The FDIC adopted rules that amend the FDIC’s deposit insurance assessment regulations. The first rule (the “Asset Based Rule“) implements a provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd‑Frank Act”) that changes the assessment base for insured depository institutions (“IDIs”) from domestic deposits to assets. The second rule (the “Large Bank Rule“) adopts changes for the deposit insurance assessment system for large institutions given the Dodd-Frank Act’s changes to the assessment base. The proposals for each of these rules were discussed in the November 16, 2010 Alert. The regulations adopted by the FDIC also incorporate rules regarding assessment dividends and assessment rates; the proposal for those rules was described in the October 26, 2010 Alert.
I. Asset Based Rule
The Asset Based Rule defines the assessment base as “average consolidated total assets minus average tangible equity,” as required by Section 331 of the Dodd-Frank Act (which was discussed in the July 28, 2010 Special Edition of the Alert); permits certain reductions for “banker’s banks” and “custodial banks”; makes conforming changes to the unsecured debt adjustment and brokered deposit adjustment, eliminates the secured liability adjustment and creates a new adjustment for an institution that holds long-term unsecured debt issued by another IDI; and revises deposit insurance rate schedules in light of the changes to the assessment base.
a. Assessment Base. The Asset Based Rule changes the assessment base to average consolidated assets minus average tangible equity. All IDIs must report their average total assets using the accounting methodology for reporting total assets as applied to Line 9 of Schedule RC-K of the Call Report (that is, the methodology established by Schedule RC-K regarding when to use amortized cost, historical cost, or fair value, and how to treat deferred tax effects). The final rule differs from the proposed rule, however, by allowing certain institutions to report average consolidated total assets on a weekly, rather than daily, basis. The final rule requires institutions with total assets of at least $1 billion and all institutions that are newly insured after March 31, 2011, to average their balances as of the close of business for each day during the calendar quarter. Institutions with less than $1 billion in quarter-end consolidated total assets on their March 31, 2011 Call Report or Thrift Financial Report (“TFR”) may report an average of their balances as of the close of business on each Wednesday during the calendar quarter or may, at any time, permanently opt to calculate average consolidated total assets on a daily basis.
There is no existing definition of “tangible equity” for IDI reporting purposes. In an effort to minimize new reporting requirements, the FDIC will use Tier 1 capital as the definition of tangible equity. In the FDIC’s view, defining tangible equity as Tier 1 capital not only avoids an increase in regulatory burden that a new definition of capital would cause, but also provides a clearly understood capital buffer for the Deposit Insurance Fund (“DIF”) in the event of the IDI’s failure. The FDIC will define the averaging period for tangible equity to be monthly, except that IDIs that report less than $1 billion in quarter-end total consolidated assets on their March 31, 2011 Call Report or TFR may report average tangible equity using an end-of-quarter balance or may at any time opt permanently to report average tangible equity using a monthly average balance.
b. Reductions for Banker’s Banks and Custodial Banks
(i) Banker’s banks
Banker’s banks, which are defined by 12 U.S.C. § 24, must be owned exclusively by IDIs or IDI holding companies and the IDI or holding company and all subsidiaries thereof must be engaged exclusively in providing services to or for other IDIs, their holding companies, and the officers, directors, and employees thereof. The Asset Based Rule requires a banker’s bank to self-certify on its Call Report or TFR that it meets the definition of “banker’s bank” set forth in 12 U.S.C. § 24. The self-certification is subject to verification by the FDIC. The final rule clarifies that banker’s banks that have funds from government capital infusion programs (such as TARP and the Small Business Lending Fund), stock owned by the FDIC resulting from bank failures or stock that is issued as part of an equity compensation program will not be excluded from the definition of banker’s bank solely for these reasons.
For an IDI that meets the definition of banker’s bank, the FDIC will exclude from its assessment base the daily average amount of reserve balances “passed through” to the Federal Reserve Board (the “FRB”), the daily average amount of reserve balances held at the FRB for its own account, and the daily average amount of its federal funds sold. The collective amount of this exclusion, however, may not exceed the sum of the IDI’s daily average amount of total deposits of commercial banks and other IDIs in the United States and the daily average amount of its federal funds purchased. The assessment base adjustment applicable to a banker’s bank will only be available to an IDI that conducts 50 percent or more of its business with non-affiliated entities (as defined under the Bank Holding Company Act or the Home Owners’ Loan Act).
(ii) Custodial Banks
The Dodd-Frank Act instructed the FDIC to consider whether certain assets should be deducted from the assessment base of custodial banks, but left it to the FDIC to define custodial banks “based on factors including the percentage of total revenues generated by custodial businesses and the level of assets under custody.” Under the final rule, the FDIC will define custodial banks as those IDIs with previous calendar year-end trust assets (consisting of fiduciary and custody and safekeeping assets ) of at least $50 billion or those IDIs that derived more than 50 percent of their revenue from trust activities over the previous calendar year. This definition is revised slightly from the definition in the proposed rule in that it expands the definition to include fiduciary assets and revenue in addition to custody and safekeeping assets and revenue. As a result, more IDIs will qualify as custodial banks.
The assessment base for custodial banks will be the daily average or weekly average – in accordance with the way the IDI reports its average consolidated total assets – of a certain amount of low risk assets – designated as assets with a Basel risk weighting of 0 percent, regardless of maturity, plus 50 percent of those assets with a Basel risk weighting of 20 percent, regardless of maturity – subject to the limitation that the daily or weekly average value of these assets cannot exceed the daily or weekly average value of those deposits classified as transaction accounts and identified by the IDI as being directly linked to a fiduciary or custody and safekeeping account.
