United States: Investment Management Developments - March 2011

INVESTMENT ADVISER USE OF SOCIAL MEDIA

In late 2010, the Securities and Exchange Commission (the SEC or the Commission) sent a "sweep" letter (the Sweep Letter) to a number of registered investment advisers requesting information on their involvement with social media and related recordkeeping practices. The Sweep Letter appears to signal heightened regulatory awareness that social media websites such as Facebook and LinkedIn are increasingly being used by investment advisers to connect with clients. Use of these sites may present regulatory issues under the advertising rules of the Investment Advisers Act of 1940 (the Advisers Act).

Sweep Letter Requests

The information requested by the SEC in the Sweep Letter indicates that the Commission is focusing on advisers' recordkeeping, training, supervisory and other policies with regard to social media use. Items requested include:

• Documents that identify the adviser's involvement with or usage of all social media websites;
• Communications made or received by the adviser on social media websites, including "snapshots" of documents;
• Policies and procedures covering the use of social media, posting communications, prospective communications and ongoing monitoring or review processes by the firm and third parties;
• Policies and procedures for firm employee use of social media in both business and personal contexts;
• Documentation of how employees are trained in using social media for business or non-business use;
• Documentation of any formal or informal disciplinary action related to firm personnel use of social media; and
• The adviser's record retention policies and procedures concerning use of social media by the adviser, its employees or any third party.

Existing Regulatory Guidance on Social Media Use

To date, the SEC has not yet addressed investment adviser use of social media directly through its releases. The Commission's 2008 release, "Commission Guidance on the Use of Company Web Sites," provided general guidance on how companies should use the Internet, with portions of the release touching on advertising regulation.

Of particular interest to investment advisers who use social media is the Commission's discussion in the 2008 release of third-party statements. The 2008 release discussed the Advisers Act's prohibitions on the use of testimonials in investment adviser advertising, which are broadly defined to include all material designed to induce a potential client or clients to subscribe to investment advisory services. While communications to existing customers are not normally considered advertising, this determination is contingent on the nature of the communication and the audience that receives it. Under the theories of entanglement and adoption, an investment adviser may be responsible for third-party content. The entanglement theory provides that if a firm or its personnel are involved with the preparation of third-party information they link to, they may be held accountable. Under the adoption theory, attribution to a firm stems from an explicit or implicit endorsement or approval of the content of third-party information. The Commission's 2008 release made clear that under these theories, the SEC may treat third-party information that an adviser links to as a prohibited testimonial under the Advisers Act. Communications to existing customers are also subject to the SEC's anti-fraud rules.

The Financial Industry Regulatory Authority (FINRA) has increased its scrutiny with respect to social media use by broker-dealers. To the extent a firm provides both brokerage and investment advisory services, it would be required to abide by both FINRA and Advisers Act rules. While FINRA guidance may not be strictly applicable to certain investment adviser activities with respect to social media, the SEC has recommended that, in the absence of specific rules under the Advisers Act, advisers should follow FINRA's rules on supervision of social media activities. FINRA's Notice 10-06, "Social Media Web Sites," released in January of 2010, provides specific rules for its members' use of social media. FINRA Notice 10-06 divides the content of social media sites into two types — static and interactive. Static content consists of relatively permanent postings such as a profile, background or wall information. Static information must be approved by a registered principal of the broker-dealer prior to its posting. Static content is considered to be an advertisement and must be treated as such. Interactive content (e.g., chat rooms), which FINRA's guidance describes as "non-static, real-time communications," must be supervised by the firm to ensure that postings do not violate the content requirements of FINRA's communication rules. These rules include following principles of fair dealing and good faith in communications with the public, making statements that have a sound basis in fact, refraining from false, exaggerated or misleading statements and ensuring that statements do not predict or project future performance.

Advertising Issues Raised by Social Media

In the Sweep Letter, the SEC requested that advisers provide documents on their use of all social media, but it pointed specifically to Facebook, Twitter, AdvisorTweets.com, LinkedIn, LinkedFa, YouTube, Flickr, MySpace, Digg, Reddit, RSS, blogs and micro-blogs. Each of these sites or types of social media has specific aspects that may create regulatory difficulties when used by an investment adviser's personnel in business or non-business contexts. For example,

• Postings on general social media websites such as Facebook, MySpace or Twitter (and the AdvisorTweets aggregator) could be considered advertisements to the extent that they describe a particular investment advisory service; similar postings on video and photograph sites like YouTube and Flickr can have similar effects.
• User ability to promote an adviser's reports, articles or other communications on social news sites may result in comments that could be considered testimonials by the Commission.
• On a business networking site like LinkedIn or LinkedFA, recommendations of an adviser's financial services may also be viewed as testimonials.
• Blogging creates static content; any recommendations of or inducement to contract for advisory services are subject to the Advisers Act's advertising rules.
• Firms that remove content, whether by deleting comments on a blog or taking down a Facebook post, may run afoul of recordkeeping requirements if a copy of the deleted communication is not archived. Removal of content without saving a screenshot could constitute destruction of records under the Advisers Act.

