Financial Services Alert - January 3, 2012

The Basel Committee on Banking Supervision (the “BCBS”) issued a proposal (the “Proposal”) implementing the disclosure requirements under Basel III that would require banks to disclose the composition of their capital and their capital ratios.  The Proposal is designed to improve the transparency and comparability of a bank’s capital base.  The Proposal sets forth the following requirements:

• a common template for banks to use to report the breakdown of their regulatory capital after January 1, 2018 that is designed to meet the Basel III requirement to disclose all regulatory adjustments, including amounts falling below thresholds for deduction, and that is intended to enhance consistency and comparability in the disclosure of the elements of capital between banks and across jurisdictions; 
• an approach designed to fulfill the Basel III requirement to provide a full reconciliation of all regulatory capital elements back to published financial statements;
• a common template for banks to use to meet the Basel III requirement to provide a description of the main features of capital instruments;
• the method of disclosure to fulfill the Basel III requirement that banks provide the full terms and conditions of capital instruments on their websites and the requirement to report the calculation of any ratios involving components of regulatory capital; and
• a modified version of the post-January 1, 2018 common template to be used by banks during the Basel III transitional period that is designed to fulfill the Basel III requirement that banks disclose the components of capital that are benefiting from transitional arrangements under Basel III.

Comments on the Proposal must be submitted to the BCBS by February 17, 2012.

As required by Section 202(g)(4) of the Dodd-Frank Act, the Financial Stability Oversight Council (the “FSOC”) issued a report (the “FSOC Report”) to Congress concerning the implementation of prompt corrective action (“PCA”) by the federal banking agencies (the “Agencies”). In June 2011 the General Accountability Office (“GAO”) issued a report (the “GAO Report”) under Section 202(g)(1)-(3) of the Dodd-Frank Act in which it evaluated, among other things, the effectiveness of PCA in resolving insured depository institutions at the lowest cost to the FDIC’s Deposit Insurance Fund (“DIF”). The GAO study concluded that the existing PCA

The GAO Report also found that “[c]apital can lag behind other indicators of bank health.” In addition to capital, the GAO Report suggested that other PCA triggers be considered by the FSOC and the Agencies, including indicators of earnings, asset quality, liquidity, reliance on unstable funding and sector loan concentrations.

The FSOC Report states that the FSOC will provide a forum for the Agencies to discuss enhancements to the PCA framework and to evaluate non-capital related PCA triggers. The FSOC concluded that the following five principles should be used in developing potential enhancements to the PCA framework:

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert and a Regulatory Notice (“Risk Alert”) regarding broker-dealer branch office inspections.  The Risk Alert was prepared in consultation with FINRA.  The Risk Alert offers suggestions to help firms better perform their supervisory obligations.  Summarizing the guidance provided in the Risk Alert, this article reviews existing requirements under FINRA rules for branch office inspections and highlights recommended improvements for branch office inspections to avoid SEC and FINRA violations.

Existing Requirements Under Nasd Conduct Rule 3010 For Broker-Dealer Branch Inspections

Under NASD Rule 3010(c), broker-dealers must conduct internal inspections of all office locations.  A written record of the inspection must be kept, which includes, among other things, the “testing and verification of the [firm’s] policies and procedures, including supervisory policies and procedures” in various areas.  (NASD Rule 3010(c)(2).)  The supervisory policies and procedures to be used when conducting branch inspections must take into consideration a variety of factors, such as (1) firm size; (2) organization structure; (3) scope of business activities; (4) the number and location of offices; (5) the nature and complexity of products and services offered; (6) the volume of business done; (7) the number of associated persons assigned to a location; (8) whether a location has a principal on-site; (9) whether the office is a non-branch location and (10) the disciplinary history of registered representatives or associated persons.  (NASD Rule IM-3010-1.)

Sections 15(b)(4)(E) and 15(b)(6)(A) of the Securities Exchange Act of 1934 (the “Exchange Act”) authorize the SEC to impose sanctions on a firm or any person that fails to reasonably supervise someone who is subject to the supervision of such firm or person and who violates the federal securities laws. 

Enhancing Supervisory Procedures For Branch Inspections With A Risk-Based Analysis

The SEC and FINRA emphasize the importance of establishing and implementing a robust set of supervisory practices and procedures that reasonably would be expected to prevent and to detect a violation of the federal securities laws.

The Risk Alert suggests a risk-based analysis and monitoring that would act as the crux of a firm’s supervisory procedures for its branch offices.  Specifically, the Risk Alert highlights three factors that would be influenced by a risk assessment process:  (1) the frequency and intensity of inspections; (2) the focus and custom-tailored qualities of inspections; and (3) the number of unannounced inspections for any given branch office.

Frequency of Inspections.  The Risk Alert calls attention to the importance of conducting unannounced inspections and that an “ongoing risk analysis should be a key element of [a] firm’s exam planning process and lead firms to engage in more unannounced exams of such offices.”  The Risk Alert suggests that branch offices that meet certain high risk criteria should be inspected more often.  Areas of high risk that would influence a firm’s supervisory practices for any given branch office include the nature and extent of outside business activities of registered branch office personnel, sales of structured products, sales of complex products, sales of private or otherwise unregistered offerings of any type, and association of the branch office with individuals who have significant disciplinary history or who previously worked at a firm with significant disciplinary history.

Customized and Focused Inspections.  The Risk Alert stresses that a risk assessment approach provides a firm with the opportunity to tailor the focus of branch office inspections around the risks specific to any given branch.  Moving away from a generic, “check the box” exam procedure, the Risk Alert promotes the use of surveillance reports, employing current technology and techniques to identify risk and construct a customized approach for the firm’s branch office inspections that reflect on the type of business conducted at each branch.

