Insights from Winston & Strawn
I recently had the opportunity to invest in individual shortterm real estate loans. Having devoted my current liquidity to a real estate investment of a different type (my own first home), I declined to the opportunity. Nevertheless, I became intrigued by this recent startup company that provides the platform for these investments. The company’s model is to provide an entirely digital platform where an individual investor can choose to buy in to a particular loan product that is administered, documented and diligenced by the company. If this business model sounds familiar, that is because the company in question is a participant in the increasingly popular “crowdfunding” space. This firm would fall under the subcategory of “crowdlending” (somewhat like a smallscale syndicated credit facility). At an aggregate invested amount of approximately $10B as of 2014 (see here), the U.S. crowdfunding market remains yet a drop in the capital markets bucket. With all of the focus on the regulation of large financial institutions (see our discussion of yet another round of large bank stress tests below), it is easy to overlook this comparatively tiny marketplace.
Regulators, however, are not overlooking crowdfunding. State regulators, in particular, are increasingly devoting time and attention to this “democratic” form of financing, both in an attempt to encourage it and to control it (see Colorado; California; New Mexico and Massachusetts as examples). Thus far, crowdfunders have been spared much of the federal oversight that has become so familiar to institutional lenders by limiting their investor base to “accredited investors” (a highly restricted pool of individuals who attain certain financial status ($1M of assets or $200K of income in two consecutive years (single $300K if joint)) and are, presumably, more sophisticated and financially protected than the average consumer (see here and here). Although, as my personal experience illustrates, marketing by crowdfunders is not limited to known accredited investors, participation in the investments offered by such firms often remains restricted to relatively highnetworth individuals. From a legal perspective, this structure avoids registration with the SEC (and all of the attendant headaches), because each investment is exempted as a private placement (Reg D offering) (although caveat that this very brief explanation is not legal advice as to whether regulators will treat these structures as being exempt).
The relatively lean regulatory oversight may be one reason why the industry is attractive to entrepreneurs. The attractiveness to individual investors is a mixture of (a) the returns (the opportunity that I reviewed offered 6%9% annualized – far better than comparative interestbearing deposit accounts of virtually any tenor), (b) the low barrier to entry (most loans were under $400K in the aggregate, so an individual investor participating in the pool could play with a much smaller hand), (c) short investment life (68 months until payoff) and (d) the ability to directly participate in investments rather than turn one’s money over to an investment manager. With those returns, minimum amounts, payoff timelines and individualized investment opportunities, crowdfunding may eventually present a legitimate competitor to traditional wealthmanagement outlets such as money center banks and managed investment vehicles – but only if the market is opened up beyond accredited investors.
There is an ongoing trend towards regulation of the crowdfunding market which includes, in many cases, an opening of the market to nonaccredited investors (see here and here and here), but thus far, these regulations are primarily being implemented at the state level, introducing a set of twentyfirst century blue sky laws in the absence of comprehensive federal regulation (see here). The Federal government attempted in 2012, by way of the JOBS Act, to provide a regulatory framework (see here), but the Securities and Exchange Commission, who has been tasked with formulating implementing rules, thus far has only proposed, but not finalized, those rules (see here).
Will blue sky laws (and the eventually inevitable comprehensive federal regulation) put a damper on the attractions of these “democratic” investments (returns, accessibility and payoff timeline)? Yes, almost certainly. However, some form of the platform is likely to withstand the rigors of both the markets and the bureaucrats. Traditional market players, who are chasing new opportunities in the face of mature and tightening financial markets, agree (see here, here and here).
As the market for, and the market power of, crowdsourcing platforms continues to grow, we at Winston & Strawn will continue to assist our clients in navigating the evolving regulatory landscape and achieving their business goals in the face of the changing field of play.
Feature: Developments in Europe
In what many considered to be a victory for London’s financial markets, the General Court of the European Union (“E.U.”) announced that the European Central Bank (“ECB”) lacked the authority to require central counterparties (“CCP”) settling eurodenominated transactions be incorporated in the euro area.
In 2011, the ECB published the “Eurosystem Oversight Policy Framework,” which described the Eurosystem’s role in the oversight of “payment, clearing and settlement systems.” That Framework included the ECB’s conclusion that infrastructures, such as CCPs, that settle eurodenominated transactions should be legally incorporated in the euro area with full managerial and operational control and responsibility over all core functions exercised from within that area. The United Kingdom (“U.K.”) brought an action before the General Court challenging the ECB’s authority to impose a location requirement on CCPs. Agreeing with the U.K., the General Court found that the E.U. would need to amend the ECB’s enabling statute before the ECB could adopt such a location requirement.
