Financial Services Alert - September 28, 2010 September 28, 2010
In This Issue

SEC Settles Enforcement Proceedings Over Regulation M Violations Related to Short Sales Outside the Separate Account Exception during the Restricted Period Prior to Purchases in a Public Offering

The SEC issued an order settling an enforcement action against a registered investment adviser  and manager of hedge funds (the “Adviser”) for violations of Rule 105 of Regulation M under the Securities Exchange Act of 1934 (“Rule 105”).  Rule 105 prohibits a person from buying an equity security made available through a public offering from an underwriter or broker or dealer participating in the offering after the person has sold short the same security during the Rule 105 restricted period beginning five business days before the pricing of the offering, or beginning on the date of filing of the registration statement, if less than five business days before pricing (the “Restricted Period”).  Rule 105 provides an exception for the purchase of an offered security in an account that is “separate” from the account through which the same security was sold short (the “Separate Account Exception”).

Violations.  In its order, the SEC found that during 2008, the Adviser violated Rule 105 with respect to follow-on or secondary offerings of four issuers (the “Offerings”).  In each case the Adviser was found to have directed the purchase of securities on behalf of a portfolio in the relevant Offering after having directed that securities of the same issuer be sold short within the Restricted Period.  In two of the transactions, the portfolios achieved significant gains.  In the other two transactions, the portfolios did not make a profit, because the offering price was greater than the short sale price, but the portfolios avoided some losses because the Offerings were priced at a discount to the market price.

Separate Account Exception Unavailable.  Three of the transactions involved purchases in the relevant Offerings on behalf of the same portfolio on whose behalf the securities were sold short during the Restricted Period.  In the fourth transaction the SEC found a violation of Rule 105 even though the portfolio that purchased the securities in the public offering was different from the portfolio that had sold the securities short during the Restricted Period.  The SEC acknowledged that the two portfolios had different portfolio managers.  Furthermore, the SEC noted that the portfolio that had the short position appeared to have purchased shares in the market sufficient to cover its short position.  Nevertheless, the SEC found that the two portfolios involved did not qualify for the Separate Account Exception, noting that the Separate Account Exception is available only where decisions regarding securities transactions for each portfolio are made separately and without coordination of trading or cooperation among or between the accounts.  In this regard, the SEC found that the Adviser’s structure permitted information to be shared across portfolios, that both portfolio managers were supervised by a Chief Investment Officer who had ultimate trading authority and that the portfolio managers involved did not make trading decisions separately.

Adviser’s Policies and Procedures. In making its findings the SEC stated that the Adviser did not have policies and procedures sufficient to prevent the Adviser from participating in the Offerings in violation of Rule 105.  The SEC found that at the time of the violations the Adviser’s compliance manual did not address Rule 105, that the Adviser had not conducted any formal firm-wide training addressing Rule 105 during the relevant time period, and that as a result, the Adviser’s investment personnel who directed the participation in the Offerings either misunderstood or were unaware of the requirements of Rule 105 when the violations occurred.  The SEC noted that the Adviser’s sole procedure relating to Rule 105 compliance was to rely on a single trader to coordinate the review of prior short sales before participating in offerings of securities, a procedure that was insufficient to prevent the violations. 

Remedial Action and Sanctions.   During the SEC’s investigation into the violations, the Adviser conducted firm-wide training addressing Rule 105, amended its compliance manual to include Rule 105, and implemented an automated system to facilitate Rule 105 reviews.  Under the terms of the settlement, which reflected the SEC’s consideration of the Adviser’s remedial efforts and cooperation, the Adviser is subject to a cease and desist order and censure, is required to pay a penalty of $260,000, and is required to pay disgorgement in the amount of $2,256,386 reflecting the amount of gain or avoidance of losses resulting from the violations.

FDIC Issues Proposed Rule to Implement Unlimited Deposit Insurance Coverage on Noninterest-Bearing Transaction Accounts

The FDIC Board of Directors issued a proposed rule (the “Proposed Rule”) to implement Section 343 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) that provides temporary unlimited deposit insurance coverage for noninterest-bearing transaction accounts.  The separate coverage for noninterest-bearing transaction accounts becomes effective on December 31, 2010, and terminates on December 31, 2012.  The Proposed Rule also serves as formal notice that the FDIC will not be extending the Transaction Account Guarantee Program (“TAGP”) beyond its scheduled expiration date of December 31, 2010.  Comments are due on the Proposed Rule by October 15, 2010.  The FDIC noted that the shorter than usual comment period is necessary to give insured depository institutions adequate time to implement the notice and disclosure requirements set forth in the proposed rule by December 31, 2010.

