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

FRB Announces Optional Pre-Filing Review Process

On July 11, 2012, the FRB issued supervisory guidance, SR Letter 12-12, (the “Guidance”) describing a new, optional process for submitting requests for pre-filing review (“Pre-filings”) of specific aspects of proposed acquisitions and other proposals prior to the formal submission of an application or notice to the FRB.  The FRB believes that the review of Pre-filings will be particularly beneficial for individuals and entities that are not frequent filers with the FRB, such as private equity firms, and for filers with novel proposals that are seeking feedback on specific areas regarding a proposal.  The Guidance indicates that “brief phone conversations or limited e-mail correspondence” will not generally be considered Pre-filings, although any request for review of substantive written materials related to a proposal would be considered Pre-filings.

While Pre-filings may be submitted for topics that are related to “specific aspects” of a proposal, Pre-filings are not intended to be a forum for negotiating the final structure of a potential proposal or for resolving significant issues of policy or law.  Examples of appropriate subjects for Pre-filings include business plans or pro forma financial information related to a potential filing or presentations outlining specific potential proposals.  Pre-filings may also include draft transactional documents as well as questions regarding the type of filing required, the individuals or entities that would need to join a filing, and whether an entity would be considered to be a “company” or have “control” under the Bank Holding Company Act or the Home Owners’ Loan Act.

The Guidance indicates that Pre-filings should be submitted to the appropriate Federal Reserve Bank, rather than directly to the FRB staff.  The Guidance states that “most pre-filings can be addressed swiftly,” although the FRB may take up to 60 days to respond.  Parties who submit Pre-filings are not required to wait until the expiration of the 60-day pre-filing period to submit a formal application or notice.  Of importance, written Pre-filing inquiries and any related materials submitted will be formally deemed to be public records of the FRB and therefore subject to the Freedom of Information Act, although the FRB will consider requests for confidential treatment.

California Federal Court Grants Partial Dismissal of SEC’s Claims Against Bond Fund’s Chief Investment Officer For Allegedly Fraudulent Statements About the Fund’s Risks

In an action brought by the SEC against a bond fund’s Chief Investment Officer for allegedly fraudulent statements regarding the fund’s risks, diversification and level of investor redemptions in the fund in violation of Section 10(b) and Rule 10b-5 of the 1934 Act, Section 17(a) of the 1933 Act, Section 34(b) of the Investment Company Act (“ICA”) and Section 206 of the Investment Advisers Act, a California federal court recently granted partial summary judgment dismissing many such claims, while permitting other claims to proceed to trial.

The court found that defendant’s description of the fund as “highly diversified” was not misleading and dismissed that claim because the undisputed evidence showed that the fund met the ICA statutory definition of issuer diversification, and defendant’s statement did not mention industry or sector diversification.  While the court determined that defendant’s statements representing the fund as an ultra-short bond fund were not misleading, it found that questions of fact existed as to whether statements were misleading that the fund was hardly more risky than a money market fund and as to the purpose of the fund’s maintenance of a higher than normal cash balance.

The court denied summary judgment as to allegedly fraudulent statements failing to disclose the fund’s risks in advertisements and on the fund’s internal website, which statements were attributed only to the defendant, as well as certain of defendant’s oral presentations about the fund.  The court also held that defendant could not be liable for allegedly fraudulent statements about the fund’s level of redemptions made internally to the fund adviser’s employees because there was no intent that those statements be transmitted to the public.  However, the court denied dismissal of a claim regarding one such statement that the defendant characterized as one of several “sounding points to provide your clients,” which a financial consultant then repeated to a fund investor.  The court further found that an issue of fact existed about the duty to disclose more detail about the fund’s holdings in Alt-A loans and denied the motion to dismiss that claim.

Proposed Settlement.  The SEC subsequently announced a proposed settlement of the case, subject to court approval, enjoining defendant from future violations of the federal securities law and requiring a payment of $325,000 in penalties and disgorgement.  Settlement of a related SEC administrative proceeding also would bar defendant from the securities industry and render him ineligible to hold certain positions associated with registered investment companies.

