United States: Conference Summary: Basel II and Basel IA: Framework, Issues and Opportunities
(Financial Services Alert – Developments of Note)

1. Conference Summary: Basel II and Basel IA: Framework, Issues and Opportunities
2. SEC Staff Guidance for Investment Company Registrants Clarifies Application of FASB Interpretation Regarding Uncertain Tax Positions and Delays Interpretation’s Effectiveness

3. ICI Issues Model Provisions for Rule 22c-2 Information Sharing Agreements in the Context of Variable Annuity and Life Insurance Products
4. Goodwin Procter Issues Client Alert Concerning Climate Change Strategies for the Financial Services Industry

On December 13, 2006, Goodwin Procter LLP and Boston University School of Law’s Morin Center for Banking and Financial Law jointly presented a one-day conference in New York on Basel II and Basel IA. Speakers included representatives from all four federal banking regulators and the New York State Banking Department, the SEC, three rating agencies, affected financial institutions, trade groups and publications, as well as partners in Goodwin Procter’s Financial Services Group. In addition, Eugene Ludwig of Promontory Financial Group, LLC was the keynote speaker.

While a detailed summary of the presentations is beyond the scope of the Alert, certain key points made in panel presentations during this conference are summarized below. These highlights were developed by Goodwin Procter attorneys attending the conference, and have not been prepared or reviewed by the applicable speaker.

The conference began with a foundation overview of the proposed Basel framework. Mr. Lyons noted that one of the primary deficiencies perceived by the regulators of the current capital rules applicable to US banks (referred to as Basel I) is their lack of sensitivity to risk in the computation of Risk-Weighted Assets. In that regard, Basel I is now viewed as an inadequate measure of capital adequacy for many banks (especially the largest and most complex banks). Accordingly, banking regulators from around the world have worked for years on revisions to Basel I, resulting in the publication of the International Convergence of Capital Measurement and Capital Standards: A Revised Framework (the "New Accord") in June 2004. The New Accord is expected to apply to banks in approximately 95 different countries.

The New Accord was approved by the European Union ("EU") Parliament in 2005 and will apply to all banks and securities firms in Europe. However, in the US, only the "advanced approach" of the New Accord is currently proposed to be adopted (although, at industry urging, other alternatives are being considered). Accordingly, as proposed in September 2006, the New Accord ("Basel II") will generally only apply in the US to the largest and most complex banks (referred to herein as the "Basel II Banks") and large securities firms. Mr. Lyons further noted that the rules applicable to US securities firms under the New Accord are in final form, while the rules which will apply to US banks are still in proposed form.

Basel II is expected to generally reduce risk-weights for the largest US banks, but it is not expected to generally redefine capital (at least initially). Furthermore, Basel II will not eliminate the current leverage ratio or the Prompt Corrective Action Rules, which has raised concerns for many in the industry as European institutions are not, and will not be, subject to similar rules. Other issues which have been raised with regard to Basel II relate to a proposed 10% aggregate warnings flag for a decrease in capital among US banks subject to Basel II, the definition of default (discussed in more detail below), and the conservative treatment of equity positions. Meanwhile, US banks that will not be subject to Basel II (approximately 9000 US banks) have raised concerns about competitive issues vis-à-vis the Basel II Banks. These non-Basel II banks will likely have the option of adopting Basel IA, which principally affects risk weights, but does not have the same focus on risk management as Basel II.

Basel II includes three pillars: (1) minimum capital; (2) supervisory review; and (3) market discipline. In that regard, Basel II demonstrates the convergence of capital and compliance (including disclosure). In order to implement Basel II, institutions will have to satisfy a number of qualification requirements, which have been broadly written. Therefore, banks adopting Basel II will have to undertake a significant effort to ensure that they have sufficient systems in place.

Mr. LaFond then discussed certain capital calculation aspects of Basel II, such as the fact that wholesale exposures will be risk weighted on an individual basis while retail exposures will be risk weighted on a pooled basis. In addition, Mr. LaFond gave a brief summary of the principal metrics: Probability of Default (PD); Exposure at Default (EAD); Loss Given Default (LGD); Expected Loss Given Default (ELGD); and Maturity (M). Mr. LaFond also noted that a credit-related loss of 5% or more in connection with the sale of an exposure is included in Basel II’s definition of default, which has raised industry concerns.

