United States: FRB Releases Draft Notice of Proposed Rulemaking Regarding "Basel II"
(Financial Services Alert – Developments of Note)

1. FRB Releases Draft Notice of Proposed Rulemaking Regarding "Basel II"
2. FRB Governor Bies Makes Presentation Concerning Certain Recent FRB Regulatory Initiatives
3. Basel Committee Issues Guidance on Use of Vendor Products in Basel II
4. MSRB Files Proposed Guidance with SEC Regarding Dealer Disclosure and Suitability Analysis Obligations Relating to 529 Plans
5. SEC 2007 Performance Budget Provides Information on Enforcement, Rulemaking, Examination and Disclosure Review Activities and Goals
6. AFSCME and The Corporate Library Release Study on Proxy Voting by Eighteen Large Mutual Fund Families
7. OTS Proposes Preapproved Bylaw Precluding Board Membership for Individuals Who Have Been Indicted or Convicted of Certain Crimes or Have Been the Subject of Certain Regulatory Sanctions
8. Report Issued Concerning Improving Privacy Notices

The FRB released a draft notice of proposed rulemaking ("NPR") regarding the implementation of the Basel II capital accord in the United States. The NPR would be published jointly by the FRB, FDIC, OCC and OTS (the "Agencies") after all of the Agencies have completed their internal review and approval procedures, including for the OCC and the OTS review by the Office of Management and Budget (which review could take up to 90 days). The FRB released the draft NPR prior to its final publication in the Federal Register in order to assist commenters in their assessment of the proposal and to help provide sufficient time for interested parties to develop comprehensive comments. Once the NPR is published in the Federal Register, FRB staff expects there will be a 120-day formal comment period.

The capital adequacy framework in the draft NPR is "intended to produce risk-based capital requirements that are more risk-sensitive than the agencies’ general risk-based capital rules, which are based on Basel I." The draft NPR provides that Basel II will be implemented in the U.S. by only large, internationally active banks, while the vast majority of U.S. banks will continue to operate under Basel I, as it will be amended. Accordingly, like the advanced notice of proposed rulemaking published by the Agencies on August 4, 2003 (the "ANPR"), the draft NPR identifies three groups of banks: (1) banks that would be required to adopt Basel II ("core banks"); (2) banks that voluntarily adopt Basel II ("opt-in banks"); and (3) banks that do not adopt Basel II ("general banks"). A core bank would have to adopt an implementation plan no later than six months after it becomes a core bank, while an opt-in bank may adopt an implementation plan at any time, but must give notice to its primary federal supervisor at least twelve months before it proposes to move to its first transitional floor phase, as described below.

An institution planning to implement Basel II in the U.S. would have to complete a satisfactory parallel run of four consecutive quarters, which may begin no earlier than January 1, 2008. In addition, to ensure a smooth transition to Basel II, the draft NPR proposes a three year transition period. In the first transition year, a Basel II bank may not reduce its risk-based capital below 95% of the level required by the current risk-based capital rules. Similarly, the draft NPR sets the transitional floor percentages for the second and third years at 90% and 85%, respectively. Moreover, the draft NPR notes that if there is a material reduction in minimum regulatory capital requirements upon implementation of Basel II (for example, a 10% or greater decline in the aggregate minimum risk-based capital requirement for all Basel II banks), the Agencies will propose regulatory changes or adjustments during the transition period.

A more detailed discussion of the draft NPR will be provided in a future edition of the Alert.

FRB Governor Susan Schmidt Bies made a presentation on March 31, 2006 to the Banking Institute at Charlotte, NC in which she commented on the FRB’s current initiatives regarding regulation of (1) capital, (2) compliance risk management, and (3) consumer protection.

