Financial Services Alert - January 27, 2009

FDIC-FIL-1-09.  The FDIC issued a financial institution letter (“FIL-1-09”) in which it directed state nonmember banks (“Banks”) to monitor and document their use of capital injections, liquidity support and/or financing guarantees the Bank may have obtained through the financial stability programs recently established by the Department of the Treasury, the FRB and the FDIC.  FIL-1-09 says that Banks are expected to document how they are continuing to meet the credit needs of creditworthy borrowers and how the Bank (or its parent company) will use these federal funds “to prudently support credit needs in their market and strengthen bank capital.”  The FDIC stated that it will be assessing how the Bank’s participation in the federal funding programs has helped the Bank support lending and support efforts to “avoid unnecessary foreclosures.”  Furthermore, FIL-1-09 states that Banks should describe their utilization of the federal funding during their bank regulatory examinations and “are encouraged” to summarize the information in published financial reports and  financial statements.

FDIC-FIL-2-09.  Separately, the FDIC issued a financial institution letter, “FIL-2-09”, in which it provided guidance concerning reporting obligations of banks that participate in the FDIC’s program under which it guarantees certain banks’, thrifts’ and holding companies’ (collectively, “Entities’”) newly issued senior unsecured debt (the “Debt Guarantee Program”).  All Entities that participate in the Debt Guarantee Program must report to the FDIC their outstanding debt balances within 30 calendar days after the last day of the month.  Reports to the FDIC must be provided by each participating Entity, i.e., affiliated banks within a banking organization should provide separate not combined reports.  Each Entity must also report whether it has issued any non-guaranteed debt during the reporting period and must certify that all reported information is accurate.  These reporting requirements are in addition to the FDIC’s requirements under FIL-139-2008, that any participating Entity in the Debt Guarantee Program register with the FDIC any individual FDIC guaranteed debt issued after December 5, 2008, within five calendar days of issuance.

Treasury Reporting Requirement.  Partially in response to Congressional criticism that the terms of Capital Purchase Program grants to banking institutions did not require that the recipient use the proceeds of the federal capital injection to make loans, the Department of the Treasury sent letters to 20 of the largest U.S. banking institutions seeking monthly reports on their levels of business loans and of consumer loans.  The Treasury’s letter also sought information from the banking institutions concerning their purchases of mortgage-backed and asset-backed securities.

Treasury’s Special Inspector General for TARP to Seek Information on Use of TARP Funds.   The Department of the Treasury’s  Special Inspector General for the Troubled Asset Relief Program (“TARP”) plans to ask all TARP fund recipients to provide a detailed description of their use of TARP funds.  Within 30 days of receiving the information request, participants in the Capital Purchase Program will be required to provide: (a) a narrative response outlining their use or expected use of TARP funds, (b) copies of pertinent documentation (financial or otherwise) supporting their response, (c) a description of their plans for complying with applicable executive compensation restrictions; and (d) a certification by a duly authorized senior executive officer as to the accuracy of all statements, representations, and supporting information provided.

The FRB granted an exemption from Regulation W permitting: (1) a bank’s securities affiliate (“Affiliate”) to hold and receive payments on variable-rate demand notes (“VRDNs”) and tender option bonds (“TOBs”) that are backed by a liquidity facility provided by the bank; and (2) the bank to purchase up to a specified amount of VRDNs and TOBs from the Affiliate.

The VRDNs are issued by a trust sponsored by a governmental entity and are supported by letters of credit issued by the bank (“LOCs”).  The VRDNs are remarketed in a process managed by the Affiliates.  If the remarketing is not successful, the holders have a right to put the VRDNs back to the trust, which would then draw upon the LOC to repurchase them.  The VRDNs have not been successfully remarketed recently, and the Affiliate is purchasing them as an accommodation to the Affiliate’s customers.  The Affiliate may either hold the VRDNs (and receive interest payments largely funded by the LOC) or sell the VRDNs to the bank.

The TOBs are similarly structured except that the trust is consolidated with, and treated as an operating subsidiary of, the bank.  As with the VRDNs, the trust enters into a LOC with the bank, and the Affiliate may purchase customer interests as an accommodation and either remarket them afterwards or sell them to the bank. 

