United States: 10th Circuit Affirms District Court Analysis of Broker-Dealer Exemption under Advisers Act as Applied to Broker-Dealer Affiliate of Insurance Company Selling Variable Insurance Product (Part 2 of 2)
(Financial Services Alert - Developments of Note - Part 2)

10th Circuit Affirms District Court Analysis of Broker-Dealer Exemption under Advisers Act as Applied to Broker-Dealer Affiliate of Insurance Company Selling Variable Insurance Product

The U.S. Court of Appeals for the Tenth Circuit (the "Appeals Court") affirmed a district court decision granting summary judgment to an insurance company and its affiliated broker-dealer (collectively referred to as the "company") that were being sued for alleged violations of the Investment Advisers Act of 1940 (the "Advisers Act") in connection with the sale of a variable universal life insurance policy. (The district court decision was discussed in the September 15, 2009 Alert.) The plaintiffs alleged that a sales representative of the company had acted as an investment adviser in recommending that the plaintiffs purchase the policy, and thus the company was subject to the Advisers Act. The plaintiffs further alleged that the company had violated the fiduciary duty it owed to the plaintiffs under the Advisers Act by failing to disclose the conflicts of interest created by the commission structures, fees and other policies that gave the sales representative an incentive to put his own financial interest ahead of the plaintiffs'.

Broker-Dealer Exclusion. The Appeals Court's analysis focused on the whether the investment advisory services provided by the sales representative fell within the broker-dealer exclusion in Section 202(a)(11)(C) of the Advisers Act, which provides that that "any broker or dealer whose performance of [advisory] services is solely incidental to the conduct of its business as a broker or dealer and who receives no special compensation therefor" is not an investment adviser for purposes of the Act. The Appeals Court found that the exclusion applies to "a broker-dealer who provides advice that is attendant to, or given in connection with, the broker-dealer's conduct as a broker or dealer, so long as he does not receive compensation that is (1) received specifically in exchange for the investment advice, as opposed to for the sale of the product, and (2) distinct from a commission or analogous transaction-based form of compensation for the sale of a product. The quantum or importance of the broker-dealer's advice is relevant only insofar as the advice cannot supersede the sale of the product as the 'primary' goal of the transaction or the 'primary' business of the broker-dealer."

Evidentiary Record. The Appeals Court held that the record established that (a) advice was given by the sales representative only in connection with the selling the variable insurance product to the plaintiffs, which was the primary object of the transaction, (b) the compensation paid the sales representative relating to the transaction was for selling the variable insurance product, not for providing investment advice; and (c) the $500 "Production Credit" paid to the sales representative for the sale of the variable insurance product was a traditional, transaction-based commission and thus was not "special compensation." Responding to plaintiffs' argument that an issue of fact sufficient to defeat a motion for summary judgment existed because of the possibility of a link between the advice given by the sales representative and the compensation received, the Appeals Court pointed to the following undisputed facts: (A) the sales representative received compensation only after selling the variable insurance product; (B) the sales representative would have been fired if he did not meet sales goals; and (C) the sales representative gave advice on other occasions without receiving compensation. The Appeals Court found that these facts compelled the conclusion that the sales representative was compensated for selling the variable insurance product, not specifically for rendering advice, and there was no basis for a reasonable jury to conclude otherwise.

The Broader Context. This decision comes against a backdrop of judicial, regulatory and legislative developments over the last several years addressing how broker-dealers and investment advisers should be regulated, particularly where their activities may overlap and in the context of servicing retail customers. As discussed in the April 10, 2007 Alert, a decision of the United States Court of Appeals for the D.C. Circuit, which was cited in both the Appeals Court's and district court's decisions, vacated a 2005 SEC rule that created additional exceptions from the definition of "investment adviser" under the Advisers Act for certain fee-based and discount brokerage programs. In conjunction with its adoption of the vacated rule, the SEC had also begun examining how it might improve its oversight and regulation of broker-dealers and investment advisers to better reflect current industry practices and investor perceptions. This effort has resulted in a RAND Corporation report on investor and industry perspectives on investment advisers and broker-dealers (as discussed in the January 8, 2008 Alert). More recently, in response to a mandate in the Dodd-Frank Act, the SEC has delivered a study to Congress recommending that broker-dealers and investment advisers be subject to a uniform fiduciary standard of conduct in providing personalized investment advice about securities to retail investors, and that the standard be no less stringent than that currently applied to investment advisers (as discussed in the January 25, 2011 Alert).

