Financial Services Alert - December 26, 2012

The FRB is requesting comment on a proposed rule (the “Proposal”) to implement the enhanced prudential standards that it is required to establish under Section 165 of the Dodd-Frank Act and the early remediation requirements it is required to establish pursuant to Section 166 of the Dodd-Frank Act.  The Proposal would apply to foreign banking organizations (an “FBO”), which generally include foreign banks with a presence in the U.S. as a result of operating a branch, agency or commercial lending company subsidiary in the U.S. or controlling a bank in the U.S. and any company of which such a foreign bank is a subsidiary.  The Proposal would also generally apply to foreign nonbank financial companies designated by the Financial Stability Oversight Council (“FSOC”) as being subject to FRB supervision; however, the FRB has stated that it expects that it would tailor the enhanced prudential standards to individual foreign nonbank financial companies, as necessary, upon designation by the FSOC.  Most aspects of the Proposal would only apply to FBOs with global consolidated assets of $50 billion or more, but certain aspects of the proposal will apply to FBOs and foreign savings and loan holding companies that reach a $10 billion asset threshold.  The proposed enhanced prudential standards include risk based capital and leverage requirements, liquidity standards, risk management and risk committee requirements, single counterparty credit limits, stress test requirements, and a requirement that certain FBOs establish an intermediate holding company through which to conduct certain U.S. operations.  The prudential standards become more stringent as an FBO’s asset size and scope of U.S. operations increase.  Comments are due on the Proposal by March 31, 2013.  A chart, prepared by Goodwin Procter, that presents a high level summary of the Proposal and illustrates how the Proposal’s prudential requirements would apply to various types of FBO’s depending on asset size and U.S. footprint is available by clicking here.

The FDIC released a study concerning community banking (the “Study”), which discusses, among other topics, the definition of “community bank,” structural changes among community and non-community banks, the geography of community banking, the financial performance of community banks compared to non-community banks, the performance of community bank lending specialty groups and capital formation at community banks.

Among the key FDIC findings in the Study were that during the 27-year period from 1984 to 2011, the asset composition of community banks changed with 26.6% of total assets being held in commercial real estate loans in 2011 as opposed to 13.2% in 1984.  During the same period, community banks’ mortgage loans decreased from 29% to 20.3%, consumer loans decreased from 8.3% to 2.7% and commercial and industrial loans remained at a level of 8.3% of total assets.  Community banks’ other assets were in other types of loans and in investment securities.

The FDIC also found in the Study that during the period from 1984 to 2011, community banks’ share of total U.S. banking assets decreased from 38% to 14%, but that community banks comprised 95% of U.S. banking organizations, 92% of FDIC-insured banks and continue to be critical to small business lending, lending to farms and job creation.

The Study developed a new definition of “community bank” that considers the extent of the institution’s traditional lending and deposit gathering activities and the limited geographic scope of the organization, as well as its size.

In a press release accompanying the Study, FDIC Chairman Gruenberg said that, in addition to the steps already taken (such as improvements to the pre-examination process to reduce FDIC requests for unnecessary or irrelevant documents and improvements to the timing of delivery and substance of post-examination reports), the FDIC will seek to “identify other steps to improve the examination and rulemaking process for community banks, while maintaining our supervisory standards.”

The large Swiss banking organization, UBS AG (“UBS”) agreed to pay an aggregate of approximately $1.5 billion in fines and other penalties (the “Aggregate Fine”) to regulators in the U.S., the U.K. and Switzerland to resolve claims that they manipulated the London Interbank Offered Rate (Libor) and other interest rate benchmarks.  These interest rate benchmarks are tied to the pricing and values of trillions of dollars of corporate and consumer loans, derivatives and other financial products.  The settlements include agreements with the U.S. Department of Justice (“DOJ”), the Commodity Futures Trading Commission (“CFTC”), the U.K.’s Financial Services Authority (“FSA”) and the Swiss Financial Market Authority.  No criminal charges were filed by the DOJ against UBS A.G., the parent holding company.  A Japanese subsidiary of UBS, UBS Securities Japan Co., Ltd. (“UBS Japan”), agreed to plead guilty to one count of felony wire fraud as part of the overall settlement.  Separately, the DOJ announced that it had commenced an action charging two former UBS traders with conspiracy wire fraud and price fixing in connection with their alleged attempts to manipulate the Yen Libor.

