Financial Services Alert - September 13, 2011

The SEC issued a concept release (the “Release”) requesting public comment to assist it in reviewing interpretive issues under the Investment Company Act of 1940 (the “Investment Company Act” or the “Act”) regarding the status under the Act of companies that are engaged in the business of acquiring mortgages and mortgage-related instruments, and rely on the exclusion from the definition of “investment company” in Section 3(c)(5)(C) of the Act (collectively, “Mortgage-Related Pools”).  The Release describes this review as being motivated by, among other things, (a) the development of new and complex mortgage‑related instruments, (b) concerns about the scope and application of SEC staff guidance, (c) the resemblance of certain Mortgage-Related Pools to investment companies such as closed-end funds that were not intended to be excluded from regulation under the Investment Company Act and (d) concern over whether a company whose primary business consists of investing in agency whole pool certificates or other mortgage-backed securities is the type of entity that Congress intended to be encompassed by the exclusion provided by Section 3(c)(5)(C).  This article provides highlights of the various requests for comment in the Release.

Past and Possible Future Guidance.  The Release observes that Section 3(c)(5)(C) does not have an extensive legislative history, has not been comprehensively addressed by the SEC and generally has been addressed in SEC staff no‑action letters only on a case-by-case basis, leading to the concern that Mortgage‑Related Pools are making judgments about their status under the Investment Company Act without sufficient guidance.  The Release requests comment on the guidance provided by SEC staff no-action letters and more generally, how difficult or easy it has been to determine the status of Mortgage-Related Pools under the Investment Company Act.  The Release highlights the following issues, among others:

• Is it appropriate to determine whether an issuer is “primarily engaged” in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate, based on whether at least 55% of the company’s assets consists of “qualifying interests” and the remaining 45% of the company’s assets consists primarily of “real estate‑type interests”?

• Should the SEC define “other liens on and interests in real estate” for purposes of Section 3(c)(5)(C)?  Should such a definition include only those assets that are directly related to real estate, rather than including, for example, interests in a mortgage or in a pool or other entity that holds real estate? 

• Should the SEC provide guidance on the treatment of specific types of mortgage‑related instruments for purposes of Section 3(c)(5)(C), noting in particular differing approaches taken by Mortgage-Related Pools with respect to certain types of CMBS.

Other Possible Considerations.  The Release observes that other factors may help differentiate companies that are primarily engaged in the real estate and mortgage banking business from companies that resemble traditional investment companies, and asks for comment on appropriate factors to consider in making those distinctions.  In so doing, the Release asks whether factors such as a company’s sources of income, its historical development, the activities of its officers, directors and employees and how the company has publicly characterized itself should be considered in determining a company’s primary business. (These factors are criteria that have been used the SEC for investment company status determinations under other provisions of the Act.)

Advance Notice of Proposed Rulemaking on Rule 3a-7.  The SEC has also issued an advance notice of proposed rulemaking (the “ANPR”) with respect to Rule 3a‑7 under the Investment Company Act, which provides a conditional exclusion for issuers of asset‑backed securities (“ABS”) from the definition of “investment company” under the Act.  Among other things, the ANPR notes the difference in the regulatory treatment of issuers of mortgage‑backed securities who rely on Rule 3a-7 and are subject to its conditions as compared to those who rely on Section 3(c)(5) and are not.  The ANPR requests comment on whether the SEC should seek statutory amendments to Section 3(c)(5) that would preclude ABS issuers from continuing to rely on that exclusion, or alternatively whether the SEC should engage in any rulemaking, consistent with Section 3(c)(5), that would define terms used in Section 3(c)(5) so as to limit its availability. 

Public Comment.  Comments on the Release and the ANPR must be submitted by November 7, 2011.

In a Memorandum Opinion and Order, the United States District Court for the Northern District of Illinois (the “District Court”) denied motions to dismiss based on the business judgment rule defense filed by former directors and officers  (the “Directors & Officers”) of the failed Heritage Community Bank (“Heritage”) in a suit filed by the FDIC against the Directors & Officers.  Heritage, which was established in 1969 and which had its headquarters in Glenwood, Illinois, was closed on February 27, 2009 by the Illinois Department of Financial and Professional Regulation and, subsequently, the FDIC was appointed Receiver for Heritage.

