Financial Services Alert - September 9, 2013 September 03, 2013
In This Issue

Agencies Re-Propose Rule Implementing Risk Retention Requirements of Dodd-Frank Act

On August 28, 2013, the FDIC, OCC, FRB, SEC, Federal Housing Finance Agency, and Department of Housing and Urban Development (collectively, the “Agencies”) issued a second Notice of Proposed Rulemaking (the “revised proposal”) that would implement the risk retention requirements of Section 941 of the Dodd-Frank Act, which amended the Securities Exchange Act of 1934 (the “Exchange Act”) by adding a new Section 15G.  Section 15G requires the Agencies to issue rules that would generally require that a securitizer of asset-backed securities (“ABS”) retain an economic interest in not less than 5% of the credit risk of the assets collateralizing such ABS.  As discussed in the April 19, 2011 Financial Services Alert, the first Notice of Proposed Rulemaking (the “original proposal”) was jointly approved in April 2011 by the Agencies.  In response to numerous comments received on the original proposal, the Agencies collectively developed the revised proposal, which includes significant modifications.

Risk Retention Options

Section 15G(c)(1)(B) of the Exchange Act generally requires a securitizer of an ABS offering to retain not less than 5 percent of the credit risk of the assets collateralizing the ABS issuance.  The original proposal provided securitizers with various options to comply with this risk retention requirement.  The revised proposal generally maintains the original framework, but makes various changes to the options that are designed to provide additional flexibility to securitizers.  For example, the original proposal’s “vertical risk retention” (5 percent of each class of ABS interests), “horizontal risk retention” (5 percent as a first-loss position), and “L-shaped risk retention” (half of risk retention held on vertical basis and the other half of risk retention held as a first-loss horizontal position), have been combined into a single “standard risk retention” option, which requires the sponsor of a securitization transaction to retain a vertical interest or horizontal residual interest, or any combination thereof.  In addition, the original proposal’s unpopular “representative sample” option has been eliminated.  The revised proposal also requires use of fair value measurements rather than the original proposal’s par value methodology in determining compliance with the risk retention requirement.  The fair value of the amount retained by the sponsor must equal at least 5 percent of the fair value of all ABS interests in the issuing entity issued as part of the securitization transaction, determined in accordance with GAAP, as of the day on which the price of the ABS interests to be sold to third parties is determined.  In conjunction with the revised proposal’s use of fair value accounting, the requirement in the original proposal that securitizers hold a premium capture cash reserve has been eliminated.

In addition to the standard risk retention option, other risk retention options would be available for certain enumerated types of transactions.  These include revolving master trusts, certain issuers of asset-backed commercial paper, issuers of commercial mortgage-backed securities, open-market CLOs, and sponsors with respect to issuances of tender option bonds by a qualified tender option bond entity.

The various options, including the standard risk retention option, generally have specific disclosure and record-keeping requirements intended to provide investors with material information about the retained interest and to permit the Agencies to monitor compliance.

Although the revised proposal generally requires a sponsor to retain the required risk, a sponsor of a securitization transaction that is using the standard risk retention option is permitted to offset the amount of its risk retention requirements by the amount of eligible interests acquired by an originator of one or more of the securitized assets, provided that certain conditions are met, including that the originator must retain the eligible interests in the same manner as the sponsor did prior to the acquisition.

Selling and Hedging Prohibited

The revised proposal generally prohibits a sponsor from selling or otherwise transferring any interests or assets that it is required to retain to any person other than an entity that is and remains a majority-owned affiliate of the sponsor.  The retained interests also may not be pledged as collateral for any obligation, unless such obligation is with full recourse to the sponsor.  The sponsor and its affiliates are also prohibited from purchasing or selling a security or other financial instrument, or entering into an agreement or derivative, with any other person if (1) the payments on the security or other financial instrument or under the agreement or derivative are materially related to the credit risk of one or more of the ABS interests that the sponsor is required to retain or one or more of the securitized assets that collateralize the ABS issued in the securitization transaction and (2) the security, instrument, agreement, or derivative “in any way reduces or limits” the sponsor’s financial exposure to the credit risk.  Similar prohibitions apply to the issuer of a securitization transaction.

Certain hedging activities are permitted under the revised proposal.  These include hedging interest rate risk (except for spread risk that is otherwise considered part of the credit risk) and foreign exchange risk arising from one or more of the retained ABS interests.  Sponsors and issuers may also buy or sell securities or other financial instruments or enter into agreements and derivatives based on an index of instruments that includes the retained ABS interests, but only if certain rules are satisfied that are designed to ensure that the relevant ABS constitute only a small portion of the index.

