Financial Services Alert - September 18, 2012

The Government Accountability Office (the “GAO”) issued a report assessing the operation of the Financial Stability Oversight Council (the “FSOC”).  The FSOC was established by the Dodd-Frank Act and is designed to identify threats to the financial stability of the U.S., promote market discipline and respond to emerging risks to the stability of the U.S. financial system.

The GAO report recommended that the FSOC consider enhancing its management mechanisms in order to provide greater accountability and transparency.  In its report, the GAO offered a number of recommendations to strengthen the accountability and transparency of FSOC decisions and activities and to improve collaboration among FSOC members and with external stakeholders.  Among other recommendations, the GAO report noted that the FSOC should:

• clarify responsibility for implementing requirements to monitor threats to financial stability across the FSOC;
• develop an approach that includes systematic sharing of key financial risk indicators across FSOC members and member agencies;
• develop a strategy to improve communications with the public;
• maintain detailed records (such as detailed minutes or transcripts) of closed door sessions;
• establish formal collaboration and coordination policies that clarify issues such as when collaboration or coordination should occur and what role FSOC should play in facilitating such coordination;
• establish a collaborative and comprehensive framework for assessing the impact of its decisions for designating financial market utilities and nonbank financial companies on the wider economy and such entities; and
• develop more systematic forward-looking approaches for reporting on potential emerging threats to financial stability in annual reports.

On a related note, following the SEC’s recent announcement that that the agency would not vote on money market fund reform proposals due to a lack of support from a majority of the SEC Commissioners (as previously detailed in the August 28, 2012 Financial Services Alert), the Systemic Risk Council, a private organization chaired by the former chair of the FDIC, suggested that the FSOC should take steps to implement reforms of the money market mutual fund industry.

The SEC settled public administrative and cease and desist proceedings against two affiliated SEC-registered investment advisers (“Adviser 1” and “Adviser 2,” collectively, the “Advisers”) and their owner, who also served as the president of the Advisers (the “Owner,” and collectively with the Advisers, the “Respondents”), related to findings regarding certain revenue sharing arrangement and their non-disclosure by the Respondents.  This articles summarizes the SEC’s findings, which the Respondents neither admitted nor denied.

Background.  Adviser 1 is a registered investment adviser that provides (i) non-discretionary investment advice through proprietary asset allocation models made up primarily of mutual funds and ETFs and (ii) back-office custodial support to both related and unrelated investment advisory firms.  Adviser 1 provides “turn-key” asset management services and back-office custodial support to approximately 60 investment advisers (the “FAs”) who use Adviser 1’s advice with retail clients, representing approximately $1.7 billion in assets, most of which is custodied with a specific broker (the “Broker”).  The majority of Adviser 1’s recommendations relate to “No Transaction Fee” mutual funds on which the Broker does not charge investors any form of commission (the “NTF Funds”).   Adviser 1 also serves as an investment sub-adviser to a registered investment company (the “SA Fund”).  The SA Fund’s primary investment adviser is a related party of Adviser 1 specifically created to serve in that capacity (the “Related Adviser”).  Adviser 2 is a registered investment adviser that offers investment advisory services to retail clients, and receives investment advice and back-office support from Adviser 1. 

Revenue Sharing Arrangement with Broker.  In September 2007, Adviser 1 and the Broker entered into a “Custodial Support Services Agreement” (“CSSA”) pursuant to which Adviser 1 agreed to perform certain services, such as facilitating asset transfers, handling client account inquiries and assisting with client paperwork and account reconciliation.  In exchange, the Broker agreed to pay Adviser 1 a certain percentage of every dollar that Adviser 1’s clients invested in the NTF Funds.  Adviser 1 did not disclose the existence of this revenue-sharing arrangement to any of the FAs, nor did Adviser 1 disclose to the FAs that it had an incentive to favor NTF Funds in its recommendations.  Adviser 1’s Form ADV also did not disclose this conflict.

Sub-Advisory Relationship.  In mid-2009, the Related Adviser, which served as the primary investment adviser to the SA Fund, proposed that Adviser 1 serve as sub-adviser to the SA Fund and that SA Fund adopt a Rule 12b-1 distribution fee.  Adviser 1 made several presentations to the Fund’s Board (the “Board”), which included statements that Adviser 1 would not receive payments or benefits from the SA Fund other than the fee paid pursuant to the sub-advisory agreement.  In actuality, Adviser 1 had an arrangement with the Related Adviser pursuant to which the Related Adviser would pay Adviser 1 approximately 15 basis points.  The Board was not aware of this arrangement and, accordingly, did not consider it when approving the sub-advisory agreement. 