Developing a Robust Social Media Policy

Based on FINRA guidance and existing Advisers Act rules, an adviser should have a strong monitoring and supervisory program in place with respect to its social media activities. To the extent practicable, a firm should develop and articulate its social media policy prior to creating a social media presence. Employee blogging, tweeting and social media activity can take place either as a part of business or private life. As the Sweep Letter indicates, the SEC is concerned with business and non-business use of social media by investment advisory firms and their personnel as well as firms' social media use, training and monitoring activities. A firm's social media policy should thus address both personal use and firm business use.

As a general matter, a firm may also want to consider dividing up its social media policy into different groupings, including: (1) information technology-related social media procedures (e.g., retention, e-hardware and disposition); (2) policies directed at company-approved users; (3) policies directed at personal, non-business use; and (4) policies directed at non-company approved users. A firm may also want to include some general instructions on "netiquette" and how company-approved users should respond to news media, investors and others.

Personal Use Social Media Policy

The tone that a firm takes in its policy for employees' personal use of social media is important. Employee-friendly policies are generally more effective than a long list of directives. In that regard, firms should consider embracing the fact that their employees do and will use social media in their private lives, but should have a policy that educates employees to influence their behavior and ensure that employees adhere to company policy. A firm's policy for personal use of social media should consider:

• Prohibiting use of the firm's name;
• Prohibiting the disclosure of trade secrets;
• Requiring that blogging or social networking not interfere with job duties;
• Prohibiting the use of company logos and trademarks;
• Addressing the permissibility of employee discussions of competitors, clients and vendors;
• Emphasizing each employee's personal responsibility for content that he or she posts;
• Requiring disclaimers when an employee blogs;
• Tying back to the firm's code of conduct or similar policy; and
• Making policies specific as overly-broad policies can trigger labor law issues.

As with any policy applicable to employee personal conduct, the social media policy should be written and posted, contain specific definitions, detail prohibited activities, require signed acknowledgment, and be enforced to punish violators. The Sweep Letter signals that the SEC is interested in determining the extent to which investment advisers are working to ensure that their employees are using social media responsibly and within the constraints of law and regulation when engaging in business, and that employee social media use outside the workplace is somehow being monitored to prevent regulatory transgressions.

Business Use Social Media Policy

A firm should tailor its social media policy for business use to its particular needs and consult with its compliance department and legal counsel to ensure the adequacy of the policy and legal ramifications of actions taken in connection therewith. It is particularly important that a firm's communication through social media be made by designated individuals who have been trained in the legal ramifications of social media use. A firm's compliance department should consider taking an active role in training, and should ensure that employees using social media on behalf of the firm are adequately supervised and that their postings are monitored for legal compliance on an ongoing basis. While not required by law, review and pre-clearance of static postings by a designated individual is a FINRA best practice that provides an additional level of assurance that the firm's business use of social media complies with the Advisers Act. Firms may also want to consider various methods of post-use review, including sampling. The type of review will vary depending on the type of social media, e.g., unscripted chat rooms, static and non-static blogs, combination blogs, etc.

A firm's social media presence should be limited to particular individuals who have been trained by and receive ongoing supervision from the firm, because actions taken to satisfy one particular aspect of the law may have unintended consequences in other areas. For instance, a decision to remove customers' descriptions of their interactions with an advisory firm in order to avoid offering testimonial evidence could be viewed as manipulating communication to present a social media presence that is misleadingly positive if negative comments about the firm are deleted. Additionally, the limited amount of space that certain social media forms allow, such as the few lines of a Facebook comment that are visible and Twitter's 140 character limit, may preclude required disclosures, including the statement that an employee's tweets or messages do not reflect the views of the firm.

Reliance on all-in-one solutions or automated processes may not be sufficient to ensure that communications are properly screened and archived. The use of an automated system or delegation of monitoring duties to a service provider will not relieve a firm from the requirement that its procedures be reasonably designed to ensure that interactive electronic communications do not violate SEC and other applicable rules. Any adviser's archiving system should be sufficient to preserve records required to be kept and to prevent prohibited material from being disseminated. The monitoring and archiving system should be examined and re-evaluated on a regular basis to ensure that relevant material is being captured and that the monitoring system continues to address effectively the compliance issues that the evolution of social media platforms poses. Compliance personnel should also be involved in testing the social media policy's effectiveness to ascertain whether communications on social media sites that should be archived are being captured for the firm's records. Firms should notify employees that their social media use will be treated as public statements and that the firm will monitor publicly-available content.

