Financial Services Alert - June 12, 2012

The FRB, FDIC and OCC (the “Agencies”) issued three joint proposed rules (the “Proposed Capital Rules”) that would enhance bank regulatory capital requirements and implement Basel III capital reforms in the U.S. and the Agencies also issued a final market risk capital rule (the “Final Market Risk Capital Rule”).  These regulatory initiatives are regarded as the most extensive changes to bank capital requirements in two decades.  The following is a brief, general summary of the Proposed Capital Rules and the Final Market Risk Capital Rule.  The Alert will cover sections of these releases and certain issues raised by these releases in greater detail in future issues.

Proposed Capital Rules

The Agencies issued the Proposed Capital Rules in the form of three notices of proposed rulemaking that are intended to restructure the Agencies’ capital requirements into “a harmonized, comprehensive framework,” and to revise the capital requirements to be consistent with both Basel III capital standards and Dodd-Frank Act requirements, including the Dodd-Frank Act minimum capital requirements for bank holding companies and savings and loan holding companies under the so-called Collins Amendment and the requirement that references to credit ratings be removed from bank capital rules and other regulations.

The first Proposed Capital Rule applies to banks, savings associations and savings and loan holding companies of any size and to bank holding companies with consolidated assets of $500 million or more (“Banking Organizations”) and increases both the quantity and quality of capital required.  Quantitative enhancements proposed include:

(1)    a minimum common equity Tier 1 capital ratio of 4.5% of risk-weighted assets (a new requirement);

(2)    a minimum total Tier 1 capital ratio of 6% (increased from 4%);

(3)    a minimum total (Tier 1 and Tier 2) capital ratio of 8% (unchanged);

(4)    a minimum Tier 1 leverage ratio of 4% of unadjusted assets;

(5)    for certain banking organizations with extensive off-balance sheet activities, a supplementary Tier 1 leverage ratio of 3% that would take into account off-balance sheet items;

(6)    a capital conservation buffer of common equity Tier 1 capital in an amount above the minimum risk-based capital requirements equal to 2.5% of total risk weight assets; and

(7)    a countercyclical buffer for “advanced approaches” Banking Organizations, initially set at zero, but which can be activated by both regulators.

The first Proposed Capital Rule would also revise certain capital definitions and, generally, make the capital requirements more stringent and “improve the loss absorbency of regulatory capital.”  For example, goodwill, which the Agencies noted “is the largest deductible item” for many Banking Organizations, would be deducted from common equity tier 1.  Moreover, the first Proposed Capital Rule would revise the Prompt Corrective Action rules to incorporate the revised regulatory capital requirements. 

The second Proposed Capital Rule would also apply to all Banking Organizations.  This Proposed Capital Rule would harmonize the Agencies’ calculation of risk-weighted assets and expand the number of risk-weighted categories.  The second Proposed Capital Rule would increase the required capital for certain categories of assets, including higher-risk residential mortgages, higher-risk construction real estate loans and certain exposures related to securitizations.  The Agencies stated that the second Proposed Capital Rule would also provide incentives for trading and clearing derivatives through central counterparties.  The second Proposed Capital Rule would also establish calculations for risk-weighted assets that do not involve the use of credit ratings.

The third Proposed Capital Rule would only apply to Banking Organizations subject to the “advanced approaches” rule (generally, those with $250 billion or more in total assets or on‑balance sheet foreign exposures of at least $10 billion) or the market risk rule (generally those with aggregate trading assets and trading liabilities at least equal to 10% of total assets or $1 billion) or both.  The Agencies said that the third Proposed Capital Rule would enhance the risk sensitivity of the advanced approaches rule by incorporating Basel III’s advanced approaches standards to “better address counterparty credit risk and interconnectedness among financial institutions.”  Under the third Proposed Capital Rule, for example, there are increased capital requirements for exposures to non-regulated financial institutions and to regulated financial institutions with total assets of $100 billion or more.

