Financial Services Alert - March 25, 2014

On March 21, 2014, a panel of the United States Court of Appeals for the District of Columbia Circuit issued its decision in the highly anticipated case relating to debit card interchange and exclusivity, NACS v. Board of Governors of the Federal Reserve System (the “FRB”). The Court overturned the district court’s opinion almost in its entirety.

Facts

As part of the Dodd-Frank Act, Congress enacted the so-called “Durbin Amendment,” so named after its sponsor Senator Richard Durbin (D-IL) which amended the Electronic Fund Transfer Act (the “EFTA”) to restrict the amount of interchange fees and required network exclusivity for debit card transactions.  Section 920(a) directed the FRB to issue regulations to ensure that interchange fees were “reasonable and proportional” to the costs incurred by the issuers in the authorization, clearance and settlement (“ACS”) of debit card transactions. Section 920(a) also permitted the FRB to adjust the interchange fee to compensate for costs incurred by the issuer to prevent fraud. Section 920(b), which prohibited network exclusivity, directed the FRB to adopt regulations to prohibit issuers and networks from restricting the number of payment card networks on which electronic debit transactions may be processed to one network or multiple affiliated networks and issuers and networks from inhibiting the ability of merchants to direct the routing of the electronic debit transaction for processing over any payment card network that may process the transactions.

In issuing a proposed rule, the FRB met with debit card issuers, payment card networks, merchant acquirers, consumer groups and circulated surveys to financial organizations, network, and merchant acquirers. Under the FRB’s final rule, which became effective in October 2011, an issuer could receive up to $0.21 per transaction plus an ad valorem amount of five basis points of the transaction’s value (0.05%). The FRB reasoned that the Durbin Amendment allowed it to consider additional costs not explicitly excluded from consideration by the statute.

Almost immediately after the final rule became effective, several merchant groups, including the NACS, filed suit challenging the final rule as “arbitrary” and “an abuse of discretion” and sought a declaratory ruling. In particular, the merchants alleged the Durbin Amendment limited the FRB’s consideration of allowable costs to the incremental cost of ACS and that by including other costs in the fee standard, the FRB acted unreasonably. With regard to network exclusivity, the merchants alleged that the FRB disregarded the plain meaning of the Durbin Amendment and misconstrued the statute by requiring all debit cards be interoperable with at least two unaffiliated payment networks of any type (either pin or signature-based); rather than requiring that all debit card transactions be capable of being routed to two unaffiliated networks of each type. The merchants moved for summary judgment.

Lower Court Ruling        

In a sharply-worded opinion, Judge Richard Leon of the United States District Court for the District of Columbia, ruled that the FRB’s final rule did not deserve Chevron deference because it countermanded the Durbin Amendment. In particular, Judge Leon held that the FRB’s rule “completely misunderstood the Durbin Amendment’s statutory directive and interpreted the law in ways that were clearly foreclosed by Congress.” Ultimately, there were two rulings by the district court: (1) the FRB’s interchange fee limits in rule were invalid under the Administrative Procedure Act and failed the first prong of Chevron deference—the statute and legislative history were clear, and therefore, it was unreasonable for the FRB to interpret the statute more broadly—because the Durbin Amendment was unambiguous in “bifurcating” the universe of debit transaction fees—those incremental ACS costs that must be considered and other costs not specific to the transaction, which must be excluded; and (2) the FRB’s rule countermanded Congressional intent by allowing a choice among unaffiliated networks for each card instead of each method of authentication. The FRB appealed to the District of Columbia Circuit Court Appeals.

Appellate Court Decision

The three-judge panel of the District of Columbia Circuit Court of Appeals resoundingly rejected the lower court’s decision.  

Interchange fee. First, the Court concluded that the FRB “reasonably interpreted the Durbin Amendment” to allow issuers to recover certain costs that are incremental to the ACS costs. The Court reasoned that (1) the term “incremental costs” has several possible definitions, (2) Congress left “unmentioned” incremental costs other than incremental ACS costs, and (3) if Congress wanted to limit issuers to recovering only incremental ACS costs, it could have done so directly by, for example, specifically instructing the FRB to adopt regulations that did so. Finding that the FRB’s interpretation was reasonable, the Court then analyzed whether the FRB reasonably concluded that issuers could recover the four specific costs challenged by the merchants:  fixed ACS costs, network processing fees, fraud losses and transaction monitoring costs. The Court acknowledged that such a task was not “an exact science” and involved policy determinations in which the FRB had “expertise” as to which the FRB was entitled to “special deference.” The Court did remand one issue relating to recovery of fraud-monitoring costs back to the FRB, asking it to articulate a reasonable justification for determining that transaction monitoring costs fell outside of the costs associated with fraud prevention.

