Funds Talk: November 2017
Topics covered in this issue include:
SEC chairman emphasizes focus on individual accountability and cybersecurity as key themes in regulatory approach to financial markets.
In response to confusion created as the SEC and FINRA implemented their respective pay-to-play regulatory frameworks, the Division of Investment Management recently issued guidance regarding the potential for related enforcement actions against investment advisers.
After warning investors about the potential risks associated with digital currency offerings, the SEC launched an enforcement action against an allegedly fraudulent ICO, showing the regulator’s ongoing focus in this emerging sector.
The U.K.’s looming Brexit will have significant consequences for London-based asset managers and has prompted many to consider the complex option of relocation within the EU.
European NPLs have become an increasingly popular investment opportunity for hedge funds and investment banks. However, firms considering investing in European NPLs should be aware of the regulatory pressures surrounding such transactions.
SEC Officials Detail Future Enforcement Priorities
Speaking at a recent event hosted by the NYU School of Law, Securities and Exchange Commission (SEC) Chairman Jay Clayton outlined the regulator’s enforcement priorities for the remainder of 2017 and beyond.
Other SEC representatives participating in the panel discussion, titled “The Securities and Exchange Commission: Priorities Going Forward,” were Stephanie Avakian and Steven Peikin, co-directors of the SEC’s Division of Enforcement, along with Peter Driscoll, acting director of the SEC’s Office of Compliance Inspections and Examinations.
The SEC unveiled its 2017 Enforcement Priorities in January and Clayton hinted that investors should not expect any dramatic shift from those priorities released at the beginning of the year, which were written under the direction of former chair Mary Jo White.
“I’m very comfortable with the approach of the staff to our job in this regard,” Clayton said, adding that his personal priority areas revolved around the themes of individual accountability and cybersecurity.
“The securities industry has rewarded many people who work in it. It is an important industry that links our industrial sector to the everyday investor, and people should behave,” he said. “And if they don’t behave, it is important to focus on individual accountability.”
Cybersecurity and Initial Coin Offerings
Clayton stated that cybersecurity and cyber crimes present a significant and increasing risk to investors and the market in general, adding that enhanced disclosure could help to ameliorate that risk.
“I am not comfortable that the American investing public understands the substantial risks that we face systemically from cyber issues and I’d like to see better disclosure around that,” he said, adding that initial coin offerings (ICOs) will be a particular area of interest.
Avakian also highlighted the SEC’s focus on ICOs, while elaborating that the regulator will also be on the lookout for ensuring financial firms take proper measures to safeguard sensitive information and cyber-related disclosure failures.
Meanwhile, Driscoll highlighted a risk alert the Office of Compliance Inspections and Examinations recently published that detailed the level of cybersecurity preparedness it observed during its examinations at various firms, with many showing a failure to address vulnerabilities after they were discovered.
One of the main priorities the SEC highlighted in January was an increased focus on protecting retail investors. In response to a question as to how the SEC balances that objective with other enforcement priorities — such as violations under the Foreign Corrupt Practices Act (FCPA) — “in a world of limited resources, where more focus on one side inevitably will mean less on another,” Avakian noted that she “wouldn’t expect to see any pendulum swing” but that “it’s fair to say we are very focused on retail investors and things that affect retail investors — as I think the Commission’s always been.” She further noted that “these are often our most vulnerable, often our most unsophisticated market participants, so they deserve a really focused level of protection.” She also stated that she does not think that there is as “strict of a trade-off as folks think.”
Both Clayton and Peikin echoed the sentiment that the focus on retail investors would not reduce the SEC’s efforts in other areas, indicating that the regulator would continue to enforce the FCPA as robustly as it has in the past.
SEC Staff Offers Pay-To-Play Compliance Date Guidance for Capital Acquisition Brokers
The Staff of the Securities and Exchange Commission’s (SEC) Division of Investment Management (the Division) recently issued responses to several questions it has received regarding Rule 206(4)-5 of the Investment Advisers Act of 1940, better known as the pay-to-play rule (the SEC rule).
