FSOC Publishes Volcker Rule Study

Developments of Note

• FSOC Publishes Volcker Rule Study
• FDIC Issues Interim Final Rule Implementing Certain Orderly Liquidation Authority Provisions
• Financial Stability Oversight Council Issues Study and Recommendations Regarding Concentration Limits on Large Financial Companies
• SEC and Other Regulators Settle Administrative Proceedings Based on How Ultra-Short Bond Fund Was Marketed and Violations of 1940 Act Concentration Policy Limits
• ICI Files Comment Letter on President's Working Group Reform Options for Money Market Funds
• SEC Staff Delivers Study on Enhancing Investment Adviser Examinations to Congress
• SEC Delivers Study on Uniform Standards for Investment Advisers and Broker-Dealers
• SEC Proposes Permanent Rules and Forms for Municipal Advisor Registration
• SEC Staff Issues No-Action Letter Modifying Relief that Permits Broker-Dealers to Rely on Registered Advisers to Perform AML Customer Identification

Other Items of Note

• New ERISA Litigation Update Available
• SEC Proposes Rules Regarding Acknowledgement and Verification of Securities-Based Swap Transactions
• CFTC Proposes Rules and Guidance for Derivatives Clearing Organizations

DEVELOPMENTS OF NOTE

FSOC Publishes Volcker Rule Study

The Financial Stability Oversight Council (the "FSOC") published its "Study and Recommendation on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds" (the "Study"). The Study, which was mandated by Section 619 of the Dodd-Frank Act, provides the federal banking agencies, the SEC, and the CFTC (collectively, the "Agencies") with recommendations that the Agencies must consider (but are not obligated to follow) in developing regulations to implement the Volcker Rule. The Agencies are required to adopt such regulations no later than nine months after the FSOC's completion of the study, meaning the regulations must be adopted by October 18, 2011.

The Volcker Rule, which was described in detail in July 28, 2010 Special Edition of the Alert, prohibits a "banking entity" from (1) engaging in trading activity in which it acts as a principal in order to profit from near-term price movements and (2) investing in, or having certain relationships with, any fund that is structured under exclusions commonly used by hedge funds and private equity funds under the Investment Company Act of 1940 (the "Investment Company Act"), unless the activity fits within one of the Volcker Rule's categories of permitted activities, such as market making, hedging, underwriting, or transactions in government securities. A "banking entity" is defined broadly to include (1) any insured depository institution, as defined in Section 3 of the Federal Deposit Insurance Act; (2) any company that controls an insured depository institution; (3) any company treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978, as amended; and (4) any affiliate or subsidiary of such a company.

Recommended Actions to Effectively Implement the Volcker Rule

The Study recommends that the Agencies consider taking the following actions in implementing the Volcker Rule:

1. Require banking entities to sell or wind down all impermissible proprietary trading desks.
2. Require banking entities to implement a robust compliance regime, including public attestation by the chief executive officer (the "CEO") of the regime's effectiveness.
3. Require banking entities to perform quantitative analysis to detect potentially impermissible proprietary trading without provisions for safe harbors.
4. Perform supervisory review of trading activity to distinguish permitted activities from impermissible proprietary trading.
5. Require banking entities to implement a mechanism that identifies to the Agencies which trades are customer-initiated.
6. Require divestiture of impermissible proprietary trading positions and impose penalties when warranted.
7. Prohibit banking entities from investing in or sponsoring any hedge fund or private equity fund, except in connection with bona fide trust, fiduciary or investment advisory services provided to customers.
8. Prohibit banking entities from engaging in transactions that would allow them to "bail out" a hedge fund or private equity fund.
9. Identify "similar funds" that should be brought within the scope of the Volcker Rule prohibitions in order to prevent evasion of the intent of the rule.
10. Require banking entities to publicly disclose permitted exposure to hedge funds and private equity funds.

Recommendations to Restrict Proprietary Trading

The Study includes a discussion of proprietary trading which outlines criteria for defining prohibited activities and describes indicia of permitted activities. The discussion also addresses the statutory limits that on permitted activities, including the prohibition on activities that would involve or result in a material conflict of interest, result in a material exposure to high-risk assets or high-risk trading strategies, pose a threat to the safety and soundness of the banking entity, or pose a threat to the financial stability of the United States.

Principles for Implementation

The Study recommends five fundamental principles that the Agencies should consider in their rulemaking and supervisory efforts with respect to proprietary trading:

1. The regulations should prohibit improper proprietary trading activity using whatever combination of tools and methods are necessary to monitor and enforce compliance with the Volcker Rule.
2. The regulations and supervision should be dynamic and flexible so the Agencies can identify and eliminate proprietary trading as new products and business practices emerge.
3. The regulations and supervision should be applied consistently across similar banking entities (e.g., large banks, hedge fund advisers, investment banks) and their affiliates to facilitate comparisons. The regulations and supervision should endeavor to provide banking entities with clarity about criteria for designating trading activity as impermissible proprietary trading.
4. The regulations and supervision should facilitate predictable evaluations of outcomes so the Agencies and banking entities can discern what constitutes a prohibited and a permitted trading activity.
5. The regulations and supervision should be sufficiently robust to account for differences among asset classes as necessary (e.g., cash and derivatives markets).

