The OCC issued an interpretive letter ("Letter 1033") permitting a national bank to hedge an equity index derivative by holding a basket of securities that do not perfectly match the derivative. The bank asserted that matching the index perfectly would have been unnecessarily costly (particularly for smaller holdings) and also would not have allowed the bank to take full advantage of the dividends received deduction under IRS rules. The bank projected that the hedge will result in a less that 1% tracking error, based on several probability scenarios, although the bank will hold less that 70% of the securities in the index. After reciting the requirements that the OCC imposes in connection with any equity derivative hedging program, Letter 1033 states that the extent of the mismatch in this case (i.e., less than 1%) was so slight as to fall within the existing authority.
NASD Provides Guidance on Outsourcing
In response to a growing trend among NASD members to outsource an increasing number of activities and functions, the NASD issued a Notice to Members (the "NTM") providing guidance to member firms regarding their responsibilities when outsourcing certain activities and functions relating to their business operations and regulatory responsibilities to third-party service providers. The NTM addresses (i) when third-party service providers will be considered "associated persons" of the member; (ii) accountability and supervisory responsibility for outsourced functions; and (iii) activities and functions that are prohibited from being outsourced.
Associated Persons
. In the NTM the NASD reminded members that "in the absence of specific NASD or MSRB rules, or federal securities laws or regulations that contemplate an arrangement between members and other registered broker-dealers with respect to such activities or functions (e.g., clearing agreements executed pursuant to NASD Rule 3230), any third-party service providers conducting activities or functions that require registration and qualification under NASD rules will generally be considered associated persons of the member and be required to have all necessary registrations and qualifications." The NTM does, however, indicate that the NASD does not view a third-party vendor solely providing back-office support services, such as a trade execution and reporting system that are utilized by registered or associated persons of a member, as an associated person of the member. The view expressed in the NTM, that service providers engaging in regulated activities may be associated persons of the member, is based on the proposition that a person engaging in activities requiring registration as a broker or dealer under the Securities Exchange Act of 1934, as amended, should be registered as a broker-dealer.Accountability and Supervisory Responsibility for Outsourced Functions
. The NTM further provides that outsourcing does not relieve members of their ultimate responsibility for compliance with all applicable federal securities laws and regulations and NASD and MSRB rules. Members should consider whether their supervisory system and written supervisory procedures adequately address outsourced activities or functions, or whether adjustment is necessary to ensure, for example, that appropriately qualified persons monitor outsourcing arrangements, or provide for due diligence on third-party service providers. Implicit in this guidance is the view that members may not merely rely on contractual representations but should have in place specific policies and procedures to monitor a service provider’s compliance with the terms of an outsourcing agreement.Activities and Functions Prohibited from Being Outsourced.
In the NTM the NASD also expresses the view that a member may not outsource direct control of its supervisory and compliance activities. However, a member may outsource activities that support its supervisory and compliance activities, such as a computer system that monitors excessive trading, provided that the firm makes its own determination that the system implemented is current and reasonably designed to achieve compliance as required under NASD Rule 3010.The NASD did not define third-party service provider and it is believed that, as used in the NTM, the term refers to any party, including affiliated entities, that are not currently associated with a member firm.
Basel Committee Provides Guidance on LGD Estimates
The Basel Committee on Banking Supervision (the "Basel Committee") provided additional guidance (the "Guidance") on estimating losses given a default ("LGD"), as is required by Pillar 1 of the Basel II capital framework (see the July 6, 2004 Alert for a detailed description of Basel II - pleae click on Next Page link at bottom of article). The Guidance is focused on the requirement that LGD estimates must "reflect economic downturn conditions where necessary to capture the relevant risks." The Guidance notes that in evaluating the ability of banks to fulfill these requirements, a Basel II working group noted 3 issues: (1) the potential for recovery rates to be lower than average may be a material source of unexpected losses for some portfolios; (2) data limitations present a significant challenge to estimating LGD (and particularly LGD during an economic downturn); and (3) there is little consensus among banks about how to incorporate LGD parameters for an economic downturn.
In light of the foregoing, the Guidance details several governing principles relating to the requirement that banks applying Basel II incorporate losses during economic downturns into their LGD estimates. First, the bank must have a rigorous and well-documented process for producing its estimates. The process must include the following components: (1) identification of appropriate downturn conditions for each asset class, generally in each jurisdiction; (2) identification of any correlations between default rates and recovery rates in the event of default; and (3) incorporation of any correlations so as to produce LGD parameters, consistent with economic downturns. In sum, as to the first principle, the Guidance instructs banks to determine economic downturn indicia, and then develop correlations to produce a LGD relevant to such circumstances. As a second principle, the Guidance directs that, in estimating recovery rates for purposes of calculating LGD, banks should include the costs of holding the recovered assets over the workout period (i.e., the time value of money) as well as a risk premium appropriate to the undiversifiable risk of the asset. The Guidance further provides several examples of how the concept in the second principle can be calculated. The Guidance also states that for each exposure banks must be prepared to provide supervisors with an estimate of long-run default-weighted average loss rate given default (as the actual LGD for any exposure may not be less than that average). The Guidance further states that, during a transition period, supervisors may establish a LGD for a particular exposure if it is not otherwise available, but such an LGD should be sufficiently conservative so as to encourage banks to develop their own LGD in accordance with Basel II and the Guidance.
OCC Approves Conversion of LLC to a National Banking Association
The OCC approved the conversion of Brown Brothers Harriman Trust Company, LLC, a New York limited liability trust company ("BBHTC-NY") into a national banking association to be called Brown Brothers Harriman National Trust Company ("BBHNTC") in OCC Conditional Approval #696 ("Approval #696"). BBHTC-NY is, and BBHNTC will be, a wholly-owned subsidiary, other than directors’ qualifying shares, of Brown Brothers Harriman & Co., a well-capitalized private bank with a history of strong earnings that was founded in 1818. Approval #696 is the first approval granted by the OCC for a conversion to a national bank from a limited liability company ("LLC"). The OCC found that § 35 of the National Bank Act does not limit the authority to convert to a national bank to those entities that are organized in corporate form. Moreover, Approval #696 states that after an LLC converts to a national banking association it may choose to follow state LLC laws for its internal governance under 12 C.F.R. § 7.2000(b), but it remains subject to all of the banking laws and regulations and bank safety and soundness standards applicable to national banking associations. The OCC cautioned that because of the flexibility of state LLC statutes there may be features, in some instances, that are inconsistent with banking laws and regulations and safety and soundness principles (e.g., instances when there are more than one owner and LLC provisions allow all of the owners to participate in management). Accordingly, in Approval #696, the OCC requires BBHTC to obtain the prior approval of the OCC before changing, among other things, its Articles of Association, By-laws that relate to the use of NY LLC law, or its ownership. One notable condition to Approval #696 is that BBHNTC is required to establish and maintain an independent audit committee, even though BBHNTC will not be FDIC-insured. The OCC also concluded that three wholly-owned, limited purpose trust company subsidiaries of BBHNTC (in Florida, Pennsylvania and Texas respectively) would, after the conversion, be deemed "operating subsidiaries" of BBHNTC.
Other Item of Note
OCC Issues Handbook Concerning Home Mortgage Disclosure
The OCC issued a Handbook concerning home mortgage disclosure that provides: (1) a discussion of the Home Mortgage Disclosure Act ("HMDA") and Regulation C thereunder, and (2) a discussion of the objectives of, as well as examples of, optional, expanded HMDA and Regulation C examination procedures.
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