Unlike the TAGP, the temporary deposit coverage for noninterest bearing transaction accounts under the Act will apply at all FDIC-insured institutions and will cover only transaction accounts that do not pay interest.  Accordingly, beginning January 1, 2011, low‑interest NOW accounts and Interest on Lawyer Trust Accounts (“IOLTAs”) currently covered under the TAGP will no longer be eligible for an unlimited deposit insurance.

The Proposed Rule sets forth notice and disclosure requirements for insured depository institutions that are designed to ensure that depositors are aware of and understand the types of accounts that will be covered by the temporary deposit insurance for noninterest bearing transaction accounts.  Insured depository institutions will be required to post a notice in their main office, each branch and, if applicable, on their website; notifying customers currently covered by the TAGP that, beginning January 1, 2011, low-interest checking accounts and IOLTAs no longer will be eligible for unlimited guarantee; and notifying customers individually of any action they take that will affect the deposit insurance coverage of funds held in noninterest-bearing transaction accounts.

OCC Issues Guidance Concerning Self-Deposit of Fiduciary Funds

The OCC issued a bulletin (the “Bulletin”, OCC 2010-37) providing guidance to national banks regarding the placement of funds, for which the national bank is a fiduciary, on deposit with the national bank or one of its affiliates.  These deposits, referred to as “self‑deposits,” include, among other deposits, short-term investment pools consisting of own‑bank deposits, omnibus cash or other processing accounts, money market deposit accounts and certificates of deposit.

The OCC states that there are two main types of self-deposited fiduciary funds: (i) self‑deposits of fiduciary funds that are awaiting investment or distribution; and (ii) self‑deposits that extend beyond one year as long term investments of the fiduciary funds.  The OCC’s main supervisory concern with self-deposits of fiduciary funds is to ensure that the national bank fulfills its fiduciary duty to provide its undivided loyalty and care to the beneficiaries of such fiduciary accounts.  The Bulletin notes that self-deposit of fiduciary funds can serve as a windfall for a national bank by providing the bank with stable funding, low cost deposits, and increased liquidity; therefore, the OCC wants to make certain that the bank’s interests do not conflict with those of a holder of a fiduciary account or its beneficiaries. 

Self-Deposits Awaiting Investment or Distribution

Under 12 CFR 9.10(b) and (c), self-deposits for fiduciary funds that are awaiting investment or distribution with a bank or an affiliated FDIC-insured depository institution are permitted, unless prohibited by applicable law.  Furthermore, a bank is required to set aside collateral to secure fiduciary funds to the extent the deposit exceeds FDIC insurance limits.  To determine the collateral requirements, a national bank must have procedures in place to identify all self-deposits of fiduciary funds awaiting investment or distribution and the applicable FDIC insurance coverage for these funds.  The collateral for such funds must be appropriate, not only when pledged, but also at all times while it is pledged.  The OCC wants the collateral valued frequently to ensure it is not impaired and that it meets or exceeds the bank’s pledge requirements.  National banks are not required to obtain a maximum rate of return for fiduciary funds awaiting investment or distribution, however, a bank must ensure that interest rates paid on such self-deposits are consistent with applicable law and with the national bank’s fiduciary duty to the account and its beneficiaries. 

Many short-term investments into which fiduciary accounts may be swept are available to national banks.  When selecting a sweep or other short-term investment vehicle, the Bulletin states, a national bank should consider the specific characteristics of the available choices (including the credit quality, return, average maturity and liquidity of such vehicles).

Self Deposits as Long-Term Investments

Under 12 CFR 9.12(a), self-deposits of fiduciary funds as long-term investments are prohibited, unless such investments are authorized under applicable law.  Deposits that extend beyond twelve months are generally assumed to be “long-term” investments.  A national bank is not required to pledge collateral for self-deposits of fiduciary funds unless the funds are awaiting investment or distribution.  As a result, a bank’s financial condition and the FDIC insurance coverage of self-deposited long-term investments are of even greater importance when assessing a national bank’s fiduciary duties to a fiduciary account and its beneficiaries.

