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Angola Russell

REGULATION OF FINANCIAL INSTITUTIONS OUTLINE


DEPOSITORY INSTITUTIONS ..................................................................................................................4 Banking History, Chartering, and Antitrust ..........................................................................4 Why Regulate? ........................................................................................................................4 History .....................................................................................................................................4 General Regulatory Structure...................................................................................................5 National Banking Act ..............................................................................................................5 The Chartering Process ...........................................................................................................6 Usury .......................................................................................................................................6 Antitrust .................................................................................................................................10 The Business of Banking..........................................................................................................14 Lending Limits .........................................................................................................................16 Limits on loans/extensions of credit to a single borrower ....................................................16 Loans to Insiders ..................................................................................................................18 Affiliates ................................................................................................................................20 Loan Participation .................................................................................................................21 Deposits .....................................................................................................................................22 Definition of Deposit, 12 USC 1831(l) (1995)...................................................................22 Letters of Credit ....................................................................................................................22 Only state and local government depositors can have secured claims .................................23 Rights Under Qualified Financial Products, 12 USC 1821(e)(8)(A)(2000)......................23 Brokered Deposits .................................................................................................................23 Federal Deposit Insurance .....................................................................................................24 Capital Adequacy ....................................................................................................................25 Generally................................................................................................................................26 Capital Ratios .......................................................................................................................26 Definitions and Risk Weightings ..........................................................................................26 Banks that are not well capitalized are restricted in their activities......................................29 What can banks do to improve the capitalization?................................................................31 Alternative Approaches to Capital Standards .......................................................................31 Critiques of Basel II...............................................................................................................32 Basel II Implementations ......................................................................................................32 Alternative Approach: Shadow committee report (March 2, 2000) ....................................33 Consolidated Capital Requirements for Financial Conglomerates (Jacksons article) ........34 Community Reinvestment Act ...............................................................................................35 Community Reinvestment Act, 12 USC 2901.......................................................................35 Tests........................................................................................................................................36 Financial Privacy and Other Consumer Protections ..........................................................37 Statutes ..................................................................................................................................38 RESPA....................................................................................................................................39 Money Laundering...................................................................................................................41 Regulation of Organization Structure ...................................................................................43 Geographic Expansion of Banks ...........................................................................................43 Bank Holding Companies .....................................................................................................45

Activities of Bank Holding Companies ................................................................................49 Banks/BHCs & Insurance pre-GLB......................................................................................51 The Gram-Leach-Bliley Act (GLB)......................................................................................52 Capital Requirements for Financial Conglomerates .............................................................60 INSURANCE COMPANIES ....................................................................................................................62 Introduction to Insurance Regulation ...................................................................................62 History ...................................................................................................................................62 Overview of Insurance Regulation .......................................................................................63 What is Insurance? ..................................................................................................................64 Interpretation of Insurance Contracts...................................................................................65 The Regulation of Insurance Company Insolvency .............................................................66 Executive Life Insurance Company: A Case Study .............................................................66 Highlights of Insolvency Regulation ....................................................................................67 Movement for federal charters for insurance companies......................................................67 Guarantee Funds ....................................................................................................................67 Insurance Rates and Risk Classification ...............................................................................68 Generally ...............................................................................................................................68 Risk Classifications ..............................................................................................................70 THE SECURITIES INDUSTRY ...............................................................................................................71 Introduction to the Securities industry .................................................................................71 History of broker dealer regulation .......................................................................................71 Overview of Broker-Dealer Regulation ................................................................................72 Definition of Broker Dealers ..................................................................................................72 Registration and Regulation ( 15 of the 1934 Act)..............................................................72 Lincoln Savings and Loan......................................................................................................73 The Obligations of Broker Dealers ........................................................................................73 Broker Dealers v. Investment Advisors ................................................................................73 Three basic functions of broker dealers.................................................................................74 Statutes ..................................................................................................................................74 Churning ................................................................................................................................75 10b-5.......................................................................................................................................75 The Obligation to Supervise .................................................................................................77 Broker-Dealers as Market-Makers and Underwriters .......................................................77 Penny Stock Regulations ......................................................................................................79 The Dilemma of Broker-Dealer Regulation .........................................................................79 Arbitration of Disputes ...........................................................................................................80 Financial Obligations of Broker Dealers ..............................................................................80 Analyst Conflicts of the Late 1990s .......................................................................................81 Background ...........................................................................................................................81 Rule making on Research Analyst Conflicts ........................................................................81 Can you really solve these problems with disclosure and structural reforms? ....................81 Self Regulatory Organizations................................................................................................82 The End of Fixed Commissions ............................................................................................82 SRO Rule Making .................................................................................................................84 Limit Orders ..........................................................................................................................86 Payment for Order Flow .......................................................................................................87

