Financial Services Alert - December 10, 2013

The Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Securities and Exchange Commission jointly adopted and the Commodity Futures Trading Commission separately adopted a final rule (the “Final Rule”) today implementing the restrictions contained in Section 619 of the Dodd-Frank Act, known as the “Volcker rule,” that generally prohibit banking entities from engaging in proprietary trading and from sponsoring and/or investing in certain types of private funds.

Goodwin Procter is preparing more extensive materials addressing the Final Rule that we plan to distribute to recipients of the Financial Services Alert in the near future.   However, some of the more significant aspects of the Final Rule include the following:

• The explanatory preamble to the Final Rule indicates that the Federal Reserve Board has exercised its authority under Section 13(c)(2) of the Bank Holding Company Act to extend by one year, until July 21, 2015, the period during which banking entities must conform their activities and investments to the requirements of the Volcker Rule. 
• The Final Rule permits trading in certain government obligations, including:
  • obligations of or issued or guaranteed by the United States;
  • an obligation, participation, or other instrument of, or issued or guaranteed by, an agency of the United States, the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation or a Farm Credit System institution chartered under and subject to the Farm Credit Act; and
  • obligations of states and their political subdivisions, including any municipal security;
• The Final Rule exempts market-making activities from the prohibition on proprietary trading, subject to certain requirements intended to ensure that exempt market making activity is customer facing and designed not to exceed the reasonably expected demands of clients.  The Final Rule does not require that market making activities be designed to generate revenues primarily from fees or other customer revenues.  However, it does require banking entities with significant trading activities to report data regarding patterns of revenue generation by market making trading desks.
• The Final Rule incorporates an exemption for risk mitigating hedging activities, subject to limitations intended to ensure that the exemption only permits hedging designed to reduce or otherwise significantly mitigate one or more specific, identifiable risks in connection with and related to the contracts or other holdings of the banking entity.
• With respect to covered funds, the Final Rule narrows the definition of covered fund from the one contained in the proposed implementing regulation in a manner that addresses many of the concerns raised during the comment process.  In particular, the Final Rule does not include all commodity pools within the definition of covered fund but instead covers pools for which (i) there is a registered commodity pool operator that has claimed an exemption under 17 C.F.R. § 4.7 for  a pool offered solely to qualified eligible persons, or (ii) there is a registered commodity pool operator and the pool has certain characteristics, including that substantially all participation units of the pool are owned by qualified eligible persons under 17 C.F.R. §§ 4.7(a)(2) and 4.7(a)(3).  The Final Rule also narrows the definition of covered fund as it applies to funds organized outside of the United States so that it focuses on funds sponsored by a U.S. banking entity or in which a U.S. banking entity is an investor.
• The Final Rule specifically excludes a number of entities from the definition of covered fund, including foreign public funds, wholly-owned subsidiaries, certain joint ventures, registered investment companies, business development companies, funds that may rely on an Investment Company Act exclusion or exemption other than Section 3(c)(1) or Section 3(c)(7), small business investment companies, certain issuers of asset backed securities, and qualifying asset-backed commercial paper conduits.  However, the Final Rule does not provide a separate exclusion for CLOs.
• A banking entity engaged extensively in certain permitted proprietary trading and covered fund activities must create and maintain a compliance program that, among other things, requires its CEO to attest annually that the banking entity has in place processes to establish, maintain, enforce, review, test and modify the required compliance program in a manner reasonably designed to achieve compliance with the Volcker rule.

The Final Rule applies to community and regional institutions, including those with less than $10 billion of total consolidated assets.  However, the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency released a document entitled “The Volcker Rule: Community Bank Applicability” in which they asserted that the vast majority of community banks have little or no involvement in prohibited proprietary trading or investment activities in covered funds and, accordingly, would not have any compliance obligations under the Final Rule if they do not engage in covered activities other than trading in certain government, agency, state or municipal obligations.  However, community banks that engage in additional activities covered by the Final Rule may need to adjust their policies and procedures accordingly.  For example, the guidance document notes that community banks engaged in other trading activities, such as risk mitigating hedging, may need to adopt an appropriate liquidity plan.  The Final Rule provides that the compliance program must be “appropriate for the types, size, scope and complexity of activities and business structure of the banking entity.”