There are certain differences between the adjustment for custodial banks in the final rule from the adjustment that would have been provided under the proposed rule. First, the final rule allows a deduction of all 0 percent risk-weighted assets and 50 percent of 20 percent risk-weighted assets without regarding to a specific maturity. In addition, the final rule allows a deduction up to the daily or weekly average value of those deposits classified as transaction accounts that are identified by the IDI as being linked to a fiduciary or custodial and safekeeping account. The final rule also limits the deduction to transaction accounts, rather than all deposit accounts, because deposits generated in the course of providing custodial services are used for payments and clearing purposes, as opposed to deposits held in non-transaction accounts, which may be part of a wealth management strategy.
c. Changes to Other Adjustments. In March 2009, the FDIC issued a final rule incorporating three adjustments into the risk-based pricing system – the unsecured debt adjustment, the secured liability adjustment, and the brokered deposit adjustment. In light of the Dodd-Frank Act’s changes to the deposit insurance assessment base, the FDIC is revisiting these adjustments.
(i) Unsecured Debt Adjustment
The Asset Based Rule revises the unsecured debt adjustment to ensure that IDIs continue to have the same incentive to issue more long-term unsecured debt than they otherwise would. The unsecured debt adjustment will be scaled to the new assessment base and will be increased to 40 basis points plus an IDI’s initial base assessment rate (“IBAR”) times the amount of long-term unsecured liabilities divided by the amount of the new assessment base. The cap on the unsecured debt adjustment will be the lesser of 5 basis points or 50 percent of an IDI’s IBAR. Unsecured debt will no longer include any Tier 1 capital.
The final rule, unlike the proposed rule, slightly alters the definition of long-term unsecured debt. Currently, long-term unsecured debt is defined as long-term if the unsecured debt has at least one year remaining until maturity. Under the final rule, long-term unsecured debt is long-term if the debt has at least one year remaining until maturity, unless the investor or holder of the debt has a redemption option that is exercisable within one year of the reporting date.
(ii) Depository Institution Debt Adjustment
Although issuance of unsecured debt by an IDI lessens the potential loss to the DIF in the event of an IDI’s failure, the FDIC noted that when this debt is held by other IDIs, the overall risk to the DIF is not reduced. The Asset Based Rule includes a new adjustment, the depository institution debt adjustment (“DIDA”), which is meant to offset the benefit received by IDIs that issue long-term, unsecured liabilities when those liabilities are held by other IDIs. In response to comments on the proposed rule, the final rule allows an IDI to exclude from the unsecured debt amount used in calculating the DIDA an amount equal to up to 3 percent of the IDI’s Tier 1 capital as posing de minimis risk. Therefore, the final rule will apply a 50 basis point DIDA to every dollar (above 3 percent of an IDI’s Tier 1 capital) of long-term unsecured debt held by an IDI when that debt is issued by another IDI.
(iii) Secured Liability Adjustment
The Asset Based Rule eliminates the secured liability adjustment. The FDIC believes that with the change in the assessment base, the relative cost advantage of funding with secured liabilities will disappear, thus eliminating the differential that led to the FDIC’s introduction of the adjustment.
(iv) Brokered Deposit Adjustment
The brokered deposit adjustment will be scaled to the new assessment base. The new formula for brokered deposits will become: BDA = ((Brokered deposits – (Domestic deposits*10%)/New assessment base)*25 basis points. In response to comments on the proposed rule, however, the final rule provides an exemption from the brokered deposit adjustment for large institutions that are well-capitalized and have a composite CAMELS rating of 1 or 2. For small institutions, the brokered-deposit adjustment will continue to apply to those in risk categories II, III, and IV when the ratio of brokered deposits to domestic deposits exceeds 10 percent, but does not apply to small institutions that are well-capitalized and have a composite CAMELS rating of 1 or 2. The final rule maintains a cap on the brokered deposit adjustment of 10 basis points.
d. Assessment Dividends. Pursuant to the Dodd-Frank Act, the FDIC has the authority to declare dividends when the DIF reserve ratio at the end of a calendar year is at least 1.5% and to suspend or limit declaration or payment of dividends from the DIF. Accordingly, the final rule provides that dividends be suspended permanently when the DIF reserve ratio exceeds 1.5%, which would increase the probability that the DIF will reach a level sufficient to withstand a future crisis. As discussed in further detail below, as an alternative to declaring dividends to prevent the DIF from becoming unnecessarily large, the FDIC will apply progressively lower assessment rate schedules when the reserve ratio exceeds 2% and 2.5%. These lower rate assessment schedules serve much the same function as dividends in preventing the DIF from growing unnecessarily large but provide more stable and predictable effective assessment rates.
e. Assessment Rate Schedule. The assessment rate schedule will be changed so that approximately the same amount of revenue would be collected under the new assessment base as would be collected under the current rate schedule and the schedules proposed by the FDIC in October 2010. The range of IBARs is the same for all sizes of IDIs (5 basis points to 35 basis points). For IDIs with less than $10 billion in total assets, the assessment rate under the schedule will depend on the risk category assigned to the IDI. Risk Category I institutions, for example, will pay IBARs between 5 and 9 basis points. IDIs with at least $10 billion in assets will not be assigned to risk categories, and may be subject to any assessment rate within the applicable range.
Under the final rule, assessment rates also may be reduced based on the DIF reserve ratio as follows:
When the DIF reserve ratio reaches 1.15%, assessment rates will be lowered significantly. Risk Category I institutions, for example, will pay IBARs between 3 and 7 basis points;
When the DIF reserve ratio reaches 2.00%, assessment rates will be lowered by approximately 25%. Risk Category I institutions, for example, would pay IBARs between 2 and 6 basis points; and
When the DIF reserve ratio reaches 2.50%, assessment rates will be lowered by approximately 50% below the rates that will take effect when the reserve ratio reaches 1.15%. Risk Category I institutions, for example, will pay IBARs between 1 and 5 basis points.
