0OCC Publishes Final Rule Governing the Use of Amortized Cost Valuation by Short-Term Investment Funds
The OCC published a final rule (the “Final Rule”) revising the requirements imposed on banks managing short-term investment funds (“STIFs”) that value the assets of the STIFs at amortized cost, rather than mark-to-market value, for purposes of admissions and withdrawals. This article discusses the current rule and key aspects of the revisions reflected in the Final Rule.
Under the current rule, a collective investment fund may qualify as a STIF, and therefore utilize amortized cost valuation for admissions and withdrawals (as an exception to the general requirement to use mark-to-market valuation for admissions and withdrawals) if the fund (1) maintains a dollar-weighted average portfolio maturity of 90 days or less (taking into account interest rate resets); (2) accrues on a straight-line basis the difference between the cost of each asset and the anticipated principal receipt on maturity; and (3) holds its assets until maturity under usual circumstances. 12 CFR 9.18(b)(4)(ii)(B) (the “STIF Rule”).
Under the Final Rule, effective July 1, 2013, the weighted average portfolio maturity requirement will be reduced from 90 days to 60 days, and additional significant conditions will be imposed for a fund to qualify as a STIF. In addition to the 60 day weighted average portfolio maturity requirement, a STIF will also be required to maintain a weighted average portfolio life maturity of 120 days or less, and will not be permitted to use interest rate resets to reduce such maturity calculation. Also, a bank that manages a STIF will be required to calculate the difference between amortized cost and market values of the STIF’s portfolio securities at least weekly, and switch to mark-to-market valuation any time the STIF’s market value falls below a net asset value of $0.995 per participating interest (sometimes referred to as “units” herein). These requirements imposed by the OCC are aimed at addressing the risk of principal loss by STIFs and at reducing the risks to banks that administer STIFs.
In addition to revising the STIF Rule’s portfolio maturity and valuation requirements, the Final Rule imposes additional operational requirements on bank trustees of STIFs that are subject to the Final Rule. The written plan governing a bank’s management of a STIF will be required to include portfolio and issuer qualitative standards and concentration restrictions. A bank managing a STIF will also be required to provide for stress tests, to be performed at least monthly, which must include an assessment of the STIF’s ability to withstand certain destabilizing events and the magnitude of each such event that would cause the difference between the STIF’s mark-to-market valuation and amortized cost valuation to exceed $0.005 per participating interest. The Final Rule provides that such a stress test should assess, at a minimum, the impact of a change in short-term interest rates, an increase in participant account withdrawals, a downgrade or default with respect to portfolio securities, and changes in the relative yields of applicable benchmarks.
The Final Rule will require banks managing STIFs to provide participating accounts and the OCC with significant portfolio-level and security-level information within five business days after the end of each month, including total assets under management, market value and amortized cost valuations, portfolio maturity measures, and identifying information with respect to each security. Furthermore, a bank managing a STIF will have to adopt procedures for notifying the OCC within one business day after the occurrence of one or more of six specified significant developments with respect to a STIF, including a difference between amortized cost and mark-to-market unit values exceeding $0.0025, repricing of a STIF’s units if its mark-to-market falls below $0.995 per unit, and other events such as suspension of withdrawals from the STIF. Finally, the Final Rule will require a bank that has suspended or limited withdrawals from a STIF and initiated liquidation of the STIF as a result of withdrawals to (1) determine that the size of the difference between amortized cost and mark-to-market unit values may cause participating accounts to experience material dilution or other unfair results; (2) formally approve the liquidation; and (3) execute the liquidation fairly and to the benefit of all participants in the STIF.
Following the proposal for revising the STIF Rule (as discussed in the April 24, 2012 Financial Services Alert), most commenters supported the revisions, but some urged the OCC to more closely track SEC Rule 2a-7, applicable to money market mutual funds (“MMMFs”). The revisions reflected in the Final Rule were informed by revisions to SEC Rule 2a-7, although the OCC noted that differences remain due to the fact that STIFs are limited to eligible fiduciary accounts and MMMFs are retail products that may be offered to the public. In this regard, the OCC did not adopt the daily and weekly liquidity requirements of SEC Rule 2a-7, although the Final Rule does require the adoption of liquidity standards that include provisions to address contingency funding needs by the STIF. The preamble to the Final Rule provides additional commentary by the OCC on those liquidity standards.
