Financial Services Alert - February 1, 2011 February 01, 2011
In This Issue

SEC and CFTC Propose Rules Requiring Registered Advisers of Private Funds to File Form PF with SEC

The SEC and the CFTC proposed joint rules (the “Proposed Rules”) that would implement provisions of the Dodd-Frank Act by creating a new Form PF, which is designed to gather information regarding the private fund industry for use by the Financial Stability Oversight Council in monitoring systemic risk. 

Advisers Required to Report.  The Proposed Rules would require periodic Form PF filings by any investment adviser registered with the SEC that advises one or more funds (each a “private fund”) that would be an “investment company” under the Investment Company Act of 1940 (the “1940 Act”) but for the exclusions from the definition of “investment company” under Section 3(c)(1) (the 100 beneficial owners exception) or Section 3(c)(7) (the “qualified purchaser” exception) of the 1940 Act.  For commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) registered with the CFTC that are also registered as investment advisers with the SEC and advise a private fund, the proposed Form PF would replace a portion of the CFTC’s proposed systemic risk reporting requirements under proposed Commodity Exchange Act Rule 4.27(d) which are discussed elsewhere in this issue.  Information reported on Form PF would generally remain confidential.

Frequency and Substance of Reports.  Under the Proposed Rules, an adviser to private funds with less than $1 billion in assets under management (a “smaller private fund adviser”) would be required to file Form PF annually and would report basic information regarding the private funds it advises, including details regarding assets under management, borrowings and leverage, derivatives, credit providers, investor concentration and fund performance.  A smaller private fund adviser managing a “hedge fund” (as defined below) would also be required to report information about the hedge fund’s strategy, counterparty credit risk and trading and clearing practices.

An adviser to private funds with $1 billion or more in assets under management (a “large private fund adviser”) would be required to file Form PF on a quarterly basis and would provide the same information required for a smaller private fund adviser, plus additional information based on the type of private funds that the large private fund adviser manages.  A large private fund adviser to a hedge fund would also be required to report on an aggregated basis details regarding the hedge fund’s exposure by asset class, geographical concentration and turnover.  In addition, a large private fund adviser to any hedge fund having a net asset value of at least $500 million would report details relating to the hedge fund’s investments, including long and short exposure by asset class, as well as leverage and collateral practices, counterparty exposure, risk profile, portfolio liquidity and redemption restrictions.  A large private fund adviser to a “private equity fund” (as defined below) would be required to report information relating to the private equity fund’s finances and investments, including borrowings, guarantees and leverage of portfolio companies and use of bridge financing.  A large private fund adviser would also be required to file certain information relating to any “liquidity fund” (as defined below) that it advises.

Definitions – Hedge Fund, Private Equity Fund and Liquidity Fund.  Form PF would define “hedge fund” as any private fund that (i) has a performance fee or allocation calculated by taking into account unrealized gains; (ii) may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital); or (iii) may sell securities or other assets short.  Form PF would define a “private equity fund” as any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund (each as defined in the Proposed Rules) and does not provide investors with redemption rights in the ordinary course.  Form PF would define a “liquidity fund” as any private fund that seeks to generate income by investing in a portfolio of short term obligations in order to maintain a stable net asset value per unit or minimize principal volatility for investors.

Estimated Burden of Reporting Obligations.  By the SEC’s own estimates, the burden imposed by the proposed reporting requirements could be significant (i.e., approximately one month of a full-time employee’s business time during each of the first three years after Form PF is adopted).

Public Comment.  Comments on the Proposed Rules are due no later than 60 days after their publication in the Federal Register.

Seventh Circuit Vacates Class Certification in Two 401(k) Excessive Fee Cases and Affirms Dismissal in a Consolidated 401(k) Stock Drop Case

On January 21, 2010, a panel of the United States Court of Appeals for the Seventh Circuit issued two important decisions, one in the current wave of 401(k) fee cases, and another in the long-standing genre of retirement plan stock drop cases.  Each decision will likely impact future jurisprudence in these areas.

