dodd frank act Archives - The National Law Forum

Chamber of Commerce Challenges CFPB Anti-Bias Focus Concerning AI

The end of last month the U.S. Chamber of Commerce, the American Bankers Association and other industry groups (collectively, “Plaintiffs”) filed suit in Texas federal court challenging the Consumer Financial Protection Bureau’s (“CFPB”) update this year to the Unfair, Deceptive, or Abusive Acts or Practices section of its examination manual to include discrimination. Chamber of Commerce of the United States of America, et al v. Consumer Financial Protection Bureau, et al., Case No. 6:22-cv-00381 (E.D. Tex.)

By way of background, the Consumer Financial Protection Act, which is Title X of the 2010 Dodd-Frank Act (the “Act”), prohibits providers of consumer financial products or services or a service provider from engaging in any unfair, deceptive or abusive act or practice (“UDAAP”). The Act also provides the CFPB with rulemaking and enforcement authority to “prevent unfair, deceptive, or abusive acts or practices in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service.” See, e.g., https://files.consumerfinance.gov/f/documents/cfpb_unfair-deceptive-abusive-acts-practices-udaaps_procedures.pdf. In general, the Act provides that an act or practice is unfair when it causes or is likely to cause substantial injury to consumers, which is not reasonably avoidable by consumers, and the injury is not outweighed by countervailing benefits to consumers or to competition.

The CFPB earlier this spring published revised examination guidelines on unfair, deceptive, or abusive acts and practices, or UDAAPs. Importantly, this set forth a new position from the CFPB, that discrimination in the provision of consumer financial products and services can itself be a UDAAP. This was a development that was surprising to many providers of financial products and services. The CFPB also released an updated exam manual that outlined its position regarding how discriminatory conduct may qualify as a UDAAP in consumer finance. Additionally, the CFPB in May 2022 additionally published a Consumer Financial Protection Circular to remind the public of creditors’ adverse action notice requirements under the Equal Credit Opportunity Act (“ECOA”). In the view of the CFPB, creditors cannot use technologies (include algorithmic decision making) if it means they are unable to provide required explanations under the ECOA.

In July 2022, the Chamber and others called on the CFPB to rescind the update to the manual. This included, among other arguments raised in a white paper supporting their position, that in conflating the concepts of “unfairness” and “discrimination,” the CFPB ignores the Act’s text, structure, and legislative history which discusses “unfairness” and “discrimination” as two separate concepts and defines “unfairness” without mentioning discrimination

The Complaint filed this fall raises three claims under the Administrative Procedure Act (“APA”) in relation to the updated manual as well as others. The Complaint contends that ultimately it is consumers that will suffer as a result of the CFPB’s new position, as “[t]hese amendments to the manual harm Plaintiffs’ members by imposing heavy compliance costs that are ultimately passed down to consumers in the form of higher prices and reduced access to products.”

The litigation process started by Plaintiffs in this case will be time consuming (a response to the Complaint is not expected from Defendants until December). In the meantime, entities in the financial sector should be cognizant of the CFPB’s new approach and ensure that their compliance practices appropriately mitigate risk, including in relation to algorithmic decision making and AI. As always, we will keep you up to date with the latest news on this litigation.

For more Consumer Finance Legal News, click here to visit the National Law Review

The Future of the CFPB: the Executive Branch and Separation of Powers

On October 18, 2019 the Supreme Court granted certiorari in Seila Law v. Consumer Financial Protection Bureau (CFPB). SCOTUS will answer the question of “whether the substantial executive authority yielded by the CFPB, an independent agency led by a single director, violates the separation of powers,” and the Justices requested that the parties brief and argue an additional issue: “If the Consumer Financial Protection Bureau is found unconstitutional on the basis of the separation of powers, can 12 U.S.C. § 5491(c)(3) [the for-cause removal provision] be severed from the Dodd-Frank Act?”

Origins of the Consumer Financial Bureau and Previous Constitutional Challenges

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) established the CFPB as an independent bureau within the Federal Reserve System designed to protect consumers from abusive financial services practices. The structure and constitutionality of the CFPB has been addressed before. In 2018, the D.C. Circuit held in PHH Corp. v. CFPB, No. 15-1177 (D.C. Cir. 2018) (PHH) that the current structure of the CFPB, which features a single director that cannot be removed by the president except for cause, “is consistent with Article II” of the Constitution.

The PHH opinion stated that Congress’ response to the consumer finance abuse that led up to the 2008 financial crisis purposely created the CFPB to be “a regulator attentive to individuals and families” because the existing regulatory agencies were too concerned about the financial industry they were supposed to supervise. It was determined that the CFPB needed independence to do its job, and the CPFB structure was designed to confer that independence. Neither PHH Corporation nor the CFPB filed a petition for certiorari to ask the Supreme Court to review the D.C. Circuit’s decision.

Background of the Seila Law Case

In Seila Law v. Consumer Financial Protection Bureau (CFPB) the Petitioner is a law firm that provides a variety of legal services to consumers, and as part of a CFPB investigation into whether Seila Law violated certain federal laws, the CFPB issued a civil investigative demand seeking information and documents. Seila Law objected to the demand on the ground that the CFPB was unconstitutionally structured and filed a petition to a federal district court for enforcement. The district court held that the structure of the CFPB did not violate the separation of powers and was constitutional, after which that district court decision was appealed. The Ninth Circuit affirmed, noting that the issues had been “thoroughly canvassed” in the DC Circuit it in PHH, and adopting the position of the PHH majority that the CFPB’s structure is constitutional. Seila Law filed a petition for a writ of certiorari with the U.S. Supreme Court seeking review of the Ninth Circuit’s ruling, and here we are.

An Experienced Federal Agency Litigator’s Perspective

Mr. Anthony E. DiResta, is co-chair of Holland & Knight’s Consumer Protection Defense and Compliance Team, and a former Director of the Federal Trade Commission’s (FTC) Southeast Regional office. Mr. DiResta was kind enough to take some time with the National Law Review to discuss the upcoming Seila Law decision and its impact on the future of the CFPB.

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NLR: Can you sum up the CFPB and separation of powers story to this point from your own viewpoint?

DiResta: The Supreme Court has decided to review this case because of the constitutionality of the CFPB’s structure, based on separation of powers. Any single leader in government who doesn’t serve at the pleasure of the President may simply have too much power, and people with certain jurisprudential philosophies about how government should be run find that an offensive situation. That’s the theory behind the certiorari decision and why SCOTUS is addressing the case – it’s really a question of constitutionality and the power of administrative agencies. Additionally, the Court will look at the severability of the CFPB in Dodd-Frank, whether it’s possible to just restructure the single leader structure, and then leave the Bureau intact to continue business as usual.

NLR: It seems many of these issues could’ve been avoided had the CFPB been structured more as a multi-member commission initially or if Congress had simply expanded FTC powers. Why do you think it was structured differently?

DiResta: That’s a matter of speculation – but I think it might have gone something like this: After the Recession in the early 2000s, many people felt that government was asleep at the wheel, letting devastating things in banking and finance and servicing to consumers run out of control, which led to serious blunders and mishaps. So it was decided that a new office was needed – and this was led by representatives in Congress like Elizabeth Warren.

Why they didn’t simply expand the power and resources of the FTC is also pure speculation – they could have merely expanded FTC’s jurisdiction and reach to achieve similar outcomes and intentions.

