Financial Services Alert - October 23, 2012 October 23, 2012
In This Issue

OCC Issues Guidance Regarding Community Bank Stress Tests

The OCC issued guidance (the “Guidance”) to national banks and federal savings associations with total consolidated assets of less than $10 billion (collectively, “Community Banks”) on using stress tests to identify and quantify risk in loan portfolios and to help establish effective strategic planning processes and maintain adequate capital.  As discussed in the October 16, 2012 Financial Services Alert, the OCC, FDIC and FRB recently published final rules regarding stress tests for larger banks.

The OCC noted that it does not endorse a particular stress testing method for Community Banks; a Community Bank’s approach to stress testing should fit its unique loan portfolio strategy, size, loan types, composition, operations, and management.  Given the smaller scale and lesser complexity of most Community Banks, the OCC noted that assessing portfolio risk and capital vulnerability can be relatively simple and need not involve sophisticated analysis or third-party consultative support.  The OCC further stated, however, that an effective stress test will have the following elements: (1) asking plausible “what if” questions about key vulnerabilities; (2) making a reasonable determination of how much impact the stress event or factor might have on earnings and capital; and (3) incorporating the resulting analysis into the bank’s overall risk management process, asset/liability strategies, and strategic and capital planning processes.

The OCC advised that Community Banks engage in stress testing or sensitivity analysis of loan portfolios at least annually and use stress testing to establish and support reasonable risk appetite and tolerances, set concentration limits, adjust strategies, and appropriately plan for and maintain adequate capital levels. The OCC stated that it expects every bank, regardless of size or risk profile, to have an effective internal process to (1) assess its capital adequacy in relation to its overall risks, and (2) to plan for maintaining appropriate capital levels.  Bank management should mitigate identified risks and vulnerabilities through actions like increased portfolio monitoring, adjusted underwriting standards, selling or hedging assets, and increasing capital and should use the results of stress tests to establish appropriate action plans that address risks when the results are inconsistent with risk tolerance levels and the bank’s overall strategic and capital plans.

The Guidance sets forth certain potential methods and approaches to stress testing, including transaction stress testing, portfolio stress testing, enterprise level stress testing and reverse stress testing and noted that a Community Bank should primarily focus on concentrations of credit or loan portfolio segments that are significant to its overall business strategy.  The OCC stated that Community Banks can conduct stress tests on identified credit concentrations, on other loan portfolio segmentations, and at the individual loan level and that selecting the appropriate factors to stress test depends on the nature of the bank’s concentration risk.  The OCC noted that while problem credits are routinely the focus of risk management, the potential effects on credit concentrations or other portfolio segments are the focus of portfolio level stress testing and stated that the appropriate time frame for a stress test scenario should be at least a two-year projection because, in any given credit cycle, losses generally emerge over a two-year period following the downturn.

The OCC mentioned that it had created a new stress test tool, available along with other tools on the OCC’s BankNet website, for income-producing commercial real estate (“CRE”) loan portfolios for banks that exceed certain CRE concentration levels.

The OCC stated the both bank management and bank examiners should use the Guidance in conjunction with the following previously published guidance on stress testing objectives and methods: the “Concentrations of Credit” booklet in the OCC’s Comptroller’s Handbook series; OCC Bulletin 2012-16, “Guidance for Evaluating Capital Planning and Adequacy”; and the Interagency Final Guidance on “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.”

FRB Approves First SLHC Deregistration Request Based on Section 604(i) of Dodd-Frank

The FRB recently approved a request made by The Northwestern Mutual Life Insurance Company (“Northwestern”) to deregister as a savings and loan holding company (“SLHC”) pursuant to Section 604(i) of the Dodd-Frank Act.  This provision amended the Home Owners’ Loan Act to exclude from the definition of SLHC a company that controls a savings association that functions solely in a trust or fiduciary capacity in the manner contemplated by Section 2(c)(2)(D) of the Bank Holding Company Act (the “BHC Act”).  Under FRB guidance, an SLHC that controls only one savings association subsidiary that meets this requirement may seek deregistration by submitting an application to the FRB.  To qualify as an institution engaged solely in trust or fiduciary activities under Section 2(c)(2)(D) of the BHC Act, (1) all or substantially all of the deposits of the institution must consist of trust funds received in a bona fide fiduciary capacity; (2) no deposits of the institution which are insured by the FDIC may be offered or marketed by or through an affiliate of the institution; (3) the institution may not accept demand deposits or deposits that the depositor may withdraw by check or similar means for payment to third parties or others or make commercial loans; and (4) the institution may not obtain payment or payment-related services from any Federal Reserve Bank or exercise discount or borrowing privileges.