London’s sense of victory, however, may be shortlived. On March 4th, the same date on which the General Court announced its decision, the European Banking Authority (“EBA”) began a threemonth consultation on remuneration policies that would formalize previously issued expectations. Among other things, the Guidelines limit bonuses to double an executive’s fixed salary. Last October, the EBA found that the U.K’s remuneration practices misclassified “allowances” which could be used to increase the fixed component of remuneration, leading to violations of the bonus cap.
The Wall Street Journal further noted that unlike the previously issued nonbinding expectations, the EBA’s proposed remuneration Guidelines would apply to small banks and some asset managers. Comments on the Guidelines should be submitted on or before June 4, 2015.
On March 4th, the EBA also published a discussion paper on the implementation of Internal Ratings Based (“IRB”) models. The consultation focuses on improving the comparability of IRB models across institutions. Comments should be submitted on or before May 5, 2015.
Last month, the European Commission opened the debate on the formation of a European Capital Markets Union. It published a Green Paper which identifies key principles which should underpin a Capital Markets Union. They include the removal of barriers to crossborder investment and the adoption of a single rulebook for financial services. The Green Paper also seeks views on overcoming obstacles to the efficient functioning of markets in the medium to longterm, including how to reduce the costs of establishing and marketing investment funds across the E.U.; how to further develop venture capital and private equity; and the treatment of covered bonds, with a specific consultation in 2015 on a possible E.U. framework.
Consultations on the E.U.’s Prospectus Directive and on Securitizations were launched in conjunction with the Green Paper. The Prospectus Directive considers ways to simplify the information included in prospectuses, examines when a prospectus is necessary, and how the prospectus approval process might be streamlined.
The consultation on Securitizations represents a first step towards a possible initiative on creating an E.U. framework for simple, transparent and standardized securitization. Comments on the Green Paper, Prospectus Directive, or Securitizations should be submitted on or before May 13, 2015.
Banking Agency Developments
Revised “DepositRelated Credit” Booklet Released
On March 6th, the Office of the Comptroller of the Currency (“OCC”) issued the "DepositRelated Credit" booklet of the Comptroller’s Handbook. This booklet replaces and clarifies the "DepositRelated Consumer Credit" booklet issued February 11, 2015. The "DepositRelated Credit" booklet references relevant supervisory guidance and includes examination procedures that OCC examiners use to assess a bank’s depositrelated credit products and services. OCC Bulletin.
On March 5th, the Federal Reserve Board released the results of its stress tests of the largest U.S. banks. All 31 of the banks tested passed both the severely adverse scenario and the adverse scenario. Federal Reserve Board Press Release. Reuters discussed the concerns U.S. banks have voiced over how the Federal Reserve conducts its annual stress tests. The banks believe that the tests fail to adequately consider the diversity in the types of loans the banks make. Test Anxiety. On March 3rd, the Treasury Department’s Office of Financial Research published a working paper on whether regulatory stress tests have become predictable and therefore less informative. The paper concludes that more information can be gleaned from the stress tests if greater diversity is employed in the scenarios. Predictable Outcome.
Treasury Department Developments
FinCEN and OCC Fine Pennsylvania Bank for Violations of the Bank Secrecy Act
On February 27th, the Financial Crimes Enforcement Network (“FinCEN”) and the Office of the Comptroller of the Currency (“OCC”) assessed a total of $1.5 million in civil money penalties against the First National Community Bank of Dunmore, Pennsylvania (“FNCB”) for willfully violating the Bank Secrecy Act. FNBC admitted that it failed to file suspicious activity reports on transactions involving illicit proceeds from a judicial corruption scheme for which Michael Conahan and Mark Ciavarella, both former Pennsylvania judges, were ultimately convicted. Conahan and Ciavarella misused their positions as judges to profit from, among other things, sending thousands of juveniles to detention facilities in which they had a financial interest. Conahan was on FNCB’s board of directors and controlled accounts at FNBC through which he processed the proceeds of his illegal activity. Despite several red flags indicating suspicious activity, FNCB did not file a single suspicious activity report related to these accounts until after Conahan’s first guilty plea in 2009. FinCEN Press Release; OCC Press Release.
