Financial Services Alert - October 12, 2010 October 12, 2010
In This Issue

Financial Stability Oversight Council Seeks Comment on the Volcker Rule and Issues Notice of Proposed Rulemaking Regarding Criteria for Designation as Systematically Significant Nonbank Financial Companies

The Financial Stability Oversight Council (the "FSOC") established by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Act") to identify threats to the financial stability of the U.S., promote market discipline by elminating expectations on the part of shareholders, creditors, and counterparties that the government will shield them from losses in the event of failure, and respond to emerging risks to the stability of the U.S. financial system held its first meeting on October 1, 2010.  Following the meeting, the FSOC issued (1) a request for information (the “Volcker ROI”) regarding matters related to the implementation of Section 619 of the Act, which is commonly referred to as the “Volcker Rule” (the “Volcker Rule”), and (2) a notice of proposed rule making (the “ANPR”) regarding the criteria the FSOC will consider in designating certain non-bank financial companies for heightened supervision.  Each of the Volcker ROI and the ANPR are described below.

Request for Information Regarding the Volcker Rule

The Volcker Rule amended the Bank Holding Company Act to add a new Section 13 that bars banking organizations from engaging in proprietary trading and sponsoring and investing in hedge funds and private equity funds, except as permitted under certain limited exceptions.  The Act requires that the FSOC conduct a study (the “FSOC Study”) and make recommendations on implementing the Volcker Rule provisions to achieve specified goals, such as protecting the safety and soundness of banking entities, protecting taxpayers and consumers, and enhancing financial stability.  Under the Volcker Rule, each of the OCC, FDIC, FRB, SEC and the Commodity Futures Trading Commission, must consider the findings of the FSOC Study in developing and adopting regulations to implement the Volcker Rule.  For a more detailed discussion of the Volcker Rule, please refer to the July 28, 2010 Special Edition of the Alert.

The FSOC Study is due to be completed by January 22, 2011.  In connection with the conduct of the FSOC Study, the FSOC has requested comments on each of the following:

  1. How the Volcker Rule can best serve to: (i) promote and enhance the safety and soundness of banking entities; (ii) protect taxpayers and consumers and enhance financial stability by minimizing the risk that insured depository institutions (and their affiliates) will engage in unsafe and unsound activities; (iii) limit the inappropriate transfer of federal subsidies from institutions that benefit from deposit insurance and liquidity facilities of the federal government to unregulated entities; (iv) reduce conflicts of interest between the self-interest of banking entities and nonbank financial companies supervised by the FRB (“Nonbank Financial Companies”), and the interests of the customers of such entities and companies; (v) limit activities that have caused, or might reasonably be expected to cause, undue risk or loss in banking entities and Nonbank Financial Companies; (vi) appropriately accommodate the business of insurance within an insurance company, subject to regulation in accordance with the relevant insurance company investment laws, while protecting the safety and soundness of any banking entity with which such insurance company is affiliated and of the U. S. financial system; and (vii) appropriately time the divestiture of illiquid assets that are affected by the implementation of the Volcker Rule.
  2. What key factors and considerations should be taken into account in making recommendations on implementing the proprietary trading provisions of the Volcker Rule?
  3. What key factors and considerations should be taken into account in making recommendations on implementing the provisions of the Volcker Rule that restrict the ability of banking entities to invest in, sponsor or have certain other covered relationships with private equity and hedge funds?
  4. What factors and considerations should inform recommendations on the definition of certain key terms, including, “banking entity,” “hedge fund,” “private equity fund,” “such similar fund,” and “proprietary trading”?
  5. What factors and considerations should be taken into account as indicative that a transaction, class of transactions or activity: (i) would involve or result in a material conflict of interest between a banking entity (or a Nonbank Financial Company) and its clients, customers or counterparties; (ii) would result, directly or indirectly, in a material exposure by a banking entity (or a Nonbank Financial Company) to high-risk assets or high-risk trading strategies; or (iii) would pose a threat to the safety and soundness of a banking entity (or a Nonbank Financial Company)?
  6. What factors and considerations should be taken into account in making recommendations on whether additional capital and quantitative limitations are appropriate to protect the safety and soundness of banking entities or Nonbank Financial Companies engaged in activities permitted under the Volcker Rule?
  7. Which practices, types of transactions or corporate structures in general have historically accounted for or involved increased risks or may account for or involve increased risks in the future?
  8. What practices, policies or procedures have historically been utilized that may have mitigated or exacerbated risks or losses, or might be useful in limiting undue risk or loss in the future?
  9. What factors and considerations should be taken into account in making recommendations to safeguard against evasion of the Volcker Rule?
  10. How should the international context be considered when implementing the Volcker Rule? Are there any factors or considerations that should be taken into account regarding the application of the Volcker Rule to banking entities or nonbank financial companies that operate outside the U. S.? What issues does implementation of the Volcker Rule present with respect to (i) domestic banking entities that have access to foreign exchanges, (ii) foreign affiliates of domestic banking entities, and (iii) foreign non-bank financial companies?
  11. What timing issues are raised in connection with the divestiture of illiquid assets affected by the prohibitions of the Volcker Rule, and how might such issues be appropriately addressed?

