Seventh Annual Capital Markets Symposium October 2, 2013
DODD FRANK: 2013 The Regulators Extend Their Reach into the Capital Markets
Symposium_4.indd 1 9/24/2013 11:28:44 AM Herrick, Feinstein LLP’s Seventh Annual Capital Markets Symposium October 2, 2013
DODD FRANK: 2013 The Regulators Extend Their Reach into the Capital Markets
Keynote Speaker: Jill E. Sommers Former Commissioner of the Commodity Futures Trading Commission
Symposium Faculty:
Michael Otten Therese Doherty Executive Director, Legal, Nomura Holdings America Partner, Herrick, Feinstein LLP Deborah Prutzman Irwin Latner Chief Executive Officer, Partner, Herrick, Feinstein LLP Regulatory Fundamentals Group LLC Patrick Sweeney Steven Schwartz Partner, Herrick, Feinstein LLP Global Head of Enforcement, Chicago Mercantile Exchange
Symposium_4.indd 3 9/24/2013 1:42:05 PM Contents
Speaker Bios 1
Symposium Materials
Regulation of Swap Dealers under Title VII of the Dodd-Frank Act 9 By Patrick D. Sweeney and Samuel Bazian Herrick, Feinstein LLP
Regulation of End Users of Swap Transactions under Dodd-Frank 23 By Patrick D. Sweeney and Marc Shepsman Herrick, Feinstein LLP
Cross Border Application of U.S. Swap Regulations: 35 Conflicts Abound at Home and Abroad By Patrick D. Sweeney, Adam D. Wolper and Kyle Shenfeld Herrick, Feinstein LLP
What’s Happening in Enforcement? 43 By Therese M. Doherty, LisaMarie F. Collins and Philip W. Raimondi Herrick, Feinstein LLP
SEC Focus Areas Regarding Investment Advisers 51 By Irwin M. Latner and John D. Cleaver Herrick, Feinstein LLP
Broker-Dealer Registration Issues Involving Private Funds 63 By Irwin M. Latner and Jessica D. Wessel Herrick, Feinstein LLP
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Jill E. Sommers Former Commissioner of the Commodity Futures Trading Commission
Jill E. Sommers was nominated by both President George W. Bush and President Barack Obama, confirmed twice by the United States Senate and served two consecutive terms as a Commissioner of the Commodity Futures Trading Commission. She ended her six years of service on July 8, 2013.
During her time at the agency, Commissioner Sommers was a consistent advocate for common sense regulation that included a thorough cost benefit analysis. In November of 2011, Ms. Sommers was named senior Commissioner with respect to MF Global matters, including overseeing the enforcement division’s investigation and ultimate filing of charges against both the companies as well as senior MF Global executives. Commissioner Sommers served as Chairman and Designated Federal Official of the Commission’s Global Markets Advisory Committee (GMAC), which discussed issues of concern to exchanges, firms, market users and the Commission regarding the regulatory challenges of a global marketplace. She also had the opportunity to represent the United States throughout the world while serving as the Commission Representative to the Technical Committee meetings of the International Organization of Securities Commissions (IOSCO).
Ms. Sommers has worked in the commodity futures and options industry in a variety of capacities throughout her career. She served as Policy Director and Head of GovernmentAffairs for the International Swaps and Derivatives Association, where she worked on a number of over-the counter derivatives issues. Prior to that, Ms. Sommers worked in the Government Affairs Office of the Chicago Mercantile Exchange (CME), where she was instrumental in overseeing regulatory and legislative affairs for the exchange.
Ms. Sommers started her career in Washington in 1991 as an intern for Senator Robert J. Dole (R-KS). She has continued her work engaging with Members of Congress on a variety of issues over the past twenty years including three Commodity Exchange Act Reauthorizations.
A native of Fort Scott, Kansas, Ms. Sommers holds a Bachelor of Arts degree from the University of Kansas. She and her husband, Mike, currently reside in the Washington, DC area and have three children ages 11, 10 and 9.
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Michael J. Otten Executive Director in the Legal Department of Nomura Holding America Inc.
Michael J. Otten is an Executive Director in the Legal Department of Nomura Holding America Inc. where he works closely with Nomura’s registered Swap Dealers, Futures Commission Merchant, Broker-Dealer, and affiliates world-wide on implementation of regulatory reforms. Prior to joining Nomura in July 2012, he spent nearly 10 years at the Commodity Futures Trading Commission (“Commission”) in Washington, DC. While at the Commission, Michael most recently served as Legal Counsel to Commissioner Jill E. Sommers, and also served as Legal Counsel to Acting Chairman Walt Lukken and Chairman Reuben Jeffery. Michael began his tenure at the Commission in the Division of Enforcement, where he served as a Chief Trial Attorney.
Prior to joining the Commission, Michael was a Partner in the Litigation Division of LeClair Ryan, a Richmond, Virginia law firm. Michael began his legal career on active-duty in the United States Air Force, Judge Advocate General’s Corps, serving as a Captain from 1994 until 1998. Michael is a graduate of Boston College Law School and Manhattanville College.
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Bios Sommers, Otten, Prutzman.indd 2 9/24/2013 11:30:15 AM Deborah Prutzman Chief Executive Officer of the Regulatory Fundamentals Group LLC
Deborah Prutzman is the Chief Executive Officer of the Regulatory Fundamentals Group LLC. She has an exceptionally wide-ranging and deep background in the domestic and international financial services industry, and has hands-on experience in regulatory risk management and corporate governance. She has earned a reputation for helping financial institutions thrive despite difficult business circumstances.
Ms. Prutzman has assembled a team of highly skilled experts with decades of expertise in the financial services regulatory environment. RFG’s objective is to bring its clients a level of counsel, creativity, and practical expertise that cuts across complex technical areas in a manner not readily available elsewhere. RFG offers an experienced brain trust that has more than 250 years negotiating financial services issues, particularly in the banking, payment and clearing systems, and asset management spaces.
As General Counsel to the Merrill Lynch Global Bank Group, Ms. Prutzman conceived and managed the reorganization of Merrill’s U.S. banking operations to create a full service federal thrift, which enabled Merrill to offer banking services throughout its network of financial advisors. She built and recruited a 60+ person team of legal and compliance professionals. Her team handled regulatory and product issues with a unique focus on “knowledge management” systems designed to assure both quality and consistency of results and business partner understanding of key issues. As part of this process, Ms. Prutzman designed the compliance infrastructure and recruited the compliance team professionals for the ML banks in the United States. In addition, she was able to obtain favorable regulatory rulings in a variety of circumstances, including the handling of “brokered deposits.”
Ms. Prutzman has also served as General Counsel of CLS Services, the world’s foreign exchange netting system, during its start-up stages. In the absence of precedent, she developed rules and contracts that satisfied the laws and regulations of 13 jurisdictions and allowed 63 of the world’s largest financial institutions to clear foreign exchange transactions on a real-time, continuously linked basis. She recruited and staffed the legal and compliance function.
Earlier in her career, Ms. Prutzman was General Counsel for the New York Clearing House Association. Also, Ms. Prutzman served as Senior Vice President and Deputy General Counsel of Chemical Bank. Ms. Prutzman has been a partner at Paul, Weiss, Rifkind, Wharton & Garrison and Arnold & Porter. She earned her law degree from Columbia University.
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Steven M. Schwartz Executive Director, Global Head of Enforcement, CME Group
Steven M. Schwartz serves as Executive Director, Global Head of Enforcement of CME Group. He is responsible for oversight of the company’s Market Regulation Department enforcement function. Prior to his role as Global Head of Enforcement, he joined the company in 2011 as the Regional Head of Enforcement for New York.
Prior to joining the company, he had over 20 years of litigation experience at various law firms. Most recently he was a partner at Winston & Strawn where he litigated complex commercial cases in the futures, securities and bankruptcy areas. He also worked for Hertzog, Calamari & Gleason and Webster & Sheffield where he litigated complex commercial cases, including some involving securities and futures trading, bankruptcy matters and product liability actions.
He earned a bachelor’s degree in business management from the State University of New York at Binghamton and a J.D. from Cornell Law School where he graduated Magna Cum Laude and Order of the Coif. He also served as an Editor on the Cornell Law Review.
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Round 2 of bios.indd 4 9/24/2013 1:24:35 PM Therese M. Doherty Partner and Co-Chair of the Securities and Commodities Litigation and Regulatory Practice Group, Herrick, Feinstein
Therese M. Doherty is a senior partner in Herrick’s Litigation Department, and Co-Chair of its Securities and Derivatives Litigation and Regulatory Practice Group. Therese’s practice is focused on derivatives, futures and securities in civil litigations and regulatory enforcement proceedings. She regularly defends and advises broker-dealers, futures commission merchants, banks and other global financial institutions. Clients also rely uponTherese to lead internal investigations. Therese is ranked in the U.S. Legal 500 Legal Directory in the area of securities ligation, which notes that her “depth of industry knowledge, and the ferocity with which she represents clients make her my go-to litigator for significant matters.”
Therese has extensive trial and arbitration experience and appears in federal and state courts around the country and different arbitration forums, including FINRA, the NFA and various commodity and security exchanges. Therese’s practice regularly involves complex claims of fraud, violations of commodities and securities laws, RICO violations, and accounting improprieties.
Therese’s regulatory practice includes defending firms and individuals in investigations and enforcement proceedings initiated by the CFTC, SEC, U.S. Attorney’s Offices, Attorneys General, self-regulatory organizations, including the NFA and FINRA, and various commodity and security exchanges. She also represents financial institutions in employment related matters, including recruitment disputes, restrictive covenants and issues involving Forms U-4, U-5 and 8T.
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Round 2 of bios.indd 5 9/24/2013 1:24:35 PM Speaker Bios
Irwin M. Latner Partner and Chair of the Hedge Fund Group, Herrick, Feinstein
Irwin Latner has a broad based practice that focuses on representing hedge fund and private equity fund managers in the establishment of private investment funds and their ongoing operations. Irwin represents both domestic and offshore managers who employ varied investment strategies and need assistance with fund set up and structuring, SEC registration and reporting, agreements with strategic investors, developing effective compliance programs, marketing and advertising practices, employment and compensation arrangements, portfolio investment transactions, derivatives, and compliance with the myriad of federal and state securities and commodities laws applicable to their business.
In addition to representing investment advisers and fund managers, Irwin represents U.S. and non-U.S. based broker dealers, placement agents, commodity trading advisers, seeding and incubation firms, family offices and other types of financial service companies and alternative investment firms.
Irwin regularly speaks at hedge fund industry seminars and is frequently quoted in the press on current hedge fund industry issues. Irwin graduated magna cum laude from Brooklyn Law School.
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Round 2 of bios.indd 6 9/24/2013 1:24:35 PM Patrick D. Sweeney Partner and Chair of the Investment Management Group, Herrick, Feinstein
Patrick D. Sweeney is Chairperson of Herrick’s Investment Management Practice Group. He represents investment managers, investment funds and investment fund fiduciaries in a wide range of corporate, regulatory and transactional matters. Pat also represents major institutional investors in corporate debt restructuring and non-U.S. investors in inbound investments.
Prior to joining Herrick, Pat practiced investment management law in-house for more than 10 years, first as senior investment counsel for Merrill Lynch Asset Management and then as General Counsel to Nomura Corporate Research and Asset Management. He began practicing law in association with Shearman & Sterling in the 1980’s, where he represented financial institutions in corporate, securities and finance transactions.
Pat is an active member of the New York City Bar Investment Management Committee and the Investment Company and Investment Adviser Subcommittee of the American Bar Association’s Business Law Section, and has participated for many years in committees, conferences and panel presentations of the Investment Company Institute, the Loan Syndications and Trading Association, the Mutual Fund Directors Forum and many other investment management industry organizations.
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Round 2 of bios.indd 7 9/24/2013 1:24:36 PM Herrick, Feinstein LLP’s Seventh Annual Capital Markets Symposium October 2, 2013
DODD FRANK: 2013 Regulation of Swap Dealers under Title VII of the Dodd-Frank Act
By Patrick D. Sweeney and Samuel Bazian
Sweeney1 Cover.indd 1 9/24/2013 11:33:44 AM Dodd Frank 2013: The Regulators Extend Their Reach into the Capital Markets
Regulation of Swap Dealers under Title VII of the Dodd-Frank Act By Patrick D. Sweeney and Samuel Bazian1
Title VII of Dodd-Frank imposes a comprehensive regulatory framework on swaps transactions and their participants, including swap dealers, major swap participants, and end-users. Title VII contains two key components. First, it establishes regulations requiring that most swaps be cleared by a registered derivatives clearing organization (DCO).2 Second, the statute creates rules that parties to a swap must follow, including reporting and disclosure requirements, business conduct standards, and capital and margin requirements. Finally, Title VII divides regulatory authority over swaps transactions between the U.S. Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC).3 Specifically, the CFTC has primary authority over the regulation of swaps, while the SEC has primary authority to regulate security-based swaps. This article will discuss solely the CFTC regulations and focus on the rules governing swap dealers.
What is a “Swap Dealer”? Title VII defines a “swap dealer” as “any person who—(i) holds itself out as a dealer in swaps; (ii) makes a market in swaps; (iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (iv) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps, provided however, in no event shall an insured depository institution be considered a swap dealer to the extent it offers to enter into a swap with a customer in connection with a originating a loan with that customer.”4 Furthermore, “[a] person may be designated as a swap dealer for a single type or single class or category of swap or activities and considered not to be a swap dealer for other types, classes, or categories of swaps or activities.”5
The term “swap dealer” only applies, however, to a person that enters into swaps as part of his regular business. Thus, if that person engages in swaps transactions for his own account, he or she will not be considered a swap dealer. Importantly, there are certain swaps that are not considered in determining whether a person or an entity is considered a swap dealer. These include: (1) swaps in which one counterparty directly or indirectly owns a majority interest in the other; (2) swaps entered into by a “cooperative with a member of such cooperative” if the cooperative has policies requiring the monitoring and reporting of swaps; (3) swaps entered into for the purpose of hedging physical positions; and (4) swaps entered into by floor traders.6
Moreover, a person will not be considered a swap dealer as a result of its swap dealing activity involving counterparties, so long as the swap positions connected with those dealing activities into which the person enters over the preceding 12 months have an aggregate notional amount of no more than $3 billon, subject to a phase in7 level of an aggregate gross notional amount of no more than $8
______1 Patrick D. Sweeney is a partner and Samuel Bazian is a summer associate at Herrick, Feinstein LLP. 2 See Dodd-Frank Act § 723. 3 See Dodd-Frank Act § 712. 4 Id. at § 721(49)(A). 5 Id. at § 721(49)(B). 6 CFTC Regulation § 1.3(6)(ii)(A). 7 Pursuant to CFTC regulations, the phase-in termination date is no later than 39 months after “the date that a swap data repository first receives swap data” from the swap dealer or, in the case where the CFTC terminates this set phase-in period
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billion. This is referred to as the “de minimis exception.” For a swap dealer that enters into swaps with “Special Entities,”8 the de minimis notional threshold amount is $25 million.9
Swap Dealers Regulations As of October 12, 2012, a swap dealer is required to register with the CFTC. A dealer that surpasses the de minimis exception level after that date is required to register with the CFTC within two months following the last day of the month in which it exceeds the de minimis threshold amount. 10 Once registered, a swap dealer must comply with the voluminous regulations of the CFTC.
Designating a Chief Compliance Officer A swap dealer is required to designate a chief compliance officer (CCO) who is generally responsible for developing “appropriate policies and procedures to fulfill the duties set forth in [Title VII] and [CFTC regulations].” Specifically, the CCO’s duties include administering the registrant swap dealer’s policies and procedures, resolving conflicts of interest, taking reasonable steps to ensure compliance with CFTC rules, and establishing procedures for the remediation of noncompliance issues.
Furthermore, the CCO must file an annual report that: describes the registrant’s written code of ethics and conflicts of interest policies and procedures; reviews the policies in place that are designed to ensure compliance with Title VII and CFTC regulations and whether improvements to those policies are needed; lists any material changes to the policies and procedures in the prior year; describes the resources devoted to compliance; and discusses any noncompliance issues addressed. The CCO or CEO must certify that the report is accurate and complete and file the report electronically with the CFTC within 90 days after the end of the registrant’s fiscal year.
Recordkeeping and Daily Trading Records Requirements A swap dealer must retain all records relating to swaps activities and the documents on which the transaction information is originally recorded.11 These records must be kept in a form that is searchable by transaction and counterparty. These records include transaction records, position records, and records of transactions executed on a swap execution facility or designated contract market, or cleared by a DCO.
Additionally, a swap dealer must keep full business and financial records, records of complaints received concerning any member of the organization, marketing and sales materials, records of data reported to a swap data repository, and real-time reporting data. Moreover, the regulations require that a swap dealer keep detailed records of its daily trading activities. These records must be sufficiently detailed so as to make possible a “comprehensive and accurate trade reconstruction for each swap.”12 A swap dealer must also retain all pre-execution trade information that leads to the execution of a swap, including oral and written communications concerning quotes, solicitations, bids, and offers, and has not published a new phase-in termination date, “five years after the date that a swap repository first receives swap data.” 8 See section below entitles “Swaps and Special Entities.” 9 See CFTC Regulation § 1.3(ggg)(iv)((4). 10 See http://www.cftc.gov/PressRoom/PressReleases/pr6348-12. 11 See CFTC Regulation § 23.201. 12 See http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/bcs_qas_final.pdf.
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regardless of communication media; execution trade information, including the terms upon which a swap is made, the trade ticket for each swap, the unique swap identifier,13 the date and time of the execution, the name of the counterparty, price of the swap, fees and commissions, and all other relevant information; and post-execution trade information, such as post-trade processing and events.
A swap dealer is further required to maintain ledgers listing: payments received; moneys borrowed and loaned; daily calculations relating to the value of each outstanding swap, the current and potential future exposure of each counterparty, initial and variation margin payable to or receivable from each counterparty, and the value of all collateral; transfers of collateral; and charges against and credits to each counterparty’s account. Finally, a swap dealer must keep daily trading records of all cash or forward transactions it executes. All of the records listed above must be kept at the swap dealer’s principal place of business. They must be retained for a period of five years from the date the record was made and made accessible during the first two years.14
Risk Management and Supervision Requirements Every swap dealer must implement a risk management program that identifies risks and sets risk tolerance limits based on various factors such as market risk, credit risk, liquidity risk, foreign currency risk, legal risk, operational risk, and settlement risk. Every quarter—as well as any time a material risk to the entity is detected—the risk management unit of each swap dealer must submit to the dealer’s governing body a “Risk Exposure Report” detailing the applicable risk exposures. The report must consider whether there should be changes to the risk management program and the time frame for implementing those changes. These reports must be submitted to the CFTC within five days of the time they are submitted to the governing body.