The FRB’s approval of Northwestern’s request is notable because it appears to be the first such deregistration request approved pursuant to Section 604(i) of the Dodd-Frank Act and because the commitments provided by Northwestern as described in the FRB approval letter suggest that an institution may disregard the amount of deposits needed to maintain deposit insurance for purposes of determining whether all or substantially all of its deposits consist of trust funds.  Prior FRB guidance has suggested that at least 99% of an institution’s deposits must consist of trust funds in order to meet this standard, but FDIC regulations require insured depository institutions to maintain at least $500,000 in non-trust deposits to maintain federal deposit insurance.  Unlike state trust companies, which may operate without deposit insurance depending upon state law, the OCC (as did its predecessor with respect to regulating savings associations, the OTS) requires federal savings associations to maintain federal deposit insurance even if they otherwise limit their business to engaging only in trust activities.

SEC Proposes Capital, Margin, and Segregation Rules for Security-Based Swap Dealers and Major Security-Based Swap Participants

The SEC voted unanimously to issue a rule proposal that would impose capital and margin requirements for security-based swap dealers (“SBSDs”) and major security-based swap participants (“MSBSPs”) and segregation rules for SBSDs.  The proposed rules are generally based on existing requirements applicable to broker-dealers and would impose different, but structurally similar, capital, margin and segregation requirements on broker-dealer SBSDs and on SBSDs not registered as broker-dealers (“stand-alone SBSDs”).  Some of the changes to the net capital rule, Rule 15c3-1 under the Securities Exchange Act of 1934 (“Exchange Act”), would also apply to broker-dealers that are not registered as SBSDs, in order to maintain a consistent capital treatment for security-based swaps and swaps.  The SEC proposed a tangible net worth capital standard for MSBSPs, recognizing that MSBSPs may be entities engaged in a diverse range of business activities different from, and broader than, the securities activities of broker-dealers and SBSDs, and that a significant percentage of their assets may consist of unsecured receivables generated in the ordinary course of their businesses, but which have a value of zero under the haircuts applied to the tentative net capital of broker-dealers under Rule 15c3-1.

The SEC acknowledged that the specific quantitative requirements included in the proposal were not derived from econometric or mathematical models, and that it had not performed a detailed quantitative analysis of the likely economic consequences of the specific quantitative requirements being included in the proposal.  Rather, the SEC stated that it had drawn from its experiences in regulating broker-dealers and had looked to comparable quantitative elements in the existing broker-dealer financial responsibility regime or, where appropriate, existing or proposed regulations of FINRA or the CFTC with respect to similar activities.  The SEC invites comment, including relevant data and analysis, regarding all aspects of the quantitative requirements reflected in the proposed rules.


The proposal would establish a fixed dollar minimum capital requirement -- $20 million for most entities, and $1 billion for broker-dealers that use the alternative net capital computation under Rule 15c3-1(a)(7) (“ANC broker-dealers”).  ANC broker-dealers have been approved by the SEC to use internal value-at-risk (“VaR”) models to determine market risk charges for proprietary securities and derivatives positions and to take a credit risk charge related to OTC derivatives transactions in lieu of the 100% haircut charged to other broker-dealers for unsecured receivables.  The proposal would also establish a ratio requirement equal to 8% of the margin required of the SBSD’s customers for cleared and non-cleared security-based swaps; thus the minimum capital requirement would be the greater of the fixed dollar minimum and 8% of the firm’s risk margin amount.  The SEC believes that the 8% margin factor would adjust the firm’s minimum capital to take into account the firm’s level of risk, since the margin required varies with the size and riskiness of the business conducted by the regulated entity.  Non-bank SBSDs and SBSDs that are broker-dealers would also be subject to ratio requirements currently applicable to OTC derivatives dealers pursuant to existing Exchange Act Rule 15c3-4, while stand-alone SBSDs would be required to comply with several similar ratio requirements through new Rule 18a-1 under the Exchange Act.

The proposal would also require SBSDs that are not approved to use internal VaR models to apply standardized “haircuts” when computing net capital for certain derivatives, including security-based swaps, with the haircuts varying based upon the class of security at issue.  

ANC broker-dealers and non-bank SBSDs would be subject to liquidity risk management requirements. 

