SEC Staff Provides No-Action Relief to Permit Joint Accounts to Include Cash Collateral From Securities Lending Program with Affiliated Lending Agent

1. SEC Staff Provides No-Action Relief to Permit Joint Accounts to Include Cash Collateral From Securities Lending Program with Affiliated Lending Agent
2. FinCEN Issues PATRIOT Act Fact Sheet Concerning Foreign Correspondent and Private Banking Accounts
3. SEC Staff Provides Additional Guidance on Use of Third-Party Ratings of Advisers and the Advisers Act Prohibition on the Use of Testimonials
4. Federal Banking Agencies Issue Guidance for "Small Entities" Concerning Compliance with Information Security Standards
5. OCIE Director Discusses Remedial Measures Undertaken by Pension Consultants in the Wake of SEC Staff Report

In a letter to the Investment Company Institute (the "ICI"), the staff of the SEC’s Division of Investment Management modified the guidance provided in The Chase Manhattan Bank, SEC No-Action Letter (pub. avail. July 24, 2001) ("Chase"). In Chase, among other things, the staff indicated it would not object if affiliated registered investment companies ("funds") were to invest their cash balances through one or more joint accounts in various money market instruments. However, the staff specifically excluded from the Chase no-action relief cash balances consisting of cash collateral from a securities lending program administered by a securities lending agent affiliated with the funds. The staff’s recent letter to the ICI removes this exclusion but leaves the terms of the no-action relief in Chase otherwise unaffected. (For a more detailed discussion of the Chase no-action letter, see the July 31, 2001 edition of the Alert.)

The U.S. Treasury Department’s Financial Crimes Enforcement Network ("FinCEN") issued a 5-page ‘fact sheet’ that serves as a prelude to the long-anticipated final rule under section 312 of the USA PATRIOT Act of 2001 (the "PATRIOT Act") pertaining to foreign "correspondent" and "private banking" accounts. The fact sheet summarizes the basic elements of the final rule and identifies a new proposed rule relating to correspondent accounts. According to the fact sheet, both the final and proposed rule will be published in the Federal Register after January 1, 2006.

The release of a fact sheet in advance of a final rule is a highly unusual step by a federal regulatory agency and likely reflects the fact that section 312 is one of the most far-reaching, complex, and controversial anti-money laundering provisions of the PATRIOT Act. FinCEN had previously attempted to issue comprehensive rules to implement section 312 in May 2002; those rules, however, met with significant and vociferous industry opposition. FinCEN officials, in public remarks, have stated that the final and proposed rules are designed to address some industry concerns and provide greater flexibility (including providing broader authority to use a risk-based approach in evaluating accounts) than the May 2002 proposed rule.

PATRIOT Act section 312 essentially requires certain U.S. financial institutions to apply due diligence, and in some cases enhanced due diligence, to (a) correspondent accounts maintained for foreign financial institutions, and (b) private banking accounts maintained for non-U.S. persons. According to the fact sheet, the final rule will cover the due diligence requirements for both correspondent and private banking accounts; it also will set forth the special, or enhanced, due diligence requirements for certain private banking accounts. The fact sheet states that the special due diligence requirements for correspondent accounts will be the subject of a separate notice of proposed rulemaking, on which interested parties will be invited to comment.

Due Diligence in the Correspondent Account Context. The fact sheet indicates that the final rule will interpret the section 312 requirements broadly in the context of correspondent banking accounts. To begin with, the correspondent account provisions will apply to U.S. banks, securities broker-dealers, futures commissions merchants ("FCMs"), and mutual funds. The rule will cover accounts that these institutions establish to receive deposits from, make payments to, or "handle other financial transactions related to" a foreign financial institution. The term foreign financial institution will include non-U.S. banks; non-U.S. branches of U.S. banks; non-U.S. entities that are analogous to securities broker-dealers, FCMs, and mutual funds; and money transmitters or currency exchangers organized under foreign laws.

The final rule will require U.S. financial institutions to establish risk-based due-diligence programs to control, detect, and report suspected money laundering activity through correspondent accounts. At a minimum, a due diligence program must (a) assess the risks posed by a correspondent account; (b) apply risk-based anti-money laundering procedures, including a periodic review of activity, to such accounts; and (c) determine whether a particular account should be subjected to enhanced due diligence procedures (which are the subject of the proposed rule discussed below).

Due Diligence and Enhanced Due Diligence for Private Banking Accounts. The fact sheet states that the final rule will require U.S. financial institutions to establish programs to detect suspicious activity conducted through private banking accounts. The rule will define private banking accounts as those accounts that (a) are established for non-U.S. individuals, (b) require a minimum aggregate deposit or other assets of $1 million, and (c) are assigned to specific employees that act as liaison with the account holder.