With the potential for SEC enforcement and further rulemaking in the wings, a robust social media policy will allow firms to address this developing issue in a manner that will keep them and their employees compliant and allow a beneficial social media presence.

CFTC AND SEC PROPOSE RULE ON MAJOR SWAP PARTICIPANT AND MAJOR SECURITY-BASED SWAP PARTICIPANT DEFINITION

The SEC and the Commodity Futures Trading Commission (CFTC) (together, the Commissions) have jointly issued a rule proposal (Proposed Rules) to define terms related to the swap and security-based swap markets as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd- Frank Act). The Proposed Rules offer definitions of the terms "swap dealer," "security-based swap dealer," "major swap participant," "major security-based swap participant," and "eligible contract participant." This article's focus is on the proposed definitions of "major swap participant" and "major security-based swap participant" (the Proposed Definitions).

The Dodd-Frank Act added the terms "major swap participant" and "major security-based swap participant" (collectively Major Participant) to the Commodity Exchange Act, as amended (the Commodity Act), and the Securities Exchange Act of 1934, as amended (the Exchange Act), respectively, to regulate entities with large swap positions that do not qualify as swap dealers or security-based swap dealers, but could still have a significant impact on the financial markets. The Proposed Definitions could have a major effect on registered investment companies, private investment funds and their advisers and commodity pool operators that do not fall within the definition of a swap/ security-based swap dealer but yet still may qualify as Major Participants. The Dodd-Frank Act requires all entities deemed Major Participants to register as such and subjects those entities to additional capital, margin and business conduct requirements.

The Dodd-Frank Act sets out three alternatives for identifying a Major Participant. It defines a Major Participant as:

• A person that maintains a "substantial position" in any of the major swap categories, excluding positions held for "hedging or mitigating commercial risk" and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan (alternative 1);
• A person whose outstanding swaps create "substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets" (alternative 2); or
• Any "financial entity" that is "highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency" and that maintains a "substantial position" in any of the major swap categories (alternative 3).

Mandated by Congress, the Commissions seek to further define Major Participants by addressing (a) the major categories of swaps or securities-based swaps, (b) the meaning of "substantial position," (c) the meaning of "hedging or mitigating commercial risk," (d) the meaning of "substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets," and (e) the meanings of "financial entity" and "highly leveraged."

Major Categories of Swaps and Securities-Based Swaps

The Commissions propose to limit an entity's designation as a Major Participant to only certain types, classes or categories of swaps or security-based swaps. An entity may be deemed a Major Participant for one category of swaps or security-based swaps but not for another. The major categories will apply only for purposes of the Major Participant definitions and are not necessarily determinative with respect to any other provision of the Dodd-Frank Act.

The Commissions propose to designate four categories of swaps for purposes of the "major swap participant" definition: rate swaps, credit swaps, equity swaps and other commodity swaps. The four major categories of swaps are intended to cover all swaps. The first category would encompass any swap that is primarily based on reference rates, such as swaps of payments determined by fixed and floating interest rates, currency exchange rates, inflation rates or other monetary rates. The second category would encompass any swap that is primarily based on instruments of indebtedness, including but not limited to any swap primarily based on one or more indices related to debt instruments, or any swap that is an index credit default swap or total return swap on one or more indices of debt instruments. The third category would encompass any swap that is primarily based on equity securities, such as any swap primarily based on one or more indices of equity securities, or any total return swap on one or more equity indices. The fourth category would encompass any swap not included in any of the first three categories. Each swap would be in the category that most closely describes the primary item underlying the swap. If a swap is based on more than one underlying item of different types, the swap would be in the category that describes the underlying item that is likely to have the most significant effect on the economic return of the swap.

The Commissions propose to designate two categories of security-based swaps for purposes of the "major security-based swap" definition. The first category would encompass any security-based swap that is based on instruments of indebtedness, or a credit event relating to issuers or securities. The second category would encompass any other security-based swaps not included in the first category.

"Substantial Position"

The Commissions are proposing two tests to define "substantial position" in alternative one of the "Major Participant" definition. One test would focus exclusively on an entity's current uncollateralized exposure; the other would supplement a current uncollateralized exposure measure with an additional measure that estimates potential future exposure. A position that satisfies either test would be a "substantial position."

Current Uncollateralized Exposure Test

The current uncollateralized exposure test would set the substantial position threshold by reference to the sum of the uncollateralized current exposure, obtained by marking-to-market using industry standard practices and arising from each of an entity's positions with negative value in each of the applicable major categories of swaps or security-based swaps. This proposed test would account for the risk-mitigating effects of netting agreements by permitting an entity to calculate its exposure on a net basis, by applying the terms of master netting agreements entered into between the entity and a single counterparty. When calculating the net exposure the entity may take into account offsetting positions with that particular counterparty involving swaps, security-based swaps and securities financing transactions to the extent that is consistent with the offsets provided by the master netting agreement. This measurement would be calculated as a daily average measured at the close of each business day in a calendar quarter. The Commissions set the uncollateralized exposure threshold for a "major swap participant" at a daily average of $1 billion for credit, equity, or other commodity swaps, and $3 billion for rate swaps. The threshold for a "major security-based swap participant" would be $1 billion for each of the two defined categories.

