Financial Law Blog

Updates on Banking Law, Investment Management Law, Securities Law, Commodities/Derivatives Law

FRB approves application by First Citizens BancShares to increase non-controlling interest in Carter Bank & Trust

The Federal Reserve Board yesterday approved an application by First Citizens BancShares to increase its ownership interest in Carter Bank & Trust from 4.9 percent to 9.0 percent of voting shares.

The BHC Act requires BHCs to request approval in order to directly or indirectly acquire more than 5% of a bank’s voting shares. In connection with the application, First Citizens made enforceable commitments (“passivity commitments”) to the Fed in order to show that it would not exercise a controlling influence over Carter Bank & Trust.

Furthermore, non-controlling interests in directly competing depository institutions may raise competitive issues under the BHC Act. Because of substantial overlap in some markets, First Citizens has also made enforceable commitments to not acquire any confidential or nonpublic financial information about Carter Bank & Trust.

Governor Tarullo discusses regulatory agenda regarding community banks, enhanced prudential standards, and U.S. branches of FBOs

Governor Tarullo delivered a speech on Friday outlining his views on a number of items on the Board’s upcoming regulatory agenda including U.S. branches of FBOs, Enhanced Prudential Standards, and regulation of community banks.

U.S. branches of FBOs — capital and liquidity

The Board will “take another look at” the capital and liquidity positions of large U.S. branches of some foreign banks:

“The actual consolidated capital positions of some such banks can be difficult for us to discern when the bank uses internal models to compute its required regulatory capital. It is critical to ensure that large U.S. branches of foreign banks do not create financial instability in the United States if their parents’ global positions come under stress.”

$50 billion Enhanced Prudential Standards cutoff — potential increase

Gov. Tarullo “would raise the threshold for enhanced prudential standards from its current $50 billion level, perhaps to $100 billion.”

Regulation of banks under $10 billion — exemption from certain rules, reduction in number of compliance exams and exercises

  • Gov. Tarullo “would entirely exempt” banks under $10 billion “from some regulations, such as the Volcker rule and the incentive compensation rule.”
  • “[T]he burden of these rules for small banks is often less in the substantive constraints they impose on bank activities than in the compliance costs they impose. Even with efforts by banking agencies to streamline implementing regulations for smaller banks, the relatively scarce compliance resources of those banks must still be directed towards assuring that no changes in substantive activities are needed and possibly documenting their compliance.”

  • Although efforts to simplify capital rules for small banks are “worthwhile,” banks may get more benefit from regulatory efforts to reduce the number of rules that apply to them and “the number of separate compliance exams and exercises.”
  • “[T]he smaller the bank, the greater the likelihood that a potential disconnect between costs and benefits of regulation is rooted in the disproportionate costs of exams, audits, and reporting.”

PIMCO settles SEC enforcement action for misleading disclosures about sources of fund performance

PIMCO agreed yesterday to pay $19.8 million to settle enforcement action by the SEC for misleading disclosures about sources of fund performance and defects in PIMCO’s fair value process.

PIMCO was able to outperform benchmarks for a new ETF by buying “odd lot” private label MBS bonds for the fund and marking them using “round lot” prices. Odd lots in that market, as opposed to round lots, are those bonds with lower face value. During the relevant period odd lots in that market traded at a “significant discount” to round lots. PIMCO bought odd lots for the fund but used values for round lots from its pricing vendor to mark these purchases. This increased the fund’s stated performance and NAV.

PIMCO’s investor-facing “Monthly Commentaries,” however, did not explain that this strategy was the reason for the fund’s performance and instead seemed to attribute performance to the private label MBS sector. The fund’s annual report, which was prepared by PIMCO, suffered from the same defect. These disclosures triggered investor-facing antifraud Rule 206(4)-8. PIMCO was also found to have violated ’40 Act, Section 34(b) because it was “responsible for the inclusion of” misleading statements in the fund’s annual report. The incorrect valuation of fund assets triggered another ’40 Act violation — SEC found PIMCO to have caused the fund’s violations of Rule 22c-1 since the fund executed transactions in its redeemable securities at prices based on an overstated NAV.

PIMCO’s pricing process was also found to violate Rule 206(4)-7: “By vesting the responsibility with its traders for determining when to report to PIMCO’s Pricing Committee any price that did not reasonably reflect market value without sufficient objective checks or guidance for elevating pricing issues to the Pricing Committee or Valuation Committee, PIMCO’s pricing policy was not reasonably designed to prevent valuation-related violations.”

FRB proposes changes to CCAR and stress testing rule; Governor Tarullo outlines next steps

The Federal Reserve Board this Monday proposed changes to CCAR and stress testing rules for the 2017 cycle. Governor Tarullo on the same day delivered a speech outlining significant changes to the programs to be proposed in early 2017.

