Industry Update

Primary Implications of the Emergency Economic Stabilization Act of 2008 for Investment Managers and Private Funds

On Friday, October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (the "EESA"), the controversial legislation intended to address the widening credit crisis.  Among other initiatives, the EESA establishes the Troubled Asset Relief Program ("TARP") through which Treasury will have the authority to buy from "financial institutions,"1 sell and manage a wide range of "troubled assets" (which are defined primarily to be real estate-related assets and securities, but may also include other assets designated by Treasury).  While the EESA and TARP have already been covered in detail in a recent Davis Polk Client Memorandum Emergency Economic Stabilization Act of 2008, the following is a brief discussion of the most significant implications of the EESA and TARP for investment managers and private funds.  

Private Fund Participation in TARP

Many hedge funds and other private funds (including structured investment pools such as CDO vehicles) have large holdings of troubled assets.  We understand that at least some members of Congress meant to exclude private funds from the definition of "financial institution" on the basis that they are not "regulated," even though, in some but not all cases, their investment advisers may be subject to regulatory supervision.2  Also, many hedge funds and at least some private equity funds are organized in jurisdictions outside of the United States.  It is doubtful that Treasury, in the first instance, will welcome the participation of private funds, but whether their inclusion is possible under Treasury discretion or whether, at some point in the future, further regulation or industry restructuring will bring them into the definition is unknown at this time. 

Sales of Troubled Assets by Private Funds to Financial Institutions

If private funds are excluded from participating directly in TARP, two provisions of the EESA seem effectively to foreclose the ability of private funds to sell troubled assets indirectly into TARP through a financial institution acting as an intermediary.  First, a financial institution generally cannot sell an asset under TARP at a price higher than its purchase price, thus leaving no financial incentive for a financial institution to act as an intermediary.  Efforts to circumvent this unjust enrichment provision would seem risky.  In addition, acting as an intermediary and selling troubled assets acquired from a private fund would subject the intermediary, just as it would any seller of assets under TARP, to the EESA's executive compensation, corporate governance and taxpayer upside requirements, thus providing a strong disincentive to act as a TARP intermediary.

Opportunities for Private Fund Managers and Other Investment Advisers

Asset Management Opportunities

Even if private funds are not permitted to participate directly in TARP, the EESA offers business opportunities for their managers.  Specifically, the EESA contemplates the use of third-party asset managers to manage the portfolio of troubled assets acquired by Treasury through TARP and on October 6, 2008, Treasury published its procedures for selecting asset managers (the "Treasury Selection Procedures").3

Treasury Selection Procedures

The primary elements of the Treasury Selection Procedures are:

  • Two Types of Asset Managers.  The Treasury Selection Procedures indicate that Treasury will seek asset managers for two distinct portfolios: (i) a securities portfolio that may comprise Prime, Alt-A and Subprime residential mortgage-backed securities ("MBS"), commercial MBS, MBS collateralized debt obligations and possibly other securities as may be designated by Treasury; and (ii) a whole loan portfolio that may include residential first mortgages, home equity loans, second liens, commercial mortgage loans, and possibly other types of mortgage loans as may be designated by Treasury.
  • Process.  Pursuant to the Treasury Selection Procedures, Treasury will solicit prospective asset managers by publishing a notice on its website and requesting responses.4  A notice will describe the minimum qualification requirements for prospective asset managers, the information required in a response and the factors that will be considered in the selection process.5  Following submission of responses, the selection process will include at least two more phases, in which prospective asset managers may be required, among other things, to provide additional information regarding their qualifications and to attend face-to-face interviews.

The Treasury Selection Procedures indicate that Treasury expects to designate multiple asset managers and sub-managers and that Treasury may not select all asset managers at the same time.