Current Uncollateralized Exposure Plus Potential Future Exposure Test

The second substantial position test takes into account the aggregate of current uncollateralized exposure and the potential future exposure within a particular category of swaps. Under this test, the potential future exposure is calculated by multiplying the total notional principal amount of the entity's swap positions by specified risk factor percentages and then discounting that number to account for master netting agreements, cleared swaps and swaps subject to daily mark-to-market margining. Under this test, the Commissions set the exposure threshold for a "major swap participant" at a daily average exposure of $2 billion for credit, equity, or other commodity swaps, and $6 billion for rate swaps. The exposure threshold for a "major security-based swap participant" would be $2 billion for each of the two defined categories.

Hedging or Mitigating Commercial Risk

The first alternative of the Major Participant definition excludes positions held for "hedging or mitigating commercial risk" from the substantial position analysis. The Commissions have proposed that the following types of swap positions be excluded from the substantial positions analysis:

• Swaps that qualify as bona fide hedges under existing Commodity Act regulations;
• Swaps that qualify for hedging treatment under Financial Accounting Standards Board Statement No. 133; or
• A swap position that is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise in the ordinary course of business from:
• • A potential change in the value of (1) assets that a person owns, produces, manufactures, processes, or merchandises, (2) liabilities that a person incurs, or (3) services that a person provides or purchases;
  • A potential change in value related to any of the foregoing arising from foreign exchange rate movements; or
  • A fluctuation in interest, currency, or foreign exchange rate exposures arising from a person's assets or liabilities.

Substantial Counterparty Exposure Test

The second alternative of the Major Participant definition seeks to measure substantial counterparty exposure, rather than a substantial position. The Commissions propose to rely on the same tests utilized to determine a substantial position, with a few significant differences. As proposed, the substantial counterparty exposure test will measure across all swap categories and will not exclude hedging or employee benefit plan positions. The exposure thresholds under this test are significantly higher than either of the substantial position tests. If an entity, in the aggregate, maintains uncollateralized swap exposure of a daily average of $5 billion or uncollateralized swap exposure plus potential future exposure of $8 billion, that entity will qualify as a Major Participant.

"Financial Entity" and "Highly Leveraged"

The third alternative of the Major Participant definition addresses any "financial entity," other than one subject to capital requirements established by an appropriate federal banking agency, that is "highly leveraged relative to the amount of capital" the entity holds, and that maintains a substantial position in a major category of swaps or security-based swaps. This test does not permit an exclusion for positions held for hedging.

"Financial Entity"

The Commissions propose to utilize the definition of financial entity from Section 2(h)(7) of the Commodity Act and Section 3C(g)(3) of the Exchange Act, respectively, as amended by the Dodd-Frank Act. As such, the statutory definition of a financial entity would be a swap dealer, security-based swap dealer, major swap participant, major security-based swap participant, commodity pool, private fund, employee benefit plan, or person predominately engaged in the activities that are the business of banking (a Financial Entity).

"Highly Leveraged"

The Commissions propose two possible definitions of the point at which a Financial Entity would be "highly leveraged" – either a Financial Entity would be "highly leveraged" if the ratio of its total liabilities to equity is in excess of 8 to 1, or a Financial Entity would be "highly leveraged" if the ratio of its total liabilities to equity is in excess of 15 to 1. In either case, the determination would be measured at the close of business on the last business day of the applicable fiscal quarter. To promote consistent application of this leverage test, Financial Entities that file quarterly reports on Form 10-Q and annual reports on Form 10-K with the SEC would determine their total liabilities and equity based on the financial statements included with such filings. All other Financial Entities would calculate the value of total liabilities and equity consistent with the proper application of U.S. generally accepted accounting principles. The Commissions solicited comments as to whether this ratio should be set at 8 to1 or 15 to 1.

Full copies of the Proposed Rules can be found at http://www.sec.gov/rules/proposed/2010/34-63452.pdf and http://www.gpo.gov/fdsys/pkg/FR-2010-12-21/pdf/2010-31130.pdf.

FBAR REGULATIONS RELEASED

The Treasury Department recently promulgated final regulations under the Bank Securities Act regarding the filing of Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts, colloquially referred to as "FBAR." The final regulations do not differ significantly from the proposed regulations that were issued early last year.

Generally, every U.S. person that has a direct ownership interest in, or signature or other similar authority over, a foreign financial account the balance in which exceeded $10,000 at any time during a year must file an FBAR with respect to that account for that year. The FBAR regulations clarify certain details of this filing requirement, and certain aspects of the regulations are of particular interest for investors and managers of investment vehicles.

