Wal-Mart Withdraws Industrial Loan Company Application

1. Wal-Mart Withdraws Industrial Loan Company Application
2. Banking Agencies Publish Supplemental Guidance on Basel II—Internal Ratings-Based Systems for Credit Risk – Part 1
3. GAO Issues Report on FRB, OTS and SEC Consolidated Supervision of Financial Services Firms
4. Federal District Court Dismisses Excessive Fee Suit Against Mutual Fund Adviser

On March 16, 2007, Wal-Mart notified the FDIC that it was withdrawing its application, filed in July 2005, seeking the grant of an industrial loan company ("ILC") charter. Wal-Mart’s application had been filed in order to reduce Wal-Mart’s cost in processing credit, debt card and electronic check transactions. Wal-Mart stated that it decided to withdraw following the FDIC’s decision in January to extend its moratorium on a number of pending ILC applications. Wal-Mart’s press release stated that Wal-Mart’s application had been surrounded by "manufactured controversy" since it was submitted nearly two years ago. "At no stage did we intend to use the ILC to establish branch banking operations as critics have suggested -- we simply sought to reduce credit and debit card transaction costs." For addition discussion of the ILC charter and issues surrounding it, see the February 6, 2007, August 22, 2006, September 27, 2005, and March 22, 2005 Alerts.

Wal-Mart’s withdrawal followed continuing opposition to its application by significant members of Congress. Recently Representative Paul Gillmor (R-Ohio) questioned whether Wal-Mart’s contractual arrangements may contemplate full-scale banking. The House Financial Services Committee is expected to hold a hearing scheduled for March 22, 2007 on H.R. 698 -- introduced by Chairman Barney Frank (D-Mass.) and Rep. Gillmor -- that would restrict the ability of non-financial organizations, such as Wal-Mart, to charter or acquire ILC affiliates.

FDIC Chairman Sheila C. Bair issued a press release stating, "Wal-Mart made a wise choice" that would remove controversy surrounding whether Wal-Mart intended to use the ILC charter to expand into traditional banking services. In addition, she stated, "They don’t need an ILC to play an important role in expanding access to financial services, they can do so by partnering with banks and others."

As discussed in previous Alerts, the four federal banking agencies published extensive proposed supervisory guidance documents (the "Supervisory Guidance") meant to supplement the US Basel II Advanced Capital Adequacy Framework (the "Advanced Framework") notice of proposed rulemaking ("NPR") issued on September 25, 2006. The Supervisory Guidance covers three distinct areas: (1) internal risk based systems for credit risk (the "IRB System"); (2) the advanced measurement approach to operational risk (the "AMA") (see the February 27, 2007 Alert); and (3) the supervisory review process for the Advanced Framework (see the February 20, 2007 Alert). This article focuses on the first half of the guidance concerning the first component, the IRB System. An article concerning the second

half of the discussion of the first component will appear in next week’s Alert. Comments on all aspects of the proposal are due May 29, 2007.

The IRB System guidance is divided into 11 chapters, that seek to describe the important elements of a bank’s advanced systems for credit risk. As indicated above, this Article covers the first 5 chapters and next week’s Alert will include an article covering the last 6 chapters. Although the guidance contains fundamental principles, it also provides that "the conceptual framework outlined in this guidance is not intended to dictate the precise manner by which banks should meet the qualification and other requirements in the NPR."

Chapter 1: Advanced Systems for Credit Risk. The first chapter focuses on the governance, system and process requirements for the IRB System. The chapter discusses how an IRB System must have 5 interdependent components: risk rating and segmentation; a risk quantification process; a data management and maintenance system; oversight and control mechanisms; and an ongoing validation process. Senior management must ensure that all 5 components function effectively, with the board of directors evaluating and approving the systems at least annually. Banks should establish specific accountability for the IRB systems, as well as comprehensive documentation about the 5 components to make the system transparent.

Chapter 2: Wholesale Risk Rating Systems. This chapter describes wholesale exposure system design and operation. The IRB System guidance provides that banks will have latitude in creating these systems, subject to four broad principles: (1) banks must be able to differentiate exposures along two dimensions, obligor default risk and loss severity upon default; (2) banks must be able to rank both obligors by likelihood of default and wholesale exposures by severity in the event of default; (3) the IRB system must be able to quantify obligor ratings in terms of probability of default ("PD"), and loss severity in terms of expected loss given default ("ELGD") and loss given default ("LGD"); and (4) the IRB system must be sufficiently accurate to ensure that similar obligors and loss severities have similar rating grades. The guidance further explains that banks may assign credit ratings based on expert judgment, numerical models, constrained judgment (i.e., expert judgment within model-defined parameters) or any combination thereof, and under any system must have a procedure for identifying, monitoring or analyzing any ratings overrides.