  • Eligibility.  To be eligible for selection under the Treasury Selection Procedures, an asset manager must be a "financial institution" as defined in the EESA.  In addition, the Securities Manager Notice also required prospective managers of the mortgage-related securities portfolio to be registered investment advisers under the U.S. Investment Advisers Act of 1940.  Presumably, any future solicitation of managers for this type of portfolio will maintain that requirement.  The Loan Manager Notice, on the other hand, did not specifically require prospective managers of the whole loan portfolio to be registered advisers.
  • Financial Agents.  Selected asset managers will be deemed "financial agents" of the United States and not contractors.  As financial agents, the Treasury Selection Procedures state, selected asset managers will "have a fiduciary agent-principal relationship with the Treasury with a responsibility for protecting the interests of the United States."6
  • Contracting Requirements.  Selected asset managers will be required to enter into a Financial Agency Agreement ("FAA") with the Treasury.  Applicants that are invited to continue to the second phase of the selection process will receive a copy of the FAA for review.  An applicant's "willingness to enter into the standard [FAA], with the established terms and conditions currently applied to financial agents of the United States, will be among the factors used in evaluating" the applicant.7
  • Small and Minority- and Women-Owned Businesses.  The Treasury Selection Procedures indicate that Treasury will issue separate notices for small and minority- and women-owned asset managers that do not meet the general eligibility requirements.  Any asset manager selected under this process would be retained as a sub-manager for a portfolio.

Significant Elements of Published Notices

As noted above, Treasury has already published its first notices under the Treasury Selection Procedures soliciting asset managers for a securities portfolio and a whole loan portfolio.  Responses to these notices were due on October 8, 2008.  Though it is not certain that further solicitations for asset managers will be made, the Treasury Selection Procedures do indicate that "as business requirements evolve, the Treasury may issue additional notices in the future to select more asset managers."8  A review of the minimum qualification standards and response information required by the published notices may be instructive, as future notices may maintain the same requirements.

Minimum Qualification Standards.  The primary minimum qualifications for an asset manager required by the Securities Manager Notice or the Loan Manager Notice were:

  • For a securities manager:
    • The manager must have been continuously engaged as a principal business in managing mortgage-related securities for the last 5 years;
    • The manager must have received an unqualified auditor's opinion for the last 5 years;
    • The manager must have at least $100 billion in dollar-denominated fixed income assets under management;
    • The manager's primary portfolio manager assigned to the Treasury's account must have at least 10 years of experience in managing fixed income assets; and
    • The manager must covenant to disclose all potential conflicts of interest, and to avoid, mitigate, or neutralize to the extent feasible and to the Treasury's satisfaction any personal or organizational conflicts of interest that may be identified by the Treasury or the manager;9 and
  • For a loan manager:
    • The manager must have been continuously engaged as a principal business in managing whole loan assets for the last 5 years;
    • The manager must currently manage a portfolio of at least $25 billion in mortgage loans, or provide clear and credible evidence that the manager can scale its capacity to manage a portfolio of at least this size;
    • The manager must covenant to disclose all potential conflicts of interest, and to avoid, mitigate, or neutralize to the extent feasible and to the Treasury's satisfaction any personal or organizational conflicts of interest that may be identified by the Treasury or the manager; and
    • The manager must be able and willing to partner with the Treasury's central whole loan custodian and trustee.10

Required Response Information.  The primary items required to be addressed by an asset manager's response to the Securities Manager Notice or the Loan Manager Notice were:

  • A detailed description of assets under management;
  • Past performance information;
  • A discussion of how best the asset manager's performance should be measured;
  • Recommendations on strategies and/or investment policies for the portfolio the manager would oversee;
  • A discussion of conflicts of interest that the manager would face if selected (including, among other things, situations where the manager or an affiliate "has a personal, business, or financial interest or relationship that relates to the [proposed] services" or "may be participating in" TARP);
  • A description of the proposed fee schedule and a declaration of the all-in costs associated with the proposed services; a fee schedule "must be aligned with the Treasury's policy goals of providing stability and preventing further disruption to the financial system, and must reflect a prudent portfolio liquidation strategy to protect the taxpayer"; and
  • A discussion of how the asset manager would provide opportunities to small and minority- and women-owned businesses to act as subcontractors.11

Investment Opportunities

In addition to the chance to act as manager of TARP assets, the EESA may create investment opportunities.  The EESA requires Treasury to "encourage the private sector to participate in purchases of troubled assets, and to invest in financial institutions."12  The EESA, however, does not provide much in the way of further detail on the nature of such participation and investment.