Concerns for Investors

• The final regulations do not currently require an FBAR filing for investors in foreign hedge funds or other foreign funds that do not have a regular net asset value determination and regular redemptions. As was the case with the proposed regulations, the final regulations "reserve" with respect to this subject and the preamble to the regulations indicate that the Treasury Department is continuing to study the matter and may impose an FBAR filing requirement at some point in the future.
• Investors in U.S. mutual funds do not have to file FBARs with respect to their accounts in the funds, even though the mutual funds themselves may invest in foreign securities. Likewise, no FBAR filing is required with respect to accounts maintained at financial institutions located in the United States, even though brokerage accounts may include securities of foreign companies and bank accounts may include interests in an omnibus account maintained offshore.
• Investors in foreign open-end mutual funds are required to file an FBAR if they meet the $10,000 filing threshold with respect to any particular such fund.
• In response to the proposed regulations, several comments were submitted requesting exemptions from FBAR filing requirements for pension plans and welfare benefit plans and for U.S. persons living abroad. In promulgating the final regulations, the Treasury Department declined to provide any such exemptions.

Concerns for Fund Managers

• U.S. entities with foreign bank accounts, securities accounts, or other financial accounts, including brokerage accounts, are required to file FBARs with respect to any such accounts over the $10,000 threshold.
• A U.S. person with "signature or other authority" over a foreign account with a balance in excess of $10,000 is required to file an FBAR, even though the requirement may generate duplicative filings. "Signature or other authority" is limited to a person who has the authority (alone or in conjunction with another) to control the disposition of money, funds or other assets in a financial account by direct written or oral communication to the person with whom the financial account is maintained.

The deadline for filing FBARs each year is June 30 of the following year. Unlike the rule for tax returns, to be timely filed, the FBAR must be received by the Treasury Department on or before the deadline – merely mailing the form by that date is not enough.

A copy of the final regulation can be found at http://edocket.access.gpo.gov/2011/pdf/2011-4048.pdf.

CFTC PROPOSES NARROWING OR ELIMINATING CPO REGISTRATION EXEMPTIONS

Recently, the CFTC proposed to modify the criteria for claiming exemption from registering as a Commodity Pool Operator (CPO) under Rule 4.5, upon which many mutual funds rely, and to rescind the exemptions from registration as a CPO under Rules 4.13(a)(3) and (a) (4), upon which private funds rely. The CFTC also called for increased filing and disclosure requirements for CPOs and Commodity Trading Advisors (CTAs) and additional filing requirements for those claiming exemptive relief from registering as a CPO.

Changes to Rule 4.5

Certain persons, including investment companies registered under the Investment Company Act of 1940 (the 1940 Act), may be exempt from registering as a CPO if they meet the criteria set forth under Rule 4.5 of CFTC regulations. Since 2003, Rule 4.5 has required qualifying entities to file a representation stating whether the entity is operated by a person who has claimed an exclusion from the definition of CPO. Currently, Rule 4.5 does not limit qualifying entities' use of commodity futures or commodity options, nor does it restrict qualifying entities from marketing themselves as commodity pools.

The CFTC has proposed that Rule 4.5 be amended to reinstate restrictions similar to those that existed pre- 2003, specifically that entities file a notice of eligibility containing representations that commodity futures or commodity options contracts will be used only for bona fide hedging purposes, or for non-bona fide hedging purposes limited to 5 percent of the liquidation value of the portfolio. In addition, the entity must not market the fund to the public as a commodity pool, or as a vehicle for trading in or otherwise seeking exposure to the commodity futures or commodity options markets. These restrictions would apply only to registered funds.

The proposed change comes in the wake of the CFTC's discovery that certain registered investment companies were offering series of de facto commodity pool interests while claiming exemption under Rule 4.5. The CFTC proposed the aforementioned modifications to stop registered investment companies from offering futures-only investment products without CFTC oversight.

Implications for Registered Funds

If the CFTC's proposal is enacted, in order to take advantage of the Rule 4.5 exemption from registering as a CPO, a registered fund would need to limit its trading of commodity futures or commodity options contracts to bona fide hedging purposes, or to non-bona fide hedging positions (in which case, the registered fund must hold the position directly and limit the aggregate initial margin and premiums required to establish the positions so as not to exceed 5 percent of the liquidation value of the registered fund's portfolio). A registered fund would also need to cease marketing itself as a commodity pool or as a vehicle for trading in, or otherwise providing exposure to, commodity interests. It is unclear how this marketing restriction will fit with SEC prospectus disclosure requirements. Finally, the registered fund would need to confirm its notice of eligibility annually.