The FDIC believes that the progressively lower assessment rate schedules will serve to provide more stable and predictable assessment rates.
f. FDIC Adjustments to Assessment Rates. The Asset Based Rule retains the FDIC Board’s ability to adopt actual assessment rates that are higher or lower than total base assessment rates without the necessity of further notice-and-comment rulemaking, provided that (1) the FDIC Board may not increase or decrease rates from one quarter to the next by more than 2 basis points (rather than the current and proposed 3 basis points), and (2) cumulative increases and decreases cannot be more than 2 basis points higher or lower than the total base assessment rates. The reduction from 3 to 2 basis points was prompted by an industry trade group, which noted that 2 basis points of the new assessment base is approximately equal to 3 basis points of the domestic deposit assessment base.
g. Effective Date for the Asset Based Rule. The rate schedule and other revisions to the assessment rules will become effective on April 1, 2011, and will be used to calculate the June 30, 2011, invoices for assessments, which will be due on September 30, 2011.
II. Large Bank Rule
The Large Bank Rule will revise the risk-based assessment system for all large IDIs. The final rule eliminates risk categories and the use of long-term debt issuer ratings when calculating the initial base assessment for large IDIs. Instead, the FDIC will use a scorecard method to calculate assessment rates for all large IDIs. The assessment system for large IDIs will combine CAMELS ratings and certain financial measures into two scorecards – one for most large IDIs and another for the remaining very large IDIs that are structurally and operationally complex or that pose unique challenges and risks in the case of failure (highly complex IDIs).
a. Large Institution Scorecard and Base Assessment Rate. Under the Large Bank Rule, the assessment rate for large IDIs will be calculated using a scorecard which is based on institution performance and financial measures as potentially modified by discretionary adjustments available to the FDIC or as a result of the unsecured debt adjustment, IDI debt adjustment, or the brokered deposit adjustment under the Asset Based Rule.
A large IDI will continue to be defined as it currently is – generally, an IDI with at least $10 billion in total assets for at least four consecutive quarters. Insured branches of foreign banks will not be included within the definition of a large IDI.
The scorecard for large IDIs assesses certain risk measures to produce two scores – a performance score (the “Performance Score”) and a loss severity score (the “Loss Severity Score”) – that will ultimately be combined and converted to an initial assessment rate.
(i) Performance Score
The Performance Score measures a large IDI’s financial performance and its ability to withstand stress. The Performance Score for large IDIs is the weighted average of three inputs: (1) weighted average CAMELS ratings; (2) ability to withstand asset-related stress measures, and (3) ability to withstand funding-related stress measures. The scorecard combines these weighted measures into a single Performance Score between 0 and 100.
(A) Weighted Average CAMELS Score
A weighted average of a large IDI’s CAMELS score constitutes 30% of the large IDI’s Performance Score. Due to a non-linear conversion, the Performance Score will increase at an increasing rate as the weighted average CAMELS rating increases.
(B) Asset-Related Stress Component
The ability to withstand stress constitutes 50% of such IDI’s Performance Score and is based on a weighted calculation combining the following financial measures:
Tier 1 leverage ratio;
Concentration measure (the higher of the ratio of higher-risk assets to the sum of Tier 1 capital and reserves or the growth-adjusted portfolio concentrations measure);
The ratio of core earnings to average quarter-end total assets; and
Credit quality measure (the higher of the ratio of criticized and classified items to the sum of Tier 1 capital and reserves measure).
Each of the measures used in calculating the asset-related stress component is described in detail in Appendix A to the Large Bank Rule. Each of the measures is also subject to a minimum and maximum cutoff, meaning that to the extent that such measures produce values that are very low or very high, the effect of such value on the Performance Score is limited.
(C) Funding-Related Stress Component
The ability of a large IDI to withstand funding-related stress constitutes 20% of the IDI’s Performance Score and is based on a weighted calculation combining two financial measures: a core deposits to total liabilities ratio, and a balance sheet liquidity ratio, which measures the amount of highly liquid assets to cover potential cash outflows in the event of stress.
Each of the measures used in calculating the funding-related stress component is described in detail in Appendix A to the Large Bank Rule. Like the measures in the asset-related stress component, each of the measures in the funding-related stress component is also subject to a minimum and maximum cutoff, meaning that to the extent such measures produce values that are very low or very high, the effect of such value on the Performance Scorecard is limited.
(ii) Loss Severity Score
The Loss Severity Score quantifies the relative magnitude of potential losses to the FDIC in the event of the IDI’s failure. It is based on a loss severity measure that the FDIC considers most relevant to assessing an IDI’s potential losses. (Appendix D to the proposal describes the calculation of the loss severity measure in detail).
The loss severity measure applies a standardized set of assumptions based on recent failures regarding liability runoffs and the recovery value of asset categories to calculate possible losses to the FDIC. In the proposed rule, the FDIC proposed including a noncore funding ratio in the Loss Severity Score as a potential proxy for franchise value. The FDIC continues to believe that franchise value is an important factor to consider in the overall assessment of loss severity, but, given that liability composition is considered in the loss severity measure, the final rule eliminates the noncore funding ratio from the Loss Severity Score. Instead, qualitative factors that affect an IDI’s franchise value will be considered in determining whether to apply a large bank adjustment.
The Loss Severity Score cannot be less than 0 or more than 100.
(iii) Total Score and Base Assessment Rate
Once the Performance and Loss Severity Scores are calculated, these scores will be converted to a total score by multiplying the Performance Score by the Loss Severity Score. An IDI’s score may not be less than 30 or more than 90.
A large IDI with a total score of 30 will pay the minimum base assessment rate, and an IDI with a total score of 90 will pay the maximum IBAR. For total scores between 30 and 90, the IBAR will rise an increasing rate as the total score increased.