Before a swap dealer may engage in a transaction involving a new product, the dealer must include in the Risk Exposure Report a new product policy that considers the product’s characteristics and counterparty involved, identifies the relevant risks, and assesses whether the product would materially alter the overall entity-wide risk profile. Furthermore, a swap dealer must establish policies mandating the use of central counterparties when clearing is required and must monitor compliance with the risk management program.
A swap dealer must also establish policies for its business trading unit that require: (1) all trading policies be approved by the entity’s governing body; (2) all counterparties to have an established credit limit; (3) specific quantitative or qualitative limits on the ability of traders to commit the capital of the swap dealer; and (4) the monitoring, documentation, and auditing of traders’ transactions.
CFTC regulations also require a swap dealer to maintain a system of diligent supervision over all activities relating to its business performed by all members or agents of the entity to ensure compliance with all regulations. A dealer must design a business continuity and disaster recovery plan that would enable the entity to resume business activities by the next day following a disaster or emergency.
______13 See section below entitled “Unique Identifiers.” 14 CFTC Regulation § 23.203(b).
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Conflicts of Interest Policies and Procedures The CFTC has published final rules addressing conflicts of interest.15 Non-research personnel are prohibited from impacting a research analyst’s research report. Similarly, research analysts may not be supervised or controlled by any employee of the swap dealer, business trading unit, or clearing unit. Moreover, non-research personnel may only review a swap dealer's research reports before publication when necessary to verify the factual accuracy of the report, provide non-substantive editing, or identify potential conflicts of interest. Even when this minimal level of review is permitted, the review must be made through authorized legal or compliance personnel of the swap dealer, regardless of whether it is written or oral. In reviewing a research analyst’s compensation, a swap dealer may not consider the analyst’s contributions to the swap dealer’s trading or clearing business.
The regulations include significant requirements mandating disclosure of any financial interests that a research analyst may have in a derivative that the analyst follows or any other material conflicts of interest that the analyst or swap dealer may have. Further, the regulations forbid a swap dealer from retaliating against a research analyst for an adverse research report.
Additionally, a swap dealer is prohibited from retaliating against any research analyst as a result of the analyst writing—in good faith—an unfavorable research report that may adversely affect the swap dealer’s pricing, trading, or clearing activities.
Finally, a swap dealer may not interfere with or influence the decision of a clearing unit of any affiliated clearing member of a DCO to provide clearing services or to make other decisions relating to a particular customer. Accordingly, a swap dealer must keep separate all information between the swap dealer’s business trading unit and the employees of an affiliated clearing member of a DCO. This partition should ensure that employees of the swap dealer do not influence or control activities of the clearing unit in any way.
“Know Your Counterparty” Prior to entering into a swap, a swap dealer must gather basic identification information of a counterparty whose identity is known to it, including the counterparty’s true name and address, as well as its principal business. The swap dealer must also obtain any facts necessary for implementing its credit and operational risk management policies, and complying with any laws, rules, or regulations. A swap dealer “may rely on the written representations of a counterparty to satisfy its due diligence requirements… unless it has information that would cause a reasonable person to question the accuracy of the representation.”16
Prohibition on Fraud The CFTC regulations generally prohibit a swap dealer from engaging in fraud. They do, however, provide for affirmative defenses to allegations of fraudulent activity if the swap dealer acted unintentionally or complied with the relevant policies and procedures in good faith. The regulations also prohibit a swap dealer from disclosing to anyone information provided by a counterparty to the swap dealer or using the confidential information for its own purposes in a way that is materially adverse to the counterparty’s interests. ______15 CFTC Regulation § 23.605. 16 CFTC Regulation § 23.402(d).
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Verification of Counterparty Eligibility Before a swap dealer may enter into a swap with a counterparty, the dealer must verify whether the counterparty is an “eligible contract participant”17 and whether the counterparty is a Special Entity.18 The swap dealer must verify whether the counterparty is eligible to elect to be a Special Entity, and if so, it must notify the counterparty of that fact. In fulfilling these requirements, the dealer may rely on the counterparty’s written representations.
Disclosure Requirements Before entering into a swap, a swap dealer must disclose to its counterparty any information necessary to allow its counterparty to assess the material risks, characteristics, incentives, and conflicts of interest relating to the transaction. If the swap is one that is not made available for trading on a designated contract market (DCM) or swap execution facility (SEF), the swap dealer is additionally required to notify its counterparty that the counterparty may request and consult on the design of a scenario analysis to allow the counterparty to assess the potential risk exposure if it were to enter into the swap. These disclosure requirements, however, do not apply to swaps that are initiated on a DCM or SEF, or to swaps in which the swap dealer does not know the identity of the counterparty prior to execution.
For uncleared swaps, the swap dealer is required to provide the counterparty with the mid-market mark of the swap, which excludes amounts for profit, credit reserve, hedging, funding, liquidity, and any other costs or adjustments. It must also provide the methodology and assumptions used to prepare the daily mark and any material changes during the term of the swap, as long as that information is neither confidential nor proprietary. With respect to cleared swaps, however, a swap dealer need only notify the counterparty that is has a right to receive the daily mark from the appropriate DCO. This daily mark must be provided to the counterparty during the term of the swap as of the close of business or such other time as the parties agree in writing.
For swaps that are required to be cleared, a swap dealer must notify its counterparty that the counterparty has the sole right to choose the DCO at which the swap will be cleared. If the swap is not required to be cleared, the swap dealer must inform the counterparty that it may elect to require clearing of the swap and the right to choose the DCO at which the swap will be cleared.
Institutional Suitability A swap dealer that recommends a swap or trading strategy involving a counterparty must: (1) undertake reasonable diligence to understand the potential risks and rewards associated with the recommended swap or trading strategy involving a swap; and (2) have a reasonable basis to believe ______17 Title VII provides that it is unlawful for any person other than an Eligible Contract Participant (“ECP”) as defined in the CEA, to enter into a swap unless executed on a DCM. There are multiple definitions for an ECP, but the two that are most germane are: (1) a corporation, partnership, proprietorship, trust, or other entity that (i) has total assets exceeding $10 million, or (ii) has a net worth exceeding $1 million and enters into an agreement in connection with the conduct of the entity’s business or to manage the risk associated with an asset owned or incurred or reasonably likely to be owned or incurred by the entity; or (2) an individual who has amounts invested in excess of (i) $10 million, or (ii) $5 million and who enters into an agreement to manage the risk associated with an asset owned or incurred or reasonably likely to be owned or incurred by the individual. 18 See section on Swaps and Special Entities.
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that the recommended swap or trading strategy involving a swap is suitable for the counterparty.19 A swap dealer must reasonably base its recommendations on information about the counterparty, including the counterparty’s investment profile, trading objectives, and ability to absorb losses. A safe harbor for the swap dealer regarding this “suitability” requirement exists if: (1) the dealer reasonably determines that the counterparty has delegated decision-making authority and is capable of evaluating investment risks regarding the swap; (2) the counterparty or its agent represents in writing that it is exercising independent judgment in evaluating the swap dealer’s recommendations; (3) the swap dealer informs the counterparty that it has not assessed the suitability of the swap for the counterparty; or (4) if the counterparty is a Special Entity, the swap dealer complies with the requirements for dealing with a Special Entity.
Swaps and Special Entities The CFTC has enacted special rules for a swap dealer that acts as an advisor or counterparty to Special Entities. A Special Entity is defined as: (1) a federal agency; (2) a state, state agency, city, county, municipality, other political subdivision of a state, or any instrumentality, department, or a corporation of or established by a state or political subdivision of a State; (3) any employee benefit plan subject to Title I of ERISA20; (4) any governmental plan as defined in Section 3 of ERISA; (5) any endowment, including an endowment that is an organization described in Section 501(c)(3) of the Internal Revenue Code; or (6) any employee benefit plan defined in ERISA not otherwise defined as a Special Entity, that elects to be a Special Entity by notifying a swap dealer or major swap participant of its election prior to entering into a swap with the particular swap dealer or major swap participant.21
A swap dealer acts as an advisor to a Special Entity when it recommends a swap or trading strategy that is tailored to the Special Entity’s specific needs. When a swap dealer advises Special Entities,22 it has a duty to determine that its recommendations are in the best interests of the Special Entity and must make reasonable efforts to obtain the necessary information to make this determination, including: (1) financial and tax statuses; (2) hedging, investment, and financing objectives; (3) experience of the Special Entity in entering into swaps; (4) and other facts and circumstances relevant to the Special Entity, market conditions, and the type of swap strategy involved.
On the other hand, there are separate regulations for a swap dealer that acts as a counterparty to Special Entities. The first requirement is that the swap dealer must have a reasonable basis to believe
______19 CFTC Regulation § 23.434. 20 ERISA is the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002). 21 CFTC Regulation § 23.401(c). 22 CFTC Regulation § 23.440(b) provides that a swap dealer does not act as advisor to a Special Entity that is an employee benefit plan if the Special Entity represents in writing that it has a fiduciary—as defined in Section 3 of ERISA—that is responsible for representing the Special Entity in connection with the swap transaction, the fiduciary represents in writing that it will not rely on the swap dealer’s recommendations, and the Special Entity represents in writing that it will comply in good faith with the written policies and procedures designed to ensure that the swap dealer’s recommendation to the Special Entity is evaluated by a fiduciary prior to the transaction. In addition, a swap dealer does not act as an advisor to any Special Entity when: the swap dealer does not express an opinion as to whether the Special Entity should enter into a swap or trading strategy involving a swap that is tailored to the particular need of the Special Entity; the Special Entity represents in writing that it will not rely on the swap dealer’s recommendations, and instead, it will rely on advice from a qualified independent representative; and the swap dealer discloses to the special entity that it is not undertaking to act in the best interests of the Special Entity.
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that the Special Entity23 has a representative that: (1) has sufficient knowledge to evaluate the transaction and risks involved; (2) is not subject to a statutory disqualification; (3) is independent of the swap dealer; (4) undertakes the duty to act in the best interest of the Special Entity; (5) makes appropriate and timely disclosures to the Special Entity; and (6) evaluates fair pricing and the appropriateness of the swap. A swap dealer dealing with Special Entities defined under Section 23.451(c)(2) or (4) must also ensure that the Special Entity’s representative is subject to certain restrictions on the political contributions that he or she may make.24
Finally, to prevent fraud, the CFTC regulations prohibit a swap dealer from offering to enter or entering into a swap or trading strategy with a governmental Special Entity within two years after any contribution to an official of that government Special Entity was made by the swap dealer or by a covered associate of the swap dealer.25 Moreover, a swap dealer and its covered associates may not: (1) provide any payment to anyone for the purposes of soliciting a government Special Entity to offer to enter into or to enter into a swap with that swap dealer, unless that person is a regulated person;26 or (2) coordinate or solicit any person or political action committee to contribute to an official of a governmental Special Entity or a political party of a state or locality with which the swap dealer is offering to enter into or has entered into a swap.
______23 The requirements set forth in the paragraph that follows does not apply to employee benefit plans subject to Title I of ERISA. When acting as a counterparty to these Special Entities, a swap dealer must reasonably believe that the entity has a representative that is a fiduciary as defined by ERISA. 24 See CFTC Regulation § 23.450(b)(1)(vii). 25 CFTC Regulation § 23.451 defines a “covered associate” as “(i) any general partner, managing member, or other person with a similar status or function; (ii) any employee who solicits a governmental Special Entity for the swap dealer and any person who supervises, directly or indirectly, such employee; and (iii) any political action committee controlled by the swap dealer or by [anyone listed in the above sections].” 26 CFTC Regulation § 23.451 defines a “regulated person” as “(i) A person that is subject to restrictions on certain political contributions imposed by the Commission, the Securities and Exchange Commission, or a self-regulatory agency subject to the jurisdiction of the Commission or the Securities and Exchange Commission; (ii) A general partner, managing member, or executive officer of such person, or other individual with a similar status or function; or (iii) An employee of such person who solicits a governmental Special Entity for the swap dealer and any person who supervises, directly or indirectly, such employee.”
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Proposed Capital and Margin Requirements The CFTC has proposed capital and margin requirements for swap dealers.27 First, a swap dealer would be required to maintain tangible net equity28 of at least $20 million plus an amount that would cover its market risk exposure and its over-the-counter derivatives credit risk associated with swap positions and hedge positions, or the minimum amount of capital required by a registered futures association of which the swap dealer is a member, whichever is greater.29
If the swap dealer is a subsidiary of a U.S. bank holding company, the swap dealer must maintain the greatest amount of: (1) $20 million of Tier 1 capital; (2) the swap dealer’s minimum risk-based ratio requirements as if the swap dealer itself was a U.S. bank-holding company; or (3) the amount of capital required by a futures association of which the swap dealer is a member.30
Second, the proposed regulations provide detailed margin requirements for uncleared swaps that differ based on whether the swap is between a covered swap entity31 and swap dealer,32 a covered swap entity and financial entity,33 or a covered swap entity and non-financial entity.34 These rules would generally require each covered swap entity to require its counterparty to post initial margin calculated under the credit support arrangements with the counterparty that are consistent with proposed Section 23.155.35
It is also important to note that Title VII provides that a swap dealer is required to notify the counterparty at the beginning of the transaction that “the counterparty has the right to require segregation of the funds or other property supplied to margin, guarantee, or secure the obligations of the counterparty.”36 If the counterparty requests that the funds be segregated, the account must be carried out by an independent third-party custodian and designated as a segregated account for the counterparty. If the counterparty does not require segregation, the swap dealer must report on a quarterly basis to the counterparty that the procedures relating to margin and collateral requirements comply with the parties’ agreement.
Reporting Requirements One of the most important regulations with which a swap dealer must comply is the swap data reporting requirement. As a threshold matter, the regulations provide that only one party to a swap must report the swap data; the regulations set rules by which the parties may determine who is
______27 The proposed CFTC capital requirements discussed here do not apply to a registered swap dealer that is already subject to minimum capital requirements established by a prudential regulator or to a swap dealer that also is a registered futures commission merchant that is subject to certain other capital requirements. 28 See CFTC Regulation § 23.102. 29 CFTC Regulation § 23.101(a)(1). 30 CFTC Regulation § 23.101(a)(2). 31 A “covered swap entity” is a swap dealer or major swap participant for which there is no prudential regulator. Proposed CFTC Regulation § 23.150. 32 See Proposed CFTC Regulation § 23.152. 33 See Proposed CFTC Regulation § 23.153. 34 See Proposed CFTC Regulation § 23.154. 35 Proposed CFTC Regulation § 23.152. 36 Title VII, § 724(c).
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obligated to be the “reporting party.”37 Any instance in which a swap dealer is a party to a swap—and when one of the counterparties will be required to report the swap data38—the swap dealer will be the reporting party.39 The swap dealer must report all of the data related to a swap to a single swap data repository.40 A swap data repository is defined as “any person that collects and maintains information or records with respect to transactions or positions in, or the terms and conditions of, swaps entered into by third parties for the purpose of providing a centralized recordkeeping facility for swaps.’’41 All reporting parties must report the swap data electronically to a swap data repository as soon as technologically practicable and within specified time frames.
Creation Data A swap dealer must report information relating to the swap at two separate times: as soon as possible after execution of the swap and during the life of the swap. The first event that triggers the reporting requirement is the execution of a swap. At that time, a swap dealer must report the swap “creation data.” Swap creation data is the confirmation data and the primary economic terms data of the swap.42
The rules that a swap dealer must follow with regard to reporting differs based on whether the swap is: (1) executed on an SEF or DCM and subject to mandatory clearing; (2) executed on an SEF or DCM and not subject to mandatory clearing; (3) not executed on an SEF or DCM and subject to mandatory clearing; or (4) not executed on an SEF or DCM and not subject to mandatory clearing. First, if the swap is executed on an SEF or DCM and must be cleared, the swap dealer is not required to report any information; instead, the SEF/DCM must report the primary economic terms data, and the DCO must report the confirmation data. Second, if the swap is executed on an SEF/DCM and not subject to mandatory clearing, the SEF/DCM must report the primary economic terms data, and the swap dealer must report the confirmation data. Third, if the swap is not executed on or pursuant to the rules of an SEF or DCM—this is referred to as an off-facility swap—but is required to be cleared, the swap dealer must report the primary economic terms, and the DCO must report the confirmation data. Finally, if the swap is neither executed on an SEF or DCM nor required to be cleared, the swap dealer must report all of the creation data.43 In general, if the swap is not subject to mandatory clearing but the swap is submitted voluntarily to and accepted by a DCO for clearing, the swap dealer is excused from reporting swap creation data.
______37 See CFTC Regulation § 45.8. 38 As discussed below, there are certain instances in which neither party will be required to report the swap data and, instead, an SEF, DCM, or DCO will be required to report the data. 39 If both parties are swap dealers, the parties must agree which of them will report the swap data. See CFTC Regulation § 45.8(d). 40 Id. at § 45.10. 41 7 U.S.C. 1a(48). 42 See CFTC Regulation § 45.3(a)(1). The regulations define “confirmation data” as “all of the terms of the swap matched and agreed upon by the counterparties in confirming the swap. For cleared swaps, confirmation data also includes the internal identifiers assigned by the automated systems of the [DCO] to the two transactions resulting from the novation to the clearing house.” In addition, “primary economic terms” is defined as “all of the terms of a swap matched or affirmed by the counterparties in verifying the swap…” CFTC Regulation § 45.1. 43 It is important to note that the deadlines for reporting this creation data following the execution of a swap varies based on these four scenarios, as well. For specific rules regarding the reporting timeframe that a swap dealer, SEF or DCM, and DCOs must comply with, see CFTC Regulation §§ 45.3-45.4.
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Continuation and Valuation Data In addition to reporting creation data after the swap is executed, a swap dealer must also report swap “continuation data” to a swap data repository throughout the swap’s existence until its expiration or termination. The regulations allow reporting parties to fulfill this requirement by reporting either “life cycle event data” or “state data,” as long as the method chosen ensures that the swap data provided to the swap data repository remains accurate. Moreover, a swap dealer must report “valuation data.” Life cycle event data is information relating to a change in primary economic terms previously reported to an SDR, and state data is “the data necessary to provide a snapshot view, on a daily basis, of all of the primary economic terms of a swap… including any change to any primary economic term or to any previously-reported primary economic terms data since the last snapshot.”44 Valuation data is used to describe the daily mark of the transaction.
Like the reporting of creation data, the party that must report the continuation and valuation data depends on whether the swap is cleared by a DCO. If it is cleared by a DCO, the DCO—and not the swap dealer—will be required to report the continuation data, and both the DCO and swap dealer must report the valuation data; if the swap is not cleared, the swap dealer must report the continuation and valuation data. If the swap dealer elects to submit life cycle event data, it must report the information on the same day that the event occurs.45 State data, on the other hand, must be reported daily. Furthermore, the swap dealer must report daily the valuation data relating to the swap.
