DOL Finalizes Replacement Securities Lending Exemption

1. Goodwin Procter to Co-Present a CLE Accredited Basel Conference, Host Post-Conference Cocktail Reception – Registration Available Now
2. DOL Finalizes Replacement Securities Lending Exemption
3. FRB Rules Bank Shares Held as Investment Advisor May Have Regulation O Implications
4. Federal and NY Bank Regulators Impose Substantial Civil Money Penalty on Bank for Significant AML Compliance Deficiencies
5. FRB Issues Interpretive Letter Granting Relief under FRA Section 23A and Regulation W
6. Director of SEC’s Division of Investment Management Discusses Asset Manager Brokerage Practices
7. FDIC Issues Additional Deposit Insurance-Related Final Rules

8. UK’s Financial Services Authority Seeks Public Comment on Appropriate Level of Regulation for Private Equity Markets

On December 13, 2006, at the W New York - Union Square Hotel, Goodwin Procter will join with the Boston University School of Law Morin Center for Banking & Financial Law in presenting a free one-day conference on Basel II and Basel IA. The conference will begin with a "Basel Basics Workshop" featuring a framework overview as well as the regulatory perspective (with panelists from all four U.S. banking regulators and rating agencies).

The remainder of the conference will address the proposed U.S. implementation and the impact it will have on U.S. financial institutions, U.S. branches and subsidiaries of foreign institutions, and securities firms, from a regulatory, legal and business perspective. This conference is targeted to executives, lawyers and compliance personnel and is intended to help banks, U.S. branches of foreign banks, broker-dealers and investment banks understand and respond to the NPR that was published in September of this year (and the Basel IA proposal due out in the near future).

Panels addressing U.S. and foreign competition and implementation issues will include prominent speakers from all four banking regulators, the SEC, the rating agencies, affected financial institutions, trade groups and publications, as well as Goodwin Procter Financial Services attorneys. In addition, Gene Ludwig of Promontory Financial Group, LLC will provide the keynote speech. Attendees and speakers are also invited to a cocktail reception following the conference.

Please visit http://www.goodwinprocter.com/basel.html to see the full agenda and to register for this event.

The Department of Labor (the "DOL") adopted a final securities lending prohibited transaction class exemption ("PTE 2006-16") under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). PTE 2006-16 permits the lending of securities by an ERISA plan to certain banks and broker-dealers and allows a plan fiduciary to be compensated for providing securities lending services to ERISA plans, so long as the conditions and requirements of the exemption are satisfied. The exemption will replace the two current securities lending class exemptions, PTE 81-6, which covers loans of securities by ERISA Plans, and PTE 82-63, which covers the payment of compensation to lending fiduciaries in connection with securities loans. The exemption incorporates many of the conditions and requirements of PTE 81-6 and also expands the relief previously available under that exemption by broadening the classes of permissible borrowers and types of collateral. The exemption generally incorporates unchanged the conditions and requirements of PTE 82-63. Some of the major changes effected by the new exemption are described below.

The exemption permits ERISA plans to lend securities to "foreign banks" and "foreign broker-dealers" as long as additional conditions are satisfied, as described below:

• "Foreign banks" include institutions with substantially similar powers to a "bank" as defined in Section 202(a)(2) of the Investment Advisers Act of 1940, as amended, that have equity capital of at least $200 million, and that are subject to regulation by the Financial Services Authority in the United Kingdom, the Office of the Superintendent of Financial Institutions in Canada, or the relevant governmental banking agency(ies) of a country where a bank received an individual securities lending exemption or authorization from the DOL (i.e., currently, Japan, Germany, the Netherlands, Sweden, Switzerland, France and Australia).

• "Foreign broker-dealers" include broker-dealers that have equity capital of at least $200 million, and that are registered and regulated under the Financial Services Authority in the U.K., a securities commission of a Province of Canada that is a member of the Canadian Securities Administration and subject to the oversight of a Canadian self-regulatory authority, or the relevant securities laws of a country where a broker-dealer received an individual securities lending exemption or authorization from the DOL (see current list of countries above).

• The written agreement for loans to foreign banks and foreign broker-dealers must be maintained at a site within the jurisdiction of U.S. courts.

• Collateral posted in connection with loans to foreign banks and foreign broker-dealers must be delivered physically, by wire transfer or by book entry in a securities depository located either in the U.S. or at an eligible foreign securities depository.

• For loans to U.K. or Canadian banks or broker-dealers, either the bank or broker-dealer must submit to the jurisdiction of the U.S., or the lending fiduciary must be a U.S. bank or broker-dealer that agrees to indemnify the lending plan for the difference between the replacement cost of the borrowed securities and the market value of the collateral, plus interest and transaction costs, if the securities borrower defaults.