The IBAR can be adjusted as a result of the unsecured debt adjustment, the depository institution debt adjustment, or the brokered deposit adjustment, in accordance with the Asset Based Rule, or through a discretionary adjustment by the FDIC, as described below.
b. Highly Complex Institution Scorecard and Base Assessment Rate. IDIs that meet the definition of “highly complex” will be subject to a more complex scorecard than ordinary large IDIs. A highly complex IDI is defined as an IDI (other than a credit card bank) with more than $50 billion in total assets that is controlled by a parent or intermediate holding company with more than $500 billion in total assets. The designation also applies to a processing bank or trust company with at least $10 billion in total assets. The scorecards for highly complex IDIs and relevant adjustments thereto are identical to the scorecard and adjustments for large IDIs, with certain exceptions described below.
(i) Performance Score
The Performance Score for highly complex IDIs will be based on the same factors – the weighted average CAMELS score, the asset-related stress component and the ability to withstand funding-related stress component – as the Performance Score for large IDIs. The weighted average CAMELS score for highly complex IDIs will be calculated in the same manner as in the scorecard for large IDIs. However, the calculations of the asset-related stress component and the ability to withstand funding-related stress component will be modified for highly complex IDIs as discussed below.
Two of the four measures used to assess a highly complex IDI’s ability to withstand asset-related stress (the Tier 1 leverage ratio and the core earnings to average quarter-end total assets ratio) will be determined in the same manner used for other large IDIs. However, the concentration measure for highly complex IDIs considers the top 20 counterparty exposures to Tier 1 capital and reserves ratio instead of the growth-adjusted portfolio concentrations used in the scorecard for large IDIs because recent experience shows that the concentration of a highly complex IDI’s exposures to a small number of counterparties – either through lending or derivatives activities – significantly increases a highly complex IDI’s vulnerability to unexpected market events. In addition, the ability to withstand asset-related stress includes a credit quality measure like the scorecard for large IDIs, but the highly complex IDI scorecard also includes a market risk measure that consists of three risk measures – trading revenue volatility, market risk capital, and level 3 trading assets.
Two of the measures (the core deposits to total liabilities ratio and the balance sheet liquidity ratio) in the ability to withstand funding-related stress component are determined in the same manner as in the scorecard for large for large IDIs, although their weights differ. However, the ability to withstand funding-related stress component in the highly complex IDI scorecard adds an additional measure – the average short-term funding to average total assets ratio – because experience during the recent financial crisis shows that heavy reliance on short-term funding significantly increases a highly complex IDI’s vulnerability to unexpected adverse developments in the funding market.
(ii) Loss Severity Score
The Loss Severity Score for highly complex IDIs is calculated the same way as the Loss Severity Score for other large IDIs, as described above.
(iii) Total Score and Base Assessment Rate
The total score and the base assessment for highly complex IDIs will be calculated in the same manner as for other large IDIs, as described above.
c. FDIC Discretionary Adjustment to the Total Score. Similar to the current system, the FDIC will have the ability to adjust a large IDI’s or highly complex IDI’s total score by a maximum of 15 points, up or down, based upon significant risk. The FDIC will any such adjustment to the total score.
In determining whether to make a discretionary adjustment, the FDIC will consider such information as financial performance and condition information and other market or supervisory information. The FDIC also must consult with an IDI’s primary federal regulator and, for state chartered institutions, state banking supervisor.
The FDIC will notify a large or highly complex IDI before making an upward adjustment to the IDI’s assessment rate so that the IDI has an opportunity to respond to or address the FDIC’s rationale for proposing an upward adjustment.
In adopting the final rule, the FDIC acknowledged the need to clarify its processes for making adjustments to ensure fair treatment and accountability and plans to propose and seek comment on updated guidelines. Accordingly, the FDIC will not adjust assessment rates until the updated guidelines are published for comments and approved by the FDIC. In addition, the FDIC will publish aggregate statistics on adjustments each quarter.
d. Updating the Scorecard
The FDIC will have the ability to update the minimum and maximum cutoff values used in the scorecard annually without further rulemaking as long as the method of selecting cut-off values remains unchanged. In particular, the FDIC can add new data from each year to its analysis and could, from time to time, exclude data from some earlier years from its analysis.
On the other hand, if the FDIC concludes that additional or alternative measures should be used to determine risk-based assessments, that the method of selecting cutoff values should be revised, that the weights assigned to the scorecard measures should be recalibrated, or that a new method should be used to differentiate among large IDIs and highly complex IDIs, such changes can be made through a future rulemaking.
e. Effective Date for the Large Bank Rule. The changes under the Large Bank Rule will be effective on April 1, 2011. Accordingly, the scorecard method will be used to calculate assessments for large and highly complex IDIs beginning with the second quarter assessment period of 2011.
On February 7, 2011, the SEC issued an order settling administrative proceedings against a registered investment adviser (the “Adviser”) and the chief executive officer of the Adviser (the “CEO”) regarding the Adviser’s allocation of initial public offerings (“IPOs”). The SEC found that (1) between February 2006 and January 2008 (the “Relevant Period”), two open-end registered investment companies (the “Relevant Funds”) advised by the Adviser improperly took part in a disproportionate number of IPOs (in comparison to much larger funds advised by the Adviser), and (2) (a) the fact that the Relevant Funds had engaged in short-term trading with respect to many of the shares received in such IPOs (“IPO Shares”) and (b) the impact of that IPO participation and short-term trading on the performance of the Relevant Funds were not properly disclosed to the Relevant Funds’ board and shareholders or the SEC. This article summarizes the SEC’s principal findings in the order.
Background. From 2003 to 2007 the Advisor launched a number of new funds and experienced significant growth in assets under management, which resulted in the Adviser being afforded increased access to IPOs. During the Relevant Period the Adviser had compliance policies and procedures in place that mandated that allocations of shares received in IPOs be made “fairly and equitably” according to a “specific and consistent basis …” Similarly, disclosures contained in the Adviser’s Form ADV indicated that allocations were to be made according to the “risk tolerance and account objective guidelines of its clients” and in a manner that was “fair and equitable, consistent with the requirements of the Investment Advisers Act of 1940 and the Investment Company Act of 1940.” In practice, prior to the Relevant Period these polices and procedures typically resulted in the Adviser allocating IPO Shares on a pro rata basis among the clients whose portfolio managers had expressed interest; however, in at least two instances the CEO directed that IPO allocations be made disproportionately in favor of the Relevant Funds. Additionally, during the Relevant Period, the Relevant Funds, which were the Adviser’s most recently launched and smallest funds, received slightly more than 50% of all IPO allocations made by the Adviser. After receiving an IPO allocation the Relevant Funds generally sold some or all of the IPO Shares within 3 days resulting in significant contributions to the positive performance of the Relevant Funds.
