Financial Services Alert - September 2, 2008 September 02, 2008
In This Issue

Goodwin Procter Sponsors Seminar on Private Equity Investing in Banks

With the capital markets in a state of transition and banks, in particular, looking for new sources of capital, our latest event couldn't come at a more opportune time. To be held in New York on Oct. 2 at the Parker Meridien Hotel, Private Equity Investing in Banks: Opportunities in a Perfect Storm will examine the latest trends in this sector of the M&A market as regulators consider ways to alleviate the burden of private equity investing in banks. Several private equity funds are being raised to invest in the banking industry, while a growing number of banking institutions are considering acquisitions, selling minority stakes or putting themselves up for sale.

Join some of the biggest names in the industry and hear from experts from both the M&A and banking communities. The conference will be anchored by keynote speaker Randy Quarles, Managing Director with The Carlyle Group, and former Under Secretary of the Treasury, followed by a panel discussing this evolving sector featuring Michael McClintock, Managing Director at Friedman Billings Ramsay and Alison Davis, Managing Partner at Belvedere Capital.  

For more information or to register, click here: http://www.sourcemediaconferences.com/FMA08/.

DOL Issues Proposed Regulation and Proposed Exemption on Investment Advice for Participant-Directed ERISA Plans

The Department of Labor (the “DOL”) issued a proposed regulation (the “Proposed Regulation”) under new Sections 408(b)(14) and 408(q) of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), as well as a proposed prohibited transaction class exemption (the “Proposed Exemption”), addressing the provision of investment advice by a firm to participants in Section 401(k) plans and individual retirement account (“IRA”) holders regarding investments in products offered by the firm or its affiliates.  The Proposed Regulation provides guidance regarding two statutory prohibited transaction exemptions that were included in amendments to ERISA and the Internal Revenue Code in 2006.  One exemption relates to “Fee-Leveling Arrangements” while the other concerns “Computer Model Arrangements.”  The Proposed Exemption goes further than the statutory exemptions by, in effect, relaxing certain conditions that must be satisfied in order for financial services firms to advise plan participants and IRA holders to invest in proprietary funds or other products that result in the receipt of compensation or other amounts by the firm or its affiliate.

General Requirements of Proposed Regulation

The Proposed Regulation sets forth and clarifies the following statutory requirements, which apply to both the exemption for Fee-Leveling Arrangements and the exemption for Computer-Model Arrangements:

  • Fiduciary Adviser.  The advice must be provided by a “Fiduciary Adviser,” which must be a registered investment adviser, a bank, an insurance company, a registered broker or dealer, or certain affiliates, employees, agents, and registered representatives of one of these entities.
  • Authorization.  The advice arrangement must be authorized by a plan fiduciary or the IRA holder.  In general, the person authorizing the arrangement cannot be the Fiduciary Adviser or any entity providing any designated investment options under the plan or IRA, or any of their affiliates.  (In the case of an IRA, it is permissible to have the arrangement authorized by the IRA holder, even if the beneficiary is an employee of the Fiduciary Adviser or provider of an investment option.)
  • Decision Making.  The investments by the plan or IRA must be made at the direction of the plan participant or IRA holder.  While the Fiduciary Adviser may provide advice, it must not make the investment decision.
  • Annual Audit.  At least annually, an “independent auditor” (as defined in the Proposed Regulation) must audit the advice arrangement for compliance with the exemption.  The Proposed Regulation provides that the independent auditor may use information obtained from a reasonable sampling of arrangements and advice provided by the Fiduciary Adviser.  In the case of an ERISA plan, results of the audit must be communicated to the fiduciary who authorized the advice arrangement.  In the case of an IRA, the results must be communicated to the IRA holder (through, for example, publication on a website); results showing non-compliance with the exemption’s conditions must be communicated to the DOL.
  • Disclosure.  The Fiduciary Adviser must disclose to the plan participant or IRA holder information relating to various matters, including, for example, compensation to be received by the Fiduciary Adviser or any affiliate in connection with an investment by the plan or IRA, any affiliation or material contractual relationship with securities or other property with respect to which advice is to be provided under the arrangement, and that the plan participant or IRA holder may separately arrange for advice from another adviser that may have no relationship with the relevant investments.
  • Reasonable Compensation/Arrangement.  The compensation received by the Fiduciary Adviser and its affiliates in connection with the investment by the plan or IRA must be reasonable, and the terms of the investment transaction must be arms-length.
  • Records.  For at least six years, the Fiduciary Adviser must maintain records showing the applicable conditions of the relevant exemption were satisfied.

