Financial Services Alert - March 6, 2012 March 06, 2012
In This Issue

FinCEN Seeks Comment on Proposal to Require Banks, Brokers, Dealers, Mutual Funds and Certain Other Financial Institutions to Establish Customer Due Diligence Programs

On February 29, 2012, the Financial Crimes Enforcement Network (“FinCEN”) issued an advanced notice of proposed rulemaking (the “Advance Notice”) in which it sought comment on a proposal to expressly require that financial institutions conduct customer due diligence (“CDD”), including by collecting beneficial ownership information for all customers, with limited exceptions.  Covered financial institutions would at this time include banks, brokers or dealers in securities, mutual funds, futures commission merchants and introducing brokers in commodities.  FinCEN stated that while the basis for a CDD obligation is “implicit” in existing anti-money laundering and suspicious activity reporting requirements, it seeks to expressly require CDD programs in order to achieve uniformity and consistency in the way that financial institutions address their CDD obligations and collect beneficial ownership information.  It believes CDD to be important in assisting criminal investigations, in facilitating tax reporting, investigations and compliance, and in promoting financial transparency and protecting the financial system from abuse in a manner consistent with international standards.

Elements of CDD Program

FinCEN stated that an effective CDD program provides a financial institution with sufficient information to develop a customer risk profile that can then be used by such financial institution to identify higher-risk customers and accounts, and contains the following four elements:

(1)      Conducting initial due diligence on customers, which includes identifying the customer, and verifying that customer’s identity as appropriate on a risk basis, at the time of account opening;

(2)      Understanding the purpose and intended nature of the account, and expected activity associated with the account for the purpose of assessing risk and identifying and reporting suspicious activity;

(3)      Except as otherwise provided, identifying the beneficial owner(s) of all customers, and verifying the beneficial owner(s)’ identity pursuant to a risk-based approach; and

(4)      Conducting ongoing monitoring of the customer relationship and conducting additional CDD as appropriate, based on such monitoring and scrutiny, for the purposes of identifying and reporting suspicious activity.

FinCEN stated that the customer identification and risk-based verification requirement would be satisfied by a financial institution’s existing customer identification program (“CIP”).  It further stated that while certain customers (namely, existing customers, provided that the financial institution has a reasonable belief that it knows the customer’s true identity; banks regulated by a federal or state regulator; governmental entities; and publicly traded companies) are exempt from CIP requirements, the CDD requirements to understand the purpose and intended nature of the accounts and to conduct ongoing monitoring would apply to such customers.

The Beneficial Ownership Element

FinCEN noted that there are currently two limited situations (regarding private banking accounts and correspondent accounts) in which financial institutions are expressly required to obtain beneficial ownership information, and that it is considering expanding the explicit requirement to obtain beneficial ownership information to all customers.

Proposed Definition of “Beneficial Owner”

Except with regard to the limited situations described in the preceding paragraph, FinCEN is considering the following two-part definition of “beneficial owner” that, in the case of legal entities, would include:

(1)      either:

(a)      each of the individual(s) who, directly or indirectly, through any contract, arrangement, understanding, relationship, intermediary, tiered entity, or otherwise, owns more than 25 percent of the equity interests in the entity; or

(b)      if there is no individual who satisfies (a), then the individual who, directly or indirectly, through any contract, arrangement, understanding, relationship, intermediary, tiered entity, or otherwise, has at least as great an equity interest in the entity as any other individual, and

(2)      the individual with greater responsibility than any other individual for managing or directing the regular affairs of the entity.

Verification of the Beneficial Owner

FinCEN noted that it is considering two possible meanings of “verification of the beneficial owner.”  In the first variation, verification would mean verifying the existence of the beneficial owner, as identified by the individual opening the account on behalf of the legal entity customer.  In the second variation, verification would mean requiring that the financial institution verify that the individual identified by the customer as the beneficial owner is indeed the beneficial owner.