On December 4, 2013, the Financial Crimes Enforcement Network (“FinCEN”) and the FRB jointly issued a final rule (the “Final Rule”) amending the definitions of “funds transfer” and “transmittal of funds” under the regulations implementing the Bank Secrecy Act, 31 CFR §§ 1010.100(w) and 1010.100(ddd), respectively, in order to prevent certain historically-covered transactions from falling outside the scope of the definitions as a result of changes to the Electronic Fund Transfer Act, first enacted in 1978 (the “EFTA”), and its implementing regulations.  The Final Rule adopts the amendments as proposed by FinCEN on December 6, 2012.

Under the regulations implementing the Bank Secrecy Act, banks and nonbank financial institutions are required to collect and retain information on funds transfers of and transmittals of funds of $3,000 or more (the “Recordkeeping Rule,” see 31 CFR § 1020.410(a) (recordkeeping requirements for banks) and 31 CFR 1010.410(e) (recordkeeping requirements for nonbank financial institutions)).  Additionally, the so-called “Travel Rule” requires banks and nonbank financial institutions to include certain information on funds transfers and transmittals of funds of $3,000 or more sent to other banks or nonbank financial institutions.  See 31 CFR § 1010.410(f).

Under the old definitions, transmittals of funds and funds transfers governed by the EFTA as well as any other funds transfers that are effected through an automated clearinghouse, an automated teller machine, or a point-of-sale system, were excluded from the definitions of “transmittal of funds” and “funds transfer.”  When the Recordkeeping and Travel Rules were adopted, the EFTA governed only electronic funds transfers, as defined in section 903(a)(7) of the EFTA, and the exclusions were intended to cover certain types of transactions and payment systems used mostly for domestic retail transactions and payments.

The Dodd-Frank Act added a new section 919 to the EFTA, creating a new system of consumer protections for remittance transfers sent by consumers in the United States to individuals and businesses in foreign countries.  According to FinCEN, that section defines “remittance transfers” “broadly,” so that most electronic transfers of funds sent by consumers in the United States to recipients in other countries, including international funds transfers sent by consumers through banks, and cash-based or account-based transmittals of funds sent by consumers through money transmitters (which have historically been covered by the definitions of transmittal of funds and funds transfer) will be subject to the new protections of the EFTA (and thus excluded from the definitions of “funds transfers” and “transmittal of funds” and the purview of the Recordkeeping and Travel Rules).  Accordingly, the Final Rule amends the definitions of transmittal of funds and funds transfer to exclude only “electronic fund transfers as defined in section 903(7) of the Electronic Fund Transfer Act,” rather than any funds transfer governed by the EFTA, so that any remittance transfer covered by section 919 of the EFTA, but not meeting the definition of electronic fund transfer set forth in section 903(a)(7) of the EFTA, would continue to be covered by the Travel and Recordkeeping Rules.

The Final Rule will be effective January 3, 2014.

The FRB issued a request for public comment (the “Request for Comment”) to Part II of the FRB’s Policy on Payment System Risk; Procedures for Measuring Daylight Overdrafts (the “PSR Policy”).  The changes to the PSR Policy largely involve changes to the posting rules for automated clearing house (“ACH”) and commercial check transactions.  The FRB said that the changes “are intended to align [the posting rules] with current operations and processing times and to strategically position the rules for future advancements in the speed of clearing and settlement.”

The changes to the PSR Policy, among other things would:

• move the posting of ACH debit transactions from 11:00 A.M. Eastern Time (“ET”) to 8:30 A.M. ET;
• provide a set of principles for establishing future posting rules for the Federal Reserve Banks’ same-day ACH service;
• move the posting time for receiving most credits for deposits of commercial checks and debits for presentments of commercial checks from 11:00 A.M. ET to 8:30 A.M. ET (and establish two other posting times at 1:30 P.M. ET and 5:30 P.M. ET); and
• adopt parallel amendments to the FRB’s Regulation J (Collection of Checks and Other Items by Federal Reserve Banks and Funds Transfers through Fedwire).

The SEC issued an Order (the “Order”) instituting administrative and cease-and-desist proceedings against Ambassador Capital Management, LLC (the “Adviser”) and the portfolio manager (the “Portfolio Manager”) for a prime money market mutual fund (the “Money Market Fund”) managed and sponsored by the Adviser.  In the Order, the SEC charges the Adviser and the Portfolio Manager with (1) making false statements to the Money Market Fund’s Board of Trustees regarding the level of risk in the Fund’s portfolio, including statements regarding maturity restrictions, exposure to European issuers, and diversification, and (2) causing the Money Market Fund to fail to comply with risk limiting conditions in Rule 2a-7 under the Investment Company Act of 1940.  The Order also alleges that the Adviser caused the Fund to fail to fully implement written stress testing procedures.  This article summarizes the SEC’s allegations in the Order, as to which there have been no findings.

