Financial Services Alert - July 26, 2011

The OCC issued a final rule last week implementing the changes to preemption standards and visitorial powers (the “Final Preemption Rule”) made by Sections 1044 to 1048 of the Dodd- Frank Act. The Final Preemption Rule became effective on July 21, 2011.

The OCC adopted the Final Preemption Rule in substantially the form originally proposed. A summary of the OCC’s proposed rule relating to preemption standards and visitorial powers was published in the May 31, 2011 Financial Services Alert. The OCC provided some important interpretive guidance related to the Final Preemption Rule in the adopting release that it issued as well as slightly modifying the text of the rule from the proposal, including the following items of note:

• The OCC in its adopting release stated that it “concludes that the Dodd-Frank Act does not create a new, stand-alone ‘prevents or significantly interferes’ preemption standard, but rather, incorporates the conflict preemption legal standard and the reasoning that supports it in the Supreme Court’s Barnett decision.”
• The OCC in its adopting release confirmed that precedent consistent with the Barnett standard, including existing OCC regulations, are “preserved.”
• As proposed, the OCC eliminated from its preemption regulations any reference to preemption of a state law that “obstructs, impairs or conditions” the exercise of a national bank’s powers as authorized by Federal law. Significantly, the OCC stated that an existing preemption precedent that is “exclusively reliant” on this standard as the basis for a preemption determination “would need to be reexamined” to ascertain whether the determination is consistent with the Barnett standard. The OCC, however, went on to state that it “has not identified any OCC-issued preemption precedent that rested only on the ‘obstruct, impair or condition’ formulation.”
• The OCC confirmed its belief that the procedural requirements applicable to an OCC determination that a state consumer financial law is preempted, apply prospectively and do not invalidate prior precedent.
• The OCC confirmed that the elimination of preemption of state laws as applied to agents of a national bank does not affect activities conducted by employees of the bank.
• The OCC revised the text of the Final Preemption Rule to clarify that impermissible visitorial powers exercised by a state attorney general or chief law enforcement officer would not include collecting information from sources other than the bank or from the bank through actions that do not constitute visitations or as otherwise authorized by Federal law. It also slightly modified the language of the Final Preemption Rule to clarify that a state attorney general or chief law enforcement officer may enforce any applicable law against a national bank (as opposed to a non-preempted state law) and to seek relief as authorized by that law. However, in the adopting release, the OCC noted that in the case of both non-preempted state law and Federal law, the law in question must provide authority for the state attorney general or chief law enforcement officer to enforce and seek relief as authorized under that law.

The U.S. Court of Appeals for the District of Columbia Circuit (the “Court”) issued an opinion vacating Rule 14a-11 under the Securities Exchange Act of 1934 (the “Exchange Act”), which allows a shareholder or a group of shareholders of an issuer subject to the proxy rules, including a registered investment company (a “fund”), to nominate directors if they meet certain conditions in the rule. Rule 14a-11 and related rule amendments (the “Proxy Access Rules”) were adopted by the SEC in August 2010. In response to the petition for review filed by the Business Roundtable and the U.S. Chamber of Commerce with the Court, the SEC stayed the November 15, 2010 effective date of the Proxy Access Rules. (For more detail on the Proxy Access Rules see the September 1, 2010 Goodwin Procter Alert and the September 7, 2010 Financial Services Alert.) The petitioners challenged the Proxy Access Rules, asserting that the SEC’s rulemaking had failed to meet the requirements of the Administrative Procedure Act because the SEC failed to adequately consider their effect upon efficiency, competition and capital formation as required by Section 3(f) of the Exchange Act and Section 2(c) of the Investment Company Act of 1940 (the “1940 Act”). This article describes the Court’s principal findings.

SEC’s Obligation to Consider Economic Impact. The Court observed that the SEC has a unique obligation to consider the economic consequences of proposed rules, and failure to do so as part of a rulemaking renders the rulemaking arbitrary and capricious and therefore, violates the standards of the Administrative Procedure Act. The Court found that the SEC had “inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters.”

Costs of Opposing Shareholder Nominees. The Court found that the SEC had not properly assessed the costs that would be incurred by issuers in opposing shareholder nominees. First, the Court held that the SEC’s prediction that directors might choose not to oppose shareholder nominees, which the SEC asserted as a basis for limiting the costs of opposing shareholder nominees, had no basis beyond mere speculation, noting that the SEC had presented no evidence of such forbearance in practice. The Court also found fault with the SEC’s failure to either (i) estimate and quantify the costs it expected companies opposing shareholder nominees to incur or (ii) claim that estimating those costs was not possible.

