Financial Services Alert - September 9, 2008

In a letter dated August 5, 2008 (the “Letter”), the FRB used its discretionary authority under Section 4(c)(9) of the Bank Holding Company Act (the “BHC Act”) to exempt from the standard activity limitations and reporting requirements of the BHC Act two entities wholly-owned by the Chinese government.  The entities would own Chinese banks with branches in the United States, and thus without the exemption would be subject to the BHC Act as if they were bank holding companies.

The Letter states that in several circumstances the FRB has recognized that there are significant policy issues with imposing the BHC Act on foreign governments.  The FRB has not deemed foreign governments themselves “companies” for purposes of the BHC Act, but has determined that that foreign-owned companies can be “companies” for those purposes.

Accordingly, the Letter determined that the Chinese subsidiaries are companies for purposes of the BHC Act.  However, pursuant to Section 4(c)(9), the FRB determined that it would be in the public interest and not substantially at variance with the purposes of the BHC Act to exempt them from its nonbanking restrictions.  The FRB imposed a number of conditions on the exemption, however, including limiting transactions between the US branches of the banks controlled by those entities and other companies controlled by them, prohibiting the entities from generally acquiring a securities or insurance company in the United States, and limiting their ability to directly or indirectly make investments in US banks or Edge corporations above defined thresholds.

The Massachusetts Department of Revenue (the “DOR”) announced in Technical Information Release 08-4 (“TIR 08-4”) that a non-Massachusetts financial institution that has failed to file required Massachusetts tax returns will face harsher treatment under the DOR’s non-filer “look-back” policy unless it identifies itself to the DOR as seeking to avail itself of TIR 08-4 by September 30, 2008.

Background.  When a taxpayer fails to file a required Massachusetts tax return, the DOR may make an assessment of tax at any time for any taxable period for which a return was due.  The statute does not limit the number of past due returns or past tax periods for which the DOR may assess tax.  However, the DOR, in previously issued TIR 03-17, provided a general seven-year look-back rule and a special three-year look-back rule for a non-Massachusetts corporation that voluntarily disclosed its failure to file, provided that there was a reasonable doubt that it had an obligation to file a Massachusetts return.

TIR 03-17 states as a general rule, subject to certain exceptions, that when the DOR determines that a taxpayer has failed to file required tax returns, the DOR will assess the taxpayer with respect to returns due during the most recent seven years.  However, to encourage voluntary compliance, TIR 03-17 also states that the Department, subject to certain exceptions, will limit assessments to the three most recent tax years in cases where certain non-filers, including non-Massachusetts corporations, voluntarily disclose their failure to file.  TIR 03-17 states that in cases in which a taxpayer seeks to apply the DOR’s three-year look-back policy, the DOR will nonetheless apply the seven-year policy, notwithstanding any voluntary disclosure, when an extensive level of business activity conducted in this state removes any reasonable doubt as to the taxpayer’s prior filing obligation.  Further, TIR 03-17 states that its discretionary policy is subject to exceptions based on consideration of particular facts and circumstances, in which cases the Department may require additional returns to be filed going back in excess of seven years.  In determining whether an exception applies, the DOR will consider whether the taxpayer has any basis for reasonable doubt about its obligation to file Massachusetts returns.

Changes in the Look-Back Policy.  In the new Technical Information Release, the DOR announces that the three-year look-back policy will not apply to non-Massachusetts financial institutions that are presumed under the statute to be “engaged in business in the commonwealth” because of in-state activity, including lending and ancillary loan activity, that exceeds specified amounts.  Instead of the three-year look-back period, the DOR will apply a five-year look-back period requiring tax filings for the tax years beginning with the tax year ending on or after January 1, 2003, if, by September 30, 2008, the taxpayer identifies itself to the DOR as availing itself of the terms of TIR 08-4 and files its returns and makes full payment of the tax due and applicable interest and penalties by December 31, 2008.  Notice that penalties generally are not waived under TIR 08-4 as they would be if the general voluntary disclosure provision under TIR 03-17 applied.  (The TIR also applies to certain non-Massachusetts corporations that use their intangible property within Massachusetts to generate gross receipts within the state for the corporation, including through a license or franchise.) 