Identification of "Bright Line" Proprietary Trading

The Study recommends that the Agencies develop criteria to identify "bright line" proprietary trading. The Study notes that a key requisite element of "bright line" proprietary trading is that the activity involves the use of a banking entity's capital and is organized and conducted for the purpose of benefiting from future price movements. In addition, the Study observes that "bright line" proprietary trading is typically characterized by one or more of the following additional characteristics:

• Organized to conduct trading activities for the sole purpose of generating profits from trading strategies;
• No formal market making responsibilities or customer exposure (or customer exposure that is not commensurate with the level of trading);
• Physical and/or operational separation from market making and other operations having customer contact;
• Trades with or is provided the services of, sell side analysts, brokers, and dealers;
• Receives and utilizes research or soft dollar credits provided by other broker-dealers; and/or
• Compensation structure similar to those of hedge fund managers and other managers of private pools of capital.

Distinguishing Permitted Activities from Impermissible Proprietary Trading Activities

The Study recognizes that, of the permitted activities under the Volcker Rule that relate to proprietary trading, the most difficult to distinguish from impermissible proprietary trading are market making-related activity, risk-mitigating hedging, and underwriting. In each of these areas, the Study identifies indicia of permitted activities that will help the Agencies in determining whether the activity is fully consistent with activities permitted under the Volcker Rule.

1. Market Making. To ensure that market making does not mask prohibited proprietary trading, the Study recommends that the Agencies should provide guidance that will assist banking entities in determining what constitutes prohibited activity. In particular, the Study recommends that the Agencies consider the SEC's 2008 guidance which established indicia of bona fide market making in equity markets, including:
   
   
   • Making continuous, two-sided quotes and holding oneself out as willing to buy and sell on a continuous basis;
   • Making a comparable pattern of purchases and sales of a financial instrument in a manner that provides liquidity;
   • Making continuous quotations that are at or near the market on both sides; and
   • Providing widely accessible and broadly disseminated quotes.
     
     

The Study also notes that the SEC has stated that, generally, market markers post quotes at a price above the national best bid and provide liquidity on the opposite side of the market. While the SEC has not provided similar guidance for less liquid markets, such as debt, derivatives, or asset-backed security markets, the Study also sets forth indicia that could be applied in less liquid markets to determine if market making activity is in compliance with the Volcker Rule.

1. Hedging. The Study recommends that, in examining the activities of a trading desk to determine whether a hedge qualifies as risk-mitigating or is instead proprietary trading, the following indicia should be considered:
   
   
   • Hedging activity should be designed to reduce the key risk factors in a banking entity's existing exposure, and should offset gains or losses that would arise from those exposures. Hedging activity should adjust over time based on changes in a banking entity's underlying exposures.
   • Hedging activity should also adjust over time if market conditions alter the effectiveness of the hedge even if the underlying positions remain unchanged.
   • Material changes in risk should generate a corresponding change in hedging activity and should be consistent with the desk's hedging policy.
     
     
2. Underwriting. The Study observes that a key challenge for the Agencies with respect to underwriting by banking entities is the identification of activity that underwriters do not need to adequately support their clients' equity and debt issuances and may indicate impermissible proprietary trading. The FSOC recommends that the Agencies consider whether a banking entity engages in the following:
   
   
   • Assisting an issuer in capital raising;
   • Performing due diligence;
   • Advising the issuer on market conditions and assisting in preparation of a registration statement;
   • Purchasing securities from an issuer for resale to the public;
   • Participating in or organizing a syndicate of investment banks; and
   • Transacting to provide a post-issuance secondary market to facilitate price discovery.
     
     

The Study also suggests that the Agencies may wish to look to existing SEC rules that set conditions on trading practices in the context of underwriting for examples of how to monitor whether an underwriting activity conforms to current regulatory requirements or takes on characteristics of proprietary trading.

Definition of "Trading Account"

As defined in the Volcker Rule, "proprietary trading" occurs when a banking entity engages in trading as a principal for the banking entity's "trading account," which generally means any account used for acquiring or taking positions in securities and other instruments for the purpose of selling in the near-term or with the intent to resell to profit from short-term price movements. The Study observes that the language regarding short-term price movements in the Volcker Rule is similar to (i) language used by FASB accounting standards to determine whether positions are "held for trading" and (ii) a broader definition of "covered positions" that are subject to the federal banking agencies' market risk capital rules. The Study recommends that, to the extent that the Agencies decide to incorporate an accounting or similar term in defining "trading account," the Agencies carefully consider how they might ensure that the prohibition on proprietary trading cannot be avoid through changes in accounting designations, such as labeling a position "available for sale" rather than "trading."

Implementation of the Proprietary Trading Prohibition

The Study recommends a four-part implementation and supervisory framework that would assist the Agencies in identifying proprietary trading activities that banking entities may not engaged in. The four-part framework would consist of (1) a programmatic compliance regime, (2) analysis and reporting quantitative metrics; (3) supervisory review and oversight; and (4) enforcement procedures for violations.

1. Programmatic Compliance Regime. The Study suggests that banking entities should be required to develop robust internal controls and programmatic compliance regimes to prevent impermissible proprietary trading. The compliance regime may require:
   
   
   • The establishment of internal policies and procedures to detect and eliminate proprietary trading;
   • The development and implementation of a program of controls to monitor trading activity and to ensure that the types and levels of risk taken are appropriate and consistent with articulated Volcker Rule policies and procedures;
   • The creation of recordkeeping and reporting systems, including for the purpose of facilitating internal compliance reviews and supervisory examinations;
   • The implementation of independent testing of the compliance regime by a banking entity's internal audit department or by outside auditors, consultants, or other qualified independent parties; and
   • Robust review of permitted activities to ensure that internal policies and procedures are being followed, combined with engagement by the Board of Directors and public attestation of compliance by the CEO.
     
