Financial Services Alert - March 27, 2012

A bipartisan group of Senators has introduced legislation that, if it becomes law, would delay the effectiveness of the Volcker rule until 12 months following the issuance by the FRB, the OCC, the FDIC, the SEC and the CFTC (collectively, the “Agencies”) of final rules to carry out the Volcker rule.  Currently, the Volcker rule provides that it will become effective on the earlier of 12 months following the adoption of such a final rule or two years after the date of enactment of the Dodd-Frank Act.  Because the Agencies have not yet issued final rules to carry out the Volcker rule, in the absence of additional legislation, the Volcker rule will become effective on July 21, 2012.  If the Agencies do not issue final rules that becomes effective prior to the Volcker rule’s effective date, banking entities subject to the Volcker rule will need to comply with the Volcker rule without the benefit of any clarification as to the Volcker rule’s scope and without the benefit of any exemptions from the Volcker rule as the Agencies may provide in a final rule.

The staff of the SEC’s Division of Investment Management (the "Staff") supplemented its "Frequently Asked Questions on Form ADV and IARD" (the "FAQ") to broaden the circumstances under which it would permit an exempt reporting adviser (an "ERA") to include a general partner, managing member or similar special purpose entity ("SPE") of one of the adviser’s private funds in the adviser's report on Form ADV and thereby satisfy the SPE's own ERA reporting obligation. (An ERA is an adviser that relies on the venture capital fund adviser exemption under Section 203(l) of the Investment Advisers Act of 1940 (the "Advisers Act") or the private fund adviser exemption under Section 203(m) of the Advisers Act.) The Staff had previously provided more limited no action relief for SPEs, as discussed in the March 20, 2012 Financial Services Alert.

The Staff's more recent no-action relief applies to the situation where an SPE delegates certain responsibility for managing a private fund to the reporting ERA, but retains and exercises discretionary authority over the private fund's assets. Such an SPE can satisfy its reporting obligation as an ERA by including in the adviser's report on Form ADV all of the information that the SPE would have provided had it reported separately, provided the following conditions are met: (i) the SPE acts as the SPE only for private funds or other pooled investment vehicles advised by the reporting adviser; (ii) the reporting adviser controls the SPE; (iii) the investment advisory activities of the SPE are subject to the Advisers Act; (iv) the SPE has no employees or other persons acting on its behalf other than officers, directors, partners or employees of the reporting adviser; and (v) the SPE, its officers, directors, partners, employees and persons acting on its behalf are subject to the reporting adviser's supervision and control, making them associated persons of the reporting adviser for purposes of the Advisers Act.

The Staff's prior guidance about reporting SPE-related information in the applicable adviser's Form ADV also applies to the circumstances of the more recent relief: (a) Schedules A and B should include an SPE's executive officer and ownership information, identifying the SPE to which the officer and ownership information relates in the "Title or Status" column of Schedule A; and (b) responses to the questions in Form ADV should relate to, and include all information concerning, the ERA and each SPE being reported in the Form ADV.

The FDIC issued a Financial Institution Letter (“FIL-14-2012”) in which the FDIC states that it has observed, in a limited number of recent incidents, that directors and officers of troubled or failing financial institutions (“FIs”) have made copies of FI and supervisory records and removed them (for the personal use of the director or officer) from the FI’s premises “in anticipation of litigation or enforcement activity against them personally.” In FIL-14-2012, the FDIC conceded that FI directors and officers need access to FI records to perform their duties and to operate the FI, but “reminded” directors and officers of FIs that in fulfilling their fiduciary duty to the FI they serve, they must at all times act in the best interests of the FI and, as part of their fiduciary obligation, may not copy and remove confidential FI documents and other information “in pursuit of the personal interest of [the director or officer].”