Mr. Nolan then summarized certain aspects of Basel II related to securitizations. Basel II defines a securitization exposure broadly to include basically any transaction that involves tranching of credit risk and in which the performance of the securitization exposure depends on the performance of underlying exposures. The Basel II definition of securitization covers both traditional and synthetic securitizations. In order to treat an exposure as a securitization exposure, certain operational requirements must be satisfied. Once these operational requirements have been met, Basel II provides three basic approaches to risk weighting of a securitization exposure: (1) the Ratings-Based Approach ("RBA"); (2) the Internal Assessment Approach ("IAA"), which is available only for qualifying exposures to asset-backed commercial paper programs; and (3) the Supervisory Formula Approach ("SFA").

Basel II also establishes a general hierarchy for which approach to use and mandates deductions for exposures that do not meet any of the approaches or that are credit-enhancing interest-only strips or represent gain on sale. Basel II also provides specific guidance as to the application of the approaches and the hierarchy to different types of synthetic securitization exposures, such as first-to-default tranches, nth–to-default tranches and super-senior tranches. However, Mr. Nolan noted that Basel II makes certain exceptions to the hierarchy to address specific issues in asset-backed securities where the general approach would not adequately recognize risks, as in the case of "AAA" rated interest-only securities, or would be unduly punitive, as in the case of multiple exposures to a single securitization. With one small exception in the RBA related to the number of ratings or inferred ratings required, Basel II does not differentiate between positions held by an originator and those held by an investor.

Ms. Martin, taking a broader view, commented that the purpose of each of Basel II and Basel IA is risk management, not capital reduction. Furthermore, Ms. Martin pointed out that institutions will not have a full understanding of these provisions until the regulators publish supervisory guidance on the subject.

Finally, Mr. Griep expressed his view that Standard & Poor’s ("S&P") is generally supportive of the Basel II framework, partly because of the general view that Basel II will result in a reallocation of capital, not a reduction in capital. In addition, Mr. Griep noted that a principal benefit of Basel II will be that both banks and regulators will be more focused on measuring and monitoring risk, and in that regard Basel II is expected to result in capital being more closely aligned with risk.

Staff from the banking agencies made presentations that are summarized below, with the general caveat that they were not speaking officially for such agencies, but were expressing their own views based on their observations.

Mr. Van Der Weide began by providing a brief summary of the history of the process to revise Basel I. The Basel Committee began the process in 1998, and the US had a significant role in developing the New Accord from the beginning. Mr. Van Der Weide noted that the New Accord is not binding on any country, but rather must be implemented by local regulators.

Mr. Van Der Weide acknowledged that Basel II is not perfect. For example, the fact that Basel II relies heavily on bank inputs raises certain risks. However, Mr. Van Der Weide does believe that Basel II is better than the current capital rules in effect for US banks, in part because: (1) Basel II is more risk sensitive; (2) Basel I is not connected to how banks manage risk (Basel II is not seamless in this regard, but there are important synergies); (3) Basel I does not include an operational risk component; (4) Basel II provides banks and supervisors with common risk metrics and language; and (5) the inclusion of Pillars 2 and 3 (while these Pillars will not affect the US regulatory atmosphere significantly, it should represent an improvement in many other countries).

Mr. Van Der Weide noted that the comment period for Basel II would likely be extended to early spring. [Editors’ note: The comment period for both Basel II and Basel IA has since been extended to March 26, 2007.] He further said that supervisory guidance regarding Basel II is expected to be published in January. Finally, Mr. Van Der Weide pointed out that Basel IA is simpler than the New Accord’s standardized approach, and will be optional for all of those institutions not required to adopt Basel II.

Mr. Cave first pointed out that the FDIC had approved the notice of proposed rulemaking for Basel IA the previous week. Furthermore, with regard to Basel II, Mr. Cave said that the FDIC is particularly looking for comments on alternatives for core Basel II banks.