INVESTMENT COMPANIES ..................................................................................................................89 Introduction .............................................................................................................................89 Investment Act of 1940 ........................................................................................................89 Classification of Investment Companies...............................................................................89 Structure of a Mutual Fund ...................................................................................................89 Definition of Investment Company .......................................................................................90 Definition of Investment Company, Section 3(a) of the 1940 Act ......................................90 Exemptions from the IC Definition, Section 3(b) of the 1940 Act.......................................90 Further Exemptions, Section 3(c) of the 1940 Act................................................................91 CMA Accounts.......................................................................................................................91 Fiduciary Duties and the Role of Directors ..........................................................................92 Extracting value from trading in portfolio securities Collateral Payments ........................92 Transfer of Advisory Contracts ............................................................................................94 Advisory Fees ........................................................................................................................95 An Interlude to the economics of mutual funds. ..................................................................96 The Role of Independent Directors .......................................................................................96 Mutual Fund Disclosure .........................................................................................................98 Two trends..............................................................................................................................98 Investment Company Disclosure Concept Release on Risk ................................................98 Some Dilemmas of Disclosure Policy ..................................................................................98 ADDITIONAL TOPICS COVERED IN CLASS .........................................................................................100 Hedge Funds............................................................................................................................100 Long-Term Capital Management ........................................................................................100 Systemic Risk ......................................................................................................................100 SECs Hedge Fund Proposal ...............................................................................................101 Brokerage Activities of Banks ..............................................................................................103 Securities v. Insurance ..........................................................................................................107 Regulatory Treatment of Variable Annuities .....................................................................107 Insurance v. Banking ............................................................................................................108 Summary .............................................................................................................................108

Depository Institutions
Banking History, Chartering, and Antitrust
Why Regulate? Corrigan, Are Banks Special? virtually all other financial markets and other classes of institutions are directly or indirectly dependent on the banking system as their standby or backup source of credit and liquidity. Depositors can get their deposits back on demand, but banks cant get their loans back on demand. This mismatch in maturities makes banks especially vulnerable to solvency concerns. Collective action problem among dispersed depositors. While theoretically depositors could choose to put their assets in risky banks, bank failures cause negative externalities (e.g. drain on deposit insurance or drain on welfare programs forced to support depositors who have lost all their money). History 1781-1836 First and Second Banks of the Untied States McCollough v. Maryland (USSC); Under the Commerce and Necessary and Proper Clauses, federal government had the power to create a federal bank (Second Bank of the United States); Held Under the Supremacy Clause, states can not tax federal banks. Congress subsequently waived the ban on state taxation for the heirs of the Second Bank of the United States tax is based on congressional acquiescence rather than a unilateral assertion of taxation power. States chartered banks during this era as well. 1832 Jacksons Veto Message Regarding the Second bank of the United States Jackson echoed the sentiments of many Americans when he expressed hostility towards eastern financial power and foreign ownership of the second national bank. 1837-1863 Era of Free Banking/No Federal Bank States passed enabling Acts allowing banks to incorporate without special grants from the state legislatures. 1863-Present Dual Banking (both Federal Banks chartered and regulated by federal regulators and State banks chartered and regulated by state regulators) 1863 National Banking Act was passed allowing banks to obtain federal charters. 1913 Federal Reserve Act was passed creating the Federal Reserve 7 member Board of Governors are appointed by the president. 12 regional Federal Reserve Banks are owned by the commercial banks in each federal reserve district. National banks are compelled to (and state banks have the option to) become members of the FRS and owners of the regional Federal Reserve Banks. The Federal Reserves Open Market Committee meets every 6 weeks to determine monetary and interest rate policy. 1933 Banking Act of 1933 (Glass Steagal) Created FDIC and required the separation of deposit institutions/commercial banking and securities firms/investment banking. 1956 Bank Holding Company Act of 1956