Regulatory Capital. Governor Bies first noted the FRB’s approval of the recent draft (discussed in the first article, above) of the interagency notice of proposed rulemaking on the Basel II capital framework (the "NPR") and described certain of the key provisions of the NPR. Ms. Bies stated that the FRB’s key reasons for pursuing Basel II were: (i) Basel II’s closer linking of capital requirements and risk, including an appropriate reflection of off-balance sheet risks and the risks associated with fee-based activities; (ii) the incentives Basel II provides to banks to implement leading risk-measurement and risk-management practices; and (iii) Basel II’s provision to bank supervisory agencies of "a more conceptually consistent and more transparent framework for assessing the link between risk and capital over time [at large, complex banks]." Governor Bies also stated that the FRB will carefully consider comments received both on the NPR and the proposal regarding revisions to Basel I, which will apply to a far greater number of banks. The FRB recognizes that the two proposals are interrelated and Governor Bies emphasized that both proposals remain subject to further changes.

Compliance Risk Management. Governor Bies then discussed the FRB’s recent focus on banks’ compliance risk management, i.e., management of a bank’s risk of legal or regulatory sanctions, and of financial loss or damage to the bank’s reputation and franchise value. Governor Bies said that the FRB expects each bank "to have a compliance culture in place across the whole institution and an infrastructure that can identify and control the compliance risks it faces, along with appropriate rewards and penalties for business managers who oversee the compliance risk." The bank’s compliance risk management program should be "dynamic" (considering risks from new or changed business activities) and "proactive" (continually reassessing risks and the adequacy of controls and providing appropriate training to strengthen risk assessment and control mechanisms). Governor Bies then stated that an integrated, enterprise-wide compliance risk management approach to Bank Secrecy Act/Anti-Money Laundering ("BSA/AML") compliance can be very effective and she discussed the FRB’s (and the other bank regulatory agencies’) efforts to communicate clearly compliance expectations through the public release of the interagency BSA/AML Examination Manual and the interagency Money Laundering Threat Assessment.

Consumer Protection. Governor Bies next discussed the FRB’s focus on consumer protection and on having banks develop specific and clear disclosures regarding complex financial products and services. Ms. Bies discussed the FRB’s (and the other banking agencies’) recent interagency guidance on "nontraditional mortgages," e.g., "interest-only" mortgages and "payment-option" adjustable-rate mortgages, and stated that the interagency guidance articulates an expectation by the regulators that banks will "ensure that their advertisements, promotional materials, and oral communications are consistent with the product terms and that these communications provide clear, balanced, and timely information about the risks." Governor Bies also noted that the FRB will hold public hearings during the summer of 2006 regarding home-equity lending. Governor Bies stated that these hearings will lead to a broad review of mortgage disclosure rules and will address predatory lending as well as the impact of changes in the mortgage and home equity loan market since 2002.

A Subgroup of the Basel Committee published a newsletter entitled "Use of Vendor Products in the Basel II IRB Framework" (the "Newsletter") intended to provide guidance on the proper validation and other considerations for a bank when using vendor products as part of its Basel II Internal Ratings-Based ("IRB") calculations. The industry’s concern has been that in vendors’ desire to keep data or processes proprietary and confidential, they may make it difficult for banks to satisfy the transparency regulators will require in evaluating IRB compliance. The Newsletter states that banks can use vendor models in their IRB processes, but the vendor models generally should be held to the same validation standards as internally developed IRB models.

The Newsletter then sets forth the following principles relating to vendor products, with the level of regulatory demands in applying them increasing proportionately in relation to the importance of the product to an institution when calculating IRB: (1) Banks must be able to document and explain the role of vendor products and the extent to which they are used within their IRB processes (e.g., as inputs to assigning exposures, or to quantifying risk estimates); (2) Banks must be able to demonstrate a thorough understanding of vendor products used in their IRB processes (including their capabilities, limitations, and overrides); (3) Vendor products must be appropriate to the bank’s exposures and risk rating methodologies and suitable for use within the IRB framework (the Newsletter also provides examples as to how a bank may supplement a non-compliant product to bring the overall approach into IRB compliance); and (4) Banks must have clearly articulated strategies for regularly reviewing the performance of vendor model results and the integrity of external data used in their IRB risk quantification processes (the Newsletter states that reviews should occur at least once per year). More generally, the Newsletter states that banks have a right to expect vendors, among other things, to demonstrate and document their validation and mapping techniques, and to provide at least a general description of the proprietary elements of their products.