DOJ Actions

UBS entered into a non-prosecution agreement with the DOJ under which UBS agreed to pay $500 million of the Aggregate Fine, and to cause UBS Japan to plead guilty to one count of wire fraud.  As noted above, separately, the DOJ filed a criminal complaint against two former UBS traders.

CFTC Action

The CFTC issued an order against UBS AG and UBS Japan citing their role in manipulating Libor, Euribor, and certain other interest rate benchmarks.  The order requires the UBS entities to pay a $700 million civil monetary penalty (part of the Aggregate Fine) and to take certain steps to ensure the integrity and reliability of UBS’s future benchmark interest rate submissions.

U.K. and Swiss Actions

Furthermore, in related actions by oversees regulators, the United Kingdom’s Financial Services Authority imposed a £160 million British Pounds (approximately $259.2 million) penalty), which is part of the Aggregate Fine, and the Swiss Financial Market Authority ordered UBS to disgorge 59 million Swiss Francs (approximately $64.3 million) (as part of the Aggregate Fine).

FINRA has provided additional Guidance on Rule 2111, the Suitability Rule, in FRN 12-55.  The new guidance amends frequently asked questions (FAQs) first published in FRN 12-25 in May, 2012, and addresses in particular the scope of the terms “customer” and “investment strategy.”  FINRA Rule 2111 became effective on July 9, 2012.  For a discussion of the original FAQs, see the article “FINRA Issues Further Guidance on Suitability Rule” in the June 5, 2012 Financial Services Alert.

Customers and Potential Investors

Question 6 of the original FAQs asked, “what constitutes a ‘customer’ for purposes of the suitability rule?”  That has become question 6(a), and FINRA has added language to clarify that the term customer includes not only a person who opens a brokerage account at a broker-dealer but also a person who does not open an account but who “purchases a security for which the broker-dealer receives or will receive, directly or indirectly, compensation even though the security is held at an issuer, the issuer’s affiliate or a custodial agent… or using another similar arrangement.”  Firms that act as placement agents but do not open customer accounts are, therefore, still responsible for determining the suitability of recommendations to investors who purchase securities for which the firm receives placement agent fees.

In newly-created question 6(b), FINRA explains that if a broker-dealer makes a recommendation to a potential investor (one who is not yet a customer), the suitability rule applies only if the potential investor subsequently purchases the security through that broker-dealer.  Thus, a broker-dealer will not be liable for making an unsuitable recommendation to a potential investor if the broker-dealer learns that the transaction is not suitable and declines to enter into the transaction with the potential investor, even if the potential investor finds another broker-dealer to execute the transaction.

Investment Strategy Recommendations

FAQ 7, addressing the meaning of “investment strategy,” was amended in part to delete the following sentence:  “The new rule would cover a recommended investment strategy involving a security or securities regardless of whether the recommendation results in a securities transaction or even mentions a specific security or securities.”  While FINRA has not explained its reasoning for this change, it is consistent with the definition of customers in new FAQ 6(b) to exclude potential investors who do not enter into a transaction with the broker-dealer.

FAQ 10, addressing investment strategies involving both a security and a non-security investment, has been split into two parts.  In FAQ 10(a), FINRA clarifies that where a recommendation does not refer to a security or securities, the suitability rule is not applicable.  This would be true, for example, where a broker recommends a non-security investment and the customer independently decides to liquidate securities positions and apply the proceeds to the non-security investment.  Finally, in new FAQ 10(b), FINRA discusses the responsibility of a broker-dealer with respect to the non-security component of a recommendation of an investment strategy with both a security and non-security component.  The broker-dealer’s suitability analysis of such a mixed investment strategy “must be informed by a general understanding of the non-security component of the recommended investment strategy.”  FINRA further states that where the non-security component involves an outside business activity of the broker-dealer (for example, an insurance business), the broker-dealer’s general understanding of the outside business activity would be based on the information and considerations required by FINRA Rule 3270 (Outside Business Activities of Registered Persons).