The FRB determined that the purchase by the bank of VRDNs or TOBs from the Affiliate would be covered transactions under Regulation W.  Because of the attribution rule, the trusts’ repurchase of VRDNs and payments of interest to the Affiliate, in each case because funded by the LOC, would be covered transactions.

In granting the exemption, the FRB noted that the exemption would not expose the bank to additional credit risk, as it is obligated to advance funds under the LOC regardless of the holder.  Moreover, the FRB limited the duration of the exemption to TOBs and VRDNs purchased by the Affiliate prior to December 31, 2009, and also imposed capital and rating requirements in connection with the transactions.

The staff of the SEC’s Division of Investment Management (the “Staff”) issued a letter providing no-action relief to a number of financial industry participants (the “Participants”) from provisions of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and the Investment Company Act of 1940, as amended (the “1940 Act”), that could apply to, and as a result of transactions resulting from, the acceptance of offers made by the Participants to purchases auction rate securities (the “Securities”) issued by registered closed‑end funds (each, a “Fund”) from certain of the Participants’ current and former customers, generally individuals, charitable organizations and certain small businesses.  The impetus for the relief was that certain Participants had entered into agreements with the SEC, state authorities and/or self‑regulatory organizations to settle various kinds of enforcement proceedings pursuant to which the Participants agreed to make offers of the type contemplated by the relief  (the “Settlements”).  Relief was also sought to permit Participants that have not entered into Settlements to voluntarily offer to repurchase Securities from their customers and former customers (these offers along with offers pursuant to Settlements, the “Offers”).  The current no‑action relief supplements relief previously granted to the Participants with respect to various provisions of the Securities Exchange Act of 1934 addressing primarily tender offer and security ownership reporting issues raised by the Offers.  The current relief is contingent on the Offers being made in accordance with the protocol established in the prior relief.

Advisers Act Principal Transactions Requirements.  The Participants requested no-action relief from Section 206(3) of the Advisers Act, which imposes certain obligations and limitations on an adviser engaging in a principal transaction with a client, including obtaining a client’s prior specific consent to the transaction in question, because some of the Securities may be held in accounts over which Participants, which are generally broker‑dealers, have investment discretion (“advisory accounts”).  The Participants requested this relief because a Participant might wish to tender Securities held in a client’s advisory account, or otherwise cause the sale of those client Securities to the Participant, in response to an Offer by the Participant.  The Staff granted the requested no-action relief provided that a Participant observes a specified offering protocol (the “Offering Protocol”).  The requirements of the Offering Protocol include, among other things, disclosure sent to the clients in question that, in general terms, states that a Participant will be acting as a principal for its own account, will not take a commission and may execute the tender absent the client’s affirmative consent after a certain time period has elapsed.   The Offering Protocol includes a requirement that a Participant solicit direction from a client regarding an Offer and allows a Participant to accept an Offer if no client instruction is received within the specified timeframe.

1940 Act Affiliated Person Status.  The Participants also sought no-action relief from various 1940 Act requirements applicable to a Fund, its affiliated persons and or affiliated persons of those affiliated persons, that would be triggered by a Participating Firm’s becoming an affiliated person of a Fund solely through ownership of the Fund’s securities, which would result if a Participant owned more than 5% of the Fund’s outstanding voting shares.  Under these circumstances, a Participant that complied with the relief’s conditions would not, for example, need to comply with the 1940 Act’s prohibition on certain transactions between a Fund and an affiliated person, or an affiliated person of an affiliated person, of the Fund.  As a condition to this aspect of the relief, the Staff indicated that it would require a Participant to implement a specified voting protocol (the “Voting Protocol”) with respect to shares of a class of a Fund’s preferred stock of a Fund held by the Participant and its control affiliates (collectively, “Participating Firm Holders”), subject to certain limited exceptions.  In general terms, the Voting Protocol requires that when Participant Firm Holders’ aggregate holdings exceed 25% of the outstanding shares of a class of a Fund’s preferred stock to vote those shares on (i) elections of directors determined solely by a vote of the Fund’s preferred stock and (ii) certain other matters requiring approval by the vote of a majority of the Fund’s preferred stock, as directed by an independent third party (such as a voting trust or a proxy adviser).  The relief applies even in circumstances where a Participant acquires all of a Fund’s preferred stock and thereby gains the right under the 1940 Act to elect two of a Fund’s directors.