Unannounced Inspections.  The Risk Alert advocates the increased use of unannounced inspections of branch offices, based on a combination of risk-based selection, random selection, and for-cause exams.  It points out the elevated possibility of securities violations if branch offices have forewarning of inspections, providing them a chance to hide, alter or destroy documentation or other information.  The Risk Alert makes note that the SEC has sanctioned firms that have not conducted unannounced examinations of their branch offices, adding to the importance of this practice. 

Additional “Best Practices” Characteristic Of Effective Supervisory Procedures

The Risk Alert states that firms should implement procedures designed to avoid conflicts of interest that may result in incomplete and ineffective branch office inspections because of “economic, commercial or financial interests that an examiner holds in the associated person or branch being inspected.”  In addition, the Risk Alert recommends the use of examiners with sufficient experience to comprehend the business being conducted at any given branch office and the character to question and challenge assumptions. 

Conclusion

Overall, the SEC and FINRA recommend that a firm’s branch inspection process (1) use a risk-based analysis to create supervisory procedures tailored to the firm’s business and compliance needs rather than the minimum requirements of Rule 3010 and (2) be implemented by supervisory personnel who are free of conflicts of interest and who have the authority and experience to conduct effective examinations and create procedures reasonably designed to prevent and detect violations of applicable law and rules.

FinCEN assessed a $25,000 civil money penalty against an individual, Mendoza, for willfully disclosing the existence of a Suspicious Activity Report (“SAR”) to a person involved in the transaction reported in the SAR.  Mendoza was an employee of a bank at the time of the unlawful disclosure and such disclosure is prohibited by the Federal Bank Secrecy Act.  Mendoza told the subject of the SAR that the SAR had been filed “and later solicited and accepted a bribe from the subject, in return for which Mendoza represented he would assist the subject with any ensuing bank proceedings or federal criminal investigation.”  The U.S. District Court for the Central District of California convicted Mendoza of “bribery and unlawful SAR disclosure.”  In addition to the $25,000 civil money penalty, Mendoza was sentenced to six months’ imprisonment.

The FRB, FDIC, OCC and SEC (the “Agencies”) jointly extended the comment period from January 13, 2012 to February 13, 2012  on the Agencies’ proposed rule (the “Proposed Rule”) to implement the Volcker Rule.  The Proposed Rule was discussed in the October 19, 2011  Financial Services Alert.

The SEC further extended until February 13, 2012 the comment period on a rule proposal designed to implement Section 621 of the Dodd-Frank Act (the “ABS Conflicts Proposal”).  In broad terms, Section 621 prohibits an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security (“ABS”), whether or not registered and including a synthetic ABS, from engaging in a transaction that would involve or result in certain material conflicts of interest.  The ABS Conflicts Proposal was briefly discussed in the September 27, 2011 Financial Services Alert.  The SEC had previously extended the comment deadline to give the public a better opportunity to consider any potential interplay between the ABS Conflicts Proposal and the more recent Volcker Rule proposal issued by the FRB, OCC, FDIC and SEC (discussed in the October 19, 2011 Financial Services Alert).  The current extension is in response to the extension of the comment period on the Volcker Rule proposal until February 13, 2012.

The Basel Committee on Banking Supervision (the “BCBS”) has issued proposed principles regarding the supervision and regulation of financial conglomerates, particularly financial conglomerates with cross-border operations.  The proposed principles would update and revise the BCBS’ current principles framework for the supervision of financial conglomerates by expanding or supplementing the current principles in the areas of supervisory powers and authority, supervisory responsibility, corporate governance, capital adequacy and liquidity and risk management.  Comments on the proposed principles must be submitted to the BCBS by March 16, 2012.

The Basel Committee on Banking Supervision (the “BCBS”) has issued a proposed clarification of the Basel III capital rules with respect to adjustments in the calculation of a bank’s regulatory capital due to unrealized gains and losses resulting from changes in the fair value of derivatives.  The proposed clarification provides that debit valuation adjustments for over-the-counter derivatives and securities financing transactions should be fully deducted in the calculation of Common Equity Tier 1 capital.  Comments on the proposed clarification must be submitted to the BCBS by February 17, 2012.

The FRB, FDIC and OCC jointly released their annual Community Reinvestment Act (“CRA”) asset-size threshold adjustments for small and intermediate small depository institutions.  The annual adjustments are based upon changes in the average of the Consumer Price Index for Urban Wage Earners and Clerical Workers  (the “CPI”) (not seasonally adjusted, for each twelve-month period ending in November, with rounding to the nearest million).  For the period ending in November 2011, the CPI increased 3.43%.  Effective January 1, 2012, a “small bank” or “small savings association” is one that as of December 31 of either of the prior two calendar years had assets of less than $1.160 billion.  An “intermediate small bank” or “intermediate small savings association” is one that had assets of at least $290 million as of December 31 of both of the prior two calendar years and less than $1.160 billion as of December 31 of either of the prior two calendar years.

The SEC issued an order amending interim final temporary Rule 15Ba2-6T under the Securities Exchange Act of 1934 to extend the Rule’s sunset provision until September 30, 2012.  Rule 15Ba2-6T provides a transitional means for municipal advisors to satisfy the registration requirements introduced by the Dodd-Frank Act until the SEC can implement a permanent registration program.  The SEC said that it is not making any substantive changes to the Rule at this time in order to avoid causing those relying on the Rule to need to make adjustments to their operations or amendments to their temporary registration forms.