Financial Services Alert - December 18, 2012

A combination of federal, local and international government actions and investigations resulted in the largest bank settlement in U.S. history (the “Settlement”), pursuant to which HSBC Bank USA, N.A., a federally-chartered banking institution (“HSBC USA”) and subsidiary of HSBC North America Holding, Inc., and HSBC Holdings plc, a financial institution holding company organized under the laws of England and Wales (“HSBC Holdings,” together with its affiliates, “HSBC”) will pay a penalty of approximately $1.9 billion as a result of anti-money laundering violations (“AML”) and violations of the sanctions programs administered by the Office of Foreign Assets Control (“OFAC”).  HSBC Holdings is the ultimate parent company of financial institutions throughout the world (“HSBC Group Affiliates”) which it owns through various intermediate holding companies.  The Settlement was not the first time that HSBC was sanctioned for AML violations—from 2003-2006, HSBC operated under a written consent order related to failure to meet certain AML requirements, and in 2010, the OCC and the FRB issued cease and desist orders to HSBC based on failures to comply with AML requirements.

$1.256 billion of the penalty results from a five-year deferred prosecution agreement (“DPA”) entered into with the U.S. Department of Justice (“DOJ”) and the United States Attorney’s Offices for the Eastern District of New York and the Northern District of West Virginia in which HSBC admitted to: (a) willful failure to maintain an effective AML program, in violation of the Bank Secrecy Act (the “BSA”); (b) willful failure to conduct and maintain due diligence on correspondent accounts, in violation of the BSA; (c) willful violation and attempted violation of the Trading with the Enemy Act, specifically willful violations of the Cuban sanctions programs administered by OFAC; and (d) willful violation and attempted violation of the International Emergency Economic Powers Act, specifically willful violations of the Iranian, Libyan, Sudanese and Burmese sanctions programs administered by OFAC.

Of particular concern was HSBC’s failure to perform due diligence on foreign affiliates and improperly risk rating customers and countries.  Specific attention was paid to HSBC’s failure to properly assess the risk involved with Mexican transactions, the failure to conduct due diligence on Mexican customers and transactions, the absence of an acceptable AML program at its Mexican subsidiary (“HSBC Mexico”), and the lack of communication among affiliated HSBC entities (including HSBC Mexico and HSBC USA).  As a result of these and other failures, at least $881 million in drug trafficking proceeds were laundered through HSBC USA.

In addition to the penalty, the DPA noted that HSBC has taken or will take several remedial measures, including for instance, spending $244 million more on AML compliance in 2011 than it had in 2009, replacing many key leaders throughout the HSBC organization, treating HSBC Group Affiliates as third parties subject to the same diligence as all other customers, exiting 109 correspondent relationships and implementing strict and uniform global AML standards that, at a minimum, require that HSBC Group Affiliates adhere to U.S. AML standards.  The DPA further requires that HSBC retain an independent compliance monitor for at least 5 years.

While, with exceptions, the DPA protects HSBC from criminal prosecution by the DOJ related to the conduct described in the DPA, it does not similarly protect from criminal prosecution present or former officers, directors, employees, agents or consultants.  Additionally, it does not protect HSBC from criminal prosecution by entities other than the DOJ.

On December 10, 2012, the SEC issued an order (the “Order”) instituting administrative proceedings (the “Proceedings”) against the eight former directors (the “Directors”) of three registered open-end funds and four registered closed-end funds (the open-end and closed-end funds, collectively, the “Funds”).  The SEC alleges that by failing to fulfill their responsibility to properly oversee the fair valuation process for the Funds during the period from January 2007 to August 2007 (the “Relevant Period”), the Directors caused the Funds to violate provisions of the Investment Company Act of 1940 (the “1940 Act”) relating to (a) the sale of open-end fund shares at a price based on net asset value (“NAV”), (b) the maintenance of internal control over financial reporting, (c) the implementation of compliance procedures relating to fair valuation and (d) the making of false statements/material omissions in registration statements.

This article summarizes the SEC’s allegations in the Order.  There have been no findings with respect to the SEC’s allegations.  The Directors have not yet filed an answer to the Order, although those who were not interested persons of the Funds within the meaning of the 1940 Act (the “Independent Directors”) have issued a public response that is briefly discussed below.  Pursuant to the SEC’s Rules of Practice, the Proceedings will be tried by an Administrative Law Judge who will issue an initial decision within 300 days from the date of service of the Order.