Finally, the CFTC has adopted final rules requiring parties to a swap to report any publicly reportable46 swap transaction and pricing data to a swap data repository in real-time.47 Real-time public reporting is defined as the “reporting of data relating to a swap transaction, including price and volume, as soon as technologically practicable after the time at which the swap transaction has been executed.”48 The swap data repository, in turn, is required to disseminate the swap transaction and pricing data to the public.
Like the other reporting regulations, if the swap is executed on or pursuant to an SEF or DCM, the SEF/DCM must report the transaction data. If the swap is an off-facility swap and one of the parties to a swap is a swap dealer, the swap dealer will be the party required to report the real-time transaction data.49
Unique Identifiers To enable regulators to aggregate and link data together across counterparties, asset classes, and transactions, the regulations provide that reporting parties must create unique identifiers for all swap
______44 Id. at § 45.1. 45 If the life cycle event relates to a corporate event of the non-reporting counterparty, the swap dealer must report the life cycle event within two business days. Id. at § 45.4(c)(1)(i)(A). 46 A publicly reportable swap transaction is: (1) any executed swap that is an arm’s length transaction that results in a corresponding change in market risk position between the two parties; or (2) any termination, assignment, novation, exchange, transfer, amendment, conveyance, or extinguishing of rights or obligations of a swap that changes the price of a swap. Id. at § 43.2. 47 The reporting party must provide the swap data repository with the data listed in Appendix A to Part 43. See id. at § 43.4(a). 48 Id. at § 43.2. 49 Id. at § 43.3(a).
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data. These identifiers include a unique swap identifier (USI), legal entity identifier (LEI), and unique product identifier (UPI).50 The parties and transactions that are required to be identified depend on whether the swap is executed on an SEF or DCM. For swaps executed on an SEF or DCM, the USI contains codes assigned to the SEF or DCM and to the swap. For off-facility swaps, the USI contains codes assigned to the swap dealer and the swap. The SEF/DCM or swap dealer must create the USI and transmit the identifier to the swap data repository to which the reporting counterparty reports creation data, the non-reporting counterparty, and the DCO, if applicable.
LEIs—currently referred to as CFTC Interim Compliant Identifiers51— identify the counterparties to a swap. The goal of LEIs is to establish a standard global identifier by which regulators may identify counterparties to a swap. Last, the UPI is used to categorize the swap asset class and the underlying product for the swap.
Historical Swap Data Reporting A swap dealer is required to report data on “historical swaps,” which includes “pre-enactment swaps” and “transition swaps.”52 Pre-enactment swaps are swaps that the counterparties entered into prior to Dodd-Frank’s enactment53 and which still existed as of April 25, 2011. Transition swaps are swaps that were executed after Dodd-Frank was enacted but before the regulations’ compliance date, and were still in existence as of April 25, 2011.
The reporting party to a historical swap is required to submit an initial data report (IDR) to a swap data repository—or to the CFTC if no swap database for swaps in the asset class in question exists— containing: the minimum primary economic terms data;54 the swap dealer’s LEI; the identifier used to identify the non-reporting counterparty; and the internal identifier used to identify the swap. In addition, the reporting party to a historical swap must report continuation data in the same way as if the swap were not a historical swap. If the pre-enactment swap expired or was terminated before April 25, 2011, the swap dealer must report such information relating to the terms of the transaction that the swap dealer had in its possession as of October 14, 2010. For transition swaps that expired or terminated prior to April 25, 2011, the swap dealer must report such information relating to the transaction that was in its possession as of December 17, 2010.
ISDA Protocols Because of the onerous burden of complying with the CFTC’s disclosure and reporting regulations, the International Swaps and Derivatives Association (ISDA) issued protocols on August 13, 2012, and March 22, 2013, with the aim of facilitating compliance with these rules. The Protocols simplify the process of amending existing swap relationship documentation so that parties to a swap may comply with new CFTC regulations and, in turn, engage in swaps transactions. The ISDA Protocols allow parties to a swap to amend their swaps documentation quickly and avoid the difficulties and
______50 Id. at § 45.5-45.7. 51 See http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/leiamendedorder.pdf. 52 See CFTC Regulation § 46.3. 53 Dodd-Frank was enacted on July 21, 2010. 54 See Appendix 1 to 17 CFR 46.
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inefficiencies associated with lengthy bilateral negotiations and disruptions to their regular trading activities.55
The Protocols function by providing swap participants with a standard set of amendments that are designed to ensure compliance with Title VII. Parties to a swap that utilize the ISDA Protocols have the ability to: “(i) supplement the terms of existing master agreements under which parties may execute Swaps or (ii) enter into an agreement to apply selected Dodd-Frank compliance provisions to their trading relationship in respect of Swaps.”56 In addition, ISDA plans to issue additional protocols that amend swap participants’ existing documentation so that they may comply with future regulations.
The ISDA August 2012 and March 2013 DF Protocols The ISDA August 2012 Dodd-Frank Protocol was implemented to address CFTC regulations regarding: (1) business conduct standards for swap dealers and major swap participants with counterparties; (2) large trader reporting for physical commodities swaps; (3) position limits for futures and swaps; (3) real-time public reporting; (4) recordkeeping and reporting requirements, chief compliance officer rules, and conflicts of interest; and (5) historical swaps. These requirements also include the “know your counterparty” and verification of counterparty eligibility rules. The protocol covers existing agreements between parties to a swap and adds notices, representations, and covenants regarding the new CFTC regulations that must be satisfied before a swap transaction may be executed.
ISDA has also issued the March 2013 DF Protocol, which is referred to as the “DF Protocol 2.0.” This Protocol is intended to address new CFTC final regulations regarding: (1) confirmation, portfolio reconciliation, portfolio compression, and swap trading relationship documentation requirements for swap dealers and major swap participants; (2) the end-user exception to the clearing requirement for swaps; and (3) the clearing requirement determination under section 2(h) of the CEA.
These Protocols enable counterparties to make single, comprehensive data disclosures to a universe of swap dealers. Parties that wish to supplement their swap documentation with the Protocols must complete an adherence letter agreeing to the terms of the Protocol Agreement,57 a questionnaire that must be submitted to the other Protocol participant, and other documentation. Once the parties to a swap complete these steps, the Protocol amendments apply to their master agreements.
______55 See http://www2.isda.org/functional-areas/protocol-management/faq/8/. 56 See ISDA August DF Protocol, available at http://www2.isda.org/functional-areas/protocol-management/protocol/8. 57 Note that there is a one-time adherence fee of $500.
22 Herrick, Feinstein LLP Herrick, Feinstein LLP’s Seventh Annual Capital Markets Symposium October 2, 2013
DODD FRANK: 2013 Regulation of End Users of Swap Transactions under Dodd-Frank
By Patrick D. Sweeney and Marc Shepsman
Sweeney2 Cover.indd 1 9/24/2013 11:34:58 AM Dodd Frank 2013: The Regulators Extend Their Reach into the Capital Markets
Regulation of End Users of Swap Transactions under Dodd-Frank By Patrick D. Sweeney and Marc Shepsman 1
Introduction Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) amends the Commodity Exchange Act (“CEA”) and the Securities Exchange Act of 1934 (the “Exchange Act”) to implement a new and comprehensive regulatory regime for previously unregulated over-the-counter (“OTC”) swaps and security-based swaps. In response to the 2007 financial crisis, Congress enacted Title VII to reduce systemic risk, increase transparency, and promote market integrity, by regulating swap dealers (“SDs”) and major swap participants (“MSPs”) and by creating sweeping new clearing, reporting, recordkeeping, and execution requirements for swap transactions. The clearing requirement, according to the CFTC, is “at the heart of Dodd-Frank,” and the new legislation makes it unlawful for any person to engage in most swap transactions unless that person submits the swap for clearing to a derivatives clearing organization (“DCO”). Certain end- users are eligible to avoid the clearing requirement. However, end-users will be subject to a number of requirements under Title VII regardless or whether their swaps are cleared.
The Clearing Requirement The core of Title VII’s regulatory overhaul is the clearing requirement. Title VII now makes it unlawful for any person to enter into a swap transaction unless that person submits the swap for clearing to a registered DCO, or a DCO exempt from registration. The clearing requirement, however, does not apply to any particular swap until that type of swap has been determined by the CFTC to be eligible for clearing. When a swap is cleared, futures commission merchants (“FCMs”) act as clearing brokers for the original swap counterparties, and bring the swap to the DCO for clearing. The DCO interposes itself into the swap transaction, thus creating two swap transactions, each of them between the DCO and one of the clearing brokers. The premise for the clearing requirement is that DCOs will help eliminate or diminish counterparty credit risk if they are mandated to: (1) collect initial and variation margin associated with swap positions; (2) mark these positions regularly and issue margin calls; (3) adjust margin requirements; and (4) close out swap positions of a customer that does not meet the margin calls. In the event that a FCM defaults, the DCO has a number of tools at its disposal to help manage and mitigate the associated risks, including transferring the defaulted swap position, and covering the losses of the default.
The DCO must provide for non-discriminatory clearing of a swap executed bilaterally or through the rules of an unaffiliated designated contract market (“DCM”) or swap execution facility (“SEF”). All persons executing a non-exempted swap must submit each swap to any eligible DCO as soon as technologically practicable, but in any event by the end of the day of execution. Counterparties to a swap transaction must either execute the transaction on the DCM, or on a registered or exempt SEF. Such execution is mandatory if the swap is required to be cleared, and made available to trade by a SEF or DCM. Each person must take reasonable efforts to verify whether the CFTC has made a determination requiring clearing of the type of swaps in which such person engages.
In December 2012, the CFTC made a determination to require clearing of interest rate swaps and credit default swaps. The CFTC has mandated compliance dates for clearing of interest rate swaps and ______1 Patrick D. Sweeney is a partner and Marc Shepsman is a summer associate at Herrick, Feinstein LLP.
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credit default swaps. Category One entities, which include SDs, security-based SDs, MSPs, security- based MSPs, and active funds, which are funds that execute 200 or more swaps per month, had until April 26, 2013, to comply with the clearing requirement. Category Two entities, which include a commodity pool, private fund, or persons predominantly engaged in the business of banking, had until July 25, 2013, to comply. All market participants must comply by October 23, 2013.
The End-User Exception Title VII provides an exception to the clearing requirement for certain end-users of swap products. The clearing requirement shall not apply if one of the counterparties to a swap: (i) is not a financial entity; (ii) is using swaps to hedge or mitigate commercial risk; and (iii) notifies the Commission how it generally meets its financial obligations associated with entering into non-cleared swaps.
Financial Entity A financial entity includes: (I) an SD; (II) a MSP; (III) a commodity pool; (IV) a private fund; (V) an employee benefit plan; and (VI) a person predominantly engaged in the business of banking. These persons thus cannot avail themselves of the end-user exception.
However, the Commission has permitted certain financial entities to rely upon the end-user exception under the small financial institution (“SFI”) exemption. A financial entity will qualify for this exemption if it: (i) is organized as a bank, the deposits of which are insured; a savings association, similarly insured; a farm credit system institution; or insured federal credit union or state-chartered credit union; and (ii) has assets of $10 billion or less on the last day of such person’s most recent fiscal year.
Moreover, the financial entity exclusion will not cover an entity whose primary business is providing financing, provided that it uses derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures, ninety percent or more of which arise from financing that facilitates the purchase or lease of products, ninety percent or more of which are manufactured by the parent company or another subsidiary of the parent company.
Hedge or Mitigate Commercial Risk In order to qualify for the end user exception, Title VII requires that one of the counterparties to the swap use the swap to hedge or mitigate commercial risk. The CFTC has clarified that a swap will be considered as used to hedge or mitigate commercial risk if the swap is economically appropriate to the reduction of risks of the conduct and management of a commercial enterprise, where the risks arise from: (A) the potential change in value of assets a person owns, produces, manufactures, processes, or merchandises, or reasonably anticipates owning, producing, manufacturing, processing or merchandising, in the ordinary course of business; (B) the potential change in value of liabilities that a person has incurred or reasonably expects to incur; (C) the potential change in value of services that a person provides or anticipates providing; (D) the potential change in the value of assets, services, inputs, products, or commodities that a person owns, produces, manufactures, processes, merchandises, leases, or sells, or reasonably anticipates the same; (E) any potential change in value related to the foregoing arising from interest, currency, or foreign exchange rate movements; or (F) any fluctuation in interest, currency, or foreign exchange rate exposures arising from that person’s assets or liabilities.
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In addition to the foregoing, the swap must not be “in the nature of speculation, investing, or trading” or used to hedge or mitigate the risk of another swap position, unless that position is itself used to hedge or mitigate commercial risk as defined above.
Notification of How End User Meets Financial Obligations A counterparty which elects the end-user exception must notify the CFTC of its identity, and indicate whether the counterparty is a financial entity, and, if so, the basis for relying upon the exception. The counterparty must further notify the Commission whether the swap is being used to hedge or mitigate commercial risk. Finally, an electing counterparty must notify the Commission how it generally meets its financial obligations by identifying one, or more, of the following categories: (1) a written credit support agreement; (2) pledged or segregated assets; (3) a written third-party guarantee; (4) the counterparty’s available financial resources; or (5) means other than categories (1) through (4). An electing counterparty with publicly traded securities must also include its SEC Central Index Key number, and indicate whether an “appropriate committee” of that counterparty’s board of directors has reviewed and approved the decision to elect the end-user exception.
In anticipation of electing the exception, an entity that qualifies for the end-user exception may annually report all of the aforementioned information. Such reporting remains effective for 365 days, during which the electing counterparty must amend any information as necessary to “reflect any material changes to the information reported.” In lieu of filing the notice itself, the end-user may rely upon the SD counterparty to report the necessary information to the CFTC on a transaction-by- transaction basis.
Treatment of Affiliates An affiliate of a person who qualifies for the end-user exception, including affiliate entities predominantly engaged in providing financing for the purchase of the merchandise or manufactured goods of the person, may qualify for the end-user exception if the affiliate, acting on behalf of the person as an agent, uses the swap to hedge or mitigate the commercial risk of the person or other affiliate of the person that is not a financial entity. However, this affiliate rule does not apply to affiliates which are: (1) SDs; (2) MSPs; (3) an issuer that is an investment company as defined by section 3 of the Investment Company Act, but for paragraph (1) or (7) of subsection (c); (4) a commodity pool; or (5) a bank holding company with over $50 billion in consolidated assets.
Clearing vs. Trading The end-user exception may excuse an end-user from the clearing requirement, but the end-user will continue to have an obligation to trade its swap on a DCM, unless the end-user is an “eligible contract participant” (“ECP”). To the extent that a DCM requires swaps traded thereon to be cleared, ECP status becomes a fourth condition to the availability of the end-user exception.
Segregation and Bankruptcy Treatment Title VII provides for the protection of collateral posted by swaps customers for cleared swaps, by imposing segregation and non-commingling requirements on FCMs. Moreover, Title VII grants to cleared swaps the protections accorded to counterparties to “commodity contracts” in the event of the liquidation of a FCM or DCO under the Bankruptcy Code.
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Segregation Requirements for Cleared Swaps The CFTC has required that an FCM must segregate all “Cleared Swaps Customer Collateral that it receives. There are two permitted methods of segregation: (1) the FCM may deposit the collateral into a Cleared Swaps Customer Account held at a Permitted Depository; or (2) the FCM may hold the collateral itself, in which case it must (i) physically separate such collateral from its own property; (ii) clearly identify each physical location in which it holds such collateral as a “Location of Cleared Swaps Customer Collateral” (the “FCM Physical Location”); (iii) ensure that the FCM Physical Location provides appropriate protection for such collateral; and (iv) record in its books and records the amount of such Cleared Swaps Customer Collateral separately from its own funds. A FCM may commingle Cleared Swaps Customer Collateral that it receives on, for, or on behalf of multiple Cleared Swaps Customers, but it may not commingle such collateral with funds belonging to the FCM, or other categories of funds belonging to the Cleared Swaps Customers of the FCM. Furthermore, an FCM is prohibited from using the Cleared Swaps Customer Collateral of one Cleared Swaps Customer to purchase, margin, or settle the Cleared Swaps of any person other than such Customer.
Notwithstanding the foregoing prohibition, an FCM may: (1) invest money, securities or other property constituting Cleared Swaps Customer Collateral; and (2) withdraw such share of the Cleared Swaps Customer Collateral as is necessary in the normal course of business to margin, guarantee, secure, transfer, adjust or settle a Customer’s Cleared Swaps with a DCO, or with a Collecting FCM, and may also apply such share to the payment of commissions, brokerage, interest, taxes, storage, and other charges in connection with such Cleared Swaps. The CFTC subjects DCOs to similar segregation and non-commingling requirements.
Segregation Requirements for Uncleared Swaps For swaps not required to be cleared, Title VII requires that an SD or MSP notify the counterparty to the swap transaction that the counterparty has the right to require segregation of funds or other property supplied to margin, guarantee, or secure the obligations of the counterparty. Furthermore, at the request of a counterparty that provides such funds to a SD or MSP, the SD or MSP must: (1) segregate the funds for the benefit of the counterparty; and (2) maintain the funds in a segregated account, separate from the assets and other interests of the SD or MSP. If the counterparty does elect to require segregation, the SD or MSP must report to the counterparty on a quarterly basis that the back office procedures of the SD or MSP relating to the margin and collateral requirements are in compliance with the agreement of the counterparties.
It should be noted that although the rule has not yet been finalized, the CFTC has proposed rules mandating SDs and MSPs to require end-users to post initial margin and variation margin as needed pursuant to the credit support agreement between them before execution of the swap, and prior to its liquidation.
Commodity Contracts Section 724(b) of the Dodd-Frank Act amended the Bankruptcy Code to clarify that cleared swaps are “commodity contracts.” Accordingly, in the event of an FCM or DCO liquidation, customers are entitled to certain protections, including the ability to close out cleared swaps and transfer cleared
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swaps and collateral. If cleared swaps are subject to liquidation, customers will receive preferential treatment of the remaining collateral. For bankruptcy purposes, customer collateral in cleared swaps accounts is treated analogously to collateral in customer futures accounts.
