Financial Services Alert - April 24, 2012 April 24, 2012
In This Issue

FRB Clarifies Volcker Rule Conformance Period

The FRB issued a Statement of Policy (the "Statement") regarding the conformance period for entities engaged in prohibited proprietary trading or private equity fund or hedge fund activities covered by Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), which set forth a new Section 13 of the Bank Holding Company Act of 1956 that is commonly known as the "Volcker Rule." The Statement provides that a covered entity under the Volcker Rule has until July 21, 2014 (the "Conformance Period") to fully conform its activities and investments to the prohibitions and requirements set forth in the Volcker Rule, unless the Conformance Period is extended by the FRB. The FRB adopted rules governing the Conformance Period for the Volcker Rule on February 9, 2011. Please see the February 22, 2011 Financial Services Alert regarding such rulemaking. The federal banking agencies and the SEC issued a proposed rule implementing the Volcker Rule in October 2011, and the CFTC later released a substantially similar proposed rule. The FRB, OCC, FDIC, SEC and CFTC (the "Agencies") have received a large number of comments, but they have not yet issued a final rule implementing the Volcker Rule. Please see the October 20, 2011 Financial Services Alert and the February 14, 2012 Financial Services Alert regarding the proposed implementing regulations. Covered entities under the Volcker Rule will have to comply with any such final rule on July 21, 2014 as well. The Agencies each plan to administer their respective oversight responsibilities under the Volcker Rule in accordance with the Statement.

The FRB noted that the Statement was issued in response to requests that the FRB clarify how the Conformance Period would apply and how the prohibitions will be enforced. The commenters making such requests sought to confirm that a banking entity would have the full period of time permitted by the Dodd-Frank Act to conform all of its investments and activities to the Volcker Rule and the final implementing rules and that activities conducted and investments made during the Conformance Period would not be subjected to the requirements of the implementing rules for the Volcker Rule during the Conformance Period. The need for clarification arose in part because guidance accompanying the joint Notice of Proposed Rulemaking to implement the Volcker Rule stated that the Agencies expected banking entities to fully conform all investments and activities to the requirements of the proposed rule as soon as practicable within the Conformance Period. Such guidance had created ambiguity regarding whether covered entities would be given the full two-year period to bring their activities and investments into conformance with the Volcker Rule, or rather if they would be expected to do so as soon as practicable, with the end of the Conformance Period serving only as the final deadline. Other commenters expressed concern as to whether a banking entity would be able to engage in new activities restricted by the Volcker Rule during the Conformance Period, such as sponsoring a new covered fund.

The Statement provides that all proprietary trading activity conducted by each banking entity must conform to the prohibitions and requirements of the Volcker Rule and the related final implementing rules by no later than the end of the Conformance Period. Additionally, the Statement provides that all activities, investments and transactions with or involving a covered fund under the Volcker Rule, including a covered fund organized and offered or sponsored by the banking entity, must conform to the Volcker Rule and the related final implementing rules by no later than the end of the Conformance Period. The Statement provides that during the Conformance Period, banking entities should engage in good-faith planning efforts, appropriate for their activities and investments, to enable them to conform their activities and investments to the requirements of the Volcker Rule and final implementing rules by no later than the end of the Conformance Period.

The Statement provides limited guidance regarding such good-faith planning efforts, which the FRB states should include evaluating the extent to which the banking entity is engaged in activities and investments that are covered by the Volcker Rule, as well as developing and implementing a conformance plan that is as specific as possible about how the banking entity will conform fully all of its covered activities and investments with the Volcker Rule and any final implementing rules by July 21, 2014, unless the Conformance Period is extended by the FRB. The Statement further provides that the good-faith efforts should take into account the statutory provisions in the Volcker Rule as such provisions will apply to the activities and investments of the banking entity at the end of the Conformance Period as well as any applicable implementing rules adopted in final form by the primary financial regulatory agency for the banking entity. The FRB also notes that the good-faith efforts may include complying with reporting or recordkeeping requirements if such elements are included in the final rules implementing the Volcker Rule and the Agencies determine that such actions are required during the Conformance Period.