Background

The Proceedings follow on the June 2011 settlement of proceedings brought by the SEC, FINRA and various state securities regulators against (1) the Funds’ investment adviser (the “Adviser”), (2) the Adviser’s affiliate, registered as both an investment adviser and a broker-dealer, which provided Fund accounting services to the Funds through its Fund Accounting Group (“Fund Accounting”), (3) the Funds’ portfolio manager (the “Portfolio Manager”), and (4) the head of Fund Accounting  (together, the “2011 Respondents”), arising out of the same general matters that the Order addresses.  (The SEC’s June 22, 2011 order (the “2011 Order”) and the related FINRA and state settlements were discussed in the July 5, 2011 Financial Services Alert.)  In broad terms, the 2011 Order is based on the SEC’s finding that between January 2007 and July 2007 the daily NAV of each of the Funds was materially inflated as a result of fraudulent conduct on the part of the 2011 Respondents relating to the pricing of securities backed by subprime mortgages held by the Funds.

The Directors

As set forth in the Order, each Fund’s board consisted of two interested directors and six Independent Directors.  In describing the Directors, the Order notes that four of the Directors (including three of the Independent Directors) are Certified Public Accountants and that all six of the Independent Directors, who collectively made up each Fund’s audit committee, were designated as Audit Committee Financial Experts.

High Proportion of Fair Valued Securities

The Order provides that during the Relevant Period, significant portions of the Funds’ portfolios contained subordinated tranches of various securitizations, for which market quotations were not readily available, and which accordingly were required to be fair valued in accordance with the requirements of Section 2(a)(41)(B) of the 1940 Act.  For example, as of March 31, 2007, more than 60% of the net assets of each of the four closed-end Funds consisted of securities that had to be fair valued, as did more than 50% of the net assets of each of the two largest open-end Funds as of June 30, 2007.

Fair Value Process

As described in the Order, the Directors delegated the responsibility for fair value determinations to the Adviser.  The Adviser’s Valuation Committee (the “Valuation Committee”), which consisted of Fund officers and Fund Accounting employees, was responsible for overseeing a process that was performed to a large extent by Fund Accounting.  Fund Accounting typically used a security’s purchase price as its initial fair value and did not change that fair value unless a subsequent sale or price confirmation varied more than 5% from the previously assigned fair value.  In addition, the Portfolio Manager occasionally contacted Fund Accounting to specify prices for particular securities, which the SEC alleges Fund Accounting routinely accepted without explanation.

The Order highlights the role that price confirmations played in the fair value process.  It notes that Fund Accounting randomly selected and sought price confirmations for as few as 10% of the Funds’ fair valued securities (except for March and June 2007 when, in connection with annual audits, confirmations were sought for 100% of the fair valued securities) and describes such confirmations as “essentially opinions on price from broker-dealers, rather than bids or firm quotes.”  Confirmations were generally sought for month-end prices, but were obtained several weeks after the respective month-end.  If a month-end price confirmation showed a price more than 5% different from a Fund’s current price for that security, Fund Accounting would typically consult the Portfolio Manager as to how the security should be priced.

During most of the Relevant Period, the Valuation Committee met monthly.  It received security sales reports for the Funds, brief explanations for greater-than-5% variances between fair values and price confirmations, and the price confirmations obtained from broker-dealers.  (A security sales report listed “information about the securities sold in each Fund in the preceding quarter, including: (1) par value sold; (2) sales price; (3) the previous day’s assigned price; (4) whether it was priced externally or internally, i.e., fair valued; (5) the resulting variance; and (6) the impact on the Fund.”)  In reviewing the pricing information provided by Fund Accounting, the Valuation Committee compared reports of sales prices to previously assigned fair values, but did not test the fair values of portfolio securities for which there had been no sale or price confirmation.  The Order notes that less than 25% of the approximately 350 fair valued securities held by the Funds were sold in the first six months of 2007.