     
2. Analysis and Reporting of Quantitative Metrics. The Study recommends that banking entities be required, as part of their compliance regime, to maintain records and provide reports to supervisors on a periodic basis. The Study identifies four categories of metrics that could be used to evaluate whether a banking entity is engaged in impermissible proprietary trading: (a) revenue-based metrics; (b) revenue-to-risk metrics; (c) inventory metrics; and (d) customer-flow metrics.
3. Supervisory Review and Oversight. The Study recommends that the Agencies implement a supervisory framework for review and oversight of trading operations, which may include:
   
   
   • Periodic review and testing of the effectiveness of banking entities' internal controls and procedures;
   • Supervisory monitoring and review of trading activities for potentially problematic trends or incidents;
   • Interviews and other frequent dialogue with traders and management;
   • Review and monitoring of quantitative data and metrics reported by banking entities for potential red flags; and
   • Examination and investigation of specific trading activity, including position-level data, on a random basis or in cases in which there is some indication that a violation may have occurred.
     
     
4. Enforcement Procedures for Violations. In addition to the statutory requirement that any prohibited activity that is identified the examination process be terminated and the investment be liquidated, the Study recommends that the Agencies be able to consider other potential supervisory or enforcement actions, such as increased oversight, reductions in risk limits, increased capital charges, or monetary penalties.

Limitations on Permitted Activities

The Study also outlines key issues for the Agencies to consider in applying the Volcker Rule's limits on the scope of permitted activities if such activities (1) result in a material conflict of interest, (2) result in material exposure to high-risk assets or high-risk trading strategies, (3) pose a threat to safety and soundness of the banking entity, or (4) pose a threat to financial stability.

1. Material Conflicts of Interest. The Study recommends that the Agencies consider the extent to which permitted activities present risks that banking entities will conduct transactions which place the banking entity's own interests ahead of its obligations to its customers and counterparties, where such conflicts might arise, and what steps can be designed to prevent the banking entity from proceeding with the transaction in a manner contrary to those obligations. The Study that suggests that the Agencies take into consideration existing conflict of interest laws applicable to banking entities engaged in permitted activities, including state law fiduciary standards, a similar duty of loyalty that applies to investment and commodity trading advisers under federal and state securities and commodities laws, and similar standards applicable to plan fiduciaries under the ERISA, and securities laws which prohibit an institution from obtaining an advantage in the securities markets by using nonpublic information it acquires about a customer or issuer.
2. Material Exposure to High-Risk Assets or High-Risk Trading Strategies. The Study encourages the Agencies to adopt a flexible framework rather than rigid definitions of "high-risk assets" and "high-risk trading strategies," and identifies the following as possible indicators of a high-risk asset or a high-risk trading strategy:
   
   
   • The introduction of new products with rapid growth;
   • Assets or strategies that include embedded leverage;
   • Historical volatility of the asset or strategy;
   • Total value at risk (VaR) of the asset or strategy;
   • Assets whose values cannot be externally priced or whose exposure cannot be quantified;
   • Assets whose risk cannot be adequately mitigated by effective hedging; and
   • The application of capital and liquidity standards would not adequately account for the risk of an asset.
     
     

The Study also encourages the Agencies to consider requiring banking entities to establish, or integrate into their existing risk management process, a committee with relevant expertise to assess the firm's potential exposure to high-risk assets and high-risk trading strategies.

1. Threat to Safety and Soundness of the Banking Entity. With respect to this limitation, the Study recommends that the Agencies use the metrics and frameworks discussed above to monitor and address the financial soundness of banking entities.
2. Threat to Financial Stability of the United States. The Study observes that it is unlikely that an activity would pose a threat to the financial stability of the United States without triggering the Volcker Rule's limitations on permitted activities, but notes that the Volcker Rule requires that the Agencies take action to prohibit permitted activities where the Agencies have concerns about an imbalance in the financial system.

Recommendations to Restrict Sponsorship of and Investments in Hedge Funds and Private Equity Funds

The Study also includes a discussion of the prohibition on sponsoring and investing in hedge funds and private equity funds. This section focuses on key issues raised in the implementation of the Volcker Rule's hedge fund and private equity fund provisions, suggests certain substantive criteria that the Agencies should use to guide legal interpretations in the rulemaking, and recommends a compliance and supervisory framework.

Principles for Implementation

The Study identifies three principles for implementation of the Volcker Rule's provisions regarding investments in or sponsorship of hedge funds and private equity funds:

1. Significant limits should be placed on the ability of banking entities to invest in hedge funds and private equity funds in order to reduce the risks banking entities face.
2. A banking entity is permitted to organize and offer, or invest in, a hedge fund or private equity fund in connection with the provision of bona fide trust, fiduciary or investment advisory services to customers.
3. The relationships between banking entities and the hedge funds and private equity funds they organize and offer should not allow those funds to circumvent the prohibition on proprietary trading.

Scope of Prohibited Activities

As explained above, the Volcker Rule prohibits banking entities from sponsoring or investing in hedge funds or private equity funds. A "hedge fund" or "private equity fund" is defined as any issuer that would be an investment company, as defined in the Investment Company Act, but for Section 3(c)(1) (not more than 100 investors) or Section 3(c)(7) (qualified purchasers) of the Investment Company Act, or such similar funds as the appropriate federal banking agencies, the SEC and the CFTC designate by regulation.