In developing any wholesale risk system, the guidance directs that banks must identify defaults in accordance with the IRB definition (rather than the bank’s own systems). As to obligor ratings, among other things: banks must assign discrete obligor ratings, with each obligor assigned to only one rating grade; in assigning the rating grade, the bank should assess the risk of obligor default for a period of at least a year taking into account adverse economic conditions; there must be at least 7 discrete non-default obligor ratings, and one rating for defaulted obligors; and banks may recognize implied support subject to certain limitations (including an inability to assume US government financial assistance unless a legal obligation on the government exists). As to loss severity, banks must have an empirically supported system to assign ELGD and LGD to each wholesale exposure. Banks must document all this rating criteria, and update it at least annually.

Chapter 3: Retail Segmentation Systems. The NPR requires banks to group retail exposures into segments with homogenous risk characteristics within 3 retail exposure subcategories: residential mortgage, qualifying retail exposures, and other retail exposures. The guidance provides that banks have substantial flexibility as to how to engage in this segmentation (e.g., by type of obligor, estimated default rates, or other criteria), subject to 4 principles: (1) the segmentation must provide meaningful differentiation of risk; (2) the segmentation must be based upon characteristics that perform consistently over time; (3) the segmentation risk drivers must be consistent with the drivers that the bank uses to measure and manage risk; and (4) the segmentation must result in accurate long-term outcomes.

In creating the segmentation architecture, banks must first place the exposures into one of the 3 subcategories listed above, and then separate the exposures into segments with homogenous

characteristics. As with the wholesale exposures, banks must document their criteria for assigning exposures, but unlike with wholesale exposures must review and update the assignment process no less than quarterly.

Chapter 4: Quantification. The quantification process is the system that assigns numerical values to the key risk parameters that are used as inputs to the IRB risk-based capital formulae. The guidance provides that each risk parameter can be broken down into 4 stages: (1) data (constructing a reference data set from which the risk parameters can be estimated): (2) estimation (applying statistical techniques to the data to determine the relationship between risk characteristics and the estimated risk parameter); (3) mapping (linking the bank’s current portfolio data and the reference data based upon characteristics); and (4) application (applying the relationship estimated for the reference data to the actual portfolio data). This chapter first provides general standards to perform this process, and focuses more specifically on PD, ELGD, LGD, and exposure at default ("EAD").

As to the general standards, among other things the guidance provides that banks: should have a fully specified process covering all the above listed stages of quantification; must separately quantify wholesale risk parameter estimates before adjusting for guarantees; can take into account guarantees for retail exposures when quantifying PD, ELGD and LGD; and only can reflect the benefits of tranched guarantees of multiple exposures by meeting the standards for synthetic securitizations. Moreover, the reference data must include periods of economic downturn conditions, or be adjusted to account for the lack of such data. More generally, banks must document how they adjust for the absence of significant data elements. Risk parameter estimates should be conservative, with judgmental adjustments not resulting in an overall bias toward lower estimates. As to mapping, a mapping process should be established for each reference data set and estimation model.

As stated above, this chapter also applies the 4 stages to each of the risk drivers. Among the significant points raised in that regard are that effects of seasoning, when material, must be considered in the PD estimates for retail portfolios; ELGD estimates must reflect the expected default-weighted average economic loss rate over a mix of economic conditions, while LGD estimates must reflect expected loss severities for exposures that default during economic downturn conditions and must be greater than ELGD; a bank only may use internal estimates of LGD with supervisory approval of a "rigorous and well-documented process"; and, as to EAD, estimates of additional drawdowns must reflect net additional draws expected during economic downturns, and cannot be negative for individual wholesale exposures or retail segments. This chapter also addresses special cases and applications (such as use of multiple legal entities in a program), and provides several quantification examples.

