Financial Services Alert - December 20, 2011

The FRB issued a proposed rule (the “Proposed Rule”) for the supervision and regulation of large bank holding companies and systemically important nonbank financial firms which implements Sections 165 and 166 of the Dodd-Frank Act.  The Proposed Rule includes a wide range of measures addressing issues such as capital, liquidity, credit exposure, stress testing, risk management, and early remediation requirements.  The Proposed Rule generally applies to all U.S. bank holding companies with consolidated assets of $50 billion or more and any nonbank financial companies designated by the Financial Stability Oversight Council (“FSOC”) as systemically important nonbank financial companies (“Covered Companies”).  Please see the February 1, 2011 Financial Services Alert and the February 15, 2011 Financial Services Alert regarding the designation of systemically important nonbank financial companies.  The FRB stated that it will issue a proposal regarding foreign banking organizations.  In general, savings and loan holding companies would not be subject to the requirements in the Proposed Rule, except certain stress test requirements.  The FRB indicated that it plans to issue a separate proposal to address the applicability of the enhanced standards to savings and loan holding companies.  The Proposed Rule states that the FRB may determine that a bank holding company that is not a Covered Company shall be subject to one or more of the standards established under the Proposed Rule if the FRB determines that doing so is necessary or appropriate to protect the safety and soundness of such bank holding company or to promote financial stability.

The Proposed Rule includes the following requirements:

• Risk-based capital requirements and leverage limits. Under the Proposed Rule, risk‑based capital and leverage requirements would be implemented in two phases.  In the first phase, Covered Companies would be subject to the capital plan rule issued by the FRB in November 2011 (the “Capital Plan Rule”).  Please see the December 6, 2011 Financial Services Alert regarding the Capital Plan Rule.  The Capital Plan Rule requires large bank holding companies to develop annual capital plans, conduct stress tests, and maintain adequate capital, including a Tier I common risk-based capital ratio greater than five percent, under both expected and stressed conditions.  In the second phase, the FRB stated that it would issue a proposal to implement a risk-based capital surcharge based on the framework and methodology developed by the Basel Committee on Banking Supervision.  Please see the November 15, 2011 Financial Services Alert regarding the risk-based capital surcharge.

• Liquidity requirements.  The liquidity requirements set forth in the Proposed Rule would also be implemented in multiple phases.  First, Covered Companies would be subject to qualitative liquidity risk-management standards generally based on the interagency policy statement on funding and liquidity risk-management practices.  Please see the March 23, 2010 Financial Services Alert regarding the interagency policy statement on funding and liquidity risk-management practices.  The liquidity standards set forth in the Proposed Rule would require Covered Companies to conduct internal liquidity stress tests and set internal quantitative limits to manage liquidity risk.  In the second phase, the FRB stated that it would issue one or more proposals to implement quantitative liquidity requirements based on the Basel III liquidity rules.  Please see the January 4, 2011 Financial Services Alert regarding the Basel III liquidity rules. 

• Single-counterparty credit limits.  The Proposed Rule sets forth requirements that would limit the credit exposure of a Covered Company to a single counterparty to 25 percent of the capital stock and surplus of the Covered Company.  Credit exposure between the largest financial companies would be subject to a stricter limit of ten percent of the capital stock and surplus of the Covered Company.

• Risk management and risk committee requirements.  The Proposed Rule requires all Covered Companies to implement enterprise-wide risk management practices that are overseen by a risk committee of the Covered Company’s Board of Directors and a Chief Risk Officer with appropriate levels of independence, expertise and stature.  The Proposed Rule requires any publicly-traded bank holding company with $10 billion or more in consolidated assets to establish a risk committee.  Such risk committee must be comprised of an appropriate number of independent directors and include at least one risk management expert.

• Stress testing requirements.  The Proposed Rule provides that stress tests of Covered Companies would be conducted annually by the FRB using three economic and financial market scenarios.  A summary of the results of such stress tests, including company-specific information, would be publicly disclosed.  In addition, the proposal requires Covered Companies to conduct one or more company-run stress tests each year and to publicly disclose a summary of the results of such stress tests.  The requirement to conduct an annual stress test applies to any financial company with more than $10 billion in total consolidated assets that is regulated by a primary federal financial regulatory agency.

• Debt-to-Equity limits for certain Covered Companies.  The Proposed Rule provides that a Covered Company must maintain a debt-to-equity ratio of no more than 15-to-1 upon a determination by the FSOC that (a) such Covered Company poses a “grave threat to the financial stability of the United States” and (b) the imposition of such a requirement is necessary to mitigate such risk posed by the Covered Company.

• Early remediation requirements.  The Proposed Rule contains measures designed to identify emerging or potential issues of Covered Companies before any such issue develops into a larger problem.  The Proposed Rule sets forth a number of triggers for early remediation, including regulatory capital levels, stress test results, market indicators, and weaknesses in enterprise-wide and liquidity risk-management.  Several such triggers are calibrated to be forward-looking.  The Proposed Rule also describes the regulatory restrictions that a Covered Company must comply with at certain remedial stages.  Under the Proposed Rule, required actions would vary based on the severity of the situation, but could include restrictions on growth, capital distributions, and executive compensation, as well as required capital raising or asset sales.

