Financial Services Alert - January 2, 2013 January 02, 2013
In This Issue

Federal District Court’s Holding that Fund Adviser Waived Attorney-Client Privilege During SEC Investigation and Subsequent Lawsuit Highlights Need for Companies to Take Steps to Preserve the Privilege

The United States District Court for the District of Minnesota (the “Court”) held that a mutual fund adviser and its founder had waived the attorney-client privilege by disclosing emails exchanged with their counsel to the SEC during the SEC’s investigation and subsequent discovery related to a lawsuit brought by the SEC against the adviser and its founder alleging breach of fiduciary duty with respect to the mutual fund.  (The suit filed by the SEC asserted that the defendants had breached their fiduciary duty by obtaining loans from a third party in return for directing the fund to invest in securities recommended by the third party and in securities of an affiliate of the third party.)  The Court’s decision, discussed in more detail below, highlights the need for companies to conduct an in-depth review of documents for possible privilege issues prior to producing such documents to regulators.  In addition, companies must carefully consider whether asserting certain defenses might support an argument that the company waived the attorney-client privilege and that the plaintiff is entitled to conduct discovery on that particular subject matter.

Background. In July 2011, the SEC issued subpoenas to the adviser and CEO while investigating allegedly improper investment of fund assets in companies with which the adviser had other business transactions.  Defendants produced documents in August 2011 pursuant to those subpoenas, including over two hundred emails between defendants and their counsel.  The SEC then filed a complaint and served defendants with discovery requests.  Defendants’ answer to the Complaint also asserted affirmative defenses that they relied on the advice of counsel.  In April 2012, defendants produced many of the same emails with their counsel, and also introduced some of those emails at the deposition of the fund’s Chief Compliance Officer.  The Court noted that those emails related to the “central issue” in the lawsuit:  the agreements between the adviser and the entities in which fund assets were invested.  Five weeks after that deposition, defendants sent a letter to the SEC claiming that their document production inadvertently disclosed attorney-client privileged communications, and the SEC moved for an order finding that defendants had waived the privilege.

Waiver of Attorney-Client Privilege.  The Court held that defendants did not intentionally waive the privilege while producing documents, but that other factors warranted a finding of waiver.  Defendants argued that the SEC’s pre-lawsuit subpoenas had an aggressive and unreasonable time frame for production, but they never asked the SEC for an extension of time.  Nor did defendants indicate what sort of review was conducted to prevent disclosure, such as a key-word search with the attorney’s name.  The Court also noted that defendants produced over two hundred emails in the pre-suit investigation and produced many of the same documents again in discovery, and concluded that “more than two hundred communications could not have gone unnoticed during a cursory review of the documents produced given the identity of the parties to the communications,” i.e., the adviser’s CEO and his counsel, which “warranted a heightened level of scrutiny,” but “defendants failed to employ basic screening procedures.”  The Court further pointed out that defendants did not take any measures to rectify the pre-lawsuit disclosures, which inactivity weighed in favor of waiver.

The sheer number of privileged documents was not the sole determining factor in the Court’s decision.  It cited one case where waiver was found regarding a single document out of 95,000 where a party’s counsel merely assumed that prior counsel reviewed the documents and failed to describe any reasonable steps taken to prevent disclosure.  In contrast, another case found no waiver where only four pages out of more than 2,000 pages were privileged, three different attorneys checked the documents prior to production, and once the mistake was discovered counsel immediately requested that they be returned.  The Court thus noted the importance of “robust screening procedures,” as well as the promptness of remedial measures, in analyzing whether waiver has occurred.

Subject-Matter Waiver.  The Court next examined whether a broader subject-matter waiver had occurred, requiring defendants to further disclose related, protected information in order to prevent a “selective and misleading presentation of evidence to the disadvantage of the adversary.”  The Court found that defendants’ use of the emails at deposition did not warrant a finding of subject-matter waiver because nothing in the record suggested that defendants deliberately disclosed those documents to gain a tactical advantage.  However, the Court held that defendants’ affirmative defenses did support a finding of subject-matter waiver.  Although defendants later amended their answer to delete explicit references to the reliance of advice of counsel defense, the remaining defenses “necessarily revolve around Defendants’ knowledge of the law and the legality of their actions, as well as the basis for their understanding of both,” and the attorney’s input “undoubtedly influenced” such understanding.  The Court found that defendants “have voluntarily injected the advice they received from [the attorney] into this dispute and placed it at issue,” and the SEC thus was entitled to examine conversations that defendants had with their attorney to explore the basis of defendants’ “good faith” beliefs and state of mind and assess the validity of those defenses.  The Court further noted that defendants amended their answer six weeks before the close of discovery and offered no explanation for the delay, and because the SEC had developed its case unimpeded with respect to privileged communications with defendants’ attorney, fairness required a finding of subject-matter waiver.