Securities and Exchange Commission
Commissioner Stein Addresses Stanford Rock Center for Corporate Governance
On March 5th, Commissioner Kara M. Stein discussed how the Securities and Exchange Commission (“SEC”) supports innovative capital formation, including the agency’s consideration of pooling classes of crowdfunding investors and regional exchanges. Stein Remarks.
A Taxing Matter
On March 5th, Bloomberg highlighted how the SEC is requiring issuers to more clearly explain their foreign tax payments. Taxing Matter.
SEC Advisory Committee on Small and Emerging Companies
On March 4th, the SEC’s Advisory Committee on Small and Emerging Companies met.
- In his remarks at the meeting Commissioner Daniel M. Gallagher provided his vision for Venture Exchanges, secondary market trading venues for small company shares. Venture Exchanges would be national securities exchanges exempt from state laws and with periodic reporting and listing requirements tailored for small businesses. They would be exempt from the National Market System rules and Unlisted Trading Privileges requirements, and would be free to structure trading however they see fit. Not only would these principles create liquidity in Regulation A+ shares, they could be extended to those shares currently traded overthecounter.
- Commissioner Luis A. Aguilar offered cautionary words concerning Venture Exchanges, suggesting that prior to their creation, an examination of why earlier forms of these exchanges, such as the American Stock Exchange’s Emerging Company Marketplace, failed. These exchanges’ tendency to experience high volatility and low liquidity must be studied and considered. In addition to market structure issues, investor protection concerns must also be addressed, particularly Exchange Act Rule 15c211, and its so called “piggyback” exception.
- The Advisory Committee (the “Committee”) submitted recommendations for the revision of the “accredited investor” definition. Because it finds that the current definition works, without exposing investors to substantial fraud risks, changes should expand, not contract, the current pool of accredited investors. The Committee therefore recommends including within the definition of accredited investor those investors who meet a sophistication test, regardless of income or net worth. Instead of attempting to protect investors by raising the accredited investor thresholds or excluding certain asset classes from the calculation to determine accredited investor, the Committee recommends that the SEC focus on enhanced enforcement efforts and increased investor education.
- Annemarie Tierney of SecondMarket Holdings, Inc. gave a presentation on secondary trading developments.
- David Weild IV of Weild & Co. and IssuWorks gave a presentation on the need for Venture Exchanges.
- Vincent Molinari of GATE Global Impact gave a presentation on market infrastructure for private and unregistered securities.
- The North American Securities Administrators Association gave a presentation on its multistate coordinated review program.
On March 4th, the SEC posted a list of alternative trading systems with effective Form ATS registrations as of March 1, 2015.
Enforcement Director Addresses Pharmaceutical Compliance Conference
On March 3rd, Andrew Ceresney, SEC Director, Division of Enforcement, discussed the enforcement of the Foreign Corrupt Practices Act (“FCPA”) across the pharmaceutical industry and disclosure and accounting issues facing the industry. Ceresney emphasized the importance of compliance programs and the benefits of self reporting and cooperation. Ceresney Remarks.
On March 2nd, the SEC announced it awarded a whistleblower payout of approximately $500,000 to a former company officer who reported information about a securities fraud resulting in an enforcement action with sanctions exceeding $1 million. Generally, officers, directors, trustees or partners who learn about a fraud through another employee are not entitled to a whistleblower award. However, an officer may be eligible for a whistleblower award if he or she reports the information to the SEC more than onehundred twenty (120) days after other responsible compliance personnel possessed the information and did not adequately address the issue. This is the first SEC whistleblower award to an officer under these circumstances. SEC Press Release.
Tangled Web of Regulations
On March 2nd, Commissioner Daniel M. Gallagher, speaking at a banking conference, expressed his concern about the number and aggregate impact of regulations that have been imposed on U.S. financial services firms since the enactment of the DoddFrank Act. He presented a diagram of the rules adopted since July 2010 affecting U.S. financial services holding companies. Gallagher Statement. After the conference Gallagher spoke to reporters about his concerns for the corporate bond market. According to Bloomberg, Gallagher expressed frustration over the failure of the SEC and other regulators to plan for possible contingencies in the event corporate bond investors flee the market when interest rates rise. Warning.
Fee Rate Advisory
On February 27th, the SEC announced that no midyear adjustment to the Section 31 fee rate for fiscal year 2015 is required. Fee Rate Advisory.