BHCs allowed banks to affiliate with banks in other states. The BHCA gave the federal reserve the power to regulate concentration and geographic expansion of BHCs and their affiliation with non-banking activities. 1980 Congress lifted the limits on interest rates that financial institutions could pay on deposits. 1991 FDICA of 1991 Among other things said that member state banks many not engage, as a principal, in activities not permitted to national banks, absent FDIC approval. The law, however, generally does not affect state bank bowers as an agent, such as real estate agency or stock brokerage activities, that are authorized by state law. 1994 Riegle-Neal Interstate Banking Act of 1994 Allows a bank holding company to own separate bank subsidiaries in every state, regardless of state law. In addition, beginning June 1, 1997 it allows a single bank to acquire, by merger, branches in other states, unless a particular state opts out by passing legislation prior to June 1, 1997 that prohibits interstate branching in the state. National banks are subject to host state laws covering consumer protection, fair lending, community reinvestment and intrastate branching, but these laws are to be enforced by the OCC. 1999 Gram-Leach-Bliley Effectively repealed Glass-Steagal by substantially liberalizing the ability of qualified bank holding companies to expand in other areas of the financial service industry, most notably, the securities and insurance businesses. General Regulatory Structure The Federal Reserve Board regulates bank holding companies. The FDIC regulates both national banks and state banks (if the state banks decide to join). Virtually all state banks join in order to be able to compete effectively with federal banks and comply with state laws. The Office of the Comptroller of the Currency (OCC) is the primary regulator of National Banks. The applicable State Bank Regulator regulates state banks. Note that while much of the regulation of national banks is consolidated in the OCC, state banks will often need to seek dual approval (from the FDIC or FR as well as the applicable state regulator) for charter amendment, branching, mergers and other changes in bank activity. Additionally federal preemption allows congress to enact laws applicable to non-member state banks as well (the uniform reserve requirements enacted in 1980 for example). National Banking Act National Banking Act, 12 U.S.C. 21 (1999)
Associations for carrying on the business of bankingmay be formed by any number of natural persons, not less in any case than five. They shall enter into articles of association, which shall specify in general terms the object for which the association is formed, and may contain any other provisions, not inconsistent with law. The persons uniting to form such an association shall, under their hands, make an organization certificate which shall specifically state: First. The name assumed by such association, which name shall include the word national. Second. The place where its operation of discount and deposit are to be carried on Third. The amount of capital stock and the number of shares.

National Banking Act, 12 U.S.C. 22 (1999) Organization Certificate

National Banking Act, 12 U.S.C. 24 (1999) Powers

[A national bank shall have the power to] First. To adopt and use a corporate seal Third. To make contracts Seventh. To exercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt . . . .

NB: Banks (unlike most DE corporations, are of limited powers; can do banking but not commerce). The Chartering Process Applications for national bank charters are submitted to the Comptroller of Currency for approval. 12 USC 1816 (2000) (today)
The factors that are requiredto be considered [in approving a charter for a new bank]are the following: The financial history of condition of the depository institution. The adequacy of the depository institutions capital structure. The future earnings prospects of the depository institution. The general character and fitness of the management of the depository institution. The risk presented by such depository institution to the Bank Insurance Fund or the Savings Association Fund The convenience and needs of the community served by such depository institution Whether the depository institutions corporate powers are consistent with the purpose of this charter.

Camp v. Pitts (USSC 1973 petitioners applied for a national bank charter and the Comptroller turned them down citing convenience and needs of the community); Held that the Comptrollers chartering decisions are to be reviewed under the arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law standard (and not de novo as petitioner had argued). E.g. courts give great deference to Comptrollers chartering decisions. Controversial is it the governments business to decide how many banks are needed and which should survive? System is skewed towards existing banks (rather than new potentially more efficient banks). Comptrollers interests are skewed towards keeping old banks going even at the cost of no new banks b/c comptroller has to bail out failed banks. Current law governing judicial review of agancies interpretation of statutes they administer: Chevron USA c. Natural Resources Defense Council, Inc. (USSC 1984); If congress has delegated authority to the agency or the statute is silent but the agencys answer is based on a permissible construction of the statute, the agencys interpretation gets substantial deference. The dual banking competitive equality contradiction On the one had we envision a banking system in which state and national banks compete with each otherBut we also strive to maintain competitive equality between state and national banks. Usury Policy Cons Theoretically a price ceiling on interest rates should lead to a shortage in supply. Restricting interest rates will mostly restrict credit for those who need it most low and middle income individuals. Pros Market inefficiencies consumers may have imperfect information or understanding of information (and disclosures might not work since consumer credit consumers are likely to be not as sophisticated as securities consumers). Unequal bargaining power banks have the money and the sophistication.

Demand may be inelastic in some instances dont want banks to be able to take advantage (e.g. pay day lenders). Usury Rule for National Banks, 12 USC 85 (1999)
Any association maycharge on any loan Interest at the rate allowed by the laws of the State, Territory, or district where the bank is located, or at a rate of 1 percent per centum in excess of the discount rate on ninety-day commercial paper in effectwhere the bank is located. Whichever may be greater, and no more, except that where by the laws of any State a different rate is limited for banks organized under state laws, the rate is so limited shall be allowed for associations organized or existing in any such State under this chapter.