In FIL-14-2012, the FDIC further cautioned FI directors and officers that in copying and removing FI and FI customer information, they may subject themselves to FDIC enforcement actions under Section 8 of the Federal Deposit Insurance Act for violations of statutory and regulatory requirements, such as:

The FDIC also stated in FIL-14-2012 that attorneys representing an FI are legally and ethically obligated “to advance the interests of the [FI] and the [FI] alone.” Moreover, the FDIC further stated that FI counsel “who advise copying and removal of records contrary to the interests of the [FI] may be engaging in violations of law, codes of professional conduct, as well as breaches of fiduciary duty.”

The Financial Services Alert will cover future developments concerning the issues raised, and the position taken, by the FDIC in FIL-14-2012.

The Technical Committee of the International Organization of Securities Commissions ("IOSCO") published for comment a consultative report on the Principles for the Regulation of Exchange Traded Funds (the "Report"). The Report proposes fifteen principles designed to apply to all exchange traded funds ("ETFs") that are organized as collective investment schemes ("CIS"), but not other exchange traded products ("ETPs") that are not organized as CIS, such as exchange traded notes. The proposed principles are intended to be common investor-protection principles and guidelines against which the industry and regulators can assess the quality of regulation and industry practices concerning ETFs. The fifteen principles are as follows:

ETF Classification and Disclosure

• Regulators should encourage disclosure that helps retail investors to clearly differentiate ETFs from other ETPs.
• Regulators should seek to ensure a clear differentiation between ETFs and traditional CIS, as well as between index-based and non index-based ETFs through appropriate disclosure requirements.
• Regulators should encourage all ETFs, in particular those that use or intend to use more complex strategies, or other complex techniques, to assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner and whether it addresses the nature of risks associated with such strategies or techniques.
• Regulators should consider imposing disclosure requirements with respect to the way in which an ETF will replicate the index (or the asset basket or the reference portfolio) it tracks (e.g., physically holding a sample or full basket of the securities that comprise the index (or the asset basket or the reference portfolio) or synthetically).
• Regulators should consider imposing requirements regarding the transparency of an ETF's portfolio or other appropriate measures in order to provide adequate information to investors concerning: (i) the index (or the asset basket or the reference portfolio) tracked and its composition; and (ii) the operation of performance tracking in an understandable form.
• Regulators should consider imposing requirements regarding the transparency of an ETF’s portfolio or other appropriate measures in order to facilitate arbitrage activity in ETF shares.
• Regulators should encourage the disclosure of fees and expenses for investing in ETFs in a way that allows investors to make informed decisions about whether they wish to invest in an ETF and thereby accept a particular level of costs.
• Regulators should encourage disclosure requirements that would enhance the transparency of information available with respect to material securities lending and borrowing activity.

Marketing and Sale of ETF Shares

• All sales materials and oral presentations used by intermediaries regarding ETFs should present a fair and balanced picture of both the risks and benefits of such products, and should not omit any material fact or qualification that would cause such a communication to be misleading.
• In evaluating an intermediary's disclosure obligations, regulators should consider who has control over the information that is to be disclosed.
• Before recommending the purchase, sale or exchange of an ETF, particularly a non-traditional ETF, an intermediary should be required to take reasonable steps to ensure that recommendation is based upon a reasonable assessment that the product is consistent with the customer’s experience, knowledge, investment objectives, risk appetite and capacity for loss.
• Intermediaries should establish a compliance function and develop appropriate internal policies and procedures that support compliance with suitability obligations when recommending any ETF.

Structuring of ETFs

• Regulators should assess whether the securities laws and applicable rules of securities exchanges within their jurisdiction appropriately address potential conflicts of interests raised by ETFs (e.g., with respect to custom indices created by affiliates, securities lending activities with affiliates, affiliated authorized purchasers and asset swaps between synthetic ETFs and affiliated counterparties).
• Regulators should consider imposing requirements to ensure that ETFs appropriately address risks raised by counterparty exposure and collateral management.

