Financial Services Alert - July 17, 2012 July 17, 2012
In This Issue

FinCEN to Hold Public Hearings on Proposal to Require Banks and Other Financial Institutions to Establish Customer Due Diligence Programs

As previously discussed in the February 29, 2012 Financial Services Alert, the Financial Crimes Enforcement Network (“FinCEN”) issued an advance notice of proposed rulemaking (the “Advance Notice”) in which it sought comment on a proposal to expressly require that financial institutions, including initially banks, brokers or dealers in securities, mutual funds, futures commission merchants and introducing brokers in commodities conduct customer due diligence (“CDD”), including by collecting beneficial ownership information for all customers, with limited exceptions.  On July 9, 2012, FinCEN issued a notice of public hearing and request for comment (the “Notice”) in which it announced that, on July 31, 2012, it will hold the first in an intended series of public hearings to obtain detailed clarification on the following issues:

(1)  How and when financial institutions currently obtain beneficial ownership information;

(2)  Whether and how financial institutions currently verify beneficial ownership information obtained from their customers;

(3)  The costs associated with obtaining beneficial ownership information under current practices, versus the expected costs associated with obtaining beneficial ownership information as discussed in the Advance Notice;

(4)  The costs associated with verifying beneficial ownership information (to the extent done under current practices), versus the expected costs associated with verifying beneficial ownership information as discussed in the Advance Notice;

(5)  Potential definitions of “beneficial owner” alternative to the definition set forth in the Advance Notice (and why such alternatives would be preferable from a financial institution’s perspective);

(6)  How identifying beneficial owners enhances a financial institution’s ability to manage risk, as well as the circumstances and account relationships in which beneficial ownership information may not be relevant in managing risk;

(7)  As a result of commenters’ suggestions that financial institutions be required to obtain beneficial ownership information on a risk-based basis: (i) how financial institutions would expect to assess risk in determining whether to obtain beneficial ownership information; (ii) specific examples of any customer or account relationships or red flags that would be considered of higher risk or lower risk for purposes of obtaining and verifying beneficial ownership information; (iii) how financial institutions would obtain and verify and beneficial ownership information on a risk basis; and (iv) for financial institutions that already obtain beneficial ownership information on a risk basis, detailed information as to when they obtain it;

(8)  The abilities and limitations of a financial institution in mitigating risk associated with its customer's underlying clients in the context of intermediated accounts;

(9)  How financial institutions currently conduct due diligence on trust accounts, including how they assess risk and what information they obtain;

(10) The differences in obtaining beneficial ownership information from foreign legal entity customers compared to domestic legal entity customers; and

(11)  Whether and how financial institutions identify whether legal entity customers are “shell companies.”

Requests to attend the hearing or to provide oral comments, as well as written outlines of oral comments, must be received by FinCEN by July 24, 2012.  The information that must accompany such requests as well as information regarding where to send such requests is available on Pages 3 to 4 of the Notice.

CFTC and SEC Approve Product Definition Rules for Swaps and Security-Based Swaps; Rules Trigger Compliance Obligations Under Certain CFTC Regulations

Please see the August 21, 2012 Financial Services Alert for an update on these developments that reflects the subsequent publication of the Product Definition Rules in the Federal Register.

CFTC Issues No Action Relief for Newly-Formed Commodity Pools, Denies Other Requested Relief

The CFTC’s Division of Clearing and Intermediary Oversight (the “Division”) published a no‑action letter on July 13, 2012 (the “Letter”) that provides temporary relief from CFTC registration requirements to general partners and advisors of commodity pools formed between July 11, 2012 and December 31, 2012.  The Letter denied other relief sought by industry groups related to CFTC registration obligations.  The Letter allows entities that are commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) under CFTC regulations to avail themselves of the “QEP Exemption” (and the corresponding exemption for CTAs) with respect to commodity pools launched after the issuance of the Letter (the Letter is dated July 10, 2012) and December 31, 2012.  To obtain relief, entities must file a claim with the CFTC.  The QEP Exemption (and the corresponding exemption for CTAs) expires on December 31, 2012.  Final rules issued by the CFTC on February 9, 2012 rescinded the QEP Exemption with respect to commodity pools formed before April 24, 2012, effective on December 31, 2012. 