Mr. Cave also gave a brief summary of the importance of capital to the banking system and some of the history of the US’s capital rules. For example, capital is important to absorb losses, curb excessive growth (the leverage ratio is particularly important in this regard) and protect the Deposit Insurance

Fund and depositors. With regard to the history of the US’s capital rules, Mr. Cave noted that such rules have undergone constant change. Furthermore, he stated that Basel I represented a significant improvement over the previous capital rules when it was implemented. In particular, he noted that Basel I, which created an overall minimum capital requirement of 8%, was more risk sensitive than the prior rules.

Mr. Cave also said that it is important for the US to maintain the leverage ratio, even for banks that adopt Basel II. Basel II does not include measures of all relevant risks (e.g., liquidity risk and concentration risk), requiring the need for such a dual framework. Furthermore, Mr. Cave commented that the topic of expanding the leverage ratio to other countries has been discussed with the Basel Committee, and others have supported that idea.

Finally, Mr. Cave said that Basel II has the potential to result in lower capital requirements for banks, as demonstrated by the results of Quantitative Impact Study 4 ("QIS-4"). Accordingly, it is important to move at a measured pace.

Mr. Snow focused on three unique aspects of US implementation of Basel II: (1) timing; (2) scope; and (3) the specificity of Basel II. With regard to timing, Mr. Snow noted that there will be a so-called "gap year" between implementation in Europe and implementation in the US, as the parallel run in Europe may begin in 2007 while the parallel run in the US may not begin until 2008. Furthermore, US banks will be subject to a longer transition period under Basel II than European banks will be under the New Accord. The OCC and the other federal banking regulators are aware that these timing issues will create a number of home/host issues, which will highlight the importance of bilateral discussions between US supervisors and foreign supervisors. Mr. Snow also said that, while the federal banking regulators recognize that not having a final rule at this point can be an impediment for US banks, it is possible that the delay could benefit US banks to a certain extent as they will be able to witness any problems that arise during Europe’s parallel run.

With regard to the scope of Basel II, Mr. Snow noted that it was always expected that implementation of the New Accord would be subject to each country’s national discretion. The federal banking regulators recognize that this national discretion can raise difficult issues, but he believes that they are committed to trying to address any such issues. Finally, with regard to the specificity of Basel II, Mr. Snow reiterated that the federal banking regulators are encouraging comments on every aspect of Basel II.

Mr. Riley focused his presentation on the mortgage lending aspects of Basel II. He noted that while banks have a lot of data in this area, there is not a lot of data during stress times. He also commented that the OTS is working on the question of how to get data for new products in this area. Accordingly, he encouraged institutions to comment on Basel II, and to provide empirical data, if possible. Mr. Riley further noted that interest rate risk is not included in Pillar 1, but rather is an element of Pillar 2. Accordingly, such risk was not accounted for in the QIS-4 results.

Ms. Wyatt recognized that there is a concern as to how competition will be affected by different treatment of the same assets under different capital rules, and how Basel II will affect the overall safety and soundness of the industry. Accordingly, the New York State Banking Department has been studying the Basel proposals very closely, and has worked with other state banking regulators in that regard. Ms. Wyatt said that there is a need for better understanding of the consequences of implementing Basel II, but that looking at European implementation of the New Accord may help in this regard. Ms. Wyatt also noted that the possibility of allowing banks to use simpler approaches than the New Accord’s advanced approach should be explored further.

Mr. French began by discussing the first consultative document related to the New Accord, published in 1999. That consultative document did not provide for capital reduction, but rather for capital equality between banks using internal measures and others. Mr. French also stated that there will be a substantial disparity between the capital requirements for credit risk in Basel II and Basel IA, and that the practical implementation of these differences is unclear. Accordingly, Mr. Finch reiterated that the FDIC is eager for any comments on Basel II and Basel IA.

