SEC Adopts Rule Regarding Redemption Fee and Intermediary Participation in Mutual Fund Efforts to Police Market Timing

At its open meeting last week, the SEC adopted new Rule 22c-2 (the "Rule") under the Investment Company Act of 1940, as amended. The Rule will require the board of any mutual fund that redeems shares within seven (7) days to adopt a redemption fee (of no more than 2% of the amount redeemed) or determine that a redemption fee is not appropriate or necessary for the fund. Unlike the SEC’s original proposal, the Rule does not require mutual funds to adopt a redemption fee. Under the Rule, mutual funds that redeem shares within seven (7) days must also enter into agreements with their intermediaries obligating the intermediaries to (i) provide information on underlying shareholder trading activity so that funds can monitor for market timing activity and (ii) implement fund instructions aimed at halting abusive underlying shareholder trading activity, e.g., by refusing further orders to fund shares from an underlying investor identified by a fund as a market-timer. The Rule will not apply to money market funds or exchange traded funds (commonly referred to as ETFs). Funds that affirmatively permit frequent trading will also be exempt from the Rule, provided that they disclose their policy of permitting frequent trading and the accompanying risks. Concurrent with the Rule’s adoption, the SEC is seeking additional comment on whether it should establish uniform parameters for redemption fees, for example, by designating a method for determining length of holding period or defining de minimis and financial hardship exceptions. In response to questions from Chairman Donaldson at the open meeting, the SEC staff indicated that it was currently reviewing draft interpretive relief on fair valuation that it expected to present to the Commission in the near term. A future edition of the Alert will discuss additional details of the Rule and the SEC’s request for comment once the SEC issues a formal release relating to them.

The SEC further extended, to September 30, 2005 (from March 31, 2005), the date for bank compliance with the broker registration requirements contained in the Gramm-Leach-Bliley Act. The release states that the SEC does not expect banks to develop compliance systems to meet the terms of the "broker" exceptions until the SEC’s proposed Regulation B is finalized. Separately, several members of the Senate signed a letter urging the SEC to issue a new proposal more consistent with legislative intent as the more aggressive push out approach in the current proposal is "fundamentally flawed."

The FRB issued a final rule amending its risk-based capital standards for bank holding companies ("BHCs") that allows the continued inclusion of outstanding and prospective issuances of trust preferred securities in BHCs’ tier 1 capital, subject to stricter quantitative limits and qualitative standards (the "Final Rule"). The FRB began reconsidering the capital treatment of trust preferred securities and other minority interests in light of supervisory concerns, domestic and international competitive equity considerations and a new rule issued by the Financial Accounting Standards Board ("FASB") in which FASB determined that instruments such as trust preferred securities should not be consolidated in a BHC’s financial statements under generally accepted accounting principles.

Under the Final Rule, trust preferred securities will be includable in the tier 1 capital of BHCs, but subject to tightened quantitative limits for trust preferred securities, qualifying cumulative perpetual preferred stock (and related surplus), minority interests related to qualifying cumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary, and minority interests related to qualifying common or qualifying perpetual preferred stock issued by a consolidated subsidiary that is neither a U.S. depository institution nor a foreign bank (collectively, "restricted core capital elements"). Restricted core capital elements includable in the tier 1 capital of a BHC will be limited to 25% of the sum of core capital elements (including restricted core capital elements), net of goodwill less any associated deferred tax liability. Certain excess amounts of restricted core capital elements may be included in tier 2 capital, subject to further limitation. For internationally active BHCs (generally, those BHCs that will be required to use the AIRB approach to measuring risk under the New Basel Accord), restricted core capital elements includable in tier 1 capital will be generally subject to a 15% limit, although they may include qualifying mandatory convertible preferred securities up to the 25% limit. Importantly, the outstanding amount of trust preferred securities will be excluded from tier 1 capital and included in tier 2 capital, and subject to certain other restrictions, in the last 5 years before the maturity of the underlying note.

