Financial Services Alert - December 3, 2013

The Financial Stability Board (the “FSB”), a group of representatives from central banks, finance ministries and financial supervisors from the Group of 20 leading economies, Hong Kong, the Netherlands, Singapore, Spain and Switzerland, issued final guidelines for financial institutions (“FIs”) entitled “Principles for An Effective Risk Appetite Framework” (the “Final Guidelines”) and proposed guidelines on promoting a strong risk culture within an FI.  The proposed guidelines (the “Proposed Guidelines”) are entitled “Guidance on Supervisory Interaction with Financial Institutions on Risk Culture.”

The Final Guidelines

In the Final Guidelines, the FSB discusses the key elements of: (1) an FI’s risk appetite framework (“RAF”); (2) an FI’s risk appetite statement; (3) an FI’s risk limits; and (4) the roles and responsibilities of an FI’s board of directors and senior management.  The Final Guidelines are focused on risk management issues for systemically important financial institutions (“SIFIs”), but the FSB states that they “are also relevant” for the supervision of other FIs and that, for non-SIFIs, supervisors may apply the Final Guidelines “proportionately so that the RAF is appropriate to the nature, scope and complexity of the activities of” the applicable FI.

After defining key risk management terms, the Final Guidelines discuss the development and establishment of an FI’s RAF, which, the FSB states, should be “an iterative and evolutionary process” that “requires buy-in across the organization.”  An effective RAF should be driven by both top-down board leadership and “bottom-up involvement of management at all levels.…”  The RAF should be adaptable to changing business and market conditions and “evaluate opportunities for appropriate risk taking and act as a defense against excessive risk-taking.…”

The Final Guidelines then discuss the key elements of an FI’s risk appetite statement, which, the FSB declares, should be easy to understand.  The FSB says that an FI’s risk appetite statement, among other things, “should be directly linked to the [FI’s] strategy, address the [FI’s] material risks under both normal and stressed market and macroeconomic conditions, and set clear boundaries and expectations by establishing quantitative limits and qualitative statements.”

In addition, the Final Guidelines state that an FI should establish specific and measurable risk limits that allocate the FI’s risk appetite statement among the FI’s business lines, legal entities, specific risk categories and asset or other areas of concentration.

Finally, the FSB provides a specific list of responsibilities with respect to an FI’s RAF for the FI’s: (1) board of directors; (2) chief executive officer; (3) chief risk officer; (4) chief financial officer; (5) business line leaders and legal entity-level management; and (6) internal auditors.

The Proposed Guidelines

The FSB issued the Proposed Guidelines to discuss the manner in which regulatory supervisors formally assess an FI’s risk culture, “particularly at SIFIs.”  The FSB states that to assess an FI’s risk culture, a supervisor must understand whether the FI’s risk culture “supports appropriate behavior within a strong risk governance framework.”  To better understand an FI’s risk culture, a supervisor, says the FSB, should increase its interactions with an FI’s board of directors, the intensity of those interactions and the level of seniority of those interactions.

In the first section of the Proposed Guidelines, the FSB describes the foundational elements of an FI’s sound risk culture and in particular, risk governance, risk appetite and compensation practices.  In the second section, the Proposed Guidelines describe what the FSB considers the key elements of an FI’s sound risk culture: (1) the tone from the top; (2) accountability; (3) an environment that promotes effective challenge; and (4) financial and non-financial incentives.

In the third and final section of the Proposed Guidelines, the FSB provides detailed guidance on how supervisors can assess each of the four risk culture indicators identified in the second section.  The FSB stresses that “assessing risk culture entails identifying the root cause of why there are supervisory findings—not just what the findings are.  It includes identifying practices, behaviors or attitudes that are not supportive of sound risk management and intervening early to address these culture observations and thereby potential excess build-up of risk.”  The Proposed Guidelines also emphasize the need for an FI to document thoroughly the elements of its risk culture.

Comments on the Proposed Guidelines are due to the FSB by January 31, 2014.

An SEC-registered adviser (the “Adviser”) was granted exemptive relief pursuant to Rule 206(4)-5 (the “Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”)  from the Rule’s two-year prohibition on receiving compensation with respect to the investments made by three Ohio state pension plans in one of the Adviser’s private funds.  The prohibition was triggered when a managing member of the Adviser (the “Contributor”) contributed to the federal Senate campaign of the Ohio State Treasurer (the “Official”) who by virtue of his office had the power with respect to each of the pension plans in question (the “Clients”) to appoint a member to the board that oversees the plan’s investments.  This article summarizes the Adviser’s amended and restated application for exemptive relief (the “Application”) on which the SEC granted the proposed relief.  (The Rule is described in the July 9, 2010 Goodwin Procter Alert; the Financial Services Alert discussed subsequent amendments to the Rule and an SEC staff Q&A.)