The Constitutionality of the CFPB

NLR: Do you think SCOTUS will rule in favor of the petitioner in Seila Law, and find the structure of the CFPB unconstitutional?

DiResta: I do. I suspect that SCOTUS will, in fact, find the structure unconstitutional on the basis of the separation of powers. But I also believe that an even more interesting part of that will be the discussion of the severability of the organization’s leadership, leaving the CFPB itself intact. If the structure is unconstitutional, how the Court recommends a remedy to correct that unconstitutionality could have far-reaching effects. This is so important – and we should all be excited that we get to watch this corrective process in action.

NLR: Is there a chance this would result in a complete restructure of CFPB, or even its possible dissolution?

DiResta: I really don’t think so – and the Court couldn’t do that anyway. The Court could recommend to Congress that a certain path for correction be followed, but it will be up to Congress to rearrange the CFPB (if that’s the result) in the best way. The legislative branch will just have to make sure it’s done, in a way that the Court recommends.

Some More Background on CFPB Constitutionality Litigation

Then-Judge, now Justice Kavanaugh was on the U.S Court of Appeals Court for the D.C. Circuit for the 2018 en banc ruling in the PHH Corp. v. CFPB case and on the 2016 three-judge decision. Judge Kavanaugh authored two opinions regarding PHH: declaring a certain aspect of the CFPB to be unconstitutional and in 2018, the dissenting opinion from the en banc U.S. Court of Appeals for the D.C Circuit’s decision overruling the 2016 panel opinion.

The 2016 panel opinion determined that the structure of the CFPB is unconstitutional stating: “The concentration of massive, unchecked power in a single Director marks a dramatic departure from settled historical practice and makes the CFPB unique among independent agencies.” And the 2016 panel also presented a view of the Constitution that vests with the president an extensive degree of unilateral authority over the executive branch’s enforcement of federal laws.

NLR: Since Justice Kavanaugh was a judge involved in a similar case – PHH Corp. v. CFPB – why is he allowed to rule on this matter again?

DiResta: I’m not an expert on judicial ethics but there does not appear to be improper bias in Kavanaugh reviewing this decision. Rather, his views in PHH reflect a philosophical perspective on separation of powers and the role of administrative agencies. In fact, I expect they’ll use his past ruling on PHH as part of their internal discussion.

Seila Law v CFPB and Election Politics

NLR: It’s difficult to ignore the political undertones of this case: a watchdog organization created, in part, with input from some high-profile democrats (most notably Elizabeth Warren, who is currently running as a candidate for president) is being challenged and that challenge is being echoed in support by largely conservative elements. In your view, is this case a litmus test for the Supreme Court delving into political issues, something it has largely tried not to do?

DiResta: No – I really don’t see this as political. Again, this is a purely constitutional question, a legal question, and it’s exactly the kind of case the SCOTUS should be deciding. If we’re honest, this is a perfect example of why we have SCOTUS in the first place: To examine how effective our public servants are behaving and performing their responsibilities under the constitutional structure revealed in the separation of powers doctrine.

Besides that, politically speaking, this could boomerang. Consider: if the Democrats win the White House in 2020, and the Court were to change the structure, that would offer any Democratic President the opportunity to appoint a new Director in 2021, and Kathleen Kraninger’s term isn’t up until 2023.

Informed Democracy at Work

While the situation with CFPB and its constitutionality is demonstrably important, DiResta touched on a few more salient – though no less important – points.

DiResta: Democracy isn’t supposed to be easy. Democracy is hard – it’s messy and complicated. It’s in its nature, and in the nature of different ideas.

In a free marketplace of ideas, people will clash when citizens are free to express themselves, and there will always be conflict – but it’s out of resolving those conflicts that democracy claims – and grows – its power and attraction. It’s so important that we – the people – see this and get to comment on it – to watch this happening.

NLR: Absolutely. In a world where the news cycle has compressed from days, to hours, to minutes – while attention spans have diminished in similar fashion – it’s increasingly important that these monumental workings in government are transparent, and that people see them.

DiResta: I couldn’t agree more. And – as a young lawyer, I had the privilege to work with some very dedicated and highly professional journalists who understood journalism as a public service, not as entertainment. These journalists saw themselves as educators, bringing light to the processes and prospects of government to citizens. And that’s how the media serves effectively as the Fourth Branch of government. A branch that presents a constant check to the power of government and its branches, and that gives the people the knowledge to make better decisions, and to vote for the best people and the best situations.

We sincerely appreciate Mr. DiResta for his thoughtful insights and for taking time out of his busy schedule to share them with the National Law Review.

ARTICLE BY William C. P. Thieme of The National Law Review / The National Law Forum LLC.

More on the CFPB on the National Law Review Financial Institutions & Banking law page.

Bank Deregulation Bill Becomes Law: Economic Growth, Regulatory Relief, and Consumer Protection Act

On May 24, President Trump signed into law the most significant banking legislation since the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in 2010. The bill – named the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “Act”) – passed its final legislative hurdle earlier this week when it was approved by the U.S. House of Representatives. Identical legislation passed the U.S. Senate last March on a bipartisan basis.

The Act makes targeted, but not sweeping, changes to several key areas of Dodd-Frank, with the principal beneficiaries of most provisions being smaller, non-complex banking organizations.

Below is a summary of several key changes:

Higher SIFI Threshold – The controversial $50 billion asset threshold under Dodd-Frank is now $250 billion, affecting about two dozen bank holding companies. Under Section 165 of Dodd-Frank, bank holding companies with at least $50 billion in total consolidated assets were subjected to enhanced prudential standards. Under the Act, the enhanced prudential standards under Section 165 no longer apply to bank holding companies below $100 billion, effective immediately. Bank holding companies with total consolidated assets of between $100 billion and $250 billion will be exempted from such standards starting in November 2019, although the Federal Reserve retains the authority to apply the standards to any such company if it deems appropriate for purposes of U.S. financial stability or to promote the safety and soundness of the particular firm.

The increase in the Section 165 threshold does not eliminate the $50 billion threshold used in other areas of regulation and supervision, such as the Office of the Comptroller of the Currency’s (“OCC”) “heightened standards,” the “living will” regulations adopted by the Federal Deposit Insurance Corporation (“FDIC”) for insured depository institutions or the Federal Reserve’s capital plan rule pursuant to which it administers the CCAR process. However, it is expected that the federal banking agencies may reconsider the appropriateness of using the $50 billion asset threshold elsewhere.

The increase in this threshold is especially important because it may spark renewed interest in M&A opportunities among regional banks that have carefully managed growth to avoid crossing $50 billion or that have otherwise been reluctant to pursue transactions in light of the significant regulatory scrutiny that has accompanied applications by large acquirors.

Volcker Rule – The Volcker Rule is amended so that it no longer applies to an insured depository institution that has, and is not controlled by a company that has, (i) less than $10 billion in total consolidated assets and (ii) total trading assets and trading liabilities that are not more than 5% of total consolidated assets. All other banking entities, however, remain subject to the Volcker Rule. The other change to the Volcker Rule relates to the name-sharing restriction under the asset management exemption, which the Act modifies slightly by easing the prohibition on banking entities sharing the same name with a covered fund for marketing or other purposes. Going forward, a covered fund may share the same name as a banking entity that is the investment adviser to the covered fund as long as the word “bank” is not used in the name and the investment adviser is not itself (and does not share the same name as) an insured depository institution, a company that controls an insured depository institution or a company that is treated as a bank holding company. This change allows separately branded investment managers within a bank holding company structure to restore using the manager’s name on its advised funds.

