Financial Services Alert - October 16, 2012 October 16, 2012
In This Issue

CFTC Issues Range of Swaps-Related Interpretive Guidance and No-Action Relief

The CFTC issued a number of no-action relief letters and interpretive guidance in the days leading up to the October 12, 2012 effective or compliance dates for several swaps-related CFTC regulations, including the product definition rules and various registration and reporting rules. 

The CFTC responded to a request from the National Association of Real Estate Investment Trusts (NAREIT) for guidance regarding whether certain real estate investment trusts are commodity pools, which is the subject of a Goodwin Procter REIT Alert, and issued separate guidance conducting a similar analysis with respect to securitization vehicles (as discussed in greater detail here).  It also provided temporary no-action relief with respect to certain market participants from certain registration requirements arising from swaps activities (as discussed in greater detail here).

Additional interpretive guidance issued by the CFTC clarified the scope of the bona fide hedging exemption from trading thresholds in light of a federal court’s September 28, 2012 decision (discussed in the October 2, 2012 Financial Services Alert) to vacate position limits rules that were referenced in the bona fide hedging exemption rules.  The Commission also issued certain interpretive guidance and no-action relief regarding eligible contract participants.

In addition, the CFTC issued no-action relief letters concerning what swaps must be included in calculations of the de minimis thresholds included in the definition of “swap dealer” and in certain calculations included within the “major swap participant” definition (as discussed in greater detail here).  The CFTC provided similar relief in a no-action letter regarding certain swaps with utility Special Entities and a no-action letter regarding swaps calculations made by certain non-US entities. 

The CFTC also issued no-action relief regarding the treatment of foreign exchange swaps and foreign exchange forwards for certain purposes.  This relief temporarily allows foreign exchange swaps and foreign exchange forwards to be currently excluded from the swap dealer de minimis thresholds and major swap participant definition, to the extent that the Secretary of the Treasury issues a final determination that is effective prior to December 31, 2012, that they should not be regulated as swaps.  The Treasury Department has issued a proposed determination, but has not yet finalized it.

The Commission also issued no-action relief regarding a final rule published in February 2012, regarding the protection of cleared swaps customer contracts and collateral, as well as commodity broker bankruptcy provisions, to ease confusion regarding whether and how certain rules would apply before a November 8, 2012 compliance date.  It also issued two separate no-action relief letters (available here and here) involving certain electric utilities, in each case to “maintain the regulatory status quo” pending final resolution of previously issued proposed orders.

The CFTC also issued a “question and answer” document on the timing of swap data reporting as well as a “Frequently Asked Questions” document on the reporting of cleared swaps. 

CFTC Issues Interpretive Guidance Concluding That Some Securitization Vehicles Are Not Commodity Pools

The CFTC’s Division of Swap Dealer and Intermediary Oversight issued interpretive guidance finding that some, but not all, securitization vehicles should not be included within the definition of “commodity pool.”  Issued in response to correspondence from the American Securitization Forum and from the Securities Industry and Financial Markets Association, the guidance rejects the commentators’ requests for relief for certain categories of issuers, such as “entities operating to some extent under any covered bond statute, entities involved in collateralized debt obligations, entities involved in collateralized loan obligations, any insurance-related issuances, and any other synthetic securitizations,” stating that such exclusions would be “overly broad.”  Instead, the guidance states that vehicles that meet various criteria “are likely not commodity pools” and lists specific criteria that, if met, warrant exclusion of the vehicle from the definition of “commodity pool” and of its operator from the definition of “commodity pool operator.”  The listed criteria are:

  • The issuer of the asset-backed securities is operated consistent with the conditions set forth in Regulation AB, or Rule 3a-7 under the Investment Company Act of 1940, whether or not the issuer’s security offerings are in fact regulated pursuant to either regulation, such that the issuer, pool assets, and issued securities satisfy the requirements of either regulation;
  • The entity’s activities are limited to passively owning or holding a pool of receivables or other financial assets, which may be either fixed or revolving, that by their terms convert to cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to security holders;
  • The entity’s use of derivatives is limited to the uses of derivatives permitted under the terms of Regulation AB, which include credit enhancement and the use of derivatives such as interest rate and currency swap agreements to alter the payment characteristics of the cash flows from the issuing entity;
  • The issuer makes payments to securities holders only from cash flow generated by its pool assets and other permitted rights and assets, and not from or otherwise based upon changes in the value of the entity’s assets; and
  • The issuer is not permitted to acquire additional assets or dispose of assets for the primary purpose of realizing gain or minimizing loss due to changes in market value of the vehicle’s assets.