Comments on the Proposed Capital Rules are due by September 7, 2012.  The Proposed Capital Rules are expected to go into effect on January 1, 2013, but Banking Organizations would not be required to be in full compliance with the final version of the Proposed Capital Rules until January 1, 2019.

Final Market Risk Capital Rule

The Final Market Risk Capital Rule would apply to any bank holding company, national bank, state member bank or state nonmember bank that has trading assets and trading liabilities equal or greater than 10% of its total assets or $1 billion (“Covered Banking Organizations”).  If in effect today, there would be approximately 25 Covered Banking Organizations.  The Final Market Risk Capital Rule reflects certain comments to proposed versions of the Rule, see the December 13, 2011 Financial Services Alert.  The Final Market Risk Capital Rule, among other things, takes into account changes to the Basel Committee’s international standards, increased sensitivity to risk, enhanced prudential requirements on internal models, increased disclosure obligations and elimination of reliance on credit ratings.  The effective date of the Final Market Risk Capital Rule is January 1, 2013.

The SEC settled administrative proceedings against a mutual fund adviser (the “Adviser”) and its affiliated mutual fund distributor (the “Distributor”) related to findings that the respondents had made misleading disclosures about the exposure to AAA-rated commercial mortgage-backed securities (“CMBS”) of two registered open-end investment companies (the “Funds”) the respondents managed/distributed.  One of the Funds focused on high yield debt securities (the “High Yield Fund”); the other focused on intermediate-term, investment grade bonds (the “Investment Grade Fund”).  Each Fund achieved its exposure to CMBS through long positions in total return swaps (“TRS”).  This article describes the SEC’s findings, which the respondents neither admitted nor denied.

CMBS Exposure.  In the second half of 2007, a portfolio management team at the Adviser identified an investment opportunity in CMBS that the Adviser caused the Funds to pursue by purchasing TRS based on CMBS spreads.  As a result of this investment program, by March 31, 2008, the High Yield Debt Fund, whose net assets were approximately $2 billion, had exposure to approximately $1 billion of CMBS based on the notional amount of its TRS positions.  The Intermediate Bond Fund, whose net assets were approximately $2.2 billion, had exposure to approximately $800 million of CMBS based on the notional amount of its TRS positions. 

Impact of the Credit Crisis.  The credit crisis of 2008 caused CMBS spreads to move against the Funds’ TRS positions triggering payment obligations to the Funds’ TRS counterparties that had to be met through the sale of portfolio securities.  The credit crisis also caused a decline in each Fund’s net asset value.  By November 2008, the High Yield Fund’s net assets were roughly equal to the notional amount of its TRS, which had remained unchanged.  In November 2008, the Adviser’s senior management directed that the Funds’ CMBS exposure be reduced to comply with internal risk management guidelines.  This directive followed a grace period granted in response to concerns expressed by the portfolio management team that compliance with the risk management guidelines would realize losses on TRS positions at a time when the team expected the CMBS market to rebound. 

Further deterioration in the CMBS markets caused further declines in each Fund’s net asset value and additional payment obligations under its TRS positions, which in turn necessitated sales of portfolio securities in a difficult market for sellers, particularly for the High Yield Fund.  By December 5, 2008, as a result of the directive to reduce CMBS exposure, the High Yield Fund’s net notional CMBS exposure had been reduced by approximately 80% and the Intermediate Bond Fund’s net notional CMBS exposure had been reduced by more than 40%.  By year-end 2008, the High Yield Fund’s share price had declined nearly 80% (compared to an average decline of approximately 26% for its peers); the Intermediate Bond Fund’s share price had declined approximately 36% (compared to an average decline of approximately 4% for its peers).  The SEC attributed this underperformance primarily to the Funds’ exposure to CMBS.