Covered Companies would be required to comply with many of the enhanced standards set forth in the Proposed Rule one year after the effective date of the final rule.  The requirements relating to enhanced risk-based capital and leverage requirements, single‑counterparty credit limits and stress testing requirements would be implemented under different timetables.  The FRB noted that it consulted with other members of the FSOC in developing the Proposed Rule.  Comments on the Proposed Rule are requested by March 31, 2012.

The OCC provided guidance (the “Guidance”) to national banks and federal savings associations (together, “Banks”) setting forth the OCC’s expectation that Banks will adopt and implement policies and procedures to address several obligations and risks associated with the foreclosure of residential properties (“Policies and Procedures”).  The OCC notes that the risks and obligations associated with such foreclosure might differ depending on a Bank’s role in the foreclosure process, i.e. whether a Bank acts as owner of the of the foreclosed property, as servicer/property manager, or as securitization trustee, as well as on contractual terms, and focused the Guidance on the Bank as owner and as servicer.  The Guidance highlights the importance of understanding the requirements imposed by Fannie Mae and Freddie Mac and the U.S. Department of Housing and Urban Development (“HUD”) on servicers and states that when a Bank acquires title to properties through foreclosure, whether as owner or servicer, it subjects itself to operating, compliance and reputational risks.  

The Guidance mandates that Banks consider certain obligations and risks when establishing and implementing their Policies and Procedures.  When functioning as the owner of a residential foreclosed property, a Bank must consider the following obligations and actions: (i) the assumption of the primary responsibilities of an owner, including providing maintenance and security, paying taxes and insurance, and serving as landlord for rental properties; (ii) for Federal Housing Administration (“FHA”)-insured mortgages, a Bank must ensure compliance with property and preservation guidance issued by HUD to preserve the insurance claim and obtain reimbursements for allowable expenses; (iii) following foreclosure, a Bank must record its ownership interest in local land records; (iv) Banks must comply with the other real estate owned (“OREO”) appraisal and accounting requirements; (v) Banks should maintain appropriate insurance on the property; (vi) some localities may require registration of foreclosed properties, properties in foreclosure, or vacant properties, and Banks should be aware of and comply with such requirements; or (vii) compliance with the Protecting Tenants at Foreclosure Act of 2009, which provides tenants with protections from eviction as a result of foreclosure on the properties they are renting.  Additionally, when functioning as the owner of a residential foreclosed property, a Bank must consider the following: (a) having sufficient staffing levels to manage its foreclosed properties portfolios and having policies, procedures, and risk management systems in place to properly oversee and manage third-party relationships; (b) prior to undertaking the rehabilitation or improvement of foreclosed properties, considering the legal authority to make expenditures on OREO and any HUD requirements for mortgages insured by the FHA; (c) the various costs, risks and opportunities associated with the disposition of foreclosed residential properties, and, in the case of foreclosed residential properties from FHA-insured mortgages, HUD requirements regarding insurance payments and allowable reimbursements; and (d) holding period issues that could result from an inability to dispose of foreclosed properties.

The Guidance also highlights obligations and actions from two sources that a Bank must consider when functioning as a servicer: (1) the Fannie Mae and Freddie Mac servicing guidelines regarding foreclosed properties; and (2) in the case of private securitizations, the obligations set forth in the relevant pooling and servicing agreement (“PSA”).  The obligations and actions highlighted are: (A) that servicers may be required to assume many of the responsibilities of an owner, as discussed above; (B) that servicers may be required to register the foreclosed properties in certain localities; (C) that servicers should review the PSA for requirements and responsibilities regarding the disposition of foreclosed properties; and (D) responsibilities that servicers may have under the Protecting Tenants at Foreclosure Act or other applicable state law requirements that provide protections to tenants from eviction on the properties they are renting as a result of foreclosure.  Additionally, when functioning as a servicer, a Bank must consider the following: (i) having sufficient staffing levels and appropriate third-party vendor oversight to manage the foreclosed properties portfolios; (ii) complying with local building codes and licensing requirements, and requirements in servicing agreements, when rehabilitating or improving on foreclosed properties; and (iii) the various costs, risks and opportunities associated with the disposition of foreclosed residential properties. 

The Guidance notes that a Bank’s responsibilities as securitization trustee will be set forth in a PSA, trust agreement or indenture, and that, as permitted by the relevant document, the Bank should work with the servicer to ensure the performance of its obligations.  The Guidance also discusses considerations associated with the decision to release a lien, rather than to foreclose.  The OCC noted that while the Guidance focuses on residential foreclosed properties, many of the same principles apply to commercial properties.

