Developments of Note
Other Item of Note
- SEC Announces 2007 National CCOutreach Seminar
Developments of Note
FRB and SEC Issue Final Version of Regulation R
The FRB approved Regulation R ("Final Regulation R") implementing the bank broker push out provisions under Title II of the Gramm-Leach-Bliley Act of 1999 ("GLBA"). The SEC, which has joint rulemaking authority with the FRB, approved the regulation last week. A bank must start complying with Regulation R on the first day of the bank’s fiscal year starting after September 30, 2008, which for many banks will be January 1, 2009. This summary provides a general overview of Regulation R. A more detailed analysis will appear in a future Alert.
Regulation R was proposed by the FRB and the SEC jointly in an effort to resolve a years-long impasse between the SEC and banks regarding the appropriate interpretation of 11 statutory exceptions in GLBA. The exceptions were intended to preserve bank activity after Congress repealed the blanket bank exemption from broker regulation. After several attempts by the SEC that were criticized by banks and banking agencies, Congress last fall required the SEC to withdraw its previous proposed rules and issue rules jointly with the FRB.
Proposed Regulation R maintained many of the aspects of previous SEC proposed rules (Regulation B and Interim Rules), but it seeks to further ease the bank regulatory burden, particularly in the areas of the "chiefly compensated" income test for exempted trust/fiduciary activity, referral compensation under the networking exemption, and exempted custody activity. The FRB received 58 comments on the proposal. Comments overall supported the regulation. NASD (now FINRA) and NASAA expressed concern about certain aspects. Many banks believed further easing was warranted.
Final Regulation R eases the trust/fiduciary exemption by expanding permissible relationship compensation to include fees for securities lending, custody services to fiduciary customers and performance (capital gains). Also, a bank will not have to calculate the chiefly compensated test for foreign branch customers under certain circumstances.
Final Regulation R broadens the custody exemption somewhat to permit a sub-custodian to rely on the exemption, permit a directed trustee to rely on either it or the trust/fiduciary exemption, clarify banks’ cross-marketing authority with respect to custody customers, permit netting/cross-trades by plan administrators/recordkeepers, and provide guidance regarding a bank custodian acting as "carrying broker."
Moreover, Final Regulation R makes minor improvements to the networking exemption by adding another referral fee safe harbor (permitting a referral fee not exceeding 1/1000th of an employee’s actual annual base salary) to the three safe harbors already present in the proposed version of Regulation R. Final Regulation R also modifies the definition of "institutional customer" exempt from the referral fee restriction to include, in addition to a company with $10 million invested, a company with $20 million in revenues (dropping the proposed $40 million in assets test). In addition, Final Regulation R permits certain trusts to be considered exempt "high net worth customers." It also allows required disclosures to institutional or high net worth customers to be made orally followed by written disclosure, and eliminates the proposed requirement that the bank determine whether the employee making the referral is subject to statutory disqualification (the broker must determine this).
Final Regulation R clarifies that a bank may rely on the sweep or money market fund exemptions if another bank collected the deposit funds.
Interpretation and Enforcement.
The FRB and SEC have stated in the draft Federal Register notice for Final Regulation R that they will jointly issue any interpretations or no-action letters/guidance. Significantly, regarding formal enforcement actions, the two agencies have stated that they will consult with each other and the appropriate federal banking agency and coordinate when appropriate. Also, with regard to Exchange Act section 29(b) risk (voiding contracts made in violation of the Exchange Act), a permanent exemption is provided if the bank acted in good faith and had reasonable policies and procedures in place, and the violation did not result in significant harm or financial loss or cost.SEC Settles Enforcement Proceeding with Pension Consultant over Failure to Disclose Conflict of Interest in Advisers Act Registration Statement Filings
The SEC settled enforcement proceedings against a pension consultant registered as an investment adviser under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), over the pension consultant’s failure to disclose that it was receiving annual payments from its preferred broker for client transactions that were contingent on the clients generating a certain level of commissions. This article summarizes the SEC’s findings in its order of settlement.
