Financial Services Alert - May 17, 2011 May 17, 2011
In This Issue

SEC Proposes Changes to Advisers Act Rule Permitting Performance Fees

The SEC issued a rule proposal that would amend Rule 205-3 under the Investment Advisers Act of 1940, which permits a registered adviser to charge a performance-based advisory fee, i.e., one based on a share of capital gains on, or capital appreciation of, a client’s account.  In relevant part, the Rule allows an adviser to charge a performance-based advisory fee to a “qualified client” who has either a threshold amount of assets under management (“AUM”) with the adviser, currently $750,000, or meets a net worth test, currently $1 million.  The proposal would:

  1. increase the AUM threshold and the net worth test to $1 million and $2 million, respectively;
  2. provide that the SEC may issue an order every five years that adjusts those tests for inflation;
  3. exclude the value of a primary residence, and related debt up to the current market value of the residence, from the qualified client net worth calculation; and
  4. revise the Rule’s transition provision to grandfather fee arrangements that were compliant with the Rule’s conditions (if applicable) at the time clients and advisers entered into the arrangements. 

AUM and Net Worth Tests.  The Dodd-Frank Act requires the SEC to revise the dollar amounts used in the Rule by July 21, 2011 and every five years thereafter to adjust for the effects of inflation.  The SEC proposes to make these adjustments using a formula based on the Personal Consumption Expenditures Chain-Type Price Index, or its successors, published by the United States Department of Commerce.  The proposing release notes that in calculating a client’s AUM an adviser could include amounts the client has made a bona fide contractual commitment to invest in the adviser’s private funds, provided the adviser has a reasonable belief the commitment will be met.

Primary Residence and Related Debt.  Although not required to do so by the Dodd-Frank Act, the SEC proposes to exclude from the Rule’s net worth standard the value of a primary residence and the amount of debt secured by the property not to exceed the property’s current market value; the amount of debt in excess of the property’s value would be included as a liability in the net worth calculation.  This proposed modification to Rule 205‑3 resembles the SEC’s proposal to exclude the value of a primary residence and related debt from the net worth calculation for purposes of the “accredited investor” definitions in Rules 215 and 501 under the Securities Act of 1933 (as discussed in the February 1, 2011 Alert); both SEC proposals refer to IRS guidance for identifying a primary residence.

Transition Rule for Registered Advisers.  Under the proposal, compliance with the Rule’s conditions for charging a performance-based advisory fee to a client would be determined based on whether the conditions in effect at the time the adviser entered into the relationship with the client were met.  Because the Rule looks through a fund that relies on Section 3(c)(1) under the Investment Company Act of 1940 (a “3(c)(1) Fund”) to treat each investor as a client, the adviser to a 3(c)(1) Fund who wishes to charge a performance-based fee would only need to ensure that an investor met the qualified client conditions in effect at the time of initial investment; subsequent changes in the Rule’s AUM and net worth tests would not affect the adviser’s ability to rely on the Rule with respect to that investor.

Transition Rule for Advisers Previously Exempt from Registration.  The proposal would also grandfather performance-based fee arrangements in the situation where an adviser that is exempt from registration with the SEC subsequently registers with the SEC (a “Formerly Exempt Adviser”).  Under the proposal, a Formerly Exempt Adviser could continue to charge a performance-based fee in a client relationship that pre-dates the adviser’s registration without meeting the Rule’s conditions.  A Formerly Exempt Adviser would, however, need to meet the Rule’s conditions for each post‑registration client charged a performance-based fee, although, as discussed above, the Rule’s conditions would only need to be met at the time the client entered into the relationship with the adviser.  Because of the manner in which the Rule “looks through” 3(c)(1) Funds, a Formerly Exempt Adviser would be able to disregard the Rule’s conditions as to pre-registration investors in a 3(c)(1) Fund with a performance-based fee (including as to any additional investments made post-registration), but would need to meet the Rule’s conditions in effect at the time of initial investment for each post-registration investor.

Public Comment.  The proposing release requests comment on many aspects of the proposal, including with respect to a transition period or delayed compliance date.  Comments must be received by July 11, 2011.

SEC Seeks Public Comment on Short Sale Disclosure

The SEC published a request for public comment (the “Request”) with regard to studies on the disclosure and reporting of short sales that the SEC’s Division of Risk, Strategy, and Financial Innovation (the “Division”) is required to conduct under the Dodd-Frank Act and whose results the SEC is required to report to Congress by July 21, 2011. 

Currently Available Data and Existing Uses of Short Sales.  As a preliminary matter, the SEC is seeking public comment on both the existing uses of short selling in securities markets and the adequacy or inadequacy of currently available information.  The SEC is also seeking public comment on the current use of short selling by equity and option market makers, as well as the ways and extent to which, if any, short selling has been associated with abusive market practices.

