Financial Services Alert - November 27, 2012

Goodwin Procter recently hosted 75 CEOs and senior managers from middle market and community banks across the region at the inaugural Northeast Banking Symposium.  The full-day conference, “Strategic Innovation in a Challenging Environment,” was sponsored by the Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island and Vermont Bankers Associations.  The event focused on the strategic importance of managing innovation and technology to address challenges faced by banks serving middle market and local communities.

At the Symposium, Goodwin Procter provided attendees with a written analysis of the substantial regulatory and related business challenges in the post-Dodd-Frank Act environment faced by banks that offer residential mortgages, given the confluence of the Qualified Mortgage, Qualified Residential Mortgage and Basel III standards.  The analysis is provided below.  An integral part of the analysis is the accompanying chart, entitled “Comparison of Qualified Mortgage, Qualified Residential Mortgage and Basel III Category I Requirements.”  The analysis and chart, which we encourage you to read and retain as a reference, were prepared by William E. Stern, Michael Whalen and Grant F. Butler of Goodwin Procter’s Banking Practice Area.

Early versions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) contained provisions that would have obligated lenders to offer consumers “plain vanilla” mortgage loans with limited terms and features.  As enacted, the Dodd-Frank Act contains no such explicit requirement, but it does impose several constraints that, in combination with proposed revisions to the risk-based capital framework for financial institutions, may lead to the same result.

As explained below and in the accompanying summary chart, the Dodd-Frank Act amended the Truth in Lending Act by imposing substantial potential liability on lenders that make mortgage loans other than “qualified mortgage” loans designed to comply with an “ability-to-repay” requirement.  Further, lenders that originate loans for securitization will need to take into account the Dodd-Frank Act’s risk retention requirement and the related exception for “qualified residential mortgage” loans, and even lenders that do not originate mortgage loans with the intent of selling them to a securitizer may need take these requirements into account to preserve their ability to later sell the loans in the secondary market.  Lenders that originate or buy loans for their own portfolios will also need to consider new capital requirements that impose higher risk-weights and result in higher capital charges on mortgage loans which do not qualify as “Category 1 mortgage loans” under the proposed Basel III framework.

Chart Comparing Qualified Mortgage, Qualified Residential Mortgage
and Basel III Category I Requirements

• “Qualified Mortgage” Standard:  The requirement that a borrower demonstrate ability to repay a mortgage loan is a centerpiece of the mortgage reforms in the Dodd-Frank Act.  Specifically, Title XIV of the Dodd-Frank Act precludes a creditor from making a mortgage loan unless the borrower has ability to repay the loan, but it also provides special protection from liability if the mortgage loan is a “qualified mortgage” loan that does not contain certain risky terms and features and meets certain underwriting requirements and points and fees limitations.  A creditor that violates the ability-to-repay requirement may be subject to substantial liability, including the sum of all finance charges and fees paid by the consumer, actual damages, statutory damages in an individual or class action, and court costs and attorneys’ fees.  In addition, a consumer may assert a violation of the ability-to-repay requirement as a defense to foreclosure by recoupment or set off.  The proposed rule released by the Federal Reserve Board before the transfer of its rulemaking authority under the Truth in Lending Act to the Bureau of Consumer Financial Protection (the “CFPB”) provides a safe harbor or presumption of compliance with the ability to pay requirement to creditors that originate loans falling within the narrow definition of “qualified mortgage.” The CFPB has indicated it may finalize the ability-to-repay rule in January 2013.
• “Qualified Residential Mortgage” Standard:  Following the recent financial crisis, there were widely held concerns that inappropriate underwriting practices and misaligned incentives between lenders and securitizers, on the one hand, and investors on the other hand, contributed to the collapse of the securitization market and the broader financial crisis.  The Dodd-Frank Act attempts to address these concerns by requiring securitizers to retain at least 5% of the credit risk of assets sold or transferred to third parties through a securitization.  A securitizer may be able to satisfy this obligation by allocating a portion of its risk retention requirement to an originator in certain circumstances, which may result in secondary market purchasers imposing risk retention requirements on banks and other lenders that originate loans for secondary market sale.  Securitizations comprised solely of mortgages loans that meet a “qualified residential mortgage” loan standard to be defined by the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, the Secretary of Housing and Urban Development and the Federal Housing Finance Agency are not subject to this retention requirement.  The Dodd-Frank Act provides relatively little guidance on the requirements for a qualified residential mortgage loan beyond reciting certain underwriting and product features that may result in lower default risk and that the agencies are required to consider and requiring that the definition of qualified residential mortgage loan be no broader than the definition of “qualified mortgage” loan.  The agencies have released a proposal that defines a “qualified residential mortgage” loan more narrowly than the currently-proposed definition of a “qualified mortgage” loan.  These agencies are expected to finalize the qualified residential mortgage loan definition early next year.
• Basel III Risk-Based Capital Framework:  The federal banking agencies have proposed revised risk-based capital rules that would implement the Basel III framework, including by raising capital requirements related to mortgage loans.  In general, these rules would assign higher risk weights to residential mortgage loans with higher loan-to-value ratios calculated in the manner required by the rule.  Further, the rules divide mortgage loans into two categories: “Category 1” mortgage loans that comply with certain prudential requirements that would qualify for lower risk-weights; and “Category 2” mortgage loans that do not meet these requirements and that would be subject to higher capital requirements than Category 1 mortgage loans.  In addition to requiring higher capital levels for certain mortgage loans, the proposed rules would treat early default clauses and premium refund clauses as credit-enhancing representation and warranties, which means that any loan sold with such representations or warranties would be subject to a 100% credit conversion factor for the life of such representation or warranty.  In response to significant comments from industry, members of Congress and state regulators, the federal banking agencies have extended the expected time line for finalizing revisions to the risk-based capital rules.  Consequently, a revised or final version of the new risk-based capital rules is not expected until well into 2013.
• The chart accompanying this summary sets forth the key requirements of the “qualified mortgage” loan safe harbor, the “qualified residential mortgage” loan exception from the risk retention requirement, and the requirements for a “Category 1” mortgage loan that would qualify for a lower risk weight than other types of mortgage loans.  The chart denotes in bold text which proposed rule establishes the most restrictive requirement.

