Banking Agencies Publish Final Rulemaking for US Basel II

Developments of Note

1. Banking Agencies Publish Final Rulemaking for US Basel II
2. SEC Staff Provides No Action Relief in Connection with Standby Letter of Credit Purchased by Money Market Fund Adviser with Respect to Fund’s Structured Investment Vehicle Holding
3. FDIC’s Proposed Amendments to Rules Concerning a Financial Institution’s Audit Committee
4. SEC Proposes Mandatory Electronic Submission for Applications for Exemptive Relief under Investment Company Act and Filings under Regulation E
5. SEC/FINRA Announce Broker-Dealer CCO Outreach Program

Developments of Note

Banking Agencies Publish Final Rulemaking for US Basel II

The federal banking agencies (the "Agencies") issued a final rulemaking ("Rule") on all aspects of the US implementation of Basel II (which currently is anticipated to begin in early 2008). The Rule is a very extensive document. This Alert will address the credit components of the Rule. Future Alerts will address collateral, equities, securitization, and operational risk rules. A proposed rule was issued for the market risk rules on September 25, 2006 (see the September 26, 2006 Alert).

I. Overview.

Despite some industry calls for more alternatives as in the international Basel II Accord (the "International Accord"), the Rule permits only the Advanced Internal Ratings Based Approach ("A-IRB Approach") for credit risk, and a coordinate Advanced Measurement Approach ("AMA Approach") for operational risk (collectively, the "Advanced Approach"). The Advanced Approach would be mandated for the largest US-based international banking institutions ("core banks," as defined below), and others could opt-in provided that they had the appropriate systems.

All other U.S. banks will continue to use the current ratings based approach, as amended to take into account a proposed standardized approach process (proposed rules are due in the first quarter of 2008). As the Rule highlights, the Advanced Approach principally affects the risk-weight denominator for purposes of calculating Tier 1 and Total capital ratios (the "Risk-Based Capital Ratios"). The Advanced Approach generally does not affect: (1) the calculation of the numerator (i.e., the qualifying capital) of the Risk-Based Capital Ratios (although the A-IRB does not require certain capital deductions, such as of non-financial equity investments); (2) the leverage capital ratio calculation; or (3) the ratios required under the Prompt Corrective Action Rules (each of which would still apply), and, as applicable, the market risk rule.

However, as stated in a release this Summer, the Agencies have agreed not to impose the proposed 10 percent limitation on aggregate reduction in risk-based capital. Instead, the Agencies will issue a series of reports during the transition period (with the 3 year transition period remaining in the Rule) to determine if any material deficiencies in the Advanced Approach exist. More generally, the Agencies sought greater harmony between the Rule and the International Accord.

II. Applicability and Implementation of the Advanced Approach.

The Agencies continue to treat as a core bank any US depository institution ("DI") that has either (1) consolidated total assets of $250 billion or more on year-end regulatory reports, or (2) consolidated total on-balance sheet foreign exposure of $10 billion or more at the most recent year-end. In addition, a US-chartered bank holding company ("BHC") is a core bank if the BHC either (i) meets the consolidated asset thresholds described above for banks (excluding from the $250 billion asset calculation assets of insurance underwriting subsidiaries), or (ii) has a subsidiary bank that is a core or opt-in bank. The Rule states this approach is intended to prevent BHCs from structuring operations for regulatory arbitrage by moving bank assets into non-bank affiliates. The Rule also provides that the OTS does not intend to apply capital requirements to savings and loan holding companies. For foreign banks with US-chartered DIs, the above-standards apply at the US-DI level, and, if applicable, US-BHC level (although the same US BHC capital exemption provided by SR 01-01 would remain available).

Despite industry comment, the Agencies also decided to retain the requirement that any DI (regardless of size or function) that is a subsidiary of a DI or BHC that uses the Advanced Approach must itself use the Advanced Approach. However, in an effort to mitigate some of the commenters’ concerns, the Rule does permit a banking organization to request a regulatory exemption from this requirement for a DI.