The Letter responds to two letters from industry groups.  In addition to the temporary relief granted by the Letter, the Managed Funds Association, the Investment Adviser Association and the Alternative Investment Management Association in a letter dated April 30, 2012  and the Investment Company Institute, in a letter dated May 21, 2012, had also requested an extension of time during  which (i) a CPO could claim an exemption from registration under 17 CFR 4.13(a)(3) (the “De Minimis Exemption”) and 17 CFR 4.5 (the “Regulated Entity Exemption”) without including swaps in the CPO’s calculations to determine whether it qualifies for the De Minimis Exemption or the Regulated Entity Exemption and (ii) entities may rely on the QEP Exemption.  The Division denied these requests.

At this point, it appears unlikely that the CFTC will provide further relief related to the rescission of the QEP Exemption or the new restrictions associated with the De Minimis Exemption.  In providing the temporary relief to newly formed commodity pools that expires on December 31, 2012, the Letter states “[t]he Division believes that setting a specific compliance date that applies to all similarly situated CPOs and CTAs is appropriate.”  Therefore, advisors to private funds or accounts that hold commodities and that presently rely on the QEP Exemption in order to avoid registering with the CFTC should turn their attention at this time to determining whether they are eligible for the De Minimis Exemption.  If they are not, they will need to begin the CFTC registration process soon in order to achieve registration by December 31, 2012.

CFTC Approves Final Rule on End-User Exception to Clearing Requirement for Swaps

The CFTC unanimously approved a final rule on the end-user exception to the clearing requirement for swaps.  The rule further develops a provision of the Dodd-Frank Act that requires swaps to be submitted for clearing to a derivatives clearing organization unless one of the counterparties to a swap is not a financial entity, is using the swap to hedge or mitigate commercial risk, and notifies the CFTC how it generally meets its financial obligations associated with entering into non-cleared swaps. 

The rule sets out the reporting requirements that apply if the counterparties choose to avail themselves of the exception.  In contrast to the proposed rule, which would have required reporting on a swap by swap basis, the final rule adds the option of annual reporting.  It also establishes criteria for determining whether a swap is “hedging or mitigating commercial risk.” Finally, the rule establishes a “small financial institution exemption” that exempts banks, savings associations, farm credit system institutions, and credit unions with total assets of $10 billion or less from the definition of “financial entity,” thereby potentially allowing them to use the end-user exception. 

The rule will become effective 60 days after its forthcoming publication in the Federal Register.

CFTC Reopens Comment Period for Proposed Rule on Margin Requirements for Uncleared Swaps

The CFTC reopened the comment period for its proposed rule, published in the Federal Register on April 28, 2011, that would establish initial and variation margin requirements on uncleared swaps for swap dealers and major swap participants.  Reopening the comment period is intended to give interested parties the opportunity to comment in light of recent international efforts to harmonize margin requirements for uncleared swaps. 

Comments are due by September 14, 2012.

FDIC Issues Letter Cautioning Depository Institutions Against Passing On Fees to Customers as “Deposit Insurance Fees,” “FDIC Fees” or Other Similarly Described Fees

The FDIC issued a Financial Institution Letter (FIL-33-2012), the “Letter”) in which the FDIC discouraged insured depository institutions (“IDIs”) from passing on fees to customers as “deposit insurance fees,” “FDIC fees” or other similarly described fees.  The FDIC said in the Letter that while IDIs are not prohibited from passing on the costs of deposit insurance to customers, they should refrain from “specifically designating that a customer fee is for deposit insurance” and from stating or implying that the FDIC is charging such a fee [to the customer].  The FDIC further stated in the Letter that by passing on FDIC fees to customers, an IDI could violate the prohibition against disclosure of confidential examination and supervisory information, as the fees imposed by the FDIC reflect its risk-based supervisory evaluation of the applicable IDI.  Moreover, fees labeled as “FDIC fees” may be misleading if “they are not reasonably related to the proportional cost of deposit insurance allocable to a particular customer…”  Generally, IDIs that take steps to recoup the costs of deposit insurance impose such charges on business customers and do not charge the fees to consumer accounts.

