FDIC Issues Several Deposit Insurance-Related Proposed Rules

1. FDIC Imposes Moratorium on ILC Actions
2. Pension Reform Bill Passes House and Goes to Senate
3. Federal Banking Agencies and FinCEN Jointly Issue Revised and Updated BSA/AML Examination Manual
4. DOL Proposes Amendments to Form 5500 Reporting Requirements
5. Certain Major Industry Players Object to Limited Basel II Options Available in US
6. SEC Chairman Testifies on Hedge Funds Before Senate Banking Committee
7. FDIC Issues Several Deposit Insurance-Related Proposed Rules

The FDIC imposed a six month (until January 31, 2007) moratorium on agency actions involving industrial loan company ("ILC") charters. During the moratorium, except in very limited circumstances where an institution or the deposit insurance fund is at risk, the FDIC will not accept, approve or deny any application for deposit insurance for an ILC, or accept, disapprove or issue a letter of intent not to disapprove any change in bank control action involving an ILC. In explaining the moratorium, the FDIC noted the recent increase in ILC charters and aggregate ILC assets, the significant public objection to the Wal-Mart application, Congressional concerns, and the number of commercial enterprises seeking an ILC charter. The FDIC stated that during the moratorium period it will review issues with the charter, and also seek public input. The moratorium itself would not implement any new standards for regulatory approvals.

The U.S. House of Representatives passed a revised version of the pension reform bill. The Pension Protection Act of 2006 (H.R. 4) will now go to the Senate for consideration, although it is not clear when the Senate will act on the bill. In addition to new pension funding rules, the pension reform bill contains provisions clarifying certain aspects of the status of hybrid plans (e.g., cash balance plans), and makes permanent the EGTRRA retirement plan savings levels. The pension reform bill also contains numerous amendments to the fiduciary duty and prohibited transaction rules under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), including provisions dealing with participant investment advice, block trading, bonding relief for registered brokers and dealers, transactions through electronic communication networks, prohibited transactions with service providers and their affiliates, foreign exchange transactions, cross trading, increased bonding levels for plans with employer securities, and relief for timely corrections of certain prohibited transactions. In addition, the pension reform bill would, if enacted, effectively amend the so-called "plan assets regulation." Under current law, an entity is not deemed to hold the "plan assets" of a plan subject to ERISA if less than 25% of each class of equity securities issued by the entity is held by "benefit plan investors," which is defined to include governmental, foreign and other plans that are not subject to ERISA. The pension reform bill would revise this test to limit the definition of "benefit plan investor" to plans subject to ERISA and/or Section 4975 of the Internal Revenue Code of 1986, as amended. The pension reform bill further provides a proportionate look-through rule when applying the so-called 25% test to a plan assets entity such as a fund of funds. The pension reform bill would not, however, increase the 25% threshold.

The FRB, FDIC, OCC, OTS, NCUA and FinCEN (the "Agencies") jointly issued a revised and updated 2006 version of their Joint Bank Secrecy Act/Anti-Money Laundering ("BSA/AML") Examination Manual (the "Manual"). The Manual was originally issued in 2005 and its contents were described in the Alert of July 12, 2005. As with the original edition of the Manual, the updated, 367-page Manual does not set new standards, but compiles existing regulatory requirements and supervisory expectations and describes what the Agencies view as sound practices in the BSA/AML compliance area. The Manual is designed to provide consistent supervisory guidance to financial institutions. In addition to organizational and formatting changes, the Agencies state that the significant revisions and updates to the Manual concern:

1. Risk Assessment – The Manual provides additional guidance regarding how a financial institution should evaluate and develop its risk assessment process;
2. Automated Clearing House ("ACH") Transactions – The Agencies have added a new section to the Manual concerning the manner in which examiners should evaluate the adequacy of a financial institution’s systems to manage risks associated with ACH activities. In connection with these changes the Agencies (with input from OFAC) have also updated the Manual’s section on OFAC compliance to add similar enhancements to the text;
3. Trade Finance Activities – The Manual includes revised examination procedures and related text that provides "additional guidance concerning trade finance gathered from industry and subject matter experts;"
4. Regulatory and Supervisory Guidance – The Manual reflects updated regulatory and supervisory guidance for the Manual sections that cover suspicious activity reporting, foreign correspondent accounts, private banking, insurance and politically exposed persons; and
5. Emerging Money Laundering Risks – The Manual reflects information concerning emerging money laundering risks, e.g., risks related to nominee incorporation services and stored value cards.