The guidance includes a statement that the Division is willing to discuss and consider whether specific securitization vehicles that do not satisfy all of the specified criteria might also be excluded from the definition, and would be willing to consider lesser forms of relief for those that do not merit exclusion. 

CFTC Provides Temporary No-Action Relief from Registration Requirements Arising from Swaps

The CFTC’s Division of Swap Dealer and Intermediary Oversight issued a no-action letter allowing introducing brokers (IBs), commodity pool operators (CPOs), commodity trading advisors (CTAs), Associated Persons (APs) of any of the foregoing, floor brokers (FBs), floor traders (FTs), and APs of futures commission merchants (FCMs) to obtain temporary relief from their obligation to register with the CFTC “where the requirement to be registered as such arises solely from the swaps activity of such person, or from the person being involved with” the transition of certain contracts by the Intercontinental Exchange, Inc. and the New York Mercantile Exchange to clearing as commodity futures and options transactions.  Effectively, the relief provides additional time for a registration to become effective, provided that it is in process. 

The relief is conditioned upon the person applying for registration with the National Futures Association (NFA) on or before December 31, 2012 and making a good faith effort to comply with the Commodity Exchange Act and CFTC regulations as if registered.  IBs, FBs, and FTs must file or provide certain additional documents identified in the letter.  The relief terminates on the date on which the NFA provides notice that the person is actually registered, or five days after the NFA provides notice that the person may be disqualified from registration.

The above relief explicitly does not apply to futures commission merchants (FCMs) (as distinguished from APs of FCMs).  The letter explains that the fact that FCMs accept customer funds in their own name requires such persons to be “fully vetted before being permitted to engage in that business.”  It also explicitly does not apply to swap dealers (SDs) or major swap participants (MSPs), citing the ability of an SD to delay registration pursuant to the provisions of the de minimis threshold and the ability of an MSP to delay registration until two months after the end of the quarter in which it meets the MSP definition.

 The no-action letter also relieves, without a termination date but subject to the conditions set forth in the letter, SDs and MSPs from the provisions of Section 4s(b)(6) of the Commodity Exchange Act, thereby potentially allowing a statutorily disqualified AP of an SD or MSP to effect swaps on behalf of the SD or MSP.  The relief is not self-executing but requires the SD or MSP to make certain notifications and submissions to the NFA and receive notification from the NFA.  Accordingly, SDs and MSPs interested in taking advantage of the relief should examine the requirements carefully.

CFTC Issues No-Action Letter Temporarily Allowing Exclusion of Swaps of Exempt or Agricultural Commodities from Swap Dealer De Minimis Threshold Calculations

On October 12, 2012, the CFTC’s Division of Swap Dealer and Intermediary Oversight (the “Division”) issued a no-action letter regarding the calculation of the amount of swap dealing activity for purposes of the de minimis exception to the definition of “swap dealer.”  The letter provides that the Division will not recommend that the CFTC take enforcement action against any person for failure to include, for purposes of calculation of the aggregate gross notional amount of swaps connected with its swap dealing activity for purposes of the de minimis exception, a swap that (i) references an exempt commodity (such as energy commodities or metals) or agricultural commodity, (ii) is executed prior to December 31, 2012, and (iii) is either cleared on a registered derivatives clearing organization or “entered into contingent upon its being subsequently exchanged for and cleared as a futures position as part of an exchange for related position transaction conducted in accordance with a [designated contract market’s] rules.” 

The relief responds to what some commentators have referred to as the “futurization” of swaps:  as explained in the letter, “[o]ver the past several weeks, several major platforms that have been providing over-the-counter markets for cleared swaps in exempt commodities have announced their intention to transition the cleared swap activities offered on those markets to cleared futures contracts.”  The relief cites IntercontinentalExchange and The CME Group, and adds that “[t]he Division has also received information indicating that other trading platforms are contemplating offering futures contracts and/or options on futures contracts as replacements for or as alternatives to cleared swaps currently transacting on such platforms.”

Later that day, the Division issued an additional no-action relief letter providing similar relief regarding swaps that (i) reference an exempt commodity or agricultural commodity and (ii) are executed prior to October 20, 2012.  It also applies similar relief for the definition of “major swap participant.”

FDIC Approves Final Rule Regarding Large Bank Stress Tests; OCC, FRB Issue Consistent and Similar Rules

The FDIC announced the publication of its final rule (the “Final Rule”) requiring state nonmember banks and state savings associations with total consolidated assets of more than $10 billion (“Covered Banks”) to perform annual stress tests, report the results of the stress tests to the FDIC and the FRB and publish a summary of the results of such stress tests.  The OCC and the FRB issued consistent and similar final rules.

