US District Court Upholds California Financial Privacy Law Against Challenge on Preemption Grounds by Bank Trade Groups

The new California Financial Information Privacy Act (known as "SB1" and widely regarded as the strictest in the nation) took effect on July 1 after the U.S. District Court for the Eastern District of California in Sacramento, California (the "Court") rejected a challenge to the law by three bank trade groups. ABA et al. v. Lockyer, No. CIV. S 04-0778, slip op. (E.D. Cal. June 30, 2004). In challenging SB1, the trade groups relied on the preemption provisions of the Fair Credit Reporting Act ( "FCRA"), as recently amended by the Fair and Accurate Credit Transactions Act of 2003, arguing that the plain language of FCRA preempts SB1 and creates a federal standard for the manner in which banks may share information with their affiliates. The Court rejected this view, concluding that information not constituting a "consumer report" is not governed by FCRA, and that FCRA does not broadly preempt all state laws regulating information sharing by affiliates, whatever the purpose or context. As proof that Congress intended FCRA to preempt state law only with respect to the sharing of information specifically defined as "consumer report" information and not with respect to the general sharing of nonpublic personal financial information among affiliates for marketing or other purposes, the Court pointed to the 1996 amendments to FCRA, which amended the definition of "consumer report" to exclude transaction and experience information. The Court concluded that the federal Gramm-Leach-Bliley Act ("GLBA"), not FCRA, governs the kind of information sharing at issue in this case, and found dispositive the fact that GLBA has a section that preserves the ability of states to enact more protective privacy laws. The trade groups may seek a preliminary injunction and intend to appeal, but such a process is expected to take months. In the meantime, the California Department of Financial Institutions has said that it will start enforcing the law immediately. SB1 prohibits financial institutions from sharing customer information with unaffiliated third parties unless such customers have "opted in" to such sharing of information and requires financial institutions, under certain circumstances, to give customers an opportunity to "opt out" of sharing of information among affiliated entities.

Basel II. The Basel Committee on Banking Supervision ("Basel Committee") finalized its revisions to the Basel risk-based capital framework ("Basel II"). The final Basel II is substantially similar to earlier versions, except for changes previously published by the Basel Committee (see the May 25, 2004 Alert), including changes in the treatment of expected losses, securitization exposures, and the effect on Loss Given Default from economic downturns. The Basel Committee also stated that, after implementation of Basel II, it intends to review the definition of eligible capital to ensure Tier 1 capital instruments "are available to absorb unanticipated losses on a going concern basis."

US Agencies’ Response. Concurrently with the publication of the final Basel II, the four US federal banking agencies issued a joint press release. The agencies reiterated that only a small number of US banking institutions (the "core institutions") would need to adopt Basel II, with the remainder subject to the current rules, except for additional institutions that wish to "opt-in" to Basel II (the "opt-in institutions"). As to the core institutions, they will be subject to a year of "parallel running" in 2007, and then be subject to two years of "prudential floors" (based on the current framework) after Basel II becomes effective in January 2008. Accordingly, the agencies suggest that core institutions, as well as opt-in institutions that wish to use Basel II as soon as possible, begin planning their implementation efforts. The agencies also stated that they expect to publish guidance on the Basel II approach to retail credit this fall, and also intend to conduct a fourth quantitative impact study ("QIS-4") later this year. While the core institutions are expected to participate, optin institutions also may participate in QIS-4, but should discuss their plans with their federal banking regulator this month. A notice of proposed rulemaking for US implementation of Basel II would then be published in mid-2005, with a final version of the regulations expected by mid-2006. Finally, the agencies reiterated that all US banking institutions (including the core institutions) would continue to be subject to the leverage and other prompt corrective action capital ratios, and that the agencies were considering changes to the current framework for US institutions not subject to Basel II.