Mr. Snow then discussed the definition of default under Basel II and stated that his primary concerns include the linkage to non-accrual standards . He noted that the advanced notice of proposed rulemaking related to Basel II (the "ANPR") generally followed the New Accord’s definition of default, but that many commenters to the ANPR recommended following long-standing non-accrual practices. However, the federal banking regulators are now hearing from other industry participants (via comments to the Basel II NPR) that they prefer the New Accord’s definition of default. Mr. Snow commented that the hard and fast 90-day rule included in Basel II, which is different from the New Accord, is also under some criticism.

Mr. Snow also discussed the inclusion of a bright line test of a 5% credit-related loss on the sale or loan of an exposure in defining a "default". Mr. Snow noted that 5% is somewhat arbitrary. He believes the important issues that need to be addressed in this regard are whether there should be a bright line test, and if so, where that bright line should be drawn. If there should not be a bright line test, then what should be done to prevent institutions from selling exposures to avoid default? Finally, Mr. Snow discussed LGD, which is an estimate of the economic loss rate if a default occurs during economic downturn conditions. He understands that the industry is not happy with this current conservatism, and therefore the regulators are requesting practical alternatives. He noted that it remains to be seen how foreign banks and foreign regulators will deal with this issue.

Ms. Scott stated that, with two different sets of capital rules, the federal banking regulators will not be able to produce a level playing field; however, they are trying to mitigate the inequalities as much as possible and increase risk sensitivity through Basel IA. Ms. Scott also noted that the capital requirements for mortgages are based on LTVs in Basel IA, which is different from Basel II. Ms. Scott further stated that the OTS is requesting comments on the use of credit scores and borrower creditworthiness. She also expressed an interest in factors to assign beneficial risk weights for small businesses. Ultimately, Ms. Scott commented, capital requirements will likely differ for banks under Basel IA and Basel II.

Ms. Martin stated that the Basel II process has improved risk management in the industry. Furthermore, she noted that the QIS-4 results were inaccurate for a variety of reasons (e.g., QIS-4 was very preliminary, it was done at a benign time in the cycle, and it only dealt with Pillar 1 requirements), and that the industry was surprised by the regulators’ reaction to it. Ms. Martin also stated that many smaller institutions may choose to stay on the existing systems (Basel I) rather than adopt Basel IA.

However, she noted that industry participants will not have a full understanding of their options until supervisory guidance is published by the regulators. Ms. Martin also mentioned that institutions employing robust risk management and capital allocation will receive competitive advantages regardless, as pricing is based on economic capital, not regulatory capital.

In response to Ms. Martin, Mr. French stated that the regulators understood that QIS-4 was conducted during a benign time, but that capital went down more significantly than the regulators wanted. Mr. Snow noted that the dialogue between the regulators and the industry is ongoing, and therefore these issues can still be addressed, and Ms. Scott reiterated the request for comments on how to increase the risk sensitivity of the rules.

Mr. Rubin then discussed the benefits of lower capital ratios, such as pricing power, the facilitation of organic growth and the facilitation of growing acquisitively. He also noted the concern of low risk institutions migrating to high risk, high return institutions (the idea that "if you are going to do the time, you might as well do the crime"). Mr. Rubin further noted that there are a number of mechanisms by which a regulatory capital regime change can impact valuation and competition, including: (1) heightened credit risk disclosure; (2) improved credit risk management and pricing; (3) the evolution of non-regulated entities and vehicles; and (4) enhanced cyclicality (which may lead to different banks being winners and losers at different points in the cycle).

Mr. Brown began by discussing how credit ratings are relevant in the standardized approach and Basel IA, and how securitizations under Basel II rely heavily on ratings. He noted that the use of ratings in securitizations could drive bank decisions on what to securitize, which may not be a good thing. Mr. Brown also discussed the external credit assessment institutions ("ECAI") approach to credit ratings and the US’s nationally recognized statistical rating organization ("NRSRO") approach. He commented that each country can choose which rating agencies to recognize, and thus some banks may have more choices on ratings. Furthermore, the NRSRO objective criteria are different from those of ECAI. Mr. Brown expects that Basel II will not have a great effect on the ratings of banks, and that capital will mostly remain the same. He noted that Basel II could entail issues with securitizations, which could have ratings impacts. He further commented that significant capital decreases would likely impact ratings.