The CFTC’s Division of Swap Dealer and Intermediary Oversight (the “Division”) has issued no-action relief to permit foreign-owned U.S. banks to exclude the swap activity of their foreign affiliates from the calculations of swap activity for purposes of the de minimis exception included in the definition of “swap dealer.”

The letter provides that the Division will not recommend that the CFTC take enforcement action against any U.S. bank that is wholly owned by a foreign entity for failure to include the swap dealing activities of its foreign affiliates, or the U.S. branches of such affiliates, with respect to swap positions executed from and after October 12, 2012, for purposes of the de minimis exception.  The relief is conditioned on a number of requirements.  Among other requirements, the bank must be indirectly wholly-owned by a foreign entity; the bank must be a nationally chartered bank regulated by a U.S. prudential regulator; its ultimate foreign owner must be registered with the CFTC as a swap dealer; the U.S. bank’s direct parent must be registered with and subject to oversight by the FRB as a financial holding company and must file its financial statements with the SEC; no swap obligations of the foreign-owned U.S. bank may be guaranteed or otherwise supported by its foreign affiliates; and the foreign-owned U.S. bank must not rely on its foreign affiliates for operational servicing of its swaps business and must make its own credit determinations with respect to its swaps activities.  Banks wishing to avail themselves of the relief must e-mail certain information to the CFTC.

The CFTC approved a final rule that will require futures commission merchants, certain introducing brokers, retail foreign exchange dealers, and certain members of designated contract markets or swap execution facilities to record oral communications that lead to the execution of a transaction in a commodity interest.  Covered communications include those concerning quotes, solicitations, bids, offers, instructions, trading, and prices.  Oral records must be retained for at least one year, while certain written records must be retained for at least five years.  The rule, which amends CFTC Regulations 1.31 and 1.35, is intended to conform the regulations to recordkeeping requirements for swap dealers and major swap participants.

The final rule will become effective on February 19, 2013.  Compliance with the oral communications recordkeeping requirements will be required no later than December 21, 2013.

The CFTC adopted interim final rules that have the effect of delaying the mandatory compliance dates applicable to various pre-existing rules.  The affected rules pertain to business conduct standards for swap dealers and major swap participants, particularly those dealing with recordkeeping and reporting requirements, standards for dealing with counterparties, and swap documentation.  These rules are generally covered by the existing ISDA Dodd-Frank Protocol or by a second ISDA protocol currently under development, and the extension was intended, in part, to give market participants more time to adopt the existing protocol and to give ISDA additional time to complete the second protocol.  In the absence of the relief, compliance with some of the rules would have been required beginning on January 1, 2013.

More specifically, compliance dates for several items included in subparts F, H, and I of Part 23 of the CFTC’s Regulations were delayed until May 1, 2013.  Compliance dates for certain rules pertaining to portfolio reconciliation and swap trading relationship documentation were delayed until July 1, 2013.  A number of compliance dates pertaining to subparts F, H, and I remain unchanged.

The interim final rules will become effective immediately upon publication in the Federal Register.

The CFTC issued a number of no-action relief letters as year-end approached.  In the absence of the relief, compliance with a number of CFTC rules and regulations would have been required starting on December 31, 2012, or January 1, 2013.  The following is a brief summary of certain of these letters.

Exclusions from the de minimis calculation for purposes of the “swap dealer” definition

Several of the no-action letters concern the manner in which calculations for the de minimis exception to the swap dealer definition are made.  Specifically, these letters allow certain swaps activities to be excluded from the calculations that must be made to determine whether an entity trades a sufficient volume of swaps to require it to register under the “swap dealer” definition.  For example, one letter permits the exclusion from the de minimis calculation of certain swaps entered into as part of “multilateral portfolio compression exercises,” which allow swap market participants to use netting and off-setting to reduce the size and number of outstanding swaps between them.