Recordkeeping and Reporting Requirements
Recordkeeping 17 C.F.R. § 45.2 provides that each SEF, DCM, DCO, SD, and MSP must keep “full, complete, and systematic records, together with all pertinent data and memoranda, of all activities relating to the business of such entity or person with respect to swaps” that fall within the jurisdiction of the CFTC. End-users are subject to a less onerous standard. They are required to keep “full, complete, and systematic records” with respect to each swap to which they are a counterparty, including all records demonstrating that they are entitled to elect the end-user exception. End-users must keep all records required to be kept throughout the life of the swap, and for a period of at least five years following final termination of the swap. End-users are permitted to keep required information in either electronic or paper form, so long as the record is retrievable, and the information contained therein is reportable. The CFTC requires records to be retrievable within five business days throughout the period during which the records are required to be kept.
For pre-enactment and transition swaps (“historical swaps”) in existence after April 25, 2011, each counterparty to the swap must keep: (1) the minimum primary economic terms of the swap; and (2) any additional records that a counterparty has in its possession at any time on or after April 25, 2011, including: (a) confirmation data; (b) any master agreement governing the swap; and (c) any credit support agreement. For pre-enactment swaps that have been terminated by April 25, 2011, each counterparty must keep all of the documents relating to the terms of the swap that were possessed on or after October 14, 2010. For transition swaps that have been terminated by April 25, 2011, each counterparty to the swap must have retained the information and documents relating to the terms of the swap that were possessed on or after December 17, 2010.
Reporting Title VII requires all swaps, whether cleared or uncleared, to be reported to newly created swap data repositories (“SDRs”). Data reporting helps increase transparency by making swap data electronically available to regulators and publicly available in real time. Thus, the CFTC believes that the reporting requirement will “enable regulators to better understand swaps in the context of allocation, and to more accurately assess their associated systemic risk, by enabling regulators to see the full record of each swap all the way back to both the original transaction and the actual counterparties.”
Swap Data Repositories SDRs are new entities created under Title VII. SDRs: (1) accept swap data; (2) confirm that data with both counterparties to a swap; (3) maintain the swap data; (4) provide direct electronic access to the CFTC; (5) provide any information required by the CFTC to comply with the public reporting requirements; (6) establish automated systems for monitoring, screening, and analyzing swap data, including the frequency of end-user exemption claims; (7) maintain the privacy of any and all swap transaction information that the SDR receives; (8) make available, upon request and on a confidential basis, information required by the CFTC; and (8) establish and maintain emergency procedures, backup facilities, and a plan for disaster recovery.
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Identifiers Each swap must be identified with a unique swap identifier. For swaps executed on an SEF or DCM, the SEF or DCM must create and transmit the unique swap identifier. For swaps that have not been executed on an SEF or DCM with an SD or MSP reporting counterparty, it is the SD or MSP that shall create and transmit the unique swap identifier. Finally, for swaps that have not been executed on a SEF or DCM with a non-SD/MSP reporting counterparty, the SDR to which the primary economic terms data is reported shall create and transmit the unique swap identifier.
Each counterparty to a swap, including end-users, must be identified in all recordkeeping and swap data reporting by a single legal entity identifier. Each entity within a corporate organization or group structure that acts as a counterparty to any swap must have its own legal entity identifier. Before a legal entity identifier system has been designated by the CFTC, each registered entity and swap counterparty must use a substitute counterparty identifier created and assigned by an SDR in all recordkeeping and swap data reporting.
Content of Reports Swap reporting requirements vary by reporting counterparty. The reporting counterparty may have to report one or both of the following: (1) creation data; and (2) continuation data. Creation data consists of primary economic terms, and confirmation data. Section 45.1 defines primary economic terms as all of the terms of a swap matched or affirmed by the counterparties in verifying the swap, including at a minimum each of the terms included in the most recent Federal Register release by the Commission listing minimum primary economic terms for swaps in the swap asset class in question. Confirmation data means all of the terms of a swap matched and agreed upon by the counterparties in confirming a swap. For cleared swaps, this term will also include the internal identifiers assigned by the automated systems of the DCO to the two transactions resulting from novation to the clearing house.
Continuation data includes all changes to the primary economic terms of the swap occurring during the existence of the swap. The reporting counterparty must report either life cycle event data or state data.
Life cycle event is defined in by the CFTC to include “any event that would result in either a change to a primary economic term of a swap or to any primary economic terms data previously reported to a SDR in connection with a swap. Examples of such events include, without limitation, a counterparty change resulting from an assignment or novation; a partial or full termination of the swap; a change to the end date for the swap; a change in the cash flows or rates originally reported; availability of a legal entity identifier for a swap counterparty previously identified by name or by some other identifier; or a corporate action affecting a security or securities on which the swap is based (e.g., a merger, dividend, stock split, or bankruptcy).”
State data means all of the data elements necessary to provide a snapshot view, on a daily basis, of all of the primary economic terms of a swap in the swap asset class of the swap in question, including any change to any primary economic term or to any previously-reported primary economic terms data since the last snapshot. At a minimum, state data must include each of the terms included in the most recent Federal Register release by the Commission listing minimum primary economic terms for swaps in the swap asset class in question.
30 Herrick, Feinstein LLP Dodd Frank 2013: The Regulators Extend Their Reach into the Capital Markets
Timing of Reporting (i) Creation Data
For swaps that are executed on an SEF or DCM, the SEF or DCM must report all required creation data as soon as technologically practicable. If the swap is accepted for clearing by a DCO, the DCO must report all of the confirmation data for the swap as soon as technologically practicable after clearing.
For swaps that are subject to mandatory clearing, and not executed on an SEF or DCM, the reporting counterparty must report all primary economic terms data for the swap, within the applicable timeline. If the reporting counterparty is an SD or MSP, it must report all primary economic terms data as soon as technologically practicable after execution, but no later than 30 minutes after execution during the first year following the compliance date, and 15 minutes thereafter. If the reporting counterparty is a non-SD/MSP, the reporting counterparty must report all primary economic terms as soon as technologically practicable after execution, but no later than 4 business hours after execution during the first year following the compliance date, 2 business hours during the second year, and 1 business hour thereafter. If the swap is accepted for clearing by the DCO, it is the DCO that must report all confirmation data as soon as technologically practicable, including the internal identifiers assigned by the automated systems of the DCO. If the swap is not accepted for clearing, the reporting counterparty must report within the applicable reporting deadline. If the reporting counterparty is an SD or MSP, the reporting counterparty must report as soon as technologically practicable, but no later than 30 minutes after confirmation if confirmation occurs electronically, or 24 hours business hours if confirmation does not occur electronically. If the reporting counterparty is a non-SD/MSP, the reporting counterparty must report as soon as technologically practicable, but no later than the end of the second business day after the date of confirmation during the first year following the compliance date, and the end of the first business day thereafter.
For swaps which are neither executed on an SEF or DCM, nor cleared, there are comparable reporting requirements for reporting counterparties. Reporting deadlines are extended, however, reflecting the likelihood that they have less technological support in place for these reporting requirements.
For historical swaps in existence on or after April 25, 2011, the reporting counterparty must report electronically to an SDR on the compliance date all of the minimum primary economic terms and relevant identifiers.
(ii) Continuation Data
Every reporting counterparty is required to ensure that all data in the SDR concerning the swap transaction remains current and accurate, and includes all changes to the primary economic terms of the swap during the existence of such swap transaction. Reporting counterparties fulfill this obligation by reporting either life cycle event data or state data.
If the swap transaction is cleared, the DCO must report to the SDR all life cycle event data for the swap, reported on the same day that any life cycle event occurs, or all state data for the swap reported daily. In addition, the DCO to which the swap transaction was submitted for clearing is required to
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report valuation data for a swap; end-users are not required to report this information for cleared swaps.
For swaps that are not cleared, the reporting counterparty must report either the life cycle data or state data to the SDR. If the reporting counterparty is a SD or MSP, all life cycle event data must be reported on the same day that any life cycle event occurs, with the sole exception that life cycle event data relating to a corporate event of the non-reporting counterparty must be reported no later than the second business day after the day on which such event occurs. State data must be reported daily. If the reporting counterparty is a non-SD/MSP counterparty, life cycle event must reported no later than the end of the second business day following the date of any life cycle event during the first year after the compliance date, and the first business day thereafter, with the sole exception that life cycle event data relating to a corporate event of the non-reporting counterparty must be reported no later than the end of the third business day following the date of such event during the first year after the compliance date, and no later than the end of the second business day thereafter.
If the reporting counterparty is an SD or MSP, the reporting counterparty must report all valuation data for the swap daily. If the reporting counterparty is a non-SD/MSP, the non-SP/MSP must report the current daily mark of the transaction as of the last day of each fiscal quarter. This report must be transmitted to the SDR within thirty calendar days of the end of each fiscal quarter. If such daily mark is not available for the swap, the non-SD/MSP must report the current valuation of the swap recorded on its books.
For each uncleared historical swap in existence on or after April 25, 2011, the reporting counterparty must report all required swap continuation data, with the exception that when a reporting counterparty reports changes to minimum primary economic terms for a historical swap, the reporting counterparty is only required to report changes in the minimum primary economic terms listed in Appendix 1 to part 46. For historical swaps that have terminated prior to April 25, 2011, the reporting counterparty must report to an SDR on the compliance date, such information relating to the terms of the transaction as was in the reporting counterparty’s possession on or after October 14, 2010.
Determination of Reporting Counterparty In swaps involving commercial end-users, the end-user generally would not be determined to be the reporting counterparty. In a swap with an SD or MSP, the SD or MSP would be the reporting counterparty. If the commercial end-user’s counterparty is a financial entity, the financial entity would be the counterparty. Only in the case of two commercial end-users would the counterparties need to agree upon which would be the reporting counterparty. It should be noted that regardless of the end- user’s reporting obligations, end-users are required to obtain a legal entity identifier.
Business Conduct Standards Title VII requires new business conduct standards between counterparties to swap transactions by creating anti-fraud, counterparty eligibility verification, and disclosure requirements. SDs and MSPs are required to implement policies and procedures to obtain and retain a record of the essential facts concerning each counterparty whose identity is known to the SD prior to the execution of the transaction, including: (i) facts required to comply with all applicable laws, regulations, and rules; (ii) facts required to implement the SD’s credit and operational risk management policies; and (iii) information regarding the authority of any person acting for such counterparty. SDs and MSPs are further required to obtain and retain a record showing the true name and address of each counterparty whose identity is known to the SD or MSP prior to the execution of the swap transaction.
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The CFTC has made it unlawful for any SD or MSP to engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative. It is similarly unlawful for any SD or MSP to: (i) disclose to any other person any material confidential information provided by or on behalf of a counterparty to the SD or MSP; or (ii) use confidential information for its own purposes in any way that would tend to be materially adverse to the interests of a counterparty. Notwithstanding the foregoing prohibition, SDs or MSPs may disclose or use material confidential information if the disclosure is authorized in writing by the counterparty, or it is necessary: (i) for the effective execution of any swap for or with the counterparty; (ii) to hedge or mitigate any exposure created by such swap; or (iii) to comply with a request of the CFTC, Department of Justice, any self-regulatory organization designated by the CFTC, a prudential regulator, or as required by law.
Prior to entering into the swap transaction, an SD or MSP must disclose to any counterparty to the swap material information concerning the swap in a manner reasonably designed to allow the counterparty to assess: (1) the material risks of that particular swap; (2) the material characteristics of the swap; (3) the material incentives and conflicts of interest that the SD or MSP may have in connection with a particular swap, including: (i) the price of the swap and the mid-market mark of the swap; and (ii) any compensation or other incentive from any source other than the counterparty that the SD or MSP may receive.
For swaps with end-users that are not made available to trade on a DCM or SEF, SDs are required to: (1) notify the end-user that it can request and consult on the design of a scenario analysis to allow the end-user to assess its potential exposure in connection with the swap; (2) provide a scenario analysis, which is designed in consultation with the end-user and at its request, and done over a range of assumptions include severe downside stress scenarios that would result in significant loss; (3) disclose all material assumptions and explain the calculation methodologies used to perform any requested scenario analysis, provided that the SD is not required to disclose confidential, proprietary information about any model it may use to prepare the scenario analysis; and (4) in designing any requested scenario analysis, consider any relevant analyses that the swap dealer undertakes for its own risk management purposes. These requirements are not applicable if the swap is initiated on a DCM or SEF, or if the SD or MSP does not know the identity of the counterparty prior to the execution of the swap.
SDs and MSPs must notify an end-user of its right to receive, upon request, the daily mark from the appropriate DCO if the swap has been submitted for clearing. For uncleared swaps, SDs and MSPs must provide the end-user with a daily mark that must be the mid-market mark of the swap, and cannot include amounts for profit, credit reserve, hedging, funding, liquidity, or any other costs or adjustments. Furthermore, for uncleared swaps, the SD or MSP must provide: (i) the methodology and assumptions used to prepare the daily mark, and any material changes during the term of the swap; (ii) additional information concerning the daily mark to ensure a fair and balanced communication, including, as appropriate that: (A) the daily mark may not necessarily be a price at which either the end-user or the SD or MSP would agree to replace or terminate the swap; (B) depending on the agreement, calls for margin may be based on considerations other than the daily mark provided to the end-user; and (C) the daily mark may not necessarily be the value of the swap that is marked in the books of the SD or MSP.
For swaps that are not required to be cleared, an SD or MSP must notify the end-user with which it enters into a swap that it is not subject to the mandatory clearing requirements of the CEA, and that the
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end-user: (1) may elect to require clearing of the swap; and (2) has the sole right to select the DCO at which the swap will be cleared.
The CFTC requires that any communication between a SD or MSP and any counterparty be communicated in a fair and balanced manner based on principles of fair dealing and good faith. An SD that recommends a swap or trading strategy involving a swap to a counterparty, other than an SD or MSP, must: (1) undertake reasonable diligence to understand the potential risks and rewards associated with the recommended swap or trading strategy; and (2) have a reasonable basis to believe that the recommended swap or trading strategy is suitable for the counterparty, which it does by obtaining information from the counterparty, including the counterparty’s investment profile, trading objectives, and ability to absorb potential losses associated with the swap or strategy.
Conclusion The new clearing requirement will fundamentally change the dynamics of the swap market. End-users who are eligible for, and properly elect to utilize, the exception may be able to avert clearing requirements and mitigate the costs of clearing. Regardless of the exception, end-users will continue to have recordkeeping and reporting obligations. End-users will have to cooperate with SDs and MSPs in order to enable them to discharge their new duties.
34 Herrick, Feinstein LLP Herrick, Feinstein LLP’s Seventh Annual Capital Markets Symposium October 2, 2013
DODD FRANK: 2013 Cross Border Application of U.S. Swap Regulations: Conflicts Abound at Home and Abroad
By Patrick D. Sweeney, Adam D. Wolper and Kyle Shenfeld
Sweeney3 Cover.indd 1 9/24/2013 11:35:18 AM Dodd Frank 2013: The Regulators Extend Their Reach into the Capital Markets
Cross Border Application of U.S. Swap Regulations: Conflicts Abound at Home and Abroad By Patrick D. Sweeney, Adam D. Wolper and Kyle Shenfeld1
Title VII of the Dodd-Frank Act2 amends the Securities Exchange Act of 1934 (the “Exchange Act”) and the Commodity Exchange Act of 1936 (“CEA”) in order to bring over-the-counter swaps (and those persons who trade, and facilitate trades, in such swaps) under the regulation of the Security and Exchange Commission (“SEC”) (in the case of “security-based swaps”), the SEC and the Commodity Futures Trading Commission (“CFTC” and, collectively with the SEC, the “Commissions”) (in the case of mixed swaps), and the CFTC (in the case of all other regulated swaps). Title VII – which subjects “swap dealers” (“SDs”)3 and “major swap participants” (“MSPs”)4 to reporting, recordkeeping, and execution requirements – is broad in scope and is not limited to the boundaries of the United States. While its potential extraterritorial reach could conceivably come into conflict with competing non-U.S. regulatory schemes, Title VII nevertheless endorses transparency and cooperation among international regulators and affirms the need to achieve international harmonization between its regulatory framework and that of competing jurisdictions. In addition to potential conflict between the Commissions and foreign regulatory commissions (and the extent to which “substituted compliance” is permissible), there are also disparities between the proposed cross-border application of swap regulations by the CFTC and SEC, respectively. It remains to be seen what level of cooperation is actually possible, both between the Commissions in their approach to cross-border derivatives regulation, and with comparable foreign oversight commissions.
CFTC’s Final Guidance While the CEA and its concomitant regulations detail how to comply with the new swap rules, they are rather vague on the subject of who and what (and the geographic location of such who and what) must comply. The statute and regulations make clear that only a “person” can be an SD or MSP, and Section 2(i) of the CEA provides, in part, that the swaps regulatory regime “shall not apply to activities outside the United States unless those activities have a direct and significant connection with activities in, or effect on, commerce of the United States . . .” However, the statute and existing regulations do not explain that nebulous standard. Instead of a clarifying regulation, on July 12, 2013, the CFTC took a step toward answering this question when it adopted its final Interpretative Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations (the “Final Guidance”).5 The Final Guidance is just what it says: guidance. As stated by the CFTC: “[u]nlike a binding rule ______1 Mr. Sweeney is a partner; Mr. Wolper is an associate; and Mr. Shenfeld was a summer associate at Herrick, Feinstein LLP. 2 The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010). 3 The CFTC defines a “swap dealer” as an entity that: (1) holds itself out as a dealer in swaps; (2) makes a market in swaps; (3) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (4) engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps. 4 The CFTC defines a “Major Swap Participant” as: (1) a person that maintains a “substantial position” in any of the major swap categories, aside from 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; (2) a person whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or (3) 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. 5 78 Fed. Reg. 45,292 (July 26, 2013).
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adopted by the Commission, which would state with precision when particular requirements do and do not apply to particular situations, this [Final] Guidance is a statement of the Commission’s general policy regarding cross-border swap activities . . .”. This section sets forth some of the pertinent aspects of the Final Guidance.
The CFTC’s Broad Reach: Definition of “U.S. person” The scope of jurisdiction contemplated in the Final Guidance largely hinges on the CFTC’s definition of “U.S. person.” This term does not appear in Title VII or the CEA and its accompanying regulations; rather, it is a creature of the Final Guidance, and is meant as a guide to assist the CFTC in determining who is covered by the CFTC’s new swap regulations. The CFTC defines “U.S. person” (and please note that this is a non-exclusive list) as follows: (i) any natural person who is a resident of the United States; (ii) any estate of a decedent who was a resident of the United States at the time of death; (iii) any corporation, partnership, limited liability company, business or other trust, association, joint- stock company, fund, or any form of enterprise similar to any of the foregoing (other than an entity described in prongs (iv) or (v) below) (a “legal entity”), in each case that is organized or incorporated under the laws of a state or other jurisdiction in the United States or having its principal place of business in the United States; (iv) any pension plan for the employees, officers or principals of a legal entity described in prong (iii), unless the pension plan is primarily for foreign employees of such entity; (v) any trust governed by the laws of a state or other jurisdiction in the United States, if a court within the United States is able to exercise primary supervision over the administration of the trust; (vi) any commodity pool, pooled account, or other collective investment vehicle that is not described in prong (iii) and that is majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v), except any commodity pool, pooled account, investment fund, or other collective investment vehicle that is publicly offered only to non-U.S. persons and not offered to U.S. persons; (vii) any legal entity (other than a limited liability company, limited liability partnership or similar entity where all of the owners of the entity have limited liability) that is directly or indirectly majority- owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v) and in which such person(s) bears unlimited responsibility for the obligations and liabilities of the legal entity; and (viii) any individual account or joint account (discretionary or not) where the beneficial owner (or one of the beneficial owners in the case of a joint account) is a person described in prong (i), (ii), (iii), (iv), (v), (vi), or (vii).