As described in the Order, the Directors received at each quarterly meeting the following documents on fair valuation matters:

• a brief report from the Valuation Committee that typically stated how often the committee had met and attested to the confirmation of fair values with third parties and the appropriateness of the valuations assigned;
• a “Fair Valuation Form” that listed the source or method of price determination as being an “[i]nternal matrix based on actual dealer prices and/or Treasury spread relationships provided by dealers”  without further definition.  There was no explanation of the “internal matrix” and no indication of what was meant by the terms “actual dealer prices” or “Treasury spread relationships provided by dealers”; and
• a security sales report.

Alleged Failures in the Directors’ Oversight

The Order alleges, both directly and indirectly, a number of deficiencies in the Funds’ fair value process.

The Order cites the Directors’ failure to “specify a fair valuation methodology pursuant to which the securities were to be fair valued” noting that the Funds’ Valuation Procedures listed various general and specific factors, which the Valuation Committee was to consider in making fair value determinations, but that

[o]ther than listing these factors, which were copied nearly verbatim from [Accounting Series Release No.] 118, the Valuation Procedures provided no meaningful methodology or other specific direction on how to make fair value determinations for specific portfolio assets or classes of assets.  For example, there was no guidance in the Valuation Procedures on how the listed factors should be interpreted, on whether some of the factors should be weighed more heavily or less heavily than others, or on what specific information qualified as ‘fundamental analytical data relating to the investments’ or ‘forces that influence the market in which these securities are bought and sold’ for particular types of securities held by the Funds.  Additionally, the Valuation Procedures did not specify what valuation methodology should be employed for each type of security or, in the absence of a specified methodology, how to evaluate whether a particular methodology was appropriate or inappropriate.  Also, the Valuation Procedures did not include any mechanism for identifying and reviewing fair-valued securities whose prices remained unchanged for weeks, months and even entire quarters.

The Order notes that the Valuation Procedures permitted the Adviser to override prices in certain instances, a feature of the process that allowed the Portfolio Manager to “arbitrarily set values without a reasonable basis and did so in a way that postponed the degree of decline in the NAVs of the Funds which should have occurred during the Relevant Period.”  The Order also notes that the Board had a responsibility consistent with Accounting Series Release No. 118 to “continuously review the appropriateness of” such valuation methods as it might specify.

The SEC asserts in the Order that throughout the Relevant Period the Directors “made no meaningful effort to learn how fair values were actually being determined” and “received at best only limited information on the factors considered in making fair value determinations and almost no information explaining why particular fair values were assigned to portfolio securities.”  For example, the SEC alleges that there was “no way” a Director could determine from quarterly board meeting materials the basis for a particular assigned fair value and that the materials relating to fair value determinations contained “boilerplate phraseology” and were “largely uninformative” and of limited utility.  In addition, meaningful explanations of fair value determinations were neither presented to the Directors (e.g., the quarterly Valuation Committee report provided no details on how fair valued securities were “randomly confirmed with third parties”) nor requested by the Directors, despite the fact that the Valuation Procedures required that the Directors receive such information on a quarterly basis.

Meaningful “explanatory notes for the fair values assigned to the securities” were not presented to the Directors, quarterly or otherwise, despite the fact that the Valuation Procedures required that the Directors receive them on a quarterly basis.  The Directors did not follow up to request explanatory notes or any other specific information regarding the basis for the values assigned them, such as how the internal matrix pricing referred to in the Fair Valuation Form, which the Directors are alleged not to have understood, operated.

The SEC alleges Board that although Fund Accounting relied heavily on price confirmations when making fair valuation decisions, the Board did not (a) establish guidelines regarding the use of price confirmations, such as how frequently they should be requested for any particular type of security, and how broker-dealers used to provide such price confirmations should be selected, or (b) require (i) identification of securities for which no price confirmation had been obtained for a particular length of time and (ii) identification and explanation of those instances where a price confirmation differed materially from the fair value assigned by Fund Accounting.  More fundamentally, the Order finds fault with reliance on price confirmations for the open-end Funds, saying that price confirmations “could not have sufficed as the primary valuation method, given the open-end [Funds’] obligation to timely price the securities” since price confirmations were typically obtained weeks after month-end.

