Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

 The Dodd-Frank Act repealed the “private adviser exemption” contained in section 203(b)(3) of the Investment  Advisers Act on which advisers to many venture capital funds vehicles had relied in order to avoid registration under the Investment Advisers Act.  Section 407 of the Dodd-Frank Act created an exemption from registration under the Investment  Advisers Act for those who act as investment advisers solely to venture capital funds and directed the SEC to define the term “venture capital.”  The SEC has issued proposed rules (Release No. IA-3111) regarding the definition of the term.  Ultimately, the SEC proposal may define venture capital so narrowly to make the exemption of little practical significance.  And even if a venture capital fund can rely on the exemption, it may still be subject to burdensome SEC reporting requirements under another SEC proposal.

The SEC proposes to define a venture capital fund as a private fund that:

  • invests in equity securities of private companies in order to provide operating and business expansion capital (i.e., “qualifying portfolio companies,”) and at least 80 percent of each company’s securities owned by the fund were acquired directly from the qualifying portfolio company;
  • directly, or through its investment advisers, offers or provides significant managerial assistance to, or controls, the qualifying portfolio company;
  • does not borrow or otherwise incur leverage (other than limited short-term borrowing);
  • does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances;
  • represents itself as a venture capital fund to investors; and
  • is not registered under the Investment Company Act and has not elected to be treated as a business development company, or BDC.

Qualifying Portfolio Company

The SEC proposes to define a venture capital fund for the purposes of the exemption as a fund that invests in equity securities issued by “qualifying portfolio companies,” which the SEC defines generally as any company that:

  • is not publicly traded;
  • does not incur leverage in connection with the investment by the private fund;
  • uses the capital provided by the fund for operating or business expansion purposes rather than to buy out other investors; and
  • is not itself a fund (i.e., is an operating company).

Private Companies.  The SEC proposes to define a venture capital fund as a fund that invests in equity securities of qualifying portfolio companies and cash and cash equivalents and U.S. Treasuries with a remaining maturity of 60 days or less.  At the time of each investment by the venture capital fund, the portfolio company could not be publicly traded nor could it control, be controlled by, or be under common control with, a publicly traded company.  Under the proposed definition, a venture capital fund could continue to hold securities of a portfolio company that subsequently becomes public.

Equity Securities Etc.  The SEC proposes to define venture capital fund for purposes of the exemption as a fund that invests in equity securities of qualifying portfolio companies, cash and cash equivalents and U.S. Treasuries with a remaining maturity of 60 days or less.  Under the proposed definition, a fund would not qualify as a venture capital fund for purposes of the exemption if it invested in debt instruments (unless they met the definition of “equity security”) of a portfolio company or otherwise lent money to a portfolio company, strategies that are not the typical form of venture capital investing.  The SEC proposes to use the definition of equity security in section 3(a)(11) of the Securities Exchange Act of 1934, or the Exchange Act, and Rule 3a11-1 thereunder.  This definition is broad, and includes common stock as well as preferred stock, warrants and other securities convertible into common stock in addition to limited partnership interests.

Portfolio Company Leverage.  Proposed Rule 203(l)-1 would define a qualifying portfolio company for purposes of the exemption as one that does not borrow, issue debt obligations or otherwise incur leverage in connection with the venture capital fund’s investments.  This definition of qualifying portfolio company would only exclude companies that borrow in connection with a venture capital fund’s investment, but would not exclude companies that borrow in the ordinary course of their business (e.g., to finance inventory or capital equipment, manage cash flows, and meet payroll).  The SEC would generally view any financing or loan (unless it met the definition of equity security) to a portfolio company that was provided by, or was a condition of a contractual obligation with, a fund or its adviser as part of the fund’s investments as being a type of financing that is “in connection with” the fund’s investment.

Capital Used for Operating and Business Purposes.  A qualifying portfolio company is one that does not distribute company assets to other security holders in connection with the venture capital fund’s investment in the company (which the SEC believes could be an indirect buyout).  Under the proposed rule, an exempt adviser relying on section 203(1) of the Investment Advisers Act would not be eligible for the exemption if it advised these types of private equity funds that in effect acquire a majority of the equity securities of portfolio companies directly from other security holders.  Correspondingly, the SEC also proposes to define a qualifying portfolio company for purposes of the exemption as one that does not redeem or repurchase outstanding securities in connection with a venture capital fund’s investment.  Because at least 80% of each portfolio company’s equity securities in which the fund invests must be acquired directly from the portfolio company, a venture capital fund relying on the exemption could purchase the remainder of the securities directly from existing shareholders (i.e., a “buyout”).  Under the proposed definition, however, a company that achieves an indirect buyout of its security holders, such as through the complete recapitalization or restructuring of the portfolio company capital structure would not be a qualifying portfolio company.

Operating Companies.  Proposed Rule 203(l)-1 would define the term qualifying portfolio company for the purposes of the exemption to exclude any private fund or other pooled investment vehicle.

Management Involvement

To qualify as a venture capital fund under the proposed definition, the fund or its investment adviser would:

  • have an arrangement under which it offers to provide significant guidance and counsel concerning the management, operations or business objectives and policies of the portfolio company (and, if accepted, actually provides the guidance and counsel); or
  • control the portfolio company.

The SEC believes a key distinguishing characteristic of venture capital investing is the assistance beyond the mere provision of capital.  Therefore it proposes that advisers seeking to rely on the rule have a significant level of involvement in developing a fund’s portfolio companies.  According to the SEC, managerial assistance generally takes the form of active involvement in the business, operations or management of the portfolio company, or less active forms of control of the portfolio company, such as through board representation or similar voting rights.  The SEC acknowledges that the nature of managerial assistance may evolve over time as the needs of qualifying portfolio companies change, and hence the proposed rule does not specify that managerial assistance has a fixed character.

