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Investment Management Legal and Regulatory Update - January 2013

January 10, 2013

Schapiro Steps Down; Money Market Reform Steps Up

Elisse Walter to Serve as Chairman.
Mary Schapiro announced on November 26, 2012 that she would be resigning as Chairman of the SEC. President Obama quickly named Elisse Walter, an SEC commissioner since 2008, as the new Chairman. Unless the Senate reapproves her position, however, Chairman Walter may only serve through December 2013, sparking speculation as to who will be her successor. Ms. Schapiro retired on December 14, 2012 after serving as the agency's head since January 2009 and as the first woman to lead the agency on a permanent basis.

SEC Debates on Money Market Reform Continue. While at the SEC, Ms. Schapiro spent a considerable amount of her time focusing on money market fund (MMF) reform, an issue that has been heating up over the past several months. In August 2012, Ms. Schapiro informed the public that three of her fellow commissioners would not support her efforts to reform MMF rules, forcing her to table any proposed rulemaking. While MMF sponsors celebrated for a moment, in September 2012, Treasury Secretary Timothy Geithner wrote a letter to the Financial Stability Oversight Council (FSOC) asking the council to formally request that the SEC enact new rules governing MMFs. Additionally, in December 2012, Commissioner Aguilar changed his view and publicly stated that he would not oppose a proposal that requires MMFs to float their NAV.

FSOC Authority. The Dodd-Frank Act provides FSOC with the authority to identify risks and respond to emerging threats to the financial stability of the United States. Further, FSOC has the authority to issue recommendations to "the primary financial regulatory agencies to apply new or heightened standards and safeguards. . . for a financial activity or practice conducted by . . . nonbank financial companies . . . if the council determines that . . . such activity or practice could create or increase the risk of liquidity [or credit among the] financial markets of the United States." Under this authority, Secretary Geithner asked FSOC to make the determination that the MMF industry, in its current form, increases liquidity and credit risk in the financial markets and, subsequently upon that determination, to present the SEC with recommendations on MMF reform pursuant to its power under Dodd-Frank.

Following the Lead. In response to Secretary Geithner's letter, the U.S. Chamber of Commerce urged him to withdraw the request. The Chamber of Commerce stated that the process Secretary Geithner recommended "would only repeat or exacerbate the flawed approach the SEC has taken [on MMFs] over the past year."

Nonetheless, on November 13, 2012, FSOC unanimously voted to publish its proposed recommendations for MMF reform and requested public comment on the following three recommendations:

Floating NAV. Require MMFs to have a floating net asset value (NAV), which is currently fixed at $1.00, that would reflect the actual market value of the underlying portfolio securities.

Stable NAV with NAV Buffer and "Minimum Balance at Risk." Require MMFs to have an NAV buffer of a tailored amount of assets of up to 1% of the value of the fund's portfolio securities. Also require that 3% of a shareholder's highest account value over $100,000 during the previous 30 days (minimum balance at risk or MBR) be available for redemption after 30 days of being in a "first loss" position.

Stable NAV with NAV Buffer and Other Measures. Require MMFs to have an NAV buffer of a tailored amount of assets of up to 3% of the value of the fund's portfolio securities combined with other measures to improve the buffer and increase MMF resiliency.

Although the proposals may not be novel to the commissioners, FSOC's action could force the SEC into unchartered territory.

Next Steps. The 60-day comment period for the proposed recommendations is scheduled to end in mid-January. Once the comment period closes, FSOC would then have to issue a final recommendation. FSOC stated, however, that it will not issue a final recommendation if the SEC moves forward with "meaningful" structural reforms. Nonetheless, if FSOC does issue a final recommendation, the Dodd-Frank Act would force the SEC into action. Under Dodd-Frank, the SEC must: (1) adopt the recommendation of FSOC; (2) implement similar standards that FSOC deems acceptable; or (3) within 90 days of the issuance, explain to FSOC in writing why the SEC is unwilling to follow the recommendation. In the event that the SEC accepts FSOC's recommendations, the SEC would then need to issue proposed rules subject to another public comment period.

