Financial Services Alert - February 12, 2013

FRB Governor Duke, a former community banker, made a presentation to the Southeastern Bank Management and Directors Conference at the University of Georgia’s Terry College of Business concerning the future of community banking.  Ms. Duke is the Chair of an FRB Subcommittee that makes recommendations about matters related to community bank supervision and regulation. 

Governor Duke stressed that credit metrics at community banks are continuing to improve since the recent financial crisis: the levels of problem loans have been reduced; credit underwriting standards remain restrictive; deposit growth has outpaced loan demand; and reliance on wholesale funding has been reduced.  Community banks’ capital positions are stronger, but they face substantial interest margin pressure because of historically low interest rates and weak loan demand.  Governor Duke stated that even with this relatively weak economic environment, community banks can thrive if they use their creativity, deep community ties; and dexterity to customize financial solutions and provided that they maintain strong risk management processes.

Governor Duke next discussed the burden of new, post-financial crisis regulations on community banks and said that the FRB recognizes that the burden of regulations often falls disproportionately on smaller banks.  However, Governor Duke asserted, community banks have been extremely successful in convincing the banking agencies to direct Dodd-Frank Act regulations primarily at larger, systemically important banks and to reject “one-size-fits-all” regulations, i.e., to cause new regulations to take into account the size and business model complexity of the applicable bank.

On February 8, 2013, the Department of Labor (the “DOL”) issued Advisory Opinion 2013-01A in response to a written request from the Securities Industry and Financial Markets Association (“SIMFA”), regarding the application of certain ERISA requirements to “cleared swap” transactions involving plans subject to ERISA.  Effective September 9, 2013, certain types of swaps with an ERISA plan as a counterparty generally must be cleared through certain clearing organizations (as discussed in the December 4, 2012 Financial Services Alert).  Prior to the issuance of this Advisory Opinion many swap clearing organizations, clearing members of such organizations and futures commission merchants had expressed concern that engaging in cleared swaps (and related transactions) with ERISA plans could subject such organizations to fiduciary liability under ERISA.  Specifically, the Advisory Opinion clarifies the following, subject to the conditions discussed below:

• Margin Is Not a “Plan Asset.”  The DOL clarified that margin received from an ERISA plan and held by a swap clearing member is not a “plan asset” for purposes of ERISA.  Instead, when an ERISA plan engages in a cleared swap transaction, its asset consists of the rights embodied in the swap contract between the plan and the clearing member (including the rights regarding margin).
• Exercise of Rights Upon Default and Other Specified Events by a Clearing Member Does Not Result in Fiduciary Status.  The Advisory Opinion explains that a clearing member that exercises its rights pursuant to an agreement negotiated with an ERISA plan’s fiduciary would not be “exercising any authority and control with regard to plan assets and would not be a plan fiduciary . . . solely by reason of liquidating the swap contracts in a plan’s account and selling any collateral posted as margin in order to pay off losses suffered by such account.”
• Clearing Members Are “Parties in Interest” to ERISA Plans.   The DOL concluded that a clearing member that enters into a direct contractual agreement with an ERISA plan provides a service to the plan and is therefore a “party in interest” with respect to such plan.  Consequently, an exemption from ERISA’s prohibited transaction rules must be available in order to enter into any such arrangement.  Pursuant to the Advisory Opinion, swap central counterparties (i.e., the clearing organization) would not be deemed to be “parties in interest” to ERISA plans solely by reason of providing swap clearing services to a plan’s clearing member because such central counterparties do not provide services directly to the plan.
• QPAM Exemption Relief.  As noted above, because a clearing member providing services to an ERISA plan is considered a “party in interest” to such ERISA plan, an exemption from ERISA’s prohibited transaction rules must be available in order to enter into any such arrangement.  The DOL explained that Prohibited Transaction Exemption 84-14, the so called “QPAM Exemption” (granting relief to transactions entered into on behalf of an ERISA plan by a “qualified professional asset manager,” or a “QPAM”) would generally be available (assuming all other conditions of the QPAM Exemption are met) to the extent that (i) a QPAM negotiates and makes the decision on behalf of the plan to enter into the services arrangement and (ii) the agreement entered into by the QPAM “sets forth all of the material terms of the provision of services and guarantee” by the clearing member.  Further, the DOL explained that the QPAM Exemption can provide relief for the guarantee provided by the clearing member and liquidation and close-out transactions executed by a clearing member if the agreement covering the primary swap transaction (i.e., the agreement to provide swap clearing services) “contains sufficient terms of the subsidiary transaction such that the potential outcomes of the subsidiary transactions are reasonably foreseeable to the QPAM when entering into the [a]greement.”