Alleged Violations

As a result of the conduct described above, the Order alleges violations of the following rules under the 1940 Act:

• Rule 22c-1, which requires the price at which the open-end Funds sell or redeem shares to be based on net asset value;
• Rule 30a-3(a), which requires the Funds to maintain internal controls over financial reporting; and
• Rule 38a-1, which requires the Funds to maintain compliance programs reasonably designed to prevent violations of the federal securities laws (including “meaningful fair-valuation methodologies and related procedures”).

The Order also alleges that the Directors willfully caused a false or misleading statement with respect to a material fact to be made in a registration statement filed with the SEC under the 1940 Act.

Independent Directors’ Statement in Response

In addition to denying the SEC’s charges, a statement released on behalf of the Independent Directors in response to the Order noted, among other things, that they had received assurances on fair value prices and the fair valuation process from a major accounting firm and the Funds’ Chief Compliance Officer, and the Funds had received no adverse comment on fair valuation in a 2005 SEC staff exam.

On Wednesday, December 12, 2012, the United States District Court for the District of Columbia dismissed a lawsuit brought by the U.S. Chamber of Commerce (the “Chamber”) and Investment Company Institute (“ICI”) against the CFTC challenging amendments to CFTC Rules 4.5 and 4.27 adopted earlier this year (the “Amendments”).  The Amendments, which were described in the February 14, 2012 Financial Services Alert, impose (1) additional conditions on an exclusion from the definition of commodity pool operator (“CPO”) available with respect to registered investment companies (“RICs”) and (2) new reporting requirements for CPOs and commodity trading advisers.

In their complaint filed on April 17, 2012, the Chamber and the ICI alleged, among other things, that the Amendments did not meet the requirements of the Commodity Exchange Act (CEA) relating to cost-benefit analysis and were arbitrary and capricious under the Administrative Procedure Act (APA).  U.S. District Court Judge Beryl Howell, however, found that the CFTC had met the requirements of the CEA and the APA, noting that the CFTC “reasonably considered the costs and benefits of the final rule, and decided that the benefits outweigh the costs.”  Judge Howell determined that certain of the new compliance obligations that will flow from registration as CPO of a RIC will not be ripe for review until the CFTC adopts final rules “harmonizing” certain CFTC and SEC regulations that apply to RICs. 

December 31, 2012 is the compliance deadline for the amendments to the Rule 4.5 exclusion.  CPOs that are required to register will have to comply with related recordkeeping, reporting and disclosure requirements within 60 days following the adoption of final rules harmonizing certain CFTC and SEC requirements as they apply to RICs.  

Investment Company Institute v. CFTC, No. 12-cv-00612 (D.D.C. Dec. 12, 2012).

The FDIC, as the receiver of the failed IndyMac Bank F.S.B. (the “Bank”), won a jury verdict in the U.S. District Court for the Central District of California of $168.8 million against three former officers of the homebuilders division (the “Division”) of the Bank.  None of the officers were directors of the Bank.  The jury found that the three defendant officers of the Division – the President and chief executive, chief lending officer and chief credit officer of the Division – had been negligent and had breached their fiduciary duties with respect to the 23 construction loans that were the subject of the jury verdict.

In the case, FDIC v. Van Dellen et al., the FDIC alleged that the defendant officers failed to implement appropriate internal controls to manage the business of the Division, failed to require borrowers to provide adequate collateral for the loans, ignored other elements of the Division’s credit policy and departed from safe and sound banking practices.  Attorneys for the defendant officers argued that the losses suffered by the Bank in connection with the 23 loans at issue resulted from the unforeseen and unprecedented widespread collapse of housing values in 2007.

The case was the first case to be filed by the FDIC against directors and officers of a failed bank in connection with the recent U.S. financial crisis and is also the first such case to go to trial.

The defendant officers and their legal counsel have not yet stated whether they will file appeals with respect to findings made by the Judge prior to the jury rendering its verdict.  One potential issue is the Judge’s finding that the three defendant officers (who, as noted above, were not directors of the Bank) could not, under California law, rely on the business judgment rule as a defense.

Subsequently, in a separate matter, the FDIC settled its suit against Michael Perry, the former Chief Executive Officer of the Bank for $12 million (with $1 million to be paid from Mr. Perry’s personal funds and up to $11 million to be provided by the Bank’s professional liability insurers).  As reported, however, the insurers are not parties to the settlement agreement and, as part of the settlement, Mr. Perry assigned his rights under the insurance policies to the FDIC.