The Act represents only the first set of changes to the Volcker Rule. The federal banking agencies are expected to release a proposal the week of May 28 to revise aspects of the regulations first adopted in late 2013.

“Off-Ramp” Relief for Qualifying Community Banks – A depository institution or depository institution holding company with less than $10 billion in total consolidated assets will constitute a “qualifying community bank” under the Act. The benefit of such a designation is that the institution will be exempt from generally applicable capital and leverage requirements, provided the institution complies with a leverage ratio of between 8% and 10%. The federal banking agencies must develop this ratio and establish procedures for the treatment of a qualifying community bank that fails to comply. The regulators have the authority to determine that a depository institution or depository institution holding company is not a qualifying community bank based on the institution’s risk profile.
Stress Testing – The Act provides relief from stress testing for certain banking organizations. Notably, bank holding companies with total consolidated assets of between $10 billion and $250 billion will no longer need to conduct company-run stress tests. Bank holding companies with more than $250 billion in assets and nonbank companies deemed systemically important still need to conduct company-run stress tests, but are permitted to do so on a “periodic” basis rather than the previously required semi-annual cycle. As for supervisory stress tests, which are conducted by the Federal Reserve, bank holding companies with less than $100 billion are no longer subject to such stress tests. Bank holding companies with total consolidated assets between $100 billion and $250 billion are subject to supervisory stress tests on a periodic basis, while such firms with $250 billion or more in total consolidated assets and nonbank companies designated as systemically important remain subject to annual supervisory stress tests.
Risk Committees and Credit Exposure Reports – The Act raises the asset threshold that triggers the need for publicly-traded bank holding companies to establish a board-level risk committee, from $10 billion to $50 billion. In addition, the Act amends Dodd-Frank’s requirement that bank holding companies with at least $50 billion in assets and nonbank companies designated as systemically important submit credit exposure reports. Instead, the Act authorizes, but does not mandate, the Federal Reserve to receive reports from these firms, but with respect to bank holding companies, only those with more than $250 billion in assets are within scope.
Exam Cycle and Call Report Relief for Smaller Institutions – The Act increases the asset threshold for insured depository institutions to qualify for an 18-month on-site examination cycle from $1 billion to $3 billion. The Act also directs the federal banking agencies to adopt short-form call reports for the first and third calendar quarters for insured depository institutions with less than $5 billion in total consolidated assets and that meet such other criteria as the agencies determine appropriate.
Small BHC and SLHC Policy Statement – The asset threshold for the application of the Federal Reserve’s Small Bank Holding Company and Savings and Loan Holding Company Policy Statement is raised from $1 billion to $3 billion. As a result, those institutions with less than $3 billion in consolidated assets are not subject to consolidated capital requirements and have the benefit of less restrictive debt-to-equity limitations.
Flexibility for Federal Thrifts to Operate as National Banks – Federal savings associations with total consolidated assets of $20 billion or less (as of December 31, 2017) may elect to be subject to the same rights, privileges, duties, restrictions, penalties, liabilities, conditions and limitations that apply to a national bank, without having to convert their charters. As a result, institutions that make the election would be exempt from certain restrictions unique to savings associations, including asset-based limitations applicable to commercial and consumer loans, unsecured constructions loans, and non-residential real property loans. To make an election, a federal savings association must provide 60 days’ prior written notice to the OCC.
“Ability to Repay” Safe Harbor for Smaller Institutions – The Act provides a safe harbor from the “ability to repay” requirement under the Truth in Lending Act (“TILA”) for mortgage loans originated and retained in portfolio by an insured depository institution or insured credit union that has, together with its affiliates, less than $10 billion in total consolidated assets. However, mortgage loans that have interest-only, negative amortization or certain other features do not qualify for this ability-to-repay relief.
Capital Treatment for HVCRE Exposures – The Act eases the treatment for certain “high-volatility commercial real estate” (“HVCRE”) loans under U.S. Basel III capital rules. HVCRE exposures had been assigned a 150% risk-weight under the U.S. standardized approach, but the Act now restricts this higher risk-weight to those exposures that constitute acquisition, development and construction (“ADC”) loans meeting a new “HVCRE ADC loan” definition. Various loans are excluded from HVCRE ADC loan definition, including loans to finance the acquisition, development or construction of one- to four-family residential properties, community development project loans, and loans secured by agricultural land. In addition, loans to acquire, refinance or improve income-producing properties and commercial real estate projects that meet certain loan-to-value ratios are also excluded from the new HVCRE ADC loan definition.
Reciprocal Deposits – The Act excludes deposits received under a reciprocal deposit placement network from the scope of the FDIC’s brokered deposit rules if the agent institution’s total amount of reciprocal deposits does not exceed either $5 billion or 20% of the institution’s total liabilities. The exclusion applies generally to a bank that has a composite condition of outstanding or good and is well capitalized, but it may be relied upon by a bank that has been downgraded or ceases to be well capitalized if the amount of reciprocal deposits it holds does not exceed the average of its total reciprocal deposits over the four quarters preceding its rating or capital downgrade.
PACE Financing – The Act requires the Consumer Financial Protection Bureau (“CFPB”) to issue ability-to-repay rules under TILA to cover Property Assessed Clean Energy (“PACE”) financing. The Act defines such financing to include a loan that covers the costs of home improvements and which results in a tax assessment on the consumer’s real property. In developing these regulations, the CFPB must consult with state and local governments and PACE bond-issuing authorities.
Protections for Student Borrowers – The Act provides protections for student loan borrowers in situations involving the death of the borrower or cosigner and those seeking to “rehabilitate” their student loans. In particular, the Act amends TILA to prohibit a private education loan creditor from declaring a default or accelerating the debt of the student obligator solely on the basis of the death or bankruptcy of a cosigner. In addition, in the case of the death of the borrower, the holder of a private education loan must release any cosigner within a “reasonable timeframe” after receiving notice of the borrower’s death. The Act also amends the Fair Credit Reporting Act by allowing a borrower to request that a financial institution remove a reported default on a private education loan from a consumer credit report if the institution offers and the borrower successfully completes a loan rehabilitation program. The program, which must be approved by the institution’s federal banking regulator, must require that the borrower make consecutive on-time monthly payments in a number that, in the institution’s assessment, demonstrates a “renewed ability and willingness to repay the loan.”
Immunity from Suit for Disclosure of Financial Exploitation of Senior Citizens – The Act shields financial institutions and certain of their personnel from civil or administrative liability in connection with reports of suspected exploitation of senior citizens. The reports must be made in good faith and with reasonable care to a law enforcement agency or certain other designated agencies, including the federal banking agencies. Personnel covered by the immunity (which include compliance personnel and their supervisors, as well as registered representatives, insurance producers and investment advisors) must have received training in elder care abuse by the financial institution or a third party selected by the institution.
Mortgage Relief – The Act contains a number of provisions easing certain residential mortgage requirements, especially with respect to such loans made by smaller institutions. The Act amends the Home Mortgage Disclosure Act to exempt from specified public disclosure requirements depository institutions and credit unions that originate, on an annual basis, fewer than a specified number of closed-end mortgages or open-end lines of credit. The Act revises the Federal Credit Union Act to allow a credit union to extend a member business loan with respect to a one- to four-family dwelling, regardless of whether the dwelling is the member’s primary residence. The Act also amends the S.A.F.E. Mortgage Licensing Act of 2008 to allow loan originators that meet specified requirements to continue, for a limited time, to originate loans after moving: (i) from one state to another, or (ii) from a depository institution to a non-depository institution. Further, the Act exempts from certain escrow requirements a residential mortgage loan held by a depository institution or credit union that: (i) has assets of $10 billion or less, (ii) originated 1,000 or fewer mortgages in the preceding year, and (iii) meets other specified requirements.
Liquidity Coverage Ratio – The Act directs the federal banking agencies to amend their liquidity coverage ratio requirements to permit certain municipal obligations to be treated as higher quality “level 2B” liquid assets if they are investment grade, liquid and readily marketable.
Custodial Bank Capital Relief – The Act requires the agencies to exclude, for purposes of calculating a custodial bank’s supplementary leverage ratio, funds of a custodial bank that are deposited with a central bank. The amount of such funds may not exceed the total value of deposits of the custodial bank linked to fiduciary or custodial and safekeeping accounts.
Fair Credit Reporting Act – The Fair Credit Reporting Act is amended to increase the length of time a consumer reporting agency must include a fraud alert in a consumer’s file. The Act also: (i) requires a consumer reporting agency to provide a consumer with free “credit freezes” and to notify a consumer of their availability, (ii) establishes provisions related to the placement and removal of these credit freezes and (iii) creates requirements related to the protection of the credit records of minors.
Cyber Threat Report – Within one year of enactment, the Secretary of the Treasury must submit a report to Congress on the risks of cyber threats to U.S. financial institutions and capital markets. The report must include: (i) an assessment of the material risks of cyber threats, (ii) the impact and potential effects of material cyber attacks, (iii) an analysis of how the federal banking agencies and the Securities and Exchange Commission are addressing these material risks and (iv) a recommendation of whether additional legal authorities or resources are needed to adequately assess and address the identified risks.

