United States: FRB Permits VPP Transactions Involving Physical Commodities

1. FRB Permits VPP Transactions Involving Physical Commodities

2. NYSE Issues Information Memo Providing Further Guidance on Member Obligations with Respect to Prohibition on Participation in Directed Brokerage Arrangements

3. GAO Issues Report Recommending that OCC Clarify the Applicability of State Consumer Protection Laws to National Banks

4. Basel Committee Issues Revised Guidance on Home-Host Information Sharing

5. FinCEN Releases FAQs Concerning Insurance Company AML and SAR Requirements

6. OCC Issues Letter Granting Waiver that Allows Certain Bank Officers and Employees to Report Personal Securities Transactions within 30 days after End of Quarter

7. SEC Provides Guidance on Electronic Filing Issues for Investment Company Registrants

8. Federal Banking Agencies and DOL Enter into Revised Agreement Concerning Information Sharing

The FRB issued an opinion permitting a bank holding company ("BHC") to engage in volumetric production payment ("VPP") transactions involving physical commodities on the basis that they are extensions of credit permissible under FRB Regulation Y. A VPP is a royalty interest in a hydrocarbon (e.g., oil) to receive specified quantities of the hydrocarbon in the future in exchange for an upfront payment. The VPP transactions are designed to provide funding to customers, and do not give the BHC the right to control production of the hydrocarbon. The VPP is entered into by a special purpose vehicle ("SPV") subsidiary of the BHC. The BHC simultaneously enters into a purchase agreement with the SPV for the BHC to receive the hydrocarbons, and the BHC arranges to sell them into the marketplace. The BHC also enters into a third party swap converting the variable proceeds it receives from the sales into fixed-rate payments. Thus, ultimately, the BHC will provide funds in connection with the VPP, and receive the amount paid plus a fixed amount in return.

In asserting that the foregoing arrangement qualified as a permissible extension of credit, the BHC stated that VPP transactions are treated as loans for US tax and accounting purposes. Moreover, the FRB determined that the fact that the VPP does not give the BHC any upside from excess production of hydrocarbons, and the BHC entered into a swap providing for a fixed return, are evidence that the VPP transactions are not designed to permit the BHC to take commodity price risk, own commodities, or engage in commodities dealing. The FRB noted that if the BHC did hold hydrocarbons for any period of time (i.e., to capitalize on increasing prices), the amount so held would count against the 5% of tier 1 capital limit that the FRB had previously authorized the BHC to engage in (as a complementary activity) physical commodities trading. However, otherwise, these VPP transactions would not count against that 5% limit. The FRB also mandated that the BHC have in place policies and procedures to ensure that these transactions do not unduly subject the BHC to legal or reputational risk (citing issues similar to those for structured finance transactions described in the May 23, 2006 Alert).

The NYSE issued Information Memo No. 06-38 ("IM 06-38") containing further guidance regarding the prohibition under NYSE Rules 401 and 476(a)(6) against a member’s participation in formal or informal directed brokerage arrangements. The Information Memo supplements guidance provided in NYSE Information Memo No. 05-54 issued in 2005 ("IM 05-54"). IM 06-38 discusses practices that an NYSE member that both sells shares and executes portfolio transactions for a mutual fund (a "selling/executing broker") should implement in order to fulfill the member’s obligations regarding the NYSE’s directed brokerage prohibition.

Due Diligence – Mutual Fund Relationships. A member firm should obtain written representations from each mutual fund for which it both sells shares and executes portfolio transactions that the fund has reasonable policies and procedures in place to prevent formal or informal directed brokerage arrangements and that the fund uses "reasonable criteria" in selecting broker-dealers that promote or sell the fund’s shares. (IM 05-54 required a selling/executing broker to assure itself on these two points, but fell short of requiring written representations.)