A second letter permits the exclusion from the de minimis calculation of certain swap activity by floor traders.  The CFTC noted in the letter that certain swaps entered into by floor traders on or subject to the rules of a swap execution facility (“SEF”) are not considered for the purpose of determining whether the floor trader is a swap dealer, provided that certain conditions are met; however, because the CFTC has not yet finalized its rules regarding SEFs, market participants could not, in the absence of relief, avail themselves of this exclusion.  Accordingly, the relief permits an entity to exclude, for purposes of the de minimis calculation, a swap that is submitted to a registered derivatives clearing organization (“DCO”) for clearing, provided that the entity complies with certain conditions of the floor trader exclusion and meets certain other conditions.  This relief expires on July 1, 2013.  Those wishing to avail themselves of the relief must e-mail certain information to the CFTC prior to December 31, 2012.

A third letter provides that, on a time-limited basis, swaps transacted on the Natural Gas Exchange (“NGX”), a Canadian entity that has applied for registration with the CFTC as a Foreign Board of Trade (“FBOT”), are not required to be considered in calculations for purposes of the swap dealer de minimis exception.  The relief expires on the earlier of (1) March 31, 2013 or (2) the granting or denial of the NGX’s application for registration as an FBOT.

Relief from reporting requirements

A number of the no-action letters provide temporary relief from certain reporting requirements.  For example, the CFTC’s Division of Market Oversight (the “DMO”) issued a no-action letter providing relief to swap dealers that are not clearing members regarding the timing of compliance with large swap trader reporting requirements for physical commodity swaps and swaptions embodied in Part 20 of the CFTC’s regulations.  The letter provides that the DMO will not recommend that the CFTC commence an enforcement action against a non-clearing member swap dealer for failure to submit certain reports under Part 20 for the period from December 11, 2012, until March 1, 2013.  Non-clearing member swap dealers satisfying the conditions of CFTC Regulation 20.10(e) have until September 1, 2013 to comply.  Any entity relying on the no-action relief must state that it is doing so in an e-mail to the CFTC by no later than the date on which the entity applies for swap dealer registration.

The DMO also issued a no-action letter providing relief to swap dealers and major swap participants from the swap data recordkeeping and swap data repository reporting requirements for “CDS Clearing-Related Swaps,” which are essentially forced swaps entered into by clearing members of a DCO in accordance with DCO rules.  The letter states that the DMO will not recommend that the CFTC take enforcement action against a reporting counterparty for failing to comply with its swap data reporting requirements for CDS Clearing-Related Swaps, subject to certain conditions.  The no-action relief expires on June 30, 2013.

An additional letter provides relief from the CFTC’s regulations involving the real-time reporting of swap transactions (embodied in Part 43 of the CFTC’s regulations) and swap data recordkeeping and reporting requirements (embodied in Part 45) in the context of prime brokerage arrangements relating to any uncleared over-the-counter transaction meeting the “swap” definition.  The letter, which acknowledges that the regulations could be read to require reporting by multiple parties, allows the parties in prime brokerage transactions to allocate reporting responsibilities between the prime brokers and executing dealers, provided that certain conditions are met.  The relief expires “on or before” June 30, 2013.

Another letter provides relief from CFTC Regulation 45.4(b)(2)(ii), which requires the reporting of valuation data for all swaps cleared by a DCO.  The letter provides that the DMO will not recommend that the CFTC take enforcement action against a swap dealer or major swap participant for its failure to comply with Regulation 45.4(b)(2)(ii), provided that certain conditions are met.  The relief will expire on June 30, 2013.

Finally, the DSIO issued a no-action letter providing relief to certain swap dealers from the requirement to prepare and furnish to the CFTC an annual report for the fiscal year that ends on December 31, 2012.  The relief only applies to swap dealers that (1) are required to register as swap dealers by December 31, 2012, (2) are currently regulated by a U.S. prudential regulator or are registrants of the SEC, and (3) have a fiscal year‑end of December 31, 2012 (“Covered Firms”).  The letter explains that under the strict terms of the regulation in question, absent relief, an annual report submitted by a Covered Firm for fiscal year 2012 would cover only a single day:  December 31, 2012.

