Financial Services Alert - March 13, 2012

On February 23, 2012, the CFTC approved a final rule (the “final rule”) pertaining primarily to the responsibilities and conduct of swap dealers and major swap participants.  Additionally, the CFTC proposed a rule (the “proposed rule”) relating to block trading and protecting the identities of swap counterparties in connection with public reporting of swap transactions.

The final rule includes a number of reporting, record-keeping, risk management, and conflict of interest rules for swap dealers and major swap participants.  For example, the rule requires swap dealers and major swap participants to keep full and complete transaction and position information for all swap activities, including all documents on which trade information is originally recorded, and to maintain such records in a manner that is identifiable and searchable by transaction and by counterparty.  Swap dealers and major swap participants are also required by the rule to keep basic business records, such as audit documentation, as well as certain financial records, records of complaints against personnel, and marketing materials.

The final rule also requires swap dealers and major swap participants to establish a risk management program consisting of written policies and procedures designed to monitor and manage the risks associated with their swap activities.  They are also required to establish policies for monitoring their traders throughout the trading day to ensure compliance with trading limits and with procedures for executing and confirming transactions. 

In addition, the final rule restricts the ability of non-research personnel to influence the content of research reports prepared by research analysts employed by a swap dealer, major swap participant, futures commission merchant, or introducing broker, and also prohibits such entities from offering favorable research or threatening to change research for existing or prospective counterparties in exchange for business or compensation.  Futures commission merchants and introducing brokers are also required by the rule to disclose in research reports whether the research analyst maintains a financial interest in any derivative of a type that the analyst follows, and the general nature of such financial interest. 

Finally, the rule requires that swap dealers and major swap participants designate a Chief Compliance Officer, and establishes certain rules regarding the qualifications, reporting lines, and duties of the Chief Compliance Officer, including the preparation of an annual report.

The final rule will go into effect 60 days after its forthcoming publication in the Federal Register. 

The proposed rule pertains to minimum block trade sizes for large notional off-facility swaps and block trades.  The proposal creates a number of specific swap categories within each of the five asset classes previously established by CFTC rule-making:  interest rate, credit, equity, foreign exchange, and other commodity swaps.  The proposed rule lays out a two-period, phased in approach:  during the initial period, which would last at least one year, the CFTC would prescribe minimum block sizes for each swap category within each asset class.  During that initial period, registered swap data repositories would collect data for each asset class; the CFTC would then analyze and use this data to establish appropriate minimum block sizes after the initial period, with the understanding that these minimum block sizes would be updated no less than annually.  The proposal, which is intended to delay the reporting of certain large trades to allow the parties time to hedge the trades before the market moves against them, also includes further measures to protect the identities of parties to block transactions. 

The CFTC had previously proposed a rule on this topic, but chose to withdraw it and replace it after reviewing the comments submitted to the previous proposal.  Comments on the revised proposed rule are due 60 days after its forthcoming publication in the Federal Register.

The SEC released the results of a third-party study that it sponsored regarding investors’ understanding of target date retirement funds (“TDFs”) and related advertisements (the “Study”).  This article presents a high-level overview of the 96-page study.

Methodology. The Study was conducted through an online survey of 1,000 investors that currently hold investments in retirement accounts (the “Investors”), approximately half of whom currently own TDFs.  The Study was conducted in three parts, in which each Investor (i) answered questions about the Investor’s background knowledge of TDFs, (ii) answered questions about the Investor’s use, comprehension and perceptions of TDFs, and (iii) reviewed one of four variations of a TDF disclosure document and responded to questions testing the Investor’s understanding of the disclosure.

Key Findings. The Study found that Investors generally have misconceptions about how TDFs operate, including: (i) a lack of understanding of the point at which the asset allocation of a TDF stops changing, (ii) a failure to understand that TDFs do not provide guaranteed retirement income, and (iii) a failure to understand that TDFs with the same year in their names do not necessarily have the same mix of assets when they reach their target date.  Additionally, the Study determined that: (i) Investors who own TDFs have fewer misconceptions about them, (ii) fewer than half of all Investors understood the correct meaning of the year in a TDF’s name or that a TDF does not provide guaranteed income during retirement, and (iii) Investors that are closer to retirement age have the highest understanding of TDFs.