In the case, FDIC v. Saphir, et al., N.D. Ill. No. 10-C-2009 (the “Case”), the FDIC seeks to recover at least $20 million that the FDIC lost in connection with the failure of Heritage allegedly because of the Directors & Officers’ “failure to properly manage and supervise Heritage and its [commercial real estate (“CRE”)] lending programs.”  Among other things, the FDIC alleges in the Case that the Directors & Officers: (1) routinely financed CRE projects without adequate analysis of their economic viability and without adequate appraisals; (2) failed to provide sufficient loan loss reserves; (3) failed to segregate loan administration functions from loan origination functions; and (4) engaged in practices (including the approval of large dividends and incentive payments that depleted Heritage’s capital) that enriched certain of the Directors & Officers and Heritage’s holding company at the expense of Heritage.

In its Memorandum Opinion and Order, the District Court found that the FDIC’s complaint in the Case met the required standard of notifying the Directors & Officers of the FDIC’s claims against them and the plausible grounds on which those claims rest.  The District Court also found that the FDIC had properly alleged each of the required elements of liability, i.e., the Directors & Officers’ duty, breach, proximate cause and resulting damages.

The District Court also rejected Directors & Officers’ contention that the FDIC’s claims should be dismissed on the grounds that Heritage’s losses resulted from bad economic conditions because the District Court found that the FDIC had alleged other plausible proximate causes and that for the claim to survive, the FDIC only needed to allege causes that were a substantial factor leading to the losses (not the sole factor or factors).

The District Court concluded that the business judgment rule defense could not be used by the Directors & Officers as a basis for dismissing the Case in a motion to dismiss at the current, relatively early stage of the case.  The District Court stated, however, that the Directors & Officers would not be barred from raising the business judgment rule as a potential defense at a later stage of the proceedings, i.e., in a motion for judgment on the pleadings or in a motion for summary judgment.

On September 7, 2011, the FDIC announced the launch of a new initiative aimed at encouraging small investors and asset managers to partner with larger investors to participate in the FDIC’s structured transaction sales of assets from failed institutions.  The initiative, called the Investor Match Program (“IMP”), allows smaller investors to use a customized database that identifies potential collaborators.  In particular, the FDIC said that the IMP is intended to expand opportunities for participation by minority and women‑owned (WMO) investors in FDIC structured sales transactions.  The IMP is also intended to transfer knowledge from larger investors and improve organizational competencies of smaller investors.

The FDIC noted that the IMP leverages technology to create an online networking platform where participants may identify potential partners and connect in a forum.  The IMP is part of a larger effort to expand outreach efforts with smaller investors.  To participate in the IMP, investors must be pre-qualified to bid in FDIC structured sales transactions.

On September 9, 2011, the Municipal Securities Rulemaking Board (MSRB”) withdrew rulemaking proposals applicable to municipal advisors that were pending with the SEC.  In the notice describing the withdrawal, Notice 2011-51, issued September 12, 2011, the MSRB stated that it plans to resubmit its rule proposals upon the SEC’s adoption of a permanent definition of “municipal advisor” under the Securities Exchange Act of 1934, as amended by the Dodd-Frank Act.  The proposals withdrawn by the MSRB were the following:

• SR-MSRB-2011-08 (July 26, 2011) (Proposed New Rule A-11, on Municipal Advisor Assessments, and New Form A-11-Interim);

• SR-MSRB-2011-10 (August 16, 2011) (Proposed Rule Change Consisting of Amendments to Rule G-20, on Gifts and Gratuities, Rule G-8, on Books and Records, and Rule G-9, on Preservation of Records, and to Clarify that Certain Interpretations by FINRA and NASD Would Be Applicable to Municipal Advisors);

• SR-MSRB-2011-12 (August 19, 2011) (Proposed Rule Change Consisting of Proposed New Rule G-42, on Political Contributions and Prohibitions on Municipal Advisory Activities; Proposed Amendments to Rules G-8, on Books and Records, G-9, on Preservation of Records, and G-37, on Political Contributions and Prohibitions on Municipal Securities Business; Proposed Form G-37/G-42 and Form G-37x/G-42x; and a Proposed Restatement of a Rule G-37 Interpretive Notice);