Any banking organization seeking to apply the Advanced Approach will have to develop detailed, Board of Director-approved, implementation plans (with core banks adopting a plan within 6 months after it achieves the requisite size), and obtain its primary Agency’s approval. For core banks, the implementation plan must include a first transitional floor period start date no later than 36 months after the later of (1) the effective date of the Rule, or (2) the date the institution met a size threshold to be a core bank. A bank also may exclude portfolios or business lines from the A-IRB if it can demonstrate that, in the aggregate, such exposures are not material to the bank. Section 22 of the Rule also details the qualification requirements for banks implementing the Advanced Approval, including process and systems requirements, risk rating and segmentation systems, quantification systems, data management and maintenance, and control and validation mechanisms.

Banks will be required to use in parallel the Advanced Approach and current capital rules for 1 year (starting in 2008, at the earliest) prior to using the Advanced Approach on a stand-alone basis. During the parallel-use period the bank will have to show that it met the A-IRB qualification requirements (but, in response to industry comment, not necessarily all of these requirements). Moreover, a banking institution will have minimum capital floors for at least three years (occurring in 2009-2011, at the earliest) after applying the Advanced Approach on a stand-alone basis (95%, 90% and 85%, respectively, of what the risk-weighted assets would be under the current rules). During the transitional periods, a bank’s capital for all non-risk based capital purposes (e.g., Reg W) will be calculated using only the Advanced Approach.

III. The A-IRB Approach.

The A-IRB approach is based on an evaluation of possible losses with respect to credit exposures over a 1 year time horizon, with a confidence level of 99.9%. As in the Notice of Proposed Rulemaking regarding the U.S. implementation of Basel II (the "NPR"), generally banks may focus on unexpected losses, rather than also include expected losses ("EL"). Excluding EL entirely, however, is dependent upon a bank maintaining sufficient eligible credit reserves to offset the EL. If EL is less than such reserves, the difference is deducted equally from Tier 1 and Tier 2 capital; if it exceeds such reserves, the bank may include such difference in Tier 2 capital up to .6 percent of credit risk-weighted assets.

The A-IRB capital formulas basically divide on-and off-balance sheet credit into two categories: wholesale and retail. The other 2 categories of assets covered by the Rule are securitizations and equities, which, as noted above, will be addressed in a future Alert. Assets not defined by any asset category generally are assigned risk weights equal to their carrying value for on-balance sheet exposures, or notional amount for off-balance sheet exposures.

Wholesale Exposures.

Wholesale exposures generally include corporate, sovereign, and interbank exposures, as well as specialized lending exposures (but not securitizations, or certain small-business exposures that qualify for retail exposure treatment). With limited exceptions for exposures to certain speculative development loans called high volatility commercial real estate ("HVCRE") (which receive less favorable capital treatment), the Rule provides the same A-IRB capital formula for all wholesale exposures. In contrast to the International Accord, the Rule does not provide lower risk weights for exposures to small-and medium-sized enterprises ("SME"). The ratings must be updated at least annually.

The first A-IRB input for general wholesale exposures is probability of default ("PD"), which is based on an internal rating the institution assigns to each wholesale obligor (or, in response to industry comment, the obligor’s guarantor), with a general minimum PD of 3 basis points (except for certain very high quality exposures, such as sovereigns). With limited exceptions for special circumstances (e.g., DIP financing and income producing property) the Rule requires each obligor (as opposed to each exposure) to have a single rating for the PD input. The bank must have at least 7 discrete grades for non-defaulted obligors and another one for defaulted obligors.

The second principal input is loss given default ("LGD"), which may not be less than zero and is expressed as an estimate of the bank’s total exposure at default ("EAD") (taking into account recoveries, guarantees (including possible double default treatment), etc.) reflecting economic downturn conditions. The Rule, like the NPR, does not require banks to determine downturn conditions for a particular category of exposures on less than a national level. A bank generates LGD with its own internal estimates (after regulatory approval). Per industry comment, the Agencies eliminated the supervisory mapping function. In response to industry comments, the Agencies also eliminated the Expected Loss Given Default input from the Rule.