Individually, each of the requirements described on the chart has the potential to tighten credit markets by imposing higher underwriting standards on particular types of lenders and limiting the types of mortgage credit these lenders may offer.  Combined, by covering a variety of lenders in various circumstances as well as secondary market purchasers, the effect of these rules is likely to be even more dramatic and may operate to effectively constrain mortgage credit in the United States to all but the most “plain vanilla” of mortgage products that satisfy the requirements of all three rules.

The SEC settled public administrative and cease and desist proceedings against a mutual life insurance company (“Respondent”) related to findings that the prospectuses and sales literature for certain of Respondent’s variable annuity products failed to sufficiently disclose key aspects of those products.  This article summarizes the SEC’s findings, which Respondent has neither admitted nor denied.

Background.  From 2007-2009, the Respondent offered a guaranteed minimum income benefit (“GMIB”) rider as an optional feature in connection with certain variable annuity products. These variable annuity products and the GMIB riders were described in prospectuses filed with the SEC under the Securities Act of 1933 and the Investment Company Act of 1940 and in sales literature filed with FINRA (the prospectuses and the sales literature together, the “Disclosure Documents”).  According to the SEC, the aggregate investment in the GMIB riders by July 2009 was approximately $2.5 billion.

GMIB Rider.  Under the terms of the GMIB rider, the GMIB value earned interest annually subject to a cap on the maximum value and, subject to certain conditions, investors had the flexibility to make withdrawals during the accumulation phase of the annuity.  The Disclosure Documents described this withdrawal feature in detail.  The SEC’s investigation focused on the disclosures regarding the impact of withdrawals once the GMIB value reached its maximum value, or “cap.”  Specifically, the SEC found that the Disclosure Documents did not sufficiently explain that once the GMIB cap was reached the GMIB value would cease to earn interest and any subsequent withdrawals would reduce the GMIB value on a pro-rata basis.  The SEC found that the Disclosure Documents implied the opposite, that interest would continue to accrue once the cap was reached and dollar-for-dollar withdrawals would still be available.

As a result of its investigation, the SEC found that a number of sales agents and others responsible for selling the GMIB riders did not understand the impact of making withdrawals after the cap was reached and some sales agents believed that investors could maximize their benefit by continuing to make annual withdrawals after the cap was reached.  The SEC found that investors engaging in this practice could have suffered significant long term consequences, including losing all the value of their future income stream.

The SEC cited several instances of emails from supervisory sales personnel and sales agents acknowledging confusion over the impact of withdrawals once the cap was reached and the disclosures regarding this feature. 

