Financial Services Alert - October 2, 2012 October 02, 2012
In This Issue

Variable Annuity Holder Allowed to Assert Section 36(b) Excessive Fee Claims Against Investment Adviser of Underlying Mutual Funds

In an action brought by an investor in a variable annuity asserting excessive fee claims in violation of Section 36(b) of the Investment Company Act of 1940 (“ICA”) against the investment adviser to the variable annuity’s underlying mutual funds, a New Jersey federal court recently denied defendants’ motion to dismiss those claims for lack of standing.  Section 36(b) imposes a fiduciary duty on the recipients of compensation for services provided to mutual funds, and allows a “security holder” in a mutual fund or the SEC to bring an action on behalf of the fund for alleged breaches of that duty.  The court rejected defendants’ argument that the plaintiff was not a “security holder” within the meaning of Section 36(b).

Excessive Fee Claim.  To effect the plaintiff’s variable annuity investment, the insurance company placed the plaintiff’s premiums into a separate account owned by the insurance company.  Plaintiff then selected certain mutual funds as investment options, in which separate account assets proportionate to the plaintiff’s holding were invested.  The overall value of plaintiff’s units in the separate account fluctuated according to the value of the underlying securities.  Plaintiff alleged that the advisory fees paid by those mutual funds were excessive because the adviser’s role was generally limited to providing supervisory input, and that the adviser contracted with sub-advisers to perform all of the investment management services for the funds.

Variable Annuity Investor as “Security Holder” of Underlying Fund.  Defendants argued that the term “security holder,” which is not defined in the ICA, refers to the legal or record owner of a security – here, the separate account – while plaintiff argued that it refers to the equitable or beneficial owner of a security.  The court noted the underlying purpose of the ICA and Section 36(b) to create protections for mutual fund holders and concluded that it made little sense to limit “holders” to entities such as the separate account or trust that lack any economic interest or stake in the transaction because they did not pay the allegedly excessive compensation.  Rather, the court stated, “Plaintiff and similarly situated investors are responsible for and paid all of the challenged fees.  Plaintiff and other investors bear the full risk of poor investment performance.  Plaintiff and other investors have the right to instruct [defendant] how to vote their shares.  Assets held in a separate account are immune from claims of [defendant’s] creditors, while being vulnerable to claims of the investors’ creditors.  And when Plaintiff decides to withdraw her investment in the [defendant’s] Funds, she, not [defendant], pays the taxes on that investment.”  The court said that this was different from a fund-of-funds situation where the investors did not enjoy the incidents of ownership in the underlying funds such as voting or receiving dividends.

Unjust Enrichment Claim Dismissed.  The court dismissed plaintiff’s claim for unjust enrichment asserted under the federal common law.  Noting that federal common law claims are warranted only where they are necessary to fill in interstices of the ICA, the court held that because plaintiff had already asserted an excessive fee claim under Section 36(b), the plaintiff’s unjust enrichment claim was not necessary to fill in the interstices of the ICA, and thus should be dismissed.

Sivolella v. AXA Equitable Life Insurance Co., No. 11-cv-4194 (D.N.J. Sept. 21, 2012).

OCC Issues Guidance on How Banks May Use SBICs to Expand Their Small-Business Finance Activities

The OCC issued an edition of its Community Developments Insight report entitled “Small Business Investment Companies: An Investment Option for Banks” (the “Guidance”).  The Guidance discusses how banks may use small business investment companies (“SBICs”) to expand their small-business finance activities.

The OCC points out in the Guidance that banks are interested in making investments in SBICs because such investments can allow banks to accomplish three objectives:  (1) earn a competitive investment return; (2) in the case of a “large” or “intermediate small” bank for Community Reinvestment Act (“CRA”) purposes, receive CRA credit for the investment under the “investment test” or the “community development test”; and (3) attract new and retain existing small business customers.  The Guidance explains that SBICs that use leverage have the potential to generate attractive investment returns because “SBICs can supplement their own private capital with [Small Business Administration] leverage in amounts of up to three times their private capital,” allowing SBICs to provide funding at lower costs than competitors relying entirely on private capital.

The Guidance also provides a discussion of how SBICs operate, the SBIC licensing process, oversight of SBICs and management of an SBIC’s operational risk.  The Guidance stresses that the bank regulatory agencies expect that a bank that invests in an SBIC has the management expertise and depth to monitor the investment effectively.

Federal Banking Agencies, FCA and FHFA Reopen Comment Period on Proposed Swap Margin and Capital Requirements

The OCC, FRB, FDIC, Farm Credit Administration, and Federal Housing Finance Agency (collectively, the “Agencies”) reopened the comment period on a proposed rule to establish margin and capital requirements for swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants for which one of the Agencies is the prudential regulator.  Although the original comment period closed on July 11, 2011 (after being extended from June 24, 2011), it has been reopened until November 26, 2012, in light of the consultative document on margin requirements for non-centrally-cleared derivatives recently published by the International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision.

Federal Court Vacates and Remands CFTC Position Limits Rule

A U.S. federal district court vacated and remanded the CFTC’s final rule imposing a position limits regime for derivatives contracts tied to twenty-eight different agricultural, metal, and energy commodities.  The rule, passed on a party line vote in October 2011, was intended by its supporters to curb excessive speculation in the commodities markets.  As previously reported, the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA) challenged the rule in court, claiming that the CFTC was required to determine that the rule is necessary and appropriate before adopting it.  The CFTC argued, in contrast, that the Dodd-Frank Act mandated the rule’s adoption and that it was therefore unnecessary for the CFTC to make such a determination. 

The court ruled that the CFTC must make a finding of necessity prior to imposing position limits.  The court’s action prevents the rule from becoming effective, but does not preclude the CFTC from subsequently adopting the same or a similar rule after having determined that the rule is necessary and appropriate.

CFTC Chairman Gensler responded to the court’s ruling with a brief statement reiterating his belief that Congress directed the CFTC to issue the rule.  The statement concluded, “I am disappointed by today’s ruling, and we are considering ways to proceed.”

FDIC Issues New Classification System for Citing Consumer Compliance Violations

The FDIC announced that it revised the classification system for citing violations identified during compliance examinations to promote better communication with institutions and consistency in the classification system.  The revised classification system replaces the current two-level system with a three-level violation system.  The key purpose of the revision and the addition of a third level of violation, according to the FDIC, is to effectively communicate the level of severity of violations so that supervised institutions may “appropriately prioritize efforts” to address identified issues.

Under the new classification system, the violations are classified as “Level 3/High Severity,” “Level 2/Medium Severity” and “Level 1/Low Severity.” 

Generally, High Severity violations are those violations that “have resulted in significant harm to consumers or members of a community” and may result in restitution to consumers in excess of $10,000.  High Severity violations also include so-called “pattern or practice” anti-discrimination law violations.  Medium Severity violations are violations that reflect systemic, recurring, or repetitive errors that represent a failure of the bank to meet a key purpose of the underlying statute or regulation.  The effect on consumers of a Medium Severity violation may be “small, but negative” or potentially negative, if left uncorrected.  The FDIC will generally seek restitution of $10,000 or less for Medium Severity violations.  Low Severity violations include those relatively minor violations that are isolated or sporadic or a systemic violation that is unlikely to affect consumers or the underlying purposes of the regulation or statute.  The FDIC states that Low Severity violations will not be reflected in the FDIC’s final report of examination if they are appropriately addressed by the bank during the examination and do not reflect a weakness in the bank’s compliance system.  The revised classification system will become effective for examinations started or after October 1, 2012.