The third principal input is EAD, which generally is the amount legally owed to the bank in the event of default (i.e., the carrying value for balance sheet amounts, plus an estimate of most off-balance sheet amounts, which estimates may reflect reduction in exposures during economic downturn).

The final principal input is the effective maturity ("M") of the obligation, which generally must be set between 1 and 5 years (with exceptions for repo-style transactions and similar obligations). Having established the exposures subject to the wholesale category and these inputs, the bank: (1) assigns wholesale obligors and exposures to rating grades; (2) assigns risk parameters (e.g., the inputs) to wholesale obligors and exposures; and (3) calculates risk weighted assets for the exposures based on regulatory formulae.

Retail Exposures.

The retail exposure category encompasses the vast majority of credit exposures to individuals. This category has 3 subcategories: (1) residential mortgages (first or subsequent liens); (2) qualifying revolving exposures ("QREs", generally credit cards and overdraft lines); and (3) other retail exposures (including auto, student, margin, and consumer installment loans, and some SMEs up to a $1 million exposure). The principal distinction between the A-IRB treatment of retail and wholesale exposures is that the former are risk-weighted in segments, rather than on an individual basis, and generally no particular number of segments is required. The ratings generally must be updated quarterly.

The credit pools generally must be segregated by their risk drivers, with PD, LGD and EAD (but not maturity) remaining important A-IRB inputs. As to PD, the Rule requires two different approaches (although it provides more flexibility than the NPR) depending upon the materiality of the seasoning effects in the pool. Unlike in the NPR, the Rule permits banks to estimate retail EAD exposures on a segment rather than individual basis.

As with wholesale exposures, there would be a 3 basis point PD minimum, and also a 10% LGD minimum for residential mortgages not federally-guaranteed. The Rule notes that a 1991 federal law mandated a 50 percent risk weight for certain 1-4 family construction and multi-family loans, and a 100 percent risk weight for certain construction loan for which the purchase contract is cancelled. The Rule basically provides an A-IRB alternative for the 50% loans, but maintains the statutory standard for the 100% loans.

Default.

As the foregoing evidences, the definition of "default" is critical to the inputs of US Basel II. In response to industry comment, the Rule amends the definition to more closely correlate to the Basel Accord. In the case of wholesale exposures, the term "default" generally will include any obligation (1) the bank considers the obligor is unlikely to pay in full, or (2) which is more than 90 days past due. An unlikeliness to pay may be indicated by, for example: (1) placing the exposure on non-accrual status consistent with Call Report instructions, (2) taking a full or partial charge off because of the obligor’s financial condition, or (3) incurring a material credit related loss on sale. Notably, the 5 percent sale on loss provision was eliminated as a trigger mandating default characterization. For retail exposures, the Rule tracks the standards in the FFIEC’s Uniform Retail Credit Classification and Account Management Policy. Unlike with wholesale classifications, the definition of default for retail purposes is determined on an exposure-by-exposure basis (as opposed to obligor basis, as with wholesale). If a US bank has a non-US subsidiary subject to an IRB approach, with Agency approval the non-US subsidiary may use the definition of default in that jurisdiction.

IV. Effect of Merger or Acquisitions.

In response to industry comment, the Rule also addresses merger and acquisition transition provisions in greater detail. A bank qualifying to use the A-IRB (and, unlike the NPR, also a bank in the process of qualifying) may use the transition provision (and thus use the general risk-based capital rule or the acquired bank’s A-IRB, as appropriate) with respect to the target’s exposure for 24 months (and 36 months with Agency approval). To obtain this transition period, the acquirer must submit a plan with its Agency within 90 days (rather than 30 in the NPR) after the consummation of the transaction.