The Final Guidance further provides that “[u]nder this interpretation, the term ‘U.S. person’ generally means that a foreign branch of a U.S. person would be covered by virtue of the fact that it is a part, or an extension, of a U.S. person.”
Thus, the Final Guidance makes clear that the CFTC will regulate all “U.S. persons” (regardless of where they are located in the world) if they surpass the thresholds warranting registration as an SD or
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MSP. And for U.S. persons, all swaps (not just those entered into with other U.S. persons) are considered in determining whether the SD or MSP threshold is met.
Registration of Non-U.S. Persons as SDs or MSPs Regardless of Location The sole fact that a “person” does not meet the definition of “U.S. person” does not mean that such “non-U.S. person” is exempt from the CFTC’s swap regulations. This is because a non-U.S. person can still meet the definition of “swap dealer” or “major swap participant,” thus requiring registration with the CFTC.
Projecting the CFTC’s expansive jurisdictional reach, the Final Guidance indicates that those swap dealers who exceed the de minimis threshold (set forth in CFTC Rule 1.3(ggg)(4)) are required to register with the CFTC as SDs, regardless of whether they are a U.S. person. The Final Guidance provides that all of the swap dealing activities of a non-U.S. person who is a “guaranteed affiliate” of a U.S. person, or who is an “affiliate conduit” of a U.S. person, must be counted toward the de minimis threshold for swap dealer registration. Conversely, a non-U.S. person who is not a guaranteed affiliate or affiliate conduit only has to count its swap dealing transactions with U.S. persons (other than foreign branches of swap dealers that are registered with the CFTC) or guaranteed affiliates of U.S. persons (with three exceptions), toward the de minimis threshold for swap dealer registration.
There is a similar analysis in connection with “major swap participants.” The Final Guidance provides that in connection with non-U.S. persons who are guaranteed or conduit affiliates of a U.S. person, “in calculating whether the applicable MSP threshold is met, [such guaranteed or conduit affiliate] would be expected to include . . . the notional value of: (1) [a]ll swaps with U.S. and non-U.S. counterparties, and (2) any swaps between another non-U.S. person and a U.S. person or guaranteed affiliate, if the potential non-U.S. MSP guarantees the obligations of the other non-U.S. person thereunder.”
Finally, the CFTC interprets Title VII’s clearing requirements to apply to any swap where one of the counterparties is a U.S. person, regardless of where the transaction actually takes place. Given the CFTC’s expansive definition of U.S. person, the amount of transactions that have to clear, even for non-U.S. persons, may be voluminous.
SEC’s Proposed Rules and Interpretive Guidance In its May 1, 2013, proposed rules and interpretive guidance6 (the “SEC Proposal”), the SEC took a different stance on the reach of Title VII beyond the borders of the United States, specifically through its proposed definition of the term “U.S. person” (which, unlike the CFTC, the SEC proposes to incorporate into a rule).
Narrowed Scope of “U.S. Person” Definition is in Line with Concept of Territoriality In line with its overall “territorial” approach, the SEC defined “U.S. person” as one of the following:
______6 Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-69490 (May 1, 2013).
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(i) Any natural person resident in the United States; (ii) Any partnership, corporation, trust, or other legal person organized or incorporated under the laws of the United States or having its principal place of business in the United States; or (iii) Any account (whether discretionary or non-discretionary) of a U.S. person.
If a U.S. person otherwise meets the definition of “security-based swap dealer’ or “major security- based swap participant” then they are subject to SEC regulation.
The SEC’s definition of “U.S. person” stems from the concept of territoriality, meaning that persons and activities in the international security-based swaps market should be regulated by the SEC based on whether their situs is in the United States. Given the reality that many security-based swaps are negotiated between entities subject to varying regulatory regimes, the SEC Proposal intends to limit SEC regulation on foreign market participants in order to relieve much of the burden associated with simultaneous or conflicting regulations.
Non-U.S. Security-Based Swap Dealers As does the Final Guidance, the SEC Proposal explains when a non-U.S. person is required to register with the SEC as a “security-based swap dealer.” Furthering the territoriality concept, for purposes of determining whether the de minimis threshold has been reached, non-U.S. persons are required to include in their calculations security-based swaps that are either: (1) entered into with U.S. persons; or (2) conducted “within the U.S.” They would not be required to include: (1) foreign branches of U.S. banks; or (2) non-U.S. persons, even if the swap is guaranteed by a U.S. person.
Non-U.S. Major Security-Based Swap Participants For purposes of determining whether a non-U.S. person exceeds the defined substantial position or counterparty exposure threshold in the definition of “major security-based swap participant,” the SEC Proposal provides that non-U.S. persons need only consider transactions with U.S. persons (including swaps with foreign branches of U.S. banks). Further, if a non-U.S. person guarantees a U.S. person’s security-based swaps, all guaranteed security-based swaps are attributed to the guarantor; but if a non- U.S. person guarantees a non-U.S. person’s security-based swaps, then only the security-based swaps with a U.S. person counterparty will be attributed to the guarantor.
Analysis of Differences between CFTC and SEC Given the difference between the SEC’s and CFTC’s proposals, the SEC’s situs approach may allow more oversight in some regards yet be narrower in others. The SEC’s reach is narrower in that its definition of “U.S. person” contains fewer prongs than the CFTC’s. However, the SEC approach is broader in that it includes transactions by any parties conducted within the U.S., a concept based on physical presence in the U.S. that the CFTC does not recognize. Being territorial in nature, the SEC definition could bring transactions under jurisdiction that involved no U.S. persons. The differences turn on how the Commissions interpret what will have a “direct and significant effect” on commerce of the United States.
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Reconciliation of Regulatory Structures Given the global nature of the swap and derivative markets, Congress felt it was necessary to provide the Commissions with the ability to implement formulae to facilitate international cooperation. It has been the responsibility of both the CFTC and the SEC to implement the concept of substituted compliance (i.e., where a person’s compliance with the laws of their home jurisdiction constitutes compliance with SEC or CFTC rules as well). The CFTC has already begun such efforts, as evidenced by its accord with the European Commission (“EC”). The SEC hopes to address cross- border cooperation as well, though its approach to substituted compliance is slightly different.
Substituted Compliance: CFTC’s Version Under the Final Guidance, and subject to the next sentence of this paragraph, non-U.S. person SDs and MSPs (as well as (i) U.S. banks that are SDs or MSPs with respect to their foreign branches, and (ii) non-U.S. non-registrants that are guaranteed or conduit affiliates, as applicable) will be allowed to comply with the entity-level and transaction-level requirements of their home jurisdictions’ (or in the case of a foreign branch of a bank, the foreign location of the branch’s) laws and regulations, instead of obligating such SDs and MSPs to comply with the requirements of Dodd-Frank. This “substituted compliance” will only be permissible if the CFTC first finds that the home jurisdictions requirements “are comparable with and as comprehensive as the corollary area(s) of regulatory obligations encompassed by the CFTC’s Entity- and Transaction-Level Requirements.”7 The CFTC states that its comparability determinations may be made on a requirement-by-requirement basis, rather than on the basis of the foreign regime as a whole. One possible ramification of this analytical approach would be a “checkerboard” of U.S. and non-U.S. regulations applicable to non-U.S. persons.
Substituted Compliance: SEC’s Version The SEC, on the other hand, approaches substituted compliance on a more holistic level. The proposed rules would permit SBS market participants to substitute compliance with comparable rules from non-U.S. jurisdictions for compliance with U.S. rules, provided certain conditions are met. If the SEC determines that a foreign regulatory regime’s requirements are comparable to the SEC’s, a foreign market participant is allowed to substitute compliance with its home country’s regime for compliance with Title VII of Dodd-Frank.
The SEC plans to separately assess the comparability of the foreign swaps regulatory regime using four different categories. If a foreign regime is “comparable to Title VII in only one category, only rules from the foreign regime that address that category may be substituted for compliance with the analogous Title VII rules. If the rules from the foreign regime are comparable to Title VII in two categories, rules from the foreign regime for those two categories may be substituted for compliance with Title VII, and so on.” The categories for consideration are: (1) requirements applicable to registered non-U.S. SBSDs; (2) requirements relating to regulatory reporting and public dissemination of SBS data; (3) requirements relating to mandatory clearing for SBS; and (4) requirements relating to
______7 The entity level requirements are based on: (1) capital adequacy; (2) chief compliance officer; (3) risk management; (4) recordkeeping; and (5) SDR reporting. The transaction-level requirements are: (1) clearing and swap processing; (2) margin and segregation for uncleared swaps; (3) trade execution; (4) swap trading relationship; (5) portfolio reconciliation and compression; (6) real-time public reporting; (7) trade confirmation; (8) daily trading records; and (9) external business conduct standards for SDs and MSPs.
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mandatory trade execution for SBS. The SEC will examine the categories on a holistic level, so that differences in particular rules or regulations will not necessarily render a foreign SBS regulatory regime unsuitable for compliance.
EC and CFTC Harmonization On July 16, 2013, the EC and the CFTC came to a cross-border accord on derivative regulation with regards to the CFTC’s extraterritorial reach under Dodd-Frank. Additionally, the CFTC granted temporary relief to non-U.S. firms from compliance with Dodd Frank rules governing SDs and MSP that were set to apply on July 12, 2013. The agreement circumvented a disturbance of cross-border derivative transactions that would likely have stemmed from the CFTC’s proposal: (1) to force all swaps involving at least one U.S. entity to be cleared in the U.S.; and (2) to subject several non-U.S. entities entering into swaps with U.S. entities to two or more sets of redundant or even conflicting regulations.
Generally speaking, the EC and CFTC have agreed to abide by and defer to the regulatory requirements of the other jurisdiction wherever such compliance is “justified.” The agreement allows non-U.S. banks as well as other major swap traders to postpone compliance with various provisions of Title VII until the CFTC decides whether the analogous EU rules are subject to comparable U.S. rules, and whether to allow such entities to with their respective jurisdictional rules rather than U.S. rules.
More specifically, the highlights of the EC and CFTC agreement and proposed guidance suggest that: (1) a non-U.S. SD that is not affiliated with or guaranteed by a U.S. person will likely only be subject to the CFTC’s transaction-level requirements in transactions with U.S. persons and guaranteed affiliates of U.S. persons; (2) for trade executions, the CFTC will permit foreign boards of trade to receive no-action relief to list swap contracts for trading via direct access, to avoid market and liquidity disruption; (3) where a swap is executed on an anonymous and cleared basis on a registered designated contract market or swap execution facility, the parties will be deemed to have met their transaction-level requirements; (4) the EC and CFTC have several identical requirements for mandatory clearing obligations, and will continue to work as one to unify international rules on margins for uncleared swaps; (5) CFTC and EMIR rules regarding DCOs are based on international minimum standards, as clearinghouses’ and central counterparties’ initial margin coverage is the key difference between them; (6) the EU and CFTC recognize that they have essentially the same rules with regards to risk mitigation for the largest counterparty swap market participants; and finally (7) the definition of “U.S. person” should encompass offshore hedge funds as well as other collective investment vehicles that are either owned by a majority of U.S. persons or that have their principal place of business within the U.S.
Further clarification may be expected from the CFTC prior to year end 2013, when the current temporary relief period expires.
42 Herrick, Feinstein LLP Herrick, Feinstein LLP’s Seventh Annual Capital Markets Symposium October 2, 2013
DODD FRANK: 2013 What’s Happening in Enforcement?
By Therese M. Doherty, LisaMarie F. Collins and Philip W. Raimondi
Sweeney1 Cover.indd 1 9/24/2013 6:19:12 PM Dodd Frank 2013: The Regulators Extend Their Reach into the Capital Markets
What’s Happening in Enforcement? By Therese M. Doherty
Introduction The industry continues to evolve from trades placed and executed by humans to electronic trading through automated trading systems and high-speed trading firms using high frequency trading algorithms. This article will examine the Commission’s increased focus with respect to automated trading systems and high frequency trading. For example, Commissioner Bart Chilton recently questioned whether exchanges such as CME were adequately monitoring high-speed trading firms given the high volume of wash trades occurring in connection with high-frequency trading. The Commission also recently released a 137 page “concept release” that poses questions to industry participants focusing on increased risk controls for automated trading systems (“ATS”) and high-speed trading firms.
Also, for the last few years, industry participants, lawyers, and compliance professionals have kept a watchful eye on how the Commission applies its broadened enforcement authority provided by Dodd- Frank relating to anti-fraud, anti-manipulation and anti-disruptive trading practices. While comment periods have come and gone, guidance has been issued, and rules implemented, the Commission has used its new enforcement authority sparingly. The Commission has alleged Rule 180.1 violations in an anti-fraud context, but we have yet to see any enforcement proceedings or actions alleging manipulation under the Commission’s broadened authority. This article analyzes the proceedings to date where the Commission has used its new anti-fraud, anti-manipulation and anti-disruptive trading practice enforcement authority.
Automated Trading Systems and High Frequency Trading In early 2013, the Commission began examining whether high-speed trading firms were violating Commission rules and regulations by using wash trades to artificially inflate volume and distort markets in futures contracts. A wash trade occurs when a party enters into, or purports to enter into, a transaction to give the appearance that purchases and sales have been made, without incurring market risk or changing the trader’s market position. In other words, a party is the buyer and seller trading with itself, taking no risk but creating the impression that a legitimate market trade has occurred. Section 4(c) of the Act expressly prohibits wash trading as do various exchange rules.
The Commission’s examination focused on suspected wash trades by high-speed firms in futures contracts tied to the value of crude oil, precious metals, agricultural commodities and the Standard & Poor’s 500-stock index, among other underlying instruments. In addition to scrutinizing high frequency trading firms, the Commission’s examination focused also on two primary exchanges, CME Group Inc. (“CME”) and the Intercontinental Exchange, Inc. (“ICE”). With respect to the CME and ICE, the Commission expressed concern that the exchanges’ systems were not sophisticated enough to prevent wash trades.
The CME’s Proposed Guidance Regarding Wash Trading On June 17, 2013, the CME issued Regulation Advisory Notice RA1308-5 (“RA1308-5”) seeking to provide updated guidance regarding compliance with CME Rule 543 (“Wash Trades Prohibited”). Specifically, RA1308-5 sought to draw a more distinct line between intentional and unintentional wash trading. RA1308-5 also provided information regarding the introduction of CME’s “Self-Match
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Prevention” functionality (“SMP”), an optional electronic functionality that, when employed, automatically blocks the matching of buy and sell orders that are submitted to CME Globex with the same executing firm ID and the same self-match prevention ID. The CME intended to implement RA1308-5 on July 1, 2013.
Commissioner Chilton gave a keynote address at the Trading Show of Chicago a week later. Commissioner Chilton’s speech focused on the high volume of wash trades occurring in connection with high frequency trading. Commissioner Chilton complained that the high volume of high frequency related wash trades were creating “fantasy liquidity” because traders were not taking market risk. Commissioner Chilton warned that the Commission was “watching” high frequency traders and that the Commission will “come into your dens and look and analyze with experts your algo programs to see if you are violating the law.” Commissioner Chilton raised concerns about the CME’s electronic prevention system and proposed RA1308-5, stating that the proposal required a lengthier review by the Commission to understand how it played into the regulator’s own efforts to police trading.
Following a dialogue with the Commission’s Division of Market Oversight, the CME withdrew the self-certification of RA1308-5 and reinstated its previous advisory notice from 2009 relating to wash trades. By letter dated July 9, 2013, the CME, on behalf of the CBOT, NYMEX, COMEX, and KCBT (collectively, the “Exchanges”) requested Commission approval to issue RA1308-5 to the marketplace. The CME thus abandoned its effort to update guidelines on wash trades without prior Commission approval. Pending Commission approval, the Exchanges planned to make RA1308-5 effective on September 9, 2013. The Commission has not yet approved RA1308-5.
Similarly, on September 9, 2013 the Commission published a Concept Release on Risk Controls and System Safeguards for Automated Trading Environments, 78 Fed. Reg. 56,542 (Sept. 12, 2013) [hereinafter “Concept Release”] available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2013-22185a.pdf. The Concept Release sets forth the Commission’s views regarding risks involved with automated trading, and preventative measures taken to date to mitigate such risks. In light of new market structures focused on automated and high frequency trading, traditional risk controls and safeguards, which largely rely on human judgment and intervention, must be reevaluated. Thus, the Concept Release is intended as “a high-level enunciation of potential measures intended to reduce the likelihood of market disrupting events and mitigate their impact when they occur.” Id. at 56551. The Concept Release also provides a comprehensive discussion and poses 124 questions related to the further potential mitigation of such risks for which it seeks comment from the industry. Presumably, the Concept Release will serve as a framework for forthcoming rules, restrictions, and trading limits relating to automated and high frequency trading.
“The Concept Release provides an overview of the automated trading environment, including its principal actors, potential risks, and responsive measures taken to date by the Commission or industry participants. The Concept Release also discusses a series of (1) pre-trade risk controls; (2) post-trade reports and other measures; (3) system safeguards related to the design, testing and supervision of automated trading systems (ATSs); and (4) additional protections designed to promote safe and orderly markets.” Press Release, CFTC Release: PR 6683-13 (Sept. 9, 2013). In each case, the Commission seeks extensive public comment regarding these measures.
46 Herrick, Feinstein LLP Dodd Frank 2013: The Regulators Extend Their Reach into the Capital Markets
Rule 180.1: The Commission’s New Anti-Fraud, Anti-Manipulation and Anti-Disruptive Trading Practices Authority With respect to Dodd-Frank enforcement, a significant augmentation of the Commission’s enforcement capabilities created by Dodd-Frank is the amendment to the statutory definition of fraudulent and manipulative conduct. Section 753 of Dodd-Frank amends § 6(c) of the Commodity Exchange Act (the “Act”) to lessen the intent required for manipulative or fraudulent conduct -- closely mirroring § 10(b) of the Securities and Exchange Act of 1934. See 7 U.S.C. § 9(1). Previously, there was a scienter requirement of specific intent to create an artificial market price. Dodd-Frank changed the intent requirement so that a violator need only act in “reckless disregard” for the illicit conduct to be deemed unlawful. Id.
