United States: Federal Bank Regulators and SEC Testify on Capital Rules; Banking Agencies also Address CRE Guidance
(Financial Services Alert – Developments of Note)

1. Federal Bank Regulators and SEC Testify on Capital Rules; Banking Agencies also Address CRE Guidance

2. NASD Issues Notice to Members Regarding "Text Box" Mutual Fund Performance Advertising Rule Changes

3. SEC Office of The Chief Accountant and Divisions of Corporation Finance and Investment Management Provide Guidance on the Effects of Prior Year Misstatements in Quantifying Current Year Misstatements

4. Correction - Massachusetts Enacts Law Amending Electronic Fund Transfer Provisions

Representatives of the four federal banking agencies (the "Banking Agencies") the Conference of State Bank Supervisors ("CSBS") and others spoke before the Financial Institutions Subcommittee of the House of Representatives on the recently published US Basel II NPR, as well as developments with respect to the outstanding proposals concerning so-called Basel IA and the guidance on commercial real estate ("CRE") concentrations. Robert Colby, the Acting Director, SEC Division of Market Regulation, also spoke on the application of Basel II to securities firms. Much of the testimony described the various proposals, all of which have, or will be, summarized in separate issues of the Alert. See the September 12, 2006 Alert for a summary of the credit and collateral components of the US Basel II NPR, the June 15, 2004 Alert for a summary of the SEC’s Basel II implementation; the October 11, 2005 Alert for a summary of the Basel IA proposal, and the January 17, 2006 Alert for a summary of the CRE guidance proposal. Accordingly, this article will focus principally on new insights raised by the regulators concerning those matters.

Basel II. The Banking Agencies expressed concern over the capital reduction and dispersion of results for similar exposures indicated by QIS4, and all pledged to closely monitor the implementation of US Basel II during the transition period to ensure safety and soundness of the US banking system. All reiterated their ongoing commitment to maintaining the prompt corrective action standards and the leverage ratio, with the FDIC citing research and asserting that the Basel Committee should consider establishing leverage ratios internationally. The Banking Agencies also addressed the fact that some of the "core" US banks under Basel II have asked for a "Standardized" option, as well as the "Advanced" option that was historically contemplated, and asked for significant industry comment on that issue. The OTS appeared to be the most open to that proposal, stating that "it is important for the [Banking Agencies] to consider whether the Standardized approach could achieve many of the same goals as the models-based approach at a lower cost and with greater clarity and transparency."

The FDIC also stated that the market risk proposal (which would apply to any banks meeting the trading book thresholds, whether or not Basel II) simultaneously issued by the Banking Agencies is intended to "address strategies banks employ to use their trading books to lower capital requirements in ways that were not originally intended." As to the more immediate future, the Banking Agencies stated that proposed regulatory reporting requirements for banks intending to adopt Basel II or the market risk amendments should be published at the same time as the Basel II NPR appears in the Federal Register, and the OTS stated that the Banking Agencies are "working toward issuance of a final Basel II rule in mid-2007".

The SEC representative discussed that since the SEC made available the Basel II capital calculation alternative to its historical 15c3-1 net capital rule, five US investment bank holding companies, and one broker dealer subsidiary of a financial holding company, have become eligible to use the alternative. The SEC’s rules do not specify whether Basel I or Basel II must be used, nor, if Basel II is chosen, compel use of the Advanced Basel II framework. Still, four of the five investment banks have selected Basel II Advanced (and the fifth is in the process) because of concerns that if they used the Standardized approach "they would be viewed as being less sophisticated than other internationally active institutions." As to the efforts of the Banking Agencies to implement US Basel II for banking institutions, the SEC stated that when the Basel II proposal is formally issued the SEC will "review the document carefully to apply the proposed approaches to securities firms in the context of their history, risk profile, and business mix," and noted that "[w]here further modifications to the calculations used by the [investment banks] are warranted, the [SEC] has authority to require their adoption."

Basel IA. As to Basel IA, the Banking Agencies reiterated their commitment to have a notice of proposed rulemaking available during the Basel II comment period (which will extend 120 days from its Federal Register publication). The FDIC noted the principal differences between Basel IA and the "Standardized" Basel II approach, namely: (1) some risk weight differentiation; (2) Basel IA does not include an operational risk charge, and (3) the Standardized approach permits some new methods to computing capital for derivatives and counterparty credit risks (similar to the Basel II Advanced approach). The FDIC also stated that the Basel IA proposal will ask if some of these differences should be eliminated. The OTS also noted that the Banking Agencies were very concerned about causing undue regulatory burden and were considering the request of many banks to remain under the current capital framework.