Mr. Norwood stated that Wachovia is one of four institutions that signed a letter urging the federal banking regulators to give Basel II banks more options, including the standardized approach (which he believes to be an appropriate model). Mr. Norwood believes that a US advanced approach is appropriate, but that a level playing field is important and therefore all US institutions should have options. He also noted that QIS-4 cannot be fully understood without the supervisory guidance aspects of Basel II. Finally, Mr. Norwood stated that excess capital is relevant to acquisition growth possibilities.

Mr. Kadish discussed how the New Accord was originally premised on the understanding that better regulated banks do not need as much capital as less well-regulated banks. He also noted the difficulty if a non-core banking institution became a core banking institution over time. Furthermore, Mr. Kadish commented that problems could arise if the US and EU definitions of default differ (as they do currently).

Ms. Hewko explained that the regulatory agencies’ primary purpose in implementing Basel II is to increase risk sensitivity without risking safety and soundness. She also stated that it is important to get comments on all 3 Pillars. With regard to transitional issues, Ms. Hewko noted that the implementation period will be slower in the US, in part as a reaction to the results of QIS-4. She said that this longer transitional period will give the regulators the opportunity to recalibrate the capital requirements, as necessary. Ms. Hewko also commented that there is no desire for all banks to move to Basel II, because the system is not broken for most banks. She acknowledged that the FRB has received letters requesting more options. However, she noted that, due to national discretion, even if the standardized approach were to be offered in the US, it would still need to be tailored for US institutions and the FRB does not want to delay the process any further. Finally, Ms. Hewko mentioned that many of the technical issues that have arisen with regard to Basel II were reactions to earlier concerns of banks about increased regulatory burden.

Mr. Ludwig noted that Basel II is the most important current bank regulatory issue, as demonstrated by Congress’s level of involvement. He believes that the most likely outcome of the Basel II process is that the largest banks will be required to adopt the advanced approaches under Basel II, and that other banks will be pushed towards using such advanced approaches. Furthermore, the leverage ratio is likely to remain in effect for all US banks. Mr. Ludwig also believes that smaller banks will be allowed to choose between Basel I and Basel IA, with Basel IA being somewhat crude because it will be a simplified approach. He commented that the US federal banking regulators may adopt an interest rate stress test as well.

Mr. Ludwig believes that some form of Basel II will be implemented in the US in large part because of the benefits of tying capital to risk and because Basel II will require banks to measure risk more closely. However, he said that there is an ideological conflict on how much capital is necessary. Accordingly, he stressed the need for scholarship on the subject of what is the correct amount of capital that should be required in a risk-based capital world. Mr. Ludwig suggested that the US supervisors should take a hard look at implementing the New Accord’s standardized approach, as that would give the US time to study its options while still being engaged in the international implementation of the New Accord. In Mr. Ludwig’s opinion, the US federal banking regulators are open to the idea of looking at the standardized approach, and to the need for study on the appropriate amount of capital.

Mr. Van Der Weide began this panel by discussing the scope of the application of Basel II. For example, with regard to a US bank holding company ("BHC") with a foreign bank subsidiary, such foreign bank subsidiary would need to comply with its local rules, but would also be a feeder for its parent US BHC from a consolidated basis. However, a foreign branch (as opposed to a foreign bank subsidiary), would not generally be subject to local capital requirements, although its capital would be consolidated up to its parent US BHC. Similarly, with regard to a foreign BHC with a US subsidiary bank, Basel II, as implemented in the US, would only need to apply if the top tier US holding company within that foreign BHC’s structure qualifies as a core institution under Basel II. A foreign bank with only a US branch, however, would not need to comply with Basel II in the US.

