United States: OCIE Announces 2013 SEC National Examination Program Priorities (Financial Services Alert For February 26, 2013)

Last Updated: February 27 2013
Article by Robert M. Kurucza

Edited by: Eric R. Fischer, Jackson B.R. Galloway and Elizabeth Shea Fries

In This Issue:

  1. OCIE Announces 2013 SEC National Examination Program Priorities
  2. SEC Staff Provides Guidance on Incorporation of 3.8% Tax on Net Investment Income Into Standardized Mutual Fund After-Tax Return Calculation
  3. FRB Extends Comment Period to April 30, 2013 on its Proposed Rule to Enhance Prudential Standards for Foreign Banking Organizations and Certain Foreign Nonbank Financial Companies
  4. GAO Issues Report on Financial Crisis Losses and Potential Impacts of the Dodd-Frank Act
  5. Reminder: Swap End-Users Must Obtain LEIs/CICIs by April 10, 2013

OCIE Announces 2013 SEC National Examination Program Priorities

The SEC's Office of Compliance Inspections and Examinations ("OCIE") published the 2013 examination priorities for its National Examination Program (the "NEP"). The priorities are organized according to the NEP's four distinct program areas: (i) investment advisers and investment companies, (ii) broker-dealers, (iii) clearing and transfer agents, and (iv) market oversight. This article focuses primarily on the examination priorities for investment advisers and investment companies.

Corporate Governance and Enterprise Risk Management. The NEP risk/examination priorities include a number of topics that apply to nearly all SEC registrants. Among these is an ongoing effort to meet with senior management and boards of entities registered with the SEC and their affiliates to discuss enterprise risk, and in particular, how financial, legal, compliance, operational, and reputational risks are managed. As described by the Staff, "[t]his initiative is designed to: (i) understand firms' approach to enterprise risk management; (ii) evaluate firms' tone at the top; and (iii) initiate a dialogue on key risks and regulatory requirements. This effort provides the NEP with an opportunity to assess overall risk management at certain registrants through discussions with independent board members, senior management, internal audit, key risk and control functions, and leaders of business lines."

Investment Companies and Investment Advisers. The ongoing priorities for investment adviser and investment company ("IA-IC") examinations in part echo those announced for OCIE's presence examination program for new advisers: (1) custody/safety of client assets: (2) conflicts related to adviser compensation arrangements; (3) performance advertising; (4) conflicts of interest related to allocation of investment opportunities; and (5) fund governance and "tone at the top." New and emerging issues for IA-IC examinations include (a) conflicts of interest that can arise for dually-registered investment adviser/broker-dealers and when separate broker-dealer and advisory organizations share common personnel; (b) the use of "alternative and hedge fund strategies" by mutual funds, ETFs and variable annuity products; and (c) payments made by advisers and funds to distributors and intermediaries, such as revenue sharing, sub-TA, and shareholder servicing fees. Other areas of IA-IC focus in the NEP are (i) "stress testing" by money market funds; (ii) compliance with exemptive orders, e.g., those permitting managed distribution plans by closed-end funds, employee securities companies, and coinvestment by advisers and their affiliates alongside funds; and (iii) compliance with the "pay-to-play" rule (Rule 206(4)-5 under the Investment Advisers Act of 1940, as amended).

SEC Staff Provides Guidance on Incorporation of 3.8% Tax on Net Investment Income Into Standardized Mutual Fund After-Tax Return Calculation

The staff of the SEC's Division of Investment Management (the "Staff") provided guidance regarding the manner in which the 3.8% tax on net investment income applicable to certain taxpayers as a result of the Health Care and Education Reconciliation Act of 2010 (the "3.8% Tax") should be incorporated into the standardized after-tax return calculation that is required under Form N-1A, the SEC registration form for open-registered management investment companies ("mutual funds"), and Rule 482 under the Securities Act of 1933, as amended, and Rule 34b-1 under the Investment Company Act of 1940, as amended, for mutual fund marketing materials presenting after-tax returns. Specifically, the Staff stated that a mutual fund should "include the 3.8% tax in after-tax return calculations (e.g., use 43.4% as the highest individual marginal federal income tax rate on ordinary income)" and ". . . should include the 3.8% tax in calculating the tax on qualified dividend income and long-term capital gains or any tax benefit resulting from capital losses required by Instruction 7 to Item 26(b)(3) [of Form N-1A] (i.e., use 23.8% as the highest individual federal long-term capital gains tax rate . . .)."