In contrast to the original proposal, the revised proposal permits the prohibitions on sale and hedging to expire prior to the final maturity or termination of the issued securities.  Specifically, the prohibitions would generally expire on the latest of (i) the date on which the total unpaid principal balance of the collateral has been reduced to 33 percent of the total unpaid principal balance of the collateral as of the closing of the securitization transaction; (ii) the date on which the total unpaid principal obligations under the ABS interests issued in the securitization transaction has been reduced to 33 percent of the total unpaid principal obligations of the ABS interests at closing; or (iii) two years after the date of the closing.  Later dates apply to the expiration of such prohibitions with respect to residential mortgages with the minimum being 5 years after the date of the closing.  The expiration of the prohibitions on sale and hedging were introduced based on an analysis of historical credit defaults for various asset classes and based on the premise that sound underwriting, which the revised proposal calls “the primary purpose of risk retention,” is less likely to be effectively promoted after a certain period of time.

Exemptions from the Risk Retention Requirement

The revised proposal includes various exemptions from the risk retention requirement.  Most notably, a sponsor is exempt from the risk retention requirements if, among other conditions, all of the assets that collateralize the ABS are qualified residential mortgages (“QRMs”).  The original proposal’s QRM definition received many negative comments; the revised proposal abandons that definition and instead defines “QRM” to equate to the definition of  “qualified mortgage” in the Truth in Lending Act and the regulations issued thereunder by the Consumer Financial Protection Bureau (the “CFPB”).  The qualified mortgage definition does not include consideration of a borrower’s credit history, loan-to-value or down payment; instead it includes an analysis of, among other things, the borrower’s ability to repay and imposes a maximum debt-to-income ratio of 43 percent.  Additionally, the qualified mortgage definition excludes certain types of loans and loan features, including interest-only loans, balloon payments and negative amortization loans, while permitting exceptions for small creditors in rural and underserved areas.

The Agencies chose to define “QRM” as “qualified mortgage” after considering an alternative approach referred to in the release accompanying the proposed rule as “QM-plus.”  As described in the release, the QM-plus approach would begin by defining “QRM” based on the same factors adopted by the CFPB in the “qualified mortgage” definition, but would then add four additional factors.  Specifically, under this approach, classification as a QRM would only be available if, in addition to satisfying the factors identified by the CFPB, all the following conditions were met:

  • The loan secures a one-to-four family real property that constitutes the principal dwelling of the borrower.  Therefore, QRM status would not be available to mortgages on, for example, house boats and vacation homes.
  • The loan must be a first-lien mortgage.  Mortgages used to purchase a residence would only be eligible for QRM status if no other recorded or perfected liens exist on the property at closing, to the knowledge of the originator.  Junior liens are permitted for QRMs used for refinancing purposes, but must be included in the loan to value calculations described below.
  • The originator must determine that the borrower meets certain credit history criteria, including not currently being 30 or more days past due on any debt obligation and not having been a debtor in a bankruptcy proceeding within the preceding 36 months.
  • The loan to value ratio at closing must not exceed 70 percent.

Under the revised proposal, down payments are eliminated as an element required to fit within the definition of QRM.

The proposed rule release requests comments on various aspects of the QM-plus approach.

Interests in commercial loans, commercial real estate loans, and automobile loans that are transferred through a securitization transaction are also exempt from the risk retention requirement, provided that certain conditions are met.  In addition, the risk retention requirements would not apply to any securitization transaction collateralized solely by certain loan assets insured or guaranteed by the United States or an agency of the United States or that involve the issuance of ABS that are so insured or guaranteed; any securitization transaction collateralized solely by loans or other assets made, insured, guaranteed, or purchased by any institution subject to the supervision of the Farm Credit Administration; any ABS issued or guaranteed by any State or political subdivision of any State; certain securitization transactions collateralized by existing ABS for which credit risk was retained or that was exempted from the credit risk retention requirements; and certain other transactions.

Comments on the revised proposal are due no later than October 30, 2013.

Court Dismisses Shareholders’ Investment Company Act Claims Brought Against Advisers and Directors of Exchange-Traded Funds for Allegedly Excessive Fees Paid by the Funds in their Securities Lending Agreements

A Tennessee federal court recently dismissed derivative claims brought under Sections 36(a), 36(b) and 47(b) of the Investment Company Act of 1940 (“ICA”) by shareholders in exchange-traded funds, against the funds’ investment adviser, the adviser’s affiliate, and the funds’ directors.  Plaintiffs alleged that the funds’ adviser and affiliate received excessive compensation from securities lending transactions executed on the funds’ behalf, and that the funds’ directors breached their fiduciary duties by allowing such transactions.

