Financial Services Alert - July 19, 2011 July 19, 2011
In This Issue

SEC Issues Order Increasing “Qualified Client” Income and Net Worth Thresholds for Performance-Based Advisory Fees

The SEC issued an order that increases two dollar amount thresholds in Rule 205-3 under the Investment Advisers Act of 1940 related to “qualified client” status; the Rule permits a registered adviser to charge a qualified client, i.e., one that meets one or the other of these thresholds (or satisfies alternative criteria under the Rule) a fee based on a share of capital gains on, or capital appreciation of, the client’s account (a “performance fee”).  Currently, under the two tests in question, a client may be a qualified client either by (a) having $750,000 under the management with an adviser immediately after entering into the advisory contract under which a performance fee will be charged or (b) having a net worth of $1.5 million immediately prior to entering into the advisory contract under which a performance fee will be charged.  The order, which effects a mandate under the Dodd‑Frank Act, increases those amounts to $1 million and $2 million, respectively, effective September 19, 2011.  The SEC continues to consider a related proposal to amend Rule 205‑3 that would effect the remainder of the Dodd-Frank Act’s mandate in this area by providing that the SEC may issue an order every five years that adjusts the assets under management and net worth tests for inflation.  Although not mandated by the Dodd‑Frank Act, the rule proposal would also (a) 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 (b) revise the Rule’s transition provision to grandfather fee arrangements that were compliant with the Rule’s conditions (if applicable) at the time a client and adviser entered into the arrangements.  For more on the proposed amendments, see the May 18, 2011 Financial Services Alert.

FRB Issues Final Rule Repealing Regulation Q, Effective July 21, 2011

The FRB issued a final rule (the “Rule”) repealing the FRB’s Regulation Q (“Reg Q”), effective July 21, 2011.  Prior to July 21, 2011, member banks of the Federal Reserve System are prohibited from paying interest on demand deposits under Section 19(i) (“Section 19(i)”) of the Federal Reserve Act.  Similarly, until July 21, 2011, Section 18(g) (“Section 18(g)”) of the Federal Deposit Insurance Act imposes the parallel prohibition on state nonmember banks. Section 627 of the Dodd-Frank Act, however, as of July 21, 2011, repeals Section 19(i) and Section 18(g).  Accordingly the FRB, in the Rule, eliminates Reg Q (including without limitation, Reg Q’s definition of “interest”) and removes references to Reg Q found in the FRB’s other regulations, interpretations and commentary.

The FRB issued a proposed version of the Rule, discussed in the April 19, 2011 Financial Services Alert and received public comments, most of which opposed the repeal of Reg Q (many of them on the grounds that the repeal would adversely affect community banks).  The FRB, however, did not make changes as a result of those comments because, the FRB stated, as a result of the enactment of Section 627 of the Dodd-Frank Act, the FRB no longer has the authority to retain Reg Q nor to postpone the effective date of the repeal beyond July 21, 2011.

California Provides Continuation of its Private Adviser Exemption from State Registration through January 17, 2012

The California Department of Corporations (the “DOC”) adopted an emergency amendment to its rules that effectively extends through January 17, 2012 the exemption from California adviser licensing requirements that is available to advisers currently able to rely on Section 203(b)(3) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).  This exemption under the Advisers Act is often referred to as the “private adviser exemption.”  The emergency amendment revises the California exemption so that it incorporates all the substantive conditions of the private adviser exemption and removes the reference in the exemption to Section 203(b)(3) of the Advisers Act, which will be eliminated from the Advisers Act effective July 21, 2011 pursuant to the Dodd‑Frank Act.  (The California exemption in question also requires that either (a) the adviser have not less than $25 million in assets under management, or (b) the adviser’s only clients be venture capital companies, as defined in the exemption.) 

In March 2011, the DOC issued a separate proposal, on which it has yet to take final action, that is designed to integrate the exemptions from California’s investment adviser licensing requirements with various aspects of the federal statutory and regulatory scheme of investment adviser oversight as modified by the Dodd-Frank Act and related SEC rulemaking.  For a detailed discussion of the March 2011 proposal, see the March 24, 2011 Goodwin Procter Alert.

GAO Issues Report on Feasibility of Forming a Self-Regulatory Organization to Provide Primary Oversight of Private Fund Advisers

As required by Section 416 of the Dodd-Frank Act, the Government Accountability Office (the “GAO”) released a report (the “Report”) on the feasibility of forming a self-regulatory organization (“SRO”) to provide primary oversight of private fund advisers.  In preparing the report, the GAO reviewed, among other things, (1) the SEC staff’s Dodd-Frank mandated study on its investment adviser examination program (discussed in the January 25, 2011 Financial Services Alert) and (2) past regulatory and legislative proposals to create an SRO for investment advisers.  The GAO also interviewed members of the staffs of the SEC, existing SROs and other regulators, and various market participants and observers.