Failure to Disclose the IPO Trading. The SEC found that during the Relevant Period none of the prospectuses, statements of additional information or annual reports of the Relevant Funds (the “Disclosure Documents”) disclosed the scope of the Relevant Funds’ participation in IPOs or the material impact that short‑term trading following IPOs had on the performance of the Relevant Funds. Additionally, none of the Disclosure Documents contained any discussion of the risks associated with short-term IPO trading, including the risks that returns might not be sustainable due to the unavailability of IPOs or that the positive impact on performance of short‑term trading could be lessened if the Relevant Funds experienced significant asset growth. Moreover, the Adviser did not disclose to the board of the Relevant Funds the extent to which the Relevant Funds were investing in IPOs, or the material impact that short‑term trading of IPO Shares had on the performance of the Relevant Funds.
Compliance Program Implementation. The SEC found that the Adviser did not sufficiently implement its compliance policies and procedures which (1) required that IPO Shares be allocated “fairly and equitably among the Adviser’s advisory clients according to a specific and consistent basis so as not to … favor or disfavor any client, or group of clients, over any other” and (2) prohibited any advertising or performance materials from being misleading and required that such materials comply with regulatory guidelines. The SEC noted the IPO allocation policies in the Adviser’s Form ADV which stated, among other things, that the Adviser “allocates its participation in [IPOs] according to the risk tolerance and account objective guidelines of its clients[, that the Adviser] evaluates a potential IPO investment in terms of its industry sector, market geography, income and growth potential, and risk and/or company specific characteristics[, and that] [b]ased on these factors, the Adviser then selects the most appropriate accounts for participation in any underwriting allocation [the Adviser] may receive.” The Adviser’s compliance policies and procedures (1) stated that “[f]ailing to disclose any material conditions, objectives, or investment strategies used to obtain the performance advertised” could be misleading, and (2) delegated responsibility for ensuring that the IPO allocation policies and procedures were implemented to the CEO. The SEC found that the Adviser did not sufficiently implement these policies and procedures, and specifically that the CEO had not directed anyone to conduct a review of the IPO allocation process to ensure that the allocation of IPO Shares was consistent with the Adviser’s policies and procedures. Moreover, no review was done of the Disclosure Documents to ensure that they adequately disclosed the contribution of IPOs to the performance of the Relevant Funds.
Compliance Program Resources. The SEC found that the Adviser failed to provide adequate resources to implement its compliance policies and procedures in a timely manner. In this regard, the SEC noted that the Chief Compliance Officer (the “CCO”), who had little prior compliance experience or training, also served in three other full-time executive roles as the firm’s Chief Operating Officer, Chief Financial Officer and Chief Administrative Officer, with little to no staff support. The SEC also noted the Adviser’s significant growth in assets under management and number of funds during the period between 2003 and 2007 and the CCO’s request for additional resources.
Documentation of IPO Indications of Interest and Brokerage Orders. The SEC found that the Adviser failed to adequately document brokerage orders related to indications of interest in IPO allocations. The Adviser’s IPO process required that individual portfolio managers make themselves aware of IPOs and, if interested, submit an indication of interest to the head trader. The SEC noted that the head trader gathered indications of interest related to IPOs in an informal manner, including oral submissions, and that records related to such indications of interest were generally discarded following the IPO. Additionally, the SEC found that the Adviser’s order memoranda for IPO purchases also contained other deficiencies, noting that (1) most were partially completed and time-stamped only at or around the time a trader received a fill for the order from the broker, and (2) many failed to identify the persons who recommended and placed the order.
Violations. The SEC found that: (i) the Adviser willfully violated Sections 17(a)(3) of the 1933 Act, Sections 206(2) and (4) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and Rule 206(4)-8 promulgated thereunder in connection with the failure to disclose the Relevant Funds’ IPO investments and short-term trading with respect to IPO shares; (ii) the Adviser willfully violated Section 34(b) of the 1940 Act by filing, transmitting and/or keeping prospectuses, statements of additional information and annual reports for the Relevant Funds that contained misleading statements of material fact or omissions of fact necessary to prevent the statements in those documents in light of the circumstances in which they were made, from being materially misleading; (iii) the Adviser caused the Relevant Funds to violate Rule 31a-1(b)(5) under Section 31(a) of the 1940 by failing to maintain and preserve a complete record for each brokerage order related to the IPO transactions; (iv) the Adviser violated Section 204 of the Advisers Act and Rule 204(a)(3) promulgated thereunder, as a result of failing to make and keep true and accurate order memoranda for the purchase and sale of IPO shares; and (v) the CEO willfully aided and abetted and caused the Adviser’s violations of Section 206(4) with respect to Rule 206(4)-7 thereunder which requires that the Adviser implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules promulgated by the SEC thereunder.
Remedial Actions and Penalties. Prior to the SEC investigation, the Adviser hired a new Chief Operations Officer and Chief Financial Officer. Additionally, during the course of the investigation the Adviser undertook various other remedial action, including (1) replacing its CCO, (2) voluntarily retaining an independent compliance consultant (“Compliance Consultant”) for the purpose of: (a) reviewing the risks and effectiveness of existing written supervisory and compliance procedures, (b) reviewing the effectiveness of the Adviser’s books and records, (c) assisting in the preparation of additional written policies and procedures for adoption and implementation by the Adviser, and (d) assisting in the preparation of additional written disclosure statements for the Adviser’s use with actual and prospective clients.
