United States: U.S. Supreme Court Hears Oral Argument in Preemption Case Concerning National Bank Operating Subsidiary
(Financial Services Alert – Developments of Note)

1. U.S. Supreme Court Hears Oral Argument in Preemption Case Concerning National Bank Operating Subsidiary
2. FRB Issues Final and Proposed Amendments to Regulation E
3. OCC Issues Interpretive Letter Concerning Application of Lending Limit to Wind Tower Loans
4. IRS Releases Notice 2006-100 on Reporting and Wage Withholding Requirements under Section 409A of the Code
5. Recently Issued Financial Services Industry Patent Raises Concerns
6. Bank Trade Associations Urge IRS to Withdraw Proposed Rule on Interest Deductions of S Corporation Banks
7. OCC Updates Manual on Branches and Relocations

8. Proposed Basel 1-A Interagency Rule Issued; Extension of Comment Period on Basel II Contemplated
9. Materials from SEC National CCOutreach Seminar and 2007 Regional Seminar Information Available on SEC Website
10. ICI Mutual Insurance Company Issues Study on Independent Fund Director Private Litigation Risk
11. NASD and NYSE Announce Plan to Form New Consolidated SRO

On November 29, 2006, the U.S. Supreme Court heard oral argument in Watters v. Wachovia Bank. At issue in this important preemption case is the Comptroller of the Currency’s regulation preempting the application of certain state laws to operating subsidiaries of national banks. The OCC’s authority to preempt state law as it applies to national banks directly already has been upheld by the Supreme Court and is not at issue in the Watters case.

The case arose when the Commissioner of Financial Services for the State of Michigan sought to prevent a mortgage banking subsidiary of Wachovia from continuing to engage in business in Michigan after it converted from a subsidiary of the parent bank holding company to a subsidiary of the bank and de-registered as a mortgage lender under Michigan law. Wachovia filed an action in district court seeking declaratory and injunctive relief, arguing that the OCC’s preemption regulation allowed it to engage in mortgage lending in Michigan without registering with Michigan authorities. After an appellate court ruled in favor of Wachovia, Michigan asked the Supreme Court to review the case.

Chief Justice Roberts appeared to have the strongest views on the question before the Court, clearly viewing an operating subsidiary as a distinct corporate entity separate and apart from the parent bank. He seemed concerned that if bank-owned mortgage companies were free from state law, they would have an unfair competitive advantage over mortgage companies not owned by banks. He questioned whether the OCC and national banks wanted "to have their cake and eat it, too" by benefiting from the limited liability afforded by operating subsidiaries while claiming immunity from state law.

Justice Breyer questioned whether the preemption issue was one of "conflict preemption" or "field preemption," and asked counsel to explain where state and federal law conflicted. Justice Stevens questioned whether Michigan law imposed any requirements that the OCC did not impose on mortgage lending subsidiaries and what the practical impact on the subsidiary’s operations would be.

Justice Scalia questioned whether the OCC’s regulation effectively eliminated the distinction in the National Bank Act between a bank and its affiliates, noting that the National Bank Act gives the OCC exclusive visitorial power over national banks, but does not mention visitorial powers in connection with their affiliates.

Justice Souter questioned whether it would be counterintuitive to assume that Congress intended national banks to be able to structure their activities using operating subsidiaries but not to allow those operating subsidiaries to exercise their powers to the fullest permissible extent.

The Justices did not pose questions to counsel at oral argument concerning other issues that were adressed in the written briefs: (1) judicial deference to regulators as articulated in the Supreme Court’s 1984 decision in Chevron U.S.A. Inc. v. Natural Resources Defense Council Inc. (467 U.S. 837); and (2) the applicability to this case of the Tenth Amendment, which reserves unspecified powers to the states.

The Supreme Court’s ruling is expected no later than June 2007. If the Supreme Court rules in favor of Michigan, national banks will need to consider whether to collapse their operating subsidiaries into the parent bank in order to continue to enjoy the benefits of preemption.

The FRB finalized a Regulation E rule on electronic check conversion and certain other electronic point-of-sale ("POS") transactions and proposed for comment an exemption for small dollar transactions from the receipt requirements of Regulation E. In the last piece of the rule-making regarding new disclosure and other requirements relating to electronic check conversion and POS transactions, the FRB finalized an interim rule adopted in August 2006 on which it had sought comment (71 FR 51,451 (August 30, 2006)). The FRB adopted the interim rule substantially as proposed. The interim rule sought to clarify certain provisions in the electronic check conversion and POS rules issued by the FRB in January 2006. The final rule explains that the requirement to obtain a consumer’s authorization to electronically collect fees for items returned due to insufficient funds applies to the person initiating an EFT to collect the fee, not to the financial institution at which the consumer’s account is held. It also includes guidance on how to disclose the amount of the fee when the amount may vary (and requires that the notice specify the amount of the fee if it can be determined at POS) and the notice requirements for obtaining authorization at POS for both the electronic collection of insufficient funds fees and electronic check conversion transactions. The interim rule also clarified that the notice given to consumers at the time of the transaction may be substantially similar to the notice posted at POS. The mandatory compliance date for the rules relating to electronic check conversion is January 1, 2007, with the exception of the requirement to disclose the amount of the returned item free (or the method of determining the fee), which has been extended to January 1, 2008.

