SEC Votes To Adopt Antifraud Rule Under Investment Advisers Act Directed At Advisers To Pooled Investment Vehicles

1. S&P Proposes Enhanced Basel II Pillar 3 Disclosures
2. SEC Votes to Adopt Antifraud Rule under Investment Advisers Act Directed at Advisers to Pooled Investment Vehicles
3. GAO Issues Report on Pension Consultant Conflicts
4. OCIE Issues First ComplianceAlert to CCOs Outlining Recent Examination Deficiencies and Weaknesses
5. OCC Proposes Rule Amendments Designed to Reduce National Bank Regulatory Burdens
6. Agencies Issue Proposed Revisions to CRA Q&As
7. SEC Approves Voluntary Data Tagging of Risk/Return Summary Information in Mutual Fund Prospectus Filings
8. US Basel II: The Discussion/Debate Continues

S&P Proposes Enhanced Basel II Pillar 3 Disclosures

As has been stated several times in the Alert, while Pillar 1 (capital) of Basel II has received significant attention, Pillar 3 (market disclosures) has received very little. Standard and Poor’s Rating Services ("S&P") recently published several key areas of supplementary Pillar 3 disclosure that is intended to "promote sound market discipline" (the "Proposed Supplemental Disclosures"). As to credit risk, the Proposed Supplemental Disclosures would involve banks providing, among other things, greater disclosure of exposure at default by risk bucket, and greater breakdown of exposures by geography. As to Operational Risk, the Proposed Supplemental Disclosures include a breakdown of capital charges for each risk factor, and the allocation of operational risk per business line. As to the trading book, the Proposed Supplemental Disclosures include the specific risk components, the characteristics and drivers of the Value-at-Risk, model, and stress testing. Moreover, the Proposed Supplemental Disclosures also seek additional information about the fair value of illiquid assets, the bank’s securitization framework, the interest rate risk in the banking book, the equity portfolios outside the trading book, foreign exchange risk, and Basel Pillar 2 disclosure. S&P also noted that in connection with Basel II it would "refine [its] own risk-adjusted capital measures and develop a comprehensive framework that will facilitate comparison of banks’ capitalization levels, a key factor in bank ratings."

The SEC voted unanimously to adopt a new antifraud rule under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), that will make it a fraudulent, deceptive, or manipulative act, practice, or course of business for an investment adviser to a pooled investment vehicle to make false or misleading statements to, or otherwise to defraud, investors or prospective investors in that pool. The rule will apply to all investment advisers to pooled investment vehicles, regardless of whether they are registered under the Advisers Act. A pooled investment vehicle will include any investment company (as defined in the Investment Company Act of 1940, as amended) and any company that would be an investment company but for the exclusions in Sections 3(c)(1) or 3(c)(7) of the 1940 Act. The new rule will take effect 30 days after its publication in the Federal Register. More detailed coverage of this development will follow the SEC’s publication of a formal adopting release. A Client Alert discussing the new Advisers Act antifraud rule as proposed is available on the firm’s website. (There has been no official indication from the SEC on when it intends to act on the accredited natural person standard for investors in private pooled investment vehicles that was proposed in December 2006 along with the Advisers Act antifraud rule and is also discussed in the Client Alert.)

The Government Accountability Office (the "GAO") recently issued a report (the "Report") on conflicts of interest involving pension consultants to defined benefit pension plans. The Report examines 24 pension consultants, 13 of which failed to disclose to their clients the potential for significant conflicts. The GAO found that the pension plans advised by the consultants who failed to disclose their potential conflicts had annual returns that were 1.3% lower than the plans with the 11 consultants that disclosed their conflicts. The Report, which was requested by Rep. George Miller, Chairman of the House Committee on Education and Labor, recommends that Congress consider amending the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), to expand the authority of the Department of Labor (the "DOL") to recover plan losses from non-fiduciaries. The Report also recommends that the DOL, the Pension Benefit Guaranty Corporation and the Securities and Exchange Commission better coordinate their oversight of conflicts of interests. The DOL, in a letter to the GAO responding to the Report, indicated that it is pursuing a regulatory initiative addressing the disclosure of conflicts and that it will soon publish proposed regulations requiring service providers to disclose information concerning the service providers’ direct and indirect compensation, fees, and other financial arrangements.