Testing of Specific Disclosure Elements. Each Investor was presented with one of four variations of a disclosure document to review that contained either: (i) a “tagline disclosure” showing the TDF’s asset allocation at the target date, (ii) a “glide path illustration” showing the percentage asset allocations over time, (iii) both the “tagline disclosure” and the “glide path illustration,” or (iv) neither the “tagline disclosure” nor the “glide path illustration.”  The Study found that which of the four disclosure variations was presented to an Investor affected the Investor’s understanding of the TDF.  Among other things, the Study determined that Investors presented with a disclosure document containing the “tagline illustration” showed a higher rate of comprehension of the asset allocation mix of the TDF at the target date, while Investors presented a disclosure document containing the “glidepath disclosure” showed an increased understanding of how the asset allocation mix of the TDF changes over time and that it will change following the target date.  Additionally, Investors receiving a disclosure document with neither the “tagline disclosure” nor the “glide path disclosure” exhibited the highest rate of understanding that TDFs do not guarantee the original investment.  The Study found that after reviewing any of the disclosure documents, a majority of Investors understood that a TDF can lose money after the target date and that the invested amount is not guaranteed. 

The SEC has made the Study part of the comment file for its proposal on TDF disclosure (as discussed in the June 29, 2010 Financial Services Alert).

The FRB issued guidance (the “Guidance,” SR 12-4) to advise community banking organizations (those with consolidated assets of $10 billion or less) of the factors considered by the FRB in determining whether to upgrade the supervisory ratings of a banking organization.  Under the Guidance, the FRB will look for “a demonstrated improvement” in the banking organization’s financial condition and risk management practices, and whether such improvements are sustainable.  In addition, the FRB said that it will assess the quality of the oversight provided by the banking organization’s board of directors and whether the board of directors actively engages in the process of correcting deficiencies.

A registered broker-dealer recently executed a Letter of Acceptance, Waiver and Consent (“AWC”) with FINRA regarding alleged violations of record retention rules applicable to emails.  In settling this matter, the firm neither admitted nor denied the charges, but consented to the entry of FINRA’s findings, which are summarized in this article.

Background.  According to the AWC, during the period October 2008 to December 2009, the broker-dealer failed to retain millions of emails.  The firm had previously upgraded its email system from a backup tape-based system to a journaling system in which employee emails were sent to one of 58 servers (with every employee being assigned to one of the servers).  The email servers sent copies of all sent and received emails to a hub transport server, which then routed the emails to the journaling server.  The journaled emails were then electronically transferred by a third-party vendor from the journaling server into the email archive.  Due to a technical fault, three of the 58 servers did not send copies through to the archives during the relevant period. 

FINRA found that the broker-dealer failed to perform sufficient quality assurance tests during its upgrading process.  Further, the firm did not apply its automated quality assurance process to each of its 58 servers, which would have detected the archiving problems.  Lastly, the monitoring software that the firm utilized was not sufficiently designed to flag reasonably foreseeable errors.

According to FINRA, the broker-dealer’s email retention failures potentially impacted at least five FINRA investigations and may have impacted the firm’s ability to produce emails fully responsive to requests in other matters.

The AWC notes that the broker-dealer has a history of failing to preserve records as required by NASD and the NYSE rules.  In 2002, while doing business under another name, the broker-dealer, along with four other firms, was disciplined for failing to preserve electronic communications.  The firm was censured and fined approximately $1.6 million, and agreed to an undertaking to certify that it had established systems and procedures reasonably designed to comply with applicable laws and rules concerning the preservation of its emails.  The broker-dealer certified that it had complied with the undertaking in 2003.

Violations.  FINRA charged the broker-dealer with failure to retain all required emails in violation of NASD Rule 3110(a), Section 17(a) of the Securities Exchange Act of 1934 and Rule 17a-4(b)(4) thereunder.  FINRA also charged the broker-dealer with failure to reasonably supervise in violation of NASD Rule 3010, because the broker-dealer’s supervisory systems and procedures relating to the retention of emails failed to timely detect the retention failures.

Sanctions.  The AWC notes that the broker-dealer detected the system failures and self-reported the violations to FINRA.  Although the AWC states that the penalty reflects credit for self-reporting and providing additional information obtained as a result of the firm’s own internal investigation, FINRA imposed, and the broker-dealer agreed to, a censure and $750,000 fine.