Financial Services Alert - July 30, 2013 July 30, 2013
In This Issue

UK Financial Conduct Authority Proposes New Rules For Pooling and Distribution of Assets Held by Failed Investment Firms

The United Kingdom’s Financial Conduct Authority (FCA) has issued a Consultation Paper proposing new rules intended to streamline the process for recovering assets from a failed investment firm (the “Proposed Rules”).  The Proposed Rules are far-reaching in scope, and, if enacted, will have a significant impact on the segregation of assets within an institution’s various custodial accounts and the priority of recovery in the event of failure.  The Proposed Rules would apply to approximately 1,500 investment management firms authorized to hold client assets and regulated by the FCA.  Given London’s position as a leading market for investment management, the Proposed Rules should be of interest to investment firms and clients around the world.

The Proposed Rules address the process for recovering client funds following the insolvency of an investment management firm.  Under existing rules, the failure of an investment firm triggers the pooling and retention of all client assets pending a re-distribution to clients based on the priority of their respective claims.  The existing rules thus prioritize legal and financial accuracy in the eventual return of client assets.

The Proposed Rules, in contrast, prioritize the speed of return of client assets.  To achieve a faster recovery, the Proposed Rules envision a two stage client money distribution process upon an event of insolvency:  First, an immediate pooling of all money held in client accounts or transaction accounts followed shortly thereafter by an initial distribution of funds based strictly on the records of the failed investment company; and second, the collection of a residual client money pool comprised of any remaining client money not swept into the first pool, plus any residual amounts left over following the initial distribution.  The residual client money pool would be distributed under a more traditional claims process.

Underlying the Proposed Rules is a debate about the benefits of accuracy in distribution of client funds versus speed of recovery.  The FCA cites the insolvency proceedings for Lehman Brothers International Europe, MF Global Ltd., Pritchard Stockbrokers Ltd. and Worldspreads Ltd. as examples of failed investment firms in which this pooling and claims adjudication process required an excessive amount of time, to the detriment of clients and broader interests of market stability.  Based on this experience, the FCA asserts that a faster return of client money yields greater benefit in the form of increased market confidence and reduced impact on clients and contractual counter-parties of the failed firm.  The Proposed Rules thus favor speed, even while acknowledging that certain clients may enjoy increased recoveries while others may receive less, or even nothing, as compared to the eventual distributions under existing rules.

The Proposed Rules would dramatically alter the process, and, potentially, the bottom line recovery upon the failure of an investment firm.  In their current form, the Proposed Rules raise several matters of concern to clients.  For example, the proposed “speed” process relies almost entirely upon the accuracy of investment company records, but history demonstrates that the records of a failed investment company may not always be the most reliable or complete.  Clients with otherwise valid priority claims could lose out in the immediate distribution scenario contemplated by the Proposed Rules.  As a result, clients will bear a greater burden to monitor and ensure that records are accurate.

The FCA seeks comment on any aspect of the Proposed Rules, including an alternate proposal that would effectively codify the existing process for pooling and claims adjudication, a process that in current form operates primarily on the basis of insolvency and company law.  The Proposed Rules are complex and contain many aspects not addressed in this summary.  Please contact Goodwin Procter for further guidance or assistance in preparing a written submission to the FCA.  The submission deadline is October 11, 2013.

SEC Staff Issues Guidance on Counterparty Risk Management Practices for Tri-Party Repurchase Agreements

The Staff of the SEC’s Division of Investment Management recently issued guidance (the “IM Guidance Update”) for mutual funds and their investment advisers relating to the use of tri-party repurchase agreements (“Tri-Party Repos”).  While the IM Guidance Update may be useful to any mutual fund that engages in Tri-Party Repos, the Staff recognizes that money market funds (“MMFs”) may find it to be particularly relevant in light of their significant holdings of Tri-Party Repos when compared to non-money market mutual funds.

Tri-Party Repos are typically structured as repurchase agreements where the fund purchases securities from a dealer counterparty subject to the dealer counterparty’s agreement to repurchase the securities at an agreed-upon date and price.  In a Tri-Party Repo, as contrasted with a bi-lateral arrangement, a third-party clearing bank facilitates settlement of the repurchase agreement by, for example, transferring securities and/or cash between the dealer counterparty’s and the MMF’s accounts at various stages of the Tri-Party Repo.