The Department of Labor (the "DOL") proposed amendments to the Form 5500 reporting requirements, including changes to disclosure of service provider compensation on Schedule C. The proposed changes would, among other things, require employee benefit plans (and direct filing entities, or DFEs, that file Schedule C) to include detailed information on service provider compensation, including information on revenue sharing payments, brokerage commissions, compensation for bundled services, and float. The proposed changes will also require that Schedule C list each service provider that receives total compensation of $5,000 or more in connection with services rendered to the plan during the plan year. The proposed changes will require significantly more information and detail than currently required on Schedule C. The proposed amendments are proposed to become effective for plan years beginning on or after January 1, 2008. Comments are due to the DOL no later than September 19, 2006.

As has been discussed previously in the Alert, the international Basel II Capital Accord permits banking and other subject financial institutions to select from three different implementation options, Standardized, Foundation, and Advanced. In other words, in Europe, where the Accord is being fully implemented, a banking institution is able to elect whether to be subject to the Standardized approach, which is most like the current capital system, or, subject to having appropriate systems in place, more sophisticated, tailored approaches like the Foundation or, even to a greater extent, the Advanced approach. Unlike their European counterparts the US bank regulators have chosen to allow US institutions only to select the Advanced approach, with the expectation that only the largest, international US institutions, rather than all as in Europe, would become subject to Basel II. (As discussed in the December 13, 2005 Alert, the US federal banking agencies are simultaneously working on so-called "Basel IA" for the remainder of the US banking institutions.)

Very recently, four of the largest US international banks that would be subject to Basel II have stated that US banks also should have the "Standardized" Basel II approach available to them. The Conference of State Bank Supervisors ("CSBS") similarly has sent a letter to the US federal banking agencies providing that "we believe it is appropriate for a dialogue on the desirability of the Standardized Approach to Basel II in the United States." The US banking regulators have not yet formally responded to these assertions, and it is not known whether they will have any impact on the pending publication of the US Basel II rules.

SEC Chairman Christopher Cox testified before the U.S. Senate Committee on Banking, Housing, and Urban Affairs about the regulation of hedge funds. In his written remarks presented to the Committee, Chairman Cox discussed regulatory concerns regarding hedge funds and SEC hedge fund enforcement activity. He also outlined measures he intends to recommend to the full Commission in response to the decision (the "Goldstein decision") of the U.S. Court of Appeals for the District of Columbia Circuit (the "Circuit Court") vacating and remanding Rule 203(b)(3)-2 and certain related rule amendments under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), which required registration of certain advisers to hedge funds (collectively, the "hedge fund adviser rules"). (See the June 26, 2006 Hedge Fund Alert for a more detailed discussion of the Goldstein decision.)

Hedge Funds – Concerns and Enforcement Activity. Chairman Cox began his remarks by discussing the work of the President’s Working Group on Financial Markets and its focus on the threat to financial market stability posed by the possible failure of one or more significant and highly leveraged investment pools. He observed that the Goldstein decision had forced the SEC back to the drawing board to devise a workable means of acquiring even basic census data to monitor hedge fund activity in a way that could mitigate systemic risk. On the issue of "retailization" of hedge funds, Chairman Cox admitted that the SEC staff was not aware of significant numbers of truly retail investors investing directly in hedge funds. Chairman Cox indicated that he nevertheless intended to recommend that the SEC take formal steps to further limit the marketing and availability of hedge funds to unsophisticated retail investors. Chairman Cox then went on to discuss the phenomenon of increased investment in hedge funds by institutional investors with retail constituencies, such as public and private pension plans, fund-of-funds investments, universities, endowments, foundations and charitable organizations, and the related potential they create for retail exposure to hedge fund risk. Chairman Cox emphasized that, notwithstanding the Goldstein decision, hedge funds are subject to SEC regulations and enforcement under the anti-fraud, civil liability and other provisions of the federal securities laws. In that regard, Chairman Cox noted that the number of enforcement cases against hedge funds had grown from four in 2001 to more than 60 since then. Chairman Cox also highlighted four of the significant hedge fund cases brought by the SEC in 2006.

Response to the Goldstein Decision. Chairman Cox indicated that in his view, the Goldstein decision rendered the SEC’s program of hedge fund oversight inadequate, and that while some improvements might be possible through administrative action, others might well require legislation. He cautioned however that, to the maximum extent possible, action to address shortfalls in hedge fund regulation should be non-intrusive and should not interfere with the investment strategies or operations of hedge funds, including their use of derivatives trading, leverage and short selling. Furthermore, the federal government should not restrict hedge funds in terms of their creativity, liquidity or flexibility, and that the costs of any regulation should be "kept firmly in mind." Chairman Cox also discussed recommendations he proposed to make to the full Commission based on the SEC staff’s ongoing evaluation of available alternatives in light of the Goldstein decision, summarized as follows:

• adopt a new anti-fraud "look through" rule based on Section 206(4) of the Advisers Act which he believed might withstand judicial scrutiny given the analysis in the Circuit Court’s opinion;