Class Decertification in Fee Cases

In one decision, the court addressed interlocutory appeals to decisions certifying classes in two excessive fee cases against large plan sponsors and the alleged fiduciaries of their 401(k) plans.  One plan had over 70,000 participants, the other over 180,000.  In each case, the district court had certified classes that included all current, former, and future participants and beneficiaries of those plans (excluding any defendant).  The court described the claims in each case similarly, that defendants:  (i) caused the plans to pay allegedly excessive fees, including revenue sharing payments; (ii) maintained allegedly imprudent investment options; and (iii) concealed material information from participants about the plans. 

The Seventh Circuit began its class certification analysis explaining that “[t]he propriety of class treatment . . . will turn on the circumstances of each case.”  The court first addressed the temporal aspect of the certified classes, finding that it was “breathtaking in its scope” where “[a]nyone, in the history of Time, who was ever a participant in the Boeing Plan, or who in the future may become a participant in the Boeing Plan, is swept into the class.”  The court next focused on plaintiffs’ allegations that certain funds made available to the plan were imprudent.  It noted that many past participants and unknown future participants may have never held precisely the same funds as named plaintiffs.  As such, the named plaintiffs could not meet the typicality and adequacy requirements for class certification under Federal Rule of Civil Procedure 23(a).  The court explained: “it seems that a class representative in a defined-contribution case would at a minimum need to have invested in the same funds as the class members” because “there must be a congruence between the investments held by the named plaintiff and those held by members of the class he or she wishes to represent.”  In part, the lack of congruence creates an impermissible conflict, where “the alleged conduct harmed some participants and helped others.”

As such, the court vacated the decisions certifying these classes and remanded for further proceedings.  The cases are Spano, et al v. The Boeing Co., et al, No. 09-3001 (7th Cir., Jan. 21, 2011) and Beesley, et al v. International Paper Co., et al, No. 09-3018 (7th Cir., Jan. 21, 2011).  

Dismissal in Stock Drop Cases

In its other decision, the court addressed final judgments in favor of defendants in two cases challenging the decision by a 401(k) plan sponsor and the alleged fiduciaries of its 401(k) plan to include a company stock fund as a plan investment option.  In this litigation, the district court had granted a motion to dismiss as to one plaintiffs’ claim, and summary judgment against the remaining plaintiffs, where participants challenged the decision to maintain a company stock fund.  The price of the challenged stock declined over 50% during the roughly one year class period, based largely on a single large transaction that, in the court’s words, “turned out very badly.”  Like many such stock drop suits, the plaintiffs alleged that defendants (i) improperly allowed the stock fund to be offered to the plan; (ii) misrepresented or failed adequately to disclose the transaction at issue; and (iii) failed to appoint, monitor, and provide adequate information to other plan fiduciaries.

The court first addressed an argument addressed to the dismissal of one plaintiff due to a release he signed which included a waiver of all ERISA claims; a release which expressly carved out “any claims for benefits” under the plans.  The court held that this release barred all ERISA claims for breach of fiduciary duty, because plaintiff received all “benefits that had already vested” when he signed the release.  

Turning to the merits of the claims brought by the non-releasing plaintiffs, the court began with an examination of the safe harbor created in ERISA Section 404(c), which relieves fiduciaries of liability where the loss results from a participant’s or beneficiary’s exercise of control.  The court agreed with the position taken by the U.S. Department of Labor that the safe-harbor would not apply to the “core decision” as to which investments will be presented to participants.  Instead, the court held that the safe harbor will apply to decisions over which the fiduciary has no control, such as participant allocation decisions. 

That said, the court held that by offering at various times three or eight other investment options, defendants allowed the plan to be adequately diversified such that “no participant’s retirement portfolio could be held hostage” to the fortunes of the company stock fund.  It also held that the stock drop at issue was not so significant as to demonstrate that the company was facing “imminent collapse” or that the stock was “so risky or worthless” that it had to be immediately withdrawn from the plan menu.  As such, regardless of the Section 404(c) defense, the court held that the lower court correctly dismissed the imprudence claims.      

