0SEC Commences Administrative Proceedings Over Adviser’s Alleged Recordkeeping and Form ADV Shortcomings and Failure to Respond to Information Requests from Board of Registered Fund Client

The SEC issued an order (the “Order”) commencing administrative and cease-and-desist proceedings against a registered investment adviser (the “Adviser”), and the Adviser’s president and sole managing member (the “President”).  The Order relates to allegations that during the period between April 2008 and June 2010 (the “Relevant Period”), the Adviser failed to maintain certain records required of it as an SEC-registered investment adviser, failed to provide the board of directors (the “Board”) of an open-end registered investment company (the “Fund”) managed by the Adviser with information requested by the Board and failed to withdraw its registration after the Fund terminated its advisory agreement with the Adviser.  This article summarizes the SEC’s allegations in the Order.  The Adviser and the President (collectively, the “SEC Respondents”) have not yet filed an answer to the Order nor has there yet been any finding with respect to the SEC’s allegations. 

Background.  During the Relevant Period, the Adviser served as the investment adviser to the Fund, under the terms of an advisory agreement (the “Advisory Agreement”).  The President also served as the acting chief compliance officer of the Fund from October 2009 until October 2010.  The Advisory Agreement provided for an annual advisory fee of 0.65% of the Fund’s average daily net assets.  The Adviser contractually agreed to limit the Fund’s total operating expenses at 1.5% of the Fund’s daily net assets for a two-year period ending April 15, 2010.  Fund expenses for that timeframe exceeded the 1.5% cap.  As a consequence, the Adviser received no advisory fees from the Fund during the Relevant Period.

The Adviser and the Fund’s Board.  In late 2008, the Board became concerned about the Adviser’s ability to meet its expense reimbursement obligations following the Adviser’s failure to make required reimbursement payments to the Fund, which caused the Fund to delay the filing of its annual report for fiscal year 2008.  Despite repeated requests from the Board, these payments remained outstanding, and the Fund’s auditor refused to release its audit opinion, which delayed the filing of the Fund’s 2009 annual report.  Ultimately, the Board liquidated the President’s personal interest in the Fund to satisfy these receivables.  In March 2010 and June 2010, prior to the completion of the Advisory Agreement’s initial two-year term, the Board requested information from the Adviser and the President in connection with the Board’s consideration of whether to renew the Advisory Agreement.  The Adviser and President failed to produce the requested documents.  In June 2010, the Board terminated the Advisory Agreement and voted to liquidate the Fund.

SEC Examination.  In April 2010, the SEC staff initiated an examination of the Adviser and the Fund.  In connection with the examination, SEC examiners sent multiple document requests to the Adviser, including requests for financial records related to the Adviser’s business that were required to be kept by the Adviser under the Investment Advisers Act of 1940.  Despite assurances that responsive documents would be forthcoming, the Adviser did not produce the requested financial records, which did not exist.  SEC examiners also provided a document request list to the President in his capacity as the Fund’s chief compliance officer for documents relating to the maintenance of the index underlying the Fund’s investment strategy.  At the conclusion of the SEC examination staff’s field work, the majority of the documents requested from the Fund, the Adviser and the President remained outstanding.  The Fund and its portfolio manager ultimately produced documents in response to a subpoena from the SEC’s Division of Enforcement.  The Adviser and the President failed to respond to the same subpoena, and the President failed to appear for investigative testimony pursuant to a subpoena.

Failure to File Form ADV Amendments and Withdraw Registration.  The Adviser registered with the SEC as an investment adviser in October 2007, but failed to file annual updates to its registration statement on Form ADV in 2009, 2010 and 2011.  The Adviser failed to file a Form ADV-W withdrawing its registration when the Board’s termination of the Advisory Agreement in June 2010 eliminated the sole basis for the Adviser’s registration with the SEC, i.e., the fact that the Adviser had a registered investment company client.