Key changes to be made to the CCAR program in 2017 (proposed rule)

  • The proposal exempts “large and noncomplex firms” from the qualitative component of CCAR. Large and noncomplex firms are those with assets above $50 billion but under $250 billion, on-balance sheet foreign exposure under $10 billion, and nonbank assets under $75 billion.
  • The proposal narrows the de minimis exception to the limitation on distributions in the capital plan rule.

Key changes to stress testing and CCAR programs after 2017 (to be proposed in early 2017)

    1. Stress Capital Buffer
  • Introduces a firm-specific “stress capital buffer,” (SCB) which would be set to the maximum decline in a firm’s CET1 capital ratio under the severely adverse scenario of the supervisory stress test before including planned capital distributions. It would have a floor of 2.5%.
  • The SCB for each firm would be recalculated after each year’s stress test. A capital plan under which the firm would fall into the buffer under the stress test’s baseline projections would not be approved.
  • Any GSIB capital surcharge, as well as any countercyclical capital buffer, would be added to the SCB (along with the 4.5% Basel III minimum CET1 ratio) to arrive at the total CET1 capital ratio required to be maintained after any distributions.
  • 2. Potential Modeling Changes
  • May assume that planned dividends will continue to be paid out under stress — but only for one year — while planned share repurchases will be “reduced”
  • May assume that balance sheets and risk-weighted assets remain constant over the severely adverse scenario horizon
  • May make changes in the unemployment rate less severe during downturns
  • May tie hypothesized path of house prices to disposable personal income
  • May incorporate funding shocks, liquidity shocks, and spillovers from the default of common counterparties into models
  • 3. Public Disclosures
  • Public disclosures will include more details on components of projected net revenues of program participants

CFTC settles enforcement action against VTB for inter-affiliate futures executed as block trades on an exchange

The CFTC on Monday settled enforcement action against VTB for inter-affiliate futures executed as block trades on an exchange. VTB entered into forex futures with a subsidiary (VTB Capital) via block trades on the CME. The subsidiary (a U.K. bank) then offset this currency exposure via the OTC cross-currency swap market. In other words, VTB purchased forex exposure through a subsidiary booking entity. As the CFTC found, this was done because the booking entity was able to receive more favorable pricing than the parent. The CFTC found that the block trade in this transaction constituted a fictitious sale violative of Section 4c(a) of the Commodity Exchange Act.

Institutions always book derivative transactions to whichever affiliate is most advantageous. Regardless of which affiliate entity needs the exposure or hedge, the derivative will still be booked through the booking entity. The exposure will then be offloaded to the affiliate that needed it (via a mirrored inter-affiliate transaction). This is normal practice for large institutions. For example, the CFTC’s recent final rule regarding cross-border application of margin requirements as well as the swaps push-out provision for banks in Dodd-Frank (which was subsequently repealed in substance) are examples of the CFTC and Congress grappling with this practice in other contexts. In some contexts, the CFTC and Staff recognize this practice as sufficiently worthwhile as to remove regulatory barriers to it — for example, in the CFTC’s clearing requirement exemption for inter-affiliate swaps and in the Staff’s no-action letters for centralized treasury affiliates (Letter 13-22 was amended by Letter 14-144).

In 2014 the CFTC settled enforcement action against RBC for taking futures positions opposite its subsidiaries via block trades on the OneChicago exchange. The consent order found that those transactions were “designed, in part, to profit from stock loan businesses, to fund one subsidiary, to optimize capital for another subsidiary, and to achieve certain tax benefits.” Since the fictitious sale doctrine has a long history of being applied to trades made for a tax benefit, one might have thought tax benefit was driving the RBC enforcement action. After the VTB settlement, however, it appears that the CFTC may view all inter-affiliate block trades on an exchange as fictitious sales.

Wells Fargo to pay $185 million in penalties to CFPB, OCC and Los Angeles for sales practices and risk management failures

Yesterday the OCC assessed a $35 million civil money penalty against Wells Fargo Bank, N.A. for risk management failures and retail sales practices. The CFPB assessed a $100 million penalty. The City Attorney of Los Angeles, Mike Feuer, whose 2015 lawsuit appears to have triggered the federal investigations, assessed a $50 million penalty in settlement in state court. The OCC found that Wells Fargo’s employee “incentive compensation program and plans … fostered … unsafe or unsound sales practices.” Specifically, thousands of Wells Fargo employees opened roughly 1.5 million deposit accounts and applied for roughly 565,000 credit card accounts for consumers, all of which may not have been authorized by the consumers. While the CFPB’s action focused on the underlying sales practices, the OCC’s action, as would be expected, focused on Wells Fargo’s risk management system.