Notably, the Study observes that many hedge funds and private equity funds are offered in reliance on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act but acknowledges that these exemptions are also used by a wide variety of funds. To prevent the restriction of an overly broad range of investment vehicles, the Study recommends that the Agencies carefully evaluate the range of funds and other legal vehicles that rely on Section 3(c)(1) and Section 3(c)(7) and consider whether it is appropriate to narrow the statutory definition by rule in some cases.

On the other hand, the Study states that some investment vehicles which share the characteristics of traditional private equity funds and hedge funds may not rely on Section 3(c)(1) or Section 3(c)(7). The Study recommends that in determining which funds should be considered "similar funds" which are subject to the Volcker Rule, the Agencies should consider the investment activities and other characteristics of the funds, including:

• Whether the fund earns an allocation based on fund performance, including both realized and unrealized gains;
• The trading or investment strategy utilized by the fund;
• Whether the fund borrows or otherwise uses material leverage for the purpose of increasing investment performance; and
• Whether the fund's capital is received from a broad group of unaffiliated investors.

Implementation of Permitted Activities

As with the proprietary trading provisions, the Volcker Rule allows banking entities to engage in certain permitted activities under exemptions to the broad prohibitions on sponsoring or investing in hedge funds and private equity funds. The Study addresses three key issues with respect to such permitted activities: (1) the meaning of "customer," (2) the treatment of feeder funds, and (3) the scope of permissible de minimis investments.

1. Customer Requirement. The Volcker Rule permits a banking entity to organize and offer a hedge fund or private equity fund if "the fund is organized and offered only in connection with the provision of bona fide trust, fiduciary, or investment advisory services and only to persons that are customers of such services of the banking entity." The Volcker Rule does not, however, define the term "customer."

The Study recommends that the Agencies clarify the meaning of "customer." The Study suggests that the Agencies consider existing definitions under banking and securities laws, and also take into account (1) whether the banking entity has a continuing relationship with the customer or knowledge of the customer's financial needs; (2) whether a customer relationship is direct or indirect; and (3) whether the relationship is initiated by the customer or the banking entity.

1. Feeder Funds. The Study notes that banking entities may, in the context of their customer-focused advisory services, provide customers with access to third-party private equity funds and hedge funds through the organization and offering of feeder funds that make investments in such third party funds. However, the Study cautions that conflicts of interest may arise in the context of such fund arrangements. In assessing whether such relationships are appropriate, the Study recommends that the Agencies consider:
   
   
   • Whether the banking entity's business relationship with the third-party fund should be subject to the Volcker Rule's prohibition of "covered transactions" (e.g., making loans, purchasing assets, extending guarantees) as well as Section 23B of the Federal Reserve Act's "arm's length" transaction requirements; and
   • The extent to which such arrangements could create the opportunity and incentive for (i) banking entities to protect hedge funds and private equity funds from losses and (ii) for those funds to expose the banking entity to outsized risk.
     
     
2. Calculation of De Minimis Investment. The Volcker Rule permits banking entities to make certain de minimis investments in hedge funds and private equity funds, subject to limits on exposure by the banking entity to 3% of the ownership interests of any single fund and 3% of the banking entity's Tier 1 capital in the aggregate.

The Study recommends that the Agencies consider rules that will avoid understating risk by defining "investment" for this purpose in a manner that will best capture the banking entity's true risk exposure. The Agencies should consider how to treat (1) the amount of customer funds invested in or committed to the fund, (2) any carried interest in the fund, and (3) the banking entity's exposure through synthetic ownership interests. In addition, the Study suggests that the Agencies consider whether investments by directors, employees, and investors who may be affiliated with the banking entity (such as non-ERISA qualified employee deferred compensation plans) should be counted toward the 3% cap.

The Study also suggests that the Agencies consider whether the de minimis calculation of the banking entity's share of a fund should reflect changes in the investor base in the fund (e.g., redemptions or other changes in commitment levels) over time or whether a one-time test at the one-year mark or at the inception of a fund would be sufficient. In addition, the Study recommends that if those changes result in a banking entity's investment exceeding the cap, the Agencies address the period of time the banking entity should have to sell down its interest to a compliant level.

Limitations on Permitted Activities

The Study notes that banking entities' permitted investments in or organizing and offering hedge funds and private equity funds are subject to the same limits as proprietary trading permitted activities. The Study's recommendations with respect to these limits on permitted activities are discussed above.

Clarification of the Term "Banking Entity"

The Study acknowledges that the Volcker Rule's definition of "banking entity," which is described above, includes any affiliate or subsidiary of a banking entity, which, arguably, creates a circular definition that would subject an advised fund (which is considered to be an affiliate) to the proprietary trading and hedge fund and private equity fund restrictions of the Volcker Rule, even though establishing an advised fund is an explicitly permitted activity. The Study recommends that the Agencies carefully consider the impact of certain Bank Holding Company Act definitions on the Volcker Rule's definition of "banking entity" and implement the term in a manner that avoids results that Congress clearly did not intend in enacting the Volcker Rule.

Monitoring Compliance

As with respect to proprietary trading, the Study recommends that the Agencies consider requiring banking entities to establish programmatic compliance regimes for ensuring compliance with the Volcker Rule's hedge fund and private equity funds limitations that will involve strong investment and risk oversight of fund activities, engagement by the Board of Directors and public attestation of the adequacy of the compliance regime by the CEO. In addition, the Study recommends that the Agencies consider requiring banking entities to disclose the nature and amount of any permitted investments in hedge funds or private equity funds.