Commodity Futures Trading Commission
Staff of the Commodity Futures Trading Commission (“CFTC”) will hold a public roundtable on Cybersecurity and System Safeguards Testing on March 18, 2015. The roundtable will review system safeguards testing requirements, including potential enhancements to further strengthen the resilience of futures exchanges, clearing organizations, and swap data repositories. CFTC Press Release.
CPO Annual Report
The CFTC’s Division of Swap Dealer and Intermediary Oversight (“DSIO”) published previously granted exemptive requests separately submitted by three commodity pool operators (“CPO”) who sought relief from the requirement that the financial statements in the respective pool’s annual report be audited. See CFTC Letter No. 1506; CFTC Letter No. 1507; CFTC Letter No. 1508. DSIO also granted the request of a fourth CPO who sought permission to file an annual report for the three commodity pools it managed for the period from their inception of trading, September 2, 2014, to December 31, 2015. The pool participants signed subscription documents, acknowledging the terms of the Pools’ offering memorandum, which included the CPO’s intent to file and distribute a 16month Annual Report for the Pools’ first fiscal year. CFTC Letter No. 1509.
On March 6th, Value Walk summarized a recent CFTC staff study on the effect volatility trading has on the underlying asset price. Volatile Effect.
Federal Rules Effective Dates
March 2014 May 2015
Federal Deposit Insurance Corporation
March 2, 2015 Transferred OTS Regulations Regarding Possession by Conservators and Receivers for Federal and State Savings Associations. 80 FR 5015.
Removal of Transferred OTS Regulations Regarding Rules of Practice and Procedure and Amendments to FDIC Rules and Regulations. 80 FR 5009.
Department of the Treasury
April 3, 2015 Department of the Treasury Acquisition Regulation; Technical Amendments. 80 FR 11595.
March 13, 2015 Documentation Related to Goods Imported From U.S. Insular Possessions. 80 FR 7537.
March 10, 2015 Government Securities Act Regulations: Large Position Reporting Rules. 79 FR 73407.
March 8, 2015 Extension of Import Restrictions Imposed on Certain Categories of Archaeological Material From the PreHispanic Cultures of the Republic of El Salvador. 80 FR 12080.
Exchanges and Self-Regulatory Organizations
Fixed Income Clearing Corporation
Amendments to FICC Default Rules Approved
On March 2nd, the Securities and Exchange Commission (“SEC”) approved the Fixed Income Clearing Corporation’s (“FICC”) proposed amendment of the clearing rules of the Government Securities Division and of the MortgageBacked Securities Division concerning a default by FICC. The FICC Default Rules make explicit the closeout netting of obligations between FICC and its clearing members in the event that FICC becomes insolvent or defaults on its obligations to its clearing members. The amendments will align the FICC’s Default Rules more closely with those of its peer central counterparties and facilitate the participation of market participants, including registered investment companies, in FICC’s services by providing members with further legal certainty regarding their rights with respect to a default by FICC. SEC Release No. 3474411.
National Futures Association
Changes to NFA’s EasyFile Registration Documentation Submission System
On March 5th the National Futures Association (“NFA”) advised that beginning March 9, 2015, swap dealers (“SD”) and major swap participants (“MSP”) will be able to view in NFA’s EasyFile Registration Documentation Submission System all NFA written communications regarding the submissions SDs and MSPs make with the CFTC regarding their compliance with CFTC Section 4s. NFA Notice I1511.
New York Stock Exchange (“NYSE”)
Price Protection for Market Maker Quotes
On March 4th, the Securities and Exchange Commission (“SEC”) approved NYSE Arca’s and NYSE MKT’s separately proposed amendment of their respective exchange rules to provide price protection for Market Maker quotes.
Deletion of Additional Order Types Proposed
On March 3rd, the SEC provided notice of NYSE Arca’s proposed elimination of additional order type combinations, the deletion of related rule text, and the restructuring of the remaining rule text in NYSE Arca Equities Rule 7.31. Comments should be submitted within twentyone (21) days after publication in the Federal Register, which is expected during the week of March 9. SEC Release No. 3474415.
Amendments to Late Filer Rule Approved
On March 2nd, the SEC approved the NYSE’s proposed amendment of Section 802.01E of its Listed Company Manual to: (i) expand the rule to impose a maximum period within which a company must file a late quarterly report on Form 10Q in order to maintain its listing, and (ii) clarify the NYSE’s treatment of companies whose annual or quarterly reports are defective at the time of filing or become defective at some subsequent date. SEC Release No. 3474412.
