OTS Finalizes 23A/23B Rules

The OTS finalized amendments to its rules governing thrift affiliate transactions in light of the FRB’s finalization of Regulation W (see the November 5, 2002 Alert). The OTS rules largely incorporate Regulation W, and also generally are intended to be less restrictive than the OTS’ historical standards. For example, the final rules conform the definition of "affiliate" to more closely correspond to the Regulation W definition (historically the OTS also had incorporated certain presumptions of control from Part 574 into the definition), and thereby generally reduce the scope of entities that would be deemed thrift affiliates. The final rules also modify the OTS’ historical position by treating reverse repurchase agreements as purchases of assets rather than loans, thereby now allowing thrifts to enter into reverse repurchase agreements with affiliates engaged in non-bank holding company activities. (HOLA precludes thrifts from lending to (but not purchasing assets from) such affiliates (the "HOLA Lending Limitation")). Unlike Regulation W (but consistent with HOLA), the OTS final rules do not strictly apply the third party attribution rules (i.e., transactions with third parties where proceeds are transferred to affiliates are deemed to be transactions with affiliates), but rather provides that such transactions only will be deemed affiliate transactions on a case-by-case basis. The final rules also divert from historical OTS precedent by not automatically attributing the activities of a subsidiary to its parent for purposes of determining whether a particular affiliate engages in activities causing it to be subject to the HOLA Lending Limitation. Rather the final rules provide that the OTS will determine on a case-by-case basis whether subsidiaries are being formed to circumvent the rule. The final rule also is more lenient than OTS historical precedent by not compelling thrifts to aggregate covered transactions between a particular affiliate and its subsidiaries to determine whether that affiliate is within the 10% of capital covered transaction limitation. Finally, because savings and loan holding companies are not subject to separate capital rules like bank holding companies, the final rules provide that for purposes of determining eligibility for the internal corporate reorganization exception from covered transactions in Regulation W (which requires the holding company to be "well-capitalized"), the OTS will determine whether a particular holding company is so capitalized. The OTS rules become effective November 6, 2003.

In an interpretive letter issued to the Securities Industry Association (the "Interpretive Letter"), the NASD indicated that under NASD Conduct Rule 2210 a member of the NASD may not publish or distribute sales material for a hedge fund that presents related performance information, even if a non-member, such as a hedge fund manager, prepared the material. (The release does not define the term "hedge fund.") As discussed in the Interpretive Letter, "related performance information" includes the performance of other, separate investment companies, funds, portfolios, accounts or composites of the foregoing managed by the same adviser or portfolio manager that manages the hedge fund being promoted. The term includes the performance of "cloned" funds and other similarly managed accounts and funds, the performance of funds or accounts that preceded or were converted into the advertised hedge fund and composites of other similarly managed, accounts or portfolios, but generally does not include the performance of a master fund of which a hedge fund is a feeder to the extent that the performance information shown reflects performance of the same portfolio securities in which the hedge fund’s assets are invested. The Interpretive Letter also indicates that members of the NASD may not use any hypothetical or back-tested performance in hedge fund sales material that does not reflect the actual performance of the hedge fund. The NASD noted that its current rules also prohibit the use of most forms of related performance information in mutual fund and variable product and sales material although it has proposed amendments to permit such use. The NASD added that, although allowing related performance information in hedge fund sales material would be inappropriate while the mutual fund/variable product proposal is outstanding, it has not ruled out permitting related performance information for hedge funds in the future, and it will consider whether the mutual fund/variable product proposal should be amended to address hedge fund sales material. The NASD’s prohibition on use of hedge fund related performance information applies to "correspondence" and "sales literature" (as defined in Rule 2210) that are used by NASD members when selling hedge fund interests. Placement agents and brokers providing capital introduction services should review all such information they provide to prospective investors to ensure compliance with NASD rules and related interpretations including the Interpretive Letter. Hedge funds have been an area of increasing focus for regulators, including the NASD. In August 2002, the NASD issued an Investor Alert regarding the marketing of funds of hedge funds and in February 2003 issued a Notice to Members advising members of their suitability obligation to investors whenever recommending or selling hedge funds (see the February 4, 2003 edition of the Alert). In April 2003, the NASD censured and fined Altegris Investments, Inc. for its use of hedge fund sales literature that failed to include certain disclosures regarding specific risks of investing in hedge funds and made unbalanced presentations about the particular hedge funds being sold. The Interpretive Letter also provides guidance regarding suitability determinations applicable to hedge fund investments, confirms existing guidance as to what constitutes a "recommendation" and suggests that while each piece of sales material must comply with Rule 2210(d), the release describing the Altegris enforcement proceeding should not be read to require that lists of risk factors be included in all hedge fund sales materials.

The OCC issued an interpretive letter ("Letter 973") discussing the laws applicable to the multi-state operation of a national bank’s fiduciary authority. The bank had a trust office in California, and was serving as indenture trustee for a customer in Washington. Letter 973 first confirms that a national bank located in one state may offer fiduciary services in other states regardless of where the customers or property reside. The relevant law for purposes of incorporating state law (to the extent required by 12 U.S.C. Section 92a) in this case was California, as that is where the bank is performing its core fiduciary activities. In other words, although the customers were located in Washington, it was the laws of California which determined the capacities in which the bank could act, and laws in Washington that purport to precondition the exercise of fiduciary power are inapplicable.

