Financial Services Alert - July 12, 2011 July 12, 2011
In This Issue

Federal Banking Agencies Issue Guidance on Counterparty Credit Risk Management

On July 5, 2011, the FDIC, FRB, OCC and OTS (collectively the “Agencies”) jointly issued guidance (the “Guidance”) to clarify supervisory expectations and sound practices for an effective counterparty credit risk (“CCR”) management framework.  The Guidance discusses board and senior management responsibilities, management reporting, risk management and risk measurement.  The Guidance is intended for banking organizations with large derivatives portfolios and not for banks with less than $1 billion in assets with limited derivative exposure, especially noncomplex exposures that are typical for community banks.

The Guidance notes that CCR is a multidimensional form of risk, affected by both the exposure to and credit quality of a counterparty.  The Agencies state that the financial crisis of 2007-2009 revealed weaknesses in many CCR policies, such as their timeliness and exposure aggregation capabilities and inadequate measurement of correlation risks.  To address these weaknesses the Guidance emphasizes several areas where banking organizations can improve monitoring and management of counterparty exposure limits and concentration risks.

The Guidance emphasizes that CCR policy and risk tolerance must first be clearly articulated by the board of directors or a board-level committee.  This articulation should create a framework for establishing exposure limits and concentrations.  Senior management must be responsible for implementing a risk measurement and management framework consistent with the banking organization’s risk tolerance.  At a minimum, the Agencies state, the guidelines should outline CCR management standards that conform to the Guidance and policies should contain a detailed, clear escalation process for review and approval of policy exceptions.

The Guidance also stresses that banking organizations should have a management reporting structure that includes concentration analysis and CCR stress testing results.  Senior management needs to have access to appropriate CCR reporting metrics that assess significant issues related to risk management, which they should review monthly.  The Guidance states that risk management functions need to have full independence from CCR related trading operations, adequate resources, and sufficient authority.

Banking organizations should employ a range of risk metrics to judge their various CCR exposures.  The Guidance suggests several areas of CCR exposure that should be measured and assessed.  The Guidance additionally provides aggregation principles for sound CCR policies.  Moreover, the Agencies state, management needs to identify, quantify, and monitor CCR concentrations in several areas.  The Guidance also provides standards for stress-testing frameworks, credit valuation adjustments, wrong-way risk, and systems infrastructure.

The Agencies note that banking organizations need to impose formalized policies and procedures which place meaningful limits on exposures as part of a CCR management framework.  The Guidance provides criteria for a sound limit system and review of exceptions.  Banking organizations also must ensure adequate margin and collateral “haircut” guidelines, as set forth in the Guidance.  Moreover, the Guidance provides criteria for validating CCR models, creating close-out policies, and managing legal risk.  Finally, the Agencies state that the Guidance is not “all-inclusive” and that banking organizations should incorporate industry best practices into their policies.

FDIC Brings Suit Against Former CEO of IndyMac; Former Washington Mutual Senior Officers Seek Dismissal of FDIC Suit on Grounds That They Should Be Protected by Business Judgment Rule

In the aftermath of the financial crisis of 2008 and the significant losses suffered by the FDIC’s Deposit Insurance Fund, the FDIC has brought eight director and officer (“D&O”) liability suits against former institution-affiliated parties of failed financial institutions and the FDIC has asserted that it intends to file more D&O suits over the next few years.  There have recently been developments in two high-profile D&O claims brought by the FDIC as receiver of failed banks, claims against the former CEO of IndyMac Bank FSB (“IndyMac”) and claims against three senior executives of Washington Mutual Bank (“WaMu”).

IndyMac claim.  The FDIC filed a lawsuit as receiver for IndyMac against Michael Perry, former CEO of IndyMac, seeking $600 million in damages on the grounds that Mr. Perry negligently allowed IndyMac to generate and purchase $10 million in risky residential mortgage loans when, the FDIC alleges, Mr. Perry knew, or reasonably should have known, that the market had become unstable and illiquid.  When IndyMac was unable to sell the loans, it had to retain them in IndyMac’s investment portfolio, and as a result of retaining these loans, the FDIC, as receiver of IndyMac, allegedly suffered $600 million in losses.  The FDIC stated that “Instead of enforcing credit standards, Perry chose to roll the dice in an aggressive gamble to increase market share while sacrificing credit standards.”  FDIC v. Perry, case number 11-5561, U.S.D.C. Central Dist. of CA (2011).

WaMu Claim.  In March 2011, the FDIC, as receiver of WaMu, filed a suit against former WaMu CEO, Kerry Killinger, former WaMu COO, Stephen Rotella, and former WaMu Home Loans President, David Schneider (and their spouses) alleging that the former executives negligently and in breach of their fiduciary duty to WaMu, allowed WaMu “to take extreme and historically unprecedented risks with WaMu’s held-for-investment home loan portfolio.”  On July 1, 2011, the defendants filed a motion seeking dismissal of the FDIC’s suit on grounds that the business judgment rule is a shield that prevents the FDIC from second guessing the executives’ allegedly good faith business decisions, which led to losses for WaMu.  The former executives’ motion also asserts that the OTS’ on-site examiners at WaMu concurred in the business decisions that came out poorly as they “knew about and approved the challenged business decisions in real time.”  FDIC v. Killinger, case number 2:11-CV-00459 MJP, U.S.D.C. Western Dist. of WA (2011).