• For loans to non-U.K. and non-Canadian foreign banks or broker-dealers, the lending fiduciary must be a U.S. bank or broker-dealer and the lending fiduciary must agree to indemnify the lending plan as described above.

The new exemption expands the types of collateral that may be posted in connection with securities loans by ERISA plans (regardless of the type of borrower) to include the following:

• "U.S. collateral" consisting of cash; government securities as defined in Section 3(a)(42)(A) and (B) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"); government securities as defined in Section 3(a)(42)(C) of the Exchange Act issued or guaranteed by certain federally-sponsored organizations (e.g., Freddie Mac); mortgage related securities as defined in Section 3(a)(41) of the Exchange Act; bank certificates of deposit and bankers acceptances that meet certain requirements; and irrevocable letters of credit issued by U.S. banks other than the borrower (or its affiliates).

• "Foreign collateral" consisting of securities issued or guaranteed by certain Multilateral Development Banks; foreign sovereign debt securities that meet certain requirements; cash collateral that is denominated as British pounds, Canadian dollars, Swiss francs, Japanese yen or Euros; irrevocable letters of credit issued by a "foreign bank" that meets certain requirements; and

• Any other type of collateral described in Rule 15c3-3 under the Exchange Act, as long as the lending fiduciary is a U.S. bank or U.S. broker-dealer and indemnifies the lending plan as described above.

The new exemption sets forth the levels of collateral that must be posted in connection with securities loans by ERISA plans as follows:

• U.S. collateral must, as in the existing exemption, equal at least 100% of the market value of the loaned securities.

• Foreign collateral, if denominated in the same currency as the loaned securities, must equal at least (1) 102% of the market value of the loaned securities or (2) 100% of such market value, so long as the lending fiduciary is a U.S. bank or U.S. broker-dealer and indemnifies the lending plan as described above.

• Foreign collateral, if denominated in a currency different than the loaned securities, must equal at least (1) 105% of the market value of the loaned securities or (2) 101% of such market value, so long as the collateral is denominated in Euros, British pounds, Japanese yen, Swiss francs or Canadian dollars and the lending fiduciary is a U.S. bank or U.S. broker-dealer and indemnifies the lending plan as described above.

In issuing the new exemption, the DOL also made the following clarifications:

• The new exemption applies to securities loans that are structured as repurchase agreements, as long as the exemption’s conditions and requirements are satisfied.

• The requirement that the compensation paid to the lending fiduciary must be "reasonable" applies on a loan-by-loan, and not an aggregate, basis.

• So-called "fee-for-hold" arrangements are within the scope of the exemption as long as the exemption’s conditions and requirements are satisfied.

• The currency in which fees will be paid may be specified in either the loan agreement or in the confirmation for the particular loan.

In the preamble to the new exemption, the DOL noted that the recently enacted ERISA Section 408(b)(17), which provides relief to certain service providers (and affiliates of service providers) from the prohibited transaction provisions of Section 406(a) of ERISA, would apply to securities loans by ERISA plans to the extent the requirements of that section are satisfied, but would not be available to exempt the payment of compensation by an ERISA plan to its securities lending agent. Such compensation payments must continue to qualify for the new exemption that incorporates the requirements of PTE 82-63.

PTE 2006-16 will be effective for transactions beginning on or after January 2, 2007, and PTEs 81-6 and 82-63 will be revoked on that date. Loans entered into pursuant to PTEs 81-6 and 82-63 prior to January 2, 2007 will continue to be covered by such exemptions as long as the conditions and requirements of those exemptions remain satisfied.

The FRB issued an interpretive letter concluding that if a bank holds the dispositive or voting power over shares of a U.S. bank or bank holding company, even in an investment advisory capacity, those holdings may have implications under FRB Regulation O. More specifically, if a bank investment advisor holds more than 10 percent or 25 percent of a banking organization’s shares in such a capacity, it will be a principal shareholder of that banking organization, or control that organization, respectively, under Regulation O. The bank’s counsel had asserted that a person should not be deemed to own, control or have the power to vote shares issued by a banking organization for purposes of Regulation O if the person is acting solely as an investment advisor. However, the FRB responded that Regulation O has no exemption for holdings in an investment advisory capacity, and (unlike the FRB’s authority under Federal Reserve Act Sections 23A and 23B) the FRB has no statutory authority to grant an exemption for such holdings.