The Federal Financial Institutions Examination Council issued guidance to assist financial institutions in identifying risks in their remote deposit capture (“RDC”) systems and in evaluating the adequacy of their risk management controls and practices.  RDC systems allow customers of financial institutions to deposit items electronically from remote locations, including from locations owned or controlled by a financial institution’s customers. 

The guidance addresses how financial institutions can implement the necessary elements of an RDC risk management process, including the identification and assessment of various types and levels of risk exposure, such as legal, compliance and operational risks, and the measures and controls required for mitigating those risks.  These mitigating controls should include guidelines for risk-based determinations of customer suitability for RDC, sound RDC vendor selection and management processes, effective periodic training for RDC customers, and customer contracts and agreements that address issues identified during the risk assessment process and clearly identify each party’s roles, responsibilities and liabilities in RDC delivery. 

The guidance also discusses the implementation of risk measuring and monitoring systems for effective ongoing oversight of RDC activities, such as setting operational benchmarks and standards and developing reports that monitor results against those standards.  Effective management oversight involves regularly reviewing the reports and periodically conducting reviews and operational risk assessments to help ensure that the monitoring and reporting process accurately reflects current policies and procedures and sound practices.  For example, reports on duplicate entries and violations of deposit thresholds may help monitor unauthorized activities.  Velocity metrics such as file size and number of files, transaction dollar value and volume, and return item dollar value and volume also assist in monitoring for fraudulent activity and capacity utilization.

The responsibilities of boards of directors and senior management for the development, implementation and ongoing operation of RDC systems are also addressed.  The guidance states that the financial institution should determine the appropriate level at which governance, oversight, and risk management of RDC should occur based on the size and complexity of the institution.  Accordingly, the guidance suggests that the board or management should approve plans, policies, and significant expenditures, and review periodic performance and risk management reports on the implementation and ongoing operation of RDC systems and services. Also depending on the size and complexity of the institution, the financial institution may wish to involve staff from information technology, deposit operations, treasury or cash management sales, business continuity, information security, audit, compliance (including BSA/AML), management, accounting, and legal in the risk assessment, implementation, or ongoing operations to provide additional expertise.  Regardless of the parties involved, however, the board and senior management are ultimately responsible for safe and sound operations, including RDC products and services.

The United States Supreme Court agreed to hear the appeal of the Clearinghouse v. Cuomo decision from the Court of Appeals for the Second Circuit.  In that decision, the Second Circuit held in that case that the OCC’s exclusive visitorial powers promulgated under National Bank Act regulations preempted and precluded the New York Attorney General’s attempts to investigate and enforce state law housing discrimination claims.  The Second Circuit found the OCC’s conclusion that national banks cannot be investigated and sued by the Attorney General regarding the business of banking was properly afforded Chevron deference, as it was not “manifestly contrary” to the National Bank Act.  The Supreme Court accepted the case to determine the scope of the OCC’s visitorial powers, on the questions of (a) whether the regulations are entitled to judicial deference under Chevron and (b) whether the regulations are invalid because they are inconsistent with the authoritative construction of the National Bank Act by the Supreme Court in First National Bank in St. Louis v. Missouri, 263 U.S. 640 (1924).  Click here for a copy of the Supreme Court’s order accepting review of the case.

The Asset Managers’ Committee and the Investors’ Committee, two private-sector committees established by the President's Working Group on Financial Markets, have released their best practices reports for hedge fund managers and investors, respectively.  The best practices for asset managers address disclosure, valuation, risk management, trading and business operations, compliance and conflicts of interest.  The best practices for hedge fund investors address hedge fund investments and allocations, hedge fund investment policy, due diligence, risk management, legal and regulatory considerations, valuation, fees and expenses, reporting and taxation.