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The Court’s decision serves as a reminder that companies should take all possible steps to implement “robust screening procedures” to prevent disclosure of privileged materials, as well as create a record of those steps, to support an argument that any disclosure of privileged materials was inadvertent.  They should also promptly notify their adversary if they learn that any such disclosure took place.  All defenses asserted in the case -- especially a reliance on advice of counsel defense -- should be weighed against the risk that the plaintiff will be allowed broad discovery of privileged material in order to explore the basis for that defense.

SEC v. Welliver, No. 11-CV-3076 (RHK/SER)(D. Minn. Oct. 26, 2012).

FDIC Modifies and Restates its Statement of Policy for Section 19 of the Federal Deposit Insurance Act

The FDIC modified and restated, effective December 18, 2012, its Statement of Policy for Section 19 of the Federal Deposit Insurance Act (the “Statement”).  Section 19 of the Federal Deposit Insurance Act prohibits an FDIC-insured bank, without the prior written consent of the FDIC, from allowing an individual who has been convicted of, or who has agreed to a pre-trial diversion program for, any criminal offense involving dishonesty, breach of trust or money laundering from participating in the conduct of the bank’s affairs, becoming affiliated with the bank or owning or controlling the bank.

The Statement, even prior to its December 18, 2012 modifications, provided that certain criminal offenses would be considered de minimis and not require the FDIC’s prior written waiver.  To be considered de minimis, an offense would have to meet all four of the criteria described below.  Only the fourth criterion listed below was modified as of December 18, 2012.

  • There is only one condition or program entry of record for a covered offense;
  • The conviction or program was entered at least five years prior to the date an application for an FDIC written waiver would otherwise be required;
  • The offense did not involve an insured depository institution or insured credit union; and
  • The offense was punishable by imprisonment for a term of one year or less and/or a fine of $2,500 or less, and the individual served three (3) days or less of actual jail time.  (Prior to December 18, 2012, the de minimis standard was more difficult to meet because the offense had to be punishable by less than one year imprisonment and/or a fine of less than $1,000 and the individual could not have served time in prison.)  The FDIC stated that it has eased this de minimis criterion because the changes pose no significant additional risk to insured depository institutions, maintain the integrity of Section 19 of the Federal Deposit Insurance Act, and appear just and reasonable.

OCC Amends its Lending Limits Rule to Extend Temporary Exception for Compliance with Derivative Transactions and Securities Financing Transactions Exposures to July 1, 2013

The OCC issued a final rule (the “Final Rule”) that extends its lending limits rule’s temporary exception for credit exposures arising from a derivative transaction or securities financing transaction from January 1, 2013 to July 1, 2013.

Section 610 of the Dodd-Frank Act revised the statutory definition of loans and extensions of credit for purposes of the OCC’s lending limits to include certain credit exposures arising from derivative transactions, repurchase agreements, reverse repurchase agreements, securities lending transactions and securities borrowing transactions.  The OCC issued an interim final rule (the “Interim Rule”) on June 21, 2012 to amend the OCC’s lending limits regulation, 12 C.F.R. Part 32, and implement Section 610 of the Dodd-Frank Act.  The OCC’s Interim Rule was described in the June 26, 2012 Financial Services Alert.  The Interim Rule included a temporary exception from the lending limit rule until January 1, 2013 for extensions of credit arising from derivative transactions or securities financing transactions.  The Final Rule extends this temporary exception to July 1, 2013 to allow banks more time to develop internal models and to comply with the modified lending limits requirements.

CFTC Issues Exemptive Order and Further Proposed Guidance on Cross-Border Application of Dodd-Frank Swaps Provisions

The CFTC issued an exemptive order and further proposed guidance (the “Order”) regarding the cross-border application of Dodd-Frank swaps provisions.  The Order builds on the proposed order and proposed guidance issued by the CFTC in July 2012 (collectively, the “Proposal”) (discussed in the July 10, 2012 Financial Services Alert).  Although the Order does not delay the deadlines for non-U.S. persons to register as a swap dealer or major swap participant, it allows certain non-U.S. persons to delay compliance with certain requirements of the Commodity Exchange Act and CFTC regulations.  It also allows certain persons to exclude certain transactions for purposes of the swap dealer de minimis exception.

