Financial Services Alert - October 28, 2008

The FDIC approved an interim rule (the “Rule”) to govern the Temporary Liquidity Guarantee Program (“TLGP”).  See the October 14, 2008 Alert for previous coverage of the TLGP.  The TLGP has two components: (a) the Debt Guarantee Program, which guarantees newly issued senior unsecured debt of participating banking organizations issued between October 14, 2008 and June 30, 2009 (“Guaranteed Debt”); and (b) the Transaction Account Guarantee Program which provides full deposit insurance coverage for non-interest bearing transaction accounts (“Guaranteed Accounts”), regardless of dollar amount.  All eligible institutions are automatically enrolled in the TLGP for the first 30 days at no cost.  Banking organizations that do not wish to participate in the TLGP must opt out by 11:59 p.m. on November 12, 2008.  All eligible financial institutions within a U.S. bank holding company or U.S. savings and loan holding company must make the same determination to opt out of each component of the TLGP.  As reported in the October 14, 2008 Alert, fees will be imposed on participants in the TLGP (i.e., those who do not opt out) after November 12, 2008.  For those who do not opt out, the FDIC’s guarantee of the Guaranteed Debt will remain in force until June 30, 2012, even if the maturity date of the Guaranteed Debt extends beyond June 30, 2012.  The guarantee of the Guaranteed Accounts will remain in effect until December 31, 2009. 

Eligible Entities

Banking organizations eligible for participation in the TLGP include (a) any FDIC-insured depository institution, (b) any U.S. bank holding company, including financial holding companies, (c) U.S. savings and loan holding companies that engage only in activities that are permissible for financial holding companies under section 4(k) of the Bank Holding Company Act (the “BHCA”) or which have at least one insured depository institution subsidiary which is the subject of an application pursuant to 4(c)(8) of the BHCA pending as of October 13, 2008, and (d) other affiliates of FDIC-insured depository institutions designated by the FDIC in consultation with the appropriate Federal banking agency.  The Rule includes a provision that allows certain otherwise ineligible holding companies or affiliates that issue debt for the benefit of an insured institution or eligible holding company to apply for inclusion in the program on a case-by-case basis.

The Debt Guarantee Program

The Rule requires that Guaranteed Debt must (a) be evidenced by a written agreement, (b) have a specified and fixed principal amount to be paid in full on demand or on a date certain, (c) be non-contingent, and (d) not be subordinated by its terms to any other liability.  Guaranteed Debt generally includes federal funds purchased, promissory notes, commercial paper, unsubordinated unsecured notes, certificates of deposit standing to the credit of a bank, bank deposits in an international banking facility of an insured depository institution, and Eurodollar deposits standing to the credit of a bank.  Guaranteed Debt does not include, among other instruments, obligations from guarantees or other contingent liabilities, derivatives, derivative-linked products, debt paired with any other security, convertible debt, capital notes, the unsecured portion of otherwise secured debt, negotiable certificates of deposit, and deposits in foreign currency and Eurodollar deposits that represent funds swept from individual, partnership or corporate accounts held at insured depository institutions. 

The FDIC will guarantee payment of unpaid principal and interest on the Guaranteed Debt accrued to the date of the bankruptcy or failure of the issuing banking organization.  In the case of delays in payment of claims by holders of Guaranteed Debt, the FDIC will pay interest at the 90-day T-Bill rate.  As reported in the October 14, 2008 Alert, the maximum amount of debt which may be guaranteed by the FDIC under the TLGP is 125% of the par value of the participating banking organization’s debt outstanding as of September 30, 2008 and scheduled to mature on or before June 30, 2009, excluding any debt extended to affiliates.  This limit may be adjusted for certain participating entities if the FDIC, in consultation with any appropriate Federal banking agency, determines that it is necessary.  If an eligible entity had no senior unsecured debt prior to September 30, 2008, the FDIC will consider the circumstances of the eligible entity and may determine an alternate threshold calculation.  The maximum amount of guaranteed debt will be calculated separately for each individual participating entity within a holding company structure.

