United States: FRB Rules BHCs May Engage In Commodity Purchase And Forward Sale Financing Transactions
Financial Services Alert - Developments of Note

1. FRB Rules BHCs may Engage in Commodity Purchase and Forward Sale Financing Transactions

2. SEC Publishes For Comment Proposed NASD Variable Annuity Suitability Rule

3. FDIC Publishes Article on Operational Risk Management

4. The SPARK Institute Updates Model Rule 22c-2 Contract Language and Issues Best Practices for Monitoring Frequent Trading

5. NASD Makes Available Webcasts on Examination Preparation and Breakpoints

6. SEC Publishes Request for Information Preparatory to Study of Impact of Broker-Dealer and Investment Adviser Regimes on Individual Investors

7. SEC Slated to Act on Soft Dollar Interpretive Release at July 12 Open Meeting

8. Independent Directors Council Issues Report on Board Consideration of Fund Mergers

The FRB issued an interpretive letter ruling that bank holding companies ("BHCs") may engage in commodity purchase and forward sale ("CPFS") transactions as a method of financing the commodity inventories of its customers. The CPFS transactions would involve commodities for which contracts have been approved for trading on a US futures exchange, and which have readily-available price quotes and are traded regularly in global commodity markets. The transactions themselves would fall into one of two types: (1) the BHC purchases a commodity from the customer and simultaneously enters into a forward sale agreement for the customer to repurchase the commodity at a future date at a fixed price, or (2) a third party is involved, either as the initial seller or ultimate purchaser of the commodity. The BHC holding title to the commodity during the CPFS transaction would mark its value daily, and would call for additional margin if its market value fell below a specified threshold. The FRB determined that the foregoing was the functional equivalent of a loan, as the BHC would earn a fixed return on the transaction and its risk would be effectively limited to counterparty risk. In this regard, the BHC represented that all non-price risks were borne by the ultimate purchaser (e.g., the purchaser would agree to purchase the commodity from the BHC "as is, where is", the ultimate purchaser would obtain insurance covering damage or theft, and the commodity would not be moved physically as a result of the transaction). In approving the transactions, the FRB required the BHC to have in place policies and procedures, among other things, to ensure the CPFS transactions have economic substance and business purpose.

The SEC published for public comment an amended version of proposed NASD Rule 2821 (the "Proposed Rule"), which would set forth specific requirements relating to the sale of deferred variable annuities. The Proposed Rule has the following four main provisions: (1) requirements governing recommendations, including a suitability obligation, specifically tailored to deferred variable annuity transactions; (2) principal review and approval obligations; (3) a specific requirement for written supervisory procedures reasonably designed to achieve compliance with the proposed rule; and (4) targeted training requirements. The Proposed Rule would apply to the purchase or exchange of a contract and the initial subaccount allocations. The Proposed Rule would not apply to sales in connection with certain qualified plans (but would apply if the member makes recommendations to individual plan participants). The NASD modified its proposal to no longer require product-specific disclosure; instead, the Proposed Rule would require a registered representative to have a reasonable belief that the customer has been informed of the material features of deferred variable annuities in general. The NASD also modified its proposed principal review and approval procedures, and now proposes to require principal review and approval no later than two business days following the transmission of the application to the insurance company (rather than prior to the transmission of the application). The deadline for comments to the SEC on the Proposed Rule is July 19, 2006. The NASD will announce the effective date of the Proposed Rule in a Notice to Members no later than 60 days following SEC approval. The effective date will be 180 days following publication of the Notice to Members.

The FDIC’s summer 2006 issue of Supervisory Insights includes an article (the "Article") by three FDIC staff members on the evolution of banking organizations’ ("Banks") operational risk management ("ORM"). The Article states that ORM is extremely difficult to manage because losses associated with ORM are very diverse and highly unpredictable. The growing complexity of the banking industry and changing regulatory capital rules have led Banks to augment traditional ORM tools, including use of appropriate internal processes, audit programs, insurance protection and other traditional risk management techniques with the application of sophisticated "quantitative concepts similar to those used to measure credit and market risks."

Definition of Operational Risk. In discussing operational risk, the Article cites the definition used by the Basel Committee on Banking Supervision (the "Basel Committee"), which describes operational risk as "the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events" (including legal risk, but excluding strategic and reputational risk). The Basel Committee grouped operational risk into seven event types: (1) internal fraud (theft, insider trading); (2) external fraud (robbery, forgery); (3) employment practices and workplace safety (worker’s compensation); (4) clients, products and business practices (fiduciary breaches, misuse of customer information, money laundering); (5) damage to physical assets (terrorism, vandalism); (6) business disruption and system failures (hardware/software failures); and (7) execution, delivery and process management (data entry errors, incomplete legal documentation).

Evolving Banking Landscape. The Article states that available data indicates that Banks’ operational risk environments are getting riskier, with 17 participating Banks reporting $5 billion of such losses in 2002, and 20 participating Banks reporting $15 billion of such losses in 2004. Some of the factors that have contributed to this increased operational risk in the banking environment are deregulation, globalization, new and highly complex financial products and services, large scale acquisitions and mergers, and increased use of outsourcing and technological advances in areas such as e-banking.