The Final Rule is virtually identical to the proposed rule, and the OCC declined to accept the requests of certain commenters that a grandfathering provision for securities held by a STIF on the publication date or effective date of the Final Rule be excluded from the 60-day weighted average portfolio maturity and 120-day weighted average portfolio life maturity calculations and that the period for reporting significant developments be extended from one business day to five business days.
The Final Rule applies to the management of STIFs by national banks, federal savings associations, federal bank branches of foreign banks and any state chartered banks in states that require comparable funds to comply with the STIF Rule. As discussed herein, the revisions reflected in the Final Rule impose significant additional obligations and costs on fiduciaries managing STIFs. Although the revisions will likely reduce the risks associated with STIFs, the income generated by STIFs complying with the Final Rule will also be reduced, disadvantaging banks subject to the Final Rule in comparison with banks not subject to such rule.
The Final Rule’s requirement that a STIF reprice the unit values when its mark-to-market value falls below $0.995 per unit and effect admissions and withdrawals at that lower mark-to-market value (rather than a constant value of $1.00 per unit) may create operational and administrative issues for bank collective and common trust funds investing in the STIF. In this regard, the Final Rule does not provide any exclusion to the foregoing requirement even if the trustee of the STIF has concluded based on all the facts and circumstances that a drop in the mark-to-market value below $0.9950 per unit is temporary and will quickly reverse (for example, in a situation in which a geopolitical event or natural disaster causes a sharp but short-lived drop in the mark-to-market value of the STIF).
Goodwin Procter LLP has advised a number of clients on matters related to the current STIF Rule and the Final Rule and would be pleased to address any questions you have regarding the revisions discussed herein and strategies for addressing these revisions, including those related to avoiding some of the potential adverse consequences of the Final Rule. We also would be pleased to address potential alternative approaches to dealing with the significant impact of the Final Rule on STIFs and their participants.
0IRS Announces Modification of Certain Timelines for Due Diligence and Other Requirements under FATCA
On October 24, 2012, the Internal Revenue Service (“IRS”) issued Announcement 2012-42 (the “Announcement”), which generally extends the timelines for withholding agents and foreign financial institutions (“FFI”) to carry out certain due diligence and other requirements under the Foreign Account Tax Compliance Act” (“FATCA”). In addition, the Announcement extends the date for withholding on gross proceeds withholdable payments from January 1, 2015 to January 1, 2017, and broadens the rules covering grandfathered obligations to include certain additional categories of obligations. The Announcement provides that these modifications will be incorporated into final regulations which are expected to be issued prior to the end of 2012. It should be noted that these modifications do not change the January 1, 2014 effective date for FATCA withholding on U.S.-source interest, dividend and other fixed and determinable payments (“FDAP”) withholdable payments. Furthermore, the Announcement makes clear that although these new timelines are intended to provide a reasonable period of time for withholding agents to review and document all preexisting accounts, once an account has been documented, withholding or reporting, as appropriate, must begin notwithstanding that the due diligence time period has not expired.
Under FATCA, the provisions of which are codified in sections 1471-1474 of the Internal Revenue Code of 1986 (the “Code”), withholding agents must withhold 30% of withholdable payments made to an FFI, unless the FFI has entered into an agreement (an “FFI Agreement”) with the IRS to, among other things, report certain information to the IRS with respect to accounts held by specified United States (“U.S.”) persons or by foreign entities in which specified U.S. persons own a substantial interest (“U.S. accounts”), or is treated as a “deemed compliant” FFI (and hence excepted from having to enter into an FFI Agreement). For these purposes, a specified U.S person is generally any U.S. person as defined in Code section 7701(a)(30), other than certain excepted persons, such as U.S. corporations the stock of which is regularly traded on an established securities market and their affiliates, organizations exempt from tax under Code section 501(c)(3), and individual retirement plans as defined in Code section 7701(a)(37). Deemed-compliant FFIs are divided into three categories: registered deemed-compliant FFIs, which must meet certain requirements for registering with the IRS as well as other requirements for qualifying for deemed-compliant status, certified deemed-compliant FFIs, which are not required to register with the IRS, and certain owner-documented FFIs, which can qualify for deemed-compliant status only with respect to withholdable payments made by certain designated withholding agents.
