United States: SEC Exam Review Prompts Risk Alert On Advisers Act Custody Rule Compliance (Financial Services Alert For March 5, 2013)

Last Updated: March 6 2013
Article by Robert M. Kurucza

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

The SEC's Office of Compliance Inspections and Examinations issued a National Examination Risk Alert that discusses areas of non-compliance with Rule 206(4)-2 (the "Custody Rule") under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), observed by the SEC's National Examination Program ("NEP").  Referring to the Custody Rule as "[o]ne of the most critical rules under the [Advisers Act]," the Risk Alert describes "widespread and varied non-compliance with elements of the [Custody Rule]," with approximately one-third of the examinations reviewed in preparing the Risk Alert exhibiting custody-related issues.  The Risk Alert groups the custody-related deficiencies observed by the NEP into the following four categories:

  • failure to recognize that an adviser has "custody" in a number of situations where an adviser or its affiliates hold or have access to client assets;
  • failure to comply with elements of the Custody Rule's "surprise examination" requirement;
  • failure to comply with the Custody Rule's "qualified custodian" requirements by, e.g., commingling proprietary and client assets in a single account; and
  • failure to satisfy various requirements of the Custody Rule when an adviser elects to comply with the Rule through the preparation and distribution of audited annual financial statements for pooled investment vehicles it manages.

The Risk Alert concludes by noting that Custody Rule deficiencies noted in examinations have resulted in actions ranging from immediate remedial measures taken by advisers to referrals to the SEC's Division of Enforcement and subsequent litigation.  In conjunction with the Risk Alert, the SEC's Office of Investor Education and Advocacy (the "OIEA") issued an Investor Bulletin that walks through the Custody Rule's components and urges advisory clients to consider particular elements of the Custody Rule in their diligence processes.

SEC Staff Grants No-Action Relief to Allow Advisory Agreement Amendment Establishing Unified Fee Structure Without Shareholder Approval

The staff of the SEC's Division of Investment Management (the "Staff") granted no-action relief to allow the amendment of an investment advisory agreement for certain exchange-traded funds (the "ETFs") to establish a unified fee arrangement without obtaining shareholder approval pursuant to Section 15(a) of the Investment Company Act of 1940, as amended ("1940 Act").  Section 15(a) of the 1940 Act generally provides that no person may serve as an investment adviser to a registered investment company except pursuant to a written contract that, among other things, has been approved by the vote of a majority of the company's outstanding voting securities.  The Staff has taken the position that any material change in an advisory agreement creates a new contract that must be approved in accordance with Section 15(a) of the 1940 Act.

The ETFs have both a sub-adviser (the "Sub-adviser"), which manages each ETF's investment program on a day-to-day basis pursuant to an investment sub-advisory agreement with the ETFs (the "Sub-advisory Agreement"), and an investment adviser (the "Adviser"), which oversees the Sub-adviser's day-to-day portfolio management pursuant to a separate advisory agreement with the ETFs (the "Advisory Agreement").  The Sub-adviser and the Adviser are not affiliated.  Because the Sub-adviser recently received an exemptive order from the SEC allowing funds for which the Sub-adviser serves as investment adviser to operate as exchange-traded funds, the ETFs' board of trustees (the "Trustees") was considering whether to terminate the Advisory Agreement, and amend the Sub-advisory Agreement to (a) reflect the termination of the Adviser and (b) replace the existing advisory fee with a unified fee under which the Sub-adviser would pay from the advisory fee each ETF's ordinary operating expenses (except for the Sub-adviser's advisory fee, taxes, interest, Rule 12b-1 fees, brokerage expenses, litigation expenses, and extraordinary or other non-routine expenses, all of which would continue to be borne by the ETF).  The fee payable to the Sub-adviser under the Sub-advisory Agreement would not increase, and there would be no change in the services currently provided by the Sub-adviser to each ETF.