Reporting and Review. A selling/executing broker’s policies and procedures implementing the directed brokerage prohibition should require any employee who is approached by a mutual fund, or by another employee, with a proposal for a directed brokerage arrangements, or who learns of information suggesting that a directed brokerage arrangement may exist, should report the matter to the employee’s designated supervisor or the selling/executing broker’s legal or compliance department. Upon receiving information concerning a potential directed brokerage arrangement from an employee or from monitoring efforts (e.g., reviews of the amount of fund sales as compared to commissions from fund portfolio transactions for correlations suggesting directed brokerage arrangements, as discussed in IM 05-54), a selling/executing broker’s supervisory personnel or legal or compliance department should promptly conduct a review of the matter, and if the review reveals evidence of directed brokerage, inform management and the fund’s CCO or other appropriate supervisory employee; the selling/executing broker should also determine whether it should report this information to the NYSE, the SEC and/or other regulatory organizations.

Employee Training. A selling/executing broker should take reasonable steps to ensure that its marketing and sales staff involved in the promotion or sale of mutual fund shares and its trading desk staff are aware of the directed brokerage prohibition and the selling/executing broker’s related obligations under NYSE Rules. Selling/executing brokers should also consider making this training part of their continuing education programs conducted pursuant to NYSE Rule 345A.

The United States Government Accountability Office ("GAO") issued its final of three reports in connection with the 2004 OCC rulemaking addressing the applicability of state laws to national banking activities and setting forth the OCC’s view of its exclusive visitorial powers with respect to national banks and their operating subsidiaries. The report examined (i) how the preemption rules clarify the applicability of state laws to national banks; (ii) how the rules have affected state consumer protection efforts; (iii) the rules’ potential effect on banks’ choice of charter; and (iv) the GAO’s recommendations to address states’ consumer protection concerns.

To prepare the report, the GAO analyzed comment letters submitted to the OCC during the rulemaking process, reviewed congressional hearing transcripts and interviewed representatives from state attorneys general and banking departments, consumer groups, state bankers associations and national and state banks in six states. The GAO found that uncertainty remains with respect to the applicability of state consumer protection laws to national banks, especially those generally prohibiting unfair and deceptive practices. Furthermore, although not all state officials agreed, most officials believed that the preemption rules limited the states’ consumer protection efforts. For example, the report noted that some state officials believe that national banks and their operating subsidiaries are less inclined to cooperate than they were previously and that some operating subsidiaries have relinquished their state licenses. Because of the many factors that inform a bank’s choice of a state or federal charter, the GAO was unable to conclude whether the preemption rules have affected the choice of charter. However, the report noted that some states have made efforts to address any potential shift, including strengthening state parity laws and changing their funding sources. Finally, the GAO recommended that the OCC undertake a formal initiative to work with the states to clarify the scope of state consumer protection laws preemption, including the characteristics of state consumer protection laws that would make them subject to preemption. The OCC generally agreed with the report and its recommendations.

The Basel Committee on Banking Supervision published revised guidance (the "Guidance") on information sharing between home and host supervisors under the new Basel II capital framework ("Basel II"). The Guidance first restates the two fundamental principles for the discussion: (1) the home country supervisor is responsible for oversight of the banking organization on a consolidated basis; and (2) host country supervisors, particularly with foreign banks, also must have their requirements understood and recognized. The Guidance focuses on "significant" foreign subsidiaries, which the Guidance concedes is an amorphous term which could either mean significant to the jurisdiction in which it is located or significant to the consolidated entity as a whole. The Guidance also notes that significant foreign branches also may be covered, particularly if local capital requirements are imposed for the branch.

The Guidance then provides general principles on information sharing, including that: (1) more information may be required if the banking organization adopts a more advanced version of Basel II; (2) as a fundamental element of corporate governance, a banking subsidiary should have, or have ready access to, Basel II information relevant to its operations (which it can then readily make available to a host supervisor); (3) the amount and frequency of information sharing among home-host regulators will vary with the significance of the entity concerned; (4) information sharing between regulators may occur in a variety of formats, ranging from oral discussion to examination reports; and (5) confidentiality laws will have to be reviewed to ensure sufficient information sharing can occur without jeopardizing proprietary information of the banking institution or its customers.

