Financial Services Alert - April 8, 2008 April 08, 2008
In This Issue

Federal District Court Rules Variable Insurance Contract Issuer May Restrict Contract Owner Market-Timing Activities

On March 31, 2008, the United States District Court for the Eastern District of Pennsylvania (the “Court”) ruled after trial that the insurance company issuer (the “Issuer”) of a $50 million variable life insurance contract (the “Contract”) was not required to permit the Contract owner (the “Market Timer”) to engage in market timing of the Contract’s mutual fund investment options.  The Market Timer has previously sued, on behalf of himself and certain affiliated entities, a number of variable insurance contract issuers, including Aetna, Allstate, Hartford, John Hancock, Phoenix Life, Prudential, and ReliaStar.  The Market Timer’s investment and litigation strategies have been profiled in The Wall Street Journal and elsewhere.

Background.  Under a variable insurance contract, the contract owner allocates account value of the contract among a variety of underlying mutual funds.  In part because of the tax advantaged status of variable insurance contracts, market timers – investors that make frequent purchases and sales of mutual funds to take advantage of short-term market changes and, in some instances, to exploit inefficiencies in fund pricing – have sometimes used variable life insurance and variable annuity contracts as the vehicle for their market-timing activities.  According the to SEC, market timing, although not illegal per se, can harm other fund shareholders because (a) it can dilute the value of their shares, if the market timer is exploiting pricing inefficiencies, (b) it can disrupt the management of the fund’s investment portfolio, and (c) it can cause the targeted fund to incur costs borne by other shareholders to accommodate the market timer’s frequent buying and selling of shares.  Most mutual funds have adopted procedures to restrict market timing.  Most issuers of variable insurance contracts have adopted similar procedures and have added language to the insurance contracts themselves expressly authorizing the issuer to restrict market timing.  Older variable insurance contracts – for example, many contracts issued before 2003 – are less likely, however, to include such language.

The Market Timer, who owns or controls a registered broker-dealer and a registered investment adviser, invests on behalf of himself, certain affiliated entities, and his clients.  Prior to 2003, the Market Timer purchased from different issuers a number of variable life insurance contracts with an aggregate coverage amount well in excess of $100 million.  The Market Timer typically sought assurances before purchase that he could continue his market timing activities.  Years later, when the contract issuers sought to restrict market timing, the Market Timer filed lawsuits against a number of them to enforce his alleged market-timing rights, with a considerable degree of success.

The Dispute.  In early 2004, the Issuer adopted new procedures restricting market timing in its variable insurance contracts.  The Issuer brought a declaratory judgment action against the Market Timer seeking declaratory relief that the new restrictions did not violate the Market Timer’s contractual rights.  The Market Timer counterclaimed for breach of contract and sought damages and injunctive relief.  The Market Timer contended that the Issuer knew that the Market Timer purchased the Contract in order to market time, that the new restrictions frustrated the contractual purpose, and that the Contract did not permit the Issuer to impose such restrictions.

The Court’s Decision.  After a ten-day trial on the merits that concluded in March 2008, the Court entered judgment in favor of the Issuer.  In a detailed 61-page decision, the Court held that the Contract did not grant the Market Timer the right to market time, and furthermore that the Market Timer was aware at the time of Contract formation in 1997 that the Issuer reserved the right to restrict the Market Timer’s ability to trade.  Accordingly, the Court granted the Issuer declaratory relief and rejected the Market Timer’s counterclaim.

Prudential v. Paul Prusky, et al., 2008 U.S. Dist. LEXIS 26330 (E.D. Pa. March 31, 2008).  Goodwin Procter LLP was trial counsel for the Issuer.

OTS Approves Rebuttal of Control for TPG Investment in Washington Mutual

By Order No. 2008-08 (“Order 2008-08”), the OTS approved the Rebuttal of Control which TPG-related entities (collectively, the “TPG Group”) filed with respect to the TPG Group’s investment in Washington Mutual, Inc. (“WaMu”).  The TPG Group acquired preferred stock of WaMu, as well as common stock and warrants in the company.  The preferred stock is mandatorily convertible into common stock upon certain events which are anticipated to occur within 3 months after the investment.  As a result of the acquisition, after the conversion the TPG Group will become the largest common shareholder of WaMu.

