United States: OCC Authorizes National Bank to Sponsor and Invest in Derivative-Based Closed End Fund
(Financial Services Alert – Developments of Note)

1. OCC Authorizes National Bank to Sponsor and Invest in Derivative-Based Closed End Fund

2. ICI Issues Paper Providing Economic Analysis of Mutual Funds Compared to Institutional Accounts

3. NASD Proposes Changes to Requirements Governing Gifts and Business Entertainment

4. FRB Issues Letter Granting Internationally Active BHCs Greater Flexibility in Meeting Capital Requirements

5. ICI Releases Second Chapter in Fair Valuation Series

6. Reminder – EDGAR Class/Series Identifier Initiative Compliance Deadline February 6, 2006

In interpretive letter 1047 ("Letter 1047") the OCC permitted a national bank to sponsor and invest in a closed end fund that in turn invests in preferred shares of companies formed by an affiliate and engaged principally in credit default swap index activities. The preferred stock invested in by the fund would be rated at least investment grade and within the highest four categories by a nationally recognized statistical rating organization. The return to the fund’s shareholders would approximate the return on a static credit default swap index single transaction. In permitting the activities, Letter 1047 first determined that national banks may sponsor and organize closed end funds as part of or incidental to the business of banking. As to the investment, Letter 1047 ruled that in this case the preferred stock underlying the fund was, in substance, a debt obligation of the companies. As a result, a national bank could invest in shares of the fund because the funds themselves were invested only in bank-eligible securities. Letter 1047 also imposed several safety and soundness requirements upon the activities, including limiting the maximum investment in a fund to one percent of a bank’s capital and surplus.

The Investment Company Institute (the "ICI") published a paper (the "Paper") designed to assist mutual fund boards with the advisory contract approval process. The Paper provides an economic analysis of the key differences between mutual funds and institutional accounts. (Under requirements adopted in 2004, mutual funds (as well as closed-end funds and certain variable insurance products) must disclose whether their boards of directors relied upon comparisons of services provided and fees paid under other advisory agreements, such as those for institutional separate accounts, in approving their funds’ advisory agreements; if a board relied on such a comparison, the disclosure must also describe the comparison and how it helped the board conclude the fund’s advisory agreement should be approved.) The Paper highlights key differences between mutual funds and institutional accounts in terms of types of investors, average account size, service demands and volume, regulatory compliance, cash flow volume and predictability, tax reporting burden, distribution costs, asset level dynamics, non-advisory services provided, product life cycles and pricing. Readers should be aware that because the Paper takes a broad economic approach, it does not take into account various structural and legal issues, e.g., legal issues associated with the indirect payment of distribution expenses through advisory fees, which may limit the usefulness of certain parts of the Paper’s analysis to mutual fund boards.

In Notice to Members 06-06 (the "NTM"), the NASD proposed interpretive material ("IM") to Rule 3060 that would adopt a more detailed, process-oriented approach to addressing the business entertainment practices of NASD members with respect to their customers’ employees. NASD Rule 3060 prohibits any firm or person associated with the firm from giving anything of value in excess of $100 to any person where the payment is related to the business of the recipient’s employer. The proposed IM would replace existing interpretive material for Rule 3060 that does not prohibit "ordinary and usual business entertainment" provided that that entertainment is "neither so frequent nor so extensive as to raise any question of propriety." Under the proposed IM, a member must have written policies and procedures that:

• define appropriate and inappropriate forms of business entertainment, including the appropriate venues, nature, frequency, types and class of accommodation and transportation in connection with business entertainment, and either dollar limits on business entertainment or specified dollar thresholds requiring advance written supervisory approval;
• are designed to promote conduct of the member and its associated persons that is consistent with their obligations to a customer and does not undermine the performance of the recipient’s duty to the recipient’s employer;
• are designed to provide for effective supervision of compliance by the member’s personnel;
• provide for detailed recordkeeping regarding business entertainment and make such information available upon written request to a customer regarding its employees;
• establish standards with respect to the qualifications of persons responsible for supervising, approving and documenting business entertainment expenses;
• provide for periodic compliance monitoring (by an independent reviewer, when practicable); and
• •equire appropriate training and education to all applicable personnel.