The FRB also proposed to amend Regulation E to create an exception to the requirement that a receipt detailing the electronic transaction be made available to consumers at POS. Under the proposed change, no receipt would be required for POS transactions of $15 or less, and the absence of a receipt for such a transaction could not be the basis for an allegation of an error under Regulation E. The comment period on the proposal will close 60 days after its publication in the Federal Register.

The OCC issued an interpretive letter ("Letter #1074") in which it addressed questions raised by the American Bankers Association ("ABA") concerning the applicability of the lending limit aggregation of loans rules to wind tower companies that sell their output to the same power company. In the fact pattern presented by the ABA, LLCs are formed to purchase and operate wind towers and sell the power that is generated. A national bank provides project debt financing to the separate LLCs, but owns no interest in the LLCs. Each LLC sells its power to a common purchaser, a major utility in the region. The LLCs’ sole business is wind power generation, but the LLCs are owned by different investors and are not financially interdependent.

Letter #1074 notes that loans to one borrower can be attributed to another when proceeds of a loan are to be used for the benefit of the other person or when a common enterprise is deemed to exist. Moreover, loans to borrowers are combined when the expected source of repayment for each loan is the same for each borrower and no borrower has another source of income available to repay the loan. Letter #1074 states that since, in the ABA’s fact pattern, the sole source of repayment of all of the LLCs’ loans is the same utility, the loans should be aggregated under the lending limit rules unless the national bank can demonstrate additional facts, e.g., the availability of one or more alternative power purchasers. Moreover, Letter #1074 states that the common control prong of the lending limit combination rules does not apply under the ABA’s fact pattern because there is no substantial financial interdependence among the LLCs. The OCC concludes Letter #1074 by reminding national banks that in making loans that involve commonalities, the bank should examine all of the facts and circumstances, including operational and transactional interdependence, and determine whether the loans represent in combination "a single risk for lending limit purposes." Last, Letter #1074 notes that in making such loans national banks should consider whether they are consistent with safe and sound banking practices.

The IRS released Notice 2006-100 (the "Notice") regarding reporting and wage withholding requirements under Section 409A of the Internal Revenue Code, the tax provision applicable to non-qualified deferred compensation arrangements ("Section 409A"). Generally, the Notice provides guidance to employers on how to report and, in certain cases, withhold with respect to amounts of non-qualified deferred compensation includible as income as a result of the failure to comply with the requirements of Section 409A. In earlier guidance, the IRS had suspended the withholding and reporting requirements for 2005.

For 2006, employers are required to report and (in the case of employees and former employees) withhold with respect to the amount of deferred compensation includible as compensation in 2006 under Section 409A. For 2005, employers are required to report (but not withhold) the amount of deferred compensation includible as compensation in 2005 under Section 409A. The Notice does not require (for 2005 and 2006) employers to withhold the additional 20% tax that is imposed on amounts includible in gross income as a result of the failure to comply with the requirements of Section 409A. Recipients of such payments will be responsible for including the 20% tax on their individual tax return.

So long as the reporting and withholding rules set forth in the Notice for 2005 and 2006 are followed, the employer and employee (or other service provider) will generally not be liable for delinquent withholding, underpayment or associated penalties. The Notice specifies that it contains "interim" guidance only – additional guidance on this topic is expected sometime in early 2007.

In recent years there have been an increasing number of patents directed towards the financial services community. Continuing this trend, on August 8, 2006, the United States Patent and Trademark Office ("USPTO") issued U.S. Patent No. 7,089,503 ("the ‘503 patent"), entitled "Mortgage Loan Customization System and Process" to Fannie Mae. This patent, which was originally filed April 3, 2002, is directed to "a computer-implemented method for providing a borrower with a mortgage loan that is customized to meet the requirements of the borrower."

Fannie Mae is a government-sponsored entity created to establish a secondary market for mortgages. Fannie Mae purchases mortgages on the secondary market and sells them as securities to investors on the open market, but it labors under a number of statutory restrictions on its activities and, in particular, is not allowed to originate loans. While there is no prohibition on the government or federally chartered companies from owning patents, news of the patent’s approval prompted several mortgage industry trade groups to ask Fannie Mae to abandon the patent. These trade groups expressed concern with the fact the patent involves processes Fannie Mae cannot engage in and with the breadth of the patent’s claims, noting that much of the technology has long been used in the mortgage industry. The concerned trade groups argued that the patent may inhibit innovation by discouraging lenders from developing their own similar software or processes to avoid potential legal battles with Fannie Mae.