The SEC published the formal release (the "Release") discussing its adoption of (a) a new rule under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), that requires each registered adviser to adopt a code of ethics; (b) related changes to Form ADV, the SEC registration form for advisers, and certain Advisers Act rules; and (c) amendments to Rule 17j-1 under the Investment Company Act of 1940, as amended (the "1940 Act"), pursuant to which advisers to registered investment companies ("funds") have already had to adopt codes of ethics to prevent their personnel from abusing access to information about fund securities trading and require certain adviser personnel to make periodic reports regarding their personal securities transactions ((a) – (c) collectively, the "Amendments"). The Amendments were adopted largely as proposed. New Advisers Act Rule 204A-1 requires each registered adviser to adopt, maintain and enforce a written code of ethics applicable to its supervised persons. An adviser’s supervised persons are its partners, officers, directors and employees, as well as any other persons who provide advice on the adviser’s behalf and are subject to the adviser’s supervision and control. An adviser’s code must set forth a standard of business conduct required of all supervised persons and require them to comply with applicable federal securities laws. The Rule does not specify a particular standard of business, but the Release indicates that the standard chosen must reflect an adviser’s fiduciary obligations and those of its supervised persons. The SEC did not adopt its original proposal to require that an adviser’s code of ethics prevent access to material non-public information about an adviser’s securities recommendations and client securities holdings and transactions by individuals who do not need the information to perform their duties. The Release does, however, remind advisers that they must maintain and enforce policies and procedures to prevent the misuse of material non-public information, which the SEC believes includes misuse of material non-public information about the adviser’s securities recommendations and clients’ securities holdings and transactions. The Release reviews a number of practices that are not required by the Rule but that many advisers already observe with respect to personal securities trading by their personnel, e.g., pre-clearance of transactions, restricted issuers lists, black-out periods and prohibitions on short-swing trading and market timing. The Release indicates that all advisers should consider these practices in drafting their codes of ethics.

Transaction and Holdings Reports by Access Persons. The Rule requires each adviser code of ethics to include a system of personal securities transaction and holdings reporting for the adviser’s access persons modeled largely on that required under 1940 Act Rule 17j-1. The SEC adopted the Rule’s definition of "access person" as proposed: an access person of an adviser is a supervised person who has access to non-public information regarding clients’ purchase or sale of securities, is involved in making securities recommendations to clients or who has access to such recommendations that are non-public. A supervised person who has access to non-public information regarding the portfolio holdings of certain affiliated mutual funds is also an access person. The Rule contains a presumption that, if a firm’s primary business is providing investment advice, then all of its directors, officers and partners are access persons. The Amendments introduce this presumption into Rule 17j-1 where it replaces the current revenuebased test for determining whether an adviser is "primarily engaged" in a business other than advising funds or advising clients. Under the Rule, an access person must make initial and annual reports of securities holdings current as of a date not more than 45 days prior to the date the individual becomes an access person or the date the report is submitted, as applicable. The Amendments make a conforming change to parallel reporting requirements under Rule 17j-1. The Rule requires an access person to submit quarterly reports of personal securities transactions no later than 30 days after calendar quarter end. The Amendments apply this deadline to quarterly reports under Rule 17j-1 as well. Like Rule 17j-1, the Rule does not require reporting with respect to certain securities, e.g., government securities. Unlike Rule 17j-1, however, the Rule requires access persons of an adviser to report transactions and holdings in shares of mutual funds for which their employer acts as adviser or for which a control affiliate of their employer acts as adviser or principal underwriter. Like Rule 17j-1, the Rule requires approval of participation in an initial public offering or private placement.

Code of Ethics Administration and Enforcement. An adviser’s code of ethics must require that (1) the adviser provide each supervised person with a copy of the code and any amendments and (2) each supervised person acknowledge receipt of those documents in writing. Although the Rule does not include employee education as a required element in adviser codes of ethics, the SEC expects most advisory firms will train employees on the principles and procedures of their codes. Under the Rule, enforcement of an adviser’s code must include the review of access persons’ personal securities reports. As discussed in the Release, this review should include an assessment of whether the access person followed the required internal procedures (such as pre-clearance), a comparison of the access person’s personal trading to any restricted lists and other assessments designed to ensure personal securities transactions are effected in a manner consistent with an adviser’s fiduciary duty to its clients. An adviser’s code of ethics must require prompt internal reporting of any code violations. An adviser can choose to have reports of code violations made either to the chief compliance officer ("CCO") or to other persons designated in the code of ethics. In the latter case, the adviser must have procedures under which the CCO receives periodic reports of all code violations.

