Financial Services Alert - October 18, 2011

The Federal Stability Oversight Council (“FSOC”) issued a proposed rule (the “Proposed Rule”) that would establish a three-stage analysis to identify non‑bank financial firms whose failure could trigger wider instability in U.S. financial markets (“non‑bank systemically important financial institutions,” or “non-bank SIFIs”).  Section 113 of the Dodd‑Frank Act (“Section 113”) authorizes the FSOC to require a non-bank financial company to be supervised by the FRB if the FSOC determines that material financial distress at the company or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the company could pose a threat to the financial stability of the United States.  Section 113 is mainly aimed at avoiding a reprise of the Lehman Brothers bankruptcy in September 2008, which sent shock waves through financial markets and the U.S. economy.  Section 113 is designed to help the FSOC identify such problems before they threaten the system as a whole.

The Proposed Rule consists of a three-stage screening process to identify which non-bank firms might qualify as a SIFI.  The first stage (“Stage 1”) would involve specific quantitative thresholds, and help the FSOC identify companies that need a further review.  Stage 1 would weed out most firms, based on a basic two-part profile— in which a firm would move to the next step in the screening process if it met an asset test, and any one of several other quantitative thresholds.  The Stage 1 asset test marker is $50 billion in global assets for U.S. firms, or $50 billion in assets in the United States for foreign non-bank financial firms.  A firm of that size need only meet one other threshold to move into the second stage of the FSOC’s consideration.  The other quantitative thresholds are: (i) $30 billion or more in gross notional credit default swaps (CDS), which are insurance-like bets on specific credit transactions; (ii) $3.5 billion of derivative liabilities (calculated after accounting for netting agreements and cash collateral); (iii) $20 billion of outstanding loans taken or bonds issued; and (iv) a minimum 15-1 assets-to-equity leverage ratio.

Firms identified as potential risks in Stage 1 would then go through a second stage with a deeper analysis that includes qualitative factors, such as consultations with primary regulators.  Finally, the third stage would involve a decision by the FSOC whether to designate the firm as a non-bank SIFI.  Any firm designated as a non-bank SIFI could request a hearing and try to convince the FSOC to modify its determination.

Comments on the Proposed Rule are due by December 19, 2011.

The Financial Crimes Enforcement Network (“FinCEN”) issued a final regulation (the “Final Regulation“) to implement Section 104(e) of the Comprehensive Iran Sanctions, Accountability and Divestment Act of 2010 (“CISADA”).  The Final Regulation requires banks in the U.S. and U.S. offices of foreign banks, upon request from FinCEN, to inquire of a specified foreign bank for which the U.S. bank maintains a correspondent account and report to the Department of the Treasury whether the specified foreign bank:

(1)   maintains a correspondent account for an Iranian-linked financial institution designated under the International Emergency Economic Powers Act (“IEEPA”);

(2)   has processed one or more transfers of funds within the preceding 90 calendar days for or on behalf of, directly or indirectly, an Iranian-linked financial institution designated under IEEPA, other than through a correspondent account; or

(3)   has processed one or more transfers of funds within the preceding 90 calendar days for or on behalf of, directly or indirectly, Iran’s Islamic Revolutionary Guard Corps or any of its agents or affiliates designated under IEEPA.

Under the Final Regulation, the U.S. bank, upon FinCEN’s request, must request that the applicable foreign bank agree to notify the U.S. bank within 30 days if the foreign bank subsequently establishes a new correspondent account for an Iranian-linked financial institution designated under IEEPA at any time within 365 days from the date of the foreign bank’s initial response to the U.S. bank.  The U.S. bank must then report the information received to FinCEN.

The Final Regulation provides a form of certification for use by the U.S. bank when making the information request to the foreign bank.  The Final Regulation recognizes that CISADA does not compel the foreign bank to respond to a request by a U.S. bank, but the Final Regulation implies that foreign banks that do not comply with requests from U.S. banks will be subject to unspecified sanctions.  The Final Regulation became effective on October 11, 2011.

On October 4, 2011, FINRA filed with the SEC a proposal to adopt new FINRA Rule 5123 governing private placements of securities.  The subject matter of this filing was originally proposed in January 2011 in FINRA Regulatory Notice 11-04 as an expansion of FINRA Rule 5122 (Member Private Offerings).  Rule 5122 governs member participation in private placements of securities issued by the member firm or a close affiliate of the member.  In April 2011, in response to comments on the proposal, FINRA announced that it was planning revisions to the proposed rule amendment (see “Director of FINRA Corporate Financing Department Discusses Possible Significant Changes to Proposed Expansion of Member Private Offering Rule“ in the April 19, 2011 Financial Services Alert).  Proposed Rule 5123 reflects those revisions.

