Financial Services Alert - December 4, 2012

The staff of the CFTC’s Division of Swap Dealer and Intermediary Oversight (the “Staff”) issued a no-action letter providing relief to operators of certain commodity pools (“Funds-of-Funds”) investing in separately managed vehicles that hold commodity interests from the December 31, 2012 deadline for registering as commodity pool operators (“CPOs”) that would otherwise have applied to them.  Subject to certain conditions, the relief continues until the later of June 30, 2013 or six months from the date that the Division of Swap Dealer and Intermediary Oversight issues guidance on the application of the de minimis commodity interest thresholds in CFTC Regulation 4.5 and 4.13(a)(3). 

The no-action letter responds to concerns expressed to the Staff regarding the difficulties that could be faced by operators of Funds of Funds that have been relying on guidance from the Division of Swap Dealer and Intermediary Oversight stating that that they may continue to rely on Appendix A until the Commission adopts revised guidance.  Part 4 of the CFTC Regulations formerly included an Appendix A, which described six factual situations in which a Fund of Funds would be in compliance with the de minimis commodity interest thresholds in CFTC regulation 4.13(a)(3); Appendix A was removed from Part 4 of the CFTC Regulations in February 2012.  The no-action relief is designed, in part, to respond to concerns expressed by industry groups and counsel for operators of Funds of Funds that differences between the guidance in Appendix A and guidance for Fund of Funds operators subsequently adopted to replace Appendix A could cause an operator of a Fund of Funds to have to register as a CPO even though there has been no change in the Fund of Funds’ exposure to commodity interests.

The no-action relief is subject to the following conditions:

• the entity claiming the relief structures its operations in whole or in part as a CPO of one or more Funds of Funds;
• the Fund of Funds with respect to which the CPO is claiming the relief (the “Investor Fund”) does not have direct commodity interest positions that would exceed the thresholds specified in CFTC Regulation 4.5 or 4.13(a)(3)(ii)(A) or (B);
• the entity claiming the relief does not know and could not have reasonably known that the Investor Fund’s indirect commodity interest exposure exceeds the de minimis commodity interest thresholds specified in CFTC Regulation 4.5 or 4.13(a)(3)(ii)(A) or (B), calculated either directly or through the use of Appendix A; and
• the Investor Fund is either a registered investment company or complies with the conditions in CFTC Regulation 4.13(a)(3)(i)(Securities Act exemption), (iii)(investor standards) and (iv)(prohibition on marketing as a commodity trading vehicle).

Reliance on the no-action relief is further conditioned on submitting to the Staff by December 31, 2012 a claim of relief stating (i) the name, main business address and telephone number of the operator; (ii) the name of the Investor Fund; and (iii) that the operator is the CPO of the Investor Fund.

The CFTC approved its first final clearing requirement determination.  The determination requires that four types of interest rate swaps (specifically, certain fixed-to-floating swaps, basis swaps, forward rate agreements, and overnight index swaps, in each case pertaining to several major world currencies) and two types of credit default swaps (North American untranched CDS indices and European untranched CDS indices meeting certain specifications) be cleared through registered derivatives clearing organizations, unless an exception to the clearing requirement applies.  The classes of swaps covered by the determination are identical to those included in the proposed version, which was previously released (discussed in the July 31, 2012 Financial Services Alert).

Compliance requirements will phase in, as follows:

• Category 1 entities (swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, and active funds) must come into compliance with the clearing requirement by March 11, 2013.
• Category 2 entities (commodity pools, private funds other than active funds, and persons predominantly engaged in activities that are in the business of banking or in activities that are financial in nature according to Section 4(k) of the Bank Holding Company Act, excluding third-party subaccounts) will be required to clear applicable swaps by June 10, 2013.
• Category 3 entities (all other entities, including third-party subaccounts and ERISA plans) will be required to clear swaps beginning on September 9, 2013.

The determination states that any swaps entered into prior to the applicable clearing requirement compliance date are not required to be cleared.

