United States: FRB Permits Deduction of Reinsurance Subsidiary from BHC Capital

(Financial Services Alert - Developments of Note)

Developments of Note

1. FRB Permits Deduction of Reinsurance Subsidiary from BHC Capital

2. OCC Issues Release Stating that Comptroller Has no Plan to Expand Real Estate Powers of National Banks

3. SEC Commissioner Glassman Discusses 2005 Broker-Dealer Related Enforcement Actions and Investor Complaints

4. OFAC’s New Côte d’Ivoire Sanctions

5. FRB Approves Final Rule on Cash Collateral Securities Borrowing Transactions

6. Federal Agencies Extend Comment Period on Nontraditional Mortgage Products

7. FinCen and CFTC Address AML Customer Identification Obligations of Futures Commission Merchants for Certain Omnibus Accounts

The FRB permitted a bank holding company ("BHC") to deconsolidate, 50 percent from each of Tier 1 and Tier 2 capital, its investment in a consolidated financial guarantee reinsurance company that was consolidated with the BHC for GAAP purposes. The FRB noted that generally the capital guidelines apply to BHCs on a consolidated basis, and thus the subsidiary’s exposures would be consolidated with the BHC, because the FRB believes a BHC would support its GAAP consolidated subsidiaries. In this case, however, the BHC made many assertions in favor of deconsolidation, including that: (1) the transactions reinsured by the subsidiary involve principally investment grade securities; (2) the BHC has committed not to invest more in the subsidiary without FRB approval; and (3) the BHC has separated the subsidiary from its organization, both by name and corporate governance structure. Moreover, the BHC stated that at least one European bank regulator would allow the requested treatment. As a result, the FRB permitted the deconsolidation based on the exception in its capital guidelines for subsidiaries that are consolidated for GAAP purposes but not for supervisory purposes.

The OCC issued a news release (the "OCC Release") stating that Comptroller of the Currency John Dugan had met with representatives of the National Association of Realtors (the "NAR") to discuss the implications of three recent OCC interpretive letters, two concerning use of bank premises and the third involving financing of a wind energy project. The OCC Release stated that Comptroller Dugan believes that the three interpretive letters; (1) have nothing to do with real estate brokerage; and (2) fall within the limited legal authority that national banks have to engage in real estate and investment activities. Finally, the OCC Release stated that the OCC has no intention of expanding its limited authority to breach the separation of banking and commerce and that the specific limits and conditions included in the interpretive letters protect the preservation of that separation. The NAR has been actively lobbying to prevent the adoption of any final rule that would allow financial holding companies and financial subsidiaries to engage in real estate brokerage activities.

At the 2006 Broker-Dealer Conference hosted by Financial Services Institute, SEC Commissioner Cynthia Glassman discussed enforcement actions against broker-dealers brought by the SEC and investor complaints about broker-dealers received by the SEC, for the year ended September 30, 2005. She noted that of the 629 enforcement actions initiated in that period, fifteen percent were filed against broker-dealers. Ms. Glassman distinguished between two broad categories of enforcement actions. The first category involved outright fraud, such as entering market timing or late trading orders, misappropriating customer funds or making unauthorized trades. The second category involved violations associated with insufficient disclosure, such as failure to disclose to customers the broker’s receipt of revenue sharing payments.

Ms. Glassman also noted that, consistent with prior years, the SEC received more complaints about broker-dealers (approximately 31% of the total) than other types of entities. Transfer of account problems caused the most complaints for 2005 (622), an increase from 2004 to 2005. Ms. Glassman suggested that brokers could easily address this problem by managing customers’ expectations when they change firms. Unauthorized transaction complaints accounted for the second largest group (522). Ms. Glassman noted that the majority of these complaints resulted not from actual unauthorized transactions but instead from customers not understanding margin calls in their accounts. She urged brokers to better educate customers about the extent of brokers’ authority over margin accounts. Complaints associated with account closings comprised the third largest category (518), rising from fifth largest in the prior year. Ms. Glassman speculated that such complaints might stem from customers incurring unexpected back-end fees or surrender charges. Again, she emphasized better education at the outset of a customer relationship as a means to preempt such misunderstandings. Problems with account records, such as customer statement errors or omissions, comprised the fourth largest group of complaints (433). Ms. Glassman attributed these complaints in large part to customer confusion, which she also suggested could be avoided with better communication. Unsuitable recommendations rounded out the top five complaints. Ms. Glassman noted that the frequency of such complaints is inversely proportional to market performance. She observed that such complaints are unavoidable and urged brokers to keep good records consistent with their compliance obligations as protection against unfounded customer claims.

On February 8, 2006, President Bush issued a new Executive Order to address the ongoing conflict and political crisis in Côte d’Ivoire. The Executive Order introduces sanctions, to be administered by the U.S. Treasury Department’s Office of Foreign Assets Control ("OFAC"), blocking the property of persons contributing to the political and social unrest in Côte d’Ivoire.