FRB Extends Comment Period to April 30, 2013 on its Proposed Rule to Enhance Prudential Standards for Foreign Banking Organizations and Certain Foreign Nonbank Financial Companies

The FRB extended from March 31, 2013 to April 30, 2013 the comment period on the FRB's proposed rule (the "Proposed Rule") that would enhance prudential standards for large foreign banking organizations and certain large foreign nonbank financial companies supervised by the FRB. The Proposed Rule was discussed in the December 26, 2012 Financial Services Alert and in the summary of the FRB's potential revisions to U.S regulation of foreign banking supervision provided in a speech by FRB Governor Daniel K. Tarullo and discussed in the December 4, 2012 Financial Services Alert.

The FRB noted that the enhanced prudential standards include risk-based capital and leverage requirements, liquidity standards, risk management and risk committee requirements, single-counterparty credit limits, and stress test requirements. The Proposed Rule is intended to implement the enhanced prudential standards and early remediation requirements under Section 165 and 166 of the Dodd-Frank Act. Two key changes for foreign banking reorganizations covered under the Proposed Rule would be that they would have to (a) allocate capital specifically to their non-branch activities in the U.S. and maintain their capital in a U.S. intermediate holding company, and (b) maintain a significant liquidity buffer in the U.S. The FRB said that it extended the comment period because "of the complexities of the issues addressed and the variety of considerations involved" with implementation of the Proposed Rule.

GAO Issues Report on Financial Crisis Losses and Potential Impacts of the Dodd-Frank Act

In the aftermath of the 2007-2009 financial crisis, the Government Accountability Office (the "GAO") issued a report (the "GAO Report") examining the losses associated with the recent financial crisis, the benefits of the Dodd-Frank Act for the U.S. financial system, and the potential costs associated with the Dodd-Frank Act.

Losses Associated with the Financial Crisis. The GAO Report states that the total losses associated with the 2007-2009 financial crisis could exceed $10 trillion. These losses stem from a steep decline in U.S. output and a severe economic downturn. The Congressional Budget Office estimates GDP may recover to its potential level by 2018; however, the GAO Report indicated that some research suggests output losses could persist well beyond 2018. In addition, the GAO Report points to increases in unemployment and declines in household wealth as significant losses associated with the crisis. The GAO Report states that persistent unemployment may result in a range of negative consequences, including skill erosion, lower future earnings, health problems and fewer educational and occupational opportunities for those affected. Declines in home prices and the value of financial assets has also led to a decrease in overall household wealth. Finally, the GAO Report notes the greater fiscal challenges faced by the government as a result of the financial crisis. Specifically, declines in output, income and employment have resulted in less tax revenue for federal, state and local governments, while the demand for social welfare services has simultaneously increased.