Affiliate’s Proxy Vote on Sub-Advisory Relationship.  Following approval by the SA Fund’s Trustees, shareholders of the SA Fund were asked to approve the addition of Adviser 1 as a sub-adviser and the adoption of a Rule 12b-1 fee.  The vast majority of the SA Fund’s shareholders were clients of Adviser 2, which had recommended the SA Fund to many of its clients.  Because it was subject to a conflict of interest in voting on these matters, Adviser 2’s proxy voting policy called for its clients who beneficially owned SA Fund shares, rather than Adviser 2, to vote the proxies in question.  Adviser 2 did not comply with this policy and voted in favor of the proposals for SA Fund to add Adviser 1 as a sub-adviser to the SA Fund and adopt a Rule 12b-1 fee. 

Violations.  The SEC found the following violations of law:

Section 206(2) and 207 of the Advisers Act – By failing to provide the SA Fund’s Board with information about Adviser 1’s separate arrangement with the Related Adviser and by failing to disclose the revenue sharing arrangement with the Broker, the SEC found that Adviser 1 willfully violated Section 206(2) the Investment Advisers Act of 1940 (the “Advisers Act”) prohibiting practices that act as a fraud or deceit on a current or prospective client and Section 207 of the Advisers Act prohibiting an untrue statement or omission of material fact in filings with the SEC, and that the Owner willfully aided and abetted and caused the foregoing violations by Adviser 1.

Section 15(c) of the 1940 Act – By misrepresenting to the SA Fund’s Board that the sub-advisory fees were the only compensation to be received by Adviser 1 in connection with the sub-advisory agreement with the SA Fund, the SEC found that Adviser 1 willfully violated Section 15(c) of the Investment Company Act of 1940 which sets forth the duty of an investment adviser to provide information to an investment company board considering the approval of an advisory contract, and that the Owner willfully aided and abetted and caused Adviser 1’s violation.

Sections 206(2) and 206(4) and Rule 206(4)-6 of the Advisers Act – By failing to implement proxy voting policies and procedures reasonably designed to ensure that shares of the SA Fund were voted in the best interests of its clients with respect to the approval of Adviser 1 as sub-adviser and the adoption of a Rule 12b-1 Plan, Adviser 2 willfully violated Section 206(2) of the Advisers Act, Section 206(4) of the Advisers Act prohibiting fraudulent or deceptive practices and Rule 206(4)-6 under the Advisers Act relating to proxy voting policies and procedures.

Sanctions and Remedial Undertakings.  In addition to agreeing to cease and desist orders and censures, the Advisers and the Owner agreed to pay the following amounts: Adviser 1 agreed to pay disgorgement of $900,000, prejudgment interest of $25,813.92 and a civil money penalty of $100,000; Adviser 2 agreed to pay a civil money penalty of $50,000; and the Owner agreed to pay a civil money penalty of $50,000.  Adviser 1 also agreed to provide a notice of the order settling this proceeding to its existing clients and for a period of one year, to prospective clients, and to retain an independent consultant to, among other things, review and make recommendations about Adviser 1’s compliance policies and procedures and disclosures to clients.

On September 5, 2012, FINRA posted Regulatory Notice 12-40 setting an effective date of December 3, 2012 for new Rule 5123, and providing information about the development of an electronic private placement filing system.  Proposed Rule 5123 was originally filed with the SEC on October 5, 2011 (see “FINRA Proposes New Rule 5123 Governing Private Placements of Securities by Member Firms” in the October 18, 2011 Financial Services Alert).  On January 19, 2012, FINRA filed Amendment No. 1 to the proposed rule change (see “FINRA Files Partial Amendment No. 1 to Proposed Rule 5123 Governing Private Placements of Securities by Member Firms” in the January 31, 2012 Financial Services Alert).  In response to further comments, FINRA filed Amendment No. 2 on March 12, 2012 and Amendment No. 3 on March 22, 2012.  The SEC approved the amended rule proposal on June 7, 2012, in Release No. 34-67157.  This article provides a brief summary of the Rule, describes changes from Amendment No. 1, and discusses FINRA’s proposed electronic filing system.

Regulation of Member Participation in Private Placements

Rule 5123 is a companion to Rule 5122, which regulates participation by FINRA member firms in offerings of their own securities or the securities of entities controlled by, controlling or under common control with the member (with “control” defined as an ownership interest of 50% or more).  Under those circumstances, unless an exemption is available, Rule 5122 requires a member to do the following:

• Provide written disclosure of the intended use of proceeds of the offering, the amount of offering expenses and the amount of selling compensation that will be paid to the member and its associated persons;
• File the private placement memorandum or other written document including the required disclosure with FINRA prior to the first time the document is provided to any prospective investor; and
• Ensure that at least 85% of the offering proceeds raised are used for business purposes, not including offering costs, discounts, commissions or any other cash or non-cash sales incentives.

Rule 5123 applies to all private offerings except member private offerings and offerings exempt from the Rule.  Unlike Rule 5122, Rule 5123 requires only that the member cause the offering memorandum or other document used to make the offering be filed with FINRA within 15 days after the first sale in the offering.  If no offering document was used, the member must make a filing, by the same date, stating that no offering document was used.  The deadline of 15 calendar days after the date of first sale was chosen in response to comments and is intended to coordinate with the deadline for filing Form D with the SEC and state securities administrators.  Rule 5123 does not require disclosure of use of proceeds or mandate any minimum use of offering proceeds for business purposes.