The Final Rule implements Section 165(i)(2) of the Dodd-Frank Act.  The FDIC issued a proposed version (the “Proposed Rule”) of the Final Rule on January 23, 2012, which was discussed in the January 24, 2012 Financial Services Alert.  The Final Rule adopts the requirements for stress tests provided in the Proposed Rule, but with certain modifications.

The Final Rule requires Covered Banks to perform annual stress tests and defines a stress test as an assessment of the potential effect of scenarios, including adverse scenario, baseline scenario and severely adverse scenario, on the consolidated earnings, losses and capital of a Covered Bank and a Covered Bank’s risks, exposures, strategies and activities.  The Final Rule points out that, for a Covered Bank, the required stress tests should be only one component of the Covered Bank’s broader stress testing activities as part of its risk management efforts.

The Final Rule, unlike the Proposed Rule, separates Covered Banks into two categories:  (1) Covered Banks with $50 billion or more in consolidated assets; and (2) Covered Banks with greater than $10 billion, but less than $50 billion in total assets.  Covered Banks with consolidated assets of $50 billion or more are required to conduct their first annual stress tests using financial data as of September 30, 2012 (but the FDIC may permit, on-a-case-by-case basis, a Covered Bank with $50 billion or more in consolidated assets to delay the performance of its stress test).  The stress test results from the larger category of Covered Banks will be due to the FDIC and the FRB in January 2013.

In a modification from the Proposed Rule, the Final Rule delays implementation to October 2013 of the stress testing requirement for Covered Banks with greater than $10 billion, but less than $50 billion in assets.  These smaller Covered Banks will use financial statement data as of September 30, 2013.

Under the Final Rule, the FDIC will provide annually to Covered Banks, no later than November 15th of the applicable year, at least three scenarios, including baseline, adverse and severely adverse scenarios, that a Covered Bank must use in performing its annual stress test.  The Final Rule also provides that the FDIC may require a Covered Bank “to include one or more additional scenarios in its stress test based on the [Covered  Bank’s] activities, level of complexity, risk profile, scope of operations and regulatory capital,” or other relevant factors.  The Final Rule also contemplates that the FDIC will require Covered Banks with significant trading activities to conduct an additional stress test using a trading and counterparty risk scenario.

Furthermore, the Final Rule requires a Covered Bank to establish and maintain a system of controls, oversight and documentation, including policies and procedures, designed to implement the stress testing requirements.  The Covered Bank’s Board of Directors and senior management must also review and approve the controls and stress testing program no less frequently than annually.

The Final Rule allows a Covered Bank owned by a holding company to conform to the stress testing and reporting timeline used by its parent holding company.  The Final Rule became effective on October 15, 2012.

FDIC Issues Final Rule to Implement Authority to Preserve Affiliate Contracts as Receiver of Systemically Important Financial Institutions

On March 27, 2012, the FDIC published a notice of proposed rulemaking (“NPR”) in the Federal Register setting forth its proposed rule relating to the enforcement of subsidiary and affiliate contracts by the FDIC as receiver of a covered financial company (a “systemically important financial institution” or “SIFI”) under Section 210(c)(16) of the Dodd-Frank Act.  (Details of the proposed rule included in the NPR can be found in the March 27, 2012 Financial Services Alert.)  The FDIC has issued the final rule (the “Final Rule”), which is substantially consistent with the proposed rule, but contains two clarifying changes and some clarifying statements added to the preamble.  The two clarifying changes relate to the FDIC possibly requiring a bridge financial company to terminate its status as a bridge financial company before completion of the resolution process and having the successor to the bridge financial company transfer assets or interests in the successor to creditors of the SIFI.  The FDIC recommends including (i) an additional clause to the definition of “specified financial condition clause,” and (ii) an additional related definition for “successor,” in each case to make it clear that section 210(c)(16) and the Final Rule continue to protect covered contracts of subsidiaries and affiliates through the completion of the resolution process, even where the process is completed by a successor to a bridge financial company and results in a change of control of the successor.  Additionally, statements were added to the preamble to clarify that absolute call rights, i.e., the right to demand performance from an affiliate of a SIFI at any time and for any reason, is not a type of remedy prohibited under the Final Rule.

SEC Issues Report on Broker-Dealer Insider Trading Prevention Practices

On September 27, 2012 the SEC’s Office of Compliance, Inspections, and Examinations (“OCIE”) issued a report (the “Report”) discussing the findings made by OCIE, FINRA, and the New York Stock Exchange’s Division of Market Regulation (the “examiners”) in their examinations of programs implemented by broker-dealers to protect against the misuse of material, non-public information (“MNPI”).

