Financial Services Alert - December 7, 2010 December 07, 2010
In This Issue

Federal Court Dismisses ERISA Breach of Fiduciary Claims over 401(k) Plan Holdings in Bank Stock

On November 24, 2010, the United States District Court for the Southern District of Ohio dismissed ERISA breach of fiduciary duty claims arising from the continued holding of a bank’s stock in a 401(k) plan sponsored by the bank for its employees.  This case was notable in the court’s rejection as a matter of law of plaintiffs’ allegations that a bank’s stock was an imprudent investment for ERISA plan participants because the bank allegedly “switched from being a conservative lender to a subprime lender” and that the bank participated in the TARP Capital Purchase Program.

Plaintiffs were participants in the bank’s 401(k) plan.  They brought a putative class action on behalf of themselves and all other current and former participants and beneficiaries of the plan from July 19, 2007 through the present whose plan accounts were invested in the bank’s stock.  They sued the bank, its directors, certain officers, and members of the 401(k) plan committee.  Plaintiffs alleged four counts under ERISA involving the plan’s holding in bank stock: that it was a breach of ERISA’s duty of loyalty and prudence to maintain the stock, and defendants breached ERISA fiduciary duties in not providing greater information about the stock; that certain defendants failed in their ERISA fiduciary duties to monitor their appointees with responsibility for plan investments; that certain defendants failed to ameliorate their alleged conflict of interest in continued holding and purchasing of bank stock for the plan; and that defendants had obligations to correct breaches by co-fiduciaries.

The complaint alleged that the purported shift in lending philosophy from a bank first characterized as a “conservative lender” to a “subprime lender” caused the bank’s stock to fall 74% during a 26 month period in July 2007 to September 2009.  The court applied a legal presumption in favor of the prudence of holding employer stock, a presumption that is applied in some, but not all circuits.  (For a discussion of the presumption of prudence, see James O. Fleckner, The Case for a Presumption of Prudence, 37 Pension & Benefits Reporter 2204, Oct. 5, 2010.)  The court held that a 74% decline alone was insufficient to rebut the presumption of prudence.  Most importantly, the court held that a business decision to enter sub-prime lending, the write-down of non-performing assets, and participation in the TARP program, are together insufficient to defeat the presumption of prudence.  It specifically rejected plaintiffs’ proposition that the bank’s “participation in the Capital Purchase Program (‘CPP’) [was] a stigma and a sign of financial stress.”

Dudenhoeffer v. Fifth Third Bancorp, et al, No. 1:08-cv-538 (S.D.OH) (Nov. 24, 2010). 

As Required by Dodd-Frank Act, FRB Discloses Detailed Information Concerning FRB Assistance Provided under Emergency Credit Facilities, Discount Window Lending Programs and Open Market Operations

In accordance with the provisions of Section 1103(b) (“Section 1103(b)”) of the Dodd‑Frank Wall Street Reform and Consumer Protection Act (which amended Section 11 of the Federal Reserve Act), the FRB posted detailed information on its public website concerning what the FRB described as “more than 21,000 individual credit and other transactions conducted to stabilize markets during the recent financial crisis, restore the flow of credit to American families and businesses, and support economic recovery and job creation in the aftermath of the crisis.”  Section 1103(b) requires the FRB to disclose certain information concerning the FRB’s emergency credit facilities, discount window lending and open market operations.  The FRB posted three years of transaction-level information concerning the following FRB credit assistance programs and credit facilities:

  • Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF)
  • Term Asset-Backed Securities Loan Facility (TALF)
  • Primary Dealer Credit Facility (PDCF)
  • Commercial Paper Funding Facility (CPFF)
  • Term Securities Lending Facility (TSLF)
  • TSLF Options Program (TOP)
  • Term Auction Facility (TAF)
  • Agency MBS purchases
  • Dollar liquidity swap lines with foreign central banks
  • Assistance to Bear Stearns, including Maiden Lane
  • Assistance to American International Group, including Maiden Lane II and III

In addition, the FRB stated that discount window and open-market operation transactions after July 21, 2010 will be posted with a two-year lag.