Accommodation of the Business of Insurance

The Dodd-Frank Act requires that the Study provide recommendations to "appropriately accommodate the business of insurance." To address these issues, the Study includes a specific section regarding insurance activities.

Permissible General Account Investments

The Volcker Rule permits the purchase, sale, acquisition or disposition of the securities referenced in the definition of proprietary trading by a regulated insurance company directly engaged in the business of insurance for the general account of the company and by any affiliate of such insurance company, provided that such activities by any affiliate are solely for the general account of such insurance company, if (i) conducted in compliance with applicable state insurance law, and (ii) the appropriate Federal banking agencies, after consultation with the FSOC and the relevant insurance commissioners of the States and territories of the United States, have not determined jointly (following notice and comment) that such applicable state insurance law is not sufficient to protect the safety and soundness of the banking entity or the financial stability of the United States.

The Study recommends that, to provide clarity for banking entities with affiliated insurance companies, the Agencies consider the following:

• The term "regulated insurance company" could be defined to include entities that are subject to regulation by the state insurance regulatory insurance agencies, such as licensed and admitted insurance companies, surplus lines insurance companies, and admitted reinsurance companies;
• In interpreting the "business of insurance," the Study urges the Agencies to strive to be consistent with the term as used and interpreted under the McCarran-Ferguson Act; and
• The term "general account," which is a fairly well recognized insurance accounting term of art, refers to all assets of the insurer that are available to satisfy its overall obligations. It does not include any separate account assets.

The Study also addresses the applicable limits on general account investments. With respect to compliance with applicable state insurance laws, the Study encourages the federal banking agencies and state insurance agencies to coordinate and enhance the examination of those insurance companies that might otherwise be subject to the Volcker Rule to ensure that they are compliant with state law and regulation, or, alternatively, require such insurance companies to certify that such activity is compliant followed by a later audit.

In addition, the Study notes that the Agencies will need to consider the timing and approach to the assessment of the states' insurance company investment laws, regulations, and guidance. The Study suggests that safe harbor provisions for insurance companies, as well as an opportunity for a state to address the inadequacy of its laws, should be considered.

Separate Account Assets

The Study acknowledges that beyond permitted general account investments, insurance companies also maintain investments in separate accounts that remain on the company's balance sheet but are legally separate from the assets of the insurance company itself. The Study notes that some commenters suggested that separate account investments should be considered permitted activity on behalf of customers and recommends that the Agencies evaluate how insurance companies make such investments.

Other Issues Related to the Business of Insurance

The Study observes that the Volcker Rule may apply to banking entities' investments in insurance products. To address commenters' concerns that some separate account products could be included in the definitions of "hedge fund" and "private equity fund" because they are offered in reliance on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act, the Study recommends that the Agencies consider this issue carefully so as not to preclude certain insurance products that Congress may not have intended to limit through the Volcker Rule.

The Study also suggests that the Agencies carefully monitor fund flows between banking entities and insurance companies to guard against "gaming" the Volcker Rule, whether it is through innovative insurance products and financial instruments, like Bank Owned Life Insurance, or use of separate accounts.

FDIC Issues Interim Final Rule Implementing Certain Orderly Liquidation Authority Provisions

On January 25, 2011, the FDIC published in the Federal Register an interim final rule (the "Interim Final Rule") clarifying how the agency will treat certain claims under the new Orderly Liquidation Authority provided in Title II of the Dodd-Frank Act. The Interim Final Rule adopts with certain changes (discussed below) the proposed rule set out in a notice of proposed rulemaking ("NPR") published in the Federal Register on October 19, 2010. For details regarding the NPR, please see the October 19, 2010 Alert.

The NPR solicited public comments on the proposed rule and certain specific questions for a period of 30 days and solicited comments on other key issues involved in the implementation of the Orderly Liquidation Authority for a period of 90 days. During the 30-day comment period, the FDIC received 27 comment letters and held two meetings with various industry representatives and trade associations. The comments received generally expressed support for the FDIC's efforts to promulgate rules for implementing the Orderly Liquidation Authority. A majority of the comments related to matters beyond the scope of the NPR, indicating the need for additional rulemaking in the future.

A number of commenters requested additional time to comment on various provisions in the NPR. Accordingly, the FDIC decided to issue the regulation as an interim final rule, with a request for comments, in order to provide the certainty of a final regulation while also permitting the FDIC the opportunity to solicit and obtain additional comments to determine if further clarifications or revisions are necessary.

The Interim Final Rule differs from the NPR by clarifying that all collateral, including U.S. government securities, will be valued at its fair market value determined as of the date of the appointment of the FDIC as receiver. In addition, with respect to the provision that the FDIC will avoid taking a lien on some or all of the assets of a covered financial company that is an insurance company (or a covered subsidiary or affiliate of an insurance company), unless it makes a determination that taking such a lien is necessary for the orderly liquidation of such company and will not unduly impede or delay the liquidation or rehabilitation of the insurance company, or the recoveries by its policyholders, the Interim Final Rule adds text clarifying that the FDIC will take a lien only on the assets of the entity to which funds are provided.

The text in the NPR was also revised in the Interim Final Rule to make clear that the treatment of contingent claims under the Orderly Liquidation Authority parallels their treatment under the Bankruptcy Code. Accordingly, the Interim Final Rule provides that the receiver shall not disallow a claim solely because the claim is based on an obligation that was contingent as of the date of the appointment of the receiver. To the extent the obligation is contingent, the receiver will estimate the value of the claim based upon the likelihood that the claim would become fixed and the probable magnitude thereof. The FDIC requested comment in the Interim Final Rule as to whether it should designate a specific time during the term of the receivership to estimate the value of contingent claims.