Changes to Rules 4.13(a)(3) and (a)(4)

Currently, Rule 4.13(a)(3) exempts certain persons from CPO registration if the interests in the pool are exempt from registration under the Securities Act of 1933 and offered only to Qualified Eligible Persons (QEPs), accredited investors, or knowledgeable employees, and the pool's aggregate initial margin and premiums attributable to commodity interests do not exceed 5 percent of the liquidation value of the pool's portfolio. Rule 4.13(a)(4) applies when the interests in the pool are exempt from registration under the Securities Act of 1933 and the operator reasonably believes that all of the participant are QEPs.

The CFTC proposes to completely rescind the exemptions provided by Rules 4.13(a)(3) and (a) (4). In its proposal, the CFTC stated that because of these provisions, a large group of market participants has evaded regulatory oversight and that continuing to exempt these entities from registering and reporting as CPOs is "outweighed by the [CFTC's] concerns of regulatory arbitrage."

Implications for Private Funds and Private Fund Advisers

Rules 4.13(a)(3) and (a)(4) would be eliminated if the CFTC's proposal is enacted. Therefore, entities that previously claimed an exemption under these rules would be required to register as CPOs, join the National Futures Association (NFA), and fulfill all associated reporting requirements – unless the entity could rely on another exemption. Registering as a CPO can be a relatively lengthy process. CPO reporting requirements include providing disclosure documents to pool participants that would be subject to NFA review and fulfilling certain recordkeeping and periodic and annual reporting requirements.

Finally, investment advisers that currently operate under an exemption from CTA registration on the basis that they provide advice to pools exempt under Rules 4.13(a) (3) and (a)(4) will be required to register as CTAs, join the NFA, and fulfill all associated reporting requirements.

Conclusion

In its proposal, the CFTC expressed awareness that industry participants may find some of the proposed changes to be extremely cost prohibitive, unclear or otherwise undesirable. The CFTC encourages members of the industry to comment on these changes — the comment period will end in late March and the full proposal is available at: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-2437a.pdf.

ICI PUSHES FOR PRIVATE LIQUIDITY FACILITY TO BOLSTER PRIME MONEY MARKET FUNDS, REJECTS OTHER OPTIONS

In a recent comment letter to the SEC, the Investment Company Institute (ICI) provided a detailed proposal for the creation of a private liquidity facility for prime money market funds, which the ICI stated is the most promising solution to bolster these funds in times of severe market stress. The ICI submitted its letter in response to the SEC's request for comment on the President's Working Group on Financial Markets (PWG) Report on Money Market Reform Options.

The PWG proposed various options for money market reform, including the creation of a private liquidity facility for money market funds. In its comment letter, the ICI stated that it favors this option over others and went on to describe a detailed plan for such a liquidity facility. Under the ICI's plan, the liquidity facility would be structured as a state-chartered bank or trust company regulated by state banking authorities and the Federal Reserve, and would be capitalized by initial contributions and ongoing fees. It would grow additional capacity by issuing time deposits (such as certificates of deposit) to third parties and when markets are operating normally, the facility would invest the proceeds of its sponsors' capital, the ICI stated. Like other banks, the liquidity facility would also have access to the Federal Reserve discount window.

The ICI proposed that an initial contribution from prime fund sponsors be based on prime money fund assets under management; the ICI's initial target is $350 million, with a minimum initial fee of $250,000 per individual firm. The ongoing commitment fee paid by participating funds would be three basis points of prime money fund assets per year. Some industry experts believe the ICI's three-basis-point proposal is high and could lead to greater consolidation in the industry because those advisors that do not want to absorb the fee may leave the market. The expense could be passed on to shareholders; however, this might adversely affect current yields.

Under the ICI's plan, all prime money market funds would be required to join the facility — those funds that decline to participate would be unable to use the amortized cost method of valuation and would be forced to convert to Treasury or government funds. In 10 years, the ICI aims for the liquidity facility to have raised $50 billion.

According to the ICI, the liquidity facility would not provide credit support, by buying distressed securities, for example. Therefore, had the liquidity facility existed in 2008, it would not have prevented the Reserve Primary Fund from "breaking the buck."

Rather, the ICI stated that the liquidity facility would strengthen prime money market funds by buying high-quality, short-term securities from such funds during times of market stress and illiquidity thereby allowing the funds to meet redemptions while maintaining a stable $1 net asset value (NAV). By its very existence, the liquidity facility would provide reassurance to investors, the ICI argues, and limit the risk that liquidity concerns in a single fund would spur redemptions in all prime money market funds.

Participating funds would be permitted to access their proportional amount of liquidity, the ICI stated; however, the liquidity facility's board of directors could provide more liquidity to a fund if necessary. The ICI outlined other conditions that would attach to a fund's ability to access liquidity, one condition being that the fund pay an additional fee.

