Financial Services Alert - January 10, 2012

The FRB issued an approval order in connection with the proposed acquisition of RBC Bank (USA), a North Carolina banking unit of Royal Bank of Canada, by The PNC Financial Services Group, Inc. that included, for the first time, the financial stability analysis required by the Dodd-Frank Act.  Among other things, the Dodd-Frank Act amended Section 3 of the Bank Holding Company Act of 1956, as amended, to require the FRB to consider “the extent to which a proposed acquisition, merger, or consolidation would result in greater or more concentrated risks to the stability of the United States banking or financial system.”

To that end, in connection with the PNC-RBC Bank transaction, the FRB considered (i) whether the proposal would result in a material increase in risks to financial stability due to the increase in size of the combining entities; (ii) a reduction in the availability of substitute providers for the services offered by the combining entities; (iii) the extent of interconnectedness among the combining entities and the rest of the financial system; (iv) the extent to which the combining entities contribute to the complexity of the financial system; (v) the extent of cross-border activities of the combining entities, and (vi) the relative degree of difficulty of resolving the combined entities.

With respect to each factor, the FRB specifically addressed the following:

• Size – The FRB considered certain measures of PNC’s size relative to the U.S. financial system (i.e., all U.S. financial institutions, aggregated), including PNC’s consolidated assets, total leverage ratio exposures, and U.S. deposits.
• Substitutability – The FRB examined whether either PNC or RBC Bank engages in any activities that are critical to the functioning of the U.S. financial system, and whether substitute providers would remain that could quickly step in to perform such activities should the combined entity suddenly be unable to do so as a result of severe financial distress.
• Interconnectedness – The FRB examined data to determine whether the combined entity’s relationships to other market participants and the similarity of product offerings could (i) transmit material financial distress experienced by the combined entity to its counterparties directly; (ii) transmit distress indirectly through a fire sale of assets or erosion of asset prices; or (iii) trigger contagion resulting in the withdrawal of liquidity from other financial institutions.
• Complexity – The FRB considered the extent to which the merged entity (on a pro forma basis) would contribute to the overall complexity of the U.S. financial system, and whether the merged entity’s assets and liabilities would hinder its timely and efficient resolution in the event it were to experience financial distress.
• Cross-border activity – The FRB examined the cross-border activities of PNC and RBC Bank to determine whether the cross-border presence of the combined organization would create difficulties in coordinating a resolution.
• Financial stability factors in combination – The FRB assessed the foregoing factors in combination to determine whether interactions among them might mitigate or exacerbate risks suggested by looking at them individually.  The FRB also considered whether the proposed transaction would provide any stability benefits and whether enhanced prudential standards applicable to the combined organization would tend to offset any potential risks.

The FRB noted that these categories are not exhaustive.  In addition, the FRB noted that it expects to issue a notice of proposed rulemaking implementing the provisions of the Dodd‑Frank Act that require the FRB to take into account a proposal’s impact on the risks to the stability of the U.S. financial or banking system.  The FRB did not give any indication as to when that proposal will be issued.

On January 4, 2012, the staff of the SEC’s Office of Compliance Inspections and Examinations issued a National Examination Risk Alert (the “Risk Alert”) with observations related to the use of social media by registered investment advisers (“advisers”).  The Risk Alert, citing the accelerated use of social media by advisers, investment advisory representatives and solicitors, indicates that, pursuant to Rule 206(4)-7 under the Investment Advisers Act of 1940 (the “Advisers Act”), advisers should adopt, and periodically review the effectiveness of, policies and procedures relating to the use of social media.  The SEC staff issued the Risk Alert following a review of certain advisers’ use of social media to evaluate whether their use complied with the federal securities laws.  In this regard, the Risk Alert emphasizes that the “use of social media must comply with various provisions of the federal securities laws, including, but not limited to, the antifraud provisions, compliance provisions and recordkeeping provisions.”

Evaluating Compliance Program Oversight of Social Media.  The Risk Alert offers a “non-exhaustive list of factors that an [adviser] may want to consider when evaluating the effectiveness of its compliance program with respect to the firm, [investment advisory representative] or solicitor use of social media.”  The Risk Alert describes, among other factors, usage guidelines, content standards, monitoring, training and content approval.  The Risk Alert emphasizes that the factors it describes should be tailored to the specific profile of the adviser and consideration should be given to other appropriate factors.  For example, the frequency with which a firm monitors activity on social media sites will be determined by its specific facts and circumstances.  The Risk Alert suggests that “using a risk-based approach, a firm may conclude that periodic, daily or real-time monitoring of the postings on a site is appropriate.”  Advisers should also consider whether to require pre-approval of all postings to social media sites, or to allow for after-the-fact review.

Third Party Postings.  The Risk Alert also addresses third-party use of an adviser’s social media site.  The staff noted that, based on its review, there were varying approaches in firm policies and procedures governing third-party postings.  Some of the more conservative policies and procedures limit third-party postings and prohibit postings by the general public, while others include disclaimers on the social media site that the adviser does not approve or endorse any third-party post.  The key issue with respect to third-party statements is whether such statements could be “testimonials” subject to the limitations of Rule 206(4)-1(a)(1) under the Advisers Act.  The Risk Alert provides that the staff has consistently interpreted that term to include a statement of a client’s experience with, or endorsement of, an investment adviser.  Applying this standard to the social media context, the Risk Alert notes, “[t]herefore, the staff believes that, depending on the facts and circumstances, the use of ‘social plug-ins’ such as the ‘like’ button could be a testimonial under the Advisers Act” and that “[i]f, for example, the public is invited to ‘like’ an [investment advisory representative’s] biography posted on a social media site, that election could be viewed as a type of testimonial prohibited by Rule 206(4)-1(a)(1).”