The amended Sub-advisory Agreement would have to be approved by a majority of the Trustees, including a majority of the Trustees who are not "interested persons" of the Sub-adviser within the meaning of the 1940 Act.  In addition, the ETFs would need to promptly notify their shareholders of the amendments to the Sub-Advisory Agreement by delivering a revised prospectus or supplement.  In granting the no-action relief, the Staff stated that its position was based particularly on representations that (1) the proposed amendments would not reduce or modify the nature and level of advisory services provided to the ETFs by the Sub-adviser and (2) the total advisory fees paid to the Sub-adviser under the amended Sub-advisory Agreement would not exceed those payable under the current Sub-advisory Agreement.

Emerging Global Advisors, LLC, SEC No-Action Letter (publ. avail. February 27, 2013).

FRB Issues Notice of Proposed Rulemaking Concerning Provision of Financial Services to Systemically Important Financial Market Utilities

The FRB issued a Notice of Proposed Rulemaking (the "Proposal") setting forth the conditions by which its Reserve Banks may provide banking services to systemically important financial market utilities ("FMUs").  The systemic risk provisions of the Dodd-Frank Act (the "Act") extend to FMUs, defined under the Act as "a person that manages or operates a multilateral system for the purpose of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions and the person."  12 U.S.C. §5462(6).  The Act authorizes the Financial Stability Oversight Council ("FSOC") to designate an FMU for enhanced risk management supervision upon a determination that the failure or disruption in the functioning of an FMU would present a risk of significant liquidity or credit problems spreading among financial institutions or markets that rely on FMUs for clearing and settlement of transactions.  Thus far, the FSOC has designated eight firms as subject to enhanced supervision: The Clearing House Payments Company LLC, CLS Bank International, Chicago Mercantile Exchange, The Depository Trust Company, Fixed Income Clearing Corporation, ICE Clear Credit LLC, National Securities Clearing Corporation, and the Options Clearing Corporation. 

As part of the framework for enhanced risk management provisions applicable to FMUs, and in the interest of ensuring market stability, the Act permits the FRB to authorize Reserve Banks to: (i) establish and maintain deposit accounts for designated FMUs; (ii) pay interest on those accounts; and (iii) provide FMUs with other ancillary financial services such as wire transfers, settlement, securities warehousing, currency exchange and check clearing, among others.  The Proposal sets forth the conditions and requirements by which an FMU may avail itself of these services from a Reserve Bank. 

At the broadest level, the Proposal's objectives are two-fold:  (1) to provide the FRB with sufficient information to assess a designated FMU's ongoing financial status and its ability to settle accounts promptly and in a safe and sound manner, and (2) to ensure that FMUs comply with requirements generally applicable to depository institutions for the maintenance of accounts and the provision of financial services from Reserve Banks.  Perhaps of greatest significance, the Proposal would require FMUs to maintain loss-absorbing capital reserves to be held separately from any other reserves ordinarily maintained by an FMU to cover participant default and other transaction-specific risks incurred in its payment, clearing and settlement activities.  In addition, the Proposal would require FMUs to remain in compliance with req+uirements imposed by their respective primary agency regulator (e.g. SEC, CFTC), with operating circulars applicable to the maintenance of accounts with the FRB, and to demonstrate an operational ability to avoid intraday overdrafts and the financial capacity to repay them as necessary.  The Proposal also calls for Reserve Banks to pay interest on account balances maintained by an FMU in the same manner and to the same extent as for depository institutions.  The Proposal seeks comment on all aspects of the Proposal, and in particular whether there any other conditions that should be imposed in keeping with the goal of reducing systemic risk in the clearing and settlement processes maintained by FMUs.  Comments are due by May 3, 2013.

FRB Governor Raskin Urges Banks to Take Proactive Role in Dealing with Reputational Risk

On February 28, 2013, FRB Governor Sarah Bloom Raskin made a presentation entitled "Reflections on Reputation and its Consequences" to the 2013 Banking Outlook Conference at the Federal Reserve Bank of Atlanta.  Governor Raskin noted that, in the aftermath of the 2007-2009 financial crisis, financial institutions of all sizes have seen a decline in the public's perception of their reputation and trustworthiness (and she added that the quality of their reputation is of particular importance to financial institutions).  Governor Raskin stated that the decline in public trust of, and confidence in, financial institutions has been increased recently by, among other things, "the Occupy Wall Street movement, payday loans, overdraft fees, rate-rigging settlements in London Interbank Offered Rate [LIBOR] cases, executive compensation and bonuses that seem to bear no relationship to performance or risk, failures in the foreclosure process, and a drumbeat of civil litigation."

