Financial Services Alert - September 30, 2008

The Internal Revenue Service (“IRS”) released Revenue Procedure 2008-63, which provides that when a securities loan is in default because the borrower (or an affiliate of the borrower) that is unrelated to the lender goes bankrupt, no gain or loss will be recognized if the lender applies the collateral to the purchase of identical securities as soon as practicable (and in any event within 30 days) after the default.  The IRS said in this case it would treat the purchase as an exchange to which Section 1058 applies, and the lender will receive the same nonrecognition treatment it would have received if the borrower had returned identical securities upon termination of the loan.  Prior to the issuance of the Revenue Procedure, it was generally believed that a default would result in recognition of gain (regardless of the reason for the default), and the IRS took that view in regulations that it proposed in 1983 that have not yet been finalized or withdrawn.  The Revenue Procedure changes that result in the case of a bankruptcy-related buy-in.  The Revenue Procedure is effective for tax years ending on or after January 1, 2008, but does not apply to securities lending defaults for reasons other than bankruptcy of the borrower or an affiliate or that are otherwise outside the scope of the Revenue Procedure.

The staff of the SEC (the “SEC staff”) issued guidance providing that securities out on loan will be deemed to be owned by the lender for purposes of the SEC’s short sale regulations, and therefore can be sold long, if the lender issues a bona fide recall of those securities within two days of the sale.  Prior to the guidance, lenders were concerned that they would not be deemed to own securities on loan for purposes of the various SEC short sale regulations, including Regulation SHO as amended by new Rule 204T, the SEC emergency short sale order banning short sales of financial stocks, and the new temporary Form SH short sale position reporting requirements.  Prior to the SEC staff’s issuance of this guidance, many brokers were marking sales of securities that were out on loan as short sales out of an abundance of caution due to uncertainty regarding the long-short status of the sales.  This resulted in an increased chance of involuntary buy-ins by brokers without pre-notice to lenders.  As a result of this uncertainty, many lenders had considered significantly reducing their participation in securities lending programs, which could have further impacted volume and liquidity of the markets.  This guidance from the SEC staff now makes clear that lenders will not be deemed to have sold short when they sell securities out on loan, provided a recall is effected within two days of the sale.  This is significant because new Rule 204T under Regulation SHO provides that a broker can close-out a delivery failure on a long sale by making a close-out purchase any time before trading begins on the sixth settlement day after the long sale, which means that lenders who sell their loaned securities long have three additional days to buy themselves in so as to not experience a failure to deliver in violation of Rule 204T.  If the sale of loaned securities were deemed “short,” Rule 204T requires a failure to deliver to be closed out no later than the beginning of trading on T+4.  These extra two days for long sales give lenders a greater chance of receiving their loaned securities back from the borrower so that they can deliver the shares before the close out date on T+6 and thus reduces the likelihood that lenders will be bought-in involuntarily by their clearing brokers.

On September 25, 2008, the staff of the SEC’s Division of Investment Management issued a no-action letter to the Investment Company Institute (the “ICI No-Action Letter”) stating that, subject to certain conditions, it would not recommend enforcement action to the SEC under Section 17(a)(2) of the Investment Company Act of 1940 (the “1940 Act”) against a U.S. depository institution, bank holding company (parent or broker-dealer affiliate) or U.S. branch of a foreign bank (each, a “bank”) that is an affiliated person, or an affiliated person of an affiliated person, of a registered investment company that holds itself out as a money market fund (a “money market fund”) if the bank purchases from that money market fund asset-backed commercial paper (“ABCP”) pursuant to the ABCP liquidity facility authorized by the FRB on September 19, 2008.  (A discussion of the ABCP liquidity facility that is being administered for the FRB by the Federal Reserve Bank of Boston (the “FRB-Boston”) is included in the September 23, 2008 Alert.)  Section 17(a)(2) provides generally that it is unlawful for an affiliated person, or an affiliated person of an affiliated person, of a registered investment company knowingly to purchase from the registered investment company any security or other property.  Under the 1940 Act, an affiliated person to a money market fund includes the investment adviser to such fund, and an affiliated person of an investment adviser usually includes any parent, sister or subsidiary company of the investment adviser.

The importance of the ICI No-Action Letter to a bank that is an affiliated person, or an affiliated person of an affiliated person, of a money market fund intending to purchase from the money market fund ABCP that meets the requirements of the ABCP liquidity facility is because the bank may not rely on Rule 17a-9 under the 1940 Act when making that purchase.  Rule 17a-9 generally exempts from Section 17(a) of the 1940 Act a purchase of a security from a money market fund if, among other things, the security is not an Eligible Security, as defined in Rule 2a-7 under the 1940 Act.  Under the ABCP liquidity facility, any ABCP bought from a money market fund with loan proceeds from the facility must be a First Tier Security (as defined in Rule 2a-7), and thus, an Eligible Security at the time the ABCP is pledged to the FRB-Boston. 