Impact on Board Performance. The Court found that the SEC relied upon insufficient empirical data when claiming that Rule 14a-11 would improve board performance and increase shareholder value. The Court found that by relying on “two relatively unpersuasive studies” and in view of the “admittedly (and at best) ‘mixed’ empirical evidence,” the SEC had not sufficiently supported its conclusion that increasing the potential for election of directors nominated by shareholders would provide the claimed benefits.

The Court found “illogical and, in an economic analysis, unacceptable,” the fact the SEC discounted the Rule 14a-11s’ potential costs, such as management distraction and reduction in board time spent on other matters such as strategic and long term thinking due to the burdens of addressing shareholder nominee matters, because those costs were associated with the traditional state law right to nominate and elect directors, and were not costs incurred for including shareholder nominees in company proxy materials.

Shareholders Representing Special Interests. The Court held that although it had not completely ignored the potential costs of shareholders who used the rule as a means to promote their narrow interests at the expense of other shareholders, the SEC had, nevertheless, failed to respond to comments arguing that investors with a special interests, such as union and government pension plans whose interests in jobs could well be greater than their interest in share value, could be expected to pursue self-interested objectives rather than the goal of maximizing shareholder value and would likely cause companies to incur costs even when a special interest shareholder’s nominee was unlikely to be elected.

Frequency of Election Contests. The Court found that the SEC arbitrarily ignored the effect of Rule 14a-11 on the total number of election contests when the SEC failed to address whether and to what extent the rule would take the place of traditional proxy contests. The Court observed that without this information the SEC had no way of knowing whether the rule would facilitate enough election contests to result in the anticipated benefit of making “‘election contests a more plausible avenue for shareholder to participate in the governance of their company.’” The Court also found that the SEC’s discussion of the estimated frequency of nominations under the rule was internally inconsistent and therefore arbitrary, because the SEC anticipated frequent use of the rule when estimating benefits, but assumed infrequent use when estimating costs.

Issues Specific to Registered Investment Companies. The Court cited a number of specific concerns regarding the propriety of the SEC’s rulemaking as it applied to funds. The Court noted that while the SEC acknowledged the significant degree of “regulatory protection” for fund shareholders provided by the 1940 Act, it did almost nothing to explain why the rule would nonetheless yield the same benefits for fund shareholders as it would for shareholders of operating companies. The Court also found that the SEC had failed to adequately address the concern that Rule 14a-11 would impose greater costs on funds by introducing into the unitary and cluster board structures commonly used by fund complexes, shareholder-nominated directors who would sit on only a single fund’s board. The SEC determined that disruptions to unitary and cluster boards could be mitigated through the use of confidentiality agreements with shareholder-nominated directors. The Court, however, found that this determination was without evidentiary support and did not respond to claims that shareholder-nominated directors would have no fiduciary duty to other funds in a fund complex and could not be legally obliged to enter into confidentiality agreements. Separately, the Court observed that while the SEC estimated costs of the rule would be lower for funds because of their mostly retail shareholder base, the SEC had failed to consider that less frequent use of the rule by fund shareholders would also reduce the expected benefits of the rule for funds.

Rule 14a-8. In a statement issued after the announcement of the Court’s decision, Meredith Cross, Director of the SEC’s Division of Corporation Finance, noted that changes to Rule 14a-8, the Exchange Act rule that requires a company under certain conditions to include a shareholder proposal in the company’s proxy materials, were unaffected by the Court’s action. Those changes to Rule 14a-8, which focused in part on shareholder proposals that seek to establish a procedure in a company’s governing documents for including one or more shareholder nominees for director in the company’s proxy materials, are discussed in the September 1, 2010 Goodwin Procter Alert and the September 7, 2010 Financial Services Alert.

The FRB issued a Supervision and Regulation Letter (the “SR Letter”) explaining the procedure for deregistration as a savings and loan holding company (“SLHC”) for companies seeking to avail themselves of a change made by Section 604(i) of the Dodd-Frank Act. Section 604(i) amended the definition of SLHC in Section 10 of the Home Owners’ Loan Act to exclude a company that controls a savings association that functions solely in a trust or fiduciary capacity as described in section 2(c)(2)(D) of the Bank Holding Company Act of 1956, as amended. The SR Letter states that, as of July 22, 2011, an SLHC that qualifies for this exclusion may submit a request to the FRB to deregister as an SLHC. All other deregistration requests (such as those resulting from divestiture of the SLHC’s savings association subsidiary) should be directed to the appropriate Federal Reserve Bank. An SLHC seeking deregistration must affirm that its sole savings association’s activities meet the following requirements:

• all or substantially all of the deposits of such institution are in trust funds and are received in a bona fide fiduciary capacity;
• no deposits of such institution which are insured by the FDIC are offered or marketed by or through an affiliate of such institution;
• such institution does not accept demand deposits or deposits that the depositor may withdraw by check or similar means for payment to third parties or others or make commercial loans;
• such institution does not obtain payment or payment-related services from any Federal Reserve Bank, including any service referred to in 12 U.S.C. § 248a; or exercise discount or borrowing privileges pursuant to 12 U.S.C. § 467(b)(7).

