Alert September 08, 2009

OCC Issues Three Interpretive Letters Concerning Collective Investment Funds

The OCC released three interpretive letters concerning collective investment funds established pursuant to 12 C.F.R. § 9.18.

OCC Interpretive Letters 1119 and 1120 

Interpretive Letters 1119 and 1120 are addressed to the same bank (the “Bank”), a trustee for index and model-drive collective investment funds established pursuant to 12 C.F.R. § 9.18.  An affiliate (the “Affiliate”) of the Bank proposed to acquire a business that provided various fixed-income indices.  The Bank requested confirmation that it would be permissible for the Bank to rely on the OCC’s determination set forth in OCC Interpretive Letters 1119 and 1120.  In OCC Interpretive Letter 919 (issued in 2001), the Bank requested confirmation that it would be permissible for the Bank to rely on the OCC’s determination set forth in OCC Interpretive Letter 919 for ninety days following the acquisition of the index provider by the Affiliate. In Interpretive Letter 919, the OCC had stated that a bank may charge fees for admissions to and withdrawals from model-driven funds in the same manner and to the same extent as section 9.18 index funds, provided, in part, that the benchmark index the model-drive fund seeks to outperform is established and maintained by an independent organization.  In Interpretive Letter 1119, a substantial percentage of the Bank’s model-driven funds were benchmarked to various indices maintained by the index provider to be acquired by the Affiliate.  The Bank contended that the index provider should continue to be considered an independent business after the acquisition.  The Bank represented that there were substantial information barriers between the Bank and Affiliate that would remain in place after the acquisition.  The Bank committed that it would continue to operate in a manner completely separate from the index business, and noted that the index provider’s fixed income indices were widely followed benchmarks in the global debt market and were not specifically tailored for use by the Bank.  The Bank fully expected the indices to continue to be maintained in a manner that met the overall needs of the marketplace generally.  The  Bank also represented that the models used by the Bank would continue to use data not within the Bank’s control for purposes of complying with the requirements of Interpretive Letter 919.  The OCC concluded that the Bank’s activities would not be inconsistent with Interpretive Letter 919 for the ninety-day period following the acquisition, and agreed to determine later whether the Bank could continue the activities after the ninety-day period. 

In Interpretive Letter 1120, the OCC determined that the Bank could continue to charge fees for admissions and withdrawals from its model-driven funds benchmarked to an affiliated index, subject to certain limitations and conditions.  Prior to the acquisition of the index provider by the Affiliate, the indices were widely used by institutional asset managers as benchmarks for fixed income index and model-driven collective investment funds, with approximately $4 trillion in assets worldwide benchmarked to the indices, and the previous owner estimated that more than 90% of fixed income investors in the United States used the indices as a benchmark.  According to the Bank, there was currently no unaffiliated index of a caliber equivalent to certain of the affiliated indices.  The Bank contended that it is not necessary for an index provider to be unaffiliated with or structurally independent of the Bank for the OCC to conclude it was permissible for the Bank to allocate costs for admissions and withdrawals.  The Bank argued that the OCC did not impose this requirements on index funds, and that the rationale for permitting the allocation of costs, which in the Bank’s view was the equitable treatment of participants in the funds, was the same as that for index funds.  The Bank also contended that the critical conditions, on which the interpretation in Interpretive Letter 919 rested, were that the allocation of costs must be authorized by the governing documents of the fund, that the index or benchmark must be a standardized index of securities that is not specifically tailored for the use of the fund manager and that the model must be based on prescribed objective criteria using independent third party data that is not within the control of the fund manager.  The Bank represented that it was and would continue to be in compliance with these conditions, and believed these conditions were sufficient to ensure that the Bank is properly motivated to act fairly and in the interests of participants.  In addition, the Bank agreed to comply with additional safeguards to ensure the indices could not be manipulated or controlled by the Bank.  First, the affiliate index would be a separate business unit within the bank holding company organization, and the Bank would not exercise direct or indirect control over any affiliated index provider.  Second, there would be an effective information barrier between the Bank and any affiliated index provider, such that the bank would not be provided access to non‑public information regarding rules, decisions and data underlying the indices before such information is provided to third parties.  Third, the Bank would not have a preferential ability over similarly situated managers to influence the methodology of an affiliated index.  Finally, to the extent the Bank based its model‑driven strategies on the products of an affiliated index provider, it would only use indices also available to unaffiliated institutional asset managers to benchmark funds. 