Recordkeeping and Social Media.  The Risk Alert also discusses the applicability of the Advisers Act’s recordkeeping requirements to an adviser’s use of social media, noting that the Act’s recordkeeping provisions do not differentiate between various media.  Therefore, according to the staff, an adviser that communicates through social media should determine that it has the ability to retain all required records related to social media communications and make them available for inspection.

The SEC adopted final rule amendments designed primarily to incorporate (a) the existing requirement under the Dodd-Frank Act (effective since July 21, 2010) that in order to qualify as an “accredited investor” for the purpose of certain registration exemptions under the Securities Act of 1933 (the “1933 Act”) for private and other limited offerings, including Regulation D, a natural person must have a net worth in excess of $1 million, excluding the value of the person’s primary residence (as discussed in the July 28, 2010 Special Edition of the Financial Services Alert) and (b) related SEC guidance regarding the treatment of indebtedness secured by a primary residence (as discussed in the August 3, 2010 Financial Services Alert).  Under these existing requirements, a natural person is an accredited investor if that natural person’s individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000 at the time the natural person purchases the security being offering in reliance on the applicable 1933 Act exemption, excluding the value of that person’s primary residence; the value of the primary residence is calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property.  The amendments substantially track the existing requirements, but also include a new sixty-day lookback with respect to debt, as follows:

• if the indebtedness securing a natural person’s primary residence at the time the security is acquired in reliance on the applicable exemption exceeds the amount of such indebtedness outstanding 60 days prior to such time (other than as a result of the acquisition of the primary residence), such excess is included as a liability when determining a natural person’s net worth. 

This additional requirement is intended to prevent an investor from using equity in the investor’s primary residence to purchase securities, with the ultimate goal of preventing unregistered securities from being sold to investors with limited assets other than their homes.  The amendments are effective February 27, 2012.

The Department of Labor issued Technical Release 2011-03R (the “Revised Release”), clarifying two aspects of Technical Release 2011-03 (the “Release”), which set forth DOL’s interim policy regarding the use of electronic media to provide information required to be furnished to participants of ERISA-covered defined contribution plans under the participant-level fee disclosure regulation, 29 C.F.R. §2550.404a-5 (the “Regulation”).  (The Release is discussed in the October 11, 2011 Financial Services Alert .)

The Revised Release clarifies that certain investment-related information required by the Regulation (including comparative information regarding the plan’s designated investment alternatives) may be furnished as part of, or along with, pension benefit statement information, either electronically in accordance with interim rules described in the Release, or in paper form consistent with the DOL regulation that generally governs the furnishing of required information under ERISA, 29 C.F.R. §2520.104b-1(b).  The Revised Release also clarifies that the furnishing of information electronically under the interim rules of the Release may be made through a continuous access website, so long as the applicable conditions of the Release’s interim rules are satisfied.

The Financial Crimes Enforcement Network (“FinCEN”) issued a report (the “Report“) assessing the impact of amendments (the “Amendments”) to FinCEN’s regulations that required mutual funds to file Currency Transaction Reports (“CTRs”) rather than Form 8300s.  A mutual fund must file a CTR for any transaction involving a transfer of more than $10,000 in currency (coin and paper money) by, through or to the  mutual fund.  A Form 8300 defined currency more broadly including, in addition to coin and paper money, cashier’s checks, bank drafts, travelers’ checks and money orders.  FinCEN stated that the Amendments, by requiring mutual funds to file CTRs, conform mutual funds’ filing requirements to those of other elements of the financial services industry and harmonize the definition of mutual fund in FinCEN’s anti-money laundering program rule with the definitions in other FinCEN rules which cover mutual funds.  The Amendments became effective on May 14, 2010, but mutual funds had until January 10, 2011 to comply with FinCEN’s recordkeeping and travel rule requirements.

The Report said that, in replacing Form 8300 with CTR filing requirements, the Amendments accomplished FinCEN’s objectives of reducing the number of unnecessary filings that mutual funds were required to make and bringing mutual funds “into a greater conformity with other financial institutions that file CTRs.”  Since the Amendments have become effective, FinCEN reported that mutual funds have, in fact, filed no CTRs.  FinCEN notes that this is not unexpected since “mutual funds rarely receive or disburse significant amounts of currency in transactions with their shareholders.”  FinCEN also stressed that mutual funds are still required to file reports on suspicious activity on Suspicious Activity Reports (“SARs”).

The United States District Court for the Southern District of New York (the “Court”) issued a decision addressing the issue of whether cash proceeds from the portfolio collateral of a collateralized loan obligation (the “CLO”) should be reinvested or distributed to noteholders when the collateral manager had committed during the reinvestment period to make certain new purchases with the proceeds, but the CLO did not receive such proceeds until after the reinvestment period had ended.  Certain holders of the CLO’s senior note classes favored distribution of the proceeds, while the collateral manager and the holder of the CLO’s junior securities (so-called income notes) advocated using the proceeds to fulfill the purchase commitments.  The Court noted that the collateral manager stood to realize higher fees if the cash proceeds were reinvested.

The Court, relying on the principle that “a written agreement that is complete, clear and unambiguous on its face must be enforced according to the plain meaning of its terms,” ruled that the over $65 million of proceeds must be distributed to the noteholders. Judge Rakoff reasoned that per “the plain language of the Indenture” governing the CLO’s notes, most collateral proceeds (including those at issue) received after the end of the reinvestment period could not be reinvested and had to be distributed to the noteholders, noting that cash proceeds could not be reinvested before they were received per the “plain meaning” of the word “reinvested”.  U.S. Bank, N.A., Trustee, Interpleader Plaintiff vs. Black Diamond CLO 2005-1 Adviser, No. 11- cv-5675 (S.D.N.Y., filed Dec. 30, 2011).