In determining to accept the offer of settlement, the SEC considered these remedial actions. In connection with the settlement and without admitting or denying the SEC’s allegations or findings, the Adviser and the CEO agreed to pay $650,000 and $65,000, respectively. The Adviser also agreed to certain undertakings, including, among other things, continuing the Compliance Consultant’s engagement.
The FDIC Board of Directors voted to issue a rule proposal (the “Proposed Rule”) to be issued jointly by the OCC, FRB, FDIC, OTS, NCUA, SEC and FHFA (the “Agencies”). The Proposed Rule would require the reporting of incentive-based compensation arrangements at a covered financial institution and prohibit incentive-based compensation arrangements at a covered financial institution that provide excessive compensation or that could expose the institution to inappropriate risks that could lead to a material financial loss. “Incentive-based compensation” is defined as “any variable compensation that serves as an incentive for performance.” “Covered financial institution” includes the following institutions with $1 billion or more in assets: a depository institution or depository institution holding company, a registered broker-dealer, a credit union, an investment adviser, Fannie Mae, Freddie Mac, the Federal Home Loan Banks, the Office of Finance of the Federal Home Loan Bank System, and any other financial institution that the appropriate Federal regulators, jointly, by rule, determine should be treated as a covered financial institution for these purposes.
The Proposed Rule would:
Require a covered financial institution to submit a report annually to its appropriate regulator or supervisor in a format specified by its appropriate Federal regulator that describes the structure of the covered financial institution’s incentive-based compensation arrangements for covered persons.
Prohibit incentive-based compensation arrangements at a covered financial institution that encourage “covered persons,” defined as executive officers, employees, directors, or principal shareholders, to expose the institution to inappropriate risks by providing to the covered person compensation that is “excessive,” as determined by standards set forth in the Proposed Rule.
Prohibit a covered financial institution from establishing or maintaining any incentive-based compensation arrangements for covered persons that encourage inappropriate risks by the covered financial institution that could lead to a material financial loss, as determined by standards set forth in the Proposed Rule.
Require a covered financial institution to maintain policies and procedures appropriate to its size, complexity and use of incentive compensation to ensure compliance with the above requirements and prohibitions.
Require a covered financial institution to document its processes for establishing, implementing, modifying and monitoring its incentive compensation arrangements.
Require deferral of at least 50% of incentive-based compensation for a minimum of three years for executive officers of “larger covered financial institutions,” defined generally as covered financial institutions with total consolidated assets of at least $50 billion, and adjustments of the deferred amounts to reflect losses during the deferral period. The Proposed Rule gives institutions flexibility in administering deferral programs. For example, deferred amounts may be released in a lump-sum at the end of the deferral period or in equal increments, pro rata, for each year of the deferral period.
Require that, at larger covered financial institutions, the board of directors or a board committee (a) identify those covered persons, other than executive officers, that have the ability to expose the institution to possible losses that are substantial in relation to the institution’s size, capital, or overall risk tolerance; and (b) approve the incentive-based compensation arrangement for such individuals.
The Proposed Rule would be effective six months after publication of the final rule in the Federal Register, with annual reports due within 90 days of the end of each covered financial institution’s fiscal year.
Public Comment. Comments must be submitted by 45 days after the date of publication of the Proposed Rule in the Federal Register following approval of the Proposed Rule by all of the Agencies.
The SEC issued an order settling administrative proceedings that it proposed to bring against a registered broker-dealer regarding the broker-dealer’s failure to supervise its registered representatives with a view to preventing their violations of Section 17(a)(2) of the Securities Act of 1933, as amended (the “Securities Act”), in connection with their offer and sale of shares in the Reserve Yield Plus Fund (the “Fund”). Section 17(a)(2) of the Securities Act prohibits the offer or sale of securities by means of any untrue statement of material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. Section 15(b)(4)(E) of the Securities Exchange Act of 1934, as amended requires broker-dealers to supervise reasonably, with a view to preventing violations of the federal securities laws, persons subject to their supervision.
In its order, the SEC found that from approximately January 18, 2007 through September 16, 2008, the broker-dealer’s representatives mischaracterized the Fund as a money market fund, as safe as cash, or as an investment with guaranteed liquidity. The SEC further found that although the broker-dealer developed training materials and procedures to train its representatives specifically regarding the Fund, the broker-dealer did not have a system to implement such procedures that was reasonably designed to prevent and detect misrepresentations or omissions by the broker-dealer’s representatives in their offer and sale of Fund shares. According to the SEC’s findings, the broker-dealer had no system to ensure that representatives actually received the training from their managers and understood the materials, and the broker-dealer did not take adequate steps, such as providing additional training, refresher courses or continuing education on the Fund, to ensure that its representatives understood the Fund. In determining to accept the broker-dealer’s settlement offer, the SEC considered the remedial efforts voluntarily undertaken by the broker-dealer to make improvements to its supervisory system. As part of the settlement, without admitting or denying any wrongdoing, the broker-dealer agreed, among other things, to pay to all current and former account owners who purchased Fund shares at the broker-dealer during the relevant period (and who continue to hold shares as of date of the order) $0.012 for each share of the Fund held by such customers, an amount which is expected to total approximately $10 million. The SEC did not impose any civil money penalty against the broker-dealer but reserved the right to do so in the future if the SEC’s Division of Enforcement believes that the broker-dealer has not complied with its undertakings as set forth in the order.
An institutional money manager registered as an investment adviser and specializing in quantitative investment strategies (the “Manager”), an affiliated registered investment adviser responsible for developing the code for Manager’s quantitative investment model and the holding company for the two advisers (“Holding Company” and, together with the two advisers, the “Respondents”) agreed to pay over $240 million to settle administrative securities fraud charges brought by the SEC alleging that the Respondents concealed an error in the computer code of the quantitative investment model used for managing the assets of Manager’s clients.
