US REGULATORS CLARIFY APPLICATION OF VOLCKER RULE’S “SOLELY OUTSIDE THE UNITED STATES” COVERED FUND EXEMPTION The Volcker Rule prohibits US Banks, bank holding companies, and foreign banks with a US presence (banking entities) from having an ownership interest in, or sponsoring, certain covered funds. The prohibition does not apply, however, to a banking entity that acquires or retains an ownership interest in, or sponsors, a covered fund “solely outside of the United States” (the SOTUS exemption). The SOTUS exemption applies if: ■ The banking entity is not organised or directly or indirectly controlled by a banking entity organised under US law (a foreign banking entity); ■ The investment or sponsorship is made pursuant to Section 4(c)(9) of the Bank Holding Company Act (BHC Act); ■ The investment or sponsorship occurs solely outside the US; and ■ No ownership interest in the covered fund is offered for sale or sold to a US resident. For purposes of the SOTUS exemption, an investment or sponsorship is made pursuant to Section 4(c)(9) of the BHC Act if the entity meets the requirements to be a qualifying foreign banking organization under the Federal Reserve’s Regulation K. If the banking entity is not a foreign banking organization, it satisfies the requirement if it meets two of the following criteria: (a) total assets held outside the US exceed total assets held in the US; (b) total revenue from business outside the US exceeds total US revenue; or (c) total net income from business outside the US exceeds total net US income. With regard to the third requirement, an investment or sponsorship occurs solely outside the US if (a) the banking entity – including its personnel – making the decision to invest in or sponsor the fund is not located in the US or organised under US law; (b) the investment or sponsorship is not accounted for as principal on a consolidated basis by a branch or affiliate located in the US or organised under US law; and (c) no financing for the investment is provided, directly or indirectly, by any branch or affiliate that is located in the US or organised under US law. With regard to the fourth requirement, the regulations implementing the Volcker Rule clarify that an ownership interest is not offered for sale or sold to a US resident if it is sold pursuant to an offering that does not target US residents (the “marketing restriction”). What remained unclear under the implementing regulations, however, was whether the marketing restriction applied only to the marketing and sales activities of the foreign banking entity looking to take advantage of the SOTUS exemption or to all covered funds. The latter approach would mean that a covered fund offered and sold by an unrelated third-party would not be eligible for the SOTUS exemption if it had any US investors. On February 27, 2015, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Commodity Futures Trading Commission (collectively, the Agencies) updated their Volcker Rule guidance to answer this question. The guidance clarifies that the Agencies interpret the marketing restriction to apply only when the covered fund is offered by the foreign banking entity seeking to take advantage of the SOTUS exemption, or its affiliates. The foreign banking entity may rely on the SOTUS exemption to invest in a covered fund, even without meeting the marketing restriction, so long as: ■ neither the foreign banking entity nor its affiliates sponsor the covered fund or participate in the offer or sale of ownership interests, for example by acting as the fund’s investment manager, investment adviser, commodity pool operator or commodity trading advisor; and ■ the foreign banking entity otherwise meets the requirements of the SOTUS exemption. Although it is somewhat inconsistent with the text of the rule, this interpretation allows a foreign banking entity to invest in covered funds alongside US investors, as long as it, or an affiliate, does not participate in the offer or sale of the covered fund. In clarifying the marketing restriction, the Agencies referred to the preamble of the final regulations implementing the Volcker Rule, which states that the marketing restriction served to limit the SOTUS exemption so that it “does not advantage foreign banking 26 | Exchange – International Newsletter entities relative to US banking entities with respect to providing their covered fund services in the US by prohibiting the offer or sale of ownership interests in related covered funds to residents of the US.” If the marketing restriction were applied to third-party activities, the Agencies explained, the SOTUS exemption may not be available, even though the risks and activities of a foreign banking entity’s investment in a covered fund occurred solely outside the US. Please contact Jeffrey.Hare@dlapiper.com for further information. US AGENCY FOR CONSUMER FINANCIAL PROTECTION TO CONSIDER RULEMAKING TO LIMIT ARBITRATION IN CONSUMER FINANCIAL SERVICES CONTRACTS The Consumer Financial Protection Bureau (the CFPB) 2015 Arbitration Study, released on March 10, 2015, lays the groundwork for rule-making to broadly restrict the use of arbitration provisions – including class-action waivers – in consumer financial services contracts. The CFPB’s Study arises under the Dodd-Frank Wall Street Reform and Consumer Protection Act’s requirement that the CFPB prepare and submit to Congress a report on the use of pre-dispute arbitration clauses in consumer financial contracts. Three years in the making, this newly released Study foreshadows a seismic change for any company that operates a retail-banking unit or – more broadly – any business that offers or provides to consumers a financial product