Additional Requirements Applicable to the Fee-Leveling Exemption

In addition to satisfying the general requirements described above, an advice arrangement will be eligible to utilize the “Fee-Leveling Exemption” only if it also satisfies the following conditions:

  • Advice Standards.  Advice provided under the arrangement must be based on generally accepted investment theories that take into account historic returns of different asset classes over defined periods of time.  Further, the advice must take into account information provided by the plan participant or IRA holder relating to age, life expectancy, retirement age, risk tolerance, other assets and income sources, and investment preferences.
  • Fee-Leveling.  Fees received (directly or indirectly) by the Fiduciary Adviser cannot vary based on the investments selected by the plan participant or IRA holder.  Compensation (e.g., salary, bonuses, commissions, awards) received, directly or indirectly, by an employee, agent, or registered representative of the Fiduciary Adviser cannot vary based on the investments selected by the plan participant or IRA holder.

Note that this fee-leveling requirement does not apply to affiliates of the Fiduciary Adviser.  For example, this condition of the exemption would not be violated solely because a brother-sister affiliate of the Fiduciary Adviser received management fees from a mutual fund in which an IRA invested based on the advice of the Fiduciary Adviser.

Additional Requirements Applicable to the Computer Model Exemption

In addition to satisfying the general requirements described above, an advice arrangement will be eligible to utilize the “Computer Model Exemption” only if it also satisfies the following conditions.

  • Solely Computer-Generated Advice.  The only investment advice provided under the arrangement must be generated by a computer model.
  • Computer Model-Standards.  The computer model used under the arrangement must meet various requirements – for example, the model must apply generally accepted investment theories that take into account historic returns of different asset classes over defined time periods, utilize personal information received from the plan participant or IRA holder, avoid recommendations that inappropriately favor investment options that are offered by, or that generate greater income for, the Fiduciary Adviser (or its affiliate), and take into account all designated investment options (other than employer securities) under the plan or IRA.
  • Certification.  An “eligible investment expert” (as defined in the Proposed Regulation) must certify that the advice arrangement satisfies the standards described above.  The Proposed Regulation includes detailed requirements for this certification.

Proposed Class Exemption

The Proposed Exemption shares some similarities with the statutory exemptions discussed above – for example, the Proposed Exemption has a fee-leveling component and a computer model component, and also incorporates a number of conditions that are similar to the general requirements described above.  However, the Proposed Exemption would go further than the existing statutory exemptions in several respects.  For example, the fee-leveling component of the Proposed Exemption would prohibit fees from varying only at the individual (employee, agent, or registered representative) level, and not at the business-entity level of the Fiduciary Adviser.  In other words, if an employee of a bank were providing advice to an IRA that invested in a bank-managed product, this condition of the Proposed Exemption would prohibit the compensation of the employee who provided the advice from varying based on the investment in that proprietary investment product, but would not prohibit the bank’s fees from varying on that basis.

Another example of the difference from the existing statutory exemptions is that under the computer model component of the Proposed Exemption the advice is not required to be based solely on the computer model.  Rather, under the Proposed Exemption, once computer-generated advice has been provided to the plan participant or IRA holder (or, in certain circumstances, once investment education information has been furnished to the IRA holder) the Fiduciary Adviser may also provide individualized advice not based on a computer model.

We note that within days after the DOL released the Proposed Exemption, Representative George Miller, chair of the Labor and Education Committee of the House of Representatives (which has jurisdiction over these types of ERISA issues) objected strongly to the proposal as providing insufficient protections for plan participants.  It is unclear at this time when (if ever) the Proposed Exemption will be issued in final form or, if it is, whether additional conditions will be added when it is finalized.

Effective Dates and Comment Deadline

The Proposed Regulation is proposed to be effective 60 days after the final version is published in the Federal Register (the statutory exemptions are generally effective already).  The Proposed Class Exemption is proposed to be effective 90 days after the final version is published in the Federal Register.  Comments are due by October 6, 2008, and the Proposed Regulation is expected to be finalized by the end of the year.

Department of Justice Revises Policies Governing Credit Given for Cooperation in Its Investigation and Prosecution of Business Organizations

The Department of Justice announced that it was making significant revisions to its policies regarding credit given for cooperation provided to the Department of Justice (the “DOJ”) in its investigation and prosecution of corporate crimes.  The revisions affect the treatment of (1) the waiver of attorney-client privilege and work product protection, (2) advancement of employees’ attorneys’ expenses, (3) joint defense agreements and (4) the sanctioning or retention of culpable employees.

