FINRA ANNOUNCES EFFECTIVE DATE OF NEW RULES RE COMMUNICATIONS WITH THE PUBLIC

Introduction

On March 29, 2012, the SEC approved FINRA's amended proposed rule revisions relating to broker-dealers' communications with the public.1 In June 2012, FINRA announced that the effective date of the new rules will be February 4, 2013. FINRA's announcement of the effective date (Regulatory Notice 12-29), together with a summary of the new rules, may be found on FINRA's website: http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p127014.pdf.

We previously discussed the impact of the revisions on the structured product market in prior issues of Structured Thoughts:

Principal Impact

The key impacts of the new rules for participants in the structured note market would be:

  • "Retail communications" (a newly defined term under the rules)2 relating to registered structured notes would need to be filed with the FINRA Advertising Department within 10 days of their first use.3 This requirement would not include prospectuses and similar documents that have been filed with the SEC. However, freewriting prospectuses that have been filed with the SEC under SEC Rule 433(d)(1)(ii)4 would still need to be filed. A variety of materials prepared by structured note underwriters, such as marketing brochures and educational materials, would be required to be filed.
  • Retail communications would need to be approved by an appropriately qualified registered principal of a FINRA member prior to their use.
  • FINRA's disclosure rules that apply to member communications, including structured products, would be supplemented to specify that:
    • Members must ensure that statements are clear and not misleading within the context in which they are made, and that they provide balanced treatment of risks and potential benefits. For example, communications must be consistent with the risks of fluctuating prices and the uncertainty of dividends, rates of return, and yield. (Rule 2210(d)(1)(D).)
    • FINRA members must consider the nature of the audience to whom the communication will be directed, and must provide details and explanations appropriate to the audience. (Rule 2210(d)(1)(E).)

Internal Training Materials

The final rules omit a proposed rule that would require a member's internal written communications relating to training to be treated as "institutional communications," which would trigger certain of FINRA's procedural and related requirements. However, FINRA reminds members that these types of materials are subject to NASD Rule 3010, which requires brokers to establish, maintain and enforce procedures to supervise their personnel.5

Conclusion

These FINRA Rules were initially proposed in July 2009. Accordingly, many broker-dealers have been planning their compliance literally for years. With the February 2013 effective date now in place, firms will have a target date for their new procedures and filings.

THE FEDERAL BANKING AGENCIES' REGULATORY CAPITAL PROPOSALS: HOW CERTAIN ASPECTS OF THE PROPOSALS RELATE TO STRUCTURED NOTES AND DEBT SECURITIES REPRESENTING INDIRECT HOLDINGS OF CAPITAL INSTRUMENTS

On June 12, 2012, the Federal banking agencies (the Office of the Comptroller of the Currency, the Federal Reserve Board and the Federal Deposit Insurance Corporation) (the "Agencies") formally proposed for comment, in a series of three separate but related proposals (each a "Proposal", and collectively the "Proposals"), substantial revisions to the U.S. regulatory capital regimen for banking organizations that, if adopted, will have a significant impact on the entire U.S. banking industry.6 Based on the core requirements of the 2011 international Basel III Accord ("Basel III"),7 and in significant part on the "standardized approach" for the weighting and calculation of risk-based capital requirements under the 2004-2006 Basel II Accord ("Basel II"),8 the Proposals will extend large parts of a regulatory capital regime that was originally intended only for large, internationally active banks to all U.S. banks and their holding companies, other than the smallest bank holding companies (generally, those with under $500 million in consolidated assets).

The Basel III Proposal, among other things, requires banking organizations to "look through" certain structured financial instruments linked to the banking organization's own common equity capital in order to compute its regulatory capital. The Standardized Approach Proposal requires a banking organization to look through certain structured products linked to the common equity of unconsolidated counterparties in order to assign a proper risk weight to those instruments.

The Basel III Proposal Approach to Deducting Investments in a Banking Organization's Own Capital Instruments

The Basel III Proposal describes how a banking organization must deduct from its regulatory capital investments in its own common equity or additional Tier 1, or Tier 2, capital instruments, whether held directly or through holdings of securities of that banking organization or any other issuer, linked to an index, a constituent of which is the banking organization's own capital instrument.

To avoid the double-counting of regulatory capital, under the Basel III Proposal, a banking organization would be required to deduct the amount of its investments in its own capital instruments, whether held directly or indirectly, to the extent such investments are not already derecognized from regulatory capital. Specifically, a banking organization would deduct its investment in its own common equity Tier 1 from the sum of its common equity Tier 1 capital elements, investments in its own additional Tier 1 from its additional Tier 1 capital, and investments in its own Tier 2 from its total capital.