The DOR observes that a taxpayer that files under the five-year look-back period may apply for an abatement if, for example, either of the two Appellate Tax Board cases on which the DOR relies in part for the TIR are reversed on appeal by the Supreme Judicial Court.  However, the DOR warns that it will not be bound by the seven-year look-back period provided for in TIR 03-17 and “will apply a look-back period that is appropriate to the circumstances” to a financial institution within the scope of the TIR that does not voluntarily file returns under the provisions of the TIR.  Accordingly, the DOR is implicitly threatening, if the entity’s facts otherwise support such an extended look-back period, to assess a financial institution for all tax years beginning on or after January 1, 1995.

Possible Action.  Even though the terms offered by TIR 08-4 are not attractive because of the relatively long five-year look-back period and the failure to waive penalties, a taxpayer may choose to make voluntary disclosure because of the threat of an extended look-back period.  If a taxpayer decides to make voluntary disclosure, it must identify itself to the DOR by September 30, 2008.

The OCC issued an interpretive letter (“Letter #869”) in which it authorized a national bank (the “Bank’) to establish an operating subsidiary as an LLC (the “Subsidiary”) that will assist customers who wish to engage in “like-kind exchanges” of property under Section 1031 (“Section 1031”) of the Internal Revenue Code (the “IRC”).  Section 1031 allows taxpayers, who meet the requirements of Section 1031, to defer tax payments on gains from real and personal business or investment properties as long as the proceeds are invested in similar properties.

The Bank represented to the OCC that the Subsidiary will offer financial advisory and investment advisory services to customers, but will not provide tax or accounting advice to customers.  The Subsidiary will also provide customers with referrals to real estate brokers and certain other third-party providers.  The Bank further represented to the OCC that the Subsidiary will advise customers to obtain tax and accounting advice from their own attorneys and accountants.  The Subsidiary also, among other things, will act as an “exchange accommodation titleholder” by temporarily holding title to property that is being positioned by a customer in connection with a Section 1031 exchange.

In Letter #869, the OCC imposed several conditions to its approval, including, among other things, that the Subsidiary will maintain adequate and appropriate risk mitigation policies, procedures and controls for these activities.

Economic Capital Models.  The Basel Committee on Banking Supervision (the “Basel Committee”) issued a consultative paper (the “Paper”) discussing the issues that banks face in designing and implementing models allowing for sufficient economic capital.  Economic capital is defined as the methods or practices that allow banks to attribute capital to cover the economic effects of risk-taking activities.  As a result of advances in risk quantification methodologies, the internal capital management needs of banks and regulatory initiatives, economic capital is being increasingly used by banks.  This increase in the use of economic capital has led to the evolution of economic modeling and measurement practices.  The Basel Committee notes that in some aspects these practices have converged and become more consistent over time, however, the notion of economic capital has broadened as its use has expanded. 

Economic capital can be analyzed and used at various levels, the Basel Committee states that Pillar 2 (supervisory review process) of the Basel II Framework may involve an assessment of a bank’s economic capital framework.  The Basel Committee cautions that there remain significant methodological, implementation and business challenges associated with the application of economic capital in banks, particularly if economic capital measures are to be used for internal assessments of capital adequacy.  The Paper contains ten recommendations by the Basel Committee that address these challenges.

The Basel Committee recommends that a bank wishing to use an economic capital model should, in its dialogue with supervisors, be able to demonstrate how the economic capital model has been integrated into the business decision making process.  The board of directors of the bank should also be able to demonstrate awareness of the gap between gross (stand alone) and net enterprise wide (diversified) risk when they define and communicate measures of the bank’s risk appetite on a net basis.  The Basel Committee states that the viability, usefulness, and ongoing refinement of a bank’s economic capital processes depend critically on the existence of a credible commitment by senior management to the process.  The economic capital models should be effectively integrated into the bank’s decision making process in a transparent and auditable way. 

The Basel Committee emphasizes the importance of risk identification, and warns that if relevant risk drivers, positions or exposures are not appropriately quantified, there is great potential for slippage between inherent risk and measured risk.  A bank should understand the limitations of the risk measures it uses, and the implications associated with its choice of risk measures.  The Basel Committee further recommends that a bank’s aggregation methods address the implications stemming from the definition and measurement of individual risk components, stating that the accuracy of the aggregation process depends on the quality of the measurement of individual risk components and the interactions between risks embedded in the measurement process.