Limitation on Leverage

Under proposed Rule 203(l)-1, the definition of a venture capital fund for purposes of the exemption would be limited to a private fund that does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the fund’s capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days.

No Redemption Rights

Proposed Rule 203(l)-1 would define a venture capital fund as a fund that issues securities that do not provide investors redemption rights except in “extraordinary circumstances” but that do entitle investors generally to receive pro rata distributions.  Unlike hedge funds, venture capital funds do not typically permit investors to redeem their interests during the life of the fund, but rather distribute assets generally as investments mature.  Although venture capital funds typically return capital and profits to investors only through pro rata distributions, such funds may also provide extraordinary rights for an investor to withdraw from the fund under foreseeable but unexpected circumstances or rights to be excluded from particular investments due to regulatory or other legal requirements.  The trigger events for these rights are typically beyond the control of the adviser and fund investor (e.g., tax and regulatory changes).

Represents Itself as a Venture Capital Fund

Proposed Rule 203(l)-1 would limit the definition of venture capital fund for the purposes of the exemption to a private fund that represents itself as being a venture capital fund to its investors and potential investors.  A private fund could satisfy this definitional element by, for example, describing its investment strategy as venture capital investing or as a fund that is managed in compliance with the elements of the SEC’s proposed rule.  Without this element, a fund that did not engage in typical venture capital activities could be treated as a venture capital fund simply because it met the other elements specified in the proposed rule (because for example it only invests in short term treasuries, controls portfolio companies, does not borrow, does not offer investors redemption rights, and is not a registered investment company).

Private Fund

The SEC proposes to define a venture capital fund for the purposes of the exemption as a “private fund,” and exclude from the proposed definition funds that are registered investment companies (e.g., mutual funds) or have elected to be regulated as BDCs.  A “private fund,” as defined in the Investment Advisers Act, is an entity that would be an investment company under the Investment Company Act but for the exceptions in section 3(c)(1) or 3(c)(7) of the Investment Company Act.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The Dodd-Frank Act repealed the “private adviser exemption” contained in section 203(b)(3) of the Investment Advisers Act on which advisers to many private equity and hedge funds had relied in order to avoid registration under the Investment  Advisers Act.  Section 408 of the Dodd-Frank Act, which added new section 203(m) of the Investment Advisers Act, directed the SEC to provide an exemption from registration under the Investment Advisers Act for those who act as investment advisers solely to private funds and have assets under management in the United States of less than $150 million.  The SEC has issued proposed rules (Release No. IA-3111) to implement this provision.  However funds which rely on this exemption may still be subject to burdensome SEC reporting requirements under another SEC proposal.

The proposed rules refer to the exemption as the “private fund adviser exemption.”  Details of the private adviser exemption are set forth below.

Advises Solely Private Funds

Proposed rule 203(m)-1 would, like section 203(m) of the Investment Advisers Act, limit an adviser relying on the exemption to advising “private funds” as that term is defined in the Investment Advisers Act.  A “private fund” is therefore defined as an entity that would be an investment company under the Investment Company Act but for the exceptions in section 3(c)(1) or 3(c)(7) of the Investment Company Act.  An adviser that acquires a different type of client would have to register under the Investment Advisers Act unless another exemption is available.  An adviser could advise an unlimited number of private funds, provided the aggregate value of the adviser’s private fund assets is less than $150 million.

Private Fund Assets

Under proposed rule 203(m)-1, an adviser would have to aggregate the value of all assets of private funds it manages in the United States to determine if the adviser remains below the $150 million threshold.  Proposed rule 203(m)-1 would require advisers to calculate the value of private fund assets by reference to Form ADV, under which the SEC proposes to provide a uniform method of calculating assets under management for regulatory purposes under the Investment Advisers Act.  In the case of a sub-adviser, it would have to count only that portion of the private fund assets for which it has responsibility.  In addition to assets appearing on a private fund’s balance sheet, advisers would include any uncalled capital commitments, which are contractual obligations of an investor to acquire an interest in, or provide the total commitment amount over time to, a private fund, when called by the fund.

Under proposed rule 203(m)-1, each adviser would have to determine the amount of its private fund assets quarterly, based on the fair value of the assets at the end of the quarter.  The SEC proposes that advisers use the fair value of private fund assets in order to ensure that, for purposes of this exemption, advisers value private fund assets on a meaningful and consistent basis.  

Assets Managed in the United States

Under proposed rule 203(m)-1, all of the private fund assets of an adviser with a principal office and place of business in the United States would be considered to be “assets under management in the United States,” even if the adviser has offices outside of the United States.  A non-U.S. adviser, however, would need only count private fund assets it manages from a place of business in the United States toward the $150 million asset limit under the exemption.

Rule 203(m)-1 would deem all of the assets managed by an adviser to be managed “in the United States” if the adviser’s “principal office and place of business” is in the United States.  The SEC would look to an adviser’s principal office and place of business as the location where the adviser controls, or has ultimate responsibility for, the management of private fund assets, and therefore as the place where all the advisers’ assets are managed, although day-to-day management of certain assets may also take place at another location.

United States Person

Under proposed rule 203(m)-1(b), a non-U.S. adviser could not rely on the exemption if it advised any client that is a United States person other than a private fund.  The proposal defines a “United States person” generally by incorporating the definition of a “U.S. person” in SEC Regulation S.  Regulation S looks generally to the residence of an individual to determine whether the individual is a United States person, and also addresses the circumstances under which a legal person, such as a trust, partnership or a corporation, is a United States person. Regulation S generally treats legal partnerships and corporations as Unites States persons if they are organized or incorporated in the United States, and trusts by reference to the residence of the trustee.  It treats discretionary accounts generally as United States persons if the fiduciary is a resident of the United States.