The court then addressed the disclosure and monitoring claims.  As to disclosure, it held that allegations of a negligent misrepresentation were insufficient to make out a claim.  In the absence of an intentionally misleading statement or a material omission where silence may be construed as misleading, no claim is established.  The court explained that omitting information about an allegedly bad business decision is not enough to state a violation of ERISA.  As to the monitoring claim, the court explained that every board member is not required “to review all business decisions of Plan administrators,” and that the appointing fiduciaries did not breach any duties as they were not shown to have “pass[ed] the buck to another person and then turn[ed] a blind eye.”   

As such, the court affirmed judgment for defendants.  The cases are Howell v. Motorola, Inc., et al, No. 07-3837 (7th Cir., Jan. 21, 2011) and Lingis, et al v. Dorazil, et al, No. 09-2796 (7th Cir., Jan. 21, 2011).  

FSOC Issues Proposed Rule on the Designation of Systemically Significant Nonbank Financial Companies

The Financial Stability Oversight Council (“FSOC”) issued a notice of proposed rulemaking (the “Proposed Rule”) setting forth the criteria and framework for determining whether a nonbank financial company should be designated systemically significant pursuant to section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  For previous coverage of the designation of systemically significant nonbank financial companies and the Dodd-Frank Act generally, please see the July 28, 2010 Special Edition of the Alert

Under the Dodd-Frank Act, if any company has 85% or more of its annual gross revenues or consolidated assets related to activities that are predominately financial in nature (as defined by section 4(k) of the Bank Holding Company Act of 1956, as amended,) the company may be designated as systemically significant and become subject to regulation by the FRB, including heightened prudential standards and other restrictions.  The Proposed Rule does not indicate whether certain types of nonbank financial companies are per se subject to or safe from designation as systemically significant.  The Proposed Rule established six criteria to be used to determine whether a nonbank financial company is systemically significant:

  • Size;
  • Lack of substitutes for the financial services and products the company provides;
  • Interconnectedness with other financial firms;
  • Leverage;
  • Liquidity risk and maturity mismatch; and
  • Existing regulatory scrutiny.

The FSOC divides these six criteria into two groups.  The first three criteria are intended to assess the potential effect from a company’s distress on the broader financial system or the economy.  The second three criteria are intended to assess how vulnerable a company is to financial distress.  The Proposed Rule also states that the application of these criteria will be adapted to fit the risks presented by particular industry sectors and the business models of such sectors.  The Proposed Rule further notes that the metrics used to measure the six criteria likely will differ across industry sectors and will be reviewed and revised by the FSOC on a periodic basis. 

The Proposed Rule implements the provisions of the Dodd-Frank Act requiring the FSOC to give companies advance notice of a proposed designation as systemically significant and the opportunity for a hearing.  Additionally, under the Proposed Rule, the FSOC would give a company written notice that it is considering designating the company as systemically significant and allowing the company to submit written materials to the FSOC regarding whether the company would pose a threat to the financial stability of the United States.  The Proposed Rule also implements the provisions of the Dodd-Frank Act permitting the FSOC to request that the FRB conduct an examination of a nonbank financial company to determine whether it should be designated as systemically significant and requiring consultation with other regulatory agencies.  Comments on the Proposed Rule must be submitted by February 27, 2011.

CFTC Proposes New Reporting Requirements for Commodity Pool Operators (“CPOs”) and Commodity Trading Advisors (“CTAs”) and Rule Amendments Affecting Compliance Obligations of CPOs and CTAs

At its open meeting on January 26, 2011, the CFTC approved new systemic risk reporting requirements under new proposed Commodity Exchange Act Regulation 4.27 and approved other rule amendments affecting compliance obligations of commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”).  Proposed new Regulation 4.27 would require CPOs and CTAs that are registered with the CFTC to file Forms CPO-PQR and CTA-PR with the National Futures Association (the “NFA”).  In addition, the rule amendments that the CFTC approved include major changes to the existing compliance regime with respect to CPO and CTA registration and disclosure requirements.  Because the formal proposing rule release was not available until this edition of the Alert was being finalized, this summary is based on the CFTC Q&A and fact sheet announcing the proposed rules.  A copy of the proposing release is available at the following link:

At the same open meeting, the CFTC approved proposed joint rules with the SEC to address reporting requirements with respect to private funds by advisers that are registered with the SEC and with the CFTC as CPOs or CTAs.  The proposed joint rules which would create a new Form PF are discussed elsewhere in this edition of the Alert

Specifically, the CFTC is proposing to:

  • Require any CPO or CTA that is registered or required to be registered with the CFTC to file proposed Forms CPO-PQR and CTA-PR, respectively, with the NFA.  According to the CFTC, proposed Forms CPO-PQR and CTA-PR would solicit information that is generally identical to the information sought through proposed new Form PF with appropriate modifications.  Proposed Regulation 4.27 utilizes a “tiered approach” to the collection of data from CPOs and CTAs in that the amount of information that a CPO or CTA will be required to disclose on the new forms (and the frequency of reporting) will vary depending on both the size of the operator or adviser and that of the advised pools.  The CFTC is also amending Regulations 145.5 and 147.3 to treat certain proprietary information collected in proposed Forms CPO-PQR and CTA-PR as non-public records.
  • Reinstate trading criteria for registered investment companies claiming exclusion from the CPO definition under Regulation 4.5.  The proposed amendments to Regulation 4.5 would restore conditions that prior to 2003 were imposed on registered investment companies that relied upon Regulation 4.5.  According to the CFTC, the proposed amendments to Regulation 4.5 are consistent with the language proposed by the NFA in its 2010 petition for rulemaking in which the NFA suggested certain revisions to the exclusion in Regulation 4.5 from the CPO definition for persons who would otherwise be regulated as such by the CFTC (as discussed in the September 14, 2010 Alert).  The NFA’s proposal was designed to foreclose reliance on the Regulation 4.5 exclusion by “commodity mutual funds,” pooled investment vehicles registered under the Investment Company Act of 1940, as amended, that are marketed as commodities futures investments to retail investors, among others;
  • Rescind the exemption from CPO registration under Regulation 4.13(a)(3) and (4) for operators of pools that are similarly situated to private funds.  According to the CFTC, operators of such pools should be subject to similar regulatory obligations to those that the Dodd-Frank Act requires of advisers of private funds (including proposed Form CPO-PQR) in order to provide improved transparency and increased accountability with respect to such pools;
  • Revise Regulation 4.7 so that CPOs may no longer claim exemption from the certification requirement that an exempt pool’s annual report contain certified financial statements and modify the participant qualification criteria of Regulation 4.7 to incorporate the SEC’s accredited investor standard by reference rather than by direct inclusion of its terms.  Regulation 4.7 currently makes available relief from certain disclosure, reporting and recordkeeping requirements to CPOs of pools that are offered solely to qualified eligible participants;
  • Require all persons claiming exemptive or exclusionary relief under Regulations 4.5, 4.13 and 4.14 to confirm their notice of claim of exemption or exclusion on an annual basis; and
  • Amend the risk disclosure statement that must be included in CPO and CTA disclosure documents to describe certain risks specific to swaps transactions.

SEC Publishes Study on Investor Access to Registration Information about Investment Advisers and Broker-Dealers

The Staff of the Office of Investor Education and Advocacy of the SEC (“OIEA”) published its “Study and Recommendations on Improved Investor Access to Registration Information About Investment Advisers and Broker-Dealers” (the “Study”).  The Study was required by Section 919B of the Dodd-Frank Act, which directed the SEC to recommend ways to improve investor access to registration information about registered and previously registered investment advisers, brokers and dealers and their respective associated persons, and to identify additional information that should be made publicly available.  The SEC is required to implement any recommendations within eighteen months of completing the study.

Conclusions.  OIEA identified various types of information it believed to be important to investors, some, but not all, of which are currently available on BrokerCheck, for broker‑dealers, or the Investment Adviser Public Disclosure (“IAPD”) section of the SEC website, for federal and state registered investment advisers.

