OCC Issues Letter Concluding Bank May Use Rating on Long-Term CDs to Meet Financial Subsidiary Debt Rating Requirement

The OCC issued an interpretive letter ("Letter #981") in which it concluded that a national bank (the "Bank") that desires to organize or acquire a financial subsidiary may rely on a rating from a nationally recognized rating agency, Standard & Poor’s ("S&P"), on the uninsured portion of the Bank’s long-term certificates of deposits ("CDs") to meet the requirements of Section 121 of the Gramm-Leach-Bliley Act of 1999 ("Section 121"). Under Section 121, a national bank may organize or acquire a financial subsidiary to engage in activities that are not otherwise permissible for a national bank, but that are financial in nature, only if the bank meets certain conditions. Where the bank wishes to have the financial subsidiary act as principal and not solely as agent, such as by engaging in securities underwriting and dealing, a bank that is one of the 50 largest FDIC - insured banks "must have at least one issue of outstanding eligible debt that is currently rated within the three highest investment grade categories by a nationally recognized statistical rating organization." As is the case for many banks, such as the Bank, that are owned by owned by bank holding companies, the holding company rather than the Bank issues all nondeposit debt needed to fund the operations of the bank holding company and its subsidiaries. The OCC concluded in Letter #981 that the Bank could satisfy the long-term debt rating requirement of Section 121 by relying on S&P’s rating of the Bank’s long-term CDs. Moreover, the OCC noted that S&P had advised the Bank that the ratings criteria, definitions and methodology used by S&P in assigning a long-term CD rating were the same as those used by S&P in rating an issue of long-term nondeposit debt.

The Rhode Island Supreme Court held that a national bank was not subject to the state’s Deceptive Trade Practices Act ("DTPA") because the DTPA contained an exception for activities subject to regulation by a government agency. The plaintiffs in the case alleged that the national bank at issue had violated the DTPA because the bank advertised a fixed APR for its credit cards, but raised the rates after the plaintiffs opened their accounts. However, the Supreme Court ruled that because the TILA and Regulation Z govern credit card activities of banks, and the OCC enforces Regulation Z as it applies to national banks and otherwise oversees their activities, the government agency exception cited above should apply. The dissent in the case stated that the application of the exception in this case conflicted with decisions by other state courts reviewing similar statutes, including state courts in Connecticut and Massachusetts. Chavers v. Fleet Bank (RI), N.A., et. al. (No. 2002201, Feb. 11, 2004).

The SEC proposed amendments to Rule 12b-1 under the Investment Company Act of 1940, as amended, that would prohibit a registered open-end management investment company (a "fund") from compensating a broker-dealer that promotes or sells fund shares (a "Selling Broker") by directing brokerage transactions to that Selling Broker. The prohibition would apply to any remuneration received or to be received by a Selling Broker from a fund’s portfolio transactions effected through any other broker or dealer, including any commission or mark up (or portion thereof). The prohibition would apply not only to directed brokerage but also to the direction of any brokerage related service, including any transaction processing function (e.g., order transmission, execution or clearance and settlement). Notwithstanding the foregoing, the proposed amendments would permit a fund (or its adviser) to direct fund portfolio transactions to a Selling Broker, provided certain conditions were met. The fund (or its investment adviser) would have had to implement, and the fund’s board (including a majority of the independent directors) approve, policies and procedures reasonably designed to prevent: (1) the persons responsible for selecting broker-dealers for fund portfolio transactions (e.g., trading personnel) from taking broker-dealer promotion or sales efforts into account in the selection process; and (2) the fund or its adviser or principal underwriter from entering into any agreement under which the fund directs brokerage transactions or revenue generated by those transactions to compensate a Selling Broker. The SEC release proposing the amendments (the "Release") seeks comment not only on the proposed amendments, but also on a variety of issues related to Rule 12b-1, e.g., whether Rule 12b-1 should be amended to provide that funds must deduct distribution-related costs directly from shareholder accounts rather than from fund assets. Comments on the Release must be received by the SEC on or before May 10, 2004. .

The FRB issued one opinion letter and one interpretative letter to units of Merrill Lynch & Co., Inc. ("Merrill Lynch"). The first letter concerns anti-tying issues under Section 106 of the Bank Holding Company Act ("Section 106") and the second letter concerns loan to affiliate issues under Section 23A of the Federal Reserve Act and Regulation W.

Anti-Tying. Merrill Lynch Bank USA ("Merrill Lynch Bank") and its affiliate, Merrill Lynch Private Finance, Inc. ("MLPF"), as part of Merrill Lynch’s securities lending program, offer loans collateralized by securities and require that the securities be held in accounts of a broker-dealer affiliated with Merrill Lynch Bank and MLPF. In general, a customer is only required to keep securities with the Merrill Lynch-affiliated broker-dealer to the extent needed to meet the collateral requirements imposed on the customer by Merrill Lynch Bank or MLPF, as the case may be. Section 106 generally prohibits a bank from conditioning or tying the purchase or price of one product upon the purchase of another separate product. The FRB stated in its opinion letter that the collateral requirement is an integral part of the loan and not a "separate product" and the fact that the collateral must be held at an affiliated broker-dealer does not make the collateral or the collateral account a "separate product" from the loan. Accordingly, the FRB concluded that the described arrangements do not violate the anti-tying rules.

Loans to Affiliates. In the second letter, Merrill Lynch Bank requested that the FRB confirm that its proposed acquisition of all of the capital stock of its affiliate MLPF (the "Acquisition") would be exempt from the inter-affiliate extension of credit restrictions of Section 23A of the Federal Reserve Act ("Section 23A") and its implementing regulation, Regulation W. The FRB concluded that since MLPF is an affiliate of Merrill Lynch Bank that (1) would become an operating subsidiary of Merrill Lynch Bank as a result of the Acquisition and (2) would have liabilities at the time of the Acquisition, the Acquisition would be deemed a purchase of assets that is a "covered transaction." However, the FRB granted the exemption from Section 23A because it concluded that the Acquisition is: (a) a one-time asset transfer that is part of a corporate reorganization designed to increase the efficiency of Merrill Lynch’s securities lending program; (b) consistent with safe and sound banking practices; and (c) "structured to ensure the quality of the transferred assets."

.OTS Publishes Update of Networking Arrangements Handbook The OTS published an update to the section of its Handbook ("Section 710") addressing Networking Activities. Section 710 discusses how thrifts are currently exempt from broker-dealer registration, and how thrifts engaging in these arrangements currently should follow the NDIP policy statement issuances and the SEC’s Chubb letter. Section 710 also describes the major types of networking arrangements (referral and standard), the use of brokerage affiliates, provides a description of the registration requirements for brokers, and discusses risk management techniques, including the use of dual employees, advertising, and sharing of customer information.

The SEC issued the adopting release for new shareholder report and quarterly portfolio disclosure requirements applicable to registered management investment companies ("funds") approved at its February 11, 2004 open meeting (as discussed in the February 17, 2004 Alert). Shareholder reports for periods ending on or after July 9, 2004 must comply with the new requirements. Funds must begin quarterly portfolio holdings disclosure with their first fiscal quarters ending on or after July 9, 2004. Other features of the new requirements will be discussed in a future edition of the Alert.

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