FinCEN, the FDIC and the New York State Banking Department announced their assessment of a $12 million civil money penalty against the Israel Discount Bank of New York ("IBDNY"). The penalty is in addition to the $8.5 million already paid by IDBNY to the New York District Attorney’s Office pursuant to a December 2005 agreement.

IDBNY was cited for numerous deficiencies in its anti-money laundering ("AML") program, including (1) inadequate risk grading of customer accounts, which led to a lack of focus on accounts exhibiting a higher risk of money laundering; (2) deficiencies in documentation of customer information, which resulted in a lack of sufficient information to detect transaction anomalies in accounts; (3) a lack of an ability to link accounts with common ownership; (4) inadequate systems to monitor transactions for money laundering and insufficient procedures for reviewing even those transactions that did raise red flags; (5) a failure to establish procedures and controls for correspondent accounts for non-U.S. persons, under the interim rules adopted pursuant to section 312 of the Patriot Act, which failure lend to a deficiency in suspicious activity report ("SAR") filings; (6) inadequate independent testing, resulting from material deficiencies in the internal audit function; (7) insufficient staffing for its BSA/AML compliance unit; and (8) failure to monitor accounts on which the bank had already filed SARs, including accounts for foreign "shell companies."

The FRB issued a letter granting E*TRADE Bank (the "Bank"), a federal savings association supervised by the OTS, two exemptions from Section 23A of the Federal Reserve Act and the FRB’s Regulation W. The first exemption permits the Bank’s parent company, E*TRADE Financial Corporation ("EFTC"), a savings and loan holding company, to contribute to the Bank, as part of an internal reorganization, all of its equity interest in E*Trade Clearing LLC ("Clearing"), an SEC-registered broker-dealer that performs clearing, settlement and related functions. The FRB also gave the Bank an exemption that will permit Clearing, after it becomes a wholly owned subsidiary of the Bank, to continue to make margin loans to customers, the proceeds of which are transferred to affiliates of the Bank.

In granting the first exemption, the FRB determined that the reorganization exemption will apply when Clearing, as a result of EFTC’s internal reorganization, became an operating subsidiary of the Bank. Without the exemption, the Bank’s purchase of the securities of its affiliate, Clearing, would be a covered transaction because (1) as a result of the transaction, Clearing would become an operating subsidiary of the Bank, and (2) Clearing would have liabilities at the time of the transaction. See 12 CFR 223.31(a). As a covered transaction, the equity interest contribution, which would represent more than 10% of the Bank’s capital stock, would exceed the quantitative limits of Section 23A and Regulation W. Although the FRB believed the reorganization would expose the Bank to the credit, market, and operational risks associated with securities clearing, the FRB determined that the Bank’s proposal is generally consistent with FRB precedent because the proposed transaction was part of a one-time internal reorganization.

The second exemption granted to the Bank is a "margin-loan exemption." As part of its business, Clearing extends margin loans to its customers, the proceeds of which may be received by both (i) an affiliated market maker, which receives most of the proceeds as payment for its sale of securities to the customer, and (ii) an affiliated introducing broker, which receives a brokerage commission out of the loan proceeds. After Clearing becomes an operating subsidiary of the Bank, the FRB would consider such margin loans to be extensions of credit by the Bank that, through Regulation W’s attribution rule, would be covered transactions. Under a related scenario, the FRB explained that covered transactions also would occur when Clearing makes a margin loan to a customer who uses the loan proceeds to buy stock of EFTC in the secondary market, if a small portion of the proceeds from Clearing’s loan are transferred to an affiliate introducing broker in the form of a brokerage commission.

The FRB recognized that the Bank would be exposed to certain risks in connection with Clearing’s margin loan transactions, including the risk that Clearing might relax its margin-credit underwriting standards or lower its price of margin credit to generate revenues for, or otherwise provide support to, its affiliates. However, the FRB granted the Bank’s exemption request after considering the following factors: (1) margin lending, which, when conducted by an SEC-registered broker-dealer such as Clearing, is subject to the FRB’s Regulation T and the NYSE’s margin maintenance rule (Rule 431), is a low-risk, highly collateralized form of lending; (2) the Bank’s credit exposure would be to thousands of unaffiliated investors; (3) Clearing must abide by the best-execution rule, which will help prevent Clearing from routing customer trades to an affiliated market maker unless such routing produce the highest quality transaction for the customer; and (4) the Bank’s and Clearing’s affiliated market makers deal in highly liquid securities and rarely maintain overnight positions. Approval of the Bank’s margin-loan exemption request is subject to the condition that the exemption apply only to margin loans (i) made by Clearing (not the Bank or any other affiliate); (ii) subject to the initial margin requirements of Regulation T; and (iii) subject to the ongoing margin-maintenance requirements of NYSE Rule 431. The Bank also must remain well-capitalized.

