United States: Nutter Bank Report, December 2013

The Nutter Bank Report is a monthly electronic publication of the firm's Banking and Financial Services Group and contains regulatory and legal updates with expert commentary from our banking attorneys.


  1. Final Volcker Rule Released; Agencies Review Treatment of CDOs Backed by TruPS
  2. Joint Statement Clarifies Safety and Soundness and CRA Effects of Qualified Mortgages
  3. Division of Banks Provides Guidance on New Mortgage Loan Servicing Rules
  4. Federal Reserve Issues Guidance on Managing Outsourcing Risks
  5. Other Developments: Tax Allocation Agreements and BSA

1. Final Volcker Rule Released; Agencies Review Treatment of CDOs Backed by TruPS

The federal banking agencies, the SEC and the CFTC have issued final jointly developed rules to implement section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") commonly referred to as the Volcker Rule. The final rules released on December 10 implement the two prongs of the Volcker Rule: the ban on short-term proprietary trading of certain securities, derivatives, commodity futures and options on such financial instruments by banking organizations for their own accounts, and restrictions on banking organizations owning, sponsoring or having certain relationships with hedge funds or private equity funds. 

  • Proprietary Trading Ban - The final rules generally prohibit banks and their affiliates from engaging in "proprietary trading" of debt and equity securities, commodities, derivatives or other financial instruments. The term proprietary trading is defined in the rules as engaging as a principal in any transaction to purchase or sell, or otherwise acquire or dispose of securities, commodities, derivatives or other financial instruments for the purpose of benefitting from short-term price movements or realizing short-term profits. The final rules include exemptions for underwriting, market-making related activities, risk-mitigating hedging, trading in certain government obligations, and trading on behalf of a customer in a fiduciary capacity or in riskless principal trades and activities of an insurance company for its general or separate account. The final rules also clarify which activities are not considered proprietary trading, provided that certain requirements are met, which include trading on behalf of customers, through a deferred compensation or similar plan, to satisfy a debt previously contracted, under certain repurchase and securities lending agreements, and for liquidity management in accordance with a documented liquidity plan, among others. 
  • Covered Fund Prohibitions – The final rules prohibit banking organizations from taking an ownership interest in or sponsoring hedge funds and private equity funds, referred to as "covered funds." Under the final rules, the term "covered fund" applies to any entity that would be required to register with the SEC as an investment company under the Investment Company Act of 1940 (the "1940 Act") but for the exemption from such registration under sections 3(c)(1) (100 or fewer beneficial owners) or 3(c)(7) (investment only by qualified purchasers) of the 1940 Act. The final rules permit a banking organization, subject to certain conditions, to invest in or sponsor a covered fund in connection with organizing and offering the covered fund, underwriting or market making-related activities, certain types of risk-mitigating hedging activities, activities that occur solely outside of the United States and insurance company activities. The final rules exempt from the definition of covered funds wholly owned subsidiaries, joint ventures and acquisition vehicles, foreign pension or retirement funds, insurance company separate accounts (including bank-owned life insurance), public welfare investment funds, and any issuer of securities backed entirely by loans subject to certain asset restrictions. Covered funds generally do not include securitizations such as residential mortgage backed securities, commercial mortgage backed securities, auto securitizations, credit card securitizations and commercial paper backed by conforming asset-backed commercial paper conduits. If a banking organization holds an investment in a covered fund that does not qualify for an exemption, the banking organization will have to divest the interest during the conformance period under the final rules.

The final rules provide compliance requirements that vary based on the size of the banking organization and the amount of restricted activities it conducts. Banking organizations that do not engage in activities covered by the Volcker Rule, other than trading in exempt government and municipal obligations, will not be required to have a compliance program. The final rules generally require banking organizations to establish an internal compliance program reasonably designed to ensure and monitor compliance with the final rules. The final rules require banking organizations to maintain documentation so that the agencies can monitor their activities for instances of evasion. The final rules also require banking organizations with significant trading operations to report certain quantitative measurements, which will be phased in based on the type and size of the organization's trading activities. The final rules become effective on April 1, 2014. The Federal Reserve Board has extended the conformance period until July 21, 2015. Banking organizations must conform their activities, investments, relationships and transactions to the Volcker Rule by no later than July 21, 2015 (or such later date as specified by the Federal Reserve).

Nutter Notes: Following the issuance of the final rules, a number of community banking organizations and trade associations expressed concern that the final rules will have the unintended consequence of requiring banking organizations to divest their interests in collateralized debt obligations ("CDOs") backed by trust preferred securities ("TruPS") because TruPS-backed CDOs typically qualify as covered funds. The federal banking agencies issued a response in the form of answers to frequently asked questions on December 19 confirming their position that, if a TruPS-backed CDO qualifies as a covered fund and a banking organization's investment in it qualifies as an ownership interest under the final rules, then the banking organization would be required to divest its interest in the TruPS-backed CDO before the end of the Volcker Rule conformance period. Consequently, many banking organizations with investments in TruPS-backed CDOs have determined that generally accepted accounting principles require that such investments be reclassified from held-to-maturity to available-for-sale, resulting in charges based on the current fair market value of the investments. On December 27, the federal banking agencies announced that they are reevaluating whether it would be appropriate and consistent with the Dodd-Frank Act to exempt TruPS-backed CDOs from the investment prohibitions of the Volcker Rule. The agencies said that they intend to address the matter no later than by January 15, 2014. The agencies also advised that their respective accounting staffs believe that any agency action in January 2014 that occurs before a banking organization issues its December 31, 2013 financial reports "should be considered when preparing those financial reports." 