Attorney-Client Privilege/Work Product.  Under the revised policies, credit for cooperation with federal prosecutors will not depend on a corporation’s waiver of attorney-client privilege or work product protection, but instead on the disclosure of relevant facts.  Under former guidance in this area, federal prosecutors could request disclosure of non-factual attorney-client privileged communications and work product.  Under the revised policies, federal prosecutors may not do so, subject to the following exceptions:  prosecutors may ask for (a) disclosure of communications supporting an advice-of-counsel defense, and (b) any communications between a corporation and corporate counsel that are made in furtherance of a crime or fraud.  Corporations that do not disclose relevant facts typically may not receive credit for cooperation. 

Advancement of Attorneys’ Fees.  The revised policies also instruct prosecutors not to consider a corporation’s advancement of attorneys’ fees to employees when evaluating the corporation’s cooperation, although a corporation’s payment of or advance of attorneys’ fees to its employees will be relevant in the rare situation where it, combined with other circumstances would rise to the level of criminal obstruction of justice. 

Joint Defense Agreement.  The revised policies indicate that mere participation in a joint defense agreement will not render a corporation ineligible for cooperation credit; however, the government may ask that a corporation refrain from disclosing information that it has received from the government to third parties. 

Sanctioning/Reforming Culpable Employees.  The revised policies do not permit prosecutors to consider whether a corporation has sanctioned or retained culpable employees in evaluating the corporation’s degree of cooperation.  Prosecutors may only consider whether a corporation has disciplined employees that the corporation identifies as culpable, and only for the purpose of evaluating the corporation’s remedial measures or compliance program.

In his remarks announcing the revised guidelines, US Deputy Attorney General Mark Filip stressed that “[n]o corporation is obligated to cooperate or to seek cooperation credit by disclosing information to the government.  Refusal by a corporation to cooperate, just like refusal by an individual to cooperate, is not evidence of guilt.  Put differently , if a business decides not to cooperate, that does not, in itself, support or require the filing of charges.  It simply means that the corporation will not be entitled to mitigating credit for cooperation, which might well be germane when a corporation otherwise could be properly prosecuted.”  Mr. Filip indicated that the revised policies were the result of “lessons learned from our prosecuting, as well as comments from others in the criminal justice system, the judiciary (see the next story in this edition), and the broader legal community.  The revised guidelines will be reflected in the United States Attorneys Manual, which is binding on all federal prosecutors in the Department of Justice.  The revised guidelines were effective immediately upon their announcement.

Federal Second Circuit Court of Appeals Affirms Dismissal of Federal Prosecution of Firm’s Employees on Grounds That Government Pressure Caused Firm to Place Conditions on Advancement of Legal Fees in Violation of Sixth Amendment

The U.S. Court of Appeals for the Second Circuit (the “Court”) affirmed a district court’s ruling that the federal government deprived the employees of a firm that was under investigation by the Department of Justice of their right to counsel under the Sixth Amendment to the U.S. Constitution by causing the firm to place conditions on its advancement of legal fees to the employees, cap the amount advanced and ultimately cease advancing legal fees.  The Court also affirmed the district court’s dismissal of its indictment against the employees because the government failed to cure its Sixth Amendment violation and because no other remedy would place the employees in the condition that would have existed absent the government’s unconstitutional acts.  The firm’s past practice had been to advance legal fees for employees facing regulatory, civil and criminal investigation without condition or limitation.  After the commencement of a federal grand jury investigation of the firm, the firm’s CEO announced that all partners of the firm asked to appear in the course of the investigation would be represented by competent counsel at the firm’s expense.   In the course of the investigation, the firm’s counsel met with the U.S. Attorney’s Office (the “USAO”) and discussed the firm’s advancement of legal fees in light of the Thompson Memorandum’s criteria bearing on the degree of cooperation provided by the target of an investigation.  The Thompson Memorandum was a January 2003 policy statement by then United States Deputy Attorney General Larry D. Thompson that articulated principles governing the Department of Justice’s discretion in bringing prosecutions against business organizations.  (After the events in this case, the Thompson Memorandum was superseded by the McNulty Memorandum, under which prosecutors could consider a company’s fee advancement policy only where the circumstances indicated that it was “intended to impede a criminal investigation,” and even then only with the approval of the Deputy Attorney General.  See the preceding story in this issue on the Department of Justice’s adoption of revised policies governing cooperation credit.)