The Statement does not directly address the extent to which a banking entity may engage in activities restricted by the Volcker Rule during the Conformance Period, particularly with respect to new activities. Absent further regulatory guidance, however, it appears that under the Statement a banking entity may engage in proprietary trading and may acquire and retain ownership interests in, sponsor and enter into covered transactions with, both new and existing covered funds during the Conformance Period, as long as the banking entity makes good-faith efforts to evaluate and fully conform such activities to the Volcker Rule and its implementing regulations by the end of the Conformance Period and in fact conforms such activities to the requirements of the Volcker Rule by the end of the Conformance Period.

Third Circuit Affirms Dismissal of Excessive Fee Claims Under the Investment Company Act Because Plaintiffs Lacked Continuous Ownership in the Funds and No Private Right of Action Exists Under Section 47(b)

The Third Circuit affirmed a decision by the United States District Court for the District of New Jersey that dismissed claims by participants in retirement plans, alleging that an insurance company and its affiliates charged the retirement plans excessive fees on annuity insurance contracts offered to plan participants in violation of Sections 36(b) and 47(b) of the Investment Company Act of 1940 ("ICA").

Section 36(b). The District Court dismissed the Section 36(b) claim because plaintiffs no longer owned any interest in the funds at issue. The Third Circuit agreed that continuous ownership of securities in the funds in question during the pendency of the litigation is required for a Section 36(b) action. It noted that Section 36(b) actions are similar to derivative actions in that they are brought on behalf of the fund, and any recovery obtained goes to the fund. The statute also plainly requires a plaintiff to be a security holder in the fund at the time the action is initiated.  The Third Circuit thus held that “[i]mposing a continuous ownership requirement throughout the pendency of the litigation assures that the plaintiff will adequately represent the interests of the security holders in obtaining a recovery for the benefit” of the fund.  Since plaintiffs no longer owned the funds, “they lack any real interest in securing a recovery.”

Section 47(b). The District Court also had dismissed plaintiffs’ claim under ICA Section 47(b), which states that a contract made or whose performance involves a violation of the ICA is unenforceable.  Plaintiffs argued that their claim was not based on a violation of Section 36(b), but instead on ICA Section 26(f), which required the fees at issue to be reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by the insurance company.  While plaintiffs acknowledged that Section 26(f) does not establish a private right of action, they asserted that Section 47(b) creates such a right because the United States Supreme Court in Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11 (1979), found a private right under a similar provision in the Investment Advisers Act (“IAA”), Section 215.  The Third Circuit disagreed, noting that while the IAA does not expressly provide for any private cause of action, Congress intended for Section 36(b) to be the “exclusive” private right of action in the ICA.  The Third Circuit further pointed out differences in the language of IAA Section 215, which renders contracts void if they violate the IAA, and ICA Section 47(b) which merely makes the contract “unenforceable” and carries no such legal implications, thus creating a remedy rather than a distinct cause of action.

ERISA.  The District Court also had dismissed plaintiffs’ claims under Sections 502(a)(2) and 502(a)(3) of ERISA, finding that plaintiffs’ theories of liability were derivative and that plaintiffs did not make the required pre-lawsuit demand on the plan’s trustees or join them in the lawsuit.  The Third Circuit disagreed and vacated dismissal of the ERISA claims, finding that ERISA’s language, legislative history and structure did not require pre-suit demand or mandatory joinder of trustees for ERISA Section 502(a)(2) and 502(a)(3) claims.

Santomenno v. John Hancock Life Insurance Company (U.S.A.), et al., No. 11-2520 (3rd Cir. Apr. 16, 2012).

Goodwin Procter LLP represented the defendants in Santomenno.

