Developments of Note
- SEC Seeks Comment on Challenged Fund Governance Requirements
- OTS Issues Opinion Regarding Preemption of State Restrictions on Gift Cards
- FRB and FinCEN Request Comments on Funds Transfer Recordkeeping Requirements and the Travel Rule
- FRB Issues Opinion Letter Concerning Application of Reg O to Insider’s Use of Bank-Owned Credit Card
- SEC Commissioner Campos Discusses Hedge Fund Activity and Regulation at SIA Conference
- Basel Committee Publishes Guidance on Bank Use of Fair Value Option
- FRB Governor Details Compliance Examination Issues
- SEC Staff Provides No-Action Relief Regarding Cross Trades Involving Accounts in which an Adviser has an Interest
Developments of Note
SEC Seeks Comment on Challenged Fund Governance Requirements
The SEC issued a formal release (the "Release") requesting comment on its rule requiring registered investment companies ("funds") that rely on certain designated exemptive rules under the Investment Company Act of 1940, as amended (the "1940 Act") (which, in practice, means most funds) to (a) have a chairman of the board who is not an interested person of the fund within the meaning of the 1940 Act (an "independent director") and (b) have a board of directors consisting of no less than 75% independent directors (collectively, the "Governance Requirements"). The Release and a status report filed with the U.S. Court of Appeals for the District of Columbia Circuit (the "Court") respond to the Court’s April 2006 ruling that vacated the Governance Requirements but stayed the Court’s mandate for 90 days to afford the SEC the opportunity to reopen the rulemaking record (see the April 11, 2006 Alert for a discussion of that ruling). The Release requests comment on the monetary and non-monetary costs associated with implementing the Governance Requirements and various aspects of the SEC’s past consideration of those costs, including, specifically: (a) direct and indirect costs associated with each of the Governance Requirements; (b) the costs estimates relied upon by the SEC in its June 2005 decision not to alter the Governance Requirements following an earlier ruling by the Court upholding the U.S. Chamber of Commerce’s initial challenge to the Governance Requirements (see the June 28, 2005 Alert for a discussion of that ruling and the July 5, 2005 Alert regarding the SEC’s subsequent reconsideration of the Governance Requirements); and (c) current cost data associated with adoption of the Governance Requirements, including implementation data for funds that have voluntarily complied with one or both the conditions. The Release also includes requests for comment on a variety of specific elements of implementing the governance requirements, e.g., the cost of hiring and recruiting independent directors. The Release notes that the SEC is particularly interested in the costs incurred by small fund groups, and that comments accompanied by supporting data and analysis are "of greatest assistance." In addition to the costs associated with governance requirements, the Release invites commenters to address any issue related to the protection of funds and fund shareholders and specifically seeks comment on whether the governance requirements will promote efficiency, competition and capital formation. The press release announcing the request for comment also indicated that SEC Chairman Cox had asked the SEC’s General Counsel to conduct a top-to-bottom review of the SEC’s process for complying with legal requirements mandating an economic analysis of rule proposals. Comments are due no later than August 21, 2006.
OTS Issues Opinion Regarding Preemption of State Restrictions on Gift Cards
The OTS issued a legal opinion concluding that federal law preempts five types of state law restrictions on gift cards for federal savings associations and their operating subsidiaries. The five types of state laws, found in multiple states, include (1) licensing requirements for those who issue or sell gift cards; (2) disclosure requirements, with respect to, for example, fees and expiration dates; (3) fee restrictions, such as on issuance fees, inactivity fees, maintenance fees and redemption fees; (4) expiration date restrictions; and (5) requirements to permit the cardholder to redeem the card for cash. Some of these laws are part of general state laws on unfair or deceptive acts or abandoned property, while others are separate state laws governing gift cards and/or gift certificates. The OTS confirmed that federal savings associations have the authority to issue gift cards because of the associations’ funds transfer authority, deposit-related powers and incidental powers, and found that the five types of state law restrictions are preempted because they impermissibly affect the associations’ operations. The OTS cautioned, however, that federal savings associations are subject to federal requirements and consumer protection standards with respect to their gift card activities, including, without limitation, the OTS fund transfer services rule, the OTS electronic operations rule, the OTS advertising rule, the OTS nondiscrimination rules, Section 5 of the Federal Trade Commission Act and the Bank Secrecy Act.