In addition, in July 2012, the U.S. Treasury Department and IRS issued a model intergovernmental agreement (“IGA”) under which an FFI would report information about its U.S. accounts to its government, and that information would be subject to a government-to-government automatic information exchange. To date, one such IGA has been signed with the United Kingdom, and the Treasury Department and IRS have announced their intention to conclude other bilateral agreements based on the model IGA.
In February 2012, the Treasury Department and IRS issued proposed regulations under FATCA (the “Proposed Regulations”). The Proposed Regulations contain detailed rules regarding the due diligence obligations of withholding agents, participating FFIs and registered deemed-compliant FFIs in order to identify the status of their account holders for FATCA purposes, and that generally are more heightened with respect to new accounts than preexisting obligations. The IRS indicated that a major purpose of the modified timelines in the Announcement is to align the due diligence timelines for U.S. withholding agents, FFIs in countries with an IGA and FFIs in countries that do not have an IGA.
Changes Made to Due Diligence Timelines by the Announcement
New Account Opening Procedures. The Announcement generally extends the timelines for implementing the new account opening procedures by changing the definition of preexisting obligations from accounts opened prior to January 1, 2013 to accounts opened prior to January 1, 2014. In the case of a participating FFI, a preexisting obligation will mean any account maintained or executed by the participating FFI prior to the later of January 1, 2014 or the date the FFI enters into an FFI Agreement. (The Announcement states that any FFI Agreement entered into prior to January 1, 2014, will have an effective date of January 1, 2014.) In the case of a registered deemed-compliant FFI, a preexisting obligation will mean any account maintained or executed prior to the date on which the FFI implements its required account opening procedures, which must occur by the later of January 1, 2014 or the date on which it registers as a deemed-compliant FFI.
Withholding and Documentation for Preexisting Obligations of Prima Facie FFIs. In addition, the Announcement addresses certain transition rules with respect to preexisting obligations. In particular, under the Proposed Regulations, a withholding agent must treat a “prima facie” FFI as a nonparticipating FFI, until it obtains documentation establishing that the payee has a different status for FATCA withholding purposes. (A prima facie FFI is generally an entity which is shown on a withholding agent’s searchable information to be a “qualified intermediary” or a “nonqualified intermediary” (as those terms are defined in Treasury Regulations issued under the withholding provisions of Code sections 1441and 1442), or to be a foreign entity that is associated with certain industry codes that are deemed indicative of financial institution status.) The Announcement provides that withholding on withholdable payments made to a prima facie FFI with respect to preexisting obligations will apply to payments made after June 30, 2014, instead of January 1, 2014 as currently provided in the Proposed Regulations. Similarly, with respect to a preexisting obligation, a participating FFI will be required to determine whether a prima facie FFI is a participating FFI, deemed-compliant FFI or a nonparticipating FFI within six months of the effective date of its FFI Agreement (that is, by June 30, 2014 for any participating FFI that enters into an FFI Agreement on or before December 31, 2013).
Withholding and Documentation for Other Preexisting Obligations.
- Other Preexisting Entity Obligations - The Announcement states that with respect to preexisting obligations, withholding agents, other than participating FFIs, will be required to document payees, other than prima facie FFIs, by December 31, 2015. Accordingly, beginning on January 1, 2016 (instead of January 1, 2015 as under the Proposed Regulations) any undocumented entity that is treated as a foreign entity but is not a prima facie FFI must be treated as a nonparticipating FFI until the withholding agent obtains sufficient documentation to establish a different status for FATCA purposes of the payee. Similarly, the Announcement states that a participating FFI will be required to perform the requisite identification procedures to determine whether an entity other than a prima facie FFI is itself a participating FFI by the later of December 31, 2015 or the date that is two years after the effective date of its FFI Agreement, and will not be required to apply certain presumption rules as to the accounts of such payees until such time.
