Financial Services Alert - December 11, 2012

The Transaction Account Guarantee (“TAG”) program, which provides unlimited FDIC insurance coverage for noninterest-bearing transaction accounts, is scheduled to expire on December 31, 2012.  Originally established by the FDIC in 2008, the first TAG program expired on December 31, 2010 and was immediately replaced by the current TAG program established under Section 343 of the Dodd-Frank Act, which sunsets at the end of this month unless Congress acts to extend the program.  A bill to extend the TAG program for two additional years was introduced in the Senate by Senator Harry Reid on November 26, 2012 and cloture was filed on the bill today with a Senate vote expected to occur on Thursday, December 13, 2012.  Should the TAG program expire as scheduled, non-interest bearing transaction accounts will still be insured by the FDIC, but deposit insurance coverage on such accounts will be subject to the standard maximum deposit insurance amount of $250,000 for all deposits at an insured depository institution held by a depositor in the same right and capacity.  As such, some depositors may have significant amounts of uninsured deposits beginning January 1, 2013.

Depositors seeking to minimize their risk of loss in the event of a bank’s failure have several options, including diversifying among FDIC-insured depository institutions and using sweep vehicles.  Sweep vehicles involve the pre-arranged transfer of funds from a deposit account to an investment vehicle, either held at the same depository institution or maintained outside of the depository institution, or to a deposit account at another depository institution.  Two common investment vehicles depositors may consider are money market funds and government securities subject to repurchase agreements. 

While sweep vehicles may provide certain advantages by moving excess funds out of an insured depository institution, they are subject to risks that should be carefully evaluated and require that the sweep arrangement be structured appropriately to minimize the risk that a prearranged movement of funds out of a deposit account and into an investment option held at a third party may not be effectuated prior to the FDIC stepping in as receiver in the event of the depository institution’s failure.  Generally, when the FDIC steps in as receiver, it uses end-of-day ledger balances as normally calculated by the depository institution for purposes of determining the amount of insured deposits and claims against the failed institution.  This means that if funds are normally swept out before the close of business, these transactions generally will be treated by the FDIC as having been completed.  However, the FDIC’s rules permit it to block any transmission of funds outside of an institution that has not taken place as of the time it is appointed as receiver.  As a result, if the funds have not actually been wired at the time the FDIC steps in as receiver, the sweep could be stopped and the funds treated as part of the depositor’s account balance.

It may be possible to address this risk by utilizing a sweep option where funds are invested in securities held at the institution or in a money market mutual fund where the fund maintains an account at the institution for purposes of accepting new share purchases, but such arrangements also need to be carefully evaluated.  For example, the FDIC has stated that it may disregard the movement of funds out of a deposit account and into a repurchase agreement unless the customer becomes the legal owner of the securities subject to the repurchase agreement or obtains a perfected security interest in those assets.  Similarly, even if a sweep arrangement utilizes a money market mutual fund that maintains an account at the same institution for purposes of accepting share purchases, it is important to evaluate how the account is registered on the institution’s deposit account records and the way in which share purchases are settled to determine whether or not funds subject to the sweep arrangement will be treated as deposits if the depository institution fails.

The SEC settled public administrative proceedings against a publicly-traded fund (the “Fund”) that had elected to be regulated as a business development company (“BDC”) under the Investment Company Act of 1940 (the “1940 Act”) and its CEO, CFO and CIO (together with the Fund, the “Respondents”) regarding the overstated value of certain Fund assets for certain periods in 2008 and 2009 during the financial crisis.  The SEC found that the Fund did not properly record and provide in various periodic and other reports the fair value of certain of its assets in accordance with FAS 157 and GAAP.  The SEC principally faulted the Fund for using cost as the fair value of certain of its holdings in debt securities and collateralized loan obligation funds (“CLOs”).  The press release accompanying the order noted that this settlement represents the SEC’s first enforcement action against a public company that failed to properly fair value its assets according to FAS 157.  This article summarizes the SEC’s findings set forth in the settlement order, which the Respondents have neither admitted nor denied.