Transition

Proposed rule 203(m)-1 includes a provision giving an adviser one calendar quarter (three months) to register with the SEC after becoming ineligible to rely on the exemption due to an increase in the value of its private fund assets.  Because qualification for the exemption depends on remaining below the $150 million threshold on a quarterly basis, an adviser could exceed the limit based on market fluctuations without any new investments from existing or new investors.  This three month period would enable the adviser to take steps to register and otherwise come into compliance with the requirements of the Investment Advisers Act applicable to registered investment advisers, including the adoption and implementation of compliance policies and procedures.  It would be available only to an adviser that has complied with all applicable SEC reporting requirements. 

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The SEC has proposed rules (Release No. IA-3110) requiring public reporting by exempt investment advisers.  The proposed reporting requirements for exempt investment advisers, which are not necessarily required under the Dodd-Frank Act, will impose substantial burdens on exempt investment advisers.  The Dodd-Frank Act neither specifies the types of information the SEC could require in reports by exempt investment advisers nor specifies the purpose for which the SEC would use the information but the regulation is nonetheless on the horizon.  And there is more regulation on the way for exempt investment advisers by way of record keeping and examination.  The first reports for exempt investment advisers will be due by August 20, 2011, so exempt investment advisers should begin to plan accordingly.

 The proposal will likely affect many exempt advisers to hedge funds, private equity funds and venture capital funds.  Open your check book, sharpen your pencils, and get ready to fill in detailed forms every year, if not more often.  Further information is set forth below.

 Overview

 The Dodd-Frank Act repealed the “private adviser exemption” contained in section 203(b)(3) of the Investment Advisers Act on which advisers to many hedge funds and other pooled investment vehicles had relied in order to avoid registration under the Act.  In eliminating this provision, Congress amended the Investment Advisers Act to create, or directed the SEC to adopt, other, in many ways narrower, exemptions for advisers to certain types of “private funds.”  Both section 203(l) of the Investment Advisers Act (which provides an exemption for an adviser that advises solely one or more “venture capital funds”) and section 203(m) of the Investment Advisers Act (which instructs the SEC to exempt any adviser that acts solely as an adviser to private funds and has assets under management in the United States of less than $150 million) provide that the SEC shall require such advisers to maintain such records, which the SEC has the authority to examine, and to submit reports “as the [SEC] determines necessary or appropriate in the public interest.”  The SEC refers to these advisers in the proposed rules as “exempt reporting advisers.”

 To implement sections 203(l) and 203(m) of the Investment Advisers Act, the SEC is proposing a new rule to require exempt reporting advisers to submit, and to periodically update, reports to the SEC by completing a subset of items on Form ADV.  The SEC is also proposing amendments to Form ADV to permit the form to serve as a reporting, as well as a registration, form and to specify the items exempt reporting advisers must complete.

 Reporting Required

The SEC is proposing a new rule, rule 204-4, to require exempt reporting advisers to file reports with the SEC electronically on Form ADV.  Rule 204-4 would require these advisers to submit their reports through the IARD using the same process as registered investment advisers.  Each Form ADV would be considered filed with the SEC upon acceptance by the IARD,  and advisers filing the form would be required to pay a filing fee.  Like IARD filings by registered advisers, the SEC would approve, by order, the amount of the filing fee charged by FINRA.  It is anticipate that filing fees would be the same as those for registered investment advisers, which currently range from $40 to $200, based on the amount of assets an adviser has under management.  The filing fees would be set at amounts that are designed to pay the reasonable costs associated with the filing and the maintenance of the IARD.

 The reports filed by exempt reporting advisers would be publicly available on the SEC website. The SEC believes because exempt reporting advisers may be required to register on Form ADV with one or more state securities authorities, use of the existing form and filing system would also permit exempt reporting advisers to satisfy both state and SEC requirements with a single electronic filing.

 Information in Reports

 In General. The SEC is proposing several amendments to Form ADV to facilitate filings by exempt reporting advisers.  First, the SEC would re-title the form to reflect its dual purpose as both the “Uniform Application for Investment Adviser Registration,” as well as the “Report by Exempt Reporting Advisers.” Second, the SEC is proposing to amend the cover page so that exempt reporting advisers would indicate the type of report they are filing.   Finally, the SEC is proposing to amend Item 2 of Part 1A, which requires advisers to indicate their eligibility for SEC registration, by adding a new subsection C that would require an exempt reporting adviser to identify the exemption(s) that it is relying on to report, rather than register, with the SEC.

 Form ADV is today designed to obtain information from registered advisers that provide a wide variety of types of advisory services, including providing advice to private funds.  Therefore, the information that the information the SEC proposes to collect from exempt reporting advisers is for the most part currently required by Form ADV.  The SEC will provide an instruction to these advisers to complete only certain items in the form, but it does not propose to change the content of the items for exempt reporting advisers.  As noted above, the SEC proposes to require exempt reporting advisers to complete a subset of Form ADV items, which would provide the SEC and the public with some basic information about the adviser and its business, but is not all of the information the SEC requires registered advisers to submit. The SEC proposes to require exempt reporting advisers to complete the following items in Part 1A of Form ADV: Items 1 (Identifying Information), 2.C. (SEC Reporting by Exempt Reporting Advisers), 3 (Form of Organization), 6 (Other Business Activities), 7 (Financial Industry Affiliations and Private Fund Reporting), 10 (Control Persons), and 11 (Disclosure Information).  In addition, exempt reporting advisers would have to complete corresponding sections of Schedules A, B, C, and D. The SEC would not require exempt reporting advisers to complete and file with the SEC other Items in Part 1A or prepare a client brochure (Part 2).

