Weekly RoundUp
June 24, 2015

Financial Services Weekly News

Federal Agency Guidance on Application of Volcker Rule to Foreign Public Funds and Joint Ventures. The staffs of the Federal Reserve Board, the Office of the Comptroller of the Currency, the FDIC, the SEC and the CFTC (the Agencies) have issued updated FAQs addressing the manner in which the Volcker rule applies to foreign public funds and to joint ventures. First, with respect to foreign public funds, the new guidance clarifies that a foreign public fund that meets certain requirements will not be treated as a banking entity for purposes of the Volcker rule. By way of background, the Volcker rule generally prohibits banking entities as defined in the rule from engaging in proprietary trading and from sponsoring and investing in certain types of investment funds, called covered funds. A banking entity may sponsor and invest in a fund that does not fall within the definition of covered fund or that is excluded from the definition of covered fund, but if the banking entity’s relationship with the fund results in the banking entity having control over the fund for purposes of the Volcker rule, then the fund will itself become a banking entity subject to the Volcker rule’s prohibitions on proprietary trading and relationships with covered funds. This aspect of the Volcker rule is potentially problematic for investment funds outside of the United States that are similar to U.S. mutual funds, since they may engage in proprietary trading that would be prohibited from the Volcker rule if they are treated as banking entities. Among other circumstances, a banking entity would be regarded as having control over a fund if the banking entity owns 25% or more of a class of voting securities of the fund, has the ability to select a majority of the fund’s directors, or controls the fund through a contract or through a controlled corporate director. The new guidance states that the staffs of the Agencies would not advise that the activities and investments of a foreign public fund sponsored by a banking entity be attributed to the banking entity as long as the foreign public fund meets certain requirements described in the FAQ and the banking entity does not own, control or hold with power to vote 25% or more of the voting shares of the foreign public fund (following the end of a one-year seeding period). The guidance goes on to state that the staffs of the Agencies would not advise that such a foreign public fund be treated as a banking entity. This guidance should make it easier for a banking entity that sponsors a foreign public fund to conclude that the fund will not be subject to the Volcker rule even if the banking entity may be deemed to control the fund for purposes of the Bank Holding Company Act as a result of the fund’s governance structure. Second, with respect to joint ventures, the Agencies have clarified the circumstances in which an entity may qualify for the joint venture exception from the definition of covered fund. The Final Rule excludes from the definition of covered fund certain joint ventures between a banking entity or any of its affiliates and one or more unaffiliated persons. To qualify for the exclusion, the joint venture (i) must be composed of not more than 10 unaffiliated co-venturers, (ii) must be in the business of engaging in activities that are permissible for the banking entity or affiliate other than investing in securities for resale or other disposition, and (iii) must not hold itself out as an entity or arrangement that raises money from investors primarily for the purpose of investing in securities for resale or other distribution or otherwise trading in securities. The new guidance states that an issuer will not qualify for the exclusion if the issuer raises money from investors primarily for the purpose of investing in securities, whether the securities are intended to be traded frequently, held for a longer duration, held to maturity, or held until the dissolution of the entity, nor will an entity qualify for the exclusion if it raises money from investors primarily for the purpose of investing in securities for resale or other disposition or otherwise trading in securities even if the entity has other purposes.

Regulatory Developments

Client Alert: SEC Proposes Pay for Performance Rules

Goodwin Procter’s Capital Markets practice has issued a Client Alert on the SEC’s proposed rule that would require most public companies to provide proxy statement disclosure regarding the relationship between their executive compensation and total shareholder return for the last five completed years. Overall, the disclosure that would be required by the proposed rules is unlikely to substantively improve the quality of information available to investors in assessing the relationship between executive compensation and company performance and, in some cases, may obscure this relationship. However, because the Dodd-Frank Act requires the SEC to adopt these rules, public companies will need to understand how the final rules will impact their overall disclosure once they are adopted. Although the timing is uncertain, the SEC could adopt final rules prior to the 2016 proxy season.

Banking Agencies Approve New Flood Insurance Rules

On June 22 the federal banking agencies announced that they had approved a joint final rule modifying regulations that apply to loans secured by properties located in special flood hazard areas. The rule implements provisions of the Homeowner Flood Insurance Affordability Act of 2014 concerning escrowing of flood insurance payments. The rule also implements provisions in the Biggert-Waters Flood Insurance Reform Act of 2012 regarding force-placed flood insurance. The rule requires regulated lending institutions to escrow flood insurance premiums and fees for loans secured by residential improved real estate or mobile homes that are made on or after January 1, 2016. The rule contains exemptions for: (1) loans that are in a subordinate position to a senior lien secured by the same property for which flood insurance is being provided; (2) loans secured by residential improved real estate or a mobile home that is part of a condominium, cooperative, or other project development, provided certain conditions are met; (3) loans that are extensions of credit primarily for a business, commercial, or agricultural purpose; (4) home equity lines of credit; (5) nonperforming loans; and (6) loans with terms not longer than 12 months. The rule also includes an exemption for a structure that is a part of a residential property if that structure is detached from the primary residence and does not also serve as a residence. The rule has a small institution exemption for certain regulated lending institutions if they have total assets of less than $1 billion. The rule provides new and revised sample notice forms and clauses. Finally, the rule provides that regulated lending institutions have the authority to charge a borrower for the cost of force-placed flood insurance coverage beginning on the date on which the borrower's coverage lapses or becomes insufficient and stipulates the circumstances under which a lender must terminate force-placed flood insurance coverage and refund payments to a borrower.