The SEC press release announcing the Order stated that the proceeding originally stemmed from “ongoing analysis of money market fund data by the SEC’s Division of Investment Management, in this case a review of the gross yield of funds as a marker of risk.”  This analysis determined that as of October 2011, the Money Market Fund’s returns significantly exceeded those of the prime money market funds in its peer group.  This finding prompted an examination by the SEC’s Office of Compliance Inspections and Examinations, as a result of which the matter was referred to the Asset Management Unit of the SEC’s Enforcement Division.

Alleged Misrepresentations to the Money Market Fund’s Board.  The Order alleges that the Adviser and the Portfolio Manager misrepresented or withheld critical facts from the Money Market Fund’s Board in violation of the anti-fraud provisions of the Investment Advisers Act of 1940.  Specifically the Order alleges that:

• the Adviser frequently exceeded self-imposed holding period restrictions for securities held by the Money Market Fund;
• the Money Market Fund regularly purchased securities that had greater than minimal credit risk as determined under the Adviser’s own guidelines;
• throughout the Eurozone credit crisis in 2011, the Portfolio Manager represented that the Adviser was trying to stay away from Italian exposure and would unload even secondhand exposure to the Italian market, when in fact the Money Market Fund continued to purchase securities issued by Italian-affiliated entities; and
• the Money Market Fund’s portfolio was not sufficiently diversified and thus had not reduced risk exposure as portrayed to the Money Market Fund’s Board of Trustees.

Alleged Violations of Rule 2a-7.  The Order alleges that the Adviser also caused the Money Market Fund to deviate from the risk-limiting provisions of Rule 2a-7 and that the Adviser failed to conduct an appropriate stress test of the Money Market Fund’s portfolio.  Because the Money Market Fund failed to follow the risk-limiting provisions of Rule 2a-7, it should not have used the amortized cost method of valuing securities under which it priced its securities at $1 per share, and the Money Market Fund should not have held itself out to the public as a money market fund or in SEC filings.

Other Violations Alleged.  The Order alleges that the foregoing actions also resulted in violations of provisions of the Investment Company Act relating to (i) recordkeeping for money market funds and (ii) compliance procedures providing for oversight of compliance by a fund’s adviser.

A hearing will take place before an administrative law judge within 30-60 days from the date of the Order.

In the Matter of Ambassador Capital Management, LLC and Derek H. Oglesby, SEC Release No. IA‑3725 (Nov. 26, 2013).

The staff of the SEC’s Division of Corporation Finance posted additional Compliance and Disclosure Interpretations  (see Questions 260.14 through 260.27) to the SEC website that address the “bad actor” disqualification provisions of the Rule 506 private offering exemption under the Securities Act of 1933 (the “Guidance”).  In broad terms, the bad actor disqualification provisions of Rule 506, which fulfill a mandate under the Dodd-Frank Act, disqualify an offering of securities from the Rule 506 exemption if any of certain categories of persons involved in, or related to, the offering (“covered persons”) is subject to a “disqualifying event” that occurs on or after September 23, 2013, or the issuer fails to appropriately disclose to investors any disqualifying event that occurred prior to that date, subject in each case to a “reasonable care” exception.   Bad actor disqualification is discussed in greater detail in the July 23, 2013 Financial Services Alert. 

This article summarizes some of the principal areas addressed in the  Guidance.  Other topics covered in the Guidance include the compensated solicitor category of “covered persons,” appropriate steps following discovery of disqualifying events and additional covered persons during an ongoing Rule 506 offering, and the scope of disqualification triggered by SEC orders to cease and desist from violations of SEC rules promulgated under Section 10(b) of the Securities and Exchange Act of 1934.

Affiliated Issuer.  The Guidance clarifies that the “affiliated issuer” category of covered persons does not refer to every affiliate of the issuer that has issued securities.  Instead, the term is limited to any affiliate (as defined in Rule 501(b) to be any person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with the issuer) that is issuing securities in the same offering.   The Guidance notes that offerings subject to integration under Rule 502(a) of Regulation D are part of the same offering for this purpose and refers to Securities Act Forms C&DIs Questions 130.01 and 130.02) as examples of co-issuer or multiple issuer offerings.