Apart from the changes in the thresholds for banks with assets above $100 billion, most of the Act’s provisions are effective immediately.

This post was written by Scott A. Cammarn and Mark Chorazak of Cadwalader, Wickersham & Taft LLP.

Read more news on banks at the National Law Review’s Finance Practice Group Page.

Supreme Court Limits Scope of Dodd-Frank Whistleblower Protections

On February 21, the US Supreme Court decided Digital Realty Trust, Inc. v. Somers (583 U.S. ____ (2018)), which resolved a circuit split related to whether the anti-retaliation provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 124 Stat. 1376 (Dodd-Frank) extend to individuals who have not reported a securities law violation to the Securities and Exchange Commission and, therefore, falls outside of Dodd-Frank’s definition of a “whistleblower.”

Paul Somers alleged that Digital Realty Trust, Inc. (Digital Realty) terminated his employment shortly after reporting suspected securities-law violations to the company’s senior management. Somers filed a case in the US District Court for the Northern District of California (District Court) alleging that his termination amounted to whistleblower retaliation under Dodd-Frank. Digital Realty moved to dismiss the claim on the grounds that Somers did not qualify as a “whistleblower” for purposes of Dodd-Frank because (1) the statute defines a “whistleblower” as someone “who provides . . . information relating to a violation of the securities laws to the [SEC];” and (2) Somers failed to report the allegations to the SEC prior to his termination. The District Court denied Digital Realty’s motion and the Ninth Circuit affirmed on the grounds that Dodd-Frank’s whistleblower protections should be read to protect employees regardless of whether they provide information to the SEC.

Reversing the District Court and the Ninth Circuit, Justice Ruth Bader Ginsburg, writing for the Court, explained that Dodd-Frank’s whistleblower retaliation provisions do not extend to an individual who has not reported alleged securities law violations to the SEC. Citing Dodd-Frank’s definition of a “whistleblower,” the Court determined that the statute explicitly required an individual to report such violations to the SEC in order to receive whistleblower protections. The Court found this interpretation of the whistleblower definition to be corroborated by Dodd-Frank’s intended purpose of motivating individuals to report securities law violations directly to the SEC.

The text of the decision is available here.

This post was written by Richard D. Marshall and Stanley V. Polit of Katten Muchin Rosenman LLP.

Read more Litigation news on the National Law Review Litigation page.

The Consumer Financial Protection Bureau – The New Sheriff in Town

The National Law Review recently published an article about The Consumer Financial Protection Bureau written by Andrew G. Berg, Karen Y. Bitar, Carl A. Fornaris, Laureen E. Galeoto, Ricardo A. Gonzalez, and Gil Rudolph of Greenberg Traurig, LLP:

Title X of the Dodd-Frank Act created the Consumer Financial Protection Bureau (“Bureau” or “CFPB”). This Bureau is focused solely on consumer financial protection. The Bureau has six primary functions,¹ including the authority and responsibility to supervise covered persons for compliance with Federal consumer financial law² and take appropriate enforcement action to address violations of same. The Bureau does not supervise covered persons for safety and soundness the way bank regulators do; rather, its sole stated interest is the protection of financial consumers in particular.

One year old on July 21, 2012, this Bureau has spent its first year aggressively pursuing its mandate: to implement and enforce Federal consumer financial law. It has been actively issuing proposed and final regulations and guidance, as well as filing amicus briefs in various court proceedings. The Bureau has also been conducting and participating in exams of covered parties. Further, it has been gathering and analyzing consumer complaints. Notably, the Bureau’s collection of consumer complaints — which began in July 2011 and was first limited to credit cards — was expanded to handle mortgage complaints in December 2011, and expanded again in March 2012 to complaints concerning bank products and services, private student loans and other consumer loans.³ The Bureau expects to begin addressing complaints about other covered non-depository institutions by the end of 2012.⁴

To date the Bureau has collected and processed a staggering 45,000 complaints,⁵ over 37,000 of which have been forwarded to the target company for review and response. Some of these complaints have been referred by the Consumer Response Section of the Bureau to the Bureau’s Division of Supervision, Enforcement and Fair Lending and Equal Opportunity for further action.⁶ The Bureau recently acknowledged that it is currently conducting private investigations into alleged violations of the Federal consumer financial laws, and regulators have publically indicated that the Bureau will soon initiate enforcement actions.⁷

The issues that the Bureau is currently investigating are questions that management, compliance officers and Boards of Directors should be asking themselves now in order to begin to address potential issues before the Bureau enforcement begins. With enforcement risk looming, now is the time to pay attention and ensure compliance with the Bureau’s regulation and guidance, assess risks and establish best practices in areas of consumer protection compliance and consumer complaint management.⁸

Who Falls Under the Bureau’s Reach?

