Financial Services Alert - April 3, 2012

The FDIC, FRB and OCC (collectively, the “Agencies”) jointly released proposed revisions to the Agencies’ leveraged finance guidance issued in 2001.  As revised, the proposed guidance (the “Proposed Guidance”) would address issues raised (e.g., limited lender protections, the absence of meaningful maintenance covenants) in connection with the recent “tremendous growth” observed by the Agencies in the volume of leveraged credit and in the participation of non-regulated investors.  The Agencies stated that the Proposed Guidance “outlines high-level principles related to safe and sound leverage lending activities” and applies to transactions “characterized by a borrower with a degree of financial or cash flow leverage that significantly exceeds industry norms as measured by various debt, cash flow or other ratios.”  The Agencies noted that very few community banking organizations have a substantial exposure to leveraged lending.

The Proposed Guidance, stated the Agencies, would refocus lenders’ attention on:

Comments on the Proposed Guidance are due by June 8, 2012.

The U.S. Court of Appeals for the Eighth Circuit upheld a grant of summary judgment dismissing plaintiff mutual fund shareholder claims in an action under Section 36(b) of the Investment Company Act of 1940 (the “1940 Act”) alleging that the advisory fees received by the funds’ adviser were excessive.  Gallus v. Ameriprise Financial, No. 11-1091 (8th Cir. March 30, 2012) (“Gallus II”).

Background and Procedural History. In the initial decision in this litigation, the District Court for the District of Minnesota granted the defendants’ motion for summary judgment and dismissed the plaintiffs’ claims under Section 36(b).  Gallus v. Ameriprise Financial, 497 F. Supp. 2d (D. Minn. 2007).  The district court based its decision on an analysis of the factors cited in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982), and held that the plaintiffs had failed to establish a genuine issue of material fact regarding whether the fees charged were so disproportionately large that they bore no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.  On appeal (“Gallus I”), the Eighth Circuit reversed, holding that the proper analysis under Section 36(b) should consider “both the adviser’s conduct during the negotiation and the end [fee] result” and that a failure in the process of negotiating a fund’s fees (as alleged by the plaintiffs) could constitute a Section 36(b) violation regardless of the actual fee levels.

The United States Supreme Court accepted Gallus I for review after agreeing to review another Section 36(b) case, Jones v. Harris Associates, 537 F.3d 728 (7^th Cir. 2008).  In conjunction with issuing its decision in Jones v. Harris Associates, 130 S. Ct. 1418 (2010) (“Harris Associates”), which was discussed in the April 6, 2010 Financial Services Alert, the Supreme Court vacated Gallus I and remanded the case to the Eighth Circuit for further proceedings in accordance with the Supreme Court’s decision in Harris Associates.  The Eighth Circuit, in turn, remanded Gallus I to the district court which reinstated its order granting summary judgment to the defendants.  The district court found that such a holding was “appropriate,” given the Supreme Court’s decision in Harris Associates which “adopted the Gartenberg framework and reasoning” that the district court had used in granting summary judgment, and dismissed the action with prejudice.  The plaintiffs appealed the district court’s decision on remand.  (For a more detailed discussion of the prior decisions in this case, see the April 14, 2009 Financial Services Alert, the April 6, 2010 Financial Services Alert and the December 21, 2010 Financial Services Alert.) 

The Eighth Circuit’s Application of Harris Associates.  The Eighth Circuit determined that the plaintiffs failed to meet their burden of raising a genuine issue of material fact that the fee charged was “so disproportionately large that it bore no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.”  As to the plaintiff’s assertion that lower fees charged the adviser’s other institutional clients was evidence of excessive fund advisory fees, the Eighth Circuit allowed that while such a disparity is likely relevant to whether fund fees “fall within the arm’s length range,” the plaintiffs had failed to set forth the additional evidence required to survive a motion for summary judgment.  Turning to the plaintiff’s arguments based on fund board deliberations and the information about its institutional client fee arrangements provided by the adviser, the Eighth Circuit observed that under Harris Associates “a process-based failure alone does not constitute an independent violation of §36(b).”  On this basis, the Eighth Circuit held that the plaintiffs’ allegations that the fund board was not informed of all relevant information could not itself make out a Section 36(b) claim.  The Eighth Circuit held that “a deficient process” could not provide the plaintiffs with the additional evidence they needed to survive a summary judgment motion given Harris Associates’ focus on whether the fee levels themselves are “outside the arm’s length range.”

The Eighth Circuit noted, however, that “[t]he fee negotiation process remains critically important, as it allows the court to determine the amount of deference to give the board’s decision to approve the fee.”  The Eighth Circuit determined that while the fund board considered the relevant factors and its process could “fairly be described as robust,” the board’s judgment was entitled to less deference “than would have been the case had [the adviser] been candid about the fees it charged its clients” and had the board not focused so heavily on a comparison between the fees charged by the funds’ adviser and those charged by other advisers, such a comparison having been identified as problematic in Harris Associates because other advisers’ fees might not themselves have been the result of arm’s‑length negotiation.  The Eighth Circuit concluded that in its initial review, the district court had subjected the fee arrangements to sufficient scrutiny under the standard set forth in Harris Associates.  Having found that the plaintiffs had failed to meet their evidentiary burden for surviving a summary judgment motion, the Eighth Circuit affirmed the district court’s dismissal of the complaint with prejudice. 