Misleading Statements to Wholesalers and Financial Advisers.  The SEC found that during November and early December 2008, the Adviser and Distributor made misleading statements in communications that were disseminated to wholesalers at the Distributor for use with financial advisers, and to financial advisers directly, to address concerns about the Funds’ performance and outlook.  These communications took the form of talking points for the Distributor’s call center representatives, an email to wholesalers, a Q&A for financial advisers and conference calls with financial advisers and wholesalers.  In broad terms, the SEC found these communications misleading because they contained statements that the SEC found inconsistent with the sale of portfolio securities and reduction in CMBS exposure that were occurring during that timeframe, such as (a) that the Funds had suffered only “paper losses,” and (b) that the Funds remained committed to their CMBS positions. 

On the basis of the foregoing, the SEC determined that (a) both the Adviser and Distributor had violated Section 17(a)(2) and Section 17(a)(3) of the Securities Act of 1933, as amended (the “1933 Act”), by (i) obtaining, directly or indirectly, money or property in the offer or sale of a security by means of any materially false statement or materially misleading omission and (ii) engaging in any transaction, practice, or course of business that operates or would operate as a fraud or deceit in the offer or sale of a security, respectively; and (b) the Distributor had willfully violated Section 206(4) of the Investment Advisers Act of 1940, as amended, and Rule 206(4)-8(a)(1) and (2) thereunder relating to fraudulent, deceptive, or manipulative conduct by an investment adviser, including as to any investor or prospective investor in a pooled investment vehicle.

Misleading Prospectus – High Yield Fund.  The SEC found that the High Yield Fund’s prospectus was “materially misleading insofar as it purported to describe the [F]und’s ‘main’ investments without adequately disclosing the [F]und’s practice of assuming substantial leverage on top of those investments.”  The prospectus disclosure regarding the Fund’s investment objective and principal investment strategies described the Fund as investing mainly in lower-grade domestic and foreign fixed-income securities.  The prospectus also described the Fund as being able to use certain derivative investments to try to enhance income or to try to manage investment risk.  Although the prospectus disclosed that derivatives could increase share price volatility, and the High Yield Fund invested more than 80% of its net assets in corporate bonds throughout 2008, the SEC deemed the prospectus disclosure inadequate because it failed to disclose that the Fund could use derivatives to such an extent that the Fund’s “total investment exposure could far exceed the value of its portfolio securities and its investment returns could depend primarily upon the performance of bonds that it did not own.”  The SEC also faulted the prospectus disclosure for failing to adequately convey to investors the heightened risk of loss associated with the Fund’s use of leverage. 

On the basis of the foregoing, the SEC determined that (a) the Adviser had willfully violated Section 34(b) of the Investment Company Act of 1940, as amended, relating to materially false or misleading statements of fact in fund documents filed with the SEC and (b) both the Adviser and Distributor had willfully violated Section 17(a)(2) of the 1933 Act.

Sanctions.  Both the Adviser and Distributor agreed to censure and a cease and desist order.  The Adviser also agreed to pay disgorgement of $9,879,706, prejudgment interest of $1,487,190, and a civil money penalty of $24,000,000.  The disgorgement amount was equal to the management fees earned by the Adviser from the High Yield Fund and the Intermediate Bond Fund for the period February 1 to December 31, 2008.  In settling the matter, the SEC took into account the cooperation afforded its staff and the remedial acts promptly undertaken by the respondents, including (i) the replacement of senior management and portfolio management personnel, (ii) enhancements to the Adviser’s risk management structure, (iii) enhancements to the Adviser’s legal department capabilities and (iv) the implementation of new controls and procedures relating to fund disclosures and marketing communications.

The International Swaps and Derivatives Association (“ISDA”) has created a web page for the organization’s contingency planning with regard to the possibility that one or more Eurozone members may leave the common currency.  ISDA has stressed that its contingency planning is not to be interpreted as implying any opinion of the likelihood of such an exit.