In support of its Rebuttal of Control request, the TPG Group represented that it would acquire the securities for investment purposes only (and not with a purpose of control) and would not acquire more than 25 percent of any class of voting securities of WaMu.  The TPG Group’s rebuttal of control agreement generally conforms to the standard OTS form.  However, in addition to one member of WaMu’s board, the TPG Group may appoint an observer to attend the WaMu board meetings, although the observer may neither speak nor vote at the meetings.  In approving the Rebuttal of Control, Order 2008-08 noted that the presence of the observer under these circumstances “does not contravene the purposes of a rebuttal of control.” 

Director of SEC’s Division of Investment Management Outlines Top Regulatory Initiatives

At the 2008 IA Compliance Best Practices Summit, Andrew Donohue, Director of the SEC’s Division of Investment Management, reviewed current top regulatory initiatives for the Division.  Mr. Donohue first noted that comments on the proposed amendments to Form ADV Part 2 are due by May 16, 2008.  (More detailed coverage of this release will appear in a future edition of the Alert).  Turning to the December 2007 Rand Report on the current state of the retail investment adviser and broker-dealer industries, Mr. Donohue indicated that the Division had already started reviewing the empirical data and analysis contained in the Rand report, and is preparing preliminary recommendations for Chairman Cox’s consideration.  (See the January 8, 2008 Alert for a more detailed discussion of the Rand Report).  Mr. Donohue then discussed recent developments relating to the application of the Advisers Act to broker-dealer activities following the decision by U.S. Court of Appeals for the D.C. Circuit to vacate rulemaking that created exceptions from regulation under the Investment Advisers Act of 1940, as amended, for certain brokerage programs.  (See the April 10, 2007 Alert for a detailed discussion of the decision.)  Mr. Donohue noted that the Division plans to make recommendations to the SEC on these matters in the next several months.  He added that future SEC examinations of dual registrant firms are likely to focus on how such firms are conducting principal trades, what compliance procedures are in place to ensure that those trades are in the client’s best interest, and how these firms advise clients about what type of account is appropriate for them. 

Mr. Donohue indicated that a current area of interest for the SEC is the rapid development of managed accounts, and specifically, the areas of suitability, client disclosures, best execution and compliance with Rule 3a-4 under the Investment Company Act of 1940, as amended, which provides a safe harbor from the definition of investment company on which managed accounts typically rely.  Mr. Donohue stated that he believes it is important for the Division to review the current conditions in Rule 3a-4 and to consider whether they continue to provide an appropriate level of individualized treatment.  Mr. Donohue advised that the Division expects to provide the SEC in the coming months with recommended guidance on soft dollars that is intended to assist mutual fund boards and compliance professionals in their oversight responsibilities.  He observed that the proposed revisions to Form ADV Part 2 would also require an adviser to discuss the conflicts of interest inherent in its soft dollar practices. 

Mr. Donohue described several SEC initiatives addressing registered advisers’ books and records obligations of investment advisers.  He indicated that the initiatives were designed to provide guidance as to what the records advisers must create, retain, and produce for examination staff, as well as how advisers may use third parties to create and store records.  Mr. Donohue also discussed the issue of investments in complex investment products, such as derivatives, noting that it is critical for investment advisory firms to have the resources in place to fully assess their risk, properly administer them and provide appropriate disclosure to clients.