Agencies Propose Rules to Conform Reporting Requirements of OTS-Regulated Savings Associations and Loan Holding Companies with those of FDIC- and FRB-Regulated Institutions

Savings and Loan Associations to File Call Reports in Lieu of the TFR. The OCC, FRB, FDIC and OTS (together, the "Agencies") issued a notice of proposed rulemaking (the "Proposed Rule") to require savings associations currently filing the Thrift Financial Report ("TFR") with the OTC to instead file Consolidated Reports of Condition and Income ("Call Reports") with the OCC and FDIC. The conversion would take place beginning with the reporting period ending on March 31, 2012; savings associations are to continue to file the TFR through December 31, 2011. The change is the result of the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") dissolving the OTS and transferring all functions relating to federal savings associations, and rulemaking authority for all savings associations to the OCC, and non rule-making functions related to state-chartered savings associations to the FDIC. All functions of the OTS relating to Savings and Loan Holding Companies ("SLHCs") are transferred to the FRB.

Increased Efficiency Anticipated. The Proposed Rule states that the OTS first explored the conversion to the Call Report in a 2007 Advance Notice of Proposed Rulemaking. While the majority of the comments received were in support of the conversion, the OTS decided in 2008 not to adopt the rule given its desire to allow savings associations to focus on their economic stability rather than facilitating the conversion. Given the improvement in the economy, the Proposed Rule states that the Agencies believe that the longer-term benefits of the conversion now outweigh the shorter-term burden associated with the first year of conversion. For the associations, the benefit is increased efficiency associated with acquiring personnel and infrastructure equipped to prepare the reports in an industry more familiar with the Call Report than the TFR. For the agencies, the Proposed Rule anticipates that having a single set of financial information for all FDIC-insured banks and savings associations will lead to more efficient evaluation and monitoring.

Estimated Burden Associated with the Conversion. For Federal savings associations filings with the OCC, The Proposed Rule estimates that the conversion will require 53.25 burden hours per quarter for an association to file, and 188 burden hours in the first year for an association to convert its systems and conduct training. For state savings associations filing with the FDIC, the Proposed Rule estimates that the conversion will require 40.42 burden hours per quarter for an association to file, and 188 burden hours in the first year for an association to convert its systems and conduct training.

Efforts to Reduce the Conversion Burden. The Proposed Rule sets forth five ways in which it would reduce the burden of conversion: (i) curtail all proposed changes to the TFR for 2011 that would increase the differences between the TFR and the Call Report; (ii) not require the inclusion of a savings association-only schedule in the Call Report; (iii) provide a "mapping" of TFR items to Call Report items, to be available on the OTS website on or before February 15, 2011; (iv) make the filing of TFR Schedule CMR during 2011 optional for OTS-regulated entities with sufficiently high ratings with the Uniform Financial Institutions Rating System; and (v) propose to cease collection of Schedule CMR beginning March 2012. The Proposed Rule notes that associations who could and would opt to not file Schedule CMR during 2011 would be required to notify their applicable regional office prior to the Schedule CMR filing deadline. The Proposed Rule notes that one factor in determining to eliminate Schedule CMR is the Agencies' belief that a uniform policy regarding interest rate risk management will be efficient.

Significant Differences Between the TFR and the Call Report. The Proposed Rule notes significant differences between the two reports, including: (i) in the TFR, data are reported for the quarter ending on the report date of several schedules, whereas in the comparable Call Report schedules, data are reported on a calendar year-to date basis; (ii) amendments to Call Reports can be filed for up to five years after the report date, as compared with only 135 days after the end of the quarter for which the amended report is being filed; (iii) in the Call Report Schedule RC-K, institutions must report average balance sheet data computed based on daily or weekly balances, as compared with the TFR Schedule SI, which also permits computation based on balances at month-end; and (iv) savings associations can report specific valuation allowances in TFR Schedule VA, but cannot do so on the Call Report.