The Municipal Securities Rulemaking Board ("MSRB") filed with the SEC proposed interpretive guidance relating to the customer protection obligations of dealers marketing 529 college savings plans. The proposed guidance, which culminates an initiative begun in 2004, is designed to strengthen and clarify dealers’ obligations to provide certain disclosures to customers investing in out-of-state 529 plans and undertake active suitability analyses for recommended 529 plan transactions. However, the proposed guidance imposes less extensive obligations on dealers than the MSRB’s 2005 proposal in this area.

The proposed guidance broadens dealers’ existing time-of-trade disclosure obligation with respect to out-of-state 529 college savings plans. Under the proposed guidance, a dealer selling an out-of-state 529 plan would have to make certain disclosures to a customer at or prior to the time of trade; subject to certain conditions, the issuer’s program disclosure document could be used to meet the out-of-state disclosure obligation. As with the out-of-state disclosure obligation, the proposed guidance’s suitability requirements represent a scaling back of the MSRB’s 2005 proposal. Where the 2005 proposal would have required a comparative suitability analysis of an out-of-state 529 plan recommended to a customer against the customer’s home state 529 plan options, the proposed guidance reiterates the basic suitability principles currently applicable to out-of-state 529 plan recommendations and advises dealers to consider whether a recommendation regarding a 529 plan is consistent with the customer’s tax status and any federal or state tax-related investment objectives the customer may have. The proposed guidance emphasizes that a dealer recommending a transaction must undertake an active suitability process involving a meaningful analysis that takes into account information about the customer and is based on the various appropriately weighted factors relevant under the particular set of facts and circumstances. The proposed guidance also reaffirms existing customer protection obligations applicable to dealer sales practices in the 529 college savings plan market.

The MSRB notice announcing the filing of the proposed guidance with the SEC (the "Notice") includes a lengthy discussion of issues raised in the MSRB’s 2005 proposal regarding the dissemination of key information to investors regarding available options in the 529 college savings plan marketplace. In the Notice, the MSRB states its view that a more comprehensive and user-friendly system of established industry sources is needed. The Notice discusses efforts in this area by the College Savings Plan Network ("CSPN") and cooperative efforts by commercial ventures, industry groups and regulators to use the CSPN utility as a central hub through which investors can access web-based resources on 529 college savings plans. The Notice goes on to indicate that the MSRB will continue to monitor this aspect of the 529 college savings plan market closely "and will consider whether further rulemaking would be appropriate in the event of any significant failures in the further development of the disclosure dissemination systems or in the efficacy of this dissemination system to address the MSRB’s stated investor protection concerns."

The MSRB’s filing with the SEC proposes that the proposed guidance become effective 60 calendar days after SEC approval. The SEC should act on the proposed guidance as soon as 35 days, but no later than 90 days, after publication in the Federal Register of a notice indicating that the proposed guidance has been filed with the SEC.

The SEC published its performance budget for fiscal year 2007 (the "Performance Budget") as part of the budget request process. The performance budget measures past SEC activity, in some cases as compared to past SEC projections, and makes projections for fiscal 2006 and 2007. Although designed to support the SEC’s budget request for fiscal 2007, the information presented in the Performance Budget provides an interesting perspective on past SEC activity and possible future activity in the areas of enforcement, examination, rulemaking and disclosure review.

Enforcement. The Performance Budget indicates that while the SEC generally projects that it will have an 85% success rate in enforcement actions it brings, the success rate in fiscal 2004 and 2005 was actually higher at 98% and 99%, respectively. The Performance Budget notes that the SEC’s enforcement program seeks to maintain an effective distribution of cases across program areas so that no category exceeds 40% of the total. Investment advisers and investment companies represented a relatively low proportion of cases during fiscal 2003, 2004 and 2005 at 7%, 7% and 8%, respectively. Broker-dealers were generally at the other end of the spectrum with percentages for the same years of 29%, 28% and 29%, respectively.