The transaction data posted by the FRB showed that some of the world’s largest banks (and some large industrial companies who used FRB funds during periods when the commercial paper market was unavailable) were the biggest users of the FRB’s credit facilities during the financial crisis.

DOL Proposes Regulation to Enhance Disclosure to Plan Participants about Target Date Funds

The Department of Labor’s Employee Benefits Security Administration released a proposed regulation (the “Proposed Regulation”) that would require additional disclosure to participants and beneficiaries of participant-directed plans (such as 401(k) plans) regarding (a) “target date” retirement funds and other similar investment options (collectively, “TDFs”) and (b) the plan’s “qualified default investment alternatives” (or “QDIAs”).  The Proposed Regulation would amend the DOL’s existing QDIA regulation (discussed in our October 30, 2007 and May 6, 2008 Financial Services Alerts) and the DOL’s recent “participant-level disclosure” regulation (discussed in our November 2, 2010 Financial Services Alert).  The Proposed Regulation is part of an ongoing joint initiative by the DOL and the SEC with respect to TDFs.

The Proposed Regulation would amend the QDIA regulation to more specifically describe certain investment-related information required to be provided in notices for all QDIAs under the QDIA regulation.  Such information would include the name of the issuer, and with respect to each QDIA, a description of each of the following: the QDIA’s objectives, the QDIA’s principal strategies and risks, the QDIA’s historical performance and the QDIA’s fees and expenses.  The DOL intends for such additional information to complement the disclosure required with respect to all plan investment alternatives under the participant-level disclosure regulation.

The Proposed Regulation would also require disclosure of specific information about TDFs that are QDIAs or are otherwise available as investment alternatives under a plan, including (to the extent this information is not already set forth in the applicable disclosure document):

  • An explanation of the asset allocation of the TDF, how the asset allocation will change over time and the point in time when the TDF will reach its most conservative asset allocation (including graphic illustrations of how asset allocation will change over time);
  • If the TDF references a particular date, an explanation of the relevance of this date (i.e., the age group for whom the investment is designed, assumptions about the participants’ contribution or withdrawal intentions on or after this date); and
  • If applicable, a statement that the participant or beneficiary may lose money investing in the TDF, and there is no guarantee that the TDF will provide adequate retirement income.

The specific TDF disclosures would be required to be included, as applicable, in QDIA notices and other disclosures under the participant-level disclosure regulation.  Comments on the Proposed Regulation are due by January 14, 2011.

Newly Formed Office of Financial Research Issues Statement on Legal Entity Identification for Financial Contracts

The Office of Financial Research (“OFR”), which was established within the Department of Treasury pursuant to the Dodd-Frank Act, issued a statement of policy regarding its preference to adopt, through rulemaking, a universal standard for identifying parties to financial contracts.  The OFR is authorized to collect data to support the Financial Stability Oversight Counsel and to set standards for reporting such data.  Currently, there is no universal system for identifying the legal entities that participate in such contracts.  Without such a universal system it is difficult to track counterparties and calculate aggregate exposures.

Among other things, the OFR’s statement of policy notes that a legal entity identifier (“LEI”) should (1) be based on a standard developed and maintained by an international voluntary consensus standards board, such as the International Organization for Standardization; (2) be unique for each legally distinct entity; (3) persist over the life of an entity regardless of corporate actions or other business or structural changes; (4) include minimal information about the entity in the identifier itself; and (5) be reliable and secure against corruption or misuse.  The entity that would issue the LEIs should be organized and operated as a not-for-profit body with a formally documented governance structure that includes balanced representation by relevant stakeholders.  The entity should also be subject to supervision and regulation.  In addition, the statement of policy notes that the issuances of LEIs must be timely and non-discriminatory, and there must be a process for developing, maintaining and publishing related reference data for each LEI issued.

If a universal LEI is established to the satisfaction of the OFR by July 15, 2011, the OFR plans to issue regulations mandating the use of the standard for data reported to the OFR.  Comments on the statement of policy are due by January 31, 2011.