- Participating FFIs and Preexisting Individual Accounts - In general, the Announcement extends the dates in the Proposed Regulations for a participating FFI to perform the required identification procedures and obtain appropriate documentation about preexisting individual accounts. If the account is a “high value” account (i.e., the account had a balance or value that exceeds $1,000,000 at the end of the calendar year preceding the effective date of a participating FFI’s FFI Agreement, or the end of any subsequent calendar year), the participating FFI must perform the requisite identification procedures and obtain the appropriate documentation by December 31, 2014, and by December 31, 2015 if the account is other than a high value account; if it fails to do so, it must treat the account holder as a “recalcitrant” account holder.
Due Date for First Report by a Participating FFI with respect to U.S. Accounts. The Announcement provides that a participating FFI will be required to file the information reports for the 2013 and 2014 calendar years with respect to accounts that must be treated as U.S. accounts or as held by recalcitrant account holders not later than March 31, 2015.
Gross Proceeds Withholding
The Announcement extends the date for withholding to commence on “gross proceeds” type withholdable payments (i.e., gross proceeds from any sale of disposition of any property of a type that can produce U.S. source interest or dividends) from January 1, 2015 to January 1, 2017.
Expansion of Grandfathered Obligations
Under the Proposed Regulations, FACTA withholding does not apply to any payments made on an obligation (which, for this purpose, includes only debt and similar instruments) that is outstanding on January 1, 2013. The Announcement provides that a grandfathered obligation will include any obligation that produces or could produce a foreign pass-through payment and that cannot produce a withholdable payment, provided the obligation is outstanding as of the date that is six months after the date on which final regulations are issued. In addition, the Announcement provides that a grandfathered obligation will include (i) any instrument that gives rise to a withholdable payment solely because the instrument is treated as giving rise to a dividend equivalent under Code section 871(m), and (ii) any obligation to make a payment with respect to, or to repay, collateral posted to secure obligations under a notional principal contract that is a grandfathered obligation.
0CFTC Proposes New Regulations for FCMs and DCOs Designed to Protect Customer and Other Assets
The CFTC unanimously proposed new regulations and amendments to existing regulations intended to enhance protections of customer money and other assets held by futures commission merchants (“FCMs”) and derivatives clearing organizations (“DCOs”). The proposal includes a discussion of MF Global and Peregrine Financial, stating that those incidents (along with other factors) “demonstrate the need for new rules and amendments to existing rules.”
The proposed new regulations and amendments would make numerous changes. For example, they would require FCMs to establish a risk management program and would allow the CFTC to order an FCM to transfer its customer business if it cannot “immediately certify,” with supporting evidence, that it has sufficient access to liquidity to continue operating. The proposals would also require that the CFTC and SRO have read-only electronic access to accounts holding certain customer funds.
The proposals would also prohibit an FCM from using one futures customer’s funds to margin or secure the positions of another futures customer, and would provide that an FCM bears sole responsibility for any losses resulting from the investment of customer funds in certain permitted financial investments. Furthermore, they would impose additional safeguards such as prohibiting an FCM from withdrawing more than 25% of its residual interest in futures customer accounts unless the FCM’s CEO, CFO, or other senior official pre-approves the withdrawal in writing.
Under the proposed amendments, an FCM or DCO investing customer funds in a money market mutual fund where the investment is held directly with the money market mutual fund or its affiliate would be subject to the following conditions, among others: (a) the value of the money market fund is computed and made available by 9:00 AM the following business day; (b) the fund is legally obligated to redeem shares and make payments to the FCM or DCO by the following business day; and (c) the money market mutual fund does not have any agreements in place that would prevent the FCM or DCO from pledging or transferring fund shares.
In addition, the proposals would mandate certain additions and enhancements to the reporting and disclosure obligations of FCMs and introducing brokers (“IBs”). They would also require that public accountants that conduct audits of CFTC registrants must be registered with the Public Company Accounting Oversight Board (“PCAOB”) and have passed a PCAOB exam.
Comments on the proposal are due 60 days after its forthcoming publication in the Federal Register.
0CFTC Issues Interpretive Guidance Regarding Swap Data Repositories and Non-US Regulators
The CFTC issued interpretive guidance designed to clarify that the confidentiality and indemnification provisions in Section 21(d) of the Commodity Exchange Act (CEA) should not operate to inhibit or prevent foreign regulatory authorities from accessing data in which they have an independent and sufficient regulatory interest.