In publishing the Bulletin, the OCC stressed its concern that a national bank’s primary responsibility is to its fiduciary duty to protect the interests of the fiduciary accounts and their beneficiaries; not the national bank’s own self interest and well-being.  When making a decision as to whether or not to self-deposit such fiduciary funds, a bank must consider many risks, including whether its liquidity, credit quality or capital are stressed.  In the context of self-deposits, the OCC states, the interests of the fiduciary account and its beneficiaries must come before the interests of the bank.

OTS Updates Examination Handbook Section on Capital Adequacy

The OTS issued an updated Examination Handbook Section on Capital Adequacy (“New Section 120”), providing extensive revisions from the previous version.  Changes include, among other things, (1) an expanded discussion on assessing compliance with minimum regulatory capital requirements, and (2) updates on the Basel International Accord.  New Section 120 also significantly expands the discussion on assessing overall capital adequacy to include: (a) a review of an institution’s own capital adequacy assessment process; (b) factors that affect capital, including material risks; (c) an assessment of the quality of capital; and (d) an assessment of capital adequacy relative to an institution’s unique risk profile.

The OTS also revised the appendices to New Section 120, incorporating the contents of former Appendix A: Capital Components and Risk-Based Capital, and former Appendix B: Supplementary Information and Issues, with updates into two new appendices: Appendix A, which focuses on the components of capital (Tier 1, Tier 2 and total capital); and Appendix B, which focuses on the calculation of risk weighted assets.  Updates provided in these appendices include, among other things: (i) a discussion on the regulatory capital treatment of TARP and CPP payments; (ii) an updated discussion on the importance of common stockholders equity as the predominant form of Tier 1 capital, and an expanded discussion on the composition of common stockholders’ equity and noncumulative perpetual preferred stock; (iii) an updated discussion of regulatory policy with regard to accounting changes affecting the treatment of on- and off-balance sheet assets; and (iv) a discussion about underwriting and qualifying residential mortgage loans for the fifty percent risk-weight category.

In addition, the OTS retained Appendix C, Prompt Corrective Action Restrictions with no changes and added a new Appendix D addressing frequently asked questions and answers regarding the risk weight treatment of various types of one-to-four family residential mortgage loans.

FinCEN Proposes Rule That Would Require Reporting of Cross-Border Electronic Transmittals of Funds

FinCEN proposed a rule that would require certain banks and money services business to report to FinCEN records of transmittal orders associated with certain cross-border electronic transmittals of funds (“CBETF”).  Existing regulations already require that these financial institutions maintain and make available, but not affirmatively report, essentially the same CBETF information.  The proposed rule would also require banks to annually file a list of taxpayer identification numbers of accountholders who transmitted or received a CBETF.  A detailed discussion of the proposed rule will be provided in a future edition of the Alert.

FDIC Board Approves Final Rule Concerning Safe Harbor Protection for Securitizations and Participations

The FDIC’s Board of Directors approved a final rule (the “Final Rule”) that will extend through December 31, 2010 safe harbor protection for applicable securitizations and participations in the event of an FDIC-insured bank’s failure.  The Final Rule is similar to the FDIC’s extension of the safe harbor on March 11, 2010.  For a discussion of the safe harbor and its extensions, see the June 16, 2009 Alert, the November 17, 2009 Alert and the March 16, 2010 Alert.  A detailed discussion of the Final Rule will appear in a future issue of the Alert.

Financial Stability Oversight Council to Hold First Meeting on October 1, 2010

Treasury Secretary Tim Geithner, Chairperson of the Financial Stability Oversight Council (the “FSOC”) established by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, announced that the FSOC would hold its first meeting on October 1, 2010 in Washington D.C.  The press release announcing the meeting stated that the FSOC will provide, “comprehensive oversight over the stability of our nation's financial system[The FSOC] is charged with identifying threats to the financial stability of the United States; promoting market discipline by eliminating expectations on the part of shareholders, creditors, and counterparties that the government will shield them from losses in the event of failure; and responding to emerging risks to the stability of the United States financial system.”