Securities and Exchange Commission (SEC)

SEC Charges Rating Agency Morningstar with Failures of Disclosure and Internal Controls in CMBS Rating Model Adjustments

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On February 16, the Securities and Exchange Commission (SEC) filed a civil action in federal district court in the Southern District of New York against the former credit ratings agency, Morningstar Credit Ratings LLC, regarding alleged failure to disclose and maintaining internal control provisions in violation of federal securities law in its CMBS ratings practice. The complaint alleges that, in 30 transactions rated by Morningstar between 2015 and 2016, Morningstar failed to disclose that its rating criteria permitted analysts to adjust property cash flow and valuation stresses on a “loan-specific basis,” which resulted in lower expected losses on CMBS classes and the assignment of credit ratings and failed to adequately maintain a system of internal controls to ensure adherence to its ratings criteria. The complaint alleges violations of the Securities Exchange Act of 1934 against Morningstar and seeks injunctive relief, disgorgement and civil penalties. Release.

SEC Adopted a New Rule Allowing Registered Funds to Enter Into Derivative Transactions

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On October 28, the Securities and Exchange Commission (SEC) adopted a new rule 18f-4 under the Investment Company Act of 1940 allowing registered funds to enter into derivative transactions, provided they comply with certain conditions intended to protect investors. The rule will become effective 60 days after publication with an 18-month transition period for compliance with the provisions and related reporting requirements. Release.

SEC Modernizes the Accredited Investor Definition

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The Securities and Exchange Commission (SEC) amended the definition of “accredited investor” to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in private capital markets. The amendments allow individuals to qualify as accredited investors based on measures of financial sophistication, including professional knowledge, experience or certification, as well as existing tests for income or net worth. The updates to the definition also expand the entities that may qualify as accredited investors. Release.

Regulatory Agencies Finalize Changes to Covered Fund Provisions of the Volcker Rule

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On July 31, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (FRB), the U.S. CFTC, the Federal Deposit Insurance Corporation (FDIC), and the U.S. Securities and Exchange Commission (SEC) published a final rule amending the regulations that implement Section 13 of the Bank Holding Company Act (the “BHC Act”), commonly known as the Volcker Rule. The final rule, which goes into effect on October 1, is intended to improve and streamline the covered fund provisions of Section 13 of the BHC Act. The final rule aims to accomplish this by, among other things, permitting the following activities: qualifying foreign excluded funds; revising the exclusions from the definition of “covered fund” for foreign public funds, loan securitizations, public welfare investments, and small business investment companies; creating new exclusions from the definition of covered fund for credit funds, qualifying venture capital funds, family wealth management vehicles, and customer facilitation vehicles; modifying the definition of “ownership interest”; and providing that certain investments made in parallel with a covered fund, as well as certain restricted profit interests held by an employee or director, need not be included in a banking entity’s calculation of its ownership interest in the covered fund. OCC Bulletin. Federal Register Final Rule.

SEC Adopts Final Rule Amending Required Financial Disclosures Regarding Acquisition and Disposal of Businesses

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On May 20, the Securities and Exchange Commission (SEC) adopted a final rule amending the existing rules for registrants that determine whether a subsidiary or an acquired or disposed business is significant and the relevant disclosure requirements for the related financial statements. The changes will become effective on January 1. Rule.

SEC Releases Guidance on Investment Advisers’ Proxy Voting Responsibilities

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On August 21, the Securities and Exchange Commission (SEC) provided guidance for investment advisers in fulfilling their proxy voting responsibilities. The Commission also issued an interpretation that proxy voting advice provided by proxy advisory firms generally constitutes a “solicitation” under the federal proxy rules. Release.

’40 Act Leeway for Mortgage REITS and Others

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The SEC Investment Management Division published a no-action letter on August 15 addressed to Redwood Trust that provides a certain degree of Section 3(c)(5)(C) compliance leeway for mortgage REITs and mortgage bankers. The Redwood letter is a recognition by the staff that the ebb and flow of mortgage loans into and out of a mortgage banking business, and the retention of cash proceeds from time to time, is an integral part of the business, as is the retention of the right to service loans to facilitate both loan sales and securitizations.

Specifically, the staff concluded that there would be no objection to Redwood treating certain MSRs and cash proceeds in the manner described below for purposes of the Section 3(c)(5)(C) exclusion from the registration requirements of the Investment Company Act of 1940. Redwood Trust No-Action Letter – 2019

  • MSRs created when mortgage loans are sold or securitized can be treated as “qualifying interests” under Section 3(c)(5)(C), and
  • Cash proceeds from mortgage principal amortizations, interest payments and payoffs in connection with real estate-related assets, as well as from the sale of such assets, including to securitization trusts, can retain the characterization of the assets from which the cash proceeds were derived for purposes of Section 3(c)(5)(C), subject to the time limitations indicated in the letter; e.g. sell whole loans and treat the cash proceeds of the sale as “qualifying interests” (subject to such time limitations).

As we stated in our April 12, 2019, letter to the SEC staff on behalf of Redwood, these cash proceeds are “integral parts of and directly related to and arising from Redwood’s mortgage banking activities” and, likewise, created MSRs “are acquired as a direct result of Redwood’s mortgage banking activities”. Our letter references the staff’s Great Ajax no-action letter of February 12, 2018, in which the staff said that it “would be willing to entertain other no-action requests to treat as qualifying interests certain other mortgage-related assets if they are acquired by an issuer as a direct result of the issuer being engaged in the business of purchasing or otherwise acquiring whole mortgage loans (e.g., certain “A-Notes” and servicing rights)”. Orrick Letter to SEC, April 12, 2019

(Redwood also obtained a no-action letter in 2017 relating to the treatment of credit risk transfer securities as “real estate-type interests” under Section 3(c)(5)(C). In the Orrick letter to the staff, we noted, among other things, that credit risk transfer securities share similar characteristics with, and have the same economic substance as, agency partial pool certificates, which are treated as “real estate-type interests” under Section 3(c)(5)(C). In its letter, the staff recognized the similarities between credit risk transfer securities and agency partial pool certificates and concluded that the credit risk transfer securities described could be treated as “real estate-type interests”.  Redwood Trust No-Action Letter – 2017 ; Orrick Letter to SEC, September 5, 2017)

SEC Staff Observation from Examinations of Investment Advisers

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On July 23, the Securities and Exchange Commission (SEC) Office of Compliance Inspections and Examinations (OCIE) published a Risk Alert on its “Observations from Examinations of Investment Advisers: Compliance, Supervision, and Disclosure of Conflicts of Interest.” The purpose of this Risk Alert is to raise awareness of certain compliance issues that OCIE observed by sharing the Staff’s observations from these examinations. The Risk Alert provides a good summary of the Staff’s observations across a broad range of compliance topics, but emphasized its specific observations relating to employees or prospective employees with disciplinary histories. As stated by the Staff: “the key takeaway is that OCIE encourages advisers, when designing and implementing their compliance and supervision frameworks, to consider the risks presented by hiring and employing supervised persons with disciplinary histories and adopt policies and procedures to address those risks.” Risk Alert.

SEC Adopts New Rules Affecting Security-Based Swap Dealers and Major Security-Based Swap Participants

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On June 21, the Securities and Exchange Commission (SEC) adopted new rules and rule amendments to establish capital, margin and segregation requirements under Title VII of the Dodd-Frank Act. These rules largely aim to increase the risk-mitigation practices of security-based swap dealers and major security-based swap participants. Release.