Respondent’s Remedial Efforts.  By March 2009, Respondent had ceased offering the riders, and by May 2009 it had revised the explanation in the relevant prospectuses of the consequences of taking withdrawals after the GMIB value reaches the cap.  Following the SEC’s investigation, Respondent removed the cap entirely from these riders so that no investor would ever reach the cap. 

Violations.  The SEC determined that the Respondent had willfully violated Section 34(b) of the Investment Company Act of 1940, which prohibits materially false or misleading statements in documents filed with the SEC.  In so finding, the SEC noted that “[p]rospectus disclosures that do not go far enough in explaining the features of a product violate Investment Company Act Section 34(b).  In re Fundamental Portfolio Advisors, Inc., 56 SEC 651, 675 (2003) (‘prospectus disclosures, while accurate, do not go far enough’).”

Sanctions.  The Respondent agreed to cease and desist from violations of Section 34(b) and to pay a $1.625 million civil penalty.  In determining the amount of the penalty, the SEC took into account Respondent’s remedial efforts.

SEC Focus on Investor Communications.  With reference to this settlement, it is also worth noting remarks made by Norm Champ, Director of the SEC’s Division of Investment Management, in a speech delivered at the ALI CLE 2012 Conference on Life Insurance Company Products shortly before the settlement agreement was announced.  Mr. Champ’s speech highlighted a number of key themes on which the staff is currently focusing, key among them, effective investor communications.  Among other things, Mr. Champ urged the insurance industry to be proactive in considering how best to inform investors about contract risks.  He noted recent decisions by companies to stop accepting additional purchase payments on outstanding contracts and to make exchange offers to terminate benefits on variable annuities.  He encouraged careful consideration of product design and disclosure going forward.

In response to a provision in the Dodd-Frank Act removing an investment grade credit rating requirement in Section ­­6(a)(5) of the Investment Company Act of 1940 (the “Investment Company Act”), which provides a registration exemption for  business and industrial development companies (“BIDCOs”), the SEC adopted new Rule 6a-5 under the Investment Company Act.  (BIDCOs are companies that operate under state statutes designed to promote direct investment and loan financing, as well as managerial assistance, to state and local enterprises.)  The new rule establishes the credit quality standard that certain debt securities must meet in order to be eligible investments for an entity relying on the BIDCO exemption. 

The Dodd-Frank Act contains a number of provisions designed to eliminate reliance on credit ratings in federal financial regulatory oversight.  The most sweeping of these is the broad mandate requiring each federal agency to conduct a review of the use of credit ratings in its rules and, based on that review, remove any reference to or requirement of reliance on credit ratings in its rules and substitute another standard of creditworthiness that it deems appropriate.  The Dodd‑Frank Act also directly amended a number of statutory provisions, such as Section 6(a)(5), to replace an existing credit rating requirement with a requirement to meet a standard of credit-worthiness to be established by the specified federal agency.  (Section 6(a)(5) formerly  required the debt securities in question to be rated investment grade by at least one nationally recognized statistical rating organization (“NRSRO”) in order to be eligible BIDCO investments.)

The BIDCO Exemption.  Among the conditions in Section 6(a)(5) for the BIDCO exemption, Section 6(a)(5)(iv) prohibits a BIDCO from purchasing any security issued by an investment company or any company exempt from the definition of investment company under Section 3(c)(1) or 3(c)(7) of the Investment Company Act (a “private fund”) unless the security is (a) a debt security that meets the standard of credit-worthiness specified by the SEC (the “Credit-Worthiness Standard”); or (b) a security issued by a registered open-end fund that is required by its investment policies to invest not less than 65% of its total assets in debt securities that meet the Credit-Worthiness Standard or are determined by the fund to be of comparable quality.

Credit-Worthiness Standard.  Under Rule 6a-5, a BIDCO meets the Credit-Worthiness Standard if the BIDCO’s board of directors or members (or its or their delegate) determines, at the time of purchase, that the debt security is (i) subject to no greater than moderate credit risk and (ii) sufficiently liquid that the security can be sold at or near its carrying value within a reasonably short period of time.  The SEC release adopting Rule 6a-5 notes that this standard is similar to the standard in Rule 10f-3 under the Investment Company Act for eligible municipal securities.  The release states that the standard of credit-worthiness in Rule 6a-5 “is designed to achieve the same degree of risk limitation as the credit rating it replaces.”  (Note that because Rule 6a-5 defines the Credit-Worthiness Standard, it also applies to the second category of eligible investments under Section 6(a)(5)(iv) as described above.)