Background. According to the SEC order describing the settlement, the Respondents concealed a material error in the model’s code that disabled one of the key components for managing risk. The error, discovered in June 2009, affected a number of accounts managed by the Manager. Employees of the Respondents who were aware of the error delayed escalating information about the error to senior officers, and did not notify the CEO of the Holding Company until November 2009. In addition, in presentations and other communications to clients and consultants after discovery of the error, the Respondents misrepresented the computer model’s ability to control risk and ascribed underperformance caused in part by the error to market volatility and factors unrelated to the error. The error was fixed between late October and early November 2009. The Respondents did not notify the SEC of the error until March 31, 2010, and first notified clients on April 15, 2010.
Violations. The SEC found that the actions of the Holding Company violated the anti-fraud provisions of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933 based on the material misrepresentations and omissions made to investors concerning (i) the model and (ii) the compliance and control procedures of the adviser affiliate that maintained the model (the “Model Affiliate”). The SEC found violations of Section 206(2) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), under which a registered adviser owes a fiduciary duty to its clients, based on (a) the material misrepresentations and omissions giving rise to the Section 17(a)(2) and (a)(3) violations, (b) the Model Affiliate’s failure to conduct a meaningful materiality analysis of the error in the code and (c) the affiliated advisers’ failure to act promptly to correct the error. The SEC also found that the Model Affiliate had violated Rule 206(4)-7 under the Advisers Act by failing to maintain compliance procedures designed to ensure that the model operated as intended and that false and misleading statements/omissions were not made to clients.
Sanctions. As part of the settlement, without admitting or denying the charges brought by the SEC, the Respondents agreed to (1) pay approximately $217 million to 608 client portfolios estimated to have experienced losses as a result of the error, (2) pay a $25 million penalty to the SEC, (3) undertake specified oversight and global compliance measures, and (4) hire an independent compliance consultant with expertise in quantitative investment techniques to make recommendations regarding (a) appropriate disclosures to investors regarding the code, (b) the reporting process relating to the model and (c) how to document and retain changes in the code.
The U.S. Court of Appeals for the Tenth Circuit (the “Appeals Court”) affirmed a district court decision granting summary judgment to an insurance company and its affiliated broker-dealer (collectively referred to as the “company”) that were being sued for alleged violations of the Investment Advisers Act of 1940 (the “Advisers Act”) in connection with the sale of a variable universal life insurance policy. (The district court decision was discussed in the September 15, 2009 Alert.) The plaintiffs alleged that a sales representative of the company had acted as an investment adviser in recommending that the plaintiffs purchase the policy, and thus the company was subject to the Advisers Act. The plaintiffs further alleged that the company had violated the fiduciary duty it owed to the plaintiffs under the Advisers Act by failing to disclose the conflicts of interest created by the commission structures, fees and other policies that gave the sales representative an incentive to put his own financial interest ahead of the plaintiffs’.
Broker-Dealer Exclusion. The Appeals Court’s analysis focused on the whether the investment advisory services provided by the sales representative fell within the broker‑dealer exclusion in Section 202(a)(11)(C) of the Advisers Act, which provides that that “any broker or dealer whose performance of [advisory] services is solely incidental to the conduct of its business as a broker or dealer and who receives no special compensation therefor” is not an investment adviser for purposes of the Act. The Appeals Court found that the exclusion applies to “a broker-dealer who provides advice that is attendant to, or given in connection with, the broker-dealer’s conduct as a broker or dealer, so long as he does not receive compensation that is (1) received specifically in exchange for the investment advice, as opposed to for the sale of the product, and (2) distinct from a commission or analogous transaction-based form of compensation for the sale of a product. The quantum or importance of the broker-dealer’s advice is relevant only insofar as the advice cannot supersede the sale of the product as the ‘primary’ goal of the transaction or the ‘primary’ business of the broker-dealer.”
Evidentiary Record. The Appeals Court held that the record established that (a) advice was given by the sales representative only in connection with the selling the variable insurance product to the plaintiffs, which was the primary object of the transaction, (b) the compensation paid the sales representative relating to the transaction was for selling the variable insurance product, not for providing investment advice; and (c) the $500 “Production Credit” paid to the sales representative for the sale of the variable insurance product was a traditional, transaction-based commission and thus was not “special compensation.” Responding to plaintiffs’ argument that an issue of fact sufficient to defeat a motion for summary judgment existed because of the possibility of a link between the advice given by the sales representative and the compensation received, the Appeals Court pointed to the following undisputed facts: (A) the sales representative received compensation only after selling the variable insurance product; (B) the sales representative would have been fired if he did not meet sales goals; and (C) the sales representative gave advice on other occasions without receiving compensation. The Appeals Court found that these facts compelled the conclusion that the sales representative was compensated for selling the variable insurance product, not specifically for rendering advice, and there was no basis for a reasonable jury to conclude otherwise.
The Broader Context. This decision comes against a backdrop of judicial, regulatory and legislative developments over the last several years addressing how broker-dealers and investment advisers should be regulated, particularly where their activities may overlap and in the context of servicing retail customers. As discussed in the April 10, 2007 Alert, a decision of the United States Court of Appeals for the D.C. Circuit, which was cited in both the Appeals Court’s and district court’s decisions, vacated a 2005 SEC rule that created additional exceptions from the definition of “investment adviser” under the Advisers Act for certain fee‑based and discount brokerage programs. In conjunction with its adoption of the vacated rule, the SEC had also begun examining how it might improve its oversight and regulation of broker-dealers and investment advisers to better reflect current industry practices and investor perceptions. This effort has resulted in a RAND Corporation report on investor and industry perspectives on investment advisers and broker‑dealers (as discussed in the January 8, 2008 Alert). More recently, in response to a mandate in the Dodd-Frank Act, the SEC has delivered a study to Congress 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 standard be no less stringent than that currently applied to investment advisers (as discussed in the January 25, 2011 Alert).
