Schapiro Steps Down; Money Market Reform Steps Up
Elisse Walter to Serve as Chairman.Mary Schapiro announced on November 26, 2012 that she would be
resigning as Chairman of the SEC. President Obama quickly named
Elisse Walter, an SEC commissioner since 2008, as the new Chairman.
Unless the Senate reapproves her position, however, Chairman Walter
may only serve through December 2013, sparking speculation as to
who will be her successor. Ms. Schapiro retired on December 14,
2012 after serving as the agency's head since January 2009 and
as the first woman to lead the agency on a permanent basis.
SEC Debates on Money Market Reform Continue. While
at the SEC, Ms. Schapiro spent a considerable amount of her time
focusing on money market fund (MMF) reform, an issue that has been
heating up over the past several months. In August 2012, Ms.
Schapiro informed the public that three of her fellow commissioners
would not support her efforts to reform MMF rules, forcing her to
table any proposed rulemaking. While MMF sponsors celebrated for a
moment, in September 2012, Treasury Secretary Timothy Geithner
wrote a letter to the Financial Stability Oversight Council (FSOC)
asking the council to formally request that the SEC enact new rules
governing MMFs. Additionally, in December 2012, Commissioner
Aguilar changed his view and publicly stated that he would not
oppose a proposal that requires MMFs to float their NAV.
FSOC Authority. The Dodd-Frank Act provides FSOC
with the authority to identify risks and respond to emerging
threats to the financial stability of the United States. Further,
FSOC has the authority to issue recommendations to "the
primary financial regulatory agencies to apply new or heightened
standards and safeguards. . . for a financial activity or practice
conducted by . . . nonbank financial companies . . . if the council
determines that . . . such activity or practice could create or
increase the risk of liquidity [or credit among the] financial
markets of the United States." Under this authority, Secretary
Geithner asked FSOC to make the determination that the MMF
industry, in its current form, increases liquidity and credit risk
in the financial markets and, subsequently upon that determination,
to present the SEC with recommendations on MMF reform pursuant to
its power under Dodd-Frank.
Following the Lead. In response to Secretary
Geithner's letter, the U.S. Chamber of Commerce urged him to
withdraw the request. The Chamber of Commerce stated that the
process Secretary Geithner recommended "would only repeat or
exacerbate the flawed approach the SEC has taken [on MMFs] over the
past year."
Nonetheless, on November 13, 2012, FSOC unanimously voted to
publish its proposed recommendations for MMF reform and requested
public comment on the following three recommendations:
Floating NAV. Require MMFs to have a floating net asset
value (NAV), which is currently fixed at $1.00, that would reflect
the actual market value of the underlying portfolio
securities.
Stable NAV with NAV Buffer and "Minimum Balance at
Risk." Require MMFs to have an NAV buffer of a tailored
amount of assets of up to 1% of the value of the fund's
portfolio securities. Also require that 3% of a shareholder's
highest account value over $100,000 during the previous 30 days
(minimum balance at risk or MBR) be available for redemption after
30 days of being in a "first loss" position.
Stable NAV with NAV Buffer and Other Measures. Require
MMFs to have an NAV buffer of a tailored amount of assets of up to
3% of the value of the fund's portfolio securities combined
with other measures to improve the buffer and increase MMF
resiliency.
Although the proposals may not be novel to the commissioners,
FSOC's action could force the SEC into unchartered
territory.
Next Steps. The 60-day comment period for the
proposed recommendations is scheduled to end in mid-January. Once
the comment period closes, FSOC would then have to issue a final
recommendation. FSOC stated, however, that it will not issue a
final recommendation if the SEC moves forward with
"meaningful" structural reforms. Nonetheless, if FSOC
does issue a final recommendation, the Dodd-Frank Act would force
the SEC into action. Under Dodd-Frank, the SEC must: (1) adopt the
recommendation of FSOC; (2) implement similar standards that FSOC
deems acceptable; or (3) within 90 days of the issuance, explain to
FSOC in writing why the SEC is unwilling to follow the
recommendation. In the event that the SEC accepts FSOC's
recommendations, the SEC would then need to issue proposed rules
subject to another public comment period.