The FDIC also received a number of comments regarding its authority under the Dodd-Frank Act to make "additional payments" to creditors. In particular, many commenters were concerned with the prohibition of any additional payments to holders of long-term debt (defined as debt with an original term of more than 360 days), based on the misapprehension that shorter-term creditors are likely to receive such payments. The Interim Final Rule was not changed from the NPR in this regard, though, as the FDIC found such concerns to be unwarranted.

The FDIC noted in the Interim Final Rule that short-term debt holders are highly unlikely to meet the criteria set forth in the Dodd-Frank Act for permitting payment of additional amounts to certain creditors. The FDIC noted that in virtually all cases, holders of shorter-term debt will receive the same pro rata share of their claim that is being provided to the long-term debt holders. Accordingly, the Interim Final Rule provides that "a potential credit provider to a company subject to the Dodd-Frank resolution process should have no expectation of treatment that differs depending upon whether it lends for a period of over 360 days or for a shorter term."

Comments on the Interim Final Rule are due no later than March 28, 2011.

Financial Stability Oversight Council Issues Study and Recommendations Regarding Concentration Limits on Large Financial Companies

The Financial Stability Oversight Council (the "Council") issued a study (the "Concentration Study") and recommendations pursuant to Section 622 of the Dodd-Frank Act regarding concentration limits on large financial companies. Section 622 of the Dodd-Frank Act, adopted as a new Section 14 of the Bank Holding Company Act of 1956, generally prohibits a financial company from combining with another company if the resulting company's consolidated liabilities would exceed 10% of the aggregate consolidated liabilities of all financial companies. This prohibition applies to the acquisition of any other company, not just other financial companies, and affects any company that controls an insured depository institution, including companies that are not registered as bank holding companies but control an insured depository institution such as a thrift or limited-purpose institution. Because of the broad application of this definition, the aggregate liabilities of all financial companies under which the concentration limit is measured will be much larger than the aggregate liabilities of all bank holding companies. For purposes of determining the concentration limit, a financial company's liabilities are measured as its total risk-weighted assets less its total regulatory capital, as determined by the risk-based capital rules. Notably, the risk-based capital rules are currently being redefined under the new Basel III standards. The FRB is required to adopt regulations by October 18, 2011, that reflect the results of the Concentration Study and recommendations of the Council.

The Concentration Study concludes that the concentration limit will reduce the risks to U.S. financial stability from increased concentration among U.S. financial companies and may result in the largest financial companies shedding risk or raising additional capital to reduce liabilities so as to permit additional acquisitions under the concentration limit. The Concentration Study further states that the Council believes that the concentration limit will provide a more comprehensive limitation on growth by acquisition than the 10% nationwide deposit cap imposed by the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 because the concentration limit also takes into account non-deposit liabilities and off-balance sheet exposures, which the Council believes will limit incentives for large financial companies to shift liabilities from deposits to potentially more volatile on- and off-balance sheet liabilities. The Council indicated that it expects the impact of the concentration limit to be neutral over the short-to medium-term, but that over the long term the concentration limit will enhance the competitiveness of U.S. financial markets by preventing dominance of those markets by a few large financial companies.

To implement the provisions of Section 622 of the Dodd-Frank Act, the Council recommended:

• Modifying the statutory definition of "liabilities" for certain companies that do not currently calculate or report risk-weighted assets.
• Modifying the calculation of aggregate financial sector liabilities to use a two-year rolling average instead of a single year for purposes of calculating the denominator of the limit and requiring the FRB to publicly report, on an annual basis and no later than July 1 of any calendar year, a final calculation of the aggregate consolidated liabilities of all financial companies as of the end of the preceding calendar year.
• Extending the exception provided in the Dodd-Frank Act for the acquisition of failing banks to other failing insured depository institutions.

The Concentration Study notes that the Dodd-Frank Act treats U.S.-based firms and foreign-based firms unequally for purposes of the concentration limit. The concentration limit for U.S. firms is based on their global liabilities, however, only the liabilities of the U.S. operations of foreign firms are measured for the concentration limit. Thus, certain acquisitions may be permissible for foreign firms that are impermissible for U.S. firms, even if such U.S. firm had equal or fewer global liabilities than the foreign firm.

SEC and Other Regulators Settle Administrative Proceedings Based on How Ultra-Short Bond Fund Was Marketed and Violations of 1940 Act Concentration Policy Limits

On January 11, 2011, the SEC announced the settlement of administrative proceedings against an ultra-short bond fund (the "Ultra-Short Fund") and a broad bond market index fund (the "Total Market Bond Fund") (collectively, the "Funds") and the Funds' investment adviser (the "Adviser") and affiliated distributor and transfer agent (the "Distributor"). The SEC's principal findings were that, between 2005 and mid-2008, (i) the Adviser and the Distributor made misleading comparisons in marketing the Ultra-Short Fund as an alternative to cash management vehicles like money market funds without adequately disclosing the Fund's relative risks and the differences between the Fund and other cash management vehicles, particularly money market funds; (ii) the Adviser and Distributor made inaccurate statements about the Ultra-Short Fund's declining net asset value ("NAV") during the credit crisis of 2007-2008; (iii) the Adviser and Distributer improperly substituted the Ultra-Short Fund's duration for its weighted average maturity ("WAM") in certain marketing materials and SEC filings; (iv) each Fund deviated from its industry concentration policy when it invested more than 25% of Fund assets in non-agency mortgage-backed securities ("MBS"); and (v) the Adviser and Distributor failed to establish and implement internal controls reasonably designed to prevent the misuse of material, nonpublic information about the Ultra-Short Fund. This article discusses highlights of the SEC's findings along with a related FINRA settlement with the Distributor.