In addition, any regulatory capital instrument issued by a banking organization that the banking organization could be contractually obliged to purchase would also be deducted from the corresponding category of regulatory capital.9 "Contractually obligated to purchase" could encompass:

  • Certain options for the banking organization's capital instruments; and
  • Mandatorily exchangeable or reverse convertible notes of any issuer linked to the banking organization's capital instruments.

A banking organization would be required to look through its holdings of index securities to deduct investments in its own capital instruments.10 The term "index securities" is not defined in the Proposals. For this article, we treat "index securities" as including debt securities of any issuer linked to an equity index, which index contains the banking organization's common equity or additional Tier 1 as an index constituent.

The Basel III Proposal uses the following approaches in order to assure that a banking organization avoids the double-counting of regulatory capital:

  • Gross long positions in direct investments in its own regulatory capital instruments may be netted against short positions in the same underlying instrument, as long as the short positions involve no counterparty risk.
  • Gross long positions in investments in its own regulatory capital instruments resulting from holdings of index securities may be netted against short positions in the same underlying index.
  • Short positions in indexes that are hedging long cash or synthetic positions may be decomposed to recognize the hedge.
    • More specifically, the portion of the index that is composed of the same underlying exposure that is being hedged may be used to offset the long position only if both the exposure being hedged and the short position in the index are covered positions subject to the Basel Market Risk Rule, the positions are fair valued on the banking organization's balance sheet, and the hedge is deemed effective by the banking organization's internal control processes.11 In turn, those processes will be assessed by the primary supervisor of the banking organization.

If the banking organization finds it operationally burdensome to estimate the exposure amount as a result of an index holding, it may, with prior approval from the primary federal supervisor, use a conservative estimate.12

The Standardized Approach Proposal

The Standardized Approach Proposal, which is applicable to the same banking organizations that would be subject to the Basel III Proposal, revised a large number, though not all, of the risk weights (or their methodologies) for banking organization assets, including corporate debt and "Equity exposures," which, as defined, would include a debt security of any issuer linked to the common stock of an unconsolidated counterparty (such as a reverse convertible, mandatorily exchangeable or stock-linked note).

Corporate exposures (including exposures to securities firms) are assigned a risk weight of 100 percent.13 Corporate exposures do not include Equity exposures.14

An "Equity exposure" includes not only securities and other direct ownership (or equivalent) interests, but interests mandatorily convertible into such interests, options or warrants for such interests, or other instruments to the extent the return on such instrument is based on the performance of a direct equity exposure.15 Consequently, mandatorily convertible or exchangeable debt securities linked to common stock, or a debt security, the performance of which is linked to a common stock, would fall within the definition of an Equity exposure. However, the definition of Equity exposure is not clear as to whether a debt security linked to a basket of common stocks (or shares of an exchange-traded fund) would constitute an Equity exposure.

Equity exposures to unconsolidated counterparties generally would be risk-weighted under one of two broad methods, depending on whether the exposure is to an entity other than an investment fund, or to an investment fund. Certain equity holdings in other financial institutions must be deducted from capital. The possible treatments of an Equity exposure are as follows:

  • Non-investment fund exposures are weighted according to the Simple Risk-Weight Approach, under which each exposure is risk-weighted individually from 0 percent to 600 percent. Equity investments in sovereigns, certain political subdivisions, and a Federal Home Loan Bank or Farmer Mac may be risk weighted below 100 percent. Any other equity investment that is 10 percent or less of a bank's capital is risk weighted at 100 percent. An investment in the same equity instrument but that exceeds 10 percent of capital will be risk-weighted at 300 (publicly traded equities) or 400 (non-publicly traded) percent. Significant investments in unconsolidated financial institutions that are not deducted from regulatory capital (see below) are weighted at 250 percent, while investments in certain firms with securitization features are risk weighted at 600 percent.
  • Equity exposures to investment funds are risk-weighted under one of three approaches. First, the Full Look- Through Approach risk-weights each individual exposure held by the firm and assigns the banking organization its pro rata share of the aggregate risk-weighted amounts of the fund. Second, under the Simple Modified Look-Through Approach, a banking organization's risk-weighted investment is its pro rata share of the adjusted carrying value of the fund's equity exposures, multiplied by the highest risk weight that the fund is permitted to hold under the prospectus (or other document). Third, under the Alternative Modified Look-Through Approach, a banking organization assigns the adjusted carrying value of its investment in a fund to different risk-weight categories provided for in the prospectus (or similar document) on a pro rata basis.
  • Three types of equity exposures relating to other financial institutions must be deducted from capital: reciprocal cross holdings, non-significant investments in the capital of unconsolidated financial institutions, and non-common stock significant investments in the capital of unconsolidated financial institutions. The deduction must be taken from the component of capital for which the underlying instrument would qualify if issued by the bank.

