United States: NASD Issues Report on Examination of Member Gift Practices and Additional Guidance on NASD Gift Rule
(Financial Services Alert – Developments of Note)

Developments of Note

1. Basel IA Comment Period Established
2. NASD Issues Report on Examination of Member Gift Practices and Additional Guidance on NASD Gift Rule
3. Federal Banking Agencies Issue Policy Statement Regarding the Allowance for Loan and Lease Losses
4. FinCEN and Federal Banking Agencies Introduce New Form SAR-DI to Reduce Duplicate Filings

5. ICI Issues Memorandum Discussing Staff Guidance on Fund-of-Funds Rules
6. ICI Issues Report on Costs to Registered Investment Companies of NYSE Proposal to Eliminate Discretionary Broker Voting on Uncontested Elections of Directors
7. Clarification: OTS Issues Separate Guidance on Commercial Real Estate Concentrations and Sound Risk Management Practices

The Basel IA capital rules, discussed in the December 12, 2006 Alert, were published in today’s Federal Register. The publication of Federal Register notification establishes March 26, 2007 as the end of the comment period for Basel IA. The Basel IA rules will also affect whether a Basel II banking organization will be permitted to elect to calculate their risk-based capital based upon rules other than Basel II, including upon the Basel IA rules.

In conjunction with the announcement that it had settled proceedings against a broker-dealer regarding gifts, travel and entertainment provided to certain personnel of a registered adviser (as discussed in the December 19, 2006 Alert), the NASD issued (a) a report on its examination of over 40 member firms’ gifts and gratuities practices (the "Report") and (b) Notice to Members 06-69 ("NTM"), which provides additional guidance on complying with NASD Rule 3060, the NASD’s gifts and gratuities rule. In general terms, Rule 3060 prohibits any NASD member or its associated persons from giving, or permitting to be given, anything of value in excess of $100 per year to any individual where the gift is in relation to the business of the recipient’s employer. Rule 3060 also requires an NASD member to maintain a separate record of all payments or gratuities "in any amount known to the member." In addition, NASD Rule 3010 requires member firms to have systems and procedures reasonably designed to achieve compliance with NASD rules, including Rule 3060.

Notice to Members 06-09. The NTM focuses on some of the more common compliance weaknesses observed in the course of the NASD’s review of gift and gratuity practices.

• Personal Gifts Exclusion. The NTM indicates that Rule 3060’s prohibitions generally do not apply to personal gifts such as a wedding gift, provided that the gift is not "in relation to the business of the employer of the recipient." A firm must analyze whether or not a gift is in relation to the business of the recipient’s employer for all gifts, regardless of whether they are given during the holiday season or in connection with life events. A number of factors are relevant to this analysis, including the nature of any pre-existing personal or family relationship between the donor and the recipient. Whether a registered representative paid for the gift is also a relevant factor; the NASD presumes that a gift is in relation to the business of the employer of the recipient when a firm bears the gift’s cost, either directly or through reimbursement.

• De Minimis and Promotional Items. The NTM indicates that Rule 3060 does not apply to gifts of de minimis value (e.g., pens, notepads or modest desk ornaments) and promotional items of nominal value displaying a firm logo. A promotional item’s value must be substantially below the $100 limit to fall within this exclusion. Customary lucite tombstones, plaques or other similar solely decorative items commemorating a business transaction generally do not fall within Rule 3060’s prohibitions, even when their cost exceeds $100. The NTM emphasizes that to fall within this exclusion an item must be solely decorative.

• Aggregation of Gifts. The NTM indicates that compliance with Rule 3060’s $100 limit per recipient requires the firm to aggregate all gift given to a particular recipient over the course of a year. Each firm’s procedures must also define the aggregation period, i.e., calendar year, fiscal year or on a rolling basis determined by the date of the first gift to a recipient.

• Gift Valuation. The NTM provides that in general gifts should be valued at the higher of cost or market value, exclusive of tax and delivery charges, provided that tickets should be valued at the higher of cost or face value. The value of a gift given to multiple recipients should be allocated pro rata among the recipients.

• Gifts Incidental to Business Entertainment. Except to the extent that they may fall within the de minimis and promotional item exclusions discussed above, gifts given during the course of business entertainment and conferences are subject to Rule 3060’s limitations and recordkeeping requirements.