Costs Associated with the Dodd-Frank Act. After summarizing the benefits of the Dodd-Frank Act, the GAO Report discusses the potential costs associated with the Dodd-Frank Act. While the Dodd-Frank Act may improve the financial system's resilience, it will also impose a number of costs on the government and the financial industry as a whole. First, in order to implement and comply with the Dodd-Frank Act, federal agencies must devote resources to fulfill their rulemaking and regulatory responsibilities. The GAO Report also notes that additional regulations imposed by the Dodd-Frank Act on financial institutions will increase regulatory compliance costs. Examples of compliance costs identified in the GAO Report include the costs for regulated firms to hire and train staff and management, devote time to compliance activities, and hire outside counsel and experts. The GAO Report notes that provisions within the Dodd-Frank Act specifically target large financial firms and that their compliance costs are expected to increase significantly more than those of other financial firms. For example, the GAO Report notes that several provisions within the Dodd-Frank Act apply only to systematically important financial institutions, which include bank holding companies with total consolidated assets in excess of $50 billion. Notwithstanding the foregoing, the GAO Report also notes that a number of the provisions within the Dodd-Frank Act are expected to impose costs on non-bank financial institutions as well. The GAO Report states that the full impact of the Dodd-Frank Act on financial firms' business remains uncertain and financial institutions are finding it difficult to measure the regulatory compliance costs because of the piecemeal way the Dodd-Frank Act is being implemented. As a result, no comprehensive data is readily available regarding the costs of regulatory compliance for financial institutions.

The GAO Report also states that certain provisions may reduce revenue of financial institutions as a result of the restrictions imposed by the Dodd-Frank Act. Examples of such provisions provided in the GAO Report include (i) the Volcker Rule, which may eliminate sources of trading and fee income for some banks by prohibiting banks from engaging in proprietary trading and restricting their sponsorship or investments in funds; (ii) swap reforms which may result in a reduction in the volume of high-profit margin swaps; (iii) the single counterparty credit limits which may decrease the derivative activity and securities lending of some banks; and (iv) the cap placed on debit card interchange fees charged by debit card issuers with at least $10 billion in assets. The GAO Report explains that quantifying the potential costs associated with the Dodd-Frank Act is difficult and the magnitude of such costs will depend, in part, on how the reforms are implemented.

In addition to the increased costs imposed on regulatory agencies and financial institutions, the GAO Report points to concern over potential unintended consequences that may result from the implementation of the Dodd-Frank Act reform. Specifically, academics and industry representatives believe that by imposing higher costs on financial institutions, the Dodd-Frank Act may indirectly impose higher costs on businesses and households, reducing their investment and consumption with a consequent effect on economic output. Similarly, the Dodd-Frank Act could make the financial system more vulnerable to a crisis. For example, the GAO Report notes that "some experts suggest that higher capital, liquidity and collateral requirements will cause regulated institutions to increase significantly their holdings of relatively safe and liquid securities, such as U.S. Treasuries." As noted in the GAO Report, such a scenario could inflate the value of securities, which could result in large losses from a subsequent correction in the valuation of the securities. In addition, the GAO Report states that the Dodd-Frank Act may lead to an inadvertent reduction in the competitiveness of U.S. financial institutions. Experts have expressed concern that the increased regulation of the U.S. financial system may cause financial activities in the United States to move to foreign jurisdictions with less stringent regulations. The GAO Report indicated that, while some quantifiable data exists regarding the potential costs associated with the Dodd-Frank Act, other costs and the impact on the economy as a whole, cannot be easily quantified (and the GAO does not offer its own quantification of these costs).

Reminder: Swap End-Users Must Obtain LEIs/CICIs by April 10, 2013

CFTC Swap Data Recordkeeping and Reporting Requirements require each counterparty to any swap that is subject to the jurisdiction of the CFTC to obtain a legal entity identifier, or "LEI," which is a unique code used to identify a legal entity in all recordkeeping and swap data reporting. The current version of the LEI is called the CFTC Interim Compliant Identifier, or "CICI."

End-users—that is, swap counterparties that are neither swap dealers nor major swap participants—are required to obtain a CICI no later than April 10, 2013. The deadline has already passed for swap dealers and major swap participants to obtain a CICI.

CICIs may be obtained at the DTCC-SWIFT Registration Portal at https://www.ciciutility.org. Those planning to apply for a CICI should first search for the registrants' name on the portal, as certain entities were pre-assigned CICIs by the organizations maintaining the site. For those that have not been pre-assigned CICIs, registration requires providing certain information about the registrant and paying a registration fee of $200.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2013 Goodwin Procter LLP. All rights reserved.

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