The Bureau’s consumer financial protection functions extend farther and wider than those of its transferor agencies.⁹ The Bureau’s regulatory authority and enforcement arm (including the power to require reports and conduct investigations) apply to large banks, large credit unions and their affiliates,¹⁰ andnon-bank entities that engage in offering or providing consumer financial products or services. Section 1024 of Title X authorized for the first time federal supervision over non-banks engaging in financial transactions, such as: mortgage brokers, originators and mortgage servicers, payday lenders, private education lenders, and credit card companies. In addition, the Bureau’s supervisory and enforcement authority applies to any “service provider”¹¹ of the large banks or large non-banks that provides a “material service” in connection with the offering or provision of a consumer financial product or service.¹² Thus, a whole new body of direct and indirect financial services providers are now subject to examination over, and compliance with laws that they never before had to be concerned with, in particular, Title X’s prohibition of unfair, deceptive and abusive acts or practices, the impact of which can have significant financial and reputational consequences for the service providers, banks and non-banks.

In recent guidance,¹³ the Bureau advised that it intends to exercise to the fullest extent its regulatory authority over service providers, including its authority to examine them for compliance with Title X’s prohibition of unfair, deceptive, or abusive acts or practices. Significantly, that guidance warned that depending on circumstances, “legal responsibility may lie with the supervised bank or nonbank as well as with the supervised service provider.” The message being conveyed is that a bank or non-bank cannot delegate its responsibility of complying with Federal consumer financial law by engaging a service provider for certain services. Accordingly, it will be important to have effective processes in place to manage the new risks of the service provider relationship created by the Bureau.¹⁴

What is on the Enforcement Horizon?

In addition to the authority to enforce “enumerated consumer laws,” the Bureau also has the authority to prohibit “unfair, deceptive, or abusive acts or practices.” As noted above, the Bureau is looking not only at covered banks and non-banks for their compliance but also their service providers to ensure that these prohibited acts and practices are not taking place.¹⁵ While the industry has been guided for years on what is unfair or deceptive by the FTC and Federal banking agencies,¹⁶ “abusive” is a new standard upon which compliance and enforcement risk hinges. The Bureau’s Supervision and Examination Manual (“Manual”), dated October 2011, provides guidance on what an “abusive” act or practice may look like.¹⁷ The description, however, of what is “abusive” is broad and leaves much to be interpreted. Moreover, a covered party may be in technical compliance with all other applicable Federal consumer protection laws, and still be in violation of UDAAP.¹⁸ Where will the Bureau be looking for possible violations of UDAAP? Recent guidance advises that “the presence of complaints alleging that consumers did not understand the terms of a product or service may be a red flag [of a UDAAP] indicating that examiners should conduct a detailed review of the relevant practice.”¹⁹ The Manual and related guidance further instructs the examiners that “every complaint does not indicate violation of law. When consumers repeatedly complain about an institution’s product or service, however, examiners should flag the issue for possible further review.”²⁰ It goes on to note that even a “single substantive complaint” may be enough to raise serious concerns that warrant further review.²¹ At bottom, consumer complaints are considered an “essential source”²² for identifying potential violations of UDAAP.

Covered parties need to be thinking today about how they are collecting, reviewing and responding to consumer complaints on financial products and services and alleged failures to comply with Federal consumer financial laws and regulations. After all, the Bureau has already looked at over 45,000 consumer complaints, and may be more aware than a covered party of possible violations occurring in its own institution. Publicly, the Bureau has also been actively looking at a broad spectrum of products and practices including reverse mortgages, debt collection, foreclosure related services, and forced place insurance products. Consequently, implementation of compliance with consumer protection laws and a consumer complaint management scheme before Bureau intervention will be key for the days ahead.

Are We in the Quiet Before the Storm?

Well-funded and headed by Richard Cordray, the former State Attorney General for Ohio, it is widely projected that his Bureau will be pro-active and aggressive in its enforcement of Federal consumer protection laws. Not surprisingly, Richard Cordray was recently quoted as stating that, “[T]here will be enforcement action this year.”²³ Moreover, it is publically known that the Bureau is privately conducting investigations. Thus, it is not a question of if, but of when.

What Does the Bureau’s Enforcement Power Look Like?

The Bureau has the power to conduct joint investigations, issue subpoenas and civil investigative demands, bring cease and desist proceedings, injunction proceedings and conduct hearings. Pursuant to its civil investigative demand power, the Bureau can require the subject to produce documents, produce tangible things, file written reports or answers, give oral testimony or a combination of the aforementioned.²⁴

In addition, the Bureau has the authority to commence civil proceedings in the U.S. District Courts, or in any court of competent jurisdiction of a state in a district where there defendant is located or resides or is doing business too seek relief, including civil penalties,²⁵ for violations of Federal consumer financial laws.

The Court in a civil action and the Bureau in an adjudication proceeding, respectively, have been given the jurisdiction and authority to grant legal and equitable relief.²⁶ Relief available includes monetary penalties that can pack a lot of punch — reaching up to $1 million per day for every day a covered party “knowingly” violates a Federal consumer protection law. The other relief available also includes the power to rescind or reform contracts, order refund of monies or return real property, restitution, disgorgement or compensation for unjust enrichment.

Is There Notice Before Enforcement?

In a bulletin released by the Bureau in November of 2011, the Bureau gave notice of some of the actions it may take, at its discretion, prior to commencing enforcement.²⁷ Most notably, the Office of Enforcement, may, prior to recommending that the Bureau commence enforcement, “give the subject of such recommendation notice of the nature of the subject’s potential violations and may offer the subject the opportunity to submit a written statement in response.” The primary focus of this responsive statement, also referred to as a NORA letter, should be on legal and policy matters relevant to the potential proceeding. However, if factual assertions are relied upon, the response must be made under oath by a person with personal knowledge of the facts.²⁸ A subject will have only 14 days from receipt of notice to respond. Understandably, notice by the Office of Enforcement may not always be appropriate, such as in instances of ongoing fraud or other situations that may require quick action.²⁹

A word of caution for covered parties is that the NORA letter may be discoverable by third parties.³⁰ The Bureau’s Rule on Confidential Treatment of Privileged Information, released on July 5, 2012, will become final on August 6, 2012.³¹ This Rule seeks to protect a covered entity’s submission of privileged information to the Bureau in response to a request for information during an examination. This Rule may not protect information voluntarily contained in a NORA.

What About the Federal Banking Agencies’ Enforcement Authority?

For all insured depository institutions and credit unions with assets in excess of $10 billion, or any affiliate thereof, the Bureau has primary enforcement authority with respect to compliance with federal consumer financial laws. The federal banking agencies that regulate such “large” institutions will continue to have enforcement authority under their long-standing enforcement powers under Section 8 of the Federal Deposit Insurance Act (the “FDI Act”) for violations of law generally. However, with respect to violations of Federal consumer financial laws specifically by such “large” institutions, if a federal banking agency wishes to trigger enforcement, the agency must first recommend that the Bureau initiate an enforcement action. If the Bureau does not initiate an enforcement action within 120 days of receipt of the recommendation, then the federal banking agency may initiate an enforcement action under its FDI Act enforcement powers.

For depository institutions with assets under $10 billion, the Bureau has no enforcement authority with respect to compliance with Federal consumer financial law. This means that the federal banking agencies have exclusive enforcement authority over these smaller institutions with respect to compliance with Federal consumer financial law.

At the End of the Day, What Does This All Mean?

It is a new day and there is a new Sheriff in town. Risk assessment, risk management, complaint management and robust compliance are top priorities. As the Bureau evolves and the meaning of “abusive” morphs into a more concrete meaning, covered parties can best protect themselves by engaging in best practices that comply with the Bureau’s guidance.