Other relief

The CFTC issued several other letters as well.  For example, one letter provides relief from the post-allocation swap timing requirement of CFTC Regulation 45.3(e)(ii)(A), a part of the swap data reporting rules involving allocations, which take place after a trade and involve a so-called “agent” allocating portions of the executed swap among various clients.  The no-action letter addresses concerns that, because swap counterparties may be located in different time zones and in jurisdictions with different business day or holiday calendars, it is possible that an agent allocating a swap will be unable to inform the reporting counterparty of the identities of the allocated entities within the timing required by the regulations.  The letter allows for additional reporting time for a swap in which the agent is located in a jurisdiction other than that of the reporting counterparty with a time zone difference greater than four hours, subject to certain conditions.  The relief provided by the letter expires on June 30, 2013.

In another letter, the DSIO provided that, notwithstanding certain business conduct standards regulations to the contrary, it will not recommend that the CFTC take an enforcement action against a swap dealer or major swap participant for failure to disclose the pre-trade mid-market mark to a counterparty in certain derivatives transactions both prior to and following the issuance of final CFTC regulations governing the registration of swap execution facilities SEFs, provided that certain conditions are met.

Finally, the CFTC’s Division of Clearing and Risk issued a no-action letter stating that it would not recommend that the CFTC take enforcement action against the Japan Securities Clearing Corporation (“JSCC”) for failure to register as a DCO, or against a qualified clearing participant of JSCC for failure to clear a swap that is required to be cleared through a registered DCO, provided certain conditions are met.  The relief expires on the earlier of December 31, 2013, or the date on which JSCC registers as a DCO with respect to its “IRS Clearing Business.” The Division of Clearing and Risk also issued a similar no-action letter pertaining to Singapore Exchange Derivatives Clearing Limited (“SGX-DC”), which expires on the earlier of December 31, 2013, or the date on which SGX-DC registers as a DCO.

The SEC issued an exemptive order granting conditional relief from compliance with certain provisions of the Securities Exchange Act of 1934 (the “Exchange Act”) in connection with a program to commingle and portfolio margin customer positions in cleared credit default swaps (“CDS”), including both swaps and security-based swaps, in a segregated account.  Portfolio margining permits margin to be established based on the overall value and risks of a portfolio of assets, rather than position by position.  The Dodd-Frank Act provided the SEC and CFTC with the authority to facilitate portfolio margining by allowing cash and securities to be held in a futures account, and futures and options on futures and related collateral to be held in a securities account, subject to some conditions.  The exemptive relief provided in the SEC order applies primarily to Sections 3E(b), 3E(d), and 3E(e) of the Exchange Act, which generally require brokers, dealers, and security-based swap dealers to treat security-based swap customer money, securities, and property as belonging to the customer and to separately account for such customer assets, restrict the ability to invest such assets of the security-based swap customer and impose certain prohibitions on the disposition and use of such assets.

The order provides exemptions for two classes of persons.  One exemption is for a clearing agency registered under the Exchange Act and registered as a derivatives clearing organization (“DCO”) under the Commodity Exchange Act (the “CEA”) to perform the functions of a clearing agency for CDS under a program to commingle and portfolio margin CDS for customer positions.  Although this exemption was requested by ICE Clear Credit, LLC, it is available to any other DCO that can satisfy its conditions.  The second exemption is for dual-registered broker-dealers and futures commission merchants (“FCMs”) that elect to offer a program to commingle and portfolio margin customer positions in CDS in customer accounts maintained in accordance with certain provisions of the CEA and related regulations.  Certain conditions apply, and are intended to preserve the ability of customers to select between the segregation requirements and customer protections afforded under the Exchange Act and the CEA, to help ensure that broker-dealers and FCMs collect sufficient margin, and to help ensure that customers receive relevant disclosures.

The order explains that the SEC believes that providing the relief is necessary and appropriate, in the public interest and consistent with the protection of investors, because it will promote a more accurate measure of the risk of the total position of the customer based on off-setting positions, and would also increase efficiency and reduce costs by more closely aligning the costs of maintaining a cleared CDS portfolio to the risks of the portfolio.

Finally, the order requests comments on the exemption generally, and specifically requests comment on whether additional conditions should apply and, if so, what those additional conditions should be and why.

The relief became effective on December 19, 2012.  Comments are due no later than February 19, 2013.