Governor Raskin urged banks to take a more proactive approach to identifying and addressing reputational risk rather than merely reacting to crises that have already occurred and resulted in reputational damage.  Governor Raskin suggested that the FRB's supervisory program could help banks to identify reputational risks sooner, and she stated that regulatory supervisors "should think about a supervisory approach that incentivizes bank managers to sufficiently contemplate, quantify if necessary, and control the factors that affect the level of such [reputational] risks before they fully emerge in an unmitigated form."

As a specific example of a current and pressing reputational risk that banks need to address proactively, Governor Raskin pointed to the reputational damage and customer distrust created by cyber attacks on banks and the resulting threats of theft of proprietary data and personal information concerning bank customers.  Moreover, Governor Raskin noted, as increasing numbers of bank customers rely on electronic and website banking services, the reputational damage that can be done to a bank by a hacker becomes larger and potentially devastating.

Comptroller of the Currency Curry Discusses Enforcement Practice and Philosophy of OCC and States That No Large Bank Is "Too Big to Prosecute"

Comptroller of the Currency Thomas J. Curry made a presentation concerning the OCC's enforcement practice and philosophy on February 26, 2013 to the National Association of Attorneys General.  Comptroller Curry noted that the OCC's first goal as a prudential regulator is to identify supervisory issues at banks early, when the problems can most easily be fixed, and then to let the banks take appropriate corrective actions, eliminating the need for the OCC to take formal enforcement actions.  The Comptroller stressed that unlike the Department of Justice ("DOJ"), which is authorized to bring civil and criminal actions against institutions and individuals for the purpose of punishing them, the OCC is not authorized to investigate or prosecute criminal activity.  In civil matters, if customers of a bank have suffered financial harm, the OCC will act quickly and take steps to see that those bank customers are compensated "in a timely fashion."  The Comptroller noted, however, that when the OCC imposes civil money penalties, the fines are often paid later in the process and only after a consent agreement is negotiated with the applicable bank.  The Comptroller stated that, as with other regulatory agencies, the vast majority of OCC actions are resolved through negotiated settlements.  He stated that there are good reasons for using negotiated settlements, where appropriate:  (1) litigated cases are expensive; (2) litigated cases take a long time to resolve; (3) outcomes of litigation are uncertain; and (4) often the applicable bank has to pay a significant monetary penalty to the OCC at the time it enters into a negotiated settlement agreement.

Comptroller Curry went on to state that, should a bank or thrift refuse to enter a consent agreement, the OCC is prepared to litigate.  He stated that "[B]efore initiating an action, we conduct a thorough review of the facts and an analysis of the law, and we do not initiate actions unless we believe they can be successfully litigated."  Also, although the OCC has no authority to prosecute criminal cases, Comptroller Curry stressed that the OCC regularly refers matters to the DOJ and works with the DOJ in developing the criminal case.

The Comptroller next stated that although banks are essential to the health of the U.S. economy, "No institution should be too big to prosecute."  Moreover, said Comptroller Curry, in almost every case where the OCC brings an action against a bank, it also considers whether actions against responsible directors, officers or other individuals are "warranted and equally supportable."

In his remarks, Comptroller Curry also stressed that under his leadership, the OCC would work cooperatively with state attorneys general, the DOJ and the Consumer Financial Protection Bureau in taking enforcement actions against banks and thrifts.

Goodwin Procter Alert Describes ESMA Remuneration Guidelines Under the Alternative Investment Fund Managers Directive

Goodwin Procter issued a Client Alert that describes the European Securities Markets Authority's publication of its final Guidelines on the remuneration of managers under the Alternative Investment Fund Managers Directive.  Although the Guidelines are aimed specifically at European managers, the disclosure and delegation elements will also affect non-European managers.

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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