OIEA noted that a single source of registration information regarding broker-dealers, investment advisers and their associated persons did not exist and that this was a reflection of the fact that two different regulatory regimes existed, each with its own separate registration system.  As it had been tasked to do, OIEA considered the advantages and disadvantages of further centralizing the BrokerCheck and IAPD systems.  Having acknowledged that currently a significant amount of registration information is publicly available, OIEA concluded that the primary advantage of a unified system would be the ability to provide investors with access to relevant data through a single request.  OIEA determined that a unified public disclosure database would be the optimal method for achieving such a goal, but cited practical difficulties of a complete structural overhaul in the allotted eighteen months as its reason for developing near-term and intermediate-term recommendations. 

Recommendations.  OIEA’s near-term recommendations include:

  • unifying BrokerCheck and IAPD search results;
  • adding a ZIP code search or other indicator of location function to BrokerCheck and IAPD; and
  • adding educational content to BrokerCheck and IAPD.

OIEA’s intermediate-term recommendations include:

  • analyzing the feasibility and advisability of expanding BrokerCheck to include information currently available in the Central Registration Depository; and
  • continuing to evaluate the expansion of IAPD content, as well as the method and format of publishing such content.

SEC Issues Final “Say on Pay” Rules

The SEC issued final rules (the “Rules”) designed to implement the provisions of the Dodd‑Frank Act that require certain issuers to (1) solicit a shareholder advisory vote on executive compensation at least once every three years, (2) periodically solicit a shareholder advisory vote on the frequency of shareholder advisory votes on executive compensation, and (3) solicit a shareholder advisory vote on so-called “golden parachute” compensation arrangements in connection with mergers or other extraordinary corporate transactions.  Under the Rules, issuers are required to implement the first two of these requirements effective with respect to proxy statements for annual or other meetings occurring on or after January 21, 2011 at which proxies will be solicited for the election of directors.  Issuers are required to implement the advisory vote on golden parachute arrangements in connection with proxy filings made on or after April 25, 2011.  Goodwin Procter will issue a separate Client Alert discussing the Rules in more detail.

NASAA Proposed Model Rule Would Exempt Certain Advisers from State Registration

The North American Securities Administrators Association (“NASAA”), a voluntary organization of securities agencies across the United States, Canada and Mexico, has proposed a model rule (the “Model Rule”) that would generally exempt investment advisers from the obligation to register at the state level, if the advisers: (i) are not subject to disqualification based upon their prior disciplinary history; and (ii) solely advise funds excluded from the definition of “investment company” under Section 3(c)(7) of the Investment Company Act of 1940 (the “1940 Act”).  Advisers exempt from state registration obligations would still be required to make certain state notice filings and pay state filing fees.

As noted by NASAA itself, the interaction between the Model Rule (to the extent adopted by states) and federal investment adviser regulations would depend upon how state and federal regulations are finalized, and certain interactions could lead to unexpected results.  For example,  under proposed Advisers Act Rule 203A(a)(2), certain advisers that are required to register at the state level would be prohibited from registering with the SEC.  However, if the Model Rule exempted those same advisers from state registration, they could elect to either: (i) register with the SEC (since the prohibition on registration under 203A(a)(2) would no longer apply); or (ii) operate as “exempt reporting advisers” under the Model Rule and proposed Advisers Act Rule 203(m)-1 (the “private fund adviser” exemption discussed in the Goodwin Procter Alert dated November 24, 2010).  Since the compliance obligations on exempt reporting advisers could prove duplicative and onerous (particularly for advisers operating in multiple states with differing regulatory regimes), certain advisers might view registering with the SEC as the more cost efficient of these two alternatives.

NASAA is considering any comments on the Model Rule before finalizing its proposal.  Once NASAA finalizes the Model Rule, one or more states may choose to formally adopt it (as proposed or in modified form) through legislation, rulemaking or other appropriate means.

