investment Company Act”) by accepting gifts from brokers with which the trader placed orders on behalf of the funds.  In ruling on the appeal, the SEC based its findings on an independent review of the record, except for matters not challenged on appeal.  This article describes the Commission’s finding that the Appellant violated Section 17(e)(1) and does not address other aspects of the decision (e.g., regarding the appeal of sanctions).  (Participating in the decision were Commissioners Casey and Walter.)

Background.  As an equity trader, the Appellant received orders from mutual fund portfolio managers and had discretion to choose the brokers, from a list of approved brokers, that would buy or sell securities on the funds’ behalf.  The Appellant sent securities transactions involving more than 2 billion shares to the ten brokerage firms from which he received gifts during a two-year period.

Section 17(e)(1).  Section 17(e)(1) of the Investment Company Act makes it unlawful for any affiliated person of a registered investment company, or any affiliated person of such a person, acting as agent, to accept from any source any compensation (other than regular salary or wages from such registered company) for the purchase or sale of any property to or for such registered company or any controlled company thereof, except in the course of such person’s business as an underwriter or broker.

Analysis.  The SEC found that the Appellant was an “affiliated person” under Section 17(e)(1) by virtue of being an employee of the funds’ adviser and was “acting as agent” under Section 17(e)(1) in directing securities trades to brokers for execution on the funds’ behalf.  The SEC also held that the various gifts received by the Appellant fell within Section 17(e)(1)’s broad definition of  “compensation,” which includes any economic benefit paid directly or indirectly to an adviser.

Addressing the fourth requirement for liability under Section 17(e)(1), that the compensation be received “for the purchase or sale of any property to or for” a registered investment company, the SEC relied on United States v. Deutsch, 631 F.2d 98 (2d Cir. 1971), and Decker v. SEC, 631 F.2d 1380 (10th Cir. 1980).  The SEC noted that in the latter decision the Tenth Circuit held that the fourth element of Section 17(e)(1) does not require proof of an intent to influence, only proof that the respondent was “‘in a position where his own interests and the interests of [his employing investment advisor] were in conflict with the interests of the [mutual funds].’”  The SEC found that in the Appellant’s case this threshold requirement had been met, and under Decker, the burden of proof fell on the Appellant to “prove that none of the gifts he received was in exchange for the brokerage business he gave to the giftors.”  According to the SEC, under Decker, the SEC’s Division of Enforcement is not required to prove a quid pro quo to make a prima facie case under Section 17(e)(1); it only has to show that the Appellant placed himself in “a position where his interests conflicted with the trust placed in him by the investment companies and, by extension, their shareholders,” whereupon “it became [the Appellant’s] task to prove that none of the gift-giving violated that trust.”  (Elsewhere in its opinion, the SEC observed that there had been no showing that the Appellant’s conduct caused demonstrable harm to investors.)

Having found that the Appellant failed to provide the necessary proof, the SEC went on to observe that liability under Section 17(e)(1) would not be precluded even if the Appellant were to establish that he never traded to the detriment of the funds.  The SEC stated that “[e]ven if [the Appellant] could prove his assertion that he ‘never bought securities at more than the lowest price for the volume requested [or] . . . [sold] securities at other than the highest price attainable,’ this does not cure the obvious ‘abuse of trust in the investment company industry’ inherent in this gift-giving – the kind of abuse that Section 17(e)(1) was designed to eliminate.  And it is not exempt from the ‘flat ban’ imposed by Section 17(e)(1) on ‘conduct tending to compromise the fiduciary judgment of affiliated persons,’ even in the absence of any ‘larcenous intent.’”

The FDIC issued a financial institution letter (the “Letter”; FIL-57-2011) in which it summarized clarifications adopted by the FDIC to its Statement of Policy (the “Revised SOP”) for Section 19 of the Federal Deposit Insurance Act (“Section 19”). Section 19 prohibits a person convicted of a criminal offense involving dishonesty, breach of trust, money laundering or drugs from participating in the affairs of an FDIC-insured institution unless the person receives the FDIC’s prior written consent. In the Revised SOP, the FDIC clarifies that no Section 19 application to the FDIC is required if a person’s conviction is “completely expunged,” i.e, the record of conviction is not accessible by any party, including law enforcement, even by court order. In addition, the Revised SOP clarified that the FDIC will view a conviction as de minimis (and not requiring FDIC approval) if it involves offenses punishable by imprisonment for a term of one year or less and/or a fine of $1,000 or less. Furthermore, the Revised SOP clarifies that a de minimis offense with respect to “bad checks” involves no more than one conviction for issuing a bad check based on one or more checks with an aggregate face value of $1,000 or less. In addition, no insured financial institution or insured credit union may be a payee on any of the checks.

FINRA issued Regulatory Notice 11-38 providing guidance to member firms on the application of the SEC’s Net Capital and Customer Protection Rules to United States Treasury securities and other securities issued, or guaranteed as to principal and interest, by the United States or any of its governmental agencies, in response to the downgrade of the long-term credit rating of the United States by Standard & Poor’s on August 5, 2011.  FINRA stated that it was providing this guidance because it had received inquiries from member firms regarding the impact of the downgrade to the application of the Net Capital and Customer Protection Rules.

FINRA advised that, under the Net Capital Rule, 15c3-1, the credit rating assigned to U.S. Treasury securities or other securities issued, or guaranteed as to principal or interest, by the U.S. or any of its governmental agencies (i.e., government securities) by any credit rating agency is not a factor in determining the net capital treatment for such securities.  FINRA staff has confirmed with the staff of the SEC that the ratings action by S&P does not alter the net capital treatment of those government securities under Rule 15c3-1(c)(2)(vi)(A), relating to so-called securities “haircuts” for government securities.

FINRA also advised that the SEC staff has confirmed that the ratings action by S&P does not affect the definition of  “qualified security” under paragraph (a)(6) of Rule 15c3-3 (the Customer Protection Rule).  Broker-dealers may continue to use government securities as “qualified securities” to meet their deposit requirement under Rule 15c3-3(e)(1).

CFTC rule proposals regarding clearing member risk management and customer clearing documentation and timing of acceptance for clearing (with related corrections) have been published in the Federal Register.  The former proposal addresses address risk management for cleared trades by futures commission merchants, swap dealers, and major swap participants that are clearing members.  The latter proposal addresses documentation between a customer and a futures commission merchant that clears on behalf of the customer, and the timing of acceptance or rejection of trades for clearing by derivatives clearing organizations and clearing members.  Comments on each proposal may be submitted no later than September 30, 2011.

The SEC announced on August 12 that in connection with the effectiveness of final rules for its whistleblower program (discussed in the May 31, 2011 Financial Services Alert) the SEC has launched a new webpage at www.sec.gov/whistleblower.  As described in the SEC’s announcement, the webpage includes information on eligibility requirements, directions on how to submit a tip or complaint, instructions on how to apply for an award, and answers to frequently asked questions.