For a fuller description of the Proposals and their effects, please see our news bulletin "The Federal Banking Agencies' Regulatory Capital Proposals – A Summary" (at http://www.mofo.com/files/Uploads/Images/120613-Federal-Banking-Agencies-Regulatory-Capital-Proposals-Summary.pdf) and our client alert "The Banking Agencies' New Regulatory Capital Proposals" (at http://www.mofo.com/files/Uploads/Images/120613-Banking-Agencies-New-Regulatory-Capital-Proposals.pdf).

NEW FINRA RULE 5123 ON PRIVATE PLACEMENTS

On June 7, 2012, the SEC approved FINRA's proposed FINRA Rule 5123, relating to private placements.16 As approved, FINRA Rule 5123 requires members selling securities issued by non-members in a private placement to file the private placement memorandum, term sheet or other offering documents with FINRA within 15 days of the date of the first sale of securities, or to indicate to FINRA that there were no offering documents used.

The new rule will apply to a wide range of private placements, but will not apply to most non-registered structured note offerings. This is because Rule 5123 excludes from its scope, among other types of offerings:

  • Section 3(a)(2) offerings of "bank notes."
  • Rule 144A and Regulation S offerings.
  • Offerings to "qualified purchasers" under the Investment Company Act, and to "institutional accounts" (as defined in FINRA Rule 4512(c).
  • Offerings to certain types of "institutional accredited investors" under Rule 501(a)(1), (2), (3) or (7).17
  • Offerings of non-convertible debt by issuers that meet the transaction eligibility criteria for registering primary offerings of non-convertible securities on Form S-3 or Form F-3.18

As to the fifth point above, an issuer will satisfy these requirements (a) if it has offered at least $1 billion in nonconvertible securities (other than common equity) in registered private offerings over the last three years, or (b) if it has at least $750 million in non-convertible securities (other than common equity) issued and outstanding that were registered under the 1933 Act. In addition, for an offering completed prior to September 2014, an issuer will satisfy this requirement if it has a reasonable belief that it would have been previously eligible to use Form S-3 for the offering because the offered security is a non-convertible, investment grade security.19

Accordingly, the principal type of unregistered offering that would be impacted by the new Rule would be a "Regulation D" or "Section 4(2)" offering to an individual investor, where the issuer did not have sufficient prior issuance volume to satisfy the Form S-3/F-3 eligibility requirements for non-convertible securities. However, through September 2014, an investment grade issuer may still receive the exemption, even if its prior issuances were not sufficient in amount to qualify.

For additional information about new Rule 5123, including the requirements for offerings that do not qualify for an exemption, please see our client alert. The alert may be found at the following link: http://www.mofo.com/files/Uploads/Images/120615-FINRA-Rule-5123.pdf.

FDIC ISSUES INVESTOR ALERT RELATING TO STRUCTURED CDS

Structured certificates of deposit, or SCDs, are financial instruments representing a deposit of a specified amount of money for a fixed period of time. Like traditional certificates of deposit, SCDs entitle the holder to his or her principal investment, plus possible additional payments. However, unlike traditional CDs, which usually pay interest periodically based on a fixed or floating rate, SCDs often pay an additional payment of principal and/or interest based on the performance of an underlying market measure.

Over the past few years, the markets have seen an increased demand for SCDs. In response to this growth in popularity, in May 2012 the Federal Deposit Insurance Company (the "FDIC") published a consumer alert titled "Market-Linked CDs: Don't Let the Possibility of Higher Returns Cloud Your View of the Potential Risks."20

The alert highlights some of the risks associated with SCDs. In sum, SCDs may possess complex features that may not be present in conventional CDs. According to the FDIC, investors should keep in mind the following questions before investing in SCDs:

  • Is the principal amount of the SCD guaranteed against loss? Specifically, are the SCDs insured by the FDIC?
  • When will the SCD mature?
  • What are the restrictions or penalties on early withdrawals?
  • How are returns on the SCD calculated?
  • If applicable, when will interest payments be made on the SCD?
  • Are the SCDs redeemable before maturity by the issuing bank?