 Private Funds.  The SEC proposes to expand the information it requires advisers to provide  about the private funds they advise in response to Item 7.B., and Schedule D. Both registered and exempt reporting advisers would complete this Item.  This amendment would incorporate the new term “private fund,” defined in section 202(a)(29) of the Act, the primary effect of which would be to require advisers to report pooled investment vehicles regardless of whether they are organized as limited partnerships.  New Section 7.B.1. would expand on the identifying information currently required to be reported in order to provide the SEC with basic organizational, operational and investment characteristics of the fund; the amount of assets held by the fund; the nature of the investors in the fund; and the fund’s service providers.  The SEC proposes to add an instruction to the item to permit an adviser that seeks to preserve the anonymity of a private fund client by maintaining its identity in code in its records to identify the private fund in Schedule D using the same code.  Among other things, the SEC is also proposing several questions to help it better understand the private fund’s investment activities and other areas of potential investor protection concerns.   For example, the form would ask about the size of the fund, including both its gross and net assets.  The form would also ask the  adviser to identify within seven broad categories (which the applicable instruction would define) the type of investment strategy employed by the adviser, and to break down the assets and liabilities held by the fund by class and categorization in the fair value hierarchy established under U.S. generally accepted accounting principles.

 Gatekeeper Information.  The proposal would  require advisers to report information concerning five types of service providers that generally perform important roles as “gatekeepers” for private funds (i.e., auditors, prime brokers, custodians, administrators and marketers).  It would require that an adviser identify them, provide their location, and state whether they are related persons.  For each of these service providers, it would also require specific information that would clarify the services they provide and include certain identifying information such as registration status. This information includes the following for each service provider.  For the auditors, whether they are independent, registered with the Public Company Accounting Oversight Board and subject to its regular inspection, and whether audited statements are distributed to fund investors.   For the prime broker, whether it is SEC-registered and whether it acts as custodian for the private fund.  For the custodian, whether it is a related person of the adviser.  For the administrator, whether it prepares and sends to investors account statements and what percentage of the fund’s assets are valued by the administrator or another person that is not a related person of the adviser.  Finally, for marketers, whether they are related persons of the adviser, their SEC file number (if any), and the address of any website they use to market the fund.

 Updating Requirements

 The SEC is also proposing to amend rule 204-1 under the Investment Advisers Act, which requires advisers to update their Form ADV filings, to require exempt reporting advisers to file updating amendments to reports filed on Form ADV.  Proposed rule 204-1(a) would require an exempt reporting adviser, like a registered adviser, to amend its reports on Form ADV: (i) at least annually, within 90 days of the end of the adviser’s fiscal year; and (ii) more frequently, if required by the instructions to Form ADV.  Consequently, the SEC is proposing to amend General Instruction 4 to Form ADV to require an exempt reporting adviser to update Items 1 (Identification Information), 3 (Form of Organization), or 11 (Disciplinary Information) promptly if they become inaccurate in any way, and to update Item 10 (Control Persons) if it becomes materially inaccurate.  The SEC is proposing the same updating requirements with respect to these Items as are applicable to registered advisers because it believes it is equally important for exempt reporting advisers to report information on a timely basis. The SEC also believes it could create confusion to apply different updating standards within each item of the form depending on who completes the item.

 Transition

 The SEC proposal would require each exempt reporting adviser to file its initial report with the SEC on Form ADV no later than August 20, 2011, 30 days after the July 21, 2011 effective date of the Dodd-Frank Act.  The SEC’s  ability to effect this transition may be affected by its need to re-program IARD.  The SEC is working closely with FINRA, its IARD contractor, to make the needed modifications, but the programming may not be completed until after the SEC adopts the proposed rules. If IARD is unable to accept filings of amended Form ADV by that time, the SEC may delay the reporting deadline until the system can accept electronic filing of the revised form.

 Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

ISS has issued its 2011 Corporate Governance Policy Update.  As expected, it will recommend voting for an annual say-on-pay vote and the update addresses other matters of importance to public issuers.

Frequency of Advisory Vote

In line with its overall client feedback, ISS is adopting a new policy to recommend a vote FOR annual advisory votes on compensation, which ISS believes provide the most consistent and clear communication channel for shareholder concerns about companies’ executive pay programs.

According to ISS, the management say-on-pay vote, or MSOP, is at its essence a communication vehicle, and communication is most useful when it is received in a consistent and timely manner. ISS states it supports an annual MSOP vote for many of the same reasons it supports annual director elections rather than a classified board structure — because it believes this provides the highest level of accountability and direct communication by enabling the MSOP vote to correspond to the majority of the information presented in the accompanying proxy statement for the applicable shareholders’ meeting.  ISS believes having MSOP votes every two or three years, covering all actions occurring between the votes, would make it difficult to create the meaningful and coherent communication that the votes are intended to provide.  Under triennial elections, for example, ISS believes a company would not know whether the shareholder vote references the compensation year being discussed or a previous year, making it more difficult to understand the implications of the vote.

Golden Parachute Vote

When an advisory vote on golden parachute compensation is required by the Dodd-Frank Act, ISS’ policy will be to make recommendations on a case-by-case basis for proposals to approve the company’s golden parachute compensation, consistent with ISS’ policies on problematic pay practices related to severance packages.  Features that may lead to an AGAINST recommendation include:

  • Recently adopted or materially amended agreements that include excise tax gross-up provisions (since prior annual meeting);
  • Recently adopted or materially amended agreements that include modified single triggers (since prior annual meeting);
  • Single trigger payments that will happen immediately upon a change in control, including cash payment and such items as the acceleration of performance-based equity despite the failure to achieve performance measures;
  • Single-trigger vesting of equity based on a definition of change in control that requires only shareholder approval of the transaction (rather than consummation);
  • Potentially excessive severance payments; or
  • Recent amendments or other changes that may make packages so attractive as to influence merger agreements that may not be in the best interests of shareholders.