or service through a contract that includes arbitration clauses, including but not limited to agreements for credit cards, checking accounts or debit cards, auto loans, prepaid cards, payday loans and retail-installment contracts. In the credit card industry alone, the Study estimates that contracts containing such clauses could bind at least 80 million Americans. The CFPB’s broad authority under the Dodd-Frank Act to promulgate rules governing arbitration provisions and the express statutory requirement that any rules ought to comport with the findings of the CFPB’s own Study – combined with the content of the Study itself – show that a rule making to prohibit or otherwise restrict the use of pre-dispute arbitration provisions is on the horizon. Never before has a federal regulator proposed rules that would make it unlawful to force consumers to go to arbitration, and the Study signals that this may happen vigorously. This represents a sea change in the ability of companies to resolve consumer disputes by arbitration. While the immediate effect of this Study and the CFPB’s follow-on rule making will impact banks and more traditional financial services companies, the ultimate effect may spill over into many other consumer contracts. The Study and future rule making should be viewed as the beginning of efforts to significantly restrict both the use of arbitration provisions and class-action waivers in most consumer contracts even when the affected business is not directly involved in the provision of financial products to consumers. What is the purpose of the Study? While arbitration clauses have long been used to resolve business-to-business contractual disputes, they began to appear frequently in consumer contracts only within the last two decades. Counsel in-house and at outside firms are well aware of the Federal Arbitration Act (FAA) and its gravitas as reiterated in the Supreme Court’s 2011 landmark decision in AT&T Mobility LLC v. Concepcion, 131 S. Ct. 179 (2011), holding that state laws deeming class-action waivers in arbitration agreements unenforceable under certain conditions are pre-empted by the FAA such that the state must enforce arbitration agreements. It is against this backdrop that the CFPB released the Study – the first ever of its kind – in conjunction with a field hearing and comments by Director Cordray regarding consumer arbitration provisions. In announcing the Study, Director Cordray explained that, while the Study does not cover arbitration agreements in commercial settings, the Study finds them to be problematic in a consumer setting. The reasoning for this determination comports with the stance of the CFPB underlying all of its consumer education efforts to date and CFPB’s enforcement actions, which have secured more than $5.3 billion in consumer relief since the CFPB’s inception: where uneven bargaining powers may exist www.dlapiper.com | 27 between a consumer plaintiff and a corporate defendant in purchasing or using consumer financial services, the goal of consumer protection includes an obligation to help level the playing field for consumers. The Dodd-Frank Act authorises the CFPB to address this issue in the context of arbitration agreements. Section 1028 therein not only mandated the Study but also provided that the CFPB “by regulation, may prohibit or impose conditions or limitations on the use of” arbitration clauses in consumer financial contracts if the CFPB finds that a prohibition or limitation on their use “is in the public interest and for the protection of consumers” and the findings in such a rule are “consistent with the study” performed by the CFPB. Given the release of the Study, the CFPB is now well along in the process of addressing consumer arbitration provisions. What did the Study conclude? The findings of the Study are numerous, but it reached certain core conclusions that will form a basis for future efforts to restrict the use of arbitration and class-action waiver provisions in consumer arbitration agreements. Among these conclusions, the Study determined that: ■ Consumer arbitration clauses are prevalent; credit card issuers representing more than half of all credit card debt have arbitration clauses in their consumer contracts ■ Consumers are sometimes afforded an opportunity to opt out of arbitration clauses, but they generally are unaware of this option or do not exercise it ■ Individual consumers are more likely to bring a lawsuit in court than to pursue a dispute in an arbitration proceeding, although arbitration proceedings conclude more rapidly than most court actions ■ Although class action litigation resulted in changes to the consumer financial market that includes tangible (monetary relief) and intangible (changes in corporate behavior) benefits, the private sector may not be doing enough to stem potentially unfair practices, and further regulation is needed ■ Arbitration clauses are effective for eliminating class actions; for instance, when credit card issuers with an arbitration clause were sued in a class action, the issuers invoked arbitration clauses to dismiss the class action nearly 66 percent of the time ■ When comparing samples of consumer accounts for companies that dropped their arbitration clauses versus those for companies that continued to use arbitration clauses, no evidence existed of either (i) a price increase to consumers or (ii) a reduced access to credit for consumers when arbitration provisions were deleted, suggesting that arguments about the business costs of foreclosing arbitration are overstated ■ Most consumers are unaware of or confused about arbitration provisions; among consumers who reported knowing what an arbitration