Financial Services Alert - March 22, 2011

On March 15, 2011, the FDIC's Board of Directors approved a Notice of Proposed Rulemaking (the “NPR”) that would implement certain provisions of its orderly liquidation authority (“OLA”) under Title II of the Dodd-Frank Act.  The NPR addresses the following issues: (1) recoupment of compensation from senior executives and directors in certain circumstances; (2) the definition of a “financial company” subject to resolution under Title II; (3) application of the power to avoid fraudulent or preferential transfers; (4) the priorities of expenses and unsecured claims; and (5) the administrative process for initial determination of claims and the process for judicial determination of claims disallowed by the receiver.

Recoupment of Compensation.  The NPR proposes criteria for the circumstances under which the FDIC as receiver will seek to recoup from senior executives and directors who are deemed to be “substantially responsible” for a covered financial company’s failure any compensation that they received during the two-year period preceding the date on which the FDIC was appointed as receiver, or during an unlimited time period in the case of fraud.  Pursuant to the NPR, in determining whether to seek to recoup compensation, the FDIC as receiver would investigate whether the senior executive or director performed his or her duties and responsibilities with the requisite degree of skill and care, and whether such person caused any loss to the covered financial company that materially contributed to its failure.

However, the NPR further provides that the most senior executives, including, but not limited to, the chief executive officer, president, chief financial officer and the chairman of the board of directors, will be subject to a rebuttable presumption that they are “substantially responsible” and thus subject to recoupment.  Individuals hired within the two years preceding the appointment of the FDIC as receiver specifically for the purpose of improving the covered financial company’s financial condition are exempted from this presumption but are still subject to clawbacks if their actions establish substantial responsibility for a failure.

Definition of “Financial Company.”  The NPR helps clarify which companies may be subject to resolution under OLA by providing additional information on the definition of “financial company” under Title II.  Pursuant to Section 201(a)(11) of the Dodd-Frank Act, any company that is “predominantly engaged in activities that the [FRB] has determined are financial in nature or incidental thereto for purposes of section 4(k) of the Bank Holding Company Act” is a “financial company” that may be subject to OLA.  Section 201(b) of the Dodd-Frank Act provides that, for the purposes of defining the term “financial company” under Section 201(a)(11), “no company shall be deemed to be predominantly engaged in [such] activities…if the consolidated revenues of such company from such activities constitute less than 85 percent of the total consolidated revenues of such company as the [FDIC], in consultation with the Secretary [of the Treasury], shall establish by regulation.”

The NPR defines the term “predominantly engaged” and creates a new definition of “financial activity” to encompass the activities the Dodd-Frank Act includes in the 85 percent calculation.  More specifically, the NPR defines a company as being “predominantly engaged” in activities that the FRB has determined are financial in nature or incidental thereto for purposes of Section 4(k) of the Bank Holding Company Act if: “(1) at least 85 percent of the total consolidated revenues of the company for either of its two most recent fiscal years were derived, directly or indirectly from financial activities or (2) based upon all the relevant facts and circumstances, the [FDIC] determines that the consolidated revenues of the company from financial activities constitute 85 percent or more of the total consolidated revenues of the company.”  The NPR notes that, as required, the FDIC consulted with the Secretary of the Treasury during the development of this portion of the proposed rule.

The NPR further defines “financial activity” to include: (a) any activity, wherever conducted, described in Section 225.86 of the FRB’s Regulation Y; (b) ownership or control of one or more depository institutions; and (c) any other activity, wherever conducted, determined by the FRB, in consultation with the Secretary of the Treasury, under Section 4(k) of the Bank Holding Company Act, to be financial in nature or incidental to a financial activity.

Treatment of Fraudulent and Preferential Transfers.  Section 209 of the Dodd-Frank Act provides that, to the extent possible, the FDIC shall seek to harmonize rules and regulations promulgated under its OLA with the insolvency laws that otherwise would apply to a covered financial company.  In that regard, the NPR addresses the powers granted to the FDIC as receiver to avoid certain fraudulent and preferential transfers and seeks to ensure that such powers are implemented consistently with the corresponding provisions of the Bankruptcy Code.