The Division of Swap Dealer and Intermediary Oversight (the “Division”) issued a no-action letter providing relief from the commodity pool operator (“CPO”) registration requirements for operators of mortgage real estate investment trusts (“mREITs”) that meet specified conditions.  Briefly, those conditions are as follows:

1. the mREIT limits the initial margin and premiums required to establish its commodity interest positions to no more than 5% of the fair market value of the mREIT’s total assets;
    
2. the mREIT limits the net income derived annually from its commodity interest positions that are not qualifying hedging transactions to less than 5% of the mREIT’s gross income;
   
   
3. interests in the mREIT are not marketed to the public as or in a commodity pool or otherwise as or in a vehicle for trading in the commodity futures, commodity options, or swaps markets; and
   
   
4. the mREIT has either (a) identified itself as a “mortgage REIT” in Item G of its last tax return on Form 1120‑REIT, or (b) if it has not yet filed its first tax return on Form 1120‑REIT, the mREIT has disclosed to its shareholders that it intends to so identify itself when it does.

To take advantage of the relief, the operator of an mREIT must electronically file a claim of relief providing certain identifying information with the CFTC.  For an mREIT operating as of December 1, 2012, the claim must be filed prior to December 31, 2012; an mREIT that commences operations after December 1, 2012 must file a claim of relief within 30 days after the date such operations commence.  In addition to describing the relief, the no-action letter notes that the Division remains “open to discussions with mREITs to consider the facts and circumstances of their mREIT structures with a view to determining whether or not they might not be properly considered a commodity pool.”

The CFTC’s Division of Market Oversight (the “Division”) provided no-action relief regarding compliance with certain CFTC reporting requirements as they pertain to counterparties located outside of the United States.  The requirements covered by the relief are included in the CFTC’s regulations on large trader reporting for physical commodity swaps (Part 20 of the CFTC’s regulations), swap data recordkeeping and swap data repository reporting requirements (Part 45), and swap data recordkeeping and swap data repository reporting requirements for historical swaps (Part 46).  Part 45 and Part 46 require that certain data fields must be included in swap data reporting, including the identification of each counterparty by a legal entity identifier (“LEI,” the current version of which is the CFTC Interim Compliant Identifier, or “CICI”), while Part 20 requires that the reporting entity disclose the identity of the counterparty in respect of which positional information is being reported in large swap trader reports and associated filings.

In response to a letter from the International Swaps and Derivatives Association stating that certain non-U.S. jurisdictions have privacy laws that may restrict or prohibit the disclosure of the required information about the non-reporting party or may require the consent of either the non-reporting party, its regulator, or both, the no-action relief states that the Division will not recommend that the CFTC commence an enforcement action against a reporting counterparty for failure to report the LEI and certain other identifying information of its counterparty if the reporting counterparty (i) has a reasonable belief, based in part on a written opinion of outside legal counsel, that the law or regulations of a non-US jurisdiction preclude the reporting of certain identifying information or could expose the reporting counterparty to criminal or civil liability for reporting such information (and, in the latter case, if it has determined that there is a material risk that such litigation may be initiated), (ii) has not yet obtained the necessary consent of the counterparty or authorization of a regulator for the disclosure of such information, and (iii) has made reasonable and demonstrable efforts to obtain such consent or authorization.  The relief expires upon the earliest of (1) the receipt of consent or authorization, (2) such time as the reporting counterparty no longer holds a reasonable belief that non-U.S. law precludes reporting the information, or (3) June 30, 2013.  The reporting party must follow certain requirements, such as retaining certain records, indicating in its reports that certain information has been withheld due to privacy laws, and, within 30 days of the expiration of the relief, updating its reports with the previously omitted information.  The letter specifies that the no-action relief “in no way” limits the CFTC’s authority to request and obtain the relevant information.

The CFTC’s Division of Swap Dealer and Intermediary Oversight (the “Division”) provided no-action relief from certain parts of Sections 3.3(e) and 3.3(f) of CFTC regulations requiring that the chief compliance officer (“CCO”) of a futures commission merchant (“FCM”) prepare and sign the FCM’s annual report, which must meet certain enumerated standards.  The relief comes in response to a request from the Futures Industry Association (the “FIA”), which argued, among other things, that many of the affected FCMs had not previously designated a CCO and that it would be difficult for a CCO to prepare a compliant annual report and make the required accompanying certifications prior to the compliance deadline.  The FIA also noted that FCMs would need to develop and test new controls and procedures to comply with new requirements and that operational concerns could complicate the preparation of the annual report.