Most Favored Lender Rule: National banks get to charge the best interest rate available to them under state law or what the state banks charge, whichever is greater(e.g. state interest rate regulation cant discriminate against national banks); designed to promote competitive equality. Tiffany v. National Bank of Missouri (USSC 1873 national bank loaned $ at 9%; host state statute provide an 8% limit for state banks and a 10% limit for all other banks); Held that 10% limit was valid b/c 85 does not make state bank rate the limit, but simply creates most favored lender policy to protect federal banks from discriminatory state legislation restricting the interest rates national banks can charge to below what state banks can charge. Marquette National Bank v. First of Omaha Service Corp. (USSC 1978 Nebraska usury laws allow banks to charge credit card holders 108% on the first $999.00 and 12% on amounts of $1000 and over; Minnesota usury laws allow banks to charge credit card holders 12%; National bank located in Nebraska sets up a service corporation qualified to do business in Minnesota (First of Omaha Service Corp.) which then proceeds to offer credit cards to Missouri residents but charge them the higher interest rates allowed in Nebraska); Held that for the purposes of usury laws a national bank can charge out-of-state credit card customers the interests rates allowed in the national banks home state. 12 USC 85 provides that national banks may charge [i]nterest at the rate allowed by the laws of the State, Territory, or district where the bank is located. Usually in a choice of law case, the courts would look to a number of factors to decide where the bank is located, but here the court simply says that a national bank is located where its certificate of organization says it is located. Under Supremacy clause of the Constitution, 85 trumps state law. If congress wants to protect usury laws it can change the statute. Note that reasoning in this decision would not work for state banks, but subsequent laws have allowed state banks to do the same thing. Interpretive letter No. 686 (OCC 1995); 85 authorizes a Pennsylvania bank with branches in New Jersey to charge interest rates allowed by NJ for loans made from branch offices located in New Jersey. Consequently the bank has two (and potentially 50 locations) for 85 purposes? Seems odd. 92a authorizes the OCC to grant fiduciary powers to a national bank to the extent that such powers may be granted to competitive institutions by the law of the state where the national bank is located. In Interpretive Letter No. 695, the OCC opined that a bank with fiduciary powers in one state can exercise fiduciary powers in another state, but only to the extent that fiduciary powers are authorized for state chartered institutions in the other state. Seems to conflict with Marquette in that Marquette said that 85 trumped state law and allowed national banks to export their home state interest rates, but according to this interpretive letter 92 does not allow the same unrestricted exportation of home state permitted fiduciary powers. Did the OCC reach this outcome b/c 92 contains the clause when not in contravention of State or local law, or is that just a reiteration of the principle of competitive equality?

In re Citibank (South Dakota), N.A. ( Fed. Res. Bull. 181, 1981); Fed approves Citicorps (a BHC) application to acquire a new bank set up by Citicorp in South Dakota; the new bank will engage in limited deposit taking and commercial lending activities, but primarily it will conduct nation wide consumer credit card lending activities currently conducted by Citibank-Buffalo). 12 USC 1842(d) (BHCA) prohibits the Board from approving any application by a bank holding company to acquire any bank located outside of the state in which the operations of the bank holding companys banking subsidiaries are principally conducted unless such application is specifically authorized by the statute laws of the state in which such bank is located South Dakota passes a law permitting out of state banks to acquire a bank charted in South Dakota, with a single banking office, that is not located or operated in such a way to make it likely to attract customers. The South Dakota Banking Commission approved Citicorps application to acquire the new bank. 12 US 1841(c) defines bank to mean any institution that (1) accepts demand deposits and (2) engages in the business of making commercial loans. The banks limited activities in these two areas satisfy this test. Note: Convenience and needs new bank will increase the availability of credit/capital in South Dakota. States like South Dakota and Delaware have effectively gutted usury laws (and cornered the consumer credit market) by placing no limits on the interest rates banks can charge on loans (including credit cards). South Dakota and Delaware require that the bank not be located or operated in a way to attract customers; Delaware also requires that the out of state bank hire 200 Delaware residents. Thus Marquette has facilitated the creation of a national market for credit cards, but undermined usury laws. States could cooperate and bring back usury laws, but this is unlikely since local interests of jobs etc. predominate. Questions of whether states consider the costs of unregulated interest rates lead to questions of whether the federal government should intervene. The result in Marquette has been extended to FDIC-Insured state-chartered banks by statute Interest Rates for State-Chartered FDIC-Insured Depository Intuitions 12 USCA 1831d (1997).
In order to prevent discrimination against State-chartered insured depository institutions, including insured savings banks, or insured branches of foreign banks with respect to the interest rates, if the applicable rate prescribed in this subsection exceeds the rate such State bank or insured branch of a foreign bank would be permitted to charge in the absence of this subsection, such State bank or such insured branch of a foreign bank may, notwithstanding any State constitution or statute which is hereby preempted for the purposes of this section, . . . [charge] interest at a rate of not more than 1 per centum in excess of the discount rate on ninety-day commercial paper in effect at the Federal Reserve bank in the Federal Reserve district where such State bank or such insured branch of a foreign bank is located or at the rate allowed by the laws of the State, territory, or district where the bank is located, whichever may be greater.

