Developments of Note
1. SEC Proposes to Issue Interpretive Guidance Regarding Client Commission Practices
2. Court Schedules Oral Argument in Chamber of Commerce Lawsuit Challenging SEC Mutual Fund Governance Rules
3. FDIC Publishes Article by Staff Member Concerning Effect of New Bankruptcy Amendments on Derivatives and Other Financial Contracts
4. FDIC Issues Guidance Concerning Corporate Codes of Conduct
5. NASD Files Proposal to Extend Due Date for Initial Annual Report and Annual Certification
6. FRB Issues Second Regulation Z Notice of Proposed Rulemaking
7. NASD Issues Amendments to Broker-Dealer Branch Office Definition
Other Item of Note
8. Goodwin Procter and RMA to Conduct Webinar on Basel IA
Developments of Note
SEC Proposes to Issue Interpretive Guidance Regarding Client Commission Practices
The SEC issued a release proposing a statement of interpretive position (the "Proposed Interpretive Statement") that interprets the scope of "brokerage and research services" within Section 28(e) of the Securities Exchange Act of 1934, as amended ("Section 28(e)"). The Proposed Interpretive Statement (i) interprets the scope of the safe harbor under Section 28(e), which allows money managers to use client commission dollars (i.e., "soft dollars") to pay for research and brokerage services without breaching their fiduciary duties to clients, (ii) reminds industry participants of the statutory requirement that money managers make a good faith determination that commissions paid are reasonable in relation to the value of the products and services provided by broker-dealers ("BDs") in connection with the managers’ fiduciary responsibilities to the advisory accounts over which they exercise investment discretion (the managers’ "Advisory Accounts"), and (iii) reiterates that BDs must be financially responsible for the brokerage and research products they provide to money managers as well as be involved in "effecting" the securities transactions. The comment period for the Proposed Interpretive Statement expires 30 days after its publication in the Federal Register.
The Proposed Interpretive Statement suggests the following specific guidelines in interpreting the scope of the safe harbor:
- the eligibility of brokerage and research services for safe harbor protection is governed by Section 28(e)(3), consistent with the standard that any such brokerage and research services provide "lawful and appropriate assistance to the money manager in the performance of his or her investment decision-making responsibilities" (the "lawful and appropriate assistance standard");
- "research services" within the safe harbor are restricted to "advice," "analyses" and "reports" within the meaning of Section 28(e)(3), which advice, analyses or reports (i) are required to reflect an expression of reasoning or knowledge ("substantive content") related to the money manager’s exercise of investment discretion over Advisory Accounts and (ii) may be original research or a synthesis, analysis or compilation of the research of others;
- "brokerage services" within the safe harbor include those products and services that relate to the execution of the trade from the point at which the money manager communicates with the BD for the purpose of transmitting an order for execution through the point at which funds or securities are actually delivered or credited to the Advisory Account or the Advisory Accountholder’s agent; and
- in the case of products or services that serve functions both related and unrelated to the investment decision-making process ("mixed-use items"), the mixed-use items must be reasonably allocated between eligible (within the safe harbor) and ineligible (outside of the safe harbor) uses, and such allocation must be documented such that the money manager is able to make the required good faith determination of the reasonableness of commissions in relation to the value of brokerage and research services provided (either in terms of the particular transaction or in terms of the money manager’s overall responsibilities for discretionary accounts).
The analysis of whether a particular product or service falls within the safe harbor usually involves three steps under the Proposed Interpretive Statement. First, the money manager must determine whether the product or service is an eligible research or brokerage product or service under the safe harbor. Second, the money manager must determine whether the eligible product or service provides lawful and appropriate assistance in the performance of his or her investment decision-making responsibilities. Third, the money manager must make a good faith determination that the amount of client commissions paid is reasonable in light of the value of products or services provided to the money manager by the broker-dealer.
The Proposed Interpretive Statement also provides that third-party research and commission-sharing arrangements can fall within the Section 28(e) safe harbor when (i) the broker-dealer receiving commissions actually provides the brokerage and research services, i.e., the broker-dealer has the direct legal obligation to pay for the services (the "provided by" element), and (ii) the broker-dealer receiving commissions is involved in effecting the trade, i.e., the broker-dealer plays a role in effecting the securities transactions beyond the mere provision of research services to money managers (the "effecting securities transactions" element).