FRB and FinCEN Request Comments on Funds Transfer Recordkeeping Requirements and the Travel Rule
The FRB and FinCEN (the "Agencies") issued an advanced notice of proposed rulemaking ("ANPR") requesting comments on a proposal to broaden the requirements that banks and certain nonbank financial institutions collect and retain information concerning funds transfers and transmittals of funds (the "Recordkeeping Requirement") and transmit certain pieces of information to other banks or nonbank financial institutions involved in a funds transfer or transmittal of funds (the "Travel Rule"). The Recordkeeping Requirement and Travel Rule currently apply to funds transfers or transmittals of funds of $3,000 or more. However, the ANPR seeks comments on the potential benefits to law enforcement and burdens to financial institutions of lowering, or even eliminating, the $3,000 threshold. Comments on the ANPR should be submitted to the Agencies no later than 60 days after publication of the ANPR in the Federal Register.
The Recordkeeping Requirement and Travel Rule were initially promulgated in 1995 pursuant to authority granted to the Agencies and, in the case of the Travel Rule, FinCEN alone, under the Bank Secrecy Act, to require financial institutions to keep records of transactions that might have a high degree of usefulness in criminal, tax or regulatory investigations and to guard against money laundering by transmitting information to financial institutions involved the payment chain. The Recordkeeping Requirement requires the originating or transmitting financial institution to collect and retain the name and address of the originator/transmittor, the amount of the payment, the execution date of the payment, any payment instructions received from the originator or transmittor and the identity of the beneficiary’s bank or recipient’s financial institution, and also to verify the identity of the person placing the order if the order is made in person and the person is not an established customer. In addition, if received, the originator’s bank or transmittor’s financial institution must maintain a record of the name and address of the beneficiary or recipient, the account number of the beneficiary or recipient and other specific identifying information concerning the beneficiary or recipient. Intermediary banks or financial institutions and the beneficiary’s bank or recipient’s financial institution must also retain copies of orders. Under the Travel Rule, the originator’s bank or transmittor’s financial institution must provide all information required under the Recordkeeping Rule with the payment or transmittal order, and intermediary institutions must transmit all information received by them to other banks or financial institutions in the payment chain.
The ANPR was issued in light of the post-September 11, 2001 recommendation by the Financial Action Task Force (an international, inter-governmental body dedicated to the development of national and international policies to combat money laundering) to implement a de minimis threshold no higher than $1,000 for the Recordkeeping Requirement and Travel Rule. In addition, the Agencies are considering the ANPR in light of their determination that advances in information technology may have reduced the burden of complying with the Recordkeeping Requirement and Travel Rule since the initial adoption of the rules in 1995.
FRB Issues Opinion Letter Concerning Application of Reg O to Insider’s Use of Bank-Owned Credit Card
The FRB published an opinion letter (the "Opinion") that the General Counsel of the FRB had written to the Acting General Counsel of the FDIC that clarifies whether and when a bank insider’s use of a bank-owned credit card would be deemed an extension of credit by the bank to the insider for purposes of Regulation O ("Reg O"). A bank-owned credit card is a credit card issued, generally by a third party financial institution, to a bank to enable the bank (through its employees) to make purchases for the bank. Typically, employees are discouraged by the bank that is their employer from making personal purchases with the bank-owned credit card. The FRB concluded in the Opinion that a bank does not make an extension of credit to an insider for purposes of Reg O at the time of issuance of the card to the insider (even if the line of credit associated with the card exceeds $15,000). In addition, the Opinion states that a bank does not extend credit to an insider for Reg O purposes when the insider uses the card for the bank’s business purposes (rather than his or her personal purposes). Furthermore, the Opinion provides that when the insider uses the business credit card to make personal purchases the bank will be deemed to have made a Reg O extension of credit to the insider "if (and to the extent that) the amount of outstanding personal charges made to the card, when aggregated with all other indebtedness of the insider that qualifies for the credit card exception in Section 215.3(b)(5) of [Reg O] exceeds $15,000." Finally, the Opinion states that incidental personal expenses charged by an insider to a bank-owned credit card will not be deemed per se violations of the market terms requirement of Reg O even though non-insiders generally do not have access to such cards from the bank. However, to satisfy this Reg O "market terms" requirement: (1) the bank must approve the insider’s use of a card only if the insider meets the bank’s normal credit underwriting standards; and (2) the card may not have preferential terms (e.g., the card may not bear a lower interest rate or permit a longer repayment period than comparable consumer credit cards issued by the bank).