Greenwood Trust v. Commonwealth of Massachusetts (1st Cir. 1992 Greenwood, a Delaware Bank, tries to charge Massachusetts customers a type of late fees prohibited under Massachusetts law); Held that the term interests in 12 USCA 1831dincludes late fees so the late fees that banks can charge are determined by the interest rate allowed by the state in which the bank is located (in this case Delaware). Supremacy Clause 12 USCA 1831d preempts state interest rate regulations to the extent that such regulations conflict with the federal statute. Although late fees may not be included in MAs definition of interest, generally words in federal statutes are defined by reference to federal law b/c (1) using state law definition may

threaten the federal policies which the statute was designed to serve; (2) desire for nationwide uniformity under a federal statute. Smiley v. Citibank (South Dakota), N.A. (USSC 1996); Ratified Greenwood, holding that a national bank could export credit card late payment fees as part of the interest rate law of state where it is located. Current OCC Interpretation 61 Fed.Reg. 4869 (to be codified in 12 CFR S 7.4001(a))

"The term 'interest' as used in 12 U.S.C. S 85 includes any payment compensating a creditor or prospective creditor for an extension of credit, making available of a line of credit, or any default or breach by a borrower of a condition upon which credit was extended. It includes, among other things, the following fees connected with credit extension or availability: numerical periodic rates, late fees, not sufficient funds (NSF) fees, overlimit fees, annual fees, cash advance fees, and membership fees. It does not ordinarily include appraisal fees, premiums and commissions . . . , fees for document preparation or notarization, or fees incurred to obtain credit reports."

Has federal ratification of interest rate exportation preempted the state law doctrine (UCC) of unconscionability? Reigle Neal Interstate Banking and Branching Efficiency Act of 1994, 12 USCA 36(f) provides that any branch of an out-of-state national bank is subject to state law with respect to consumer protection (and certain other matters) as if it were a branch of a host state bank. However state law does not apply to the extent that it has been preempted by federal law, or if the OCC determines that application of such law would have a discriminatory effect on the branch relative to host state banks. Wachovia, NA v. Burke (D. Conn. 2004 Wachovia sets up a mortgage lending subsidiary in Connecticut; State commissioner says mortgage lenders in Connecticut must be licensed by Connecticut); Held that operating subsidiaries of national banks are regulated exclusively by federal banking authority. Basically before this case it is clear that national banks have the power to power to operate through subsidiaries and make real estate loans and that they cant be visited by state regulators, but is not clear whether the operating subsidiaries which are not part of the national charter can be visited by state regulators. Controversial holding operating subsidiaries (not chartered per se) of national banks are regulated exclusively by federal banking authorities. Relevant Nation Bank Powers The Power to Make Real Estate Loans Statutory Authority in 12 U.S.C. 371(a) Implementing OCC Regulations: 12 C.F.R. 34.1 (2004) The Power to Operate Through Subsidiaries No Express Statutory Authority (but activities incidental to banking authorized under 12 U.S.C. 24 (Seventh)) Implementing Regulations for Operating Subsidiaries at 12 C.F.R. 5.34 (2004) Implementing Regulation for Real Estate Powers Specify Application to Operating Subsidiaries (12 C.F.R. 34.1 (2004)) OCC Regulation on Visitation 7.4000 General rule
(1) Only the OCC or an authorized representative of the OCC may exercise visitorial powers with respect to national banks, except as provided in paragraph (b) of this section. . . . (2) For purposes of this section, visitorial powers include: (i) Examination of a bank; (ii) Inspection of a bank's books and records;

(iii) Regulation and supervision of activities authorized or permitted pursuant to federal banking law; and (iv) Enforcing compliance with any applicable federal or state laws concerning those activities

7.4006 Applicability of State law to national bank operating subsidiaries.

Unless otherwise provided by Federal law or OCC regulation, State laws apply to national bank operating subsidiaries to the same extent that those laws apply to the parent national bank.

Applicability of state law to national bank operations. 12 C.F.R. 7.4009 (2004)

(a) Authority of national banks. A national bank may exercise all powers authorized to it under Federal law . . . (b) Applicability of state law. Except where made applicable by Federal law, state laws that obstruct, impair, or condition a national bank's ability to fully exercise its powers . . . do not apply to national banks (Barnette). (c) Applicability of state law to particular national bank activities. (1) The provisions of this section govern with respect to any national bank power or aspect of a national bank's operations that is not covered by another OCC regulation specifically addressing the applicability of state law. (2) State laws on the following subjects are not inconsistent with the powers of national banks and apply to national banks to the extent that they only incidentally affect the exercise of national bank powers:(i)Contracts; (ii)Torts; (iii) Criminal law; (iv) Rights to collect debts; (v) Acquisition and transfer of property; (vi) Taxation; (vii) Zoning; and (viii) Any other law the effect of which the OCC determines to be incidental to the exercise of national bank powers or otherwise consistent with the powers set out in paragraph (a) of this section.