The CFTC adopted final rule amendments (the “Amendments”) to its regulations regarding the types of permissible investments for customer segregated accounts (“Segregated Accounts”).  The Amendments impose certain restrictions on the types and level of investments that futures commission merchants (“FCMs”) and derivatives clearing organizations (“DCOs”) can make with customer assets, as well as revise the general standards associated with these restrictions.  As a result of public comments submitted in response to the CFTC’s original proposal (the “Original Proposal”, as discussed in the November 16, 2010 Financial Services Alert), the Amendments provide DCOs and FCMs more flexibility in investing customer funds than under the Original Proposal.  Of particular note, the Amendments, while still placing limits on investments in money market fund (“MMFs”) by Segregated Accounts, provide greater flexibility to invest customer funds in MMFs than originally proposed.

Statutory and Regulatory Overview.  Section 4d(a)(2) of the Commodity Exchange Act and Regulation 1.25 thereunder limit the types of investments for Segregated Accounts to obligations of the United States and obligations guaranteed as to principal and interest by the United States, general obligations of States or political subdivisions thereof, investments in MMFs, obligations issued by government-sponsored enterprises, bank certificates of deposit, commercial paper, corporate notes and general obligations of sovereign nations.  Regulation 1.25 also sets forth the general standard that such investment limitations are consistent with the goal of ensuring that funds in Segregated Accounts “must be invested in a manner that minimizes their exposure to credit, liquidity, and market risks both to preserve their availability to customers and DCOs and to enable investments to be quickly converted to cash at a predictable value in order to avoid systemic risk.” 

Narrowed Scope of Investment Choices and Related Restrictions (other than MMFs).  The Amendments narrow the scope of investment choices set forth above by eliminating or restricting the use of certain instruments.  The following is a brief overview of these changes, including a description of certain of the more significant differences from the Original Proposal:

• The Amendments continue to permit investment of customer funds in government-sponsored entities (“GSEs”).  However, Segregated Accounts may only invest in the obligations of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac) while these entities remain under the conservatorship or receivership of the Federal Housing Finance Authority.
• The Amendments permit investments in corporate notes or bonds or commercial paper only if such instruments are fully guaranteed as to principal and interest by the Temporary Liquidity Guarantee Program.
• The Amendments permit investments in CDs only if such instruments can be redeemed at the issuing bank within one business day, with a penalty for early withdrawal limited to accrued interest earned according to its written terms.
• The Amendments prohibit investments in foreign sovereign debt; the CFTC did state, however, that it will consider exemptions from this restriction on a case-by-case basis. 

MMF Investment Limitations.  As noted above, the Amendments impose heightened restrictions on the use of MMFs by FCMs and DCOs for Segregated Accounts.  However, the Amendments significantly relax certain of the more stringent limitations that would have been imposed under the Original Proposal.  The following is a brief overview of these changes, including a discussion of the significant differences from the Original Proposal:

• Under the Original Proposal, aggregate investments in MMFs would have been limited to 10% of the total assets in the Segregated Account and no more than 2% of the total assets in such account could have been invested in any single family of MMFs.  Under the Amendments, the CFTC distinguishes between (1) MMFs that are comprised of obligations of the U.S. government (“Treasury MMFs”) and all other MMFs (“Non-Treasury MMFs”) and (2) MMFs with at least $1 billion in assets that are managed by a management company with at least $25 billion in MMF assets under management (“Large MMFs”) and all other MMFs (“Small MMFs”).  There is no asset-based concentration limit to the aggregate amount that a Segregated Account can invest in Large Treasury MMFs.  A Segregated Account may invest up to 50% of its assets in Large Non-Treasury MMFs.  A Segregated Account may invest up to 10% of its assets in Small MMFs, regardless of whether such MMFs are Treasury or Non-Treasury.  Furthermore, there is no issuer-based concentration limit to the amount that a Segregated Account can invest in a single Treasury MMF or in a “family” of Treasury MMFs.  A Segregated Account may invest up to 10% of its assets in a single Non-Treasury MMF or 25% of its assets in Non-Treasury MMFs in the “same family of funds.”
• The Amendments clarify the acknowledgement letter requirement in the context of MMFs.  Under Regulation 1.25, FCMs or DCOs that invest customer funds in MMFs must obtain an acknowledgement letter from the “sponsor of the fund and the fund itself” when the MMF shares are held by a shareholder servicing agent.  The Amendments clarify that the acknowledgement letter should be obtained “from a party that has substantial control over [MMF] shares purchased with customer segregated funds and has the knowledge and authority to facilitate redemption and payment or transfer of the customer segregated funds invested in shares of the [MMF]” and remove the current language in Regulation 1.25(c)(3) relating to the issuer of the acknowledgment letter when the shares of the fund are held by the fund’s shareholder servicing agent.
• The Amendments also provide certain additional exceptions to Regulation 1.25’s “next day redemption” requirements by accounting for Rule 22e-3 under the Investment Company Act of 1940, which permits an MMF to suspend redemptions and postpone payment of redemptions in order to facilitate an orderly liquidation, provided certain conditions are met.  

Effective and Compliance Dates.  The Amendments are effective February 17, 2012.  Compliance with the Amendments is required beginning June 18, 2012.