Financial Services Alert - June 17, 2014

The SEC, FRB, OCC and FDIC (collectively, the “Agencies”) recently issued FAQs regarding implementation of Section 13 of the Bank Holding Company Act (the “Volcker Rule”).  (The FAQs issued by each of the Agencies are substantially identical.  The version published by the SEC is available here.)  The Volcker Rule generally prohibits banking entities from engaging in proprietary trading and from sponsoring and/or acquiring or retaining an ownership interest in, a hedge fund or private equity fund.  On December 10, 2013, the Agencies and the Commodity Futures Trading Commission issued regulations implementing the Volcker Rule.  The FAQs address certain questions related to implementation of the Volcker Rule:

• The FAQs provide additional guidance on when banking entities subject to the requirement to report certain quantitative measurements must begin reporting data.
• The FAQs address the definition of trading desk and conclude that, in some circumstances, a trading desk may span more than one legal entity.  The FAQs also explain how the relevant entities should calculate and report quantitative metrics in this circumstance.
• With respect to the conformance period, the FAQs confirm that a banking entity is not required to deduct its permitted investment in covered funds from its Tier 1 capital until the end of the conformance period, which is currently July 21, 2015.
• With respect to loan securitization vehicles that are not covered funds, the FAQs state that servicing assets may be any type of asset but that any servicing asset that is a security must be a permitted type of security, including cash equivalents.  The FAQs explain that the Agencies interpret “cash equivalents” to mean high quality, highly liquid short term investments whose maturity corresponds to the securitization’s expected or potential need for funds and whose currency corresponds to either the underlying loans or asset-backed securities.
• The FAQs confirm that an entity that is formed and operated pursuant to a written plan to become a foreign public fund will not be treated as a covered fund during its seeding period in a manner consistent with the treatment of investment companies and business development companies for purposes of the Volcker Rule.
• The FAQs also provide additional guidance on the name sharing restrictions applicable to covered funds organized and offered by a banking entity as part of a trust, fiduciary, investment or commodity trading advisory business.

Separately, the OCC also recently issued interim examination procedures applicable to national banks, federal savings associations, and federal branches and agencies of foreign banks with respect to activities subject to the Volcker Rule. The interim procedures are focused on assessing the extent to which OCC supervised banking entities have identified their activities and investments that are subject to the Volcker Rule and have begun to conform these activities to the requirements of the Volcker Rule as well as progress toward creating required policies and procedures.

FRB Governor Daniel K. Tarullo made a provocative presentation concerning bank corporate governance and prudential regulation to corporate and financial law professors and other attendees at the Midyear Meeting of the Association of American Law Schools.

In his presentation, Governor Tarullo pointed out that the recent financial crisis provided support for the proposition that banks require both enhanced microprudential level (regulation at the individual bank level e.g., increased capital and liquidity requirements) and microprudential regulation (regulation designed to protect the U.S. economy as a whole and avoid a harmful contraction of credit in a significant geographic region or to an industry sector).  Because management of risk is central to the activities of banks, stated Governor Tarullo, we need to consider ways in which prudential regulation does and should influence bank risk-taking decision-making.  One example of a step already taken to influence risk management by banks is the Dodd-Frank Act’s requirement that bank holding companies with more than $10 billion in total assets establish a risk management committee comprised of independent directors.

Governor Tarullo next discussed three kinds of regulatory and supervisory measures that he believes can better align bank corporate governance with prudential regulation.

Changing Compensation Incentives for Senior Executives

Governor Tarullo observed that stock option and other equity-based compensation arrangements for senior managers do a good job of aligning the executives’ interests with those of diversified shareholders “who value the upside of risk-taking and whose limited liability makes them relatively less concerned with catastrophic downside possibilities.”  However, regulatory objectives are focused on avoiding the catastrophic downside risk and preservation of the bank.  Ways of realigning these incentives noted Governor Tarullo include: (1) having a bank’s return on debt as well as return on equity reflected in incentive compensation calculations, and (2) making a significant portion of incentive compensation deferred and subject to clawback and forfeiture.  In addition, stated Governor Tarullo, incentive realignment can be addressed by increasing capital market discipline through imposition of a requirement that a banking organization maintain specified minimum amounts of long-term debt that would be converted to equity upon the insolvency of the banking organization.  Governor Tarullo stated that requiring establishment of this class of convertible debt would indirectly influence a bank’s corporate governance because senior managers of the institution would need to understand, monitor and address the concerns of a new constituency, those of at-risk debt holders.