Controlling Operational Risk. The Article states that Banks have learned that "intuition alone is not sufficient to drive the ORM process." Therefore, Banks are using quantitative measurement of historical loss data, formal risk assessments, statistical analyses and independent evaluations of risk as well as Banks’ traditional ORM tools. Banks are also adding enterprise-wide oversight of operational risk to the traditional management of the risk on a business line or "silo" basis. Under this approach, as set forth in greater detail in a table in the Article, the business line "owns" the risk, but the approach by which it is identified and measured qualitatively and quantitatively is established by an enterprise-wide oversight function, and reported to senior management and the board of directors in a concise, uniform manner. The Article states that the use of these modern ORM tools: (1) increases risk awareness and mitigation opportunities; (2) helps to evaluate the adequacy of capital relative to the Bank’s overall risk profile; and (3) enhances risk management by providing a common framework for managing the risk.

Quantifying Operational Risk and Regulatory Capital. Banks’ efforts to quantify operational risk have varied significantly both "in the methods used and levels of sophistication, ranging from largely qualitative or judgmental approaches to complex statistical modeling." The Article discusses how Basel II will require the largest US Banks to quantify operational risk as part of their capital calculations, and then describes how the loss distribution approach ("LDA") has emerged as the most common statistical method to estimate a Bank’s operational risk exposure. Through the LDA, Banks combine the four elements of Basel II’s advanced measurement approach to operational risk (internal data, external data, scenario analysis, and business environment and internal control factors) with other qualitative and quantitative factors to derive risk exposure estimates. For a discussion of the Basel II quantitative approaches, see the April 11, 2006 Alert.

Conclusion. The Article concludes that ORM has emerged as a distinct discipline within supervisors’ expectations for a Bank’s risk management program. The Article states that while most Banks will continue to calculate regulatory capital under Basel I or Basel I-A (regimes that have "no explicit operational risk capital component"), the risk management techniques being used by the largest Banks can be used to some degree by Banks of any size.

The SPARK Institute, a trade organization for retirement plan service providers ("TPAs"), updated model contractual language it issued in January 2006 for use by retirement plan record keepers ("record keepers") in complying with the information sharing agreement requirements of Rule 22c-2 under the Investment Company Act of 1940, as amended. (In broad terms, under Rule 22c-2 most mutual funds must have a contractual right to require an intermediary that maintains omnibus accounts for its customers to produce certain information regarding underlying customer purchase and sale activity and comply with fund instructions to restrict such activity. See the March 15, 2005 and March 7, 2006 Alerts for additional information on the Rule and its requirements, including amendments recently proposed by the SEC.) The SPARK Institute also issued best practices for use by record keepers in monitoring frequent trading in mutual funds. The Rule 22c-2 contractual language update and best practices were accompanied by a press release discussing the results of a SPARK Institute survey of the extent to which record keepers are prepared to meet the current October 16, 2006 compliance deadline for Rule 22c-2. More than 70% of record keepers responding indicated that they could not reasonably be ready to provide the information required under Rule 22c-2 by the October deadline. Based on the survey and discussions with its members, the SPARK Institute proposed a two tiered extension consisting of an April 30, 2007 deadline for entering into the information sharing agreements required by Rule 22c-2 and a July 31, 2007 deadline for the commencement of information sharing contemplated under those agreements. On a related note, the press release discussing the survey indicated that most record keepers surveyed expect to be able to collect certain redemption fees by June 30, 2007 with "76% of record keepers that provide services directly to plans . . . apply[ing] redemption fees to participant initiated exchanges only, . . . [and] 24% of the record keepers . . . apply[ing] redemption fees to other participant level transaction on a limited accommodation basis."

The NASD introduced the first installment of its "What to Expect" series of webcasts that focuses on what member firms can expect from an NASD examination, including practical tips for making the process go smoothly. The NASD expects that, given the amount of regulatory change recently, the webcast will be of particular interest to firms on a 4-year examination cycle (the 3,000 NASD member firms in the low-risk classification) whose next examination is imminent. Over the next year, the NASD will provide additional installments in the series focusing on enforcement investigations, U4/U5 disclosures, written supervisory procedures, advertising reviews, the handling of customer complaint and corporate finance filings. The NASD also introduced a webcast that explores mutual fund breakpoints (thresholds for volume discounts on sales charges) and the role of breakpoint discounts in mutual fund share class suitability evaluations. This webcast highlights different ways of reaching breakpoint thresholds and provides an overview of the NASD Breakpoint Search Tool, an NASD resource designed to help registered representatives determine applicable breakpoints for particular funds.

The SEC issued a Request for Information ("RFI") and draft Solicitation for a study that will involve collecting, categorizing and analyzing empirical data regarding the marketing, sale, and delivery of financial products, accounts, programs and services offered to individual investors by broker-dealers and investment advisers. The SEC indicated that it was contemplating such a study in the adopting release for Rule 202(a)(11)-1 under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), which addresses the status under the Advisers Act of broker-dealers that provide advisory services (as discussed in detail in the May 31, 2005 Alert). The RFI solicits from potential contractors and other persons interested in the study informal expressions of interest and comment on the draft Solicitation that may help the SEC in formulating the requirements to be set forth in the final Solicitation. All submissions must be received no later than 2 p.m. on July 19, 2006.

Action on the soft dollar interpretive release proposed by the SEC in September 2005 (see the September 27, 2005 Alert) is the first item on the agenda for the SEC’s open meeting on Wednesday, July 12.

The Independent Directors Council, an outgrowth of the Investment Company Institute’s Directors’ Committee, released a report that reviews the applicable legal and business considerations for a fund board being asked to consider a fund merger. The report discusses considerations ranging from comparative investment objectives, policies, restrictions and risks to merger alternatives, summarizing these considerations in a checklist provided as an appendix to the report.

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