SEC at Work. While Secretary Geithner and FSOC
were hard at work proposing these recommendations, the SEC was
conducting the MMF study that commissioners Luis Aguilar, Troy
Paredes and Dan Gallagher had previously requested in August 2012.
On December 5, 2012, the SEC released that study, which found that
while MMFs under the 2010 reforms are "more resilient now to
both portfolio losses and investor redemptions than they were in
2008," no MMF would have endured the losses that the Reserve
Primary Fund suffered in 2008 without breaking the buck. The study
did concede the conclusion that, assuming MMFs are using the
maximum weighted average maturity of 60 days, which the 2010
reforms decreased from 90 days, MMFs' probability of breaking
the buck has declined. The study's analysis of increased
transparency in MMFs, however, was inconclusive. Finally, the study
examined the effect that the potential reforms would have on
investor redemptions in MMFs, indicating that investors may shift
some assets into unregulated investments or private funds with
stable NAVs. The study reported that its findings were favorable
for financial companies, who "are well suited to identify
alternate mechanisms for short-term financing," and
municipalities, who should not encounter difficulties in managing
their debt financing "given other structural shifts in the
market for these types of securities."
Given the lack of precedence on this topic and the economic impact
these proposals may have on the MMF industry, a court challenge of
the FSOC recommendations is likely.
Sources: Reuters: U.S. Treasury Weighs Money
Fund Reforms, Faces Hurdles (Aug. 23, 2012); U.S. Government
Accountability Office Report to Congressional Requesters (Sept.
2012); Financial News: Geithner Asks FSOC to Urge Action on Money
Funds (Dec. 7, 2012); U.S. Chamber of Commerce Correspondence (Nov.
5, 2012); Ignites: Chamber: FSOC Too Quick to Intervene (Nov. 6,
2012); Ignites: FSOC Ready to Take Up Money Fund Reforms (Nov. 9,
2012); Securities Regulation & Law Report: Chamber Asks
Geithner to Withdraw Request for FSOC Recommendation on Money Funds
(Nov. 12, 2012); Bloomberg Business Week: Walter to Become SEC
Chairman After Schapiro Steps Down (Nov. 26, 2012); U.S. Department
of the Treasury: Financial Stability Oversight Council Releases
Proposed Recommendations for Money Market Mutual Fund Reform (Nov.
13, 2012); The New York Times: As Official Drops Out, SEC Race
Shifts (Nov. 28, 2012); Ignites: SEC Staff: 2010 Reforms No
Cure-All (Dec. 6, 2012).
CFTC Rule 4.5 Withstands Litigation Challenges
In 2012, the Commodity Futures Trading Commission (CFTC) adopted amendments to Rule 4.5 under the Commodity Exchange Act that narrow the available exclusions from the definition of a commodity pool operator (CPO). See "CFTC Rescinds and Narrows Registration Exemptions for Funds" in our April 2012 update.
The CFTC amendment prompted the Investment Company Institute
(ICI) and the U.S. Chamber of Commerce (collectively, the
plaintiffs) to join forces in arguing that the CFTC did not
adequately follow the rules under the Administrative Procedures Act
in amending Rule 4.5. See "ICI and U.S. Chamber of
Commerce File Lawsuit Regarding CFTC Rule Amendments" in our
July 2012 update.
On June 18, 2012, the CFTC filed a motion for summary judgment. In
its July 2, 2012 response to the summary judgment motion, the
plaintiffs argued that while the CFTC relied on the Dodd-Frank Act
and the 2008 financial crisis to justify its rule amendment, the
Dodd-Frank Act did not require the rule amendment at issue, and the
financial crisis does not justify investment company regulation.
The plaintiffs further argued that the CFTC did not undertake an
analysis of existing investment company regulation but, instead,
formulated a rule that expands the regulation of entities that are
already subject to SEC and FINRA regulation.
On December 13, 2012, D.C. District Court Judge Beryl Howell
dismissed the plaintiffs' suit and held that the CFTC
adequately conducted a cost-benefit analysis in amending Rule 4.5
and that the CFTC's reasoning was not arbitrary and capricious.