Network exclusivity. The Court also rejected the merchants’ argument that the Durbin Amendment “unambiguously” required that there be multiple unaffiliated network routing options for each debit card transaction. The Court noted that the FRB’s rule “seems to comply perfectly with Congress’s command,” and ruled that the FRB’s final rule does exactly what Congress contemplated—under the rule, issuers and networks are prohibited from restricting the number of payment card networks on which an electronic debit transaction may be processed to only affiliated networks.

The FRB released the summary results of the 2014 annual stress tests conducted by large financial institutions pursuant to the Dodd-Frank Act.  30 banking organizations participated in the 2014 stress tests.  The financial institutions participating in the 2014 stress tests hold in the aggregate approximately $13.5 trillion of assets, or nearly 80% of domestic bank holding company assets.

The capital adequacy of the participating banks are measured in an adverse and in a severely adverse scenario.  Under the severely adverse scenario, projected loan losses at the 30 bank holding companies participating in the 2014 stress tests would total $366 billion during the nine quarters of the scenario.  Under such scenario, the aggregate Tier 1 common capital ratio of the institutions would fall from an actual 11.5% in the third quarter of 2013 to the minimum level of 7.6%.  The severely adverse scenario models for a deep recession with a sharp rise in the unemployment rate, a drop in equity prices of nearly 50%, and a decline in house prices to levels last seen in 2001.  The FRB noted that the performance of the participating institutions in the 2014 stress test was significantly improved over performance in the initial stress tests conducted in 2009. 

Of the 30 participating institutions, all but one maintained Tier 1 capital in excess of the 5% threshold to be considered “adequately capitalized” under the severely adverse scenario.  Further, only one other institution failed to maintain Tier 1 capital in excess of the 6% threshold to be considered “well capitalized” under the severely adverse scenario.

The FRB noted that the quantitative results from both the adverse and the severely adverse scenarios in the supervisory stress tests are only one component in the FRB’s analysis during its Comprehensive Capital Analysis and Review (“CCAR”).  CCAR is an annual exercise in which the FRB evaluates the capital planning processes and capital adequacy at the largest financial institutions.  The FRB will announce the results of the CCAR on Wednesday, March 26, 2014 at 4 p.m. EDT.  The results of the CCAR affect the ability of the subject financial institutions to make capital distributions.

In a speech presented to the Association of Certified Anti-Money Laundering Specialists on March 17, 2014, Comptroller of the Currency Thomas J. Curry said that the OCC is seeing progress in terms of the priority that senior managers of large banks is giving to Bank Secrecy Act (“BSA”) – Anti-Money laundering (“AML”)/compliance.  The Comptroller noted that nonetheless, over the past five years there have been many significant BSA compliance failures by large banks, and those deficiencies have been the focus of a great deal of media attention. 

Historically, OCC enforcement actions for such BSA/AML compliance system deficiencies have been brought against the applicable bank rather than against its senior executives or board.  BSA/AML compliance failures have been attributed to “the collective decision making of a great many people over a long period of time.”  When significant civil money penalties are assessed against a bank or the management component of the bank’s CAMELS rating is lowered, those sanctions are absorbed by the bank’s shareholders or the bank itself rather than by accountable senior managers, said Comptroller Currency.  Comptroller Curry said, however, that when the OCC looks “at the issues underlying [a bank’s] BSA infraction, they can almost always be traced back to decisions and actions of the institution’s Board and senior management.”  The underlying BSA/AML compliance deficiencies, said Comptroller Curry, fall into four categories:

• The bank’s culture of compliance;
• The resources committed by the bank to BSA compliance;
• The strength of the bank’s information technology and monitoring processes; and
• The quality of the bank’s risk management processes.

These four areas, said the Comptroller, receive a great deal of attention from senior management, including the Chief Executive Officer, which is why when the OCC discovers lapses in a bank’s BSA compliance record, the bank’s CAMELS rating for the management component is adversely affected. To “walk the talk” on the importance of BSA compliance, a bank’s board and senior management need to have a record of:

“providing increased resources, increasing the authority and stature of the BSA Officer within the organization, and ensuring proper incentives are incorporated throughout the organization, including the business lines.”