OCIE Director Identifies Top 10 Compliance Issues

At the 2008 IA Compliance Best Practices Summit, Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), reviewed OCIE’s “Top 10” compliance issues.  (See  the February 5, 2008 Alert for coverage of a related speech by Ms. Richards on frequently asked questions about SEC examinations.)  Ms. Richards reiterated OCIE’s risk-based approach to selecting firms for examination, which seeks to identify those firms that have the greatest potential to pose harm to investors, based on firm size, type of investment activities, and any prior indications of weak compliance controls or supervision.  Ms. Richards emphasized that OCIE also examines a random sample of advisers that are not otherwise targeted for examination, and targets newly-registered advisers for limited-scope inspections.  Mr. Richards indicated that, in view of the increasing number of firms that are operating as both registered broker-dealers and investment advisers, the OCIE is working on a pilot aimed at creating a common examination module for such dual registrants.

Mr. Richards then reviewed the following top ten areas of exam focus for OCIE:

  • Controls Over Valuation.  OCIE examiners are focusing on what controls firms have in place to value structured products, illiquid securities or other difficult-to-price securities.  She noted that examiners will generally look at whether a firm understood the nature of the security before buying it, whether the firm had a plan on how to price the security, whether the firm has adequate processes and procedures for risk management, valuation, and accounting, and whether the firm has disclosed the risks of investments in illiquid securities to its clients.
  • Controls over Non-Public Information.  OCIE regards insider trading as a high priority for all types of entities – broker-dealers, advisers and funds.  Examiners will focus on whether a firm has identified the source and type of non-public information that it and its employees may be privy to, whether the firm has created and implemented adequate procedures to maintain the confidentiality of that information, and whether the firm is periodically testing those procedures.
  • Senior Investors.  The SEC has prioritized the protection of seniors.  Consequently, OCIE is interested in understanding the practices that firms are developing in specific areas related to senior investors, including marketing and advertising to seniors, account opening, product and account suitability, ongoing review of the relationship and suitability of products, discerning the changing needs of seniors, surveillance and compliance reviews, and training for firm employees.
  • Compliance and Supervision.  OCIE examiners will seek to understand an adviser’s compliance program and whether it is the product of a risk-assessment process conducted to identify the firm’s compliance risks and conflicts of interest.  OCIE is also very interested in seeing how compliance procedures are actually implemented and that an effective annual review was performed.
  • Portfolio Management.  OCIE examiners are interested in whether the securities recommendations and investments made for clients are consistent with an adviser’s disclosures and client investment objectives and restrictions.  OCIE is currently giving particular scrutiny to investments in structured products and other complex derivative instruments, as well as money market funds and compliance with Rule 2a-7 under the Investment Company Act of 1940, as amended.
  • Brokerage Arrangements and Best Execution.  OCIE examiners will look at whether an adviser seeks best execution, whether it uses soft dollars consistent with its disclosures, and whether the adviser periodically and systematically evaluates the costs and benefits of its brokerage arrangements.  Examiners are particularly looking for any inappropriate and/or undisclosed use of soft dollars for the benefit of the adviser, and the use of any affiliated or preferred broker-dealers for excessive commission payments, kickbacks to the adviser, or other undisclosed arrangements.
  • Allocations of Trades.  Examiners will be looking for any instances of cherry-picking and client favoritism in allocations.  Examiners will also review a firm’s testing of allocations.
  • Performance Advertising, Marketing and Fund Distribution Activities.  OCIE is interested in whether funds and advisers have effective policies and procedures to make sure that their marketing materials contain accurate information, and in whether conflicts of interest have been effectively disclosed.  Ms. Richards emphasized that this area is one where the OCIE continues to find deficiencies.
  • Safety of Clients’ and Funds’ Assets.  OCIE examiners will look for funds and advisers to have effective policies and procedures for safeguarding their clients’ assets and for instances where an adviser has made false representations regarding performance results or account holdings.  OCIE will review the firm’s custodian arrangements, including whether the adviser has “surprise audits,” and whether it has a process for regularly reconciling the securities balances shown on its books with those shown on custodians’ books.
  • Information Processing and Protection.  OCIE is interested in whether an adviser has effective policies and procedures for capturing, compiling, maintaining and reporting relevant and timely information in its books and records (including e‑mail and instant messages), and in reports to clients and regulators.  Examiners will be looking for controls that protect this information from hackers or other unauthorized persons, and for measures in a firm’s business continuity plan that will prevent an adviser’s books and records from being destroyed in a disaster.

