Financial Services Alert - March 29, 2011

FINRA has issued a request for comments (FRN 11-11) on a concept proposal for a rule to identify and manage conflicts of interest involving the preparation and distribution of debt research reports.  The proposal is the result of a determination by FINRA staff to engage in definitive rulemaking relating to debt research, in part as a result of observations of increased risk to retail investors from complex debt securities, citing as an example allegations of misconduct in the auction rate securities (“ARS”) market.

NASD Rule 2711 regulates the preparation and distribution of research by member firms concerning equity securities, as defined in section 3(a)(11) of the Securities Exchange Act of 1934, but not of research concerning debt securities.  FINRA notes that SEC Regulation AC, which requires certification of research by research analysts, applies to both equity and debt research.  In a 2005 report on their respective research analyst rules, the NASD and NYSE Regulation, the predecessors to FINRA, indicated that they intended to monitor the extent to which member firms adopted the Guiding Principles of the Bond Market Association (now part of SIFMA) as applied to debt research.  The NASD and NYSE Regulation subsequently found cases where member firms lacked any policies and procedures to manage debt research conflicts to comply with applicable SRO ethical and anti-fraud rules.  Those findings were reported in Notice to Members 06-36.

Bifurcated Approach to Debt Securities

FINRA proposes to take a bifurcated approach to the regulation of debt research, depending on whether the research is provided to retail customers or only to institutional customers.  In recognition of the fact that institutional customers often engage in transactions with member firms on a counterparty basis, rather than a customer basis, FINRA’s proposed approach would require disclosures only of a general nature to institutional customers (defined to mean the same as an “institutional account” for purposes of the FINRA suitability rule).  Certain restrictions intended to prevent debt research personnel from being influenced by the investment banking and sales and trading departments would also apply to research provided to institutional customers.  Institutional customers could elect to be treated like retail customers under the rule.

Under the proposed debt research rule, debt research provided to retail customers would be subject to all of the requirements applicable to equity research.  In addition, the debt research rule would also address conflicts between the research department and sales and trading personnel, an area not currently covered by the equity research rule.  FINRA notes that it does not envision proposing, with respect to debt research, the ban on research analysts receiving pre-IPO shares or the imposition of quiet periods around the issuance of research reports.

Request For Comments

FINRA has specifically requested comments on the application of bifurcated treatment, including whether the institution-only carve-out is likely to affect the availability of debt research to retail customers.  However, comments on all aspects of the conceptual rule are invited.  Comments are due by April 25, 2011.

On March 28, 2011 the OCC, FRB, FDIC, SEC, Federal Housing Finance Agency and Department of Housing and Urban Development (the “Agencies”) announced that they would be considering approval of a notice of proposed rulemaking (“NPR”) addressing the credit risk retention provisions of Section 941 of the Dodd-Frank Act.  Since the announcement, both the FRB and FDIC have approved the issuance of the NPR and requested comments on the proposal.

The NPR generally requires sponsors of asset-backed securities (“ABS”) to retain at least 5% of the credit risk of the assets underlying the securities.  However, as required by the Dodd-Frank Act, the NPR includes a number of exemptions for these requirements, including an exemption for U.S. government-guaranteed ABS and for mortgage-backed securities that are collateralized exclusively by “qualified residential mortgages” (“QRMs”).  The NPR narrowly defines QRMs, incorporating high standards regarding documentation of income, past borrower performance, a low debt-to-income ratio for monthly housing expenses and total debt obligations, elimination of payment shock features, a maximum loan-to-value or LTV ratio, a minimum down payment, and other quality underwriting standards.  Also included in the QRM standards are certain loan servicing requirements.

The NPR would also allow Fannie Mae and Freddie Mac to satisfy their risk retention requirements as sponsors of mortgage-backed securities through their 100% guarantees of principal and interest for as long as they are in conservatorship or receivership with capital support from the U.S. government. 

A more detailed summary of the NPR will be published soon in a future edition of the Alert.

The OCC issued a bulletin (OCC 2011-10, the “Bulletin”) concerning the safety and soundness, legal and accounting concerns raised by what the OCC characterizes as “an increasing number of programs [the “OREO Exchange Programs”] targeted at banks to exchange [other real estate owned, “OREO”]  for other assets to reduce nonperforming assets.”