Short Position Reporting.  Section 417(a)(2)(A) of the Dodd-Frank Act requires the Division to study real time reporting of short sale positions of publicly listed securities either to the public or, alternatively, only to the SEC and FINRA.  Noting the breadth of this charge, the SEC included 12 groups of questions on real time reporting of short positions in the Request.  Among other things, the SEC seeks public comment on the nature of “real time” reporting (e.g., whether it should consist of continuous updates made as soon as practicable or frequent “snapshots” throughout the trading day); the definition of a short “position” (e.g., whether short “positions” should include derivatives and index components); the effects of real time reporting on the behavior of short sellers and other investors (e.g., whether the availability of such data creates new opportunities for unfair or otherwise abusive market practices); which parties would be in a position to collect and disseminate short positions in real time; the efficacy of establishing a significant reporting threshold; and how experiences with short sale position reporting regimes in foreign jurisdictions should inform the analysis of feasibility, benefits and costs.

Transaction Reporting.  The Request also seeks public comment on the feasibility, benefits and costs of conducting a voluntary pilot program in which public companies would agree to have all sell portions of trades of their shares marked “long,” “short,” and/or “market maker short” and all buy portions of trades marked as “buy” and/or “buy to cover” and reported in real time through the Consolidated Tape.

Comments must be received on or before June 23, 2011.

FDIC Board of Directors Approves Notice of Proposed Rulemaking on Retail Foreign Exchange Transactions That is Similar to NPR on the Same Topic Previously Issued by OCC

The FDIC Board of Directors approved a notice of proposed rulemaking (the “ NPR”) that imposes safety and soundness requirements (including, among others, margin requirements, customer disclosure requirements, capital requirements) on insured depository institutions (“IDIs”) for whom the FDIC serves as principal federal regulator.  The NPR is similar to the notice of proposed rulemaking on the same topic issued by the OCC, which is described in the May 3, 2011 Alert and is also consistent with rules on retail foreign exchange transactions issued by the FRB and the CFTC.  The FDIC notes that the NPR applies only to transactions with retail customers and only to futures, options and similar transactions, such as rolling spot trades (and does not cover forward contracts or spot contracts).  The NPR limits the definition of retail customers to certain small businesses and individuals with $10 million or less invested on a discretionary basis and who are not “using the trades to reduce risks associated with other investments.”  FDIC Chairman Bair said that the FDIC believes the NPR, currently, would not affect any FDIC-regulated IDI with total assets of less than $1 billion, but that adoption of the NPR would prevent a financial institution that faces restrictions in the area because of tightened regulation by the OCC, FRB or CFTC from seeing the FDIC’s lack of a rule ‘as an arbitrage opportunity.”  Comments on the NPR must be received by June 16, 2011.

FINRA Fines Broker-Dealer for Late Delivery of Mutual Fund Prospectuses to Customers

FINRA announced that it had fined a broker-dealer $1,000,000 for its failure to deliver prospectuses in a timely manner to customers who purchased mutual funds in 2009, and for failure to make timely amendments to Forms U4 and U5.  In settling this matter, the broker-dealer neither admitted nor denied the charges, but consented to the entry of FINRA’s findings, which are summarized in this article.

Untimely Prospectus Delivery.  FINRA found that in 2009 the broker-dealer failed to deliver prospectuses within three business days of the transaction, as required by federal securities laws, to customers who purchased mutual funds, resulting in a violation of FINRA Rule 2010.  The broker-dealer had contracted with a third-party service provider to mail the prospectuses to customers.  FINRA found that the broker-dealer did not take adequate corrective measures after broker-dealer officials received statistical data at quarterly meetings with service provider personnel showing that between four percent and nine percent of its mutual fund customers failed to receive required prospectuses by the settlement date for their transactions (“exceptions”).  Additionally, the broker-dealer’s operations staff received daily reports on exceptions from the service provider and was in daily communication with the service provider regarding the resolution of exceptions.  FINRA found that the primary cause of exceptions was the failure of certain mutual funds to ensure that the broker-dealer had enough paper copies of their prospectuses at all times and that the broker-dealer took no action to cause the mutual funds to address the shortfall problem.  FINRA also faulted the broker-dealer for failing to use the service provider’s “print on demand” (“POD”) service extensively during the period in question.  For its POD service, the service provider maintained electronic versions of the relevant prospectuses which it could print and send to the broker-dealer’s customers when the inventory of paper copies provided by the mutual fund was insufficient.  FINRA also noted that the broker‑dealer’s management supervisory group responsible for prospectus delivery had conducted monthly statistical reviews showing that customers were not receiving mutual fund prospectuses on a timely basis.