Rulemaking. The Performance Budget includes projections regarding rulemaking activity for fiscal year 2006 and 2007. In fiscal 2006, the SEC plans to (a) implement its rulemaking initiative regarding mutual fund redemption fees, (b) take final action on initiatives to address mutual fund late trading (presumably this means the "hard 4 p.m. close" proposal), (c) propose changes to the mutual fund disclosure regime, (d) repropose changes to the adviser registration disclosure requirements, (e) take final action on its soft dollars interpretive release and propose related disclosure rules, (f) repropose additional point-of-sale disclosure/confirmation requirements, (g) take final action on Regulation B and (h) propose and take final action on revisions to the net capital rule. For fiscal 2007, the Performance Budget indicates that the SEC intends to take action to (1) implement its mutual fund late trading initiative, (2) take final action on mutual fund disclosure reforms, (3) take final action on changes to the adviser registration disclosure requirements, (4) take final action on its recent proposal to allow electronic delivery of proxy statements, (5) implement the soft dollars interpretive release and take final action on related disclosure rules, (6) take final action on its point-of-sale disclosure/confirmation initiative, (7) implement Regulation B, and (8) implement revisions to the net capital rule. Rule 12b-1 appears in the Performance Budget as an area of SEC rulemaking activity, but no projections are made for either fiscal 2006 or 2007.

Examinations. The Performance Budget reflects the SEC’s new examination approach for investment advisers that provides for routine examination of advisers with higher risk profiles on a 3-year cycle and routine examination of advisers with lower risk profiles on a random basis. For fiscal 2002 through fiscal 2005, roughly 1,500 advisers were examined each year. According to the Performance Budget, adviser examinations are projected to remain at that level for fiscal 2006 and 2007. There were 304 and 318 investment company examinations for fiscal 2002 and 2003, respectively. Investment company examinations more than doubled in fiscal 2004 to 783, declining to 582, somewhat higher than the 500 planned, in fiscal 2005. 350 investment company examinations are projected for each fiscal of 2006 and 2007. The Performance Budget includes a measure of the number and percentage of examinations finding "significant" deficiencies, a measure first implemented in 2005. Significant deficiencies are described as those that may have caused harm to customers or clients of the firm, had a higher potential to cause harm or reflective recidivist misconduct. Significant deficiencies are distinguished from those that are more technical in nature, such as failing to include all information required to be part of a particular record. The Performance Budget indicates that in fiscal 2005 769 investment adviser and investment company examinations included a finding of significant deficiencies, representing 37% of total examinations that year. 47% of broker-dealer exams in fiscal 2005 included examiner findings of significant deficiencies. The Report observes that anecdotal evidence indicates that the fiscal 2005 levels are considerably higher than those of a few years ago.

Disclosure Review. The Performance Budget addresses the SEC staff’s compliance with the Sarbanes-Oxley Act’s requirements regarding the review of reports filed by operating companies and investment companies with the SEC pursuant to the securities laws. In general terms, the Sarbanes-Oxley Act mandates that the SEC review each issuer’s applicable filings once every three years. In fiscal 2003, only 10% of investment company issuers were reviewed. That amount increased significantly in fiscal 2004 to 54% but fell short of the fiscal 2005 projection of 45% at 37%. The Performance Budget projects that 33% of investment company issuers will be reviewed in fiscal 2006 and 2007, which is the minimum amount necessary to comply with the Sarbanes-Oxley Act. The Performance Budget also discusses the SEC’s goal to review initial registration statements for investment companies within 30 days after they are filed (60 days for insurance products separate account registration statements). It also notes that the SEC aims to comment on post-effective amendments within 45 days after filing and preliminary proxy statements within 10 days after filing. In discussing the SEC’s fiscal 2007 budget request, the Performance Budget notes that as a benchmark, the SEC staff aims under normal circumstances to provide comments within the foregoing timeframes for at least 85% of registration statements, 90% of post-effective amendments and 99% of preliminary proxy statements. The figures for fiscal 2003 through 2005 indicate that the SEC staff has generally met these goals.