OCIE Announces Retirement-Targeted Industry Reviews and Examinations Initiative

The SEC’s Office of Compliance Inspections and Examinations (OCIE) announced in a National Exam Program Alert dated June 22 that NEP staff intends to focus on certain registered investment advisers and broker-dealers that provide services or sell investment products to retail investors. Examination focus areas will include whether the adviser or broker has a reasonable basis for its recommendations, conflicts of interest, supervision and compliance controls, marketing and disclosure.

FINRA Issues Report on Cybersecurity Practices in Response to Concerns About Distributed Denial of Services Attacks on Member Firms

In an Information Notice dated June 19, FINRA noted that within the past two weeks, several member firms had informed FINRA that they have been subject to distributed denial of services (DDoS) attacks originated by a cyber-criminal group known as DD4BC. According to FINRA, a successful DDoS attack renders a website or network unavailable for its intended users by overwhelming the site with incoming messages. It appears that DD4BC has been targeting financial services and broker-dealer firms that have an online presence. In these incidents, DD4BC first sends the firm an email announcing that the firm will be a target for a DDoS attack, but that the firm can avoid the attack by paying a ransom in Bitcoin. DD4BC conducts a short “demonstration” attack, typically lasting about one hour, with the threat of further attacks if the ransom is not paid. DD4BC requests payment within 24 hours to prevent further attacks. The Information Notice provides advice about responding to such communications or attacks, and refers to the Report on Cybersecurity Practices, issued on February 3, 2015, in which it highlights effective practices for cybersecurity programs.

Enforcement and Litigation

SEC Announces Settlement of Enforcement Action Against Firm Offering Security-Based Swaps Online

On June 17, the SEC announced that it had entered an order instituting proceedings and imposing a cease-and-desist order in settlement of an enforcement action against Sand Hill Exchange (Sand Hill) and two individuals for offering security-based swaps to retail investors without filing a registration statement for the offering or registering Sand Hill as a national securities exchange. Sand Hill began as an online business involving the valuation of private startup companies along the lines of a fantasy sports league. According to the SEC, Sand Hill changed its business model, inviting web users to use real money (dollars or Bitcoin) to buy and sell contracts referencing pre-IPO companies and their value. The SEC found that these contracts were securities-based swaps. In addition to the cease-and-desist order, the respondents agreed to pay a $20,000 penalty. The SEC announcement includes a link to an investor alert entitled Beware of Fantasy Stock Trading Websites that contains useful information not only for investors but for companies considering offering similar online products. Goodwin Procter represented Sand Hill and the individual respondents in the SEC enforcement action. In the Matter of Sand Hill Exchange et al., File No. 3-16598 (6/17/15).

SEC Sanctions Adviser and Fund Board for Section 15(c) Violations

On June 17 the SEC announced a consent order (“Order”) instituting administrative and cease-and-desist proceedings against an investment adviser and affiliated administrator, as well as the independent and interested members of the board of an investment company managed by the investment adviser. The Order relates both to that investment company (Fund One) and a second investment company (Fund Two) overseen by a different board. Only the members of the board of Fund One were involved in the Order. The SEC (1) sanctioned the investment adviser for violations of Section 15(c) of the Investment Company Act of 1940 for providing incomplete information to Fund One’s board in connection with the board’s initial approval of advisory agreements for a new fund and for providing incomplete and inaccurate information to Fund Two’s board in connection with the annual approval of the continuation of advisory agreements for existing funds, (2) sanctioned the members of Fund One’s board (including both its independent and interested members) for violations of Section 15(c) for failing to follow up on the incomplete information before approving Fund One’s advisory agreements and (3) sanctioned the Administrator for omitting from Fund Two’s shareholder report a discussion of the board’s 15(c) process, as required by Item 27(d)(i) of Form N-1A. In addition to the cease-and-desist orders, the SEC required the board members each to pay a civil penalty of $3,250 and the adviser, the administrator and their owner jointly and severally to pay a civil penalty of $50,000. In the Matter of Commonwealth Capital Management, LLC, et al., File No. 3-16599 (6/17/15).

FINRA Fines Two Firms for Failing to Supervise the Transmittal of Funds to Third-Party Accounts

On June 22, FINRA announced that it had entered into a Letter of Acceptance, Waiver and Consent (AWC) with Morgan Stanley Smith Barney, LLC (Morgan Stanley), imposing a fine of $650,000 and an AWC with Scottrade, Inc., imposing a fine of $300,000. FINRA found that the firms had failed to implement reasonable supervisory systems to monitor the transmittal of customer funds to third-party accounts. Both firms had previously been cited for weak supervisory systems by FINRA examination teams but, according to FINRA, neither took the necessary steps to correct the supervisory gaps. In the case of Morgan Stanley, FINRA found that from October 2008 to June 2013, three registered representatives in two different branch offices converted a total of $494,400 from 13 customers by creating fraudulent wire transfer orders and branch checks from the customer's accounts to third-party accounts.

SEC Charges 36 Underwriting Firms for Fraudulent Municipal Bond Offerings

On June 18, the SEC issued a press release announcing  enforcement actions against 36 municipal underwriting firms which from 2010 through 2014 violated federal securities laws by selling municipal bonds using offering documents that contained materially false statements or omissions about the bond issuers’ compliance with continuing disclosure obligations. The firms also allegedly failed to conduct adequate due diligence to identify the misstatements and omissions before offering and selling the bonds to their customers. The cases are the first brought against underwriters under the Municipalities Continuing Disclosure Cooperation Initiative, a voluntary self-reporting program targeting material misstatements and omissions in municipal bond offering documents. The SEC entered separate orders for each firm, linked in the press release. The firms agreed to cease and desist from violations of the applicable federal securities laws in the future and to pay civil penalties that aggregated to approximately $9 million. Each firm also agreed to retain an independent consultant to review its policies and procedures on due diligence for municipal securities underwriting.