On the same day that the CFTC approved the determination, its Division of Clearing and Risk (the “Division”) issued two no-action letters pertaining to clearing.  The first no-action letter provides that the Division will not recommend that the CFTC commence an enforcement action against a person for failure to clear a credit default swap or interest rate swap with a majority-owned affiliate, if certain other conditions are met.  The second no-action letter provides that the Division will not recommend that the CFTC commence an enforcement action against a counterparty for failure to clear a credit default swap or interest rate swap if one of the counterparties is an “exempt cooperative” and the swap is entered into with a member of the exempt cooperative in connection with originating a loan for the member or hedging or mitigating commercial risk related to or associated with loans to members.  Each no-action letter addresses matters that are the subject of rule proposals on which the CFTC has yet to take final action.  (The CFTC’s proposal to exempt swaps between two affiliated counterparties from mandatory clearing, subject to certain conditions, is available here; the CFTC’s proposal to exempt certain swaps entered into by qualifying cooperatives from mandatory clearing, subject to certain conditions, is available here.)  The relief provided by each no-action letter expires on the earlier of April 1, 2013, or the effective date of a CFTC rulemaking finalizing a corresponding exemption.

The CFTC staff withdrew parts of its previously-released “Frequently Asked Questions on the Reporting of Cleared Swaps.”  According to the CFTC press release, the withdrawn questions (“Which party has the authority to select the particular SDR for purposes of cleared swap reporting?”, “May a DCM, SEF or DCO that is also registered as an SDR or legally affiliated with an SDR require counterparties to use their ‘captive’ SDR for reporting swap transactions?”, and “Where must the resulting swaps created through the clearing process be reported?”) and corresponding answers are currently under consideration as part of the CFTC’s review of a proposed Chicago Mercantile Exchange rule.

The CFTC amended its no-action letter on “pay-to-play” rules (the original release of which was reported in the November ­­27, 2012 Financial Services Alert).  The amendment inserts a clause to clarify that the scope of relief provided in the letter extends only to dealings with governmental plans that are not otherwise covered by the pay-to-play rules of the SEC and/or Municipal Securities Rulemaking Board.

The CFTC’s Division of Market Oversight (the “Division”) issued no-action relief from certain reporting rules regarding “bespoke or complex” swaps, which it defined as swaps that are (a) not listed for trading on a designated contract market; (b) not available to be traded on a swap execution facility; (c) not eligible to be cleared by a derivatives clearing organization; (d) not eligible to be confirmed through an electronic matching confirmation system; and (e) not represented in Financial products Markup Language (“FpML”).  The relief pertains to certain items required to be reported under the CFTC’s real-time public reporting rules (embodied in Part 43 of the CFTC’s regulations) and its swap data recordkeeping and swap data repository reporting requirements (embodied in Part 45 of the CFTC’s regulations).  As described in the no-action relief, the International Swaps and Derivatives Association has explained that FpML does not currently support bespoke or complex products for all fields required in Parts 43 and 45.  Accordingly, the Division has stated that it will not commence an enforcement action against a reporting party for failure to report the information required but not supported by FpML under both Parts 43 and 45, in each case until the earlier of such time that the relevant data elements can be electronically represented in FpML or June 30, 2013.

The staff of the CFTC’s Division of Swap Dealer and Intermediary Oversight (the “Staff”) issued a no-action letter stating that it will not recommend that the SEC take an enforcement action for failure to register as a commodity pool operator (“CPO”) against a CPO that meets the definition of “family office” in SEC Rule 202(a)(11)(G)-1 under the Investment Advisers Act of 1940 (the “SEC Family Office Rule”).  Adopted by the SEC in June 2011, the SEC Family Office Rule defines “family office” for purposes of the exclusion from the definition of “investment adviser” in Section 202(a)(11)(G) of the Advisers Act, which was added by the Dodd-Frank Act.  (See the June 23, 2011 Goodwin Procter Alert for a detailed discussion of the SEC Family Office Rule and the February 14, 2012 Financial Services Alert for a discussion of a subsequent SEC staff FAQ on the SEC Family Office Rule.)

Notice of Claim.  To rely on the Staff’s guidance, a CPO must comply with the SEC Family Office Rule, as amended, regardless of whether it “seeks to be excluded from the Investment Advisers Act of 1940,” and must file a notice of claim with the CFTC.  The notice of claim must provide certain identifying information for the CPO claiming the relief and, where applicable, the name of the pool(s), for which the claim is being filed.