The NPR notes two areas in which there is a potential for inconsistent treatment of transferees under OLA as compared to a Chapter 7 bankruptcy liquidation.  The first issue relates to the standard used in determining whether the FDIC can avoid a transfer as fraudulent or preferential under OLA.  In order to harmonize OLA with the Bankruptcy Code, the NPR makes clear that the FDIC may not avoid as preferential the grant of a security interest perfected by the filing of a financing statement in accordance with the provisions of the Uniform Commercial Code (UCC) or other non-bankruptcy law where a security interest so perfected could not be avoided in a case under the Bankruptcy Code.

The second issue relates to the 30-day grace period, in the preferences provisions of the Bankruptcy Code, in which a security interest in transferred property may be perfected after such transfer has taken effect between the parties.  Although Title II of the Dodd-Frank Act does not contain any such express grace period, in order to harmonize OLA regulations with otherwise applicable insolvency law to the extent possible, the NPR provides that the OLA avoidance provisions would apply the 30-day grace period as provided in the Bankruptcy Code, including any exceptions or qualifications contained therein.

Priorities of Expenses and Unsecured Claims.  The NPR would add a new Subpart A regarding the priorities of expenses and unsecured claims in the receivership of a covered financial company.  The proposed rule lists each of the eleven priority classes of claims established under the Dodd-Frank Act in the order of its relative priority: (1) claims with respect to post-receivership debt extended to the covered financial company where such credit is not otherwise available (generally borrowings from the FDIC to manage receivership costs); (2) other administrative costs and expenses; (3) amounts owed to the U.S. (primarily consisting of money that the FDIC draws from the Treasury’s orderly liquidation fund to cover liquidation expenses); (4) wages, salaries and commissions earned by an individual within 6 months prior to the appointment of the receiver up to a specified amount; (5) contributions to employee benefit plans due with respect to such employees up to a specified amount; (6) claims by creditors who have lost setoff rights by action of the receiver; (7) other generally unsecured creditor claims; (8) subordinated debt obligations; (9) wages, salaries and commissions owed to senior executives and directors; (10) post‑insolvency interest, which shall be distributed in accordance with the priority of the underlying claims; and (11) distributions on account of equity to shareholders and other equity participants in the covered financial company.  Pursuant to the NPR, each above class will be paid in full before payment to the next priority, and if funds are insufficient to pay any class of creditors, the funds will be allocated among creditors in that class pro rata.

Administrative Claims Process and Judicial Determination Procedures.  The NPR also would add a new Subpart B to clarify how creditors can file claims against the receivership estate, how the FDIC as receiver will determine those claims, and how creditors can pursue their claims in federal court.  Generally, creditors must file their claims with the FDIC as receiver by a “claims bar date.”  The FDIC will determine whether to allow or disallow a claim no later than 180 days after the claim is filed (subject to any extension agreed to by the claimant).  If the FDIC disallows the claim, the claimant may seek judicial review of the claim within 60 days.  This judicial review would be a de novo determination of the claim by the court on its merits and not just a review of whether the FDIC abused its discretion in disallowing the claim.

It is important to note that no court has jurisdiction to hear any claim against either the covered financial company or the receiver unless the claimant has first obtained a determination of the claim from the receiver or otherwise exhausted the administrative claims process.  As noted in the NPR, the administrative claims process under OLA is closely modeled after the claims process set forth in the Federal Deposit Insurance Act for receiverships of insured depository institutions and is designed to maximize efficiency while reducing the delay and additional costs that could be incurred in a different insolvency regime.

Comments on the NPR are due to the FDIC no later than 60 days after its publication in the Federal Register. 

