Financial Services Alert - September 20, 2011

The SEC issued an advanced notice of proposed rule making (the “ANPR”) that requests comment on various aspects of Rule 3a‑7 under the Investment Company Act of 1940 (the “Investment Company Act” or the “Act”).  Rule 3a-7 provides a conditional exclusion for issuers of asset‑backed securities (“ABS”) from the definition of “investment company” under the Act.  The ANPR principally focuses on the requirements of Rule 3a‑7 but also addresses how certain holders of securities issued by Rule 3a‑7 issuers treat those securities for purposes of determining their own status under the Investment Company Act and the comparative treatment of ABS issuers under the exclusion provided by Section 3(c)(5) of the Act and under Rule 3a-7.  The SEC cites (a) the Dodd‑Frank Act’s mandate that the SEC review the use of credit ratings in SEC regulations (with an eye towards substituting alternative standards of credit-worthiness) and (b) market developments since the Rule was adopted as the principal reasons the SEC is considering rulemaking in this area.  The ANPR also formally withdraws the SEC’s 2008 proposal to amend Rule 3a‑7, which proposed to replace the credit rating condition in Rule 3a-7 with a condition limiting the sale of securities of a Rule 3a-7 issuer to certain institutional investors.

This article presents highlights from the ANPR’s various requests for comment, which in addition to those noted below, cover a variety of related topics such as industry practice.

ABS Investor Protection Concerns under the Investment Company Act.  The ANPR focuses on three aspects of Rule 3a‑7.  The first is the Rule’s requirement that an issuer’s fixed‑income securities generally must be rated by at least one nationally recognized securities rating organization (“NRSRO”) in one of the four highest ratings categories.  The ANPR describes this condition as having been adopted because the SEC expected NRSRO due diligence on ABS issuers to address its investor protection concerns under the Investment Company Act, namely:  (i) self‑dealing by insiders, misvaluation of assets and inadequate asset coverage; (ii) the benefits of an independent review of an ABS issuer’s structure and intended operations; and (iii) preservation and safekeeping of an ABS issuer’s assets and cash flow.  The ANPR’s second and third areas of focus are Rule 3a-7’s limitations on the acquisition and disposition of the “eligible assets” underlying ABS and the Rule’s conditions addressing the safekeeping of an ABS issuer’s eligible assets and their cash flow.

The ANPR also requests comment on whether (a) various provisions of the Dodd‑Frank Act, (b) related SEC rules and (c) other SEC rulemaking related to ABS issuances may provide an alternate means of addressing Investment Company Act investor protection concerns.

Valuation, Asset Coverage and Self-Dealing.  The ANPR seeks comment on a number of alternative approaches to addressing Investment Company Act investor protection concerns with respect to Rule 3a-7 issuers, including the following:

• imposing specific requirements or limitations on the structure and operations of an ABS issuer, such as specifying the particular manner in which the issuer’s assets should be selected and valued, specifying the manner in which the issuer’s depositor and sponsor may structure the issuer to help guard against self-dealing, and prohibiting any person involved in the operation of the issuer from engaging in specific activities that may adversely affect payment of the ABS’ obligations consistent with their terms;

• adopting a principles-based approach that could, for example, require an ABS issuer’s organizational documents to set forth:  (1) specific rules and responsibilities of persons involved in the issuer’s organization and operation; (2) the specific terms and conditions pursuant to which the issuer may acquire or dispose of eligible assets; and (3) policies and procedures reasonably designed to prevent insiders from engaging in activities that may adversely affect payments to ABS holders.

Independent Review.  The ANPR states that the SEC is currently considering replacing the rating condition in Rule 3a‑7 with a condition providing for an independent review of an ABS issuer and its intended operations prior to the sale of its securities.  This condition could require an issuer to obtain an opinion from an independent evaluator that the independent evaluator reasonably believes, based on information available at the time the ABS are first sold, that the ABS issuer was structured and would be operated in a manner such that the expected cash flow generated from the underlying assets would likely allow the issuer to have the cash flow at times and in amounts sufficient to service expected payments on the ABS.  Alternatively, an ABS issuer could itself be required to provide a similar certification in its offering documents based on the views of an independent evaluator.  For the purpose of these possible conditions, the ANPR suggests that an independent evaluator could be an independent person, including an NRSRO, that has the expertise and experience in the structuring or evaluating of ABS issuers and their securities.  The ANPR observes that the independent review that it proposes under Rule 3a‑7 would be different from one performed in connection with the certification requirement included in the SEC’s 2011 proposal relating to shelf registration of ABS, but suggests that the scope of these reviews could be made consistent with each other so that one review could satisfy both purposes.