Future Regulation

The EESA contains several provisions that foretell additional regulation for private funds and their managers.  Specifically, the EESA orders two government studies of the current regulatory system and requires recommendations regarding "whether any participants in the financial markets that are currently outside the regulatory system should become subject to the regulatory system."13  These reports must be completed by early 2009.14

1. The EESA defines "financial institution" as:
[A]ny institution, including, but not limited to, any bank, savings association, credit union, security broker or dealer, or insurance company, established and regulated under the laws of the United States or any State, territory, or possession of the United States, the District of Columbia, Commonwealth of Puerto Rico, Commonwealth of Northern Marianas Islands, Guam, American Samoa, or the United States Virgin Islands, and having significant operations in the United States, but excluding any central bank of, or institution owned by, a foreign government.

EESA, Section 3(5). 

2. As a policy matter, it does not appear beneficial to exclude private funds from the EESA.  Rather, if the goal of the EESA is to restore financial stability, it would seem desirable to include private funds, which are an important source of liquidity in the financial system.  If Treasury does include private funds in the TARP, however, Treasury will face difficult issues in determining how to apply the EESA's corporate governance, executive compensation and taxpayer upside requirements in the context of a private fund.

3. See U.S. Dep't of the Treasury, Process for Selecting Asset Managers Pursuant to the Emergency Economic Stabilization Act of 2008, available at

4. On October 6, 2008, Treasury published three notices soliciting asset managers and other agents for the following three roles:  (i) securities portfolio managers, (ii) whole loan portfolio managers and (iii) a single provider of custody, accounting, auction management and other infrastructure services.  See U.S. Dep't of the Treasury, Notice to Financial Institutions Interested in Providing Securities Asset Management Services for a Portfolio of Troubled Mortgage-Related Assets (2008) ("Securities Manager Notice"), available at; U.S. Dep't of the Treasury, Notice to Financial Institutions Interested in Providing Whole Loan Asset Management Services for a Portfolio of Troubled Mortgage-Related Assets (2008) ("Loan Manager Notice"), available at; U.S. Dep't of the Treasury, Notice to Financial Institutions Interested in Providing Custodian, Accounting, Auction Management and Other Infrastructure Services for a Portfolio of Troubled Mortgage-Related Assets (2008) ("Infrastructure Provider Notice"), available at  Responses to these notices were due by Wednesday, October 8, 2008, before this issue went to press, and are thus not discussed in detail here.  For more information about these notices, however, please see the October 7, 2008, Davis Polk Client Newsflash [] describing them (the "DPW Treasury Notice Newsflash").

5. As discussed in more detail in the DPW Memorandum, absent clarification by Treasury to the contrary, any asset manager that contracts with Treasury should assume that all aspects of its participation in TARP, including its fees, contractual arrangements and performance, will be public.  In addition, as also discussed further in the DPW Memorandum, participating asset managers may become subject to detailed conflict of interest rules.  Treasury, on October 6, 2008, published interim guidelines for managing potential conflicts of interest under the EESA.  See U.S. Dep't of the Treasury, Interim Guidelines for Conflicts of Interest (Oct. 6, 2008) ("Interim Conflicts Guidelines"), available at  These guidelines, however, are more in the nature of steps Treasury should take to identify conflicts and do not set forth any specific conflict mitigation procedures a participating manager would need to adopt.

6. Treasury Selection Procedures at 1.

7. Id. at 2.

8. Id.

9. See Securities Manager Notice at 5-6.

10. See Loan Manager Notice at 5-6.

11. See Securities Manager Notice at 6-8; Loan Manager Notice at 6-7.

12. EESA, Section 113(a)(3).

13. ESSA, Sections 105(c)(1), 125(b)(2).

14. The first report, to be conducted by the Congressional Oversight Panel (established by the EESA), is due by January 20, 2009.  The second report, to be prepared by Treasury, is due by April 30, 2009.

Treasury Announces Guarantee Program for Money Market Funds

On September 29, 2008, Treasury opened a temporary guarantee program for money market funds (the "Program").  Treasury will guarantee the share price of eligible money market funds that apply for and pay to participate in the Program.  Eligible money market funds include funds regulated under Rule 2(a)(7) under the Investment Company Act of 1940 that are publicly offered, have a policy of maintaining a stable net asset value ("NAV") of $1.00 per share, and had an NAV on September 19, 2008 of at least $0.995.  Funds whose NAV was less than $0.995 on September 19th were not eligible to participate.  Consequently, the Reserve Primary Fund, which announced on September 16, 2008 that its NAV had fallen to $0.97, was not eligible for the Program.