SEC Approves FINRA Proposal to Consolidate and Amend NASD and NYSE Communications Rules and Interpretations

On March 29, 2012, the SEC issued a release approving a FINRA proposal to adopt NASD Rule 2210 and 2211, and related interpretive materials, as FINRA Rules 2210 and 2212 through 2216, and to delete portions of NYSE Rule 472 and related supplementary materials.  The newly adopted FINRA rules are:

  • 2210 – Communications with the Public
  • 2212 – Use of Investment Companies Rankings in Retail Communications
  • 2213 – Requirements for the Use of Bond Mutual Fund Volatility Ratings
  • 2214 – Requirements for the Use of Investment Analysis Tools
  • 2215 – Communications with the Public Regarding Security Futures
  • 2216 – Communications with the Public about Collateralized Mortgage Obligations

The text of the new FINRA rules and related supplementary materials (collectively, the “New Rules”) is available in SR-FINRA-2011-035.


NASD Rules 2210 and 2211, and the interpretive materials following Rule 2210, govern FINRA members’ communications with the public, other than communications concerning options, which are governed by FINRA Rule 2220.  NYSE Rule 472, as incorporated into the FINRA rulebook following the merger of the NASD and NYSE regulatory operations, governs communications with the public of FINRA members that are also members of the NYSE.


A significant change made by the New Rules is to redefine certain types of communications.  Prior to the New Rules, communications have been classified into the following categories: advertisement; sales literature; correspondence; institutional sales material; public appearance; and independently prepared reprint, with each category subject to different procedures.  The definitions of advertisement and sales literature have over time taken on meanings that may not be obvious from their plain language.  A key difference between advertisements and sales literature is that advertisements are materials made available to the public, while sales literature is material that is made available only to customers.  Thus, material available on a password-protected area of a member firm’s website could be treated as sales material.

Under FINRA Rule 2210, the categories of communications are reduced to the following three:

  • Correspondence – any written communication that is distributed or made available to 25 or fewer retail investors within any 30 calendar-day period;
  • Retail communication – any written communication that is distributed or made available to more than 25 retail investors within any 30 calendar-day period; and
  • Institutional communication – any written communication that is distributed or made available only to institutional investors, but does not include a member’s internal communications used to train or educated registered persons about the products or services of the member.

“Written communications” are defined to include electronic communications.  “Institutional investor” is generally defined under FINRA Rule 2210 as in NASD Rule 2211, and includes registered investment companies, insurance companies, banks, registered broker-dealers, registered investment advisers and other entities and natural persons with at least $50 million in assets, and also certain persons acting solely on behalf of an institutional investor.


FINRA Rule 2210, which is summarized below, reflects existing filing requirements for communications with certain changes and additions.

First Year Filing.  For its first year after becoming a FINRA member, a firm must file with FINRA, at least 10 business days before first use, all retail communications intended to be published or used in publicly available media, except for broker-prepared free writing prospectuses, which may be filed within 10 business days of first use.  Under the current rule, the one-year period does not begin to run until a member firm first seeks to use an advertisement, even if the firm has been a member for months or years before first using an advertisement.  FINRA Rule 2210 preserves FINRA’s authority to determine that a member should be required, based on its prior filing experience, to continue to make pre-use filings after the first year. 

Pre-Use Filing.  Pre-use filing will be required for retail communications (1) concerning registered investment companies that include self-created rankings; (2) concerning security futures (unless submitted to another self-regulatory organization); and (3) including bond mutual fund volatility rankings.  Communications concerning collateralized mortgage obligations (“CMOs”) will have to be filed within 10 business days after first use, rather than prior to first use as currently required. 

Filing After First Use. The following materials will have to be filed within 10 business days after first use:

  • All retail communications concerning registered investment companies not subject to the first year or pre-use filing requirements;
  • Retail communications concerning, or written reports produced by, an investment analysis tool;
  • Retail communications concerning registered CMOs; and
  • Retail communications concerning structured products, such as equity- or index-linked notes.