SEC Commissioner Campos Discusses Hedge Fund Activity and Regulation at SIA Conference
In a speech at the Securities Industry Association’s Hedge Funds & Alternative Investments Conference, SEC Commissioner Roel C. Campos discussed hedge fund activism, individual and market risks associated with hedge funds, and current and possible future hedge fund regulation. Responding to industry complaints regarding the length of examinations and related document requests, Commissioner Campos indicated that the SEC staff attempts to conclude examination within 120 days after the completion of field work, but emphasized that "an examination will take as long as it will take." He further observed that since the February 2006 deadline for compliance with the SEC’s hedge fund adviser registration requirements, the number of hedge fund advisers examined has been roughly proportionate to their representation in the registered adviser population as a whole. Commissioner Campos also responded to concerns that the SEC may further regulate hedge fund advisers, stating that he had seen no evidence of the need for further regulation, that he believed any such regulation currently would be premature and that he was not aware of any plans to regulate hedge funds themselves. Commissioner Campos did, however, indicate that he believed the SEC should issue guidance for hedge funds in the area of asset valuation. He also noted that the SEC staff had discussed the possibility of modifying Form ADV to request information in additional areas such as auditors, adviser preparation of account statements and prime brokers, in order to assist the examination process.
Basel Committee Publishes Guidance on Bank Use of Fair Value Option
The Basel Committee on Banking Supervision ("Basel Committee") published guidance (the "Guidance") on bank use of the fair value option for financial instruments, as is permitted under International Accounting Standard 39 ("IAS 39"). The Guidance notes that while it specifically refers to IAS 39, it is not intended to amend that issuance. Rather, the Guidance suggests prudential and supervisory principles that should be relevant to banks implementing IAS 39, or similar national standards in many countries (see the description in the March 28, 2006 Alert). Most fundamentally, the Guidance provides seven principles intended to describe supervisors’ expectations for, and to promote sound risk management, control, valuation and capital practices by banks with regard to their use of the fair value option.
The specific principles are as follows: Principle 1: Supervisors expect a bank’s use of the fair value option to fully comply with accounting standards (e.g., by having appropriate risk management controls, disclosures, and supporting documentation); Principle 2: Supervisors expect banks to have in place appropriate risk management systems prior to implementing the fair value option and on an ongoing basis (the Guidance details specific components of such systems, and highlights the need for senior management approval and independent oversight and testing); Principle 3: Supervisors expect banks will not apply the fair value option to instruments for which they are unable to estimate fair values (a particularly rigorous review, including backtesting, should apply to illiquid instruments); Principle 4: Supervisors may require banks to provide them supplemental information to assist the regulators to assess the impact on the bank of the fair value option (e.g., how significant are illiquid items, or unrealized gains, to equity and regulatory capital); Principle 5: Supervisors should assess a bank’s risk management and control practices in relation to the fair value option (with greater focus the more extensive the bank’s use of the option); Principle 6: Supervisors should consider such risk management processes when assessing capital adequacy (including perhaps deducting from risk capital unrealized gains and losses if risk management is inadequate generally, or with respect to new types of instruments; and Principle 7: Regulatory capital should be adjusted for gains and losses resulting from changes in the bank’s own credit risk (e.g., to prevent a bank from recognizing gain on its own debt if its creditworthiness deteriorates).
FRB Governor Details Compliance Examination Issues
FRB Governor Mark Olson gave a detailed speech concerning what examiners are looking for in compliance examinations. As general initial comments, he stated that examiners’ expectations will increase with the size and complexity of the organization, and that the growing complexity of banking organizations and their regulatory frameworks have caused the FRB to take a greater interest in their ability to manage compliance risk. Turning specifically to the examination process, Governor Olson stated that in scoping out an examination, FRB examiners will evaluate previous exams to determine if concerns have been raised with the organization’s compliance–risk assessment, with institutions having less than a satisfactory record receiving a more extensive review. He then noted that exams are not intended to be "gotcha games" involving one-time breaches, but rather to concentrate more on structures and controls. The majority of the remainder of the speech focused on 5 key areas of examination emphasis:
Board and Senior Management Oversight
. The focus here is setting a tone at the top of a top-to-bottom compliance culture. Examiners also will look to ensure that roles are understood and well-defined, and any current compliance risks are identified. Moreover, examiners will evaluate the risk assessment process, to ensure it aggregates identified risks and informs senior management as appropriate. Governor Olson also noted that examiners will determine whether the compliance program has sufficient financial resources and staff to carry out its functions effectively.Policies and Procedures.