Savings and Loan Associations to File Call Reports in Lieu of the TFR. The OCC, FRB, FDIC and OTS (together, the “Agencies”) issued a notice of proposed rulemaking (the “Proposed Rule”) to require savings associations currently filing the Thrift Financial Report (“TFR”) with the OTC to instead file Consolidated Reports of Condition and Income (“Call Reports”) with the OCC and FDIC. The conversion would take place beginning with the reporting period ending on March 31, 2012; savings associations are to continue to file the TFR through December 31, 2011. The change is the result of the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) dissolving the OTS and transferring all functions relating to federal savings associations, and rulemaking authority for all savings associations to the OCC, and non rule-making functions related to state-chartered savings associations to the FDIC. All functions of the OTS relating to Savings and Loan Holding Companies (“SLHCs”) are transferred to the FRB.
Increased Efficiency Anticipated. The Proposed Rule states that the OTS first explored the conversion to the Call Report in a 2007 Advance Notice of Proposed Rulemaking. While the majority of the comments received were in support of the conversion, the OTS decided in 2008 not to adopt the rule given its desire to allow savings associations to focus on their economic stability rather than facilitating the conversion. Given the improvement in the economy, the Proposed Rule states that the Agencies believe that the longer-term benefits of the conversion now outweigh the shorter-term burden associated with the first year of conversion. For the associations, the benefit is increased efficiency associated with acquiring personnel and infrastructure equipped to prepare the reports in an industry more familiar with the Call Report than the TFR. For the agencies, the Proposed Rule anticipates that having a single set of financial information for all FDIC-insured banks and savings associations will lead to more efficient evaluation and monitoring.
Estimated Burden Associated with the Conversion. For Federal savings associations filings with the OCC, The Proposed Rule estimates that the conversion will require 53.25 burden hours per quarter for an association to file, and 188 burden hours in the first year for an association to convert its systems and conduct training. For state savings associations filing with the FDIC, the Proposed Rule estimates that the conversion will require 40.42 burden hours per quarter for an association to file, and 188 burden hours in the first year for an association to convert its systems and conduct training.
Efforts to Reduce the Conversion Burden. The Proposed Rule sets forth five ways in which it would reduce the burden of conversion: (i) curtail all proposed changes to the TFR for 2011 that would increase the differences between the TFR and the Call Report; (ii) not require the inclusion of a savings association-only schedule in the Call Report; (iii) provide a “mapping” of TFR items to Call Report items, to be available on the OTS website on or before February 15, 2011; (iv) make the filing of TFR Schedule CMR during 2011 optional for OTS-regulated entities with sufficiently high ratings with the Uniform Financial Institutions Rating System; and (v) propose to cease collection of Schedule CMR beginning March 2012. The Proposed Rule notes that associations who could and would opt to not file Schedule CMR during 2011 would be required to notify their applicable regional office prior to the Schedule CMR filing deadline. The Proposed Rule notes that one factor in determining to eliminate Schedule CMR is the Agencies’ belief that a uniform policy regarding interest rate risk management will be efficient.
Significant Differences Between the TFR and the Call Report. The Proposed Rule notes significant differences between the two reports, including: (i) in the TFR, data are reported for the quarter ending on the report date of several schedules, whereas in the comparable Call Report schedules, data are reported on a calendar year-to date basis; (ii) amendments to Call Reports can be filed for up to five years after the report date, as compared with only 135 days after the end of the quarter for which the amended report is being filed; (iii) in the Call Report Schedule RC-K, institutions must report average balance sheet data computed based on daily or weekly balances, as compared with the TFR Schedule SI, which also permits computation based on balances at month-end; and (iv) savings associations can report specific valuation allowances in TFR Schedule VA, but cannot do so on the Call Report.
SLHCs to Submit the Same Reporting Forms as Bank Holding Companies (“BHCs”). In a “Notice of Intent to Require Reporting Forms for Savings and Loan Holding Companies” (the “Notice”), the FRB stated that beginning with the March 31, 2012 reporting period, SLHCs will be required to submit the same reports as BHCs. The change is the result of the provisions of the Dodd-Frank Act dissolving the OTS and transferring all functions of the OTS relating to SLHCs to the FRB. The relevant report forms are FR Y-6, FR Y-7, FR Y-9C, FR Y-9LP, FR Y-9SP, FR Y-9ES, FR Y-9CS, FR Y-10, FR Y-11/S, FR 2314/S, FR Y-8, and FR Y-12/2A. The forms are filed either quarterly, semi-annually, annually, or are event-generated. The FRB intends to produce more information related to these forms, including burden estimates, in a future notice to be published in the Federal Register on July 21, 2011, when the FRB will assume supervision of SLHCs. The Notice states that SLHCs are to continue to submit required reports according to the current reporting schedule through December 31, 2011.
FDIC and OTC Propose Rule to Require Savings Association to File data through the Summary of Deposits Survey (SOD) with the FDIC. In a Notice of Proposed Rulemaking, the FDIC and OTS announced their proposal to require savings association currently filing branching and deposit data through the Branch Office Survey System (“BOS”) with the OTS to file through the Summary of Deposits Survey (“SOD”) with the FDIC, starting on June 30, 2011. The change is being made pursuant to Dodd-Frank, and the FDIC states that it will be more efficient and will lead to more uniform data-collection and comparisons among all FDIC-insured institutions. Because the FDIC does not require single-office institutions to file the SOD, with the changes, certain institutions who currently report data through the BOS, namely single-office savings associations, will not have to report through the SOD. A trust-only savings association with more than a single office will need to file through the SOD, whereas no trust-only institutions were required to file through the BOS. The BOS and SOD collection processes are sufficiently similar that the FDIC does not anticipate an increase in the estimated burden hours per institution.
Public Comment. Comments on the Proposed Rules are due no later than April 11, 2011.