What went wrong at Wells Fargo through the lens of the OCC’s Risk Management System (3 Lines of Defense) requirements

Frontline Units
  • “The Bank’s Community Bank Group failed to adequately oversee sales practices and failed to adequately test and monitor branch employee sales practices.”
Independent Risk Management
  • “The Bank lacked an Enterprise-Wide Sales Practices Oversight Program and thus failed to provide sufficient oversight to prevent and detect the unsafe or unsound sales practices”
  • “The Bank lacked a comprehensive customer complaint monitoring process that impeded the Bank’s ability to … assess customer complaint activity across the Bank … [and] analyze and understand the potential sales practices risk.”
Internal Audit
  • “audit coverage was inadequate because it failed to include in its scope an enterprise-wide view of the Bank’s sales practices.”

RBC settles SEC enforcement action for false and misleading statements in fairness presentation

The SEC last week settled enforcement action against RBC for false and misleading statements in a fairness presentation regarding the sale of a public company.

RBC was the sell-side financial adviser to a listed company in connection with its sale to Warburg Pincus. RBC’s fairness presentation to the company’s Board incorrectly described company EBITDA figures as analyst “consensus projections.” This lowered the company’s valuation, because in fact analysts would have at least added back $6.3 million of one-time expenses. In related shareholder litigation, the Court of Chancery found that “RBC knew that the Board was uninformed … but failed to disclose the relevant information to further its own opportunity to close a deal, get paid its contingent fee, and receive additional and far greater fees for buy-side financing work.” As the court observed, “On Saturday morning, the ‘consensus’ precedent transaction range was $13.31 to $19.15. On Saturday afternoon, it was $8.19 to $16.71, entirely below the deal price.” The final offer made by Warburg Pincus was $17.25.

RBC’s figures were subsequently used in the company’s proxy statement. Consequently, RBC was found to have caused the company’s violation of Exchange Act rule 14a-9, the general antifraud rule for proxies.

Apollo to pay $52.7 million for failure to adequately disclose right to accelerate monitoring fees (and other violations)

Apollo agreed to pay $52.7 million on Tuesday to settle enforcement action by the SEC for failure to disclose to investors that it may accelerate monitoring fees paid by portfolio companies, along with other violations. While Apollo did disclose that it “may receive monitoring fees,” the SEC found that Apollo failed to adequately disclose that it “may accelerate future monitoring fees upon termination of the monitoring agreements.” When monitoring fees were accelerated with respect to a portfolio company (following an IPO or sale), Apollo did disclose the amount accelerated after the fact. However, the right to accelerate was not disclosed to LPs prior to commitments of capital (i.e., in fund documents). This type of nondisclosure is viewed as a breach of fiduciary duty for an investment adviser, which in turn is viewed as a violation of the antifraud provisions of the Advisers Act.

Apollo joins private equity advisers Blackstone ($39 million) and KKR ($30 million) which had settled SEC enforcement actions for fiduciary duty breaches in 2015. Apollo is at least the ninth private equity adviser to be subject to SEC enforcement action since statutory exclusions relied upon by private fund advisers were narrowed by Dodd-Frank. SEC Staff noted that the enforcement program with respect to private equity fund advisers has so far focused on three broad areas: (1) advisers that receive undisclosed fees and expenses; (2) advisers that impermissibly shift and misallocate expenses; and (3) advisers that fail to adequately disclose conflicts of interests, including conflicts arising from fee and expense issues.

When margin posted on swaps is not excluded from net capital

Assets “not readily convertible into cash” are excluded in calculating net capital for a broker-dealer. SEC Division of Trading and Markets Staff last week took a no-action position that margin collateral posted by a broker-dealer to a DCO for a cleared swap need not be excluded in calculating net capital. Furthermore, even if the swap is not cleared, the initial margin need not be excluded if certain requirements are met. Variation margin on a non-cleared swap, however, must be excluded.

SEC brings enforcement action for whistleblower award waivers in employee agreements

The SEC this week settled an enforcement action for whistleblower award waivers in employee agreements.

Health Net Inc employee agreements waived the employees’ rights to any whistleblower award to which they may be entitled under the Exchange Act. The SEC found that by including such provisions the firm “directly targeted the SEC’s whistleblower program by removing the critically important financial incentives that are intended to encourage persons to communicate directly with the Commission staff about possible securities law violations.” In so doing, the firm violated Exchange Act Rule 21F-17, which prohibits impeding communication with the SEC about possible securities law violations.

This enforcement action follows last week’s enforcement action for confidentiality provisions without a whistleblower carveout in employee agreements. It is at least the fourth action this year against listed companies for impeding potential whistleblowers through provisions in employee agreements.

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