Court Schedules Oral Argument in Chamber of Commerce Lawsuit Challenging SEC Mutual Fund Governance Rules
The U.S. Court of Appeals for the District of Columbia Circuit (the "Court") issued an order scheduling oral argument for January 6, 2006 in the lawsuit by the U.S. Chamber of Commerce (the "Chamber") challenging the SEC’s adoption of certain additional governance requirements for registered investment companies ("funds") in June 2004. (The governance requirements in question mandate that 75% of each fund’s board be independent and that each fund’s board have an independent chairman in order for the fund to rely on certain widely used exemptive rules under the Investment Company Act of 1940, as amended.) The Court had earlier stayed the January 16, 2006 compliance date for the contested fund governance requirements pending its review of the Chamber’s challenge. The timing of the oral argument and uncertainties regarding the timing or nature of any final decision by the Court present challenges for those funds’ boards that have decided to delay taking action to implement the governance requirements pending the outcome of the Chamber’s challenge to these requirements. If the Court quickly reaches a decision to reject the Chamber’s challenge and lifts the stay, funds may be subject to the original January 16, 2006 compliance date. However, the compliance date remains postponed if the Court does not reach its decision before January 16, 2006. In addition, the Court or the SEC could extend the compliance date, even if the Court upholds the governance requirements. Finally, the Court could strike down the requirements or send the matter back to the SEC for reconsideration. (For more on the Chamber’s challenge, see the June 21, 2005, June 28, 2005, July 5, 2005 and August 23, 2005 editions of the Alert.)
FDIC Publishes Article by Staff Member Concerning Effect of New Bankruptcy Amendments on Derivatives and Other Financial Contracts
The financial contracts provisions of the bankruptcy reform legislation, which became effective on October 17, 2005, are the subject of a new article by a member of the FDIC staff entitled "Adjusting the Rules: What Bankruptcy Reform Will Mean for Financial Market Contracts." The article discusses the special treatment in bankruptcy proceedings and FDIC receiverships of securities contracts, forward contracts, repurchase agreements, and swap agreements (collectively defined in the FDIC legislation as "qualified financial contracts" and often referred to as "QFCs"). To reduce systemic risk to the financial markets, counterparties to QFCs may "terminate and net their exposures and liquidate . . . pledged collateral to protect them from losses that could result . . . if the counterparties were subject to lengthy insolvency proceedings." The article states that the four key achievements of the bankruptcy code amendments in this area are:
- They "harmonize the key statutes governing the insolvency of financial market participants," providing market participants with greater certainty in managing risk. Prior to the amendments, the Bankruptcy Code and Federal Deposit Insurance Act ("FDI Act") diverged substantially in their treatment of QFCs with insolvent financial institutions.
- They "update and expand the definitions of the protected contracts to accommodate developments in the marketplace" -- for example, by clarifying that repurchase transactions can qualify as securities contracts (and thus will be QFCs) even if they do not satisfy the Bankruptcy Code’s definition of "repurchase agreement."
- They "expand the availability of cross-product netting under the FDI Act and the Bankruptcy Code" by providing that "master netting agreement participants" are entitled to exercise close-out netting rights under certain circumstances. Close-out netting is described as the ability to terminate a financial contract, determine the net amount due, and liquidate any collateral that has been pledged under the financial contract.
- They "clarify the powers of the FDIC as conservator or receiver for a failed bank" to repudiate or transfer QFCs within one business day of the failure to another financial institution, again providing market participants with greater certainty and the FDIC with flexibility in exercising its powers as a receiver.
Although not highlighted in the article, the Bankruptcy Code amendments did make a substantive change in the procedures for FDIC receiverships. Previously, counterparties to a QFC with a bank in an FDIC receivership could not exercise default rights with respect to any type of default prior to the close of business on the business day following appointment of the receiver. Under the amendments, the one-day delay is limited to defaults based on ipso facto clauses—those based on insolvency or the appointment of the FDIC as a receiver.
The bankruptcy reform legislation including the financial contract provisions were the subject of a special issue of the Alert issued on April 21, 2005.
FDIC Issues Guidance Concerning Corporate Codes of Conduct
The FDIC issued a Financial Institution Letter (FIL – 105 – 2005, the "FIL") in which it reminds financial institutions ("FIs") of the importance of adopting an effective, written, internal corporate code of conduct or ethics policy (the "Code"). The Code, states the FDIC, should cover the entire organization, including all subsidiaries and business activities engaged in by the FI. The FIL states that the Code should convey the message that the FI’s Board believes that "integrity and ethical values of the highest standard should be maintained" by the FI. Furthermore, the Code should reflect the FI’s Board’s clear expectations as to acceptable business practices and prohibited conflicts of interest. At a minimum, the Code should address: (1) safeguarding confidential information; (2) ensuring the integrity of records; (3) providing strong internal control over assets; (4) providing candor in dealing with auditors, examiners and legal counsel; (5) avoiding self-dealing and other conflicts of interest and limitations on acceptance of gifts and favors; (6) observing applicable laws and regulations (including, among others, management interlock restrictions, limits on extensions of credit to FI insiders and limits on golden parachute and indemnification payments); (7) employment background checks; (8) involving internal auditors in monitoring compliance with the Code; (9) establishing a hot line or other mechanism for the repotting of questionable activity; (10) penalties for violating the Code; (11) providing periodic training and acknowledgment of the Code; and (12) periodically updating the Code to reflect new business activities and changes in law and regulation.