The SEC’s Office of Compliance Inspections and Examinations ("OCIE") released its first ComplianceAlert letter designed to inform CCO’s about common deficiencies and weaknesses identified in OCIE’s recent examinations activity. The ComplianceAlert discusses findings in the following areas, among others:

Rule 19a-1 Notices for Closed-End Fund Distributions – OCIE examination staff found that many funds that paid a return of capital to their shareholders did not accompany the distribution with an appropriate written notice describing the source(s) of the distribution in accordance with Section 19(a) of the Investment Company Act of 1940, as amended (the "1940 Act"), and Rule 19a-1 under the 1940 Act. Section 19(a) of the 1940 Act requires a registered investment company to disclose the source of a dividend or distribution that is not made from net income. Rule 19-1 under the 1940 Act generally prescribes the form of that disclosure. The ComplianceAlert noted that this deficiency was not cured by the subsequent distribution of tax reporting forms that described the distributions source(s).

Adviser Advertising. The most common deficiencies uncovered in OCIE’s risk-targeted examination review of performance advertising by several registered investment advisers were failures to comply with SEC requirements for performance advertising such as those that require (i) the deduction of the advisory fees from performance results, (ii) the disclosure of whether performance results reflect dividends and (iii) the disclosure of relevant facts regarding the comparability of a particular index used as a benchmark. OCIE noted inadequacies in advisers’ compliance policies and procedures where they failed to (a) address the operations or practices of the adviser’s businesses, (b) ensure that third party consultants used compliant presentations, (c) address the methods used to treat cash (and equivalents) when "carving out" separate equity and fixed income performance from balanced accounts, (d) verify compliance with GIPS performance presentation standards prior to making claims of GIPS compliance, (e) require consistent comparison of composites to appropriate benchmarks and (f) ensure accurate

composite descriptions. OCIE staff also found that many advisers had inappropriately advertised a partial list of past specific recommendations. In firms with fewer deficiencies, OCIE staff noted practices such as (i) following a multi-level review process involving an adviser’s performance group, portfolio managers and marketing group to ensure the accuracy of marketing materials, (ii) reviewing "tolerance reports" that compare all composite accounts to their respective benchmarks on a monthly basis, (iii) reviewing all accounts on at least a quarterly basis to ensure proper composite construction and maintenance, and (iv) using a second independent pricing service to periodically verify the accuracy of prices supplied by a primary pricing service. Examiners found that inadvertent errors in calculation of performance results appear to have been reduced by the increased use of automated software programs to calculate performance.

Mutual Fund "As-Of" Transaction Practices – Examiners found that several fund complexes allowed intermediaries to enter as-of transactions (which are a means to correct legitimate errors in the processing of fund share orders) in the investment network system without implementing effective controls to review the legitimacy of the reasons cited by the intermediaries for the as-of transactions. Some funds had inadequate or no procedures for monitoring the cumulative effect on net asset value ("NAV") of as-of trades, and fund boards had not reviewed or approved their funds’ overall policies and procedures for processing fund shares. OCIE also found that many funds did not have control procedures expressly requiring their transfer agents to maintain documentation of the reason for allowing an as-of transaction, or retain correspondence relating to as-of transactions. Examiners also found instances where as-of processing was unnecessarily delayed a day or more after receiving the as-of transaction request in good order (or becoming aware of a processing error that required an as-of transaction to correct it).

Adviser Disaster Recovery Plans – The ComplianceAlert reviewed provisions of disaster recovery plans for advisers located in Louisiana and Mississippi that had proven effective in allowing those advisers to provide uninterrupted advisory services despite the natural disaster caused by Hurricane Katrina. These measures included: (1) designating a pre-arranged remote location for short-term and possible long-term use, (2) establishing alternate communications protocols to contact staff and clients, such as cell phones, text messaging, web-based e-mail accounts or an Internet website, (3) providing remote access to business records and client data through appropriately secured means that ensure ongoing compliance with Regulation S-P and other confidentiality requirements, (4) providing temporary lodging for key staff where necessary as a result of a firm’s relocation, (5) maintaining accurate and up-to-date contact information for all third-party service providers and being familiar with their business continuity plans, (6) making contingency arrangements for the temporary or permanent loss of key personnel, (7) training personnel to execute a firm’s business continuity plan in the event of a disaster, (8) periodic testing, evaluation and revision of disaster preparedness plans and (9) maintaining sufficient insurance and financial liquidity.