SEC Proposes Rule Amendments to Reflect Dodd-Frank Act Accredited Investor Standards

The SEC issued a rule proposal designed to incorporate (a) the requirement under the Dodd-Frank Act (effective since July 21, 2010) that in order to qualify as an “accredited investor” under the 1933 Act’s rules, including Regulation D, a natural person must have a net worth in excess of $1 million, excluding the value of the person’s primary residence (as discussed in the  July 28, 2010 Special Edition of the Alert) and (b) related SEC guidance regarding the treatment of indebtedness secured by a primary residence (as discussed in the August 3, 2010 Alert), as well as make related technical changes.  As proposed to be revised, the affected definition in Rules 215 and 501 under the Securities Act of 1933 would read as follows:

Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of purchase, exceeds $1,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property.

The SEC makes clear in the proposal that it intends for any excess of secured debt on a primary residence over the value of the primary residence (when the property is “under water”) to be subtracted from the value of other assets.  The SEC requests comment on a variety of issues, including the timing of the net worth determination, whether to define “primary residence” (a topic on which the release provides guidance) and whether to provide a transition rule to allow subsequent investment, e.g., in a rights offering, by an investor who previously qualified but was disqualified by the Dodd-Frank Act.  Comments on the proposal are due by March 11, 2011.

FRB Issues Supervisory Letter on the Impact of High-Cost Credit Protection Transactions on Capital Adequacy

The FRB issued a supervisory letter (Letter SR 11-1, the “Letter”) which provides guidance concerning the potential impact of high-cost credit protection transactions on banking organizations’ overall capital adequacy.  The FRB notes that if a banking organization pays too high a fee for a specific credit protection transaction, rather than safely and soundly managing the banking organization’s credit risk, the banking organization may, in effect, be paying, in the form of premiums and fees, a high percentage of the expected losses in the applicable pool of assets.  In the Letter, the FRB instructs supervisory staff that in the cases of such high-cost credit protection transactions, examiners should carefully scrutinize the transaction and, when appropriate, preclude favorable risk-based capital treatment.

CFTC Proposes Position Limits for Physical Commodity Derivatives

The CFTC issued a rule proposal designed to implement provisions of Title VII of the Dodd-Frank Act that require it to establish position limits for certain physical commodity derivatives.  The proposal would simultaneously establish position limits and limit formulas for certain physical commodity futures and option contracts executed pursuant to the rules of designated contract markets (‘‘DCM’’) and for economically equivalent physical commodity swaps.  The proposal would also establish aggregate position limits that would apply across different trading venues to contracts based on the same underlying commodity.  The proposal includes exemptions for bona fide hedging transactions and for certain positions established prior to the adoption of final rules, new account aggregation standards, visibility regulations and new requirements and standards for position limits and accountability rules implemented by DCMs and swap execution facilities.  Comments must be received no later than March 28, 2011.

Financial Crisis Inquiry Commission Issues Final Report on Causes of the Financial Crisis of 2008

The Financial Crisis Inquiry Commission (“FCIC”) released, on January 27, 2011, its final 662-page Report (the “Report”) regarding the causes of the 2008 financial crisis.  The Report, which represents the views of the six-member majority (six out of ten Commissioners), concludes that the crisis was avoidable and assigns culpability to a broad range of factors and entities, including, among others:

  1. Fannie Mae’s and Freddie Mac’s failure to react to the risks of the subprime mortgage market and the housing bubble and the loosening of their credit underwriting standards;
  2. lapses in regulatory oversight;
  3. loose corporate governance practices and executive compensation practices that rewarded risk-taking without claw-back and other protections;
  4. inadequate levels of capital at banks and investment banks;
  5. credit rating agencies that gave asset pools high ratings with insufficient due diligence;
  6. bankers who failed to account for risks in the housing market;
  7. greater concentrations of high-risk trading in financial institutions’ trading portfolios;
  8. misuse of over-the-counter derivatives;
  9. misguided government housing and other policies; and
  10. fraud and, to a greater extent, greed.

The Report does not assign primary responsibility for the financial crisis to any one factor or entity and does not make any specific policy recommendations.  The Report includes two dissents, one by three members of the minority and one by Peter Wallison, the fourth member of the minority on the FCIC.