The OCC issued an interpretive letter (“Letter #1136”) concluding that when a federal savings association (“FSA”) is required to abide by the terms of a capital maintenance agreement (“CMA”), the FSA is subject to the restriction on charter conversion imposed by Section 612(c) of the Dodd-Frank Act (“Section 612(c)”).  Section 612(c) states that an FSA may not convert to a state bank or state savings association during any period when the FSA is subject to “a cease and desist order (or other formal enforcement order) issued by, or a memorandum of understanding entered into with, [the OTS or OCC] with respect to a significant supervisory matter.”

The OCC said in Letter #1136 that although Section 612(c) does not explicitly reference a CMA or written enforcement agreement, both logic and legislative history make it clear that a CMA, which as a matter of law is a written enforcement agreement entered into within the meaning and for the purposes of Section 8 of the Federal Deposit Insurance Act, is a type of enforcement agreement covered by Section 612(c).  The OCC noted in Letter #1136 that it would make no sense to allow an FSA to convert to a state charter if it were subject to a formal written enforcement agreement such as a CMA, while at the same prohibiting the conversion (as Section 612(c) does) if the FSA is subject to an informal memorandum of understanding.

On March 30, 2012, 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 address certain Form ADV disclosure obligations regarding an adviser’s “advisory affiliates” that may apply with respect to an operating company (particularly an operating company in the financial industry) because the adviser has a private fund client (e.g., a private equity fund or venture capital fund) that has taken a significant ownership interest in the company, and/or persons associated with the adviser participate in the company’s management in connection with the investment.  Under these circumstances, the adviser could be regarded as having indirect “control” of the operating company, thereby making the company an “advisory affiliate” as to which the adviser must report in response to various items in Form ADV.  The Staff stated that it would not recommend enforcement action under these circumstances if an adviser does not treat such an operating company (and/or the persons it controls) as an advisory affiliate (i) for purposes of Item 7 of Part 1A (identification of financial industry affiliations) and Item 10 of Part 2A (material business relationships with financial industry affiliates), unless the adviser has a business relationship with the operating company unrelated to the investment by the adviser’s private fund client, which relationship otherwise creates a conflict of interest between the adviser and the fund, or (ii) for purposes of Item 11 of Part 1A (disciplinary information).

On March 30, 2012, the staff of the SEC’s Division of Investment Management (the “Staff”) supplemented its Investment Management Staff Issues of Interest posting on the SEC website to include no-action relief for a newly registering adviser from provisions of the Investment Advisers Act of 1940 (the “Advisers Act”) that require an adviser’s contracts to provide that (i) the contract may not be assigned without the client’s consent and (ii) if a partnership, the adviser will notify its clients of any change in membership within a reasonable time after such change (both provisions together, “Sections 205(a)(2) and (3)”).  Consistent with past relief designed to minimize the disruption to contracts that were permissible when they were entered into by newly registering advisers, the Staff stated that it would not recommend enforcement action against an adviser that has applied for registration, but was not registered or required to be registered when it entered into its advisory contracts, if the adviser does not amend an advisory contract to include the provisions required under Sections 205(a)(2) and (3), provided that: (i) the advisory contract was entered into or last amended prior to the submission of the adviser’s application for registration; (ii) any future amendment of the advisory contract will include the provisions required under Sections 205(a)(2) and (3); (iii) the adviser undertakes to operate and perform under the advisory contract as if it contained the provisions required under Sections 205(a)(2) and (3); and (iv) the adviser discloses such undertaking to the client and, in the case of a private fund client, each investor (or independent representative of the investors) in such client.

Goodwin Procter’s ERISA Litigation Practice published its latest quarterly ERISA Litigation Update.  The Update discusses (1) a federal district court decision addressing the fiduciary status of an advisor to a plan assets fund, (2) the settlement of class action claims asserted by plans and other entities against a bank in connection with its investment of securities lending collateral and (3) a Sixth Circuit decision addressing (a) the application of the Moench presumption at the pleading and (b) the application of ERISA’s safe harbor defense for losses caused by a participant’s exercise of control to the selection of investments a plan offers.

The FRB, the FDIC and the OCC issued guidance clarifying that the effective date of Section 716 (“Section 716”) of the Wall Street Transparency and Accountability Act (such Act comprising Title VII of the Dodd-Frank Act) is July 16, 2013.  Section 716, commonly referred to as the “Swaps Pushout Provision,” prohibits Federal assistance to any swaps entity, as defined in Section 716, with respect to any swap, security-based swap, or other activity of the swaps entity.  “Federal assistance” is defined in Section 716 as, for certain purposes specified in Section 716(b)(1), the use of (1) any advances from any Federal Reserve credit facility or discount window that is not part of a program with broad‑based eligibility under section 13(3)(A) of the Federal Reserve Act, and (2) FDIC insurance or guarantees.

The SEC announced that it has entered into a memorandum of understanding with the Cayman Islands Monetary Authority (CIMA) and a memorandum of understanding with the European Securities and Markets Authority (ESMA).  The two memoranda of understanding, which provide for consultation, cooperation and the exchange of information related to the supervision and oversight of cross-border regulated entities, follow on similar arrangements that the SEC has concluded with Canadian provincial securities regulators.