Predatory lending and the operating subsidiary problem OCC wants to regulate banking issues at the national level so that rules will be uniform. But will OCC regulate enough? Some states have virtually no regulation so any thing the OCC does will be better. But some states have quite extensive regulation can comptroller step in and perform this level of regulation on a local level? Antitrust Which regulator will need to approve a bank merger/acquisition depends on the parties and the structure of the transaction. If an individual buys control of a national bank, the individual must file with the OCC for review under the CBCA. If the bank being acquired is a state chartered bank, the BBCA filing must be with the FDIC. If the individual acquiring control forms a corporation to acquire the bank, then the acquisition will be governed by the Bank Holding Company Act (BHCA) and the filing must be with the Federal Reserve. If two banks are being merged, where the surviving bank is a national bank, approval must come from the OCC under the Bank Merger Act, while if the surviving bank is a state chartered nonmember bank, approval under the Bank Merger Act must come form the FDIC. In theory, since the same antitrust standards are being applied in each case, the result should not vary among regulators. But many bank antitrust practitioners believe that results can vary, and so frequently the structuring of the transaction is an important consideration. Herfindalhl-Hirschman Index (HHI) The DOJ bank merger guidelines use the HHI index (the sum of the squares of the percentages of market share of the individual banks in the market) to calculate market concentration. The maximum HHI index is 10,000 (100% * 100%). Regulators look to both size of and change in HHI in determining whether a merger is permissible. Enlarging market makes HHI look lower. While the guidelines are not binding on federal banking agencies, the agencies must be aware of them since the DOJ can seek to enjoin any bank merger.

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In deciding bank merger cases under the antitrust laws, the courts have tended to use market share figures as the primary consideration, and have not delved into all the economic subtleties of the competitive effects of each merger case. Courts have, however considered more complex economic factors especially where the market is difficult to define. Such considerations may include barriers to entry, rapid technology change, character of competition, and trends towards concentration. These factors, however, are hard for courts to integrate and quantify, so secondary consideration generally operate only a basis for attack on a merger that looks harmless in market share terms. Basic BHC Approval Rules, 12 USC 1842(a) (1999)
It shall be unlawful, except with the prior approval of the Board, (1) for any action to be taken that causes any company to become a bank holding company; (2) for any action to be taken that causes a bank to become a subsidiary of a bank holding company; (3) for any bank holding company to acquire . . . more than 5 per centum of the voting shares of such bank; (4) for any bank holding company . . . to acquire all or substantially all of the assets of a bank; or (5) for any bank holding company to merge or consolidate with any other bank holding company. (1) The Board shall not approve- (A) any acquisition . . . which would result in a monopoly, or which would be in furtherance of any combination or conspiracy to monopolize or to attempt to monopolize the business of banking in any part of the United States, or (B) any other proposed acquisition . . . whose effect in any section of the country may be substantially to lessen competition, or to tend to create a monopoly, or which in any other manner would be in restraint o[f] trade, unless it finds that the anticompetitive effects of the proposed transaction are clearly outweighed in the public interest by the probable effect of the transaction in meeting the convenience and needs of the community to be served. (2) In every case, the Board shall take into consideration the financial and managerial resources and future prospects of the company or companies and the banks concerned, and the convenience and needs of the community to be served.

Competitive Factors under BHC, 12 USC 1842(c) (1999)

In re Society Corp. 78 Fed Res. Bull. 302 (1992); Federal Reserve Board approves the acquisition of a bank by a BHC over the objections of the DOJ. Example of how defining the market can be an issue. Need to define product market before you can define the geographic market. DOJ argues the relevant product market is commercial loans and that based on that, the geographic market is four particular counties. FRB hold that the relevant product market is a cluster of services and based on that, the geographic market is the entire Cleveland banking market. Following this opinion the DOJ filed an antitrust law suit which was settled the same day with Society agreeing to sell additional branches. Federal Reserve Board v. DOJ The Federal Reserve Board and the DOJ often reach different conclusions in defining the geographic market. The Fed, by using the cluster of services product market, sees a larger geographical area in which the cluster is offered and fairly consistent pricing exists. The DOJ focuses on how far customers are willing to travel for individual banking services, which often results in a much smaller geographical area for product competition. Both the Federal Reserve Board and the Department of Justice uses two of the same screens to identify potentially anticompetitive mergers: Post-merger HHI of 1,800 or higher Change in HHI of 200 or more