Safekeeping of Assets and Cash Flow.  The ANPR seeks comment on whether Rule 3a‑7 should be amended to strengthen the provisions relating to the preservation and safekeeping of ABS assets and cash, for example, by (1) imposing limits on the ability of a servicer to co‑mingle cash of an ABS issuer with the servicer’s own assets for periods of time prior to transferring applicable amounts to the trustee of the ABS, (2) addressing any timing mismatch between the receipt of collections from ABS assets and distributions to ABS holders, and (3) addressing recent issues that have arisen in determining the ownership of mortgages that have been securitized.

Applicability of Other Statutes and Regulations.  The ANPR also requests comment on whether various provisions of the Dodd‑Frank Act, related SEC rules and other SEC rulemaking related to ABS issuances may provide an alternate means of addressing ABS-related Investment Company Act investor protection concerns.  The ANPR also posits that existing or proposed provisions of other SEC rules applicable to ABS issuers, although designed to serve different purposes, may also mitigate Investment Company Act investor protection concerns regarding ABS, and could be considered for inclusion in Rule 3a‑7 in lieu of the current credit rating condition.  Among such provisions cited in the ANPR are the following:

• Rule 193 under the Securities Act of 1933 which generally requires an ABS issuer to perform a review of its underlying assets that, at a minimum, provides reasonable assurance that the disclosure in the issuer’s prospectus regarding those assets is accurate in all material respects;

• the SEC’s 2011 rule proposal regarding shelf registration eligibility requirements for ABS issuers, which includes a requirement that an issuer’s underlying transaction agreements provide for a “credit risk manager” to review the underlying assets in specified circumstances;

• Section 27B of the Securities Act of 1933, added by the Dodd-Frank Act, which generally prohibits an underwriter, placement agent, initial purchaser, sponsor or any affiliate or subsidiary of the foregoing, of an ABS issuer from engaging in any transaction that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity for a period of one year after the date of the first closing of the sale of the ABS (this provision takes effect only upon the effective date of yet-to-be proposed implementing rules);

• risk retention requirements for ABS sponsors proposed by the SEC and other federal regulators in a joint rulemaking discussed in the April 19, 2011 Financial Services Alert. 

The ANPR also requests comment on the possibility of limiting the availability of Rule 3a‑7 to issuers of ABS as defined in Regulation AB or to issuers that meet the additional limitations imposed by the ABS shelf registration eligibility requirements.

Investment Company Status Determinations by Holders of Rule 3a-7 ABS.  The ANPR requests comment on whether the SEC should consider limiting or clarifying the manner in which certain holders of securities issued by Rule 3a‑7 issuers factor the exclusion provided by Rule 3a‑7 as applied to those holdings into the holder’s determination of its own status under the Investment Company Act.  The ANPR describes the situation in which a company holds 50% or more of the outstanding voting securities of a Rule 3a‑7 issuer, making the Rule 3a‑7 issuer a “majority‑owned subsidiary” whose securities are not counted as “investment securities” for purposes of calculating whether the company meets the “40% test” for investment company status under Section 3(a)(1)(C) of the Investment Company Act.  The ANPR observes that the activities of certain companies established to purchase equity and residual interests in collateralized loan obligations and collateralized debt obligations of issuers relying on Rule 3a‑7 suggest that they are in the business of investing in securities (i.e., they are investment companies for purposes of the Investment Company Act). The ANPR requests comment on two possible alternatives for addressing this situation:  (1) modifying Rule 3a-7 to specify that an issuer relying on it would be deemed an investment company for the limited purpose of the definition of “investment securities” in Section 3(c)(1)(C)(i) and (2) modifying Rule 3a‑7 so that issuers relying on it are investment companies for purposes of the Investment Company Act but are exempted from the Act’s requirements.