General Market Integrity and Efficiency

• ETF exchanges should consider adopting rules to mitigate the occurrence of liquidity shocks and transmission across correlated markets (e.g., automatic trading interruption mechanisms).

IOSCO has requested general comments on the proposed principles and on specific concerns cited in the Report. Comments are due on or before June 27, 2012.

The FDIC issued a notice of proposed rulemaking (the “Proposal”) that would implement the FDIC’s authority to prevent termination of contracts as receiver of systemically important financial institutions (“SIFIs”). The Proposal would establish the scope and conditions of the FDIC’s power under section 210(c)(16) (“Section 210(c)(16)”) of the Dodd-Frank Act, as receiver for a SIFI or subsidiary of a SIFI, to enforce contracts of that SIFI’s subsidiaries or affiliates despite the presence of contract clauses that otherwise would terminate, accelerate or provide other remedies based on the financial institution’s failure. Specifically, the Proposal would establish the required notice to counterparties, provide certain defined terms and solidify the receiver’s obligation, if the SIFI has supported the affiliate contract with a guarantee or otherwise, to either provide adequate protection to the counterparty or transfer the supporting obligation to a qualified third party.

The purpose of Section 210(c)(16) and the Proposal is to maximize the value of a troubled SIFI’s assets and operations, and to provide for an orderly liquidation process. As the ability to continue key operations, transactions and services is essential to maximizing value and preventing the spread of systemic risk, the Proposal would preserve contracts in full force and effect to allow the FDIC, as receiver, to continue operating SIFI subsidiaries without triggering a cascading series of defaults, and without causing otherwise viable subsidiaries also to be placed into receivership. The Proposal thus reflects a desire to prevent destructive ripple effects on financial markets and the economy, by facilitating the continued operation of SIFI subsidiaries, which may otherwise be healthy businesses.

Section 210(c)(16) provides the FDIC with authority to invalidate “specified financial condition clauses,” which the Proposal defines as any provision granting a counterparty termination, acceleration or default rights in connection with the receiver’s appointment or its exercise of the orderly liquidation authority. The Proposal would confirm the FDIC’s duties when exercising this authority. If the counterparty on a contract with a SIFI subsidiary enjoys any “support” from the SIFI, which the Proposal defines as any guarantee or other financial assistance provided to or on behalf of the subsidiary, the receiver must choose one of two options in order to exercise its power under the statute. The receiver would have to (a) transfer the SIFI’s supporting obligations to a bridge financial company or qualified third-party transferee by 5:00 p.m. Eastern Time on the business day following appointment as receiver, or (b) provide adequate protection to the relevant counterparties. The Proposal explains that “adequate protection” may be provided in a number of ways, including cash payments to counterparties covering any shortfalls resulting from the failure to assign the contract, a guarantee of the relevant contractual obligations and any other relief that will provide the counterparties with the equivalent of the form of support provided by the SIFI. Finally, the Proposal requires the FDIC, as receiver, to promptly take steps to notify counterparties whenever it transfers “support” or provides “adequate protection,” although this requirement may be satisfied by a posting on the website of the FDIC or the SIFI, and actual notice is not a prerequisite to the receiver exercising its authority under Section 210(c)(16).

The FDIC is specifically requesting comments with respect to the clarity and mechanics of the Proposal, consistency with related regulations and the adequacy of notice to counterparties. Comments on the Proposal are due no later than May 29, 2012.

The FDIC issued a notice of proposed rulemaking (the “NPR”) that would, if adopted, amend the FDIC assessment regulations for large and highly complex financial institutions, generally those with more than $10 billion in total assets (“Large FIs”). The NPR would amend FDIC regulations, adopted in 2011 to make deposit insurance premiums more sensitive to risks taken by a Large FI, and that are to be codified at 12 CFR 327.9. The FDIC said that the changes in the NPR would address certain banking industry concerns by:

Comments on the NPR are due no later than May 29, 2012.