The private banking requirements will apply to the same U.S. financial institutions as are subjected to the correspondent account due diligence requirements – that is, banks, broker-dealers, FCMs, and mutual funds. That said, FinCEN acknowledges in the fact sheet that mutual funds do not offer private banking accounts.

The final rule will require U.S. financial institutions to: (a) determine all nominal and beneficial owners of a private banking account; (b) determine the source of all funds deposited into a private banking account, and the purpose and expected use of the account; (c) review account activity to ensure that such activity is consistent with information gathered about an account’s source of funds, purpose and expected use; and (d) ascertain whether an owner of an account meets the broad definition of "senior foreign political figure," (see, definition below) and thus subject to enhanced scrutiny.

The final rule will require enhanced due diligence as to private banking accounts established for senior foreign political figures – a term that includes senior foreign government officials, their close associates and family members, and companies formed for their benefit. The mandated enhanced due diligence must include procedures designed "to detect and report transactions that may involve the proceeds of foreign corruption."

Implementation Schedule for the Final Rule’s Requirements. The fact sheet says that those U.S. institutions covered by the final rule will have 90 days from the date the rule is published in the Federal Register to apply the required due diligence and enhanced diligence to "new" correspondent and private banking accounts. According to the fact sheet, existing accounts and those accounts established before the above-noted 90-day compliance period must be subjected to the final rule’s diligence requirements within 270 days from the date the rule is published in the Federal Register.

Proposed Enhanced Due Diligence for Correspondent Accounts. Finally, the fact sheet states that a proposed rule will be issued to implement section 312’s enhanced due diligence requirements for correspondent accounts. Section 312 requires enhanced due diligence for correspondent accounts maintained for a foreign bank that operates under an off-shore license, in a jurisdiction found to be non-cooperative in international money laundering efforts, or in a jurisdiction deemed to be of primary money laundering concern (under section 311 of the PATRIOT Act). The fact sheet does not give much detail on what enhanced due diligence is proposed in the rulemaking; the fact sheet only says that the proposal would give U.S. financial institutions some flexibility to apply enhanced due diligence procedures on a risk-assesses basis that is tailored to the characteristics of the specific account.

The fact sheet, in many ways, raises more questions than it answers. Those answers, one hopes, will be supplied in the final and proposed rules and the Federal Register notices that accompany them. The Alert will summarize the final and proposed rules after they have been published in the Federal Register.

The staff of the SEC’s Division of Investment Management issued a letter (the "Letter") discussing the extent to which a third party’s reliance on client evaluations of an adviser could cause that rating to be a testimonial within the meaning of Rule 206(4)-1 under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), and therefore subject to the Rule’s prohibition on the use of testimonials. In general terms, the Rule states that the use of a testimonial of any kind is a fraudulent practice prohibited by Section 206(4) of the Advisers Act. In issuing the Letter, the staff sought to address questions raised by advisers as to whether a third-party rating that relies on client evaluations, as one of many factors (but not the primary factor), is a testimonial under the Advisers Act.

Evaluating Third-Party Adviser Ratings as Testimonials. Noting that whether a third party rating is a testimonial depends on upon all the facts and circumstances relating to the rating, the staff indicated that a third-party rating that relies primarily on client evaluations of an adviser would be a testimonial. The staff acknowledged, however, that when a third party includes a client evaluation as part of its process for formulating an adviser’s rating, but client responses, relative to other criteria, are an insignificant factor in the rating’s formulation, the rating would not be a testimonial. In the staff’s view, an adviser considering whether a third-party rating is a testimonial or should evaluate, among other things, (1) criteria used by the third party when formulating the rating, and (2) the significance of client evaluations of an adviser as a criterion in the rating’s formulation. The Letter suggests that an adviser may find it necessary to contact a third party to obtain the information necessary to properly evaluate whether or not the third party’s rating is a testimonial for purposes of the Advisers Act.

Permitted Use of Third-Party Ratings Deemed Testimonials. The Letter makes several references to one of the staff’s most recent no-action letters addressing client testimonials (DALBAR, Inc. (pub. avail. March 24, 1998) ("DALBAR")), where the staff allowed an adviser to use a particular third party rating even though the rating was deemed to be a testimonial. Among the principal facts sited by the staff in granting the DALBAR no-action relief were that (a) the DALBAR rating did not emphasize favorable client responses or ignore unfavorable responses, (b) the DALBAR rating represented all or a statistically valid sample of the responses provided by an adviser’s clients, (c) the questionnaire sent to clients was not designed to produce any pre-determined results benefiting the adviser and was structured to make it equally easy for a client to provide negative or positive responses and (d)

DALBAR did not perform any subjective analysis or show any results, but instead assigned numerical ratings after averaging client responses for each adviser.

