Financial Services Alert - October 29, 2013

The FRB, OCC and FDIC (the “Agencies”) jointly issued a notice of proposed rulemaking (the “Proposed Rule”) that would establish a minimum liquidity coverage ratio (the “LCR”) for banking organizations with $250 billion or more in total assets or $10 billion or more in on-balance sheet foreign exposure and for such organizations’ subsidiary depository institutions with $10 billion or more in total consolidated assets (collectively, “Covered Banking Organizations”).  The Proposed Rule would also apply to nonbanking companies that have been designated by the Financial Stability Oversight Council for supervision by the FRB because they are “systemically important financial institutions” that do not have significant insurance operations and to any depository institution subsidiaries with $10 billion or more of consolidated assets of such nonbanking companies.  The Proposed Rule, however, would not apply to banking organizations that have opted-in to the advanced approaches rule.  The Agencies noted that the Proposed Rule is generally consistent with the Basel Committee’s LCR standard “but is more stringent in certain areas.”

Under the Proposed Rule, a Covered Banking Organization is required to hold high quality liquid assets (“HQLAs”) in an amount equal to or greater than its projected cash outflows minus its projected cash inflows during a short-term stress period. For Covered Banking Organizations, the LCR standard is based on a 30-calendar day stress scenario.  Qualifying HQLAs include assets such as central bank reserves, government debt and corporate debt.  In its release accompanying the Proposed Rule, the FRB noted that the Proposed Rule “specifies how a firm’s projected net cash outflows over the stress period would be calculated using common, standardized assumptions about the outflows and inflows associated with specific liabilities, assets, and off-balance-sheet obligations.”

The FRB is also proposing on its own to implement a modified, less stringent  version of the LCR as an enhanced prudential standard for bank holding companies and savings and loan holding companies without significant insurance or commercial operations that have $50 billion or more in total assets, but are not otherwise covered under the Proposed Rule.  This LCR standard set by the FRB for smaller Covered Banking Organizations (“Smaller Covered Banking Organizations”) would be based on a 21-calendar day (rather than a 30-calendar day) stress scenario.

In addition, the Agencies have reserved the right under the Proposed Rule to apply the LCR to a company not otherwise covered because of the company’s asset size, level of complexity, risk profile, scope of operations, and affiliation with foreign or domestic covered companies or the risk they pose to the financial system.  Banking organizations with less than $50 billion in consolidated assets are not subject to the Proposed Rule.  Covered Banking Organizations (including Smaller Covered Banking Organizations) are required to be in 80% compliance with the Proposed Rule by January 1, 2015 and in full compliance with the Proposed Rule by January 1, 2017.  Comments on the Proposed Rule are due by January 31, 2014.

The FRB, FDIC, OCC and NCUA (collectively, the “Agencies”) jointly issued guidance to financial institutions entitled InterAgency Supervisory Guidance Addressing Certain Issues Related to Troubled Debt Restructurings (the “Guidance”).  In the Guidance the Agencies discuss certain issues concerning the accounting treatment and regulatory credit risk grade of commercial and residential real estate loans that have undergone troubled debt restructurings (“TDRs”).  Under generally accepted accounting principles (“GAAP”) the restructuring of debt is a TDR if the creditor grants a concession to the debtor (that it would not otherwise grant) “for economic or legal reasons related to the debtor’s financial difficulties.”  In the Guidance the Agencies state that they “continue to view prudent modifications as positive actions when they mitigate credit risk, and [the Agencies] will not criticize banks for engaging in prudent workout arrangements, even if the modified loans result in TDRs.”   The Agencies confirm that the Guidance is consistent with GAAP and with the FRB’s, FDIC’s and OCC’s joint guidance issued in 2009 that is entitled Policy Statement on Prudent Commercial Real Estate Loan Workouts.

The Guidance discusses accrual treatment of loans under GAAP and when a loan that is on nonaccrual may be restored to accrual status.  Next the Guidance explains the distinctions between a decision to modify a loan’s credit risk grade or classification and a decision to designate the loan as a TDR.  Every TDR is an impaired loan for GAAP purposes and the Guidance discusses the analysis that the Agencies expect a bank to conduct to determine whether the TDR is collateral dependent or is not collateral dependent. The Guidance then reviews the Agencies’ supervisory expectations regarding the ways banks will address the differences in impairment management and classifications and charge-off treatment for loans that are collateral dependent and for loans that are not collateral dependent.  The Guidance then discusses a bank’s right to capitalize expenses used by a bank to protect its position on a loan, e.g., by paying real estate taxes or hazard insurance premiums.  The Agencies also make it clear that the Guidance should be read in conjunction with prior guidance provided by the Agencies and the applicable accounting principles and standards issued by the Financial Accounting Standards Board.