Regulation of Non-European Firms under Markets in Financial Instruments Directive II – A Progress Report

The Current Position in Europe

Any non-European firm carrying on any investment service with European clients or counterparties currently operates under a patchwork of different national regulatory regimes, ranging from the liberal (e.g., the UK where all cross border business is permitted except with retail investors) through to the restricted (e.g., Germany where all solicitation and marketing is technically prohibited but an unofficial tolerated practice appears to have developed that allows institutional business to carry on in a gray zone).

The European Commission’s Proposals

The European Commission in October 2011, therefore, set out proposals (amongst many other things) to harmonize the European regulatory regime for non-European firms dealing with Europeans.  These proposals, if they are enacted in this form, will prohibit a non-European person from carrying on any regulated financial services business with a European person except:

(1)  where a firm itself has established an authorized branch in the European Union (subsidiaries or branches of other group firms will not be sufficient);

(2)  neither the specific business nor the relevant client relationship has been solicited by the non-European firm (the so-called “reverse solicitation test”); or

(3)  the business is undertaken only with “eligible counterparties” – in effect banks, brokers, investment managers, insurance companies, etc.  To use this exemption, the firm would have to be included on a list maintained by the European Securities and Markets Authority – a quasi-European supra-regulatory authority.

This has, rightly, been referred to as “Fortress Europe,” and we are monitoring its possible consequences for US firms carefully as the proposals pass through the various stages.

The Official Response

The Presidency of the Council of the European Union (the representative of Member States’ governments) has recently published a progress report on the MiFID II legislative proposals.   The aim of the progress report is to provide an update on the status of the various discussions and issues that have arisen from MiFID II.  Although the report states that there is, “in principle,” agreement on a number of the proposals, it is also clear that a number of issues are still to be resolved, some even potentially requiring discussion at a political level.

The report notes that “several Member States have expressed serious concerns and have strong reservations” about the Commission’s proposal on third countries.  The Member States’ view is that the proposal is “unnecessary and disproportionate.”  The report, though, appears to indicate that the substance of the proposals should in due course be amenable to agreement by the relevant countries.

The United Kingdom’s House of Lords European Committee scrutinizing the draft text is more critical, however, calling the proposal “deeply flawed” and urging the UK government to ensure that the final version of the text does not close the European financial market to non-European firms:

So where does this leave us?  There is clearly considerable opposition to the proposal to close European markets to third country firms.  The only question, though, is how effective this opposition will be given that the same argument was lost in the final position of the Alternative Investment Fund Managers Directive.  Under this directive, from 2018, non-European managers will be prohibited from promoting funds to European investors unless that manager is also authorized in the European Union. 


It is expected that agreement on these issues should reached by the end of the year, with the Directive not coming into force before 2015.

FFIEC Issues Statement on Cloud Computing Services

On July 11, 2012, the federal financial regulatory agencies, through the Federal Financial Institutions Examination Council (“FFEIC”), issued a joint interagency statement (the “Statement”) on the use of cloud computing services by financial institutions.  In particular, the statement focused on the risks associated with such services.  Cloud computing provides its users with information technology (“IT”) services through the internet, rather than through owned or leased IT servers or platforms.  This outsourcing of IT services offers many benefits to users, including increased operational efficiencies, lower costs and better backup services.  However, the FFIEC warns that use of cloud computing involves many of the same risks as traditional IT outsourcing, as well as certain risks that are particular to cloud computing.

The Statement first focuses on the due diligence that a financial institution should perform before outsourcing any significant IT functions to a cloud computing vendor.  A financial institution should understand how the vendor encrypts data, segregates the data of its various users, and backs up the data in the cloud.  The Statement also recommends confirming with the cloud computing vendor that it is aware that a financial institution, as a client, has particular regulatory requirements for safeguarding its customer data.  The vendor should be able to meet such requirements, and adapt its services should any of the requirements change. 