• take emergency action to restore certain transitional and exemptive elements of the hedge fund adviser rules that (a) grandfathered newly registered hedge fund advisers with respect to the Advisers Act’s performance fee restrictions and performance data recordkeeping requirements, (b) extended the period to provide audited financials for funds of hedge funds under the Advisers Act’s custody rule and (c) provided relief to registered offshore hedge fund advisers from certain requirements under the Advisers Act as applied to the advisers’ offshore funds; and

• increase the net worth threshold for an individual to have accredited investor status in unregistered hedge fund offerings to $1.5 million (which would achieve the same result as the hedge fund adviser rules, which treated individual investors in hedge funds that pay performance fees as subject to the $1.5 million net worth threshold under the Advisers Act’s performance fee rule).

The reaction of the other Commissioners to these proposals is difficult to predict. Only two of the Commissioners who acted on the hedge fund adviser rules remain on the Commission - Atkins, who opposed it, and Campos, who favored it. (Chairman Cox noted at the outset of his remarks that the views expressed were his as SEC Chairman and did not represent the position of the Commission itself.) Chairman Cox concluded his remarks by noting that he had instructed the SEC staff to continue its risk-based examinations of registered hedge fund advisers and that the SEC would continue to work with other U.S. regulators and with the Financial Services Authority in the U.K. to coordinate hedge fund adviser oversight.

The FDIC issued a series of proposed rules required by the Federal Deposit Insurance Reform Act of 2005 ("FDI Reform Act") and the Federal Deposit Insurance Reform Conforming Amendments Act of 2005 ("Amendments"). Most of the proposed rules address issues relating to deposit insurance assessments, including which insured institutions will be subject to assessments, how much will be assessed and how excess assessment amounts will be distributed. Many predict significant assessments for most insured depository institutions in 2007. Because of the complexity of the rules under the FDI Reform Act and Amendments and because the FDIC must issue final rules in these areas by November 5, 2006, banks should consider the possible effects of the rules and consider whether they wish to submit comments.

Risk-Based Premiums The FDIC has proposed linking deposit insurance assessments more closely to the risk insured institutions pose to the consolidated Deposit Insurance Fund ("DIF"). Currently most insured institutions do not pay an assessment for deposit insurance. Under the new proposal, most well capitalized and well managed insured institutions would be charged an assessment of two to four basis points per $100 of insured deposits. For institutions with over $10 billion in assets, the amount of the assessment would be determined by factors including the institution’s CAMELS component ratings, long-term debt issuer ratings, and, for some mid-sized institutions, financial ratios. For institutions with less than $10 billion in assets, assessment amount factors would include CAMELS component ratings and current financial ratios.

The proposal would condense the current nine risk categories into four, designated I, II, III and IV with I comprising institutions posing the lowest risk. Those institutions in Risk Category I would be assessed two to four basis points per $100 of insured deposits annually. The rates for Risk Category II, III and IV institutions would be seven, twenty-five and forty basis points respectively per $100 of insured deposits annually. Using December 31, 2005 figures, the FDIC estimates that nearly 95% of insured depository institutions would fall within Risk Category I.

Within Risk Category I, larger and smaller banks are again treated somewhat differently. Insured institutions with over $10 billion in assets would be charged at one of six rates (or buckets) within the range of two to four basis points per $100 of insured deposits. The FDIC retains the discretion under the proposed rule to examine the characteristics of institutions within a given bucket and reclassify which bucket an institution falls within. Smaller insured institutions would pay a rate between two and four basis points per $100 of insured deposits based on a formula. Some larger banks have objected to the proposed six bucket approach noting that given large amounts involved in the computation, the increments between the six rates could be significant and place large banks at a potential disadvantage relative to smaller banks. FDIC Chairman Sheila Bair noted in a July 19, 2006 speech that a final rule could integrate both approaches for both larger and smaller institutions.

The proposed rule outlines possible variations to the factors considered in determining assessment amounts and the FDIC has invited comment on the merits of the variations. Comments on the proposed risk-based premiums rule are due by September 22, 2006.

To assist depository institutions in calculating the possible effects of the proposed risk-based assessment rule, the FDIC has placed an assessment calculator function on the FDIC’s website. Users are able to input sample CAMELS component ratings and financial information to determine assessment amounts under both the large and small bank formulas. The calculator is available at http://www.fdic.gov/deposit/insurance/rule.html.

Designated Reserve Ratio. The FDIC is required under the FDI Reform Act to set by regulation the Designated Reserve Ratio ("DRR") for the DIF within a proscribed range. The FDIC’s proposed rule would establish the DRR at 1.25% of estimated insured deposits, the same goal ratio that has been maintained for several years.

