FDIC, OCC and FRB Issue Revised Proposed Changes to Community Reinvestment Act Rules; OTS Issues Final Rule Granting Large Thrifts Flexibility to Choose Weights Assigned to CRA Lending, Investment and Service Tests

The FDIC and OCC jointly and the FRB, separately, (collectively, the "Agencies") issued substantially identical Notices of Proposed Rulemaking (the "NPRs"), concerning proposed revisions to the Agencies’ regulations implementing the Community Reinvestment Act ("CRA"). The NPRs state that the Agencies are responding to public comments on proposals regarding CRA set forth in releases issued in February and August 2004. The NPRs would, among other things: (1) amend the definition of "small institution" to mean a bank with total assets of less than $1 billion (rather than the current $250 million), regardless of the size of its holding company; (2) exempt banks with assets between $250 million and $1 billion, referred to as "intermediate small banks," from the current data reporting obligations concerning originations and purchases of small business, small farm and community development loans; (3) subject intermediate small banks to a two-part test (a streamlined small bank lending and a community development test) instead of the current three-pronged test (lending, investment, and service); (4) require, for intermediate small banks, a satisfactory community development rating, as well as a satisfactory small bank lending rating, to qualify for an overall CRA rating of "Satisfactory"; (5) revise the definition of "community development" for all banks of any size to make it more flexible and responsive to the community development needs of underserved rural areas and designated disaster areas; (6) clarify when discriminatory or other illegal lending practices – for example, by a bank’s affiliate – may result in the lowering of a bank’s CRA rating; and (7) adjust the asset size for small and intermediate small banks based upon changes in the Consumer Price Index. The community development test would include an assessment of services and the number and size of loans and investments made to promote development. In addition, it is anticipated that branch location as a factor in determining whether a bank is delivering services to low-and moderate-income neighborhoods would move from the community development aspect of the service test to the new community development test. Banks with less than $250 million in assets will continue to be evaluated on the basis of the lending test exclusively. Comments on the NPRs are due 60 days after publication in the Federal Register.

Subsequently, the OTS issued a final rule (the "OTS Rule") granting large retail thrifts the power to choose the weighting assigned to the lending, investment and service tests when the OTS assesses the thrift’s CRA performance. Under the OTS Rule, a large retail thrift may choose a lending test weighting of from 50% to 100% and investment and service tests weighting of from 0% to 50% each, provided that the aggregate weighting of the three factors equals 100%. The OTS deferred a decision on the manner in which it will address community development aspects of thrift examinations. The OTS Rule will become effective on April 1, 2005.

The U.S. District Court for the Southern District of New York granted the defendant directed trustee’s motion for summary judgment to dismiss certain of the plaintiffs’ claims regarding the investment of Worldcom’s retirement plan assets in Worldcom stock. In In re Worldcom, Inc. ERISA Litigation, the court dismissed the plaintiffs’ breach of fiduciary duty claims under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), related to the Merrill Lynch Trust Company FSB ("Merrill Lynch") in its role as the plan’s directed trustee.

Notably, the court looked to Field Assistance Bulletin 2004-03 (the "Bulletin") issued by the Department of Labor (the "DOL") on the fiduciary duties of directed trustees. The court stated that Merrill Lynch as a directed trustee was an ERISA fiduciary, citing the Bulletin in support of this conclusion. The Court then, however, analyzed the actions of Merrill Lynch in light of the DOL’s guidance set forth in the Bulletin. The court held that the plaintiffs did not show that Merrill Lynch had non-public information regarding Worldcom’s stock that would warrant Merrill Lynch taking extraordinary action. In addition, the court stated that "when a directed trustee receives a direction to invest plan assets in the securities of a company, or when plan assets are already invested in such securities, a directed trustee has a fiduciary duty of inquiry under ERISA when it knows or should know of reliable public information that calls into serious

question the company’s short-term viability as a going concern." The court then noted that while there were numerous negative press and analyst reports regarding WorldCom’s prospects, other analysts were more optimistic and during the period in question numerous sophisticated institutional investors continued to hold and/or purchase WorldCom stock. The court concluded that there were no genuine issues of fact as to whether there was "reliable public record information that called into serious question WorldCom’s ongoing viability much less its imminent collapse." On this basis, the court held that Merrill Lynch did not have a duty under ERISA to investigate whether the continued investment of plan assets in WorldCom stock was imprudent.

Although, as a legal matter, this ruling applies only to the Southern District of New York, this is the first major ruling that relies on the Bulletin and it is possible that other courts may look to this case for guidance in ruling on similar cases elsewhere.

An SEC Administrative Law Judge (the "ALJ") issued a rare ruling against the SEC’s Division of Enforcement in a case involving the sale of Class B shares of mutual funds. Among other charges, the SEC alleged that three brokers had committed fraud in connection with the sale of Class B shares by failing to disclose to their customers that (a) investments of $250,000 or more in a fund’s Class A shares would have produced materially higher returns than the same investment in Class B shares because of the availability of breakpoints and the lower expenses for Class A shares, and (b) the registered representatives received higher commissions if they sold Class B shares rather than Class A shares ("differential compensation"). The ALJ agreed with the registered representatives that investments in Class A shares did not always outperform Class B shares. In addition, with respect to the SEC’s claim that the brokers’ had a duty to disclose differential compensation, the ALJ noted that industry practice at the time was for registered representatives not to disclose differential compensation, and that while the SEC had since proposed a rule that would require disclosure of differential compensation (see the February 17, 2004 Alert), there was no case precedent or rule in effect at the time of the conduct in question that would have required a registered representative to disclose differential compensation. In the absence of supporting authority, the ALJ declined to rule in the SEC’s favor. The SEC also argued that one of the brokers, who was also an associated person of an investment adviser, had continued to have the fiduciary obligations of an investment adviser even when he sold his advisory clients securities in his capacity as an associated person of a broker-dealer. In finding for the broker, the judge pointed to the lack of any case precedent holding that an associated person of an investment adviser cannot "change hats" and act in the capacity of an associated person of a broker-dealer without continuing to owe the higher duties of an adviser to its clients and noted that in the current instance the broker had disclosed to his clients the capacity in which he was acting. Further guidance on this and related issues is expected when the SEC takes final action on recent proposed guidance regarding when a broker’s activities may subject the broker to regulation as an investment adviser. (See the January 25, 2005 Alert for a discussion of this proposal and related SEC action.)

The FRB adopted a final rule amending its risk-based capital standards for bank holding companies ("BHCs") that allows the continued limited inclusion of outstanding and prospective issuances of trust preferred securities in BHCs’ tier 1 capital. Trust preferred securities and other restricted core capital will be subject to stricter quantitative limits and qualitative standards. The new quantitative limits become effective after a five-year transition period. A discussion of the final rule will be provided in a future edition of the Alert.

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