Financial Services Alert - November 18, 2008 November 18, 2008
In This Issue

SEC to Consider Adopting Mutual Fund Summary Prospectus Proposal at November 19 Open Meeting

The agenda for the SEC’s open meeting scheduled for Wednesday, November 19, 2008 at 10:00 a.m. includes consideration of whether to adopt its “Summary Prospectus” proposal, which will (i) revise the disclosure requirements for the statutory prospectus currently used by registered open‑end management investment companies (“mutual funds”) and (ii) create the new Summary Prospectus for use in mutual fund sales.  The proposed disclosure changes create a brief, self-contained presentation of key fund characteristics that would appear in both the current statutory prospectus and the new Summary Prospectus.  In addition, under the proposal, the Summary Prospectus could be used to satisfy certain prospectus use and delivery requirements under the Securities Act of 1933, as amended (the “1933 Act”), subject to several conditions that include providing investors access to the statutory prospectus and other fund documents via the Internet.  (For a detailed discussion of the proposal, see the December 5, 2007 Alert.) 

The open meeting agenda announcement also indicates that the SEC will consider whether to adopt related amendments to Form N-1A, the registration form for mutual funds, including amendments that address exchange-traded funds (“ETFs”).  Although not clear, the reference to ETF disclosure requirements appears to suggest that the SEC will be looking at amendments to Form N-1A proposed in April of this year as part of a broader ETF initiative.  The proposed ETF disclosure changes are designed to focus the disclosure provided in ETF prospectuses on the needs of secondary market investors in ETFs.  A companion element of the ETF initiative would eliminate exemptive relief from the statutory prospectus delivery requirements previously granted to broker-dealers for sales of ETFs in the secondary market in favor of allowing those obligations to be met by delivery of a Summary Prospectus (or the product description currently required to be delivered under the rules of listing exchanges if the Summary Prospectus proposal has not been adopted by the time the SEC takes final action on the ETF initiative).  Given its close relationship to the proposed ETF prospectus disclosure changes, the proposal affecting ETF prospectus delivery requirements may also be addressed at the November 19 meeting.  (See the April 1, 2008 Alert for a detailed discussion of the ETF initiative, which also includes (1) codification of exemptive relief that the SEC has provided in the past to allow index based ETFs and actively managed ETFs to operate and (2) new Rule 12d1-4 under the Investment Company Act of 1940, as amended (the “1940 Act”), which would allow registered funds to invest in ETFs to acquire ETF shares in excess of the limits in Section 12d(1) of the 1940 Act.)

OFAC Issues Guidance for the Securities Industry

The Office of Foreign Assets Control (“OFAC”) of the U.S. Treasury Department (“Treasury”) has issued two pieces of guidance for the securities industry: (1) Opening Securities and Futures Accounts from an OFAC Perspective (the “Account Opening Guidance”) and (2) Risk Factors for OFAC Compliance in the Securities Industry (the “Risk Factor Guidance”)

Broad Application of OFAC Programs.  In the Account Opening Guidance, OFAC makes clear that all securities and futures firms, like all U.S. persons, are subject to OFAC’s economic and trade sanctions programs, and provides guidance intended to assist securities and futures firms with OFAC compliance when opening new accounts.  The Account Opening Guidance recommends that all securities and futures firms establish and maintain effective, risk-based OFAC compliance programs.  In the event of an OFAC violation involving a securities and futures firm, OFAC will consider the strength of its OFAC compliance program when determining the severity of potential enforcement actions.

OFAC Screening Focus.  The Account Opening Guidance identifies two specific stages of account relationships that firms should focus on in their OFAC compliance programs:  (1) the client acceptance process and (2) the selection of new investments.  The guidance recommends that firms screen new clients and proposed transactions against OFAC’s list of Specially Designated Nationals (“SDNs”) and other sanctions programs and maintain records of the results of such screening.  OFAC also recommends that, depending on a firm’s specific risk profile, periodic screening regarding non‑accountholders, such as beneficiaries, guarantors, or principals, also may be warranted.