Judge Howell further explained that it is not the court's role
to second-guess the CFTC's analysis. In refuting the
plaintiffs' argument that the rule subjects certain entities to
dual regulation by the SEC and the CFTC, the court explained that
the SEC itself actually admitted that it has not efficiently
regulated entities that invest in derivatives.
On December 27, 2012, the plaintiffs filed a brief notice with the
court indicating that they intend to appeal the court's ruling
but did not disclose on what grounds they intend to file the
appeal. Nonetheless, because of the timing, this ruling confirms
that mutual funds unable to meet the amended Rule 4.5 exemption
from CPO registration must have registered with the CFTC by
December 31, 2012.
Sources: ICI and Chamber of Commerce
Memorandum in Response to CFTC's Cross-Motion for Summary
Judgment (July 2, 2012); ICI Heads to Court with CFTC (Oct. 5,
2012); CFTC's Notice of Clarification Regarding the Alternate
Net Notional Test and Submission of Citation (Oct. 15, 2012);
Ignites: Funds Fight, Prepare for Commodity Regs Simultaneously
(Oct. 19, 2012); ICI and Chamber of Commerce's Supplemental
Submission in Response to the Court's Inquiry Concerning the
Definition of "Bona Fide Hedging" (Oct. 22, 2012);
Ignites: CFTC Beats Back ICI-Chamber Suit (Dec. 13, 2012).
SEC Charges Mutual Fund Directors for Failure to Oversee Asset Valuation
The SEC Enforcement Division's Asset Management Unit
continues to prioritize asset valuation investigations. Most
notably, the SEC recently brought charges against eight former
Morgan Keegan mutual fund board members for allegedly violating
their fair valuation responsibilities under the federal securities
laws. According to the SEC, the Morgan Keegan board delegated its
fair valuation responsibility to a valuation committee without
providing meaningful substantive guidance on how fair valuation
determinations should be made. The SEC alleged that the fund
directors then made no meaningful effort to learn how fair values
were being determined, received only limited information about the
factors involved with the funds' fair value determinations, and
obtained almost no information explaining why particular fair
values were assigned to portfolio securities. The SEC asserted that
the directors' failure to fulfill their fair value-related
obligations was particularly inexcusable given that fair-valued
securities made up the majority of the funds' net asset values
-- in most cases more than 60 percent.
The SEC previously charged the funds' accountant and adviser,
Morgan Keegan & Company and Morgan Asset Management,
respectively, for fraudulently overstating the value of securities
backed by subprime mortgages. Without admitting or denying the
SEC's allegations, Morgan Keegan paid $200 million to settle
the 2010-2011 enforcement action.
Valuation Procedures. The funds' valuation
procedures listed various factors for the valuation committee to
consider when making fair value determinations. These factors
included fundamental analytical data relating to the investment,
the nature and duration of restrictions on disposition, market
influences, the type of security, the issuer's financial
statements, the cost of the security on its purchase date, the size
of the holding and other various factors specifically relating to
restricted securities. The SEC asserted that the factors were
copied nearly verbatim from the SEC's Accounting Series Release
No. 118. According to the SEC, other than listing these factors,
the valuation procedures did not provide any specific guidance on
how to actually implement these factors in making the fair value
determinations or how to evaluate whether specific factors were
appropriate for a given security. Moreover, the directors did not
provide any guidance beyond the insufficient valuation
procedures.
The funds' valuation procedures required that the directors
receive explanatory notes for the fair values assigned to
securities. However, the SEC alleged that no such notes were ever
provided to the directors, and they never followed up to request
such notes or any other specific information about the basis for
the assigned fair values.
Determining Fair Value. The SEC alleged that fund
accounting assigned fair values without using any reasonable
analytical method to ensure a fair value. Instead, they typically
set the fair value at the security's purchase price and only
changed that value if a subsequent sale or price confirmation
varied more than 5% from the purchase price. If more than a 5%
variance existed, fund accounting allegedly allowed the portfolio
manager to select the fair value. The SEC asserted that the
portfolio manager took advantage of the fact that fund accounting
allowed him to arbitrarily set values without a reasonable basis
and that he did so in a way that postponed the decline in the NAVs
of the funds. The SEC asserts that, as a result, the NAVs of the
funds were materially misstated for five months in 2007.