SEC at Work. While Secretary Geithner and FSOC were hard at work proposing these recommendations, the SEC was conducting the MMF study that commissioners Luis Aguilar, Troy Paredes and Dan Gallagher had previously requested in August 2012. On December 5, 2012, the SEC released that study, which found that while MMFs under the 2010 reforms are "more resilient now to both portfolio losses and investor redemptions than they were in 2008," no MMF would have endured the losses that the Reserve Primary Fund suffered in 2008 without breaking the buck. The study did concede the conclusion that, assuming MMFs are using the maximum weighted average maturity of 60 days, which the 2010 reforms decreased from 90 days, MMFs' probability of breaking the buck has declined. The study's analysis of increased transparency in MMFs, however, was inconclusive. Finally, the study examined the effect that the potential reforms would have on investor redemptions in MMFs, indicating that investors may shift some assets into unregulated investments or private funds with stable NAVs. The study reported that its findings were favorable for financial companies, who "are well suited to identify alternate mechanisms for short-term financing," and municipalities, who should not encounter difficulties in managing their debt financing "given other structural shifts in the market for these types of securities."

Given the lack of precedence on this topic and the economic impact these proposals may have on the MMF industry, a court challenge of the FSOC recommendations is likely.

Sources: Reuters: U.S. Treasury Weighs Money Fund Reforms, Faces Hurdles (Aug. 23, 2012); U.S. Government Accountability Office Report to Congressional Requesters (Sept. 2012); Financial News: Geithner Asks FSOC to Urge Action on Money Funds (Dec. 7, 2012); U.S. Chamber of Commerce Correspondence (Nov. 5, 2012); Ignites: Chamber: FSOC Too Quick to Intervene (Nov. 6, 2012); Ignites: FSOC Ready to Take Up Money Fund Reforms (Nov. 9, 2012); Securities Regulation & Law Report: Chamber Asks Geithner to Withdraw Request for FSOC Recommendation on Money Funds (Nov. 12, 2012); Bloomberg Business Week: Walter to Become SEC Chairman After Schapiro Steps Down (Nov. 26, 2012); U.S. Department of the Treasury: Financial Stability Oversight Council Releases Proposed Recommendations for Money Market Mutual Fund Reform (Nov. 13, 2012); The New York Times: As Official Drops Out, SEC Race Shifts (Nov. 28, 2012); Ignites: SEC Staff: 2010 Reforms No Cure-All (Dec. 6, 2012).

CFTC Rule 4.5 Withstands Litigation Challenges

In 2012, the Commodity Futures Trading Commission (CFTC) adopted amendments to Rule 4.5 under the Commodity Exchange Act that narrow the available exclusions from the definition of a commodity pool operator (CPO). See "CFTC Rescinds and Narrows Registration Exemptions for Funds" in our April 2012 update.

The CFTC amendment prompted the Investment Company Institute (ICI) and the U.S. Chamber of Commerce (collectively, the plaintiffs) to join forces in arguing that the CFTC did not adequately follow the rules under the Administrative Procedures Act in amending Rule 4.5. See "ICI and U.S. Chamber of Commerce File Lawsuit Regarding CFTC Rule Amendments" in our July 2012 update.

On June 18, 2012, the CFTC filed a motion for summary judgment. In its July 2, 2012 response to the summary judgment motion, the plaintiffs argued that while the CFTC relied on the Dodd-Frank Act and the 2008 financial crisis to justify its rule amendment, the Dodd-Frank Act did not require the rule amendment at issue, and the financial crisis does not justify investment company regulation. The plaintiffs further argued that the CFTC did not undertake an analysis of existing investment company regulation but, instead, formulated a rule that expands the regulation of entities that are already subject to SEC and FINRA regulation.

