Financial Services Alert - April 26, 2011 April 26, 2011
In This Issue

Massachusetts Proposes Revised Investment Adviser Registration Exemptions

The Massachusetts Securities Division (the “Division”) has proposed phasing-out a commonly-used investment adviser registration exemption and creating new, more narrow registration exemptions.  The Division’s proposals are responses to the Dodd-Frank Act’s elimination of the federal Advisers Act registration exemption for advisers with fewer than 15 clients and the related creation of new federal registration exemptions.  (See the July 23, 2010 Goodwin Procter Alert for a discussion of changes to Advisers Act exemptions under the Dodd-Frank Act and the November 24, 2010 Goodwin Procter Alert for a discussion of related SEC rulemaking.)  The Division’s proposals are also consistent with a similar proposal from the North American Securities Administrators Association, which was discussed in the February 1, 2011 Alert.

The Division’s proposals would narrow the existing Massachusetts registration exemption for advisers to “institutional buyer” entities (i.e., 501(c)(3) charitable entities and entities accepting only “accredited investors” investing at least $50,000) and make the exemption available only on a limited “grandfathered” basis.  Advisers could continue to rely upon the exemption only for currently existing “institutional buyer” entities, so long as those entities do not, in the future, accept additional beneficial owners or funds from existing investors.  (The Division did not specifically comment on whether the exemption, as modified, would allow for certain routine transactions, such as transfers of fund interests among investor affiliates and calling down existing capital commitments.)

The Division’s proposal would also create new Massachusetts registration exemptions for advisers whose only clients are “venture capital funds” or funds excluded from the definition of “investment company” under Section 3(c)(7) of the Investment Company Act of 1940.  For this purpose, “venture capital fund” would be defined by reference to the SEC’s definition of the term, which has been proposed, but not finalized (as discussed in the November 24, 2010 Goodwin Procter Alert).  Advisers relying upon the new exemptions would be required to file in Massachusetts any reports they file with the SEC as “exempt reporting advisers.”  (The SEC has proposed, but not adopted, reporting requirements for exempt reporting advisers, as discussed in the November 24, 2010 Goodwin Procter Alert.)  The Division’s proposed exemptions are subject to additional conditions, including the absence of any disqualification based on certain disciplinary matters. 

The ultimate impact of the Division’s proposal will depend on how it interacts in its final form with yet-to-be finalized SEC rules regulating investment advisers.  Assuming the Massachusetts and SEC proposals become final in their current forms, these interactions could be especially meaningful for Massachusetts advisers that provide advice to even a single so-called “3(c)(1) fund” that relies upon the existing “institutional buyer” exemption and do not expect to register with the SEC (perhaps based upon another exemption such as the “family office” exemption (see the October 19, 2010 Alert for a discussion of SEC rulemaking regarding this exemption)).  Those advisers could be required to register in Massachusetts and, in some cases, comply with the SEC’s requirements for “exempt reporting advisers.”  The resulting dual compliance obligations for those advisers could prove duplicative and onerous (perhaps leading some advisers to conclude that registering with the SEC, if available as an alternative, would be more cost efficient).

The Division is considering comments on its proposals through June 24, 2011.  However, since the Division’s proposals rely upon regulations that the SEC must promulgate, the SEC’s adoption of its final rules can be expected to impact the Division’s overall timing.  The SEC is expected to finalize its relevant rules before July 21, 2011.

FRB Seeks Comments on its Intention to Apply Certain Supervisory Guidance to SLHCs

The FRB issued a notice seeking comment on its intent to apply certain supervisory guidance to savings and loan holding companies (“SLHCs”).  Title III of the Dodd-Frank Act transfers supervisory functions (including rulemaking) relating to SLHCs and their non‑depository subsidiaries to the FRB on July 21, 2011.

