Insights from Winston & Strawn

In response to an EU Commission request, the European Securities and Markets Authority (“ESMA”) issued on April 11 its key principles for a European framework on loan origination by Alternative Investment Funds (“AIF”).

As of today, loan origination by funds has been allowed and framed by most of the EU Member States in past years, including in France (as summarized in the ESMA Opinion’s Annex). Indeed, one of the aims of such a movement was to offer businesses new funding opportunities while banks were restrained in their capacity to grant traditional loans due to the economic crisis in Europe and the stricter prudential rules that were applied to them after 2008—and access to capital market can be tough for small or medium enterprises (“SME”).

Therefore, the EU Commission has intended, while determining its Action Plan on Building a Capital Markets Union, to contemplate how regulations could be harmonized in order to facilitate cross-borders funds operation while ensuring appropriate regulation from an investor protection and financial stability perspective. Following this Action Plan issued on September 30, 2015, the Commission asked ESMA to provide input as to the key issues on which the Consultation that will be led by the Commission in the second quarter of 2016 could focus.

In this context, ESMA outlines elements that could form part of a harmonized European framework on loan origination—either through a legislative proposal or by way of an ESMA instrument that would supplement the Alternative Investment Funds Management Directive (“AIFMD”). The ESMA opinion strictly contemplates what it considers to be loan origination activities, which is defined as situations where an investment fund provides credit, while acting as a sole or a primary lender, excluding therefore loan participation or loan restructuring activities. Thus, in its opinion, ESMA:

  • Recommends that the Consultation discusses whether authorization of loan originating funds and/or their managers is deemed necessary and whether there is merit in establishing additional requirements that exceed those already contained in AIFMD;
  • Considers that loan originating funds shall be set up as closed-ended vehicles, with no redemption rights (exceptions should be assessed in the Consultation);
  • Recommends that Consultation discusses whether such funds should be opened to retail investors, with regards to the specific risks they imply;
  • Establishes a framework for loan originating AIFs and their managers that contains rules to mitigate risks arising from liquidity and maturity transformation, as well as risks related to imprudent lending;
  • Recommends that the Consultation discusses the opportunity to set in place leverage limits, stress tests obligations, and new reporting requirements;
  • Makes recommendations regarding diversification, eligible investments and eligible debtors (loan to individuals, consumers, financial institutions, collective investment schemes, AIF manager, and related parties should be prohibited, and certain borrowing purposes should also be forbidden); and
  • Recommends that the Consultation discusses the need for possible mitigants to address the systemic risk.

To be complete, it must be noted that loan origination by AIFs is already possible in the context of specific AIF vehicles, such as EuVECA, EuSEF, and ELTIF. The ESMA opinion does not cover such vehicles.

On a general point of view, the success of such harmonized regulation will depend on the adoption of rules reasonable with regards, on one hand, to the specificities of a fund’s organization and activities—which fundamentally differ from those of credit organizations—in order to make loan origination activities competitive for funds; and, on another hand, the necessity to frame such activities in order to protect funds’ investors’ interests.

Feature: FCA Eyes Reforms to Investment Banks’ Cross-Selling Practices and the IPO Process

On April 13th, the UK Financial Conduct Authority (“FCA”) released a report containing the interim findings of its investment and corporate banking market study. The FCA began investigating investment and corporate banking practices in May 2015 following its review of wholesale sector competition, which noted potential concerns about competition in the investment and corporate banking sector. The FCA’s interim report, which focuses on the primary market activities of investment and corporate banks, identifies several areas of concern in banks’ market practices, especially related to cross-subsidies and the initial public offering (“IPO”) process.

The report found that many investment banks offer corporate broking and lending to their customers at below cost or at a low rate of return, but expect to generate profits by winning the customers’ future business for transactions involving debt capital markets, equity capital markets, and mergers and acquisitions. The FCA’s analysis shows that investment banks are successful in cross-subsidizing their broking and lending services with business from primary market transactions. Nearly two-thirds of roles in the primary market transactions the FCA examined went to banks that had existing relationships with the client during the two years prior to the transaction. And the FCA found that the exchange of low cost banking services for participation in lucrative primary market transactions went beyond a “commercial expectation”: many larger banks include contractual clauses that prevent clients from using the services of other banks in future transactions. The FCA fears that this practice harms competition by preventing smaller banks that only offer transactional services or other advisers from winning primary market business. In addition, smaller corporate clients with fewer banking relationships may feel pressured to award transactional business to their lending bank. The FCA indicated it would take steps to eliminate the use of contractual clauses that restrict the banks that clients may use for transactional business.