In cases where the golden parachute vote is incorporated into a company’s separate advisory vote on compensation, ISS will evaluate the “say on pay” proposal in accordance with these guidelines, which may give higher weight to that component of the overall evaluation.

Director Attendance

ISS’ current policy is to recommend a vote AGAINST or WITHHOLD from individual directors who attend less than 75 percent of the board and committee meetings without a valid excuse, such as illness, service to the nation, work on behalf of the company, or funeral obligations.  If the company provides meaningful public or private disclosure explaining the director’s absences, ISS will evaluate the information on a case-by-case basis taking into account the following factors:

  • Degree to which absences were due to an unavoidable conflict;
  • Pattern of absenteeism; and
  • Other extraordinary circumstances underlying the director’s absence.

The key policy change is to remove the private disclosure option for explaining absences; articulating the reasons that are acceptable; and clarifying the policy application when the attendance disclosure does not conform with SEC requirements.

In 2011, ISS will generally recommend a vote AGAINST or WITHHOLD from individual directors who attend less than 75 percent of board and applicable committee meetings (with the exception of new nominees).  Acceptable reasons for director(s) absences are generally limited to the following:

  • Medical issues/illness;
  • Family emergencies; and
  • If the director’s total service was three meetings or less and the director missed only one meeting.

These reasons for director(s) absences will only be considered by ISS if disclosed in the proxy or another SEC filing.  If the disclosure is insufficient to determine whether a director attended at least 75 percent of board and committee meetings in aggregate, ISS will generally recommend a vote AGAINST or WITHHOLD. 

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The SEC has proposed new rules entailing how security-based swap transactions should be reported and publicly disseminated. The rules are proposed under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which generally authorizes the SEC to regulate security-based swaps. The proposed rules represent an important step in the SEC’s continuing effort to increase the transparency of the security-based swap market and fulfill mandates under the Dodd-Frank Act.

 Under the proposed rules, known as Regulation SBSR (proposed Rules 900 through 911):

  • Parties to a security-based swap transaction would be required to report information about each transaction to a registered security-based swap data repository.
  • The registered security-based swap repository would be required to publicly disseminate certain of that information in a timely fashion.

 More specifically, the proposed rules would:

  • Specify the categories of information to be reported to a repository in real time and publicly disseminated. Among other things, this would generally include information about the asset class of the security-based swap, information about the underlying security, the price, the notional amount, the time of execution, the effective date and the scheduled termination date.
  • Specify certain additional categories of information to be reported to a repository for regulatory purposes, but not publicly disseminated. Among other things, this would generally include the counterparty; the broker, trader and desk ID; the amounts of any up-front payments and description of the terms of the payment streams; the title of any master agreement governing the transaction; and, the data elements needed to determine the market value of the transaction.
  • Require the reporting of certain events that result in changes to previously reported information about a security-based swap transaction.
  • Identify which counterparty to a security-based swap transaction would be required to report information to a repository.

To facilitate the reporting and dissemination of the information, the rules would require that registered security-based swap data repositories:

  • Establish and maintain policies and procedures regarding security-based swap transaction data that would be reported and disseminated.
  • Register with the SEC as securities information processors.

 Parties who report to the registered repositories, and who are registered as security-based swap dealers or major security-based swap participants, would be required to establish and maintain policies and procedures designed to ensure that they comply with applicable reporting obligations.

 With respect to block trades, the SEC will propose and solicit comment on general criteria that would be used to determine block trade thresholds, without proposing actual thresholds at this time. At a later date, the SEC expects to consider a recommendation that would propose and solicit comment on specific block trade thresholds.

 Finally, as required by the Dodd-Frank Act, the rules would exempt security-based swaps from the calculation of fees under Section 31 of the Exchange Act.

 Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

Section 727 of the Dodd-Frank Act amends the Commodity Exchange Act by inserting a new section 2(a)(13), which requires public availability of swap transaction data.  The Dodd-Frank Act specifies that swap price and volume data be reported to the public as soon as technologically practicable after the swap has been executed. The Dodd-Frank Act also requires that reported information does not identify the participants to the swap transaction.  The CFTC has proposed rules to implement Section 727 of the Dodd-Frank Act.

 Parties Responsible for Reporting

 The proposed rules require the parties to a swap to report swap data to a real-time disseminator, which would be either a swap data repository that accepts data for the particular asset class, or to a third-party service provider. Such report must be made as soon as technologically practicable.

 Parties to a swap may satisfy this requirement by executing the transaction on a swap market, which is either a swap execution facility, or SEF, or a designated contract market, or DCM. Under the proposed rules, the swap market would be responsible for reporting the swap data to a real-time disseminator as soon as technologically practicable following execution of the transaction.

 For swaps executed off of a SEF or DCM, the proposed rules specify an order of precedence for reporting the swap pricing and volume data. If the swap includes a swap dealer, then the swap dealer is responsible for reporting. If the swap does not include a swap dealer but does include a major swap participant, or MSP, then the MSP is responsible for reporting the swap. If the swap includes two swap dealers or two MSPs, then the parties to the swap must choose which party must report.  If the swap does not include either a swap dealer or a MSP, then the parties to the swap must choose which party must report.

 Data to be Reported

The proposed rules specify data fields that must be reported to the public. The data fields provide meaning to the price of the swap by defining the contract type, the underlying asset class and commodity, the tenor of the swap, the payment frequencies, and other relevant fields.

 Timing of Reporting

 The proposed rules require that swap transactions be reported to a real-time disseminator as soon as technologically practicable. Upon receipt of the data, the real-time disseminator must make the swap transaction data publicly available as soon as technologically practicable.  Reports for block trades and large notional swap transactions are subject to a delay in reporting to the public.