According to the Report, the general consensus among regulators, industry representatives, investment advisers and others was that forming a private fund adviser SRO while possible, would face several challenges.  First, Congress would need to enact legislation to allow for the formation of such an SRO.  Second, the SRO would face formation challenges and costs, including raising necessary start-up capital and reaching agreement on the fees to be imposed by the SRO and the SRO’s governance structure, as well as attracting, hiring and retaining qualified personnel.  Given the principles-based approach of the Investment Advisers Act of 1940 (the “Advisers Act”) and related SEC rules, an SRO for private fund advisers would also face challenges in adopting the kind of rules-based approach to member regulation typically taken by SROs as a means of addressing the conflicts inherent in self regulation.  According to the SEC staff and industry representatives, it would be difficult for a private fund adviser SRO’s rules to capture how the fiduciary duty principles that are the focus of Advisers Act regulation would apply in all possible circumstances.

The Report also found that, although a private fund adviser SRO could assist with the capacity challenges that the SEC currently struggles with in its oversight of investment advisers, a private fund adviser SRO’s jurisdiction would necessarily be limited to a fraction of all registered investment advisers since the majority of all registered investment advisers advise clients other than private funds.  In this way, the formation of a private fund adviser SRO might do little to alleviate the SEC’s burdens as the SEC would still retain oversight of the majority of registered investment advisers as well as of the private fund adviser SRO itself.  The Report cited the risk of fragmentation of investment adviser oversight and regulation in the event that a private fund adviser SRO were to create interpretations or rules inconsistent with SEC positions on the same matters.  Regulators and industry representatives both expressed concern that limiting a private fund adviser SRO’s authority to private funds could make it difficult for the SRO to understand other aspects of an adviser’s activities that may affect its private funds. 

The Report concludes by noting that other options for addressing the SEC’s adviser oversight capacity constraints – forming an SRO to examine all advisers and charging user fees to fund SEC examinations – also involve trade-offs.

SEC Adopts Interim Final Rule for Broker-Dealers Engaging in Retail Foreign Exchange Transactions

The SEC adopted an interim final temporary rule (the “Interim Retail Forex Rule”), effective July 15, 2011, which permits broker-dealers registered with the SEC to continue to engage in foreign exchange transactions with persons who are not “eligible contract participants.”  This rulemaking was made necessary by Section 742(c) of the Dodd-Frank Act, which amended the Commodity Exchange Act (“CEA”) effective July 16, 2011 to provide that a person for which there is a Federal regulatory agency, including a broker‑dealer registered under Section 15(b) (except pursuant to paragraph 11) or 15C of the Securities Exchange Act of 1934 (the “Exchange Act”), may not enter into, or offer to enter into, a foreign exchange transaction described in Section 2(c)(2)(B)(i)(I) of the CEA with a person who is not an eligible contract participant as defined in the CEA (an “ECP”) except pursuant to a rule or regulation of a Federal regulatory agency allowing the transaction under such terms and conditions as the agency shall prescribe (a “retail forex rule”).  Transactions described in CEA Section 2(c)(2)(B)(i)(I) include “an agreement, contract, or transaction in a foreign currency that … is a contract of sale of a commodity for future delivery (or an option on such contract) or an option (other than an option executed or traded on a national securities exchange) registered pursuant to section 6(a) of the [Exchange Act].”

Under Section 742, a retail forex rule must provide for similar treatment of all agreements, contracts and transactions in foreign currency that are functionally or economically similar to agreements, contracts or transactions described in CEA Section 2(c)(2)(B)(i)(I).  Section 742 also requires a retail forex rule to prescribe appropriate requirements with respect to disclosure, recordkeeping, capital and margin, reporting, business conduct, and documentation, and may include such other standards or requirements as the Federal regulatory agency determines to be necessary.

As a consequence of Section 742’s amendment to the CEA, effective July 16, 2011, broker‑dealers registered with the SEC may not engage in off-exchange forex futures and options transactions with a retail customer except pursuant to a qualifying retail forex rule adopted by the SEC.  This prohibition does not apply to forex transactions with a customer that qualifies as an ECP or transactions that are spot forex contracts or forward forex contracts even if the customer is not an ECP.  However, as discussed below, the SEC has determined to treat a so‑called “rolling spot” forex transaction as a retail forex transaction required to be covered by a retail forex rule.