Request for Comments on Notice of Proposed Rulemaking Regarding Criteria for Designation as Systematically Significant Nonbank Financial Companies

Section 113 of the Act (“Section 113”) gives the FSOC the authority to determine that a nonbank financial company is systemically significant and require that such nonbank financial company be subject to regulation by the FRB, including heightened and broadened prudential standards and other restrictions.  For a nonbank financial company to be considered systemically significant, the FSOC must determine that the failure, nature, scope, size, scale, concentration, interconnectedness or mix of activities of the nonbank financial company could pose a threat to the financial stability of the U.S.  Section 113 of the Act requires that, when making such a determination, the FSOC must consider certain factors including: the company’s leverage, the nature of the assets and liabilities of the company, the company’s reliance on short-term funding, the nature of the company’s activities, its interconnectedness with other systemically significant financial companies and its importance as a source of credit and liquidity.  For a more detailed discussion of Section 113 and its requirements, please refer to the July 28, 2010 Special Edition of the Alert.

The FSOC issued the ANPR to gather information as it begins to establish the specific criteria and analytical framework by which it will designate nonbank financial companies for enhanced supervision under the Act.  The FSOC has not requested comments on the procedural requirements of Section 113; however, the FSOC has requested comments on the questions set forth below related to the criteria for designation as a systemically significant nonbank financial company.

  1. What metrics, quantitative or qualitative, should be used by the FSOC to measure the factors required by Section 113 when making determinations under Section 113, and should certain factors be weighted more heavily than other factors?
  2. What types of nonbank financial companies should be reviewed for designation under Section 113?  Should the analytical framework, considerations, and measures used by the FSOC vary across industries or time? If so, how?
  3. What role should international considerations play in designating foreign nonbank companies? Are there unique considerations for foreign nonbank companies that should be taken into account?
  4. Are there simple metrics that should be used to determine whether nonbank financial companies should be considered for designation?
  5. How should the FSOC measure and assess the scope, size, and scale of nonbank financial companies? 
  6. How should the FSOC measure and assess the nature, concentration, and mix of activities of a nonbank financial company?  Are there specific measures of market concentration that can be used by the FSOC to determine the importance of a company as a source of credit for households, businesses, and State and local governments, and as a source of liquidity for the U. S. financial system? 
  7. How should the FSOC measure and assess the interconnectedness of a nonbank financial company?
  8. How should the FSOC measure and assess the leverage of a nonbank financial company? 
  9. How should the FSOC measure and assess the amount and types of liabilities, including the degree of reliance on short-term funding of a nonbank financial company?  
  10. How should the FSOC take into account the fact that a nonbank financial company (or a subsidiary or affiliate) is already subject to financial regulation in the FSOC’s decision to designate a firm?  Are there particular aspects of prudential regulation that should be considered as particularly important (e.g., capital regulation, liquidity requirements, consolidated supervision)?  Should the FSOC take into account whether the existing regulation of the company comports with relevant national or international standards?
  11. Should the degree of public disclosures and transparency be a factor in the assessment?  Should asset valuation methodologies (e.g., level 2 and level 3 assets) and risk management practices be factored into the assessment? 
  12. How should the government’s extension of financial assistance to nonbank financial companies be considered in designating companies?
  13. Please provide examples of best practices used in evaluating and considering various types of risks that could be systemic in nature. 
  14. Should the FSOC define “material financial distress” or “financial stability”? If so, what factors should be considered in developing those definitions? 

Request for Comments

Comments in response to the Volcker ROI and on the ANPR are due to the FSOC by November 5, 2010. 

Basel Committee Issues Final Version of its Corporate Governance Principles and Guidance

The Basel Committee on Banking Supervision (the "Basel Committee") issued revised final Principles and Guidance (the “Guidance”) concerning sound corporate governance of banking organizations (“Banks” and each a “Bank”).  The Guidance updates 2006 Basel Committee guidance on bank corporate governance and reflects modifications that the Basel Committee believes are appropriate in view of the bank and insurance company corporate governance failures that came to light during the financial crisis that began in mid-2007.  The Basel Committee states that the Guidance: (1) is not intended to add a new regulatory layer on top of existing, national statutes; (2) is intended to assist Banks in enhancing their corporate governance framework and to assist Bank supervisors in assessing the quality of their corporate governance framework; (3) should be implemented in a manner that reflects the size, complexity, structure, economic significance to and risk profile of the Bank; and (4) should be applied in a manner consistent with applicable national law. 