The IM Guidance Update provides the Staff’s views on the types of legal and operational considerations that a MMF and its investment adviser should consider if a counterparty fails and defaults on its obligations under a Tri-Party Repo.  The IM Guidance Update focuses on the importance of advance planning for the handling of a default of a Tri-Party Repo and cites the following examples of prudent risk management practices in this context:

  • Review the master repurchase agreements and related documentation to consider any specified repo default procedures.  The IM Guidance Update states that the MMF may want to consider preparing templates of any notifications or other documents that may be necessary in the event of a default.
  • Consider operational aspects of managing a default.  The IM Guidance Update states that a MMF may want to review the MMF’s systems and those of its custodian to ensure that they are “capable of appropriately holding, valuing, trading and accounting for the collateral underlying” the MMF’s repurchase agreements.
  • Consider, to the extent possible, whether there are potential legal considerations under the Investment Company Act of 1940 (the “1940 Act”) or otherwise that the fund could consider in advance or will need to evaluate at the time of any repo default.  The IM Guidance Update discusses a number of considerations under Rule 2a-7 under the 1940 Act, which is the rule that provides the regulatory framework applicable to MMFs.  In this regard, the IM Guidance Update recognizes that Rule 2a-7’s limitations on a MMF’s portfolio (for example, with respect to maturity and the types of securities eligible for MMF investments, so called “eligible securities”) may present issues if a fund is forced to accept a Tri-Party Repo’s underlying collateral.  The IM Guidance Update also notes that the MMF should identify any required notifications to the SEC and/or the MMF’s board of directors as a result of a default.  In addition, the IM Guidance Update highlights the possibility that a defaulted repo might trigger an automatic stay under the U.S. Bankruptcy Code or federal banking laws and regulations.

Second Circuit Affirms Dismissal of 1933 Act Claims Alleging Failure to Disclose Risks of Exchange-Traded Funds That Focused on Meeting Daily Benchmarks

The Second Circuit recently affirmed a decision by a New York federal court dismissing claims by investors in certain ProShares exchange-traded funds (“ETFs”) that the prospectuses contained in the registration statements for those funds failed to disclose risks in violation of Sections 11 and 15 of the Securities Act of 1933 (“1933 Act”).  Plaintiffs brought a class action on behalf of purchasers of shares in 44 ETFs during the period August 2006 to June 2009 against the funds, their adviser and distributor, and individuals alleged to be control persons of those entities.  The Second Circuit agreed with the district court that the disclosures did in fact warn of the exact risks that later materialized, and thus “a [s]ection 11 claim will not lie as a matter of law.”

The three types of ETFs at issue were:  (1) an Inverse ETF that aimed to replicate the inverse movement of a specified index over one day; (2) an Ultra Long ETF that tried to double the performance of the underlying index or benchmark on a daily basis; and (3) an Ultra Short ETF designed to double the inverse of the performance of the underlying index or benchmark on a daily basis.  As the Second Circuit noted, the ETFs’ views “were expressly myopic: long-term objectives were blurred because they were focused only on meeting a benchmark tied to an underlying index one day at a time with a portfolio of different securities.”  Plaintiffs alleged that the funds’ prospectuses omitted the risk that if the funds were held for more than one day, the funds’ performance could diverge widely from the performance of the underlying indices and result in substantial losses during a relatively brief period of time, despite the overall direction of the underlying indices.  However, the Second Circuit agreed with the district court that such risks were disclosed:  the prospectuses stated that “[o]ver time, the cumulative percentage increase or decrease in the net asset value of the [ETFs] may diverge significantly from the cumulative percentage increase or decrease in the multiple of the return of the Underlying Index” due to a compounding effect of daily gains and losses, and that such divergence “could result in the total loss of an investor’s investment.”

The Second Circuit found Plaintiffs’ arguments to be inconsistent, by criticizing Defendants for including some of those risk disclosures in the ETFs’ statements of additional information (“SAIs”) instead of the prospectuses themselves, while also claiming that those same disclosures misled Plaintiffs about the risks.  Plaintiffs also argued that because Defendants changed the risk disclosures at the end of the class period to acknowledge that volatility could cause an ETF to “move in [the] opposite direction as the index” and that investors should be willing to “monitor and/or periodically rebalance their portfolios,” Defendants had conceded that their prior disclosures were inadequate, but the Second Circuit rejected that argument:  “[t]o hold an issuer who alters disclosures deemed adequate in the first instance suddenly liable because it found a better way to say what has already been said would perversely incentivize issuers not to strive for better, clearer disclosure language.”

