Financial Services Alert - August 19, 2014 August 19, 2014
In This Issue

Expanded Financial Services Alert to Debut in September

Beginning in September, Goodwin Procter’s weekly Financial Services Alert will have a new look, a new name and expanded national and international coverage.  The new publication will be called the Financial Services Weekly News Roundup, and will provide headlines and brief summaries of legislative, regulatory, judicial, and industry developments of note with links to primary sources.  We will continue to distribute more detailed analyses of financial industry news and trends through regular and timely client alerts, and of course, are always pleased to respond to requests for more information on any particular topic of interest.

Goodwin Procter has a long history of serving the financial services industry, and has been reporting on legal and regulatory developments for more than 15 years.  We look forward to continuing to keep you informed and updated.  We hope you find the new format, which was based in part on reader feedback, easier to use and share and, as always, we welcome your suggestions on ways we can further improve the publication.

ICI Mutual Issues Expert Roundtable Report on Mutual Fund Fee Litigation Under Section 36(b) and ERISA

ICI Mutual issued an Expert Roundtable Report on trends in mutual fund fee litigation under Section 36(b) of the Investment Company Act of 1940 and the Employee Retirement Income Security Act of 1974 (ERISA).  The report provides highlights from a roundtable discussion in which the panelists, one of whom was Goodwin Procter partner Jamie Fleckner, reviewed  various aspects of ERISA and Section 36(b)-based fee litigation (such as the types of plaintiffs and defendants, the violations alleged, and the fund industry’s experience to date) and offered predictions for the future.

OFAC Issues New Guidance Regarding Status of Entities Owned by Specially Designated Nationals and Blocked Persons

The U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”) issued new guidance regarding the status of entities that are 50% or more owned by persons or entities whose property and interests in property are blocked by Executive Order or regulations administered by OFAC (each such person, a “Blocked Person”).  Under prior guidance issued in February 2008, OFAC considers a Blocked Person to have an interest in all property and interests in property of any entity in which the Blocked Person owns, directly or indirectly, a 50% or greater interest, which means that such an entity is also treated as a Blocked Person even if it is not listed as a Specially Designated National or otherwise identified in an annex to an Executive Order relating to a sanctions program (an “SDN”).  Under the new guidance, OFAC now considers one or more Blocked Persons to have an interest in property of an entity in which such Blocked Persons own, individually or in the aggregate, directly or indirectly, a 50% or greater interest.  This type of entity is also treated as a Blocked Person even if it is not specifically identified as an SDN.

In connection with issuing the new guidance, OFAC has updated the FAQs that appear on its website to address in more detail the manner in which it will apply this 50% rule.  The FAQs make it clear that OFAC will aggregate the interests held by Blocked Persons in an entity for purposes of determining whether or not the entity must be treated as a Blocked Person even if the interests of the Blocked Persons in that entity are blocked under different sanctions programs administered by OFAC.  The FAQs also clarify that one or more Blocked Persons will be considered to indirectly own an interest in an entity if that interest is held through an entity that is 50% or more owned in the aggregate by the Blocked Persons.  If an entity is treated as a Blocked Person because one or more Blocked Persons own 50% or more of the entity but the Blocked Person or Blocked Persons later divest a sufficient amount of its or their interests in the entity in a transaction that occurs entirely outside of the United States and that does not involve U.S. persons so that the resulting combined ownership interest in the entity owned by Blocked Persons is less than 50%, the FAQs clarify that the entity will no longer be automatically considered a Blocked Person.  However, if property of an entity owned 50% or more by one or more Blocked Persons comes into the United States or within the possession or control of a U.S. person and is blocked, the property will remain blocked even if the interests of the Blocked Person or Blocked Persons in the entity fall below 50%.  The property remains blocked unless OFAC authorizes the unblocking of or other dealings in the property or removes the Blocked Person from the list of SDNs.

The FAQs clarify that OFAC applies a 50% rule for purposes of determining the scope of the sectoral sanctions recently created in the Ukraine-related context.  Specifically, the persons and entities identified in the Sectoral Sanctions Identification List created in July 2014 and entities owned 50% or more in the aggregate by one or more of such persons or entities will be subject to such sectoral sanctions (which do not require blocking of property but impose a more limited set of transaction related restrictions).

The OFAC guidance also cautions U.S. Persons to exercise care when dealing with entities in which one or more Blocked Persons directly or indirectly own an interest that is less than 50% or which one or more Blocked Persons may control by other means, even if the entity is not itself treated as a Blocked Person.  For instance, OFAC takes that position that a U.S. person may not enter into a contract signed by a Blocked Person even if the Blocked Person is signing the contract in his or her capacity as an officer or director of an entity that is not itself a Blocked Person, and U.S. persons may not procure goods, services or technology from or enter into transactions with a Blocked Person, even if the transactions are mediated or conducted through a third party that is not a Blocked Person.  OFAC also noted that entities that are not Blocked Persons but in which one or more Blocked Persons own an interest or over which one or more Blocked Persons may exercise control may be the subject of a future OFAC designation or other enforcement action.