The SEC issued a rule proposal designed to fulfill a mandate under the 2012 Jumpstart Our Business Startups (“JOBS”) Act to adopt rules that implement changes to the federal securities laws under the JOBS Act that permit capital raising through “crowdfunding.”  In broad terms, an issuer that conducts a crowdfunded offering may raise up to $1 million from a large number of accredited and unaccredited investors by selling securities through a broker or through a new type of SEC-registered intermediary known as a “funding portal.”  When sold through these intermediaries, crowdfunded securities will be exempt from the registration requirements of the Securities Act of 1933, and state securities laws.  Among other limitations, crowdfunding is not available to any issuer that (1) is required to file reports under Section 13 or Section 15(d) of the Securities Exchange Act of 1934, or (2) is an investment company as defined in Section 3 of the Investment Company Act of 1940 (the “1940 Act”), or is excluded from the definition of investment company by Section 3(b) or Section 3(c) of the 1940 Act.  (For a more detailed discussion of the JOBS Act provisions governing crowdfunding and funding portals, see the April 25, 2012 Goodwin Procter Alert.)  Comments on the SEC rule proposal are due 90 days after its publication in the Federal Register.

In a related development, FINRA published for comment proposed rules and forms for funding portals that become FINRA members in accordance with the crowdfunding provisions of the JOBS Act.  Comments on the FINRA proposal are due by February 3, 2014.

Crowdfunding will not be available to issuers, investors and intermediaries until after the implementing rules are final.

On July 30, 2013, the SEC voted to adopt amendments to certain broker-dealer financial responsibility rules, as reported in the August 13, 2013 Financial Services Alert.  Those amendments became effective on October 21, 2013.  On October 17, 2013, the SEC issued an order (Release No. 34-70701) granting a temporary exemption from certain of those amendments until March 3, 2014 (the “Order”).

In advance of the October 21 effective date, industry representatives advised the SEC staff that some broker-dealers had determined that they would be unable to complete by that date the significant operational and systems changes necessary to comply with certain of the final rule amendments.  For example, carrying broker-dealers, which maintain custody of customer securities and cash, have said that they are unable to comply before the effective date with the requirements of Rule 15c3-3(e)(5).  That provision places restrictions on a carrying broker‑dealer’s ability to use cash bank deposits to meet the reserve deposit requirements for customer accounts or proprietary securities accounts of broker-dealers (PAB accounts) by excluding cash deposits held at an affiliated bank and limiting cash held at non-affiliated banks to an amount not greater than 15% of the bank’s equity capital, as reported by the bank in its most recent Call Report.  Carrying broker-dealers advised the SEC that opening new reserve accounts and making appropriate systems changes by the October 21 effective date would be a challenge in part because it is necessary to negotiate new reserve account agreements and obtain acknowledgment letters required by Rule 15c3-3(f) from the new banks.

The Order provides a temporary exemption until March 3, 2014 for compliance with the amendments to the following:

• Rule 15c3-1(c)(2)(iv)(E)(2).  This paragraph provides that a broker-dealer need not deduct cash and securities held in a securities account at a carrying broker-dealer except where the account has been subordinated to the claims of creditors of the carrying broker-dealer.
• Rule 15c3-3, except paragraph (j)(1).  The amendments to Rule 15c3-3 include revisions to the definitions of “fully paid securities,” “margin securities,” “bank,” “free credit balances” and “other credit balances,” new definitions for “PAB account” and “Sweep Program,” and the addition of paragraph (e) relating to special reserve accounts for the exclusive benefit of customers and PAB accounts.  New paragraph (j)(1) is excepted from the exemption because it incorporates requirements from Rule 15c3-2 relating to customers’ free credit balances that are already in effect.  Rule 15c3-2 was eliminated by the amendments.
• Rule 15c3-3a.  This is Exhibit A to Rule 15c3-3 and contains the formula for determination of customer and PAB account reserve requirements of brokers and dealers.
• Rule 17a-3.  This rule was amended to add paragraph (a)(23), requiring broker-dealers to make records documenting the credit, market and liquidity risk management controls established and maintained by the broker-dealer to assist it in analyzing and managing the risks associated with its business activities.
• Rule 17a-4. This rule was amended to add paragraph (e)(9), requiring that records made pursuant to Rule 17a-3(a)(23) be maintained until three years after the termination of the use of the risk management controls documented in the records.

The SEC did not grant a temporary exemption from the other amendments to the financial responsibility rules, which became effective on October 21.  Those include amendments to Rule 15c3-1 other than paragraph (c)(2)(iv)(E)(2), new paragraph (j)(1) of Rule 15c3-3, and the new requirements of Rule 17a-11 (Notification Provisions for Brokers and Dealers) relating to net capital computations.

The Investor as Purchaser Subcommittee (the “Subcommittee”) of the SEC’s Investor Advisory Committee (the “Committee”) issued two principal recommendations (the “Recommendations”) regarding SEC adoption of a uniform standard of duty for investment advisers and broker‑dealers engaged in the delivery of personalized investment advice to retail investors.

