Federal Reserve Board Issues Comprehensive Affiliate Rules Under Sections 23A and 23B of Federal Reserve Act

Transcription

1 The Derivatives Report June 2001 Federal Reserve Board Issues Comprehensive Affiliate Rules Under Sections 23A and 23B of Federal Reserve Act By Greg Lyons Financial Services Practice Group, Goodwin Procter LLP To provide integrated services most efficiently and successfully in the new financial services marketplace, institutions best able to navigate and implement the FRB rules will have a substantial advantage when seeking to coordinate their bank and nonbank operations. The Federal Reserve Board released on May 4 comprehensive proposed [1], interim final [2], and final rules [3] (the Rules ) regarding sections 23A and 23B of the Federal Reserve Act [4]. These sections govern most transactions between banks and their affiliates. The term banks includes all national banks, as well as insured state member and nonmember banks and, for certain purposes, U.S. branches and agencies of foreign banks. While the Office of Thrift Supervision (OTS) separately issues rules for thrifts and their affiliates under sections 23A and 23B, federal law specifies that the OTS rules for insured thrifts must be at least as strict as the Rules. Thus, the Rules are relevant to all organizations that have a bank or thrift as a member, except organizations having only uninsured state banks. The importance of the Rules is derived from the need to maximize efficiencies and advantages to compete successfully in the modern financial services marketplace. Rather than operating banks and their affiliates as separate and distinct enterprises, organizations with banks as a member having increasingly sought ways to coordinate and integrate the resources, products, and services of their banks with their nonbank affiliates. The greater geographic and product flexibility afforded nonbank affiliates of financial holding companies under the Gramm-Leach- Bliley Act of 1999 (the GLBA) will only serve to increase this trend. The Rules establish for the first time a comprehensive regulatory framework addressing the degree to which, and with what regulatory burdens, this coordination and integration may occur. Given the FRB s preamble statement that it considers sections 23A and 23B to be two of the most important statutory protections against a bank suffering losses because of transactions with affiliates, it can reasonably be expected that the FRB will vigorously enforce these provisions. General Protections of Sections 23A and 23B Congress passed sections 23A and 23B to protect a bank from adverse consequences as a result of imprudent transactions with its affili-

2 ates, such as mortgage companies, securities firms, and insurance companies. Congress feared that without some legislative protection, for example, a bank s parent might cause the bank to support imprudently a floundering affiliate, ultimately resulting in the bank s failure and adverse consequences to taxpayers as a result of draws on the FDIC insurance fund. To avoid this result, section 23A applies quantitative limits and other requirements on many transactions (called covered transactions ) that result in a flow of funds from a bank to its affiliate, including purchases of assets from, loans to, investments in, and guarantees on behalf of, an affiliate. Section 23B applies more generally to protect all transactions (including service contracts) between a bank and its affiliates by requiring that they be on terms no less favorable to the bank than those that the bank could obtain from an unaffiliated third party. New FRB Rules The discussion below analyzes each component of the Rules. Proposed Rule By far the most voluminous portion of the Rules is the proposed rule (the Proposal ), which is designated proposed FRB Regulation W and sets out the basic framework of how the FRB applies and interprets sections 23A and 23B. Because the FRB intends Regulation W to be a single, comprehensive reference tool for this area, a significant portion of the Proposal mirrors the traditional statutory provisions in, and FRB interpretations of, sections 23A and 23B. Comments on the Proposal are due by August 15, Quantitative limits Section 23A limits covered transactions to 10% of the bank s capital and surplus with any one affiliate and 20% with all affiliates in the aggregate. The Proposal confirms that a bank need not reduce a preexisting covered transaction to conform to these limitations because its capital subsequently declines or the covered transaction later increases in value. However, the Proposal provides an incentive to banks to reduce excesses by declaring that a bank may not engage in any new covered transaction if existing covered transactions with any affiliate (not just the affiliate with which the new transaction is contemplated) exceed 10% of the bank s capital and surplus. Collateral The Proposal also provides additional detail on how to comply with the section 23A requirement to collateralize certain covered transactions. If a deposit account is used as collateral, it must be specially earmarked as described in the Proposal. Moreover, the Proposal specifies that some types of assets are not acceptable collateral, including intangible assets (such as mortgage servicing rights), guarantees, and bank securities. Special rules and deductions also apply if the bank does not have a first priority interest in the collateral. Finally, relaxing the FRB s historical approach, the Proposal states that, under certain circumstances, the collateral requirements will not apply to the undrawn portion of an extension of credit to an affiliate. Low-quality assets Concerning low-quality assets, the Proposal maintains the FRB s traditional exception for renewing or providing additional funding to existing participations. However, it adds as a prerequisite a new regulatory prior-notice requirement. Timing and valuation As to the timing of covered transactions, the Proposal departs from industry practice by 2