The Options Clearing Corporation
Disapproval Proceedings Instituted for Proposed Clearing Fund Amendment
On March 2nd, the Securities and Exchange Commission (“SEC”) instituted proceedings to determine whether to approve or disapprove The Options Clearing Corporation’s (“OCC”) proposed amendment of Rule 1001(a) to permit OCC to collect additional financial resources from its clearing members by increasing the size of its clearing fund on an intramonth basis when OCC determines that such action should be taken to ensure the clearing fund has sufficient resources to protect OCC against potential losses under simulated default scenarios. SEC Release No. 3474406.
FDIC Bound by PreReceivership Asset Contracts
On March 4th, a divided Ninth Circuit panel affirmed a district court’s judgment finding that the Federal Deposit Insurance Corporatoin (“FDIC”), as receiver for a failed bank, breached the terms of a prereceivership asset contract. Professional Business Bank (“PBB”) sold to First Heritage a fifty percent (50%) participation interest in a commercial loan. The participation agreement prohibited First Heritage from transferring that interest without PBB’s prior approval. After First Heritage failed the FDIC, as receiver, sold the commercial loan interest to a third party without PBB’s prior consent and PBB sued for breach of contract. Rejecting the FDIC’s defense, the Ninth Circuit held that Section 1821(d)(2)(G)(i)(II) of the Financial Institutions Reform, Recovery and Enforcement Act does not immunize the FDIC from breach of prereceivership contract claims. Bank of Manhattan, N.A. v. FDIC.
OSHA Publishes Whistleblower Procedural Rules
On March 5th, the Occupational Safety and Health Administration (“OSHA”) published the final rules implementing the SarbanesOxley Act’s whistleblower protection provisions as amended by the DoddFrank Act. The rule establishes the final procedures and time frames for the handling of retaliation complaints under SarbanesOxley, including procedures and time frames for employee complaints to OSHA, investigations by OSHA, appeals of OSHA determinations to an administrative law judge (“ALJ”) for a hearing de novo, hearings by ALJs, review of ALJ decisions by the Administrative Review Board, and judicial review of the Secretary of Labor’s final decision. The new rules are effective immediately. 80 FR 11865. See also Law360 (subscription required).
Global Regulators Seek Comment on NonBank SIFI Proposal
On March 4th, the Financial Stability Board and the International Organization of Securities Commissions published for comment “Assessment Methodologies for Identifying NonBank NonInsurer Global Systemically Important Financial Institutions.” The proposed methodologies aim to identify nonbank noninsurer financial entities whose distress or disorderly failure would cause significant disruption to the wider financial system and economic activity at the global level. Detailed sectorspecific methodologies include nearfinal methodologies for finance companies and market intermediaries and a revised proposal on sectorspecific methodologies for asset management entities. The latter comprises a revised methodology for investment funds (including hedge funds) and a new proposed methodology for asset managers. Comments should be submitted on or before May 29, 2015. FSB Press Release.
A Modest Proposal
On March 4th, the American Banker published a critique of the Financial Stability Board’s total lossabsorbing capacity proposal. A Modest Proposal.
U.K. Regulators Investigating Bank of England MoneyMarket Auctions
On March 4th, the Financial Times reported the U.K. Serious Fraud Office is investigating whether officials at the Bank of England manipulated liquidity auctions held in late 2007 and early 2008 at a time when the interbank lending markets were becoming illiquid. Serious Fraud.
MakerTaker Bill Proposed
On March 3rd, Representative Stephen F. Lynch introduced H.R. 1216, the “MakerTaker Conflict of Interest Reform Act of 2015.” The bill would require the Securities and Exchange Commission (“SEC”) to conduct a pilot program to assess the impact of an alternative to the makertaker pricing model in which rebates or payments are paid to brokers in order to attract trades to particular stock exchanges. Lynch Press Release.
On March 2nd, Reuters quoted Federal Deposit Insurance Corporation Vice Chair Thomas M. Hoenig as saying he disagrees with Commodity Futures Trading Commission Chair Timothy Massad’s comments regarding banking leverage ratios. Massad questioned the leverage ratios saying he feared stricter requirements would cause traders to trade overthecounter. Regulatory Division.
Agencies Provide Volcker Rule Guidance
On February 27th, federal financial regulators jointly issued updated guidance on the Volcker rule, the provision of the DoddFrank Act which prohibits proprietary trading by banks. The guidance discusses the application of marketing restrictions to the activities of a foreign banking entity that is seeking to rely on a covered fund exemption. Volcker Rule Guidance.