To participate, an eligible fund was required to submit an executed "Guarantee Agreement" and program fee by 11:59 pm Washington, D.C. time on October 8, 2008.  The Program's initial term is three months, which Treasury may extend until September 18, 2009.

The guarantee will be triggered if a participating fund's NAV drops below $0.995.  If triggered, shareholders will receive $1.00 per covered share.  Shareholders will be covered for shares up to the lesser of (i) the number of shares the shareholder owned of the fund on September 19, 2008 or (ii) the number of shares the shareholder owned of the fund on the date on which the guarantee is triggered.  Guarantee payments will be made on the condition that (x) the fund is liquidated within 30 days and (y) Treasury receives written assurances from the fund that there is no legal impediment to the distribution of the guarantee payment.

Treasury also issued Notice 2008-81 announcing that tax-exempt funds may participate in the Program without violating a tax law restriction on federal guarantees of tax-exempt bonds.  The Notice states that Treasury and the Internal Revenue Service will not assert that the Program causes a violation of this restriction, ensuring that shareholders of tax-exempt participating funds may continue to claim the benefits of tax exemption with respect to interest dividends designated as exempt under Section 852(b)(5) of the Internal Revenue Code.

The Program will be funded by assets of the Exchange Stabilization Fund, which was established by the Gold Reserve Act of 1934 and has approximately $50 billion in assets.

International Working Group of Sovereign Wealth Funds Reaches Agreement on Draft Guidelines

Members of the International Working Group of Sovereign Wealth Funds (the "IWG") have reached a preliminary agreement on a set of voluntary guidelines regarding sovereign wealth fund ("SWF") governance, accountability and investment practices.  The IWG, which represents SWFs from 23 countries, plans to present the proposed framework to a committee of the International Monetary Fund on October 11, 2008, in Washington, D.C.  The guidelines are intended to "promote a clearer understanding of the institutional framework, governance, and investment operations of SWFs, thereby fostering trust and confidence in the international financial system," according to a statement released by the co-chairs of the working group.  The group also announced a decision to explore the establishment of a standing working group to review and update the guidelines as financial markets and cross-border investment regimes evolve.

SEC Announces CCOutreach National Seminar

The SEC has announced that the next CCOutreach National Seminar for mutual fund and investment advisers will be held on November 13, 2008 at the SEC's Washington, D.C. headquarters.  The seminar will feature several panel presentations at which SEC staffers and chief compliance officers will discuss issues related to the subprime crisis; new developments in the law regarding books and records, soft dollars and trading; the intersection of compliance and disclosure and lessons from significant examination findings and recent enforcement actions.  Attendance is limited to 500 people, and adviser and mutual fund chief compliance officers are given priority on a first-come, first-served basis.  The seminar will also be webcast at

SEC Rules and Regulations

Latest Developments Regarding SEC's Emergency Short Selling Orders

As reported in several Davis Polk Client Newsflashes (links to which are provided below), on September 17 and 18, 2008, the SEC issued a number of emergency orders relating to short selling.  Several of these orders were extended by the SEC on October 1 and 2.  A summary of the matters covered by the emergency orders and their status follows.

Ban on short sales of certain financial companies.  On September 18, the SEC issued an order temporarily banning all persons from short selling publicly traded securities of 799 financial companies.  The order was later amended to permit exchanges that list financial companies to determine which firms would be covered by the prohibition.  On October 1, the SEC announced that the order would expire on the third business day following the enactment of the Emergency Economic Stabilization Act of 2008 (the "EESA").  As discussed above, the EESA was signed into law on October 3 and the SEC announced soon thereafter that the short sale prohibition would expire at 11:59 p.m. on October 8, 2008.