• Supervision and Recordkeeping. The NTM indicates that in order to meet Rule 3010’s supervisory system requirements, a member firm must have systems and procedures reasonably designed to ensure that gifts subject to Rule 3060’s limitation are (i) reported to the firm, (ii) reviewed for compliance with Rule 3060 and (iii) appropriately reflected in the firm’s records. These procedures should include provisions reasonably designed to ensure that the person making the gift is not responsible for determining whether the gift is personal or subject to the Rule 3060 limitation. Gifts of de minimis value and nominal promotional commemorative items are not subject to Rule 3060’s recordkeeping requirements.

The Examination Report. The Report identifies a number of weaknesses in the supervisory and recordkeeping practices of the more than 40 member firms the NASD reviewed for compliance with the Rule 3060 over a two-year period. The firms included in the review ranged in size from fewer than 20 to over 24,000 registered representatives and included local, regional, national and multi-national broker-dealers. The Report found that most firms did not have an adequate system of recordkeeping to enable reliable monitoring and detection of Rule 3060 violations. The Report identified the following as the most common recordkeeping system deficiencies:

• failure to maintain records of gifts and entertainment aggregated by individual recipient;

• failure to require brokers to provide complete attendee information for all ticketed events, including whether the broker attended; and

• failure to maintain a firm-wide, centralized recordkeeping system for all gifts and entertainment capable of aggregating gifts and entertainment by recipient on an annualized basis.

The Report observed that these deficiencies not only failed to satisfy the recordkeeping requirements of Rule 3060, but also failed to serve as the basis for adequate supervision.

As part of the examinations that formed the basis for the Report, the NASD reviewed each firm’s written supervisory procedures regarding Rule 3060 and the manner in which the firm supervised and enforced its procedures. The Report identified a number of weaknesses, including the following:

• Gifts. The Report found that very few firms required pre-approval of gifts. Instead, they appeared to focus their supervisory approval process on obtaining information after a gift had been given to determine whether the gift was reimbursable under the firm’s travel and expense policies. In many cases, supervisors did not require brokers to provide complete recipient information before approving gifts. In addition, electronic systems used to gather gift information did not have "forced fields" or other safeguards to ensure that all pertinent information was collected prior to processing a gift approval.

• Entertainment. The Report found that firms did not have procedures reasonably designed to ascertain whether entertainment was appropriate and consistent with Rule 3060 and applicable state and federal laws. While most firms required supervisory approval for reimbursement of business entertainment expenses, the approval process appeared to focus primarily on cost control rather than preventing entertainment that would potentially have the effect of causing the recipient to act in a manner inconsistent with the best interests of the recipient’s employers. The Report noted that most firms also failed to articulate through written procedures, or otherwise, clear standards as to the types and levels of entertainment that were acceptable. As with the procedures relating to gifts, the failure to provide requested information, such as attendee names and details of entertainment, did not prevent acceptance of event information in automated systems or supervisory approval of expenses.

• Tickets. The Report found that member firms reviewed purchased thousands to millions of dollars in tickets to sporting events, concerts and other forms of entertainment each year, yet very few had adequate controls in place to monitor the manner in which these tickets were used and to whom they were given. Whether firm employees purchased tickets and later sought reimbursement, or used tickets provided by their firms for the purpose of entertaining clients, firms did not diligently enforce complete and accurate reporting of attendee information, including the persons entertained and whether firm personnel accompanied them. (The NASD interprets Rule 3060 to provide that unless an associated person of the member firm attends an event with a client who has been given a ticket, the ticket is deemed a gift (rather than business entertainment) and therefore counts towards Rule 3060’s $100 limit). The Report also noted that a significant number of the firms examined did not provide written guidance to their associated persons that employee attendance at ticketed events was necessary to prevent a ticket from becoming a gift. In addition, while some firms required employees to list prospective attendees before giving the employees bulk tickets, virtually all firms failed to verify, after an event occurred, that an associated person of the firm attended the event. Firms similarly failed to ensure that client attendee lists were updated to reflect actual (rather than projected) attendees.

The Report indicates that more disciplinary action may be forthcoming and urges firms to revisit their policies and procedures for complying with Rule 3060 and meeting related recordkeeping and supervisory obligations. To inform their Rule 3060 compliance review efforts, the Report refers member broker-dealers to the guidance in NTM 06-69 and to proposed IM-3060 relating to gifts and business entertainment. Proposed IM-3060, which was announced in January 2006 around the same time as a similar NYSE policy, involves a more detailed, principles-based approach to gift and business entertainment practices, and is designed to supersede existing NASD guidance. (For a summary description of IM-3060, see the January 31, 2006 Alert. In April 2006, the NASD filed IM-3060 with the SEC which has not taken any action on the proposal.)