OCC Issues Interpretive Letters Clarifying Treatment of Debt Cancellation Contracts

The OCC issued two interpretive letters (“Letter #1093” and “Letter #1095”), responding to questions from national banks seeking guidance regarding retail installment sales contracts (“RICs”) and debt cancellation contracts (“DCCs”) related to a consumer’s purchase of an automobile. 

In Letter #1093 national banks sought confirmation that they could use automobile dealerships as non-exclusive agents who could offer DCCs to consumers who were entering into RICs, which would be acquired by the national bank sponsoring the DCC.  Any such DCC would be contingent upon the national bank’s acquisition of the underlying RIC from the automobile dealership.  In dealing with this issue, the OCC first noted that it is well established (under 12 CFR § 37) that a national bank has the authority to provide DCCs to consumers.  The OCC also confirmed that a national bank could enter into DCCs for loans that the national bank originated as well as for loans that the national bank purchased.  The OCC stated that it treats the purchase of an RIC by a national bank from an automobile dealership as a permitted application of a national bank’s lending powers, and thus an extension of credit on which a national bank can put forward a DCC.

The OCC clarified that this conclusion is not changed because the offer of the DCC by the automobile dealership is conditioned upon the sale of the underlying RIC to the national bank that is sponsoring the DCC.  Finally, the OCC noted that the consumer protection standards and safety and soundness requirements of 12 CFR § 37 apply to DCC transactions.

Letter #1095 addresses how national banks can charge consumers for the DCCs.  The OCC points out that 12 CFR § 37.5 provides that a national bank is permitted to offer a consumer the option to pay for the DCC with either a single payment or with a bona fide option to pay in monthly or periodic payments.  Letter #1095 makes it explicitly clear that in order to comply with OCC regulations, any monthly or other periodic payment must be made over the full life of the loan or over the period from the sale of the DCC until the underlying loan is repaid.  Any series of payments over a shorter period would not be deemed to constitute “bona fide” monthly or other periodic payments.

Policy Statement on Financial Market Developments Issued by PWG

The President’s Working Group on Financial Markets (the “PWG”) undertook a thorough analysis of the recent turmoil in the financial markets triggered by the delinquencies in the subprime mortgages and issued a Policy Statement.  The Policy Statement identifies the underlying weaknesses which led to the sub-prime mortgage industry crisis, and to address those weaknesses, makes recommendations for regulators and industry participants, i.e., originators, underwriters, investors, asset managers, and credit rating agencies.

Causes of the Turmoil .  The PWG has identified the following factors contributing to the crisis:

  1. Dramatic weakening of the underwriting standards for sub-prime mortgages beginning in late 2004 and extending to early 2007 - participants failed to obtain sufficient information or conduct comprehensive risk assessments on instruments that were often very complex, and instead relied excessively on credit ratings;
  2. Faulty assumptions underlying rating methodologies and subsequent re-evaluations by credit rating agencies (“CRAs”) of credit products - this resulted in significant downgrading of sub-prime residential mortgage backed securities (“RMBS”), especially collateralized debt obligations (“CDOs”) that held RMBS and other asset backed securities (“CDOs of ABS”).  The number and severity of negative ratings actions eroded investor confidence causing seizure of many structured finance markets;
  3. Serious risk management weaknesses at some large U.S. and European financial institutions, especially with respect to concentration of risks, valuation of illiquid instruments, pricing of contingent liquidity facilities and management of liquidity risks – these weaknesses were particularly evident with respect to managing risks of holding CDOs of ABS, sponsoring or supporting off-balance sheet conduits that issued asset-backed commercial paper (“ABCP”) and syndicating leveraged loans;
  4. Regulatory policies, including inadequate capital and disclosure requirements, that failed to mitigate risk management weaknesses at financial institutions.