The fund’s adviser managed the funds’ investment activities and hired its affiliate, a national banking association, to perform securities lending services for the funds.  Specifically, the affiliate acted as an intermediary between the funds and those who wanted to borrow securities from the funds to generate revenue from short-selling transactions.  Use of the adviser’s affiliate for such a role is usually prohibited by ICA Section 17’s restrictions on related party transactions because of the inherent conflicts of interest, but here, the adviser’s affiliate obtained an exemptive order from the SEC permitting the relationship.  Plaintiffs alleged that the adviser’s and affiliate’s fees for these lending transactions – a total of 40% of the net revenue earned by the funds – were excessive compared to fees paid by funds that used unaffiliated lending agents for such transactions.

The court agreed with the defendants that the plaintiffs failed to state a claim under any of the ICA statutes at issue, for the following reasons.

Section 36(b)

The court acknowledged that the plaintiff shareholders had an express private right of action under ICA Section 36(b) to bring a claim on behalf of the funds alleging that the adviser and its affiliate received excessive compensation in breach of their fiduciary duties.  However, Section 36(b)(4) states that it shall not apply to compensation or payments made in connection with transactions subject to ICA Section 17 “or orders thereunder.”  Because the SEC had expressly granted the adviser and its affiliate’s predecessors an exemptive order under Section 17 for the transactions at issue, the court dismissed the Section 36(b) claim:  “[b]y the plain text of Section 36(b)(4), the SEC Exemption Order removes the transactions at issue from [the] scope of Section 36(b).”

Sections 47(b) and 36(a)

Section 47(b) of the ICA provides that a contract that is made, or whose performance involves, a violation of the ICA is unenforceable by either party.  Section 36(a) authorizes the SEC to bring an action to enforce breaches of fiduciary duty involving personal misconduct.  The court noted that unlike Section 36(b), neither Section 47(b) nor Section 36(a) expressly creates a private right of action for investors.

The court agreed with the reasoning in several other courts’ decisions declining to imply a private right of action under Section 47(b), and further noted that plaintiffs failed to demonstrate that they had an implied private right of action to enforce the alleged predicate violations under Sections 17(d), 17(e) and 36(a).  The court pointed out the absence of “rights-creating language” in those statutes, and stated that if Congress had intended to create a private right of action under Section 36(a), it would have expressly authorized private suits, as it did in subsection (b) of the very same statute.

The court dismissed the claims without prejudice and gave plaintiffs until September 17, 2013 to file a motion for leave to amend their complaint.

Laborers’ Local 265 Pension Fund v. iShares Trust, Case No. 3:13-cv-00046 (M.D. Tenn. Aug. 28, 2013).

SEC Sanctions Adviser Employee for Concealing Personal Securities Transactions and Misleading Chief Compliance Officer

The SEC settled administrative proceedings against the former employee (the “Adviser Employee”) of an adviser for four registered funds (the “Funds”) over his failure to report personal securities transactions as required by the Funds’ and adviser’s joint code of ethics (the “Code”) and for misleading the funds’ and adviser’s chief compliance officer (the “CCO”) about his personal trading through false representations regarding compliance with the code and falsification of documents related to his personal trading.  The SEC found violations by the Adviser Employee of Rule 17j-1 under Investment Company Act of 1940 (the “1940 Act”) which (i) governs the conduct of certain persons affiliated with a registered fund when they purchase or sell a security held or to be acquired by the fund and (ii) requires periodic reporting of personal securities transactions by certain personnel of a fund and its adviser.  The SEC also found that the Adviser Employee had violated Rule 38a‑1(c) under the 1940 Act, which prohibits personnel of a fund or its adviser from directly or indirectly taking “any action to coerce, manipulate, mislead, or fraudulently influence the fund's chief compliance officer in the performance of his or her duties.”   The SEC press release announcing the settlement noted that it was the Commission’s first settlement under Rule 38a‑1(c).  This article summarizes the SEC’s findings, which the Adviser Employee neither admitted nor denied.

Relationship with the Adviser and the Funds.  From December 1999 to January 2011, the Adviser Employee was employed in various capacities by the adviser, including serving as assistant portfolio manager.  The Adviser Employee served as an officer and assisted in managing the portfolios of the Funds.   On January 9, 2011, the Adviser Employee was placed on administrative leave, and three days later, resigned.