¹The Bureau’s Six Primary Functions include: 1) conducting financial education programs; 2) collecting, investigating, and responding to consumer complaints; 3) collecting, researching, monitoring, and publishing information relevant to the functioning of markets for consumer financial products and services to identify risks to consumers and the proper functioning of such markets; 4) supervising covered persons for compliance with the Federal consumer financial law, and taking appropriate enforcement action to address violations of Federal consumer financial law; 5) issuing rules, orders, and guidance implementing Federal consumer financial law; and 6) performing such support activities as many be necessary or useful to facilitate the other functions of the Bureau. See Sec. 1021 (c).

²See generally Sec. 1021, of Subtitle B — General Powers of the Bureau. See also Sec. 1002(14). Under Title X, “Federal consumer financial law,” includes: 1) the provisions of Title X, such as Sec. 1031’s prohibition of unfair, deceptive or abusive acts or practices (“UDAAP”); 2) the enumerated laws found at Sec. 1002(12), which include the Alternative Mortgage Transaction Parity Act of 1982, the Consumer Leasing Act of 1976, the Electronic Fund Transfer Act, the Equal Credit Opportunity Act, the Fair Credit Billing Act, the Fair Credit Reporting Act, the Home Owners Protection Act of 1998, the Fair Debt Collection Practices Act, subsections (b) – (f) of section 43 of the Federal Deposit Insurance Act, sections 502 – 509 of the Gramm-Leach-Bliley Act, the Home Mortgage Disclosure Act of 1975, the Home Ownership and Equity Protection Act of 1994, the Real Estate Settlement Procedures Act of 1974, the S.A.F.E. Mortgage Licensing Act of 2008, the Truth in Lending Act, the Truth in Savings Act, section 626 of the Omnibus Appropriations Act, 2009, and the Interstate Land Sales Full Disclosure Act; 3) the laws for which authorities are transferred under Subtitles F and H; and 4) any rule or order prescribed by the Bureau under Title X, enumerated consumer law or authorities transferred under subtitles F & H. Federal consumer financial law does NOT include the Federal Trade Commission Act. Title X should be reviewed and consulted for other exceptions.

³ See the CFPB’s Consumer Response Annual Report, dated March 31, 2012.

⁴ See Id.

⁵ See Id., and the CFPB’s Consumer Response: A Snapshot of Complaints Received, dated June 19, 2012.

⁶See the CFPB’s Consumer Response Annual Report, dated March 31, 2012. The complaint database, referred to in the report, is publicly viewable and is creating concerns by the consumer financial industry that it might result in making them a target of plaintiffs’ law firms or consumer protection groups which can utilize the public information for their own aims in unfair and deceptive practices actions. Under the process for complaint handling set-up by the Bureau, a company has 15 calendar days to respond to the complaint. The company can respond to the consumer via a secure portal; the consumer then has an opportunity to dispute the response. The Consumer Response section prioritizes for review and investigation those complaints where the consumer disputes the response or where the companies fail to timely respond. For more information on the CFPB’s complaint collection and processing see the report of the CFPB, on Consumer Response Annual Report, dated March 31, 2012 and CFPB’s Consumer Response: A Snapshot of Complaints Received, dated June 19, 2012. See also the Bureau’s proposed rule on Disclosure of Consumer Complaint Data, Federal Register, Vol. 77, No. 121, 6/22/12.

⁷See New York Times article, “New Agency Plans to Make Over Mortgage Market,” by Wyatt, E., 7/5/12. See also the statements made by Richard Hackett, Assistant Director, Office of Installment & Liquidity Lending Markets Research, Markets & Regulations CFPB, at the PLI Program on 4/24/12, titled “Title X & XIV of the Dodd-Frank Act: The New Consumer Financial Protection Bureau” (his statements were made with the caveat that his statements are his own and not those of the Bureau); and the CFPB Annual Report 2012, Fair Debt Collections Practices Act (“FDCPA”), at pp. 17, wherein the Bureau stated that it is “currently conducting non-public investigations of debt collection practices to determine whether they violate FDCPA or the Dodd-Frank Act.”

⁸Supervised entities are expected “to have an effective compliance management system adapted to it business strategy and operations.” See the Supervision and Examination Manual, CMR 1, dated October 2011.

⁹Consumer financial protection functions previously held by the Board of Governors, the FDIC, the Federal Trade Commission, the National Credit Union Administration, the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Department of Housing and Urban Development were transferred to the Bureau as annunciated in Section 1061 of Title X. The FTC and the Bureau have overlapping authority with regards to certain enumerated consumer laws; there is currently a Memorandum of Understanding in place between the two agencies with regards to the enforcement of the Fair Debt Collection Practices Act. See The CFPB Annual Report 2012, Fair Debt Collection Practices Act, at p. 21 and App. A.

¹⁰Section 1025 of Title X authorized the Bureau to supervise large insured depository institutions and credit unions with more than $10 billion in total assets. In addition, the Bureau has supervisory authority over all affiliates and service providers of a large bank and credit union. Section 1026 of Title X authorizes the Bureau to require reports from smaller insured depository institutions and to include its examiners at the prudential regulator’s examinations in order to assess compliance with the Federal consumer financial laws.

¹¹“Service Providers,” include any person who “provides a material service to a covered person in connection with the offering or provision by such covered person of a consumer financial product or service, including a person that — (i) participates in designing, operating, or maintaining the consumer financial product or service; or (ii) processes transactions relating to the consumer financial product or service (other than unknowingly or incidentally transmitting or processing financial data in a manner that such data is undifferentiated from other types of data of the same form as the person transmits or processes).” Sec. 1002(26). Regarding examinations or requiring of reports by service providers, Sec. 1024(e) and 1025(d), state that the Bureau shall coordinate with the appropriate prudential regulator as applicable. Thus, under Title X, service providers are to be subject to the authority of the Bureau, “to the same extent as if such service provider were engaged in a service relationship with a bank, and the Bureau were an appropriate Federal banking agency under section 7 (c) of the Bank Service Company Act.

¹²Presently, the Bureau is focusing on third party debt collectors/service providers hired by the large banks and non-banks. In addition, it is anticipated, that on the finalization of the Bureau’s proposed “larger participant” rule this summer, that larger non-bank debt collectors will fall under the Bureau’s supervisory and enforcement authority per Sec. 1024 (a)(1)(B). Last, under Section 1024(a)(1)(C), the Bureau’s authority may extend to others whom the Bureau has reasonable cause to determine has engaged or is engaging in conduct which poses risks to consumers with regard to the offering or provision of consumer financial products or services.

¹³The CFPB Bulletin 2012-03, dated April 13, 2012, set forth guidance concerning service providers and the Bureau’s expectations with regards to banks and non-banks in managing the risks of the service provider relationships. Five specific steps that banks and non-banks should take to ensure their business arrangements do not pose “unwarranted risks to consumers,” include: 1) Conducting thorough due diligence to verify that the service provider understands and is capable of complying with Federal consumer financial law; 2) Requesting and reviewing the service provider’s policies, procedures, internal controls, and training materials to ensure that the service provider conducts appropriate training and oversight of employees or agents that have consumer contract or compliance responsibilities; 3) Including in the contract with the service provider clear expectations about compliance, as well as appropriate and enforceable consequences for violating any compliance-related responsibilities, including engaging in unfair, deceptive, or abusive acts or practices; 4) Establishing internal controls and on-going monitoring to determine whether the service provider is complying with Federal consumer financial law; 5) Taking prompt action to address fully any problems identified through the monitoring process, including terminating the relationship where appropriate.