CFTC Rule 180.1 (which mirrors SEC Rule 10b-5) implements § 6(c)(1) of the Act. Rule 180.1 further broadens the Commission’s previous anti-fraud authority by permitting enforcement even in the “absence of any market or price effect” related to the alleged conduct. 76 Fed. Reg. at 41401. The Commission interprets its new authority broadly -- Rule 180.1 prohibits certain behavior “in connection with” swaps, commodities contracts or futures contracts. The Commission interprets the words “in connection with” to reach all fraudulent conduct in connection with the purchase, sale, solicitation, execution, pendency, or termination of any swap, futures contract or contract for the sale of any commodity, including payment obligations under a swap. Hence, this expansion is also distinguishable from prior authority by extending the Commission’s enforcement power to all commodity-related transactions regardless of the contract type.
While the Commission has brought claims asserting Rule 180.1 violations in an anti-fraud context, the derivatives community has yet to see Rule 180.1 challenged or otherwise put to the fullest use of its enforcement power by the Commission. To date, the Commission has generally alleged violations of new Rule 180.1 in recent actions concerning Ponzi schemes1 or retail commodity transactions2. These cases have resulted in consent orders, default judgments or remain pending. The derivatives ______1 See e.g. Commodity Futures Trading Commission v. Atlantic Bullion & Coin, et al., No. 12-cv-1503-JMC (D.S.C. June 6, 2012) (charging a purported silver brokerage firm and its president with fraud in connection with operating an alleged $90 million Ponzi scheme, in violation of the Act and Commission regulations); Commodity Futures Trading Commission v. Schiller, No. 12-cv-4043 (N.D. Ill. May 24, 2012) (alleging that a floor broker made material misstatements to investors, misappropriated investor accounts to support a “lavish lifestyle,” (Compl. ¶ 2) and issued fraudulent account statements to investors. Invoking Rule 180.1, the complaint alleged that the defendant committed the unlawful acts “knowingly or with reckless disregard for the truth); Commodity Futures Trading Commission v. Schmickle, No. 12-CV-0971 (E.D. Wis. Sept. 24, 2012) (alleging violations of Rule 180.1 against an unregistered commodity trading adviser (“CTA”) and its operator in an alleged Ponzi scheme and claiming that the manipulative and/or deceptive statements used to induce investors were made “intentionally or recklessly.”
2 See e.g. Commodity Futures Trading Commission v. Leighton, No. 12-cv-4012-PSG-SS (C.D. Cal. May 8, 2012) (alleging violations or Rule 180.1 where that the defendant is alleged to have deceived at least 42 pool participants to invest in his pool by making material misstatements about his trading performance history, among other things. The defendant allegedly perpetrated the scheme by transmitting fabricated account statements to pool participants.); Commodity Futures Trading Commission v. Smithers, No. 12-CV-81165-KAM (S.D. Fl. Oct. 22, 2012) (alleging violations of Rule 180.1 where the defendant fraudulently represented to several FCMs that someone other than himself had opened and controlled certain commodity trading accounts related to retail commodity investments he solicited. The Commission alleged that, besides the misstatements made to certain FCMs, the defendant also made false statements to investors about his performance history and misappropriated investor monies.).
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community has not seen substantive application of the “reckless disregard” standard, arguably the most significant element of the new rule. Nor has the derivatives community seen Rule 180.1 applied in an anti-manipulation context.
Anti-Disruptive Trading Actions and Guidance In addition, Section 747 of Dodd-Frank amended § 4c(a) of the Act to add a new section (§ 4c(a)(5)) that authorizes the Commission to prosecute specific instances of anti-disruptive trading practices. See 7 U.S.C. § 6c(5). Section 4c(a)(5) makes it unlawful for industry participants to (i) fail to honor bids or offers placed in the open market, (ii) exhibit intentional or reckless disregard for the orderly execution of orders during a market’s closing period, or (iii) engage in improper bid/offer cancelling conduct known as “spoofing (bidding or offering with the intent to cancel the bid or offer before execution).” Id. The Commission interprets the prohibitions in § 4c(a)(5) of the Act to be distinct statutory provisions from the anti-manipulation provisions in Section 753 of Dodd Frank.
The Commission’s ability to bring enforcement actions for certain types of anti-disruptive trading activity did not begin here. For example, in March 2011, the Commission filed and simultaneously settled charges against a proprietary trading firm for engaging in activity resembling “spoofing” on the soybean futures market. In the Matter of Bunge Global Markets, Inc., CFTC Docket No. 11-10 (Mar. 22, 2011). The Commission alleged that the traders at issue placed contract orders during the pre- opening session, but had no intention of actually executing the orders and cancelled them prior to the open. Id. Without any direct “spoofing” authority, the Commission successfully alleged a violation of § 4c(a)(2)(B) of the Act which makes it unlawful to cause a non-bona fide price to be reported. Id. at 4-5.
Now, in addition to limited prior authority, the Commission has new statutory authority specifically aimed at anti-disruptive trading tactics. See 7 U.S.C. § 6c(5). The Commission issued proposed guidance in 2011 (Antidisruptive Practices Authority, 76 Fed. Reg. 14943 [March 18, 2011]) and recently finalized its guidance on May 28, 2013. See Antidisruptive Practices Authority, 78 Fed. Reg. 31890 (May 28, 2013). The Commission clarifies that the scope of the new rules applies to “any trading, practices, or conduct” on a regulated exchange and there is no separate “manipulative intent requirement.” 78 Fed. Reg. at 31892. However, the Commission states that the new rules do not apply to block trades or exchanges for related positions (“EFRPs”). Id.
The finalized guidance addresses each of the three specific anti-disruptive rules separately. The Commission clarifies that the first rule, prohibiting bid and offer violations, does not contain any intent requirement. 78 Fed. Reg. at 31893. Rather, engaging in such conduct is a “per se” rule violation resulting in strict liability for each offense. Further, violations of this nature are highly fact specific and a single instance could result in an enforcement action. The rule prohibits the purchase of a contract at a price higher than the lowest available price offered or the sale of a contract at a price lower than the highest available price bid. Id. The Commission clarifies that the second rule prohibits intentionally or recklessly engaging in any transactions that disrupt the orderly execution of trades during the closing period of the applicable market. 78 Fed. Reg. at 31895. Attempts to “bang” or “mark the close” are deemed intentional violations of this rule. Id. Lastly, the third new anti- disruptive trading rule prohibits “spoofing” or the intentional cancelling of a bid or offer before execution. 78 Fed. Reg. at 31896. While the Commission will evaluate “market context” and patterns of trading activity prior to making an enforcement determination, “even a single instance of trading activity” can violate this rule. Id.
48 Herrick, Feinstein LLP Dodd Frank 2013: The Regulators Extend Their Reach into the Capital Markets
Within two months after releasing this finalized guidance, the Commission (in conjunction with the UK’s Financial Conduct Authority) filed, and simultaneously settled, its first enforcement action applying the new anti-disruptive trading rules. In the Matter of Panther Energy Trading LLC, et al., CFTC Docket No. 13-26 (Jul. 22, 2013). Here, the Commission fined a high-frequency trading firm and its owner $2.8 million for engaging in the entry of algorithmic bids and offers that were intentionally cancelled prior to execution. Id. The alleged purpose of this illicit conduct was to create enough interest on one side of the market to increase the likelihood that the firm’s legitimate orders would be filled on the opposite side of the market. See id. at 3. The Commission found that the respondents used an algorithm designed to cancel orders prior to execution. As a result of this conduct, the Commission fined the firm the exact amount of its disgorged profits, and presented a warning to the high-frequency trading community that their algorithms are not outside the scope of regulatory scrutiny.
In a related context, FINRA and several equities-based exchanges recently fined a large brokerage firm $9.5 million for failing to supervise certain direct-market high-frequency trading customers that allegedly engaged in certain manipulative and disruptive trading activities in the markets at issue. In re Newedge USA, LLC, FINRA Letter of Acceptance, Waiver, and Consent, No. 20090186944 (July 10, 2013). Specifically, FINRA found that the brokerage firm did not have adequate surveillance tools to detect the illicit actions of certain customers. Accordingly, even brokerage houses are not immune from the obligation to prevent the harmful effects of anti-disruptive trading activity.
Conclusion In light of the Commission’s comments, efforts and broadened authority under Dodd-Frank, the derivatives community certainly has some insight into Commission’s focus with respect to enforcement priorities. While the derivatives community has not yet seen Rule 180.1 invoked in an anti-manipulation context, one can only assume such a proceeding is on the horizon. Similarly, we can expect to see the Commission crack down on high-speed trading firms that violate Commission rules and regulations by way of high frequency trading algorithms.
Herrick, Feinstein LLP 49 Herrick, Feinstein LLP’s Seventh Annual Capital Markets Symposium October 2, 2013
DODD FRANK: 2013 SEC Focus Areas Regarding Investment Advisers
By Irwin M. Latner and John D. Cleaver
Latner1 Cover.indd 1 9/24/2013 11:43:53 AM Dodd Frank 2013: The Regulators Extend Their Reach into the Capital Markets
SEC Focus Areas Regarding Investment Advisers By Irwin M. Latner and John D. Cleaver
Introduction Investment advisers should be aware of the SEC’s “hot button” issues in order to successfully undergo SEC compliance exams or avoid them for as long as possible. In a series of recent speeches, releases and enforcement actions, the SEC has amplified its broad effort to improve compliance, prevent fraud, inform policy and monitor systemic risk. As always, the SEC may select any registered investment adviser for examination for any reason or no reason at all. Recently, however, the SEC has more specifically targeted those investment advisers whose operations raise certain red flags. In early 2013, the SEC published its examination priorities in order to set forth the main risk areas the SEC perceives as posing threats to investors. These stated priorities, along with an analysis of recent enforcement actions brought by the SEC, provide a growing rubric for investment advisers to consult to determine their likelihood of being selected for an SEC examination and how best to prepare for one.
How Does the SEC Arrive at the Door? The National Examination Program Initiative In October 2012, the SEC Office of Compliance Inspections and Examinations (“OCIE”) released an industry letter to executives and principals of fund management firms that sets forth the SEC’s “Presence Exam Initiative.” This initiative is directed to all investment advisers that were required to register due to the repeal of the “private adviser exemption” in the Investment Advisers Act of 1940 (the “Advisers Act”) by Section 402 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Pursuant to this new initiative, the SEC intends to conduct “focused, risk-based examinations” of newly registered advisers to private funds over the following two years. The exams will be conducted through the SEC’s National Exam Program (“NEP”), which is a division of the OCIE. This initiative consists of three phases:
• Engagement Phase: Nationwide outreach to inform newly registered firms about their obligations under the Advisers Act. • Examination Phase: Examination of newly registered private fund advisers which is the primary focus of this article. • Reporting Phase: At the conclusion of the two-year initiative, the NEP will report its findings to the SEC and the public, describing common issues, problems, and trends that were identified through its presence exams of newly registered private fund advisers.
Types of SEC Exams An SEC examination of a firm, though unpleasant, is almost inevitable, and thus should be viewed as an opportunity to make sure the firm is fully compliant. All SEC examinations are performed by the OCIE and generally focus on the risks specific to a firm. In addition to presence exams targeted at private fund advisers, the SEC conducts other types of exams of all registered investment advisers. The following additional types of exams conducted by the SEC are triggered by different factors and involve different levels of rigor.
Routine Exams Once upon a time, the SEC had a stated goal of inspecting all investment advisers on a regular schedule. While this goal is no longer feasible due to the SEC’s limited resources and the volume and
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complexity of the newly registered investment advisers resulting from the Dodd-Frank Act, “routine” exams still occur, though with less frequency than in the past. These routine exams simply mean that a firm’s “number has come up.” Generally, these exams are preceded by approximately two weeks’ of warning time, with the SEC informing the firm in writing of the documents it would like to see and the questions it would like to ask. These exams are generally performed without any prior suspicion of violations or high risk activities, and generally examine the structure of the firm, its assets under management and the documentation kept by the firm in marketing its services and supporting its purported track record.
“For Cause” Exams Since the goal of subjecting every investment adviser to a routine exam has proved too ambitious, the SEC has begun targeting its examinations based on tips, complains and referrals (“TCR”). OCIE has embarked on surprise “for cause” exams (i.e., exams that are conducted without any advance notice or on very short notice) in large part as a response to a perceived lack of attention to tips about Ponzi schemes such as the Madoff scandal. A tip, referral or complaint may come from an individual reporting a securities law violation, a media report or from the SEC’s own routine exam. The TCR approach complements, but does not replace, the other exams that the SEC has at its disposal. The advent of the TCR surprise examination system has had tangible consequences for firms that, under the prior system of announced examinations, took compliance seriously only once they received an SEC letter of examination.
“Sweep” Exams These exams typically target a number of firms at the same time in order to review a certain compliance issue that the SEC considers a broad-based risk. These exams (usually in the form of document requests) can result from data gleaned in routine or for cause exams where the SEC learns of certain prevalent compliance problems affecting the investment advisory industry.
“Higher Risk” Exams The SEC seeks to examine “higher risk” advisers every three years. Often, these exams are preceded by a routine exam in order to determine whether the firm warrants a “higher risk” exam. The factors that determine whether a firm poses a “higher risk” are manifold, including assets under management, employees with disciplinary histories, having an affiliated broker-dealer or several affiliated businesses, an incomplete Form ADV and significant indicia of non-compliance in prior exams. Once at the door, the examiner will likely focus on the most typically troublesome areas for firms, including conflicts of interest, valuation, portfolio management, advertising and asset verification. Fund managers and other advisers flagged as high risk firms can generally expect more frequent examinations and more extensive scrutiny by SEC examiners.
Aberrational Performance As part of the SEC’s recent focus on private fund managers, the SEC has targeted certain managers for examination based on the SEC’s belief that the manager has exhibited “aberrational performance.” Although indicia of non-compliance with other “hot button” focus areas (e.g. non-compliance with the custody rule, violation of marketing and performance rules, or any of the other areas discussed in Part Two below) could also raise red flags, aberrational performance alone can trigger an exam without necessarily requiring the SEC to look further. The SEC, via its aberrational performance review, has sophisticated tools to analyze a fund’s returns vs. the returns of the market and may target a fund manager for investigation if the fund consistently beats industry indices. Compliance exams triggered
54 Herrick, Feinstein LLP Dodd Frank 2013: The Regulators Extend Their Reach into the Capital Markets
by the SEC’s aberrational performance review of hedge funds, private equity funds and mutual funds has resulted in numerous enforcement actions by the SEC. For example, the SEC charged New York- based hedge fund ThinkStrategy Capital Management LLC and its managing director with fraud, alleging deceptive conduct to bolster the track record, size and credentials of the two funds they managed. The proprietary risk analytics employed by the SEC targeted these two funds and eventually led to charges that ThinkStrategy overstated its assets and longevity and obscured the volatility of its investments. On January 3, 2013, the U.S. District Court for the Southern District of New York ordered ThinkStrategy and the fund’s manager to jointly and severally pay disgorgement of approximately $4 million and a civil penalty of $1 million.
What should an investment adviser do if it has a legitimate run of market beating returns? Though the investment adviser may still be targeted by the SEC’s aberrational performance initiative, the adviser can rebut any SEC suspicions by demonstrating compliance with all underlying rules regarding marketing, performance advertising, asset valuation, recordkeeping, and other applicable SEC rules and regulations that pertain to accurately calculating and marketing the fund’s performance returns.
Once at Your Door, What is the Examiner Looking For? Compliance Generally Upon registration with the SEC, private fund advisers must comply with all of the applicable provisions of the Advisers Act and SEC rules thereunder. Some of these compliance requirements include:
• Compliance Rule. Registered advisers must adopt and implement written policies and procedures to prevent violations of the Advisers Act, conduct an annual review of the policies and procedures and designate a chief compliance officer responsible for implementing and administering the policies and procedures. • Books and Records Rule. Registered advisers must keep accurate and current books and records related to the advisory business. • Form ADV. Registered advisers must file an annual Form ADV, including at least Parts 1A and 2A. Advisers must also amend the Form ADV annually within 90 days of the fiscal year end of the advisory business and promptly upon any information in the Form ADV becoming inaccurate. • Code of Ethics Rule. Registered advisers must adopt a code of ethics which sets forth what is expected of all employees of the adviser and the rules regarding personal trading of securities by adviser personnel. • Advertising Rule. All investment advisers are prohibited from making any false or misleading statements in their offering documents or marketing materials.
In an example of a registered adviser running afoul of its compliance obligations, the SEC took enforcement action earlier this year against IMC Asset Management, Inc. for a failure to have written policies and procedures in place that were reasonably designed to prevent violations of the Advisers Act. The SEC alleged that the adviser’s written policies were outdated and concerned the adviser’s predecessor, which was a registered broker-dealer. Additionally, the SEC alleged that the firm’s chief compliance officer performed no compliance-related functions at all and had no prior compliance experience.
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Further, investment advisers are fiduciaries to their clients, and, accordingly, must act in the best interests of their clients in dispensing investment advice. The fiduciary duties of loyalty and good faith are woven into virtually all of the discussion below regarding the SEC focus areas.
In a particularly flagrant case of a violation of fiduciary duty, the SEC brought an action against Martin Currie, a Scotland-based fund management group, for steering a U.S. publicly-traded fund into an investment in order to bolster another client’s fund business in the midst of the 2008 financial crisis. In this case, the U.S. fund’s board was led to believe that its investment was a routine one, when it was in fact a direct ploy to alleviate another client’s illiquidity problems. Commenting on the action, Robert Khuzami, then director of the SEC’s Division of Enforcement, summarized an investment adviser’s fiduciary duty as requiring “an undivided and disinterested loyalty [with] full and fair disclosure of all material conflicts of interest.”
Custody Rule Requirements The custody rule (Rule 206(4)-2) is one of the most critical rules in the Advisers Act. Specifically, Rule 206(4)-2(d)(2) provides that all investment advisers must comply with the custody rule if it or its related person holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them. The following are key features of the custody rule:
• Qualified Custodian. An adviser with custody of a client’s assets generally must keep client funds with a qualified custodian. See Rule 206(4)-2(a)(1). • Client Notices. When an adviser opens an account with a qualified custodian, it must provide notice to the client in writing with specific information. See Rule 206(4)-2(a)(2). • Client Account Statements. An adviser must have at least a reasonable basis for believing that the qualified custodian sends quarterly, or more frequent, account statements to the client. See Rule 206(4)-2(a)(3). • Annual Surprise Exams. An adviser with custody of client assets must undergo an annual surprise examination by an independent public accountant which is registered with and subject to regular inspection by the PCAOB. See Rule 206(4)-2(a)(4) and 206(4)-2(a)(6)(i). Advisers that use a related person as a custodian of client assets must also obtain a written internal control report at least annually. See Rule 206(4)-2(a)(6)(ii).