FinCEN to Issue Additional Guidance; Existing Requirements Not Superseded

FinCEN anticipates that it would provide additional guidance regarding customers that may be considered low risk (and therefore exempt for purposes of this beneficial ownership requirement), as well as identifying types of customers that may simply necessitate identification of the beneficial owner, and those that are of heightened risk requiring both identification and verification of the beneficial owner. Similar to the CIP requirement, FinCEN also anticipates that it would provide guidance to financial institutions on what they should do in the event they are unable to identify or verify a beneficial owner. 

FinCEN emphasized that the proposed explicit requirement to obtain beneficial ownership information, and the proposed definition are not meant to replace existing explicit or implicit requirements under the Bank Secrecy Act.

Comments Sought Regarding the Beneficial Ownership Element

FinCEN seeks comments on several aspects of the beneficial ownership requirement including, but not limited to, comments regarding a potential exemption from the beneficial ownership requirement for legal entity customers that are exempt under the CIP rules as well as how to apply the beneficial ownership requirement to existing customers.

Issues for Additional Comment

In addition to the above-sought comments, FinCEN seeks comments on the following issues:

(1)      Aside from policies and procedures with respect to beneficial ownership, the changes that would be required in a financial institution’s CDD processes as a result of the adoption by FinCEN of an express CDD rule as described in the Advance Notice;

(2)      The changes that the above-described beneficial ownership requirement would impose, the proposed definition of “beneficial owner,” and considerations related to the beneficial ownership of assets in an account held by an intermediary;

(3)      The circumstances under which a financial institution currently obtains beneficial ownership information on a customer or accountholder;

(4)      How financial institutions currently obtain beneficial ownership information;

(5)      Whether the current, primarily risk-based, approach to a CDD program requirement results in varied approaches across industries or varied approaches within industries;

(6)      If there are other elements of CDD that would be more effective in facilitating compliance with anti-money laundering program requirements and other obligations under FinCEN’s regulations;

(7)      The information that should be required in order to identify, and verify on a risk basis, the identity of the beneficial owner;

(8)      Whether there are products and services, or customers that should be exempted from the requirement to obtain beneficial ownership information due to there being: (a) substantially less risk of money laundering or terrorist financing associated with the account; (b) limited value associated with the beneficial ownership information in mitigating money laundering/terrorist financing risk; or (c) an inability to obtain the required information due to other legal requirements;

(9)      Financial institutions that should not be covered by a CDD rule based on the products and services offered; and

(10)      The impact of a CDD program on consumers or other customers.

Comments must be received by May 4, 2012.

FINRA Requests Comment on Revised Rule Proposal to Address Conflicts of Interest Related to Debt Research Reports

FINRA has issued a request for comment (FRN 12-09) on a revised proposal for a rule to identify and manage conflicts of interest involving the preparation and distribution of debt research reports to retail and institutional investors.  The proposed rule in large part parallels the requirements of NASD Rule 2711 for equity research reports, with some important differences. The revised proposal maintains a tiered approach, adopted in a concept proposal (FRN 11-11) released in March 2011, based on whether the debt research is distributed to retail or institutional investors.  The revised proposal also incorporates some changes based on comments submitted regarding the concept proposal. 

Identifying and Managing Conflicts of Interest

The revised proposal includes most of the provisions contemplated by the concept proposal.  In that regard, the revised proposal requires member firms to establish, maintain and enforce policies and procedures reasonably designed to identify and manage conflicts of interest related to debt research reports.

Prepublication Review. The policies and procedures would be required to prohibit prepublication review, clearance or approval of debt research reports by persons involved in investment banking or sales and trading as well as generally prohibit prepublication review by a subject company.  Unlike the current rule on equity research reports, the proposed rule includes a firm’s sales and trading departments as possible sources of conflicts of interest for the research department.

Coverage. With respect to coverage determinations, the policies and procedures would be required to restrict input by investment banking or sales and trading personnel to ensure that the final decisions are made independently by research management.

Solicitation and Marketing of Investment Banking Transactions. The proposed rule would require firms to prohibit debt research analysts from participating in the solicitation of investment banking services and other marketing on behalf of issuers and to prohibit banking personnel from directing a debt research analyst to engage in sales and marketing efforts or communication with current or prospective customers related to an investment banking deal. 