Adviser’s Political Contributions Policy

The Adviser implemented its political contributions policy (the “Policy”) in August 2009 shortly after the Rule was proposed and approximately a year before it was adopted.  The Policy required all employees, and any members of an employee’s immediate family living with, or financially dependent on, the employee, to pre-clear all contributions to state and local office incumbents and candidates, a requirement that is more restrictive than the Rule.   At adoption, the Adviser provided the Policy to each employee, and subsequently circulated the Policy in the Code of Ethics that each employee is required to review, and confirm compliance with, on an annual basis.  In 2011, the Adviser began requiring all new employees qualifying as “covered associates” of the Adviser under the Rule to complete a Political Contribution Questionnaire regarding all political contributions of any size at any level since March 14, 2011.  Following the Rule’s implementation, the Adviser conducted compliance training including a discussion of the Policy that reiterated the need to pre-clear contributions to state or local officials running for federal office.  As part of its compliance testing program, the Adviser conducted random reviews of campaign contribution databases looking for employee names.   One of these reviews discovered the contribution by the Contributor that triggered the Rule’s compensation ban (the “Contribution”).

The Contributor and the Contribution

The Contributor is one of the Adviser’s 11 managing members and has been a manager of one of the Adviser’s investment strategies for eight years.  He and his spouse each made a $2,500 contribution to the Official’s U.S. Senate campaign on May 22, 2011.  The Contributor, who had historically made permissible campaign contributions to candidates for federal office who share certain political views with the Official, was under the mistaken impression that contributions to federal candidates who held state or local office would not trigger the prohibition on compensation under the Rule and were not prohibited by the Policy.  The Adviser identified the Contribution as a violation of the Rule on November 2, 2011.

Steps Taken Following Discovery

The Adviser took the following steps after discovering the Contribution:

Return of Contribution.  Within 24 hours of the Adviser’s discovery of the Contribution, the Adviser and the Contributor secured the Official’s agreement to return the Contribution.

Notice to Client and Escrow of Advisory Fees.  The Adviser promptly notified each Client of the Contribution and the application of the Rule’s two-year prohibition on compensation with respect to the Client’s Fund investment.  The Adviser informed each Client that the fees charged to the Client’s capital account in the Fund since May 22, 2011, the date on which the Contribution was made, were being placed in escrow and that, absent exemptive relief, those fees would be refunded and no additional fees would be charged to the Client for the duration of the two-year period.  The Adviser established an escrow account for the Clients and deposited an amount equal to the sum of all fees paid to the Adviser and its affiliates, directly or indirectly, with respect to the Clients for the two-year period beginning May 22, 2011.

Limits on Contact Between Contributor and Clients.  The Adviser took steps to limit the Contributor’s contact with any representative of a Client for the duration of the two-year period beginning May 22, 2011, including informing the Contributor that he could have no contact with any representative of a Client other than making substantive presentations to the Client’s representatives and consultants about the investment strategy the Contributor manages.

Pre-Clearance of All Contributions Going Forward.  The Adviser revised the Policy to require pre-clearance of all campaign contributions.

Mandatory Considerations in Granting Relief

The Rule mandates that the SEC consider specified factors in determining whether to grant relief from the two-year prohibition on compensation (but does not limit the SEC’s ability to consider other factors).  Each factor specified in the Rule is listed below followed by the Adviser’s arguments addressing that factor:

Whether the exemption is necessary and appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Advisers Act;

The Adviser asserted that the Clients’ respective investment decisions regarding the Fund were free of any improper influence from the Contribution as evidenced by the fact that (i) the relationships with the Clients pre-dated the Contribution, and that only one Client invested subsequent to the Contribution, (ii) the Official may only appoint a single board member out of 11 in the case of two Clients and out of 9 in the case of the third, and at the time of the Contribution, had not made any board appointments.  The Adviser argued that in the absence of evidence that either the Contributor or the Adviser intended to, or actually did, interfere with any Client’s merit-based process for the selection or retention of advisory services, the interests of the Clients are best served by allowing the Adviser and its Clients to continue their relationship.

Whether the investment adviser, (A) before the contribution resulting in the prohibition was made, adopted and implemented policies and procedures reasonably designed to prevent violations of the Rule;

The Adviser noted that it had implemented the Policy, which exceeds the Rule’s requirements, shortly after the Rule was proposed and substantially before it was adopted.  The Adviser also pointed to the Policy’s compliance monitoring component.

(B) prior to or at the time the contribution which resulted in such prohibition was made, had no actual knowledge of the contribution; and

The Adviser acknowledged that “actual knowledge of the Contribution at the time of its making could be imputed to the Adviser, given that the Contributor was a Managing Member and the Executive Managing Member was aware of the Contributor’s interest in the Official, although not specifically of the fact of the Contribution.”  The Adviser noted, however, that (1) no employee of the Adviser other than the Contributor knew of the Contribution prior to its discovery by the Adviser in November 2011 and (2) the Contributor believed he was acting in compliance with the Policy and simply misunderstood its application to state officials running for federal office.   The Adviser also noted that the Rule had only been in force for nine weeks at the time of the Contribution.