2. Joint Statement Clarifies Safety and Soundness and CRA Effects of Qualified Mortgages

The federal banking agencies have issued a joint policy statement to clarify that home mortgage loans will not be subject to safety-and-soundness criticism based solely on their status as Qualified Mortgage loans or non-Qualified Mortgage loans. The policy statement issued on December 13, titled Interagency Statement on Supervisory Approach for Qualified and Non-Qualified Mortgage Loans, also provides clarification on Community Reinvestment Act ("CRA") considerations related to Qualified Mortgage and non-Qualified Mortgage loans offered by banks. According to the statement, the agencies wish to emphasize that a bank may originate both Qualified Mortgage and non-Qualified Mortgage loans, based on its business strategy and risk appetite. The statement reminds banks that the agencies expect banks to underwrite home mortgage loans prudently, addressing key risk areas such as loan terms, borrower qualification standards, loan-to-value limits, documentation requirements and portfolio- and risk-management practices, regardless of whether a loan is a Qualified Mortgage loan. From a consumer protection perspective, the statement says that the agencies responsible for conducting CRA evaluations do not expect that a bank's decision to originate only Qualified Mortgages, absent other factors, would adversely affect that bank's CRA evaluations.

Nutter Notes: The CFPB's Ability-to-Repay Rule implements Section 129C of the Truth in Lending Act, created by the Dodd-Frank Act, which requires lenders to make reasonable, good faith determinations that consumers have the ability to repay mortgage loans before extending such loans. The Ability-to-Repay Rule provides a lender with a presumption of compliance with the rule for each loan that meets the regulatory definition of a Qualified Mortgage. Under the CFPB's Ability-to-Repay Rule, a Qualified Mortgage may not have certain features, such as negative amortization, interest-only payments, or certain balloon structures, and must meet limits on points and fees and other underwriting requirements. The Ability-to-Repay Rule allows lenders to satisfy the requirements of the rule without making loans that meet the regulatory definition of a Qualified Mortgage, referred to as "non-Qualified Mortgage" loans, by applying eight underwriting standards and verifying a borrower's information using reasonably reliable third-party records. The Massachusetts Division of Banks issued an industry letter on December 23 that outlines the Division's expectations for compliance by Massachusetts banks with the Ability-to-Repay Rule. The Division stated in the letter that it will not subject a home mortgage loan to "unwarranted regulatory criticism based solely on the loan's status" as a non-Qualified Mortgage. 

3. Division of Banks Provides Guidance on New Mortgage Loan Servicing Rules

The Division of Banks has published answers to frequently asked questions about recent amendments to its debt collection and loan servicing regulation, which applies to all banks engaged in debt collection or third-party loan servicing activities. The questions and answers issued on December 18 clarify certain of the Division's new mortgage loan servicing rules and their relationship with the CFPB's new mortgage loan servicing rules that become effective on January 10, 2014. For example, the Division's new mortgage loan servicing rule prohibits unfair and unconscionable mortgage loan servicing practices and makes failure to comply with certain new CFPB mortgage loan servicing requirements a violation of the Division's new rule. However, the CFPB's new mortgage loan servicing requirements are not yet effective. The Division's answers to frequently asked questions clarifies that compliance with the CFPB's regulations cited in the Division's new mortgage loan servicing rule (see 209 CMR 18.21A(1)(e) through 209 CMR 18.21A(1)(h)) is not required in advance of the effective date of the CFPB's regulations, which is scheduled for January 10, 2014. The Division's answers to frequently asked questions also clarifies that if the CFPB's new mortgage loan servicing requirements that are specifically referenced in the Division's rule do not apply to a "small servicer" (as defined in the CFPB's new mortgage loan servicing rules), then the Division's rule does not apply to such entities either. However, the Division's guidance points out that small servicers are still required to comply with certain of the CFPB's mortgage servicing rules.

Nutter Notes: The Division of Banks' amended debt collection and loan servicing regulation (209 CMR 18.00), which established new standards of conduct for debt collection and third-party loan servicing, became effective on October 11, 2013. According to the Division, the amended regulation is meant to complement recently adopted foreclosure prevention rules that require home mortgage lenders and servicers to modify certain mortgage loans if the cost of modification is less than the cost of foreclosure. Among other changes, the amendments provide examples of loan servicing practices that are considered unfair or unconscionable both in general and specifically with respect to mortgage loan servicing. The amended regulation directs mortgage loan servicers to comply with additional requirements related to evaluating borrowers for loss mitigation options, providing borrowers with written acknowledgement of receipt of loan modification documentation, concluding the modification process before initiating foreclosure, providing borrowers with contact information for a designated individual, and offering or accepting alternative loss mitigation options. All loan servicers are also required under the amended regulation to maintain procedures to ensure accurate and timely updating of borrowers' account information. 