OFAC Compliance and AML Customer Identification Programs.  The Account Opening Guidance notes that a strong OFAC compliance program will share certain common characteristics with a Customer Identification Program (“CIP”), including procedures to assess the risks posed to the firm by each customer and transaction.  Despite these similarities, the Account Opening Guidance recognizes two key differences between OFAC and CIP requirements.  First, although Treasury’s Financial Crimes Enforcement Network (“FinCEN”) has stated that are not required to look-through omnibus accounts to identify the underlying beneficial owners, OFAC due diligence on beneficial owners of such accounts may be necessary because OFAC applies broadly to all property and interests in property of a sanctions target that is within the possession or control of a U.S. person.  Second, while FinCEN has indicated that it will not take action against clearing firms for failure to apply the CIP rule to certain accounts introduced on a fully disclosed basis, such relief does not extend to OFAC compliance.  Firms that delegate OFAC compliance responsibilities to third parties remain liable for any OFAC violations that occur due to the third parties’ negligence, although OFAC will take the a firm’s role and access to customer information into account in the event of an enforcement action.

Risk Factor Analysis.  The Risk Factor Guidance may be helpful to firms when implementing the risk assessment portion of OFAC compliance programs.  Recognizing the importance of a risk-based approach to OFAC compliance, the Risk Factor Guidance stresses the need for OFAC due diligence by securities firms and identifies possible risk factors that may warrant heightened scrutiny.  These risk factors include (1) a high number of international transactions, (2) a large number of non-U.S. customers or accounts, particularly in high-risk jurisdictions, (3) foreign broker-dealers which are not subject to OFAC regulations, (4) investments in foreign investment funds or securities, (5) personal investment corporations or personal holding companies beneficially owned by non-U.S. persons, (6) very high net worth institutional accounts, investment funds, and intermediary relationships that lack transparency regarding investments and beneficial owners, (7) business introduced by third parties based in high risk or inadequately regulated countries, and (8) confidential private banking accounts established for non-U.S. persons.

OFAC Revokes Authorization to Process “U-turn” Transfers Involving Iran

OFAC has revoked a general license which permitted U.S. depository institutions to process “U-turn” transfers involving Iran.  A “U-turn” transfer is a dollar-denominated transfer that starts at one non‑U.S., non-Iranian bank, moves through correspondent accounts at U.S. banks, and ends at a second non‑U.S., non-Iranian bank.  OFAC’s action is intended to prevent transfers made by Iranian parties to dollarize transactions through the U.S. financial system.  OFAC’s action broadens the scope of previous actions that prohibit U-turn transactions involving two Iranian banks, Bank Saderat and Bank Sepah.

Regulation R On Track to Take Effect on January 1, 2009

As a reminder, on January 1, 2009, Regulation R – the joint regulation of the Federal Reserve Board (“FRB”) and Securities Exchange Commission (“SEC”) implementing the bank brokerage provisions of the Gramm-Leach-Bliley Act (“GLB Act”) – will become effective for all banks and thrifts in the United States.  Under Regulation R, banks and thrifts will no longer enjoy blanket exemptions from the definition of “broker” in the federal securities laws and, effectively, will have to “push out” various securities activities to SEC-registered broker-dealers and conform other securities activities to fit within Regulation R’s detailed requirements.  

In recent conferences and public presentations, the FRB and SEC staff have re-affirmed the January 1 compliance deadline and have said that the agencies will not extend the deadline in light of the financial markets crisis.  Moreover, we understand some banks already have faced regulatory inquiries about their plans and efforts to ensure compliance with the new regulation.  Goodwin Procter’s financial services practice includes several lawyers with substantial expertise if you have questions or need assistance with Regulation R compliance.

SEC’s Office of Compliance Inspections and Examinations Posts Core Initial Information Request for Investment Adviser Examinations

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) has posted on the SEC website a “Core Initial Request for Information” (the “Core Request”) that it will use in investment adviser examinations.  The Request indicates that it is focused on advisers that provide only traditional money management services to non‑fund clients, and that for an adviser whose business is broader in scope, e.g., the adviser sponsors a family of registered investment companies, sponsors one or more privately offered funds, participates in PIPES offerings, participates in a wrap fee program, is also registered as a broker‑dealer or acts as a manager of managers, the Core Request will be supplemented to address the additional activities and relationships.  Although not as lengthy or detailed as the controversial inspection request letter released by the SEC’s Northeast Regional Office, the Core Request covers a wide range of information, including results of, and output from, transactional (quality control) and periodic (forensic) testing designed to evaluate the effectiveness of an adviser’s compliance policies and procedures.  As with past SEC staff information requests, the Core Request includes a number of items that are not reflected in the SEC’s rules regarding books and records required to be kept by investment advisers.