CRE. The Banking Agencies stated that the CRE guidance was issued in response to the dramatic increase in the CRE exposure of small- and mid-sized banks (generally, between $100 million and $10 billion of assets) in particular over the past few years, and the historic volatility of CRE loans. However, the Banking Agencies emphasized that the guidance was not intended to impose hard caps on the maximum size of the CRE portfolio, or impose specific additional capital requirements as the size of a bank’s CRE exposure increases. Rather, the FRB stated that banks should view the 100/300 thresholds in the guidance as "supervisory screens that examiners should use to identify banks with potential CRE concentration risk." The OCC noted that the "overwhelming majority" of potentially affected institutions already hold capital exceeding the regulatory minimums by more than 200 basis points, and "as a result, these institutions generally would not be affected by the capital adequacy part of the guidance." Moreover, the OCC stated that "our focus in applying this guidance will be first and foremost on risk management practices." To address concerns that examiners might apply the guidance unevenly, the FRB stated that "the agencies are also developing interagency training materials about the new guidance for their examiners to support more effective and consistent implementation." However, in recognition of the affect of industry comment, the OTS Director stated that the guidance is being redrafted now, and it is his "expectation that we will modify the guidance to address the comments, to clarify the underlying theme of [Banking Agency] risk management expectations for the industry, and to make sure the guidance conveys this intent more clearly."

The NASD issued a Notice to Members (the "NTM") regarding amendments to NASD Conduct Rules 2210 and 2211 recently approved by the SEC (as discussed in the July 18, 2006 Alert). The amendments impose certain disclosure and presentation requirements on NASD member communications with the public, other than institutional sales material and public appearances, that present non-money market mutual fund performance information ("performance sales materials"). To comply with the amendments, performance sales material must disclose: (1) standardized performance information mandated by Rule 482 under the Securities Act of 1933, as amended, and Rule 34b-1 under the Investment Company Act of 1940, as amended; and (2) to the extent applicable, the Fund’s maximum front-end or back-end sales charge and annual operating expense ratio; all of this information must be presented prominently and, and in any print advertisement, appear in a prominent text box. The NTM indicates that all member performance sales materials used on or after April 1, 2007 must comply with these new requirements. In addition to reviewing the new requirements, the NTM addresses four principal issues that arose during the public comment process for the amendments, as summarized below.

Prominence Requirements. The amendments require the specified information to be set forth "prominently." The NTM indicates that the NASD will apply the same prominence and proximity standards for disclosure of fund expense ratios as those used for standardized performance and sales charges under SEC performance advertising rules. When fund performance data is presented on a website, members may present standardized performance using a hyperlink, provided that the linked performance is presented prominently consistent with the standards of SEC Rule 482.

Text Box Requirement. The amendments require performance sales materials in the form of print advertisements to disclose required performance, sales charge and expense ratio information in a prominent text box. Only the required information and, at the member’s option, comparative performance and fee data, along with other disclosures that are required to be in the advertisement under SEC Rule 482 and Rule 34b-1, may appear in the text box. Accordingly, a text box may include the prospectus disclosure language required by Rule 482, the performance of a relevant benchmark index or a comparison of the Fund’s expense ratio to the average expense ratio of similar funds. The NTM states that the text box requirement applies only to print advertisements, such as those in newspapers, magazines or other periodicals, and does not apply to printed sales literature (such as fund fact sheets, brochures or form letters), or to websites, television or radio commercials or any other form of electronic communication.

Annual Fund Operating Expense Ratio. The amendments require performance sales material to disclose a fund’s total annual operating expense ratio, gross of any fee waivers or expense reimbursements, as stated in the fund’s prospectus fee table, current as of the date of submission of the material for publication, or as for other communications with the public, as of the date of distribution. The NTM indicates that the amendments do not preclude performance sales material from also presenting a fund’s subsidized expense ratio, as long as the presentation of both expense ratios is fair and balanced. In this regard, the NASD expects a member disclosing a subsidized expense ratio to also disclose whether the applicable fee waivers or expense reimbursements are voluntary or mandated by contract and the time period during which the waiver or reimbursement obligation is in effect. In print advertisements, subject to the foregoing requirements, a subsidized expense ratio may appear in the text box with the mandated unsubsidized expense ratio.

Previously Filed Performance Sales Material. The NTM notes that, at a minimum, members will be required to add a fund’s unsubsidized total annual fund operating expense ratio to previously filed sales material in order to comply with the amendments. The NTM states that refiling will not be necessary if the only change to previously filed performance sales material is the addition of the required expense ratio disclosure. To the extent performance sales materials that are print advertisements must be modified to include a prominent text box, they must be refiled with the NASD on the grounds that this change "alters the content and presentation of the performance information." The NTM urges members that have questions about whether they must refile previously filed performance sales material to contact the NASD staff.

The SEC’s Office of the Chief Accountant and Divisions of Corporation Finance and Investment Management issued Staff Accounting Bulletin 108 (the "SAB"), which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SAB indicates that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. The SAB also describes circumstances under which a registrant may record a one-time cumulative effect adjustment to correct errors existing in prior years that, based on appropriate use of the registrant’s former approach, had previously been considered immaterial, and discusses related disclosures that would need to be made in connection with such an adjustment.

In the September 5, 2006 Alert, the report on the recently-enacted Massachusetts law relating to electronic funds transfers and the return of checks incorrectly stated that Chapter 279 of the Laws of 2006 (the "Act") requires Massachusetts financial institutions to provide copies of up to 10 canceled checks per year free of charge. The correct number of canceled checks is 25. We regret the inadvertent error.

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