Insights from Winston & Strawn

Shadow Banking ­ “50 Shades of Grey” and Shape­shifting…

In the field of financial services regulation, you may be forgiven for not having recognized the stimulating connections here. The Federal Reserve’s Vice Chairman, Stanley Fischer, has urged regulators in the US and abroad to respond to regulatory gaps in order to “tame” the so­called shadow banking sector – i.e., the non­bank institutions that provide credit. The shadow banking sector encompasses hedge funds, broker dealers, mutual funds, exchange­traded funds, private equity funds, money market funds and repurchase agreements, as well as loans between individuals and pawn shops. They may often hold riskier assets that the banks have moved off their balance sheets. Quipped a former deputy governor of the Bank of England, “The financial services industry is a shape­shifter,” always seeking gaps in regulations, forcing regulators to be ever playing catch­up. Although the many reforms adopted have made the non­bank sector less vulnerable than it was before the 2007­2009 global financial crisis, the shadow banking sector’s jump to $75 trillion worldwide in 2013 – compared to just $5 trillion in the previous year – has caused the Financial Stability Board to state that this sector poses a systemic risk. Noting that the “bright lines” between banks and non­banks have disappeared, Cleveland Fed President Loretta Mester said we have instead “50 Shades of Grey.” “And,” she commented, “as you know with 50 Shades of Grey, it can be painful…”

In certain economies such as China and India, the high percentage of all business and individual transactions utilizing shadow banking raises the risk that those governments will not be able to assist in the event of a collapse since these entities ­ outside the regulated banking sector ­ lack access to protection such as deposit insurance and government bailout assistance. Open­ended funds, for example, often allow daily share redemptions which, in a panicked atmosphere, could have the same effect as a run on the bank. And in contrast to the banks, the shadow banking industry’s often smaller, less long­lived and well­established entities may have less reputational loss to fear in the event of a meltdown.

And yet, while calls for regulation of this area are understandable, the downside is also evident. The large banks have already retreated from certain activities, such as mortgage lending to households, partly in response to greater litigation, fines, and compliance costs, and bad publicity. Adopting regulations without a broad perspective on the overall impact of the rules is not in the nation’s, or the world’s, economic and societal interests, commented the SEC’s Chief Economist Mark Flannery: “If you regulate shadow banks, there may be less room for further evasion (of regulations), but there is also less room for innovation,” and he emphasized the need for policy makers to look beyond the impact on the regulated entities and focus on “which regulation is going to be effective for the society and the economy.”

Susan Berkwitt

Feature: Foreign Corrupt Practices Act

Last week, the Securities and Exchange Commission (“SEC”) announced its third Foreign Corrupt Practices Act (“FCPA”) enforcement action for 2015. Filed against FLIR Systems Inc., the settled administrative proceeding alleged that FLIR financed a “world tour” of personal travel for government officials in the Middle East who helped decide whether their countries would purchase FLIR products. FLIR earned more than $7 million in profits from sales influenced by these gifts and agreed to settle the charges by paying disgorgement of $7,534,000 and prejudgment interest of $970,584. Because FLIR self­reported the violations and cooperated in the investigation, the penalty assessed against it was $1 million. FLIR also agreed to report its FCPA compliance efforts to the SEC for the next two years. View the administrative order here.

This latest FCPA action illustrates what SEC Enforcement Director Andrew Ceresney recently told the House Capital Markets Subcommittee, that “pursuing violations of the FCPA remains a critical part of our enforcement efforts.” In his testimony Ceresney provided the Subcommittee with a brief overview of how the Enforcement Division’s specialized FCPA unit conducts its investigations, noting how SEC staff interacts with other U.S. agencies as well as foreign law enforcement and regulatory authorities. View the text of Ceresney’s prepared testimony here.

In a speech given in March, Ceresney specifically focused on FCPA enforcement in the pharmaceutical industry. He described the three types of misconduct the agency has seen in that industry: “Pay­to­Prescribe;” bribes to get drugs on the approved list or formulary; and bribes disguised as charitable contributions. Because bribes come in many shapes and sizes, the Commission has adopted a broad interpretation of what is proscribed by the FCPA. View the text of Ceresney remarks here.