Plaintiffs in Excessive Fee Suit Against Mutual Fund Adviser Seek Supreme Court Review of Seventh Circuit Decision Rejecting Gartenberg Analysis

The plaintiff shareholders in an excessive fee suit brought under Section 36(b) of the Investment Company Act of 1940, as amended (the “1940 Act”), against an adviser (the “Adviser”) for registered open-end funds (the “Funds”) in which they had invested have filed a petition for a writ of certiorari seeking Supreme Court review of the decision in Jones v. Harris Associates L.P., 527 F.3d 627 (7th Cir. 2008) (“Harris Associates”).  Harris Associates affirmed the dismissal by the US District Court for the Northern District of Illinois (Eastern Division) of the plaintiff’s suit (as discussed in the June 3, 2008 Alert).  The plaintiffs’ filing follows a unanimous vote by a panel of the US Court of Appeals for the Seventh Circuit (the “Seventh Circuit”) to deny a petition for rehearing of its decision in Harris Associates (as discussed in the August 19, 2008 Alert).  A request for rehearing en banc was also narrowly denied, occasioning a dissent by one of the Seventh Circuit’s leading judges.  Although it affirmed the District Court’s decision, Harris Associates expressly rejected the multi-factor analysis for suits under Section 36(b) of the 1940 Act established by the US Court of Appeals for the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982).  The split in authority among the circuits on this issue created by Harris Associates is the basis for the plaintiff’s request for review.  A response to the petition is due on December 3, 2008.

Recent Developments in the Treasury’s Troubled Asset Relief Program

The deadline for participation in the Treasury’s Capital Purchase Program (“CPP”) expired on November 14, 2008 for public banks.  In the most recently issued CPP FAQs, the Treasury addressed which banks are deemed “public” banks for purposes of this deadline.  For the purposes of the CPP, a “public” bank, savings association, bank holding company, or savings and loan holding company is a company (1) whose securities are traded on a national securities exchange and (2) that is required to file, under the federal securities laws, periodic reports such as annual and quarterly reports on Forms 10-Q and 10-K with either the SEC or its primary federal bank regulator.

CPP Investments for Private Banking Organizations

On November 17, 2008, the Treasury released the term sheet for private institutions, which have until December 8, 2008 to apply for CPP investments.  This term sheet and deadline do not apply to mutual banking organizations or S corporations.  The Treasury is continuing to work on structures for mutual banking organization and S corporations, and will release a term sheet and deadline for those institutions in the future.  Many of the terms of the preferred securities issued by private banking organizations  to the Treasury (the “Preferred Securities”), such as the investment size, dividend rate, redemption restrictions, voting rights, and executive compensation requirements, are identical to those for public banks.  Please see the October 14, 2008 Alert for further discussion of the terms for preferred securities issued under the CPP by public banks. 

The dividend and repurchase restrictions for private banking organizations differ from those for public banks.  The Treasury’s consent for share repurchases is required for ten years instead of three years.  Further, from the third anniversary date until the tenth anniversary date, the Treasury must consent to any increase in dividends on common shares greater than 3 percent per year.  In addition, after ten years, private banking organizations participating in the CPP are prohibited from paying common dividends or repurchasing any equity securities or trust preferred securities until all Preferred Securities held by the Treasury are redeemed or have been transferred by the Treasury to a third party.  The Preferred Securities will not be subject to any contractual restrictions on transfer or the restrictions of any stockholders’ agreement or similar arrangement; however, the Treasury and any subsequent holders of the Preferred Securities will not effect any transfer of the Preferred Securities which would require the private bank to become subject to securities reporting requirements.  For as long as the Treasury holds Preferred Securities, private banking organizations participating in the CPP are barred from entering into transactions with related persons unless such transactions are on arms length terms and have been approved by the organization’s audit committee or a comparable body of independent directors.