SEC Staff Provides No Action Relief in Connection with Standby Letter of Credit Purchased by Money Market Fund Adviser with Respect to Fund’s Structured Investment Vehicle Holding

The staff of the SEC’s Division of Investment Management granted no-action relief from the affiliated transaction prohibitions of Sections 17(a) and 17(d) of the Investment Company Act of 1940, as amended (the "1940 Act"), to allow a money market fund adviser to proceed with an arrangement under which it would purchase an irrevocable standby letter of credit from its parent, a bank, in order to enable the money market fund to continue to hold securities of a structured investment vehicle ("SIV"), whose short-term securities had been downgraded by Moody’s Investors Service Inc. The downgrade triggered the provisions of Rule 2a-7 under the 1940 Act requiring reconsideration of a holding that no longer meets certain credit quality criteria governing which securities a money market fund may purchase. The letter of credit issued by the adviser’s parent, whose cost would be paid by the adviser, would cover all amounts due for the life of, and at the maturity of, the SIV securities held by the Fund, and would cause the SIV securities held by the money market fund to have the same money market fund eligible credit quality ratings as the adviser’s parent.

FDIC’s Proposed Amendments to Rules Concerning a Financial Institution’s Audit Committee

As reported in the October 23, 2007 Alert, the FDIC Board of Directors approved a notice of proposed rulemaking ("NPR") that would amend Section 36 of the Federal Deposit Insurance Act ("Section 36") and its implementing regulation, Part 363 ("Part 363"). The NPR was published in the Federal Register on November 2, 2007. This article discussed the proposed amendments in the NPR relating to FDIC-insured financial institutions’ ("FIs") audit committees. The audit committee provisions of Section 36 and Part 363 are applicable to FIs with total assets of $500 million or more. The changes in the NPR are applicable to both FIs that are privately held and those that are affiliates of a publicly-owned company. Many of the changes, stated the FDIC, are designed to incorporate certain corporate governance practices of public companies implemented under the Sarbanes-Oxley Act of 2002 into the corporate governance requirements for FIs that are subject to Part 363.

(1) Composition. An FI subject to Part 363 must have an independent audit committee composed entirely of outside directors (i.e., directors who are not officers or directors of the FI or any of its affiliates). In addition, an outside director must be "independent of management," except that a minority of audit committee members of FIs with total assets of $500 million or more, but less than $1 billion, need not be independent of management. An FI’s Board must determine at least annually whether its existing and proposed audit committees satisfy the foregoing requirements. If the FI is owned by a bank holding company (whose depository institution subsidiaries constitute 75% or more of the holding company’s total assets) and the FI meets certain other criteria, the FI can satisfy Part 363’s audit committee requirements at the holding company level.

If an FI has total assets of more than $3 billion, (a "Large FI"), its audit committee must: (a) include members with banking or related financial management expertise; (b) have access to its own outside counsel; and (c) not include any members who are large customers of the Large FI. If the Large FI is a subsidiary of a bank holding company and relies on the holding company audit committee to satisfy Part 363, the holding company’s audit committee may not include any members who are large customers of the Large FI.

The FDIC proposes in the NPR that an FI’s Board be required to maintain and use an approved set of written criteria for evaluating audit committee member independence and that the results and bases for the Board’s determination be recorded in the Board’s minutes.

(2) "Independent of Management" Considerations. The FDIC proposes that in determining whether an audit committee member meets the "independent of management" requirements, the Board use the independence criteria for audit committee members in the listing standards of the national securities exchanges and regard as not independent any director who owns or controls 10% or more of any class of the FI’s voting securities. The Board may also consider additional criteria that it deems appropriate under its circumstances when it determines whether a director is independent of management.