The Staff’s response addresses an ambiguous regulatory area created in recent years as both the SEC and registered national securities associations worked toward creating and implementing their respective pay-to-play rules. The SEC’s response provides assurance to investment advisers that they will not face an enforcement action as a result of this disparity, pending its remediation.
“Pay to play” describes the practice of investment advisers and other individuals making campaign contributions and related payments to elected officials and political candidates in the hopes of influencing how and where management contracts for public pension plan assets and similar government investment accounts are awarded. Adopted in 2010, the SEC rule includes prohibitions designed to preclude not only direct political contributions by investment advisers, but also other ways that advisers may engage in pay-to-play arrangements.
The Staff response covers a range of topics, including questions related to compliance dates; the definitions of a covered associate, government entity and official; third-party solicitors; and others. Most significantly, the response included new guidance regarding the compliance date for the pending ban on third-party solicitation for capital acquisition brokers (CABs).
Capital Acquisition Brokers
CABs are registered broker-dealers engaging in a limited range of activities including distribution and solicitation activities with government entities on behalf of investment advisers. The guidance addresses inquiries regarding the SEC rule’s prohibition on covered investment advisers paying third parties in order to solicit government business on their behalf, although the SEC rule does permit payments to a third party that is a “regulated person,” which is defined, in part, to include a registered broker or dealer that is itself subject to pay-to-play rules adopted by a registered national securities association.
This ban on third-party solicitation was originally set to come into effect on July 31, 2015. However, because both the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB) had not yet established their own pay-to-play rules at that time, the Division indicated it would not recommend enforcement action for such third-party transactions until those rules were established. Subsequently, FINRA rules 2030 and 4580 – establishing rules covering the activities of member firms engaged in the distribution or solicitation activities with government entities on behalf of investment advisers – were approved in 2016 and became effective on Aug. 20, 2017 (the FINRA pay-to-play rules). As a result, the SEC’s relief regarding such activities expired as the FINRA rules were in place.
Also in 2016, the SEC approved FINRA regulations that apply exclusively to firms that both meet the definition of a CAB and elect to be governed under these rules (collectively, the CAB rules). Under the CAB rules, CABs are subject to certain FINRA rules, but are not explicitly covered by the FINRA pay-to-play rules. Although FINRA filed a proposed rule change with the SEC on Aug. 18 to adopt CAB rules 203 and 458, which would apply the established FINRA pay-to-play rules to CABs, until any such amendments take effect CABs would remain outside the definition of a “regulated person.” As a result, an investment adviser and its covered associates would remain prohibited from providing payments to any CAB in order to solicit a government entity for investment advisory services. Therefore, the Staff was asked if it would recommend enforcement action to the SEC against an investment adviser or its covered associates under rule 206(4)-5(a)(2)(i) for the payment to any person that is a CAB to solicit a government entity for investment advisory services. In response, the Staff stated that the Division would not recommend enforcement action to the SEC “against an investment adviser or its covered associates under rule 206(4)-5(a)(2)(i) for payment to any person that is a CAB to solicit a government entity for investment advisory services on behalf of the investment adviser or its covered associates” until any rules subjecting CABs to the FINRA pay-to-play rules come into effect.
Court Freezes Assets of Defendants Who Offered Allegedly Fraudulent ICOs
On Sept. 29, 2017, the Securities and Exchange Commission (SEC) brought an emergency enforcement action against Maksim Zaslavskiy, REcoinGroup Foundation LLC (REcoin) and DRC World Inc. (also known as Diamond Reserve Club) (Diamond), alleging they defrauded investors in a pair of initial coin offerings (ICOs), in violation of the anti-fraud and registration provisions of the federal securities laws.