Comptroller Curry posed the question of whether the OCC, as a bank’s supervisor, should “demand that institutions designate and hold senior managers responsible for BSA risk management just as they would for any other activity or line of business?” While it is usually easy to determine accountability and lines of responsibility at community banks, the Comptroller stated that “[a]t large, complex, globally active institutions, where we have heightened expectations, it is much less clear and those lines are often blurred.” Comptroller Curry stressed that when he called for direct accountability of senior managers, he was not calling for criminal prosecution of bank senior managers because the determination of whether a criminal prosecution is warranted is “solely the responsibility of law enforcement.”

Comptroller Curry concluded the portion of his remarks concerning bank senior manager accountability for BSA compliance deficiencies by stating:

“Where there has been a serious breakdown in BSA compliance as a result of a conscious decision not to commit the requisite resources and expertise necessary to maintain a program that meets the requirements of the law, someone has to be accountable.”

Goodwin Procter’s ERISA Litigation Practice published its latest quarterly ERISA Litigation Update.  The update discusses (1) the Eighth Circuit’s decision in Tussey v. ABB, the first ERISA excessive fee class action to proceed to a trial on substantially all of the pleaded claims; (2) Tiblier v. Dlabal, in which the Fifth Circuit ruled that a plan investment advisor could not be held liable under ERISA for plan losses as a result of an investment as to which the advisor did not act as a fiduciary; (3)  Fuller v. Suntrust Banks, in which the Eleventh Circuit affirmed the dismissal of claims challenging, under ERISA, the use of proprietary funds in a financial services company’s own retirement plan; and (4) Skin Pathology Associates v. Morgan Stanley, in which the U.S. District Court for the Southern District of New York dismissed a class action complaint brought by a company sponsoring a 401(k) plan, in which it was alleged, among other claims, that the plan’s broker was liable for committing a prohibited transaction.   The update also provides information on the upcoming Goodwin Procter CLE Webinar – “Supreme Court Hears Dudenhoeffer: Implications for Stock Drop and Other ERISA Fiduciary Litigation” and conferences at which ERISA Litigation Practice Partners will be presenting.

FINRA filed with the SEC proposed amendments to FINRA Rule 2210, related to communications with the public, and FINRA Rule 2214, which sets forth requirements for the use of investment analysis tools (the “Amendments”).  FINRA Rules 2210 and 2214 became effective on February 4, 2013 in connection with FINRA’s adoption of comprehensive rules for communications with the public (the “Communications Rules”).  For a description of the Communications Rules, please refer to the April 24, 2012 Financial Services Alert (discussing the SEC’s approval of the Communications Rules), the July 17, 2012 Financial Services Alert (discussing the effective date for the Communications Rules), and the January 15, 2013 Financial Services Alert (discussing FINRA guidance on the Communications Rules).

Amendments to FINRA Rule 2210

FINRA Rule 2210 generally establishes content, approval, filing and other requirements with respect to communications with the public by FINRA member broker-dealers.  The Amendments include proposals to amend FINRA Rule 2210 as follows:

Exclusion of Certain Research Reports from Filing Requirements. FINRA proposes to exclude from the filing requirements of FINRA Rule 2210 research reports concerning only securities listed on a national securities exchange, other than research reports which must be filed pursuant to Section 24(b) of the Investment Company Act of 1940 (the “1940 Act”).  In explaining the Amendment, FINRA stated its belief that the likelihood of harm to investors resulting from the distribution of research reports concerning only exchange-listed securities is significantly lessened due to additional investor protection standards that apply to research reports, including (i) the comprehensive disclosure, content and analyst independence requirements of NASD 2711 and SEC Regulation Analyst Certification, and (ii) the liquidity and price discovery mechanisms in place for securities that are listed on a national securities exchange, which  reduces the risk that a research report could manipulate a security’s trading price. 

FINRA noted that Section 24(b) of the 1940 Act requires a registrant, and the underwriter for such registrant, to file all advertisements, pamphlets, circulars, form letters and other sales literature (including research reports) addressed to or intended for distribution to prospective investors with the SEC within 10 days of distribution of such material, and that Rule 24b-3 under the 1940 Act deems such material to be filed with the SEC upon its filing with FINRA.  Because of this separate filing requirement, FINRA does not believe it appropriate to include investment company research reports within the proposed exclusion.

