United States: OCIE Associate Director Discusses Examination Program for Broker-Dealers
(Financial Services Alert – Developments of Note)

1. OTS Concludes that County Lending Restrictions are Preempted
2. ICI Rule 22c-2 Working Group Issues Package with Form of Rule 22c-2 Agreement and Other Model Documents for Use in Communicating with Intermediaries Regarding Rule 22c-2 Compliance
3. Federal Banking Agencies Extend Comment Period on Interagency Guidance on Concentrations in Commercial Real Estate Lending
4. FRB Allows Bank Holding Company to Acquire Subsidiary Providing Forward Exchange Transaction Services
5. FinCEN Provides Guidance on the Treatment of NSCC Fund/SERV Accounts for Purposes of New Correspondent Account AML Due Diligence Requirements
6. FinCEN Issues Survey Concerning Cross-Border Wire Transfer Data
7. OCIE Associate Director Discusses Examination Program for Broker-Dealers

The OTS issued an opinion in March 2006 (the "Opinion") concluding that federal law preempts the applicability to federal savings banks of county laws that seek to prohibit mortgage loans that: (1) include the financing of single premium credit life insurance; (2) provide for excessive upfront points, fees, or prepayment penalties; or (3) provide compensation paid to any person. In preempting the laws, the Opinion cited a series of judicial decisions and prior OTS rulings holding that the OTS has exclusive authority with respect to federal savings bank lending. The Opinion also stated that only the OTS, and not any county authority, could enforce any local laws that were not preempted. As with the preemption issue, the Opinion cites judicial authority and prior regulatory determinations in support of that position.

An Investment Company Institute working group on Rule 22c-2 under the Investment Company Act of 1940, as amended, consisting of representatives of mutual funds, transfer agents, banks/trust companies, third party administrators/recordkeepers and other service providers issued a package of documents designed to assist mutual funds in the process of working with financial intermediaries to meet the Rule’s requirements. (In general terms, the Rule requires a written agreement between a fund and each of its intermediaries (an "Intermediary Agreement") under which the intermediary must share information about underlying shareholder activity and agree to cooperate with fund instructions to restrict such activity.) The package contains (a) sample cover correspondence, (b) a sample Intermediary Agreement, (c) an executive summary of the Rule, (d) an analysis of information sharing pursuant to Intermediary Agreements and federal and state privacy regulations, (e) suggested forms for communicating (i) a fund’s excessive trading policies and (ii) a fund’s expectations regarding the frequency and type of its requests for underlying shareholder information and (f) information on a National Securities Clearing Corporation ("NSCC") data sharing service designed to support the transmission of information requests and responses pursuant to Intermediary Agreements. In a related announcement, NSCC provided additional details on this standardized data sharing service.

The FRB, FDIC, OCC and OTS (the "Agencies") jointly extended the comment period from March 14, 2006 to April 13, 2006 on the Agencies’ proposed guidance regarding concentrations in commercial real estate lending (the "Guidance"). The Guidance, which was described in detail in the January 17, 2006 Alert, states that high concentrations of commercial real estate loans may make some financial institutions more vulnerable to a downturn in economic conditions and describes sound risk management practices to address concentrations in commercial real estate lending.

The FRB issued an opinion permitting a bank holding company to acquire a subsidiary ("Section 1031 Subsidiary") that provides services to customers seeking to make forward exchanges of real property pursuant to Section 1031 of the Internal Revenue Code. Section 1031 provides taxpayers with deferral of gain when exchanging property for another property of "like kind." In a forward exchange transaction under Section 1031, a taxpayer first sells his or her property and later purchases a replacement property. In order to successfully complete such transactions, the proceeds of the sale of the taxpayer’s property must be held by a "qualified intermediary." The Section 1031 Subsidiary would act as a qualified intermediary and perform certain other activities to facilitate forward exchange transactions, including providing transaction documents, investing property sale proceeds until the taxpayer purchases a replacement property, and transferring funds to effect the taxpayer’s purchase of the replacement property. In rendering its opinion, the FRB concluded that the activities of the Section 1031 Subsidiary are permissible real estate settlement services, trust company functions, and financial advisory services under Section 225.28(b) of Regulation Y.

In response to a request from the Investment Company Institute, the Financial Crimes Enforcement Network ("FinCEN") indicated that mutual fund accounts maintained by a financial intermediary, e.g., a broker-dealer, through the Fund/SERV mutual fund transaction clearing and settlement facility maintained by National Securities Clearing Corporation ("NSCC") should be treated under FinCEN’s new correspondent account rule (the "Rule") in a manner similar to their treatment under the mutual fund AML Customer Identification Program ("CIP") requirements. Like the CIP requirements, the Rule mandates that mutual funds conduct certain AML due diligence on customer accounts, in this case, on correspondent accounts maintained for non-U.S. financial institutions. In its guidance on the Rule, FinCEN indicated that a mutual fund would not maintain a correspondent account for a non-U.S. financial institution when an NSCC member intermediary that is a U.S. financial institution subject to Section 312 of the Patriot Act opened an account with a mutual fund on behalf of the NSCC member intermediary’s customers (and the mutual fund therefore would not be required to perform due diligence under the Rule with respect to that Fund/SERV account or the NSCC member intermediary’s customers). The FinCEN guidance did indicate, however, that if NSCC were to admit a foreign financial institution as a member, a mutual fund would be required to treat a Fund/SERV account opened by that NSCC member as a correspondent account subject to the appropriate level of due diligence and monitoring under the Rule. This FinCEN guidance on the Rule echoes a 2003 FAQ on the mutual fund CIP requirements in which the staffs of the Treasury and the SEC indicated that when an intermediary opens an account with a mutual fund through NSCC Fund/SERV, the intermediary, not the intermediary’s customers on whose behalf fund shares are held, is the fund’s customer for purposes of CIP due diligence requirements.