The Treasury will also receive warrants to purchase, upon net settlement, a number of net shares having an aggregate liquidation preference equal to 5% of the Preferred Securities amount on the date of investment (the “Warrant Preferred”).  The initial exercise price of the warrants will be $0.01 per share unless the participating banking organization’s charter requires a greater par value per share.  The Treasury intends to immediately exercise the warrants.  The warrants will have the same rights, preferences, privileges, voting rights and other terms as the Preferred Securities, except that the Warrant Preferred will pay a 9% annual dividend and the Warrant Preferred may not be redeemed until all of the Preferred Securities have been redeemed.

The Treasury has discretion to exempt certain investments from the warrant requirements and has determined not to require a warrant to purchase Warrant Preferred for a limited class of qualifying institutions.  The Treasury will not require the issuance of Warrant Preferred shares if the size of the investment is less than $50 million and the banking organization is a certified Community Development Financial Institution (“CDFI”).  Institutions must file an application for certification as a CDFI by December 8, 2008.  If an institution has applied for CDFI certification, and it is eligible for funding under the CPP, it will receive conditional approval contingent on receiving the CDFI certification, which must be approved by January 15, 2009.

Treasury Secretary Paulson Outlines Three Priorities for Use of Remaining TARP Funds

On November 12, 2008, Treasury Secretary Henry Paulson outlined three priorities for the use of the remaining Troubled Asset Relief Program (“TARP”) funds and abandoned the plan to use TARP funds for the purchase of troubled mortgage assets. 

New Capital Purchase Programs.  The Treasury is designing new capital purchase programs for financial institutions.  The Treasury is evaluating programs that will attract private capital to financial institutions, potentially through matching investments (see the November 12, 2008 Alert for further discussion of private equity matching investments).  The Treasury is also considering investments in non-bank financial institutions that are not currently eligible under the CPP.  This may include insurance companies (four insurance companies recently acquired thrifts to access the CPP).  In addition, there have been efforts by members of Congress to make automotive companies eligible for TARP funds. 

Support for the Asset-Backed Securitization Markets.  The Treasury is looking for ways to support the asset-backed securitization market in order to increase the availability of consumer finance such as car loans, student loans and credit cards.  With the FRB, the Treasury is exploring the development of a potential liquidity facility for highly-rated AAA asset-backed securities, which may include providing federal financing to private investors.  Secretary Paulson indicated that such a program would be targeted at consumer financing, but that it may also be used to support new commercial and residential mortgage-backed securities lending. 

Mortgage Loan Modifications.  The Treasury is exploring ways to mitigate mortgage foreclosures and achieve more aggressive mortgage modification standards.  Secretary Paulson cited as a model the mortgage modification protocol developed by the FDIC through IndyMac Bank.  Secretary Paulson also highlighted the modification program announced by the Treasury, the FHFA, the GSEs, HUD and the Hope Now alliance, which adopts an explicit affordability target similar to the FDIC’s model.  However, in an interview on November 17, 2008, Secretary Paulson stated that he does not intend to use the remaining $410 billion of unallocated TARP funds unless it is absolutely necessary.  Secretary Paulson further stated that he wishes to preserve the funds and the flexibility of the TARP for the incoming administration.

Proposed FDIC Loan Modification Program

The FDIC has separately proposed a loan modification program that is targeted at homeowners who have missed at least three monthly payments on their mortgage, but have not filed for bankruptcy.  Under the program, the homeowner’s mortgage payments would be reduced to no more than 38 percent of the household’s monthly income.  The FDIC has proposed using government guarantees in conjunction with loan modifications.  Under the plan, up to half of a modified loan’s losses would be guaranteed in the event of default.  Mortgage servicers would be paid $1,000 per modified loan to cover the costs of modification.

Meeting the Needs of Creditworthy Borrowers

The FRB, the FDIC, the OCC and the OTS underscored Secretary Paulson’s remarks by issuing a joint statement on meeting the needs of creditworthy borrowers.  The statement encourages financial institutions to lend prudently and responsibly to creditworthy borrowers, work with borrowers to preserve homeownership and avoid preventable foreclosures, adjust dividend policies to preserve capital and lending capacity and employ compensation structures that encourage prudent lending.  The federal banking agencies noted that financial institutions’ adherence to these expectations will be reflected in examination ratings for safety and soundness, compliance with laws and regulations, and Community Reinvestment Act performance.