The FRB noted its intention to assess the condition, performance and activities of SLHCs on a consolidated risk-based basis in a manner that is consisted with the FRB’s established approach regarding bank holding company (“BHC”) supervision, and identified three elements of its current supervisory program that it believes are critical to the effective evaluation of the consolidated condition of holding companies: (1) the FRB’s consolidated supervision program for large and regional holding companies, (2) the FRB’s supervisory program for small, noncomplex holding companies, and (3) the FRB’s holding company rating system.

The FRB believes that its consolidated supervision program may entail more intensive supervisory activities than under current OTS practice, at least for some SLHCs; nevertheless, the FRB does not believe that application of the consolidated supervision program to SLHCs would require any specific action on the part of SLHCs prior to July 21, 2011 or cause undue burden on an ongoing basis.

In addition, for a number of small, noncomplex SLHCs, the FRB expects that application of its supervisory program for small, noncomplex holding companies may have the effect of reducing burden as onsite examinations/inspections will no longer be required.

Finally, the FRB believes that its holding company rating system – known as “RFI/C(D)” (commonly referred to as “RFI”) – is similar to the OTS rating system for SLHCs (known as “CORE”), and as such, the FRB is considering transitioning SLHCs to the RFI rating system as the FRB conducts its own independent supervisory assessment of the condition of the SLHC after July 21, 2011.

The FRB noted that one material difference between the OTS and FRB supervisory programs for holding companies is the assessment of capital adequacy.  Currently, SLHCs are not subject to minimum regulatory capital ratio requirements.  Section 171 of the Dodd‑Frank Act requires that BHCs and SLHCs be subject to minimum leverage and risk based capital requirements that are not less than the generally applicable leverage and risk-based capital requirements applied to depository institutions.  The FRB is considering applying to SLHCs the same consolidated risk-based and leverage capital requirements as those to which BHCs are subject, to the extent reasonable and feasible taking into consideration the unique characteristics of SLHCs and the requirements of the Home Owners’ Loan Act.  In addition, the FRB noted that it, together with the other Federal banking agencies, expects to issue a notice of proposed rulemaking in 2011 that will outline how Basel III-based requirements will be implemented for all institutions, including any relevant provisions needed to comply with the Dodd-Frank Act.

The FRB requests comment with regard to:

(1)   The burden of these potential modifications to supervisory activities on SLHCs; and

(2)   Whether there are any unique characteristics, risks, or specific activities of SLHCs that should be taken into account when evaluating which supervisory program should be applied to SLHCs and what changes would be required to accommodate these unique characteristics.

Additionally, the FRB is seeking comment on the following:

(3)   What instruments that are currently includable in SLHCs’ regulatory capital would be either excluded from regulatory capital or more strictly limited under Basel III?  How prevalent is the issuance of such instruments?  What is the appropriateness of the Basel III transitional arrangements for non-qualifying regulatory capital instruments?

(4)   Are the proposed Basel III-based transition periods appropriate for SLHCs and, if not, what alternative transition periods would be appropriate and why?

Finally, the FRB is seeking specific comment with respect to what methods the FRB should consider implementing for assessing capital adequacy for SLHCs during the period between July 21, 2011 and implementation of consolidated capital standards for SLHCs.

Comments on are due on or before May 23, 2011.

FRB Requests Comments Regarding its Studies Mandated by the Dodd Frank Act Concerning the Resolution of Financial Companies Under the Bankruptcy Code

The FRB issued a notice and request for information (the “ Notice”) regarding two studies that the FRB is required to conduct pursuant to Sections 216 and 217 of the Dodd-Frank Act (the “Act”) regarding the resolution of financial companies under the Bankruptcy Code.  Under Section 216 of the Act, the FRB, in consultation with the Administrative Office of the United States Courts (“AOUSC”) must conduct a study (the “Section 216 Study”) concerning the resolution of financial companies under Chapter 7 and Chapter 11 of the Bankruptcy Code.  Under Section 217 of the Act, the FRB, in consultation with the AOUSC, must conduct a second study (the “Section 217 Study”) concerning international coordination relating to the resolution of systemic financial companies under the Bankruptcy Code and applicable foreign law.