Reporting of short sales on Form SH.  On September 17, SEC Chairman Christopher Cox announced his intention to propose an emergency order to the Commission requiring hedge funds and other large investors to disclose their short positions.  That order was promulgated on September 18, amended on September 21, and extended by the SEC on October 2.  Although the extended order will expire at 11:59 p.m. on October 17, the SEC has stated that it intends to issue an interim final rule that will permit the reporting requirement to remain in effect following the expiration of the order while the SEC solicits public comment. 

Under the order, all institutional investment managers that are Form 13F filers for the calendar quarter ended June 30, 2008, became required to report their short sale activity in Section 13(f) securities each week on new Form SH, starting with the week of September 22.  A Form SH report must be filed by 5:30 p.m. each Monday following a week in which the manager effected short sales, and must include the following information:

  • the number and value of 13(f) securities sold short;
  • the opening short position (which is deemed to have been zero on the morning of September 22);
  • the closing short position;
  • the largest intraday short position; and
  • the time of the largest intraday short position.

Form SH is not required to be filed if no reportable short sales have been effected since the previous filing of Form SH.  The order also provided a de minimis exception for short sales if (i) they constitute less than 0.25% of the class of the issuer's issued and outstanding Section 13(f) securities (as reported in the issuer's most recent SEC filings) and (ii) the fair market value of the short position is less than $1,000,000.  If two or more institutional investment managers exercise investment discretion with respect to the same securities, only one manager must report, although the non-reporting manager must file a report identifying the reporting manager.

Form SH must be filed electronically through the SEC's EDGAR system on a non-public basis.  Although the SEC initially indicated that Form SH filings would be made publicly available following a two-week lag, the SEC stated on October 2 that disclosure under the order will be made only to the SEC, and forms filed under the order, including those that were due on September 29, will remain non-public to the extent permitted by law without the need to submit a confidential treatment request.  Explaining the change in its position, the SEC cited its concern that "publicly available Form SH data could give rise to additional, imitative short selling that was not intended by the Commission's Order."  However, the SEC has not foreclosed the possibility of requiring some type of public disclosure in the future (including under the forthcoming interim final rule). 

Rule 204T close-out requirement.  On September 17, the SEC adopted Rule 204T, which imposes new requirements and penalties for failures to deliver equity securities for clearance and settlement by the settlement date (ordinarily, T+3).  If a short sale violates the close-out requirement, then any broker-dealer acting on the short seller's behalf will be prohibited from further short sales in the same security - for any customer - unless the shares are pre-borrowed.  The order was extended once and is scheduled to expire at 11:59 p.m. on October 17, although the SEC has stated that it intends to issue an interim final rule that will permit Rule 204T to remain in effect following the expiration of the order while the SEC solicits public comment. 

Elimination of options market maker exception.  On September 17, the SEC amended Rule 203(b)(3) of Regulation SHO to eliminate an exception from the short selling close-out provisions of the rule that permitted an options market maker to maintain fail positions indefinitely.  As a result of the amendment, options market makers are treated the same as other market participants with respect to the T+3 close-out requirements that effectively prohibit naked short selling.  Options market makers are required to close out existing fail positions subject to Rule 203 within 35 consecutive settlement days from the date of the amendment.  The SEC considers the amendment to have been adopted as a final rule pursuant to the September 17 emergency order. 

Rule 10b-21 anti-fraud rule.  Rule 10b-21 became effective as of September 17.  The rule provides that it will be a "manipulative or deceptive device or contrivance" under Section 10(b) of the Securities Exchange Act of 1934 for any person to deceive a broker-dealer, a clearing organization participant or a purchaser about their intention or ability to deliver securities in time for settlement and then fail to deliver such securities.  The SEC stated that the rule "expressly targets fraudulent short selling transactions."  The SEC considers Rule 10b-21 to have been adopted as a final rule pursuant to the September 17 emergency order. 

See the Davis Polk Client Newsflashes regarding the orders:

Electronic Filing of New Form D Implemented

September 15, 2008 marked the first day the new Form D could be filed electronically with the SEC.  As before, an issuer must file Form D with the SEC within 15 days of the issuer's first sale of securities offered pursuant to Regulation D of the Securities Act of 1933.  In addition, issuers must continue to file Form D in paper format with the relevant state authorities.  Until March 15, 2009, Form D filers may file the new Form D either electronically or in paper format or may file the Temporary Form D (which is essentially the old Form D) in paper.  On March 16, 2009, the transition period will end and all Form D filers will be required to electronically file the new Form D. 

