Financial Services Alert - October 11, 2011 October 11, 2011
In This Issue

ICI and IDC Issue White Paper on Risk Oversight by Registered Fund Boards

The Investment Company Institute (ICI) and Independent Directors Council (IDC) issued a white paper (the “White Paper”) designed to assist directors of registered investment companies (“funds”) in carrying out their risk oversight responsibilities.  The White Paper emphasizes that fund advisers have primary responsibility for risk control which fund boards oversee in fulfillment of their general fiduciary duties, and stresses that there is no uniform approach to board risk oversight, which will vary depending on a fund’s particular circumstances.  The White Paper reviews approaches to identifying and categorizing fund risks and describes adviser risk management practices and different board mechanisms for overseeing risk. Appendices to the White Paper provide (a) topics for board/adviser discussion of risk oversight, (b) a discussion of investment risk, related analytics and adviser risk management practices, (c) a glossary of risk terminology and (d) a list of publications and websites with additional information on risk management.  Among other things, the White Paper recommends that fund boards periodically reevaluate risk management oversight practices and suggests (1) including risk oversight in the annual evaluation of board effectiveness; (2) considering risk oversight as part of any long-term strategy or planning session; (3) seeking feedback on risk oversight approach from third parties, such as consultants, external auditors, or fund or board counsel; and (4) participating in continuing education opportunities to stay abreast of industry and regulatory developments, including in the area of risk management and oversight.

DOL Issues Interim Policy on Providing Information Via Electronic Media under Participant-Level Fee Disclosure Regulation

Background.  The Department of Labor Issued Technical Release No. 2011-03 Technical Release No. 2011-03 (the “Release”), setting forth its interim policy regarding the use of electronic media to provide information required to be furnished to participants of ERISA‑covered defined contribution plans under the participant-level fee disclosure regulation, 29 C.F.R. §2550.404-5 (the “Regulation”) (discussed in the November 2, 2010 Financial Services Alert) that become effective next year (as described in the July 19, 2011 Financial Services Alert).  The Release indicates that DOL is continuing to review issues regarding the electronic delivery of information to participants under the Regulation (and under ERISA more generally).  Until further guidance is issued, DOL will not take any enforcement action with respect to compliance with the disclosure requirements of the Regulation against plan administrators who furnish information electronically in accordance with the rules described in the Release.

Under the Regulation, plans that provide participants with the right to direct investments must furnish participants with specified information regarding the plan, the designated investment alternatives available under the plan, and the fees and expenses that may be charged against their plan accounts or those investment alternatives.  (For purposes of this article, references to plan “participants” include plan beneficiaries.) 

Special Rules for Certain Disclosures that May Be Included in Benefit Statements.  The Release notes that under the Regulation certain information may be furnished as part of a pension benefit statement that is provided to participants pursuant to ERISA §105(a)(1)(A)(i) (a “Benefit Statement”), including (among other things) the identity of the plan’s designated investment alternatives, specified information regarding the mechanics of providing investment instructions, and certain information concerning fees charged to participant accounts under the plan.  When this  information is furnished as part of a Benefit Statement, it may be delivered to participants using electronic media in accordance with guidance DOL has issued concerning the delivery of Benefit Statements.  In this regard, the DOL’s Field Assistance Bulletin 2006-03 (the “FAB”) permits Benefit Statements to be furnished by providing participants continuous access to the relevant information through one or more secure websites, subject to conditions specified in the FAB.  Participants must be furnished with a notice that (a) explains the availability of the Benefit Statement information and how that information can be accessed by participants; (b) apprises participants of their right to request and obtain (free of charge) a paper version of the Benefit Statement; and (c) is written in a manner calculated to be understood by participants.

Generally Applicable Rules.  The following rules are applicable in situations where the special rule described above does not apply – i.e., because the relevant information required to be furnished by the Regulation is not of the type that may be included in a Benefit Statement under the special rule, or because the plan administrator chooses not to include the information in the Benefit Statement even though it could have come within the special rule.

This information may be provided using electronic media consistent with the generally applicable DOL regulation that provides a safe harbor for using electronic media in the furnishing of information required by ERISA, 29 C.F.R. section 2520.104b-1(c).  Under that safe harbor, it generally is permissible to provide information to participants  electronically if access to the plan sponsor’s electronic information system is an integral part of the participant’s duties as employee, and certain other conditions are satisfied.  In other situations, the safe harbor can be utilized only if the participant has affirmatively consented to electronic delivery under specified procedures.