Late Amendments to Forms U4 and U5.  FINRA found that the broker dealer did not promptly report required information to FINRA regarding its current or former representatives.  Under FINRA rules, a securities firm must ensure that information on its representatives’ applications for registration (Forms U4) is kept current in FINRA’s Central Registration Depository.  A firm must also ensure that it updates a representative’s termination notice (Form U5) after the representative leaves the firm.  These forms must be updated within 30 days of the firm learning that a significant event has occurred with respect to the representative.  From July 2008 through June 2009, the broker-dealer filed 147 late amendments to the Form U4 relating to customer complaints, arbitrations, civil litigation, regulatory matters and bankruptcies, and 40 late amendments to the Form U5 relating to customer complaints arbitrators and civil litigation.  These represented 8.1% and 7.6% of the amendments to the Form U4 and Form U5, respectively, that the broker-dealer filed during that period.

Prior Disciplinary Matters.  The broker-dealer has previously been subject to two other FINRA disciplinary actions regarding similar matters.  FINRA fined the broker-dealer $1,400,000 in 2009 because it had failed to deliver prospectuses and product descriptions to customers who had purchased any of nine different investment products in 2003 and 2004, and failed to maintain an adequate supervisory system to ensure such delivery was made.  As part of the remedial undertakings for this prior disciplinary matter, an officer of the broker-dealer had executed an attestation on August 14, 2009 that the broker-dealer had implemented supervisory systems reasonably designed to achieve compliance with prospectus delivery requirements.  Additionally, FINRA fined the broker-dealer $1,100,000 in 2009 because, during the period from 2003 through 2008, the broker-dealer failed to have policies and procedures in place to mail 800,000 required notifications to customers.

SEC Chairman Testifies that Private Adviser Registration under Dodd Frank Expected to Occur in Q1 2012

Consistent with recent SEC correspondence to NASAA and members of Congress, SEC Chairman Mary L. Schapiro stated in her testimony before the Senate Committee on Banking, Housing and Urban Affairs that the registration of hedge fund advisers and private equity advisers with the SEC pursuant to Title IV of the Dodd-Frank Act is expected to occur in the first quarter of 2012.  The SEC has not yet taken formal action to delay the compliance date for the Dodd-Frank Act’s changes to the federal adviser registration scheme, which under the strict terms of Title IV are effective July 21, 2011.  In addition, the SEC has not yet taken final action on Dodd-Frank related rule proposals, such as those defining new venture capital adviser and private fund adviser exemptions.

SEC Requests Public Comment on the Feasibility of Assigned Credit Ratings for Structured Finance Products

The SEC issued a request for public comment on the feasibility of a system in which a public or private utility or a self-regulatory organization assign NRSROs to determine credit ratings for structured finance products.  The SEC is considering this issue as part of a study mandated by the Dodd-Frank Act that must also address the credit rating process for structured finance products and the conflicts associated with the “issuer-pay” and “subscriber-pay” models.  The SEC must submit a report to Congress by July 21, 2011 that sets forth its findings from the study and any recommendations for regulatory or statutory changes that the SEC determines should be made to implement the study’s findings.  Comments must be submitted by 120 days after the request for public comment is published in the Federal Register.

CFTC Extends Comment Period for Proposed Margin Regulations

The CFTC issued a notice extending until July 11, 2011 the comment period on its earlier proposal regarding initial and variation margin requirements for swap dealers (“SDs”) and major swap participants (“MSPs”) (as discussed in the May 3, 2011 Alert) in order to allow its comment period to run concurrently with that of a related proposal.  Under the related proposal, the CFTC would amend existing capital and financial reporting regulations for futures commissions merchants (“FCMs”) that also register as SDs or MSPs, and provide for supplemental FCM financial reporting relating to the segregation of swap customers’ funds (as discussed in the May 3, 2011 Alert).

CFTC Reopens and Extends Dodd-Frank Act Rulemaking Comment Periods

The CFTC issued a notice reopening and/or extending the comment period for a number of its rulemaking proposals designed to implement provisions of the Dodd‑Frank Act regulating swaps.  The proposals subject to this comment period reopening/extension are listed in the notice.  The notice also requests comment on the order in which the CFTC should consider final Dodd-Frank related rulemakings.  June 3, 2011 is the deadline for submitting comments on the rulemaking proposals and matters discussed in the notice.

Reporting of Securities Holdings on Treasury Form SLT to Commence with Reports as of September 30 instead of June 30

The U.S. Department of Treasury (the “Treasury”) revised the commencement date for reporting on its proposed TIC Form SLT, which was originally planned to become effective for reports as of June 30, 2011, pushing it back at least until the report as of September 30, 2011.  Form SLT is a part of the Treasury Information Capital Reporting System, and is designed to allow the FRB and the Treasury to track information regarding U.S. securities held by non-U.S. Persons and non-U.S. securities held by U.S. persons.  U.S custodians and investment managers will be subject to Form SLT reporting requirements.  Future editions of the Alert will contain a more detailed description of the reporting requirements to be imposed by Form SLT.