On December 13, 2012, D.C. District Court Judge Beryl Howell dismissed the plaintiffs' suit and held that the CFTC adequately conducted a cost-benefit analysis in amending Rule 4.5 and that the CFTC's reasoning was not arbitrary and capricious. Judge Howell further explained that it is not the court's role to second-guess the CFTC's analysis. In refuting the plaintiffs' argument that the rule subjects certain entities to dual regulation by the SEC and the CFTC, the court explained that the SEC itself actually admitted that it has not efficiently regulated entities that invest in derivatives.

On December 27, 2012, the plaintiffs filed a brief notice with the court indicating that they intend to appeal the court's ruling but did not disclose on what grounds they intend to file the appeal. Nonetheless, because of the timing, this ruling confirms that mutual funds unable to meet the amended Rule 4.5 exemption from CPO registration must have registered with the CFTC by December 31, 2012.

Sources: ICI and Chamber of Commerce Memorandum in Response to CFTC's Cross-Motion for Summary Judgment (July 2, 2012); ICI Heads to Court with CFTC (Oct. 5, 2012); CFTC's Notice of Clarification Regarding the Alternate Net Notional Test and Submission of Citation (Oct. 15, 2012); Ignites: Funds Fight, Prepare for Commodity Regs Simultaneously (Oct. 19, 2012); ICI and Chamber of Commerce's Supplemental Submission in Response to the Court's Inquiry Concerning the Definition of "Bona Fide Hedging" (Oct. 22, 2012); Ignites: CFTC Beats Back ICI-Chamber Suit (Dec. 13, 2012).

SEC Charges Mutual Fund Directors for Failure to Oversee Asset Valuation

The SEC Enforcement Division's Asset Management Unit continues to prioritize asset valuation investigations. Most notably, the SEC recently brought charges against eight former Morgan Keegan mutual fund board members for allegedly violating their fair valuation responsibilities under the federal securities laws. According to the SEC, the Morgan Keegan board delegated its fair valuation responsibility to a valuation committee without providing meaningful substantive guidance on how fair valuation determinations should be made. The SEC alleged that the fund directors then made no meaningful effort to learn how fair values were being determined, received only limited information about the factors involved with the funds' fair value determinations, and obtained almost no information explaining why particular fair values were assigned to portfolio securities. The SEC asserted that the directors' failure to fulfill their fair value-related obligations was particularly inexcusable given that fair-valued securities made up the majority of the funds' net asset values -- in most cases more than 60 percent.

The SEC previously charged the funds' accountant and adviser, Morgan Keegan & Company and Morgan Asset Management, respectively, for fraudulently overstating the value of securities backed by subprime mortgages. Without admitting or denying the SEC's allegations, Morgan Keegan paid $200 million to settle the 2010-2011 enforcement action.

Valuation Procedures. The funds' valuation procedures listed various factors for the valuation committee to consider when making fair value determinations. These factors included fundamental analytical data relating to the investment, the nature and duration of restrictions on disposition, market influences, the type of security, the issuer's financial statements, the cost of the security on its purchase date, the size of the holding and other various factors specifically relating to restricted securities. The SEC asserted that the factors were copied nearly verbatim from the SEC's Accounting Series Release No. 118. According to the SEC, other than listing these factors, the valuation procedures did not provide any specific guidance on how to actually implement these factors in making the fair value determinations or how to evaluate whether specific factors were appropriate for a given security. Moreover, the directors did not provide any guidance beyond the insufficient valuation procedures.

The funds' valuation procedures required that the directors receive explanatory notes for the fair values assigned to securities. However, the SEC alleged that no such notes were ever provided to the directors, and they never followed up to request such notes or any other specific information about the basis for the assigned fair values.

Determining Fair Value. The SEC alleged that fund accounting assigned fair values without using any reasonable analytical method to ensure a fair value. Instead, they typically set the fair value at the security's purchase price and only changed that value if a subsequent sale or price confirmation varied more than 5% from the purchase price. If more than a 5% variance existed, fund accounting allegedly allowed the portfolio manager to select the fair value. The SEC asserted that the portfolio manager took advantage of the fact that fund accounting allowed him to arbitrarily set values without a reasonable basis and that he did so in a way that postponed the decline in the NAVs of the funds. The SEC asserts that, as a result, the NAVs of the funds were materially misstated for five months in 2007.