(C) after learning of the contribution, (1) has taken all available steps to cause the contributor involved in making the contribution which resulted in such prohibition to obtain a return of the contribution, and (2) taken such other remedial or preventive measures as may be appropriate under the circumstances

The Adviser cited the actions listed above under “Steps Taken Following Discovery.”

Whether, at the time of the contribution, the contributor was a covered associate or otherwise an employee of the investment adviser, or was seeking such employment;

The Adviser (i) identified the Contributor as a “covered associate” of the Adviser, (ii) cited the various measures taken to limit contact between the Contributor and the Clients after discovery of the Contribution, and (iii) represented that the Contributor has had (a) no contact with any representative of a Client outside of the permitted  presentations on the investment strategy the Contributor manages, and (b) no contact with any member of a Client’s board.

The timing and amount of the contribution which resulted in the prohibition; and

The Adviser reiterated that its relationships with the Clients pre-date the Contribution, that only one Client invested subsequent to the Contribution, and that amount of the Contribution was consistent with the giving history of the Contributor and his wife.

The nature of the election (e.g., Federal, State or local); and the contributor’s apparent intent or motive in making the contribution that resulted in the prohibition, as evidenced by the facts and circumstances surrounding such contribution.

The Adviser argued that the nature of the election and other facts and circumstances indicate that the Contributor’s apparent intent in making the Contribution was not to influence the selection or retention of the Adviser.  The Adviser pointed to the Contributor’s long history of making permissible contributions to federal candidates that share the political views of the Official and asserted that the amount of the Contribution, profile of the candidate, and characteristics of the campaign fell squarely within the pattern of the Contributor’s other substantial political donations (as discussed elsewhere in the Application in greater detail).  The Adviser noted that while the Contributor could not vote in the Ohio Senate election, the Contributor had a legitimate interest in the outcome of the campaign given that his wife grew up in Ohio where she owns a house and has extended family.

The Adviser characterized the Contributor’s violation of the Policy and the Rule as resulting from a mistaken belief that all contributions to federal campaigns were permissible and exempt from pre‑clearance under the Policy.   As evidence of the lack of any improper motive, the Adviser cited the fact that the Contributor never spoke with the Official or anyone else about the authority of the Official over the Client’s investment decisions, and never mentioned the Clients, their relationship to the Adviser, or any other existing or prospective investors to the Official.  The Adviser also cited the limited contact between the Contributor and Official, the fact that the Contributor had few discussions with others about his meeting with the Official, and the fact that the Contributor never told any prospective or existing investor (including the Clients) or any relationship manager at the Adviser about the Contribution.

Timing

The Contribution was made on May 22, 2011 triggering the two-year compensation ban.  The initial application was filed on October 16, 2012.  The amended and restated application was filed on July 5, 2013.  The SEC issued the notice of the application for the order on October 17, 2013.  The SEC issued the final order granting relief on November 13, 2013.

In the Matter of Davidson Kempner Capital Management, SEC Rel. No. IA-3715 (Nov. 13, 2013).

In conjunction with the release of a preliminary report describing an initiative by the Registration, Inspections, Compliance and Examinations Section of the Massachusetts Securities Division of the Office of the Secretary of the Commonwealth (the “Division”) to examine advisers that registered with the Commonwealth as a result of the Dodd-Frank Act (“Switch Advisers”), the Division issued a policy statement (the “Policy Statement”) addressing compliance with the two elements of the Division’s custody requirements applicable to investment advisers registered with the Commonwealth: (1) custody resulting from trustee and other similar relationships with clients; and (2) the deduction of advisory fees from client accounts.  Although it identifies fifteen different categories of deficiencies found in the Switch Adviser examinations, the preliminary report highlights custody rule compliance as an area of particular concern.

Custody.  The Policy Statement provides that, while custody under 950 MASS. CODE REGS. 12.205(5)(b)(1) is defined by reference to the SEC custody rule under the Investment Advisers Act of 1940, the Division does not recognize  the exception from the definition of custody available to an SEC-registered adviser “[w]hen a supervised person of the adviser serves as the executor, conservator or trustee for an estate, conservatorship or personal trust solely because the supervised person has been appointed in these capacities as a result of family or personal relationship with the decedent, beneficiary or grantor (and not as a result of employment with the adviser).”  The Policy Statement provides that investment advisers with custody “by virtue of trustee relationships (or other similar sorts of relationships) raise significant regulatory concerns” and that “[t]hese regulatory concerns exist whether the supervised person functions as a sole or co-trustee.”

Fee Deduction.  The Policy Statement reminds  Massachusetts-registered advisers that (a) the Division’s waiver of the requirement for independent verification of custodial assets when custody exists solely because of an adviser’s withdrawal of advisory fees directly from clients’ accounts is conditioned on the adviser: (i) having written authorization from the client to deduct advisory fees from the account held with the qualified custodian; and (ii) sending the qualified custodian and client an invoice or statement of the amount of the fee to be deducted from the client’s account each time a fee is directly deducted.  Records demonstrating compliance with these procedures must be maintained and preserved for a period of not less than five years, the first two years in an appropriate office of the investment adviser.