Violations.  As a result of the conduct described above, the Order alleges violations of the following provisions of the federal securities laws:

  • Section 15(c) of the Investment Company Act of 1940 which imposes a duty on an investment adviser to a registered investment company to furnish such information as may reasonably be necessary for the fund’s directors to evaluate the terms of the fund’s advisory contract with the investment adviser;

  • Section 204 of the Investment Advisers Act of 1940 (the “Advisers Act”) and Rules 204-1(a)(1) and 204-2(a)(1), (2), (4), (5), and (6) thereunder which require an investment adviser to file annual amended Forms ADV, and make, keep and produce certain books and records; and

  • Section 203A of the Advisers Act and Rule 203A-1(b)(2) thereunder which prohibits investment advisers with assets under management of less than $25 million from registering with the SEC, unless the adviser is an investment adviser to a registered investment company, or comes within one of the specified exemptions.

0Standard Chartered Bank Settles Enforcement Action Brought by NY Department of Financial Services for $340 million; Regulatory Order Alleged Bank’s New York Branch Hid from Regulators $250 billion in Iranian Transactions

On August 6, 2012, the Superintendent of the New York Department of Financial Services (the “Department”) issued an order (the “Order”) against Standard Chartered Bank’s New York Branch (“SCB”) in which the Department alleged that SCB, for nearly ten years, violated applicable New York and U.S. laws and regulations and “schemed with the Government of Iran and hid from regulators roughly 60,000 secret transactions [the “SCB Transactions”] involving at least $250 billion, and reaping SCB hundreds of millions of dollars in fees.”  On August 14, 2012, the Department announced that it had settled the matter with SCB for $340 million (the “Settlement”).

The Department alleged in the Order that the SCB Transactions involved Iranian government-owned banks including the Central Bank of Iran/Markazi, Bank Saderat and Bank Melli, Iranian companies and other Iranian entities and that SCB officers “willingly” engaged in the SCB Transactions.  The Department charged in the Order that SCB’s actions left the U.S. financial system vulnerable to terrorists and corrupt regimes.  SCB is reported to be the fifth largest bank in the United Kingdom.  The legal basis asserted by the Department for the Order was that the SCB Transactions violated New York laws because SCB failed to maintain accurate books and records, failed to report crimes and misconduct, falsified reports and falsified business records.  The Order also suggested that SCB violated federal OFAC orders and directives involving Iran.  In particular, the Order stated that SCB engaged in wire stripping, routing SCB transactions through SCB’s New York branch after first stripping from wire transfer messages information used to identify Iran or sanctioned individuals or entities.  SCB had countered by stating that it used “U-turning” for many of the SCB Transactions, which SCB had argued was deemed permissible by the Department of the Treasury and OFAC until 2008.  U-turning is a practice in which an Iranian bank could buy and sell dollars as long as a non-U.S. bank acted as intermediary on both sides of the transaction.  The Department of the Treasury and OFAC have indicated that use of U-turning until 2008 was only permissible if the bank in question used strong due diligence procedures before completing a transaction for one of its clients.  Significantly, the Order alleged that SCB “conspired with Iranian clients to transmit information to [SCB’s] New York Branch by removing or otherwise misrepresenting wire transfer data that could identify Iranian parties.”

The Order had directed SCB to appear at a hearing to be held at the Department on August 15, 2012 at which SCB would have been requested to demonstrate why SCB’s New York banking license should not be revoked and why SCB’s dollar-clearing operations should not be suspended.  As a result of the Settlement, the hearing was cancelled.  The Settlement requires SCB to employ a monitor for at least two years to ensure that SCB’s New York operations comply with Bank Secrecy Act requirements.  It has also been reported that, as part of the Settlement, SCB “agreed to put in permanent officials who will audit [SCB’s] internal procedures to prevent offshore money laundering.”

The Settlement is with the Department only and does not bind federal regulators.  It has previously been reported in the financial press that OFAC, the FBI, the Department of Justice, the FRB and other federal agencies are conducting investigations of, or are considering whether they will bring actions against, SCB related to these and other matters.  As pointed out by the financial press, the fact that the Department acted alone by issuing the Order is unusual, since federal and state bank regulatory agencies generally act in concert in bringing enforcement actions against banking institutions.