Business Development Companies Holding Rule 3a-7 Issuers.  The ANPR requests comment on whether Rule 3a‑7 should be amended to prohibit a business development company (a “BDC”) from treating securities of a Rule 3a‑7 issuer as counting towards the “70% basket” of a BDC’s portfolio that must be invested in securities of certain types of issuers.  The ANPR states that as a general matter the SEC presently does not believe that Rule 3a‑7 issuers are the type of small, developing and financially troubled businesses in which it was intended BDCs should primarily invest.

Section 3(c)(5) Exclusion vs. Rule 3a-7 Exemption. The ANPR observes that the exclusion from the definition of “investment company” provided by Section 3(c)(5) of the Investment Company Act is not subject to any conditions specifically addressing the Investment Company Act investor protection concerns presented by ABS issuers, and as a consequence, ABS issuers relying on Section 3(c)(5) and those relying on Rule 3a‑7 are subject to somewhat disparate regulatory treatment based solely on the type of financial assets they hold.  The ANPR notes that Section 3(c)(5) was designed to exclude from the definition of “investment company” certain factoring, discounting and mortgage companies, and did not specifically contemplate ABS issuers, which generally did not exist at the time Congress passed the Investment Company Act.  In the aftermath of the recent financial crisis, given the role that issuers of mortgage-backed securities played in that crises, the SEC is seeking comment on whether it should seek statutory amendments to Section 3(c)(5) that would preclude ABS issuers from continuing to rely on that exclusion.  (The SEC had previously considered this issue in 1992 in connection with proposing and adopting Rule 3a-7, but elected to defer any action pending experience with the Rule.)  Alternatively the ANPR seeks comment on 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 must be submitted by November 7, 2011.

 

The SEC issued an order instituting administrative and cease-and-desist proceedings against a registered investment adviser (the “Adviser”) and its sole owner, who also served as its president, chief executive officer and chief compliance officer (the “Owner” and collectively with the Adviser, the “Respondents”) for failing to properly disclose in Form ADV that the Adviser received fees for promoting a third-party investment manager (the “Investment Manager”) and misrepresenting the Adviser as “independent” in promotional materials and on the firm’s website.  This article summarizes the SEC’s allegations, which have not been proven.

Form ADV Disclosures.  The Adviser provided institutional investors with fee-based investment advisory services, which included recommending investment managers, and claimed to provide “independent” investment advice.  Form ADV updates filed with the SEC and made available to clients in 2009 and 2010 included representations about the Respondents’ independence.  Specifically, the Adviser’s response to Item 8.B.3 of Form ADV Part I, which required a registered adviser to disclose whether it has any sales interests in the securities it recommends, stated that the Adviser did not have any such sales interests.  Also, the Adviser’s response to Item 13 of Form ADV Part 2, which required a registered adviser to disclose whether it receives an economic benefit from a non-client in connection with giving advice to clients, stated that the Adviser received no such economic benefit.  Schedule F of the Adviser’s Form ADV Part 2 also represented that the Adviser would “disclose to clients … all matters that reasonably could be expected to impair [the Adviser’s] ability to make unbiased and objective recommendations” and specifically stated that the Adviser did “not accept any fees from investment managers or mutual funds.”

Website and Promotional Materials.  The Adviser represented in its promotional materials and on its letterhead that it was an independent investment adviser.  Articles on the Adviser’s website touted the benefits of independent investment advice, stating that “[t]he best investment advisors are independent – without affiliations to … money managers” and that clients “need a strategy they can trust, because investments … should be based on merit, not … undisclosed compensation.”

Payments from Investment Manager.  The SEC alleges that the Adviser received payments in 2010 from the Investment Manager for recommending to the Adviser’s clients that they transfer their accounts to, invest/continue to invest with and make additional investments with the Investment Manager.  The first payments related to recommendations by the Adviser that clients move their accounts from an advisory organization that the owner of the Investment Manager left to found the Investment Manager.  In the aggregate payments to the Adviser by the Investment Manager for referrals represented approximately 25% of the Adviser’s total revenue in 2010.  The Respondents’ clients invested over $80 million with the Investment Manager, including investments in funds managed by the Investment Manager.  Their assets represented approximately 90% of the Investment Manager’s total assets under management.  The Adviser did not to disclose to its clients the services rendered to, or fees paid by, the Investment Manager.  In addition, the Adviser failed to update the disclosures in the relevant portions of its 2009 Form ADV filings (as discussed above) when those disclosures became materially inaccurate and subsequently made disclosures in 2010 filings that were materially false when filed.  (In January 2011, the SEC filed an emergency civil injunctive action against the Investment Manager regarding alleged misappropriation of client assets by the Investment Manager’s owner and subsequently obtained orders appointing a receiver for the Investment Manager’s assets and barring the Investment Manager’s owner from association with various types of SEC-registered securities industry participants.)