Misleading Comparisons. The Ultra-Short Fund was marketed in sales materials as a cash alternative that provided a higher yield with slightly more risk than a money market fund. The SEC found that investors were not adequately informed about the Ultra-Short Fund's relative risks and, more specifically, about possible fluctuations in the Fund's NAV and about differences in the maturities and credit quality of the securities held by the Fund compared to securities held by money market funds. Although the Ultra-Short Fund's prospectus better explained these differences, the prospectus disclosure did not cure the deficiencies in how the Fund was marketed.

Declining NAV. In the summer of 2007, during the unfolding credit crisis, the Ultra-Short Fund's NAV began to decline, and it experienced significant redemptions. The SEC found that the Adviser and Distributor made inaccurate statements and omissions regarding the Ultra-Short Fund's redemption activity by stating that the Fund was selling securities to raise cash to capitalize on investment opportunities in the current market environment and to meet redemptions and that the Fund's short maturity structure mitigated price erosion experienced by some of the Fund's peers. The Adviser and Distributor held a series of conference calls and issued written materials to investors and their financial advisors stating that the decline in the Ultra-Short Fund's NAV represented unrealized, rather than realized, losses. The Ultra-Short Fund's lead portfolio manager misled investors by understating the Fund's outflows as "minimal" when the Fund had sold over $2 billion in assets to satisfy redemption requests.

Ultra-Short Fund's Weighted Average Maturity ("WAM"). During 2006-2007, the SEC found that the Adviser and Distributor substituted the Ultra-Short Bond Fund's duration for its WAM in certain marketing materials and in an annual shareholder report filed with the SEC. During the relevant period, the Ultra-Short Fund's duration was less than its WAM. The Adviser and Distributor did not make this substitution for any other affiliated fund. In some instances, the replacement figure was footnoted to indicate that it represented duration, but in various sales materials and one filing with the SEC, the footnote was omitted. In addition, the Adviser and Distributor fixed the Ultra-Short Fund's duration in the various listings at 0.5 when it in fact fluctuated between 0.4 and 0.6.

Deviation from the Funds' Concentration Policies. Each Fund's registration statement disclosed that it would not concentrate more than 25% of its assets in any industry and identified non-agency MBS as an industry. Pursuant to Section 13 of the Investment Company Act of 1940, as amended (the "1940 Act"), any change in the concentration policy would require shareholder approval. The SEC found that by early 2006, the Ultra-Short Fund, at the Adviser's direction, exceeded its concentration limit; the Fund also mischaracterized non-agency MSB securities held by the Fund in SEC filings thereby disguising the deviation from its concentration policy. The Adviser then sought and received from the Fund's board of trustees approval of a concentration policy change that reclassified non-agency MBS so that they were no longer an industry. No shareholder approval of these changes was sought. The Total Market Bond Fund subsequently increased its investment in non-agency MBS above 20% of the Fund's assets, and the Ultra-Short Fund increased its investment in non-agency MBS to 50% of assets. The SEC also found that the Funds had failed to follow the proper procedure for disclosing the change in policy in their registration statement filings. The revised concentration policies were disclosed in a filing pursuant to Rule 485(b) under the Securities Act of 1933 (the "1933 Act"), which is available, with respect to changes in substantive content, only if the filer is providing certain financial information or information about portfolio managers, or making non-material changes. The SEC found that the concentration policy change was material and consequently the Funds' filing should have been made pursuant to Rule 485(a) under the 1933 Act; the SEC staff typically reviews Rule 485(a) filings.

Misuse of Material Nonpublic Information. Neither the Adviser nor the Distributor had adequate policies in place to prevent the misuse of material nonpublic information about the Fund, taking into consideration the nature of their businesses. The SEC found that the Adviser and Distributor failed to maintain appropriate information barriers concerning nonpublic and potentially material Fund information. The Adviser and Distributor did not have policies in place to review redemptions of Fund shares by all their personnel and the funds they sponsored for compliance with the general policy. Although certain personnel, including the Ultra-Short Fund's portfolio managers, had to obtain pre-approval of their redemptions of Fund shares, there was no policy requiring pre-approval of redemptions of Fund shares by other personnel of the Adviser and Distributor whose duties provided them with material nonpublic information about the Ultra-Short Fund, and there were no specific policies and procedures governing redemptions by portfolio managers who managed affiliated funds of funds. Consequently, an affiliated charitable fund and several affiliated funds of funds were able to redeem their shares of the Ultra-Short Fund during its decline based on material nonpublic information.

Violations. The SEC found that: (i) the Adviser and Distributor willfully violated Sections 17(a)(2) and (3) of the 1933 Act in connection with the misleading statements and willfully aided and abetted and caused violations of Section 34(b) of the 1940 Act; (ii) the Adviser willfully violated the anti-fraud provisions of Section 206(4) of the Advisers Act of 1940 (the "Advisers Act") and Rule 206(4)-8 thereunder for its misleading statements; (iii) the Fund's trust willfully violated Section 13(a) of the 1940 Act by violating the Funds' concentration policy, and the Adviser aided and abetted and caused the violation; and (iv) the Distributor violated Section 15(g) of the Securities Exchange Act of 1934 and the Adviser violated Section 204A of the Advisers Act by failing to establish, maintain and enforce adequate written policies and procedures to prevent the misuse of material nonpublic information.