Recordkeeping. The Amendments include changes to existing Advisers Act recordkeeping rules designed to capture various documents created under the Rule. In this regard, the Release notes that although the SEC proposed but did not adopt a requirement that records of access persons’ personal securities reports be maintained electronically in an accessible database, the SEC has strong expectations that most advisers will need to maintain these records electronically in order to meet their responsibilities to review these records and monitor compliance with their codes.

Form ADV. As proposed, the Amendments revise Form ADV to incorporate a requirement that Part II of the Form describe an adviser’s code of ethics to clients and that, upon request, an adviser furnish clients with a copy of its code of ethics. The Release notes that an adviser that discloses its policies and procedures to a client may be subject to action under the anti-fraud provisions of the Advisers Act if the adviser subsequently deviates materially from those policies and procedures.

Rule 17j-1. In addition to the changes to Rule 17j-1 discussed above, the Amendments add a presumption to Rule 17j-1 that directors, officers and general partners of a fund are access persons of the fund.

Compliance Date. The compliance date for the Amendments is January 7, 2005. By that time, an adviser must have adopted, and be prepared to maintain and enforce, its code of ethics, which includes (a) identifying access persons; (b) providing a copy of the code of ethics to each supervised person and receiving the necessary acknowledgement; (c) collecting an initial holdings report from each access person; and (d) arranging for the submission of quarterly transaction reports (transaction reports for the calendar quarter ended March 31, 2005 will be due no later than April 30, 2005). Until an adviser begins to comply with the Rule, related changes to Advisers Act recordkeeping requirements and the new code of ethics disclosure requirement for Form ADV Part II, the adviser must continue to comply with the Advisers Act's current personal securities transaction recordkeeping requirements.

The IRS issued a proposed rule (REG-117307-04) that may cause foreign insurance companies that do business in the United States to be subject to tax on income from portfolio stock investments. A foreign corporation engaged in a trade or business within the United States generally is subject to U.S. tax on income that is effectively connected with such trade or business in a manner similar to the taxation of U.S. corporations. In determining whether income is effectively connected with the conduct of a trade or business in the United States, one of the factors taken into account is whether the income is derived from assets used in or held for use in the conduct of such trade or business (the "Asset-use Test"). The Asset-use Test generally provides that stock of a corporation (whether domestic or foreign) is not an asset used in or held for use in the conduct of a trade or business in the United States. The proposed rule provides that the general rule excluding stock from the Asset-use Test does not apply to stock held by a foreign insurance company unless such company owns directly, indirectly or constructively 10 percent or more of the voting power or value of the corporation’s stock. According to an IRS release, the rationale for the proposed rule is that insurance companies hold investment assets, such as stocks and bonds, to fund their obligations to policyholders and to meet their surplus requirements. Therefore, stock held in an investment portfolio may be an asset held for use in the trade or business of a foreign insurance company. By contrast, stock of a subsidiary generally is not held for the purpose of meeting an insurance company’s business needs. The 10 percent threshold is intended to distinguish portfolio stock held to fund policyholder obligations and surplus requirements from investments in a subsidiary. The IRS has requested comments regarding whether the 10 percent threshold provides an appropriate standard for determining whether stock is a portfolio investment for these purposes. The proposed rule will apply to taxable periods beginning on or after the date the rule is adopted as a final regulation. Comments (and requests for a public hearing) must be received by September 23, 2004.

SEC to Consider Proposing Registration Requirements for Hedge Fund Advisers At its open meeting on Wednesday, July 14, 2004, the SEC will consider whether to propose (a) a new rule under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), that will require hedge fund advisers to register with the SEC, and (b) accompanying amendments to certain existing Advisers Act rules and Form ADV, the registration form for investment advisers.

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