The SR letter also states that, in reviewing a request to deregister, the FRB will obtain a copy of the institution’s most recent examination report, will consult with the institution’s primary regulator, and may request other additional information in order to verify that the company satisfies the statutory requirements in order to qualify for the exclusion. The SR Letter indicates that the FRB will formally acknowledge and act on a deregistration request.

The Financial Stability Oversight Council (“FSOC”) has issued a final rule (the “Rule”) establishing the criteria for designating financial market utilities that facilitate the transfer, clearing or settlement of financial transactions as systemically important. The Rule creates a two-stage process to determine whether the failure or disruption of a financial market utility would create or increase the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the United States financial system. The first stage consists of a quantitative review of the systemic importance or connectedness of financial market utilities that the FSOC will use to determine a preliminary set of systemically important financial market utilities. In the second stage, the financial market utilities identified through the first stage will be subject to a more in-depth review, with a greater focus on qualitative factors, in addition to institutional and market specific considerations. The quantitative review will take into consideration the aggregate monetary value of transactions cleared by the financial market utility, its exposure to counterparties, its relationship or interdependence with other financial market utilities, and the effect a failure or disruption of the financial market utility would have on the broader financial system. The FSOC may also consider other factors that it deems appropriate.

If a financial market utility is subject to the second stage of review, the FSOC will notify such financial market utility and provide it with an opportunity to submit written materials to the FSOC in support of or in opposition to its designation as systemically important. Financial market utilities that are designated as systemically important will be subject to specific risk management standards as well as additional examinations and reporting requirements. Systemically important financial market utilities that are registered clearing agencies will be regulated by the SEC; systemically important financial market utilities that are registered derivatives clearing agencies will be regulated by the CFTC; systemically important financial market utilities that are insured depository institutions will be regulated by their primary federal banking regulator; and all other systemically important financial market utilities will be regulated by the FRB. Systemically important financial market utilities will have access to the FRB’s emergency lending facilities.

The CFTC, SEC and FRB delivered the report to the Senate Committees on Banking, Housing, and Urban Affairs and Agriculture, Nutrition, and Forestry and the House Committees on Financial Services and Agriculture mandated by Section 813 of the Dodd-Frank Act, which requires them to jointly develop risk management supervision programs for clearing entities that have been identified as systemically important (“DCEs”) by the Financial Stability Oversight Council. As directed by Section 813, the report makes recommendations in four areas: (1) improving consistency in the DCE oversight programs of the SEC and CFTC, (2) promoting robust risk management by DCEs, (3) promoting robust risk management oversight by regulators of DCEs, and (4) improving regulators’ ability to monitor the potential effects of DCE risk management on the stability of the financial system of the United States. The report also provides an introduction to the role of systemically important financial market utilities generally and DCEs specifically in the financial system, a high-level overview of DCE risks and risk management, an outline of the generally accepted elements of a sound risk-based supervisory program and an overview of the current supervisory programs at the CFTC, the SEC, and the FRB.

As required by the Dodd-Frank Act, the GAO issued a report (the “Report”) on the FRB’s emergency lending practices under Section 13(3) of the Federal Reserve Act during the recent economic crisis (and specifically between December 1, 2007 and July 21, 2010) (the “Economic Crisis Period”). During the Economic Crisis Period, the FRB made more than $1 trillion in emergency loans. The GAO reviewed, among other things, the FRB’s criteria for extending emergency credit, its use, selection and payment of vendors, management of conflicts of interest, policies to secure loan repayment and treatment of program participants during the Economic Crisis Period. The Report concludes that in using its emergency lending powers during the Economic Crisis Period, the FRB complied with the requirements of its existing policies, but the FRB’s policies and procedures, said the GAO, should be enhanced to address the FRB’s expanded role during an economic crisis, loan requests from non-traditional borrowers and the resulting need for tightened internal controls.

The OCC issued an interim final rule (the “Rule”) in which it republished, renumbered as OCC regulations and made certain technical changes to those former OTS regulations that the OCC has decided to enforce after the July 21, 2011 merger of the OTS with and into the OCC. The OCC stated that it will consider, later in 2011, making more substantive amendments to the former OTS regulations transferred to the OCC under the Rule. The Rule became effective on July 21, 2011. The OCC said that the Rule would be published in the August 9, 2011 issue of the Federal Register and that the deadline for comments on the Rule will be October 11, 2011.