Mr. Van Der Weide then commented that the home/host issues under Basel II will be qualitatively the same as they were under Basel I, although he acknowledged that they could be significantly different from a quantitative perspective. Accordingly, the key issues from a home/host perspective are: (1) substantive divergences between US and EU rules; (2) the "gap year"; and (3) the US not implementing the foundation or standardized approaches of the New Accord. Mr. Van Der Weide noted that the FRB has not yet decided how to make a determination that a foreign bank in the US has capitalization similar to a US bank (as required) given the differences between the US and the EU rules.

With regard to the ways in which home/host issues are being addressed, Mr. Van Der Weide stated that the Accord Implementation Group is important as a multilateral discussion body that can deal with these issues. In addition, bilateral discussions between regulators of multinational organizations will also be important for resolving such issues. Finally, Mr. Van Der Weide noted that QIS-4 (in the US) and QIS-5 (in the EU) raised many similar issues, so some home/host issues may be alleviated to the extent that future EU implementation of the New Accord may change.

Mr. Riley commented that a lot of home/host issues will simply depend on the different regulators coordinating with each other. Furthermore, he said that most issues will need to be resolved on a case-by-case basis. However, because the US Basel II rules have not yet been finalized, it is difficult to know at this point what the ultimate home/host issues are likely to be. Finally, Mr. Riley noted that thrift holding companies do not have a Pillar 1 capital requirement, but rather have capital rules similar to Basel II’s Pillar 2, which creates other issues.

Mr. Lagumbay expressed his belief that implementation of the New Accord and Basel II has posed major challenges for global institutions such as Bank of America, and has resulted in such global institutions devoting significant resources to such implementation. However, rather than viewing this implementation as a compliance exercise, Bank of America has used this as an opportunity to further improve its risk management. Mr. Lagumbay noted that Bank of America will be using the standardized approach for all of its operations outside the US in order to meet its various international requirements. He believes that this will minimize Bank of America’s home/host issues, at least from a Pillar 1 perspective. However, he said that Bank of America is beginning to see that home/host issues will be critical from a Pillar 2 perspective. Mr. Lagumbay did say, though, that the fact that Pillar 2 is not new in the US has been helpful.

Mr. Chamberlain then discussed The Bank of New York’s ("BONY") experience with Basel II. BONY is a low-risk, low-default portfolio bank that manages itself based on economic capital. Mr. Chamberlain indicated that BONY has known since the beginning of the Basel II process that it would be required to adopt the advanced approach, and that its only real home/host issues arise with its operations in the United Kingdom, Belgium and Luxembourg. Mr. Chamberlain views home/host issues as a 3 bodied problem (i.e., the two regulators and the bank). He noted that the regulators have a lot of incentives to cooperate with each other, but that they also have incentives not to give up their sovereignty. Like Bank of America, BONY will be using the standardized approach for its operations outside the US, and Mr. Chamberlain believes that all US banks under Basel II will use the standardized approach outside of the US. Furthermore, Mr. Chamberlain said he believes any US bank operating under Basel IA in the US will also use the standardized approach for its non-US operations.

Ms. Willenbucher began by describing the background of SEC implementation, including the EU financial conglomerates directive. She discussed Rule 15c3-1 of the Securities Exchange Act of 1934, which allows voluntary net capital compliance instead of haircuts. These rule amendments are designed to align capital structure. The broker-dealer, which needs $1 million in net capital to be eligible, must itself make an application to the SEC. The Rule 15c3-1 amendments, in part, responded to the Drexel failure in the 1990s. Thus, the SEC can now see how unregulated affiliates impact the broker-dealer. Further, the SEC was required to undertake the consolidated supervised entity (CSE) equivalent by January 1, 2005 to comply with the EU financial group directive. CSE is implemented on a case-by-case basis. Ms. Willenbucher stated that had Merrill Lynch not applied to be a CSE, the EU would have taken control of overseeing Merrill Lynch (and therefore Merrill Lynch became the first firm to become a CSE). Ms. Willenbucher noted that the investment banks were pleased by the SEC’s CSE rules, which subjects those firms to Basel standards.