SLHCs to Submit the Same Reporting Forms as Bank Holding Companies ("BHCs"). In a "Notice of Intent to Require Reporting Forms for Savings and Loan Holding Companies" (the "Notice"), the FRB stated that beginning with the March 31, 2012 reporting period, SLHCs will be required to submit the same reports as BHCs. The change is the result of the provisions of the Dodd-Frank Act dissolving the OTS and transferring all functions of the OTS relating to SLHCs to the FRB. The relevant report forms are FR Y-6, FR Y-7, FR Y-9C, FR Y-9LP, FR Y-9SP, FR Y-9ES, FR Y-9CS, FR Y-10, FR Y-11/S, FR 2314/S, FR Y-8, and FR Y-12/2A. The forms are filed either quarterly, semi-annually, annually, or are event-generated. The FRB intends to produce more information related to these forms, including burden estimates, in a future notice to be published in the Federal Register on July 21, 2011, when the FRB will assume supervision of SLHCs. The Notice states that SLHCs are to continue to submit required reports according to the current reporting schedule through December 31, 2011.

FDIC and OTC Propose Rule to Require Savings Association to File data through the Summary of Deposits Survey (SOD) with the FDIC. In a Notice of Proposed Rulemaking, the FDIC and OTS announced their proposal to require savings association currently filing branching and deposit data through the Branch Office Survey System ("BOS") with the OTS to file through the Summary of Deposits Survey ("SOD") with the FDIC, starting on June 30, 2011. The change is being made pursuant to Dodd-Frank, and the FDIC states that it will be more efficient and will lead to more uniform data-collection and comparisons among all FDIC-insured institutions. Because the FDIC does not require single-office institutions to file the SOD, with the changes, certain institutions who currently report data through the BOS, namely single-office savings associations, will not have to report through the SOD. A trust-only savings association with more than a single office will need to file through the SOD, whereas no trust-only institutions were required to file through the BOS. The BOS and SOD collection processes are sufficiently similar that the FDIC does not anticipate an increase in the estimated burden hours per institution.

Public Comment. Comments on the Proposed Rules are due no later than April 11, 2011.

OTHER ITEMS OF NOTE

SEC Proposes Registration of Security-Based Swap Execution Facilities

The SEC issued a release proposing Regulation SB SEF under the Securities Exchange Act of 1934 (the "1934 Act") that will create a registration framework for security-based swap execution facilities ("SB SEFs"); establish rules consistent with the Dodd-Frank Act's fourteen enumerated core principles for SB SEFs; and implement a process for an SB SEF to submit proposed changes to its rules. The proposal provides interpretive guidance on the definition of "security-based swap execution facility" in Section 3(a)(77) of the 1934 and establishes exemptions for a registered SB SEF from the 1934 Act's definition of "exchange" and from regulation as a broker pursuant to Section 15(b) of the 1934 Act. Comments must be received by April 4, 2011.

CFTC Issues Rule Proposal for Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants

The CFTC issued a rule proposal that would establish requirements for swap trading relationship documentation for swap dealers and major swap participants. Comments are due by April 11, 2011.

CFTC Proposes Orderly Liquidation Termination Provision in Swap Trading Relationship Documentation for Swap Dealers and Major Swap Participants

The CFTC issued a rule proposal that would establish parameters for the inclusion of an orderly liquidation termination provision in the swap trading relationship documentation for swap dealers and major swap participants. Comments are due by April 11, 2011.

CFTC Issues Rule Proposal Regarding Commodity Options and Agricultural Swaps

The CFTC issued a rule proposal that would implement regulations under which swaps in agricultural commodities and all commodity options (including options on both agricultural and non-agricultural commodities), other than options on futures, may transact subject to the same rules as all other swaps. Comments are due by April 4, 2011.

SEC Proposes Condition Regarding Prior Issuances to Replace Investment Grade Credit Rating Requirement in Determining Form S-3 and Form F-3 Eligibility

In accordance with a mandate in the Dodd-Frank Act requiring federal agencies to review the use of credit ratings in their regulations and remove them as appropriate, the SEC issued a proposal that would remove the condition for use of Forms S-3 and F-3 for offerings of non-convertible securities that currently requires an issue to have an NRSRO investment grade rating, and substitute a test tied to the amount of debt and other non-convertible securities issued in the prior three years. Comments on the proposal must be received by March 28, 2011.

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