The OCC, FRB, FDIC, OTS and NCUA (the "Agencies") jointly issued a new interagency policy statement (the "Policy Statement") regarding the Allowance for Loan and Lease Losses ("ALLL"). The Policy Statement revises and replaces a 1993 policy statement that addressed issues concerning the ALLL. The Agencies also released answers to a series of frequently asked questions ("FAQs") regarding the ALLL. The Agencies stress the importance of the ALLL to a depository institution’s ("DI") financial statements and the need for each DI to develop, maintain and document the comprehensive, systematic and consistently applied process the DI uses to determine its ALLL and the provision for loan losses. The process of determining the ALLL should be appropriate for the size, scope, nature and risk of the DI’s lending activities. The Agencies state that a DI’s ALLL should be at a level that is "prudent, conservative, but not excessive [and that reflects] management’s best estimate from within an acceptable range of estimated losses ..." The FAQs cover topics in five categories: (1) nature and purpose of the ALLL; (2) Board and management responsibilities; (3) appropriate ALLL level; (4) factors in estimating credit losses; and (5) measurement of estimated credit losses.

FinCEN, the FRB, OCC, OTS, FDIC and NCUA (collectively, "the "Agencies") jointly issued a revised form of suspicious activity report ("SAR") for depository institutions. The Agencies stated that new Form SAR-DI has been revised to support the Agencies’ new joint filing initiative intended to reduce the number of duplicate filings for a single suspicious transaction. Joint filings, however, are not permitted if the suspicious transaction involves an insider of a depository institution. Depository institutions should use the current Form SAR until June 30, 2007. They have the option of using either Form SAR or new Form SAR-DI beginning on June 30, 2007. Use of Form SAR-DI will become mandatory for depository institutions on December 31, 2007.

In a memorandum to its members, the ICI indicated that the members of the SEC staff had stated that they did not expect the SEC or its staff to take action (e.g., through disclosure review, inspection deficiency letters or enforcement referrals) if a fund failed to include as part of the "Acquired Fund Fees and Expenses" shown in its prospectus fee table the fees and expenses of structured finance products, collateralized debt obligations and other securities not traditionally thought of as pooled investment vehicles, even though they rely on Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, as amended (the "1940 Act"). The ICI memorandum also indicated that the staff invited industry suggestions for a workable distinction between those securities and the pooled investment vehicles such as mutual funds, hedge funds and private equity funds, which were meant to be captured by the disclosure requirement. In addition, in the context of Rule 12d1-2 under the 1940 Act, the staff is apparently open to industry suggestions for a definition of "securities" that would accurately reflect the investments in derivative instruments permitted under the prior exemptive relief on which the Rule is based. The ICI memorandum also indicates that the staff may address technical questions from the industry on the fund-of-funds rules in a Q&A format.

The ICI issued a report assessing the impact on registered investment companies of the New York Stock Exchange’s proposal to eliminate discretionary broker voting on uncontested election of directors. The report, which is based on a survey of ICI members and information provided by Automatic Data Processing, Inc., a major service provider in the proxy solicitation process, concluded that the proposal uniquely affects investment companies as compared to corporate issuers.

In the December 19, 2006 Alert, the report on the federal banking agencies issuance of final guidance relating to commercial real estate concentrations ("CRE") and sound risk management practices (the "Guidance") incorrectly identified the OTS as joining the FRB, FDIC and OCC in issuing the Guidance. However, concurrently with the issuance of the Guidance by the other federal banking agencies, the OTS issued its own guidance applicable to savings associations (the "OTS Guidance"). Unlike the Guidance issued by the other agencies, the OTS Guidance does not contain specific numerical thresholds for determining whether a savings association has a CRE concentration. The OTS’ reasoning for not including numerical thresholds is based on factors the OTS determined were unique to savings associations, including, among other things, the 400 percent capital investment limit on loans secured by nonresidential real estate applicable to savings associations under existing regulation. Rather than focus on a numerical threshold to determine whether a CRE concentration exists, the OTS Guidance provides that OTS examiners will focus on whether a savings association has performed an assessment of its CRE concentration risks and implemented risk management systems and controls appropriate to mitigate such risks.

Goodwin Procter LLP is one of the nation’s leading law firms, with a team of 650 attorneys and offices in Boston, New York and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

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