Ceresney’s description of the attributes of an effective FCPA compliance program can be applied to all industries. Effective compliance programs not only possess compliance personnel, but also extensive policies and procedures, training, vendor reviews, due diligence on third­party agents, expense controls, escalation of red flags, and internal audits to review compliance. The benefits of self­reporting and cooperation were also explained. These include reduced charges and penalties and non­prosecution or deferred prosecution agreements in instances of outstanding cooperation. And, Ceresney warned, given the increased access the SEC has provided to whistleblowers, the possible consequences of failing to self­report have become particularly acute.

The SEC has a webpage dedicated to the FCPA. The website includes links to the FCPA’s recordkeeping and internal control provisions, SEC enforcement cases, and the SEC Division of Enforcement’s Enforcement Cooperation Program. It also includes a link to the “Resource Guide to the U.S. Foreign Corrupt Practices Act.” Jointly published by the SEC and the Department of Justice, the guide provides insights into SEC and Justice Department enforcement practices.

FINRA – Regulatory Matters at a Glance

Please click here to view a summary of the regulatory notices, rule filings, guidance and the like published by the Financial Industry Regulatory Authority (“FINRA”) during the previous month, Banking Agency Developments

OCC Mutual Savings Association Advisory Committee to Meet

The Office of the Comptroller of the Currency (“OCC”) will host a public meeting of the Mutual Savings Association Advisory Committee on April 28, 2015. OCC Press Release.

Small Bank Holding Company Policy Statement Expanded

On April 9th, the Federal Reserve Board issued a final rule to expand the applicability of its Small Bank Holding Company Policy Statement and also apply it to certain savings and loan holding companies. The policy statement facilitates the transfer of ownership of small community banks and savings associations by allowing their holding companies to operate with higher levels of debt than would normally be permitted. The final rule raises the asset threshold of the policy statement from $500 million to $1 billion in total consolidated assets. All firms must still meet certain qualitative requirements, including those pertaining to nonbanking activities, off­ balance sheet activities, and publicly­registered debt and equity. The final rule is effective 30 days after publication in the Federal Register. Federal Reserve Board Press Release.

OCC Bulletin on Regulatory Capital Rule

On April 6th, the OCC published a Bulletin concerning the guidance it issued along with the Federal Reserve Board and the Federal Deposit Insurance Corporation regarding the regulatory capital rule. Presented in the form of frequently asked questions and answers, the guidance discusses the agencies’ interpretations of the rule.

Banking Agencies to Hold Third Paperwork Reduction Act Meeting

The federal banking agencies will hold an outreach meeting on May 4, 2015, at the Federal Reserve Bank of Boston as part of their regulatory review under the Economic Growth and Regulatory Paperwork Reduction Act of 1996 (“EGRPRA”). The agencies also announced the expansion of the scope of the EGRPRA review to cover more recent regulations. At the Boston outreach meeting and in other venues, the agencies will take comment on all regulations that have been issued in final form up to the publication date of the last EGRPRA notice, which is expected by year end. See, e.g., FDIC Press Release; OCC Bulletin.

Securities and Exchange Commission

Regulatory Relief

No­Action Relief Granted to Fund of Funds

On April 3rd, the SEC’s Division of Investment Management granted Franklin Templeton Investments’ request for no­action relief from the limits in Section 12(d)(1)(A) of the Investment Company Act for a floating rate instruments fund of funds.

Other Developments

12b­1 Fees

On April 9th, Think Advisor summarized the remarks of Paula Drake, Chief Counsel of the SEC’s Office of Compliance Inspections and Examinations. SEC staff is looking at conflicts of interest in the areas of Rule 12b­1 fees, revenue sharing, and sub­transfer agency fees. In particular, the SEC is concerned about whether a fund’s board is being adequately informed regarding 12b­1 fee payments and whether 12b­1 fees are being used properly. 12b­1 Fees.

