Financial Services Alert - June 7, 2011 June 07, 2011
In This Issue

FinCEN Notice 2011-1 (Revised) Extending Filing Date Related to Exceptions for Certain Individuals with Signature or Other Authority over a Foreign Financial Account

On June 2, 2011, the U.S. Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) issued FinCEN Notice 2011-1 (Revised) (the “Notice”), extending until June 30, 2012 the date for filing Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (“FBAR”), by certain individuals with signature or other authority only over certain foreign financial accounts. 

The Notice relates to certain exceptions provided in the Final Rule issued by FinCEN that went into effect on March 28, 2011.  (The Final Rule was discussed in the March 1, 2011 Alert.)  In particular, the Final Rule provides filing relief in the form of exceptions for certain officers and employees with signature or other authority over, but no financial interest in, a foreign financial account owned or maintained by an entity described in 31 CFR §§1010.350(f)(2)(i)-(v) of the Final Rule.  For example, §1010.350(f)(2)(iv) provides an exception for an officer or employee of an entity with a class of equity securities (or American depository receipts) listed on any United States national securities exchange, and for an officer or employee of a United States subsidiary of such a listed entity if the parent entity is a United States entity and the subsidiary is named in a consolidated FBAR filed by the parent.  Those exceptions apply only with respect to accounts maintained by the entity that is the employer of the respective officer or employee, however.  As discussed in our March 1, 2011 Alert, FinCEN had considered and rejected comments that this exception also should apply with respect to officers and employees of a United States listed parent entity who have signature authority over, but no financial interest in, a foreign financial account of a United States subsidiary of the parent, or vice versa, as well as with respect to officers or employees of a United States subsidiary of a foreign entity.  In addition, the Final Rule did not retain an exception that had been available under the prior FBAR instructions for officers and employees with signature or other authority only over a foreign financial account of a foreign subsidiary of a United States listed parent entity that was included in an FBAR filed by the parent.

In response to comments on the Final Rule, the Notice extends the FBAR filing date to June 30, 2012 for individuals described in the following two categories:

(1)   an employee or officer of an entity under §1010.350(f)(2)(i)-(v) who has signature or other authority over and no financial interest in a foreign financial account of a “controlled person” of the entity; or

(2)   an employee or officer of a “controlled person” of an entity under §1010.350(f)(2)(i)‑(v) who has who has signature or other authority over and no financial interest in a foreign financial account of the entity, the “controlled person,” or another “controlled person” of the entity.

For this purpose, a “controlled person” means a United States or foreign person more than 50 percent owned (directly or indirectly) by an entity under §1010.350(f)(2)(i)-(v).  Thus, the extension would apply to situations like those mentioned above that FinCEN had decided not to cover in the Final Rule. 

The Notice states that, in light of questions it had received concerning the application of the exceptions in §1010.350(f)(2)(i)-(v), FinCEN is granting this extension “to allow these individuals additional time to file FBARs based on their signature or other authority in situations (1) through (2) described above.”  Thus, it does not appear at this time that FinCEN intends to broaden the exceptions in §1010.350(f)(2)(i)-(v), but only to allow additional time for individuals described in the Notice to comply.  Furthermore, for all other United States persons with an FBAR filing obligation, the filing deadline remains unchanged.

FINRA Issues Complaint Charging Sole Distributor of REIT with Soliciting Investors without Fully Investigating Suitability and Related FINRA Advertising Rule Violations

FINRA announced that it has issued a complaint (the “Complaint”) commencing disciplinary proceedings against the best efforts underwriter and sole distributor (the “Distributor”) of a series of ten real estate investment trusts (the “REITs”).  The Complaint alleges that since January 2011 the Distributor has solicited investors to purchase shares of the most recently launched REIT (the “New REIT”) without conducting a reasonable investigation to determine whether the New REIT was suitable for investors.  The Complaint also alleges that the Distributor provided misleading information on its website regarding performance figures and the source of the distributions made by the New REIT.  This article summarizes FINRA’s allegations in the Complaint as to which no findings had been made as of this article’s publication. 