Alleged Violations.  The SEC alleges that based on the conduct described above, Respondents willfully violated Sections 206(1) and 206(2) of the Advisers Act by employing devices, schemes or artifices to defraud clients or engaging in transactions, practices or courses of business that defrauded clients or prospective clients.  The SEC further alleges that the Respondents willfully violated Section 207 of the Advisers Act by making untrue statements of a material fact in registration applications or reports Respondents filed with the SEC and willfully omitting to state in such applications or reports material facts which were required to be stated therein.  The SEC also alleges that the Owner willfully aided and abetted and caused the Adviser’s violations of, Section 204 of the Advisers Act and Rule 204-1(a)(2) thereunder by failing to update registration applications or reports the Respondents filed with the SEC when the information contained therein became materially inaccurate.

The DOL issued a press release announcing that it will repropose an amendment to the rule that defines “investment advice” for purposes of determining fiduciary status under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  It has been nearly a year since the DOL’s prior proposal to amend the definition of “investment advice,” which was discussed in the November 23, 2010 Financial Services Alert.  According to its press release, the DOL anticipates that the re-proposed amendment will seek to revise the rule by “clarifying that fiduciary advice is limited to individualized advice directed to specific parties, responding to concerns about the application of the regulation to routine appraisals and clarifying the limits of the rule’s application to arm’s length commercial transactions, such as swap transactions.”  The DOL also anticipates providing “exemptions addressing concerns about the impact of the new regulation on the current fee practices of brokers and advisers, and clarifying the continued applicability of exemptions that have long been in existence that allow brokers to receive commissions in connection with mutual funds, stocks and insurance products.”  The DOL expects to issue its new proposal in early 2012.

FinCEN issued a notice and request for comments (the “Notice”) pursuant to which FinCEN would require electronic filing, beginning June 30, 2012, of all Bank Secrecy Act reports (other than the Report of International Transportation of Currency or Monetary Instruments, which is filed at the applicable port of entry or exit with the Department of Homeland Security’s Customs and Border Protection or with the Commissioner of Customs).  FinCEN stated that making electronic filing mandatory (when combined with a new and improved electronic filing system that FinCEN will introduce in advance of the June 30, 2012 deadline) would “enhance the quality of [FinCEN’s] electronic data, improve our analytic capabilities in supporting law enforcement requirements and result in a significant reduction in real costs to the U.S. government and ultimately to U.S. taxpayers.”  Comments on the Notice are due by November 15, 2011.

The FDIC Board of Directors adopted a final rule (the “Final Rule”) concerning the requirement under Section 165(d) of the Dodd-Frank Act that large bank holding companies with assets of $50 million or more and other financial companies designated by the Financial Stability Oversight Counsel as “systematically important” submit formal resolution plans referred to as “living wills.”  See the discussion of the proposed version of the Final Rule in the April 5, 2011 Financial Services Alert.  The FDIC stated that the Final Rule “sets specific standards for the resolution plans, including requiring a strategic analysis of the plan’s components, a description of the range of specific actions to be taken in the resolution, and analyses of the company’s organization, material entities, interconnections and interdependencies, and management information systems among other elements.”  The Final Rule provides greater flexibility than the proposed version of the rule, and the initial due date for living wills from the first of three staggered groups of covered companies will be July 1, 2012.  The FDIC Board also approved a separate Interim Final Rule that requires resolution plans from large FDIC-insured depository institutions that are not subject to the federal Bankruptcy Code.  The Interim Final Rule will have a 60-day comment period after it is published in the Federal Register and will be effective January 1, 2012.  The Final Rule must also be approved by the FRB and will be effective 30 days after it is published in the Federal Register.