At an SIA Institutional Brokerage Conference, Andrew J. Donohue, Director of the SEC’s Division of Investment Management, shared his views on conflicts of interest facing asset managers generally with respect to their brokerage practices, in addition to discussing asset managers’ duty of best execution and issues facing asset managers that rely on the safe harbor under Section 28(e) of the Securities Exchange Act of 1934, as amended (the "1934 Act"). Mr. Donohue also briefly mentioned an additional soft dollars initiative, which he indicated would involve providing "additional disclosure and related guidance to fund boards regarding soft dollars and broker services."

Client Brokerage Conflicts of Interest. Mr. Donohue indicated that he had a continuing concern over whether advisers in all cases seek best execution, or whether in certain instances other considerations may be influencing their placement of client trades. He briefly discussed Rule 12b-1(h) under the Investment Company Act of 1940, as amended, which generally requires a mutual fund to have policies and procedures reasonably designed to prevent persons responsible for placing the fund’s portfolio transactions from taking into account a broker-dealer’s promotion or sale of the shares of the fund or any other fund. He cautioned that advisers should be mindful that the rule applies to all mutual fund portfolio trades and arrangements with broker-dealers, and does not refer only to brokerage, as did the former NASD rule addressing this issue. In particular, he urged asset managers to ensure that their procedures address principal trades. More broadly, Mr. Donohue recommended that advisers learn from the revenue sharing enforcement proceedings that prompted the adoption of Rule 12b-1(h), and consider other instances where evolving business practices, especially those related to trade placement, might create new conflicts between the interests of asset managers and their obligations to their clients.

Best Execution. Turning to issues of best execution, Mr. Donohue discussed technological developments in the area of brokerage, trade routing and trade allocation, and the increasing demands placed on broker-dealers by their institutional clients for quantitative measures of execution quality. He posited that if basic brokerage is now becoming more of a commodity, at least for many large-cap equity trades, any time that an adviser pays more than the bare minimum execution-only rate, the adviser may find its clients questioning the additional cost. He nevertheless encouraged the advisers to make effective use of technology and their own professional judgment to help them consider which trades may be appropriate for low-cost platforms and which may require greater management and cost to execute. Noting that regulators and industry participants tend to focus mostly, if not exclusively on equity trades when addressing best execution, Mr. Donohue reminded his audience that best execution applies equally to fixed income securities and other asset classes. Mr. Donohue acknowledged the greater difficulty of quantifying overall trading costs and execution quality with respect to certain fixed income securities, but indicated that he was hopeful that the advisory industry will develop meaningful, quantifiable fixed income execution measures and evaluation methods for non-equity securities, and he encouraged the asset management industry, its clients and the dealer community to work to improve and perfect the tools already in development to measure non-equity trade execution.

Soft Dollars. Mr. Donohue also discussed conflicts of interest faced by advisers that use client commissions to acquire research from broker-dealers as permitted under Section 28(e) of the 1934 Act. He focused primarily on situations where clients that have limited an adviser’s discretion with respect to the selection of broker-dealers, e.g., clients that direct their own brokerage, clients that participate in wrap fee programs or SMAs and clients that prohibit or limit the use of their commissions to acquire research, may be benefiting from research obtained with the commission dollars of other clients that have not restricted the adviser’s brokerage discretion. Mr. Donohue encouraged advisers to examine these types of situations and consider whether they have appropriately evaluated the conflicts these situations create, whether their clients understand these conflicts, and whether enhanced disclosure to clients may be necessary.

The FDIC issued several final rules (the "Final Rules") required by the Federal Deposit Insurance Reform Act of 2005 ("FDI Reform Act") and the Federal Deposit Insurance Reform Conforming Amendments Act of 2005 ("Amendments"). The Final Rules address, among other matters, issues relating to the risk-based nature of deposit insurance assessments, quarterly payments of premiums, the setting of a target designated reserve ratio ("DRR") and new required FDIC membership signage. Previously the FDIC had issued final rules under the FDI Reform Act concerning, among other things, (a) a one-time credit assessment and (b) assessment dividends (see the October 17, 2006 and October 24, 2006 Alerts).

The Final Rules regarding the risk-based premiums, the quarterly collection of premiums and the DRR will all become effective on January 1, 2007. The Final Rule regarding the new signage will become effective one year after the publication of that Final Rule in the Federal Register.