A participating banking organization may elect to issue certain non-guaranteed senior unsecured debt on or before November 12, 2008 before issuing the maximum amount of Guaranteed Debt. Election of this option would require a participating banking organization to pay a nonrefundable fee in exchange for which it will be able to issue, at any time and without regard to the cap, non-guaranteed senior unsecured debt with a maturity date after June 30, 2012.  This fee would be applied to the par or face value of senior unsecured debt, excluding debt extended to affiliates, outstanding as of September 30, 2008, that is scheduled to mature by June 30, 2009.  The fee would equal an annualized 75 basis points that would be charged for the six month period for which the Debt Guarantee program will be available. 

The Transaction Account Guarantee Program

Guaranteed Accounts are defined by the Rule as a transaction account on which the insured depository institution pays no interest and does not reserve the right to require advance notice of intended withdrawals.  This definition encompasses traditional checking accounts that allow for an unlimited number of deposits and withdrawals at any time.  This definition does not, however, encompass negotiable order of withdrawal (“NOW”) accounts and money market deposit accounts.  If the funds in an account are at any point swept into an interest-bearing account, that account does not qualify for a guarantee under the TLGP.  In addition, funds swept into non-transaction accounts such as savings accounts are not covered.  The Rule makes an exception to this treatment of sweep accounts where funds are swept from a non-interest bearing transaction account to a non-interest bearing savings account.  In that case, the swept funds will be fully guaranteed under the TLGP.  Otherwise, funds swept into an interest-bearing account will be insured under the FDIC’s general deposit insurance regulations.

Public Disclosure

The FDIC will maintain and post on its website a list of those banking organizations that have opted out of either or both components of the TLGP so that possible lenders and transaction account depositors can tell when an entity has opted out of the TLGP.  All participating banking organizations must clearly identify, in writing and in a commercially reasonable manner, whether newly issued debt is guaranteed under the TLGP.  Participating banking organizations must also post notices which indicate its participation, and if participating in the Transaction Account Guarantee Program, that all funds held in Guaranteed Accounts are insured in full by the FDIC.

Request for Comment

Federal Reserve Bank of New York’s Money Market Investor Funding Facility. 

As discussed in the October 21, 2008 edition of the Alert, the FRB-NY has created a money market investor funding facility (the “MMIFF”) to provide senior secured funding to a series of special purpose vehicles (the “PSPVs”) to finance until April 30, 2009 the purchase of certain instruments from money market funds.  Since the announcement of that program (the “MMIFF Program”), the FRB-NY has published a “Questions & Answers” (the “Q&A”) in which it has provided additional information about the MMIFF Program, the MMIFF and the PSPVs. 

Among other things, the Q&A states:

• A money market fund that transfers an eligible asset to the PSPVs will receive (a) cash representing 90 percent of the amortized cost of the eligible asset and (b) asset-backed commercial paper (“ABCP”) issued by the relevant PSPV representing 10 percent of the amortized cost of the eligible asset and having a stated interest rate of 25 basis points less than the stated interest rate applicable to the eligible asset.  Each ABCP investor will receive a contingent distribution of funds up to 25 basis points above the yield on the assets it sold to the PSPV, to the extent there is available accumulated income in the PSPV.  Each PSPV will have a short‑term rating of at least A-1/P-1/F-1 by at least two nationally recognized statistical rating organizations (“NRSROs”).
• All ABCP held by investors will be subordinated to the FRB-NY loans to the PSPVs.
• There will be five PSPVs, each holding assets issued by ten issuers.  Each issuer will have a short‑term debt rating of at least A-1/P-1/F-1 by at least two NRSROs, and be among the largest issuers of highly rated short-term liabilities held generally by money market funds.  Issuers are expected to include European in addition to U.S.‑based global financial institutions.
• There will be limitations on how much an investor may sell to a PSPV.  As discussed below, the SEC has issued to J.P. Morgan Securities Inc. (“JPMorgan Securities”), the sponsor and manager of the PSPVs, a no-action letter that describes those limits (the “JPMorgan No-Action Letter”).