Background.  The Distributor has served as the best efforts underwriter and sole distributor of the REITs since 1992.  Providing services to the REITs has been the principal source of income for the Distributor, accounting for 60-70% of gross revenue annually since 1996.  The securities of each of the REITs are registered with the SEC and the REITs are reporting companies; however, the securities of the REITs are not traded on any stock exchange and are illiquid.  The New REIT was opened in January of 2011 and since that time the Distributor has sold over $300 million of the total $2 billion offering.  There are currently four REITs, other than the New REIT, that continue to operate (the “Existing REITs”).  Each of the Existing REITs is closed to new investment.  The Existing REITs were founded and managed by the same manager and invest almost exclusively in the same subsection of the real estate market (i.e., extended stay hotels). 

The Existing REITs were opened between 2004 and 2008 with an offering price of $11 per share and have maintained an $11 price per share despite (1) market fluctuations, including as a result of the economic downturn for commercial real estate in general and the hotel and hospitality industry in particular, (2) net income declines, (3) increased leverage through borrowings, and (4) return of capital to investors through distributions.  Since inception, each Existing REIT has paid monthly distributions to its shareholders at a rate of between 7.0% and 8.0%.  Each of the REITs provided for dividend reinvestment at $11 per share through a Dividend Reinvestment Plan (the “DRIP”), and provided for limited redemption of shares at $11 under a Unit Redemption Program (the “URP”).  The Existing REITs based their unchanging valuations upon the fact that they were continuously selling and redeeming shares at $11 per share under the DRIP or URP, as applicable.

Failure to Conduct a Reasonable Investigation.  FINRA alleges that the Distributor failed to conduct due diligence into the valuation of the New REIT’s shares that was sufficient to serve as a reasonable basis for recommending that its customers, who are primarily unsophisticated investors and the elderly, invest in the New REIT.  The Complaint notes that in addition to its customer-specific suitability obligation, the Distributor and its registered representatives have a duty to perform reasonable due diligence to understand the potential risks and rewards associated with a security it recommends to customers, and to determine whether the recommendation is suitable for at least some investors based upon that understanding (so-called “reasonable basis” suitability). 

FINRA alleges that the Distributor was aware, or should have been aware, of certain valuation irregularities and other improprieties related to the earlier REITs that should have caused it to engage in further due diligence before recommending and selling the New REIT’s shares.  Specifically, FINRA alleges that (a) the failure of the Existing REITs to change their valuation or sufficiently reduce their distributions in light of (1) changes in market conditions and (2) changes or declines in financial performance of the respective REIT, and (b) the fact that the distribution rates of the Existing REITs were not supported by Funds from Operations (a non-GAAP measurement frequently used by real estate investment trusts), were red flags that should have caused the Distributor to engage in further due diligence before recommending any investment in the New REIT. 

The Distributor’s due diligence process is alleged to have been insufficient because of its reliance in large part upon information in the REITs’ public securities filings (including the opinions issued by the REITs’ outside auditors which did not address the valuation process), brief meetings with management and inadequately performed analysis, that, among other failures, did not address the red flags highlighted above.  The Complaint notes that, as sole distributor, the Distributor cannot accept the valuation and other material disclosures in the public filings, but rather, has a duty to conduct its own due diligence into such matters.  Moreover, the Complaint states that the Distributor had not sufficiently availed itself of the privilege under the terms of an agency agreement between the Distributor and the REITs to request certain non-public information concerning the “business and financial condition” of the REITs. 