Any transaction involving a bank intending to rely on the ICI No-Action Letter must meet the following conditions: (a) the money market fund’s investment adviser must determine which ABCP will be purchased from the money market fund based on then-current market conditions and the fund’s redemption needs, (b) those determinations must be made consistent with the investment adviser’s fiduciary duty to the fund, and in the best interest of fund shareholders, and (c) the fund must keep and maintain records of the transactions as required by Rules 31a-1 and 31a-2 under the 1940 Act.

As discussed in the September 23 Alert, on September 29, 2008 to reduce liquidity strains being experienced by money market mutual funds (“MM Funds”), the FRB established a special lending facility (the “Facility”) that allows depository institutions (“DIs”, and each a “DI”) to borrow on a nonrecourse basis from the Federal Reserve Bank of Boston (“FRB-Boston”) if the DI uses the proceeds from the loan to purchase asset-backed commercial paper (“ABCP”) from MM Funds.  The ABCP purchased using proceeds from the Facility must be pledged to secure the loan from the FRB‑Boston.

On September 26, 2008, the OCC issued an interim final rule (the “Interim Rule”), under which a DI may assign a zero percent risk weight to the ABCP purchased by the DI during the period from September 19, 2008 and January 31, 2009.  The Interim Rule became effective on September 19, 2008, and comments may be submitted to the OCC until October 31, 2008.

On September 29, 2008, the Treasury finalized the terms of its program to provide a temporary guarantee to any registered investment company that holds itself out as a money market fund (a “money market fund”).  (An earlier proposal of the Treasury’s program was discussed in the September 23, 2008 Alert.)  Under the Treasury program, in the event a participating fund “breaks a buck”, a covered shareholder (as described below) generally will receive $1.00 per covered share (as described below), subject to certain adjustments and, importantly, subject to the overall amount of funds available to all money market funds in the program.  Currently, the assets of the Exchange Stabilization Fund, which are valued at approximately $50 billion, have been made available to guarantee any payment to covered shareholders of a money market fund participating in the program.  Below are some additional terms of the Treasury program.

Eligible Funds.  Any registered investment company that holds itself out as a money market fund, maintains a stable net asset value per share of $1.00, and offers shares that are registered under the Securities Act of 1933, as amended, generally may participate in the program.  The program does not limit participation to taxable or tax-exempt funds; both may participate.  The guarantee provided under the program applies on a fund-by-fund basis, irrespective of whether a participating money market fund is one of a series or family of funds.

Covered Shareholders.  A shareholder of a participating money market fund who was a shareholder of record of that fund on September 19, 2008 and who is a shareholder of record as of the date of a guarantee event (as described below) is covered under the program.  Note that shareholders of money market funds do not participate directly in the program, and only may benefit from the program if the money market fund in which they have invested participates.

Covered Shares.  The number of shares held by a covered shareholder that are covered by the program is the lesser of (a) the number of shares owned by the covered shareholder on September 19, 2008 and (b) the number of shares owned by the covered shareholder on the date of a guarantee event.  Shares of the covered shareholder held as of September 19, 2008 remain as covered shares even if they are sold and later repurchased before a guarantee event.

Guarantee (Trigger) Event.  A guarantee event occurs when, any time after September 19, 2008, the fund’s market-based net asset value per share is less than $0.995, unless promptly cured.

Status of NAV Support Agreements.  If a money market fund has a NAV support agreement in effect at the time of a guarantee event, the fund generally must take all necessary action to receive payment under that agreement.  A money market fund may not amend, terminate or withdraw from a NAV support agreement on which it has relied at any time on or after September 19, 2008, and it must renew or extend the NAV support agreement if it has the option do so.

Conditions for Payment.  The following events, among other conditions, must occur before the Treasury will pay under the program:

• The guarantee event must occur before the termination date of the program;
• The money market fund generally must be liquidated within 30 days of the guarantee event; and
• The Treasury must receive written assurances that there is no legal impediment to the disbursement of guarantee payments.

Effective Date.  Provided that a money market fund is a participant in the program by October 8, 2008, the guarantee provided to the fund by the program is retroactive to September 19, 2008.

Date of Termination of the Program/Extension of the Program.  The program will terminate on December 18, 2008.  The Treasury, in its sole discretion, may extend the program to any date on or before September 18, 2009.  If the program is extended, a money market fund may continue to participate provided that as of the extension date, it has a market-based net asset value per share of at least $0.995.

Cost to Participate in the Program.  A money market fund intending to participate in the initial period of the Treasury program must pay the following fees:

• If the fund’s market-based net asset value per share is greater than or equal to $0.9975, the fee is $1 multiplied by the number of covered shares multiplied by 0.00010 (1 basis point); or
• If the fund’s market-based net asset value per share is less than $0.9975 but greater than or equal to $0.995, the fee is $1 multiplied by the number of covered shares multiplied by 0.00015 (1.5 basis points).

Fees to participate in any extension of the program will be determined at the time of the Treasury’s decision to extend the program.