Fund’s 2008/2009 Valuations and 2010 Restatement

Background.  As described in the SEC settlement order, during fiscal years 2008 and for the first two quarters of 2009, the Fund, whose common stock trades on the NASDAQ Global Market, held investments in (i) debt securities issued by privately-held middle market companies and (ii) equity tranches of CLOs managed by the Fund’s wholly-owned investment adviser.  The CEO and CIO were primarily responsible for valuing the Fund’s debt securities.  The CFO was primarily responsible for valuing the CLO interests.  In each case, the valuations were sent to the Fund’s valuation committee for review and approval.  As a BDC, the Fund was subject to the same requirements under the 1940 Act with respect to valuation as a registered closed-end fund, including Section 2(a)(41)(B)(ii) of the 1940 Act, which requires a registered fund’s board of directors to determine, in good faith, the fair value of portfolio assets for which market quotations are not readily available.  The Fund’s board of directors had delegated its statutory obligation regarding fair value determinations to a valuation committee consisting of three board members.

Debt Security Valuations.  The Fund was required to use valuation methodologies consistent with FAS 157 beginning with the first quarter of 2008.  During 2008, the Fund determined fair value for debt securities it determined were liquid based on third-party pricing services.  It used an enterprise value (“EV”) method of determining fair value for debt securities determined to be illiquid.  The EV methodology used EBITDA multiples of comparable companies to generate an EV for the security’s issuer.  If all of an issuer’s debt of seniority equal to, or greater than, that of the security held by the Fund had a value less than the issuer’s EV, then the Fund valued the security at the Fund’s cost.  If an issuer’s EV was less than the amount of such debt, the Fund would adjust the fair value of the security to be less than cost.  During the fourth quarter of 2008, the Fund determined that all of the debt securities it held were illiquid, that any trades reflected distressed transactions and that any price quotes from third party sources did not reflect fair value, and on that basis, valued all of its debt securities using the EV method.

CLO Valuations.  The valuation methods the Fund used for its CLO holdings varied based on a CLO’s “seasoning.”  Under the Fund’s policy, if a CLO had made four or more contractual payments, the Fund valued its interest in the CLO using a model that took into account market conditions, such as discount, prepayment and default rates.  If a CLO had not yet made four contractual payments, the Fund valued its interest in the CLO at the Fund’s acquisition cost.  The Fund valued seven of its nine CLO interests using the market-based model.  The remaining two CLO interests (“CLO 8” and “CLO 9”) which comprised 72% of the Fund’s CLO portfolio, were valued at cost. 

As of December 31, 2008, the CFO calculated the value of CLO 8, which had generated four quarterly payments, using the Fund’s model incorporating market data to be $10.98 million.  Notwithstanding this calculation, the CFO used the Fund’s cost basis in the holding, $11.9 million, as its fair value.  As of December 31, 2008, the CFO valued CLO 9, which had not yet generated four contractual payments, at the Fund’s cost, $28.9 million.

In its financial statements, the Fund did not disclose that CLO 8 and CLO 9 interests were valued at cost.  Rather, in disclosure prepared by the CFO, the Fund stated that they were valued using a discounted cash flow model that reflected prepayment and loss assumptions, as well as projected performance. 

May 2010 Restatement.  On May 28, 2010, the Fund restated its financial statements for all four quarters of 2008 and for the first two quarters of 2009.  The restatement revealed that the value of the Fund’s debt security holdings had been overstated by 9% in fiscal year 2008 and its CLO holdings had been overvalued by 64%, with the result that the Fund’s net asset value had been overstated by 27%.  The restatement also reported that the Fund had identified errors in its fair value measurements of its illiquid securities; and that the Fund had material weaknesses with respect to its internal controls for valuing portfolio assets.  The restatement acknowledged that the Fund’s internal control over financial reporting was not properly designed to implement an appropriate valuations methodology and procedures to value the Fund’s illiquid investments consistent with the requirements of Fair Value Measurements and Disclosures as required by GAAP because the Fund’s prior valuation procedures did not adequately take into account certain market inputs and other data.

SEC Analysis 

FAS 157.  The SEC noted that FAS 157 became effective for financial reporting with respect to fiscal periods beginning after November 2007, and therefore the Fund was required to prepare its financial statements in conformity with FAS 157 beginning with its financial statements for the first quarter of fiscal 2008.  The SEC observed that FAS 157 defines fair value as an exit price, which reflects the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.  The SEC further commented that FAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and should be determined based on assumptions market participants would use in pricing an asset. 

The SEC explained that FAS 157 provides that fair value should be measured using valuation techniques consistent with three broad approaches to measure fair value – the market approach, the income approach, and the cost approach.  The market approach examines prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. The income approach utilizes valuation techniques to convert future amounts to a single discounted present value amount.  The cost approach relies on the amount that currently would be required to replace the assets in service.  The SEC also noted that in October 2008, FASB issued Statement FAS 157-3, providing guidance on fair valuing assets where there is little, if any, market activity.  Statement FAS 157-3 stated that “[e]ven in times of market dislocation, it is not appropriate to conclude that all market activity represents forced liquidations or distressed sales.”