Chapter 5: Wholesale Credit Risk Protection. Chapter 5 provides further guidance on how banks may recognize contractual arrangements for exposure-level credit protection (guarantees/credit derivatives). The guidance highlights that, as a general matter, wholesale credit protection only affects IRB capital requirements if they affect specific exposure to an obligor, although pool-level guarantees may be used under limited, specified circumstances. For wholesale exposures, valid credit protections are recognized through one of 3 mutually exclusive approaches: PD substitution, LGD adjustment, or the recognition of double default benefits. A bank’s credit policies must specify when it is appropriate to use a particular approach. For example, if the credit protection makes it less likely that the bank will experience a default, then PD substitution may be appropriate. If the credit protection affects the loss after a default has occurred, then LGD adjustment is more likely to be appropriate. In any event, banks must ensure that the credit protection represents unconditional and legally binding commitments to pay.

The Government Accountability Office ("GAO") issued a report concerning the consolidated regulatory supervision of financial services firms’ ("FSFs") programs of the FRB, OTS and SEC. The report is entitled "Financial Market Regulation: Agencies Engaged in Consolidated Supervision Can Strengthen Performance Measurement and Collaboration" (the "Report"). The GAO states that consolidated

supervision of FSFs has become more important because large FSFs have grown dramatically, are offering more complex and varied financial products and services and are being required to manage their risks on an enterprise-wide basis. The policies and procedures of the Agencies vary because of the differences in the activities and character of the FSFs they oversee and other factors, such as the fact that the FRB and OTS are focused on protecting depositors, while the SEC is focused on protecting investors.

The GAO concluded that the FRB, OTS and SEC (collectively, the "Agencies") are "generally meeting criteria for comprehensive, consolidated supervision." The Report, however, states that there is a need for clearer objectives and performance measures. The FRB and OTS should develop a way to better measure how and whether consolidated supervision is enhancing the supervision of an FSF’s primary bank. Similarly, the SEC should develop better measures of how and whether SEC consolidated supervision contributes to the SEC’s oversight of, for example, a registered broker/dealer.

The Report also suggests that the Agencies improve their collaboration and exchange of information concerning FSFs. The GAO notes that the Agencies have made progress with respect to certain specific FSFs, e.g., by conducting joint supervisory meetings, including foreign supervisors, and developing common examination approaches; but, the GAO concludes, there is more than can be done to enhance the Agencies’ collaboration and process integration with respect to large FSFs. The Report urges the Agencies to "take a more systematic approach to agreeing on roles and responsibilities and establishing compatible goals, policies and procedures on how to use available measures as efficiently as possible."

The Report states that the Agencies generally agreed with the recommendations of the GAO set forth in the Report. In response to one of the recommendations in the Report, the SEC has transferred all SEC oversight of each FSF classified by the SEC as a "Consolidated Supervised Entity" (each a "CSE") to the SEC’s Division of Market Regulation. Previous SEC oversight responsibility for CSEs had been split between the Office of Compliance Inspections and Examinations and the Division of Market Regulation.

The US District Court for the Northern District of Illinois (Eastern Division) (the "Court") ruled in favor of an adviser (the "Adviser") on its motion to dismiss a suit brought by shareholders of registered open-end funds managed by the Adviser (the "Funds") under Section 36(b) of the Investment Company Act of 1940, as amended (the "1940 Act"). The derivative suit alleged that the Adviser had breached the fiduciary duty it owed the Funds under Section 36(b) by virtue of the fact that (a) the fees it charged the Funds for its advisory services were disproportionate to the value of those services and (b) the Adviser impermissibly retained savings it realized from economies of scale as the Funds grew. The plaintiffs argued that their claim was evidenced by the fact that the Adviser charged generally lower advisory fees and offered breakpoints (scheduled fee discounts) at generally lower asset levels to its institutional clients pursuing investment objectives comparable to those of the Funds. The plaintiffs also pointed to the Funds’ trustees’ various relationships with, or connections to, the Adviser, e.g., one trustee was a retired Adviser employee and received deferred compensation from the Adviser, certain trustees had social and business relationships with said trustee while others had social and business relationships with Adviser employees. In reviewing the facts of the case, the Court noted that before approving the advisory fees, a committee of board members met several times to review information from the Adviser regarding the Funds’ performance, the services the Adviser provided to the Funds, comparisons with fees charged to the Adviser’s other clients and comparisons with fees charged by other advisers managing similar funds. The committee received presentations from the Funds’ manager and made recommendations to the full board on whether to approve the contracts. In its decision, the Court addressed motions for summary judgment by the plaintiff shareholders and the Adviser.