SEC Staff Provides No-Action Relief from Advisers Act Registration to a Wholly-Owned Subsidiary Advising Foreign Funds Whose Sole Investor Was Adviser’s Parent

The Staff of the SEC’s Division of Investment Management (the “Staff”) issued a no-action letter stating that it would not recommend enforcement action against a wholly-owned subsidiary (the “Adviser”) providing investment advisory services solely to four foreign funds (the “Funds”) in which the Adviser’s parent (the “Parent”) is the only investor.  The Adviser, a New York corporation, is a wholly-owned subsidiary of the Parent, a Japanese insurance federation.  The Adviser was established as a separate entity for tax reasons and operates solely for the purpose of providing investment advisory services to the Funds, each a series of a trust established under Bahamian law.  The Adviser has its only place of business in New York City and has assets under management in the United States in excess of $150 million.  All investment management personnel of the Adviser are seconded from the Parent.  The Adviser pays the salaries of its personnel.  The Adviser does not hold itself out to the public as an investment adviser and intends to provide investment advisory services solely to the Funds and any future private funds in which the Parent or one of its wholly‑owned subsidiaries is the only investor.  The Funds are designed to enable the Parent to pool and invest premiums received from its insureds to meet claim obligations and other operating costs of the Parent’s business. Neither the Parent nor the Adviser has received any investment direction from any of the Parent’s insurers or from any third party.

Whether an investment adviser must register under the Investment Advisers Act of 1940 (the “Advisers Act”) depends in part on whether it is an “investment adviser,” which the Advisers Act defines in basic terms as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”  The Adviser, which had relied on the “private adviser exemption” eliminated by the Dodd‑Frank Act effective July 21, 2011, sought relief from the Staff on the grounds that it was not an “investment adviser” subject to the Advisers Act because it was not in the business of “advising others.”  In granting relief, the Staff cited in particular representations from the Adviser that (1) it is a wholly-owned subsidiary of the Parent; (2) it was established and has been operated for the sole purpose of providing investment advisory services to the Parent via the Funds in which the Parent is the only investor; (3) the Adviser does not hold itself out to the public as an investment adviser; and (4) the Funds are established solely for the benefit of the Parent and consist solely of the Parent’s assets.

SEC Staff Posts FAQ on Mid-Sized Advisers

The staff of the SEC’s Division of Investment Management has posted Frequently Asked Questions Regarding Mid-Sized Advisers on the SEC website.  The FAQ removes Minnesota from the list of states in which a mid-sized adviser would not be “subject to examination” by a state securities authority, leaving only New York and Wyoming.  For a discussion of the mid-sized adviser category under the Investment Advisers Act of 1940 (the “Advisers Act”) created by the Dodd-Frank Act, see the June 30, 2011 Goodwin Procter Alert, which discusses state versus federal regulation under recent Advisers Act rulemaking designed to implement changes in the federal regulation of investment advisers effected by the Dodd‑Frank Act.

FinCEN Issues Guidance on Actions that U.S. Financial Institutions Should Take as a Result of Recent Unrest in Syria

The Financial Crimes Enforcement Network (“FinCEN”) issued an advisory (the “Advisory“) urging U.S. financial institutions (“FIs”) “to take reasonable risk-based steps with respect to the potential increased movement of assets that may be related to the current unrest in Syria.”  The Advisory reminds FIs to apply enhanced scrutiny to their review of private banking accounts of foreign political figures, and to their monitoring of transactions for potentially misappropriated or diverted state assets, the proceeds of bribery or public corruption and for other illegal payments.

SEC Provides Limited Extension of Compliance Deadlines for New Risk Management Control Requirements Applicable to Broker-Dealers with Market Access

The SEC has extended the July 14, 2011 compliance date for certain provisions of Rule 15c3-5 under the Securities Exchange Act of 1934.  Rule 15c3-5 requires brokers or dealers with access to trading securities directly on an exchange or alternative trading system (“ATS”) and broker‑dealer operators of an ATS that provide access to trading securities directly on their ATS to a person other than a broker-dealer, to establish, document and maintain a system of risk management controls and supervisory procedures.  The new compliance date for (i) all Rule 15c3-5 requirements as they apply with respect to fixed income securities and (ii) the requirements of Rule 15c3-5(c)(1)(i) as it applies with respect to all securities, is November 30, 2011.  (Rule 15c3-5(c)(1)(i) addresses financial risk management controls and supervisory procedures designed to prevent the entry of orders that exceed appropriate pre-set credit or capital thresholds.)  The compliance date for all other provisions of Rule 15c3-5 remains July 14, 2011.  For a more detailed discussion of Rule 15c3-5, see the November 16, 2010 Alert.