In the Notice, the FRB solicits public comment with respect to the Section 216 Study regarding: (1) the effectiveness of Chapter 7 and Chapter 11 of the Bankruptcy Code in facilitating the orderly resolution or reorganization of systemic financial companies; (2) whether a special court or panel of special masters or judges should be established to oversee cases involving the bankruptcy of financial companies; (3) whether amendments to the Bankruptcy Code should be enacted regarding the resolution of financial companies; (4) whether amendments to the Bankruptcy Code, the Federal Deposit Insurance Act and other insolvency laws should be adopted regarding the manner in which qualified financial contracts of financial companies are treated; and (5) the pros and cons of creating a new chapter or subchapter of the Bankruptcy Code to deal with financial companies.

The FRB seeks public comment with respect to the Section 217 Study regarding: (1) the current level of international coordination; (2) current mechanisms and structures for facilitating international cooperation; (3) barriers to effective international coordination; and (4) ways to improve international coordination of resolution of financial companies to minimize the impact on the financial system while not creating moral hazard.

Comments are due no later than 30 days after the Notice’s publication in the Federal Register.

SEC Administrative Law Judge Finds Insider Trading Violations by Mutual Fund Portfolio Manager Resulting from Recommendations to Family Members

An administrative law judge (the “ALJ”) issued an initial decision related to cease and desist proceedings against the portfolio manager (the “Portfolio Manager”) of a short term municipal bond fund (the “Short Term Fund”) as a result of insider trading violations stemming from the Portfolio Manager’s recommendation that certain family members sell their holdings in the Fund.  The ALJ found that the Portfolio Manager improperly recommended that his daughter and certain other family members sell their holdings in the Short Term Fund while he was in possession of material non-public information regarding the Short Term Fund (“MNPI”).  This article summarizes the ALJ’s principal findings in the order.

Background.  From 2003 until 2008 the Portfolio Manager was the head portfolio manager for the Philadelphia office of a registered investment adviser (the “Adviser”), and was responsible for the management of approximately $5 billion in fixed income investments, including the Short Term Fund and a municipal bond fund managed using the same investment approach, but having a longer duration (collectively with the Short Term Fund, the “Funds”).  A significant portion of the net worth of certain family members of the Portfolio Manager, including his two daughters, his ex-wife, and his brother-in-law and sister-in-law, was invested in the Short Term Fund.  In connection with the market disruptions experienced in 2008, the performance of the Funds began to suffer and the Funds experienced significant redemption pressure, including large redemptions from certain institutional shareholders. 

On September 17, 2008, the Portfolio Manager engaged in a telephone conversation with his daughter in which the daughter asked the Portfolio Manager what they were going to do about her investments in light of the economic crisis.  In response to his daughter’s concerns the Portfolio Manager gave general responses counseling her that if she was concerned then she should sell her holdings in the Short Term Fund, and that her mother and other family members should, as well. 

During the period between September 17, 2008 and October 3, 2008, the Portfolio Manager became aware of certain MNPI regarding the Funds, including: (1) that a large institutional shareholder had indicated that it intended to redeem its holdings in the Short Term Fund that were approximately equal to 10% of the Short Term Fund’s assets, and had commenced a redemption program toward that end, (2) that management of the Adviser had directed the Portfolio Manager to significantly raise the cash level in the portfolios of each of the Funds in order to meet the anticipated demand for redemptions, and (3) that the Adviser was discussing closing the Funds, and had determined that if it determined to close one Fund, then the other would be closed, as well.

On October 3, 2008, the Portfolio Manager and his daughter engaged in another telephone conversation during which the Portfolio Manager brought up the previous discussions regarding the daughter’s holdings in the Short Term Fund and when informed that she had redeemed a portion of her holdings he instructed her that she should “go with the full route.”  Following this conversation, several members of the Portfolio Manager’s family, including his two daughters, his ex-wife, his brother-in-law and sister-in-law, took action to redeem their holdings in the Short Term Fund.