No Disqualifying Events under Non-U.S. Authority.  Bad actor disqualification is not triggered by actions taken in jurisdictions other than the United States, such as convictions, court orders, or injunctions in a foreign court, or regulatory orders issued by foreign regulatory authorities.

Disclosure Regarding Multiple Placement Agents.  The obligation to provide disclosure about pre-September 23, 2013 bad acts by placements agents requires disclosure to each investor regarding all placement agents involved with the offering at the time of sale (and their related persons), not just with respect to the particular placement agent that solicited the investor.  No disclosure is required with respect to placement agents no longer involved with the offering.

No Waiver of Disclosure Obligation.  The Guidance states that Rule 506(e) does not provide a procedure for an issuer to seek a waiver with respect to the obligation to disclose pre-September 23, 2013 disqualifying events.

Covered Person Due Diligence.  An issuer may reasonably rely on “a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to, for example, contractual covenants, bylaw requirements, or an undertaking in a questionnaire or certification.”  For an offering that is continuous, delayed or long-lived, the Guidance provides that periodic updates are required and may be accomplished through “bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances.”

Covered Person Determinations -  Reasonable Care Exception.  The Guidance clarifies that, in addition to due diligence regarding the existence of disqualifying events, the reasonable care exception also applies to situations where an issuer was “unable to determine that a particular person was a covered person, or initially reasonably determined that the person was not a covered person but subsequently learned that determination was incorrect.”

The National Futures Association (the “NFA”) has issued guidance reminding market participants of CFTC regulations that require any person claiming an exemption or exclusion under CFTC Regulation 4.5, 4.13(a)(1), 4.13 (a)(2), 4.13 (a)(3), 4.13 (a)(5) or 4.13 (a)(8) from the requirement to register as a commodity pool operator (“CPO”) or commodity trading advisor (“CTA”) to annually affirm their notice of exemption or exclusion within 60 days of calendar year end, which is March 3, 2014 for the current affirmation cycle.  The guidance states that failure to affirm such exemption or exclusion by March 3, 2014 will result in the automatic withdrawal of such exemption or exclusion on that date, thereby subjecting the person to the regulations applicable to CPOs or CTAs and to possible CFTC enforcement action for non-compliance.

The guidance explains the procedures for affirming notices of exemptions or exclusions and contains a list of frequently asked questions and answers.  The guidance also explains how an NFA member can fulfill its NFA Bylaw 1101 obligation to confirm that another party has affirmed its exemption.

The Securities Industry and Financial Markets Association (“SIFMA”), International Swaps and Derivatives Association (“ISDA”), and Institute of International Bankers (“IIB”) filed a suit against the CFTC in the U.S. District Court for the District of Columbia, challenging the CFTC’s cross-border guidance (the “Guidance,” discussed in the July 23, 2013 Financial Services Alert) and certain related advisories.  The plaintiffs argue, among other things, that the Guidance is actually or should be a rule, and that the adoption of the Guidance unlawfully circumvented the requirements of the Administrative Procedure Act.  For example, the plaintiffs contend that the Guidance lacks the required cost/benefit analysis, fails to respond adequately to comments received on the proposed versions of the Guidance, and “radically changed” in certain respects from the proposed versions without giving the public the opportunity to comment on those changes.  The complaint also alleges that the adoption of the Guidance ignored the requirements of the Regulatory Flexibility Act, Paperwork Reduction Act, and Small Business Regulatory Enforcement Fairness Act.  In addition, the plaintiffs contend that the Guidance exceeds the scope of the CFTC’s authority under Section 2(i) of the Commodity Exchange Act.

The SEC has issued an order (the “Order”) approving an amendment (the “Amendment”) to FINRA Rule 5131 relating to New Issue Allocations and Distributions (the “Rule”).   (The text of the Amendment is available in Exhibit 5 of FINRA’s filing with the SEC seeking approval of the Amendment.)  The Amendment provides a limited exception to the “anti-spinning” provision of the Rule by allowing members to rely subject to certain conditions on written representations from a fund of funds account that does not look through to the underlying beneficial owners of a private fund invested in the fund of funds (the “Amendment”).  The Amendment was proposed by FINRA in a rule proposal (the “Original Proposal”) filed with the SEC on August 23, 2013 (File No. SR-FINRA-2013-0357).   For a summary of other provisions of the Rule, please refer to the November 30, 2010 Financial Services Alert.