Shortly after each month end, fund accounting randomly selected and
sought price confirmations for as few as 10% of the funds' fair
valued securities. These price confirmations were essentially
opinions on price from broker-dealers, rather than actual bids or
firm quotes. The SEC noted that the price confirmations were
further lacking because fund accounting requested month end prices
several weeks after the respective month-end -- a process that
would not provide timely price confirmations for the
securities.
Finally, the SEC noted that the funds' valuation procedures did
not include any mechanism for identifying and reviewing fair-valued
securities whose prices remained unchanged for weeks, months and
even entire quarters.
"While it is understood that fund directors typically assign
others the daily task of calculating the fair value of each
security in a fund's portfolio, at a minimum they must
determine the method, understand the process and continuously
evaluate the appropriateness of the method used," said William
Hicks, Associate Regional Director of the SEC's Atlanta
Regional Office.
Sources: SEC Release No. 30300 (Dec. 10,
2012); SEC Charges Eight Mutual Fund Directors for Failure to
Properly Oversee Asset Valuation, Release No. 2012-259 (Dec. 10,
2012).
Audit Committee Annual Evaluation of Independent Auditor
On October 15, 2012, the Independent Directors Council and other
financial organizations, including the Association of Audit
Committee Members, Inc., Center for Audit Quality, Corporate Board
Member/NYSE Euronext, Mutual Fund Directors Forum, National
Association of Corporate Directors and Tapestry Networks, published
an assessment questionnaire to assist mutual fund audit committees
in performing their annual evaluations of a fund's independent
auditor.
Investment company audit committees are responsible for overseeing
the integrity of the company's financial reporting process and
controls and for supervising the independent auditor. In fulfilling
these responsibilities, the audit committee should consider
annually evaluating the independent auditor and reporting the
results of its evaluation to the investment company's board of
directors. The audit committee's evaluation should consider the
qualifications and performance of the auditor, the quality of the
auditor's communications with the audit committee and the
company, and the auditor's independence, objectivity and
professional skepticism. To assist the audit committee in
evaluating these factors, it may use an assessment questionnaire
that highlights the most important areas of consideration.
Assessment Process. In conducting its
assessment, the audit committee should evaluate its experience with
the auditor during the current engagement period. The committee
should also consider the experiences of others within the company,
including management, internal audit and key managers, as
applicable. However, the audit committee should not compile these
observations retrospectively at the end of the year; instead, the
auditor's performance should be continuously evaluated
throughout the audit process.
Quality of Services and Sufficiency of Resources.
To ensure that the independent auditor provides a quality audit,
the audit committee should first assess whether the primary members
of the audit engagement team possess the relevant skills and
experience. Factors to consider include industry, accounting and
auditing knowledge, as well as company-specific financial reporting
risks. The engagement team should also have access to specialists
for unique issues that may arise both domestically and abroad and
should perform a risk assessment for the company at the outset of
the engagement. Finally, the audit committee should understand how
the audit firm complied with and responded to its most recent
inspection by the Public Company Accounting Oversight Board
(PCAOB).
To gain further knowledge about the auditor's services and resources, the audit committee may also consider asking the following questions:
- Did the auditor dedicate adequate resources to the audit?
- Did the auditor ask for feedback on the services provided?
- Was the lead engagement partner accessible?
- Did the risk assessment identify the appropriate risks, including company- and industry-specific risks?
- Did the auditor meet the objective performance criteria?
- Did the auditor appropriately respond to changing circumstances?
- Did the auditor advise the audit committee of its findings or results from the audit in a timely manner?
- Were the audit costs and any intermittent changes to those costs reasonable for the company?
Communication and Interaction with the Independent Auditor. The audit committee must maintain regular and open communication with the independent auditor. While PCAOB standards and SEC rules require certain auditor communications, the auditor should also engage in quality discussions with the audit committee to ensure that the committee understands each stage of the audit process and any significant issues that arise. The following questions may help promote open and productive communications:
- Did the audit engagement partner explain accounting and auditing issues in a professional and understandable manner?