(3) Duties. Under Section 36 and Part 363, an FI’s audit committee must review the basis for the annual Part 363 Annual Report (on internal controls and compliance with specified laws) with both the FI’s management and its independent public accountant. In addition, the audit committee’s duties should reflect the FI’s size and the complexity of its operations. The FDIC proposes in the NPR that the audit committee explicitly be made responsible for the appointment, compensation and oversight of an independent public accountant who performs services required under Part 363. In this connection, the NPR states that the audit committee must satisfy itself that the independent public accountant is in compliance with the independence, peer review and other qualifications under Part 363, and the audit committee should also make certain that the FI complies with the filing requirements relating to the engagement, resignation and dismissal of an independent public accountant.

(4) Independent Public Accountant Engagement Letter. The FDIC proposes to require audit committees to ensure that an FI’s audit engagement letters (and any related agreements) with its independent public accountant for services under Part 363 do not contain any limitation of liability provisions that: "(1) indemnify the independent public accountant against claims made by third parties; (b) hold harmless or release the independent public accountant from liability for claims or potential claims that might be asserted [by the FI], other than claims for punitive damages; or (c) limit the remedies available to the [FI]." The NPR would not preclude the use of alternative dispute resolution agreements and of jury trial waivers.

(5) Transition Period for Forming and Restructuring Audit Committees. The NPR provides a one-year transition period for forming or restructuring the audit committee on each of three occasions: (1) when the FI first becomes subject to Part 363; (2) when its total assets first reach the $1 billion level; and (3) when its total assets first reach the $3 billion level.

Comments on the NPR are due to the FDIC by January 31, 2008.

SEC Proposes Mandatory Electronic Submission for Applications for Exemptive Relief under Investment Company Act and Filings under Regulation E

The SEC proposed amendments to the rules governing its EDGAR electronic filing system that would require electronic submission of applications for orders under any section of the Investment Company Act of 1940, as amended (the "1940 Act"), and of filings under Regulation E made by small business investment companies and business development companies, thereby making the filings publicly available on the SEC website. The proposed amendments would also make the temporary hardship exemption from the electronic filing rules, which allows mandatory electronic filing to be made in paper form under certain conditions, unavailable for submission of exemptive applications under the 1940 Act, and would eliminate the requirements that (a) verifications accompanying an application for exemptive relief under the 1940 Act be notarized, and (b) each application be accompanied by a draft notice.

Electronic Filing of Applications for Orders under the 1940 Act

. Under current SEC rules regarding the filing of applications under the 1940 Act, only applications for deregistration by investment companies must be filed electronically on EDGAR. All other applications for orders under the 1940 Act made by registered investment companies, affiliated persons of registered investment companies, issuers seeking to avoid investment company status and others, must submit their applications in paper form. These paper applications are available to the public only from the SEC’s public reference room or electronically from private services, which usually charge a fee for this service. In addition, there is generally a 30 day delay after an application is filed with the SEC before private services are able to make it available. The proposed amendments would make EDGAR filing of 1940 Act applications mandatory, making them publicly available on the SEC website shortly after filing. The release proposing the amendments discusses various aspects of the proposed requirement including the different categories of submission types and the treatment of applications from multiple applicants. Requests for confidential treatment would continue to be made in paper form pursuant to Rule 101 of Regulation S-T. Citing the lack of any submission exigency or submission deadline associated with applications under the 1940 Act, the SEC proposes to make the temporary hardship exemption under Rule 201 of Regulation of S-T unavailable in the case of applications for orders under the 1940 Act. (Rule 201 provides a temporary exemption from the electronic filing requirements when the filer experiences unanticipated technical difficulties that prevent the timely preparation and submission of an electronic filing.) Under the proposed amendments, an applicant would still be able to apply for a continuing hardship exemption under Regulation S-T Rule 202 if it cannot submit all or part of an application without undue burden or expense. In addition, the SEC staff could use its delegated authority to grant a filing date adjustment pursuant to the Rule 13(b) of Regulation S-T.

