Financial Services Alert - December 13, 2011 December 13, 2011
In This Issue

OCC Proposes Rule Amendments to Remove References to Credit Ratings and Provides Guidance on Due Diligence Requirements in Determining Whether Investment Securities Are Eligible for Investment

The OCC announced the issuance of proposed amendments to remove references to credit ratings from various OCC regulations and related proposed guidance designed to assist national banks and federal savings associations in meeting due diligence requirements for assessing credit risk for portfolio investments.  In particular, the OCC is proposing to amend the definition of “investment grade” to remove the current reference to credit ratings and to replace other references to credit ratings with alternative standards of creditworthiness for the purposes of its regulations at 12 CFR parts 1, 16, 28, and 160.

National Bank Regulations.   Under the proposed amendments to parts 1 and 16, a security would be “investment grade” if the issuer of the security has an adequate capacity to meet financial commitments under the security for the projected life of the asset or exposure.  The “adequate capacity to meet financial commitments” standard would replace language in §§ 1.2 and 16.2 which currently reference NRSRO credit ratings.  To meet this new standard, national banks would be required to determine that the risk of default by the obligor is low and the full and timely repayment of principal and interest is expected.

While a bank would be permitted to consider external credit ratings and assessments, it would be required to supplement external ratings with due diligence processes and analyses that are appropriate for the bank’s risk profile and for the size and complexity of the instrument.

Foreign Banking Institutions.   The OCC’s capital equivalency deposit regulation at 12 CFR 28.15 currently allows for the use of certificates of deposit or bankers’ acceptances as part of the deposit, if the issuer is rated investment grade by an internationally recognized rating organization.  The OCC is proposing to remove the requirement referencing credit ratings provided by ratings organizations. Instead, the issuer of the certificate of deposit or banker’s acceptance must have “an adequate capacity to meet financial commitments for the projected life of the asset or exposure.”

Diligence Requirements for Assessing Credit Risk for Portfolio Investments.  The proposed guidance sets forth the OCC’s expectation that national banks and Federal savings associations should conduct an appropriate level of due diligence to determine that an investment security is a permissible investment, which may include consideration of internal analyses, third party research and analytics including external credit ratings, internal risk ratings, default statistics, and other sources of information as appropriate for the particular security.  Under the proposed guidance, the depth of the due diligence would be a function of the security’s credit quality, the complexity of the structure, and the size of the investment.  The more complex a security’s structure, the more credit-related due diligence an institution would need to perform, even when the credit quality is perceived to be very high.  Bank management would need to ensure that it understands the security’s structure and how the security will perform in different default environments, and be particularly diligent when purchasing structured securities.  National banks and federal savings associations would have to consider a variety of factors relevant to the particular security when determining whether a security is a permissible and sound investment.  The range and type of specific factors would vary depending on the particular type and nature of the securities.  The proposed guidance includes a list of factors that may be relevant to evaluating potential purchases of Corporate Bonds, Municipal Government General Obligations, Revenue Bonds or Structured Products.

Public Comment.  Comments on the proposed amendments and guidance must be submitted no later than December 29, 2011.

Federal Bank Regulatory Agencies Seek Comment on Additional Revisions to the Market Risk Capital Rules

On December 7, 2011, the FRB, the FDIC and the OCC (collectively, the “Agencies”) issued a joint release announcing they are seeking comment on an amendment to the notice of proposed rulemaking (the “NPR”) to modify the Agencies’ market risk capital rules, published in the Federal Register on January 11, 2011 (the “January 2011 NPR”).

Under the Dodd-Frank Act, all federal agencies must remove references to, and requirements of, reliance on credit ratings from their regulations and replace them with appropriate alternatives for evaluating creditworthiness.  The January 2011 NPR included modifications to the agencies’ market risk capital rules for banking organizations with significant trading activities.  The NPR proposes alternative standards of creditworthiness to be used in place of credit ratings in determining the capital requirements for certain debt and securitization positions covered by the market risk capitalization rules.  Such alternative standards include the use of country risk classifications published by the Organization for Economic Cooperation and Development for sovereign positions, company-specific financial information and stock market volatility for corporate debt positions, and a supervisory formula for securitization positions.