Considerations.  The SEC expressly chose not to specify particular factors or tests that are required for a determination under Rule 6a-5.  The adopting release notes that “number and scope of factors that may be appropriate to making a credit quality determination with respect to a security may vary significantly depending on the particular security.”  The release goes on to provide that:

The standard we are adopting is designed to limit BIDCOs to purchasing debt securities issued by investment companies or private funds of sufficiently high credit quality that they are likely to maintain a fairly stable market value and may be liquidated easily, as appropriate, for the BIDCO to support its investment and financing activities.  Debt securities (or their issuers) subject to a moderate level of credit risk would demonstrate at least average credit-worthiness relative to other similar debt issues (or issuers of similar debt).  Moderate credit risk would denote current low expectations of default risk associated with the security, with an adequate capacity for payment by the issuer of principal and interest.  In making their credit quality determinations, a BIDCO’s board of directors or members (or its or their delegate) can also consider credit quality reports prepared by outside sources, including NRSRO ratings, that the BIDCO board or members conclude are credible and reliable for this purpose.  [footnotes omitted]

Effectiveness.  Rule 6a-5 becomes effective December 24, 2012.

The staff of the CFTC’s Division of Clearing and Intermediary Oversight issued a no-action letter providing guidance regarding CFTC Regulation 23.451, a “pay-to-play” rule which prohibits (subject to certain exceptions) swap dealers from entering into a swap with a governmental Special Entity within two years after any contribution to an official of such governmental Special Entity was made by the swap dealer or its “covered associates” (certain managers and employees of the swap dealer).  Regulation 23.451 is a component of the business conduct standards for swap dealers adopted by the CFTC in February 2012.  The no-action letter addresses dealings with certain “governmental plans,” as defined in the Employee Retirement Income Security Act of 1974 (“ERISA”), and the application of the Regulation’s “look-back” provision.

Governmental Plans.  In the no-action letter, the CFTC’s Division of Swap Dealer and Intermediary Oversight states that it will not recommend enforcement action against any swap dealer or covered associate for failure to comply with Regulation 23.451 with respect to “governmental plans” as defined in Section 3 of ERISA.  The letter notes that Regulation 23.451’s limitations continue to apply with respect to other governmental Special Entities as defined in the Regulation, which also include any “State, State agency, city, county, municipality, other political subdivision of a State, or any instrumentality, department, or a corporation of or established by a State or political subdivision of a State.”  The letter explains that the relief is intended, in part, to harmonize CFTC regulations in this area with “pay-to-play” rules enacted by the SEC and the Municipal Securities Rulemaking Board, neither of which apply with respect to officials of federal or other non-state or non-local government agencies, instrumentalities, or plans.

Two-Year Look-Back.  The no-action letter also clarifies that the two-year “look-back” during which contributions are prohibited does not include any time period that precedes the date on which a swap dealer is required to register as such.  For example, for an entity that is required to register as a swap dealer on December 31, 2012 (the earliest date on which an entity will be required to register as a swap dealer), any contributions made by it or its covered associates prior to December 31, 2012, are not included in the “look-back.”

The staff of the CFTC’s Division of Swap Dealer and Intermediary Oversight and Division of Market Oversight issued a  no-­­action letter that delays the onset of certain swap dealer reporting obligations.  Pre-existing CFTC regulations and guidance stated that swap dealers must begin reporting under the real-time public reporting rules (embodied in Part 43 of the CFTC’s regulations), swap data repository reporting rules (embodied in Part 45), and historical swap data repository reporting rules (embodied in Part 46) by the earlier of the date on which the swap dealer is required to register as a swap dealer and the date on which it applies for registration.  Therefore, registering as a swap dealer before the registration deadline required the swap dealer to begin reporting under these regulations earlier than would have otherwise been required.  Responding to concerns raised by market participants, the no-action letter effectively allows swap dealers to delay reporting until the deadline for them to register as such, even if they register earlier.  This relief applies to the Part 43 and Part 45 reporting rules and expires on April 10, 2013, at which point all swap counterparties must be in compliance with their reporting obligations.

In response to a request by the International Swaps and Derivatives Association expressing concern that the large volume of historical swaps could make meeting the Part 46 reporting compliance date difficult, the no-action letter also extends the deadline for the reporting of historical swaps to 30 days after the swap dealer is required to begin reporting swap transaction data under the Part 43 and Part 45 reporting rules, after giving effect to the extension provided in the no­-action letter.  This relief also expires on April 10, 2013, with the result that those swap dealers required to register on or in the 29 days prior to April 10, 2013 will not have 30 days between the applicable compliance dates.