The pension consultant provides consulting services and education services to institutional retirement plans, endowments, foundations and hospital plans ("retirement plan clients"). It also offers educational and consulting services to investment managers that provide investment advice to retirement plan clients ("investment manager clients"). In 1998, the pension consultant sold its affiliated broker-dealer to a third party. As a part of that transaction, the pension consultant entered into a services agreement with the third party which agreed to pay the pension consultant a specified amount per year for eight years with 8% of the annual payment contingent on the broker-dealer’s generating gross brokerage commissions from the pension consultant’s clients above a certain minimum threshold. The services agreement required the pension consultant to inform its retirement plan clients that the third party was the pension consultant’s preferred broker should the clients elect to pay for pension consultant’s services through directed brokerage (an arrangement where the client requests that its brokerage business be directed to a particular broker-dealer that has agreed to pay an adviser’s fees for that client). The pension consultant also agreed to inform its investment manager clients that the third party was its exclusive broker should the clients want to pay for the pension consultant’s services with soft dollar credits (an arrangement where the broker-dealer allocates a portion of client brokerage commissions to an account which is used to pay for certain brokerage and research services, including services provided by third party vendors, for the adviser’s benefit). The pension consultant sent annual letters to its retirement plan clients and investment manager clients informing them of these options.
From 1999 to 2005, the pension consultant’s Form ADV II, which is part of its investment adviser registration statement and includes information required to be communicated or made available to clients and prospective clients, stated that the pension consultant was obligated by the terms of the services agreement to inform its plan sponsor clients that the third party was the pension consultant’s preferred broker and to inform its investment manager clients that the third party was pension consultant’s exclusive broker if a client chose to pay the pension consultant’s fees through directed brokerage or soft dollar arrangements. In contrast to the actual terms of the services agreement, however, this disclosure indicated that under the terms of the services agreement the third party made "periodic fixed payments" to the pension consultant each year; this statement was echoed in a written response provided by the pension consultant to an inquiry from a potential retirement plan client regarding whether payments from the third party to the pension consultant were in any way dependent on future brokerage activity. (The SEC attributed this erroneous statement to confusion among the pension consultants’ employees regarding the nature of the relationship between the pension consultant and the third party.) In September 2005, following an examination by the SEC staff, the pension consultant revised its Form ADV Part II to reflect the contingent payments under the services agreement. As a result of the prior inaccurate disclosures in the pension consultant’s Form ADV Part II, which it is required to update at least annually and file with the SEC (currently, by maintaining a copy in its files), the SEC found that the pension consultant had violated Section 207 of the Advisers Act, an anti-fraud provision of the Act relating to investment adviser registration statements filed with the SEC, and ordered the pension consultant to cease and desist from Section 207 violations. (The order included no findings regarding violations of the anti-fraud provisions of the Advisers Act relating to communications with clients or prospective clients.)
Foreign Bank US Branch Obtains Regulation W Exemption
The FRB granted a Regulation W affiliate transaction exemption permitting a US branch of a foreign banking institution to engage in reverse repurchase agreements or securities borrowing transactions (collectively, "securities financing transactions" or "SFTs") with its broker dealer affiliate. The approval permits the branch, via the broker-dealer, to extend credit to market participants in need of short-term liquidity to finance holdings of residential and commercial mortgage loans, consumer and commercial loans, equipment financings, and other related assets, as well as commercial paper, asset-backed securities, and other structured products (the "Assets").
The approval letter largely tracks the reasoning and conditions in approvals provided to US banks in connection with their broker-dealer seeking to provide liquidity in a largely similar manner (see the August 28, 2007 Alert). The approval letter clarified, however, that while the exemption only would be permitted while the FRB’s special discount window lending facility is available, the branch could hold to maturity any SFT that is opened during the discount window period. In addition. the approval letter stated that a subsidiary of the foreign bank would pledge funds equal to 5 percent of the assets to ensure that the branch will not incur losses in connection with the SFTs.
SEC Votes to Propose Amendments Regarding Interpretive Rules under the Advisers Act Affecting Broker-Dealers and to Adopt Temporary Advisers Act Rule regarding Principal Trades by Dually Registered Advisers with Advisory Clients
At its open meeting on September 19, 2007, the SEC voted to propose rule amendments to its rules under the Investment Advisers Act of 1940, as amended (the "Advisers Act") that would reinstate three interpretive provisions of a rule addressing the application of the Advisers Act to certain activities of broker-dealers that was vacated by the Court of Appeals for the District of Columbia Circuit (the "Court") in a suit brought by the Financial Planning Association (see the April 10, 2007 Alert for a discussion of this decision and the May 22, 2007 Alert which describes related SEC action). The SEC also voted to adopt, on an interim final basis, a temporary rule that will establish an alternative means for an investment adviser dually registered as a broker-dealer to comply with the requirements of Section 206(3) of the Advisers Act regarding principal transactions with clients whose accounts are non-discretionary. This article is based on an SEC press release announcing these developments.