Alternatively, this information may be furnished electronically under interim rules described in the Release.  These interim rules generally apply only if the participant has provided the participant’s email address voluntarily to the plan.  For this purpose, a participant’s provision of an email address will be considered voluntary if the participant is required to provide the address in order to access a secure continuous access web site that houses information required by the Release, so long as the participant is provided with an initial notice explaining (among other things) that the participant has the right to request and receive, free of charge, a paper copy of any of the relevant information, or to opt out of the electronic delivery arrangement completely.  The interim rules generally require that this initial notice be provided with the plan’s request to the participant for the email address; however, in certain circumstances it is permissible to utilize participant email addresses that are on file with the plan sponsor, the employer, or the plan administrator so long as the initial notice is provided to the relevant participants between 30 and 90 days prior to the date when information required by the Regulation is first provided to participants.  The interim rules also require that the plan provide participants with an annual notice describing (among other things) the right to opt out of the electronic delivery arrangement, and that other specified conditions be satisfied.

FINRA Proposes Amendments to Customer Account Statement Rule to Address Values of Unlisted Equity Securities of REITs and Direct Participation Programs

FINRA issued Regulatory Notice 11-44 (the “Notice”) seeking comments on a proposal to amend NASD Rule 2340 (Customer Account Statements) to address the way that the per share estimated values of unlisted real estate investment trusts (“REITs”) and unlisted direct participation programs (“DPPs”) are reported by FINRA member firms on the account statements they provide to their customers.  The amendments would, among other things, limit the time period during which the offering price may be used as the basis for the per share estimated value to the “Initial Offering Period,” as defined in the amended rule (and discussed below), and require firms to deduct organization and offering expenses from per share estimated values during the Initial Offering Period.  After the Initial Offering Period, firms would be required to calculate the per share estimated value based on an appraisal of the assets, liabilities and operations of the REIT or DPP.


Unlisted REITs and DPPs.  REITs, defined in section 856 of the Internal Revenue Code, are pass-through entities that offer investors an equity interest in a pool of real estate assets.  DPPs are defined in FINRA Rule 2310 and offer investors an equity interest in an entity such as a limited partnership that provides pass-through tax consequences and distributes income from underlying assets, which may be real estate or other types of assets.  REITs and DPPs may be offered privately or registered with the SEC for sale to the public.  REITs and DPPs may also be listed on an exchange or unlisted.  Because the value of listed securities of REITs and DPPs is established by the market, the definitions of REIT and DPP found in NASD Rule 2340(d) exclude securities listed on a national securities exchange.  The definitions also exclude REIT and DPP issuers that are not public companies. 

Customer Account Statements.  NASD Rule 2340 requires general securities firms (i.e., firms other than those that do not carry customer accounts and do not hold customer funds or securities) to send account statements to customers at least quarterly.  The account statements must include a description of any securities positions, money balances and account activity since the firm issued the prior account statement.  Rule 2340(c) addresses the estimated values of DPPs and REITs on customer account statements and states that the estimated value for DPP and REIT securities may be obtained from the annual report, an independent valuation service or any other source.  The Rule requires that firms develop a per share estimated value on a customer account statement from data that is not more than 18 months old. 

Rule 2310, applicable to offerings of DPPs and REITs, prohibits a firm from participating in a public offering of a DPP or REIT unless the general partner or sponsor represents that it will include a per share estimated value in each annual report. In the Notice, FINRA states that current industry practice is to use the value in the issuer’s annual report as the per share estimated value on a customer account statement.

Proposed Amendments

Initial Offering Period Defined.  “Initial Offering Period,” would be defined in the proposed amendments by reference to the period in SEC Rule 415(a)(5), which applies to shelf offerings.  This period would be three years from the effective date of the shelf plus, in the event that a new registration statement is filed with the SEC during the initial three-year period, a period ending on the earlier of the effective date of the new registration statement or 180 days after the end of the initial three-year period.

Use of Offering Price During Initial Offering Period.  Unlisted REITs and DPPs are generally sold at a fixed price during the initial offering period and beyond.  The proposed amendment would permit firms to base the per share estimated value on the offering price only during the Initial Offering Period, but would require that the per share estimated value so derived reflect a deduction of the amount of organization and offering expenses as defined by FINRA Rule 2310(a)(12).  Rule 2310 provides conditions for member participation in public offerings of DPPs and REITs, including a limit on the total amount of organization and offering expenses.