• SR-MSRB-2011-14 (August 23, 2011) (Proposed Rule Change Consisting of Proposed Rule G-36, on Fiduciary Duty of Municipal Advisors, and a Proposed Interpretive Notice Concerning the Application of Proposed Rule G-36 to Municipal Advisors); and

• SR-MSRB-2011-15 (August 24, 2011) (Proposed Interpretive Notice Concerning the Application of Rule G-17, on Conduct of Municipal Securities and Municipal Advisory Activities, to Municipal Advisors).

The MSRB also explained that SR-MSRB-2011-13 (August 22, 2011) (Proposed Rule Change Consisting of Proposed New Rule G-44, on Supervision of Municipal Advisory Activities, Along with Related Proposed Amendments to Rule G-8, on Books and Records, and Rule G-9, on Preservation of Records) was already undergoing revision and would not be re-filed at this time.

The staff of the SEC’s Division of Investment Management issued a letter to the Investment Company Institute providing no-action relief for an alternative method of complying with a provision of the SEC’s recordkeeping requirements under the Investment Advisers Act of 1940 (the “Advisers Act”) that was adopted in conjunction with Rule 206(4)-5, the “pay to play” rule under the Advisers Act which addresses political contributions by investment advisers and certain of their personnel.  Among other things, Rule 204-2(a)(18)(i)(B) under the Advisers Act generally requires a registered investment adviser to keep a list of all government entities which are or were investors in any registered investment company that is an investment option of a plan or program of a government entity (“Covered Investment Pool”) to which the adviser provides or has provided investment advisory services, as applicable, in the past five years, but not prior to September 13, 2010.  The compliance date for this requirement is September 13, 2011.

In summary, the no-action relief permits an adviser to maintain the following records in lieu of those required under the strict terms of Rule 204-2(a)(18)(i)(B):

• Each government entity that invests in a Covered Investment Pool whose account can reasonably be identified as being held in the name of or for the benefit of the government entity on the records of the Covered Investment Pool or its transfer agent;

• Each government entity whose account was identified as that of a government entity – at or around the time of the initial investment – to the adviser or one of its “client servicing employees” (with specific responsibility for servicing a particular government entity), “regulated persons” (as defined in Rule 206(4)-5) or “covered associates” (as defined in Rule 206(4)-5);

• Each government entity that sponsors or establishes a qualified tuition program pursuant to Section 529 of the Internal Revenue Code of 1986 (a “529 Plan”)and has selected a specific Covered Investment Pool as an option to be offered by that 529 Plan; and

• Each government entity that has been solicited to invest in a Covered Investment Pool either (i) by a covered associate or regulated person of the adviser; or (ii) by an intermediary or affiliate of the Covered Investment Pool if a covered associate, regulated person, or client servicing employee of the adviser participated in or was involved in such solicitation, regardless of whether such government entity invested in the Covered Investment Pool.

Goodwin Procter’s M&A/Corporate Governance Practice issued a client alert discussing the SEC’s announcement that it would not challenge the decision by the U.S. Court of Appeals for the D.C. Circuit vacating SEC rules that would have established a mandatory procedure applicable to all public companies (including registered investment companies) under which eligible shareholders could nominate director candidates to be included in a company’s proxy statement (the “proxy access rules”).  In its announcement, the SEC also noted that related amendments to Rule 14a‑8, which were adopted at the same time as the proxy access rules but had been stayed pending the Court’s decision, would go effective upon the date of the stay’s expiration, expected to be September 13, 2011.  (The amendments to Rule 14a-8 (also known as the shareholder proposal rule) were discussed along with the proxy access rules in the September 7, 2010 Financial Services Alert.)

At the CFTC’s September 8, 2011 open meeting, CFTC Chairman Gary Gensler made available a tentative outline of rulemaking topics the CFTC will address to implement Dodd-Frank Act reforms during the remainder of 2011 and the first quarter of 2012.