Reactions to the FCA’s findings and pledge to eliminate restrictions on banking choices in contracts were mixed. Bankers across the industry agreed that smaller banks and boutique advisers would stand to benefit from reforms to cross-selling practices, but some warned that additional restrictions could harm smaller corporate clients. One industry insider cited by The Financial Times noted that companies benefit from cross-selling, and eliminating the practice would make it more difficult for companies to access revolving credit facilities. Banking professor Peter Hahn told The Guardian that the FCA’s proposed reforms, while “good ideas,” would probably have only a small effect on the market. Reuters interviewed another banker who agreed with Hahn’s assessment and doubted that eliminating these clauses would significantly impact cross-selling since a client’s decision to award transactional business to a bank is often based on trust.

The FCA’s report also focused on possible conflicts of interest in the IPO process. The FCA raised concerns about the current market practice for IPOs, which imposes a blackout period between the publication of research conducted by banks connected to the offering and the publication of the offering’s final approved prospectus. This practice prevents independent analysts from conducting their own research by gaining access to the issuer’s management and other sources of information about the offering. As a result, investors only have research produced by a connected bank to consider until the approved prospectus is made available the day the offering commences. The FCA worries that connected research is at a greater risk of being biased in favor of the offering since connected analysts may feel pressured by the issuer to produce positive research.

To address the potential conflicts of interest in IPO research and provide investors with more information earlier in the IPO process, the FCA requested comments on a discussion paper that contains proposals for IPO reforms. The discussion paper considers three potential models for a restructured IPO process that would move up the publication of the approved prospectus to make the prospectus the primary source of information for investors and allow independent analysts access to the issuer’s management earlier in the process. Comments on the FCA’s discussion paper should be submitted on or before July 13, 2016.

In addition to potential conflicts caused by the sequencing of the IPO process, the FCA also examined the allocation of IPO shares in an occasional paper published alongside the interim report. The paper looked at data from IPOs conducted in the UK between January 2010 and May 2015 to determine whether investment banks reward certain clients by making favorable IPO allocations to those investors. The study found that syndicate banks made favorable share allocations to investors who proved helpful in pricing the IPO by providing the bank with useful information such as price-sensitive bids or attending meetings with the issuer prior to the IPO. The study also found that book-runners awarded favorable IPO allocations to investors who generated high revenues in other parts of their businesses, especially through brokerage commissions. The FCA plans to conduct additional supervisory work to better understand how banks manage potential conflicts of interest arising from IPO share allocation.

The industry, as a whole, generally reacted favorably to possible changes to the IPO process. Organizations representing institutional investors praised the FCA’s proposals as welcome relief to the “information asymmetry” that currently exists in the IPO process, according to an article in The Telegraph. The Financial Times cited another industry insider who praised the proposed reforms as a way to bring the UK’s IPO process more in line with the U.S. and to give companies greater flexibility in deciding when to enter the market.

The FCA indicated that it expects to finish its investment and corporate banking market study and release its final report sometime this summer. The agency did invite comments on its interim report, which should be submitted on or before May 25, 2016.

Banking Agency Developments

Federal Reserve

FRB Implements New Procedures for Examiners to Conduct Off-Site Loan Reviews

On April 19th, the Federal Reserve Board applied new procedures for examiners to conduct off-site loan reviews for community and small regional banks. Federal Reserve Press Release.

Treasury Department Developments


FSOC Releases Update on Review of Asset Management Products and Activities

On April 18th, the Financial Stability Oversight Council (“FSOC”) released a public update on its review of potential risks to financial stability that may arise from certain asset management products and activities. FSOC Press Release.

Securities and Exchange Commission

SEC Will Consider Consolidated Audit Trail Proposal at Open Meeting

The Securities and Exchange Commission (“SEC”) will hold an open meeting on April 27, 2016, to consider whether to solicit comments on a proposed national market system (“NMS”) plan to create, implement, and maintain a consolidated audit trail (“CAT”). SEC Sunshine Act Meeting Notice.

SEC Modifies and Extends Pilot Period for NMS Plan to Address Extraordinary Market Volatility

On April 21st, the SEC issued an order approving the Tenth Amendment to the NMS Plan to Address Extraordinary Market Volatility, or the limit up-limit down (“LULD”) plan. The SEC’s order modifies the manner in which the LULD plan establishes the reference price in cases where a security does not trade in the opening auction on the primary listing exchange to prevent trading pauses unrelated to extraordinary volatility. The order also extends the pilot period until April 21, 2017, to permit the self-regulatory organization participants to analyze how the LULD plan operated during the market volatility on August 24, 2015. SEC Press Release.