In addition, in conversations with the Investment Company Institute and others, we have learned the following about the MMIFF Program:

• The MMIFF Program is intended to cover any fund that is registered as an investment company under the Investment Company Act of 1940 (the “1940 Act”), and that holds itself out as a money market fund (i.e., it meets the requirements of Rules 2a-7(c)(2), (c)(3) and (c)(4)), not just those money market funds that maintain a stable net asset value.
• The PSPVs maximum liability at any one time is intended to be $600 billion in eligible assets.  As acquired instruments mature and are paid off, the principal amounts of such instruments are intended to be reapplied to the original $600 billion limit.
• The FRB-NY expects to publish the list of the 50 issuers of the eligible assets within the next two weeks.

Separately, the Staff of the SEC’s Division of Investment Management (the “Staff”) issued to JPMorgan Securities no-action relief with respect to money market fund participation in the MMIFF Program in which, among other things, the Staff stated that:

• It would not recommend enforcement action to the SEC under Sections 2(a)(41), 34(b) and 35(d) of the 1940 Act, and Rules 2a-4 and 22c-1 thereunder (which relate to the calculation of an investment company’s net asset value) if a money market fund treated the PSPV-issued ABCP as “Asset Backed Securities” for purposes of Rule 2a-7 under the 1940 Act;
• It would not recommend enforcement action to the SEC under Sections 2(a)(41), 34(b) and 35(d) of the 1940 Act, and Rules 2a-4 and 22c-1 thereunder if a money market fund investing in ABCP complied with Rule 2a-7’s diversification requirements by adhering to the following conditions instead of the “look through” provisions of Rule 2a-7(c)(4)(ii)(D)(1)(i):
• The fund may not acquire any ABCP if such acquisition would result in all ABCP representing more than 2.5 percent of the fund’s total assets;
• At the time of its acquisition by the fund, ABCP must be a First Tier Security (as defined in Rule 2a-7(a)(12));
• If a fund makes additional purchases of securities issued by an issuer that is one of the ten issuers the securities of which may be held by a PSPV, for diversification purposes, the fund must add the entire value of its ABCP issued by that PSPV to the value of all of its other holdings of securities of the issuer; and
• If a fund acquires in the secondary market ABCP issued by a PSPV, for diversification purposes, the fund must add the entire value of the such ABCP to the value of all of its holdings of the securities of each of the ten issuers the securities of which may be held by the PSPV in addition to the value of all of its holdings of the securities of that issuer.
• It would not recommend enforcement action to the SEC under Section 12(d)(3) of the 1940 Act if a money market fund participating in the MMIFF Program acquires PSPV-issued ABCP even though the PSPVs are advised by affiliated persons of financial institutions that that have significant securities-related businesses and are issuers of securities that are eligible for purchase by the PSPVs.  Section 12(d)(3) generally prohibits an investment company from purchasing a security issued by a broker, dealer, a person engaged in the business of underwriting, an investment adviser to an investment company, or a registered investment adviser.

Treasury Guarantee Program.

As discussed in the September 30, 2008 and October 14, 2008 editions of the Alert, the U.S. Treasury is providing a temporary guaranty program for certain money market funds (the “Treasury Program”), which guarantees the value of the shares of participating money market funds that were owned by beneficial owners as of the close of business on September 19, 2008.   FINRA has issued a notice to its members in which it announced that member communications with the public that are covered by NASD Rule 2210, when discussing the Treasury Program, should provide in substance the following information:

• The Treasury Program provides a guarantee to participating money market fund shareholders based on the number of shares invested as of the close of business on September 19, 2008;
• Any increase in the number of shares an investor holds after the close of business on September 19, 2008 will not be covered;
• If a customer closes his or her account with the fund or broker-dealer, any future investment will not be covered;
• If the number of shares a customer holds fluctuates over the period, the investor will be covered for the lesser of the number of shares held as of the close of business on September 19, 2008 or the current amount; and
• The Treasury Program expires on December 18, 2008, unless extended by the Treasury.

In addition, FINRA expects that when a customer transfers an account from one brokerage firm to another, and the customer owns shares of a money market fund that is participating in the Treasury Program, the receiving brokerage firm should refer to the guarantee and inform the customer that he or she could lose the benefit of the guarantee upon the closure of the account in the account transfer or upon the transfer of the account to the receiving firm.