 Block Trades and Large Notional Swaps

 A block trade is a swap of large notional or principal value that:

  • is made available for trading on a SEF or DCM;
  • occurs off the SEF’s or DCM’s trading system or platform pursuant to the SEF or dDCM rules;
  • is consistent with the appropriate minimum block size requirements in the proposed rules; and
  • is reported in accordance with the SEF’s or DCM’s rules and procedures and subject to the appropriate time delay in the proposed rules.

 Block trades and large notional swaps are similar in that they are both swaps of large notional or principal value. However, unlike a block trade, a large notional swap is a swap that is not available for trading or execution on a swap execution facility or designated contract market.  A large notional swap must be consistent with the appropriate minimum size requirements in the proposed rules. Additionally, a large notional swap must be reported in accordance with the appropriate time delay in the proposed rules.

 Under the proposed rules block trades and large notional swaps are subject to a delay in the reporting of swap transaction and pricing data to the public. For standard contracts, which are traded on a SEF or DCM or are subject to the end-user exemption, the reporting delay is 15 minutes. The reporting party is responsible for transmitting the swap transaction and pricing data to the real-time disseminator as soon as technologically practicable. The real-time disseminator would hold the data until the expiration of the 15-minute period following execution.

 For customized trades, the CFTC is requesting comment regarding the appropriate time delay for reporting such large notional swap transactions.

 Appropriate Minimum Block Size

 The proposed rules specify a procedure using two tests—the distribution test and the social size multiple test—to determine the appropriate minimum block size for block trades and large notional transactions. The distribution test determines the transaction size that is larger than 95 percent of transactions for that category of swap instrument over the past calendar year. The social size multiple test is the transaction size that is five times the largest of the mean, median, and mode of transaction sizes for that category swap instrument over the past calendar year. The appropriate minimum block size would be the larger size determined by those two tests. SDRs would be responsible for determining the appropriate minimum block size.

 The CFTC is requesting comment on whether a third test should also be applied in determining the minimum appropriate block size. Specifically, should the minimum appropriate block size be set so that no more than 10 percent of swap transactions in the category of swap instrument would have qualified as a block trade or large notional swap transaction?

 Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The Federal Reserve Board has requested comment on a proposed rule to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act that give banking firms a defined period of time to conform their activities and investments to the so-called Volcker Rule.

The Volcker Rule generally prohibits banking entities from engaging in proprietary trading in securities, derivatives, or certain other financial instruments, and from investing in, sponsoring, or having certain relationships with a hedge fund or private equity fund.  The statute generally provides banking entities two years to bring their activities and investments into compliance with the Volcker Rule, and allows the Board to extend this conformance period for specified periods under certain conditions.  The Dodd-Frank Act requires that the Board issue rules implementing the Volcker Rule’s conformance period.

In developing the proposed rule, the Board consulted with the Department of the Treasury, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, and the Commodity Futures Trading Commission.

Comments on the proposal must be submitted within 45 days after publication in the Federal Register, which is expected shortly.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

In Morrison v. National Australia Bank, the Supreme Court limited the extraterritorial scope of  Section 10(b) of the Securities and Exchange Act of 1934 by holding that the antifraud provision only applies to domestically listed security transactions.  130 S. Ct. 2869, 2884 (2010).

Notwithstanding this decision, the Securities and Exchange Commission,  pursuant to its rulemaking authority and Section 929Y of the Dodd-Frank Wall Street Reform and Consumer Protection Act, is seeking comment regarding whether the Exchange Act should be extended to cover transnational securities fraud.  When the Dodd-Frank Act was signed into law less than a month after the Morrison decision, section 929P of the Dodd-Frank Act amended district court jurisdiction over actions brought under the Exchange Act by the Commission or the United States alleging violations of the antifraud provisions to include conduct that occurs outside of the United States.  This grant of jurisdiction may be expanded even further, as section 929Y of the Dodd-Frank Act requires the Commission to seek public comment and conduct a study to determine whether federal jurisdiction extends to private rights of action – a result that would be inconsistent with the Supreme Court’s holding in Morrison

Among others, the Commission requests comments on the following issues:

  • The scope of such a private right of action, and whether it should be limited to extend just to institutional investors.
  • What implications such a private right of action would have on international comity.
  • The economic costs and benefits of extending a private right of action.
  • Whether a narrower standard should be adopted.
  • The circumstances, if any, under which a private plaintiff could pursue claims under the antifraud provisions of the Exchange Act where the purchase or sale of the security occurred outside the United States.
  • Whether it makes a difference if the security was issued by a U.S. or non-U.S. company.
  • Other factors should be considered.

Thus, notwithstanding the Morrison decision, it appears that transnational security fraud claims may be fair game after all.  The SEC is accepting comments until February 18, 2011. 

Go here for more information.

The CFTC has proposed rules on the registration of swap dealers and major swap participants.  The Dodd-Frank Act requires all swap dealers and major swap participants to be registered.  It contains definitions of “swap dealer” and “major swap participant” but requires the CFTC to adopt rules that complete certain aspects of those definitions. Those rules will be separately proposed and adopted.

General Registration Provisions

Registration will not be required until the forthcoming CFTC rules further defining the “swap dealer” and “major swap participant” terms (referred to as the Definitional Rules) become effective.  Under the proposed registration rules, however, starting April 15, 2011, persons who believe that they are swap dealers or major swap participants will be permitted (but not required) to register.  Registration would only become mandatory once the Definitional Rules become effective.

The Dodd-Frank Act adds a new Section 4s to the Commodity Exchange Act (CEA), which requires registered swap dealers and major swap participants to meet specific requirements in the areas of capital and margin, reporting and recordkeeping, daily trading records, business conduct standards, documentation standards, trading duties, appointing a chief compliance officer, and, with respect to uncleared swaps, segregation of customer funds.  Such requirements are referred to in the proposed rules as the Section 4s Requirements. The Section 4s Requirements will be specifically set forth in additional CFTC rulemakings.