3 providing that section 23A applies (with certain exceptions) to intraday, as well as overnight, transactions. Regarding valuation, the Proposal requires banks to value investments in affiliate securities and purchases of affiliate assets at the greater of cost or carrying value, resulting in the aggregate amount of a covered transaction increasing if the value of the security or asset increases after the bank acquires it. The Proposal also reduces the flexibility provided by a 1999 FRB interpretation for a bank to accept affiliate securities as collateral. Bank-affiliate merger and acquisition transactions The Proposal also addresses how the section 23A rules will apply to bank mergers with affiliates and contributions of stock of an affiliate to a bank. Of particular note, the Proposal states that (with limited exceptions) if a holding company contributes the stock of an entity to a bank and the entity becomes a bank subsidiary, all liabilities of the entity (not just liabilities to affiliates) will be deemed part of a covered transaction, even if there is a net transfer of value to the bank. Exemptions Also set out are numerous exemptions from the section 23A requirements. Notably, the Proposal and its preamble both expand the exemption currently in 12 C.F.R. section to cover the purchase of any type of loan from an affiliate and provide restrictions on its use. One such restriction disallows a bank from satisfying its requirements simply by having an affiliate use the bank s underwriting standards. Furthermore, while intraday credits would be considered covered transactions (as stated above), the Proposal exempts intraday exposures resulting from securities-clearing and settlement transactions and payment transactions from the section 23A requirements. Indeed, it was reported in the May 7, 2001, issue of the American Bankers [5] that FRB General Counsel J. Virgil Mattingly stated to the Board of Governors of the FRB during his presentation concerning the Rules that the provisions dealing with intraday transactions are narrowly drafted and are intended to stop only one type of transaction, a deliberate intraday overdraft made by a bank to an affiliate that needs the funding that day to get through the day. Derivatives Although not actually proposing provisions, the Proposal s preamble makes clear that the FRB is strongly considering subjecting at least some credit exposures arising out of derivatives to the section 23A limitations. The Proposal seeks additional comment on issues such as which derivatives should be treated as loans and the appropriate reporting, quantitative, and collateral obligations. Based on responses, the FRB intends to issue a proposal on treatment of derivatives. US branches/agencies of foreign banks To ensure competitive equality between US and foreign banks, the Proposal would apply sections 23A and 23B to US branches and agencies of foreign banks when they are engaging in transactions with affiliates directly engaged in the US in any of the following activities authorized under the GLBA: insurance underwriting, securities underwriting and dealing, merchant banking, and insurance company investment activities. Definitions Finally, the last subpart of the Proposal amends certain definitions in sections 23A and 23B. Of particular significance, unregistered investment 3