Internal Investigation. On October 7, 2008, the Adviser became aware of the series of redemption requests by members of the Portfolio Manager’s family and commenced an internal investigation into the facts of the redemption requests to determine what prompted the activity.  As part of the internal investigation the Portfolio Manager was interviewed and provided an account of the telephone conversations with his daughter that significantly differed from the transcripts of those telephone calls, particularly where the Portfolio Manager recounted that he had stated in each conversation that he could not provide investment advice as to the Short Term Fund.  As a result of the internal investigation, the Adviser determined not to honor several redemption requests from members of the Portfolio Manager’s family.  Further, the Adviser determined that the Portfolio Manager had breached the Adviser’s Code of Ethics (the “Code”) by disclosing MNPI and by not being truthful during the internal investigation.  At the conclusion of the internal investigation the Adviser terminated the Portfolio Manager

Insider Trading.  The ALJ determined that the facts supported a decision that the Portfolio Manager was guilty of insider trading, which under applicable law generally requires that the actor (a) be in possession of material, non-public information that is intended to be used for a proper purpose, and then, (b) misappropriates or otherwise misuses that information, (c) with scienter, (d) in breach of a fiduciary duty or other duty arising out of a relationship of trust or confidence.  In reaching this decision the ALJ found that when the Portfolio Manager recommended that his daughter sell her holdings in the Short Term Fund: (1) the Portfolio Manager was in possession of MNPI; (2) he misused MNPI by advising his daughter that she and his former wife should sell their shares of the Short Term Fund; (3) he acted with the requisite scienter, (i.e., in general terms, having a mental state embracing the intent to deceive, manipulate or defraud); and (4) he acted in breach of his fiduciary duty to the Adviser and the Short Term Fund. 

In analyzing whether the Portfolio Manager acted with scienter, the ALJ observed that the intent required for scienter can either be established by willfulness or by extreme recklessness, noting that a number of facts supported a finding that the Portfolio Manager was either willful or extremely reckless with respect to the use of MNPI when “tipping” his daughter.  The ALJ found that the Portfolio Manager was aware of the prohibitions against insider trading, as evidenced by his express agreement to comply with the Adviser’s Insider Trading Policy which stated that “[i]t is a violation of United States federal law . . . for any employee to trade in, or recommend trading in, the securities of a company . . . while in possession of material, nonpublic information.”  The ALJ held that the Portfolio Manager’s false exculpatory statements in response to questioning during the Adviser’s internal investigation indicated a “consciousness of guilt.”   As evidence of the Portfolio Manager’s extreme departure from the standard of ordinary care, the ALJ cited the Portfolio Manager’s failure to seek input from the Adviser’s internal legal or compliance department prior to advising his daughter to sell her shares in the Short Term Fund, which the ALJ contrasted with the actions of another portfolio manager for the Adviser who was also in possession of MNPI regarding the difficulties faced by the Short Term Fund and had sought compliance department pre-approval of a proposed sale of a personal holding in the Fund during the same timeframe (and been refused). 

In determining that the Portfolio Manager’s actions violated fiduciary duties to the Adviser and the Short Term Fund the ALJ explained that (a) the Portfolio Manager owed a duty of loyalty and confidentiality to the Adviser as his employer, and had acknowledged such duties through his agreement to comply with the Code, and (b) the Portfolio Manager, as an investment adviser to the Short Term Fund, also owed the Fund a fiduciary duty.  The ALJ found that the Portfolio Manager breached his fiduciary duties to both the Adviser and the Short Term Fund when he advised his daughter and his former wife to sell shares in the Short Term Fund with an aggregate value of close to $2 million while in possession of MNPI, in violation of management’s directive to increase the cash position of the Short Term Fund, and against the best interests of the Short Term Fund, which was ill positioned given market conditions to deal with large redemptions.