Plaintiffs’ Motion for Summary Judgment. In denying the plaintiffs’ motion for summary judgment, the Court identified Green v. Nuveen Advisory Corp., 295 F.3d 738 (7th Cir. 2002) ("Green") as the leading case governing its evaluation of the plaintiffs’ claim despite factual differences between Green and the

case before the Court. (Green dealt with a closed-end, tax-exempt leveraged fund, whose leverage was controlled by the fund’s adviser; the plaintiffs in that case alleged that the fact that the adviser could affect its compensation, which was based on assets under management, by increasing the fund’s leverage created an impermissive incentive for the adviser that in and of itself violated the fiduciary duty owed under Section 36(b) of the 1940 Act.) The Court noted that in Green, the 7th Circuit had defined the fiduciary duty owed under Section 36(b) more broadly than other circuits that viewed liability as existing under Section 36(b) only when the advisory fee was excessive. The Court indicated that the applicable test under Green was whether or not an actual conflict of interest had resulted in an identified effect on shareholders’ interests. The Court then addressed the plaintiffs’ arguments that (a) one of the trustees was an interested party and therefore ineligible to vote to approve advisory fee arrangements because the trustee received deferred compensation from the Adviser, (b) the trustees were so enmeshed with the Adviser through social and professional relationships that they could not have exercised independent judgment regarding the fees charged by the Adviser and (c) the Adviser’s failure to disclose the previously described deferred compensation arrangement and the relationships between that trustee and other members of the board voided the advisory fee arrangements. As an initial matter, the Court noted that, on the evidence presented, the Funds’ board of trustees met the 1940 Act’s requirements regarding the proportion of the board having certain affiliations with the Adviser. The Court went on to find that even drawing all inferences in favor of the plaintiffs, a treatment more favorable than that required of the Court in ruling on the plaintiffs’ motion, the plaintiffs had only described a situation where persons financially dependent on the Adviser had the ability to influence some of the board members to favor the Adviser’s interest over those of Fund shareholders, but had not shown that the Adviser had attempted to exercise that influence. The Court also noted that there was no evidence that the failure to make the disclosures cited by the plaintiffs had affected the amount of the Adviser’s fees.

Adviser’s Motion for Summary Judgment. In ruling on the Adviser’s motion to dismiss the plaintiffs’ suit, the Court indicated that the prevailing standard for suits involving claims under Section 36(b) of the 1940 Act was Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F2d 923 (2nd Cir. 1982) ("Gartenberg"), a case involving a registered open-end fund for which an adviser provided investment advice as well as administrative and other services. The Court noted that under the Gartenberg standard it needed to examine all factors bearing upon whether the Adviser’s compensation was within the range that could be expected to result from arm’s-length bargaining. The Court noted that in the specific context presented in Gartenberg, the 2nd Circuit observed that facts pertinent to the question of the disproportionality of the adviser’s fee included not only the comparability of fees, but also the cost to the adviser to provide services to the fund; the nature and quality of the services provided, including the fund’s performance history; whether and to what extent the adviser realizes economies of scale as the fund’s assets increase; the volume of orders from the fund’s investors that needed to be processed; and the conduct of, expertise, and level of information possessed by the trustees charged with approving the fee at the outset. The Court noted that in determining whether there was a triable issue of fact on the question of whether the advisory fee charged to the Funds were so disproportionately large that they could not have been the result of arm’s-length bargaining between the Adviser and the Funds’ board, no single outcome could be expected, instead, there was a range of acceptable results. In response to the plaintiffs’ argument that the Funds’ fees should be compared to those charged the Adviser’s institutional clients, the Court noted that shareholders in at least nine other mutual funds were paying fees at the same level that the Funds were. The Court also noted that the Funds’ fees fell within a range that extended from a low-end figure below what the institutional clients were paying to a high-end figure beyond the fees that other mutual fund clients paid, thus preventing a conclusion that the fee amounts were indicative of self-dealing. (Although not specifically cited in its analysis relating to the plaintiffs’ argument, the Court noted that the services the Adviser provided to its institutional clients were more limited than those provided to the Funds.) In response to the plaintiffs’ arguments that the board members’ review of the advisory arrangements was rendered meaningless by the conflicts of interest noted above, the Court cited its reasons for disagreeing with similar arguments in the plaintiffs’ motion for summary judgment. The Court also observed that the evidence presented by the parties indicated that the board as a whole was operating without any conflict that would prevent it from engaging in arms’-length negotiations with the Adviser. In response to the plaintiffs’ final argument

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