The Statement also discusses the internal adjustments that a financial institution needs to make to use cloud computing properly.  Auditing practices should be updated to be able to determine if a vendor’s internal controls are sufficient.  A financial institution may also need to provide its internal auditors with additional training or hire additional personnel to ensure sufficient experience with shared environments and virtualized technologies. 

The Statement also recommends that financial institutions using cloud computing revise their information security policies and practices.  Maintaining data privacy is still ultimately the financial institution’s responsibility, so additional monitoring and data inventory may be required to ensure compliance.  Lastly, financial institutions need to review the legal, regulatory and reputational considerations that must be addressed when a financial institution uses cloud computing.  Financial institutions should also revise their business continuity plans to reflect the use of such new services.

FINRA Sets Effective Date for New Rules Consolidating and Amending NASD and NYSE Rules and Interpretations Relating to Communications with the Public

FINRA issued a Regulatory Notice announcing that the effective date for new rules consolidating and amending NASD and NYSE Communications Rules and Interpretations is February 4, 2013.  The new rules, which were approved by the SEC on March 29, 2012, are as follows:

  • 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 SEC approved FINRA’s proposal to adopt the new rules by release dated March 29, 2012.  The content of the SEC release approving the new rules was discussed in the April 24, 2012 Financial Services Alert

In announcing the effective date of the new rules, FINRA also provided guidance with respect to the application of the new rules.  Among the topics covered in the guidance are the following:

Reason to Believe Standard. Noting that the definition of “institutional investor” in both new Rule 2210(a)(4) and in the prior rules require that “[n]o member may treat a communication as having been distributed to an institutional investor if the member has reason to believe that the communication or any excerpt thereof will be forwarded or made available to any retail investor[,]” FINRA confirmed that this standard does not impose an affirmative obligation on the member to inquire as to whether an institutional investor intends to distribute the communication to retail investors.  Additionally, FINRA confirmed that this standard does not create an obligation for a fund underwriter to supervise the associated persons of recipient broker-dealers, and provided guidance on how a member should respond in the event that it becomes aware that a recipient institutional investor, is or may be, distributing the communication to retail investors.

Exemptive Relief.  Noting that new Rule 2210(b)(1)(E) and new Rule 2210(c)(9) allow FINRA to grant exemptive relief with respect to pre-use approval requirements and concurrent-with-use filing requirements, respectively, FINRA clarified that it only intends to grant such relief in unique circumstances on a case-by-case basis.  Furthermore, FINRA clarified that any such relief will apply only to the firms that have applied for the relief.  If FINRA determines that similar relief is warranted for similarly situated members, it will file a proposed rule change.

Illustrations of Impact of Tax Decisions.  Noting that new Rule 2210(d)(4)(C) adds new language  concerning comparative illustrations of the mathematical principles of tax-deferred versus taxable compounding, FINRA describes in detail the required content of such illustrations and confirms that the standards contained in the new rule apply to any illustration of tax-deferred versus taxable compounding, regardless of whether it appears in a communication promoting variable insurance products or some other communication, such as one discussing the benefits of investing through a 401(k) retirement plan or individual retirement account.

Social Media. FINRA notes that under new Rule 2210(c)(7)(M) communications that are posted on an online interactive electronic forum, such as an electronic bulletin board or an interactive forum that is contained on a social media website, are considered retail communications; however, they are excluded from new Rule 2210’s filing obligations.

Goodwin Procter Alert: SEC Adopts Final Rules on Listing Standards for Compensation Committee and Compensation Adviser Independence

Goodwin Procter’s Capital Markets Practice issued a client alert describing final rules adopted by the SEC pursuant to the Dodd-Frank Act which: (1) direct the national securities exchanges to adopt listing standards regarding the independence of compensation committees and the engagement and independence of compensation advisers, and (2) impose additional proxy statement disclosure requirements regarding the use of compensation consultants.