Deadlines.  A CPO in operation as of December 1, 2012 seeking to rely on the relief must file its notice of claim by December 31, 2012, and by March 31, 2013, must confirm that (i) it is a family office within the meaning and intent of the SEC Family Office Rule and (ii) it will notify the Division if it is no longer a family office within the meaning and intent of the SEC Family Office Rule.  A CPO that commences operations after December 1, 2012 must, within 30 days after it begins to operate as a family office, file its notice of claim, and confirm that (a) it is a family office within the meaning and intent of the SEC Family Office Rule and (b) it will notify the Division if it is no longer a family office within the meaning and intent of the SEC Family Office Rule.

FRB Governor Daniel K. Tarullo discussed potential significant changes to how the FRB regulates U.S. operations of foreign banks in a speech that Governor Tarullo presented at the Yale School of Management on November 28, 2012.  Governor Tarullo stated that he expected the FRB, in the coming weeks, to issue a Notice of Proposed Rulemaking (the “NPR”) that would modify FRB supervision of large foreign banking organizations (“FBs”) to reflect the change in their activities in the U.S. and the risks attendant to those changes and to implement the enhanced prudential standards mandated by the Dodd-Frank Act.  Governor Tarullo described three modifications to FRB supervision of U.S. FBs that the FRB is likely to include in the NPR:

1. FBs with the largest level of U.S. operations would be required to establish a top-tier U.S. intermediate holding company (“IHC”) over all of its U.S. bank and nonbank subsidiaries (but not the applicable FB’s U.S. branches and agencies that are part of the foreign bank itself).
2. The same capital rules that apply to U.S. bank holding companies would apply to IHCs.  Moreover, enhanced prudential standards required by the Dodd-Frank Act such as stress testing requirements, risk management requirements and single counterparty credit limits would be applied to the U.S. operations of FBs.
3. IHCs would be subject to liquidity requirements that are consistent with those proposed for large U.S. bank holding companies, and branch and agency networks of foreign banks with large U.S. operations would also be subject to liquidity requirements.

In concluding his remarks, Governor Tarullo noted that his remarks are only an outline of the proposed changes that the FRB is discussing and that the “all-important details” would be provided in the NPR.

The FRB, the FDIC, the OCC and the Conference of State Bank Supervisors (collectively, the “Agencies”) issued an interagency statement entitled “Restrictions on Conversions of Troubled Banks”, (the “Interagency Statement”) on the implementation of Section 612 of the Dodd-Frank Act.  According to the Agencies, the Interagency Statement should be read in conjunction with the FFIEC’s 2009 Statement on Regulatory Conversions. Section 612 prohibits the conversion of state-chartered banks and savings associations to national banks or federal savings associations, and vice versa, where the applicable banking institution is subject to a cease and desist order or memorandum of understanding concerning a significant regulatory matter.  The Agencies have interpreted this provision to apply to all formal enforcement actions, (i.e., orders, agreements, directives or other documents).  Section 612 does provide a limited exception to the general prohibition, although the Agencies expect that exceptions will rarely be granted.

Under Section 612, the conversion restriction does not apply where the following conditions all are met: (1) the Agency that would become the supervising agency (the “Prospective Agency”) provides the current supervising agency (the “Current Agency”) with written notification of the proposed conversion and the Prospective Agency’s plan to address the significant regulatory matter that is the subject of the enforcement action; (2) the Current Agency does not object to the proposed conversion or proposed plan; (3) the Prospective Agency agrees to implement the plan; and (4) where a final enforcement action is issued by a state attorney general, the proposed conversion is conditioned upon compliance with the terms of the final enforcement action.  To facilitate any prospective conversion, the Agencies recommend that institutions contact the current and prospective state and federal chartering and banking authorities to discuss the proposed conversion prior to filing an application. 

The Interagency Statement also discusses Section 612’s notification and information sharing requirements, most of which concern information sharing requirements between and among Agencies.  For example, under Section 612(e)(2), the Current Agency is to notify the Prospective Agency of all investigations that may result in a formal enforcement action, and to provide access to all investigations and supervisory information.  Of note to institutions, however, is the requirement to provide a copy of the conversion application to both the Current Agency and the Prospective Agency at the time that the application is filed with the chartering authority.