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But the Federal Reserve Board and the DOJ typically differ on both the relative product market and the weight given to thrift deposits in judging competitive effects in the relevant geographical market. The FRB typically gives thrift deposits a 50% weight, while the DOJ (believing that thrifts, restricted by law form investing more than 10% of their assets in commercial loans, do not compete with banks in the important area of commercial loans particularly to small and mid sized businesses) gives them only 20% weight. This means that the DOJ is more likely to view markets as being more concentrated. Riegle-Neal Concentration Rules, 12 USC 1842(d)(2) (1995)
(A) The Board may not approve an application [for a BHC to purchase a bank] if the applicant (including all insured depository institutions which are affiliates of the applicant) controls, or upon consummation of the acquisition for which such application is filed would control, more than 10 percent of the total amount of deposits of insured depository institutions in the United States. (B) The Board may not approve an application . . .if- "(i) immediately before the consummation of the acquisition for which such application is filed, the applicant . . . controls any insured depository institution. . . in the home State of any bank to be acquired or in any host State in which any such bank maintains a branch; and "(ii) the applicant . . . upon consummation of the acquisition, would control 30 percent or more of the total amount of deposits of insured depository institutions in any such State.

General idea - Banks can only have 10% of national market and 30% of local market. Suggests that we have heightened anti-trust concerns where banks are involved. Changes in Anti-Trust review under Gramm-Leach-Bliley Act of 1999 (see Sections 131-133 of Act; Appendices A-45-46 & B-29 to -30) Amendments to Hart-Scott-Rodino Act 15 U.S.C. 18a (2000) Specifically, the HSR Act's (c)(7) exemption, 15 U.S.C. 18a(c)(7), as amended by section 133(c)(1) of Gramm-Leach-Bliley, provides an exemption from HSR requirements for "transactions which require agency approval under . . . . section 1842 of title 12 [Section 3 of BHCA], except that a portion of a transaction is not exempt under this paragraph if such portion of the transaction (A) is subject to section 4(k) of the Bank Holding Company Act of 1956; and (B) does not require agency approval under section 3 of the Bank Holding Company Act of 1956." (Language added by section 133(c)(1) is italicized.) The HSR Act's (c)(8) exemption, 15 U.S.C. 18a(c)(8), pertaining to transactions which require agency approval under section 4 of the BHCA, is amended in a parallel fashion by section 133(c)(2) of Gramm-Leach-Bliley. Section (c)(8) of the HSR Act exempts such transactions provided that the materials filed with the agency are contemporaneously submitted to the enforcement agencies at least thirty days prior to consummation. Interests in Nonbanking Organizations Section 4 of the BHCA
(a) Except as otherwise provided in this chapter, no bank holding company shall . . . acquire direct or indirect ownership or control of any voting shares of any company which is not a bank . . . ..... (c) Exemptions . . . (8) shares of any company the activities of which had been determined by the Board by regulation or order under this paragraph as of the day before November 12, 1999, to be so closely related to banking as to be a proper incident thereto (subject to such terms and conditions contained in such regulation or order, unless modified by the Board) . . . (k) (1) In general. Notwithstanding subsection (a), a financial holding company may engage in any activity, and may acquire and retain the shares of any company engaged in any activity, that the Board, in accordance with paragraph (2), determines (by regulation or order)- (A) to be financial in nature or incidental to such financial activity; or

Activities that are Financial in Nature Section 4(k) of the BHCA (new)

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(B) is complementary to a financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally.

Required Notification for Financial Activities Section 4(k)(6) of the BHCA (new)
(A) In general A financial holding company that acquires any company or commences any activity pursuant to this subsection shall provide written notice to the Board describing the activity commenced or conducted by the company acquired not later than 30 calendar days after commencing the activity or consummating the acquisition, as the case may be. (B) Approval not required for certain financial activities Except as provided in subsection (j) with regard to the acquisition of a savings association, a financial holding company may commence any activity, or acquire any company, pursuant to paragraph (4) or any regulation prescribed or order issued under paragraph (5), without prior approval of the Board.

Reigle-Neal Interstate Authority 12 USC 1842(d)(1) (1999)


The board may approve an application by a bank holding company that is adequately capitalized and adequately managed to acquire control of . . . a bank located in a State other than the home State of such bank holding company, without regard to whether such transaction is prohibited under the law of any State.

Tie-Ins etc. Anti-Tying Rules, 12 USC 1972(1)(1995)


A bank shall not in any manner extend credit, lease or sell property of any kind, or furnish any service, or fix or vary the consideration for any of the foregoing, on the condition or requirement- (A) that the customer shall obtain some additional credit, property, or service from such bank other than a loan, discount, deposit, or trust service; (B) that the customer shall obtain some additional credit, property, or service from a bank holding company of such bank; .... The Board may by regulation or order permit such exceptions to the foregoing prohibition as it considers will not be contrary to the purposes of this chapter.