Investor Advisory Committee

On April 9th, the SEC’s Investor Advisory Committee met. Reuters summarized comments made during the meeting concerning the creation of a database that would allow consumers to more easily check the backgrounds of financial services providers. Database. In her opening remarks, SEC Chair Mary Jo White said that SEC staff are completing their initial review of the definition of “accredited investor,” that the Commission will act by May 6, 2015 on the tick size pilot, and that advanced discussions on the harmonization of a fiduciary duty standard and on third party examinations of investment advisers will be held. Additional SEC priorities for the year include completion of the Dodd­Frank Act compensation rulemakings and adoption of final crowdfunding rules. White Statement.

Investor Publication on Regulation SHO Published

On April 8th, the SEC’s Office of Investor Education and Advocacy published an updated online investor publication on short sales and Regulation SHO. Key Points About Regulation SHO.

The SEC’s Accounting Quality Model

On April 7th, Corporate Counsel described the SEC’s Accounting Quality Model, which analyzes an issuer’s financial submissions for irregularities. Accounting Quality.

Staff Announcements

The Director of the Office of Compliance Inspections and Examinations (“OCIE”), Andrew Bowden, will leave the SEC at the end of April to return to the private sector. Marc Wyatt will serve as OCIE Acting Director. The Associate Director of the Office of Analytics and Research in the Division of Trading and Markets, Gregg E. Berman, will leave the agency later this month.

Commodity Futures Trading Commission

Review of Foreign Board of Trade Application Deferred

On April 9th, Reuters reported the Commodity Futures Trading Commission (“CFTC”) has delayed its review of the London Metals Exchange’s application for registration as a foreign board of trade. Deferral.

No­Action Relief Granted to U.S. Subsidiaries of Canadian Entity

On March 31st, the CFTC’s Division of Swap Dealer and Intermediary Oversight advised it will not recommend enforcement action with respect to the use of wholly­owned United States subsidiaries by a Canadian company to participate in commodity pools organized and operated in the United States. The Canadian company is the real estate investment subsidiary of an entity formed by a Canadian province to invest assets of pension and insurance plans. The United States subsidiaries are formed for tax purposes, and neither the Canadian company nor any of its United States subsidiaries seeks or accepts United States investors or participants. CFTC Letter No. 15­22.

Federal Rules Effective Dates

April 2015 ­ June 2015

Commodity Futures Trading Commission

May 26, 2015             Residual Interest Deadline for Futures Commission Merchants. 80 FR 15507.

Federal Housing Finance Agency

April 10, 2015            Federal Home Loan Bank Capital Stock and Capital Plans. 80 FR 12753.

Federal Housing Finance Board

April 10, 2015            Federal Home Loan Bank Capital Stock and Capital Plans. 80 FR 12753.

Securities and Exchange Commissio

June 15, 2015            Nationally Recognized Statistical Rating Organizations. 79 FR 55077.

[This rule is effective November 14, 2014; except the amendments to Sec. 240.17g­3(a) (7) and (b)(2) and Form NRSRO, which are effective on January 1, 2015; and the amendments to Sec. 240.17g­2(a)(9), (b)(13) through (15), Sec. 240.17g­5(a)(3)(iii)(E), (c)(6) through (8), Sec. 240.17g­7(a) and (b), and Form ABS­15G, which are effective June 15, 2015. The addition of Sec. Sec. 240.15Ga­2, 240.17g­8, 240.17g­9, 240.17g­ 10, and Form ABS Due Diligence­15E are effective June 15, 2015.]

May 18, 2015             Regulation SBSR­Reporting and Dissemination of Security­Based Swap Information. 80 FR 14563.

Security­Based Swap Data Repository Registration, Duties, and Core Principles. 80 FR 14437.

Treasury Department

April 3, 2015              Department of the Treasury Acquisition Regulation; Technical Amendments. 80 FR 11595.

Exchanges and Self­Regulatory Organizations

Financial Industry Regulatory Authority

Information Notice Concerning the Securities Trader Qualification Examination

On March 31st, the Financial Industry Regulatory Authority (“FINRA”) advised that it intends to submit to the SEC a proposed rule change that would replace the Equity Trader registration category and qualification examination (Series 55) with a Securities Trader registration category and qualification examination (Series 57). FINRA will file the proposal in conjunction with the national securities exchanges’ filing of a proposed rule change to replace the Proprietary Trader qualification examination (Series 56) with the Securities Trader qualification examination (Series 57) in their respective registration rules. In anticipation of the proposed rule change, FINRA will conduct a job analysis survey to inform the development of the Series 57 qualification examination. FINRA Information Notice.

