FASB Issues Statement on Accounting for Servicing of Financial Assets

Developments of Note

1. FASB Issues Statement on Accounting for Servicing of Financial Assets

2. OCC Permits National Banks to Hold Sub-Investment Grade Debt to Hedge Derivative Risks

3. SEC Approves Amendment to NASD Interpretive Material 3013 Regarding Timing of Report Related to Annual CEO Compliance Certification

4. FRB Issues Final Rule Concerning Shift of Liability for Unauthorized "Remotely Created Checks" from Paying Bank to Depositary Bank

5. OCC Publishes Response to National Association of Realtors’ Letter Challenging Real Estate and Investment Powers of National Banks

6. FinCEN and Federal Banking Agencies Propose Revisions to SAR for Depository Institutions

7. SEC Commissioner Atkins Provides Views on Regulatory Matters at Industry Conference

8. FinCEN Postpones Compliance Deadline for New Correspondent Account Rule

The FASB amended FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, with respect to the accounting for separately recognized servicing assets and liabilities by issuing Statement of Financial Accounting Standards No. 150, Accounting for Servicing of Financial Assets ("Statement 150"). Statement 150 requires an organization to recognize servicing assets and liabilities whenever it becomes obligated to service a financial asset by entering into a servicing contract upon: (1) a transfer of the servicer’s assets that meets the requirements for sale accounting; (2) a transfer of the servicer’s assets to a special purpose vehicle in a guaranteed mortgage securitization if the transferor retains all resulting securities and classifies them as available-for-sale or trading securities; or (3) an acquisition of financial asset servicing obligations not related to financial assets of the servicer or its affiliates. In such circumstances, Statement 150 requires, if practicable, an entity to measure the servicing assets and liabilities at fair value. Thereafter, an entity may value the assets using either (1) the current amortization method, with fair value assessment of impairment or increased obligation as of each reporting date, or (2) a new fair value method, with servicing assets and liabilities measured at fair value on each reporting date and changes in fair value in earnings reported for the period in which they occur.

FASB issued Statement 150, in part, because many reporting entities use derivatives to mitigate the risks inherent in servicing. Reporting entities that do not use hedge accounting for these derivatives are exposed to income statement volatility because the derivatives are measured at fair value, while the servicing assets have been measured using the amortization method described above. The amortization method does not permit recognition of increases in the fair value of servicing assets beyond their amortized carrying amount. Statement 150 removes that disparity for entities electing to report servicing assets using the fair value method. Statement 150 must be adopted as of the beginning of an entity’s first fiscal year that begins after September 15, 2006. Earlier adoption is permitted if an entity has not yet issued financial statements (including interim statements) for any fiscal year period. Statement 150 also permits a one-time re-classification of certain available-for-sale securities to trading securities, notwithstanding the restrictions of FASB Statement 115.

The OCC issued an interpretive letter ("Letter 1051") permitting a bank to enter contingent credit default swaps ("C-CDS") and hold below investment grade debt to hedge credit risk and liability exposures arising from its derivatives activities. Letter 1051 states that national banks may use derivatives to hedge risks from a "gamut of activities" that exist on the bank’s balance sheet and income statement, including holding assets, taking liabilities, assuming off-balance sheet risks, and hedging market risk. In this case, the national bank would use below investment grade debt to hedge risks arising from permissible derivatives transactions, and the bank raised the issue that, because of concerns about counterparty bankruptcy, it had to acquire that debt whenever necessary (even if that results in holding below investment grade debt for some period of time). Letter 1051 noted that holding below investment grade debt in the manner described was an essential part of the bank’s risk management activities associated with derivatives and therefore was permissible. Before it could engage in the activity, however, the bank had to demonstrate to the examiner-in-charge that it had sufficient risk measurement and management procedures in place.

The SEC approved an amendment to NASD Interpretive Material 3013 ("IM-3013") that establishes the deadline for submission to an NASD member’s board of directors and audit committee, or equivalent bodies (collectively, "Governing Bodies"), of a report (the "Report") that evidences certain compliance processes prepared in conjunction with annual compliance certifications by the member’s chief executive officer pursuant to NASD Rule 3013. The Report must be reviewed by the member’s chief executive officer, chief compliance officer and any officers the member may deem necessary to make the certification. Under the amendment, the Report may be submitted to a member’s Governing Bodies either before or after execution of the Rule 3013 certification, provided that the Report is received at the earlier of the Governing Bodies’ next scheduled meetings or within 45 days after the certification’s execution. The NASD Notice to Members (the "NTM") announcing SEC approval of the amendment indicates that NASD Rule 3013 and IM-3013 are not intended to require a member’s Governing Bodies to review or consider the Report as a condition to the CEO’s execution of the Rule 3013 certification; rather, submission of the Report is intended to ensure that the Governing Bodies remain informed regarding the member’s compliance systems in the context of their overall responsibility for the member’s governance and internal controls. The amendment became effective with SEC approval on March 17, 2006. Member CEOs must execute their first certifications pursuant to Rule 3013 no later than April 1, 2006.