- Did the auditor discuss the company's accounting policies, estimates and judgments and compare them to industry trends?
- Was the auditor sensitive to and professional about inadequate or imperfect internal controls and procedures?
- Does the auditor keep the audit committee up-to-date on leading practices and current developments in accounting principles and auditing standards?
Auditor Independence, Objectivity and Professional Skepticism. To exercise objective judgment and professional skepticism, the auditor must be independent of the investment company complex. In reviewing the company's disclosures, the auditor should evaluate the company's use of estimates and assumptions and question any processes or policies that appear inadequate. Based on this review, the auditor should be able to justify or explain the company's findings and opine on whether the company's financial statements comply with generally accepted accounting principles (GAAP). To ensure independence and oversight, the audit committee may also consider the following questions:
- Did the auditor discuss all independence factors, including exceptions, with the audit committee?
- What safeguards has the audit firm put in place to detect independence issues?
- Did the auditor's perspective conflict with management's perspective on any accounting issues? If so, did the auditor take the lead role to reconcile these views?
For sample questions on each of these topics and an example form
to evaluate your independent auditor, please refer to the white
paper, Audit Committee Annual Evaluation of the External Auditor
cited below.
Sources: Association of Audit Committee
Members, Inc., Center for Audit Quality, Corporate Board
Member/NYSE Euronext, Independent Directors Council, Mutual Fund
Directors Forum, National Association of Corporate Directors and
Tapestry Networks: Audit Committee Annual Evaluation of the
External Auditor (Oct. 2012).
SEC Extends Temporary Rule Regarding Principal Trades with Certain Advisory Clients
The SEC has extended the date on which Rule 206(3)-3T of the
Advisers Act will sunset to December 31, 2014. Rule 206(3)-3T,
adopted in September 2007 on an interim basis, provides investment
advisers that are also registered as broker-dealers with an
alternative means to satisfy Section 206(3) of the Advisers Act,
permitting the broker-dealers to act in a principal capacity in
transactions with certain advisory clients. Under Rule 206(3)-3T,
broker-dealers may sell certain securities held in the proprietary
accounts of their firms that would otherwise not be available on an
agency basis to their advisory clients, yet still protects clients
from conflicts of interest as a result of these transactions.
The Dodd-Frank Act required the SEC to complete a study on the
regulatory requirements applicable to broker-dealers and investment
advisers, including Rule 206(3)-3T. The staff delivered its study
to Congress on January 21, 2011 but the process of reviewing the
recommendations from the study is ongoing, and the SEC did not
believe it would complete its analysis of broker-dealer and
investment advisor regulatory requirements by the rule's
scheduled sunset on December 31, 2012. Further, the SEC believed
that allowing the rule to sunset could limit the access of affected
non-discretionary advisory clients to certain securities and could
require advisory firms to make substantial changes in a short time
period.
Sources: SEC Proposed Rule Release No. IA-3483
(Oct. 9, 2012); SEC Final Rule Release No. IA-3522 (Dec. 20,
2012).
SEC Issues Securities Lending Guidance
On November 6, 2012, the SEC released guidance on securities
lending by open-end and closed-end mutual funds. Under the
Investment Company Act, funds may choose to lend their portfolio
securities to generate additional income provided that their
investment objectives, policies and restrictions authorize such
lending. The release reviewed the objectives and participants in
securities lending transactions, and the SEC staff provided
investment companies with an extensive list of no-action letters
addressing various areas of concern for funds when lending
portfolio securities.
Summary of Securities Lending. Pursuant to a
written agreement between the borrower and the lender, funds
generally lend their portfolio securities to broker-dealers, who
then re-lend them to other market participants. As protection for
the fund, the borrower will post collateral, which typically
consists of cash. The value of the borrower's collateral must
be at least equal to the value of the borrowed securities, and the
borrowed securities' value is marked-to-market daily.
Securities lending may be an attractive source of income for funds
but has come under increased scrutiny due to losses experienced by
some funds during the financial crisis. Because securities lending
raises various issues under the Investment Company Act, the SEC
compiled a list of relevant no-action letters covering common
securities lending issues. Examples of such issues include loan
collateralization, approval of fees, proxy voting and treatment of
collateral. This list of no action letters may prove useful to a
fund navigating the securities lending territory and can be found
on the SEC's website by clicking here.