The SEC issued a proposal to readopt without change relevant portions of Rules 13d-3 and 16a-1 under the Securities Exchange Act of 1934 (the “1934 Act”) in order to preserve the status quo regarding their application to persons who buy or sell security-based swaps following the July 16, 2011 effectiveness of Section 13(o) added by the Dodd-Frank Act.  Section 13(o) provides that “[f]or purposes of [Section 13 and Section 16 of the 1934 Act], a person shall be deemed to acquire beneficial ownership of an equity security based on the purchase or sale of a security-based swap, only to the extent that the Commission, by rule, determines after consultation with the prudential regulators and the Secretary of the Treasury, that the purchase or sale of the security-based swap, or class of security-based swap, provides incidents of ownership comparable to direct ownership of the equity security, and that it is necessary to achieve the purposes of this section that the purchase or sale of the security-based swaps, or class of security-based swap, be deemed the acquisition of beneficial ownership of the equity security.”  The proposal follows consultation with the Secretary of the Treasury, the prudential regulators (consisting of the Federal Reserve, the Office of the Comptroller of the Currency, the Farm Credit Administration, the Federal Housing Finance Agency, and the Federal Deposit Insurance Corporation) and the CFTC. The SEC proposal notes that the SEC staff is engaged in a separate project to develop proposals to modernize reporting under Sections 13(d) and 13(g) of the 1934 Act.  Comments on the proposal are due by April 15, 2011.

The FRB issued an order (the “Order”) approving the retention by The Goldman Sachs Group, Inc. (“Goldman”), a bank holding company that has elected financial holding company status, of 9.8% of the outstanding common stock of a Tennessee bank holding company, Avenue Financial Holdings, Inc. (“Avenue”).  Goldman stated that it did not propose to control or exercise a controlling influence over Avenue, and the FRB approval under the Order is subject to passivity commitments from Goldman (the “Passivity Commitments”) that are set forth in an appendix to the Order.  The FRB states in the Order that the Passivity Commitments are

“substantially similar to those on which the Board has previously relied in determining that an investing bank holding company would not be able to exercise a controlling influence over another bank holding company or bank…”

The specific Passivity Commitments agreed to by Goldman are as follows:

“The Goldman Sachs Group, Inc. (“Goldman Sachs”), New York, New York, and its subsidiaries and affiliates (collectively, the “Goldman Sachs Group”), will not, without the prior approval of the Board or its staff, directly or indirectly:

1. Exercise or attempt to exercise a controlling influence over the management or policies of Avenue Financial Holdings Inc. (“Avenue Financial”), Nashville, Tennessee, or any of its subsidiaries;
2. Have or seek to have more than one representative of the Goldman Sachs Group serve on the board of directors of Avenue Financial or any of its subsidiaries;
3. Permit any representative of the Goldman Sachs Group who serves on the board of directors of Avenue Financial or any of its subsidiaries to serve (i) as the chairman of the board of directors of Avenue Financial or any of its subsidiaries, (ii) as the chairman of any committee of the board of directors of Avenue Financial or any of its subsidiaries, (iii) as a member of any committee of the board of directors of Avenue Financial or any of its subsidiaries if the Goldman Sachs Group representative occupies more than 25 percent of the seats on the committee, or (iv) as a member of any committee of the board of directors of Avenue Financial or any of its subsidiaries with the authority to act on behalf of the full board of directors between formal meetings;
4. Have or seek to have any employee or representative of the Goldman Sachs Group serve as an officer, agent, or employee of Avenue Financial or any of its subsidiaries;
5. Take any action that would cause Avenue Financial or any of its subsidiaries to become a subsidiary of Goldman Sachs;
6. Own, control, or hold with power to vote securities that (when aggregated with securities that the officers and directors of the Goldman Sachs Group own, control, or hold with power to vote) represent 25 percent or more of any class of voting securities of Avenue Financial or any of its subsidiaries:
7. Own or control equity interests that would result in the combined voting and nonvoting equity interests of the Goldman Sachs Group and its officers and directors to equal or exceed 25 percent of the total equity capital of Avenue Financial or any of its subsidiaries, except that, if the Goldman Sachs Group and its officers and directors own, hold, or have the power to vote less than 15 percent of the outstanding shares of any class of voting securities of Avenue Financial, the Goldman Sachs Group and its officers and directors may own or control equity interests greater than 25 percent, but in no case more than 33.3 percent, of the total equity capital of Avenue Financial or any of its subsidiaries;
8. Propose a director or slate of directors in opposition to a nominee or slate of nominees proposed by the management or board of directors of Avenue Financial or any of its subsidiaries;
9. Enter into any agreement with Avenue Financial or any of its subsidiaries that substantially limits the discretion of Avenue Financial’s management over major policies and decisions, including, but not limited to, policies or decisions about employing and compensating executive officers; engaging in new business lines; raising additional debt or equity capital; merging or consolidating with another firm; or acquiring, selling, leasing, transferring, or disposing of material assets, subsidiaries, or other entities;
10. Solicit or participate in soliciting proxies with respect to any matter presented to the shareholders of Avenue Financial or any of its subsidiaries;
11. Dispose or threaten to dispose (explicitly or implicitly) of equity interests of Avenue Financial or any of its subsidiaries in any manner as a condition or inducement of specific action or non-action by Avenue Financial or any of its subsidiaries; or
12. Enter into any other banking or nonbanking transactions with Avenue Financial or any of its subsidiaries, except that the Goldman Sachs Group may establish and maintain deposit accounts with Avenue Financial, provided that the aggregate balance of all such deposit accounts does not exceed $500,000 and that the accounts are maintained on substantially the same terms as those prevailing for comparable accounts of persons unaffiliated with Avenue Financial.