Finally, the Guidance gives examples of the types of information sharing it contemplates. For example, among other things, the Guidance contemplates that the banking organization may provide to the host supervisor: its plans for Basel II implementation at the local level; its plans for complying with Pillar 2 at the local level, and its schedule for addressing any Basel II gaps. The information the home supervisor could provide to the host supervisor includes: if Basel II systems are developed centrally, components of the framework relevant to local implementation; sections of exam reports relevant to local operations; and specifics about any local exams contemplated by the host supervisor. Finally, as to information that the host could provide the home supervisor, the examples include: information relevant to Basel II implementation at the local level; information on Basel II implementation, if developed at the local level; and any concerns about home supervision of an entity’s operations.

The Financial Crimes Enforcement Network ("FinCEN") issued guidance in the form of frequently asked questions ("FAQs") concerning anti-money laundering ("AML") program and suspicious activity reporting ("SAR") requirements for insurance companies covered under FinCEN regulations on the basis of the fact that these insurance companies offer certain specified types of insurance products ("Covered Insurance Companies" and "covered products"). Among the points made in the FAQs are:

(1) Covered Insurance Companies are not currently required to have a Customer Identification Program, but they are required to obtain relevant and appropriate customer-related information to meet the requirement that they administer an effective AML program; (2) Covered Insurance Companies should report suspicious activities on Form SAR-SF until FinCEN makes available and publishes guidance on proposed new Form SAR-IC; (3) Covered Insurance Companies are required to have formally adopted written AML policies and procedures by May 2, 2006 and to have a reasonable plan for training all appropriate agents and brokers, but FinCEN recognizes that some Covered Insurance Companies may require additional time to complete training of all appropriate agents and brokers; and (4) in the definition of "covered products" under 31 C.F.R. § 103.137, the phrase "Any other insurance product with features of cash value or investment" is designed to "ensure that any newly developed products in the life insurance and annuity areas that have cash value or investment features" and that "are particularly vulnerable to money laundering" are considered a "covered product." FinCEN recognizes that group life insurance policies and group annuities would generally not be "covered products" because "they are administered according to guidelines that make them generally less vulnerable to abuses by participants in the plan."

The OCC issued an interpretative letter ("Letter 1062") in which it granted a national bank (the "Bank") a waiver of the requirement under 12 C.F.R. § 12.7(a)(4) ("§ 12.7(a)(4)") that bank officers and employees who make investment recommendations or decisions for customers ("Covered Os & Es") report their respective personal securities transactions to the bank within 10 business days after the end of the applicable calendar quarter. The OCC noted that the SEC had, since the last revision of § 12.7(a)(4) by the OCC, liberalized a similar reporting requirement under the federal securities laws to increase the time period during which Covered Os & Es can file personal securities trading reports from 10 business days to 30 business days after the close of the applicable calendar quarter. In Letter 1062, the OCC granted the requested waiver of the § 12.7(a)(4) 10-day reporting requirement and stated that Covered Os & Es of the Bank may file such reports within 30 business days after the end of the calendar quarter.

The SEC issued a notice discussing the following procedural issues affecting EDGAR filings by investment company registrants: (a) what can and cannot be corrected after an EDGAR filing has been accepted, (b) requests for post-acceptance corrections, (c) filing under the wrong CIK, (d) duplicate filings, (e) filings with wrong or missing series or class (contract) identifiers, (f) withdrawal of filings and (g) filing date adjustment requests.

The OCC issued a bulletin concerning the entry of the federal banking agencies, the FRB, FDIC, OCC, OTS and NCUA (collectively, the "Agencies") into a new interagency agreement (the "Agreement") with the Department of Labor ("DOL") concerning sharing of information between the Agencies and DOL. The Agreement authorizes the Agencies to notify the DOL of possible violations by a financial institution of certain ERISA provisions. The Agreement "authorizes referrals when a bank serves as a plan administrator or plan sponsor, as well as when a bank acts in either a fiduciary or co-fiduciary capacity, but is not a plan administrator or sponsor."

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