Shortly after each month end, fund accounting randomly selected and sought price confirmations for as few as 10% of the funds' fair valued securities. These price confirmations were essentially opinions on price from broker-dealers, rather than actual bids or firm quotes. The SEC noted that the price confirmations were further lacking because fund accounting requested month end prices several weeks after the respective month-end -- a process that would not provide timely price confirmations for the securities.

Finally, the SEC noted that the funds' valuation procedures did not include any mechanism for identifying and reviewing fair-valued securities whose prices remained unchanged for weeks, months and even entire quarters.
"While it is understood that fund directors typically assign others the daily task of calculating the fair value of each security in a fund's portfolio, at a minimum they must determine the method, understand the process and continuously evaluate the appropriateness of the method used," said William Hicks, Associate Regional Director of the SEC's Atlanta Regional Office.

Sources: SEC Release No. 30300 (Dec. 10, 2012); SEC Charges Eight Mutual Fund Directors for Failure to Properly Oversee Asset Valuation, Release No. 2012-259 (Dec. 10, 2012).

Audit Committee Annual Evaluation of Independent Auditor

On October 15, 2012, the Independent Directors Council and other financial organizations, including the Association of Audit Committee Members, Inc., Center for Audit Quality, Corporate Board Member/NYSE Euronext, Mutual Fund Directors Forum, National Association of Corporate Directors and Tapestry Networks, published an assessment questionnaire to assist mutual fund audit committees in performing their annual evaluations of a fund's independent auditor.

Investment company audit committees are responsible for overseeing the integrity of the company's financial reporting process and controls and for supervising the independent auditor. In fulfilling these responsibilities, the audit committee should consider annually evaluating the independent auditor and reporting the results of its evaluation to the investment company's board of directors. The audit committee's evaluation should consider the qualifications and performance of the auditor, the quality of the auditor's communications with the audit committee and the company, and the auditor's independence, objectivity and professional skepticism. To assist the audit committee in evaluating these factors, it may use an assessment questionnaire that highlights the most important areas of consideration.

Assessment Process. In conducting its assessment, the audit committee should evaluate its experience with the auditor during the current engagement period. The committee should also consider the experiences of others within the company, including management, internal audit and key managers, as applicable. However, the audit committee should not compile these observations retrospectively at the end of the year; instead, the auditor's performance should be continuously evaluated throughout the audit process.

Quality of Services and Sufficiency of Resources. To ensure that the independent auditor provides a quality audit, the audit committee should first assess whether the primary members of the audit engagement team possess the relevant skills and experience. Factors to consider include industry, accounting and auditing knowledge, as well as company-specific financial reporting risks. The engagement team should also have access to specialists for unique issues that may arise both domestically and abroad and should perform a risk assessment for the company at the outset of the engagement. Finally, the audit committee should understand how the audit firm complied with and responded to its most recent inspection by the Public Company Accounting Oversight Board (PCAOB).

To gain further knowledge about the auditor's services and resources, the audit committee may also consider asking the following questions:

  • Did the auditor dedicate adequate resources to the audit?
  • Did the auditor ask for feedback on the services provided?
  • Was the lead engagement partner accessible?
  • Did the risk assessment identify the appropriate risks, including company- and industry-specific risks?
  • Did the auditor meet the objective performance criteria?
  • Did the auditor appropriately respond to changing circumstances?
  • Did the auditor advise the audit committee of its findings or results from the audit in a timely manner?
  • Were the audit costs and any intermittent changes to those costs reasonable for the company?