Calculating Per Share Estimated Value after the Initial Offering Period.  The proposed amendments would provide that after the Initial Offering Period, members furnishing per share estimated values in customer accounts may only use a per share estimated value calculated based on an appraisal of the assets, liabilities and operations of the DPP or REIT and derived from data no less current than the data in the most recent annual report.  The Notice states that firms would not be required to immediately update the per share estimated values shown in customer account statements when a new value appears in the DPP or REIT annual report, but that firms must use reasonable efforts to address operational or technical requirements associated with updating per share estimated values, to ensure that updating occurs as promptly as practicable.  The Notice further states that firms that require more than one statement cycle to update the per share estimated values are likely to raise a presumption that the firm is not making reasonable efforts.

Unreliable or Non-Compliant Information.  The proposed amendments would provide that a member must refrain from providing a per share estimated value, from any source, if it knows or has reason to know the value is unreliable, based upon publicly available information or nonpublic information that has come to the member’s attention, and that a member may refrain from providing a per share estimated value if the most recent annual report of a DPP or REIT does not contain a per share estimated value that complies with the requirements of the amended rule for the applicable period.  If the member refrains from providing a per share estimated value, the customer account statement must disclose:

  • that unlisted DPP or REIT securities are illiquid;

  • that the value of the security is different from its purchase price and may be less than the purchase price;

  • that an estimated valuation of the security is unavailable; and

  • the reason the value does not appear in, or has been removed from, the account statement.

Public Comment Requested.  FINRA has requested comments on the proposed amendments to Rule 2340.  The comment period expires on November 12, 2011.

CFTC Issues Proposals Regarding Compliance Timetables for Requirements Relating to Swap Trading Relationship Documentation, Margin for Uncleared Swaps and Swap Clearing and Trade Execution

The CFTC issued two rule proposals regarding the timing of compliance with various requirements regarding swap trading and clearance under the Dodd-Frank Act and its implementing rules.  The first proposal addresses the compliance timetables for (1) proposed rules regarding swap trading relationship documentation that swap dealers (“SDs”) and major swap participants (“MSPs”) must execute with counterparties and (2) proposed rules regarding margin requirements that apply to SDs and MSPs that are not banks with respect to swaps not cleared by a registered derivatives clearing organization.  In the expectation that certain types of counterparties may need additional time to comply with the new requirements once adopted, the CFTC proposes to group counterparties into four different categories which will be assigned compliance dates of 90, 180 and 270 days after final rules defining the applicable requirements are published in the Federal Register.  The proposal notes that its implementation is contingent on the finalization of other pending rule proposals.

The second CFTC proposal addresses the clearing requirement for swaps under Section 2(h)(1)(A) of the Commodity Exchange Act (the “CEA”) and the trade execution requirements for swaps under Section 2(h)(8)(A) of the CEA.   For reasons similar to those discussed above with respect to the first rule proposal, the CFTC proposes to group counterparties into three different categories which could, at the CFTC’s discretion, be assigned compliance dates with respect to the Section 2(h)(1)(A) clearing requirement of 90, 180 and 270 days after the CFTC determines that a new group, category, type or class of swaps must be cleared; the corresponding trading execution requirement would be triggered by the later of the compliance date for the clearing mandate or 30 days after the relevant swap is available for trading on either a swap execution facility or a designated contract market.  The CFTC would make the decision whether or not to implement a compliance timetable in connection with its mandatory clearing determination, and would base its decision on the considerations outlined in the CFTC’s proposing release.  The proposal notes that the CFTC will need to finalize pending rule proposals regarding its mandatory clearing determination process and related matters before it begins making mandatory clearing determinations.

Comments on both proposals must be submitted no later than November 4, 2011.

Federal Banking Agencies Issue Proposed Regulation Implementing Requirements of the Volcker Rule

The FRB, FDIC and OCC (the “Federal Banking Agencies”) each released and requested public comment on a proposed regulation that would implement the “Volcker Rule” requirements of Section 619 of the Dodd-Frank Act.  In general, the Volcker Rule prohibits insured depository institutions, bank holding companies and their subsidiaries or affiliates (1) from engaging in certain “proprietary trading” for their own account, and (2) from owning, sponsoring or having specified relationships with a hedge fund or private equity fund.  The Federal Banking Agencies developed the proposed regulation jointly with the SEC and consulted with the CFTC.  The SEC and CFTC are expected to issue comparable releases regarding the proposed regulation shortly.  Comments to the Federal Banking Agencies on the proposed regulation are due by January 13, 2012.  The Alert will provide detailed coverage of the proposed regulation in a future issue.