Non-bank MSBSPs would be required to maintain a positive tangible net worth.  The term “tangible net worth” would be defined to mean the MSBSP’s net worth as determined in accordance with generally accepted accounting principles in the U.S., excluding goodwill and other intangible assets.  In determining net worth, all long and short positions in security-based swaps, swaps and related positions would need to be marked to their market value.  Further, a non-bank MSBSP would be required to include in its computation of tangible net worth all liabilities and obligations of a subsidiary or affiliate that the MSBSP guarantees, endorses or assumes, either directly or indirectly.  MSBSPs would also be required to comply with Rule 15c3-4.


Margin requirements for SBSDs would be modeled on those set for broker-dealers.  Unless an exception applies, SBSDs would need to collect both initial and variation margin from counterparties to non‑cleared security-based swap transactions.  The proposal details how these margins will be calculated and what constitutes acceptable collateral.  Certain exceptions would apply.  For example, non-bank SBSDs would not need to collect margin collateral for transactions with commercial end users.  The SEC is seeking comment regarding whether SBSDs should be required to collect initial margin in transactions with each other (variation margin would be required).  MSBSPs would be required to calculate and collect or deliver collateral covering variation margin, but not initial margin.  Margin requirements for both SBSDs and MSBSPs will be subject to a $100,000 minimum transfer amount.  Under this provision, an SBSD or MSBSP would not be required to collect or deliver collateral to meet an account equity requirement if the amount required to be collected or delivered is $100,000 or less.  If the minimum transfer amount is exceeded, the entire account equity requirement would need to be collateralized, not just the amount over $100,000.


The proposal would establish additional collateral segregation requirements for cleared and non-cleared security-based swaps.  It would allow an SBSD to commingle counterparty collateral in a segregated account under certain conditions.  SBSDs would be required to maintain possession and control of all “excess securities collateral,” which refers to securities and money market instruments of security-based swap customers held by the SBSD that exceed the SBSD’s current exposure to the customer, excluding certain securities and instruments held by a clearing agency and certain securities and instruments held by another SBSD.  This is similar to provisions of Exchange Act Rule 15c3-3 that require broker-dealers to maintain possession and control of fully-paid securities and excess margin securities.  Non-bank SBSDs would also be required to maintain a separate reserve of funds or qualified securities for the benefit of their security-based swap customers.

Public Comment

Comments on the proposal are due 60 days after its forthcoming publication in the Federal Register.

SEC Staff Issues Legal Bulletin on Shareholder Proposals

The Division of Corporation Finance issued Staff Legal Bulletin No. 14G which addresses shareholder proposals submitted in accordance with Rule 14a-8 under the Securities Exchange Act of 1934.  The topics addressed in the bulletin are (1) proof of ownership under Rule 14a‑8(b)(2)(i) for purposes of verifying whether a beneficial owner is eligible to submit a proposal under the Rule; (2) the manner in which companies should notify proponents of a failure to provide proof of ownership for the one-year period required under Rule 14a-8(b)(1); and (3) the use of website references in proposals and supporting statements.

Goodwin Procter Alert: NYSE and NASDAQ Submit Proposed Listing Standards on Compensation Committee Independence and Compensation Adviser Engagement/Independence

Goodwin Procter’s Capital Markets Practice issued a Client Alert that discusses listing standard proposals submitted by the NYSE and NASDAQ to address SEC rules mandated under the Dodd-Frank Act concerning the independence of compensation committees and the engagement and independence of compensation advisers.  (The NYSE and NASDAQ proposals preserve existing exemptions from compensation committee listing standards for registered open-end and closed-end investment companies, among other categories of issuers.)

Goodwin Procter Alert: New Iran Sanctions Law Closes Foreign Subsidiary Loophole

Goodwin Procter’s National Security & Foreign Trade Regulation Practice issued a Client Alert discussing the new Iran Threat Reduction and Syria Human Rights Act of 2012 (the “Act”).  The Act, among other things, (i) closes a loophole under which a foreign subsidiary of a U.S. company could engage in transactions with Iran provided it acted independently of, and was not facilitated by, a “U.S. person;” and (ii) requires domestic and foreign companies that issue securities traded on a U.S. exchange to disclose to the SEC certain sanctions – related business dealings of the issuer and its affiliates.