NASD Files Proposal to Extend Due Date for Initial Annual Report and Annual Certification
The NASD filed with the SEC a proposed rule change to amend NASD Rules 3012, 3013 and IM-3013. Rule 3012 requires that NASD members submit to their senior management no less than annually a report detailing (1) their supervisory controls systems that test and verify the adequacy of their supervisory procedures, (2) their summary of test results, and (3) any additional or amended supervisory procedures created in response to the test results. Rule 3013 and IM-3013 require the chief executive officer of NASD member firms to certify annually that the member has in place "processes" to establish, maintain, test, and modify its written supervisory procedures. The processes should be evidenced in a report that, pursuant to IM-3013(3), the CEO and the Chief Compliance Officer review before the CEO executes the annual certification.
As proposed, the due dates would be revised as follows:
- Rule 3012: extend report deadline from January 31, 2006 to April 1, 2006; and
- Rule 3013 CEO and IM-3013 Report: extend report and certification deadline from December 1, 2005 to April 1, 2006.
If the April 1, 2006 deadline becomes effective, members electing to wait until the deadline should ensure their initial report covers the period from January 31, 2004 up to the submission date in the initial report. Each subsequent report must encompass the 12 months following the date of the initial report. The NASD filed the proposed rule change for immediate effectiveness and has requested that the SEC waive the 30 day period for the rule change to become operative in order to allow NASD members as much time as possible to adjust their procedures to the new dates being proposed.
FRB Issues Second Regulation Z Notice of Proposed Rulemaking
The FRB issued a second advance notice of proposed rulemaking ("ANPR") concerning the open-end credit rules of Regulation Z, which implements the federal Truth in Lending Act ("TILA"). This second ANPR, which adds 49 questions to the initial ANPR issued in December 2004, solicits public comments with respect to the manner in which the FRB should implement amendments to TILA made by the recent changes to the Bankrupty Code (as reported in the April 21, 2005 Alert). These TILA amendments require new open-end credit disclosures in the areas of minimum payments, introductory rates, late fees, credit card solicitations over the Internet, and both open- and closed-end high loan-to-value ratio home equity loans. These amendments also restrict the termination of open-end credit accounts due to inactivity. Comments must be received by the FRB no later than December 16, 2005.
NASD Issues Amendments to Broker-Dealer Branch Office Definition
The NASD issued Notice to Members 05-67 ("NTM 05-67") announcing the effective date of amendments to the definition of branch office in NASD Rule 3010 and the adoption of interpretative material ("IM-3010-1") to provide NASD members with guidelines on factors to be considered in conducting internal inspections of offices. The NASD has revised the branch office definition as part of a coordinated effort by regulators in conjunction with the development of a new centralized branch office registration system. The NYSE’s new branch office definition became effective on September 9, 2005 upon approval by the SEC. The NASD definition will become effective on May 1, 2006. It is up to each individual U.S. jurisdiction to adopt the new definition on its own timetable.
The New Definition of Branch Office.
As it has been revised, the NASD and NYSE define the term branch office to mean any location where one or more associated persons of a member regularly conduct the business of effecting any transactions in, or inducing or attempting to induce the purchase or sale of any security, or any location which is held out as such. This definition is substantially identical to the definition of "office" in SEC Rules 17a-3 and 17a-4. The definition provides for certain limited exclusions (e.g. primary residences (subject to certain conditions), offices of convenience, non-sales/back office not held out to the public, the floor of a national securities exchange); however, any location that is responsible for supervising the activities of associated persons at one or more "non-branch locations" is considered to be a branch office.IM-3010-1 and Related NYSE Information.
NTM 05-67 also announced the adoption of new interpretative material, IM-3010-1, that provides guidelines for the internal inspection of offices. The guidelines state that a firm’s written supervisory procedures should take into consideration, among other things, the firm’s size, organizational structure, scope of business activities, number and location of offices, the nature and complexity of products and services offered, the volume of business done, the number of associated persons assigned to a location, whether there is a principal on-site, whether the office is a non-branch location, and the disciplinary history of associated persons. In addition IM-3010-1 provides that the procedures established and the reviews conducted must ensure that the quality of supervision at remote offices is sufficient to assure compliance with applicable securities laws and regulations and NASD rules, and that a member must be especially diligent in establishing procedures and conducting reviews of non-branch locations. The NYSE in IM 05-74, though noting that business locations that are exempt from registration as branch offices are not subject to annual inspection requirements, cautioned that the supervisory procedures for such locations should include criteria to determine the appropriateness of on-site "for cause" reviews to ensure compliance and utilize risk-based techniques. The NYSE cited essentially the same factors to consider when developing supervisory procedures as the NASD did in IM-3010-1.Other Item of Note
Goodwin Procter and RMA to Conduct Webinar on Basel IA
The comment period for the Advance Notice of Proposed Rulemaking on Basel IA (discussed in the October 11, 2005 issue of the Alert) will run through January 18, 2006. Goodwin Procter has partnered with the RMA to conduct a webinar on the specifics of Basel IA and its practical implications. The webinar will take place on Friday, November 4, 2005 from Noon - 1:30 EST. For more information, please contact us by e-mail at: [email protected]
Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.
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