The SEC’s complaint alleged that the defendants sold unregistered securities and that the digital tokens or coins being offered did not actually exist, though the defendants raised at least $300,000 from hundreds of investors between July 2017 and the date of the complaint. The SEC further alleged that the defendants touted the REcoin ICO as “The First Ever Cryptocurrency Backed by Real Estate” and told investors they could expect significant returns from their investments (between 10-15% in the case of Diamond) when neither company had any real operations, and made other false and misleading statements regarding the defendants’ previous fundraisings and investment activities — representations that “recklessly disregarded” the reality. The SEC also alleged that Zaslavskiy attempted to circumvent the securities registration requirements by refashioning the sale of interests in Diamond as “memberships in a club” and the Diamond ICO as an “Initial Membership Offering.”
The U.S. District Court for the Eastern District of New York granted the SEC’s request to temporarily and preliminarily freeze the assets of the defendants. Its decision stated that Zaslavskiy remains a threat to cause “continued and additional harm to investors,” as he is launching or has already launched as many as 18 different websites to promote the sale of the fraudulent coins and continues to send frequent e-mails to investors about purchasing “tokens.” The SEC’s complaint seeks permanent injunctions and disgorgement plus interest and penalties. For Zaslavskiy, the SEC also seeks an officer-and-director bar and a bar from participating in any offering of digital securities.
The enforcement action came after the SEC’s Office of Investor Education and Advocacy issued an investor alert earlier in 2017 that noted the increasing prevalence of ICOs and the potential risks associated with the promises of high returns in the new investment space. Further, the SEC released an investigative report on July 25, 2017, in connection with DAO tokens, warning that “virtual” organizations’ offers and sales of digital assets may be subject to the requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934. While that report by the SEC does not indicate that all offerings by virtual organizations are securities, it puts the industry on notice that some virtual tokens may be securities. In finding that the DAO tokens were securities, the SEC applied the Howey test (from SEC v. W.J. Howey Co., 328 U.S. 293 1946) to conclude that the DAO tokens were investment contracts and, in turn, securities. Very simply, the Howey test requires that (1) there is an investment of money in a common enterprise, (2) the investors had a reasonable expectation of profit and (3) these profits are derived from the managerial efforts of others. Most recently, on Sep. 25, the SEC announced the creation of a new Cyber Unit that will focus on targeting cyber-related misconduct including those involving distributed ledger technology and initial coin offerings.
These public warnings and the establishment of a Cyber Unit, combined with this latest court action, demonstrate the SEC’s ongoing focus on digital currencies and their associated offerings. They demonstrate a clear pattern that ICOs and virtual organizations are firmly on the SEC’s radar and that, in the absence of a valid exemption, the regulator intends to exert its authority over such entities and hold them to the same regulatory standards as traditional securities transactions.
Industry participants can expect this trend to continue in the coming years as ICOs become increasingly common, and should ensure that their activities with respect to ICOs comply with all relevant securities laws in order to avoid similar regulatory attention.
Brexit and the Potential Relocation of Asset Management Services in Paris
The U.K. will exit the European Union on March 29, 2019, or at a later date agreed upon with the EU. On this date, the U.K. will likely become a third country vis-à-vis the EU and will need to have negotiated regulatory equivalences to access the single market through passporting rights for specific products or services.
U.K.-based asset managers, including key U.S. players managing EU portfolios from London, are therefore at risk of losing their access to clients located in the 27 other EU member states. Their right to operate across the EU is indeed established under, among others, MiFID and AIFMD passporting regimes, and it is not clear whether the U.K. will manage to negotiate new passporting rights for asset management and other financial services. In any case, movement of staff and transmission of data between the U.K. and the EU might get cumbersome, and clearing and settlement of euro-denominated transactions might be transferred to an EU member state.
While London is likely to keep its status as Europe’s main financial center, relocation of specific financial services can be expected, regardless of the passporting rights negotiated by the U.K. Financial services in the U.K. account for £30 billion in annual revenues, with asset management accounting for around £20 billion in annual revenue with £7 trillion in assets under management.