0FRB, FDIC and OCC Extend Comment Period on Regulatory Capital Proposals

The FRB, FDIC and OCC (the “Agencies”) announced that they were extending the comment period to October 22, 2012 on the three notices of proposed rulemaking (the “NPRs”), issued in June, 2012, that would revise and replace the Agencies’ existing capital rules.  The NPRs would, generally, increase capital requirements and implement the capital standards for U.S. banks under the Basel III banking accords.  The NPRs were discussed in the June 12, 2012 issue of the Financial Services Alert.  The Agencies stated that the comment period on the NPRs was extended “to allow interested persons [including small banks] more time to understand, evaluate and prepare comments on” the NPRs.

0FRB Issues Final Rule Concerning Financial Market Utilities Risk Management Standards (Regulation HH)

The FRB issued Regulation HH, Designated Financial Market Utilities as a final rule (the “Final Rule”), which implements provisions of Sections 805(a) and 806(e) of the Dodd-Frank Act  by establishing (i) risk-management standards for certain financial market utilities (“FMUs”) designated as systemically important by the Financial Stability and Oversight Council (the “Council”) and (ii) standards for determining when a designated FMU is required to provide advance notice of proposed changes to its rules, procedures, or operations that could materially affect the nature or level of risks presented by the designated FMU.  The basic risks that FMUs must manage include credit risk, liquidity risk, settlement risk, operational risk, and legal risk.


Title VIII of the Dodd-Frank Act, the Payment, Clearing, and Settlement Supervision Act of 2010, was enacted to mitigate systemic risk in the financial system and to promote financial stability, in part, through enhanced supervision of designated FMUs.  The Dodd-Frank Act defines an FMU as a person that manages or operates a multilateral system for the purpose of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions and the person.

Pursuant to Section 805(a)(1) of the Dodd-Frank Act, the FRB is required to establish risk management standards governing the operations related to the payment, clearing, and settlement (“PCS”) activities of certain FMUs that are designated as systemically important by the Council.

Section 806(e)(1) of the Dodd-Frank Act requires a designated FMU to provide 60 days’ advance notice to its Supervisory Agency, as defined in the Dodd-Frank Act, of any proposed change to its rules, procedures, or operations that could, as defined in rules of each Supervisory Agency, materially affect the nature or level of risks presented by the designated FMU.

The FRB first published for comment a notice of proposed rulemaking in April 2011, proposing a new part to the Code of Federal Regulations (12 CFR Part 234, Regulation HH) to establish risk-management standards for designated FMUs and requirements for advance notice of material changes to a designated FMU’s rules, procedures, or operations.

Final Rules

Risk-Management Standards

International Standards.  The risk-management standards are based on the international risk-management standards developed by the Committee on Payment and Settlement Systems (“CPSS”) and the Technical Committee of the International Organization of Securities Commissions (“IOSCO”).  CPSS and IOSCO issued a final report on the Principles for Financial Market Infrastructures, which update the international standards that were in existence at the time the notice of proposed rulemaking was issued, the Core Principles for Systemically Important Payment Systems (the “Core Principles) and Recommendations for Securities Settlement Systems and the Recommendations for Central Counterparties (collectively, the “CPSS-IOSCO Recommendations”).  The FRB will continue to use the Core Principles and CPSS-IOSCO Recommendations as the basis for the standards, but will consider the new Principles for Financial Market Infrastructures for any future revisions.

Applicability of Standards to Retail Payments.  In response to comments regarding the inapplicability of certain standards contained in the proposed rules to retail payment systems (e.g., automated clearing houses and check clearinghouses) which could potentially be designated as systemically important FMUs, the FRB modified proposed §§ 234.3(b) and 234.4(b) that clarify that the application of individual risk-management standards could be waived in a situation where such standards could not appropriately be applied to a particular designated FMU.   In addition, the FRB (i) noted that with respect to a designated FMU that operates more than one payment system (e.g., one large-value and one retail), standards would apply only with respect to the system that provided the basis for the Council’s designation of the FMU; (ii) modified §§ 234.3(a) and 234.4(a) to require a designated FMU to “implement rules, procedures, or operations designed to ensure that it meets or exceeds” the risk- management standards set forth in these sections; and (iii) deleted the word “should” from the individual standards to clarify that these are requirements with which a designated FMU must comply.