FINRA Rule 2210 also codifies prior FINRA guidance by modifying the exclusion from filing available for prospectuses filed with the SEC or any state to expressly provide that free writing prospectuses filed with the SEC pursuant to Rule 433(d)(1)(ii) under the Securities Act of 1933 (the “Securities Act”) are not within the exclusion.  In addition, retail communications that are posted on an online interactive electronic forum and press releases issued by closed-end investment companies that are listed on the NYSE pursuant to section 202.06 of the NYSE Listed Company Manual are excluded from the filing requirements.


FINRA Rule 2210 maintains the current prohibition in the content standards against communications predicting or projecting performance, implying that past performance will recur or making any exaggerated or unwarranted claim, opinion or forecast.  As in the current rule, hypothetical illustrations of mathematical provisions will be permitted, providing that they do not predict or project the performance of an investment or investment strategy.  Rule 2210 clarifies that FINRA allows two additional types of projections of performance in communications with the public:  (1) projections of performance in reports produced by investment analysis tools otherwise meeting the requirements of the rules and (2) price targets in research reports on debt or equity securities.

The content standards of FINRA Rule 2210 do not apply to prospectuses, preliminary prospectuses, fund profiles and similar documents that have been filed with the SEC, but do apply to investment company prospectus published pursuant to Securities Act Rule 482 and a free writing prospectus filed with the SEC pursuant to Securities Act Rule 433(d)(1)(ii).


FINRA has advised the SEC that it intends to publish a regulatory notice by 90 days following SEC approval of the rule changes, or by June 27, 2012, and that the implementation date for the New Rules will be no later than 365 days following SEC approval, or by March 29, 2013, in order to afford member firms time to alter their internal policies and procedures in response to the requirements of the New Rules.


The SEC has requested public comment on its approval of the New Rules.  Comments may be submitted no later than April 25, 2012.

OCC Issues Notice of Proposed Rulemaking that Would Revise Requirements for Short-Term Investment Funds

The OCC issued a notice of proposed rulemaking (the “Proposed Rule”) that would revise the requirements of the OCC’s short-term investment fund (“STIF”) rule, 12 CFR 9.18(b)(4)(ii)(B).  The OCC said that the Proposed Rule would add to and revise the requirements for collective investment funds that are STIFs by requiring banks’ STIFs to

  • “operate with a primary objective of a stable net asset value (NAV) of $1.00 per participating interest;
  • have a dollar-weighted average portfolio maturity of 60 days (revised down from 90 days);
  • have a dollar-weighted average portfolio life maturity of 120 days;
  • adopt (1) portfolio and issuer qualitative standards and concentration restrictions and (2) standards to address contingency funding needs;
  • adopt shadow pricing procedures—one that reflects the value of a fund’s assets at amortized cost and another that reflects the market value of the fund’s assets—and calculate the difference at least on a weekly basis;
  • adopt procedures for stress testing the STIF’s ability to maintain a stable NAV and report adverse stress testing results to the managing bank’s senior risk management;
  • provide a monthly disclosure to STIF plan participants and the OCC;
  • adopt procedures that require a bank that administers a STIF to notify the OCC prior to or within one business day after the occurrence of one or more of six specific events;
  • use mark-to-market value accounting, instead of amortized cost accounting, if the market value of the portfolio falls below a NAV of $0.995 per participating interest; and
  • adopt procedures to take certain actions if a bank suspends or limits withdrawals and initiates liquidation of the STIF as a result of redemptions.”

The OCC stated that the general objective of the changes to STIF requirements set forth in the Proposed Rule is intended to add safeguards that would mitigate the risk of loss to a STIF’s principal.

Comments on the Proposed Rule are due by June 8, 2012.