National Futures Association

EasyFile System Changes

On April 8th, the National Futures Association advised commodity pool operators (“CPO”) who have delegated investment management authority to another CPO in accordance with CFTC No­Action Letter 14­69 and/or CFTC No­Action Letter 14­126 of changes to NFA's EasyFile system. NFA Notice to Members I­15­13.


Principles­Based Approach to Misuse of Non­Public Information Proposed

On April 8th, the SEC provided notice of NYSE MKT’s proposed adoption of a principles­based approach to prohibit the misuse of material nonpublic information by Specialists and e­Specialists by deleting Rule 927.3NY and section (f) of Rule 927.5NY. Comments should be submitted within 21 days after publication in the Federal Register, which is expected during the week of April 13. SEC Release No. 34­74677.

Longer Period Designated for Consideration of Proposed Mid­Day Auction

On April 6th, the SEC designated May 24, 2015 as the date by which it will approve, disapprove, or institute disapproval proceedings regarding the New York Stock Exchange’s proposed adoption of new Rule 124 to conduct a daily single­priced auction at a specified time in lower­volume securities (“Midday Auction”) and to amend Rule 104 to codify the obligation of Designated Market Makers to facilitate the Midday Auction. SEC Release No. 34­74648.

Proposed Changes to Order Types and Modifiers

On April 3rd, the SEC provided notice of the New York Stock Exchange’s (“NYSE”) and NYSE MKT’s withdrawal of their individually proposed amendments to their respective rules governing order types and order modifiers. On April 8th, the SEC provided notice of NYSE’s and NYSE MKT’s individual submission of new proposals that would make their respective rules regarding order types and order modifiers clearer and easier to navigate. Neither proposal is intended to reflect changes to functionality. Comments on either proposal should be submitted within 21 days after publication in the Federal Register.


Codification of Ownership and Control Reporting Proposed

On April 8th, the SEC provided notice of OneChicago’s proposed adoption of new OCX Rule 516 which would require Clearing Members to submit to the Exchange, account information related to reportable positions in OneChicago Contracts. OneChicago currently requires such reporting, but has not previously codified this requirement in its Rulebook. Comments should be submitted within 21 days after publication in the Federal Register, which is expected during the week of April 13. SEC Release No. 34­74679.

Judicial Developments

Court Finds No Core in Big Apple’s Claims

On April 9th, the Eleventh Circuit affirmed the judgments entered in the SEC’s favor in a lawsuit against investor relations firm Big Apple Consulting and its executives. The SEC alleged that defendants made material misrepresentations and omissions while touting the stock of CyberKey Solutions, which falsely claimed to have a multi­million dollar government contract for encrypted flash drives. Appealing the judgments entered against them, defendants argued that under Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011), they could not be liable under Section 17(a)(2) of the Securities Act because they did not “make” the misleading statements. The Court, however, disagreed. It found that the language of Section 17(a)(2) encompasses a broader range of conduct than that in Section 10(b) of the Securities Exchange Act, which was the statute considered by the Supreme Court in Janus. Addressing the SEC’s aiding and abetting claim under Section 20(e) of the Securities and Exchange Act, the Court further held that the district court did not err when it found that severe recklessness was sufficient to constitute acting “knowingly” under Section 20(e). SEC v. Big Apple Consulting USA, Inc.

