Financial Services Alert - March 12, 2013

Comptroller of the Currency Thomas J. Curry presented a written statement and testified on March 7, 2013 before the U.S. Senate Committee on Banking, Housing & Urban Affairs concerning supervision of national banks’ and thrifts’ (collectively, “Banks”) Bank Secrecy Act/Anti-Money Laundering (“BSA/AML”) compliance, BSA/AML compliance failures at large Banks, and the OCC’s enforcement of BSA/AML violations by Banks and by directors, officers and employees of Banks.

Comptroller Curry covered a broad range of topics and provided substantial background information in his testimony, but one area of particular interest was his discussion of recent BSA/AML compliance corporate governance breakdowns at some of the largest Banks (e.g., HSBC, Citibank and J.P. Morgan) that have led to large monetary penalties.

Comptroller Curry testified that he believes that, in general, BSA/AML compliance problems stem from four “root causes”: (1) lack of a strong culture of compliance within a Bank; (2) failure to commit sufficient and expert resources to BSA/AML compliance; (3) weaknesses in information technology and monitoring processes; and (4) lack of sound risk management.  In the aftermath of the 2007-2009 financial crisis, the OCC, said Comptroller Curry, has seen “too many banks inappropriately cut staffing and spending for BSA and anti-money laundering compliance as austerity measures…”

Comptroller Curry said that the OCC is currently in the process of preparing “detailed guidance to banks” concerning sound corporate governance processes for BSA/AML compliance that will incorporate many of the corporate governance compliance requirements imposed on certain large Banks in recent OCC BSA/AML enforcement actions, “including business line accountability for BSA/AML compliance and the independence of the compliance function.”

In his testimony, Comptroller Curry provided (as examples of concepts and provisions that the OCC may use in its future guidance) a list of nine corporate governance compliance requirements included in certain recent OCC BSA/AML enforcement actions:

1. “A designated BSA Officer with sufficient knowledge, funding, authority, independence, compensation, and supporting staff to perform his or her assigned responsibilities and maintain effective compliance with the BSA and its implementing regulations;
2. An effective governance structure to allow the BSA Officer and the compliance function to administer the program independently by reporting directly to the board of directors, or a committee thereof, with clear lines of responsibility beginning with senior management and including each line of business that is required to comply with the BSA;
3. Clearly defined channels for informing the board of directors, or a committee thereof, and senior management, of compliance initiatives, compliance risks, new product development, identified compliance deficiencies, and corrective actions undertaken;
4. Compliance staff with the appropriate level of authority and independence to implement the BSA/AML compliance program and, as needed, question account relationships, new products and services and business plans;
5. Policies and procedures that clearly outline the BSA/AML responsibilities of senior management and relevant business line employees, and that hold senior management and line of business management accountable for effectively implementing bank policies and procedures, and fulfilling BSA/AML obligations;
6. A well-defined succession plan for ensuring the program’s continuity despite changes in management, staffing, or structure, and policies and procedures to ensure that problems with excessive turnover of compliance staff or the BSA Officer function are identified, investigated and appropriately addressed by the board;
7. Policies and procedures to ensure that the bank’s risk profile is periodically updated to reflect higher risk banking operations (products, services, customers, entities, and geographic locations) and new products and services;
8. An enterprise-wide management information system that provides reports and feedback that enables management to more effectively identify, monitor, and manage the organization’s BSA risk on a timely basis; and
9. A strong BSA/AML audit function that ensures that identified deficiencies are promptly addressed and corrected.”           

With respect to potential strengthening of the OCC’s enforcement tools used against directors, officers and employees of Banks, Commissioner Curry said that the OCC is “exploring the possibility of regulatory changes that could enhance our ability to take removal and prohibition actions against bank officers, directors and employees that engage in violations of the BSA.” 

The Alert will provide a detailed discussion of the OCC’s BSA/AML corporate governance compliance guidance once it is issued and will continue to follow related developments.

The OCC released a bulletin (the “Bulletin”) providing guidance to national banks and thrifts (“Banks”) that manage short-term investment funds (“STIFs”) on the process such Banks must use for making monthly reports to the OCC.  Pursuant to the OCC rule (12 CFR 9.18(b)(4)(ii)(B), the “STIF Rule”) that imposes additional requirements on Banks managing STIFs that value assets at amortized cost, rather than mark-to-market value, for purposes of admissions and withdrawals, such Banks will be required 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.  The STIF Rule was summarized and discussed in the October 30, 2012 Financial Services Alert. 

Banks managing STIFs will be required to comply with all provisions of the STIF Rule beginning July 1, 2013, with the first monthly reports due August 7, 2013.  These reports will need to include, with respect to each STIF a Bank manages, total assets under management, market value and amortized cost valuations, portfolio maturity measures, and identifying information with respect to each security held by such STIF.  As promised in the preamble to the release of the STIF Rule, the OCC in the Bulletin has informed Banks how to gain access to the secure file transfer protocol website through which they must submit such reports.  The process is explained on the OCC’s website, which provides the registration request form, a template spreadsheet for the monthly reports and related instructions. 