Under the CFTC’s proposed rules, swap dealers and major swap participants would register on a provisional basis until such time as all of the CFTC rules implementing Section 4s Requirements become effective. Provisionally registered swap dealers and major swap participants would be immediately subject only to those Section 4s Requirement rules (if any) as are effective at the time they file their registration application, and they would be permitted to come into compliance with the remaining Section 4s Requirements as each of the separate rules for those requirements becomes effective.  Once all of the rules implementing the Section 4s Requirements become effective, provisionally registered swap dealers and major swap participants who have come into compliance would become fully registered, and the need for provisional registration would cease. Persons registering after that time would immediately be fully registered and subject to all of the Section 4s Requirements.

Extraterritorial Reach

New Section 2(i) of the CEA, which was added by Section 722(d) of the Dodd-Frank Act, states that provisions of the CEA that were enacted by Title VII of the Dodd-Frank Act (which includes the definition of swap dealer, and the registration requirement) 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,” or contravene rules or regulations the CFTC may promulgate to prevent evasion.

The CFTC must determine under which circumstances a person who engages in the activities set forth in new Section 1a(49) of the CEA (“swap dealing activities”) outside the U.S. shall be required to register as a swap dealer. By its terms, Section 2(i) sets a floor that must be met for the swap provisions of the CEA to apply abroad.  Thus, a person whose swap dealing activity has no connection or effect of any kind, direct or indirect, whether through affiliates or otherwise, to U.S. commerce would not be required to register as a swap dealer.  The CFTC also recognizes the role that considerations of international comity play in determining the proper scope of extraterritorial application of federal statutes.

The CFTC requests comment as to what level of swap dealing activity outside the U.S. would qualify as having a direct and significant connection with activities in or effect on commerce of the U.S., thereby requiring a person outside the U.S. to register as a swap dealer.  In particular, in view of the global nature of the swap markets and the ability to transfer swap-related risks within affiliated groups, the CFTC requests comment on when swap dealing activity with or by non-U.S. affiliates of U.S. persons has a “direct and significant connection with activities in, or effect on” U.S. commerce for purposes of Section 2(i) of the CEA.  For example, to what extent do persons outside the U.S. who engage in swap dealing activity with non-U.S. affiliates of U.S. persons (such as the non-U.S. subsidiary of a corporate parent headquartered in the U.S.) engage in swap dealing activity that has a direct and significant connection with activities in, or effect on, U.S. commerce?

Registration of major swap participants raises different jurisdictional issues, because the definition of major swap participant specifically focuses on the degree of risk that an entity’s swaps pose to U.S. counterparties and the U.S. market.  Thus, the CFTC believes the analysis of whether a non-U.S. entity should register as a major swap participant would turn upon, among other things, swap positions with U.S. counterparties (including the use of a U.S. clearing agency or swap execution facility) or that involve U.S. mails or any means or instrumentality of interstate commerce.  The CFTC requests comment on these interpretive issues.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The Commodity Futures Trading Commission, or CFTC, has proposed rules to implement new statutory provisions enacted by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The proposed regulations establish conflicts of interest requirements for swap dealers, or SDs, and major swap participants, or MSPs, for the purpose of ensuring that such persons implement adequate policies and procedures in compliance with the Commodity Exchange Act, or CEA, as amended by the Dodd-Frank Act.

 Conflicts of Interest in Research or Analysis

 Section 731 of the Dodd-Frank Act requires, in relevant part, that SDs and MSPs “establish structural and institutional safeguards to ensure that the activities of any person within the firm relating to research or analysis of the price or market for any commodity or swap . . . are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of persons whose involvement in pricing, trading, or clearing activities might potentially bias their judgment or supervision.”

 Much of the relevant language in section 731 of the Dodd-Frank Act is similar to certain language contained in section 501(a) of the Sarbanes-Oxley Act of 2002, which amended the Securities Exchange Act of 1934 by creating a new section 15D.  In relevant part, section 15D(a) mandates that the SEC, or a registered securities association or national securities exchange, adopt “rules reasonably designed to address conflicts of interest that can arise when securities analysts recommend equity securities in research reports and public appearances, in order to improve the objectivity of research and provide investors with more useful and reliable information, including rules designed . . . to establish structural and institutional safeguards within registered brokers or dealers to assure that securities analysts are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of those whose involvement in investment banking activities might potentially bias their judgment or supervision . . . .”

 Unlike section 15D of the Securities Exchange Act of 1934, section 731 of the Dodd-Frank Act does not expressly limit the requirement for informational partitions to only those persons who are responsible for the preparation of the substance of research reports; rather, section 731 could be read to require informational partitions between persons involved in pricing, trading or clearing activities and any person within a SD or MSP who engages in “research or analysis of the price or market for any commodity or swap,” whether or not such research or analysis is to be made part of a research report that may be publicly disseminated.

 However, the CFTC believes that an untenable outcome could result from implementing informational partitions between persons involved in pricing, trading or clearing activities and all persons who may be engaged in “research or analysis of the price or market for any commodity or swap,” given that persons involved in pricing, trading or clearing activities are routinely—or even primarily—engaged in “research or analysis of the price or market for” commodities or swaps.  Sound pricing, trading and/or clearing activities necessarily require some form of pre-decisional research or analysis of the facts supporting such determinations.

 Therefore, given the untenable alternative, the proposed rules reflect the CFTC’s belief that the Congressional intent underlying section 731 with respect to “research and analysis of the price or market of any commodity or swap” is primarily intended to prevent undue influence by persons involved in pricing, trading or clearing activities over the substance of research reports that may be publicly disseminated, and to prevent pre-public dissemination of any material information in the possession of a person engaged in research and analysis, or of the research reports, to traders.