Through the custody rule, the SEC emphasizes the importance of ensuring that clients are protected from theft or misuse of their assets. OCIE has cited significant custody rule deficiencies in about one- third of funds examined, including failures to recognize that the firm has custody at all, to meet the custody rule’s surprise examination obligations and to satisfy the custody rule’s qualified custodian requirements. Firms facing more lenient penalties for violating the custody rule may be required to bolster their written compliance procedures. Harsher penalties include referral to the SEC’s Division of Enforcement.
The SEC has brought numerous enforcement actions for violations of the custody rule. Most prominently, the Madoff case demonstrated the most egregious kind of fraudulent conduct surrounding the misappropriation of client assets. More recently, in In re Gerasimowicz, the SEC instituted administrative and cease-and-desist proceedings against a registered adviser due to various violations of the custody rule, including the lack of an annual surprise examination of the adviser and the failure to timely distribute annual audited financial statements prepared in accordance with GAAP (thus failing to satisfy the “audit approach” discussed below).
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The Custody Rule “Audit Approach” An adviser to a private fund can avoid the client notices and client account statement requirements (Rule 206(4)-2(a)(2)-(3)), and is deemed to have satisfied the surprise exam requirement (Rule 206(4)- 2(a)(4)), if the adviser distributes, at least annually, audited financial statements to investors in the fund. This “audit approach” is relied on by many fund advisers, but many advisers trip up by failing to comply in the following ways:
• The accounting firm that conducted the audit was not “independent” under Regulation S-X. • The audited financial statements were not prepared in accordance with GAAP. • Audited financial statements were only made available upon request, rather than distributed to all fund investors. • Audited financial statements were not sent to investors within 120 days of the private fund’s fiscal year end (or 180 days for a fund of funds). • The auditor was not PCAOB-registered and examined. • A final audit was not performed upon the liquidation of the fund. • The adviser requested investor approval to waive the annual financial audit and did not obtain a surprise examination. Many advisers seek such a waiver in connection with a fund’s liquidation or when assets under management are small. However, the SEC has stated that an adviser must either undergo a surprise examination or comply with the audit approach in its entirety, including a final audit upon liquidation of the fund.
Marketing and Performance The investment management industry is a highly competitive one which is uniquely prone to inaccuracy or fraud in performance marketing. Often, aberrational performance, as discussed above, can be primarily linked to misstatements in a firm’s marketing of its track record. The SEC will look closely at the accuracy of the advertised performance, both hypothetical and back-tested, as well as all methodologies and assumptions used by the firm. The SEC may also examine any changes to the marketing practices of the firm in response to the SEC’s new rule, which implemented the JOBS Act mandate by eliminating the prohibition on general solicitation in connection with private offerings under Regulation D. The new SEC rule becomes effective September 22, 2013.
In the Matter of GMB Capital Management LLC, the SEC alleged that the investment adviser solicited investors with marketing materials containing material misrepresentations, including citations of performance purportedly based on actual trades but actually based on back-tested hypothetical trades. The SEC also found that the investment adviser had misrepresented its utilization of qualitative pricing models in driving investment decisions. Further, earlier this year, the SEC announced the settlement of a civil enforcement action against Oppenheimer Asset Management Inc. and one of its affiliates, which alleged that the firms distributed marketing materials containing misleading disclosures regarding valuation methodologies and the internal rate of return of one of the funds that Oppenheimer advised.
Last year, the SEC alleged that the executives of Miami-based hedge fund adviser Quantek Asset Management LLC misrepresented to investors that they had personally invested in a Latin America- focused hedge fund. The SEC found that Quantek made repeated misrepresentations in marketing materials, side letters, and other fund documents about its executives having “skin in the game” along
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with the investors, when, in fact, Quantek’s executives never invested their own money in the fund. Bruce Karpati, then co-chief of the SEC Enforcement Division’s Asset Management Unit, cautioned that “private fund investors are entitled to the unvarnished truth about material information such as management’s skin in the game or the adviser’s handling of related-party transactions” when those investors are making an investment decision.
Investment Adviser and Broker-Dealer Registration As an initial matter, failing to register as an investment adviser when required to under Section 202(a)(11) of the Advisers Act could result in harsh consequences such as civil lawsuits, an SEC enforcement action or disgorgement of any profits. Absent the availability of an exemption, any person that, for compensation, is engaged in the business of providing advice to others or issuing reports or analyses regarding securities must register with the SEC as an investment adviser. Further, the nature of the marketing practices of an investment adviser may trigger an SEC inquiry into whether the investment adviser should also register as a broker-dealer. Section 3(a)(4)(A) of the Securities Exchange Act broadly defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others” and Section 3(a)(5)(A) defines a “dealer” as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.” If, absent an exemption, an investment adviser is either a broker or a dealer, it must register as such with the SEC. A current industry hot button issue is whether in-house marketing departments of private funds need to separately register with the SEC as a broker-dealer as a result of their marketing practices. In most cases, an external fund marketing firm which receives success- based fees is typically required to register with the SEC as a broker-dealer.
The SEC enforcement action in In the Matter of Ranieri demonstrates the SEC’s focus on prohibiting unregistered individuals from having substantive communications with prospective investors. In this case, a hired consultant of Ranieri Partners solicited investors and provided them with key investment documentation, falling far outside the scope of a simple “finder’s” role. Ranieri Partners paid a sizeable penalty for employing a consultant that performed broker-dealer services but failed to properly register with the SEC.
Conflicts of Interest The SEC has identified conflicts of interest as a key area of concern in its risk-based analysis of investment advisers. In fact, this area is so broad that virtually any unsavory investment adviser behavior can be explained in terms of a conflict of interest. As one example in the context of broker- dealers, the SEC released a public report of FINRA, NEP and NYSE examinations regarding broker- dealer compliance with Exchange Act Section 15(g), which requires broker-dealers to “establish, maintain and enforce written policies and procedures reasonably designed . . . to prevent the misuse . . . of material non-public information” by the firm or its associates. This report also highlighted the necessity of mitigating the misuse of material non-public information by documenting potential conflicts in this area, monitoring certain individuals or groups and implementing physical barriers. The lesson to be gleaned from this report is that investment advisers should have clear policies and procedures regarding their handling of material non-public information and the related conflicts of interest.
Other more specific conflicts that the SEC may focus on include:
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• Valuation (discussed below): Incentives to provide high valuations for illiquid positions and inflating asset values to attract investors and charge more fees. • Compensation-Related Conflicts and Incentives: Incentives to place investors in accounts with higher fees relative to the services provided. • Portfolio Management-Related Conflicts: Incentives to give preferential treatment to certain clients over others in side-by-side account situations or investing client assets in securities that have a higher risk than the stated risk appetite of the client. • Transfer Agent Conflicts: Incentives of persons who are both principals of transfer agents and owners or affiliates of issuers or vendors. • Investment Adviser/Broker-Dealer Affiliations: Incentives associated with putting the client into an affiliated investment adviser or a broker-dealer account.
Conflicts of interest can also be conceptualized in general terms depending on the “stage” in which the private fund finds itself. For example, the fund-raising stage could present unique conflicts of interest in the form of preferential terms in side-letters (e.g., redemption rights) or marketing decisions regarding use of past performance results. Funds in the investment stage may face conflicts of interest in the form of insider trading, investment allocation and fee allocation (e.g. shifting fees to a less favored fund or investor). Funds in the management stage may face valuation conflicts of interests. Finally, funds in the exit stage may be incentivized to drag-out the divestment of the fund in order to continue to collect a management fee.
The SEC has propounded three major ways in which a private fund adviser can mitigate conflicts of interest. First, the adviser should have an effective compliance program which is led by a dynamic team that understands all of the material conflicts of interest inherent in the fund’s business model. Conflicts must be identified, controlled, and reviewed periodically to make sure the risks are being continuously managed and mitigated. This process must also respond to the evolving business model of the firm.
Second, the compliance and ethics program should be robust and tailored to the specific firm. The federal securities laws require every broker-dealer and investment adviser to have written policies and procedures to prevent violations of the securities laws (see Rule 206(4)-7 of the Advisers Act). The U.S. Federal Sentencing Guidelines set forth key elements of an effective compliance and ethics program, including educating and training leadership and employees about the program, standards, and procedures to prevent criminal or illegal conduct, oversight via an organization’s board or senior management, leadership that embodies the ethical guidelines of the program, auditing and monitoring the effectiveness of the program, incentivizing persons to comply with the program and disciplining them for non-compliance, taking all reasonable steps to respond to any criminal conduct, and tailoring the compliance and ethics program to address any deficiencies.
Third, the above process for mitigating conflicts should be part of the firm’s culture and fully woven into the firm’s overall risk management strategy. Ultimately, the firm’s senior management needs to be engaged in the conflict of interest mitigation process by considering risks inherent in the firm’s business processes. Although leaders of the firm are tasked with establishing this culture, leaders should repeatedly emphasize the importance of all members of a firm assessing and mitigating conflicts.
Examples of SEC enforcement actions concerning conflicts of interest are myriad. In re Matthew Crisp, the SEC alleged that an investment adviser to a private equity fund usurped investment
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opportunities from the adviser’s funds while failing to disclose this conflict of interest. This not only violated the adviser’s code of ethics, but it also violated the anti-fraud provisions of the federal securities laws.
Further, in September 2012, the SEC instituted an administrative proceeding against Focus Point, an Oregon-based investment advisory firm, for its failure to disclose compensation through a revenue- sharing agreement and other conflicts of interest. The SEC cited a serious conflict of interest in that Focus Point did not disclose to customers that it was receiving revenue-sharing payments from a brokerage firm that managed mutual funds being recommended to clients. As the SEC stated, “[b]ecause Focus Point received a percentage of every dollar that its clients invested in these mutual funds, there was an incentive to recommend these funds over other investment opportunities in order to generate additional revenue for the firm.”
Allocation of Investments Although this area could be included in the conflicts of interests section, it is important enough to highlight separately. The SEC often focuses on procedures by which registered advisers allocate trades among its clients, particularly if a potential conflict of interest exists (such as when a principal of the adviser is invested in a particular investment vehicle but not others managed by the adviser). Also, for example, if a firm manages side-by-side accounts or manages performance-based and non- performance based fee accounts, the SEC will focus on whether the firm has controls in place to avoid preferential treatment of certain investors or allocation of investments to higher fee accounts. The SEC may also focus on issues pertaining to order aggregation or order allocation of customer and proprietary trades to purchase and sell securities. The SEC may also key in on issues such as “partial fills” (when an order to purchase or sell securities exceeds the amount of securities purchased or sold) or “split fills” (when an order for securities is placed but cannot be filled at once). A partial fill could result in an investment adviser allocating the purchased securities or sale proceeds among investors in a manner different from the investors’ original orders. A split fill could result in different prices and different brokerage fees caused by executing the investors’ orders in more than one transaction. These situations may be monitored closely by the SEC as they are rife with potential favoritism of certain investors over others.
In December 2012, the SEC filed an action against Aletheia Research and Management, Inc., and its CEO, alleging the unfair allocation of profitable trades to trading accounts of Aletheia employees, the CEO, and other favored clients to the detriment of other non-favored investors. The SEC alleged that this practice of “cherry-picking” amounted to a breach of the fiduciary duty owed to all advisory clients. The SEC also alleged that Aletheia failed to properly implement policies and procedures that could have prevented this cherry-picking scheme in the first place.
Valuation The SEC has also put much focus on valuation risks, an area that poses a veritable minefield for advisers that manage less liquid or hard-to-value portfolios. Such risks include the inconsistent application of pricing procedures, accuracy of advertised performance (whether hypothetical or back- tested), third-party pricing agents assigning inaccurate values, and use of flawed assumptions and methodologies. Further, a private fund adviser may implement improper compilation methods or receive inflated fees based on all of the foregoing valuation missteps.
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In order to avoid an SEC enforcement action, private fund managers with less liquid portfolios should establish a valuation committee and should ensure that the committee meets as often as necessary given the nature of the fund’s valuation risks. Valuation committees should review the firm’s valuation policies and procedures at least annually and should ensure that these policies and procedures are accurately disclosed in Part 2 of Form ADV, in the fund’s offering documents and in all marketing and investor due diligence materials.
Recent violations that have resulted in SEC enforcement actions include writing up assets to boost fees, increase fundraising, and improve reporting to databases, and writing down assets after a fund winds down. Most SEC enforcement actions brought in the past couple of years have involved simple fraud as to the value of assets. For example, in 2011, the SEC agreed to a $200 million settlement with Morgan Keegan & Company and Morgan Asset Management in an enforcement action involving the fraudulent valuation of subprime mortgage-backed securities during the 2008 financial crisis. Then, in 2012, the SEC brought an enforcement action against three top executives at KCAP Financial Inc., alleging that the executives overstated the fund’s assets by ignoring certain market-based activities stemming from the financial crisis. Specifically, the SEC alleged that KCAP valued its two largest collateralized loan obligations at cost, rather than at the “exit price” as required by applicable accounting standards.
In SEC v. Yorkville Advisors, the SEC alleged that a fund adviser “overvalue[d] assets under management and exaggerate[d] the reported returns of hedge funds they managed in order to hide losses and increase the fees collected from investors.” The SEC alleged that Yorkville did not adhere to its own valuation policies, withheld adverse information provided by its auditors about the fund’s investments and illiquidity, and attracted more than $280 million in investments from pension funds and funds of funds by virtue of its valuation misstatements. The SEC stated that Yorkville’s returns were inconsistent with its investment strategy, putting the fund “front and center on [the] radar screen.”
Other Focus Areas There are various other areas that the SEC may focus on in an examination of an advisory firm. For example, the SEC may focus on asset verification even when custodial arrangements do not present obvious risks of misappropriation. The SEC also considers governance, or the “tone at the top”, as a key component in assessing risk. An examiner may investigate whether an adviser is making full and accurate disclosures to the fund’s board and whether the fund’s directors (including the directors of an offshore private fund) are conducting sufficient reviews of service providers, contract approvals, expenses, viability of the fund, and valuation procedures.
Practical Guidelines In order to “pass” an SEC compliance exam, or avoid a “for cause” exam altogether, a firm should heed the following guidelines:
• Consider having a third party firm that specializes in SEC examinations conduct a “mock exam” to gauge its compliance and preparedness. • Review past deficiency letters and ensure all deficiencies have been addressed. • Prepare employees and senior management for SEC staff interviews. • Be proactive about identifying and managing conflicts.
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• Segregate privileged information. • Remediate conflicts with strong policies and risk controls. • Have evidence of testing policies and procedures. • Be forthcoming about any potential problems. • Be courteous and cooperative.
62 Herrick, Feinstein LLP Herrick, Feinstein LLP’s Seventh Annual Capital Markets Symposium October 2, 2013
DODD FRANK: 2013 Broker-Dealer Registration Issues Involving Private Funds
By Irwin M. Latner and Jessica D. Wessel
Latner2 Cover.indd 1 9/24/2013 11:35:59 AM Dodd Frank 2013: The Regulators Extend Their Reach into the Capital Markets
Broker-Dealer Registration Issues Involving Private Funds By Irwin M. Latner and Jessica D. Wessel
Introduction In recent years, the Securities Exchange Commission (“SEC”) has increased its enforcement focus on investment advisers and broker-dealers.1 Several of these enforcement actions have resulted from the SEC’s investment adviser compliance initiative, which focuses on registered investment advisers that lack effective compliance programs designed to prevent securities laws violations.2 These enforcement actions have involved abnormal performance returns by private funds, misleading disclosures to investors, and improper fee arrangements.
Most notably, the SEC has increased its focus on the issue of whether private fund adviser personnel (i.e., marketing employees or independent consultants) are acting as unregistered brokers in violation of Section 15(a) of the Securities Exchange Act of 1934 (the “Exchange Act”). In March 2013, the SEC imposed sanctions on, and issued a cease-and-desist order to, Ranieri Partners LLC (“Ranieri”), the private equity firm founded by mortgage bond pioneer Lewis S. Ranieri, in connection with the activities of an unregistered independent consultant (the “Ranieri Order”). Shortly thereafter, David W. Blass, Chief Counsel of the SEC’s Division of Trading and Markets, delivered remarks at an American Bar Association meeting (the “Blass Speech”) in which he indicated his views with respect to broker-dealer registration concerns raised by (i) sales of interests in private funds and the role of in- house marketing departments and (ii) fees paid to private equity fund managers related to portfolio company transactions.
The Ranieri Order and the Blass Speech build upon the SEC’s historical, expansive interpretation of the definition of a “broker” under the Exchange Act, and reflect the SEC’s current thinking and enforcement approach in the private fund area. That is, the Ranieri Order and the Blass Speech reiterate the SEC’s view that the receipt of transaction-based compensation in connection with the sale of securities is a “hallmark” of broker-dealer activity. Recently, however, a United States District Court has rejected the SEC’s view that transaction-based compensation alone would require a person to register as a broker-dealer.3 In SEC v. Kramer, the court rejected a single-factor approach, holding that the determination of whether a person acts as an unregistered broker in violation of Section 15(a) of the Exchange Act is a multi-faceted exercise, which is based on several factors.
In light of the SEC’s recent enforcement efforts, private fund advisers should be mindful of Exchange Act implications when entering into marketing arrangements (whether involving in-house or external marketers) in connection with the sale of private fund interests. In particular, private fund advisers ______1 This is due, in part, to the SEC’s creation of an Asset Management Unit (the “Unit”) within its Division of Enforcement. The Unit is a national specialized unit, which focuses on misconduct by investment advisers, investment companies and private funds. Julie M. Riewe and Marshall S. Sprung are the Co-Chiefs of the Unit. 2 The SEC also filed several enforcement actions against hedge funds which were triggered by investigations of abnormal performance returns reported by the funds. Other actions against investment advisers included cases against (A) UBS Financial Services of Puerto Rico and two executives for misleading disclosures relating to certain proprietary closed-end mutual funds; (B) Morgan Stanley Investment Management for an improper fee arrangement; and (C) OppenheimerFunds for misleading investors in two funds suffering significant losses during the financial crisis. UBS paid more than $26 million to settle the SEC’s charges while OppenheimerFunds paid more than $35 million for its violations. 3 See SEC v. Kramer, 778 F. Supp. 2d 1320 (M.D. Fla. 2011) (rejecting the argument that the receipt of transaction-based compensation, without more, caused Stephens to be a “broker” under the Exchange Act).
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should be aware of the legal and practical implications of structuring marketing arrangements with their in-house personnel.