In its comment letter, the ICI went on to express its opposition to other options proposed by the PWG, including: requiring money market funds to float their NAVs; imposing mandatory redemptions in kind; insurance programs for money market funds; a two-tier system with stable NAV money market funds reserved for retail investors; regulating stable NAV money market funds as special purpose banks; and imposing enhanced constraints on alternative investments to money market funds. More about the ICI's position regarding these options can be found in its comment letter at: http://www.ici.org/pdf/11_sec_pwg_com.pdf.

Aside from commenting on reform options discussed by the PWG, the ICI recommended in its letter that the SEC consider implementing a new rule requiring intermediaries, such as broker-dealers, to provide information to money market funds about their investors. This, the ICI asserted, would make it easier for funds to comply with "know your investor" procedures newly required by the SEC. If funds could better identify their investors, they could better evaluate their liquidity needs and thereby mitigate risk, the ICI went on to note.

Industry participants do not all agree that a liquidity facility structured in accordance with the ICI's plan is the best solution. We are following this issue and will keep you updated.

The PWG Report on Money Market Reform and the SEC's related request for comment can be found here: http://www.sec.gov/rules/other/2010/ic-29497.pdf.

INDUSTRY COMMENTS ON FINRA'S DISCLOSURE REQUIREMENT

FINRA issued Regulatory Notice 10-54 (the Notice) requesting comment on a concept proposal to require broker-dealers, on or before commencing a business relationship with a retail customer, to provide a disclosure document describing in plain English the accounts and services it offers as well as conflicts of interest and any limitations on the broker-dealer's duties to its retail customers.

The Notice envisages the proposed disclosure to be similar in purpose to Form ADV Part II, which is a brochure provided to clients by investment advisers that discloses information about the advisers. The disclosure document was proposed in response to certain requirements set forth in the Dodd-Frank Act. The Act requires the SEC to conduct a study of the regulatory gaps and overlap between investment adviser and broker-dealer regulation. It also requires the SEC to facilitate simple and clear disclosures of material conflicts by both broker-dealers and investment advisers.

The Notice provides an overview of the types of disclosure that would be required in addition to current required sales practice disclosures, including, among other things, information about the broker-dealer's products and services, conflicts of interest, and compensation arrangements.

FINRA received in excess of 50 comment letters on this proposal. Below are synopses of several of the comment letters.

The ICI filed a letter supporting the initiative with the exception that mutual fund underwriters should be excluded or exempted from the disclosure requirement, because, as the ICI explains, the business model and regulatory requirements applicable to mutual fund underwriters are significantly different from those of retail broker-dealers. The ICI asserts that the proposed disclosure would be essentially meaningless to a mutual fund investor and that the delivery requirements for the disclosure statement would be disruptive. The ICI requests that FINRA detail how the rule would be applied to mutual fund underwriters if they are not exempted from the rule. In its comment letter, the National Society of Compliance Professionals (NSCP) agrees that a broker-dealer that exists only as a distributor for a mutual fund company possesses a very different business model than that of other broker-dealers. Thus, the NSCP argues, the scope of the FINRA proposal may be overly broad in that it would incorrectly treat all broker-dealers alike.

Another industry participant, Wells Fargo Advisors (WFA), urges in its comment letter that there be a "coordinated and cohesive rulemaking approach" between the SEC and FINRA, and that it would be premature to divorce FINRA's efforts from federally mandated rulemaking by the SEC under Section 913 of the Dodd-Frank Act. WFA posits that the final SEC rules could affect what FINRA would deem appropriate disclosures at the commencement of a business relationship between a broker-dealer and a retail customer. The NSCP comment letter agrees that the FINRA proposal is premature to the extent that it is intended to precede future SEC rulemaking. The NSCP notes that a FINRA disclosure document that might become obsolete as a result of SEC rulemaking would cause confusion among investors and firms.

The views offered by industry participants responding to the FINRA concept proposal indicate that while many agree that broker-dealer disclosure at the inception of a business relationship with a retail customer is appropriate, they also believe that such a requirement must be focused in coverage and coordinated with SEC rulemaking efforts. FINRA will review and consider these comment letters in proceeding with its concept proposal.

A copy of the Notice can be found at: http://www.finra.org/Industry/Regulation/Notices/2010/P122361. Comments on the Concept Proposal can be found at http://www.finra.org/Industry/Regulation/Notices/2010/P122362.

INDUSTRY EXPERTS REACT TO FINCEN'S PROPOSED SUSPICIOUS ACTIVITY REPORT DATABASE

The Financial Crimes Enforcement Network (FinCEN) has begun designing a new Bank Secrecy Act (BSA) suspicious activity report database (the Database). The BSA requires, among other things, financial institutions – including mutual funds – to report suspicious transactions by filing Suspicious Activity Reports (SARs). The Database will be a new electronic SAR filing system. FinCEN recently invited comment on the Database's proposed data fields (the Proposal) that will support electronic SAR filings. FinCEN stated in its notice and request for comment that it "does not propose any new regulatory requirements nor changes to the requirements related to suspicious activity reporting."