The relief provides that the Division will not recommend that the CFTC take enforcement action against a “Covered Firm”—an FCM that was registered with the CFTC as of June 4, 2012, and is currently regulated by a U.S. prudential regulator or registered with the SEC—that fails to satisfy Sections 3.3(e) and 3.3(f) of the CFTC’s regulations if: (1) the Covered Firm’s annual report contains certain enumerated information; (2) the annual report covers the full fiscal year, although the CEO/CCO certification may be limited to the period from October 1, 2012 through fiscal year end; (3) the annual report is electronically furnished to the CFTC no later than 90 days after the Covered Firm’s fiscal year end; and (4) the Covered Firm satisfies the requirements of subparagraphs (f)(1) and (f)(4) of CFTC Regulation 3.3 (which require the CCO to provide the annual report to the Covered Firm’s board of directors or senior officer, and require the FCM to promptly furnish an amended annual report if material errors or omissions are identified).  The relief applies only to the first annual report required to be furnished by a Covered Firm to the CFTC for the fiscal year that ends on or before March 31, 2013.

The CFTC’s Division of Swap Dealer and Intermediary Oversight provided no-action relief pertaining to swap dealers and major swap participants from the prohibition against association with certain persons subject to statutory disqualification.  The Commodity Exchange Act, as amended by the Dodd-Frank Act, requires swap dealers and major swap participants not to permit any person associated with a swap dealer or major swap participant (an “Associated Person”) who is subject to a statutory disqualification (such as those who have violated certain laws) to effect or be involved in effecting swaps on behalf of the swap dealer or major swap participant.  The relief, which responds to a recommendation from the National Futures Association, provides that swap dealers and major swap participants need not comply with this prohibition with respect to persons who fall into either of the following categories: (1) non-domestic Associated Persons who deal only with non-domestic swap counterparties and (2) persons employed in a clerical or ministerial capacity.

The CFTC’s Division of Swap Dealer and Intermediary Oversight (the “Division”) issued a no-action letter providing relief from the requirement that certain applications to register with the CFTC be accompanied by fingerprint cards for certain non-U.S. principals.  Specifically, the relief applies with respect to those principals who have not resided in the United States since reaching 18 years of age (“Non-U.S. Principals”).  The relief letter notes that the National Futures Association (“NFA”), which receives the fingerprint cards, submits them only to the FBI.  The letter also acknowledges that the fingerprint requirement may violate the privacy laws of certain non-U.S. jurisdictions.

The relief provides that an applicant for registration may submit, for non-U.S. Principals, either (i) a fingerprint card or (ii) a certification, signed by a person with authority to bind the applicant, that a reasonable criminal history background check using a reputable commercial service was conducted and did not reveal matters that would result in disqualification (other than those disclosed); the certification must also state that the applicant will maintain records documenting the performance and results of the background check.  Registrants that wish to avail themselves of the relief must list each Non-U.S. Principal on its application, submit a Form 8-R for each along with the certification, and notify the NFA within 30 days after the filing of the Form 8-R that it has not submitted a fingerprint card.  The no-action letter notes that the Division will continue to explore alternatives to the fingerprint requirement in the context of Non-U.S. Principals, and may revisit the guidance set forth in the letter at a future date, but without prejudice to those who have already relied on the letter.

Goodwin Procter’s ERISA Litigation Practice published its latest quarterly ERISA Litigation Update.  The update discusses (1) a Third Circuit decision holding that a nonfiduciary who is not a “party in interest” may be liable for knowingly participating in a fiduciary’s violation of ERISA Section 406(b)(3)’s anti-kickback provisions, (2) a district court decision granting summary judgment in a suit challenging an insurer’s use of a retained asset account to settle group life insurance benefits, and (3) a district court decision denying a motion to dismiss ERISA claims in a case challenging the use by a financial services company of affiliated investment products as options for its 401(k) plans.