Third-Party Ratings - Other Anti-Fraud Concerns. The Letter also reiterated cautionary guidance from DALBAR regarding factors advisers should consider when determining whether an advertisement containing a third-party rating (including one that is a testimonial) would run afoul of a separate prohibition under the Advisers Act against the use of false or misleading advertisements. In this regard, the Letter noted that an advertisement could be considered false or misleading if it implies, or would lead a prospective client to infer, something about the adviser or its clients’ experiences that is not true, and that the prospective client would not have been inferred had all material facts been disclosed. The factors sited by the staff were as follows:

1. Whether the advertisement discloses the criteria on which the rating was based;
2. Whether the adviser is aware of facts that would call into question the validity of the rating or the appropriateness of advertising the rating (e.g., the adviser knows that it has been the subject of numerous client complaints relating to the rating category or in areas not included in the survey);
3. Whether the adviser also discloses any unfavorable rating it has received;
4. Whether the advertisement states or implies that the adviser was the top rated adviser in a category where it was not rated first;
5. Whether the advertisement clearly and prominently discloses the category for which the adviser’s rating was calculated or determined, the number of advisers surveyed in that category and the percentage of advisers that received that rating;
6. Whether the advertisement discloses that the adviser’s rating may not be representative of any one client’s experience because the rating reflects an average or sample of the experiences of the adviser’s clients;
7. Whether the advertisement discloses that the rating is not indicative of the adviser’s future performance; and
8. Whether the advertisement prominently discloses who created and conducted the survey, and that advisers paid a fee to participate in the survey.

The federal bank and thrift agencies (the "Agencies") published a compliance guide for small entities to assist them in compliance with the Interagency Guidelines Establishing Information Security Standards (the "Guidelines"). The compliance guide is required to be issued under the Small Business Regulatory Enforcement Fairness Act of 1996, which requires agencies to issue such guides for small businesses. The Small Business Administration has published a table of Small Business Size Standards that defines a "small business" based upon whether it fits within a size limit for its industry. For example, the current upper limit to qualify as a "small business" for a commercial bank or savings institution is $165 million in total assets. The compliance guide summarizes the Guidelines and the obligations of financial institutions to establish risk-based policies and procedures designed to insure the confidentiality of customer information. The compliance guide discusses the important terms used in the Guidelines, how to assess risks and how to design and implement an information security program appropriate to the institution’s risk profile. It also addresses the institution’s response to incidents of unauthorized access to customer information and oversight of service providers. The compliance guide also provides a list of resources for institutions to use in designing their programs. The Agencies noted that the compliance guide does not address the applicability of any other federal or state laws or regulations relating to the safeguarding of customer records and information.

In a recent speech, Lori Richards, Director of the SEC Office of Compliance Inspections and Examinations discussed measures undertaken by pension consultants in light of recommendations made by the SEC staff in a May 16, 2005 report (the "Report") discussing sweep examinations of certain pension consultants. (See the May 24, 2005 Alert for discussion of the Report.) In response to the staff’s recommendation that pension consultants insulate their advisory activities from other business activities as a means of eliminating or mitigating conflicts of interest, Ms. Richards noted that firms had ceased affiliations with broker-dealers, closed broker-dealer subsidiaries, exited business lines involving services to money managers and otherwise eliminated business activities giving rise to conflicts of interest vis-à-vis pension consulting clients. Ms. Richards also discussed a range of structural and information containment measurers undertaken by pension consultants to address conflicts of interest, e.g., (a) implementing firewall procedures designed to prevent the sharing of client information across divisions and with affiliates, (b) installing computer-based firewalls to limit access to information across business lines and divisions, (c) reorganizing consulting and advisory businesses to operate as separate profit centers and (d) organizing dedicated compliance and risk management teams in each business group to oversee conflicts of interest. With respect to the staff’s recommendation that pension consultants improve their disclosure of material conflicts of interest, Ms. Richards noted that firms had instituted policies such as (1) providing clients with separate conflict of interest disclosure documents that discuss business relationships with money managers, (2) making specific disclosure to individual clients about conflicts a firm has with respect to particular money managers it recommends, (3) allowing advisory clients to request specific financial information related to a consultant’s business relationships with individual managers and (4) distributing responses to the issues raised in the Report and in "Selecting and Monitoring Pension Consultants: Tips for Planned Fiduciaries" which the SEC and DOL issued in connection with the Report. Ms. Richards also discussed remedial measures implemented by pension consultants to address potential conflicts of interest arising out of gifts, gratuities, entertainment, contributions or donations provided to clients or received by money managers. She noted that firms have amended their codes of ethics to better address these issues by providing additional guidelines and restrictions, implementing dollar limits on gifts given to, or received from, anyone doing business with the consultant and adopting gift reporting requirements. While Ms. Richards viewed the overall response by pension consultants to the Report as a positive one, she cautioned that not all pension consultants had implemented policies governing the payment of their fees with directed brokerage, and more than a handful of consultants failed to offer to provide a copy of their code of ethics to clients as required in Part II of Form ADV.

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