The ComplianceAlert also addressed deficiencies OCIE found in broker-dealer examinations relating to (1) 529 college savings plan sales, (2) sales of collateralized mortgage obligations and REITs, (3) supervisory procedures relating to Reg. SHO, (4) charges in separately managed accounts that were inconsistent with customer agreements and offering documents, (5) part-time financial and operations principals and (6) broker-dealer expense-sharing arrangements.

The OCC proposed amendments to a number of its regulations designed to reduce the regulatory burdens imposed on national banks. Many of the amendments are principally technical or clarifying in nature. However, some effect more substantive amendments to the current regulations (in many cases codifying interpretive rulings), and those are the focus of this article. Comments on the proposal are due by September 4, 2007.

Investment Securities. The proposal would allow the OCC, on a case-by-case basis, to permit a national bank to acquire an investment security that is not one of the "generic types" set forth in the regulation,

provided that the bank could demonstrate that it is consistent with Section 24(Seventh) and safe and sound banking practices. Moreover, as to investments in pooled vehicles, the proposal would amend the regulation (1.3(h)) to permit national banks to invest in pools consisting not only of permissible investment securities, but in any pool holding bank permissible assets, provided that the interests meet certain credit quality and marketability standards.

Fiduciary Powers. The proposal would eliminate the requirement in the current regulation that, before providing fiduciary services in a state, national banks obtain an opinion of counsel that the proposed activities do not violate state or Federal law.

Intermittent Branches. To remove an ambiguity, the proposal would eliminate any subsequent application requirements for recurring, temporary branches that serve the same site at regulator intervals (e.g., college registration periods and state fairs).

Operating Subsidiaries. Rather than the current standard, in light of FIN 46R, the proposal would characterize an operating subsidiary as an entity that satisfies the following two requirements: (1) the bank has the ability to control the management and operations of the entity by owning 50% or more of the voting stock or otherwise, and (2) the operating subsidiary is consolidated with the bank under Generally Accepted Accounting Principles ("GAAP"). This change would preclude a national bank from treating as a subsidiary an entity that it controls through majority ownership, but which is held under an arrangement whereby another party holds most of the economic interests. The proposal also would expressly recognize that limited partnerships may be operating subsidiaries, and increase the types of activities in operating subsidiaries subject to after-the fact notice procedures to include such things as payroll processing, merchant processing, financial data processing for third parties, administrative tasks in benefits administration, and activities the OCC has approved for a non-controlling investment by a national bank.

Other Equity Investments. The current OCC regulation for minority equity investments (5.36) provides no procedure for a national bank when it cannot qualify for after-the fact notice, either because the bank is not an eligible bank or because the proposed activity does not qualify The proposal would fill this void, and require the national bank to make the historically required representations to the extent possible and also explain why the desired activity is a permissible one for a national bank.

Changes in Permanent Capital. The proposal would reduce the expedited review period for a national bank to change its permanent capital (5.46) from 30 to 15 days.

Change in Bank Control. The proposal amends the OCC’s change in control regulations (5.50) to establish a rebuttable presumption that immediate family members are acting in concert when acquiring shares of a bank. In addition, the proposal amends the change in control regulation to implement Section 705 of the 2006 federal regulatory relief legislation by allowing the OCC to extend the time period for considering an application to take into account the acquiring party’s business plans, and to use that information in determining whether to disapprove an application. Moreover, for clarity, the proposal would add to the regulation the statutory requirement that whenever a change in control occurs, the bank will promptly report to the relevant banking regulator any change to the CEO or any director of the bank during the next 12 month period, and include in the report a statement of the past and current business and professional affiliations of the CEO or director.

