Financial Services Alert - April 15, 2014 April 15, 2014
In This Issue

FINRA Requests Comment on the Effectiveness and Efficiency of its Rules on Gifts and Gratuities and Non-Cash Compensation and its Rules on Communications With the Public

As part of an assessment of selected rules and related administrative processes, FINRA has issued Regulatory Notice14-15 and Regulatory Notice14-14 seeking public comment on the effectiveness and efficiency of its (a) Gifts and Gratuities and Non-Cash Compensation Rules and (b) Communications With the Public Rules, respectively.   These requests for public comment are part of the first phase of a review process, in which FINRA will assess the efficacy and efficiency of the rule or rule set as currently implemented, including FINRA’s internal administrative processes.  FINRA staff will report its findings to the Board of Governors and make a general staff recommendation as to whether the rule or rule set should be maintained as is, modified or deleted.  If the findings report recommends modification of rules, FINRA will separately engage in its usual rulemaking process to propose amendments to the rules based on the findings.

The Gifts and Gratuities and Non-Cash Compensation Rules consist of the following:

  • FINRA Rule 3220 (Influencing or Rewarding Employees of Others)
  • FINRA Rule 2310(c) (Direct Participation Programs)
  • FINRA Rule 2320(g)(4) (Variable Contracts of an Insurance Company)
  • FINRA Rule 5110(h) (Corporate Financing Rule – Underwriting Terms and Arrangements)
  • FINRA Rule 2830(I)(5) (Investment Company Securities)

The Communications With the Public Rules consist of the following:

  • FINRA Rule 2210 (Communications with the Public)
  • FINRA Rule 2212 (Use of Investment Company Rankings in Retail Communications
  • FINRA Rule 2213 (Requirements for the Use of Bond Mutual Fund Volatility Ratings)
  • FINRA Rule 2214 (Requirements for Use of Investment Analysis Tools)
  • FINRA Rule 2215 (Communications with the Public Regarding Securities Futures)
  • FINRA Rule 2216 (Communications with the Public Regarding Collateralized Mortgage Obligations)

FINRA seeks answers to the following questions with respect to each set of rules, along with any supporting data or evidence:

  1. Have the rules effectively addressed the problem(s) they were intended to mitigate?
  2. What have been experiences with implementation of the rule set, including any ambiguities in the rules or challenges to comply with them?
  3. What have been the costs and benefits arising from FINRA’s rules? Have the costs and benefits been in line with expectations described in the rulemaking?
  4. Can FINRA make the rules more efficient and effective, including FINRA’s administrative processes?

Comment Period.   The deadline for submission of comments on each set of rules, originally set for May 8, 2014, has been extended through May 23, 2014.

FRB to Extend Volcker Rule Conformance Period for Existing CLOs

The FRB announced its intention to provide banking entities with two additional one-year extensions to conform their ownership interests in and sponsorship of certain collateralized loan obligations (“CLOs”) to the requirements of the Volcker Rule.  Unless an exemption applies, the Volcker Rule prohibits banking entities from sponsoring, acquiring or retaining an ownership interest in any covered fund, which generally includes any fund that would be an investment company but for reliance upon Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940.  The definition of “covered fund” provides several exceptions, including a loan securitization exception for certain vehicles that hold loans and do not hold securities except in limited circumstances. 

Certain CLOs are currently sponsored by banking entities or have issued interests to banking entities that may be deemed to be ownership interests for purposes of the Volcker Rule (e.g., the senior class of notes may have the right to replace the investment manager).  Many CLOs rely on Section 3(c)(7) to avoid investment company status, and if they include, as they often do, a small bucket for debt securities (as opposed to loans), such CLOs are captured by the “covered fund” definition and are not able to avail themselves of the loan securitization exception.  Therefore, banking entities will not be permitted to sponsor or maintain an ownership interest in such CLOs once the conformance period ends (assuming no substantive changes to the rule or unless the banking entity can avail itself of a separate exemption for certain issuers of asset-backed securities).  As a result, banking entities may be required to divest certain holdings in certain CLOs prior to the end of the conformance period.

The FRB’s actions would give banking entities until July 21, 2017, to conform their ownership interests in and sponsorship of CLOs to the statute.  The relief would be limited to CLOs in place as of December 31, 2013, and that do not qualify for the exclusion in the final rule for loan securitizations.  The FRB announced its intention to enact the extensions in August, 2014 and then again in August, 2015. 

The FRB noted that the other federal agencies involved with enforcing the Volcker Rule will recognize the further extensions of the conformance period; those agencies stated in a letter to the Chairman of the House of Representatives Committee on Financial Services that they “support the statement issued by the Federal Reserve Board” extending the conformance period with respect to CLOs.  The FRB had previously extended the conformance period until July 21, 2015. 

The reaction of members of Congress and industry participants was generally one of disappointment, because the FRB’s extension of the conformance period, without additional relief, is still expected to force write-downs of investments and fire sales of assets as banks are forced to divest non-conforming assets prior to the end of the conformance period.