provision was, 75 percent did not know that they were subject to an arbitration clause; also, of consumers who were subject to arbitration clause and reported knowing what a class action was, nearly 50 percent of such consumers believed that they could still participate in a class action, reflecting their lack of understanding of the effects of an arbitration agreement ■ While assessing the overlap between private class actions and public enforcement actions in the context of consumer financial litigation, there was no overlapping private class action complaint in 88 percent of the enforcement actions; similarly, there was no overlapping public enforcement action case in related public enforcement actions 68 percent of the time, again underscoring that many aspects of consumer financial services disputes are not addressed by the private sector ■ Where overlapping activity did exist, the Study found that public enforcement activity was preceded by private activity 71 percent of the time; by contrast, private class action complaints were preceded by public enforcement activity only 36 percent of the time. The Study illuminates point-by-point each of the CFPB’s justifications for a future rule making that would dramatically alter the landscape in the consumer financial services context through restricting mandatory consumer arbitration. Here are links to the report and fact sheet. 28 | Exchange – International Newsletter What can businesses expect from future rule making efforts by the CFPB? ■ CFPB rule making to restrict arbitration in consumer financial services contracts: The CFPB will spare no expense or effort in future rule making to limit arbitration and will do so aggressively. In many ways, arbitration clauses strike at the heart of the reason why the CFPB exists. Given the consumer complaints reviewed in the Study, it is apparent that the CFPB seeks to respect dual objectives in carrying out its mission: a commitment to the market and to consumers. The Study seems to show that the CFPB believes that arbitration clauses for consumers are contracts of adhesion, involving no bargaining and an offering of provisions on a take-it-or-leave-it basis. Even if servicing errors, billing errors and other back-office functions cannot be made unlawful per se because consumers in the free market can choose the products they want, the arbitration provision is anathema to the CFPB. It is – based on the Study’s research – not a result of free-market bargaining and wipes away whatever last-ditch solution customers might have to remedy mistreatment in the private market: the assumptions that individual actors have agency to act and may pursue self-help mechanism in the courts if the contract is not performed to satisfaction are evaporated with arbitration clauses. The CFPB likely will conclude that arbitration clauses (or at least “no-class arbitration” provisions) have a very limited place – or no place at all – in consumer financial services contracts. If this is the ultimate result of the CFBP’s rule making efforts, almost all consumer financial services disputes will need to be resolved in court rather than by arbitration or arbitration tribunals will see greater attempts by consumers to proceed on a class basis. ■ The CFPB may rely on unfairness to eliminate or restrict consumer arbitration provisions: The Study’s findings foreshadow a possible intention of the CFPB to regulate consumer arbitration clauses through the legal doctrine of unfairness. The three elements under CFPB and Federal Trade Commission (FTC) jurisprudence to demonstrate an act or practice is unfair are that (i) the practice was likely to cause substantial harm to consumers; (ii) where such harm could not be reasonably avoided by consumers; and (iii) the practice had no countervailing benefit to consumers or competition. By reporting that arbitration clauses are in standard-form contracts and that consumers are unaware of their actual effect, the Study sets the stage for the CFPB to decide that consumers are unable to reasonably avoid the harm flowing from purportedly injurious provisions when they are unable to bargain them away or even intellectually appreciate their significance. Similarly, the Study’s assertion that companies that dropped arbitration clauses offered products that did not increase financial harm to consumers or restrict consumers’ access to credit is telling. This finding elucidates the CFPB’s likely intent to lay groundwork in rule making for finding that the practice of inserting arbitration clauses in consumer contracts does not have a genuine countervailing benefit to consumers, meeting element (iii) of an unfairness claim. Accordingly, companies should expect to see early movements in the initial rulemaking process by the CFPB to entertain a potential rule that restricts or prohibits arbitration clauses through the Unfairness prohibition in Sections 1036(a) and 1031(a) of the Dodd-Frank Act. ■ Private class actions are not sufficient to address the issue: Although the industry and commentators have opined on the harm that elimination of mandatory arbitration will cause through higher costs from frivolous class action litigation, in the calculus of the CFPB, it is not a zero-sum game. The externalities imposed by class action lawyers’ conduct who may act based on financial incentives are considered to be unfortunate downfalls of the legal system for consumer financial protection, which the CFPB likely considers to be vastly offset by the benefits achieved from class action litigation. The CFPB has implicitly admitted in its Study that (1) enforcement programs, even its own, are no silver bullet for identifying and redressing harms that