Debt Security Valuations.  In reviewing the valuation methodologies that the Fund had applied to its debt securities, the SEC found that the EV method did not calculate or inform the public what the exit price for a debt security was, but rather provided an assessment as to whether the entire principal balance owed to the Fund was likely to be repaid by the issuer.  The SEC also found that the CEO and CIO had improperly decided to disregard all market activity in the fourth quarter of 2008 in valuing the Fund’s debt securities.  Upon restatement, 13 of the Fund’s debt securities were fair valued using prices reported by third-party pricing services in the fourth quarter of 2008 that were significantly lower than those originally reported.

In particular, the SEC noted that one of the Fund’s debt securities, issued by Ford Motor Credit, was trading between 41-45% of par on December 31, 2008 and was the subject of an oversubscribed tender offer early in March 2009, pursuant to which a total of $1.2 billion of the security was repurchased at between 38-47% of par.  Nonetheless, the Fund valued the security at 70% of par in its 10-K for the period ending December 31, 2008 (a value subsequently restated at approximately 41% of par).  In addition, the SEC noted that actual trading activity was reported during December 2008 on TRACE for two other bonds held by the Fund that showed dramatically lower valuations than the fair values the Fund assigned to those bonds in its filing on Form 10-K.  The SEC observed that in the 2010 restatement, the Fund largely used an income-based approach to value its debt securities, which involved calculating the present value of projected principal and interest payments.

CLO Valuations.  In reviewing the valuation methodologies the Fund used for its CLO interests, the SEC found that the Fund acted improperly in valuing certain of the CLO interests at cost, without taking into consideration significant changes in market conditions, as reflected in changes to market discount, default and prepayment rates, between the date of purchase and the December 31, 2008 valuation date.  Furthermore, the SEC found that the Fund’s public filings were misleading to the extent the disclosures indicated that CLO interests were valued based upon a discounted cash flow model that utilized prepayment and loss assumptions and project performance, when in fact certain of the CLO interests were valued at the Fund’s historical cost.

Violations and Sanctions

The SEC determined that the Fund had violated its obligations to file complete, timely and accurate annual, quarterly and current reports as required by Rules 13a-1, 13a-11, 13a-13 and 12b-10 under the Exchange Act, to maintain accurate books and records under Section 13(b)(2)(A) of the Exchange Act and to maintain an adequate system of internal accounting controls under Section 13(b)(2)(B) of the Exchange Act.  The SEC determined that the CEO, CFO and CIO violated Rule 13b2-1 under the Exchange Act by causing the Fund’s violations of Section 13(b)(2)(A) and that the CEO and the CFO improperly filed Sarbanes-Oxley certifications with respect to the Fund’s internal accounting controls pursuant to Rule 13a-14 under the Exchange Act in the Fund’s quarterly and annual reports filed with the SEC pursuant to Section 13(a) of the Exchange Act.

The Fund, the CEO, the CFO and the CIO were ordered to cease and desist from future violations of the Exchange Act.  The CEO and the CIO were each ordered to pay a $50,000 civil penalty.  The CIO was ordered to pay a $25,000 civil penalty.

On November 30, 2012, the Staff of the SEC’s Division of Risk, Strategy, and Financial Innovation issued a report (the “Report”) in response to questions posed by Commissioners Aguilar, Paredes and Gallagher relating to money market fund reform.  The Report follows Chairman Schapiro’s decision to withdraw a money market fund reform proposal due to a lack of support from a majority of the SEC Commissioners, as discussed in the August 28, 2012 Financial Services Alert. Following the SEC’s decision to not advance proposed money market fund reform, as reported in the November 20, 2012 Financial Services Alert, the Financial Stability Oversight Council approved proposed recommendations for the structural reform of money market mutual funds.

The Report categorizes the Commissioners’ questions and the Staff’s responses into three groups:

Redemptions and Movement to Treasury Funds During 2008 Financial Crisis.  The Report addresses the causes of investor redemptions of prime money market fund shares and purchases of Treasury money market fund shares during the 2008 financial crisis.