The FRB, FDIC, OCC and OTS (the "Agencies") jointly issued for public comment proposed revisions (the "Proposed Revisions") to the Interagency Questions and Answers Regarding Community Reinvestment (the "Q & As"). The Q & As were originally issued in 1996, and have been periodically amended, to provide guidance with respect to Community Reinvestment Act ("CRA") regulations. In addition to clarifying aspects of the current Q & As, the Proposed Revisions provide additional guidance regarding, among other things, investment in minority- and women-owned financial institutions ("FIs"), CRA treatment of purchased loan participations and CRA treatment of small business loans secured by one-to-four family residences. The Agencies state that certain of the Proposed Revisions are intended by the Agencies to encourage FIs to "work with homeowners who are unable to make mortgage payments" by making FIs aware that they will receive consideration for CRA credit for the FI’s foreclosure prevention programs for low- and moderate-income homeowners, consistent with the Agencies’ April 2007 Statement on Working with Mortgage Borrowers. Comments on the Proposed Revisions are due by September 10, 2007.

The SEC approved final rule amendments that expand its voluntary program for interactive data tagging of information in electronic filings to permit mutual funds to submit data tagged risk/return summary information. The risk/return summary at the front of mutual fund prospectuses includes information about a fund’s investment objectives and strategies, risks, costs (including expense information) and historical performance. Data tagging labels information in electronic filings using standardized definitions so that the information can be retrieved, searched and analyzed through automated means. Use of data tagging is designed to increase the ability of investors, analysts and others to collect and use information in disclosure documents filed electronically with the SEC. The rule amendments use a taxonomy of data tags developed by the Investment Company Institute. The submission of tagged risk/return summary information, which may begin starting August 20, 2007, will be supplemental and will not replace the official versions of the information required in mutual fund prospectuses.

Senior members of the FRB and FDIC continue to provide arguably inconsistent reports about the status and progress of US Basel II.

FRB. In his speech, FRB Governor Kroszner first focused on the need for Basel II given the increasing complexity of the global banking industry. He further discussed 4 major issues present since the US Basel II proposal. First, many commentators have expressed concern about the differences between US and European Basel II. Mr. Kroszner responded that although US regulators generally should seek consistency with the global standards, the US has always been different from Europe and many of the differences are consistent with the national discretion envisioned by Basel II. Second, commentators have expressed concern about the complexity of Basel II. Mr. Kroszner responded that such complexity reflects the nature of the large US banks in the system, although the principles-based approach in Basel II does provide some flexibility to US banks in implementation. Third, there has been the concern of unintended consequences or distortions, such as "unreasonable declines in capital requirements." Mr. Kroszner asserted that to respond to these issues "we need to take the important next step of actually implementing Basel II for U.S. banking organizations." Finally, he noted the concern of the smaller US banks being at a competitive disadvantage, and stated that the agencies are sensitive to the importance of preventing multiple capital frameworks from creating artificial competitive inequalities.

As to timing of implementation, Mr. Kroszner stated that the US banking regulators will continue to oversee capital during every stage of implementation, and determine whether any adjustments to the framework are required before the temporary floors during implementation are removed. Nonetheless, he stated that the FRB agrees with the Government Accountability Office that finalizing the U.S. Basel II rules will unto itself "generate crucial information to enable the agencies to make future assessments of the strengths and weaknesses of the Basel II rule for the U.S. banking system."

FDIC. At a speech at the end of June, FDIC Chairman Bair appeared to take a much more cautious approach toward Basel II and its implementation. She first highlighted 4 significant risks she recognizes in Basel II itself. First, the Basel II advanced approaches "comes uncomfortably close to letting banks set their own capital requirements." She stated that the US banking crises in the late 1980s highlighted the dangers of undercapitalization in the US banking system. Second, she stated that the "jury is still out on whether the Basel II advanced approaches can tie capital requirements to risk, as intended." She stated that, accordingly, the latitude given the large banks in setting capital could create wide disparities in the capital treatments of identical assets. Third, she stated that even if the advanced approaches could deliver a correlation between capital and risk, the capital may be too low. She highlighted the drop in capital for mortgage loans cited in QIS-4, and the fact that it relied purely upon historical data in determining those numbers, and said that these "kinds of results are simply unacceptable." Finally, she expressed the concern that US bank regulators may be ill-equipped to mitigate the inadequacies of the advanced approach, citing the troubles of subprime market as an example of a situation where regulators were unable to see developing problems.

As to timing, in contrast to the tone of FRB Governor Kroszner, Ms. Bair stated that "[t]o be honest and frank, we don’t know yet whether Basel II’s advanced approaches will work." She further stated that safeguards to declines in risk-based capital "should be removed only when the global framework has proved its capital sufficiency and reliability" (emphasis in original).

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