Violations and Sanctions.  The ALJ found that the Portfolio Manager willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder, which prohibit fraudulent conduct in the offer and sale of securities and in connection with the purchase and sale of securities.  Further the ALJ found that the Portfolio Manager willfully violated Sections 206(1) and 206(2) of the Advisers Act, which prohibit fraudulent conduct by an investment adviser.  The ALJ ordered that: (a) the Portfolio Manager cease and desist from committing or causing any violations or future violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Sections 206(1) and (2) of the Advisers Act, (b) the Portfolio Manager be barred from association with an investment adviser, and (c) the Portfolio Manager pay disgorgement in the amount of $9,403.55 representing the amount of the losses avoided by certain family members.  The SEC Division of Enforcement recommended that the ALJ impose a civil money penalty in an amount up to $130,000 for each act based on the Portfolio Manager’s intentional misconduct and the risk of substantial loss to the shareholders of the Short Term Fund; however, the ALJ determined that no civil money penalty was warranted because the Portfolio Manager’s reckless disregard of a regulatory requirement did not result in significant harm to the shareholders of the Short Term Fund.

FINRA Proposes to Amend NASD Rule 2830 Regarding Investment Company Securities

On April 19, 2011, FINRA filed a rule proposal with the SEC to amend NASD Rule 2830 (Investment Company Securities) and to incorporate it into the FINRA rulebook as FINRA Rule 2341.  Rule 2830 applies to the activities of FINRA member firms in connection with the offering of securities of companies registered under the Investment Company Act of 1940.  Excluded from the rule are variable contracts of an insurance company, the sale of which is governed by FINRA Rule 2320.

Rule 2830, among other things, imposes limits on the amount and types of compensation member firms may receive for the sale of investment company shares.  Paragraph (l)(4) currently prohibits a member from receiving cash compensation from an offeror of investment company shares unless the compensation is described in a current prospectus of the investment company.  By interpretation of the FINRA staff (in Notice to Members 99‑55, Question #18), the information requirement may also be satisfied by disclosure in a fund’s statement of additional information (“SAI”).  When special cash compensation arrangements are made available by the offeror to a member, and those arrangements are not available on the same terms to all members that distribute the investment company’s shares, paragraph (1)(4) prohibits the member from entering into the arrangement unless details of the arrangement are disclosed in the prospectus.  Proposed Rule 2341 would amend paragraph (l)(4) by shifting the disclosure obligation from the issuer to the member entering into the arrangement.  Members receiving special cash compensation would be required to make two types of disclosure.  First, the member would be required to prominently disclose in paper or electronic form, prior to the time a customer first purchases shares of an investment company through the member, the following matters:

  • that the member has received, or has entered into an arrangement to receive, cash compensation from investment companies and their affiliates, in addition to sales charges and service fees disclosed in the prospectus fee table;
  • that this additional cash compensation may influence the selection of investment company shares that the member and its associated persons offer or recommend to investors; and
  • a reference (or in the case of electronically delivered documents, a hyperlink) to the web page or toll-free number of the member firm at which the second type of disclosure, described below, is provided.

For existing customers as of the effective date of the rule change, the disclosure above would have to be made by the later of 90 days after the effective date of the rule change or prior to the customer’s first purchase of investment company shares through the member.

A member would also be required to provide the following information, in a web page or through a toll-free telephone number, and update it at least annually:

  • A narrative description of the additional cash compensation received from offerors, or to be received pursuant to an arrangement entered into with an offeror, and any services provided or to be provided by the member to the offeror or its affiliates for the additional cash compensation;
  • If applicable, a narrative description of any preferred list of investment companies to be recommended to customers that the member has adopted as a result of the receipt of additional cash compensation, including the names of the investment companies on the list; and
  • The names of the offerors that have paid, or entered into an arrangement to pay, this additional cash compensation to the member.

The amended rule would add a definition of “cash compensation” that would include, among other things, payments under revenue sharing arrangements between the member firm and the investment company’s adviser in connection with the sale and distribution of the investment company shares.  The amended rule would also codify existing exemptions from the rule for exchange-traded funds (“ETFs”).

FINRA proposes to provide a delay of implementation of the rule for up to 365 days following SEC approval to allow member firms adequate time to prepare for compliance.  Comments on the rule proposal will be due within 45 days of publication in the Federal Register.