Financial Services Alert - April 17, 2012

A Massachusetts security corporation is an entity that receives beneficial Massachusetts tax treatment but is required to restrict its activities in two ways: (1) it may engage exclusively in buying, selling, dealing in, or holding securities on its own behalf and not as a broker; and (2) the securities must be acquired and held for investment purposes.  On September 30, 2011, the Massachusetts Department of Revenue (the “DOR”) issued a working draft of a Directive on the Scope of Certain Permissible Activities and Use of a Security Corporation (the “Original Draft Directive”) that restricted the ability of a security corporation shareholder to pledge its stock in the security corporation as collateral for a loan to the shareholder.  Security corporation classification would be denied or revoked if: (1) the stock pledged represented more than fifty percent of the value or total combined voting power of the corporation; or (2) there were negative covenants or restrictions in connection with the pledge that related to the scope of permitted assets, liabilities, or activities of the corporation. Under certain circumstances, those restrictions were to go into effect the day after the Original Draft Directive was issued.

On April 6, 2012, the DOR issued a revised working draft Directive (the “Revised Draft Directive”) that removed the above restrictions imposed by the Original Draft Directive.  The Revised Draft Directive does observe, however, that certain activities would result in denial or revocation of security corporation classification.  Many of these prohibited activities were understood by practitioners to exceed activities permitted to a security corporation.  The Revised Draft Directive includes a nonexclusive list of prohibited activities; for example, a security corporation may not act as guarantor of a loan to a shareholder, and  a security corporation’s assets (as opposed to its stock) may not be pledged as security for a loan to a shareholder.  It also includes a nonexclusive list of restrictive covenants that are impermissible as part of the pledge of a security corporation stock to a lender; namely, a covenant that allows the pledgee to become a direct creditor of a security corporation or that requires the pledgor to withdraw securities from the security corporation through a distribution and pledge those securities to the lender, or a covenant that directs the security corporation’s investments to securities of the shareholder or the pledgee. 

Both the Original and Revised Draft Directives address in similar ways the circumstances in which a security corporation could acquire appreciated securities from an affiliate and subsequently sell those securities to a third party without resulting in revocation of security corporation classification.  For example, a security corporation may not be used as a conduit for the sale of appreciated securities for the purpose of sheltering the gain on the sale from the general corporate excise tax rate.

While focused primarily on making it easier for smaller companies to raise capital in the United States, the loosening of regulatory restrictions applicable to private offerings  under the Jumpstart Our Business Startups Act (H.R. 3606) (the “JOBS Act”) includes the following changes relevant to private funds:

• The JOBS Act increases the thresholds at which companies are required to register under the Securities Exchange Act of 1934 (i) from $1 million to $10 million in total assets and (ii) from 500 to 2,000 holders of record of a class of securities, provided no more than 500 holders of record are unaccredited (disregarding in each case individuals holding securities pursuant to an employee compensation plan).


• The JOBS Act requires the SEC to revise Rule 506 of Regulation D under the Securities Act of 1933, which provides a safe harbor for private offerings, by July 4, 2012 to eliminate the ban on general solicitation and general advertising in certain private placements that are sold only to accredited investors or qualified institutions. 

The Act’s ultimate impact on the extent to which private funds and other issuers of securities may conduct general solicitations remains uncertain at this time.  The SEC must issue the rules required by the Act.  In addition, other limits on general solicitations (arising under state, federal or non-U.S. laws and regulations) may serve  to limit an issuer’s use of general solicitation even in the absence of the prohibitions the JOBS Act eliminates.

The U.S. Court of Appeals for the Fourth Circuit (the “Appeals Court”) vacated and remanded a lower court’s decision, holding that the repossession provisions in Maryland’s Credit Grantor Law are not subject to federal preemption.  In the case, the plaintiff entered into a retail sales installment contract for the purchase of a used vehicle.  The defendants, a national bank and its affiliate, repossessed the vehicle after the plaintiff failed to make payments.  The defendants sent the plaintiff a notice stating that the vehicle would be sold at a private sale and that she had a right to redeem the vehicle.  However, in violation of requirements of Maryland’s Credit Grantor Law, the notice did not disclose the location of the vehicle or the time and place where it was to be sold.

The plaintiff filed a putative class action against the defendant alleging violations of the Credit Grantor Law.  The defendants then moved to dismiss the class action for failure to state a claim, alleging the relevant provisions of the Credit Grantor Law were preempted by the National Bank Act and its implementing OCC regulations.  The lower court ruled in favor of the defendants and dismissed the class action, and the plaintiff appealed.

In its opinion, the Appeals Court reversed the lower court’s dismissal based on federal preemption for a number of reasons.  First, the OCC regulations do not expressly preempt state repossession laws.  Second, citing Aguayo v. U.S. Bank, 653 F.3d 912 (9th Cir. 2011), the Appeals Court concluded that the National Bank Act and OCC regulations do not “occupy the field” of lending regulation because the OCC has “explicitly avoided full field preemption in its rulemaking” and had not “been granted full field preemption by Congress.”  Third, preemption was not appropriate because repossession rights are granted to national banks under state law, not federal law.

The Appeals Court rejected the defendants’ argument that the power granted by the National Bank Act to make loans included the power to collect on the loans and, therefore, “preemption is implied.”  The Appeals Court noted that in the OCC regulations, debt collection and extension of credit are related, but treated differently. In reaching its decision, the Appeals Court also pointed to the U.S. Supreme Court’s recognition that national banks are subject to state debt collection laws and cited National Bank v. Commonwealth, 76 U.S. 353 (1869).

The European Commission (the “EC”) issued a report (the “EC Report”) stating that the EC will propose legislation before year-end 2012 that would revise European Anti-Money Laundering (“AML”) rules by implementing, updating and enhancing changes that have been adopted by the Financial Action Task Force.  The proposed changes addressed in the EC Report would concern, among other things, increased use in AML compliance of a risk-based approach, enhanced international cooperation, strengthened enforcement powers and greater transparency.

Separately, the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority (the “EU Agencies”) issued a report (the “EU Agencies Report”) in which they concluded that the EU AML requirements concerning determination of the identity of account holders need to be made uniform in all of the EU’s 27 member states.  The EU Agencies stated in the EU Agencies Report that the lack of harmonization of EU countries’ AML customer identification rules “has weakened the overall effort to restrict money laundering and halt terrorist financing.”

For a discussion of recent proposed changes to AML customer due diligence requirements in the U.S., see “FinCEN Seeks Comment on Proposal to Require Banks, Brokers, Dealers, Mutual Funds and Certain Other Financial Institutions to Establish Customer Due Diligence Programs,” in the March 6, 2012 Financial Services Alert.