The Report includes a number of possible explanations for investor redemptions in September 2008, but recognizes that it is difficult, if not impossible, to attribute the redemptions to any single explanation.  Possible explanations examined in the Report include the Reserve Primary Fund’s “breaking the buck” and a “flight to quality” by risk averse investors, as well as a flight by investors to funds offering liquidity, transparency, and performance.  The Report also discusses the influence on redemptions of the failure and, in some cases government-sponsored rescue, of prominent financial institutions, including The Bear Stearns Companies, Inc., Lehman Brothers Holdings, Inc., American International Group, Inc., the Federal National Mortgage Association, and the Federal Home Loan Mortgage Corporation.

Efficacy of 2010 Money Market Reforms.  The Report includes an analysis of the 2010 money market fund reforms, which were discussed in detail in the March 5, 2010 Financial Services Alert, in three general areas: (1) their impact on fund characteristics, (2) their effectiveness during the events of the summer of 2011, including the Eurozone sovereign debt crisis and the U.S. debt ceiling impasse, and (3) their potential impact had they been in place in 2008.

The Report finds “that funds are more resilient now to both portfolio losses and investor redemptions than they were in 2008.  That being said, no fund would have been able to withstand the losses that The Reserve Primary Fund incurred in 2008 without breaking the buck, and nothing in the 2010 reforms would have prevented The Reserve Primary Fund’s holding of Lehman Brothers debt.”

Impact of Future Reforms.  The Report explores how future reforms might affect the demand for investments in money market fund substitutes and the implications for investors, financial institutions, corporate borrowers, municipalities, and states that sell their debt to money market funds.  The Report describes the characteristics of existing investment alternatives to prime funds, including bank deposit accounts, bank collective trust funds, local government investment pools, offshore funds, private funds, separately managed accounts, ultra-short bond funds, short-duration exchange-traded funds, and direct investments in money market instruments, and discusses the potential impact should investment shift from money market funds to these alternatives.

LOOKING AHEAD

Recent news reports indicate that Commissioner Aguilar has said he would support a proposal requiring money market funds to adopt a floating net asset value, which is one of the reform alternatives that was ultimately withdrawn by Chairman Schapiro earlier in the year.  It is important to note, however, that Commissioner Aguilar’s support may not be enough to advance proposed performs at the SEC in light of Chairman Schapiro’s impending departure scheduled for Friday, December 14, 2012.  After Chairman Schapiro’s departure, and until a fifth Commissioner is appointed, the SEC will be left with just four commissioners – two of whom, Commissioners Paredes and Gallagher, opposed the earlier reforms.

The CFTC’s Division of Swap Dealer and Intermediary Oversight (the “Division”) issued an interpretation and no-action relief letter (the “December letter”) pertaining to the definition of “commodity pool” and the commodity pool operator (“CPO”) registration requirements for certain securitization vehicles.  The letter builds on interpretive guidance (the “12-14 Letter”) released by the Division in October (discussed in the October 16, 2012 Financial Services Alert) that expressed the view of the Division that securitization vehicles meeting certain enumerated criteria should not be included within the definition of “commodity pool” and their operators should not be included within the definition of “commodity pool operator.”  The December letter consists of three main parts that (1) provide a variation on the conditions to relief available under the 12-14 Letter, (2) grant relief for certain securitization vehicles whose last issuance was before October 12, 2012 and (3) extend the CPO registration deadline for operators of securitization vehicles to March 13, 2013 and remind issuers that the Division continues to be open to discussions regarding other appropriate relief from the CPO registration requirements.

Alternative Conditions.  The December letter expresses the view of the Division that certain securitization vehicles may be properly excluded from the “commodity pool” definition even if they do not satisfy all the conditions enumerated in the 12-14 Letter.  The December letter states that, although the criteria enumerated in the 12-14 Letter included a requirement that the securitization vehicle is operated consistent with the conditions set forth in the SEC’s Regulation AB or Rule 3a-7 under the Investment Company Act of 1940, certain securitization vehicles that do not satisfy the operating or trading limitations included in Regulation AB or Rule 3a-7 may be excluded from the commodity pool definition if, among other things, they (1) satisfy the criterion with respect to the ownership of financial assets, (2) use swaps no more than contemplated by Regulation AB or Rule 3a-7, and (3) do not use swaps to create investment exposure.  The December letter then analyzes examples of asset backed commercial paper, collateralized debt obligations, repackaging vehicles, and covered bond transactions, in each case examining various hypothetical fact patterns and generally finding that whether such a vehicle would or would not be considered a commodity pool depends upon factors such as whether the investment is “essentially” in the financial assets of the vehicle or if the swaps provide a significant component of the investment. 