ICI and U.S. Chamber of Commerce Challenge Changes to CFTC Exemption for Advisers to Registered Funds

The Investment Company Institute (ICI) and the U.S. Chamber of Commerce filed a complaint in the U.S. District Court for the District of Columbia challenging amendments to Rule 4.5 under the Commodity Exchange Act (CEA).  The amendments, which were discussed in the February 14, 2012 Financial Services Alert, increase the number of conditions an adviser to a registered investment company must meet to claim an exemption from regulation by the CFTC as a commodity pool operator (CPO); the amendments, in part, reinstate trading and marketing conditions that were part of Rule 4.5 prior to 2003.  The complaint alleges a number of defects in the CFTC’s rulemaking process under the CEA and Administrative Procedures Act (APA), including failure to conduct the cost/benefit analysis required under CEA and failure to provide reasoned explanations for various aspects of the rulemaking as required by the APA and the CEA.  The suit also challenges new quarterly reporting requirements for CPOs that the CFTC added to Rule 4.27 under the CEA in the same rulemaking with the Rule 4.5 amendments.  The complaint asks that the amendments to Rule 4.5 and 4.27 be vacated and that the court postpone the effectiveness of the amendments until the case is concluded.

CFTC and SEC Approve Entity Definition Rules

The CFTC and SEC approved, in simultaneous meetings, the final so called “entity definition rules” defining the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.”  The rules were prepared jointly by the two agencies.  The final rules and related explanatory releases are not yet available.  The final rules will become effective 60 days after publication in the Federal Register.

Swap Dealer/Security-Based Swap Dealer.  The Commissions announced that the new rules follow the text of the Dodd-Frank Act in defining “swap dealer” and “security-based swap dealer” as any person who (i) holds itself out as a dealer in swaps or security-based swaps, (ii) makes a market in swaps or security-based swaps, (iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account or security-based swaps, or (iv) engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps or security-based swaps.  However, swaps or security-based swaps entered for a person’ own account and not as part of a regular business are excluded. 

Both the CFTC and SEC rules contain a de minimis exemption from “swap dealer” and “security-based swap dealer” status.  The respective exemptions will be available to persons that, over the prior 12 months, entered into not more than $3 billion in notional of swaps (or $3 billion in notional of credit default swaps or $150 million of other types of security-based swaps).  During the initial phase-in period, however, the threshold amount will be $8 billion in notional of swaps (or $8 billion in notional of credit default swaps or $400 million of other types of security-based swaps). 

Major Swap Participant/Major Security-Based Swap Participant.  The new CFTC and SEC rules defining “major swap participant”  and “major security-based swap participant” also track those Dodd-Frank Act definitions, which capture (i) a person that maintains a “substantial position” in any of the major swap (or security-based swap) categories, subject to certain exclusions; (ii) a person whose outstanding swaps (or security-based swaps) create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets”; or (iii) any “financial entity” that is highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency and that maintains a ‘substantial position’ in any of the major swap categories.  (An entity that meets the definition of swap dealer or security-based swap dealer is excluded from the definition of major swap participant or major security-based swap dealer, respectively.)  The rules elaborate on many of the terms included in the definition and offer, for example, specific, numerical tests to determine whether a person holds a “substantial position” in various swap categories, as well as definitions of terms such as “substantial counterparty exposure” and “highly leveraged.”  The approach taken by the SEC to the definition of “major security-based swap participant” corresponds to the CFTC’s.

Hedging Transactions.  The rules exclude certain hedging transactions from the calculations used to determine whether an entity qualifies as a “swap dealer,” “security-based swap dealer,” “major swap participant,” or “major security-based swap participant,” respectively.  These exclusions are based on the Commissions’ position that bona fide hedging is inconsistent with swap dealing.   Additionally, positions held for hedging or mitigating commercial risk or employee benefit plan operational risks will be excluded from the determination of whether an entity is a “major swap participant” or “major security-based swap participant.”  It is important to note that the Commissions are not excluding all transactions that hedge or mitigate risk, but will exclude swaps entered into for the specific hedging purposes identified in the rules.  The rules will clarify the definition of “hedging,” using a narrow interpretation that will exclude swaps entered into for the purpose of portfolio hedging or anticipatory hedging.