SEC Proposes Amendments to Form ADV and Changes to “Pay-to-Play” Regulations in Connection with Dodd-Frank Act Implementation

The SEC issued proposed rules and rule amendments (the “Implementing Rules”) that would (a) require advisers who are exempt from registration under either the Venture Capital Exemption or the Private Fund Adviser Exemption, as discussed in recent Goodwin Procter Alerts (“Exempt Reporting Advisers”), to file certain information with the SEC, and (b) give effect to other provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  Although the Implementing Rules focus to a significant extent on Exempt Reporting Advisers, the proposed changes to Form ADV Part 1A would apply to all investment advisers, and set forth new, detailed reporting requirements focused on private funds managed by registered investment advisers.  The Implementing Rules also include proposed amendments to Rule 206(4)-5, which was adopted in July 2010 (as discussed in the July 9, 2010 Goodwin Procter Client Alert) and is not fully effective, which are designed to (1) ensure that Exempt Reporting Advisers remain subject to the rule, (2) allow payments to a “regulated municipal adviser” in accordance with the rules of the Municipal Securities Rulemaking Board and (3) clarify the definition of “covered associate” to include entities such as general partners.

Calculation of Assets Under Management

The SEC proposes to create a defined term “regulatory assets under management,” which would be used to determine whether an adviser is eligible to be registered with the SEC.  Specifically, regulatory assets under management would include all “securities portfolios” (i.e., the total value of a portfolio if at least 50% of its total value consists of securities) for which an adviser provides continuous and regular supervisory or management services (without any deduction for leverage or other accrued but unpaid liabilities but including uncalled capital commitments).  An adviser would be required to include proprietary assets, assets managed without receiving compensation, and assets of foreign clients in the regulatory assets under management calculation, all of which an adviser currently may, but is not required to, include in calculating assets under management in current Form ADV Part 1A. The SEC is proposing to require advisers to use the fair value (not the cost) of private fund assets in determining their regulatory assets under management.  (The Implementing Rules would define “private fund” as an investment company that relies on the exclusion in Section 3(c)(1) or 3(c)(7) under the Investment Company Act of 1940 (the “1940 Act”).) The SEC specifically noted that it is not proposing to require advisers to determine fair value in accordance with GAAP, but did request comments as to whether it should require the use of GAAP. 

Private Fund Reporting

The SEC is proposing extensive amendments to the information that an adviser is required to report on its private funds under Item 7.B. of Form ADV Part 1A.  These amendments would, in part, re-instate the Form ADV Part 1A amendments that the SEC adopted in 2004 as part of its “hedge fund adviser registration” rulemaking, but which were vacated in connection with the 2006 decision in Goldstein v. Securities and Exchange Commission

Under the proposed amendments, the SEC would no longer require an adviser to report funds that are advised by affiliates, and would allow a sub-adviser to exclude private funds for which an adviser is reporting on another Schedule D.  In addition, an adviser sponsoring a master‑feeder arrangement could submit information on an aggregate basis for the master fund and all of the feeder funds that would otherwise be submitting substantially identical data.

Section 7.B.1.A. of Schedule D to Form ADV Part IA would require identifying information for each private fund, including the fund’s name, as well as the state or country where the fund was organized, and the name of its general partner, directors, trustees or persons occupying similar positions.  The adviser would also need to provide information about the regulatory status of the fund and its adviser, including the exclusion from the 1940 Act on which the fund relies, whether the adviser is subject to a foreign regulatory authority, and whether in offering its securities the fund relies on an exemption from registration under the Securities Act of 1933. 

The adviser would also be required to disclose the size of the fund, including both its gross and net assets, and the extent of leverage it employs.  In addition, the adviser would be required to identify in which of the following categories the fund falls based on its investment strategy: (i) hedge fund; (ii) liquidity fund; (iii) private equity fund; (iv) real estate fund; (v) securitized asset fund; (vi) venture capital fund; or (vii) other private fund.   An adviser that is a sub-adviser to a private fund would be required to identify by name and SEC file number any other advisers to the fund.  An adviser would further be required to break down the assets and liabilities held by a private fund by class and categorization in the fair value hierarchy established under GAAP.   Finally, an adviser would be required to disclose the number and the types of investors in a private fund, as well as the minimum amounts required to be invested by fund investors. 

