United States: DOL Proposes Amendment to Prohibited Transaction Exemption Concerning Interest-Free Loans
(Financial Services Alert - Developments of Note)

The Department of Labor (the "DOL") proposed an amendment to Prohibited Transaction Exemption 80-26 ("PTE 80-26") under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). PTE 80-26 is a class exemption that permits parties-in-interest with respect to employee benefit plans to make interest-free loans to such plans if certain conditions are met. Currently under PTE 80-26, such an interest-free loan must be either (i) for the payment of ordinary operating expenses of the plan, including the payment of benefits and periodic premium payments, or (ii) for a period of not more than three business days for a purpose incidental to the ordinary operation of the plan. If finalized, the proposed amendment would eliminate the three business day limitation on interest-free loans for a purpose incidental to the ordinary operation of the plan. The proposed amendment will become effective on the date after the date the final exemption is published in the Federal Register. Comments are due to the DOL no later than January 31, 2005.

The FRB issued an interpretive letter (the "Letter") permitting a foreign bank subject to the restrictions of the US Bank Holding Company Act (the "BHCA") to establish an investment trust under German law that acquired US real estate even though the foreign bank would thereby hold title to the real estate. The trust would not be sold to US persons, and all property management and other services provided to the US real estate would be obtained from unaffiliated parties.

The FRB evaluated the permissibility of the activity under Regulation K, which permits a bank to engage in fiduciary activities to the extent permitted under Regulation Y. Regulation Y permits banks to acquire assets in good faith in a fiduciary capacity. Among other things, to support its position that this exemption applies, the bank represented that: (1) the affiliates of the German bank establishing and maintaining the trust were subject to German banking law and oversight; (2) under German law, the real estate would be held in a trust very similar to US trusts; (3) the trust is not a separate legal entity; and (4) the German bank would acquire no interest in the trust.

In a recent no-action letter, the staff of the SEC’s Division of Investment Management agreed that an arrangement where an adviser reduces its advisory fee for each fund in a group of mutual funds when the group’s composite performance exceeds a specified rate of return would not violate prohibitions in the Investment Advisers Act of 1940, as amended, against advisory fees based on capital gains or capital appreciation in a client’s account, and related staff interpretations of those prohibitions. The amount of any fee reduction under the proposed arrangement would be calculated once annually based on a composite of asset-weighted returns for all funds in the group for a trailing ten-year period. The formula for calculating a fund’s return would eliminate the effect of the fund’s fees and expenses. Once determined, the amount of any fee reduction would apply equally to each fund in the group, regardless of fund size, performance or advisory fee rate, for a one-year period. The target rate of return against which composite fund performance would be measured under the fee reduction arrangement was arrived at through negotiations between the adviser and the funds’ trustees who are not interested persons of the funds (the "independent trustees") within the meaning of the Investment Company Act of 1940 Act, as amended. The independent trustees were assisted in this process by an independent financial consultant. The mutual funds in question are used as vehicles for variable insurance products issued or administered by the adviser and one of its subsidiaries. The fee reduction arrangement is intended to allow fund shareholders to benefit through lower expenses as the adviser achieves anticipated profitability levels in managing the funds and administering their related variable insurance products. The adviser proposed the fee reduction arrangement following discussions with the fund’s independent trustees regarding potential economies of scale.

The FDIC issued a study (the "Study") on a type of identity theft known as account-hijacking. Account hijacking is unauthorized access and misuse of existing asset accounts "and it occurs primarily through phishing and hacking." The FDIC suggests that banks consider: (1) upgrading password-based systems; (2) using sophisticated software to detect and defend against phishing attacks; (3) strengthening consumer education programs regarding avoidance of online scams; and (4) placing a greater emphasis on information sharing among banks, government agencies and technology providers. The FDIC also seeks public comment by February 11, 2005 on the Study and hopes to use those comments to formulate future guidance to the banking industry.

FRB Governor Bies discussed how a system of enterprise risk management has evolved in banking supervision as banking organizations have grown larger and more complex. Particularly since the expansion of powers permitted by the Gramm-Leach-Bliley Act in 1999, the FRB has determined that supervisory oversight at the bank holding company level is particularly critical because public disclosure (and thus market discipline) occur largely at the consolidated level. More generally, as banking organizations have increased in complexity, the FRB has moved from evaluation on a separate legal entity basis "toward more forward-looking assessments of the adequacy of risk management and financial factors of the consolidated organization." In this regard, the proposed new holding company rating system (discussed in the July 27, 2004 Alert) emphasizes risk management to a greater degree, and includes subcomponents considering (1) the competence of the board and senior management, (2) policies and procedures, (3) risk monitoring and management information systems, and (4) internal controls, all to better align the rating system with the FRB’s supervisory practice. Governor Bies specifically highlights the benefits of the Committee of Sponsoring Organizations of the Treadway Commission’s recently developed framework on enterprise risk management, which she declares may become a "standard for enterprise risk management."

The OTS entered into a consent order (the "Consent Order") with Ernst & Young LLP ("E&Y"), the former independent auditor of the failed thrift, Superior Bank, FSB, that requires E&Y to adopt specific internal controls and policies in connection with E&Y’s audits of federally–insured savings associations ("Thrifts"). As part of the Consent Order, E&Y agreed, among other things, to: (1) establish a review group in its national office (the "Review Group") to supervise all audits of Thrifts; (2) provide for rotation of the partner-in-charge of the audit, the independent review partner and other partners on the audit engagement team; (3) take certain steps before providing an audit for a new client that is a Thrift, including documenting the reasons for the change in auditors; (4) have the partner-in-charge and the independent review partner perform certain designated procedures in connection with each E&Y audit of a Thrift; (5) perform audits of Thrifts in accordance with Generally Accepted Auditing Standards; (6) provide a "qualified opinion" or a "going concern" opinion under specified circumstances; (7) cause auditors to consult with the Review Group or Review Group designated experts for any matter where the "applicable [Generally Accepted Accounting Principles] literature relating to a significant matter is unclear or nonexistent"; (8) require that certain working papers be prepared in connection with each audit report for a Thrift; and (9) comply with specified audit partner and audit manager experience and training requirements. The OTS states in its press release accompanying the Consent Order that CPA firms that audit Thrifts "should give consideration to adopting most, if not all, of the practices required of E&Y in the Consent Order."

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