Pre-October 12, 2012 Issuers.  The December letter provides no-action relief to “any operator” of a securitization vehicle for failing to register as a commodity pool operator if (1) the issuer issued fixed income securities before October 12, 2012 that are backed by payments on or proceeds received in respect of cash or synthetic assets owned by the issuer, (2) the issuer has not and will not issue new securities on or after October 12, 2012, and (3) the issuer provides certain information to the CFTC upon request.

Deadline Extension. The December letter states that the Division will not recommend that the CFTC take enforcement action against the operator of a securitization vehicle that cannot avail itself of the relief described in the December letter or the 12-14 letter for failure to register as a commodity pool operator until March 31, 2013.  The December letter also echoes the 12-14 Letter in stating that the Division remains “open to discussions” with sponsors of securitization vehicles to determine whether such securitization vehicles would properly be considered a commodity pool and if other types of relief may be appropriate. 

The CFTC’s Division of Swap Dealer and Intermediary Oversight (the “Division”) has issued a no-action letter providing relief to business development companies (“BDCs”) subject to regulation under the Investment Company Act of 1940.  Although the letter expresses the Division’s view that BDCs are commodity pools that would be required to register with the CFTC in the absence of relief, the letter states that the Division will not recommend that the CFTC take enforcement action against the operator of a BDC if the BDC satisfies certain enumerated criteria, summarized as follows: 

• The BDC must have elected to be treated as a BDC under Section 54 of the Investment Company Act of 1940 and must continue to be regulated by the SEC as a BDC. 
• The BDC must not market itself as a commodity pool or otherwise as a vehicle for trading in the commodity futures, commodity options, or swaps markets. 
• Either (1) the BDC must use swaps, commodity futures or commodity options contracts for bona fide hedging purposes within the meaning and intent of certain CFTC regulations and must limit the aggregate initial margin and premiums required to establish positions outside of those regulations to five percent of the liquidation value of the BDC’s portfolio, calculated as provided in the letter, or (2) the aggregate net notional value of commodity futures, commodity options contracts, or swaps positions not used solely for bona fide hedging purposes must not exceed 100 percent of the liquidation value of the BDC’s portfolio. 

A BDC wishing to take advantage of this relief must file a claim to perfect the use of the relief by e-mailing certain information to the CFTC prior to December 31, 2012 (or, for a BDC that begins to operate after December 1, 2012, within 30 days after it begins to operate as a BDC).

The CFTC’s Division of Market Oversight issued a no-action relief letter that extends the date by which swap dealers must be in compliance with their swap data reporting obligations with respect to equity swaps, foreign exchange swaps, and other commodity swaps due to disruptions in testing and development of reporting systems caused by Hurricane Sandy.  The relief, which applies to all swap dealers, extends the compliance deadline to February 28, 2013 with respect to the real-time public reporting rules and the swap data recordkeeping and reporting requirements rules, and to March 30, 2013, with respect to the swap data recordkeeping and reporting requirement rules pertaining to historical swaps.

The International Organization of Securities Commissions (“IOSCO”) published final reports on securitization and asset-backed securities.  In its report entitled “Principles for Ongoing Disclosure of Asset Backed Securities,” IOSCO focuses on eleven principles intended to provide guidance to securities regulators developing or reviewing their regulatory regimes pertaining to ongoing disclosure with respect to asset-backed securities (“ABS”).  The Principles include:  (a) the provision of information to investors on a periodic basis; (b) the disclosure of material events in “event-based reports”; (c) the need for reports to investors to contain sufficient information to allow investors to perform their own independent due diligence; (d) the need for disclosure to be complete, clear, and not misleading; (e) the presentation of disclosure in a format that facilitates the analysis of information by investors; (f) the clear identification of the person or entity responsible for publishing the disclosure and the person or entity responsible for gathering the information; (g) timeliness of disclosure; (h) equal and simultaneous access to disclosure by all investors and market participants; (i) equivalent disclosure to be made promptly in all jurisdictions in which the securities are listed or admitted to trading; (j) the filing of ongoing reports with the relevant regulator; and (k) the storage of ongoing information to facilitate public access to it.

IOSCO also recently issued a report entitled “Global Developments in Securitisation Regulation.” Among other things, that report (1) assesses the current state of securitization in various markets throughout the world, (2) discusses “observations and findings” about regulatory and industry initiatives in areas such as risk retention and disclosure, and (3) proposes recommendations regarding incentive alignment and risk retention, transparency and standardization, and further issues to be considered.