Communication and Interaction with the Independent Auditor. The audit committee must maintain regular and open communication with the independent auditor. While PCAOB standards and SEC rules require certain auditor communications, the auditor should also engage in quality discussions with the audit committee to ensure that the committee understands each stage of the audit process and any significant issues that arise. The following questions may help promote open and productive communications:

  • Did the audit engagement partner explain accounting and auditing issues in a professional and understandable manner?
  • Did the auditor discuss the company's accounting policies, estimates and judgments and compare them to industry trends?
  • Was the auditor sensitive to and professional about inadequate or imperfect internal controls and procedures?
  • Does the auditor keep the audit committee up-to-date on leading practices and current developments in accounting principles and auditing standards?

Auditor Independence, Objectivity and Professional Skepticism. To exercise objective judgment and professional skepticism, the auditor must be independent of the investment company complex. In reviewing the company's disclosures, the auditor should evaluate the company's use of estimates and assumptions and question any processes or policies that appear inadequate. Based on this review, the auditor should be able to justify or explain the company's findings and opine on whether the company's financial statements comply with generally accepted accounting principles (GAAP). To ensure independence and oversight, the audit committee may also consider the following questions:

  • Did the auditor discuss all independence factors, including exceptions, with the audit committee?
  • What safeguards has the audit firm put in place to detect independence issues?
  • Did the auditor's perspective conflict with management's perspective on any accounting issues? If so, did the auditor take the lead role to reconcile these views?

For sample questions on each of these topics and an example form to evaluate your independent auditor, please refer to the white paper, Audit Committee Annual Evaluation of the External Auditor cited below.

Sources: Association of Audit Committee Members, Inc., Center for Audit Quality, Corporate Board Member/NYSE Euronext, Independent Directors Council, Mutual Fund Directors Forum, National Association of Corporate Directors and Tapestry Networks: Audit Committee Annual Evaluation of the External Auditor (Oct. 2012).

SEC Extends Temporary Rule Regarding Principal Trades with Certain Advisory Clients

The SEC has extended the date on which Rule 206(3)-3T of the Advisers Act will sunset to December 31, 2014. Rule 206(3)-3T, adopted in September 2007 on an interim basis, provides investment advisers that are also registered as broker-dealers with an alternative means to satisfy Section 206(3) of the Advisers Act, permitting the broker-dealers to act in a principal capacity in transactions with certain advisory clients. Under Rule 206(3)-3T, broker-dealers may sell certain securities held in the proprietary accounts of their firms that would otherwise not be available on an agency basis to their advisory clients, yet still protects clients from conflicts of interest as a result of these transactions.

The Dodd-Frank Act required the SEC to complete a study on the regulatory requirements applicable to broker-dealers and investment advisers, including Rule 206(3)-3T. The staff delivered its study to Congress on January 21, 2011 but the process of reviewing the recommendations from the study is ongoing, and the SEC did not believe it would complete its analysis of broker-dealer and investment advisor regulatory requirements by the rule's scheduled sunset on December 31, 2012. Further, the SEC believed that allowing the rule to sunset could limit the access of affected non-discretionary advisory clients to certain securities and could require advisory firms to make substantial changes in a short time period.

Sources: SEC Proposed Rule Release No. IA-3483 (Oct. 9, 2012); SEC Final Rule Release No. IA-3522 (Dec. 20, 2012).

SEC Issues Securities Lending Guidance

On November 6, 2012, the SEC released guidance on securities lending by open-end and closed-end mutual funds. Under the Investment Company Act, funds may choose to lend their portfolio securities to generate additional income provided that their investment objectives, policies and restrictions authorize such lending. The release reviewed the objectives and participants in securities lending transactions, and the SEC staff provided investment companies with an extensive list of no-action letters addressing various areas of concern for funds when lending portfolio securities.

Summary of Securities Lending. Pursuant to a written agreement between the borrower and the lender, funds generally lend their portfolio securities to broker-dealers, who then re-lend them to other market participants. As protection for the fund, the borrower will post collateral, which typically consists of cash. The value of the borrower's collateral must be at least equal to the value of the borrowed securities, and the borrowed securities' value is marked-to-market daily. Securities lending may be an attractive source of income for funds but has come under increased scrutiny due to losses experienced by some funds during the financial crisis. Because securities lending raises various issues under the Investment Company Act, the SEC compiled a list of relevant no-action letters covering common securities lending issues. Examples of such issues include loan collateralization, approval of fees, proxy voting and treatment of collateral. This list of no action letters may prove useful to a fund navigating the securities lending territory and can be found on the SEC's website by clicking here.