New ERISA Litigation Update Available

Goodwin Procter’s ERISA Litigation Practice published its latest quarterly ERISA Litigation Update.  The update discusses (1) a Sixth Circuit decision affirming the dismissal of claims brought by a participant in a defined contribution plan against his employer for losses incurred when his plan account was transferred from a stable value fund to a life cycle fund that qualified as a QDIA, (2) the certification of a class in an ERISA case alleging breach of fiduciary duty and prohibited transactions against an insurance company in connection with revenue sharing practices under group annuity contracts issued to administrators of defined contribution retirement plans, and (3) a Fourth Circuit decision holding that ERISA’s catch-all provision allows wide-ranging relief against breaching fiduciaries, including a surcharge and equitable estoppel, consistent with dicta in the Supreme Court’s Amara decision.

U.K. Development of Note - Tax and Chancery Chamber Upholds FSA Sanctioning of Swiss Fund Manager and Brokers for Marking the Close

The Upper Tribunal, Tax and Chancery Chamber of the United Kingdom (the “Tribunal”) issued a decision (the “Decision”) upholding the United Kingdom, Financial Services Authority’s (the “FSA”) decision to ban and fine the Switzerland-based manager (the “Manager”) of a hedge fund (the “Fund”), and two traders at a London-based broker (the “Broker”) for committing “market abuse” by deliberately manipulating the market price of certain securities in order to increase the valuation of certain of the Fund’s holdings on certain portfolio valuation dates in violation of Section 118 of the Financial Services and Markets Act of 2000 (the “FSMA”).   In general terms, Section 118 defines market abuse to include effecting transactions that (a) “give, or are likely to give, a false or misleading impression as to the supply of, or demand for, or as to the price of, one or more qualifying investments [securities traded on a regulated market within the European Union], or (b) secure the price of one or more such investments at an abnormal or artificial level.”

The Manager’s Trading Activity.  Through an investment adviser (the “Adviser”) which he wholly owned, the Manager advised a private fund (the “Fund”), in which he held a roughly one-quarter interest, with the remainder held by family and close friends.  On December 31, 2007, the Manager gave orders to the Brokers to be executed in various stocks on European and U.S. exchanges represented in roughly half of the Fund’s portfolio at the close of business with (as the FSA alleged, but the Manager denied) the intention to increase the closing price of the securities which in turn would increase the value of the Fund.  Most of the stocks were comparatively illiquid and subject to wide price spreads such that even small trades could have a significant impact on their prices.  The Manager and the traders then engaged in similar activities on behalf of the Fund on January 31, 2008.

Finding of Market Abuse.  The Tribunal accepted as a finding of fact that the Manager did not place the orders to increase the management fees that he received from the Fund, which were based on year-end and month-end Fund net asset values, but partly for reasons of pride to make him look more like a competent manager and to dissuade investors from leaving the Fund and partly to support the relevant companies in which the trades were made.  Nonetheless, the Tribunal found that the instructions to trade in particular securities to support/increase their prices and the transactions implementing those instructions constituted market abuse under the FSMA irrespective of the particular motives underlying them, and on that basis, upheld the FSA’s determination that the conduct of the Manager and the traders constituted market abuse under Section 118 of the FSMA.

Sanctions.  The Tribunal ordered that: (a) the Manager pay a fine of £900,000 and pay disgorgement in the amount of £362,950 representing the amount of the Manager’s illicit gains from the activity, (b) the status of the senior trader at the Broker as an “approved person” be revoked (effectively, a ban with respect to the UK financial services industry) and that he be required to pay a fine of £650,000, subject to adjustment following a future proceeding relating to his personal circumstances, and (c) that the status of the junior trader at the Broker as an “approved person” be revoked.

Analysis.  The Tribunal’s decision illustrates the following important points:

  1. The FSA is willing to take, and the Tribunal is willing to uphold, action against fund managers outside of the United Kingdom.  The result here is consistent in this regard with the FSA’s decision in January 2012 to fine the manager of a U.S.‑based hedge fund for engaging in market abuse in violation of Section 118 of the FSMA.
  2. The Tribunal is prepared to increase fines imposed by the FSA when it does not deem them to be sufficient.  Noting that the conduct of the Manager and the traders was “as serious a case of market abuse of its kind as one might conceive,” and finding that the FSA was originally too lenient, the Tribunal increased the fine to be paid by the senior trader from £550,000 to £650,000.
  3. Brokers effecting abusive trades based on instructions by a manager may also be fined or banned from participation in the financial service industry.  Despite the fact that neither the Broker nor the traders received any particular benefit from the conduct other than the commission earned in executing transactions for an important client, the Tribunal sanctioned the traders based on a finding that they should have realized that the transactions were abusive and refused to execute them.  (No action was taken against the Broker, which dismissed both traders following an internal investigation and disciplinary inquiry.)