Scope of Risk Management Standards.

Efficiency – The FRB decided to adopt the efficiency standard in proposed § 234.4(a)(8), determining that it furthers the objectives of Title VIII of the Dodd-Frank Act, although commenters argued that it exceeds these objectives because it addresses operating system issues and not risk matters.

Access Criteria –  The FRB decided to adopt the access criteria standard in proposed § 234.4(a)(9), determining that it encourages the reduction of risk concentration, although commenters argued that it did not relate to any of the risks contemplated by Title VIII of the Dodd-Frank Act.

Governance – The FRB decided to adopt the governance standard in proposed § 234.4(a)(10), determining that effective, accountable, and transparent governance arrangements are critical to effective risk management, although commenters argued that while the decisions made by a designated FMU’s governing body can affect the risks it presents, the particular governance structure itself did not present such risks.

Independent Model Validation.  The FRB adopted the annual model validation standard in proposed § 234.4(a)(17), which requires a qualified person to evaluate the designated FMU’s margin model, if such FMU operates as a central counterparty (a “CCP”).  As adopted, § 234.4(a)(17) requires that the qualified person be someone who does not perform functions associated with the CCP’s margin model, although commenters suggested that such qualified person should also have to be independent of the CCP.

Financial Resource Coverage.  Proposed § 234.4(a)(15) would require a designated FMU that is acting as a central securities depository (a “CSD”) to institute risk controls that include collateral requirements and limits, and ensure timely settlement in the event that the participant with the largest payment obligation is unable to settle when the CSD extends intraday credit.  Proposed § 234.4(a)(18) would require a designated FMU that is acting as a CCP to maintain sufficient financial resources to withstand, at a minimum, a default by the participant to which it has the largest exposure in extreme but plausible market conditions.  In response to commenters’ concern regarding appropriately addressing the interconnectedness of a designated FMU’s participants and the suggestion of applying an additional measurement using a percentage of aggregate exposure (33 percent being suggested by commenters), the FRB plans to consider the approach in the context of revisions to Regulation HH in light of the Principles for Financial Market Infrastructures.

Legal Certainty of Netting Arrangements.  The FRB decided the legal framework standard as proposed sufficiently provided for legal certainty, although a commenter had suggested that more legal certainty was needed to ensure that netting of payments between participants would be honored in a bankruptcy or other insolvency proceeding.

Advance Notice of Material Changes

Proposed §§ 234.5(c)(1) – (3) proscribe the definition of “material” for purposes of Section 806(a) of the Dodd-Frank Act, providing non-exclusive lists of changes that would be deemed material, in addition to defining the term “materially affect the nature or level of risks presented” to mean matters as to which there is a “reasonable possibility that the change could materially affect the performance of clearing, settlement, or payment functions or the overall nature or level of risk presented by the designated financial market utility.”  Commenters suggested (i) narrowing the scope of the definition, (ii) shortening the list of inclusions, or (iii) expanding the list of inclusions.

The FRB (i) adopted the “reasonable possibility” language as proposed; (ii) revised the proposed regulatory text to state that the term “materially affect the nature or level of risks presented” means matters as to which there is a reasonable possibility that the change could “materially affect the overall nature or level of risk presented by the designated financial market utility, including risk arising in the performance of payment, clearing, or settlement functions”; (iii) revised the proposed regulatory text to provide that the changes that “materially affect” the areas identified in § 234.5(c)(2) would be considered changes that materially affect the nature or level of risks presented by the designated FMU; and (iv) eliminated the examples in proposed §§ 234.5(c)(3)(i) and (ii).

The FRB adopted the remainder of the proposed sections relating to advanced notice of material changes as originally proposed.

The Final Rule becomes effective September 14, 2012.