Misleading Statements.  The Complaint alleges that, by providing performance figures for all of the REITs in conjunction with a presentation of the New REIT on its website, the Distributor misleadingly implied that the New REIT would achieve similar results.  Moreover, the performance figures for the prior REITs were misleading because, among other things, they (1) masked reductions in the distribution rates made by certain of the Existing REITs, (2) failed to disclose material information regarding the distributions of the prior REITs, including the fact that the income from those REITs was insufficient to support the 7% -8% returns that the REITs sought to pay, and that the REITs borrowed funds to meet their distribution goals, and (3) mischaracterized the source of distributions as “net income and a return of capital, primarily in the form of depreciation” when, in fact, the return of capital was not primarily from depreciation. 

Violations and Relief Requested.  FINRA alleges that by failing to conduct adequate due diligence to fulfill its reasonable-basis suitability obligation, which also violates its duty to observe high standards of commercial honor and just and equitable principles of trade, the Distributor violated NASD Rule 2310 and FINRA Rules 2310(b) and 2010.  Additionally, FINRA alleges that by distributing communications with the public that contained misleading statements and omitted material information, which also violates its duty to observe high standards of commercial honor and just and equitable principles of trade, the Distributor violated NASD Rule 2210(d)(1) and FINRA Rule 2010.  For these violations, FINRA has requested that, among other things, the Distributor be subject to one or more of the sanctions found in FINRA Rule 8310(a), including monetary sanctions and full disgorgement of, or restitution for, any and all ill-gotten gains.

Basel Committee Modifies Credit Valuation Adjustment Capital Charge

On June 1, 2011, the Basel Committee on Banking Supervision (the “Basel Committee”) issued a press release announcing a “minor modification” of the credit valuation adjustment (which is used to cover the risk of loss caused by changes in the credit spread of a counterparty due to changes in its credit quality) as a result of a review of Basel III’s treatment of counterparty credit risk in bilateral trades.  The review showed that the standardized method as originally set out in Basel III in December 2010 could be unduly punitive for low-rated counterparties with long maturity transactions.  Therefore, to “narrow the gap between the capital required for CCC-rated counterparties under the standardized and the advanced methods, the Basel Committee agreed to reduce the weight applied to CCC-rated counterparties from 18% to 10%.”  All other aspects of the regulatory capital treatment for counterparty credit risk and credit valuation adjustment risk remain unchanged from the December 2010 Basel III text.  The Basel Committee noted that, by their estimates, the capital requirements for counterparty credit risk under Basel III will double the level required under Basel II (which addressed counterparty default and credit migration risk, but not mark-to-market losses due to credit valuation adjustments).

Barney Frank Urges SEC to Consider Fiduciary Standard Appropriate for Broker-Dealers and Not Merely Based on Investment Adviser Model

Section 913 of the Dodd-Frank Act requires the SEC to deliver a study on the standards of care applicable to broker-dealers and investment advisers and to evaluate whether there are gaps or shortcomings to the existing legal and regulatory standards.  The SEC delivered its study on January 21, 2011 (as discussed in the January 25, 2011 Alert).  Section 913 also amends Section 15 of the Securities Exchange Act of 1934 (the “1934 Act”) and Section 211 of the Investment Advisers Act of 1940 (the “Advisers Act”) to authorize the SEC to promulgate rules governing the duty of care for broker‑dealers that provide personalized investment advice to retail customers.  The SEC staff is currently working on proposed rules relating to the standard of care for broker-dealers; the SEC website lists rules under Section 913 among those planned to be proposed or adopted between August and December 2011.

On May 31, 2011, Congressman Barney Frank, who introduced the Dodd-Frank Act in the House of Representatives and oversaw its passage as then Chairman of the House Committee on Financial Services, delivered a letter to Mary Schapiro, the SEC Chairman, regarding the SEC’s authority under the Dodd-Frank Act to impose a higher standard on broker-dealers that provide personalized investment advice to their customers.  In his letter, Congressman Frank states that the language adopted in Section 913 “recognizes some of the differences between broker-dealers and investment advisors, particularly with respect to the receipt of commission income and the fact that many broker-dealers do not continually provide advice to their customers.”  Significantly, the letter points out that the requirement (in new Section 211(g) of the Advisers Act added by the Dodd-Frank Act) that the new standard be “no less stringent than” the standard in Advisers Act Section 206(1) and (2) “was not intended to encourage the SEC to impose the [Advisers Act] standard on broker‑dealers, but to ensure that the new standard would not be a ‘watered down’ version of the investment advisor’s fiduciary standard.”