¹⁴See Id. at p. 2.

¹⁵See Secs. 1021(c)(4), 1031(a), 1036 of Title X; and The CFPB Annual Report 2012, Fair Debt Collections Practices Act, p. 11.

¹⁶See FTC guidance under Sec. 5 of the Federal Trade Commission Act.

¹⁷The Supervision and Examination Manual, dated October 2011, mirrors the language of the Sec. 1031(d), in describing an abusive act or practice as one that: “Materially interferes with the ability of a consumer to understand a term or condition of a consumer financial product or service; or takes unreasonable advantage of — a lack of understanding on the part of the consumer of the material risks, costs, or conditions of the product or service; The inability of the consumer to protect its interests in selecting or using a consumer financial product or service; or the reasonable reliance by the consumer on a covered person to act in the interests of the consumer.”
¹⁸See CFPB, Guidance Documents, Supervision and Examination Manual, Version 1.0, Consumer Laws and Regulations: Unfair, Deceptive or Abusive Acts or Practices.

¹⁹Id.

²⁰The Supervision and Examination Manual, dated October 2011 at UDAAP 10.

²¹Id. at UDAAP 10.

²²CAP, Guidance Documents, Supervision and Examination Manual, Version 1.0, Consumer Laws and Regulations: Unfair, Deceptive or Abusive Acts or Practices.

²³See Richard Cordray’s, Director of the Bureau, statement, “[T]here will be enforcement action this year, and we have quite a bit of activity going on.” New York Times article, “New Agency Plans to Make Over Mortgage Market,” by Wyatt, E., 7/5/12.

²⁴See Sec. 1052(c).

²⁵See Sec. 1055(c), which provides that, “Any person that violates, through any act or omission, any provision of Federal consumer financial law shall forfeit and pay a civil penalty pursuant to this subsection.” Three tiers of penalties are identified, including: a) For any violation of law, rule, or final order or condition imposed in writing by the Bureau, a civil penalty may not exceed $5,000 for each day during which such violation or failure to pay continues. b) Notwithstanding paragraph (a), for any person that recklessly engages in a violation of a Federal consumer financial law, a civil penalty may not exceed $25,000 for each day during which such violation continues. c) Notwithstanding paragraphs (a) and (b), for any person that knowingly violations a Federal consumer financial law, a civil penalty may not exceed $1,000,000 for each day during which such violation continues.

²⁶See Sec. 1055 (a).

²⁷See CFPB Bulletin 2011-14 (Enforcement), Notice and Opportunity to Respond and Advise, dated November 7, 2011.

²⁸See Id.

²⁹See Id.

³⁰See Id.

³¹See Federal Register, Vol. 77, No. 129, 7/15/12, regarding 12 CFR Part 1070, Confidential Treatment of Privileged Information.

With Form PF Compliance Dates Quickly Approaching, Advisers Managing $150 Million or More of Private Fund Assets Should Begin to Prepare

An article about Form PF Compliance written by Eric R. Markus, Victor B. Zanetti, and William L. Rivers of Andrews Kurth LLP recently appeared in The National Law Review:

On October 26, 2011, the Securities and Exchange Commission (the “SEC”) adopted Rule 204(b)‑1 under the Investment Advisers Act of 1940 (the “Advisers Act”) to require certain investment advisers that advise private funds to periodically complete and file the SEC’s new Form PF.¹ Rule 204(b)-1 implements sections 404 and 406 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) and is intended to provide the SEC with information relevant to assessing the risks that certain advisers and funds pose to the stability of the financial system. Although Form PF is filed confidentially and exempt from the Freedom of Information Act, the SEC is permitted to share this information with other federal agencies (most notably the Commodity Futures Trading Commission and the Financial Stability Oversight Council).

The requirements of the rule and Form PF are novel and the amount of information required to be assembled can be—at least in certain instances—quite substantial. With the initial compliance dates for investment advisers to certain large private funds approaching in June 2012, now is the time for investment advisers to become familiar with this new regulatory requirement, to determine when their initial Form PF filing will be due, and to identify and begin to assemble the types and extent of the information that will be required.

The full text of the adopting release and the final rule is available here. The full text of Form PF is available here.

What Investment Advisers Are Subject to Rule 204(b)-1 and Must File Form PF?

The new rule requires any investment adviser registered (or required to register) with the SEC under the Advisers Act that advises one or more “private funds” and has, in aggregate, $150 million or more in private fund assets under management to file Form PF. For purposes of determining whether they meet certain regulatory thresholds established by Form PF, related advisers must aggregate their assets under management; however, related advisers do not need to aggregate their assets if they are “separately operated.”²

What is a “Private Fund”?

The term “private fund” is defined in Section 202(a)(29) of the Advisers Act as any issuer “that would be an investment company,” as defined in the Investment Company Act of 1940, as amended (the “ICA”), but is excepted by virtue of the exemptions provided in Section 3(c)(1) (funds with fewer than 100 beneficial owners) or Section 3(c)(7) (funds owned exclusively by qualified purchasers) of the ICA. Real estate funds relying on the exemption provided in Section 3(c)(5) of the ICA are not required to file Form PF (although many real estate funds, because of the nature and structure of their investments, rely on the exemptions provided under Section 3(c)(1) or (7) and therefore may be required to file).

Form PF establishes different treatment—in terms of initial filing dates, the frequency of filings and the content of those filings—based on the characteristics of the private funds involved and their advisers. The most important distinction that Form PF draws in this regard is between “Large Private Fund Advisers” and all other investment advisers to private funds.

What is a “Large Private Fund Adviser”?

A “Large Private Fund Adviser” is defined as a private fund adviser that meets any one or more of the following criteria:

it has at least $1.5 billion in regulatory assets under management attributable tohedge funds as of the end of any month in the most recently completed fiscal quarter;
it has at least $1.0 billion in combined regulatory assets under management attributable to liquidity funds and registered money market funds³ as of the end of any month in the most recently completed fiscal quarter; and/or
it has at least $2.0 billion in regulatory assets under management attributable toprivate equity funds as of the last day of the adviser’s most recently completed fiscal year.

How are Regulatory Assets Under Management Calculated?

The term “regulatory assets under management” has the same meaning given to it in the SEC’s recent amendments to Part 1A, Instruction 5.b of Form ADV. This definition measures assets under management gross of outstanding indebtedness and other accrued but unpaid liabilities.

In addition, in order to prevent an adviser from restructuring the way it manages money to avoid compliance with Form PF, the rule requires regulatory assets under management to include (a) assets of managed accounts advised by the adviser that pursue substantially the same investment objective and invest in substantially the same positions as private funds advised by the firm unless the value of those accounts exceeds the value of the private funds with which they are managed; and/or (b) assets of private funds advised by any of the adviser’s “related persons” other than related persons that are separately operated.

What is a “Hedge Fund”?

Form PF defines a “hedge fund” as any private fund that is not a securitized asset fund⁴if it meets any of the three following criteria:

it is permitted to pay one or more investment advisers (or their related persons) a performance fee or allocation calculated by taking into account unrealized gains;
it is permitted to borrow an amount in excess of one-half of its net asset value (including any committed capital); and/or
it is permitted to sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration).