In re ProShares Trust Securities Litigation, No. 12-3981 (2d Cir. July 22, 2013).

SEC Staff Grants No-Action Relief to Treat Government Mortgage-Backed Securities and Private Mortgage-Backed Securities as Part of the Same Industry for Purposes of Registered Funds’ Industry Concentration Policies

The staff of the SEC’s Division of Investment Management (the “Staff”) granted no-action relief permitting two registered investment companies, via separate requests for relief, to treat mortgage-backed securities (“MBS”) issued or guaranteed by U.S. federal agencies or government-related guarantors ("Government MBS") as being part of the same industry together with private mortgage-backed securities (“Private MBS”) for purposes of each company’s fundamental industry concentration policy (“Concentration Policy”) adopted in accordance with Section 8(b)(1) of the Investment Company Act of 1940, as amended (the “1940 Act”).

Concentration Policy Requirements

Section 8(b)(1) of the 1940 Act requires a registered fund to state in its registration statement whether it reserves the freedom to concentrate investments in a particular industry or group of industries.  If such freedom is reserved, Section 8(b)(1) requires the fund to include in its registration statement a statement briefly indicating, in so far as practicable, the extent to which the fund intends to concentrate its investments, i.e., the fund must state its Concentration Policy.  Section 13(a)(3) of the 1940 Act requires a fund to obtain shareholder approval to change its Concentration Policy.

Neither the 1940 Act nor the registration forms for open-end and closed-end funds specify how to define an “industry” for purposes of a fund’s Concentration Policy.  Former Guide 19 to Form N-1A provides that a fund may select its own industry classification; however, such classification must be (1) reasonable and (2) should not be so broad that the primary economic characteristics of the companies in a single class are materially different.

Closed-End Fund Request for No-Action Relief

A new closed-end investment company in the process of registering under the 1940 Act (the “Closed-End Fund”) planned to invest 80% of its assets in fixed-income securities and proposed to implement a Concentration Policy to invest “at least 25% of its total assets in mortgage related securities,” including both Government MBS and Private MBS.  The Closed-End Fund represented that it had included narrative disclosure accompanying its fundamental investment restrictions to clarify that notwithstanding its general policy of excluding securities of the U.S. Government and its agencies or instrumentalities when measuring industry concentration, Government MBS would not be excluded from "mortgage related securities" as such term is used in the Closed-End Fund’s Concentration Policy.  In connection with the Staff’s review of the Closed-End Fund’s registration statement, the Staff requested that the Closed-End Fund revise its Concentration Policy to clarify whether the Closed-End Fund will invest at least 25% of its assets in Private MBS.  The matter was ultimately referred to the Office of Chief Counsel for the Division of Investment Management.  The Staff advised the Closed-End Fund that the Staff would not recommend enforcement action if the Closed-End Fund implemented the Concentration Policy, provided the Closed-End Fund promptly sought confirmation of its position in a formal written request.

Open-End Fund Request for No-Action Relief

An open-end investment company registered under the 1940 Act (the “Open-End Fund” and collectively with the Closed-End Fund, the “Funds”) that invests 80% of its assets in mortgage-related securities had a policy that restricted the Open-End Fund from investing “more than 25% of its total assets in the securities of issuers in a particular industry or group of industries other than obligations issued or guaranteed by the U.S. Government or its agencies or instrumentalities.”  The effect of this policy was to limit the Open-End Fund’s ability to invest in Private MBS to less than 25% of the Open-End Fund’s assets.  By classifying Government MBS and Private MBS as a single industry, the Open-End Fund's investment adviser, based on its analysis of economic conditions affecting the MBS in which the Fund invests, would have the flexibility to increase or decrease the Fund's exposure to Private MBS above or below 25% of the Fund's assets without violating the revised Concentration Policy.  To secure this added flexibility, the Open-End Fund sought and obtained shareholder approval of a Concentration Policy to permit the Open-End Fund to invest more than 25% of its assets in mortgage-backed securities, including both Government MBS and Private MBS.  The Open-End Fund then sought no-action relief from the Staff to treat Government MBS and Private MBS as being part of the same industry for purposes of its Concentration Policy.