Sources: SEC Report: Securities Lending by
U.S. Open-End and Closed-End Investment Companies (Nov. 6,
2012).
Last Minute Discussion Over Hedge Fund Advertising Rule
Pursuant to the 2012 Jumpstart Our Business Startups Act (JOBS
Act), Congress directed the SEC to lift advertising bans for hedge
funds, private equity funds and other private offerings. Congress
believed that repealing the advertising restrictions would reduce
the regulatory burden for small businesses and allow them to reach
investors in the private marketplace. The SEC responded by
introducing a proposal in August 2012 that would eliminate the
prohibition against general advertising solicitation and general
advertising in Rule 506 of Regulation D. See our October 2012
update for more information.
Recently released e-mails, however, depict the SEC's hesitation
in approving the final rule. These e-mails indicate that on May 23,
2012, the SEC recommended to the commissioners that they issue an
"interim final rule" in August, which would have
immediately ended the advertising ban. However, on August 29, 2012,
the SEC issued a proposed rule, which requires public comment,
delaying a potential implementation date.
Chairman Walter has echoed this hesitation over the advertising
rule. At a small business capital formation conference, she stated,
"If allowing general solicitation results in increased
incidence of fraud or sale of securities to investors that
don't have the sophistication to understand the risks and
merits of a particular investment, we will have failed not only
investors but small businesses as well." She continued, saying
"[w]e must be vigilant about the potential consequences,
particularly the unintended consequences of a change like this and
consider ways to mitigate potential harms to investors while
preserving the rule's intended effects."
While Chairman Walter did not indicate that she would block the
rule, she has said that she hopes the SEC will consider various
safeguards. The comment period for the proposed rule has ended, and
we are awaiting further SEC action.
Sources: The Wall Street Journal, Market
Watch: Regulator Fears Fraud from Hedge-Fund Ad Rules (Nov. 15,
2012); Reuters: Emails Suggest SEC's Schapiro Delayed JOBS Act
Rule Amid Concerns About Legacy (Dec. 1, 2012); FIN Alternatives,
Hedge Fund & Private Equity News: Speculation Surrounds Hedge
Fund Advertising Rule (Dec. 3, 2012).
FINRA Considering New Disclosure Rules
The Financial Industry Regulatory Authority, Inc. (FINRA) has
collected information about compensation structures at numerous
different brokerage firms, intending to learn more about how
brokers are handling conflicts of interest. After reviewing the
information, FINRA is considering a rule change to increase
transparency in broker recruiting incentives.
The proposed rule would require brokers to disclose recruitment
compensation packages in connection with transferring customer
accounts to the new firm. Often, in changing from one brokerage
firm to another, brokers receive substantial financial incentives,
including signing bonuses, causing speculation that such incentives
may induce registered representatives to change firms. FINRA's
concern is that, in conjunction with their move, brokers may
encourage their clients to open accounts at the new brokerage firm
by promising better securities products. By focusing on new sales
rather than on the client's needs, brokers may overlook their
suitability obligation to their clients, which requires brokers to
focus on client-specific factors such as age and risk tolerance
when recommending investments.
Sources: Reuters: FINRA Reviewing Conflicts of Interest at U.S. Brokerages (Oct. 24, 2012); Investment News: FINRA to Consider New Disclosure Rule (Nov. 28, 2012).
Capital, Margin and Segregation Requirements for
Security-Based Swap Dealers and Major Security-Based Swap
Participants
The SEC has proposed capital and margin requirements for
security-based swap dealers (SBSDs) and major security-based swap
participants (MSBSPs) and segregation requirements for SBSDs
pursuant to Dodd-Frank.
Capital Requirements for SBSDs. The proposed rule
requires SBSDs to calculate (1) the minimum amount of net capital
-- or highly liquid capital -- the SBSD must maintain and (2) the
amount of net capital the SBSD is currently maintaining. Generally,
SBSDs that are not broker-dealers and are not using internal models
must maintain minimum net capital of at least the greater of $20
million or 8% of the firm's risk margin amount. SBSDs that are
broker-dealers and are not using internal models must maintain
minimum net capital of the greater of $20 million or 8% of the
firm's risk margin amount plus the amount that Rule 15c3-1
under the Exchange Act requires.