SEC Releases Equity Market Structure Advisory Committee Meeting Agenda

On April 21st, the SEC announced the agenda for the upcoming meeting of its Equity Market Structure Advisory Committee, which will be held on April 26, 2016. The committee will consider recommendations regarding a possible access fee pilot and trading venues regulation, among other matters. The committee invites the public to submit written comments on the topics under consideration in advance of the meeting. SEC Press Release

SEC Division Directors Review Activities Before House Financial Services Subcommittee

In testimony before the U.S. House Financial Services Subcommittee on Capital Markets and Government Sponsored Entities on April 21st, SEC Division of Economic Risk and Analysis (“DERA”) Director Mark J. Flannery, Office of Compliance Inspections and Examinations (“OCIE”) Director Mark Wyatt, Office of Credit Ratings (“OCR”) Director Thomas J. Butler, and Office of the Whistleblower (“OWB”) Chief Sean McKessy reviewed the responsibilities and recent activities of their respective divisions and offices, explaining how these activities represent the evolving approach to securities regulation and oversight sparked by the financial crisis. According to a report in Law360, Director Butler faced tough questioning from the panel regarding the SEC’s efforts to regulate credit rating agencies.

Investment Management Releases Most Recent Money Market Fund Statistics

On April 20th, the SEC’s Division of Investment Management published updated money market fund statistics. The updated statistics include data as of March 31, 2016. Money Market Fund Statistics.

SEC Will Pursue Its Own Asset Management Rules, Says White

SEC Chair Mary Jo White issued a statement at FSOC’s public meeting on April 18th in which she indicated her support for FSOC’s Update Statement on its review of asset management products and activities for potential financial stability risks. White also stated that FSOC’s update does not necessarily indicate the direction the SEC will take in its own final asset management rules, which she noted will be based on information the SEC receives from public comment and analysis performed by DERA. White Statement.

SEC Releases Online Tool to Help Filers Calculate Filing Fees

On April 18th, the SEC announced the release of a new online tool that it hopes will improve the accuracy of filing fee calculations for certain form submissions to EDGAR. The Registration Fee Estimator covers the most common filings used by companies to register initial public offerings, debt offerings, asset-backed securities, close-ended mutual funds, limited partnerships, and small business investment companies. SEC Press Release.

Norwegian Stock Exchange’s Rule 902(b) Designation Extends to Marketplace for Small and Midsized Enterprises

The SEC’s Division of Corporation Finance confirmed in a no-action letter issued on April 13th that it would not object if the reference to Oslo Børs, Norway’s independent stock exchange, as “a designated off-shore securities market” under Rule 902(b) of the Securities Act also includes Merkur Market, a marketplace offered by Oslo Børs for small and midsized growth companies. SEC No-Action Letter.

Commodity Futures Trading Commission

CFTC and Canadian Authorities Sign Counterparts to MOU to Enhance Supervision of Cross-Border Regulated Entities

On April 20th, the U.S. Commodity Futures Trading Commission (“CFTC”) announced that Chairman Timothy Massad signed Counterparts with authorities in three Canadian provinces to a 2014 Memorandum of Understanding (“MOU”) regarding cooperation and the exchange of information in the supervision and oversight of regulated entities that operate on a cross-border basis in the U.S. and in Canada. Chairman Massad signed the Counterparts to the MOU with Peter Klohn, Chair of the Financial and Consumer Services Commission in New Brunswick; Roger Sobotkiewicz, Chairperson of the Financial and Consumer Affairs Authority of Saskatchewan; and Paul E. Radford, Chair of the Nova Scotia Securities Commission (Canadian Authorities). The scope of the MOU includes markets and organized trading platforms, central counterparties, trade repositories, and intermediaries, dealers, and other market participants. CFTC Press Release.

Federal Rules Effective Dates

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Exchanges and Self-Regulatory Organizations

Financial Industry Regulatory Authority

FINRA Offers Guidance to Firms on Pension Income Stream Products

The Financial Industry Regulatory Authority (“FINRA”) issued a regulatory notice on April 19th that reminds member firms of their responsibilities relating to the sale of pension income stream products. The notice explains that firms must independently assess whether a particular pension stream product is a security or risk violating FINRA rules if they misidentify a pension stream product as a non-security product. FINRA also encouraged firms to adopt special procedures and training to help representatives in understanding the features of these products and determining if pension stream products fulfill their customers’ needs. FINRA Regulatory Notice 16-12.