The Order maintains the Proposal’s system of classifying certain requirements as “entity-level” and others as “transaction-level.” Entity-level requirements, which apply to all of the firm’s activities or transactions, include those pertaining to capital adequacy, chief compliance officer, risk management, swap data recordkeeping, swap data repository reporting, and large-trader reporting.  Transaction-level requirements, in contrast, apply on a transaction-by-transaction basis and include those pertaining to clearing and swap processing, margining and segregation for uncleared swaps, trade execution, swap trading relationship documentation, portfolio reconciliation and compression, real-time public reporting, trade confirmation, daily trading records, and external business conduct standards.

The Order permits non-U.S. persons that register as swap dealers or major swap participants to delay compliance with certain entity-level requirements until July 12, 2013.  Non-U.S. swap dealers and non-U.S. major swap participants are also permitted to comply with the transactional-level requirements of their local jurisdiction (rather than those imposed by the Commodity Exchange Act and CFTC regulations) for transactions with a non-U.S. counterparty, as are foreign branches of U.S. swap dealers and U.S. major swap participants with respect to swaps with a non-U.S. counterparty.

The Order allows a non-U.S. person to exclude from its calculations regarding the swap dealer de minimis exception (i) any swap where the counterparty is not a U.S. person and (ii) any swap where the counterparty is a foreign branch of a U.S. person that is registered as a swap dealer or represents that it intends to register as such by March 31, 2013.  In addition, a non-U.S. person that is engaged in swap dealing activities with U.S. persons as of December 21, 2012 may exclude from the swap dealer de minimis calculations the swaps of its U.S. affiliates under common control.  A non-U.S. person that is engaged in swap dealing activities with U.S. persons as of December 21, 2012 and that is an affiliate under common control with a registered swap dealer is also permitted to exclude swaps connected with the swap dealing activity of any non-U.S. affiliate under common control that is either (i) engaged in swap dealing activities with U.S. persons as of December 21, 2012 or (ii) is registered as a swap dealer. 

The Order includes a definition of “U.S. person,” which generally includes (i) a natural person who is a resident of the United States, (ii) a corporation, partnership, limited liability company, or certain other business forms organized or incorporated under the laws of a state or other jurisdiction of the United States or, effective as of April 1, 2013 for certain business entities, having its principal place of business in the United States; (iii) certain pension plans for the employees, officers, or principals of an entity described in the previous clause; (iv) an estate of a decedent who was a resident of the United States at the time of death, or a trust governed by the laws of a state or other jurisdiction of the United States; or (v) an individual account or joint account where the beneficial owner is a person described in a previous clause.  The definition is narrower than that included in the Proposal.  However, the release accompanying the order states that “the [CFTC] wishes to emphasize that the discussion here is not, and should not be construed as, an indication of, or a limitation on, the definition of the term ‘U.S. person’ that the [CFTC] may adopt in final cross-border interpretive guidance.”

The release also notes that the CFTC views a foreign branch of a U.S. person to itself be a U.S. person, adding that if a foreign branch were a swap dealer or major swap participant, its U.S. principal would be required to register as such. 

The Order also requests additional comments on certain matters raised by the Proposal. 

The Order became effective on December 21, 2012, and the relief provided thereunder will expire on July 12, 2013.  Comments on the Order are due 30 days after its forthcoming publication in the Federal Register.

CFTC Issues No-Action Relief for Operators of Pools Investing in Legacy Securitization Vehicles

The CFTC’s Division of Swap Dealer and Intermediary Oversight (the “Division”) issued no-action relief for operators of pools invested in certain securitization vehicles formed prior to October 12, 2012 (a “legacy securitization vehicle”) that are addressed in no-action relief available under CFTC Staff Letter 12-45 (“Letter 12-45”) (discussed in the December 11, 2012 Financial Services Alert ).  The new no-action letter notes that Letter 12-45 only provided relief from the obligation to register as commodity pool operators (“CPOs”) to the operators of covered securitization vehicles, and did not address investors in such vehicles.  Accordingly, the new no-action letter provides that the Division will not recommend that the CFTC take enforcement action for failure to register as a CPO against the operator of a fund that invests in a legacy securitization vehicle whose operator is entitled to no-action relief under the terms of Letter 12-45, and who would not otherwise be required to register as a CPO.

