Financial Services Alert - November 1, 2011

The SEC announced that it had approved rules jointly drafted with the CFTC that are designed to fulfill the Dodd-Frank Act mandate to collect information from advisers to hedge funds and other private funds as necessary for use by the Financial Stability Oversight Council (FSOC) in assessing systemic risk. The new private fund reporting rules will require periodic, confidential submission of private fund information to the SEC on new Form PF by SEC-registered advisers with at least $150 million in private fund assets under management. The CFTC also announced its approval of the joint rules, which direct registered commodity pool operators (CPOs) and commodity trading advisers (CTAs) that are also registered with the SEC to file any required private fund information with the SEC on Form PF.  The joint rules also allow such jointly registered advisers to use Form PF to report information to the SEC with respect to commodity pools that would otherwise have to be reported to the CFTC.  (Because of the timing of the SEC’s posting of the adopting release and Form PF, this article is based solely on the SEC’s and CFTC’s press releases announcing the adoption of Form PF.  Goodwin Procter will provide more in-depth coverage of this development in a future publication.)

Reporting – Large Private Fund Advisers and Smaller Private Fund Advisers. The focus and frequency of reports on Form PF will depend on whether an adviser is a “large private fund adviser” or a “smaller private fund adviser.”  An adviser is a large private fund adviser if it falls into one of the three following categories, each of which has its own particular reporting requirements:

• Large hedge fund advisers (at least $1.5 billion in assets under management attributable to “hedge funds”) must make quarterly Form PF filings within 60 days of fiscal quarter-end updating information on hedge funds managed including (1) aggregate information regarding exposures by asset class, geographical concentration, and turnover by asset class and (2) for each hedge fund with a net asset value of $500 million or more, information relating to exposures, leverage, risk profile, and liquidity (but no position-level information).

• Large liquidity fund advisers (at least $1 billion in combined assets under management attributable to “liquidity funds” and registered money market funds) must make quarterly Form PF filings within 15 days of fiscal quarter-end updating information for each liquidity fund with respect to (1) types of assets, (2) risk profile‑related matters, and (3) the extent to which the liquidity fund complies with conditions in Rule 2a-7 under the Investment Company Act of 1940 governing registered money market funds.

• Large private equity fund advisers (at least $2 billion in assets under management attributable to “private equity funds”) must make annual Form PF filings within 120 days of fiscal year-end responding to questions focused primarily on the extent of leverage incurred by portfolio companies, the use of bridge financing, and investments in financial institutions.

All other advisers required to file Form PF are “smaller private fund advisers” that will have to file Form PF annually within 120 days of fiscal year-end, reporting only limited information for their private funds regarding size, leverage, investor types and concentration, liquidity and performance.  A smaller private fund adviser managing hedge funds will also have to report information about fund strategy, counterparty credit risk, and use of trading and clearing mechanisms.

Compliance Dates.  The following advisers will begin filing Form PF following their first fiscal year or fiscal quarter, as applicable, ending on or after June 15, 2012:

• Advisers with at least $5 billion in assets under management attributable to hedge funds

• Advisers with at least $5 billion in combined assets under management attributable to liquidity funds and registered money market funds

• Advisers with at least $5 billion in assets under management attributable to private equity funds

All other private fund advisers will begin complying with Form PF requirements following the end of their first fiscal year or fiscal quarter, as applicable, ending on or after December 15, 2012.

The Department of Labor issued a final regulation (the “Regulation”) regarding two statutory prohibited transaction exemptions relating to the provision of investment advice to beneficiaries of IRAs and participants in 401(k) plans and other defined contribution plans that provide for participant direction of investments.  The Regulation is for the most part similar to the proposed regulation published by the DOL in March 2010 (see the March 2, 2010 Financial Services Alert), although there are some differences.  The Regulation becomes effective December 27, 2011.

The Regulation sets forth standards regarding two prohibited transaction exemptions added to ERISA and the prohibited transaction provisions of Section 4975 of the Internal Revenue Code by the Pension Protection Act of 2006.  In general, absent an exemption, a fiduciary providing investment advice to an IRA beneficiary or plan participant would be engaging in a prohibited transaction if the advice would result in the receipt of incremental compensation by the fiduciary advisor or its affiliates -- e.g., if the fiduciary advises the IRA beneficiary or plan participant to invest in investment vehicles that pay a fee to the adviser or its affiliates.  The statutory exemptions permit such advice under a “fee-leveling” arrangement or a “computer-model” arrangement, subject to certain limitations and conditions that are set forth in the statute and explained the Regulation.