FRB, FDIC and OCC Issue Final Rule Regarding Leverage Ratios for Largest Top-Tier Bank Holding Companies

On April 8, 2014, the FRB, FDIC and OCC (collectively, the “Agencies”) released a final rule (the “Final Rule”) concerning the leverage ratio standards for large, interconnected U.S. banking organizations.  The Final Rule applies to any U.S. top-tier bank holding company with more than $700 billion in total consolidated assets or more than $10 trillion in assets under custody (a “Covered BHC”).  The Final Rule also applies to any insured depository institution subsidiary of a Covered BHC (a “Covered IDI,” and together with the Covered BHC, a “Covered Organization”).  In July 2013, the Agencies proposed leverage ratios which were consistent with the ratio adopted by the Basel Committee on Banking Supervision (the “Basel Committee”); the Final Rule provides for several ratios that are higher than those adopted by the Basel Committee. 

Under the Final Rule, a Covered IDI must maintain a supplementary leverage ratio of at least 6% (up from 3% proposed by the Basel Committee), and a Covered BHC must maintain a minimum supplementary leverage ratio of 5% (up from 3%).  Under the Final Rule, a Covered BHC that maintains a leverage buffer of Tier 1 capital in an amount greater than 2% of its total leverage exposure is not subject to limitations on distributions or discretionary bonus payments.  The Final Rule is effective January 1, 2018 and currently applies to eight U.S. banking organizations.

The Agencies adopted the Final Rule under the premise that the largest banks have an outsized impact on the banking system, and therefore should be required to hold higher levels of capital, as strong capital is an important safeguard that helps financial institutions navigate periods of financial or economic stress.  The Agencies stated that they believe the Final Rule will strengthen the Covered BHCs, and indirectly, the financial industry, by decreasing the likelihood of capital shortfalls. 

Opponents of the Final Rule have noted that the Final Rule will make U.S.-based Covered Organizations less competitive in the international marketplace.  Further, some note that the Final Rule does little to limit systemic financial risk, as the Final Rule does not address the leverage ratios or capital requirements of participants in the “shadow” banking industry.  Last, a number of critics stated that the increased leverage ratios are arbitrary, and that there are no quantitative studies showing the cumulative impact of such changes.

FFIEC Warns Financial Institutions that Financial Regulators Expect Them to Address Risks from Widely Reported Material Computer Security Vulnerability

On April 10, 2014, the Federal Financial Institutions Examination Council (“FFIEC”), whose members are the FRB, FDIC, OCC, NCUA, CFPB and the State Liaison Committee (the “Financial Regulators”), issued an alert (the “Alert”) to financial institutions stating that the Financial Regulators expect institutions “to incorporate patches on systems and services, applications and appliances using OpenSSL and upgrade systems as soon as possible to address” the so-called “Heartbleed Vulnerability,” which is a widely-reported material security vulnerability that may have affected some banks’ computer networks.  Open SSL, stated the Alert, “is an open-source implementation of the Secure Sockets Layer (SSL) and Transport Layer Security (TLS) protocols commonly used to protect data in transit.”  The Alert reported that the Heartbleed Vulnerability has existed since December 31, 2011 and may have allowed hackers “to access the private ‘keys’ to banks’ servers, allowing them to decrypt and view sensitive information.”  Specifically, the Alert states that financial institutions should take the following steps, as appropriate:

  • Ensure that third party vendors that use OpenSSL on their systems are aware of the vulnerability and take appropriate risk mitigation steps;
  • Monitor the status of their vendors’ efforts;
  • Identify and upgrade vulnerable internal systems and services; and
  • Follow appropriate patch management practices and test to ensure a secure configuration.

Goodwin Partner Publishes Article Concerning the Impact of Volcker Rule on Fund Sponsors Affiliated with Non-U.S. Banking Organizations

Goodwin Procter partner, Bill Stern, recently published a feature article entitled Impact of the Volcker Rule on fund sponsors affiliated with non-US banking organizations in Butterworths Journal of International Banking and Financial Law.  In addition to providing a brief summary of the Volcker Rule, the article makes the following key points.

  • Fund sponsors affiliated with banking organizations with a branch, agency or depository institution subsidiary in the U.S. may be subject to the Volcker Rule, even if they conduct their fund activities outside of the U.S.
  • The final Volcker Rule regulations tailor the definition of “covered fund” to mitigate to some extent the rule’s extraterritorial impact outside of the U.S.
  • Important questions remain about how the Volcker Rule will be applied in practice and will affect certain types of funds, such as funds-of-funds and parallel fund structures.

Goodwin Procter Alert - The SEC’s Whistleblower Program: 2013 Results and What to Expect in 2014

Goodwin Procter has issued a client alert that reviews the 2013 SEC Annual Whistleblower Report and public statements on the whistleblower program by SEC representatives, and provides steps for companies to consider in ensuring that they have effective internal complaint procedures and related investigative protocols.