The Final Rule also eliminates a long-standing requirement of the FRB that trust preferred securities include a call option in order to qualify for inclusion in tier 1 capital, and provides clarification of various technical requirements for the underlying note. The Final Rule includes a five-year transition period for application of its quantitative limits, ending March 31, 2009. The Final Rule will take effect 30 days from the date of its publication in the Federal Register, but the FRB noted that it will not object if a banking organization wishes to apply its provisions beginning on the date it is published in the Federal Register.

The SEC has reopened the comment period on rules proposed in January 2004 that would require broker-dealers to enhance the information which they provide their customers at the "point of sale" and otherwise on the costs and conflicts of interest associated with the distribution of mutual funds, 529 plans and variable insurance products. The proposal includes new rules 15c2-2 and 15c2-3, amendments to Rule 10b-10, the SEC’s confirmation rule, and amendments to Form N-1A, the registration form for mutual funds, to improve the disclosure of sales loads and revenue sharing payments. In addition to re-opening the comment period the SEC has revised the content and format of the point of sale disclosure and confirmation disclosure being proposed to address comments and other feedback which suggested that the disclosure requirements needed to be revised to more effectively communicate information to investors, while more efficiently balancing the benefits of disclosure against the costs of compliance. The SEC has also proposed that brokers use the Internet as a disclosure medium to supplement point of sale and confirmation disclosure and to provide investors with more detailed information on revenue sharing and other broker compensation practices. Comments must be submitted to the SEC by April 4, 2005.

The FRB, FDIC, OCC, and NCUA, (collectively, the "Agencies") issued in final form their Overdraft Protection Programs Joint Agency Guidance ("Guidance"). The Agencies had initially published proposed guidance in June 2004 in which the OTS had also joined. The OTS did not join in the final Guidance, but promulgated its own guidance separately. The Guidance is comprised of five sections: (i) an introduction, which contrasts traditional programs in which banks might pay consumer overdrafts on a discretionary, ad-hoc basis with more recent approaches in which overdraft protection programs with a defined credit limit are marketed actively to consumers; (ii) an overview of the regulatory concerns with such programs, including credit, legal, reputation, safety and soundness, and other risks, with a particular focus on the practice of marketing overdraft protection to consumers as a short-term credit facility; (iii) a review of the safety and soundness considerations involved in such programs; (iv) a discussion of the legal risks, together with a summary of the compliance requirements imposed by various federal statutes and regulations, including the Federal Trade Commission Act (the "FTC Act"), the Truth in Lending Act, the Equal Credit Opportunity Act, the Truth in Savings Act, and the Electronic Fund Transfer Act, together with their implementing regulations; and (v) and a listing of best practices, which encourage adequate consumer disclosures and fair program features.

One significant focus in considering the Guidance had been as to whether the payment of consumer overdrafts by financial institutions was an extension of credit to the consumer subject to the disclosure and other requirements of Regulation Z and the Truth in Lending Act. The Guidance affirms that overdraft protection programs are loans, but that, under Regulation Z, fees for paying overdraft items are currently not considered finance charges if the institution has not agreed in writing to pay overdrafts. The Guidance further states that, even where the institution agrees in writing to pay overdrafts as part of the deposit account agreement, fees assessed against a transaction account for overdraft protection services are finance charges only to the extent the fees exceed the charges imposed for paying or returning overdrafts on a similar transaction account that does not have overdraft protection. By contrast, overdraft lines of credit are universally considered loans and are fully subject to Regulation Z. The Agencies leave open the door to the possible future adoption of a different rule in situations in which overdrafts are being paid by the financial institution on more than an occasional basis. The OTS version of the Guidance omits certain references to overdraft protection programs as extensions of credit as well as an entire segment of the Guidance—Legal Risks—as adopted by the Agencies. The OTS’ position is that if the product is a loan, overdraft fees should be disclosed as finance charges; if overdraft fees are not disclosed as finance charges, the product should not be deemed a loan.

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