In response to FinCEN's request for comment, some industry experts expressed concern over the breadth of the changes FinCEN's Proposal may entail. Specifically, the ICI commented that implementing the Proposal would require mutual funds and their agents to expend significant financial and personnel resources. This is because the Proposal includes a number of new data fields, which will change how SAR filers collect and process suspicious activity information. Mutual funds and their agents may also need to revise their policies, procedures and systems that support suspicious activity reporting to ensure compliance with the new system. The Proposal could impact electronic systems already used by funds to manage the SAR filing process by necessitating technical changes and personnel training. The impact on any particular mutual fund will vary depending on, among other things, whether the fund currently uses a customized or proprietary system for SAR filing. Industry experts have requested more detail concerning the information technology specifications of FinCEN's Proposal so as to fully assess the impact and cost of the proposed changes.

The ICI also expressed concern that completing data fields will require subjective determinations, adding complexity and time to filing SARs. Certain proposed data fields would require the person completing the report to classify suspicious activity information by checking a box, which would require that person to use his or her discretion in analyzing suspicious behavior. For these data fields, reasonable people could come to different conclusions (i.e., check different boxes) based on the same information. This could cause inconsistencies among and within reporting institutions. Making such subjective determinations may also lengthen the time it takes the filer to complete a SAR. Industry experts expressed concern that variations in responses will diminish law enforcement's ability to gain meaningful information from SARs. It may also cause government examiners to scrutinize or criticize filers unnecessarily for such inconsistencies. Based on these issues, industry experts recommend that FinCEN revise or eliminate some of the proposed data fields.

The ICI has urged FinCEN to maintain an open dialogue with the financial services industry and, should FinCEN put the Database into operation, allow for an extended implementation period of 18 months.

Mutual fund anti-money laundering officers in particular should be aware of the foregoing proposed changes and challenges they may pose. Drinker Biddle is following these issues and will keep you updated.

FinCEN's notice and request for comment, which contains information about the proposed Database, can be found at http://edocket.access.gpo.gov/2010/pdf/2010-26038.pdf. The ICI's letter in response can be found here: http://www.ici.org/pdf/24793.pdf.

AFFILIATED FIRMS AND CHIEF COMPLIANCE OFFICER CHARGED WITH ALTERING DOCUMENTS BY SEC

The SEC brought administrative proceedings against Buckingham Capital Management, Inc. (BCM), a registered investment adviser, and its registered broker-dealer parent company, The Buckingham Research Group, Inc. (BRG), for failure to establish, maintain and enforce compliance policies and procedures reasonably designed to protect material nonpublic information, taking into account the nature of their respective and interconnected businesses – including forthcoming research and pending customer and portfolio trades. BCM also failed to conduct the required annual review of its compliance policies and procedures for 2005. The former chief compliance officer for both firms, Lloyd Karp, was found to have aided and abetted and caused those failures. The two firms have a close working relationship. They share common office space and management, and BCM's trading accounts for approximately 25 percent of BRG's commission revenue. The firms and Karp agreed to settle the SEC's case against them.

The SEC's order also found that, while preparing for a 2006 examination by SEC staff, BCM discovered that it was missing pre-approval forms for more than 100 employee trades in 2005. Instead of producing the incomplete employee trading records to the SEC exam staff, BCM altered its records by creating and adding forms, and produced the existing records along with the added forms to the SEC exam staff without telling the staff what it had done. In addition, BCM discovered that its compliance review logs for 2005 and 2006 were incomplete. Karp, who was on medical leave during the 2006 examination, had not initialed and dated the compliance logs and had not checked them regularly. Instead of producing the incomplete compliance logs, BCM staff altered the firm's records by replacing the incomplete logs with newly-created ones. The SEC found that BCM then produced the newly created replacement logs to the SEC exam staff without disclosing what had been done.

The firms and Karp agreed to settle the SEC's cases against them. Without admitting or denying the SEC's findings, BRG agreed to pay a penalty of $50,000, BCM agreed to pay a penalty of $75,000, and Karp agreed to pay a penalty of $35,000. They also consented to an order that: censures all of the respondents; requires BRG to cease and desist from committing or causing any violations or future violations of Section 15(f) of the Exchange Act; requires BCM to cease and desist from committing or causing any violations and any future violations of Sections 204(a), 204A and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder; and requires Karp to cease and desist from causing any violations and any future violations of Section 15(f) of the Exchange Act and Sections 204A and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder. The order also requires that both firms engage an independent consultant to review and make recommendations regarding their compliance policies and procedures.

A copy of the SEC complaint can be read in its entirety by clicking on the following link: http://www.sec.gov/litigation/admin/2010/34-63323.pdf.

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