The sanctions, which are specifically targeted at persons, entities, or organizations that contribute to political and social unrest in Côte d’Ivoire, are limited in scope. They introduce a new category of specially designated persons ("SDNs") for Côte d’Ivoire, which are persons, entities or organizations found to: (1) constitute a threat to the peace and reconciliation process in Côte d’Ivoire; (2) be in serious violation of International Law in Côte d’Ivoire; (3) have directly or indirectly supplied, sold or transferred to Côte d’Ivoire arms or assistance, advice or training related to military activities; (4) have publicly incited violence and hatred contributing to the conflict; or (5) have provided material, financial or technical assistance to any person, entity, or organization designated as or that meets the criteria for designation as a Côte d’Ivoire SDN. The initial list of Côte d’Ivoire SDNs includes only three names: Eugene Ngoran Kouadio Djue, Martin Kouakou Fofie, and Charles Ble Goude.

As with other OFAC sanctions programs, U.S. persons, which include foreign branches and representative offices of U.S. companies, are prohibited from engaging in or attempting to engage in any transactions with Côte d’Ivoire SDNs. In addition, U.S. persons are required to block any property of a Côte d’Ivoire SDN, or any property in which a Côte d’Ivoire SDN has an interest, that is in or comes into the United States or otherwise comes under the control of a U.S. persons wherever located. There are no restrictions on transactions with Côte d’Ivoire that do not involve SDNs or a person or entity believed to be owned, controlled or acting on behalf of a Côte d’Ivoire SDN.

Any U.S. person that violates the Côte d’Ivoire sanctions may be subject to civil penalties of up to $11,000 per violation and criminal penalties of up to the greater of $500,000 for organizations ($250,000 for individuals) or twice the pecuniary gain per violation. Individuals may also be imprisoned for up to 10 years. Additional information regarding the Côte d’Ivoire sanctions can be found on OFAC's website at http://www.ustreas.gov/offices/enforcement/ofac/programs/coted.shtml

The FRB approved a final rule (the "Final Rule") for state member banks and bank holding companies subject to the market risk rules that revises the risk-based capital treatment for certain cash-collateralized securities borrowing transactions. The Final Rule will make permanent, and expand the scope of, an interim final rule issued by the FRB, OCC and FDIC in December 2000 (the "Interim Rule"). The FRB believes the Final Rule "more appropriately aligns the capital requirements for these transactions with the risk involved and provides a capital treatment for U.S. banking organizations that is more in line with the capital treatment to which their domestic and foreign competitors are subject."

Under the Interim Rule, a banking organization could exclude from risk-weighted assets receivables arising from the posting of cash collateral associated with securities borrowing transactions to the extent such receivables were collateralized by the market value of the securities borrowed, subject to certain conditions. The Interim Rule required that: (1) the transaction be based on securities includable in the trading book that are liquid and readily marketable; (2) the transaction be marked to market daily; (3) the transaction be subject to daily margin maintenance requirements; and (4) the transaction be a securities contract under section 555 of the Bankruptcy Code, a qualified financial contract under section 11(e)(8) of the Federal Deposit Insurance Act, or a netting contract between or among financial institutions under sections 401-407 of the Federal Deposit Insurance Corporation Improvement Act of 1991, or the FRB’s Regulation EE.

The Final Rule is substantially similar to the Interim Rule, but revises the fourth condition described above to broaden the types of securities borrowing transactions that qualify for beneficial risk-based capital treatment. Under the Final Rule, if the transaction does not meet the fourth condition described above, it can still fall within the scope of the rule if the transaction is exempt from any automatic stay in bankruptcy, insolvency, or similar proceedings, or is conducted on a basis that is either overnight or that provides the banking organization the unconditional right to terminate that transaction at will. However, a transaction may only qualify under this new criteria if the banking organization has conducted "sufficient legal review to reach a well-founded conclusion" that its rights under the agreement under which the transaction is executed are legal, valid, binding, and enforceable. No such review is necessary for those transactions that qualify under the fourth condition of the Interim Rule, as described above.

The revisions to the four th condition in the Final Rule are meant to resolve, "in a manner that preserves safety and soundness, technical difficulties banking organizations may have had in meeting" the fourth condition under the Interim Rule for certain securities borrowing transactions. The Final Rule is pending approval by other federal banking regulators and will be effective upon its publication in the Federal Register.

The federal financial regulatory agencies (the FRB, FDIC, OCC, OTS and NCUA, and collectively the "Agencies") extended the comment period to March 29, 2006 on the Agencies' proposed guidance on nontraditional mortgage products discussed in the December 27, 2005 Alert.

FinCen and the CFTC issued a FAQ confirming that a Futures Commission Merchant (an "FCM") may generally treat a financial intermediary that maintains an omnibus account with the FCM as the "customer" for purposes of the FCM’s AML Customer Identification Program even when, under certain limited circumstances, the FCM receives information about underlying beneficial owners of assets in the omnibus account.

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