Requirements for Stress Testing and Capital Planning That Help to Regulate Risk-Taking Decisions

Governor Tarullo pointed out that it would be very difficult for bank supervisors to develop a rule that would require a bank to implement a risk appetite plan that matched regulatory objectives.  However, bank supervisory programs that require a bank to conduct stress tests and develop and implement a capital plan “serve as partial surrogates for such a rule.”  Stress tests allow bank regulators to evaluate at an early stage whether a bank’s risk-taking is consistent with the bank supervisor’s microprudential and macroprudential objectives.

Enhanced Board Oversight of Risk Management and Potential Change in Fiduciary Duties of Bank Directors

In discussing actions that have the effect of improving the risk assessment and risk management capacity of bank boards of directors, Governor Tarullo noted efforts to enhance management information systems that improve the quality of data and other information provided to bank boards.  He also noted the value brought to the board decision-making process by including independent board members and by having members with relevant expertise and experience.  Bank regulators, said Governor Tarullo, should expect that a banking organization board’s risk management decisions are made on an enterprise-wide basis and that the board is spending a sufficient amount of time on overseeing key risk management and control functions.

Furthermore, Governor Tarullo suggested that consideration be given to expanding the fiduciary duties of directors of banking organizations to more closely align these duties with meeting regulatory objectives.  While such changes in fiduciary duties would require amendments to state corporate laws and are beyond the powers of bank regulators, Governor Tarullo stated that such changes would be likely to make bank boards more responsive to interests beyond those of diversified shareholders i.e., to interests of regulators and society as a whole.  Governor Tarullo further noted that broadening of a bank director’s fiduciary duties would make “the courts . . . available as another route for managing the divergence between private and social interests in risk-taking,” by providing a mechanism to hold a bank director liable for an alleged breach of his or her broadened fiduciary duty.

The SEC settled administrative proceedings against Christopher B. Ruffle (the “Portfolio Manager”) over his role in causing The China Fund, Inc., a U.S. registered closed-end fund (the “Registered Fund”),  to engage in a securities transaction that benefited an affiliated hedge fund (the “Hedge Fund”).   At the time, the Portfolio Manager served as lead portfolio manager of both funds.   This article provides a brief description of the settlement order (the “Order”), whose findings the Portfolio Manager neither admitted nor denied.  The Order contains the same basic findings of fact as a 2012 settlement entered into by the affiliated registered investment advisers (the “Advisers”) that employed the Portfolio Manager and served as investment advisers to the Registered Fund and the Hedge Fund.  See the June 5, 2012 Financial Services Alert for a detailed description of the transaction the Order addresses.

In the Order, the SEC found  that the Portfolio Manager willfully aided, abetted, and caused violations by the Hedge Fund of Section 17(d) of the Investment Company Act of 1940 and Rule 17d-1 thereunder which prohibit an affiliated person of a registered investment company or any affiliated person of such affiliated person, from participating in any joint enterprise, other joint arrangement, or profit-sharing plan (a “joint  arrangement”) unless it obtains an order from the SEC permitting the joint arrangement.  As the basis for this determination, the SEC cited the fact that the Portfolio Manager knew that the transaction in question involved the specific benefit provided to the Hedge Fund “and knew (or was reckless in not knowing) that the transaction raised affiliation concerns.”

In addition to being subject to a cease and desist order, the Portfolio Manager is prohibited for 12 months from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter.  The Portfolio Manager also agreed to pay a $150,000 civil money penalty.

In the Matter of Christophe B. Ruffle, SEC Release No. ICA-31066 (June 2, 2104).