Section 21(c)(7) of the CEA (codified as 7 U.S.C. 24a(c)(7)) requires swap data repositories (“SDRs”) to “make available all data obtained by the [SDR]” to domestic and foreign regulators under certain circumstances. CEA Section 21(d) (codified as 7 U.S.C. 24a(d)), however, requires that entities receiving that data must first provide the SDR with a written agreement stating that it will abide by certain confidentiality restrictions and will indemnify the SDR and CFTC for any expenses arising from litigation relating to the information provided.
Although previous CFTC rulemaking specified that an “appropriate foreign regulator” may access SDR data without executing a confidentiality and indemnification agreement, the CFTC chose to issue interpretive guidance in response to concerns that certain aspects of the rules remained unclear. The final interpretive guidance clarifies that a registered SDR would not be subject to the confidentiality and indemnification provisions if it is also registered or recognized in the regulatory regime of a foreign jurisdiction and if the relevant data has been reported to the SDR pursuant to the foreign jurisdiction’s regulations. The guidance also provides that a foreign regulator’s access to data from a registered SDR that is also registered or recognized in the regulatory regime of the foreign jurisdiction and where the data has been reported pursuant to the foreign jurisdiction’s regulations “will be dictated by that foreign jurisdiction’s regulatory regime and not by the CEA or Commission regulations.”
The guidance passed on a 3-2 party line vote. Commissioners Sommers and O’Malia issued a joint dissenting statement explaining that the guidance fails to incorporate comments received from the European Securities and Markets Authority and that the guidance does not relieve U.S. regulators other than the CFTC and SEC of the requirement to execute an indemnification agreement—which Commissioners Sommers and O’Malia state they are prohibited from doing—before they can directly access SDR swap data.
0SEC Adopts Standards for Risk Management and Operations of Clearing Agencies
The SEC approved a final rule that establishes standards applicable to clearing agencies, including those that clear security-based swaps. New Rule 17Ad-22 under the Securities Exchange Act of 1934 establishes minimum requirements for risk management procedures and controls to be maintained by registered clearing agencies.
Operations and Risk Management Practices. The Rule requires registered clearing agencies that perform central counterparty services to publish, implement, and enforce written policies and procedures designed to meet certain minimum requirements for their operations and risk management practices on an ongoing basis. The rules require standards with respect to (a) the measurement and management of credit exposures, (b) margin requirements, (c) financial resources (requiring registered clearing agencies that perform central counterparty services to maintain sufficient financial resources to withstand a default by the participant, or the two participants in the case of a security-based swap clearing agency, to which it has the largest exposure “in extreme but plausible market conditions”), and (d) an annual model validation process.
Central Counterparty Services. The Rule requires a registered clearing agency that serves as a central counterparty to: (a) provide the opportunity for a person who does not perform any dealer or security-based swap dealer services to obtain membership in order to clear securities for itself or on behalf of other persons; (b) refrain from using minimum portfolio size and minimum transaction volume thresholds as conditions to membership; and (c) provide the ability to obtain membership to persons who maintain net capital equal to or greater than $50 million (with higher requirements permissible if the central counterparty demonstrates to the SEC that such higher threshold is necessary to mitigate risks that could not be managed by other measures). The Rule also requires registered clearing agencies that perform central counterparty services to calculate and document compliance with applicable financial resource requirements no less frequently than quarterly.
Disclosure and Other Requirements. Under the Rule, a registered clearing agency must post its annual audited financial statements on their website. Finally, the Rule establishes certain minimum standards applicable to each registered clearing agency, in fifteen categories including “custody of assets and investment risk,” “operational risk,” “governance,” “default procedures,” “timing of settlement finality,” and “risk controls to address participants’ failures to settle.”
The Rule becomes effective 60 days after its forthcoming publication in the Federal Register.
0Independent Directors Council Issues Report on Board Oversight of Exchange-Traded Funds
The Independent Directors Council issued a report designed to assist fund directors in their oversight of exchange-traded funds (“ETFs”) and inform directors of fund complexes that invest in ETFs or may launch ETFs in the future. The report provides a basic overview of ETFs and discusses the following topics: exemptive relief, design and investment objective, contractual relationships, trading of ETF shares, portfolio management and trading of underlying securities, and disclosure.
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