The OCC issued a paper entitled Today’s Credit Markets, Relationship Banking and Tying (the "Paper") in which it concluded that there is little evidence that national banks are forcing customers to buy products the customers do not want in violation of the anti-tying rules. The [anti-tying statute], said the OCC "does not apply to voluntary tie-ins nor prohibit by its terms tying arrangements based on a customer’s meaningful choice from an array of products and services offered in an effort to meet a bank’s profitability standards." In the Paper, the OCC defines and provides legal and economic analyses of relationship banking. The Paper notes that banks have made only modest inroads in the investment banking market and do not have the market power necessary to force a commercial customer to accept an impermissible tying arrangement. Relationship banking, concludes the OCC, is "more likely the result of cost savings, not anti-competitive tying."

The ten federal agencies (including, among others, the FDIC, FRB, OCC and OTS) that are the members of the federal Interagency Task Force on Fair Lending (the "Task Force’) jointly published a brochure, Putting Your Home on the Loan Line is Risky Business (the "Brochure") alerting consumers to the risks of high-cost home loans and of dealing with predatory lenders. The Brochure provides guidance to consumers on ways to avoid borrowing pitfalls and urges consumers to comparison shop home loan requests and to take note of differences in, among other things, interest rates, payment size, term of the loan, points, fees and other loan costs. Consumers, states the Brochure, should also have an attorney, financial counselor or knowledgeable friend review the loan documents related to the request for credit. The Task Force further reminds consumers in the Brochure that consumers have a broad range of legal rights when they seek credit using their home as security, and, in particular, reminds consumers that if they are using their home as security for credit such as a home equity loan, line of credit or second mortgage, the consumer has three business days after signing the loan documents to rescind the transaction. Separately from the issuance of the Brochure , FRB Governor Gramlich made a public speech concerning predatory lending issues in which he concluded that predatory lending requires a "nuanced and balanced response" by regulators. While the issuance of appropriate regulations and the commencement of enforcement actions should be used to combat predatory lending abuses, said Mr. Gramlich, "we should not lose sight of the fact that responsible, subprime lending programs provide a welcome extension of home mortgage and other credit to previously underserved groups – a true democratization of credit markets."

SEC Chairman William H. Donaldson announced that the SEC staff has begun drafting rules designed to address abuses in connection with late trading and market timing of mutual fund shares. The rules are expected to be submitted for formal consideration by the SEC no later than November 2003 and, if approved, will then be published as proposals for public comment. In the area of late trading, Mr. Donaldson indicated that the staff will be considering among other measures (a) a requirement that an order for the purchase of fund shares must be received by a fund, rather than an intermediary such as a broker-dealer, prior to the time as of which the fund’s net asset value is determined in order to receive that net asset value, and (b) additional procedures and controls designed to prevent late trading and ensure compliance with new pricing requirements. With respect to market timing, he noted that new rules and form amendments under consideration could (w) require fund offering documents to make explicit disclosure of market timing policies, (x) require funds to have procedures for complying with their representations regarding market timing, (y) emphasize funds’ obligation to fair value their holdings under certain circumstances to minimize market timing arbitrage opportunities, and (z) reinforce fund directors’ obligation to consider the adequacy and effectiveness of fund market timing practices and procedures. Mr. Donaldson added that he had asked the staff to consider whether additional requirements were necessary to prevent the misuse of material, non-public information, including selective disclosure of portfo lio holdings information.

The OCC issued an interpretive letter ("Letter 952") concerning the location of a national bank: (1) for corporate status purposes; and (2) in determining the national bank’s citizenship for federal diversity jurisdiction. Letter 952 states that for corporate status purposes under the National Bank Act and other banking laws, a national bank’s location is determined by its current "main office" as designated in the national bank’s current articles of association, which may be different from the place designated in the national bank’s organization certificate and original articles of association. The "main office" is "primarily a term of legal, rather than business, significance." Accordingly, Letter 952 states, although the national bank must conduct at least a minimal amount of business at its main office, the office need not be its most significant office and it need not be the office at which the national bank conducts any minimum portion of its business. In the context of an interstate merger, the resulting bank may select as its main office any one of the main offices or branches of any of the banks in the merger (including a branch in a state that is different from the state of the former main office of the acquiring bank). For purposes of diversity jurisdiction in federal courts, Letter 952 concludes that a national bank is a citizen of two states: (1) the state in which its principal place of business is located; and (2) the state in which its main office is currently located as reflected in its articles of association.

The NYSE and Nasdaq have filed amendments to their respective corporate governance rule proposals with the SEC. These rules would apply to investment companies listed on the NYSE and Nasdaq, but generally in a more limited manner than to listed operating companies. Once final rules are adopted, a listed fund/company will have until the earlier of (a) its first annual meeting after January 14, 2004 or (b) October 31, 2004 to comply with the applicable requirements, subject to certain exceptions for foreign private issuers, small business issuers and issuers with staggered boards. Greater detail will be available through a future issue of the Alert.

The FASB announced that it was delaying the implementation of its Interpretation No. 46, Consolidation of Variable Interest Entities. Public companies now must complete their evaluation of entities that existed prior to February 1, 2003 and consolidate them as appropriate for the first period ending after December 15, 2003 (i.e., calendar year companies will consolidate in their December 31, 2003 financial statements). Entities formed after January 31, 2003 are not entitled to the deferral.

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