Currently, mutual due diligence programs pursuant to the Rule must in place by April 4, 2006 with respect to all correspondent accounts established on or after that date. The Rule also requires the due diligence program to be applied to correspondent accounts in existence prior to April 4, 2006 by October 7, 2006. Goodwin | Procter LLP held a webinar on the Rule and its requirements, which is available on the firm’s website at http://www.goodwinprocter.com/webinar_patriotact.asp. The Alert issued a January 30, 2006 Special Edition providing answers to selected questions raised at the Webinar. The December 20, 2005 Alert discussed guidance on the Rule provided by FinCEN in the form of a fact sheet issued prior to the formal release of the Rule.

The Financial Crimes Enforcement Network ("FinCEN") issued a survey (the "Survey") to banking and financial services trade groups (which are distributing the Survey to their respective members) "seeking information about the feasibility and impact of implementing a cross-border wire transfer reporting requirement under the Bank Secrecy Act." FinCEN is required by the Intelligence Reform and Prevention Act of 2004 to conduct the Survey. The Survey does not cover all wire transfers, only those that are "cross border electronic transfers of funds." Financial institutions currently keep records of these wire transfers, but are not required to file reports with the government regarding these transactions. The results of the Survey are expected to help FinCEN evaluate and balance the benefits to anti-money laundering enforcement efforts of collecting such data against the costs of the additional regulatory burden that would be imposed on U.S. financial institutions. FinCEN stated that Canada, Australia and "many other countries" already have systems in place to collect this type of information. FinCEN expects to deliver its feasibility study to Congress with respect to this issue by late spring 2006.

In her speech at the Bond Market Association’s February 2006 legal and compliance conference, Mary Ann Gadziala, Associate Director of the SEC’s Office of Compliance Inspections and Examinations ("OCIE"), discussed various aspects of the SEC’s examination program for broker-dealers, including current examination priorities. Ms. Gadziala noted that OCIE is moving more and more towards the coordination of its examinations across regulatory disciplines (broker-dealer, investment adviser, investment company, transfer agent, clearing agency) in circumstances where a large firm has subsidiaries with a variety of registrations under the federal securities laws. She noted that for these large firms certain risks/issues often cross formal organizational boundaries, e.g., gifts and gratuities, revenue sharing, use of confidential customer information and supervision. She added that the use of coordinated reviews also takes into account the fact that firms may address regulatory responsibilities on a consolidated basis for all their various securities-related activities, e.g., business continuity planning, anti-money laundering, information security and risk management. Ms. Gadziala also discussed increasing coordination of examination information with bank regulatory agencies, the Commodities Futures Trading Commission, FinCEN and other relevant regulators. She also mentioned work in progress with the FRB on a number of initiatives to share relevant examination information and coordinate risk assessment.

Internal Audit. Ms. Gadziala described an OCIE initiative in which examination staff limit their review of areas where the staff has confidence in the effectiveness of the internal audit work done by the firm being examined; under this approach, the staff focuses its review on high risk areas and areas not adequately covered by the firm’s internal reviews. She further indicated that implementing this initiative requires that OCIE enhance its review of the effectiveness and objectivity of work done by firms’ internal audit programs. She outlined some of the factors SEC examiners may consider in assessing an internal audit program, as follows:

• Adequacy of the audit universe – internal audit’s assessment to determine the areas of risk, risk rankings and the effectiveness of risk controls.
• Incorporation of the foregoing information into the design and implementation of the audit plan.
• The extent to which top management, which has overall responsibility for the audit, is kept informed on audit issues.
• The competence and objectivity of internal auditors and the effectiveness of their work.

Examination Priorities. Ms. Gadziala discussed OCIE’s current broker-dealer examination priorities for 2006, including inter-dealer and retail mark-ups and payments for bond rating trips (with a focus on situations where excessive expenses for meetings between municipal officials and rating agencies are ultimately borne by bond holders as a cost of offering). She listed a number of other currently targeted examination priorities for 2006 including the following:

1. Sales practices and supervision, covering:

• general suitability examinations to identify sound and weak practices;
• branch exams, particularly remote offices, independent contractors, and foreign branches;
• products, including variable annuities, mutual funds, and bonds.

2. Compliance, internal controls, and risk management, including:

• consolidated supervised entities, particularly inter-affiliate transactions, unregulated material affiliates, and new products and businesses;
• OTC derivatives dealers;
• the largest institutional and retail broker-dealers with an increased focus on legal and compliance risks and controls.

3. Net capital and customer reserves, with some focus on Rent-A-Finops, assumption of liabilities, customer versus capital investment, and the alternative capital calculation for consolidated supervised entities.

4. Business continuity practices, including:

• the Interagency White Paper for significant firms (discussed in the April 13, 2003 Alert);
• compliance by all firms with self-regulatory organization rules and general business continuity planning risk management.

5. Anti-money laundering, including:

• compliance programs, training, audits;
• Suspicious Activity Reporting;
• Customer Identification Programs;
• broker-dealers with bank or insurance affiliates and online broker-dealers;
• Section 312 of the USA PATRIOT Act, including enhanced due diligence for accounts with foreign banks and foreign correspondent accounts.

6. Back office operations and new products and services, particularly:

• risk management for new products;
• ensuring back office operations and controls keep pace with new product and business developments;
• information security issues, including privacy, identity theft, computer viruses, and stolen information.

7. Best execution and trading activities, including:

• compliance with requirements regarding disclosure of order execution and routing information under Reg. NMS and with Reg. SHO (short sales practices);
• use of customer trading information;
• valuations;
• information barriers.

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