For a full discussion of the revised rules that alter the information requirements and mandate the electronic filing of Form D, see the February 2008 Investment Management Regulatory Update.

SEC Expanding Market Manipulation Investigation-Will Require Statements Under Oath

On September 19, 2008, the SEC announced an expansion of its investigation into alleged manipulation of the securities of financial institutions. As reported in the August 2008 Investment Management Regulatory Update, the SEC, in coordination with NYSE Regulation and FINRA, is examining investment advisers and broker-dealers to evaluate their compliance controls relating to preventing the spread of false information. The SEC's expansion of the investigation will require certain hedge fund managers, broker-dealers and institutional investors to provide statements under oath regarding their trading positions. A formal order approved by the Commission will also allow SEC enforcement staff to subpoena additional documents or require testimony.

Registered Investment Advisers Required to Deliver Prompt Notice of Changes to Custody Arrangements

Given the recent changes sweeping through the financial industry, registered investment advisers should be mindful of their obligation to provide notice to their clients regarding any change in custody arrangements.

Rule 206(4)-2(a)(2) under the Investment Advisers Act of 1940 (the "Advisers Act") requires investment advisers that are registered or required to register under the Advisers Act to provide written notice to their clients of custody account arrangements, including the qualified custodian's name and address and the manner in which the funds or securities are maintained.  This notice must be sent promptly whenever an account is opened or whenever there are any changes to the information provided.  Advisers may send such notices to an independent representative if the client has designated an independent representative to receive notices pursuant to Rule 206(4)-2(a)(4).

Further, advisers that have made changes to their custody arrangements should review their disclosures in Item 9 of Form ADV Part I and promptly file an amendment if any information provided has "become inaccurate in any way" (General Instruction 4 to Form ADV).


SEC Charges Investment Adviser with Failing to Protect Client Information

On September 11, 2008, the SEC charged LPL Financial Corporation ("LPL") with failing to adopt policies and procedures reasonably designed to protect its customer's information, in violation of Regulation S-P.  According to the SEC, despite being aware of vulnerabilities, LPL maintained lax security policies relating to its online trading system that exposed customer accounts to unauthorized access and trading.  LPL consented to an order in settlement of the proceeding.

LPL is a registered investment adviser, broker-dealer and transfer agent that provides brokerage, custody and clearing services for more than one million customer accounts through over 8,000 independent contractor registered representatives.  Each registered representative is given online access to LPL's trading platform called "BranchNet" in order to open customer accounts and place trades for customers. 

Section 30(a) of Regulation S-P (the "Safeguards Rule") requires every broker, dealer, investment company and investment adviser registered with the SEC to adopt policies and procedures reasonably designed to insure the security and confidentiality of customer records and information, protect against anticipated threats to the security of customer records and information and protect against unauthorized access to customer records and information. 

In December 2006, LPL concluded an internal audit of BranchNet that revealed a number of security deficiencies, including (1) no minimum password length or other password strength requirements, (2) no automatic lockout after a number of unsuccessful login attempts and (3) eight hours of inactivity required before a session timed out.  The audit concluded that these and other deficiencies increased the likelihood of unauthorized access.  According to the SEC, despite the audit's findings, LPL failed to take any corrective action. 

Between July 2007 and February 2008, there were a number of unauthorized connections to BranchNet resulting in 209 attempted trades worth over $700,000 in 68 customer accounts.  Non-public information of at least 10,000 customers was also exposed.  While LPL was able to block a number of the trades, some were executed, resulting in losses which LPL reimbursed.

The SEC charged LPL with recklessly disregarding the Safeguards Rule by failing to have policies and procedures "reasonably designed" to protect customer records and information.  Under the settlement with the SEC, LPL was censured and ordered to pay a civil monetary penalty of $275,000, and agreed to:

  • design and implement policies and procedures for training employees and registered representatives regarding safeguarding customer records;
  • retain an independent consultant to evaluate LPL's Safeguard Rule compliance policies and report recommendations to improve compliance to LPL and the SEC; and
  • adopt all the independent consultant's recommendations, unless the SEC specifically allows otherwise.