Industry Request for Rulemaking.  In the release adopting the Interim Retail Forex Rule, the SEC states that it had not been aware of industry concerns with respect to the operation of Section 742 of the Dodd-Frank Act in the absence of SEC rulemaking, and that this concern was brought to its attention for the first time in June of 2011.  Without a retail forex rule, after July 16 there could have been adverse effects on the ability of SEC-registered broker-dealers to facilitate the settlement of foreign securities transactions for retail customers, e.g., when a broker‑dealer purchases a foreign currency or exchange a foreign currency for U.S. dollars on behalf of a retail customer in connection with the customer’s purchase or sale of a security listed on a foreign exchange and denominated in the foreign currency.  In particular, the SEC recognized that Section 742 could operate to preclude broker‑dealers from continuing to engage in some types of foreign exchange transactions that are inherent in certain of their customers’ securities transactions, and that serve to minimize their customers’ risk exposure to changes in foreign currency rates.

Because the SEC has not had time to consider and propose for comment rules designed to address investor protection concerns specific to retail forex transactions, the SEC has adopted the Interim Retail Forex Rule, which is designed to enable broker-dealers to engage in retail forex business under the existing regulatory regime for one year.

Operation of the Interim Retail Forex Rule.  The Interim Retail Forex Rule thus does not impose any new substantive requirements on broker-dealers engaging in retail forex transactions.  The heart of the Interim Retail Forex Rule is paragraph (b), which provides that a registered broker or dealer may engage in a retail forex business provided that the broker or dealer complies with the Exchange Act, the rules and regulations thereunder, and the rules of the self-regulatory organizations of which the broker or dealer is a member, including the disclosure, recordkeeping, capital and margin, reporting, business conduct and documentation requirements of those rules and regulations as they apply to retail forex transactions.  Paragraph (a) contains relevant definitions, and paragraph (c) provides that any broker or dealer complying with paragraph (b) will be deemed to be acting pursuant to a qualifying retail forex rule, as required by CEA Section 2(c)(2)(B)(i)(I).  Paragraph (d) provides that the Interim Retail Forex Rule will expire on July 16, 2012. 

Rolling Spot Forex Transactions.  The SEC has determined that rolling spot transactions should be treated as retail forex transactions rather than as spot transactions that are excepted from the definition of retail forex transactions.  A rolling spot transaction is one that initially requires delivery of currency within two days.  In practice, contracts with a retail customer for a rolling spot forex transaction may be renewed for additional two-day periods every other day indefinitely, so that no currency is actually delivered until one party affirmatively closes out the position.  Thus, in the definition of “retail forex transaction” in the Interim Retail Forex Rule, the exception for a spot transaction provides that it must be a contract of sale that (1) results in actual delivery within two days or (2) creates an enforceable obligation to deliver between a seller and buyer that have the ability to deliver and accept delivery, respectively, in connection with their line of business (effectively excluding retail customers who are not engaged in a forex business and do not have the ability to deliver or accept delivery of foreign currency).

Request for Public Comment.  Although it became effective on July 15, 2011, the SEC has requested public comment on the Interim Retail Forex Rule.  The adopting release also requests comment on permanent rulemaking to address retail forex transactions and more generally, on the appropriate regulatory framework for retail forex transactions.  Comments are due 60 days after Interim Retail Forex Rule’s publication in the Federal Register.

GAO Issues Report Stating Bank Regulators Will Need More Information from Banks to be Able to Enforce Volcker Rule in Effective Manner

The General Accountability Office (the “GAO”) issued a report (the “Report“) concluding that bank regulators will need more information from banks than is currently available to be able to enforce the Volcker Rule effectively.  The Volcker Rule, Section 619 of the Dodd‑Frank Act, is designed to restrict the trading activities of depository institutions (“DIs”) for their own account (rather than for customers) and to limit DIs’ ownership and sponsorship of hedge funds and private equity funds.  The GAO concluded in the Report that while it was possible to measure trading activities of a proprietary stand‑alone trading desk, information on DIs’ other proprietary trading activities is extremely difficult or impossible to measure because DIs do not maintain records of such activities.  The banking regulatory agencies are required to adopt regulations under the Volcker Rule by October 2011, but DIs will not be required to comply with the Volcker Rule for two years after the regulations are adopted.

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

The Department of Labor (the “DOL”) issued a final rule (the “Extension”) finalizing its recently announced intention to further extend from January 1, 2012 to April 1, 2012 the effective date for the interim final regulation under Section 408(b)(2) of 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 Financial Services Alert.  The DOL indicated that it expects to issue the final Section 408(b)(2) regulation before the end of 2011.