the CFPB believes are inflicted on consumers and (2) private class action litigation (versus a government enforcement action) is more likely to be filed first in these matters. Thus, despite the disproportionately high www.dlapiper.com | 29 incidence of private litigation that could arise solely from plaintiffs’ attorneys’ profit motivations, the CFPB may view a single class action success as important for consumers and society. For these reasons, the legitimate arguments regarding the flaws of the class action system are likely to fall on deaf ears at the CFPB. ■ More litigation is to be expected: If arbitration clauses are prohibited or restricted by the CFPB, businesses will see a marked increase in the amount of litigation asserted by consumers under many consumer financial protection laws, including the Electronic Fund Transfer Act, the Equal Credit Opportunity Act, the Fair Debt Collection Practice Act, the Fair Credit Billing Act, the Fair Credit Reporting Act, the Homeowner Protection Act of 1998, the Real Estate Settlement Procedures Act, the Truth in Savings Act, the Truth in Lending Act, the Credit Repair Organization Act, and the Telephone Consumer Protection Act, among others. Conclusion While the Study reports a wealth of empirical information, ultimately it will be used to justify the CFPB’s future conduct in upcoming rulemaking that is likely to greatly limit or eliminate arbitration provisions or class-action waivers in consumer financial services contracts. Resulting restrictions in the availability of consumer arbitration provisions will spill over into other consumer contracts. Businesses can mitigate these coming risks by using the time before the rule making to make thoughtful comments to the CFPB and to assess their dispute-resolution provisions and their business practices and procedures. Please contact Jenny.Lee@dlapiper.com for further information. COMMERZBANK FINED $1.45 BILLION FOR AML AND SANCTIONS FAILINGS Commerzbank AG (Commerzbank) has agreed to pay various United States authorities US$1.45 billion and to take a number of remedial actions, including the dismissal of four employees, after a large number of sanctions and AML regulation violations. A summary of Commerzbank’s breaches and the penalties imposed on Commerzbank is set out below. The facts are set out in more detail in a consent order dated 12 March 2015 entered into between The New York State Department of Financial Services (Department) and Commerzbank. Structural and Procedural Deficiencies in Commerzbank’s AML Compliance Programme Commerzbank’s New York Branch (New York Branch) maintained correspondent accounts for Commerzbank’s foreign branches. However the New York Branch did not have access to due diligence information about customers of these foreign branches and hence could not conduct AML monitoring. Foreign branches often transmitted payments to the New York Branch using non-transparent SWIFT payment messages that did not disclose the identity of the remitter or beneficiary. As a result of not having access to all of the relevant information about transactions, the New York Branch’s compliance procedures were ineffective and fewer alerts or red flags were raised than would have been if all of the relevant information had been shared. Even when alerts or red flags were raised in respect of transactions from foreign branches, the New York Branch compliance staff did not have direct access to the customer information necessary to investigate the alerts or red flags and had to request such information directly from the relevant foreign branch or Commerzbank’s Frankfurt office. Responses to such requests often took many months or were inadequate, which prevented the New York Branch from investigating alerts properly and led to alert backlogs. On a number of occasions after information had not been provided from foreign offices, New York Branch employees carried out their own inadequate searches of the internet and public databases and subsequently closed off alerts. There were instances where compliance staff in the New York Branch attempted to strengthen transaction monitoring filters by adding the names of certain high-risk clients to the filters, but were prevented from doing so by staff at the Frankfurt office. 30 | Exchange – International Newsletter Alteration of Transaction Monitoring System to Reduce Number of Alerts Until 2010, the thresholds of the transaction monitoring system were set based on a desire not to produce too many alerts. In 2011 a compliance staff member was asked by two senior compliance employees to reduce the thresholds in order to reduce the number of alerts generated. Facilitation of Fraud by the Olympus Corporation Between the late 1990s and around 2011, the Olympus Corporation (Olympus) perpetually committed account fraud in order to conceal hundreds of millions of dollars in losses from its auditors and investors. This fraud was carried out through several Commerzbank group companies and branches including the New York Branch. The New York Branch facilitated transactions totalling more than US$1.6 billion that supported or were related to Olympus’ fraud, most of which did not trigger alerts in the New York Branch’s transaction monitoring system. However, two large transactions in 2010 did raise alerts in the New York Branch. When responding to a request by the New York Branch for information on these transactions, personnel in the Singapore office did not relay any concerns about Olympus. This was despite personnel employed by the Singapore office having identified the same two transactions as suspicious and having broader concerns about Olympus in respect of its structure and transactions.