Trading Activity.  From 2006 through 2010, the Adviser Employee engaged in 850 personal securities transactions, many involving positions that were held for only a few days.  640 of these trades were not reported as required under Rule 17j-1 or pre‑cleared as required under the Code.  14 of the unreported trades did not comply with the Code’s restrictions on trading in securities that the Funds were buying or selling.  At least 91 of the unreported trades were in “Securities Held or to be Acquired by a Fund,” a defined term under Rule 17j-1 that, when applied in the context of the Funds, meant (a) any security subject to reporting under Rule 17j-1 that, within the most recent 15 days, (1) was or had been held by a Fund or (2) was being or had been considered by a Fund or the adviser for purchase by a Fund; and (b) any option to purchase or sell, and any security convertible into or exchangeable for, a security described in (a).  Rule 17j-1(b) prohibits an employee of a fund’s adviser, in connection with the purchase or sale, directly or indirectly, of a security held or to be acquired by the fund, from (i) employing devices, schemes, or artifices to defraud a fund, (ii) making untrue statements of a material fact to the fund or omitting to state material facts necessary in order to make the statements made to the fund, in light of the circumstances under which they were or are made, not misleading, (iii) engaging in acts, practices or courses of business which operate or would operate as a fraud or deceit on the fund, or (iv) engaging in manipulative practices with respect to the fund.

Misrepresentations and Document Falsification.  The Adviser Employee submitted false quarterly and annual reports of his personal securities transactions and falsely certified his annual compliance with the Code.  In an effort to conceal his trading activity, the Adviser Employee created documents, such as false pre-clearance request approvals, and altered existing documents, such as trade confirmations and brokerage statements.  In late 2010, when the CCO raised issues concerning the Adviser Employee’s compliance with the Code, the Adviser Employee claimed that he had closed certain brokerage accounts that were in fact open and in which he had executed trades that should have been pre-cleared under the Code.  The Adviser Employee also accessed and altered the hard copy file of his previously submitted brokerage statements to create the false impression his trading was in compliance with the Code.

Sanctions.  In addition to a cease-and-desist order, the Adviser Employee agreed to pay disgorgement of $231,169, prejudgment interest of $23,889, and a penalty of $100,000.  The Adviser Employee also consented to a five-year bar industry bar, whose breadth reflects the Dodd-Frank Act’s expansion of the permitted scope of this sanction.  Under the bar, the Adviser Employee is (a) barred from association with any (i) broker, (ii) dealer, (iii) investment adviser, (iv) municipal securities dealer, (v) municipal advisor, (vi) transfer agent, or (vii) nationally recognized statistical rating organization; and (b) prohibited from serving or acting as an (1) employee, (2) officer, (3) director, (4) member of an advisory board, (5) investment adviser or depositor of, or (6) principal underwriter for, (x) a registered investment company or (y) affiliated person of such investment adviser, depositor, or principal underwriter, with the right to apply for reentry after five years to the appropriate self-regulatory organization, or if there is none, to the SEC.

In the Matter of Carl D. Johns, SEC Release No. IA-3655 (August 27, 2013).

SEC Exam Review Prompts Risk Alert on Adviser Business Continuity Plans

Prompted by wide-ranging damage and the disruptions to the capital markets caused by Hurricane Sandy, the SEC’s National Examination Program (“NEP”) reviewed the business continuity plans and disaster recovery plans (together, “BCPs”) of approximately 40 investment advisers in areas affected by the storm and issued an advisory with its findings.  The NEP made general observations, described noteworthy practices and weaknesses, and identified possible considerations for advisers going forward, in the following seven categories: (1) widespread disruption considerations; (2) alternative location considerations; (3) vendor relationship considerations; (4) telecommunications services and technology considerations; (5) communication plan considerations; (6) regulatory and compliance considerations; and (7) review and testing considerations.   For example, the NEP observed that some advisers did not acquire or critically review service providers’ Statement on Standards for Attestation Engagements No. 16 reports (“SSAE 16 reports”) and BCPs, and that in doing so, these advisers did not ensure that the service providers’ plans incorporated key business continuity controls affecting the advisers’ ability to execute their own BCPs.  Additional weaknesses were noted, such as (a) a failure to have geographically diverse office locations, (b) a failure to identify which personnel were responsible for executing and implementing various parts of the BCP, and (c) a reluctance to undertake critical systems testing due to costs.  The advisory also sets forth several possible future considerations to improve functionality during times when operations are impaired, such as (i) reviewing the IT infrastructure of service providers, particularly with respect to their physical locations, (ii) engaging alternate internet providers or obtaining guaranteed redundancy from their current provider, and (iii) testing the operability of all critical systems under the BCP using various scenarios.  The NEP encourages advisers to consider their BCPs’ effectiveness in light of the observations in the advisory.