Proposed Rule Amendments.
The proposed rule amendments would re-codify prior SEC guidance as to (a) when advice is "solely incidental" to the conduct of business as a broker-dealer within the meaning of Section 202(a)(11)(C) of the Advisers Act and (b) when a broker-dealer receives "special compensation" for providing investment advice within the meaning of Section 202(a)(11)(C), as described below. (Subsection (C) of Section 202(a)(11) of the Advisers Act provides a "broker-dealer exception" from the definition of "investment adviser." It states that "any broker or dealer whose performance of [advisory] services is solely incidental to the conduct of its business as a broker or dealer and who receives no special compensation therefor" is not an investment adviser for purposes of the Act.)Separate Fee or Contract
. When a broker-dealer charges a separate fee or separately contracts for advisory services, its advice would not be considered "solely incidental" to the business of brokerage.Discretionary Asset Management.
A broker-dealer that exercises investment discretion would not be considered to be providing advice that is "solely incidental" to the business of brokerage.Discount Brokerage.
A broker-dealer that charges a commission for discount brokerage that is less than what it would charge for full-service brokerage would not be regarded as receiving "special compensation".The proposed rule amendments would also re-codify the SEC interpretation that a broker-dealer dually registered as an investment adviser is considered an investment adviser solely with respect to those accounts for which it provides services that subject it to the Advisers Act. Comments on the proposed amendments must be received no later than November 2, 2007.
The Temporary Rule.
As a result of the Court’s decision in the Financial Planning Association suit, which takes effect as early as October 1, broker-dealer customers with fee-based accounts must decide whether to convert their accounts to (a) fee-based accounts that are subject to the Advisers Act or (b) commission-based brokerage accounts. In general terms, Section 206(3) requires written disclosure to, and informed consent from, a client prior to the completion of, each transaction with an adviser acting on a principal basis. The temporary rule is designed to enable a dually registered broker-dealer’s non-discretionary customers that convert their current fee-based brokerage accounts to fee-based advisory accounts to have continued access to securities available on a principal basis from the firm despite the fact that the conversion will cause these principal transactions to be subject to Section 206(3) of the Advisers Act. Temporary Rule 206(3)-3T permits an adviser to comply with Section 206(3) of the Advisers Act when engaging in principal transactions with a non-discretionary advisory account by, among other things, (i) providing written prospective disclosure regarding the conflicts arising from principal trades; (ii) prospectively obtaining written, revocable consent from the client authorizing the adviser to enter into principal transactions; (iii) making certain disclosures either orally or in writing and obtaining the client’s consent before each principal transaction; (iv) sending the client confirmation statements disclosing the capacity in which the adviser has acted and disclosing that the adviser informed the client that it may act in a principal capacity and that the client authorized the transaction; and (v) delivering an annual report to the client that itemizes the principal transactions. The temporary rule requires that the investment adviser be registered as a broker-dealer under Section 15 of the Securities Exchange Act of 1934, as amended (the "1934 Act"), and that each account for which the adviser relies on the temporary rule be a brokerage account subject to the 1934 Act, and the rules thereunder, and the rules of the self-regulatory organization(s) of which it is a member. Compliance with the temporary rule will not relieve an investment adviser from its fiduciary obligations under the Advisers Act or by other applicable federal law, including the duty to seek best execution of client transactions, as well as the duty to disclose material facts necessary to alert clients to an adviser’s potential conflicts of interest. The temporary rule will expire on December 31, 2009. Comments on the temporary rule must be received by November 30, 2007.Federal Banking Agencies Issue Final Rules Expanding Examination Cycle for Certain Small Banks and Thrifts
The OCC, FRB, FDIC and OTS (the "Agencies") jointly adopted final rules (the "Final Rules", which are substantially identical to the interim rules issued in April 2007) that implement Section 605 of the Financial Services Regulatory Relief Act of 2006 ("FSRRA") and that expand the examination cycle for certain small insured banks and thrifts and U.S. branches and agencies of foreign banks. The Final Rules allow well-capitalized and well-managed banks and thrifts with up to $500 million in total assets and a composite CAMELS rating of 1 or 2 to qualify for an 18-month (rather than a 12-month) on-site examination cycle. Prior to the enactment of FSRRA, only banks and thrifts with total assets of less than $250 million were eligible for an 18-month cycle. The Final Rules became effective on September 25, 2007.