The OCC states that in the typical OREO Exchange Program, the bank’s OREO asset is to be exchanged for a so-called “performing asset” which, the OCC states, is frequently “an equity interest in the entity acquiring the OREO or a trade for a large volume of loans such as home equity lines of credit.” 

Safety and soundness, legal and accounting issues frequently raised in these exchanges of OREO assets for a minority equity interest in such an LLC include:

1. the bank’s loss of control over its OREO assets;
2. the questionable liquidity and value of the asset for which the OREO has been exchanged;
3. the commingling of the bank’s OREO with poorer quality real estate assets;
4. significant up-front and management fees;
5. unfavorable priority of payments between the banks and equity investors;
6. the entity acquiring the assets may be involved in activities that are  not permissible for national banks; and
7. the exchange transaction may not be a “true sale” for accounting purposes.

Another type of OREO Exchange Program that the OCC has been seeing is a program that offers an “adjusted price trade,” where a bank’s OREO or nonperforming loans would be purchased at book value provided that the bank purchase other assets at inflated values.  The OCC notes that a transaction of that type is not only unsafe and unsound, but may involve fraud if it results in misrepresentations on the bank’s financial statements.

The OCC notes that in a limited number of circumstances a national bank may acquire a noncontrolling equity interest in an LLC in exchange for its interest in an OREO property.

Finally, the Bulletin provides a list of actions a bank should take before entering into an OREO exchange for other assets.  Some of the steps identified by the OCC involve:

1. documentation of purpose and legal permissibility of the transaction;
2. determination of accounting treatment of the transaction;
3. documentation as to why the exchange will increase the aggregate value of the real estate held by the Bank;
4. confirmation of accurate valuation of the OREO and the assets for which it would be exchanged;
5. verification that adequate risk management, measurement and tracking systems, and monitoring systems are available or in place; and
6. putting processes in place to dispose of the interest in the entity (for which the OREO was exchanged) within five years from the date the bank acquired the OREO (unless the OCC grants an extension).

The Financial Crimes Enforcement Network (“FinCEN”) and the federal banking agencies, the FRB, FDIC, OTS, OCC and NCUA (collectively with FinCEN, the “Agencies”) issued a joint advisory (the “Advisory”) concerning the Agencies’ expectations as to how financial institutions (“FIs”) will manage the risks associated with accepting accounts from foreign embassies, consulates and missions (collectively, “Foreign Missions”).  The Advisory supplements, but does not supersede, the Agencies’ June 2004 “Guidance on Accepting Accounts from Foreign Governments, Foreign Embassies and Foreign Political Figures.”

The Advisory stresses that FIs should assess and understand the risks associated with a relationship with a specific Foreign Mission and its accounts, and should monitor and take steps to mitigate the risks identified.  The Agencies emphasize that FIs may provide services to Foreign Missions as long as the FIs remain in compliance with the Bank Secrecy Act (“BSA”).

The Advisory states that FIs should assign a risk rating to a Foreign Mission account that reflects the specific characteristics of the account and, in mitigating the risks, may take steps such as:

1. Entering into a written agreement with the Foreign Mission that defines the terms of the use of the account, “setting forth available services, acceptable transactions and access limitations;”
2. Offering limited purpose accounts (e.g., payroll, rent and utilities, routine maintenance accounts), which are generally considered to pose a lower BSA compliance risk;
3. Diligent account monitoring of compliance with the terms of account limitations and the terms of any servicing agreements;
4. Educating Foreign Mission customers on the requirements of the BSA and other related U.S. banking laws and regulations.

Finally, the Agencies state that they will not require an FI to close or refuse an account or relationship with a Foreign Mission “except in extraordinary circumstances (for example, when violations of law are identified that warrant an administrative enforcement action).”

Goodwin Procter issued a Client Alert that discusses the California Department of Corporation’s invitation for comment on a proposal that would amend the existing rules governing certain exemptions from California’s investment adviser licensing requirements to address changes to the federal statutory and regulatory scheme regulating the registration of and exemption of investment advisers under the Investment Advisers Act of 1940 as a result of the Dodd-Frank Act.

The staff of the SEC’s Division of Investment Management has posted on the SEC website responses to questions about Rule 206(4)-5 under the Investment Advisers Act of 1940 (the “pay to play rule”).  Topics covered include (a) recordkeeping, (b) the definitions of  “covered associate,” “government entity” and “official,” (c) use of third-party solicitors and (d) interpretations of MSRB Rule G-37 as authority regarding the pay to play rule.