The Anti-Spinning Provisions of Rule 5131.  The Rule was designed by FINRA to address historical abuses in the allocation and distribution of IPO shares, which the Rule refers to as “new issues.”  For purposes of the Rule, “new issues” are any initial public offering of an equity security as defined in Section 3(a)(11) of the Securities Exchange Act of 1934, made pursuant to a registration statement or offering circular.  Paragraph (b) of the Rule prohibits FINRA member firms participating in a distribution of IPO shares, and their associated persons, from allocating shares to any account in which an executive officer or director of a public company or a covered non-public company, or a person materially supported by such an officer or director, has a beneficial interest: (1) if the company is currently an investment banking services client of the member or the member has received compensation from the company for such services in the past year, (2) if the person responsible for making the allocation decision knows or has reason to know that the member intends to provide or be retained to provide investment banking services in the next three months, or (3) on the express or implied condition that the executive officer or director, on behalf of the company, will retain the member for the performance of future investment banking services.

The “anti-spinning” prohibitions in the Rule do not apply to allocations of IPO shares to certain classes of accounts or persons to whom IPO shares may also be sold notwithstanding the restrictions of FINRA Rule 5130, the New Issue Rule, including registered investment companies, certain common trust funds, insurance company general, separate or investment accounts that meet certain account size and other requirements, and certain retirement plans.  Additionally, the “anti-spinning” prohibitions in the Rule do not apply to allocations of IPO shares to any account in which the beneficial interests of executive officers and directors of the company and persons materially supported by such executive officers and directors in the aggregate do not exceed 25% of such account (the “de minimis exception”).

Supplementary Material 5131.02 to the Rule permits a FINRA member firm to rely on a written representation obtained within the prior 12 months from the beneficial owner(s) of an account, or a person authorized to represent the beneficial owner(s) of an account, as to whether any such beneficial owner is an executive officer or director or person materially supported by an executive officer or director and if so, the company on whose behalf such executive officer or director serves.  On the basis of this guidance, firms typically comply with the anti-spinning provision by issuing questionnaires to their customers to ascertain whether any person with a beneficial interest in a customer’s account falls in one of the categories of persons covered by Rule 5131 and as applicable, whether the ownership interest falls within the de minimis exception.

The Amendment.  Since the effective date of the “anti-spinning” provision in 2011, FINRA has received feedback from its member firms that obtaining the information necessary to ensure compliance with the Rule, and eligibility for the de minimis exception, has proved difficult.  In particular, FINRA member firms expressed that they (and their customers) have had difficulty obtaining, tracking and aggregating information from private funds regarding indirect beneficial owners, such as participants in a fund of funds, for use in determining an account’s eligibility for the de minimis exception and that these difficulties have resulted in compliance difficulties and restrictions, including in situations where the ability of an underwriter to confer any meaningful financial benefit to a particular investor by allocating IPO shares to the account is impracticable.

As a result, FINRA proposed, and the SEC has approved, an amendment to the Supplementary Material 5131.02 to permit FINRA member firms to rely upon a written representation obtained within the prior 12 months from a person authorized to represent a fund of funds account that does not look through to the beneficial owners of a fund invested in the fund of funds account,  except for beneficial owners that are control persons of the investment adviser to the  fund, provided that the fund:

1. is a “private fund” as defined in the Investment Advisers Act of 1940;
2. is managed by an investment adviser that does not have a control person in common with the investment adviser to the fund of funds;
3. has assets greater than $50 million; 
4. owns less than 25% of the account and has no single investor with a beneficial interest of 25% or more; and
5. was not formed for the specific purpose of investing in the account.

As approved by the SEC, the Amendment does not include an additional condition that was part of the Original Proposal under which the fund could not have a beneficial owner that also was a control person of the investment adviser to the fund of funds.  This condition was eliminated  in response to industry comments. 

Implementation Date; Comments.  The SEC approved the Amendment on an accelerated basis and directed FINRA to announce the effective date for the Amendment in a Regulatory Notice to be published no later than January 26, 2014, with the effective date to be no later than March 27, 2014.  Comments on the Amendment are due no later than December 26, 2013.