Goodwin Procter  LLP has advised a number of clients on matters related to the STIF Rule and would be pleased to address any questions you have regarding the requirements imposed by the STIF Rule, including those related to avoiding some of the potential adverse consequences of the STIF Rule.  We also would be pleased to address potential alternative approaches to dealing with the significant impact of the STIF Rule on STIFs and their participants.

The Office of Chief Counsel of the IRS made a field attorney advice memorandum (the “Memorandum”) publicly available that discusses whether, and to what extent, a bank’s costs related to holding other real estate owned (OREO) property must be capitalized under Section 263A of the Internal Revenue Code. The Memorandum was released by the IRS on August 10, 2012 and was recently noted in an article published by the Bureau of National Affairs.

The Memorandum states that under Section 263A direct costs and an allocable share of indirect costs associated with an OREO property produced or held primarily for resale must be capitalized up to the dollar amount of the basis of such property.  To the extent, however, that the OREO property is held for the production of rental or investment income, rental operating expenses for the OREO property would not be required to be capitalized under Section 263A.

The discussion in the Memorandum does not break new legal ground, but (in the aftermath of the 2007-2010 financial crises) it is useful in that it provides confirming advice that is in accordance with existing IRS precedent and tax principles.  Although useful as general guidance, it is important for banks to be aware that a field attorney advice memorandum, such as the Memorandum, cannot be cited or relied upon as precedent.

The SEC issued a request for data and other information (the “Request”) to inform its consideration of whether to exercise rulemaking authority granted by the Dodd-Frank Act to (a) adopt uniform standards of conduct for broker-dealers and investment advisers when they provide personalized investment advice about securities to retail customers, and (b) otherwise harmonize broker-dealer and investment adviser regulation.  The Request follows on a Dodd-Frank Act mandated study conducted by the SEC staff (the “Study”) recommending that broker‑dealers and investment advisers be subject to a uniform fiduciary standard of conduct in providing personalized investment advice about securities to retail investors, and that the SEC consider harmonizing certain regulatory requirements for broker-dealers and investment advisers where such action appears likely to enhance investor protection.  (The Study was described in the January 25, 2011 Financial Services Alert.)

The Request seeks information on many different aspects of the current retail market for personalized investment advice and how it might be affected by the various alternative regulatory changes the Request posits or that might be suggested by commenters.  The Request also sets forth in significant detail a broad range of different types of information, particularly quantitative data, sought by the SEC, and includes suggested submission guidelines.  This article focuses on the Request’s discussion of possible standards of fiduciary standards of conduct for providing personalized investment advice about securities to retail customers, and areas of possible regulatory harmonization for broker-dealers and investment advisers.

Rulemaking Authorized But Not Mandated; Retail Customer Context

Section 913 of the Dodd-Frank Act gives the SEC discretionary rulemaking authority under the Securities Exchange Act of 1934 (the “Exchange Act”) and the Investment Advisers Act of 1940 (the “Advisers Act”) to adopt rules establishing a uniform fiduciary standard of conduct for all broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers.  Section 913 specifies that such standard of conduct “shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice” and that the standard “shall be no less stringent than the standard applicable to investment advisers under Sections 206(1) and 206(2) of the Advisers Act when providing personalized investment advice about securities.”  Section 913 defines retail customer to mean a natural person, or the legal representative of such natural person, who (1) receives personalized investment advice about securities from a broker-dealer, or investment adviser; and (2) uses such advice primarily for personal, family, or household purposes.  The Request emphasizes that the SEC is under no obligation to take action in this area, even after consideration of the information it receives in response to the Request. 

Uniform Standard of Fiduciary Conduct – Duty of Loyalty and Duty of Care

The Request presents a uniform standard of conduct for providing personalized investment advice about securities to retail customers as the basis for public comment, but disclaims it as a policy view or an indication of the ultimate direction of any regulatory action, should any be taken.  This uniform standard consists of two components, a duty of loyalty and a duty of care.  

Assumptions.  A number of assumptions would apply to the uniform standard, including the following:  (a) “personalized investment advice about securities” would include (i) a “recommendation,” as interpreted under existing broker-dealer regulations, and (ii) any other actions or communications that would be considered investment advice about securities under the Advisers Act, but would not include (A) “impersonal investment advice” as defined in the Advisers Act or (B) general investor educational tools that are not otherwise “recommendations”; (b) the uniform standard would accommodate different business models and fee structures, and would permit broker-dealers to continue to receive commissions (and would not have to charge an asset-based fee) and engage in principal trades; (c) the offering or recommending of only proprietary or a limited range of products would not, in and of itself, be considered a violation of the uniform standard; (d) the uniform standard would not generally require a broker-dealer or investment adviser to either (i) have a continuing duty of care or loyalty to a retail customer after providing personalized investment advice about securities, or (ii) provide services to a retail customer beyond those agreed; and (e) existing law and guidance governing broker-dealers, including SRO rules and guidance, would continue to apply to broker-dealers.