Banking Agencies Propose Guidance on Garnishment of Exempt Federal Benefit Funds
The four federal banking agencies and the National Credit Union Administration jointly proposed guidance on best practices regarding procedures when a financial institution (a "bank") receives a garnishment order with respect to a deposit account containing exempt federal benefit funds. The proposed guidance first explains that, as a general matter, Social Security benefits, Supplemental Security Income benefits, Veterans’ benefits, Federal Civil Service retirement benefits, and Federal Railroad retirement benefits are protected by federal from garnishment orders and the claims of judgment creditors. However, banks also are required by state law to comply with deposit account garnishment orders and, in some states, are even liable for funds withdrawn from a deposit account after the bank has received a garnishment order.
The proposed guidance highlights that these sometimes conflicting rules can raise difficult compliance issues. The guidance suggests that banks implement policies and procedures to address this topic, including procedures designed to let the consumer know as quickly as possible of the garnishment process and to release exempt funds from an account as soon as possible. In addition, the "best practices" the proposed policy recommends include: providing the consumer information about the types of funds that are exempt, notifying the creditor or court if the bank knows a frozen account contains exempt funds, minimizing NSF and other costs for frozen accounts containing exempt funds, and offering customers segregated accounts for their exempt funds.
Comments on the proposal are due 60 days after its publication in the Federal Register.
IRS Seeks to Expand Look-Through Rules for Segregated Asset Accounts
The Internal Revenue Service ("IRS") has recently taken two steps to broaden the application of the "look-through" rules for segregated asset accounts. The Internal Revenue Code (the "Code") provides that segregated asset accounts used to fund variable annuity or life insurance contracts must be "adequately" diversified in order for the variable contract to be treated as an annuity or as a life insurance contact. However, existing law also provides that, in certain cases, this diversification requirement may be satisfied under a "look-through" rule.
While all of the beneficial interests in a regulated investment company ("RIC"), real estate investment trust ("REIT"), partnership or trust generally must be held by one or more insurance company, for purposes of this requirement, beneficial interests held by a "qualified pension or retirement plan" are disregarded. In August the IRS issued revenue ruling guidance expanding the types of plans considered qualified pension or retirement plans. The new types of plans include a simple retirement account described in section 408(p) the Code ("408(p) Plan"); a deemed IRA described in section 408(q); a Roth IRA described in section 408A; a section 415(m) plan that is also a "governmental plan" within the meaning of section 414(d); and a section 457(f) plan that has as its sponsor either (i) a charitable organization described in section 818(a)(4), or (ii) a governmental organization described in section 818(a)(4), whose employees are described in section 403(b)(1)(A)(ii).
In July the IRS also issued Proposed Regulations which, if finalized, would expand the list of permitted investors that may hold beneficial interests in a RIC, REIT, partnership or trust while still permitting use of the "look-through" rule by segregated accounts. The new permitted investors include (1) qualified tuition programs under Section 529 of the Code ("529 Plans"); (2) foreign pension or retirement plans primarily for the benefit of nonresident aliens ("NRA Plans"); and (3) accounts that are segregated under Puerto Rican law from the general assets of the insurance company that owns the account ("PR Plans").
The same proposed regulations clarify the authority of the IRS to impose flexible remedies for any inadvertent diversification failure, including now allowing the IRS to impose a tax of less than what the policyholders would have owed if "they were treated as receiving the income on the contract." The period for public comment on the Proposed Regulations extends through October 29, 2007.
Other Item of Note
SEC Announces 2007 National CCOutreach Seminar
SEC Chairman Christopher Cox announced the beginning of registration for the SEC’s annual CCOutreach National Seminar sponsored jointly by the SEC’s Division of Investment Management and the Office of Compliance Inspections and Examinations. As in prior years, in addition to panel discussions, the CCOutreach National Seminar will address questions and issues raised at the regional CCOutreach seminars recently held by SEC examination staff. Registration materials and other information are available at http://www.sec.gov/info/ccoutreach.htm. The agenda available along with the registration materials indicates that the National Seminar will address (a) the interaction between compliance and operations, (b) how CCO’s deal with new products and business change, (c) compliance concerns unique to fixed-income and derivative managers and (d) examination and risk assessment processes.