To compute net capital, an SBSD must make certain net worth
adjustments, including deducting illiquid assets and taking other
capital charges. This calculation results in the "tentative
net capital." The SBSD must then take prescribed percentage
deductions, or "standardized haircuts," from the
mark-to-market value of proprietary positions included in its
tentative net capital. The SEC believes that such standardized
haircuts will help account for market risk inherent in certain
positions and create a liquidity buffer for protection against
other risks in the business. The proposed rule indicates that those
firms using internal models would also be subject to tentative net
capital requirements, in addition to the minimum net capital
amount.
To cover potential future exposure, the proposed rule requires
SBSDs to take capital charges when security-based swap customers
and security-based swap counterparties do not meet certain margin
requirements. Additionally, SBSDs must establish and maintain a
risk management control system.
Capital Requirements for MSBSPs. The proposed rule
requires MSBSPs to maintain a positive tangible net worth, rather
than the net liquid asset test imposed on SBSDs. The MSBSP would
calculate its tangible net worth in accordance with GAAP, excluding
goodwill and other intangible assets, but including assets such as
property, equipment and unsecured receivables.
Margin Requirements. The SEC is proposing to
require SBSDs and MSBSPs to collect collateral from counterparties
to security-based swaps that are not cleared by a registered
clearing agency. This margin requirement would be based on the
margin rules currently applicable to broker-dealers. Under the
broker-dealer margin rules, an accountholder must "maintain a
specified level of equity in a securities account at a
broker-dealer (i.e., the market value of the assets in the account
must exceed the amount of the accountholder's obligations to
the broker-dealer by a prescribed amount)."
SBSD Margin Requirements. To comply with the
margin requirements, SBSDs must perform the following calculations
at the close of each business day for each account carried for a
counterparty: (1) calculate the amount of equity, or current
exposure, in the account; and (2) determine the amount of margin,
or potential future exposure, in the account. Following these
calculations, on the next business day, the SBSD must collect cash,
securities and/or money market instruments from the counterparty in
an amount at least equal to the negative equity, or current
exposure, in the account plus the margin amount.
MSBSP Margin Requirements. Similar to SBSDs,
MSBSPs must make daily calculations as to the amount of equity in
each counterparty's account. On the business day following the
calculation, the MSBSP must collect cash, securities and/or money
market instruments from the counterparty based on a positive equity
calculation. Alternatively, the MSBSP would have to deliver
collateral to a counterparty that had current exposure to the
MSBSP. Unlike SBSDs, however, MSBSPs are not required to calculate
a margin amount.
Segregation. The SEC proposed segregation
requirements for cleared and non-cleared security based swaps to
protect customer property and distinguish it from SBSD property.
For non-cleared swaps, unless the customer requests individual
segregation or waives segregation, the SBSD, by default, must use
an alternative omnibus or "commingled" account for funds
related to non-cleared swaps. Pursuant to the omnibus segregation
requirements, the SBSD must maintain an account exclusively for
security-based swap customers. A separate account ensures that the
cash and qualified securities in the account are identified as
security-based swap customers' property and are isolated from
the SBSD's proprietary assets. The segregation requirements
would also require an SBSD to maintain possession or control of a
customer's "excess securities collateral," or the
securities and money market instruments that have a market value
over the SBSD's current exposure to the customer.
The comment period on the proposed rule is scheduled to close on
January 22, 2013.
Sources: SEC Proposed Rule Release No.
34-68071 (Oct. 18, 2012); Federal News: SEC Agrees to Propose
Capital, Margin and Segregation Requirements for Swap Entities
(Oct. 22, 2012); Investment Company Institute Letter Re: SEC
Proposes Capital, Margin, and Segregation Requirements for
Security-Based Swap Dealers and Major Security-Based Swap
Participants (Oct. 25, 2012); Investment Company Institute Letter
Re: Margin and Capital Requirements for Covered Swap Entities (Nov.
20, 2012).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.