In response to the criticism of its patent, Fannie Mae announced on November 21, 2006 that it would grant non-exclusive, royalty-free licenses under the patent and would respond to any company that sent it an e-mail request. Fannie Mae did, however, resist the trade groups’ request to place the technology entirely in the public domain, citing the need to protect its intellectual property assets and to protect itself from patent infringement claims. It is unclear whether the terms of any proffered license will be acceptable to mortgage industry participants.

Fannie Mae owns several patents in addition to the ‘503 patent and also has a number of patent applications pending before the USPTO. Additionally, a continuation of the ‘503 patent is still pending before the USPTO, which could allow Fannie Mae to secure additional claims on its invention.

Several bank trade associations have submitted comment letters urging the IRS to withdraw proposed regulations (REG-158677-05) issued under Section 1363 of the Internal Revenue Code (the "Code"). The proposed regulations address the applicability of the "special bank rules" contained in the Code to S corporation banks and would apply section 291 of the Code to S corporation banks beyond the third S corporation year. Section 291 disallows a deduction for 20% of a bank’s interest expense allocable to the bank’s holding of tax-exempt obligations. Specifically, the proposed regulations state that section 1363(b), which addresses the computation of an S corporation’s taxable income, does not prevent the application of any special rule applicable to banks under the Code, including section 291. Additionally, the proposed regulations state that section 1363(b)(4) does not prevent section 291 from applying to banks that have elected S corporation status. Thus, under the proposed regulations, S corporation banks would find the amount of their interest expense limited by section 291 in all taxable years.

Since 1996, when Congress first allowed banks to become S corporations, section 1363(b)(4) has been interpreted to apply the section 291 limitation to S corporation banks for only the first three years following the S election. The comment letters note that Congress has amended Subchapter S several times since 1996 without changing section 1363(b)(4), although it has had the opportunity to do so. The commenters claim that Congress’ failure to address the issue evidences Congress’ view that the law is being applied correctly. The comment letters also make reference to discussions between national bank tax experts and IRS personnel in which the IRS has previously indicated that guidance was unnecessary given the clear language of section 1363(b)(4).

The IRS is accepting comments on the proposed regulations, and intends for the proposed regulations to apply to taxable years of corporations beginning on or after August 24, 2006.

The OCC issued an updated version of its licensing manual on "Branches and Relocations" (the "Manual"). The Manual contains OCC policies and procedures regarding national bank establishment and relocation of branches and relocations of a national bank’s main office. The Manual, among other things: (1) provides a list of types of facilities that are not deemed by the OCC to be a "branch;" (2) reviews the application process (including both expedited and standard review); (3) discusses jointly owned branches and interstate banking; (4) reviews the application process for messenger services and mobile branches; and (5) discusses various forms of temporary branches.

The FDIC and FRB approved a revised proposed interagency Basel 1-A rule that, among other things, would give banking institutions not subject to Basel II the option of either complying with Basel 1-A or remaining subject to existing risk-based capital rules. A summary of the new proposed Basel 1-A rule will be included in a future issue of the Alert. The proposed Basel 1-A rule will not be published in the Federal Register until it is approved by the OCC and OTS (after OMB review). The FDIC Board also approved an extension of the comment period on Basel II "to coincide with the Basel 1-A comment period, "i.e., 90 days from the date of publication in the Federal Register.

The CCOutreach Program section of the SEC website now includes materials handed out at the national seminar for mutual fund and investment adviser chief compliance officers hosted by SEC examination staff last month in Washington, DC. The materials include a brochure that outlines the examination process for all types of SEC registrants and a list of common examination areas for investment advisers that describes for each area the documents and information requested by SEC examination staff and related tests performed. The SEC website also includes information on proposed topics for the 2007 regional CCOutreach seminars to be held April-June 2007. http://www.sec.gov/info/ccoutreach.htm.

ICI Mutual Insurance Company ("ICI Mutual") issued a study addressing private civil litigation risk for independent directors of registered funds. The study examines the nature of the private litigation risk faced by independent fund directors and discusses strategies for (a) preventing, or ensuring favorable resolution of, civil litigation and (b) reducing the direct and indirect financial impact on independent directors and their funds. The study is based on ICI Mutual’s discussions with independent directors and outside legal counsel to independent directors, analysis of claims reported to it and review of publicly available information on fund litigation and related issues.

The National Association of Securities Dealers (the "NASD") and NYSE Group, Inc. announced that they have signed a letter of intent to consolidate their regulatory operations into a new self-regulatory organization ("SRO") that will be the private sector regulator for all securities brokers and dealers doing business with the public in the United States. The new SRO is expected to begin operations in the second quarter of 2007. The transaction is subject to completion of definitive documentation and customary closing conditions. In addition, it will require certain amendments to the NASD by-laws, which are subject to an NASD member vote. The plan is also subject to review and approval by the SEC.

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