Sources: SEC Report: Securities Lending by U.S. Open-End and Closed-End Investment Companies (Nov. 6, 2012).

Last Minute Discussion Over Hedge Fund Advertising Rule

Pursuant to the 2012 Jumpstart Our Business Startups Act (JOBS Act), Congress directed the SEC to lift advertising bans for hedge funds, private equity funds and other private offerings. Congress believed that repealing the advertising restrictions would reduce the regulatory burden for small businesses and allow them to reach investors in the private marketplace. The SEC responded by introducing a proposal in August 2012 that would eliminate the prohibition against general advertising solicitation and general advertising in Rule 506 of Regulation D. See our October 2012 update for more information.

Recently released e-mails, however, depict the SEC's hesitation in approving the final rule. These e-mails indicate that on May 23, 2012, the SEC recommended to the commissioners that they issue an "interim final rule" in August, which would have immediately ended the advertising ban. However, on August 29, 2012, the SEC issued a proposed rule, which requires public comment, delaying a potential implementation date.

Chairman Walter has echoed this hesitation over the advertising rule. At a small business capital formation conference, she stated, "If allowing general solicitation results in increased incidence of fraud or sale of securities to investors that don't have the sophistication to understand the risks and merits of a particular investment, we will have failed not only investors but small businesses as well." She continued, saying "[w]e must be vigilant about the potential consequences, particularly the unintended consequences of a change like this and consider ways to mitigate potential harms to investors while preserving the rule's intended effects."
While Chairman Walter did not indicate that she would block the rule, she has said that she hopes the SEC will consider various safeguards. The comment period for the proposed rule has ended, and we are awaiting further SEC action.

Sources: The Wall Street Journal, Market Watch: Regulator Fears Fraud from Hedge-Fund Ad Rules (Nov. 15, 2012); Reuters: Emails Suggest SEC's Schapiro Delayed JOBS Act Rule Amid Concerns About Legacy (Dec. 1, 2012); FIN Alternatives, Hedge Fund & Private Equity News: Speculation Surrounds Hedge Fund Advertising Rule (Dec. 3, 2012).

FINRA Considering New Disclosure Rules

The Financial Industry Regulatory Authority, Inc. (FINRA) has collected information about compensation structures at numerous different brokerage firms, intending to learn more about how brokers are handling conflicts of interest. After reviewing the information, FINRA is considering a rule change to increase transparency in broker recruiting incentives.

The proposed rule would require brokers to disclose recruitment compensation packages in connection with transferring customer accounts to the new firm. Often, in changing from one brokerage firm to another, brokers receive substantial financial incentives, including signing bonuses, causing speculation that such incentives may induce registered representatives to change firms. FINRA's concern is that, in conjunction with their move, brokers may encourage their clients to open accounts at the new brokerage firm by promising better securities products. By focusing on new sales rather than on the client's needs, brokers may overlook their suitability obligation to their clients, which requires brokers to focus on client-specific factors such as age and risk tolerance when recommending investments.

Sources: Reuters: FINRA Reviewing Conflicts of Interest at U.S. Brokerages (Oct. 24, 2012); Investment News: FINRA to Consider New Disclosure Rule (Nov. 28, 2012).

Capital, Margin and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants

The SEC has proposed capital and margin requirements for security-based swap dealers (SBSDs) and major security-based swap participants (MSBSPs) and segregation requirements for SBSDs pursuant to Dodd-Frank.