The Agencies have requested comments on the NPR by February 2, 2012, and expect to publish a final market risk capital rule after reviewing comments to both the NPR and the January 2011 NPR.

OCC Issues Bulletin Concerning Process of Integrating OTS Policy Guidance

The OCC issued a bulletin (the “Bulletin”) concerning the process it will use to integrate OTS policy guidance documents (the “OTS Guidance”).  The OCC said that it is beginning a comprehensive rulemaking project to integrate OTS rules applicable to federal savings associations with OCC rules applicable to national banks.  The OCC stated that its goal is “to produce a consistent supervisory approach and integrated policy platform for national banks and federal savings associations, while recognizing differences anchored in statute.”  The OCC noted that there are more than 1,000 OTS documents that the OCC will need to address.

The OCC stated that its process for integrating the OTS Guidance would involve two phases.  In Phase I the OCC intends to rescind certain documents, including OTS documents that:

(a)  transmitted or summarized rules, interagency guidance or Examination Handbook sections (but not the OTS guidance or rule itself);

(b)  are no longer useful because the OTS was merged into the OCC or because of the passage of time; and

(c)  duplicate existing OCC guidance.

The Bulletin also states that the OCC, during Phase I, will also rescind outdated OCC guidance.

During Phase II, the OCC stated that it would review OTS Guidance that requires further analysis, substantive revisions or combination with other guidance or that applies only to federal savings associations.  The OCC stressed in the Bulletin that former OTS Guidance remains applicable to federal savings associations until rescinded, superseded or retired by the OCC.

SEC Extends Comment Period for Proposal Regarding Conflicts of Interest for Certain Securitizations

The SEC extended until January 13, 2012 the comment period on a rule proposal designed to implement Section 621 of the Dodd-Frank Act (the “ABS Conflicts Proposal”).  In broad terms, Section 621 prohibits an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security (“ABS”), whether or not registered and including a synthetic ABS, from engaging in a transaction that would involve or result in certain material conflicts of interest.  The ABS Conflicts Proposal was briefly discussed in the September 27, 2011 Financial Services Alert.  

The SEC has extended the comment deadline (originally December 19, 2011) to give the public a better opportunity to consider any potential interplay between the ABS Conflicts Proposal and the more recent Volcker Rule proposal issued by the FRB, OCC, FDIC and SEC (discussed in the October 20, 2011 Financial Services Alert).  The comment period for the Volcker Rule proposal closes on January 13, 2012; the SEC would consider a further extension of the ABS Conflicts Proposal comment period if the Volcker Rule proposal comment period is extended beyond January 13, 2012.

SEC Announces Compliance Outreach Program National Seminar for Adviser and Fund CCOs and Senior Officers

The SEC staff announced that it will be holding the Compliance Outreach Program’s 2012 National Seminar for investment adviser and investment company chief compliance officers and senior officers in Washington, DC on January 31, 2012.  The Seminar will be simulcast on the SEC website here, with the webcast archived for future access.  The agenda for the January 2012 Seminar is available here.

Massachusetts Securities Division Postpones Hearing on Revised Investment Adviser Registration Exemptions and Related Public Hearing

The Massachusetts Securities Division (the “Division”) postponed until January 5, 2012 and January 6, 2012, respectively, the dates for a public hearing and for submission of public comment on a revised proposal that would phase out a commonly-used exemption from registration as an investment adviser with the Commonwealth and create a new private fund adviser registration exemption.  The revised proposal was discussed in the November 15, 2011 Financial Services Alert.

SEC Announces Charges Against Hedge Fund Managers Arising out of Aberrational Performance Inquiry

The SEC announced four additional enforcement actions stemming from its Aberrational Performance Inquiry, an initiative to combat hedge fund fraud by identifying and investigating abnormal investment performance.  The initiative uses proprietary risk analytics to evaluate hedge fund returns for performance that appears inconsistent with a fund’s investment strategy or other benchmarks and then subjects funds identified by this process to further scrutiny.  The initiative, which is being conducted by the Asset Management Unit of the Division of Enforcement, is ongoing.