The new OFAC guidance, which became effective on August 13, 2014, applies to U.S. persons, which generally include U.S. citizens and permanent residents, persons in the United States, entities incorporated in or organized under U.S. law and their foreign branches and, for certain purposes, subsidiaries of U.S. entities.  The new guidance highlights the need for U.S. persons, including financial institutions as well as private funds and their sponsors and managers, to conduct detailed due diligence on their counterparties, including with respect to ownership structure.

Should you have questions regarding this new OFAC guidance, please contact either Richard Matheny or Bill Stern.

FinCEN Issues Advisory to U.S. Financial Institutions Regarding Promotion of a Culture of Compliance

The Financial Crimes Enforcement Network (“FinCEN”) issued an advisory (the “Advisory”) to U.S. financial institutions (“FIs”, and each an “FI”) in which FinCEN highlights “the importance of a strong culture of [Bank Secrecy Act (BSA)/Anti-Money Laundering (AML)] compliance for senior management, leadership and owners of all FIs subject to FinCEN’s regulations regardless of size or industry sector.”  FinCEN states that it issued the Advisory in response to the significant recent civil and criminal enforcement actions against banks for shortcomings in their BSA/AML compliance programs and deficiencies with respect to leadership and organizational focus regarding implementation of such programs.  FinCEN stresses that while the Advisory provides guidance on how an FI may strengthen its BSA/AML compliance program, the Advisory does not change existing obligations under BSA/AML requirements nor reflect a new, higher level of regulatory expectations than those that already existed under applicable law and regulation.

The Advisory then discusses ways in which an FI can strengthen its BSA/AML compliance culture:

  • By having engaged leadership that supports the FI’s BSA/AML compliance program;
  • By seeing that the FI’s BSA/AML compliance program is not compromised by revenue interests;
  • By sharing relevant BSA/AML information throughout the FI’s organization;
  • By having the FI’s leadership provide adequate human and technological resources to support the BSA/AML program;
  • By having the FI’s BSA/AML program tested by an independent and competent party; and
  • By making certain that the FI’s leadership and staff understand the purpose of the BSA/AML program and the manner in which the BSA/AML reports are used and effectively work to assist law enforcement authorities in fighting criminal and terrorist activities.

SEC Settles with Dually Registered Adviser Over Best Execution, Disclosure and Principal Transactions

The SEC settled administrative proceedings against an investment adviser, Dominick & Dominick LLC, a firm registered with the SEC both as an investment adviser and a broker-dealer (the “Adviser” or “D&D”), and Robert X. Reilly, the Adviser’s Chief Operating Officer (the “COO”), over the Adviser’s practices related to achieving best execution for advisory clients, Form ADV disclosure, and compliance with the principal transactions prohibitions of Section 206(3) of the Investment Advisers Act of 1940 (the “Advisers Act”).  This article summarizes the SEC’s findings in the settlement order (the “Order”), which the respondents have neither admitted nor denied, and related exemptive relief.

Background

During the relevant time period, the Adviser offered its clients five types of advisory programs.  The Adviser also provides brokerage services to nearly all of its advisory clients, serving in the capacity of introducing broker.  The COO was responsible for adopting and implementing D&D’s best execution policies and procedures and conducting the Adviser’s best execution analyses for its advisory clients.

Best Execution Analysis

Consideration of Commissions.  The SEC faulted monthly best execution analyses conducted by the Adviser from March 2008 through December 2012 on selected advisory client trades because they only compared the price for a security obtained by the clearing broker used by the Adviser to the Bloomberg price for the same date and time without considering the commissions that certain advisory clients paid.

Comparison of Actual Commissions Paid.  During the same period, the SEC found that when the Adviser did examine the brokerage commissions advisory clients were charged, it did so only twice, once in 2008, and again following a 2012 SEC exam, and in each instance the Adviser only compared its schedule of brokerage commissions with other advisers’ brokerage commission schedules without examining the actual commissions charged to certain advisory clients.

Renegotiated Clearing Agreement.  The SEC faulted the Adviser for not analyzing whether certain of its advisory clients continued to receive best execution after it negotiated an amendment to the agreement with its clearing broker in August 2012 that reduced the clearance and execution costs the Adviser paid for equity, options and fixed income transactions and increased the Adviser’s share of the commissions charged to all of its customers (including certain of its advisory clients) without altering the allocation of responsibilities between the Adviser as an introducing broker and its clearing broker.

Best Execution Procedures

The SEC found that from January 2008 through December 2012, the Adviser did not meet its obligation to adopt and implement written best execution policies and procedures reasonably designed to ensure compliance with the Advisers Act.  The SEC cited the fact that the Adviser’s written policies and procedures “made little mention of any actual policies or procedures,” “referred only to fixed income transactions,” and “did not consider commissions charged to advisory clients as part of its overall best execution analysis.”

Disclosure – Margin Loan Rebates and Commission Rates

The SEC found that until corrected following a 2012 SEC staff examination, the Adviser failed to disclose the conflict to which it was subject because it received a rebate from its clearing firm consisting of a significant portion of the interest paid by certain advisory clients to the clearing firm for margin loans.  The SEC also found that the portion of the Adviser’s Form ADV provided to clients (the “Brochure”) contained the following misleading statement of material fact: “[w]e have negotiated commission rates with D&D for our clients which we believe to be competitive with rates available elsewhere for similar services.”  The SEC determined that this statement wrongly suggested that there had been an arms-length negotiation between the Adviser in its capacity as investment adviser and the Adviser in its capacity as broker.