One condition applicable to fee-leveling arrangements under the Regulation is that neither the fiduciary adviser, nor any of the adviser’s employees, agents, or registered representatives, may receive from any party (including an affiliate) any fee or other compensation that varies depending on the basis of any particular investment selected by the participant or beneficiary.  Significantly, this does not preclude the receipt by affiliates of the fiduciary adviser (other than employees, agents, or registered representatives) of fees or compensation that vary based on the selection of investments by partcipants or beneficiaries (e.g., the selection by participants or beneficiaries of investment vehicles advised or sponsored by such affiliates).  The Regulation makes clear that this condition applies to compensation (including salary, bonuses, and commissions) and “other things of value” (including promotions) received by employees of the fiduciary adviser.  The DOL’s preamble to the Regulation includes a discussion of the applicable considerations in determining whether this condition is satisfied with respect to compensation received by employees of the adviser.  The exemption for fee-leveling arrangements is also subject to a number of other conditions, which (among other things) establish standards for the advice provided under the arrangement, and require specified disclosures by the adviser, authorization by an independent fiduciary, and an annual independent audit of compliance with the applicable conditions.

One condition regarding computer model arrangements under the Regulation is that the computer model used in providing the advice generally must take into account all available designated investment options without giving inappropriate weight to any specific option.  (For this purpose, designated investment options do not include brokerage windows and similar arrangements.)  Under the March 2010 proposal, this condition would not have required the computer model to take into account certain excepted categories of designated investment options – i.e., employer stock, certain asset allocation funds, and annuities (providing a stream of retirement income guaranteed by an insurer).  The final Regulation changes this rule so that employer stock and asset allocation funds must be taken into account if they are available as designated investment options (although the final Regulation retains the proposal’s exclusion of annuities from this requirement).  The Regulation also imposes a number of other conditions applicable to computer model arrangements – including (among other things) standards applicable to the computer model used to provide the advice, disclosure requirements, approval by an independent fiduciary, and an annual independent audit of compliance with the relevant conditions to the exemption.

Notably, in its preamble to the Regulation, the DOL makes clear that the existence of the statutory exemptions addressed in the Regulation does not affect the availability of other potentially applicable prohibited transaction exemptions or other DOL guidance relating to participant investment advice and prohibited transactions (such as the 2001 SunAmerica advisory opinion).

As a result of the increase in total reserve liabilities and net transaction accounts of all depository institutions between June 30, 2010 and June 30, 2011, the FRB issued a final rule (the “Final Rule”) amending Regulation D, Reserve Requirements of Depository Institutions.  The Final Rule reflects the annual indexing of the reserve requirement exemption amount and the low reserve tranche for 2012.  Specifically, the Final Rule sets the reserve requirement exemption amount for 2012, the amount of total reservable liabilities of each depository institution that is subject to a 0% percent reserve requirement, at $11.5 million (up from $10.7 million in 2011).  The Final Rule also sets the low reserve tranche for 2012, the amount of net transaction accounts at each depository institution that is subject to a 3% reserve requirement, at $71.0 million (up from $58.8 million in 2011).  Thus, a net transaction account balance of $11.5 million or less will be exempt from reserve requirements, while a net transaction account balance above $11.5 million and up to and including $71.0 million will be subject to a 3% reserve requirement and a net transaction account balance above $71.0 million will be subject to a 10% reserve requirement.  The Final Rule also increases the nonexempt deposit cutoff level (to $271.5 million for 2012, up from $252.6 million in 2011) and the reduced reporting limit (to $1.521 billion in 2012, up from $1.415 billion for 2011). 

For depository institutions that report deposit data weekly, the new low reserve tranche and reserve requirement exemption amount will apply to the fourteen-day reserve computation period that begins Tuesday, November 29, 2011, and the corresponding fourteen-day reserve maintenance period that begins Thursday, December 29, 2011.  For depository institutions that report deposit data quarterly, the new low reserve tranche and reserve requirement exemption amount will apply to the seven-day reserve computation period that begins Tuesday, December 20, 2011, and the corresponding seven-day reserve maintenance period that begins Thursday, January 19, 2012.   The Final Rule notes that for all depository institutions, the new values of the nonexempt deposit cutoff level, the reserve requirement exemption amount, and the reduced reporting limit will be used to determine the frequency at which a depository institution submits deposit reports.  The Final Rule will become effective 30 days after its date of publication in the Federal Register.

A registered broker-dealer recently executed a Letter of Acceptance, Waiver and Consent (the “AWC”) with FINRA regarding allegations that it failed to deliver prospectuses in a timely manner to customers who purchased mutual funds in 2009, resulting in a violation of FINRA Rule 2010.  In settling this matter, the broker-dealer neither admitted nor denied the charges, but consented to the entry of FINRA’s findings, which are summarized in this article.

