OTS Rules Thrift Op Subs May Underwrite ABS

The OTS issued an interpretive letter ("P-2004-5") holding that thrifts may establish an operating subsidiary to own, sell and underwrite asset-backed securities ("ABS"). The thrift had conducted such ABS underwriting activities through a holding company subsidiary, but to save on discounts and commissions, now wished to perform the activities through an operating subsidiary. The ABS underwriting activities at issue concerned mortgage loans, automobile loans and receivables, and other consumer loans, including securities that are unrated or are rated less than investment grade. P-2004-5 holds that such activities are permissible either under existing direct OTS precedent, or as an incidental power. In connection with the securitization of unrated or less than investment grade securities of the type described in the letter, the OTS concludes that such securities are not the type of junk bonds that Congress intended to prohibit by Section 28 of the Federal Deposit Insurance Act.

The FDIC issued a Financial Institution Letter ( FIL – 122 – 2004 ) providing guidance concerning the internal control attestation standards that auditors of FDIC insured banks with $500 million or more in total assets ("Large Banks") should follow to comply with the FDIC’s audit and reporting requirements under Section 36 of the Federal Deposit Insurance Act and 12 C.F.R. Part 363 ("Part 363"). Under Part 363, Large Banks must file an annual report (the "Annual Report") with the FDIC (and other applicable federal and state supervisors) including a statement of management’s responsibilities for establishing and maintaining an adequate internal control structure and procedures for financial reporting (both using generally accepted accounting principles and regulatory accounting principles). The Annual Report also is required to contain an assessment by management of the effectiveness of internal controls over financial reporting as of the prior year-end and a report by the financial institution’s independent auditors on management’s assertion concerning the adequacy of internal controls. To date, auditors have followed American Institute of Certified Public Accountants ("AICPA") attestation standard 501 ("AT 501") when reporting on internal controls. Section 404 of the Sarbanes-Oxley Act of 2002 ("Section 404") imposes similar internal control and attestation requirements on public companies, including publicly-held banks and bank holding companies. Under Section 404, however, auditors of public companies are required to follow the Public Company Accounting Oversight Board Auditing Standard No. 2 ("AS No. 2"). Section 404 and AS No. 2 require more extensive testing and documentation of internal control than those required by Part 363 and AT 501. The FDIC states that a Large Bank that is not a public company need only have its auditor follow AT 501 to satisfy Part 363. For a Large Bank that is a public company, but a "non-accelerated filer" with the SEC, its auditor may follow AT 501 rather than AS No. 2 for 2004 and until AS No. 2 becomes effective for it in 2005. A Large Bank that is a subsidiary of a public holding company that is an SEC "accelerated filer," but is not itself a public company has a choice, it may have its auditor use AT 501 for the bank subsidiary, even though its holding company uses AS No. 2 or it may choose to have the auditor’s work performed for the subsidiary also follow AS No. 2. The FDIC notes that the Auditing Standards Board of the AICPA is working on a project to revise AT 501 (for years after 2004) that is likely to render it more like AS No. 2. As reported in the Oct. 26, 2004 Alert the FDIC also has held meetings with the AICPA and other bank regulatory agencies to discuss potential future revisions to AT 501 and the FDIC anticipates that the Part 363 requirements will more closely resemble Section 404 requirements for years after 2004.

On January 31, 2005, new NASD rules and rule amendments that could significantly impact how broker-dealers which are NASD members ("Members") inspect their offices, establish, maintain and test internal controls, and generally supervise their business, will go into effect. (See NASD Notice to Members 04-71 (October 2004)) The most noteworthy change, new Rule 3012, requires the following:

1. Designation of one or more principals to establish, maintain, and enforce a system of supervisory controls and procedures that test and verify that the Member’s supervisory procedures are reasonably designed to comply with applicable securities laws and NASD rules. Designated principal(s) will be required to submit annually to the Member’s senior management a report detailing the system of supervisory controls, test results and significant exceptions, and any additional supervisory procedures created in response to test results.
2. That a person senior or "otherwise independent" to a producing manager perform the day-to-day supervisory reviews of the producing manager’s account activity. In order to be "otherwise independent" of a producing manager, the reviewer may not report either directly or indirectly to the producing manager, must not otherwise have supervisory responsibility over the activity being reviewed (including not being compensated based upon the revenues accruing for those activities) and must alternate review responsibility with another qualified person every two years or less. However, if a Member is too limited in size and resources to comply with these requirements because, for example, the Member has only one office or an insufficient number of qualified personnel, the Member may have a principal who is "sufficiently knowledgeable" of the Member’s supervisory control procedures perform the supervisory reviews, in accordance with the "limited size and resources exception" set forth in Rule 3012. Members relying on this exception should document their reasons. The NASD intends to file a rule change to require in the future that Members notify the NASD when relying on the exception.
3. That a Member have in place "heightened supervisory procedures" for the supervision of a producing manager who is responsible for 20 percent or more of the revenue generated by the business units supervised by the producing manager’s supervisor. For purposes of this provision only, "heightened supervision" means those supervisory procedures that evidence supervisory activities that are designed to avoid conflicts of interest that serve to undermine complete and effective supervision because of the economic, commercial or financial interests that the supervisor holds in the associated persons being supervised, e.g., unannounced supervisory reviews.

In another significant change likely to impact a Member’s existing branch office inspection practices, NASD Rule 3010 has been amended to require firms to codify the minimum inspection cycles for a Member’s offices, including establishing minimum inspection cycles, and require that off ice inspections include the testing and verification of the Member’s policies and procedures in certain specified areas. Each office inspection should be memorialized in a written report which covers: (a) safeguarding of customer funds and securities; (b) maintaining books and records; (c) supervision of customer accounts serviced by branch office managers; (d) transmittal of funds between customers and registered representatives and between customers and third parties; (e) validation of customer address changes; and (f) validation of changes in customer account information. As amended, Rule 3010 requires that an office inspection may not be conducted by the branch office manager for that office, any person within that office who has supervisory responsibilities, or any individual who is directly or indirectly supervised by such persons. However, if a Member is so limited in size and resources that it cannot comply with this limitation, the Member may have a "knowledgeable principal" perform the inspections. Depending upon the position of the person within the Member who conducts the inspection a Member must have in place "heightened inspection" procedures for the inspection of an office where the producing manager is responsible for 20 percent or more of the revenue generated by the business units supervised by the producing manager’s supervisor. For purposes of applying this provision only, "heightened inspection" shall mean those inspection procedures that are designed to avoid conflicts of interest that serve to undermine complete and effective inspection because of the economic, commercial or financial interests that the branch manager’s supervisor holds in the persons and businesses being inspected, e.g., unannounced office inspections. Among other changes, Rule 3110 has been amended to require that before any customer order is executed the account name/designation must be placed upon the memorandum for each transaction. Rule 2510(a)(1) has been amended to limit time and price discretionary authority to the day it is granted, absent a specific, written, indication signed and dated by the customer. This limitation does not apply to orders in an institutional account pursuant to "Good-Till-Cancelled" instructions issued on a "not held" basis. Any exercise of time and price discretion must be reflected on the order ticket. Rule 3110 has been further amended to provide that no change to account name/designation should be made unless approved in writing by an appropriately qualified principal informed on the essential facts, which facts should be documented in writing and preserved for three years. Finally, IM-3110 has been amended to limit the time that a Member may hold mail for a customer.

The new NASD rules and rule amendments should be read in conjunction with new NASD rule 3013 as part of an overarching regulatory scheme (See the Alerts of Sept. 28, 2004 and Nov. 9, 2004). New Rule 3013 requires that each Member’s chief executive officer ("CEO") certify annually that senior executive management has in place processes to: (1) establish, maintain and review policies and procedures reasonably designed to achieve compliance with applicable securities laws rules, and regulations; (2) modify such policies and procedures as changes and events dictate; and (3) test the effectiveness of such policies and procedures on a periodic basis, the timing of which is reasonably designed to comply with applicable regulatory requirements. IM-3013 provides the language for the CEO certification and gives further guidance as to the requirements and limitations of Rule 3013. According to the NASD’s design the establishment of the supervisory system required to be adopted in Rule 3010 should result from the processes that are the subject of the Rule 3013 certification. Also, Rule 3012 requires the testing and verification necessary to ensure compliance with applicable securities laws, rules and regulations, and if necessary to amend or create additional supervisory procedures.

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