Proposed Amendments to 1940 Act Application Requirements

. The SEC proposed two additional amendments to Rule 0-2 under the 1940 Act, which specifies certain requirements applicable to applications for orders under the 1940 Act for which no form is specifically prescribed. The proposed amendments would eliminate the requirement under Rule 0-2 that the signature of each person executing an application for an order under the 1940 Act be notarized. The proposed amendments would also eliminate the requirement that applicants include draft notices as exhibits to their applications for orders under the 1940 Act.

Electronic Filings by Small Business Investment Companies and Business Development Companies

. The proposed amendments would require small business investment companies registered under the 1940 Act and business development companies regulated under the 1940 Act to make filings under Regulation E, which provides an exemption from registration of the foregoing companies’ securities under the Securities Act of 1933, as amended, electronically via EDGAR.

Public Comment

. The proposing release requests comment on various aspects of the proposed amendments. Comments must be received by the SEC no later than December 14, 2007.

SEC/FINRA Announce Broker-Dealer CCO Outreach Program

The SEC and FINRA (formerly the NASD) announced a new program designed to help broker-dealer Chief Compliance Officers ("CCOs") ensure "effective communication about compliance risks, maintain effective compliance controls, and foster strong compliance programs within their firms." The CCOutreach BD program is similar to the ongoing CCOutreach Program for the CCOs of registered investment advisers and registered investment companies. The SEC’s Office of Compliance Inspections and Examinations, in coordination with the SEC’s Division of Market Regulation, will sponsor the CCOutreach BD program, together with FINRA. The program will feature a National Seminar at SEC headquarters in Washington, D.C., tentatively scheduled for March 2008, as well as regional compliance seminars across the country. The SEC and FINRA are soliciting input from broker-dealer CCOs on agenda items for the National Seminar. The SEC and FINRA have posted the following list of potential agenda items for the National Seminar on the SEC website at http://www.sec.gov/info/bdccoutreach.htmand on the FINRA website at www.finra.org/bdccoutreach, where more detailed information about the National Seminar and regional seminars will be posted as it becomes available:

(1) Sales Practices: Supervision and compliance in retail sales, suitability and disclosure, with particular focus on variable products, senior issues, producing managers, written supervisory procedures, and other areas of concern.

(2) Trading Issues: Compliance programs for trading activities, best execution, Regulation SHO, and to prevent front running.

(3) Debt Securities Issues: Mark-ups and mark-downs, fair pricing, trade reporting and supervision.

(4) Conflicts of Interest: How are conflicts of interest identified, managed and addressed? Gifts, entertainment, revenue sharing and other conflicts.

(5) New Products: (particularly structured products, hedge funds and ETFs). How to ensure compliance with respect to new products — what can firms do with respect to fostering good compliance before new products are sold?

(6) Protecting Customer Data and Non-Public Information: How to address data privacy issues, vulnerabilities, Regulation S-P, identity theft and hacking into customer accounts, and information leakage.

(7) CCOs and Compliance Programs within the Organization: Integrating compliance within the organization and helping to establish a culture of compliance. Dealing with business managers, role of supervisor vs. compliance officer. Leveraging from the work performed by other units (internal audit, operations). Practices around CCO designation — multiple CCOs, reporting lines of CCOs.

(8) Annual Compliance Report: What works to make it valuable to management and to regulators? Creating a compliance calendar. How are deficiencies identified and described? What are some useful practices to follow when conducting the review of the compliance program?

(9) The CCO’s Role in Businesses that are Constantly Changing: What do CCOs do to keep up and keep compliance up-to-date? How are new regulations integrated into the compliance program? Conducting risk assessments, how can compliance risks within the firm be identified and addressed in a changing environment?

(10) Regulatory Compliance Examinations: What to expect in an examination, how to prepare for an examination, dealing with examiners, and responding to regulatory examination findings.

(11) Business continuity / pandemic planning: How can firms prepare for pandemics and other potential business continuity issues?

(12) Regulation NMS: Compliance programs for Regulation NMS.

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