Building on “Broker-Dealer Policies and Procedures Designed to Segment the Flow and Prevent the Misuse of Material Nonpublic Information,” a report issued by the SEC’s Division of Market Regulation in March 1990, the Report notes that in many instances broker-dealers may receive MNPI regarding their clients and market events in the course of their business operations – such as investment banking services, the creation and issuance of financial instruments, including debt, and trading activities – often under circumstances in which a duty of trust and confidentiality may be owed to the client or another party.

In broad terms, the Report cites conflicts of interest and other issues of concern found by the examiners and highlights effective practices the examiners observed at some broker-dealers.

Concerns cited by the examiners include:

  • A significant amount of informal, undocumented interaction occurred between groups that have MNPI and internal and external groups with sales and trading responsibilities that might profit from the misuse of such MNPI;
  • Senior management with access to MNPI from one business unit also oversaw other business units that could potentially profit from misuse of the MNPI, and there were few, if any, restrictions or monitoring to help prevent such misuse;
  • Risk controls were not implemented to address (i) certain business units that possess MNPI such as sales, trading or research personnel who receive MNPI for business purposes; (ii) institutional and retail customers or asset management affiliates with access to MNPI; or (iii) firm personnel who receive MNPI through business activities outside of investment banking, such as sitting on bankruptcy committees or sitting on the boards of public companies;
  • Some broker-dealers did not review the trading activity within accounts of institutional customers, asset management affiliates, or retail customers when certain business units came into possession of MNPI; and
  • Some broker-dealers had no formal controls in place to manage instances where employees transitioned from business units with MNPI to business units that were restricted from receiving MNPI.  Instead, several broker-dealers relied on “self reporting” by employees.

While recognizing that these concerns by themselves may not necessarily suggest violations of Section 15(g) of the Securities Exchange Act of 1934, which requires broker-dealers to adopt procedures to prevent the misuse of MNPI, the Report states that the broker-dealers engaging in behaviors giving rise to the concerns may find it helpful to review their policies and procedures in light of the practices the examiners found to be effective.

Generally speaking, these effective practices include:

  • Developing processes that differentiate between types of MNPI based on the source from which the information originated within the broker-dealer (e.g., the business unit) or the nature of the information (e.g., transaction type), and creating tailored exception reports that take into account the differing nature of the information;
  • Monitoring access rights for key cards and computer networks to help ensure that only authorized personnel have access to sensitive areas;
  • Expanding the scope of instruments reviewed for potential misuse of MNPI by traders beyond the traditional types of securities to include credit default swaps, equity or total return swaps, loans, and components of pooled securities, ETFs, warrants, and bond options;
  • Monitoring employee access to electronic MNPI;
  • Implementing restrictions on employee access to the “Printing and Production” areas within broker-dealers when such areas are producing private-side documents, such as mergers/acquisitions term sheets, or offering memoranda and pitch books for IPOs; and
  • Implementing controls on private-side e-mails to protect against inadvertent electronic disclosure of MNPI to those without a legitimate business need for it.

The Report concludes that while broker-dealers are enhancing their controls in response to developments in business activities, technologies and business structures, the examiners were able to identify gaps in controls, which they brought to the attention of the broker-dealers at the conclusion of their examinations.  OCIE further stated that it is the SEC staff’s intention to continue to review broker-dealers’ Section 15(g) policies and procedures going forward.

SEC Examination Staff Announces “Presence Exam” Strategy For Newly Registered Private Fund Advisers

The staff of the National Examination Program in the SEC’s Office of Compliance Inspections and Examinations (OCIE) made publicly available a letter discussing a new examination initiative regarding newly registered private fund advisers (advisers to private funds that registered after the effectiveness of SEC rulemaking regarding adviser registration matters pursuant to the Dodd-Frank Act).  The two-year initiative involves outreach to newly registered advisers, focused risk-based examinations of certain newly registered private fund advisers (referred to as “Presence Exams”) and following the conclusion of the Presence Exams, reports to the SEC and the public on the initiative.