Risk-Based Premiums. The Final Rules link deposit insurance assessments more closely to the risk that insured institutions pose to the consolidated Deposit Insurance Fund ("DIF"). Currently most insured institutions do not pay an assessment for deposit insurance. Under the Final Rules, most well-capitalized and well-managed insured institutions would be charged an assessment of 5 to 7 basis points per $100 of insured deposits. For institutions with over $10 billion in assets ("Large Banks"), the amount of assessment will be determined by factors including the institution’s CAMELS component ratings, and, if available, long-term debt issuer ratings. Large Banks will be assessed charges on a continuous scale that replaces the proposed six rate subcategories. The FDIC responded to concerns expressed by the industry that the "six bucket" system could have meant large jumps in premiums due to small increases in risk. Financial ratios will not be an element of the calculation of assessments for Large Banks. For institutions with less than $10 billion in assets ("Small Banks"), assessment amount factors will include CAMELS component ratings and current financial ratios. Small Banks with assets between $5 billion and $10 billion can request treatment as a Large Bank and Large Banks that do not have rated debt will be treated as Small Banks. The FDIC determined in the Final Rules not to consider a Small Bank’s ratio of volatile liabilities to gross assets as a risk factor.

The Final Rules condense the current nine risk categories into four, designated I, II, III and IV, with I comprising institutions posing the lowest risk. Those institutions in Risk Category I would be assessed 5 to 7 basis points per $100 of insured deposits annually. Risk Category I is separated into two segments, "minimum" assessed 5 basis points and "maximum" assessed 7 basis points. The rates for Risk Category II, III and IV institutions would be 10, 28 and 43 basis points, respectively, per $100 of insurance deposits annually.

The Final Rules also provide that the FDIC will apply assessment credits to offset 100% of a bank’s entire premium change in 2007 and up to 90% of a bank’s premium charge in 2008, 2009 and 2010 until the credit is exhausted. The FDIC, in the Final Rules, reduced from 7 to 5 years the period during which de novo banks would be assessed premiums at the Category I highest rate. The increased charge for de novo banks will not be assessed until 2010 and those de novo banks that are subsidiaries of established bank holding companies will be exempt from the increased charge. In addition, in the Final Rules, the FDIC excluded Federal Home Loan Bank advances from the risk-based formula.

Quantity Premium Collection. The Final Rules also provide procedural changes in assessment collections. The primary effect involves collecting assessments at the end of each quarter and using more recent data to determine assessment amounts. Currently, assessments are collected prior to the quarter in which insurance is provided. Under the Final Rules, the capital evaluation and report of condition on which the assessment will be based will be performed as of the assessment date. Payment of the assessment amount will be due on the last day of the following quarter. For example, invoices for the first quarter of 2007 will be sent by the FDIC on June 15, 2007 with payment due on June 30, 2007.

New Insured Deposit Signage and Logo. Due to the merger of the Bank Insurance Fund ("BIF") and Savings Association Insurance Fund ("SAIF") into the DIF, the FDIC issued Final Rules on new signs and a new insured deposit logo (that is gold and black) to be displayed by insured institutions. Previously required signs were specific to the insurance fund covering an insured institution’s deposits (BIF or SAIF). The new signs may be used by all insured depository institutions. The new official sign is similar to the current sign used by banks, but with language noting that each depositor is insured to at least $100,000. Under the Final Rules, banks are allowed to use alternative colors under some circumstances and have up to a one-year transition period (increased from the six months in the proposal) to use up their current stocks of material.

Designated Reserve Ratio. The FDIC was required under the FDI Reform Act to set by regulation the Designated Reserve Ratio ("DRR") for the DIF within a proscribed range. The FDIC’s Final Rules establish the DRR at 1.25% of estimated insurance deposits.

If the actual reserve ratio falls below the DRR, the FDIC is empowered to require increased assessments to increase the reserve ratio. The FDI Reform Act and Amendments also removed a requirement that the actual reserve ratio meet the DRR within a specified timeframe. Due to a significant expansion in estimated insurance deposits, the FDIC stated that it expects that the reserve ratio will fall below 1.25% at the end of 2006 and that the FDIC is aiming to have the DRR restored to a 1.25% level within three years.

The United Kingdom’s Financial Services Authority (the "FSA") published a discussion paper seeking feedback from the private equity industry and public policy makers as to whether the FSA has correctly identified the risks posed by growth in the private equity market and whether the FSA’s regulatory approach appropriately addresses those risks. Among other things, the discussion paper describes two enhancements in this area that the FSA has already undertaken: (a) establishing an "alternative investments centre of expertise" by integrating private equity firms and supervision staff into the existing hedge fund managers’ supervision team and (b) continuing its proactive monitoring of institutional leverage and credit markets. Comments on the discussion paper must reach the FSA by March 6, 2007.

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