SEC Staff Provides Guidance on Rule 14a-8 Regarding Shareholder Proposals

The staff of the SEC’s Division of Corporation Finance issued Staff Legal Bulletin (“SLB”) No. 14D, which provides updated guidance on Rule 14a-8 under the Securities  Exchange Act of 1934 governing shareholder proxy proposals.  Specifically, SLB No.14D contains information regarding:

  • shareholder proposals that recommend, request, or require a board of directors to unilaterally amend the company’s articles or certificate of incorporation;
  • a new SEC e-mail address established for the receipt of Rule 14a‑8 no-action requests and related correspondence;
  • whether a company must send a notice of defect if the company’s records indicate that the proponent has not owned the minimum amount of securities for the required period of time as set forth in rule 14a‑8(b); and
  • the requirement that a proponent send copies of correspondence to the company and the manner in which the company and a proponent should provide additional correspondence to us and to each other.

FRB and Treasury Department Issue Final Rule on Funding of Unlawful Internet Gambling

The FRB and U.S. Treasury Department issued a final rule implementing the Unlawful Internet Gambling Act (the “Act”).  The new rule, which is designated as FRB Regulation GG, will require financial institutions participating in certain payment systems to develop compliance policies and procedures designed to identify and restrict unlawful Internet gambling transactions.  As a general matter, compliance with the new rule will become mandatory by December 1, 2009.  We will provide a more detailed description of Regulation GG is a coming issue of the Alert.

Massachusetts Information Security Rules Effective Date Delayed

The Massachusetts Office of Consumer Affairs and Business Regulation (“OCABR”) announced late last week that it has delayed the effective date of the state’s new information security rules. The rules, which were issued in final form on September 22, 2008, had been scheduled to go into effect on January 1, 2009.  Most provisions of the information security rules will now go into effect on May 1, 2009. The mandatory compliance date for provisions requiring written certification of compliance from third‑party service providers and for the encryption of portable electronic devices other than laptops has been extended to January 1, 2010.

As discussed in a September 29, 2008 Goodwin Procter Client Alert, “New Massachusetts Regulations to Mandate Comprehensive Information Security Requirements,” these information security rules are written very broadly, specifically referencing “all persons that own, license, store or maintain personal information about a resident of the Commonwealth.” The rules, which are available here, have stricter requirements (particularly in the areas of vendor contracts and data encryption) than federal standards or those of other states.

Although the OCABR has granted a temporary reprieve, entities that may be subject to the requirements should continue preparations.

SEC Proposes Roadmap for the Potential Use by Certain U.S. Issuers of Financial Statements Prepared in Accordance with International Financial Reporting Standards

The SEC has proposed a Roadmap that would permit certain U.S. issuers to use financial statements prepared in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board in their filings with the SEC.  The Roadmap includes milestones that, if achieved, could lead to the use of IFRS being required for U.S. issuers in 2014.  In general terms, an issuer would be eligible for early use of IFRS if it were among the 20 largest companies globally in a particular industry and IFRS were used as the basis of financial reporting more often than any other basis of financial reporting among the 20 largest listed companies worldwide in that industry.  The proposed Roadmap relates solely to U.S. issuers with respect to their periodic reporting requirements under Sections 13 and 15(d) of the Securities Exchange Act of 1934 (the “1934 Act”), proxy and information statements under Section 14 of the 1934 Act and registration statements under Section 12 of the 1934 Act and Section 7 of the Securities Act of 1933.  The Roadmap does not extend to issuers that are investment companies under the Investment Company Act of 1940, or to other types of financial reports that are filed or furnished to the SEC by regulated entities, such as registered broker‑dealers.

Goodwin Procter Publishes Client Alert on Bilski Decision Restricting Patentability of Software, Business Methods

Goodwin Procter’s Intellectual Property Group has issued a Client Alert discussing a decision by the Federal Circuit upholding a ruling by the US Patent Office denying a patent for methods of hedging in commodities trading.

Goodwin Procter Issues Client Alert Discussing FINRA’s Proposed Changes to Research Analyst Quiet Periods

Goodwin Procter’s Securities & Corporate Finance Practice has issued a Client Alert discussing a proposal by the Financial Industry Regulatory Authority (“FINRA”) that would liberalize existing rules restricting the issuance of analyst research around initial public offerings and secondary offerings.