As a result of displeasure expressed by the USAO regarding the firm’s advancement of fees to its employees being interviewed by the USAO as part of its investigation, the firm subsequently adopted a policy that capped fees, conditioned their advancement on an employee’s cooperation with the government and ceased advancement upon an employee’s indictment.  The letter advising employees of the policy was also sent to the USAO.  In response to government pressure, the firm also revised a memorandum it had sent to employees advising them, among other things, that it might be advantageous for them to exercise their right to counsel if they became the subjects of the investigation.  The revised memorandum reflected a change urged by the USAO that employees be told that they could meet with investigators without counsel.  In response to a request from the firm’s counsel, the USAO informed the firm’s counsel whenever an employee refused to cooperate fully.  The firm’s counsel informed the employees’ lawyers that fee advancement would cease unless the employees cooperated; employees who did not cooperate were fired, and the firm ceased advancing their fees.  At the conclusion of the USAO’s investigation, the firm entered into a deferred prosecution agreement, paid a $46 million fine and agreed to cooperate in any future government investigation or prosecution.

OTS Issues Guidance on Curtailing, Suspending or Terminating Home Equity Lines of Credit

The OTS issued guidance (the “Guidance”) to federal savings associations (“FSAs” and each an  “FSA”) concerning management of an FSA’s home equity line of credit (“HELOC”) program and curtailing, suspending or terminating a customer’s HELOC.  The Guidance states that when curtailing, suspending or terminating a HELOC, an FSA must ensure that it is acting in compliance with, among other consumer protection laws and regulations, the Truth-in-Lending Act, the Equal Credit Opportunity Act, the Fair Housing Act and OTS rules regarding nondiscrimination.  The Guidance notes that the Truth-in-Lending Act prohibits an FSA from terminating a HELOC and accelerating repayment of the balance except in cases of: (1) fraud or material misrepresentation; (2) failure to meet repayment terms for any outstanding  balance; or (3) actions adversely affecting the  property.  The Guidance further states that an FSA lender may also freeze or reduce a HELOC when the value of the collateral “declines significantly” below the appraised value, the borrower cannot make payments because of a material change in finances or the loan is materially in default.  Moreover, the Guidance notes that a lender’s action to suspend or reduce a HELOC must be based upon a sound factual assessment of the value of the individual property (which need not be an appraisal).  The Guidance also includes discussions on, among other things, procedures an FSA should use to provide customers with proper advance notice of changes to HELOCs and treatment of borrower requests to reinstate credit privileges.

Appeals Court Strikes Down New Jersey’s Ability to Hire External Investment Managers for State Pension Fund Investments

A New Jersey appellate court (the “Court”) struck down as invalid a group of regulations adopted by the Division of Investment of the New Jersey Department of Treasury (the “Division”), authorizing the Director of the Division to engage external investment managers to manage pension fund investments.  The unpublished opinion in Communications Workers of America v. Rousseau, Nos. A-5198-04T1, A-5378-04T1, A-6126-04T1, 2008 WL 3876032 (N.J. Super. App. Div. Aug. 22, 2008), found that the Division lacks the statutory authority from the Legislature to delegate its investment responsibilities to external managers.  The Court, citing case law from environmental and water cases, bases its conclusion that the regulations exceed statutory authority on the applicable standard of care, which the court found did not allow for delegation of management duties.  Although the State argued that the Division’s staff lacked the expertise to make prudent investment decisions in certain areas and thus needed external managers, the Court was not persuaded.  The Court did distinguish between external professionals providing investment advisory services, as opposed to managers with discretion to invest state pension funds, noting that there was authorization to seek the former, but not the latter.

The Court left intact another set of challenged regulations authorizing the Director of the Division to invest state pension funds in alternative investments such as private equity funds and hedge funds.  The appellant unions also challenged particular investments made by the Division, charged with managing state employee pension funds, because those investments included certain private equity fund and other alternative investments.  The Court rejected that challenge and found the private equity and hedge fund investments to be within the Division’s authority. 

At stake is whether the decision requires New Jersey to unwind contemplated or actual arrangements with external managers, as is the delegation by state fiduciaries of such management duties.  Regardless of whether the state officials believe the external managers to be better qualified to manage state pension funds in particular investment strategies, for now, short of action by the New Jersey Legislature or a ruling from a higher court, the Division has no authority to delegate management services.