Tenth Circuit Rules that “Extender Statutes” Permit NCUA to Bring Otherwise Time-Barred RMBS Suits

The Tenth Circuit has held that provisions of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”) that extend the time period for a government regulator to bring “any action” on behalf of a failed financial organization, often referred to as “extender statutes,” permit the National Credit Union Administration to sue various defendants for state and federal securities laws violations on behalf of two credit unions that were in conservatorship (and, later, involuntary liquidation).  The credit unions had purchased various residential mortgage-backed securities in 2006 and 2007.  The NCUA sued various parties in 2011, alleging materially false and misleading statements in the offering documents.  The defendants argued that that the extender statutes do not apply to repose periods (which are similar to the time limits of statutes of limitations), that the repose period of the relevant portion of the Securities Act is three years, and that the NCUA cannot bring suit because more than three years had passed since the RMBS were offered and purchased.  They also argued that the extender statutes cover only state common law claims, not statutory claims such as those arising from the Securities Act.

The Tenth Circuit explained the distinction between statutes of limitations and statutes of repose by noting that, although statutes of limitations begin running when an injury is discovered or reasonably should have been discovered, statutes of repose are fixed cutoff dates usually independent of variables such as a plaintiff’s awareness of a violation.  Furthermore, although statutes of limitation may be tolled for equitable reasons, repose periods generally cannot be. 

The Tenth Circuit concluded, based on an analysis of the language used in the extender statutes as well as how certain terms are used in other legislation and in case law, that the extender statutes apply to statutes of repose as well as statutes of limitations.  The court also held that the extender statutes apply to statutory as well as common law claims.  As a result, the court ruled that the extender statutes permit the NCUA to bring the suits.

Although the ruling technically applies only to the extender statute applicable to the NCUA, a similar analysis would seem to hold for the extender statute included in FIRREA applicable to the Federal Deposit Insurance Corporation, which, the Tenth Circuit noted, uses identical language.  The court’s opinion also notes, in a footnote, that other courts have construed “materially similar” extender statutes to find that they cover federal and state statutory claims.

NCUA v. Nomura Home Equity Loan, Case Nos. 12-3295 and 12-3298 (Tenth Cir. Aug. 27, 2013).

Goodwin Procter Alert: Massachusetts Supreme Judicial Court Decision Affirms Trustee Decanting Authority

Goodwin Procter issued a client alert that discusses the Massachusetts Supreme Judicial Court’s decision in Morse v. Kraft regarding the ability of a trustee to decant trust assets by distributing them to a new trust in lieu of making an outright distribution to the beneficiary, and the decision’s potential implications for existing irrevocable and revocable trusts.

Former CEO of Failed Bank Enters Plea Agreement Admitting that He Caused Bank to File False Call Reports with FDIC to Conceal Losses from Problem Loans

The former Chief Executive Officer and Chairman (the “CEO”) of the failed Summit Bank (the “Bank”), a Washington state-chartered bank with $142.7 million of total assets, entered into a plea agreement (the “Plea Agreement”)  under which the CEO admitted that he was guilty of knowingly making or causing to be made a false entry concerning a material matter in Call Reports filed by the Bank with the FDIC and that the false entry was made with intent to defraud the FDIC.  The foregoing constituted a violation of Title 18, United States Code, Section 1005.

As described in the Plea Agreement and admitted to by the CEO, between March 2009 and April 2011 the CEO and his son, the Bank’s President, took actions and directed others to take actions to remove millions of dollars of loans from the Bank’s Past Due Reports at the end of each quarter and thereby reduce the volume of problem loans reported in the Bank’s quarterly Call Reports to the FDIC during that period.  Among the steps taken by the CEO to conceal the volume of problem loans from the FDIC were:

  • Overdrawing borrowers’ checking accounts to  make past due loan payments so that the past due loans did not appear on Call Reports;
  • Giving borrowers with troubled loans a larger loan balance, with proceeds of the increased loan balance used to make payments on the past due loans, so that the past due loans did not appear on the Call Reports; and
  • Using loan proceeds “to make payments on wholly separate past due loans in order to cause the past due loan not to appear on the Call Report.”

As part of the Plea Agreement, the CEO agreed to a lifetime prohibition from participating in the conduct of the affairs of an FDIC-insured institution.  The CEO also agreed to pay a $300,000 fine to the United States.  Furthermore, under the Plea Agreement the CEO will serve a jail term of from 12 months to 41 months after he is sentenced on November 15, 2013.