Note that for purposes of the first criteria above, the fund must only be authorized to pay a fee based on unrealized gains (the classification applies whether or not the performance fee is actually paid). In the Adopting Release, the SEC clarified that the periodic calculation or accrual of performance fees based on unrealized gains solely for financial reporting purposes (as many private equity funds do) will not cause a private fund to be classified as a hedge fund. For purposes of the second and third criteria cited above, the private fund must be authorized to undertake such activities; actually undertaking the activities is not required.⁵

What is a “Liquidity Fund”?

Form PF defines a “liquidity fund” as any private fund “that seeks to generate income by investing in a portfolio of short term obligations in order to maintain a stable net asset value per unit or minimize principal volatility for investors.” Thus, a liquidity fund would be a private fund that resembles a registered money market fund.

What is a “Private Equity Fund”?

Form PF defines a “private equity fund” as any private fund that is not a hedge fund, liquidity fund, securitized asset fund, real estate fund,⁶ or venture capital fund⁷and does not provide investors with a right to redeem their interests in the ordinary course.

Does the SEC’s Focus on Hedge Funds, Liquidity Funds and Private Equity Funds Mean that Other Types of Private Funds are Not Subject to Rule 204(b)(1) and Form PF?

No. As the charts below show, an investment adviser that is not a Large Private Fund Adviser and that does not advise any hedge funds, liquidity funds or private equity funds must still prepare and file Form PF if it advises private funds with $150 million or more in private fund assets.

What are the Initial Compliance Dates for Form PF?

Form PF and Rule 204(b)-1 establish June 15, 2012 as the initial “compliance date” for any registered investment adviser (or an adviser that is required to register) that meets one or more of the following criteria:

it has at least $5.0 billion in regulatory assets under management attributable to hedge funds as of the last day of its fiscal quarter most recently completed prior to June 15, 2012;
it has at least $5.0 billion in combined regulatory assets under management attributable to liquidity funds and registered money market funds as of the last day of its fiscal quarter most recently completed prior to June 15, 2012; and/or
it has at least $5.0 billion in regulatory assets under management attributable to private equity funds as of the last day of its first fiscal year to end on or after June 15, 2012.

An adviser subject to the June 15, 2012 compliance date as a result of its advice to hedge funds and/or liquidity funds/money market funds will need to file its initial Form PF for the first fiscal quarter ending after June 15, 2012. For most such advisers, this will be for the fiscal quarter ending June 30, 2012 (and will be due August 29, 2012 for hedge fund advisers and July 15, 2012 for liquidity fund advisers). An adviser subject to the June 15, 2012 compliance date as a result of its advice to private equity funds will need to file its initial Form PF for the first fiscal year ending after June 15, 2012. For most such advisers, this will be for the fiscal year ending December 31, 2012 (and will be due April 30, 2013).

For all investment advisers that are not subject to the June 15, 2012 compliance date, the compliance date will be December 15, 2012. However, whether such advisers will be filing with respect to the first fiscal quarter or first fiscal year ending after that date (and the deadline for such filing) will depend on the type of private funds advised and the amount of assets under management as set forth in Table I below.

TABLE I

Regulatory assets under management for the fiscal quarter or year (as the case may be) ending immediately after June 15, 2012 are, for hedge funds and liquidity funds, measured as of the last day of the fiscal quarter ending immediately prior to such date, and for private equity funds measured, as of the last day of the fiscal year ending immediately prior to such date. For any other Form PF filing under Rule 204(b)-1, regulatory assets under management, for quarterly Form PF filers, are measured as of the end of each month in the immediately preceding fiscal quarter (and the threshold is passed if, as of any month end, the assets under management exceed the relevant threshold), and, for annual Form PF filers, are measured solely as of the last day of the immediately preceding fiscal year.

What Type of Information Must Be Included in the Form PF?

As with other issues under the new Form PF, the answer to this question depends on the size and nature of the private funds advised. Investment advisers to private funds (other than Large Private Fund Advisers) have much more limited disclosure obligations than Large Private Fund Advisers. In addition, as it relates to Large Private Fund Advisers, the additional disclosures required have been tailored to whether the private fund advised is a hedge fund, liquidity fund or private equity fund. Table II below summarizes the information requirements imposed by Form PF.

TABLE II

Investment Advisers should start now to determine whether they will be required to file the new Form PF, to determine the applicable filing date for any form PF filing, and to identify and begin to assemble the required information necessary to complete the form.

1. See Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Release No. IA-3308; File No. S7-05-11 (October 31, 2011) (the “Adopting Release”).

2. An adviser is not required to aggregate its private fund assets with those of a related person if the adviser is not required to complete Section 7.A of Schedule D to its Form ADV with respect to such related person. The criteria for excluding a related person from Section 7.A of Schedule D to an adviser’s Form ADV include (i) the adviser having no business dealings with the related person in connection with advisory services provided to its clients; (ii) the adviser not conducting shared operations with the related person; (iii) the adviser not referring clients or business to the related person, and the related person not referring prospective clients or business to the adviser; (iv) the adviser not sharing supervised persons or premises with the related person; and (v) the adviser having no reason to believe that its relationship with the related person otherwise creates a conflict of interest with its clients.

3. An adviser that manages liquidity funds and registered money market funds must combine the assets in those funds for purposes of determining whether it qualifies as a Large Private Fund Adviser.

4. A securitized asset fund is a private fund whose main purpose is to issue asset backed debt securities.

5. This test does not require that the fund’s organizational documents expressly prohibit such leverage or short-selling as long as “the fund in fact does not engage in these practices … and a reasonable investor would understand, based on the fund’s offering documents, that the fund will not engage in these practices.” SeeAdopting Release at page 28.

6. A real estate fund is defined as a private fund that invests primarily in real estate and real estate-related assets as long as it is not a hedge fund and does not provide investors the right to redeem in the ordinary course.

7. A venture capital fund is defined by reference to Rule 203(l)-1 of the Advisers Act. That rule is complex, subject to various exceptions, definitions and other discussions, and easily could be the subject of its own client alert. In short, a venture capital fund is defined as a private fund that: (i) holds no more than 20 percent of the fund’s capital commitments in certain non-qualifying investments; (ii) does not incur leverage, other than limited short-term borrowing; (iii) does not offer its investors a right to redeem except in extraordinary circumstances; (iv) represents itself as pursuing a venture capital strategy; and (v) is not registered as a business development company.

8. For purposes of calculating the amount of regulatory assets under management by a manager to a liquidity fund, regulatory assets under management include the combined assets under management attributable to all liquidity funds and registered money market funds.

9. A “Large Private Fund Adviser” includes (i) any adviser that has at least $1.5 billion in regulatory assets under management attributable to hedge funds, (ii) any adviser that has at least $1.0 billion in regulatory assets under management attributable to liquidity funds and registered money market funds, or (iii) any adviser that has more than $2.0 billion in regulatory assets under management attributable to private equity funds.

10. An adviser solely to private funds other than hedge, liquidity and private equity funds would not be a Large Private Fund Adviser regardless of the assets under management in those funds.

11. See Note 9.

12. Form PF requires additional disclosures in Section 2b by Large Private Fund Advisers with respect to any hedge fund that has a net asset value of at least $500 million.

13. See Note 10.

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