0SEC Issues Report on Municipal Securities Market

After a two-year examination of the structure and integrity of the municipal securities market, the SEC issued a report on the municipal securities market (the “Report”) mandated by the Dodd–Frank Act.  In broad terms, the Report cites two primary concerns regarding the municipal securities market: (1) concerns relating to disclosure requirements and (2) concerns relating to the municipal securities market structure; and provides a number of specific recommendations, particularly with respect to improving disclosure and price transparency for investors.

Disclosure Concerns

The Report identifies several areas of concern regarding existing disclosure practices in the municipal securities market. The main areas of concern relate to the types of disclosures in offering documents made by municipal entities at the time of issuance, continuing disclosure practices and compliance, the timing and content of financial statements, the nature and level of disclosures regarding derivatives, pension obligations, conflicts of interest and certain material relationships, and the adoption and implementation of quality internal controls and procedures by an issuer that would ensure proper disclosure and financial reporting.

The Report recommends a combination of approaches to improve disclosure in the municipal securities market, including legislative and regulatory recommendations.

Legislative Recommendations to Address Disclosure Concerns

The Report provides several recommendations to improve disclosure practices in the municipal securities market. Among other things, the Report recommends legislation that would provide the SEC with the authority to establish disclosure requirements and principles, including timeframes, frequency of dissemination of municipal securities offerings, and continuing disclosures and minimum disclosure requirements, including financial statements and other financial and operating information.

The Report notes that such authority would allow the SEC to be able to address the lack of disclosure by municipal entities.  The SEC cites concerns that certain municipal entities are not disclosing the impact of their pension funding obligations, their other post-employment benefit obligations, the underlying assumptions used to calculate those post-employment benefit obligations, the exposure of such municipal entities to derivatives and conflicts of interests, and certain other relationships or practices.  If granted sufficient authority, the SEC would be able to consider and implement disclosure policies and procedures to ensure appropriate disclosure and financial reporting by municipal issuers.

The Report also recommends eliminating the availability of exemptions from registration with the SEC to conduit borrowers who are not municipal entities under Section 3(a)(2) of the Securities Act of 1933 (the “Securities Act”) as a means of improving municipal security participant disclosure.  The Report notes that it does not seek the elimination of other exemptions available to conduit borrowers, such as nonprofits, which benefit from an exemption from registration under Section 3(a)(4) of the Securities Act.  The Report emphasizes, however, that a conduit borrower should not be exempt from registration simply because the conduit issuer through whom it has access to the capital markets is entitled to such an exemption as a municipal entity.

Regulatory Recommendations to Address Disclosure Concerns

The Report notes that the SEC found that compliance with continuing disclosure obligations under Rule 15c2-12 of the Securities Exchange Act of 1934 has been inconsistent.  Rule 15c2-12 was created to establish standards for the procurement and dissemination of disclosure documents by underwriters as a means of enhancing the accuracy and timeliness of disclosure to municipal securities investors.  While Rule 15c2-12 has been amended over the years as the municipal securities market has evolved, the Report concludes that a “one-size-fits-all” approach to disclosure is unnecessary and undesirable.  The Report suggests that disclosure rules should instead focus on the need for greater and more timely disclosure in several key areas, such as disclosures relating to financial information, the use of standard accounting principles, and the avoidance of “stale” or misleading information.

The Report also recommends amendments to Rule 15c2-12 to achieve the recommended results should the legislative approach not be feasible. Such amendments would include amending the definition of “final official statement,” which the Report notes does not currently establish the form and content of financial information and operating data required to be disclosed in an official statement for a primary offering of municipal securities.

The report notes that the SEC should also consider issuing updated interpretive guidance regarding the disclosure obligations of municipal securities issuers.  The Report cites the comprehensive interpretative guidance of the disclosure obligations from the 1994 amendments to Rule 15c2-12 which addressed the disclosure of conflicts of interest, the disclosure of the terms and risks of securities, and the disclosure of the importance of the timeliness of financial statements.

Market Structure Concerns

In the Report, the SEC also identifies several concerns regarding the structure of the municipal securities market. In contrast to its recommendations with respect to the disclosure concerns and recommendations highlighted above, the SEC’s recommendations regarding market structure do not include additional statutory authorization for the SEC.  Instead, the Report recommends that the SEC and the Municipal Securities Rulemaking Board (the “MSRB”) use existing authorization to adopt new rules to enhance price transparency and disclosures to, and execution of transactions for, investors.