Rigorous and comprehensive validation of the economic capital model is recommended by the Basel Committee.  A bank should assess the extent to which its dependency structures are appropriate for its credit portfolio, under both normal and stress circumstances.  The Basel Committee suggests that a bank should understand the trade-offs involved in choosing between the currently used methodologies for measuring counterparty credit risk.  Complementary measurement processes such as stress testing should also be used, although such approaches may still not fully cover all counterparty credit risk exposures.  Finally, the Basel Committee recommends that close attention should be paid to measuring and managing instruments with embedded option features which if not adequately performed can present risks that are significantly greater than suggested by the risk measure.  The Basel Committee notes the importance of recognizing the trade-offs between using an earnings based or economic value based approach to measuring interest rate risk in the banking book.

Compliance.  Separately, the Basel Committee released a survey of the implementation of the compliance risk principles it adopted in the April 2005 paper entitled “Compliance and the compliance function in banks” (the “Compliance Paper”).  In the survey, the Basel Committee states that the results indicate that in a substantial majority of the respondent jurisdictions, banks manage and supervise the compliance function as an important risk management control function, and are in line to varying degrees with the Compliance Paper.  The Basel Committee asserts that the survey shows that the high-level principles described in the Compliance Paper remain relevant and are reflected in current supervisory frameworks or in reforms still under way.  Twenty of the twenty-one jurisdictions surveyed reported some form of compliance requirements, and the Basel Committee stated that a large majority of the respondents have a compliance framework that closely follows the principles described in the Compliance Paper.  The survey found that market conduct (such as conflicts of interest, fair customer treatment and suitable customer advice) and prudential laws and regulations were the areas most frequently involved in compliance incidents; the prevention of money laundering and terrorist financing was also frequently mentioned.

The U.S. Court of Appeals for the Second Circuit (the “Court”) upheld a jury finding that membership interests in limited liability companies formed to finance the production and distribution of films (the “LLCs”) were securities for the purposes of the federal securities laws despite provisions in the LLCs’ organizational document indicating that members participated in the management of the Company.  The issue came before the Court on an appeal of securities fraud convictions related to the marketing of interests in the LLCs.  Among other things, the defendants-appellants challenged the sufficiency of the evidence supporting the jury’s determination that the membership interests in the LLCs were securities. 

The “Howey” Test.  The Court noted that the hybrid nature of limited liability companies made it critical for courts to look beyond the formal terms of a limited liability company membership interest to the reality of the parties’ position in order to evaluate whether there was a reasonable expectation of significant investor control under the test set forth in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”), for determining whether a given financial instrument or transaction constitutes an “investment contract” and, therefore, a security under the federal securities laws.  More specifically, Howey defined an investment contract as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”  The Court indicated that it had subsequently interpreted “solely” to permit a court to “consider whether, under all the circumstances, the scheme was being promoted primarily as an investment or as a means whereby participants could pool their own activities, their money and the promoter’s contribution in a meaningful way.” SEC v. Aqua- Sonic Prods. Corp., 687 F.2d 577 (2d Cir. 1982) (“Aqua-Sonic”).  In Aqua-Sonic, the Court distinguished between companies that seek the “passive investor” and situation where there is a “reasonable expectation . . . of significant investor control.”

Analysis of Offering and Organizational Documents.  In analyzing the nature of the memberships interests in the LLCs, the Court first looked to the LLCs’ offering and organizational documents, noting that were its review confined to those documents it would likely have concluded that the LLC membership interests were not securities.  Testimony at trial indicated that the LLCs were structured so as to minimize the possibility that membership interests would constitute securities.  The offering documents indicated that each member was required to participate in the management of an LLC retaining one vote for each membership interest acquired, with each “important decision relating to the business of the company” being submitted to a vote of the members.  The offering documents further indicated that each member of an LLC was required to participate in its management by serving on one or more committees established by the members.   The operating agreement for one of the LLCs indicated that it would be managed by its Members with each member having a right to act for and bind the LLC in the ordinary course of business. 