Mr. Eichner discussed how the Drexel failure in the 1990s was a wake-up call for the SEC. Drexel was in capital compliance, but the broker-dealer structure had changed from small partners to inclusion within a large holding company. Legislation in the early 1990s changed the U.S. rules; however, without Europeans, the CSE program would not have gotten off the ground. Five firms have opted into CSE status, and the SEC has found it challenging to take responsibility for the whole enterprise, not just the broker-dealer.

The traditional capital rule structure encouraged firms to put derivatives and other complicated products in places other than the U.S. broker-dealer. The consensus is that most commercial banks are still grappling with what Basel II means. However, securities firms think much more about market risk and the trading book (the SEC has taken an expansive view of the trading book), as well as how the business is managed. Mr. Eichner noted broker-dealers have a different risk profile than banks, and Basel I and II is not a big change for them.

Mr. Geny, described four pillars of Basel II affecting risk management assessment: (1) risk governance; (2) risk management; (3) risk measurement; and (4) risk intelligence and infrastructure. Moody’s has found that U.S. firms are weak in reporting to CFOs and also major differences between firms. Moody’s has found that securities firms are well positioned for risk management, but views operational risk with concern as the back office is not widely respected. Moody’s expects improved risk management as a result of CSE.

Mr. Foley discussed the shortcomings of Basel II. He generally views Basel II as a healthy development for securities firms and banks to implement risk management. However, problems include varying Basel II implementation among countries. Mr. Foley expressed comfort that the regulators will not allow banks and securities firms to significantly decrease capital, and he indicated that S&P will not rely on Basel II to decide a rating in any event. Mr. Foley also stated that operational risk issues often come from market risk issues. He further noted that market risk almost never causes a broker-dealer to go out of business, but that operational risk is a major issue and trading risk can put a firm out of business. S&P will consider possible big losses that could put a company out of business and what controls could be in place to stop this from happening.

In response to questions, Mr. Eichner indicated that the SEC will consider the rules that the bank regulators adopt. The SEC will look at the relative increases in capital for securities firms, and not require firms to build in a hypothetical Basel I infrastructure for purposes of Basel II risk-weighted asset floors. The SEC will also consider lessons from European regulators. The SEC has worked to consider the entire holding company and not just the broker-dealer.

In addition, in response to a question on market perceptions of banks opting into the CSE, Mr. Foley answered that S&P would not consider CSE compliance to change perception of the entity, as the budget for such compliance is large. Mr. Geny added that CSE compliance has the benefit of providing incentives for firms to improve risk management systems and internal communications.

Mr. Picone began this panel presentation by providing a brief summary of securities lending, which generally involves collateralized transactions (85-90% collateralized by cash) whereby an agent bank indemnifies the lender of securities against broker default. These transactions have historically been low risk events for agent banks. Recently, agent banks have also been offering indemnification against default by repo counterparties and for mark-to-market risk. However, such indemnifications lead to high risk-based capital requirements under Basel I. Mr. Picone noted that the market has begun to evolve further, in that increasing numbers of brokers now want to give equities, rather than cash, as collateral. (The Department of Labor recently changed certain ERISA rules in light of this evolving market.) However, because of the high risk-based capital requirements for these transactions under Basel I, one institution requested that the FRB allow it to use its sophisticated value-at-risk (or VaR) model to recognize the covariances of such transactions, similar to the market risk type rules. Mr. Picone commented that the use of such a model is similar to the treatment of repo-style transactions under Basel II.

Mr. Van Der Weide noted that Basel I’s treatment of securities finance transactions (such as securities lending) is not optimal, largely because such treatment is based heavily on accounting rules that are not risk sensitive. Recognizing this, as well as the low risk of such transactions, the federal banking agencies began moving towards Basel II’s treatment in this area. For example, the FRB, OCC and FDIC issued an interim rule in December 2000 regarding securities borrowing for banks using the market risk rules. In addition, due to the very low risk of securities lending transactions, as well as certain competitive equity issues with foreign banks, the agencies began in 2003 to provide relief in the securities lending area to agent banks on a case-by-case basis similar to that provided in Basel II by allowing certain banks to use their internal models to determine their exposure. (Such relief, however, was contingent on the quality of a bank’s internal model.) Mr. Van Der Weide further noted that the FRB is now open to discussions regarding synthetic securitization of margin loans. However, Mr. Van Der Weide expressed the view that the federal banking agencies are unlikely to provide any additional piecemeal implementation of any aspects of Basel II.