The Guidance articulates fourteen corporate governance principles, which can be summarized generally as follows:

  1. The Board has overall responsibility for the Bank, including approving and overseeing implementation of the Bank’s strategy, risk management, corporate governance and corporate values.  The Board should also oversee senior management.
  2. Board members should be and remain qualified.  They should receive training and clearly understand their role in the Bank’s corporate governance.
  3. The Board should define appropriate governance practices for its own work and confirm that such practices are followed and periodically reviewed for possible improvements.
  4. The Board  of a parent holding company is responsible for seeing that there is adequate corporate governance throughout the corporate organization.
  5. Under Board direction, senior management should see that the Bank operates in a manner consistent with the Bank’s business strategy, risk tolerance/appetite and Board policies.
  6. Banks should have an effective internal controls system and risk management function (including a chief risk officer) with sufficient authority, stature, independence, resources and access to the Board.
  7. Risks should be identified and monitored on an ongoing firm-wide and individual entity basis, and should be updated as a Bank engages in new or expanded activities and as the external risk landscape changes.
  8. A Bank should have robust internal communications about risk, both across the organization and through reporting to the Board and senior management.
  9. The Board and senior management should use effectively the work of the external auditors, the internal auditors and other internal control functions.
  10. The Board should actively oversee the compensation system design and operation and monitor the compensation system to see that it operates as intended.
  11. An employee’s compensation should be aligned with prudent risk taking.  Compensation should:  be adjusted for all types of risks; be symmetric with risk outcomes; have payment schedules that are sensitive to time horizons of risks; and have a mix of cash, equity and other compensation that is consistent with risk alignment.
  12. The Board and senior management should know and understand the Bank’s operational structure and the risks it poses.
  13. If a Bank operates through special purpose structures that impede transparency, its Board and senior management should understand the purpose, structure and unique risks of these operations.  They should also try to mitigate these risks.
  14. The governance of the Bank should be adequately transparent to its shareholders, depositors and other stakeholders.

The Guidance concludes with a discussion of the role of supervisors with respect to Bank corporate governance.  Supervisors should make Banks aware of the supervisors’ expectations for sound corporate governance.  Moreover, the Guidance states that supervisors should regularly conduct a comprehensive evaluation of a Bank’s overall corporate governance policies and practices and the Bank’s implementation of those policies and practices.  Furthermore, supervisors should monitor a Bank’s internal and external reports, including reports from internal and external auditors.  Supervisors should require effective and prompt remedial action by a Bank to address material weaknesses in its corporate governance policies and practices.  Finally, supervisors should cooperate with other supervisors in other jurisdictions to supervise a Bank’s corporate governance policies and practices.

HSBC Subject to FRB and OCC Enforcement Orders for AML Deficiencies

The FRB and the OCC each issued an enforcement order (the “Orders”) after finding internal control deficiencies in the Bank Secretary Act/anti-money laundering (“BSA/AML”) compliance programs of the U.S. subsidiaries of HSBC Holdings plc, including HSBC North American Holdings, Inc. (“HNAH”), and HSBC Bank USA, N.A. (“HSBC Bank”).  The OCC’s order, a consent order, identified various BSA/AML compliance deficiencies by HSBC Bank, including failure to develop internal controls for customer due diligence, procedures for monitoring and reporting suspicious activity and independent testing for BSA/AML compliance.  The OCC also noted other deficiencies, including inadequate risk-based monitoring procedures for wire transfers, failure to monitor banknote or “bulk cash” transactions from mid-2006 to mid-2009, failure to collect or maintain adequate customer due diligence records for certain of its operations, inability to fully and timely comply with suspicious activity reporting obligations, and failure to appropriately designate certain customers as high-risk, including politically-exposed persons.  The OCC primarily attributed these deficiencies to insufficient manpower and lack of adequate, formalized procedures.

To remedy these BSA/AML deficiencies, HNAH and HSBC Bank agreed with the FRB and the OCC, among other things, to prepare and submit an action plan for improving their BSA/AML compliance programs; recruit and hire a qualified regional compliance officer and BSA officer; engage an independent consultant to conduct an independent review of their BSA/AML compliance programs, implement appropriate procedures for performing customer due diligence and enhanced due diligence when opening, renewing or modifying accounts; improve wire transfer monitoring and suspicious activity reporting; provide BSA/AML training to appropriate personnel; develop and maintain an effective program to audit their BSA/AML programs; and ensure that their BSA/AML compliance programs satisfy certain benchmarks within 90 days of the Orders’ issuance.