The FDI Reform Act instructs the FDIC to consider (1) the risk of losses to the DIF in both current and future years, (2) economic conditions affecting depository institutions, (3) the desirability of stable assessment rates for depository institutions, and (4) other factors the FDIC deems appropriate. The FDIC, after analyzing these factors may set an annual ratio of 1.15% to 1.50% of estimated insured deposits. If the actual reserve ratio falls below the DRR, the FDIC is empowered to require increased assessments to increase the reserve ratio.

The FDI Reform Act and Amendments also removed a requirement that the actual reserve ratio meet the DRR within a specified timeframe. Due to a significant expansion in estimated insured deposits, the FDIC expects that the reserve ratio will fall below 1.25% at the end of 2006 and notes that reserves could fall below the statutory floor of 1.15%. This trend opens for debate the issue of how quickly the FDIC should attempt to raise the reserve ratio to meet the DRR and whether a reserve ratio of 1.25% would be overly disruptive due to the high assessments caused. Chairman Bair noted in a speech in late July 2006 that given current estimates minimum assessment rates could be as much as ten basis points above the proposed minimum rate if the reserve ratio is to be restored to 1.25% within one year. If that process is achieved over two years, the minimum assessment rate would be approximately five basis points above the proposed minimum.

Comments on the proposed DRR rule are due by September 22, 2006.

One-time Assessment Credit. The FDI Reform Act also mandated the FDIC to determine procedures to allocate a $4.7 billion one-time assessment credit to rebate amounts paid by insured banks and thrifts to bolster the deposit insurance funds in the early-to-mid 1990s. Under the FDI Reform Act, the FDIC is instructed to issue the credits to each "eligible insured depository institution," a defined term in the FDI Reform Act, or the institution’s successor based on the institution’s assessment base on December 31, 1996, the end on the last year most depository institutions paid an assessment. The assessment credit may be applied to future assessments owed by a depository institution. Such assessment credits could be of significant assistance to insured institutions if assessments increase significantly in 2007 as forecast.

The FDIC issued a proposed rule to clarify those eligible for the assessment credit. The one-time assessment credit proposed rule seeks to define what institutions are successors for purposes of the credit. The FDIC’s proposed rule defines successor to include the acquiring, assuming or resulting institution in a merger transaction. The term successor does not include the results of "all transactions in which an insured depository institution either directly or indirectly acquires the assets of, or assumes liability to pay any deposits made in , any other insured depository institution."

The primary effect of this definition of successor is to permit depository institutions that have subsequently sold deposits held on December 31, 1996 to claim the assessment credit on those deposits rather than permitting the acquirer of such deposits to claim the credit. The FDIC states in the preamble to the proposed rule that other definitions of successor were considered that would have "followed the deposits" permitting acquirers to claim the assessment credit. The FDIC is seeking comment on both the proposed approach and the alternative "follow the deposits" approach. The comment period for the proposed one-time assessment credit rule has been extended to August 16, 2006.

Premium Collection. The FDIC also has proposed procedural changes to assessment collections. The primary effect would involve collecting assessments at the end of each quarter and using more recent data to determine assessment amounts. Currently, assessments are collected prior to the quarter in which insurance is provided. Under the proposed rule, the capital evaluation and report of condition on which the assessment will be based would be performed as of the assessment date. Payment of the assessment amount would be due on the last day of the following quarter. The comment period for the proposed premium collection rule has been extended to August 16, 2001.

Assessment Rebates. In May, 2006 the FDIC proposed a two-year interim rule governing the payment of rebates from the DIF. Under the FDI Reform Act and Amendments, in the event that the ratio of funds in the DIF exceeds 1.35% of estimated insured deposits, half of the assessment income received by the FDIC must be returned to depository institutions. If the ratio exceeds 1.50%, all assessments must be returned. Under the proposed rebate rule, a depository institution’s share of rebates from the DIF would be based on the institution’s share of the 1996 assessment. The FDIC may suspend rebates if (1) the DIF faces a significant risk of losses during the next year and (2) the FDIC Board justifiably finds that losses will be sufficiently high that the reserve ratio should continue to grow. The FDIC noted that the prospect of a rebate during the period of the proposed interim rule is unlikely. The comment period for the proposed rebate will has been extended to August 16, 2006.

New Insured Deposit Signage and Logo. Due to the merger of the Bank Insurance Fund and Savings Association Insurance Fund into the DIF, the FDIC issued a proposed rule on new signs and insured deposit logo to be displayed by insured institutions. Previously required signs were specific to the insurance fund covering an insured institution’s deposits. The proposed new signs may be used by all insured depository institutions. The new official sign would be similar to the current sign used by banks, but with language noting that each depositor is insured to at least $100,000. The proposed rule would also permit insured savings associations to use the shortened notation "Member FDIC" in advertising as insured banks have been permitted to do. Comments on the proposed signage rule are due by September 15, 2006.

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