Clarification with Respect to Free Writing Prospectuses. FINRA proposed to amend FINRA Rule 2210 to clarify that free writing prospectuses that are exempt from filing with the SEC are not subject to the rule's filing or content standards.  FINRA explained that since the effective date of the Communications Rules there has been some confusion as to the applicability of the filing and content requirements of FINRA Rule 2210 to free writing prospectuses.  The Amendments clarify that (i) a free writing prospectus that is exempt from filing with the SEC pursuant to Securities Act Rule 433 is not subject to the filing requirements and content standards of FINRA Rule 2210, and (ii) that the filing and content requirements apply to free-writing prospectuses required to be filed with the SEC pursuant to Securities Act Rule 433(d)(1)(ii).

Amendments to FINRA Rule 2214

FINRA Rule 2214 generally establishes the requirements for FINRA member broker‑dealers when making use of investment analysis tools.  FINRA is proposing to correct a mistaken cross-reference in the Rule by replacing a reference to FINRA Rule 2210(c)(3)(D) with the correct reference to FINRA Rule 2210(c)(3)(C), which relates to the filing requirement for any template for written reports produced by, or retail communications concerning, an investment analysis tool. 

Public Comment

FINRA’s filing with the SEC proposes that comments on the Amendments be submitted no later than 21 days after the SEC publishes the proposal in the Federal Register.

The staff of the SEC’s Division of Investment Management granted no-action relief from Section 15(a) of the Investment Company Act of 1940, as amended (the “1940 Act”), that will permit a registered fund (the “Fund”) to enter into a subadvisory agreement without securing prior shareholder approval, on terms otherwise consistent with Rule 15a-4 under the 1940 Act even though the circumstances that created the need for the agreement are not among those for which the Rule provides relief.

Background.  The Global Natural Resources Team (the “GNR Team”) of the Fund’s investment adviser (the “Adviser”) currently manages the Fund.  The Adviser and certain members of the GNR Team entered into a separation agreement under which the GNR Team will separate from the Adviser (the “Separation”).  The GNR Team formed a new entity (the “Subadviser”) that is intended to serve as an investment subadviser to the Adviser with respect to the Fund following the Separation in order to secure the continuing services of the GNR team in managing the Fund.  The investment advisory agreement (the “Advisory Agreement”) between the Fund and the Adviser authorizes the Adviser to retain one or more subadvisers at its own cost to provide advisory services to the Fund.  The Adviser proposes to enter into a subadvisory agreement with the Subadviser (the “Subadvisory Agreement”) under which the Subadviser will be compensated and supervised by the Adviser.  The fees paid by the Fund to the Adviser under the Advisory Agreement will remain unchanged.  Because of the imminent consummation of the Separation and the benefits to the Fund of avoiding any interruption in the provision of portfolio management services by the GNR Team, the Adviser proposes to enter into the Subadvisory Agreement upon the consummation of the Separation (the “Closing Date”), which will occur prior to securing the shareholder approval required under Section 15(a) of the 1940 Act.  The Fund’s board has approved the Subadvisory Agreement, and a shareholder meeting for the purpose of approving the Subadvisory Agreement has been scheduled.

Unavailability of Rule 15a-4.  Rule 15a-4 permits a person to act as an adviser to a registered investment company under an interim advisory agreement that has not been approved by the fund’s shareholders for a period of 150 days following the date on which the previous contract terminated, subject to the Rule’s conditions.  This temporary exemption is available when the previous advisory contract was terminated by (a) the board of directors, (b) the vote of a majority of the fund’s outstanding voting securities, (c) a failure to renew the previous advisory contract, or (d) an assignment of the previous advisory contract, as defined in Section 2(a)(4) of the 1940 Act (each, a “Rule 15a-4 Event”).  The request for relief notes that the circumstances of the Separation do not fall within any of the Rule 15a-4 Event categories.

Staff Response.  In granting the request for relief, the Staff noted that the Sub-Advisory Agreement would comply with the conditions in Rule 15a-4(b)(2) under the 1940 Act and would not continue beyond 150 days if Fund shareholders did not approve the agreement as required under Section 15(a) of the 1940 Act.  The Staff also noted the representations in the request for relief that the Fund and the Adviser needed a reasonable period of time to perform sufficient due diligence regarding the Subadviser and to provide the Fund's board with sufficient information and opportunity to consider approval of the Subadvisory Agreement and that those circumstances prevented the Adviser and the Fund from having sufficient opportunity prior to the Closing Date to obtain shareholder approval of the Subadvisory Agreement.