Capital Requirements for SBSDs. The proposed rule requires SBSDs to calculate (1) the minimum amount of net capital -- or highly liquid capital -- the SBSD must maintain and (2) the amount of net capital the SBSD is currently maintaining. Generally, SBSDs that are not broker-dealers and are not using internal models must maintain minimum net capital of at least the greater of $20 million or 8% of the firm's risk margin amount. SBSDs that are broker-dealers and are not using internal models must maintain minimum net capital of the greater of $20 million or 8% of the firm's risk margin amount plus the amount that Rule 15c3-1 under the Exchange Act requires.

To compute net capital, an SBSD must make certain net worth adjustments, including deducting illiquid assets and taking other capital charges. This calculation results in the "tentative net capital." The SBSD must then take prescribed percentage deductions, or "standardized haircuts," from the mark-to-market value of proprietary positions included in its tentative net capital. The SEC believes that such standardized haircuts will help account for market risk inherent in certain positions and create a liquidity buffer for protection against other risks in the business. The proposed rule indicates that those firms using internal models would also be subject to tentative net capital requirements, in addition to the minimum net capital amount.

To cover potential future exposure, the proposed rule requires SBSDs to take capital charges when security-based swap customers and security-based swap counterparties do not meet certain margin requirements. Additionally, SBSDs must establish and maintain a risk management control system.

Capital Requirements for MSBSPs. The proposed rule requires MSBSPs to maintain a positive tangible net worth, rather than the net liquid asset test imposed on SBSDs. The MSBSP would calculate its tangible net worth in accordance with GAAP, excluding goodwill and other intangible assets, but including assets such as property, equipment and unsecured receivables.

Margin Requirements. The SEC is proposing to require SBSDs and MSBSPs to collect collateral from counterparties to security-based swaps that are not cleared by a registered clearing agency. This margin requirement would be based on the margin rules currently applicable to broker-dealers. Under the broker-dealer margin rules, an accountholder must "maintain a specified level of equity in a securities account at a broker-dealer (i.e., the market value of the assets in the account must exceed the amount of the accountholder's obligations to the broker-dealer by a prescribed amount)."

SBSD Margin Requirements. To comply with the margin requirements, SBSDs must perform the following calculations at the close of each business day for each account carried for a counterparty: (1) calculate the amount of equity, or current exposure, in the account; and (2) determine the amount of margin, or potential future exposure, in the account. Following these calculations, on the next business day, the SBSD must collect cash, securities and/or money market instruments from the counterparty in an amount at least equal to the negative equity, or current exposure, in the account plus the margin amount.

MSBSP Margin Requirements. Similar to SBSDs, MSBSPs must make daily calculations as to the amount of equity in each counterparty's account. On the business day following the calculation, the MSBSP must collect cash, securities and/or money market instruments from the counterparty based on a positive equity calculation. Alternatively, the MSBSP would have to deliver collateral to a counterparty that had current exposure to the MSBSP. Unlike SBSDs, however, MSBSPs are not required to calculate a margin amount.

Segregation. The SEC proposed segregation requirements for cleared and non-cleared security based swaps to protect customer property and distinguish it from SBSD property. For non-cleared swaps, unless the customer requests individual segregation or waives segregation, the SBSD, by default, must use an alternative omnibus or "commingled" account for funds related to non-cleared swaps. Pursuant to the omnibus segregation requirements, the SBSD must maintain an account exclusively for security-based swap customers. A separate account ensures that the cash and qualified securities in the account are identified as security-based swap customers' property and are isolated from the SBSD's proprietary assets. The segregation requirements would also require an SBSD to maintain possession or control of a customer's "excess securities collateral," or the securities and money market instruments that have a market value over the SBSD's current exposure to the customer.

The comment period on the proposed rule is scheduled to close on January 22, 2013.

Sources: SEC Proposed Rule Release No. 34-68071 (Oct. 18, 2012); Federal News: SEC Agrees to Propose Capital, Margin and Segregation Requirements for Swap Entities (Oct. 22, 2012); Investment Company Institute Letter Re: SEC Proposes Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants (Oct. 25, 2012); Investment Company Institute Letter Re: Margin and Capital Requirements for Covered Swap Entities (Nov. 20, 2012).

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