Mr. Cave agreed that Basel I does not work well with regard to securities finance transactions. He noted that the main challenges in this area are whether the agreements that are being used are enforceable and whether they have been tested. Accordingly, Mr. Cave commented that, while the new Basel II approaches move the treatment of these transactions in the right direction, there are still uncertainties.

The SEC’s Office of the Chief Accountant and the Division of Investment Management (collectively, the "Staff") issued guidance (the "Guidance") discussing the ability of investment company registrants ("funds") to rely on certain IRS guidance and practices when determining the technical merits of their tax positions under FASB Interpretation No. 48 ("FIN 48"). The Financial Accounting Standards Board ("FASB") issued FIN 48 to clarify the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. Among other things, FIN 48 prescribes a threshold for financial statement recognition of the benefit of a tax position taken or expected to be taken in a tax return (which also results in financial statement recognition of a tax liability if a tax position does not meet the threshold). To meet the prescribed threshold it must be more likely than not that the tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The Staff issued the Guidance because of concerns expressed by the Investment Company Institute regarding (a) the extent to which FIN 48 may limit the sources of authority that may be relied on assessing whether the recognition threshold has been met and (b) the special difficulties funds may face in meeting FIN 48’s requirement that it be applied for fiscal years beginning after December 15, 2006.

Sources of Authority. In the Guidance, the Staff indicates that it does not believe FIN 48 places any limits on the type of evidence that an enterprise can look to in making its determination of the technical merits of a tax position. The Guidance states that the list of forms of evidence set forth in paragraph 7 of FIN 48 should not be viewed as the only evidence that may serve as the basis for such a determination; less formal forms of guidance from the taxing authority should also be considered, with fund management weighing the available forms of evidence based on their persuasiveness. The Guidance also provides that to the extent applicable, funds can, and should, consider the taxing authority’s practice of addressing fund industry issues on a prospective basis as part of the administrative practices and precedents of the taxing authority.

Implementation Date. With respect to FIN 48’s implementation date, the Guidance allows a fund to implement FIN 48 in its calculation of net asset value ("NAV") as late as its last NAV calculation in the first required financial statement reporting period for its fiscal year beginning after December 15, 2006. The Guidance illustrates the effect of delayed implementation with the following examples:

• A December 31 fiscal year end open-end or closed-end fund would implement FIN 48 no later than the NAV for June 29, 2007 (the last business day of the fund’s semi-annual reporting period) and the fund’s financial statements for that semi-annual reporting period.

• An open-end or closed-end fund whose fiscal year end is the last day of February would implement FIN 48 no later than its August 31, 2007 NAV and financial statements as of that date.

• Business development companies ("BDCs") would also implement FIN 48 no later than the last day of the first reporting period beginning after December 15, 2006, which for a calendar year end BDC would be the Form 10-Q for the period ending March 31, 2007.

• A unit investment trust would implement FIN 48 no later than December 31, 2007, which is the date of the information contained in its next report on Form N-SAR for fiscal years beginning after December 15, 2006.

The Investment Company Institute (the "ICI") issued model contractual provisions designed to assist mutual funds in complying with the information sharing agreement requirements of Rule 22c-2 under the Investment Company Act of 1940, as amended, with respect to issuers of variable annuity or life insurance contracts that offer the funds as investment vehicles. The ICI and the National Association for Variable Annuities jointly developed the model clauses. (See the October 3, 2006 Alert for a discussion of the recent amendments to Rule 22c-2 and related compliance dates.)

Goodwin Procter’s Environmental & Energy Practice Group issued a Client Alert concerning climate change strategies for the financial services industry. The Client Alert discusses the concerns, risks and potential opportunities associated with climate change for banks and other lenders. The Client Alert is also available on the firm’s website.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2007 Goodwin Procter LLP. All rights reserved.