These should define and communicate the key goals and processes of the compliance program. Examiners will ensure that they provide for adequate risk identification, assessment, measurement, and control, and also delineate accountability and lines of authority.Internal Controls.
Governor Olson declared that internal controls are a "particularly crucial element of a compliance-risk management program," with effective controls including appropriate reporting lines and separation of duties, as well as positive and negative incentives. Controls should include periodic testing, independent review, and escalation of issues as appropriate. In larger organizations, examiners will want to know more generally how the compliance function maintains independence from the business lines.Monitoring and Reporting.
This involves identifying and communicating compliance concerns to the appropriate parties. Governor Olson stated that examiners are focused on ensuring that business lines do not silo information, but rather share it appropriately. Moreover, he noted that large organizations generally have information systems that provide compliance reports at the transaction level.Training.
Governor Olson also stated that examiners will ensure training is not overlooked. Generally, they will assess whether staff understands the financial institution’s compliance culture, and its compliance-risk issues, and high-level compliance policies and procedures.Governor Olson concluded his remarks discussing the Bank Secrecy Act ("BSA") and fair lending compliance issues. As to the BSA, he noted that the regulators are seeking examination consistency, and that an updated examination manual is expected to be published this Summer. As to fair lending, he recommended that banks evaluate their own HMDA data to evaluate fair lending compliance.
SEC Staff Provides No-Action Relief Regarding Cross Trades Involving Accounts in which an Adviser has an Interest
The staff of the SEC’s Division of Investment Management (the "Staff") provided no-action relief (the "Relief") regarding whether accounts in which an adviser and/or its control persons hold an interest are subject to Section 206(3) of the Investment Advisers Act of 1940, as amended (the "Advisers Act"). (In general terms, Section 206(3) requires written disclosure to, and consent by, a client before any principal transaction with its adviser.) In brief, the Relief provides that an account in which an adviser and/or its control persons hold an interest will not be treated as subject to Section 206(3) unless their aggregate ownership is more than 25% of the account. The Staff provided the Relief to an adviser (the "Adviser") that intended to engage in cross trading between client accounts (the "Accounts") and two private investment funds (the "Funds"), in which the adviser held small interests, a 6.237% ownership interest in one and a 1.4405% ownership interest in the other, and for which the Adviser’s general partner acted as general partner and portfolio manager. In discussing the ownership threshold, the Staff noted that it may be appropriate in some cases to include the ownership interest of a family member of a controlling person (for example, a spouse or a dependent child) with the ownership interest of the controlling person and/or investment adviser. The Staff expressly did not address how the ownership of account interests by non-controlling personnel of the Adviser would affect the applicability of Section 206(3) to the proposed cross trades. The Staff observed that ownership of interests of 25% or less by investment advisers and/or controlling persons may present the opportunity for significant conflicts of interest between an investment adviser and its clients, which may implicate Sections 206(1) and (2) of the Advisers Act and the duty they impose to make full and fair disclosure of all material facts to a client regarding a transaction or activity in which the adviser proposes to engage. The Staff noted that an adviser’s duty under Sections 206(1) and (2) may require it to disclose information about transactions with client accounts involving any account in which the adviser and/or its controlling persons have an ownership interest, regardless of whether Section 206(3) applies. Toward that end, the Staff recommended each adviser consider monitoring interests it and/or its controlling persons own in accounts the adviser manages, and the terms of transactions involving those accounts. The Staff also suggested that compliance personnel of an investment adviser consider, to the extent practicable, in addition to direct economic interests, interests of an adviser and/or its controlling persons in accounts (such as economic interests of family members and persons with social and/or business relationships with the adviser and/or its controlling persons) that may create incentives to favor one account over another.
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