Required Documentation.  A money market fund intending to participate in the program must submit, and the Treasury must receive, on or before 11:59 pm Washington, D.C. time on October 8, 2008 the following:

• Guarantee Agreement, two forms of which (for single and multiple funds) may be found on the Treasury’s website (note that according to the instructions accompanying the form of Guarantee Agreement, the agreement may not be altered except to insert identifying information, adding signature blocks, and completing Annex A (information about the fund or funds));
• Execution Notice (a form of which is included as Exhibit G to the Guarantee Agreement);
• Acknowledgment and Investment Adviser Undertaking from each investment adviser to the fund (a form of which is found immediately after the form of Guarantee Agreement); and
• The fee for payment to participate in the program.

The FDIC issued an interim rule (the “Interim Rule”) which the FDIC stated is intended to simplify and modernize its deposit insurance rules for revocable trust accounts.

Under the FDIC’s coverage rules, there are two types of revocable trust accounts insured: informal trust accounts and formal trust accounts.  Informal trust accounts are comprised of a signature card on which the owner designates the beneficiaries to whom the funds in the account will pass upon the owner’s death.  Informal accounts are sometimes called “payable-on-death” (POD accounts), “in trust for,” (ITF accounts) or “Totten Trust” accounts.  Formal revocable trusts are accounts established in connection with estate planning (e.g., living trusts, family trusts, marital trusts, generation-skipping trusts).  Prior to the Interim Rule, the FDIC rules provided that both informal and formal revocable trust accounts were insured up to $100,000 per “qualifying beneficiary” designated by the account owner.  Qualifying beneficiaries were limited to the account  owner’s spouse, children, grandchildren, parents and siblings.  The per-qualifying beneficiary FDIC coverage was separate and in addition to the $100,000 coverage that the qualifying beneficiary would receive on his or her own account or accounts at the same bank. 

In the Interim Rule the concept of “qualifying beneficiaries” has been eliminated.  The relationship of the beneficiary to the trust account owner no longer affects deposit insurance coverage.  Under the Interim Rule, a trust account owner with $500,000 or less in revocable trust accounts at a single bank is insured up to an amount equal to $100,000 multiplied by the number of different beneficiaries.  The FDIC stated that this will apply to the vast majority of revocable trust account owners.  For revocable trust account owners who have more than $500,000 in one bank and who have named more than five different beneficiaries in the revocable trust or trusts, the maximum coverage is the greater of $500,000 or the aggregate amount of all of the beneficiaries’ proportional interests in the revocable trust or trusts limited to $100,000 per beneficiary.  As the FDIC points out, the “impact of the [Interim Rule] results in no depositor being insured for an amount less than he or she would have been entitled to under the former revocable trust account rules.”

In addition, the Interim Rule provides that in determining FDIC coverage for living trust accounts, a life estate interest is valued at $100,000 and irrevocable trusts that spring from a revocable trust upon the death of the irrevocable trust account owner are insured under the revocable trust rules.

The Interim Rule became effective on September 26, 2008, and the deadline for comments is December 1, 2008.

The OCC issued an updated version of its Policy Statement on Minority-Owned National Banks (the “Statement”).  The Statement says that the OCC recognizes the importance of minority-owned banks in their communities and in the national banking system.  The Statement defines a minority-owned bank as one that is more than 50% owned or controlled by African Americans, Native Americans, Hispanic Americans, Asian Americans or women.  The Statement declares that the OCC is committed to employing measures and resources that will “encourage and preserve minority ownership of national banks.”  In particular, the Statement states that the OCC provides advice and technical assistance to minority-owned bank applicants, assists minority-owned banks as part of the supervisory process, supports investments by national banks in minority-owned banks pursuant to public welfare investment authority and will give national banks Community Reinvestment Act credit for investments in minority-owned banks.  The Statement also says that starting in 2008, the OCC’s Annual Report will include a summary of OCC activities to support minority-owned national banks.

The Massachusetts Office of Consumer Affairs and Business Regulation released new rules requiring all entities that own, license, store or maintain personal information about a resident of the Commonwealth of Massachusetts to develop, implement and maintain a comprehensive written information security program and meet specific computer information security requirements.  The requirements have no exemption for entities subject to other regulations, apply to entities outside of Massachusetts who have personal information of Massachusetts residents, and contain far more specific security requirements than exist under other regulations.  The compliance date for the new regulations is January 1, 2009.  A Goodwin Procter Client Alert discussing this development in detail is available here.

The SEC announced that chief compliance officers (“CCOs”) for registered funds and investment advisers can begin registering for the annual CCOutreach National Seminar to be held on November 13, 2008, at the SEC’s Washington, D.C., headquarters.   The agenda for the National Seminar at http://www.sec.gov/info/cco/ccons2008agenda.pdf lists panel discussions on (a) compliance challenges from the subprime crisis, including valuation and liquidity, (b) recordkeeping, soft dollars, and trading issues, (c) disclosure issues, including the summary prospectus proposal and proposed changes to Form ADV Part II, and (d) examinations and enforcement actions.  Adviser and fund CCOs will be given priority on a first-come, first-served basis.  The seminar will be webcast at www.sec.gov. 

Registration information is available at http://www.sec.gov/info/cco/cconsreg.htm.