The OCC noted that the purpose of requiring an independent third party index provider “was to ensure that the indices used as benchmark’s for the Bank’s model driven funds were not within the control of, or subject to manipulation by, the Bank’s model-drive fund managers.”  The OCC stated, “we believe this purpose can be achieved by appropriate arrangements even where an affiliate of the Bank owns and maintains the benchmark indices.  We further believe the Bank’s commitments and representations provide such appropriate arrangements.”  For these reasons, the OCC determined that the Affiliate would not be within the control of the Bank and therefore deemed it “independent” consistent with Interpretive Letter 919.  In addition to the conditions and commitments described above, the OCC also required the Bank to notify its Examiner in Charge in writing if it decides in the future to use other indices owned and controlled by the Affiliate as benchmarks for its model driven funds.  Although the Bank requested that the OCC make the determination in Interpretive Letter 1119 permanent with respect to its Affiliate’s ownership of the index provider and with respect to any index provider that hereafter may be owned or controlled by an affiliate of the Bank, the OCC’s determination was limited to the Bank’s use of the indices that were acquired by its affiliate in connection with the September 2008 acquisition. 

OCC Interpretive Letter 1121 

In Interpretive Letter 1121, a bank that served as trustee for a collective investment fund (the “Fund”) that invested in commercial real estate requested a waiver from 12 C.F.R. § 9.18(b)(5)(iii), which provides that a collective investment fund invested primarily in real estate or other assets that are not readily marketable may require a prior notice period, not to exceed one year, for withdrawals.  The OCC has previously determined that this provision requires payment of such withdrawal requests within the one-year notice period.  At the time of the request, the Fund had pending redemption requests representing over 20% of the total interests in the Fund.  Due to the size of the pending redemption requests and current economic and market conditions, including unusual illiquidity in the commercial real estate market, the bank had determined that there would not be sufficient cash available to meet all pending redemption requests within the one-year period, and requested a waiver pursuant to 12 C.F.R. § 9.18(c) to permit a longer redemption period for the Fund.  The bank contended that requiring it to meet the one-year redemption period would either force a fire sale of the Fund’s real estate assets or an in-kind distribution of those assets to withdrawing participants, neither of which would be in the best interests of the Fund’s participants.  The bank contended that applicable fiduciary standards weighed against selling the assets at fire sale prices, and that an in-kind distribution would not benefit withdrawing participants because it would provide them not with cash, but with an illiquid asset, and would also create significant ERISA, tax, and valuation issues that would increase transaction costs. 

In recent years, the OCC has concluded that national banks and other institutions that must comply with Section 9.18 to receive favorable tax treatment may restrict admissions and withdrawals for certain illiquid funds if they have valid reasons for doing so and the admissions and withdrawal policies are consistent with fiduciary duties.  The OCC permitted an extended redemption period in this case, provided that the bank meets the following criteria:  (1) the Fund’s Declaration of Trust must clearly authorize a redemption period of more than one year; (2) the Fund’s redemption policy, including the extended redemption period, must be fully disclosed to participants; (3) the bank must have valid reasons for an extended redemption period, and it must be necessary given the nature of the assets; (4) the bank must determine that an extended redemption period is consistent with fiduciary principles and in the best interests of all participants, both withdrawing and remaining; and (5) participants in the Fund must be limited to those who meet the definition of “institutional investors” and that are tax exempt retirement, profit sharing, or stock bonus plans administered by a trustee or a board of trustees.  The bank represented that it met all the criteria.  The OCC also required the bank to provide quarterly status reports to the Examiner-In-Charge detailing its efforts to satisfy pending redemption requests.