4. Federal Reserve Issues Guidance on Managing Outsourcing Risks

The Federal Reserve has released new guidance on managing risks associated with outsourcing bank activities to third-party service providers. The guidance published on December 5 with Supervision and Regulation Letter No. SR 13-19, titled Guidance on Managing Outsourcing Risk, applies to all banking organizations supervised by the Federal Reserve. The new outsourcing guidance expands on the FFIEC Outsourcing Technology Services Booklet (2004) that addresses outsourced information technology services. The new outsourcing guidance addresses risk management issues related to outsourced activities beyond traditional core bank processing and information technology services, such as accounting, appraisal management, internal audit, human resources, sales and marketing, loan review, asset and wealth management, procurement, and loan servicing. The new outsourcing guidance applies to all service provider relationships regardless of the type of bank activity that is outsourced. It describes risks from the use of service providers, discusses board of directors and senior management responsibilities, and outlines supervisory expectations for managing risks associated with service provider relationships. The new outsourcing guidance also recommends contractual terms that should be considered by a banking organization when entering into an agreement with a third-party service provider.

Nutter Notes: Considering the Federal Reserve's new outsourcing guidance as an indication of supervisory expectations, examiners will generally expect contracts with service providers to clearly define the rights and responsibilities of each party, including support, maintenance, and customer service, contract timeframes, and compliance with applicable laws. The new outsourcing guidance also suggests that contracts with service providers should address training of employees of the banking organization, the ability of the service provider to subcontract services, the distribution of disclosures to the banking organization's customers, insurance coverage requirements, and terms governing the use of the banking organization's property, equipment and staff. The new outsourcing guidance includes more detailed recommendations for contract provisions dealing with cost and compensation, the banking organization's right to audit, performance standards, security and confidentiality of the banking organization's confidential information and its customers' information, ownership and license of intellectual property, the service provider's liability cap, and indemnification obligations. For example, the guidance recommends that outsourcing contracts should provide for service provider indemnification of the banking organization for any claim against the banking organization resulting from the service provider's negligence. 

5. Other Developments: Tax Allocation Agreements and BSA 

  • Federal Banking Agencies Propose Guidance on Tax Allocation Agreements

The federal banking agencies on December 19 issued a request for public comments on proposed joint supplemental guidance on income tax allocation agreements between banks and their holding companies. According to the agencies, the proposed guidance is meant to reduce confusion regarding ownership of any tax refunds and to clarify how sections 23A and 23B of the Federal Reserve Act apply to tax allocation agreements. Comments on the proposed guidance are due by January 21, 2014.

Nutter Notes: The proposed guidance would instruct banks and their holding companies to review their tax allocation agreements to ensure that the agreements expressly acknowledge that the holding company receives a tax refund from a taxing authority as agent for its subsidiary bank. The proposed guidance includes a sample paragraph that banks could include in their tax allocation agreements to facilitate the agencies' instructions. 

  • Definitions Used in Exclusions from BSA Recordkeeping Requirements Amended

The Federal Reserve and the Financial Crimes Enforcement Network ("FinCEN") issued a final rule on December 3 that amends the definitions of "funds transfer" and "transmittal of funds" under the regulations that implement the Bank Secrecy Act ("BSA"). According to the agencies, the amendments are needed to retain the current scope of the definitions as a result of changes to the Electronic Fund Transfer Act ("EFTA") made by the Dodd-Frank Act. The amendments become effective on January 3, 2014.

Nutter Notes: The regulations that implement the BSA exclude from BSA recordkeeping requirements certain types of transactions and payment systems that are used mostly for domestic retail transactions and payments. These exclusions (namely ATM, point-of-sale and automated clearinghouse transactions) were made by cross-referencing the EFTA in the definitions of funds transfer and transmittal of funds. As a result of this cross-referencing, amendments to the EFTA made by the Dodd-Frank Act would have unintentionally expanded the scope of the transactions excluded from BSA recordkeeping requirements. 

Nutter Bank Report

Nutter Bank Report is a monthly electronic publication of the Banking and Financial Services Group of the law firm of Nutter McClennen & Fish LLP. Chambers and Partners, the international law firm rating service, after interviewing our clients and our peers in the profession, has ranked Nutter's Banking and Financial Services practice among the top banking practices in the nation. The 2012 Chambers and Partners review says that a "broad platform" of legal expertise in the practice "helps clients manage challenges and balance risks while delivering strategic solutions," while the 2013 Chamber and Partners review reports that Nutter's bank clients describe Nutter banking lawyers as "proactive" in their thinking, "creative" in structuring agreements, and "forward-thinking in terms of making us aware of regulation and how it may impact us," which the clients went on to describe as "indicative of a true partner." Visit the U.S. rankings at ChambersandPartners.com. The Nutter Bank Report is edited by Matthew D. Hanaghan. Assistance in the preparation of this issue was provided by Lisa M. Jentzen.

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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