The issues raised in the alert are not necessarily new, and to some extent, the alert repeats some of the prior points made by other regulators.21 However, the alert is a useful reminder that the FDIC is one of the many regulators that has taken an interest in ensuring that structured products are properly marketed and sold.

For a further discussion of structured certificates of deposit, see Volume 1, Issue 13 of Structured Thoughts at http://www.mofo.com/files/Uploads/Images/101004-Structured-Thoughts-Issue-13.pdf, as well as our Frequently Asked Questions at http://www.mofo.com/files/Uploads/Images/Frequently-Asked-Questions-about-Structured-Certificates-of-Deposit.pdf.

Footnotes

1 The new FINRA rules may be found at the following link: http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/industry/p127016.pdf. The SEC's effectiveness order may be found at the following link: http://www.sec.gov/rules/sro/finra/2012/34-66681.pdf.

2 See Rule 2210(a)(5). The rule generally refers to written or electronic communications made available to more than 25 "retail investors" in any 30-day period.

3 Rule 2210(c)(3)(E). Under the original proposal, these documents would need to be filed prior to their first use. This requirement would not apply to non-registered instruments, such as structured certificates of deposit, or structured bank notes.

4 Rule 433(d)(1)(ii) requires underwriters to file free-writing prospectuses that they distribute "in a manner reasonably designed to lead to its broad unrestricted dissemination."

5 Regulatory Notice 12-29, page 5.

6 Office of the Comptroller of the Currency ("OCC"), Federal Reserve Board, Federal Deposit Insurance Corporation ("FDIC"), Regulatory Capital Rules: (i) Implementation of Basel III; Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Periods and Prompt Corrective Action ("Basel III Proposal"); (ii) Standardized Approach for Risk-Weighted Assets; Market Discipline and Disclosure Requirements ("Standardized Approach Proposal"); and (iii) Advanced Approaches Risk-Based Capital Rule; Market Risk Capital Rule. All three of these Proposals were first approved and published by the Federal Reserve Board on June 7, 2012, but the three Agencies jointly announced their publication on June 12.

7 Basel Committee on Banking Supervision ("Basel Committee"), Basel III: A Global Regulatory Framework For More Resilient Banks and Banking Systems (Dec. 2010; rev. June 2011).

8 Basel Committee on Banking Supervision, Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework (rev. comprehensive version June 2006).

9 Subpart C – Definition of Capital, §§ _ .22(c)(1)(i), (ii) and (iii).

10 Subpart C – Definition of Capital, § _ .22(c)(1)(v).

11 Subpart C – Definition of Capital, § _ .22(c)(v)(A) – (C).

12 Basel III Proposal, Supplementary Information, III.B.3 at 69. The same approach to avoid double-counting of regulatory capital would be used in calculating the amount of investments in the capital instruments of unconsolidated "financial institutions" (a broadly defined term that is designed to capture any entity whose primary business is financial activities) where such investments exceed certain thresholds. Subpart A – General Provisions, § _ .2, Investment in the capital of an unconsolidated financial institution (2) – (3).

13 Subpart D, § _ .32(f).

14 Subpart A, § _ .2, Corporate exposure (10).

15 Subpart A, § _ .2, Equity exposure.

16 See Notice of Filing of Amendments No. 2 and No. 3 and Order Granting Accelerated Approval of Proposed Rule Change, as Modified by Amendments No. 1, No. 2, and No. 3 to Adopt FINRA Rule 5123 (Private Placements of Securities) in the Consolidated FINRA Rulebook, Exchange Act Release No. 67517 (June 7, 2012), available at http://www.sec.gov/rules/sro/finra/2012/34-67157.pdf.

17 Regulation D offerings to individual investors would not qualify for this exclusion.

18 General Instructions to Form S-3 and Form F-3.

19 In August 2011, the SEC revised its eligibility criteria for Form S-3 and Form F-3 to remove the eligibility test based on investment grade status. However, the SEC "grandfathered" issuers through September 2014.

20 The FDIC's alert may be found at the following link: http://www.fdic.gov/consumers/consumer/news/cnspr12/marketlinkedcds.html

21 The SEC issued an investor alert in 2006: http://www.sec.gov/answers/equitylinkedcds.htm. The NYSE also issued a notice to its member firms in 2006: http://www.cecouncil.com/Documents/00002401.htm. In addition, earlier this year, representatives of FINRA indicated that FINRA was reviewing sales of structured CDs.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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