Analysis of Actual Operations.  Notwithstanding the offering and organizational documents, the Court concluded that the evidence presented at trial regarding the LLCs’ operations supported the jury’s conclusion that there could be no reasonable expectation of investor control, and that the membership interests were securities subject to the federal securities laws.  Evidence presented at the trial emphasized that in actuality members played an extremely passive role in the management and operations of the LLCs.  For each LLC, only two member committees were formed with significantly less than 1% of members serving on each committee.  The Court also pointed to the fact that members’ managerial rights and obligations did not accrue until the LLCs were “fully organized,” with “interim managers” initially holding legal control rights in deciding almost every significant issue prior to the completion of fundraising.  The Court also pointed to the fact that members appear not to have negotiated any terms of the LLCs’ organizational documents.  The Court echoed the Fifth Circuit in finding that investors may be so lacking in requisite expertise, so numerous or so dispersed that they become utterly dependent on centralized management, counteracting a legal right of control.  Williamson v. Tucker, 645 F.2d 404 (5^th Cir. 1981).  The LLCs’ members had no particular expertise in film or entertainment and therefore would have had difficulty exercising their formal rights under LLCs’ organizational documents.  The Court further found that their number and geographic dispersion left investors particularly dependent on centralized management.  In conclusion, the Court found that upon consideration of the totality of the circumstances, the jury could have determined that, notwithstanding the offering and organizational documents drafted to suggest active participation by the LLCs’ members, the defendants-appellants sought and expected passive investors for the LLCs, and therefore the membership interests that they marketed were securities subject to the federal securities laws.

The FDIC issued a Financial Institution Letter (the “Letter,” FIL-84-2008) regarding banks’ liquidity risk management.  The FDIC stated that a bank’s liquidity risk management program is expected to reflect the bank’s complexity, risk profile and scope of operations.  The Letter stresses that banks that use wholesale funding, securitizations, brokered deposits and other high-rate funding strategies “should ensure that their contingency funding plans address relevant stress events.”  Such “stress events” may involve a bank’s sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, difficulty renewing or replacing funding as it matures, the demise of a business line or the loss of a large depositor or counterparty.  The Letter states that banks that have complex liquidity risk exposures should use pro forma cash flow analyses, among other readily available tools, to measure their liquidity risk.

The Letter reminds banks that the limits set forth at 12 CFR §337.6 on the use of brokered deposits by banks that are less than well capitalized should be reflected in a bank’s Contingency Funding Plan (“CFP”).  The Letter also reminds banks that even when the FDIC grants a less than well-capitalized bank a waiver to accept brokered deposits, restrictions are imposed on the maximum interest rate that can be paid on such deposits.  The FDIC states that a bank’s CFP should provide “practical and realistic” funding alternatives that can be used by a bank as access to funding is reduced.

Moreover, the FDIC states that banks that present high levels of liquidity risk because of dependence on volatile, credit-sensitive or concentrated funding sources, will generally by expected by the FDIC to maintain higher than minimum capital levels.  Furthermore, the FDIC specifically cautions banks in the Letter that they need to set liquidity risk tolerances and/or limits that are “appropriate for the complexity and liquidity risk profile of the institution and…employ both quantitative targets and qualitative guidelines.”

The OCC issued Community Development Investment Letter #2008-1 (the “CDI Letter”) in which the OCC concluded that a national bank that made an investment (the “Investment”) in a fund (the “Fund”) that will finance solar energy-producing facilities can count the Investment under 12 USC §24 (Eleventh) and 12 CFR Part 24 as a qualifying community development and public welfare investment.  The Fund will invest in various limited liability entities that will develop, acquire, install and maintain solar energy-producing facilities and provide electricity for specified properties, primarily benefiting low- and moderate-income individuals and areas in California.

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As previously summarized in the February 26, 2008 Alert (“SEC Issues Adopting Release for Form D Electronic Filing Requirement and Form D Revisions”), newly-revised Form D and related electronic filing rules become effective on September 15, 2008. The electronic filing requirements are subject to a 6-month transition period during which electronic filing of the newly-revised version of Form D is optional.  During the transition period, issuers may (a) make a paper filing using the “temporary” Form D, which differs slightly from the current paper form, (b) make a paper filing using the newly-revised version of Form D, or (c) file electronically using the newly-revised version of Form D. The transition period ends March 16, 2009, when the newly-revised version of Form D and electronic filing become mandatory.