When the Worst Comes to Pass

On April 7th, the Tenth Circuit partially reinstated a class action securities fraud lawsuit brought against former executives of Delta Petroleum. Plaintiffs allege defendants made materially false and misleading statements as to why Opon International withdrew its planned $400 million investment in Delta’s core asset. The Tenth Circuit found that defendants’ statements were false and misleading because they were open to multiple interpretations whereas the actual reason for Opon’s withdrawal, the value of the assets, was not. Plaintiffs adequately alleged scienter because defendants were at least reckless in disregarding the risk that their statements were misleading. And the complaint contained adequate allegations of loss causation under a theory of “materialization of a concealed risk;” the risk that the asset was not marketable at $400 million materialized when Delta announced 16 months later that it could not find an investor. The significance of intervening events in that 16­month period is a question of fact which cannot be determined at the pleadings stage. Nakkhumpun v. Taylor.

Recklessness Suffices in Civil Insider Trading Case

On April 6th, Judge Rakoff of the U.S. District Court for the Southern District of New York denied defendants’ motions to dismiss a civil insider trading suit brought against them by the SEC even though the related criminal prosecution had been withdrawn. In doing so, Rakoff noted that while a person is guilty of criminal insider trading only if that person committed the offense "willfully," a person may be civilly liable if that person committed the offense recklessly. And under the facts alleged by the SEC here, the complaint adequately pleaded that defendants knew or recklessly disregarded that the source of the insider information received a personal benefit in disclosing information to the tippee and that the tipper in doing so breached a duty of trust and confidence to the owner of the information. Among other things, the Court noted, the SEC alleged specific facts showing that the tipper and tippee shared a close mutually dependent financial relationship and had a history of personal favors; the tipper expressed gratitude to the tippee and his satisfaction that the tippee benefitted from the insider information; and that defendants, remote tippees, knew of the relationship between the tipper and tippee. SEC v. Payton.

Former Big Law Partner’s 7­Year Sentence Affirmed

On April 3rd, the Ninth Circuit, addressing an issue of first impression, held that the district court properly applied the “Broker­Dealer” enhancement under U.S. Sentencing Guidelines and the “Special Skill” enhancement to David Tamman after he was convicted of being an accessory after the fact to crimes of mail fraud and unregulated offer and sale of securities. Tamman, a former partner in the Los Angeles office of a major law firm, was found to have knowingly prepared private placement memoranda containing material omissions and to have backdated and altered documents after the SEC and National Association of Securities Dealers opened investigations. The Court found that the Sentencing Guidelines commentary prohibiting simultaneous application of the Broker­Dealer and Special Skill enhancements did not apply when the Broker­Dealer enhancement pertained to a principal’s offense and the Special Skill enhancement to the defendant accessory’s offense. The Court further found that the loss inflicted by Tamman’s co­defendant’s crime was foreseeable despite Tamman’s status as an accessory to the crime. Similarly, the district court did not err in including victims of the co­ defendant’s crime, where those victims were reasonably foreseeable to Tamman. U.S. v. Tamman.

Industry News

Shifting Targets

On April 10th, Bloomberg discussed the latest target for those concerned about systemic risk, the possible systemic risks posed by clearinghouses. Shifting Targets.


On April 9th, the New York State Department of Financial Services updated its May 2014 report entitled, “Report on Cyber Security in the Banking Sector.” The update discusses the results of a survey it conducted last fall of 40 banking organizations about the management of their third­party service providers. According to DealBook, the Department is preparing recommended guidelines addressing banks’ relationships with third­party service providers. Guidelines.

IMF Asset Manager Study

On April 8th, the International Monetary Fund (“IMF”) published a study of the asset management industry. The study recognizes that the asset management industry is a valuable source of liquidity and that asset managers are less likely to default because end investors bear losses and gains from the funds’ assets. Nonetheless the study calls for greater transparency, in the form of more data, and oversight. It specifically notes the risks posed by long­term or illiquid bond funds which permit daily redemptions, incentive problems between managers and end­users, and herding ­ the tendency for portfolio managers to trade in the same manner as their peers. IMF Press Release.

Carried Interest

On April 3rd, The Hill published an article on private equity funds written by Eileen Appelbaum, senior economist at the Center for Economic and Policy Research. Applebaum called for the disclosure of private equity fund’s carried interest, the performance fees paid to private equity funds. Carried Interest. On April 7th, Victor Fleischer, a University of San Diego law professor, endorsed Appelbaum’s suggestion in a blog post for DealBook. Endorsement.