Supervision.  The proposed rule would require firms to implement policies and procedures to limit the supervision of debt research analysts to persons not engaged in investment banking or sales and trading.  Firms would have to erect information barriers between debt research analysts and persons engaged in investment banking or principal trading activities.

Budget and Compensation.  The proposed rule would limit determination of a firm’s debt research department budget to senior management, other than persons engaged in investment banking or principal trading activities, and would prohibit compensation determinations based on non-research activities or transactions.  The proposed rule would, however, permit persons making budget and compensation decisions to consider the revenues and results of the firm as a whole, and would permit any person to provide input to senior management regarding the demand for and quality of debt research.

Personal Trading.  The proposed rule would require firms to implement policies and procedures to limit trading by a debt research analyst in securities whose performance is materially dependent upon the performance of securities covered by the research analyst.

Retaliation and Promises of Favorable Research.  The proposed rule would require firms to prevent retaliation against debt research analysts by any employee of the member as the result of an adverse, negative or otherwise unfavorable debt research report or public appearance by the debt research analyst and to prohibit promises to a subject company by employees of the member of favorable debt research as inducement for the receipt of business compensation.

Content and Disclosure in Debt Research Reports

For purposes of some disclosure requirements, the proposed rule would distinguish between institutional investors and retail investors.  Institutional investor would have the same meaning as “institutional account” in FINRA Rule 4512(c) and would include banks, insurance companies, registered investment companies, registered investment advisers and any individual or entity with total assets of at least $50 million.  A retail investor would be any person other than an institutional investor.

With respect to debt research distributed to retail investors (retail debt research), the proposed rule would impose most of the same disclosure requirements that apply in the equity research context, with a few modifications to account for the difference between debt and equity markets.  The revised proposal requires firms to include certain disclosures with respect to facts, recommendations or ratings in debt research reports, including any valuation methods used or risks involved in achieving the recommendation or rating.  In addition, firms must include disclosures regarding historical ratings or recommendations by the member firm as well as whether the firm has provided investment banking services in the past 12 months with respect to subject companies.

The proposed rule would require firms to disclose in debt research reports all conflicts that reasonably could be expected to influence the objectivity of the debt research report and that are known or should have been known by the firm or the debt research analyst on the date of publication or distribution, including, among other disclosures, if the firm received any non-investment banking compensation from the subject company in the past 12 months or if the debt research analyst has any financial interest in the debt or equity securities of the subject company.

Standards Applicable to Research Distributed to Institutional Investors

The proposed rule would exempt research distributed solely to eligible institutional investors (institutional debt research) from most of the provisions regarding supervision, coverage determination, budget and compensation determination and all of the disclosure requirements applicable to debt research reports distributed to retail investors.  The concept proposal contemplated that institutional investors could be treated as institutional investors unless they elected to be treated as a retail investor for the purposes of this rule.  FINRA is now proposing that member firms would be required to treat otherwise eligible institutional investors the same way they treat retail investors unless the institutional investor affirmatively notifies the firm that it wishes to forego treatment as a retail investor and receive the more limited protections afforded to debt research distributed only to institutional customers.

Certain provisions would still apply to debt research distributed to eligible institutional investors, including the prohibitions on: (i) prepublication review of debt research reports; (ii) debt research analysts participating in the solicitation and marketing; and (iii) investment banking personnel directing a debt research analyst to engage in sales and marketing efforts.  The provisions prohibiting retaliation against debt research analysts and promises of favorable debt research would also apply to institutional debt research.  While the revised proposal would not require institutional debt research to carry the specific disclosures applicable to retail debt research, it would require that such research carry general disclosures prominently on the first page, including that the report is intended solely for institutional investors. 

Additionally, the revised proposal would require firms to implement policies reasonably designed to ensure that institutional debt research is made available only to eligible institutional investors.  A firm may not rely on the exemptions for institutional debt research if it has reason to believe that the research will be redistributed to retail investors.  Thus, if despite having in place reasonably designed policies and procedures, a firm learns that a party has been routinely redistributing institutional debt research to retail investors, the firm must discontinue distribution of institutional debt research to that party until it reasonably concludes that measures have been taken to prevent future improper redistribution.