Principal Transactions

The SEC found that from January 2008 through August 2012, the Adviser engaged in approximately 140 principal transactions with advisory clients without obtaining consent prior to completion of the transactions as required under Section 206(3) of the Advisers Act.  The Order also found that this practice was not consistent with the Brochure disclosures that the Adviser would “not act as principal in any transaction for your accounts or act as agent on both sides of any transaction, unless you have granted us permission to do so prior to the completion of the transaction.”  The Adviser’s actual practice was to “send a letter to the advisory client after a transaction was executed but before settlement, providing details of the transaction and stating that it had engaged in the transaction as a principal.”  The letter did not seek client consent to proceed with or settle the transaction, and the Adviser did not otherwise obtain client consent.

Violations

The SEC found that the Adviser violated, and the COO caused the Adviser to violate, (1) Section 206(2) of the Advisers Act, which makes it unlawful for an adviser to engage in any transaction, practice, or course of business that operates as a fraud or deceit upon any client, (2) Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, which require registered advisers to adopt written programs designed to ensure compliance with the Advisers Act, (3) Section 206(3) of the Advisers Act governing principal transactions, and (4) Section 207 of the Advisers Act, which prohibits material misstatement or omissions in any registration application or report filed under the Advisers Act.

Sanctions

Among other sanctions, the Adviser agreed to pay disgorgement of $136,523 and prejudgment interest of $11,083.60 into a fund to be paid to affected current and former advisory clients.  The Adviser also agreed to pay a civil monetary penalty of $75,000.  The COO agreed to pay a civil monetary penalty of $10,000.

The Adviser was also required to retain for one year an independent compliance consultant to assist it in developing and implementing policies and procedures reasonably designed to promote compliance with the Advisers Act, including best execution and related disclosures to advisory clients, and Section 206(3) requirements for principal transactions.  The Order notes that the SEC’s decision to enter into the Order included consideration of remedial acts promptly undertaken by the Adviser, specifically (A) revisions to the Adviser’s best execution policies and procedures to include “consideration of the total cost of effecting advisory client transactions” and (B) the engagement of a compliance consultant.  The Order also cites cooperation afforded the SEC staff.

“Bad Actor” Exemptive Relief.  On the same date as the Order, the Adviser received exemptive relief from the “bad actor” disqualification provisions of Rule 506 under the Securities Act of 1933.  The Adviser sought the relief because it understood that the Order could prevent certain affiliated and third party issuers that have retained the Adviser or certain of its affiliated persons from relying on the Rule 506 private offering exemption.  Specifically, the Adviser understood that the requirement in the Order that it “hire a qualified consultant would be considered a ‘disqualifying event’ as it places certain limitations on [the Adviser]’s ‘activities, functions or operations’ under Rule 506(d)(1)(iv) of Regulation D.”  As a condition of the exemptive relief, the Adviser agreed to “furnish (or cause to be furnished) to each purchaser in a Rule 506 offering that would otherwise be subject to the disqualification under Rule 506(d)(l) as a result of the Order, a description in writing of the Order a reasonable time prior to sale.”

Dominick & Dominick LLC and Robert X. Reilly, SEC Release No. IA-3881 (Jul. 28, 2014).

CFPB Issues Consumer Advisory Concerning Risks of Virtual Currencies; Announces it Will Accept Consumer Complaints Regarding Virtual Currency Products and Services

The Consumer Financial Protection Bureau (the “CFPB”) issued a consumer advisory (the “Advisory”) in which it describes risks faced by consumers when engaging in transactions that involve virtual currencies.  The CFPB also announced that it would begin to accept consumer complaints regarding a virtual currency product or service.

After describing virtual currencies generally, the CFPB cautions consumers that, among other things, they should: (i) be aware that virtual currencies can experience dramatic price fluctuations; (ii) know with whom they are dealing before entering into a virtual currency transaction (e.g., obtain information about a dealer who proposes to sell the consumer virtual currency and check whether a virtual currency exchange is, as required, registered with FinCEN); (iii) understand the full costs of the transaction (including potential mark-ups to the exchange rate or other fees); (iv) be aware that virtual currencies are targets for hackers and scammers; (v) be aware that virtual currency companies may not offer help or refunds for lost or stolen customer funds; and (vi) understand that there is no governmental guarantee that stands behind virtual currency accounts.  The CFPB in the Advisory also urges consumers to take steps to protect their private keys (used to access their virtual currency) from theft or loss.

The CFPB’s Advisory follows up on prior guidance related to the risks of virtual currencies issued by FinCEN, the SEC and certain federal and state bank regulators that focus upon financial institution safety and soundness concerns, investor protection and prevention of criminal activity rather than consumer protection.  The CFPB did not indicate in the Advisory (or otherwise) that it intended to issue regulations concerning virtual currency.