Regulatory Framework for Broker-Dealer Registration Section 15(a)(1) of the Exchange Act makes it unlawful for any “broker” or “dealer” to make use of the mails or means of instrumentalities of interstate commerce to effect transactions in any security, or to induce or attempt to induce the purchase or sale of any security, unless that broker or dealer is registered with the SEC pursuant to the Exchange Act. The Exchange Act defines the term (i) “broker” to mean any person engaged in the business of effecting transactions in securities for the account of others and (ii) “dealer” to mean any person engaged in the business of buying and selling securities for his own account; provided, however, that this definition does not include any person insofar as he buys or sells securities not as a part of a regular business.4 Brokers and dealers are generally required to register with the SEC if they use the mails or any means or instrumentality of interstate commerce either to effect transactions or to attempt to induce the purchase or sale of any security.
Generally, issuers sell their own securities through their officers and employees without SEC registration by taking advantage of the “Issuer Exemption” under the Exchange Act. Historically, the SEC has stated that an issuer generally does not meet the definitions of “broker” or “dealer” under the Exchange Act because the securities are not being sold for the account of others, nor is the issuer both buying and selling its securities.5 In turn, the associated persons of an issuer relying on the Issuer Exemption typically rely on the registration safe harbor contained in Exchange Act Rue 3a4-1. Pursuant to Rule 3a4-1, an associated person of an issuer shall not be deemed to be a broker solely by reason of his participation in the sale of the securities of such issuer if the associated person (i) is not subject to a statutory disqualification, as that term is defined in Section 3(a)(39) of the Exchange Act, at the time of his participation; (ii) is not compensated in connection with his participation by the payment of commissions or other remuneration based either directly or indirectly on transactions in securities; (iii) is not at the time of his participation an associated person of a broker or dealer; and (iv) (A) limits the offering and selling of the issuer’s securities only to broker-dealers and other specified types of financial institutions; (B) performs substantial duties for the issuer other than in connection with transactions in securities, was not a broker-dealer or an associated person of a broker-dealer within the preceding 12 months, and does not participate in selling an offering of securities for any issuer more than once every 12 months; or (C) limits activities to delivering written communication by means that do not involve oral solicitation by the associated person of a potential purchaser.
If a person cannot rely on the Issuer Exemption, it may nevertheless be exempt from SEC registration pursuant to a limited “Finder’s Exception” that was developed by the SEC staff in the early 1990s.6 However, since that time, the SEC has voiced its disapproval with the Finder’s Exception.7 In a 2010 no-action letter, the SEC staff denied no-action relief to Brumberg, Mackey & Wall, P.L.C. (“BMW”), a law firm, in connection with BMW’s proposed fundraising activities for an energy technology
______4 See Sections 3(a)(4) and 3(a)(5) of the Exchange Act. 5 The SEC has noted that “the [Exchange] Act has customarily been interpreted not to require the issuer itself to register as either a broker or a dealer.” See Exchange Act Release No. 34-13195, 1977 WL 174110, Jan. 21, 1977. 6 See Paul Anka, SEC No-Action Letter (available July 24, 1991). 7 See Record of Proceedings of 2008 Annual SEC Government-Business Forum on Small Business Capital Formation (Nov. 20, 2008).
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company.8 In its letter denying no-action relief, the SEC staff stated that the receipt of compensation directly tied to the sale of securities would give BMW a “salesman’s stake” and, in turn, would create a heightened incentive for BMW to engage in sales efforts. Accordingly, the SEC staff declined to issue the requested no-action relief and would not refrain from taking enforcement action if the firm proceeded with its proposed compensation plan without registering as a broker-dealer.9
Notwithstanding this historical approach, a United States District Court recently rejected the SEC’s position that the receipt of transaction-based compensation, absent any other indicia of broker-dealer activity, is enough to require a person to register with the SEC as a broker-dealer.10 In SEC v. Kramer, the court noted that the distinction between a finder and a broker-dealer remains largely unexplored, and both the case law and the SEC’s informal, “no-action” letter advice is highly dependent on the facts of a particular arrangement.11
In Kramer, Kenneth R. Kramer (“Kramer”) and Bruce Baker (“Baker”) entered into a written agreement whereby Kramer and Baker promised to cooperate in presenting to each other prospective merger and acquisition candidates, potential sources of investment and venture capital funding, and other forms of business opportunities, and to share any fee or compensation resulting from the successful conclusion of a business arrangement. Prior to this agreement, Skyway Aircraft (“Skyway”) agreed to pay Baker a 5% commission (i) on capital raised on behalf of the company; (ii) on the purchase price of any acquisition or merger resulting from Baker’s introducing Skyway and a third party; and (iii) on the total value of any contract brought to Skyway by Baker. The evidence at trial showed that Kramer received transaction-based compensation in two instances.12
In its analysis, the Kramer court stated that while the factors developed in SEC v. Hansen are instructive for finding broker-dealer activity, they are not exclusive.13 Rather, the evidence of broker- dealer activity must demonstrate involvement at “key points in the chain of distribution,” such as participating in the negotiation, analyzing the issuer’s financial needs, discussing the details of the transaction, and recommending an investment.”14 Thus, the court concluded that Kramer’s involvement was not enough to make him a broker-dealer. The court found that Kramer told a small but close group about Skyway and opined that Skyway seemed like a good investment. The court stated that the broker analysis under Section 15(a) of the Exchange Act permits examination of a wide ______8 See Brumberg, Mackey & Wall, P.L.C., SEC No-Action Letter (available May 17, 2010). In its incoming letter, BMW stated that the company “would engage BMW to assist them in the acquisition of funding for financing to fund the operations and development of [the company].” The letter also stated that BMW’s proposed role would be limited to the introduction of BMW’s contacts who may have an interest to the company. Further, BMW stated it would not (i) engage in negotiations with potential investors; (ii) provide any information about the company to potential investors that may be used as a basis for negotiations; (iii) recommend any investment in the company; or (iv) provide any assistance to potential investors. 9 Id. 10 See footnote 3. 11 See SEC v. Kramer, 778 F. Supp. 2d at 1336-37. 12 Kramer arranged a meeting between Nick Talib, a registered broker-dealer, Baker and Skyway. Following this meeting, Talib raised a substantial amount of financing for Skyway by selling shares to investors, and both Baker and Kramer received a payment from Skyway based on the success of the introduction. Kramer also received compensation from Baker based on Kramer’s reporting to Baker of certain purchases of Skyway shares. 13 Id. at 1334. 14 Id. at 1336 (quoting Cornhusker Energy Lexington, LLC v. Prospect St. Ventures, 2006 WL 2620985, at *6 (D.Neb.2006).
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array of factors, including those factors already identified in applicable precedent. In the absence of a statutory definition of “effecting securities transactions” or “engaged in the business” in the definition of “broker” under the Exchange Act, the court stated that certain factors determine whether a person qualifies as a broker. Further, the court stated that one factor may evidence broker activity while another may support the absence of broker activity. However, one factor alone (e.g., transaction-based compensation) is not determinative. Therefore, in the absence of a statutory definition enunciating otherwise, the court found that the test for broker activity must remain cogent, multi-faceted, and controlled by the Exchange Act.
Accordingly, the court held that neither applicable precedent nor statutory language permits the conclusion, based on the admissible evidence, that Kramer acted as an unregistered broker in violation of Section 15(a) of the Exchange Act. Further, the court found that the SEC failed to show by a preponderance of the evidence that Kramer engaged in the business of effecting transactions in securities for the accounts of others.
The Kramer decision is encouraging in that a court has rejected the SEC’s position that the receipt of transaction-based compensation alone is enough to cause a person to be considered a broker-dealer under the Exchange Act. Yet, while this decision is persuasive authority in the Middle District of Florida, it is not binding on the SEC in other jurisdictions. Nevertheless, the SEC seems to be taking an aggressive approach to long-standing practices in the private fund industry, especially in light of the Ranieri Order and the Blass Speech, both of which emphasize transaction-based compensation as a “hallmark” of broker-dealer activity.
The Ranieri Order In the Ranieri Order, the SEC found that the independent consultant, William M. Stephens (“Stephens”), operated as an unregistered broker in violation of Section 15(a) of the Exchange Act because he actively solicited investors on behalf of private funds managed by Ranieri’s affiliates and, in return, received transaction-based compensation totaling approximately $2.4 million. The SEC further found that Ranieri and Donald W. Phillips (“Phillips”), Ranieri’s then Senior Managing Partner, did not take adequate steps to prevent Stephens from having substantive contacts with potential investors. Accordingly, the SEC imposed sanctions on, and issued a cease-and-desist order to Ranieri Partners in connection with the activities of its independent consultant, Stephens.15 The SEC found that Stephens operated as an unregistered broker because he actively solicited investors on behalf of Selene Residential Mortgage Opportunity Fund L.P. (“Selene I”) and Selene Residential Mortgage Opportunity Fund II L.P. (“Selene II”) (collectively, the “Selene Funds”), private funds managed by Ranieri’s affiliates. Based on the following actions, the SEC found that Stephens engaged in the business of effecting transactions in securities in violation of Section 15(a) of the Exchange Act:
• Stephens distributed private placement memoranda (“PPMs”), supplemental PPMs, subscription documents, presentation, and other marketing materials to potential investors in the Selene Funds. • Stephens attended meetings with Phillips and potential investors. ______15 The terms of Stephens’ engagement with Ranieri were reflected in consulting services agreements prepared by outside counsel to Ranieri Partners. Ranieri Partners agreed to pay Stephens a fee equal to 1% of all capital commitments made to the Selene Funds by investors introduced by Stephens.
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• Stephens communicated directly with investors, including providing details about the Selene Funds’ respective investment strategies. • Stephens met with, and provided diligence materials to, a potential investor’s outside consultant for money manager selection and retention. • Stephens described the investment to a potential investor as a “rare opportunity to earn above market returns,” and encouraged the investor to consider the investment. • Stephens sent a potential investor a list of current and prospective investors for Selene I, which included a list of expected dates and amounts of the investors’ respective capital commitments. • Stephens drafted correspondence for Phillips’s signature that addressed key questions raised by a potential investor whom Stephens had contacted and met with. • Stephens told a potential investor that “returns to [Selene I] have been strong and the outlook for [Selene II] looks real positive with Ranieri Partners taking on the role of market leader in this space.” In the same email, Stephens stated that investor would pay a lower management fee if it made a commitment before the first closing for Selene II.
Based on the foregoing, the SEC found that Stephens actively solicited investors on behalf of the Selene Funds and, in return, received transaction-based compensation totaling approximately $2.4 million.
The SEC further found that Ranieri and Phillips, Ranieri’s then Senior Managing Partner, did not take adequate steps to prevent Stephens from having substantive contacts with potential investors. For example:
• Phillips sent Stephens copies of the Selene Funds’ executive summaries, which summarized their respective investment strategies, and provided Ranieri’s view of the distressed mortgage marketplace and the firm’s competitive advantages in such marketplace. • Ranieri’s personnel provided Stephens with copies of PPMs, supplemental PPMs, subscription documents, presentation, and other marketing materials for the Selene Funds. • Stephens attended meetings with Phillips and potential investors. • Ranieri reimbursed Stephens for travel and entertainment expenses incurred on trips both with and without Phillips in connection with capital raising for the Selene Funds.
The Ranieri Order imposed sanctions on Ranieri, Philips and Stephens.16 As a result of the conduct described above, the SEC found that (i) Ranieri caused Stephens’ violations of Section 15(a) of the ______16 The Ranieri Order required Ranieri Partners to cease and desist from committing or causing any further violations of Section 15(a) of the Exchange Act, and to pay a civil money penalty of $375,000. Further, the Ranieri Order required that Phillips (i) cease and desist from committing or causing any further violations of Section 15(a) of the Exchange Act; (ii) be suspended from association in a supervisory capacity with any broker, dealer, investment adviser, municipal securities dealer municipal adviser, transfer agent, or nationally recognized statistical rating organization for a period of nine (9) months; and (iii) pay a civil money penalty of $75,000.
The Ranieri Order also provided that Stephens (i) is barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization; (ii) is prohibited from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter; and (iii) is barred from participating in any offering of a penny stock, including: acting as a promoter, finder, consultant, agent or other person who engages in activities with a broker, dealer or issuer for purposes of the issuance or trading in any penny stock, or inducing or attempting to induce the purchase or sale of any
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Exchange Act; (ii) Phillips willfully aided and abetted and caused Stephens’ violations of Section 15(a) of the Exchange Act; and (iii) Stephens willfully violated Section 15(a) of the Exchange Act.
Speech by David W. Blass, Chief Counsel of the SEC’s Division of Trading and Markets On April 15, 2013, David W. Blass, Chief Counsel of the SEC’s Division of Trading and Markets delivered a speech to the American Bar Association’s Trading and Markets Subcommittee in which he discussed broker-dealer registration in the context of private fund advisers. Blass stated that the SEC staff is increasingly focused on examining private fund advisers, both due to new regulatory requirements and the SEC’s own observations in the private fund space, particularly related to (i) sales of interests in private funds and (ii) fees related to portfolio company transactions.
More specifically, Mr. Blass focused on two issues in his remarks: (i) the payment of transaction- based compensation by a private fund adviser to its personnel for selling interests in a fund and the hiring of personnel whose only or primary functions are to sell interests in the fund; and (ii) the receipt of transaction-based compensation by the private fund adviser, its personnel or its affiliates for purported investment banking or other broker activities relating to one or more of the fund’s portfolio companies. The second issue is more common among private equity fund advisers that execute leveraged buyout strategies.
With respect to the sale of fund interests, Mr. Blass provided the following examples of activities, or factors, that might require private fund adviser personnel to register with the SEC as a broker-dealer: (i) marketing securities (shares or interests in a private fund) to investors; (ii) soliciting or negotiating securities transactions; or (iii) handling customer funds and securities. Moreover, Mr. Blass stated that the importance of the above activities is heightened where the employee receives compensation based on the outcome or size of the securities transaction (i.e., transaction-based compensation). Thus, it appears that, in light of the Kramer case and the Ranieri Order, the SEC and its staff consider the receipt of transaction-based compensation to be a “hallmark” of broker activity, which will cause them to scrutinize private fund adviser personnel arrangements more closely for other indicia of broker- dealer activity.17
In addition, Mr. Blass addressed the unique issues that arise in the context of securities offerings by certain private equity fund advisers, particularly those whose funds follow a leveraged buyout strategy. In such circumstances, private fund advisers may collect other types of fees in addition to advisory fees, which Mr. Blass remarked may call into question whether such advisers are engaging in activities that require broker-dealer registration. Examples of these additional fees include fees that the private fund adviser directs a portfolio company of the fund to pay directly or indirectly to the adviser or one of its affiliates in connection with the acquisition or disposition (including an IPO) of a portfolio company or a recapitalization of a portfolio company. These fees are often described as penny stock. Any reapplication by Stephens to be an associated person of a broker-dealer will be subject to the applicable laws and regulations governing the reentry process.16 Stephens was ordered to pay disgorgement of $2,418,379.20 and prejudgment interest of $410,248.75, but payment of such amount was waived based upon his sworn representations in his Statement of Financial Condition dated January 28, 2013 and other documents submitted to the SEC. 17 Mr. Blass also provided a list of key questions private fund advisers should ask in connection with their internal marketing arrangements: (1) how does the adviser solicit and retain investors?; (ii) do employees who solicit investors have other responsibilities?; and (iii) how are the personnel who solicit investors compensated?
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compensation for “investment banking activity,” including negotiating transactions, identifying and soliciting purchasers or sellers, or structuring transactions.
Practical Implications for Private Fund Advisers In light of the SEC’s recent enforcement efforts, private fund advisers should be mindful of Exchange Act implications when entering into marketing arrangements (whether involving in-house or external marketers) in connection with the sale of their private fund interests. A private fund adviser may engage SEC-registered broker-dealers (“Placement Agents”) pursuant to written agreements, which will alleviate concerns about independent consultants engaging in unregistered broker activity in connection with the offering of private fund interests.
However, a private fund adviser may desire to hire employees or engage independent consultants that are not registered with the SEC as broker-dealers. In our experience, private fund advisers generally do not rely on the Issuer Exemption for such arrangements because they do not fit within its parameters. First, an independent consultant normally does not come within the Issuer Exemption because it would generally not qualify as an “associated person of an issuer” for purposes of the exemption. With respect to the fund manager’s employees, they would also normally not be eligible for the Issuer Exemption because the employee is typically compensated, directly or indirectly, based on transactions in securities (i.e., based on their successful capital raising efforts). Also, since private fund managers are frequently, if not continuously, engaging in capital raising activities, their marketing personnel have likely participated in selling one or more offerings of securities within the preceding 12 months.
Notwithstanding the difficulties in structuring in-house marketing personnel arrangements to comply with the Issuer Exemption, a private fund adviser utilizing internal personnel to market its funds (either in lieu of or in addition to arrangements with Placement Agents) should attempt to stay within spirit of the Issuer Exemption even if they cannot meet all of its requirements. Thus, an adviser should seek to structure its marketing arrangement as an employer-employee relationship that is mindful of the factors enumerated in SEC v. Hansen and SEC v. Kramer for determining the presence of broker activity. Accordingly, a private fund adviser should make a good faith effort to ensure that the relationship with its marketing employees satisfies as many of these factors as possible. For example, a private fund adviser might structure a marketing arrangement so that the employee performs substantial duties for or on behalf of a private fund other than in connection with the sale of its interests. This may include investor relations, marketing, strategic planning, deal structuring, assisting with regulatory and investor reporting and disclosures or other non-sales related responsibilities. Similarly, the employee’s compensation can be based on overall firm performance and other factors in lieu of the success of the employee’s individual sales efforts.
With respect to portfolio company transaction fees paid to private fund advisers that advise private equity funds with a leveraged buyout strategy or other private equity strategy, factors weighing against the determination of broker status may include (i) the fact that an adviser normally has “skin in the game” or a substantial equity investment in the issuer and often plays a major role in the issuer’s decision-making, (ii) the fact that full disclosure of the adviser’s ancillary portfolio company activities and related fees is normally made in the fund’s offering documents and in the relevant portfolio company transaction documents, (iii) the portfolio company transactions that generate the fees normally involve sophisticated institutional counterparties, and (iv) in many cases, the adviser is already registered as an investment adviser with the SEC and subject to substantial regulation and
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fiduciary duties. Interestingly, Mr. Blass stated that a private equity fund adviser would likely not be considered to be engaged in broker activities where 100% of such portfolio company transaction fees paid to the adviser are used to offset or reduce the amount of management fees otherwise payable by fund investors. In other words, this arrangement could be viewed as an alternative method of paying the manager its management fee.
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