The proposed IM defines "business entertainment" broadly to include entertainment in the form of any social event, hospitality event, charitable event, sporting event, entertainment event, meal, leisure activity or event of like nature or purpose. For this purpose, the proposed IM also includes any transportation and/or lodging accompanying or relating to the activity or event. The proposed IM codifies the NASD’s longstanding position that a member must accompany, or participate with, the recipient in order for entertainment to be business entertainment (otherwise, the entertainment is a gift under Rule 3060). While the proposed IM does not provide specific dollar amounts or limitations, it does indicate that a member’s supervisory policies and procedures must clearly articulate the factors used to determine the appropriateness of business entertainment in any particular case and how those determinations are made, monitored and enforced. The NTM identifies as the overriding principle of the proposed IM that a member or its associated persons should not do or give anything of value to an employee of a customer that is intended or designed to cause, or otherwise would be reasonably judged to have the likely effect of causing, such employees to act in a manner that is inconsistent with the best interests of their employer. The proposed IM expressly states that a firm may not offer anything of value, including but not limited to business entertainment, that comprises conduct that is illegal under any applicable law or would expose the member, customer or recipient to civil liability to any governmental authority or agency.

Issuance of the NTM coincided with the announcement by the New York Stock Exchange (the "NYSE") that it will submit a rule filing to the SEC proposing guidance on its rule governing business entertainment that uses a similarly process-oriented approach. (Both the NYSE and NASD announcements discussed their staffs’ collaboration to develop a consistent approach in this area.) The NYSE’s press release noted that in addition to requirements broadly comparable to those outlined in the NTM, the NYSE’s proposed rule would also require member organizations to give notice to clients, acting in a fiduciary capacity, that detailed information on the entertainment of the client’s employees is available upon request. Comments on the proposed IM must be received by the NASD no later than February 23, 2006.

The FRB issued an interpretive letter to Wachovia Corporation (the "Letter") in which the FRB concluded that an internationally active bank holding company ("BHC") may include in its calculation of tier 1 capital trust preferred securities that manditorily convert into noncumulative perpetual preferred securities. Under the FRB’s risk based capital guidelines for BHCs (the "Capital Guidelines"), an internationally active BHC generally must limit its restricted core capital elements to 15% of its aggregate core capital elements. An internationally active BHC may, however, have restricted core capital elements that total as much as 25% of its tier 1 capital if the excess capital over the 15% limit is in the form of qualifying mandatory convertible preferred securities.

The Capital Guidelines themselves state that qualifying mandatory convertible preferred securities obligate the investors to purchase a fixed amount of the BHC’s common stock within a short period, generally within 3 years. In the Letter, however, the FRB states that (in addition to the traditional voting common stock) noncumulative perpetual preferred stock "is also a high form of tier 1 capital and is not a restricted core capital element." Accordingly, the FRB concludes in the Letter that an internationally active BHC, such as Wachovia, may issue mandatory convertible preferred securities that mandatorily convert to non-cumulative preferred stock rather than common stock and include such mandatory convertible preferred securities within its 25% of tier 1 capital limit.

The ICI released "The Role of the Board", the second chapter in its Fair Valuation Series designed to assist non-money market mutual funds and their boards with securities valuation issues. "The Role of the Board" discusses the fund board’s role in fair valuation and briefly reviews issues related to (a) when a fund must use fair value, (b) the development of fair value processes, (c) allocation of fair valuation duties (including consideration of the use of third party pricing vendors) and (d) ongoing review of fair valuation procedures. This chapter also provides an overview of SEC enforcement activity against fund directors based on their role in fair valuing portfolio securities. A subsequent chapter in the series will explore the use of third party pricing vendors in greater detail. The ICI is producing the Fair Valuation Series in collaboration with ICI Mutual Insurance Company and the Independent Directors Council.

Open-end investment companies and insurance company separate accounts issuing variable annuity contracts or variable life insurance policies are reminded that the EDGAR series/class/contract identifier initiative compliance deadline is February 6, 2006. As discussed more fully in the July 26, 2005 Alert ("SEC Adopts Requirement to Include Series/Class/Contract Information in Mutual Fund/Separate Account Filings on EDGAR"), each open-end investment company or insurance company separate account (generally, a "Fund Registrant") will be required to enter information regarding its currently existing series and classes (or contracts) on EDGAR prior to the February 6, 2006 "Mandatory Identification Date." On and after the Mandatory Identification Date, failure to include the correct identifiers for a series and/or class (or contract) to which a filing relates will mean that the filing for that series and/or class (or contract) has not been accepted by EDGAR, and thus not filed with the SEC. Each Fund Registrant in a complex should ensure that each of its series and classes (or contracts) is assigned an identifier prior to February 6, 2006 and that new series and classes (or contracts) receive identifiers going forward.

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