SEC Staff Provides Additional Guidance Regarding Money Market Fund Reform

On October 5, 2010, the staff of the SEC’s Division of Investment Management (the “Staff”) updated its FAQs concerning amendments to Rule 2a-7 under the Investment Company Act of 1940, as amended (the “1940 Act”), and other rules and forms relating to money market funds that were adopted by the SEC earlier this year.  Those amendments were discussed in the March 5, 2010 Alert, and the Staff’s previous set of responses to questions regarding the amendments were discussed in the June 1, 2010 Alert.  Below is a summary of the additional responses recently added by the Staff to Staff Responses to Questions About Money Market Fund Reform and Staff Responses to Questions about Rule 30b1-7 and Form N-MFP.  (Capitalized terms not otherwise defined have the meaning given to them in Rule 2a-7)

Website Posting Requirements. The Staff provided additional guidance regarding the website posting requirement in Rule 2a-7(c)(12).

  • The Staff previously indicated that a money market fund must provide on its website a link to each of its Forms N‑MFP filed during the previous twelve months, not just a link to the SEC’s website or to the page on the SEC’s website that allows a user to search for a company’s filings.  In the new responses, the Staff further clarified that a money market fund can satisfy this requirement by “creating a link to a fund specific web page on the SEC website that contains links to (at least) each of the fund’s most recent 12 monthly Form N-MFP filings.”  A money market fund may link to its EDGAR section of the SEC website and limit the results to Form N-MFP filings using the restrictions available on the website.  The fund should not limit the date range in its search.  (See Question V.C.2.)
  • A “private” money market fund (one that is not registered under the 1940 Act) that undertakes to comply with Rule 2a-7 in order to permit investments in the fund by registered investment companies in excess of limitations set forth in Section 12(d) of the 1940 Act will not be deemed to violate prohibitions on general solicitation and advertising of the Securities Act of 1933, as amended (the “1933 Act”), by posting information on its website in compliance with Rule 2a-7.  The purposes of the posting must be to permit registered investment companies to invest in the private money market fund in reliance on Rule 12d1-1 under the 1940 in excess of Section 12(d) limits.  The information posted must be limited to that required by Rule 2a-7, and the private money market fund may not use its website to sell securities or for general solicitation or advertising purposes.  (See Question V.F.1.)
  • Similarly, a money market fund that is registered only under the 1940 Act and sells its securities without registering them under the 1933 Act in reliance on Rule 506 of Regulation D thereunder and/or Section 4(2) of the 1933 Act will not be deemed to violate prohibitions on general solicitation and advertising information by posting information on its website in compliance with Rule 2a-7.  The information posted must be limited to that required by Rule 2a-7, and the “1940 Act only” fund may not use its website to sell securities or in a manner that conditions the market for the sale of its securities.  (See Question V.G.1)

Form N-MFP. The Staff provided further guidance on responding to questions about a money market fund’s holdings in repurchase agreements under Item 32 of Form N-MFP.  The Staff also provided new responses clarifying that a money market fund need not respond to certain items of Form N-MFP pertaining to designated NRSROs; these responses are consistent with the Staff’s position (discussed in the August 24, 2010 Alert) that pending its review of the use of NRSRO ratings in Rule 2a-7 conducted pursuant to Section 939A of the Dodd-Frank Wall Street Reform Act, a money market fund’s board need not designate NRSROs as otherwise required under amended Rule 2a-7.

President Signs Bill Removing Dodd-Frank Act Provisions Designed to Protect the Confidentiality of Information Obtained by the SEC

President Obama signed into law S. 3717 which removed provisions added to the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisers Act of 1940 by Section 929I of the Dodd-Frank Consumer Financial Protection and Wall Street Reform Act that would have limited the SEC’s ability to disclose records or information provided to, or obtained by it, under those statutes.

SEC Proposes Disclosure Rules for Asset-Backed Securities Pursuant to Dodd-Frank Act

The SEC issued a rule proposal pursuant to Section 943 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which would require issuers of asset-backed securities to disclose certain repurchase history information to the SEC and in prospectuses and ongoing reports, and would require NRSROs to provide information about representations, warranties and enforcement mechanisms available to investors in reports accompanying credit ratings for asset‑backed securities offerings.  The period for public comment on the proposal continues through November 15, 2010.  The SEC must adopt final rules addressing the matters specified in Section 943 by January 17, 2011.