SEC Takes Additional Time to Decide on FINRA’s Proposed Reporting Requirements for ATSs

On April 15th, the SEC designated June 3, 2016, as the date by which it will approve, disapprove, or institute disapproval proceedings regarding FINRA’s proposal to adopt new rules to require alternative trading systems (“ATSs”) to submit additional order information to FINRA. SEC Release No. 34-77635.

ICE Clear

ICC Proposes Changes to Its Stress Testing Framework

On April 15th, the SEC requested comments on a proposed rule change filed by ICE Clear Credit LLC (“ICC”) to update and formalize its Stress Testing Framework. Comments should be submitted on or before May 12, 2016.SEC Release No. 34-77633.

SEC Designates Longer Period to Consider ICE Clear Europe’s Proposed Additions to Permitted Cover

On April 15th, the SEC designated May 31, 2016, as the date by which it will approve, disapprove, or institute disapproval proceedings regarding ICE Clear Europe Limited’s (“ICE Clear Europe”) proposed rule changes to provide additional categories of securities, including treasury bills and floating and inflation-linked government bonds, to ICE Clear Europe to satisfy certain margin requirements. SEC Release No. 34-77634.

Municipal Securities Rulemaking Board

MSRB Reviews Outcome of Board’s Quarterly Meeting

On April 18th, the Municipal Securities Rulemaking Board (“MSRB”) summarized the activities of its Board of Directors at its quarterly meeting, which took place on April 13th and 14th. The Board reviewed public feedback to its proposed guidance on the prevailing market price and proposed amendments to the procedures for the close-out of open inter-dealer transactions. The Board indicated it will solicit comments on a proposed approach to establishing continuing education requirements for municipal advisors. MSRB Press Release.


NYSE Proposes Listing Standards for Equity Investment Tracking Stocks

On April 21st, the SEC requested comments on the New York Stock Exchange LLC’s (“NYSE”) proposal to adopt initial and continued listing standards for the listing of Equity Investment Tracking Stocks and adopt fees specific to Equity Investment Tracking Stocks. Comments should be submitted within 21 days of publication in the Federal Register, which is expected the week of April 25, 2016. SEC Release No. 34-77674.

SEC Takes More Time to Consider NYSE Exchanges’ Proposed Back-Up Plans For Determining Official Closing Prices

On April 21st, the SEC designated June 9, 2016, as the date by which it will approve, disapprove, or institute disapproval proceedings regarding NYSE’s and NYSE MKT LLC’s (“NYSE MKT”) separately filed proposals to amend their respective rules to establish procedures for how the exchanges would determine an Official Closing Price if they are unable to conduct a closing transaction.

SEC Approves NYSE Exchanges’ Proposal Regarding Cage Allocation to Co-Located Users

On April 21st, the SEC approved NYSE’sNYSE MKT’s, and NYSE Arca Inc.’s (“NYSE Arca”) separately filed proposals to amend their respective rules to establish procedures for the allocation of cages to co-located Users, to provide for the waiver of certain fees under certain conditions for Users on a waitlist for a cage, and to amend the visitor security escort fee.

NYSE Exchanges Propose New Fees for End Users

On April 18th, the SEC provided notice of separate proposals filed by NYSENYSE MKT, and NYSE Arca that would amend their respective rules to establish fees relating to end users and amend the definition of “affiliate,” as well as to amend the co-location section of their relevant Price Lists and fee schedules to reflect these changes. Comments should be submitted on or before May 13, 2016.

Industry News

Regulators Release Rules in an Effort to Limit Banker Bonuses

On April 21st, DealBook reported that regulators have released rules that are meant to restrict how large financial institutions can pay their top executives. Under the new limits, the highest paid employees at the largest banks would have to wait at least four years before they would get parts of their yearly pay. If the proposals are finalized in the next few months, banks would also have to retrieve bonuses from bankers who take risks that lead to big financial losses. DealBook.

FSOC’s Interagency Group Will Examine Hedge Fund Leverage

On April 18th, Bloomberg reported on FSOC’s announcement that it will form an interagency group to scrutinize hedge fund leverage. The new group, which will include the heads of the U.S. Treasury Department, the Federal Reserve and the SEC, will focus on analyzing data and studying risk factors including counterparty exposures and trading strategies. Bloomberg.