Staff Response

In granting each request for relief, the Staff cited representations by the Closed-End Fund and Open-End Fund that Government MBS and Private MBS have similar economic and risk  characteristics.  In particular, the Staff noted that both types of instruments responded to similar developments affecting housing and real estate markets, and were subject to similar risks, including prepayment, extension, and interest rate risks.  The Staff also reiterated its view that to satisfy the standard under Section 8(b)(1) for describing a fund’s Concentration Policy, “a fund must clearly and precisely describe, with as much specificity as is practicable, the circumstances under which the fund intends to concentrate its investments.”  The Staff’s responses also acknowledged prior Staff guidance permitting a fund’s Concentration Policy to exclude securities issued by governments or political subdivisions of governments, and stated that in granting the relief the Staff did not intend to preclude a fund from excluding those securities from its Concentration Policy on the basis that those issuers are not members of any industry or group of industries.

BlackRock Multi-Sector Income Trust, SEC No-Action Letter (publ. avail. July 8, 2013).

Morgan Stanley Mortgage Securities Trust, SEC No-Action Letter (publ. avail. July 8, 2013).

SEC Announces Arrangements with EU/EEA Member State National Regulators for Cross Border Supervisory Cooperation Regarding Asset Management Industry

The SEC issued a press release announcing that it has established supervisory arrangements with financial regulators of the member states of the European Union (EU) and the European Economic Area (EEA) as part of long-term strategy to improve the oversight of certain entities in the asset management industry that operate across national borders.  Distinct from the investigatory focus of enforcement cooperation arrangements, supervisory cooperation arrangements involve mechanisms for consultation and the exchange of information related to the ongoing oversight of global firms and markets, including information designed to assist in monitoring risk concentrations, identifying emerging systemic risks, and understanding the compliance cultures of globally-active regulated entities.  The newly-established arrangements also facilitate the ability of the SEC and its counterparts to conduct on-site examinations of registered entities located outside the United States.

DOL Advisory Opinion Clarifies that Revenue Sharing Payments Are Not Plan Assets

The Department of Labor (the “DOL”) issued Advisory Opinion 2013-03A (July 3, 2013) under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  This advisory opinion, issued in response to a request from Principal Life Insurance Company (“Principal”), addresses whether revenue sharing payments received by a plan recordkeeper constitute “plan assets” subject to ERISA’s fiduciary duty and prohibited transaction rules.  In the facts underlying the advisory opinion, Principal receives revenue sharing payments (such as 12b-1 fees, shareholder and administrative services fees, or similar payments) from the investment options made available to the plans for which it provides recordkeeping services.  Principal in turn creates a bookkeeping account to which it credits part of the revenue sharing payments it receives.  Those credits may be used, in accordance with the applicable recordkeeping agreement or at the direction of a plan fiduciary, to pay proper expenses incurred in administering the plan.  The advisory opinion emphasizes that no part of the revenue sharing payments are segregated from the general assets of Principal for the benefit of the plan, and no representations are made to the plan or its participants that those payments will be set aside for the benefit of the plan or its participants.  Under these facts, the advisory opinion concluded that the plan’s asset was the contractual obligation of Principal to apply the credits for the benefit of the plan, but not the actual revenue sharing payments themselves.  The advisory opinion makes it clear that the determination of whether the revenue sharing payments are plan assets will turn on the specifics of how the arrangement is structured.

DOL Provides Flexibility on Timing of Disclosures for Participant-Directed Plans

The Department of Labor (the “DOL”) issued Field Assistance Bulletin (“FAB”) 2013-02A (July 22, 2013) under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  This FAB provides one-time transition relief that enables plan administrators to reset the timing of the annual participant disclosure requirements imposed by DOL regulations under Section 404(a) of ERISA.  Those regulations required administrators of 401(k) plans, and other plans under which participants can direct the investment of their account, to provide certain investment disclosures to plan participants no later than August 30, 2012, as discussed in the May 1, 2012 Financial Services Alert , and annually thereafter.  (See our May 1, 2012 FSA.)  The FAB states that the DOL will not take enforcement action if a plan administrator resets the timing of these annual disclosures, either by providing the 2013 disclosure by February 25, 2014, or by providing the 2014 disclosure by February 25, 2015.  Plan administrators may only reset the timing of their annual disclosure once, for either 2013 or 2014, and must also make the determination that doing so will benefit the plan’s participants and beneficiaries.  The FAB is designed to allow administrators to shift to a disclosure cycle that is based on the calendar year.