Findings.  The Subcommittee preceded the discussion of its Recommendations with a series of findings, including the following:

1. both broker-dealers and investment advisers play an important role in helping Americans organize their financial lives, accumulate and manage retirement savings, and invest toward other important long-term goals, such as buying a house or funding a child’s college education;
2. when the federal securities laws were enacted, Congress drew a distinction between broker-dealers, who were regulated as salespeople under the Securities Exchange Act of 1934 (the “Exchange Act”), and investment advisers, who were regulated as advisers under the Investment Advisers Act of 1940 (the “Advisers Act”);
3. the roles of some broker-dealers and investment advisers have converged, with many broker-dealers offering advisory services, such as investment planning and retirement planning, that are similar to the services offered by investment advisers and marketing themselves in ways that highlight the advisory aspect of their services;
4. broker-dealers and investment advisers are subject to different legal standards when they offer advisory services – a suitability standard for broker-dealers and a fiduciary duty for investment advisers, which afford different levels of protection to the investors that rely on their services;
5. investors typically make no distinction between broker-dealers and investment advisers, and most are unaware of the different legal standards that apply to their advice and recommendations; and
6. investors may be harmed if they choose a financial adviser under a mistaken belief that the financial adviser is required to act in their best interest when that is not the case, receive recommendations that comply with a suitability standard but carry additional costs or risks without affording additional benefits, or fail to receive the ongoing account supervision that they expect based on the manner in which brokers’ advisory services are sometimes marketed.

The Subcommittee stated in its findings that the key difference between the suitability standard currently in place for broker-dealers and the fiduciary duty standard currently in place for investment advisers is the requirement that investment advisers, as fiduciaries, act in the best interests of their clients and appropriately manage and fully disclose conflicts of interest that could bias their recommendations.  The Subcommittee noted that although many investors don’t understand the meaning of “fiduciary duty,” or know whether it or suitability represents the higher standard, investors generally treat their relationships with both broker-dealers and investment advisers as relationships of trust and expect that the recommendations they receive will be in their best interests.   Accordingly, in making the recommendations, the Subcommittee stated its belief that personalized investment advice to retail customers should be governed by a fiduciary duty which includes an enforceable, principles-based obligation to act in the best interest of the customer, regardless of whether that advice is provided by an investment adviser or a broker-dealer.

Recommendation Number 1.  The Subcommittee recommended that the SEC conduct a rulemaking to impose a fiduciary duty on broker-dealers when they provide personalized investment advice to retail investors.  In making this recommendation, the Subcommittee stated that it favors accomplishing this rulemaking by amending the Advisers Act to narrow the broker-dealer exclusion from the Advisers Act while also providing a safe harbor for brokers who do not engage in broader investment advisory services or hold themselves out as providing such services.  Additionally, the Subcommittee recognized that the SEC is considering rulemaking under Section 913(g) of the Dodd-Frank Act (“Section 913”), noting that adoption of a uniform fiduciary standard for investment advisers and broker-dealers was recommended by the staff of the SEC in the Study on Investment Advisers and Broker-Dealers completed in January of 2011 as required by Section 913 (the “Section 913 Study”).  The Section 913 Study was covered in the January 25, 2011 Financial Services Alert. The Subcommittee recommended that, if the SEC chooses to adopt rules imposing a uniform fiduciary duty on investment advisers and broker-dealers under Section 913, such rules should:

1. ensure that the uniform fiduciary duty standard is no weaker than the existing Advisers Act standard by incorporating an enforceable, principles-based obligation to act in the best interests of the customer;  
2. ensure the continued availability of transaction-based recommendations, by being sufficiently flexible to permit the existence of certain sales-related conflicts of interest, subject to a requirement that any such conflicts be fully disclosed and appropriately managed; and
3. prohibit or restrict certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the SEC deems contrary to the public interest and the protection of investors, while recognizing that some forms of transaction-based payments would be acceptable under a fiduciary standard.

The Subcommittee provided supporting rationales for each aspect of the recommendation, including a discussion of reports by various industry groups supporting the adoption of a uniform standard.

Recommendation Number 2.  The Subcommittee recommended that in connection with any rulemaking adopting a uniform fiduciary duty standard for investment advisers and broker-dealers, the SEC should also adopt a uniform, plain English disclosure document to be provided to customers and potential customers of broker-dealers and investment advisers that covers basic information about the nature of services offered, fees and compensation, conflicts of interest, and disciplinary record.

The Subcommittee noted that relevant topics included in such a disclosure document might include a description of: the services provided; the fees and expenses related to such services; the compensation structure paid to the broker‑dealer or investment adviser; related conflicts of interest; any limitations on the services; the professional background of the representatives of the broker-dealer or investment adviser; and any disciplinary history.

The Subcommittee stated that Form ADV, which investment advisers use to disclose to their clients, provides a reasonable starting point for designing such a document; however, the Subcommittee noted limitations in Form ADV and recommended that the SEC work to develop an effective document conveying the relevant information to investors in a way that enables them to act on that information.

Consideration of the Recommendations.  The Committee was scheduled to consider the Recommendations on October 10, 2013; however, consideration was postponed and no action has been taken with respect to the Recommendations by the Committee or the SEC.