CFTC Issues Time-Limited No-Action Relief Regarding Certain Counterparty Reporting Requirements

The CFTC’s Division of Market Oversight (the “Division”) issued no-action relief regarding certain counterparty reporting requirements included in Part 45 and Part 46 of the CFTC’s regulations, which pertain to swap data recordkeeping and reporting requirements for non-historical swaps and to swap data recordkeeping and reporting requirements for historical swaps, respectively.  The relief is based on industry concerns that industry participants might sometimes be unable to obtain the necessary information from non-reporting counterparties in a timely manner.  As a result, the Division stated that it would not recommend that the CFTC take enforcement action against reporting counterparties for failure to report certain enumerated information about non-reporting counterparties (such as whether the non­­-reporting counterparty is a major swap participant with respect to the swap, whether it meets the definition of “financial entity,” and whether it is a U.S. person) until April 10, 2013.  The relief is only available to the extent that such information is not provided by the non­-reporting counterparty and is otherwise unavailable to the reporting counterparty after a good faith effort to obtain such information; the relief expires earlier than April 10, 2013, if the information becomes available to the reporting counterparty earlier.  

CFTC Issues Time-Limited No-Action Relief to Swap Dealers Regarding Certain Reporting Requirements

The CFTC’s Division of Market Oversight (the “Division”) issued no-action relief regarding the reporting of certain swap transaction data by swap dealers.  The relief, which is generally premised on concerns by industry participants that technical difficulties would prevent them from meeting the reporting requirements in a timely manner, applies in several different situations:

  • Swaps executed by a swap dealer’s branches located in emerging market jurisdictions (as defined in the relief) need not comply with certain reporting requirements included in Part 43 of the CFTC’s regulations (which covers real-time public reporting), Part 45 (swap data recordkeeping and reporting requirements), and Part 46 (swap data recordkeeping and reporting requirements for historical swaps) prior to April 30, 2013, or as soon as technologically practicable upon resolution of the technological issues preventing timely compliance, whichever comes first;
  • Certain “exotic/multi-leg swap transactions,” which are transactions involving a single executed swap that, by convention or for technological/operational reasons must (currently) be captured as multiple swaps for reporting purposes, may be reported on a component-by-component basis (that is, not reported on a composite basis) for purposes of certain regulations included in Parts 43 and 45.  This relief expires on April 30, 2013, or as soon as technologically practicable upon resolution of the technological issues preventing timely compliance, whichever comes first;
  • Swap dealers need not comply with the Part 45 reporting requirements mandating that a report for subsequent post-trade allocations, compressions, or novations be linked to the unique swap identifier (“USI”) of the previously reported initial swap.  This relief expires on April 30, 2013, or as soon as technologically practicable upon resolution of the technological issues preventing timely compliance, whichever comes first; 
  • In the absence of the relief, regulations included in Parts 43 and 45 require that certain “life cycle events,” such as partial terminations, terminations, partial exercises, exercises, and credit events, must be linked to the original trades and not reported as new trades.  However, the relief provides that a swap dealer whose systems cannot distinguish between such life cycle events and new swaps is not required to (and should not) report life cycle events at all; those swap dealers that cannot withhold the reporting of such life cycle events may report them, albeit incorrectly, as new swaps.  This relief expires on April 30, 2013, or as soon as technologically practicable upon resolution of the technological issues preventing timely compliance, whichever comes first.

The above relief is subject to various conditions, such as a requirement that the swap dealer’s chief information officer document the technical difficulties necessitating the relief and that the swap dealer update, correct, or amend its previous reports after resolving the technical difficulties.

U.S. Chamber of Commerce and Investment Company Institute Appeal Federal District Court Ruling Upholding Amendments to CFTC Regulations Affecting Registered Investment Companies

The United States Chamber of Commerce and the Investment Company Institute filed a notice of appeal to the U.S. Court of Appeals for the District of Columbia Circuit of the December 2012 ruling by the U.S. District Court for the District of Columbia upholding rulemaking with respect to CFTC Rules 4.5 and 4.27 that imposes additional conditions on an exclusion from the definition of commodity pool operator (“CPO”) available with respect to registered investment companies and creates new reporting requirements for CPOs and commodity trading advisors.  The District Court’s decision was reported in the December 18, 2012 Financial Services Alert.