Presence Exams

The letter states that examination staff conducting a Presence Exam will review one or more of the following areas:

  • Marketing.  OCIE staff will review marketing materials and how private fund investors are solicited, including the use of placement agents.
  • Portfolio Management.  OCIE staff will review portfolio decision-making practices, including the allocation of investment opportunities and whether those practices are consistent with disclosures to investors.
  • Conflicts of Interest.  OCIE staff will review the procedures and controls used to identify, mitigate, and manage conflicts of interest, including (a) allocation of investments, fees and expenses; (b) sources of revenue; (c) payments by private funds to advisers and related persons; (d) outside business activities and personal securities trading of adviser personnel; and (e) transactions by advisers with affiliated parties.
  • Safety of Client Assets.  OCIE staff will review compliance with provisions of the Investment Advisers Act regarding the safekeeping of client assets including the custody rule, which may involve the review of independent audits of private funds.
  • Valuation.  OCIE staff will review valuation policies and procedures, including those for fair valuing illiquid or difficult to value instruments.

SEC Proposes to Extend Sunset of Temporary Rule Regarding Certain Principal Transactions for Advisers Until December 31, 2014

The SEC issued a release proposing to extend until December 31, 2014 (from December 31, 2012) the date on which Rule 206(3)-3T under the Investment Advisers Act of 1940 (the “Advisers Act”) will sunset.  Rule 206(3)-3T was adopted as a temporary rule in 2007 following a decision by the Court of Appeals for the District of Columbia Circuit that struck down an SEC rule addressing the application of the Advisers Act to certain activities of broker-dealers (see the April 10, 2007 Financial Services Alert for a discussion of this decision).  The Rule is designed to enable a dually registered broker-dealer’s nondiscretionary customers that have converted their current fee-based brokerage accounts to fee-based advisory accounts to have continued access to securities available on a principal basis from the firm without requiring the firm to comply with the strict terms of Section 206(3)’s disclosure and consent requirements. The SEC staff has posted a Small Entity Compliance Guide that summarizes and explains the Rule. 

The release states that the SEC is seeking the extension because it continues to believe that the issues raised by principal trading, including the restrictions in Section 206(3) of the Advisers Act and the SEC’s experiences with, and observations regarding, the operation of Rule 206(3)-3T, should be part of a broader consideration of the regulatory requirements applicable to broker-dealers and investment advisers in connection with the Dodd-Frank Act.

Reminder: European Short Selling Regulation Effective November 1 Applies to US Persons

The European Short Selling Regulation (previously discussed in the July 10, 2012 Financial Services Alert) comes into effect on November 1, 2012.  U.S. persons trading in stocks listed on European exchanges, even when the trade is executed outside the European Economic Area (the “EEA”), e.g., when the short sale of a stock listed on both European and non-European exchanges is executed on the latter or executed OTC, will be subject to number of requirements, including the following:

  • Net short positions of 0.2% (and incremental changes thereto) and above must be disclosed to the relevant regulatory authority in the EEA.  Net short positions above 0.5% (and incremental changes thereto) must be publicly disclosed.  Disclosures will need to be made in both cases via reporting systems established by the regulator in the country where the relevant market is established.
  • Uncovered short positions are prohibited (even if they are permitted under US law and the rules of the US exchange where the trade in a dually-listed stock is undertaken).

An exemption is available with respect to positions taken by a market maker as part of the function of market making, subject to the following conditions: (i) the European Commission must have determined that the non-EEA exchange operates under equivalent standards to those in the EEA (to date, the Commission has made no such determinations); and (ii) the market maker has given at least 30 days’ notice to the relevant regulatory authorities that it will use the exemption (although it is still not yet clear to which authorities such notice should be submitted).

These provisions do not apply if the primary market (judged by turnover) for a dually listed stock is based outside the EEA.

As previously noted, the European Short Selling Regulation also includes restrictions on short positions in government debt. 

Goodwin Procter Alert: Department of Justice’s Hart-Scott-Rodino Fine for Biglari May Signal Increased Enforcement Effort

Goodwin Procter Alert discusses the $850,000 fine assessed by the Department of Justice Antitrust Division against publicly traded Biglari Holdings, Inc. to resolve allegations by the Federal Trade Commission that Biglari acquired voting securities of Cracker Barrel Old Country Store, Inc. without filing notification under the Hart-Scott-Rodino (“H-S-R”) Act - the second significant civil penalty that DOJ has imposed within the last year for an apparent first time violation of the HSR Act’s reporting requirements.

Goodwin Procter Alert: Filing Deadline Approaches for Exemption from California Investment Adviser Registration

Goodwin Procter’s Private Investment Funds Practice issued a client alert discussing new investment adviser regulations adopted by the California Department of Corporations that eliminate an existing exemption from registration in California for an adviser that has fewer than 15 clients (and meets certain other conditions), and replace it with a new, substantially different exemption that has an October 26, 2012 deadline for action by advisers that intend to rely on the new exemption.