The FRB issued new guidance to refine and clarify its programs for the consolidated supervision of bank holding companies (“BHCs”) and the combined U.S. operations of foreign banking organizations (“FBOs”) (the “Consolidated Supervision Guidance”).  Also, together with the Consolidated Supervision Guidance, the FRB released guidance clarifying supervisory expectations with respect to compliance risk management programs and oversight at large banking organizations with complex compliance profiles (“Compliance Risk Management Guidance”) (together with the Consolidated Supervision Guidance, the “Guidance”).   The FRB’s press release indicated that, although the FRB began formulating the Guidance before the recent turmoil in the financial markets, the enhanced approaches to consolidated supervision and compliance risk management across firms is expected to support a more resilient financial system.  FRB Governor Randall Kroszner further explained that the Guidance “will better equip our supervisory staff, working closely with other US and foreign supervisors and regulators, to understand and assess the full range and scope of a banking organization’s operations and risks.”

The Consolidated Supervision Guidance is designed to foster consistent FRB supervisory practices and assessments across institutions with similar activities and risks.  It describes how FRB staff develop an understanding and assessment of the consolidated operations of a BHC and the U.S. operations of an FBO through continuous monitoring activities, discovery reviews, and testing activities, as well as through interaction with, and reliance to the fullest extent possible on, other relevant supervisors and functional regulators.  The FRB emphasized its risk-focused and “portfolio” approach (assessing and evaluating practices across groups of organizations with similar characteristics and risk profiles) to consolidated supervision.

The Consolidated Supervision Guidance also clarifies the FRB’s policy of maintaining for each BHC and the combined U.S. operations of each FBO: (a) an understanding of key elements of the banking organization’s strategy, primary revenue sources, risk drivers, business lines, legal entity structure, governance and internal control framework, and presence in key financial markets; and (b) an assessment of (i) the effectiveness of risk management systems and controls over the primary risks inherent in the organization’s activities, (ii) the organization’s financial condition, and (iii) the potential negative impact of non-bank operations on affiliated depository institutions.

The Compliance Risk Management Guidance endorses the principles set forth in the April 2005 paper issued by the Basel Committee on Banking Supervision entitled “Compliance and the Compliance Function in Banks” (as discussed in the May 10, 2005 Alert). The guidance also clarifies certain FRB supervisory policies regarding compliance risk management programs and oversight at large banking organizations with complex compliance profiles.  In particular, the Compliance Risk Management Guidance emphasizes the importance of (i) implementing a firm-wide approach to compliance risk management and oversight; (ii) ensuring that compliance staff are independent from the firm (e.g., ensuring compliance compensation is not based on the firm’s financial performance); (iii) ensuring robust compliance monitoring and testing procedures are in place for identifying weaknesses in existing compliance risk management controls; and (iv) ensuring that senior management and boards of directors are fulfilling their duties to establish and promote an effective risk management program.

As discussed in the October 7, 2008 Alert, in accordance with the authority granted to the FRB under the Emergency Economic Stabilization Act of 2008, the FRB has announced that the Federal Reserve Banks (the “Reserve Banks”) will pay interest on banks’ required reserve balances and on excess balances (balances held in excess of required reserve balances and contractual clearing balances).

The Massachusetts of Consumer Affairs and Business Regulation has provided guidance regarding its new regulations 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 make specific computer information security requirements.  The regulations, which have a January 1, 2009 compliance date, are discussed in detail in a Goodwin Procter Client Alert available here.

The newly issued guidance consists of the following:

• Frequently Asked Questions – available at http://www.mass.gov/Eoca/docs/idtheft/idbreachfaqs.pdf
• Small Business Guide for Formulating a Comprehensive Written Information Security Program ‑ available at http://www.mass.gov/Eoca/docs/idtheft/sec_plan_smallbiz_guide.pdf
• Compliance Checklist ‑ available at http://www.mass.gov/Eoca/docs/idtheft/compliance_checklist.pdf