The Extension also amends the DOL’s participant‑level fee disclosure regulations (discussed in the November 2, 2010 Financial Services Alert) to extend the deadline for certain retirement plans with participant-directed investments to disclose specified plan fee, expense and other information to participants to the later of (i) 60 days following the date the new Section 408(b)(2) requirements become effective, or (ii) 60 days after the first day of the first plan year of the plan beginning after November 1, 2011 (e.g., May 31, 2012 for a calendar year plan).

CFTC Adopts Anti-Fraud Rules

The CFTC adopted final rules that broadly prohibit fraud and manipulation in connection  with any swap, or contract of sale of any commodity in interstate commerce, or contract for future delivery on or subject to the rules of any registered entity (as defined under the Commodity Exchange Act).  These final rules become effective August 15, 2011.

CFTC Issues Order Postponing Effectiveness of Various Elements of New Dodd-Frank Regulatory Framework for Swaps

The CFTC issued an order that provides temporary exemptive relief from certain requirements in the Commodity Exchange Act (the “CEA”) resulting from the Dodd-Frank Act that otherwise became effective on July 16, 2011 under the terms of the Act.  The relief contains two principal elements.  The first provides a temporary exemption from provisions that reference terms such as “swap,” “swap dealer,” “major swap participant,” or “eligible contract participant” that the Dodd-Frank Act requires the CFTC and SEC to “further define” (which the agencies had not done by July 16); the exemption continues until the effective date of final rules defining those terms or December 31, 2011, whichever is earlier.  The second element of the order temporarily exempts certain transactions (primarily in financial, energy and metals commodities) from certain CEA provisions that apply as a result of the repeal of various CEA exemptions and exclusions under the Dodd‑Frank Act; the exemption applies until the repeal or replacement of certain CFTC regulations or December 31, 2011, whichever is earlier.

CFTC Staff Grants No-Action Relief Designed to Ease Dodd-Frank Transition

The CFTC’s Division of Clearing and Intermediary Oversight and Division of Market Oversight issued a staff no-action letter designed to supplement exemptive relief from certain requirements in the Commodity Exchange Act (the “CEA”) resulting from the Dodd-Frank Act that otherwise became effective on July 16, 2011 under the terms of the Act.  The exemptive relief is discussed elsewhere in this edition of the Alert.  The no‑action letter provides relief from (1) certain segregation requirements with respect to collateral for uncleared swaps that apply to swap dealers and major swap participants; (2) certain registration requirements that apply to a derivatives clearing organization that clears swaps; and (3) requirements applicable to swap dealers and major swap participants regarding the duties and designation of a chief compliance officer.  The no-action letter notes that it does not limit the CFTC’s applicable anti-fraud and anti-manipulation authority.  The no-action relief expires upon the earlier of the effective date of rulemaking that completes the definition of relevant terms in accordance with the Dodd-Frank Act or December 31, 2011.

SEC Grants Accelerated Approval for Continuation of FINRA Pilot Regarding Margin Requirements for Credit Default Swaps

The SEC approved on an accelerated basis a FINRA proposal to continue an existing pilot regarding margin requirements for certain transactions in credit default swaps under FINRA Rule 4240 and make related updating changes to the Rule.  As extended, the pilot program will expire on January 17, 2012.  Comments on the changes to Rule 4240 may be submitted no later than 21 days after its publication in the Federal Register.

SEC Grants Accelerated Approval for Rule Temporarily Limiting the Application of FINRA Rules with respect to Security-Based Swaps

The SEC approved on an accelerated basis a FINRA proposal to adopt FINRA Rule 0180 which is designed to ease the transition to the treatment of security-based swaps as securities under the Securities Exchange Act of 1934 (the “Exchange Act”) pursuant to the Dodd-Frank Act, and related consequences under FINRA rules.  FINRA Rule 0180 exempts members’ activities and positions with respect to security-based swaps from FINRA rules, subject to certain exceptions.  Among the exceptions are (a) FINRA Rule 2010 (standards of commercial honor and principles of trade), FINRA Rule 2020 (use of manipulative, deceptive or other fraudulent devices), FINRA Rule 3310 (anti-money laundering program) and FINRA Rule 4240 (margin requirements for credit default swaps); and (b) to the extent they would have applied as of July 15, 2011, NASD Rule 3110 (books and records) and all successor FINRA Rules to such NASD Rule, the FINRA Rule 4500 Series (books, records and reports); and the FINRA Rule 4100 Series (financial condition).  Rule 0180 will expire on January 17, 2012 although FINRA intends to amend the expiration date in subsequent filings as necessary to ensure that its expiration date is coordinated with the termination of relevant provisions of the SEC exemptive order addressing related issues under the Exchange Act.  Comments on Rule 0180 may be submitted no later than 21 days after its publication in the Federal Register.