 Many elements of the proposed rule, particularly those provisions relating to potential conflicts of interest surrounding research and analysis, have been adapted from National Association of Securities Dealers (NASD) Rule 2711.  To construct the “structural and institutional safeguards” mandated by Congress under section 731 of the Dodd-Frank Act, the proposed rule establishes specific restrictions on the interaction and communications between persons within a SD or MSP involved in research or analysis of the price or market for any derivative and persons involved in pricing, trading or clearing activities.  The proposed rules also impose duties and constraints on persons involved in the research or analysis of the price or market for any derivative.  For instance, such persons will be required to disclose conspicuously during public appearances any relevant personal financial interests relating to any derivative of a type that the person follows. SDs and MSPs similarly will be obligated to make certain disclosures clearly and prominently in research reports, including third-party research reports that are distributed or made available by the SD or MSP.  Further, SDs and MSPs, as well as employees involved in pricing, trading or clearing activities, will be prohibited from retaliating against any person involved in the research or analysis of the price or market for any derivative who produces, in good faith, a research report that adversely impacts the current or prospective pricing, trading or clearing activities of the SD or MSP.

 To address the possibility that the proposed rules could be evaded by employing research analysts in an affiliate of a SD or MSP, the proposed rules also will restrict communications with research analysts employed by an affiliate.  An affiliate will be defined as an entity controlling, controlled by, or under common control with, a SD or MSP.  Moreover, the exceptions to the definition of “research report” are designed to address issues typically found in smaller firms where individuals in the trading unit perform their own research to advise their clients or potential clients.  These exceptions do not in any way impact or lessen the restrictions placed on firms that prepare research reports and release them for public consumption.  According to the CFTC, any attempt by such firms to move research personnel into a trading unit to attempt to avail themselves of the exception will result in insufficient “structural and institutional safeguards” and will be a violation of Section 731 of the Dodd-Frank Act and the proposed rules.

 Conflicts of Interest of Swap Dealers and Major Swap Participants in Clearing

Section 4s(j)(5), as established by section 731 of the Dodd-Frank Act, requires SDs and MSPs to implement conflicts of interest systems and procedures that “establish structural and institutional safeguards to ensure that the activities of any person within the firm . . . acting in a role of providing clearing activities or making determinations as to accepting clearing customers are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of persons whose involvement in pricing, trading, or clearing activities might potentially bias their judgment or supervision and contravene the core principles of open access and the business conduct standards described in this Act.”

 The CFTC interprets the conflicts of interest provision under section 4s(j)(5) to require informational partitions between:

  • persons making clearing determinations; and
  • persons involved in pricing and trading swaps (i.e., risk-taking units).

 According to the CFTC, this interpretation would protect against potential bias or interference in relation to “providing clearing activities.”

 The provision of clearing activities includes acts relating to:

  • whether to offer clearing services and activities to customers;
  • whether to accept a particular customer for the purposes of clearing derivatives;
  • whether to submit a transaction to a particular derivatives clearing organization;
  • setting risk tolerance levels for particular customers;
  • determining acceptable forms of collateral from particular customers; or
  • setting fees for clearing services.

 However, the proposed rules are not intended to hinder the execution of sound risk management programs by SDs or MSPs, or by any affiliate of a SD or MSP.

 To prevent anti-competitive discrimination in providing access to central clearing, the CFTC proposed rules that will subject SDs and MSPs to restrictions that prevent risk-taking units from interfering with decisions by any affiliated clearing member of a derivatives clearing organization regarding whether to accept a client for clearing services.  Under the proposed restrictions, all such decisions regarding the acceptance of customers for clearing should be made in accordance with publicly disclosed, objective, written criteria.  Risk-taking units (i.e., those persons involved in pricing and trading swaps) would also be prevented from interfering with the provision of clearing activities.

An affiliate will be defined as an entity controlling, controlled by, or under common control with, a SD or MSP.  Under the term “affiliate,” in any situation where a person is dually registered as a SD or MSP, and as a futures CFTC merchant, or FCM, the restrictions on clearing activities set forth in the proposed regulations are intended to apply to the relationship between the business trading unit of the SD or MSP and the clearing unit of the FCM, even though the business trading unit and clearing unit reside within the same entity.

 Other Issues

 In addition to mandating the establishment of “appropriate informational partitions” within SDs and MSPs that focus on the activities of persons involved in the “research or analysis of the price or market for any commodity or swap,” section 731 of the Dodd-Frank Act also requires SDs and MSPs to “implement conflict-of-interest systems and procedures that . . . address such other issues as the CFTC determines to be appropriate.”  Having considered the potential conflicts of interest that may arise in a SD or MSP, the CFTC proposed rules that will address the potential for undue influence on customers.  The intended cumulative effect of the proposed rules is to fulfill Congress’s objective that SDs and MSPs construct “structural and institutional safeguards” to minimize the potential conflicts of interest that could arise within such firms.

 The CFTC recognizes the potential development of a complex web of incentives and relationships surrounding SDs and MSPs, particularly with respect to such questions as:

  • whether to enter into a cleared or uncleared trade,
  • whether to refer a counterparty to a particular futures CFTC merchant for clearing, or
  • whether to send a cleared trade to a particular derivatives clearing organization.

 To address this issue, the CFTC is proposing to require that each SD and MSP implement policies and procedures mandating the disclosure to its customers of any material incentives or any material conflicts of interest it has that relate to a customer’s decision on the execution or clearing of a transaction.  Such disclosures will enable customers to make fully-informed business decisions, thereby minimizing the potential influence of any incentives or conflicts of SDs and MSPs.

 Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.