On November 27, 2012, the SEC announced the settlement of administrative proceedings pursuant to Section 15(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) against four India-based financial services firms (the “Respondents”) for soliciting and providing brokerage services to U.S. institutional investors without being registered as broker-dealers as required by Section 15(a) of the Exchange Act.  The SEC announcement, and links to the four orders settling the aforementioned proceedings, are available here.  This article describes the SEC’s findings in the settlement orders, which the Respondents neither admitted nor denied.

Absent an applicable exception or exemption, Section 15(a) of the Exchange Act generally prohibits a broker or dealer from making use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security without being registered with the SEC as a broker-dealer.

In the settlement orders, the SEC found that Respondents used U.S. jurisdictional means to engage in one or more various brokerage activities such as:

• buying and selling securities of Indian issuers on behalf of U.S. investors in exchange for transaction-based compensation;
• distributing research reports to U.S. investors and following up with U.S. investors with respect to such reports;
• organizing and sponsoring conferences in the U.S.;
• participating as one of several broker-dealers in initial public offerings; and
• meeting with U.S. investors on a one-on-one basis.

Chaperoning Agreements for Foreign Broker-Dealers.  Rule 15a-6 under the Exchange Act provides conditional exemptions under which unregistered foreign broker-dealers may effect transactions with or for U.S. institutional investors in certain limited circumstances.  More specifically, Rule 15a-6 provides that an unregistered foreign broker-dealer may legally engage in certain U.S. cross-border business if such foreign broker-dealer has entered into a chaperoning agreement with a U.S. registered broker-dealer.  Under such agreements, the U.S. registered broker-dealer must agree to perform the following functions on behalf of the unregistered foreign broker-dealer:

• effect the transactions, other than negotiating their terms;
• issue all required confirmations and account statements;
• maintain required capital related to such transactions;
• be responsible for extending or arranging margin, if any, to or for the customer;
• receive, deliver and safeguard funds and securities on behalf of the customer;
• maintain required books and records related to the transaction;
• participate to the extent necessary in oral communications between associated persons of the foreign broker-dealer and U.S. institutional investors;
• obtain information from the foreign broker-dealer necessary to determine that the foreign broker-dealer is not disqualified by disciplinary history from use of the exemption; and
• serve as agent for service of process for civil actions brought by the SEC or any self-regulatory organization against the foreign broker-dealer.

After being contacted by the SEC, each of the Respondents undertook corrective action, including entering into chaperoning agreements as provided for in Rule 15a-6, and in one case, initiating registration with the SEC as a broker-dealer.

Sanctions.  In their settlements with the SEC, each Respondent agreed to a censure and disgorgement of an amount proportionate to the transaction-based compensation earned in violation of Section 15(a) of the Exchange Act and the applicable rules promulgated thereunder.

The staff of the SEC’s Division of Investment Management (the “Staff”) has posted to its Investment Management Staff Issues of Interest page on the SEC website interpretive guidance regarding the exemption from registration under the Investment Advisers Act of 1940 (the “Advisers Act’) provided by Section 203(b)(6) of the Act.  The guidance addresses requests for clarification regarding the impact of amendments to this statutory provision effected by the Dodd-Frank Act.  Section 203(b)(6) exempts from the requirement to register with the SEC: “(A) any investment adviser that is registered with the Commodity Futures Trading Commission as a commodity trading advisor whose business does not consist primarily of acting as an investment adviser, as defined in section 202(a)(11) of [the Advisers Act], and that does not act as an investment adviser to (i) an investment company registered under [the Investment Company Act of 1940 (the “1940 Act”)]; or (ii) a company which has elected to be a business development company pursuant to section 54 of [the 1940 Act (a “BDC”)] and has not withdrawn its election; or (B) any investment adviser that is registered with the Commodity Futures Trading Commission as a commodity trading advisor and advises a private fund, provided that, if after the date of enactment of the [Dodd-Frank Act], the business of the advisor should become predominately the provision of securities-related advice, then such adviser shall register with the Commission.”