Securities and Exchange Commission v. Kimon P. Daifotis and Randall Merk, No. C 11-00137 WHA (N.D. Cal. June 12, 2012); SEC Litigation Release No. 22415 (July 16, 2012).

A Goodwin Procter partner served as an expert witness in the litigation.

U.S. Senate Permanent Subcommittee on Investigations Issues Report Finding That HSBC’s U.S. Affiliate Had Weak AML Compliance Practices and Controls

The U.S. Senate Permanent Subcommittee on Investigations issued a 330-page report entitled U.S. Vulnerabilities to Money Laundering, Drugs, and Terrorist Financing – HSBC Case History (the “Report”), which concluded that HSBC Bank USA, N.A. (“HSBC US”), the U.S. affiliate of HSBC (which operates in more than 80 countries) had deficient anti-money laundering (“AML”) compliance practices and controls and processed large transactions for HSBC affiliates in Mexico and other foreign countries with insufficient scrutiny of the source of the funds.  Among the AML compliance lapses at HSBC US identified in the Report were:

  1. Over seven years, HSBC US, HSBC bankers in Europe and two HSBC affiliates in the Middle East executed 28,000 transactions without complying with OFAC rules that require disclosure of possible links to Iran.  The 28,000 transactions had an aggregate value of $19.4 billion;
  2. Over a period of less than four years, HSBC US cleared more than $290 million in suspicious bulk U.S. dollar travelers checks bought by Russians at a Japanese regional bank;
  3. Over ten years, HSBC opened over 2,000 accounts for bearer share corporations, entities that the Report described as inviting “secrecy and wrongdoing by assigning ownership to whomever has physical possession of the shares”; and
  4. Dealing with a Saudi Arabian bank whose founder had suspected links to al-Qaida.

The Report focused on five areas of AML compliance weaknesses at HSBC US: servicing high-risk affiliates; avoiding or ignoring OFAC requirements; ignoring links to terrorist financing; clearing suspicious travelers’ checks; and offering bearer share accounts.

The Report criticized the OCC, HSBC US’s federal bank regulator, for its failure to supervise HSBC US effectively.  The Report also took exception to the OCC’s treatment of AML deficiencies as compliance lapses rather than as safety and soundness weaknesses. 

FINRA Delays Effectiveness of Rule Amendments Requiring Use of New Standardized Electronic Continuing Membership Application Form

FINRA filed a rule proposal with the SEC delaying the effectiveness of amendments to NASD Rule 1012 and NASD Rule 1017 (the “Amendments”) adopting a new standardized electronic Form CMA until August 27, 2012.  The Amendments, which were previously scheduled to become effective on July 23, 2012, were approved by the SEC on May 31, 2012.  The contents of the Amendments were discussed in the March 20, 2012 Financial Services Alert.  FINRA stated that it intends to permit voluntary use of electronic Form CMA between July 23 and August 27.

Updates to SEC Form PF FAQ

The staff of the SEC’s Division of Investment Management (the “Staff”) updated its FAQ regarding Form PF.  The updates address:

  • how to include relying advisers and special purpose entities in Form PF

  • no-action relief for advisers that programmed internal systems or provided responses in filings based on assumptions that proved to be inconsistent with subsequent guidance issued by the Staff

  • the definition of “gross notional exposure”

  • the use of Question 4 to explain responses to other items in the Form

  • an exception to the requirements for calculating net asset value that allows the deduction of deferred compensation amounts under certain conditions

  • valuing derivatives in determining the value of a parallel managed account

  • the types of transactions that are borrowings for purposes of providing information on the value of a fund’s borrowing in response to Questions 12 and 43, and the valuation of short sales for this purpose

  • who are counterparties for purposes of the questions regarding credit counterparty exposure, and the calculation of credit counterparty exposure for different types of transactions

  • reporting exchange-traded derivatives

  • the definition of “listed equity derivative”

  • accounting for a position that could fall in multiple sub-asset classes identified in Questions 26 and 30

  • providing a geographical breakdown of fund investments

  • reporting the effect of different market factors in a fund’s risk management monitoring in response to Question 42

  • circumstances under which it is permissible to net across positions when reporting the aggregate value of all derivatives positions in Question 44