The new proposal creates a separate rule for private placements other than member private offerings (as defined in Rule 5122) and imposes disclosure and filing requirements similar to those applicable to member private offerings.  Rule 5123 also contains most of the exemptions found in Rule 5122, with two exceptions discussed below.  A critical difference between Rule 5122 and proposed Rule 5123 is that the proposed rule does not include the substantive requirement that at least 85% of offering proceeds be used for the business purposes disclosed in the offering material.  That requirement received the largest number of comments in opposition to the January proposal.

Proposed Rule Provisions

Applicability and Exemptions.  Rule 5123 would apply to participation by a member or associated person of a member in any offering conducted in reliance on an exemption from registration under the Securities Act of 1933 (“Securities Act”), unless one of the exemptions under Rule 5123 applies.  “Participation” includes not only offering and selling securities in the offering but also “participation in the preparation of a private placement memorandum, term sheet or other disclosure document in connection with such private placement.” 

Most of the exemptions available under Rule 5122 would be available under the proposed rule.  Those include exemptions for sales to certain categories of investors, including:

• institutional accounts, as defined in NASD Rule 3110(c)(4);

• qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act of 1940; and

• qualified institutional buyers, as defined in Securities Act Rule 144A.

There are also exemptions for specified types of offerings, including:

• offerings of exempted securities, as defined in Section 3(A)(12) of the Securities Exchange Act of 1934;

• offerings made pursuant to Securities Act Rule 144A;

• Offerings made pursuant to Securities Act Regulation S; and

• offerings filed with FINRA under Rules 2310, 5110, 5121 and 5122.

The exemption for offerings filed under Rule 5110 (the Corporate Financing Rule) is necessary because Rule 5110 requires filing of some exempt offerings, including offerings by banks exempt under Securities Act Section 3(a)(2) and offerings exempt under Rule 504 of Regulation D.

The two exemptions provided by Rule 5122 that would not be available under proposed rule 5123 are the exemptions for (1) offerings in which a member acts in a wholesaling capacity and (2) offerings of certain credit derivatives.

Disclosure.  A member participating in a private placement subject to Rule 5123 would be required to provide to each investor prior to sale a private placement memorandum or term sheet describing the anticipated use of offering proceeds, the amount and type of offering expenses and the amount and type of compensation provided or to be provided to sponsors, finders and consultants and members and their associated persons in connection with the offering.  If the private placement issuer has not prepared a private placement memorandum or term sheet, the member must prepare and provide to investors a disclosure document that contains the disclosures required by the rule. 

Filing with FINRA.  The private placement memorandum, term sheet or other disclosure document, and any exhibits thereto, must be filed with FINRA by the participating member or associated person no later than 15 calendar days after the date of first sale, and any material amendment to the offering material must be filed with FINRA no later than 15 days after the date of first use. In response to comments to the earlier rule proposal, FINRA has removed any reference in the proposed rule to review by FINRA of the filed offering material.  Commenters were concerned about the possibility of receiving requests by FINRA staff to amend offering material after it had already been provided to investors.  In its statement in response to comments, FINRA said:

Moreover, by requiring a “notice” filing [i.e., post-sale] FINRA will remove any implication that the FINRA staff will provide comments on a filing; that such filing with FINRA could be a precondition to commencing an offering; or that members should expect to receive any FINRA staff input before proceeding with an offering.  The proposed filing requirement would nevertheless provide FINRA staff with timely access to information about the private placement business of FINRA members.

The proposed rule would require every participating member to make its own filing rather than to rely on a filing made by another member.  There would be no fee for filing in the rule as proposed.

Request For Comments

FINRA has requested that comments on the proposed rule be submitted to the SEC within 21 days after publication in the Federal Register.

The Federal Insurance Office (“FIO”) created as part of the Department of the Treasury by the Dodd-Frank Act announced that it is seeking public comment to assist it in conducting a study on how to modernize and improve the system of insurance regulation in the United States.  The topics for comment listed in the FIO’s formal request for comment published in the Federal Register largely track the considerations for the study specified by the Dodd‑Frank Act.  Comments must be submitted no later than December 16, 2011.  The FIO must deliver its study to Congress by January 21, 2012.