The DOL stressed in the Advisory Opinion that an ERISA plan’s decision to enter into any swap arrangement remains a fiduciary action subject to ERISA’s general fiduciary duties and standards.  Finally, the DOL confirmed that it had conferred with Commodity Futures Trading Commission (“CFTC”) officials regarding the Advisory Opinion, who authorized the DOL to state that they “do not believe the conclusions reached in this [Advisory Opinion] are inconsistent” with the Commodity Exchange Act (the “CEA”) or “the CFTC’s regulation of cleared swap transactions under the CEA.”

The SEC adopted amendments to the expiration dates of certain interim final rules adopted in July 2011 (that were described in the July 5, 2011 Financial Services Alert).  The interim final rules provide exemptions under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Trust Indenture Act of 1939 to security-based swaps that were security-based swap agreements prior to the effective date of Title VII of the Dodd-Frank Act.  Because the Dodd-Frank Act defines security-based swap agreements as “securities,” such instruments would have become subject to various requirements applicable to securities in the absence of the interim final rules.  The interim final rules, however, generally exempt such instruments from the requirements of the relevant statutes, other than certain anti-fraud provisions.  The interim final rules were originally scheduled to expire on February 11, 2013.  The amendments extend the expiration date to February 11, 2014. 

The FDIC issued a Financial Institution Letter (FIL-3-2013) alerting banking institutions to recent modifications by the FDIC to the Statement of Policy for Section 19 of the Federal Deposit Insurance Act (the “FDI Act”).  Section 19 of the FDI Act prohibits, without the prior written consent of the FDIC, a person convicted of certain criminal offenses, including any criminal offense or plea bargain involving dishonesty, a breach of trust, or money laundering, from participating in the affairs of an FDIC-insured depositary institution.

The FDIC, for insured institutions, and the FRB, for bank holding companies and savings and loan holding companies, have traditionally granted waivers for individuals with such convictions on the grounds that the underlying criminal offense met all of the four criteria listed below and were deemed de minimis. Prior to the recent modifications, the FDIC Statement of Policy for Section 19’s  (the “Statement of Policy”) four (4) criteria for judging whether an offense was de minimis (all of which had to be met) were:  (i) there is only one conviction or program entry of record for a covered offense; (ii) the offense was punishable by imprisonment for a term of one year or less and/or a fine of $1,000 or less, and the individual did not serve time in jail; (iii) the conviction or program was entered at least five (5) years prior to the date an application would otherwise be required; and (iv) the offense did not involve an insured depository institution or insured credit union. The FDIC’s modifications to the Statement of Policy revise clause (ii) to now read:  “the offense was punishable by imprisonment for a term of one year or less and/or a fine of $2,500 or less [rather than $1,000 or less], and the individual did not serve more than three (3) days of actual jail time [rather than requiring that no jail time has been served].”  The FDIC said that it expects the modifications to the Statement of Policy to reduce the number of Section 19 applications and to reduce the regulatory burden on banking institutions.

Section 19 and the related Statement of Policy apply to all employees, board members, and consultants at an insured institution.  Offenses covered by Section 19 have no statute of limitations; therefore, an insured institution must consider a job applicant’s entire legal history prior to such applicant’s start date.  Whoever knowingly employs an individual contrary to Section 19 may be fined up to $1,000,000 for each day Section 19 is violated and may face up to five (5) years in jail.  The FDIC noted that both Section 19 and the modifications to the Statement of Policy apply to all FDIC-insured depository institutions and pre-empt any applicable state laws.

The Statement of Policy, as modified, became effective on December 18, 2012.