The primary concerns cited in the Report include the limited access that investors currently have to pre-trade price information, the disparity in access to pricing information that institutional investors have in comparison to retail investors, the lack of an explicit rule regarding best execution that applies to market participants in the municipal securities market, and the lack of liquidity and price transparency in the municipal securities market that makes it more expensive for investors to trade municipal securities than to trade corporate bonds or equity securities.

Regulatory Recommendations to Address Market Structure Concerns

In order to address these concerns regarding the market structure of the municipal securities market, the Report recommends that the SEC and the MSRB adopt new rules pursuant to existing legislative authority to increase pre-trade and post-trade price transparency and improve execution of transactions for investors.

To improve pre-trade price transparency and provide access to firm bid and ask quotations, the Report observes that the SEC could consider amendments to Regulation ATS to require an alternative trading system (ATS) with material transaction or dollar volume in municipal securities to publicly disseminate its best bid and offer prices and, on a delayed and non-attributable basis, responses to “bids wanted” auctions.  In addition and in conjunction with such amendments, the Report suggests that the MSRB should consider rules requiring a broker’s broker with material transaction or dollar volume in municipal securities to publicly disseminate the best bid and offer prices on any electronic network it operates and, on a delayed and non-attributable basis, responses to “bids wanted” auctions.

The Report also provides recommendations to improve post-trade price transparency.  The Report notes that institutional investors tend to have access to a variety of sources of municipal securities pricing information, while retail investors have access to relatively little pricing information about municipal securities.  To combat this discrepancy, the Report recommends that the MSRB consider requiring municipal bond dealers to report “yield spread” information to its Real-Time Transaction Reporting System (RTRS) to supplement existing interest rate, price, and yield data.  The Report also recommends that the MSRB promptly pursue enhancements, such as enhanced search functionality, to its Electronic Municipal Market Access system website (“EMMA”) so that retail investors have better access to pricing and other municipal securities information.  The Report also provides additional suggestions involving education and increased disclosures by dealers to retail investors of pricing information in order to improve pricing and increase transparency.

The SEC also recommends that the MSRB consider issuing more detailed interpretive guidance to assist dealers in establishing the “prevailing market price” for a municipal security, for purposes of determining whether the price offered a customer is fair and reasonable.  The Report recommends that the MSRB consider adopting a rule that would require municipal bond dealers to seek “best execution” of customer orders for municipal securities, as no such rule is currently in place.

0CFTC/SEC Product Definition Rules Published in Federal Register to be Effective on October 12, 2012

The joint CFTC/SEC rules further defining the terms “swap,” “security-based swap,” and “security-based swap agreement” have been published in the Federal Register.  The product definition rules, as they are generally known, also provide interpretive guidance regarding mixed swaps.

The effective date of the rules is October 12, 2012.  As previously reported, compliance will be required for a number of other CFTC rules, such as those requiring swap dealers and major swap participants to apply for registration as such, starting on the same day.  Some rules, including a rule pertaining to real-time public reporting of swap transaction data as well as rules pertaining to swap data recordkeeping and reporting requirements, have a series of dates for which compliance will be required with regard to different products or entities.  The first of those dates is October 12, 2012, with subsequent compliance dates of January 10, 2013 and April 10, 2013.

0SEC to Host Market Technology Roundtable and Consider Rule Addressing Capacity and Reliability of Exchange Systems

The SEC announced it will host a roundtable entitled “Technology and Trading: Promoting Stability in Today’s Markets” on September 14 to gather systems experts and explore ways to improve the capacity and integrity of market infrastructure.  Following the trading anomalies generated by a large electronic trading platform on August 1, SEC Chairman Mary Schapiro said that while recently adopted circuit breakers and clearly defined rules guided the exchanges and markets through the volatility that resulted, she was urging the SEC staff to accelerate ongoing efforts to propose a rule that would require exchanges and other market centers to establish specific programs to ensure the capacity and reliability of their technological systems.