Duty of Loyalty.  The duty of loyalty element of the uniform standard would require an investment adviser or broker-dealer to eliminate any material conflicts of interest arising in connection with providing personalized investment advice about securities to retail customers, or provide full and fair disclosure to retail customers about those conflicts.  This duty would involve disclosure to retail customers in the form of a “general relationship guide” similar to Form ADV Part 2A, supplemented as necessary from time to time either orally or in writing.  The proposed standard would not subject broker-dealers to the transaction-by-transaction disclosure and consent requirements of Section 206(3) of the Advisers Act for principal trades (although these requirements would continue to apply to investment advisers), but would at a minimum, as with other conflicts of interest, require a broker-dealer to disclose material conflicts of interest arising in principal trades with retail customers.  The uniform standard would prohibit certain sales contests and the receipt or payment of non-cash compensation (e.g., trips and prizes) in connection with the provision of personalized investment advice about the purchase of securities.  The uniform standard would incorporate, and apply to broker-dealers, prior guidance and precedent under the Advisers Act regarding (A) the allocation of investment opportunities among clients and among a firm’s client and proprietary accounts and (B) the aggregation (“bunching”) of client orders.

Duty of Care.  The duty of care element of the uniform standard would impose the following obligations on an investment adviser or broker-dealer when providing personalized investment advice about securities to retail customers:

Suitability - The uniform standard would require an investment adviser or broker-dealer “to have a reasonable basis to believe that its securities and investment strategy recommendations are suitable for at least some customer(s) as well as for the specific retail customer to whom it makes the recommendation in light of the retail customer’s financial needs, objectives and circumstances”;

Product-specific requirements - The uniform standard would impose “[s]pecific disclosure, due diligence, or suitability requirements for certain securities products recommended (such as penny stocks, options, debt securities and bond funds, municipal securities, mutual fund share classes, interests in hedge funds and structured products)”;

Best execution - A broker-dealer, or an investment adviser responsible for selecting broker-dealers to execute client trades, would have a duty to “seek to execute customer trades on the most favorable terms reasonably available under the circumstances”; and

Fair and reasonable compensation - Compensation for services would have to be “fair and reasonable, taking into consideration all relevant circumstances.”

The Request briefly describes alternatives to the uniform standard, including:

• imposing a uniform disclosure requirement for broker-dealers and investment advisers addressing key facets of products or services they offer, and related conflicts of interest;
• imposing the uniform fiduciary standard of conduct described above, but without subjecting broker-dealers to existing Advisers Act guidance and precedent regarding fiduciary duty;
• applying the uniform fiduciary standard described above only to broker-dealers, possibly establishing a broker-dealer specific “best interest” standard of conduct no less stringent than the current standard under Advisers Act Sections 206(1) and 206(2); and
• specifying certain minimum professional obligations under an investment adviser’s duty of care not currently specified by rule.

The Request notes that commenters may formulate additional alternative approaches to the uniform standard and the other approaches it describes.

Regulatory Harmonization

The Request outlines potential areas for harmonization of the regulatory schemes for broker-dealers and investment advisers.  As with its discussion of a possible uniform standard of fiduciary conduct, the Request notes that the identification of potential areas for harmonization is not meant to suggest a policy view on the SEC’s part, the direction of any proposed action, or that any action will ultimately be taken.  The general areas cited (with selected examples) are as follows:

Advertising and Other Firm Communications – harmonizing requirements related to the content of advertising and customer communications rules and establishing consistent internal pre-  and post-use review and filing requirements for similar materials.

Finders and Solicitors - establishing similar disclosure requirements regarding any conflict associated with a solicitor’s or finder’s receipt of compensation for referring a retail customer.

Supervision - establishing a “single set of universally applicable requirements versus scaling requirements based on the size (e.g., number of employees or a different metric) and nature of a broker-dealer or an investment adviser.”

Licensing and Registration of Firms - harmonizing the disclosure requirements in Form ADV and Form BD to the extent they address similar issues and conducting a substantive review of investment advisers prior to registration.

Continuing Education Requirements for Adviser and Broker-Dealer Personnel - subjecting investment adviser personnel to federal qualification examinations and continuing education requirements.

Books and Records – expanding the recordkeeping requirements for investment advisers to match the broker-dealer obligation to retain all communications received and sent, as well as all written agreements (or copies thereof), relating to a firm’s “business as such.”

Submission Deadline

The deadline for submission of data and other information and for public comment in response to the Request is July 5, 2013.