The approach to Section 211(g) described in Congressman Frank’s letter also suggests how the SEC might appropriately exercise its rulemaking power under sub‑paragraph (1) of Section 15(k) of the 1934 Act added by the Dodd-Frank Act.  Unlike Section 211(g), Section 15(k) states that if the SEC establishes a new standard of conduct for broker-dealers when providing personalized investment advice about securities to a retail customer, “the standard of conduct for such broker or dealer with respect to such customer shall be the same as the standard of conduct applicable to an investment adviser under section 211” of the Advisers Act.  Congressman Frank’s letter endorses a thoughtful approach, rather than mere application of the Advisers Act standard, in setting a standard of care for broker‑dealers that provide personalized investment advice to retail customers, and Congressman Frank encourages the SEC to continue with the deliberate approach he believes the staff is taking.

Agencies Extend Risk Retention Rulemaking Comment Period

In April, the OCC, FRB, FDIC and SEC, in conjunction with the Federal Housing Finance Agency and the Department of Housing and Urban Development (the “Agencies”), issued a notice of proposed rulemaking (the “NPR”) to implement the credit risk retention requirements of Section 941 of the Dodd-Frank Act.  For details regarding the NPR, please see the April 19, 2011 Alert.  The Agencies announced today that they are extending the comment period on the NPR from June 10, 2011 to August 1, 2011 to allow interested persons more time to analyze the issues and prepare comments.

DOL Proposes Extension of Effective Dates for New Service Provider and Participant-Level Retirement Plan Fee Disclosure Requirements

The Department of Labor (the “DOL”) issued a proposal (the “Proposal”) finalizing its previously announced intention to extend from July 16, 2011 to January 1, 2012 the effective date for the interim final regulation under Section 408(b)(2) of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), that would require enhanced disclosure from certain pension plan service providers to plan fiduciaries.  The interim final regulation was discussed in the August 3, 2010 Alert.  The Proposal would also amend the DOL’s participant-level fee disclosure regulations (discussed in the November 2, 2010 Alert) to extend the deadline for a plan to disclose specified plan fee and expense information to participants from 60 to 120 days following the date the new requirements begin to apply to the plan.  Comments on the Proposal are due by June 15, 2011.

FDIC Board of Directors Creates Advisory Committee on Systemic Resolutions

The FDIC’s Board of Directors created an 18-member Advisory Committee (the “Committee”) to provide advice and guidance to the FDIC on the resolution of large, systemically important institutions.  The Committee will not have decision-making authority.  The FDIC stated that the Committee is expected to provide guidance on:

  1. the effects on financial stability and economic conditions from a systemically important company’s failure;
  2. how resolution strategies would affect stakeholders and customers of these entities;
  3. tools the FDIC can use to wind down the operations of a failed organization; and
  4. tools the FDIC needs to assist in cross-border relations with foreign regulators and governments when a systemic company has international operations. The first meeting of the Committee is scheduled for June 21, 2011.

FDIC Issues Letter Encouraging FDIC-Supervised Banks Who Have Class of Equity Securities Registered with FDIC to Use FDIC Electronic System to Provide Securities Exchange Act and FDIC Securities Filings to the FDIC

The FDIC issued a Financial Institution Letter (the “Letter,” FIL-40-2011) in which it encouraged FDIC-supervised banks that have a class of equity securities registered with the FDIC under the Securities Exchange Act (and such banks’ associated parties) to access the FDIC’s electronic filing system, “FDIC Connect”, to provide the FDIC with copies of their SEC filings, including, without limitation, periodic reports, proxy materials, other securities disclosure documents and related correspondence.