4 funds would be made affiliates of a bank for purposes of the Proposal if the bank or an affiliate advised the funds and the bank or an affiliate held more than a 5% voting stake in them. The Proposal also seeks comment on whether state bank subsidiaries (such as real estate management subsidiaries) that are engaged in activities impermissible for the bank itself but are not financial subsidiaries should be subject to section 23A s restrictions. The Proposal also would consider keepwell agreements [6] to be covered transactions and requests comment on how to treat securitizations in which the bank transfers assets to a special-purpose vehicle. Finally, the Proposal expands the definition of low-quality assets and makes clear that commercial paper is a security for purposes of applying section 23A. Interim Rule The FRB also published an interim rule (the Interim Rule ) concerning derivative transactions and intraday credit extensions with affiliates to satisfy the GLBA s requirement that rules be issued concerning these areas by May 12, The Interim Rule notes that the Proposal (as described above) seeks to address more substantively how these matters should be handled for section 23A purposes. Nonetheless, in accordance with GLBA, the Interim Rule requires banks to adopt policies and procedures to monitor, manage, and control credit exposures from derivative transactions (defined identically to the capital guidelines) and intraday credit exposures to affiliates. Moreover, the Interim Rule highlights that derivative transactions always have been, and will continue to be, subject to the market terms requirement of section 23B. Among other things, this requirement forces banks to collateralize derivatives with affiliates in the same manner as they would with unaffiliated parties. The Interim Rule also would make some intraday credit with affiliates subject to section 23B. Although the Interim Rule does not become effective until January 1, 2002, as stated above, the FRB believes that section 23B by its terms currently applies to derivative transactions with affiliates. Final Rule The FRB also published a final rule (the Final Rule ) implementing interpretations and exemptions, generally involving a registered broker-dealer affiliate of the bank, for which the FRB sought comment in One component of the Final Rule exempts from the section 23A requirements certain loans to third-party borrowers who then use the funds to make purchases through or from bank affiliates (the loan exemptions ). The second component expands the ability of a bank to purchase securities from a registered securities affiliate (the purchase exemption ). Loan exemptions The attribution rules of section 23A generally dictate that a loan by a bank to an unaffiliated third party is deemed a loan to a bank affiliate to the extent that the loan proceeds are used for the benefit of, or transferred to, that affiliate. However, as an exception to that general rule, the Final Rule includes an interpretation that section 23A does not apply when the loan proceeds are used to enter into an agency transaction with any affiliate of the bank if two conditions are met. First, the securities or other assets purchased by the borrower are not issued by, or sold from the inventory of, the affiliate, and second, no affiliate retains any portion of the loan proceeds. Moreover, so long as the loan proceeds are used to purchase securities from a registered bank affiliate acting as a broker-dealer or riskless principal, the affiliate can retain a portion of the loan proceeds to pay its commissions. In addition, if a bank has a preexisting (not merely pre-approved) line of credit with a 4

5 third-party borrower established for other purposes, the Final Rule exempts from the section 23A restrictions the borrower s use of the proceeds to purchase securities underwritten or held as principal by a registered broker-dealer affiliate of the bank. The loan exemptions are effective June 11, Purchase exemption As described at the outset of this article, bank purchases of assets from an affiliate are generally covered transactions and thus subject to the limits of section 23A. Section 23A itself exempts from this restriction bank purchases of affiliate assets that have a readily identifiable and publicly available market quotation. The Final Rule further expands this exemption to certain securities purchased by a bank from its registered broker-dealer affiliate. Among other requirements, the new exemption requires that the security have a ready market (as defined by SEC regulation), be eligible for direct purchase by a state member bank (a broader standard than the 1998 proposal), and be quoted routinely on an unaffiliated electronic service. Notably, the FRB specifically considered and did not propose exempting from section 23A limitations (unless the US guarantees them) securities issued by an affiliated mutual fund and asset-backed securities issued by an affiliate. The purchase exemption also is effective June 11, Conclusion In its recently published Rules, the FRB provides substantial additional insight into the application of sections 23A and 23B to transactions between a bank and its affiliates. While some of the positions in the Rules represent a relaxation of the statutory provisions, many of the provisions are likely to increase the likelihood that an unwitting institution will be deemed to violate those provisions. In sum, institutions best able to navigate and implement the Rules will have a substantial advantage when seeking to coordinate their bank and nonbank operations to provide integrated services most efficiently and successfully in the new financial services marketplace. It is our understanding that, after the Rules become effective, the staff of the federal bank regulatory agencies will, as part of their subsequent examination of a financial institution, review the institution s Transactions with Affiliates Policy (or any similar policy dealing with compliance with sections 23A and 23B) to determine whether the policy has been appropriately revised to conform to the Rules requirements C.F.R. Part 223 (Regulation W), Docket No. R C.F.R. Part 250 (Miscellaneous Interpretations), Docket No. R-1104, effective 1/1/ C.F.R. Part 250 (Miscellaneous Interpretations), Docket Nos. R01015, R See 12 U.S.C. section 221 et seq. 5 See 6 A special form of guarantee in the form of a promise by a corporate parent to keep a subsidiary solvent. The original version of this article was published in 4 Financial Services Alert No. 37 (May 8, 2001). For further information, or to be added to the Alert s distribution lisp contact either Greg Lyons (tel.: ) or Eric Fischer (tel.: ). Goodwin Procter LLP, a firm of over 450 lawyers has one of the largest financial services practices in the US Greg Lyons is an attorney with the Boston firm of Goodwin Procter. He can be reached via respectively at glyons@goodwinprocter.com The Derivatives Report, June Reprinted with permission. All rights reserved. 5