Paris as an Alternative Financial Center for Asset Managers
As the only European city on a par with London, Paris is home to the ESMA and five of the top 10 EU banks. It also benefits from a full financial ecosystem, proximity to high-profile clients, a deep pool of skilled professionals, good infrastructures and cheap office space.
Paris is already the leading asset management industry in continental Europe with more than 630 asset managers (among them, four asset managers are in the top 20 global ranking, and three global custodians are in the top 10 global ranking) and around €3.8 trillion in assets under management (i.e., 31% of the total assets managed in the EU27 and twice the size of Germany).
The Paris financial center also benefits from a high-quality regulatory environment and from efficient and responsive regulators. For example, funds authorization takes around 17 working days in France, against two to four months in Luxembourg. Finally, Euronext Paris launched a funds listing platform, “Euronext Fund Services”, on May 15, 2017.
Recent Efforts to Increase Paris’ Attractiveness
The perceived hurdles to relocation in Paris — a hostile tax environment, onerous employment laws and bureaucracy — are in the process of being overcome by various business-friendly reforms launched under French President Macron’s mandate. The measures, detailed by the prime minister in a speech in July 2017, are already implemented or in the course of being implemented.
- Cut to the corporate tax: The corporate tax will be cut from 33% to 25% before 2022.
- Rescission of the highest bracket of the payroll tax: Remunerations over €152,000 will be subject to a 13.5% payroll tax, compared to 20% as of today.
- Capital revenues taxation reform: The scope of the French wealth tax (ISF) will no longer apply on financial assets but will be limited to real estate assets. Saving interests and financial products will be subject to a 30% flat tax.
- Extension of the impatriés regime: The advantageous fiscal regime (28% rate) for workers moving or returning to France will apply for eight years instead of five as of today.
- Abolishment of the extension of the European tax on financial transactions to intraday transactions.
- Commitment of the government to fiscal stability and predictability.
Deregulation of the labor market
- Labor law reforms: Those reforms have been enacted by way of ordinance on Sept. 22, 2017. They provide employers with more flexibility in the hiring and firing of employees, notably by (i) shortening the delay to challenge a dismissal, (ii) capping unfair dismissal compensation granted by labor courts, (iii) broadening the legal definition of economic layoffs and (iv) giving priority to enterprise-level agreements over branch agreements.
- Easier firing of finance workers: “Risk taker” employees’ (e.g., traders’) bonuses will no longer be included in the calculation of unfair dismissal compensation granted by labor courts, which will lower the cost of firing high-paid finance employees.
Simplified regulatory and administrative framework
- Simplification of financial regulation: To avoid making financial regulation more burdensome in France than in other EU countries, the French government pledged not to add any provision not mandated by EU banking and financial regulations when transposing them into French law. Existing additional provisions from past transpositions might be repealed: Kramer Levin Paris is an active member of the Paris Europlace Committee in charge of identifying French “gold-plating” transpositions of EU Directives and adjusting the French legal framework accordingly.
- International, English law commercial court: An international commercial court will be set up in Paris for financial contracts and more generally cross-border business law disputes. The court will apply English law and the proceedings will be held in English.
- Fast-track authorization by the regulators: In September 2016, the French Autorité des Marchés Financiers launched AGiLITY, a welcoming program for financial institutions supervised by the English FCA that includes access to English-speaking assistants, a pre-authorization process of under two weeks and full authorization in under two months.
- “Welcome to Paris Region”: In order to minimize red tape, a hub for informing and accompanying companies wishing to relocate their activities in Paris has been set up as of the end of 2016.
- New international schools will open soon in Paris.
- CDG Express: Acceleration of the construction of the CDG Express line between CDG airport and Paris City Center and, more generally, modernization of the transportation facilities with the Grand Paris project.
View the Brexit and the Paris alternative infographic here .