Penalties. Without admitting or denying the SEC's allegations or findings, the Adviser and the Distributor agreed to pay a total of $118,994,996, including $52,237,149 in disgorgement of fees by the Adviser, a penalty by the Adviser of $52,237,149, a penalty of $5 million by the Distributor and prejudgment interest of approximately $9.2 million. The Adviser, Distributor and the Funds also consented to an SEC order requiring them to cease and desist from committing or causing future violations of the federal securities laws. The SEC order requires them to comply with certain undertakings, including correction of all disclosures regarding the Funds' concentration policies. In addition, the SEC censured the Adviser and Distributor, and required them to retain an independent consultant to review and make recommendations about their policies and procedures to prevent the misuse of material nonpublic information.

FINRA Settlement. FINRA concurrently announced its settlement with the Distributor, requiring it to pay $18 million for improper marketing of the Fund, including misleading statements and material omission of information about the Fund.

SEC Complaint Against Former Lead Portfolio Manager of Ultra-Short Fund and Former Adviser President. The SEC also filed a separate complaint based on the same underlying facts against (a) the former lead portfolio manager of the Ultra-Short Fund, who also formerly served as the chief investment officer of the fixed income funds sponsored by the Adviser, and (b) the former president of the Adviser, who was also a trustee of the Ultra-Short Fund and is currently an executive vice president of the Distributor, alleging similar securities law violations as well as scienter-based claims.

ICI Files Comment Letter on President's Working Group Reform Options for Money Market Funds

On January 10, 2011, the Investment Company Institute (the "ICI") filed a detailed letter (the "ICI Letter") with the SEC commenting on the October 2010 Report of the President's Working Group on Financial Markets on Money Market Fund Reform Options (the "Report"). The Report was discussed in the November 2, 2010 Alert. The ICI Letter strongly endorses the option to establish a private liquidity facility (the "Liquidity Facility") for money market funds ("MMFs") to support MMFs' liquidity needs, particularly in times of market turmoil. In the ICI Letter, the ICI reiterates its objection to requiring a MMF to float its net asset value ("NAV") and, in general, states its objection to the other reform options in the Report. The ICI Letter provides a detailed description of the mechanics and funding of the Liquidity Facility.

The Liquidity Facility would be formed as a state-chartered bank or trust company initially capitalized by member funds and their sponsors. It would only be available to prime MMFs (i.e., MMFs other than tax-exempt, government or Treasury MMFs), and all prime MMFs would be required to participate in the Liquidity Facility. Under normal conditions, the Liquidity Facility would generally invest in U.S. Treasury and agency bills. However, during times of unusual market distress, the Liquidity Facility could purchase high-quality, short-term securities at amortized cost from prime MMFs, allowing MMFs to meet redemption requests while maintaining a stable $1.00 NAV even if markets for certain holdings were frozen. The ICI believes that the Liquidity Facility would "help protect the broader money market by allowing funds to avoid the need to sell portfolio instruments into a challenging market." The ICI Letter and accompanying Appendix provide details on, among other things, the permissible assets and asset concentration limits of the Liquidity Facility during normal and "liquidity operations" conditions.

A MMF could access the Liquidity Facility only if it demonstrated a liquidity need after exhausting a substantial portion of the large liquidity buffer each MMF must maintain under SEC rules implemented in 2010. In addition, a MMF that had already "broken the buck" would not be able to access the Liquidity Facility. Moreover, the ICI Letter imposes a number of specific conditions with respect to the creation of the Liquidity Facility. In particular, as referenced above, the ICI reiterated its opposition to a floating NAV requirement, noting that MMFs' ability to continue to maintain a stable $1.00 NAV is a condition to the creation of the Liquidity Facility. The ICI Letter also describes other conditions pertaining to the cost of the Liquidity Facility and the interplay with bank regulatory requirements for banks that sponsor money market funds.

The Liquidity Facility would be capitalized through a combination of (1) initial contributions from each sponsor of a MMF participant in the Liquidity Facility, with the amount of each sponsor's contributions based on its sponsored MMFs' assets under management provided that no sponsor would contribute more than 4.9% of the Liquidity Facility's initial capital or less than $250,000, and (2) ongoing commitment fees from participating MMFs. The ICI Letter indicates that the initial commitment fee would be for 3 basis points per year on the MMF's assets under management. The ICI Letter also indicates that this fee rate could be increased as yields on MMF instruments increase and discusses the anticipated capacity of the Liquidity Facility over various time periods. In its third year, the Liquidity Facility would begin to issue time deposits (e.g., certificates of deposits) to third parties to further build its capacity. These time deposits would be designed to be "eligible securities" for purchase by MMFs. The Liquidity Facility would also have access to the Federal Reserve discount window, according to the ICI Letter. The ICI Letter specifically notes that the Liquidity Facility will not provide credit support (e.g., by purchasing distressed instruments); instead, it is intended only to meet the liquidity needs of participating prime MMFs. In this regard, as noted above, the ICI Letter includes limitations on the types of instruments that the Liquidity Facility would purchase, as well as limits on portfolio construction.

The ICI Letter also proposes that the SEC adopt a new rule mandating that intermediaries, such as broker-dealers, provide information to MMFs to facilitate MMFs' ability to comply with "know your investor" requirements.

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