MA Division of Banks Holds Hearings Regarding 11 Banking, Credit Union and Other Licensee Regulations

The Massachusetts Division of Banks (the “Division”) announced that it would hold two public, informational hearings to solicit comments regarding 11 of the Division’s banking, credit union and other licensee regulations.  The Division said that the hearings were being held to “streamline and modernize regulations governing the financial services industry,…”

The first hearing was held on July 30, 2013 in Boston and covered the following six of the Division’s  bank and credit union regulations:

  • 209 CMR 31.00: Establishment and Operation of Electronic Branches of Financial Institutions and for the Protection of Consumers in Electronic Fund Transfers
  • 209 CMR 32.00: Disclosure of Consumer Credit Costs and Terms
  • 209 CMR 33.00: Conversion by Co-Operative Banks and Savings Banks from Mutual to Stock Form (Sub-parts C&D Only)
  • 209 CMR 40.00: Unfair and Deceptive Practices in Consumer Transactions
  • 209 CMR 49.00: Insurance Sales by Banks and Credit Unions
  • 209 CMR 53.00: Determination and Documentation of Borrower’s Interest

The second hearing will be held in Boston on August 13, 2013 and will cover the following five regulations related to non-banks that cover mortgage lenders, brokers and originators, consumer finance companies and money service businesses, debt collectors, check cashers and loan servicers:

  • 209 CMR 20.00:  Small Loans, Sales Finance Companies and Insurance Premium Finance Companies
  • 209 CMR 42.00: The Licensing of Mortgage Lenders and Mortgage Brokers
  • 209 CMR 44.00: Licensing of Foreign Transmittal Agencies
  • 209 CMR 45.00: The licensing and Regulation of Check Cashers
  • 209 CMR 48.00: Licensee Record Keeping

All written comments on the above-listed regulations must be submitted to the Division by 5:00 p.m. on August 20, 2013.

FDIC Releases Second Series of Videos Designed to Provide Information to Bank Directors

The FDIC released a second series of videos designed to provide useful and clear information to bank directors concerning corporate governance, compliance and risk management topics.  The first series of videos by the FDIC was discussed in the April 9, 2013 Financial Services Alert.

The second series of FDIC videos, each of which runs approximately one-half hour in length, covers the following topics:

  • Interest Rate Risk
  • Third-Party Risk
  • Corporate Governance
  • The Community Reinvestment Act
  • Information Technology (IT)
  • The Bank Secrecy Act

The FDIC stated that, before the end of 2013, it expects to release a third group of videos that will provide technical training to bankers on a broad range of issues.  The FDIC said that the first six modules in this upcoming group of videos would address, respectively,

  • Fair Lending
  • Appraisals and Evaluations
  • Interest Rate Risk
  • Troubled Debt Restructurings and the Allowance for Loan and Lease Losses
  • Evaluation of Municipal Securities
  • Flood Insurance Coverage

Community Lending Enhancement and Regulatory Relief Act of 2013, Which Would Provide Relief to Community Banks, is Introduced in U.S. Senate

On July 24, 2013, Senators Jerry Moran (R-Kan.), Jon Tester (D-Mont.) and Mark Kirk (R-Ill.), introduced a bill, the Community Lending Enhancement and Regulatory Relief Act of 2013 (the “CLEAR Relief Act of 2013”), S. 1349, which is similar to House bill H.R. 1750, a bill that was introduced in April 2013.  If passed, the CLEAR Relief Act of 2013 would provide substantial regulatory relief for community banks by:

  • Exempting banks with consolidated assets of $1 billion or less from the Sarbanes-Oxley Section 404(b) internal-controls assessment requirement.
  • Requiring the FRB to revise its Small Bank Holding Company Policy Statement by increasing the qualifying consolidated asset threshold from $500 million to $5 billion.
  • Exempting from any escrow requirements any first lien mortgage on the principal dwelling of a consumer held by a lender with $10 billion or less in total assets; and
  • Providing “qualified mortgage” status under the CFPB’s ability-to-repay rules for any mortgage originated and held in portfolio for at least three years by a lender with less than $10 billion in total consolidated assets.

The Alert will follow developments concerning this proposed legislation.