FINRA found that the broker-dealer did not take adequate corrective measures to ensure timely delivery of prospectuses following mutual fund transactions despite being on notice that not all customers were receiving prospectuses within three business days of their transactions, as required by federal securities laws. The broker-dealer had contracted with a third-party service provider to mail the prospectuses to customers.  The service provider provided daily reports to the broker-dealer identifying, among other things, a cumulative list of all mutual fund transactions for which the service provider had been unable to deliver a prospectus by the settlement date (“exceptions”), the number of days that each prospectus was late and reasons for the exceptions.  The broker-dealer’s procedures required its operations department on a daily basis to: review the exception report, correct any issues identified as exceptions, and provide the updated information back to the service provider.  As a consequence, the broker-dealer’s operations staff was in daily communication with the service provider regarding the resolution of exceptions.  In addition, at quarterly meetings with service provider personnel, broker-dealer officials received statistical data showing prospectus delivery exceptions for between four percent and five percent of the broker-dealer’s mutual fund customers. 

FINRA found that the primary cause of exceptions was that certain mutual fund companies failed to ensure that the broker-dealer had enough paper copies of their prospectuses at all times and that the broker-dealer took no action to cause the mutual funds to address the shortfall problem.  FINRA also faulted the broker-dealer for failing to take other actions available to it to ensure that its customers were receiving prospectuses on time, including noting that the broker-dealer did not make use of the service provider’s “print on demand” (“POD”) service extensively during the period in question.  For its POD service, the service provider maintained electronic versions of the relevant prospectuses which it could print and send to the broker-dealer’s customers when the inventory of paper copies provided by a mutual fund was insufficient. 

The broker-dealer agreed to be censured and to pay a monetary fine in the amount of $100,000.

The staff of the SEC’s Division of Investment Management (the “Staff”) provided no-action relief requested by the Department of Labor (the “DOL”) with respect to registered fund performance disclosures made by plan administrators to plan participants or beneficiaries to satisfy the DOL’s new participant-level retirement plan fee disclosure requirements in DOL Regulation 2550.404a-5 under ERISA (the “Participant Disclosure Regulation”).  (The Participant Disclosure Regulation was most recently discussed in the July 19, 2011 Financial Services Alert.)  In broad terms, the no-action relief provides that (a) performance information for registered funds that is required by the Participant Disclosure Regulation’s disclosure requirements will be treated as complying with the standards for performance information set forth in Rule 482 under the Securities Act of 1933 (the “1933 Act”) and (b) such information need not be filed with the SEC pursuant to Rule 497 under the 1933 Act or an applicable national securities association (e.g., FINRA) pursuant to Section 24(b) of the Investment Company Act of 1940.  The letter also conveys the Staff’s understanding that the staff of FINRA intends to interpret FINRA’s rules applicable to the information provided by a Plan Administrator to Plan Participants that is required by and complies with the disclosure requirements under the Participant Disclosure Regulation in a manner consistent with the Staff’s position expressed in the no-action relief.

The CFTC issued a notice proposing to amend its July 14, 2011 order providing temporary exemptive relief from certain requirements in the Commodity Exchange Act (the “CEA”) resulting from the Dodd-Frank Act that otherwise became effective on July 16, 2011 under the terms of the Act.  The relief contains two principal elements.  The first provides a temporary exemption from provisions that reference terms such as “swap,” “swap dealer,” “major swap participant,” or “eligible contract participant” that the Dodd-Frank Act requires the CFTC and SEC to “further define” (which the agencies had not done by July 16).  Under the proposal, this exemption would continue until the earlier of the effective date of final rules defining the relevant terms or July 16, 2012 (instead of December 31, 2011 under the order currently). 

The second element of the July 14 order temporarily exempts certain transactions (primarily in financial, energy and metals commodities) from certain CEA provisions that apply as a result of the repeal of various CEA exemptions and exclusions under the Dodd-Frank Act.  Under the proposal, this exemption would apply until the earlier of (i) July 16, 2012 (instead of December 31, 2011 under the order currently) or (ii) such other compliance date as the CFTC may determine.  (Under the current order, the relief under the second part of the exemption would expire on December 31, 2011.)  The CFTC’s proposed changes to the July 14 order would also broaden the second element of the exemption so that as of January 1, 2012 it would apply to any agreement that fully meets the conditions for exemptive relief under part 35 of the CFTC’s regulations at December 31, 2011. 

Comments on the CFTC’s proposal must be submitted on or before November 21, 2011.