Opportunities Related to European Non-Performing Loans
The outstanding amount of non-performing loans (NPLs) held by EU banks is estimated to be just over €1 trillion, or approximately $1.2 trillion.
These NPLs, which are loans in default for at least 90 days, are emerging as a key issue for European banks. With banking authorities pushing for disposal of NPLs, many EU banks are now looking to reduce their exposure while investors, including U.S. hedge funds (which are not subject to U.S. or EU prudential regulations), are eyeing opportunities for European NPL investments.
Regulatory Pressure on NPLs Disposal
Three considerations should boost NPLs sales by EU banks in the near future:
- European banking authorities are increasing their pressure on EU banks to reduce their exposure to NPLs. After an EBA study on 160 European banks completed in July 2016, the ECB published its final guidance to banks of NPLs on March 20, 2017. This guidance mandates banks with high NPL exposure to establish realistic, time-bound NPL recognition and disposal strategies. Indeed, NPL exposure contributes to banks’ profitability decline by requiring additional provisioning and capital constraints and affects their ability to finance the European economic growth.
- The new International Financial Reporting Standard (IFRS) 9, applicable as of Jan. 1, 2018, will oblige EU banks to significantly increase their depreciation of NPLs by valuing them on the basis of the expected losses, and no longer on the basis of the likelihood of a severe credit event as was the case so far. Moreover, the ECB will reportedly soon request EU banks to fully (i.e., 100%) depreciate loans newly qualified as NPLs, while NPLs are only subject to an average depreciation of 46.9% as of today on their balance sheets. Finally, the European Commission has recently announced it is working on an initiative designed to reduce current NPL levels and to prevent their future increase.
- Some U.S. hedge funds set up in 2013 will have the next year to draw down commitments from their investors, which, if not used, will be canceled.
The European NPL Market
At mid-2017, €42 billion of distressed portfolio trades have been completed in Europe and €87 billion are ongoing. UniCredit finalized a €17.7-billion Italian NPLs deal with Pimco and Fortress in July 2017, and similar large-scale deals by other banks are currently being negotiated. Hedge funds and investment banks have emerged as a key source of demand for EU NPLs.
Investors sometimes resort to securitization (mainly in the form of RMBSs) to finance their portfolio acquisition and enhance their returns, as Loan Star and Oaktree did with recently acquired Irish portfolios. The Financial Stability Review published by the ECB in May 2017 includes proposals to support NPL securitization. However, an exclusion of self-certified mortgage loans from portfolios eligible for securitization, which was recently included in the new EU draft STS securitization regulation, might harm the ability of investors to securitize NPLs after Jan. 1, 2019.
The Untapped French NPLs Market
The French market is characterized by a high stock of NPLs amounting to €147 billion, the second-highest absolute amount in the Eurozone behind the Italian market. BNP Paribas (€42 billion), Crédit Agricole (€30 billion), BPCE (€26 billion) and Société Générale (€25 billion) are the largest NPLs holders, while Crédit Foncier de France is reported to become a seller.
The French market is still relatively untapped. With an NPL ratio of 3.9% (the average ratio for the EU is 5.6% and exceeds 10% in some member states), the regulatory pressure for NPL disposal is indeed relatively low and banks have for now favored internal work-out solutions. However, as high-NPL banks are reaching the limits of their internal work-outs capacity, the situation is changing rapidly. The French NPL market is now expecting strong growth over the coming years, and Deloitte predicts that NPL sales in France will double by 2020 to reach at least €10 billion.
While the French market had only been addressed by a few players until now (including Cerberus with the support of its special servicer MCS), specialist NPL investors have started to put resources into the French market over the past few months, and foreign buyers, especially U.S. investors, have been more and more involved in NPL transactions since 2015.
Moreover, while sales had so far been almost exclusively focused on corporate and leasing loans, a €40-million consumer portfolio sale occurred during the first quarter of 2017, and two large mortgage NPLs sales are ongoing.
View the Opportunity in distress infographic here .