Changes from Amendment No. 1

The final text of Rule 5123 contains the following changes from the proposal in Amendment No. 1:

• The requirement to provide specific disclosure concerning the use of proceeds was deleted;
• In the exemption in Paragraph (b)(1)(G) for offerings solely to (among others) employees and affiliates of the issuer, FINRA added a cross-reference to the definition of “affiliate” in Rule 5121 (Public Offerings of Securities with Conflicts of Interest); and
• The filing requirement was amended to require not only that the original offering documents be filed but also that any “materially amended versions” of offering documents used in connection with a sale be filed within 15 calendar days of the date of first sale.

New Private Placement Filing System

In Regulatory Notice 12-40, FINRA stated that it is developing a private placement filing system to receive the offering documents that firms must file under the new rule.  Firms will access the filing system through the Firm Gateway and file documents in searchable Portable Document Format (PDF).  In response to comments, FINRA will allow a firm to submit a filing on behalf of other firms involved in the sale of the private placement.  A firm that makes a filing on behalf of itself and other firms must identify the other firms as part of its submission. FINRA expects that the new filing system will be operational by December 3, 2012, the effective date of the Rule.  FINRA reminded firms that filings under Rules 5122 and 5123 are “notice” type filings, and that FINRA does not respond to these filings with a comment letter or provide a clearance letter.

Paragraph (d) of the Rule provides that FINRA will accord confidential treatment to all documents and information filed pursuant to the Rule.

In response to a mandate in the Dodd-Frank Act, the SEC submitted to Congress a study prepared by its staff on the feasibility and desirability of standardizing certain elements of credit ratings and their underlying methodologies.  As directed by the statute, the study examines the viability and practicability of: (i) standardizing credit rating terminology; (ii) standardizing the market stress conditions under which ratings are evaluated; (iii) requiring a quantitative correspondence between credit ratings and a range of default probabilities and loss expectations (under standardized conditions of market stress); and (iv) standardizing credit rating terminology across asset classes.  The SEC staff solicited public comment regarding the mandated topics, and reviewed publicly available information on the subject of standardization in credit ratings.  The study sets forth a number of findings, as follows:

• Standardizing credit rating terminology may facilitate comparison of credit ratings across agencies and could result in a decrease in the opportunities for manipulating credit ratings, although this may not be feasible given the number and uniqueness of rating scales and the variances in methodologies used by credit rating agencies. 
• Requiring a quantitative correspondence between credit ratings and a range of default probabilities and loss expectations could lead to greater accountability; however, such correspondence may not always exist because credit ratings are also based on qualitative factors. 
• Most credit rating agencies believe it is desirable to have standard credit rating terminology across all asset classes; however, credit ratings have not historically been comparable across asset classes. 
• Transparency in credit ratings may be more achievable and more practicable than implementing standardization.

Based on these findings, the SEC staff recommended that no further action be taken with respect to: (i) standardization of credit rating terminology; (ii) standardizing the market stress conditions under which ratings are evaluated; (iii) requiring a quantitative correspondence between credit ratings and a range of default probabilities and loss expectations (under standardized conditions of market stress); and (iv) standardizing credit rating terminology across asset classes.   In addition, the staff concluded that it would be more efficient to focus on the rulemaking initiatives mandated under the Dodd-Frank Act with respect to credit ratings, which, among other things, are designed to promote transparency with respect to the performance of credit ratings and the methodologies used to determine credit ratings.

The FDIC issued a Financial Institution Letter (FIL-38-2012, the “FIL”) in which the FDIC cautioned state nonmember banks that before purchasing a participation in a loan they are expected to implement an appropriate credit risk management framework that should include “effective loan policy guidelines, written loan participation agreements, independent credit analysis and review procedures, and a comprehensive due diligence process.”  The FDIC noted in the FIL, however, that the FDIC is aware that purchasing banks sometimes have over-relied on the bank that has originated the loan, which “in some instances caused significant credit issues and contributed to bank failures.”  The FDIC noted that some instances where the purchasing bank has over-relied on the originating financial institution have involved the purchasing bank’s purchase of interests in loans where the borrower is from a different state or the borrower or obligor is in a business that is unfamiliar to the purchasing bank.  The  FIL emphasizes that the FDIC expects that banks that purchase loan participations will perform the “same degree of independent credit and collateral analysis as if they were the [originating bank.]"

The CFTC issued a list of frequently asked questions on the timing of swap dealer registration.  Among other things, the FAQ clarifies that, despite the October 12 compliance date for the CFTC regulations requiring the registration of swap dealers, “a person that takes advantage of the de minimis exception in CFTC regulation § 1.3(ggg)(4), as any person is permitted to do, would not be a swap dealer on October 12, 2012 and would not be required to apply to be registered on that date.”  Effectively, therefore, the FAQ provides that the registration deadline for a swap dealer is December 31, 2012.