The page includes a link to ISDA’s current Eurozone Contingency Planning Update.  According to the update, ISDA is preparing specific advice and protocols that would apply to certain asset classes and in anticipation of certain potential issues or developments, which will be published when ready.  Advice provided in the update includes the suggestion that industry participants review their derivatives contracts currently in force and take steps to reduce the risk that Euro-denominated obligations might be subject to redenomination should a Euro exit occur.  The update also recommends that, among other things, participants review fallback and “disruption” events specified in derivatives contracts currently in force to identify and address potential issues.

Finally, the page links to the ISDA Members Portal.  The password-protected portal, available to ISDA members, includes memoranda regarding the potential impact of a Eurozone exit on specific asset classes.

To meet the requirements of Section 1025 of the Dodd-Frank Act, the Consumer Financial Protection Bureau (the “CFPB”) and the FRB, FDIC, OCC and NCUA (the “Prudential Regulators”) entered into a Memorandum of Understanding (the “MOU”) pursuant to which the CFPB and the Prudential Regulators will coordinate their supervision of depository institutions and insured credit unions with total assets of more than $10 billion and their affiliates (“Large Banking Institutions”).  The CFPB and the Prudential Regulators said they would coordinate, among other things, the scheduling of examinations, the simultaneous conducting of examinations (unless the applicable Large Banking Institution requests separate examinations) and the sharing of draft reports of examinations for comment.

The CFPB and the Prudential Regulators said that the MOU will cover coordinated supervision of Large Banking Institutions concerning:

(1) compliance with federal consumer financial laws and some other federal laws that regulate consumer financial products and services;

(2) consumer compliance risk management programs;

(3) underwriting, sales, marketing, servicing and collections of consumer financial products; and

such other matters as to which the CFPB and the Prudential Regulators may agree in the future.

Banking institutions that are smaller than Large Banking Institutions will continue to be supervised and examined with respect to consumer compliance by their primary Prudential Regulator, but the CFPB will write the consumer regulations that will be enforced by the applicable Prudential Regulator of the specific smaller banking institution.

The SEC issued an order extending until nine months after the compliance date of a final rule it adopts for the registration of municipal advisors under the Securities Act of 1934, as amended, the ban on the use of a third party to solicit advisory business under Rule 206(4)‑5 under the Investment Advisers Act of 1940, as amended (the “Pay to Play Rule”).  In relevant part, the Pay to Play Rule prohibits an adviser and its covered associates from providing or agreeing to provide, directly or indirectly, payment to any third party for solicitation of advisory business from any government entity on behalf of such adviser, unless the third-party falls in designated categories of regulated persons (the “third party solicitor ban”).  These regulated persons originally comprised SEC-registered investment advisers and registered broker-dealers subject to pay to play restrictions adopted by a registered national securities association.  When the Dodd-Frank Act created a new category of SEC-registrants in the form of municipal advisors, the SEC expanded regulated persons to include a municipal advisor subject to pay to play restrictions and extended the original compliance date for the third party solicitor ban to June 12, 2012.  The SEC has adopted the current compliance date extension for the third party solicitor ban in view of the MSRB’s withdrawal of a proposed pay to play rule regarding the solicitation activities of municipal advisors and amendments to several existing MSRB rules related to pay to play practices pending the SEC’s adoption of a permanent definition of the term “municipal advisor.”

Goodwin Procter’s ERISA & Executive Compensation Practice has issued an Employee Benefit Update examining two regulations adopted by the U.S. Department of Labor (“DOL”) that go into effect this summer and add significant new disclosure requirements affecting the operation of plans subject to the Employee Retirement Income Security Act (“ERISA”):  (1) a “service provider regulation” that requires certain persons or entities that provide services to retirement plans subject to ERISA (“Plans”) to disclose to relevant Plan fiduciaries information regarding (among other things) the compensation they receive in connection with those services and (2) a “participant disclosure regulation” that applies to Plans that permit participants to direct investments and requires that specific disclosures be made to participants concerning Plan expenses and various aspects of the designated investment alternatives under the Plan.