Communications Between Debt Research Analysts and Trading Desk Personnel

The revised proposal maintains the general prohibition against sales and trading personnel attempting to influence the content of a debt research report.  In supplementary materials, FINRA would offer guidance with respect to permissible interactions between debt research and sales and trading and principal transactions personnel.  Specifically, the proposed supplementary material would state that (i) sales and trading personnel may communicate customers’ interests to debt research personnel, so long as debt research analysts do not respond by publishing research that is intended to benefit a trading position of the firm, a customer or a class of customers and (ii) debt research analysts may provide custom analysis to sales and trading customers, provided such communications are not inconsistent with the analyst’s currently published or pending research and any subsequent research that is not for the purpose of benefiting any firm or customer positions.

Distribution of Member Research Reports

The proposed rule would require firms to establish, maintain and enforce policies and procedures reasonably designed to ensure that a firm does not selectively distribute a debt research report to trading personnel or a particular class of customers in advance of other customers.  In supplementary materials, FINRA explained that this would not prohibit member firms from offering different research products to different classes of customers.  For example, a firm could provide one kind of research to customers with a long-term investment horizon and another to customers with a short-term investment horizon. 

Prohibitions on Information in Pitch Materials

The proposed supplementary materials would state that FINRA interprets the proposed rule to prohibit the use in pitch materials of any information about a member’s debt research capacity in a manner that suggests that the member might provide favorable research coverage.

No Imposition of Quiet Period

Unlike NASD Rule 2711, which applies to equity research reports, the revised proposal does not impose quiet periods around the issuance of debt research reports.

Request For Comments

Comments are due by April 2, 2012.

SEC and CFTC Propose Rules to Address FCRA Requirements regarding Identity Theft Programs and Credit Card Changes of Address

The SEC and CFTC (the “Commissions”) jointly issued proposed rules that would (a) require financial institutions and creditors subject to a Commission’s jurisdiction to develop and implement a written identity theft prevention program addressing identity theft in connection with certain existing accounts or the opening of new accounts and (b) establish special requirements under which a credit or debit card issuer subject to a Commission’s jurisdiction would have to assess the validity of change of address notifications under certain circumstances.  The Commissions have issued the rule proposal because the Dodd-Frank Act amended the Fair Credit Reporting Act of 1970 (“FCRA”) to add the Commissions to the list of federal agencies required to jointly prescribe and enforce identity theft red flags rules and card issuer rules. 

The proposed rules are substantially similar to rules adopted in 2007 by the federal banking regulators and the FTC in response to prior amendments to FCRA; the proposed rules do, however, contain examples and minor language changes designed to facilitate compliance by entities under the Commissions’ jurisdiction.  Comments on the proposed rules must be submitted by May 7, 2012.

FinCEN Issues Advisory to Internal and External Counsel of Financial Institutions Reminding Them That They Must Maintain Confidentiality of SARs

The Financial Crimes Enforcement Network (“FinCEN”) issued an advisory (the “Advisory”) to financial institutions, and in particular their internal and external legal counsel, that they must maintain the confidentiality of Suspicious Activity Reports (“SARs”).  FinCEN said that an increasing number of private parties are seeking SARs from financial institutions for use in civil litigation and other matters.  The Advisory reminds financial institutions that they “and their current and former directors, officers, employees, agents and contractors could be subject to civil and criminal penalties for the unauthorized disclosure of a SAR.”  FinCEN also notes in the Advisory that financial institutions may want to remind their counsel of the strict requirements of SAR confidentiality.

FRB Extends Comment Period on Proposed Rule for the Supervision and Regulation of Large Bank Holding Companies and Systemically Important Nonbank Financial Firms

The FRB extended the comment period from March 31, 2012 to April 30, 2012 on the FRB’s proposed rule concerning the supervision and regulation of large bank holding companies and systemically important nonbank financial firms.  For a description of the proposed rule, see the December 20, 2011 Financial Services Alert.  The FRB stated that it was extending the comment period because of “the range and complexity of the issues addressed in the rulemaking…”