The American Federation of State, County and Municipal Employees ("AFSCME"), the largest union in the AFL-CIO, and The Corporate Library ("TCL"), a research firm focusing on corporate governance matters with an emphasis on best practices, released a report (the "Report") examining proxy voting by eighteen large mutual fund families on executive compensation-related proxy proposals. The Report covers both management and shareholder proposals presented at corporate annual meetings during the period from July 1, 2004, to June 30, 2005. The tone and conclusions of the Report are very similar to those of a September 2004 AFL-CIO report on mutual fund proxy voting and executive compensation issues (discussed in the September 14, 2004 Alert).

Using information collected from filings by the selected fund families on Form N-PX (which mutual funds use to file their proxy voting records with the SEC), the Report examines how the fund families voted (a) on proxy proposals relative to the recommendations made by issuers’ management, (b) with respect to management and shareholder proposals and (c) with respect to proposals addressing option expensing, performance-based options and severance. The Report analyzes the selected fund families’ relative voting records in each of the foregoing proposal categories and on that basis divides the fund families into four classifications designed to reflect the degree to which their relative voting records meet the Report’s standard for serving shareholder interests. For purposes of the Report’s analysis, votes against management recommendations on compensation-related proposals are regarded favorably, i.e., as being in the best interest of shareholders. Votes against management proposals are similarly regarded as being more likely to serve shareholder interests. Votes for shareholder proposals are also viewed as being more likely to serve shareholder interests. Votes for expensing proposals, performance-based option proposals and proposals to cap severance or change in-control payouts to executives are regarded as serving shareholder interests. In addition to analyzing the voting activity of the selected fund families for each category of proposal, the Report presents a separate analysis of voting results for each fund family that, in addition to proxy voting information for the designated proposal categories, also shows percentages of votes cast for and against management compensation-related proposals for companies rated "A" and those rated "F" on compensation practices by TCL, with the stated aim of ascertaining the degree to which each fund family takes into account company-specific compensation practices when making voting decisions. Finally, in what is described as an effort to present a comprehensive picture of how each fund family has dealt with executive compensation issues relative to the other fund families, the Report presents a composite ranking for each fund family based on the average of the fund family’s relative ranking in the following proxy proposal categories: management recommendations, management proposals and shareholder proposals.

The OTS issued a proposed rule (the "Proposed Rule"), which would amend the OTS’s corporate governance regulations to add a new preapproved bylaw that could be adopted by a federal savings association ("FSA") without prior OTS approval. The preapproved bylaw would expressly preclude persons from serving on the board of directors of a FSA if they are under indictment for, or have been convicted of, certain crimes involving dishonesty or breach of trust, or have been subject to certain final cease and desist orders by any banking agency for conduct involving dishonesty or breach of trust. The proposed bylaw would also preclude service as a member of the FSA’s board of directors by any person who has been found by a regulatory agency or court to have breached a fiduciary duty under circumstances involving personal profit; committed a willful violation of any law, rule, or regulation governing banking, securities, commodities, or insurance; or committed a willful violation of a final cease and desist order issued by a banking, securities, commodities or insurance regulatory agency. The Proposed Rule would also allow a FSA to adopt a bylaw that would bar such persons from nominating individuals for membership on the board of directors of the FSA. Comments on the Proposed Rule are due by April 17, 2006.

A report jointly commissioned by the FRB, FDIC, FTC, NCNA, OCC and SEC (the "Agencies") as part of a joint project to develop paper-based, financial privacy notices that are easier for consumers to understand and use, has been issued by Kleimann Communication Group ("Kleinmann"), the consultants selected by the Agencies to execute the first phase of the project. Kleinmann’s report includes a prototype notice, a discussion of the prototype’s features and the methodology used in developing the prototype and analysis of the research and testing conducted during the prototype’s development. The report completes the first of the two phases in the Agencies’ research project. The second phase, a quantitative study to be planned and contracted for separately by the Agencies, will assess the prototype notice.

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