The FRB issued final amendments to Regulation CC ("Reg. CC")—together with conforming amendments to Regulation J (collectively the "Final Rule") that result in a shift from the paying bank to the depositary bank of the liability for any losses attributable to an unauthorized "remotely created check." "Remotely created check" is defined as a check that is not created by the paying bank and that does not bear a signature applied, or purported to be applied, by the person on whose account the check is drawn. Such items have in the past also been called preauthorized drafts, telechecks and paper drafts. The shift is effected by the creation under Reg. CC of transfer and presentment warranties under which the depositary bank warrants to the other banks in the collection chain that the remotely created check that it is transferring or presenting to the paying bank is authorized by the person on whose account the check is drawn. The Final Rule, however, clarifies that the transfer and presentment warranties apply only to the fact of authorization by the account holder, the amount stated on the check, and issuance to the payee stated on the check. The Final Rule does not affect the rights of checking account holders, who even now have no liability for unauthorized checks drawn on their accounts. The rationale behind the shift of liability to the depositary bank is that the depositary bank, as bank for the party that initially created and has deposited the remotely created check, is presumably in the best position to ensure that its customer has obtained authorizations for its remotely created checks. The purpose of adopting the Final Rule (on the Reg. CC level) is to create a uniform national rule, thus avoiding the situation in which a paying bank and a depositary bank that are parties to the same check collection are subject to different rules because they are located in different states. For a discussion of the proposed version (which, among other things, proposed a somewhat different definition of "remotely created check") see, the April 12, 2005 Alert. The Final Rule becomes effective on July 1, 2006.

The OCC published its response ("Letter 1053") to a letter submitted by the National Association of Realtors challenging the legal basis of three recent OCC interpretive letters — two dealing with the authority of national banks to own different types of bank premises, and one dealing with an energy project financing transaction (for a discussion of these letters, please refer to the December 27, 2005 Alert). In Letter 1053, the OCC defends the legal basis for its conclusions in the three interpretive letters and reiterates that each letter: (1) falls within the limited authority of national banks to engage in real estate and investment activities; (2) has nothing to do with real estate brokerage; (3) does not open the door for national banks to engage in broad-based real estate development activities; and (4) does not breach the separation between banking and commerce.

FinCEN, the FRB, FDIC, OCC, OTS and NCUA (the "Agencies") jointly issued a proposal (the "Proposal") to revise and reformat the form of Suspicious Activity Report by Depository Institutions (the "SAR"). The Proposal is designed to standardize the form of SAR with current forms of suspicious activity reports being filed by other types of financial institutions, e.g., mutual funds and broker-dealers. The Proposal also allows for joint filing by financial institutions (other than in connection with matters that involve insider abuse). The Proposal includes the necessary data blocks and instructions for completing a jointly-filed SAR. Comments on the Proposal are due by April 18, 2006 and the Agencies state that, once finalized, the new form of SAR will be required for reporting suspicious activities if the filing is made after December 31, 2006.

In a speech last month at the IA Compliance Best Practices Summit 2006, SEC Commissioner Paul S. Atkins discussed his views on a range of compliance-related regulatory issues. In his remarks on the SEC’s hedge fund adviser registration requirements (see the December 10, 2004 Alert), Mr. Atkins related that some SEC staff members feel that Form ADV does not currently provide all of the information necessary for the SEC staff’s new risk-based approach to examination (see the September 27, 2005 Alert). He went on to note that some staffers had gone so far as to suggest that this problem could be addressed by gathering further information from advisers through quarterly filings (a measure that Mr. Atkins did not appear to support judging from the tenor of his remarks). Mr. Atkins discussed positive steps that the SEC has taken to assist firms in meeting their compliance obligations, but had harsh words for initiatives in which the SEC staff had requested that Chief Compliance Officers ("CCOs") indicate whether their firms were spending "enough" on compliance and provide written lists of all material compliance breaches. He observed that in his experience such measures served to isolate CCOs from other parts of their firms and hindered their effectiveness with fellow employees.

As he has in past public statements, Mr. Atkins criticized what he termed attempts by the SEC staff to set regulatory standards through the SEC’s inspection and enforcement programs, rather than through formal rulemaking, noting that e-mail retention and production had been the subject of such informal standard setting. He indicated that various issues relating to guidance in this area were still under consideration internally at the SEC, but it was his hope that these issues would be resolved in the near future. Referring to a November 2005 survey conducted by the Investment Adviser Association and a February 2006 report by the Securities Industry Association, Mr. Atkins expressed a strong awareness of the monetary and opportunity costs associated with devoting advisory firm resources to the compliance area and the need for the SEC to be cognizant of those costs in setting regulatory policy. Mr. Atkins also indicated his belief that the incentive structure in the enforcement division should be revaluated so that enforcement staff would be rewarded for acting with deliberation and judgment, noting that he was concerned that "big penalties get collected the way an athlete collects trophies." Mr. Atkins also discussed the bill introduced in Congress by Representatives Vito Fossella and Michael Castle that would, among other things, (a) eliminate the SEC’s Office of Compliance Inspections and Examination ("OCIE") and return the compliance/inspection function to the Divisions of Investment Management and Market Regulation, (b) impose a requirement that the SEC Commissioners approve sweep examinations and (c) require written notification of the closure of inquiries and inspections. Mr. Atkins did not indicate whether he favored a stand-alone OCIE or the reorganization that would occur under Representatives Fossella’s and Castle’s bill, noting arguments in favor of both arrangements. He did, however, note his concern about overlap and duplication in SEC sweep examinations and stated that OCIE had committed to him that the SEC Commissioners will have the opportunity to "weigh in on sweep examinations before they occur."

In response to concerns expressed by representatives of the financial services industry about the substantial systems, forms and procedural changes required by FinCEN’s new correspondent account rule (the "Rule"), issued under Section 312 of the USA Patriot Act, FinCEN extended the Rule’s initial compliance deadline by 90 days . Covered financial institutions will now have until July 5, 2006 (rather than until April 4, 2006) to establish the due diligence program and procedures required by the Rule for all correspondent accounts established on or after that date. The Rule’s effective date for pre-existing correspondent accounts remains October 2, 2006; however, this date will now apply to correspondent accounts that exist prior to July 5, 2006, rather than prior to April 4, 2006. Goodwin | Procter LLP held a webinar concerning the Rule and its requirements, which is available on the firm’s website at http://www.goodwinprocter.com/News_Events/Webinars/New_Patriot_Act_Rules_Requirin.aspx

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