Information Regarding Service Providers

Section 7.B.1.B. of Schedule D to Form ADV Part 1A would require an adviser to provide information regarding five types of service providers that the SEC perceives as “gatekeepers” for private funds: auditors, prime brokers, custodians, administrators and marketers.  For each private fund, an adviser would have to identify each of these service providers, provide their locations, and state whether they are related persons.  The SEC would require specific information for each service provider regarding its services and registration status, including the following:

  • Auditors: whether the they are independent, registered with the Public Company Accounting Oversight Board (PCAOB) and subject to its regular inspection, and whether audited statements are distributed to fund investors.
  • Prime Brokers: whether they are SEC-registered and whether they act as custodian for the private fund. 
  • Custodians: whether they are related persons of the adviser. 
  • Administrators: whether they prepare and send account statements to fund investors and what percentage of the fund assets are valued by the administrator or another person that is not a related person of the adviser. 
  • Marketers: whether they are related persons of the adviser, their SEC file number (if any), and the address of any website they use to market the fund.

Information about an Adviser’s Business

The SEC is also proposing to revise Item 5 of Form ADV Part 1A, which requires an adviser to provide basic information regarding the adviser’s business, including its services, and clients.

The SEC proposes to expand the list of client types and require an adviser to provide the approximate amount of assets under management attributable to each client type using the new regulatory assets under management determination and state the approximate percentage of its clients that are not United States persons.  An adviser that discloses that it has a registered investment company client would be required to provide that investment company’s SEC file number under the 1940 Act, which would enable SEC examination staff to cross check Form ADV disclosures against corresponding disclosures in investment company filings.

Other Business Activities and Financial Industry Affiliations

The SEC is proposing to expand the range of financial industry affiliates to be identified in both Items 6 and 7 of Form ADV Part 1A to include affiliations with a trust company, registered municipal advisor, registered security-based swap dealer, and major security-based swap participant, the latter three of which are new SEC-registrants as a result of the Dodd-Frank Act.  The SEC is also proposing to require additional reporting in the corresponding sections of Schedule D, which would include disclosure relating to the use of other business names and identifying information for each related person listed in Item 7.A., including more details about the relationship between the adviser and the related person, whether the related person is registered with a foreign financial regulatory authority, and whether the adviser and related person share certain kinds of non-public information or personnel with access to that information.  The SEC stated that this additional information would allow it to link disparate pieces of information concerning an adviser and its affiliates and to identify whether the adviser controls the related person or vice versa.  The SEC also noted that the additional information would provide it with a tool to identify advisory activities by unregistered affiliates.

Participation in Client Transactions

Under Item 8 of Form ADV Part 1A an adviser is required to indicate if it has discretionary authority to determine the brokers or dealers for client transactions and if it recommends brokers or dealers to clients.  The SEC proposes requiring additional disclosure as to whether any of the brokers or dealers are related persons of the adviser.  In addition, an adviser that indicates that it receives “soft dollar benefits” would also report whether all those benefits qualify for the safe harbor under Section 28(e) of the Securities Exchange Act of 1934 for eligible research or brokerage services.  Finally, the SEC is proposing to add a new question requiring an adviser to indicate whether it or any of its related persons receives compensation for client referrals, which is designed to complement the existing question concerning whether an adviser compensates any person for client referrals.

Reporting $1 Billion in Balance Sheet Assets

Section 956 of the Dodd-Frank Act requires the SEC and certain other federal regulators, to adopt rules or guidelines addressing certain excessive incentive-based compensation arrangements, including those of any registered investment adviser with $1 billion or more in assets on its own balance sheet.  In anticipation of rulemaking related to that mandate, the SEC is proposing to require each adviser to indicate in Item 1 of Form ADV Part 1A whether or not the adviser had $1 billion or more in assets as of the last day of the adviser’s most recent fiscal year.  For these purposes, an adviser’s total assets would be determined in the same manner as the amount of “total assets” is determined on the adviser’s balance sheet for its most recent fiscal year end.

Public Comments

Comments on the proposed rules are due within 45 days of publication in the Federal Register.