Recommendations .  The PWG makes recommendations in the Policy Statement that, broadly speaking, call for adoption of stronger standards with regard to securitized credit instruments by all market participants.  The highlights of the recommended measures are as follows: 

  1. Mortgage origination:  regulators should adopt stronger standards and conduct more rigorous oversight of entities involved in mortgage origination, including adoption by all states of the standards set forth by federal regulators for non-traditional and sub-prime mortgage lending (along with effective enforcement mechanisms for non-compliance with such standards), stronger licensing standards for mortgage brokers, stronger consumer protection rules and disclosure requirements, which may be effected through Truth in Lending Act (“TILA”) and Home Ownership and Equity Protection Act (“HOEPA”) regulations that are presently under review.  (Separately, Ben Bernanke, the Chairman of the Federal Reserve, previewed the proposed HOEPA regulations, as follows:  (a) the new stricter rules proposed under HOEPA would, inter alia, prohibit a lender from engaging in a pattern of making higher-priced loans that a borrower could not reasonably be expected to repay from income or assets other than the borrower’s house; (b) lending will no longer be permitted on “stated income” and lenders would have to verify the income or assets of the borrower, (c) higher-priced loans would require an escrow account for real estate taxes and hazard insurance, (d) prepayment penalties would be banned in situations where buyer was particularly vulnerable, e.g., where debt-income ratio exceeded 50% and, when permitted would be required to expire at least sixty days before a scheduled increase in loan payment; and (e) certain advertising practices, which have a tendency to deceive consumers, would be banned); 
  2. Market discipline:  overseers of institutional investors should require investors and their asset managers to obtain better information (including information about underlying asset pools) on an initial and on-going basis from underwriters and develop an independent view of the risk characteristics of securitized credit instruments, rather than relying solely on CRAs.  The PWG will engage private sector to create a committee to develop best practices regarding disclosure to investors of securitized credits;
  3. CRAs:  CRAs should disclose the qualitative reviews performed by them on originators of assets and require underwriters of ABS to represent the level and scope of due diligence performed on underlying assets, CRAs should adopt measures to  enhance the transparency and integrity in credit rating process;
  4. Risk management  practices:  financial institutions should review their risk management practices, and US banking regulators and the SEC should review their current guidance, to identify and remedy the weaknesses in risk management practices that the present turmoil has revealed.  The PWG will support formation of a private-sector group to reassess implementation of the Counterparty Risk Management Policy Group II’s existing guiding principles and recommendations regarding risk management, risk monitoring and transparency, and supervisors of financial institutions should closely monitor and ensure that their financial institutions remedy risk management weaknesses;
  5. Regulatory policies:  The PWG makes several recommendations for adopting regulatory policies that would, inter alia, provide incentives for financial institutions to hold capital and liquidity cushions, require them to make detailed disclosures of off-balance sheet commitments, improve the quality of disclosures about fair value estimates for complex and other illiquid instruments, and enhance guidance related to pipeline risk management for firms that use an originate-to-distribute model.  The Basel Committee on Banking Supervision and IOSCO should review the capital requirements for ABS CDOs and other re-securitizations and for off-balance sheet commitments, and FASB should be encouraged to evaluate the role of accounting standards in current market turmoil;
  6. OTC derivatives:  infrastructure for the OTC derivates market should be enhanced to, inter alia, improve the accuracy and timeliness of trade data submissions and the resolution of trade matching errors.  Moreover, supervisory agencies should encourage the amendment of standard credit derivative trade documentation to provide for cash settlement in accordance with the terms of a cash settlement protocol and to develop a longer term plan for an integrated operational infrastructure supporting OTC derivatives that is reliable and efficient, and captures all significant processing events over the entire life-cycle of trades.
The PWG plans to issue a follow-up statement in the fourth quarter of 2008 that will assess how far implementation of  the above‑described recommendations has progressed, and consider whether further steps are needed to address weaknesses in the financial markets.