The terms used in these commitments have the same meanings as set forth in the Bank Holding Company Act of 1956 (“BHC Act”), as amended, and the Board’s Regulation Y.

Goldman Sachs understands that these commitments constitute conditions imposed in writing in connection with the Board’s findings and decisions in Goldman Sachs’s application to retain 9.8 percent of the outstanding common stock of Avenue Financial, pursuant to section 3(a)(3) of the BHC Act, and, as such, may be enforced in proceedings under applicable law. Goldman Sachs further understands that it generally must file an application and receive prior approval of the Board, pursuant to section 3(a)(3) of the BHC Act, for any subsequent acquisition of control of voting shares of Avenue Financial that would result in Goldman Sachs, directly or indirectly, owning or controlling additional voting shares in excess of 9.8 percent of the outstanding common shares of Avenue Financial.”

The Passivity Commitments, as the FRB stated, are substantially similar to those required in prior FRB orders, but in a few instances, as with other applicants or notificants, examples of restrictions within a commitment have been tailored to the specific application or notice.  For example, Commitment 9’s express limitation on interfering in Avenue’s policies or decisions regarding employing and compensating executive officers does not appear in many sets of passivity commitments and, in some sets of commitments, restrictions on interfering in “personnel decisions” appear.  We believe that the FRB’s Order in the Goldman Sachs matter provides a useful illustration of the FRB’s current thinking on passivity commitments.

The California Corporations Commissioner (the “Commissioner”) issued an invitation for comments on a proposal to amend the rules governing certain exemptions from California’s investment adviser licensing requirements (the “Amendments”).  The proposal is being made in anticipation of the July 21, 2011 effectiveness of changes to the federal regulatory scheme for adviser registration and oversight resulting from the Dodd‑Frank Act.  California currently exempts from its licensing requirements an investment adviser that relies on Section 203(b)(3) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), (the current federal “private adviser” exemption for advisers with fewer than 15 clients who meet certain additional conditions) provided that either (a) the adviser has not less than $25 million in assets under management, or (b) the adviser’s only clients are venture capital companies, as defined in the exemption.   In view of imminent changes in federal investment adviser regulation, particularly the Dodd-Frank Act’s elimination of the Section 203(b)(3) federal private adviser exemption upon which the current California exemption is in part based, the Commissioner’s proposal would replace the current conditions for the exemption with new requirements, including the following:

• The adviser must be exempt from federal registration either as (a) a “venture capital fund adviser” under Section 203(l) of the Advisers Act or (b) a “private fund adviser” under Section 203(m) of the Advisers Act.  (Both exemptions are discussed in more detail in the November 24, 2010 Alert, which describes SEC rule proposals that would define and clarify these statutory exemptions and create reporting obligations for these “exempt reporting advisers.”)
• The adviser must file the same reports with the Commissioner that an “exempt reporting adviser” would be required to file with the SEC (as discussed in the November 24, 2010 Alert).
• The adviser must either (i) have assets under management (as defined in the proposal) of not less than $100,000,000 or (ii) provide investment advice only to “venture capital companies.”   This condition would use the definition of “venture capital company” in the current exemption, which, in general terms, requires that the entity in question meet an ongoing test regarding the proportion of its assets that constitute venture capital investments in operating companies (as defined in the exemption).

Comments are due by March 28, 2011.  A Goodwin Procter client alert addressing the Amendments in more detail will be made available to Alert readers.

The staff of the SEC’s Division of Investment Management has posted on the SEC website responses to questions about Form ADV Part 2A (brochure) and Part 2B (brochure supplement).  The questions regarding the brochure cover topics such as (1) identification of material changes, (2) required headings, (3) risk disclosures for investment strategies/methods of analysis and (4) brochure delivery to fund investors.  The questions regarding the brochure supplement cover topics such as (a) delivery obligations when a supervised person provides advisory services on a temporary basis or following a predecessor’s resignation or termination, (b) delivery obligations when investment recommendations are computer-generated, (c) explanation of professional designations and (d) identification of supervising persons.

The Basel Committee on Banking Supervision (“BCBS”) has reportedly agreed on (i) criteria for identifying those banks that will be deemed global systemically important banks (“Global SIBs”) and (ii) the amount of additional capital surcharges on such banks.  According to several publications, criteria such as size, complexity, interconnectedness with other financial institutions, scale of international operations and the ability for other banks to absorb its functions, will be used to determine which banks will be identified as Global SIBs.  Such banks would face a sliding scale of capital surcharges based on the risk they pose to the global financial system in the event of their failure, as determined pursuant to the abovementioned criteria.  Regulators would regularly evaluate which banks would be subject to such capital surcharges, and at what amounts.

The BCBS reportedly has not yet determined what component of these capital surcharges must be comprised of common equity.  The BCBS’s recommendations will also be subject to further review from the Financial Stability Board.  The Alert will continue to monitor and report on important developments in this area.

The CFTC issued a proposal that would make certain conforming amendments to its rules governing the registration of intermediaries to incorporate references to swap dealers, major swap participants and swap execution facilities.  The proposal also includes modernizing and technical amendments to the rules governing intermediary registration.  Comments on the proposal are due by May 9, 2011.

The CFTC issued a proposal that supplements previous proposals relating to the clearance of swaps.  The proposal addresses the submission of swaps for processing and clearing by swap dealers and major swap participants, the acceptance and clearing of swaps by designated clearing organizations and the transfer of customer positions and related funds among clearing members of a derivatives clearing organization.  Comments are due by April 11, 2011.

On March 18, 2011, the CFTC terminated its proposed rulemaking regarding the prohibitions on disruptive trading practices in new Section 4c(a)(5) of the Commodity Exchange Act added by the Dodd-Frank Act and issued a proposed interpretation of those prohibitions that reflects comments received on the earlier proposal.  Section 4c(a)(5) makes it “unlawful for any person to engage in any trading, practice, or conduct on or subject to the rules of a registered entity that— (A) [v]iolates bids or offers; (B) [d]emonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period; or (C) [i]s, is of the character of, or is commonly known to the trade as, ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).”  Section 4c(a)(5) becomes effective on July 16, 2011.  Comments on the proposed interpretation are due by May 17, 2011.