General idea banks cant condition the offering of one service on the purchase of another service. In re Fleet Financial Group, 80 Fed. Res. Bull. 1134 (1994 Fleet wished to offer its customers a Fleet One Account which included various discounts and premiums on various Fleet services to customers who maintained at least two accounts at fleet for a monthly fee of $14; Additionally, customers could avoid the $14 fee by keeping a $10,000 combined balance with fleet); Held that to the extent that 106 prohibits Fleets program, Fleet is granted an exemption. The Board has previously granted exemptions where the proposal would not have anticompetitive effects and where there were benefits to the public such as lower costs to customers on banking services. The statutory traditional bank product exception permits a bank to tie a product or service to a loan, discount, deposit, or trust service offered by that bank. Because a customer could qualify for the Fleet One Account and the discount on that account based solely on deposit balances and because Fleet will continue to offer customers all products involved in the arrangement separately and at competitive prices, there is no incentive for a customer to establish a brokerage account, or obtain any other product, that the customer does not want in order to obtain the Fleet One Account or the discount on that account. The banking markets in which Fleet operates are generally competitive and no Fleet bank appears to have sufficient power to force a customer to purchase any tied in product.

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Note that now there is a general safe harbor for combined balance accounts. It requires that bank deposits count at least as much towards the minimum balance as non-deposit products such as brokerage accounts and mutual fund holdings (protects community banks). SCFC ILC, Inc. v. Visa USA, Inc. (10th Cir. 1994 Sears, the company that issues Discover Cards, acquired the assets of a bankrupt company including its Visa license and proposed to issue Visa cards; Visa had a bylaw that prohibited this); Held that Visas bylaw denying membership to any entity issuing discover, American express or any other competing card does not violate antitrust laws because while it may hurt a competitor, it does not hurt competition. To be judged anticompetitive, joint ventures must actually or potentially harm consumers. 1 of the Sherman Act forbids agreements in restraint of trade, but the rule of reason limits that to forbidding only those agreements the anticompetitive consequences of which outweigh their legitimate business justifications. Two part test Does Visa posses market power (the ability to raise prices by restricting output)? If so, the court must then assess the procompetitive justifications of the alleged anticompetitive conduct. The court looks at the issuer market (e.g. Chase Visa, Citibank Visa etc. interbrand /intrasystem competition) as opposed to the general purpose charge card market (e.g. Visa, MasterCard, Discover etc. intersystem competition). At the issuer level, the market is remarkably unconcentrated. While Visa does have the power to make collective rules for the Visa issuers, this isnt necessarily market power. Visa claimed that the bylaw protected its property from intersystem competitors who otherwise would enjoy a free ride at this time of entry; there was testimony that after duality was permitted (the practice of an issuer issuing both Visa and MasterCard) Visa and MasterCard competed less aggressively. No evidence that bylaw effects price or output; Sears does not need Visa to compete in the issuer market; it can issue another Discover Card. Note that in 1973 the 8th Circuit had caused Visa to repeal a bylaw preventing its members from issuing MasterCards. Visa and MasterCard (dual) issuers have great incentives to assure that the two networks and their products are nearly identical. When discover first came out, it dramatically increased competition at the system level. While allowing discover issuers to issue Visa might lead to short term benefits in competition (interest rates etc.) on the issuer level, in the long run it might reduce competition at the system level.

The Business of Banking


Banks have the unique ability to acquire insured deposits at relatively low interest rates due to the backing of federal deposit insurance; demand deposits make makes unusually susceptible to runs; federal deposit insurance creates moral hazard. Two issues How do we make sure that all entities engaged in the business of banking organize themselves as banks? Once organized as banks, why and how are these organizations limited to the business of banking? Opinion of the Texas Attorney General (1995 Universities had a program like crimson cash whereby students would give the universities $ and the universities would give them a debit card with which the students could buy stuff at schools and some local stores); Held that the universities are not engaging in the business of banking.

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an entity is not necessarily a bank just because it engages in certain acts that are typical of banks; rather one must look to the activities of an entity as a whole. There was a Florida case where another university was found to have engaged in the business of banking, but the TAG says that that case is inapposite b/c there students could use their debit cards to get $ from ATMS and so the University was determined to be paying checks. It is possible that statutory provisions which broadly authorize universities to provide student services provide implied authority for the debit card programs. National Bank Powers, 12 USC 24 (1999)
A national bank shall have the power to First adopt a corporate seal Third make contracts Seventh. To exercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt . . .

Arnold Tours, Inc. v. Camp (1st Cir. 1972 MA travel agencies are suing Camp (OCC) b/c OCC
has issue a release saying that banks can operate travel agencies as an incidental power necessary to carry on the business of banking); Held that operating a travel agency is NOT necessary (meaning convenient or useful) in connection with the performance of one of the banks established activities pursuant to its expressed powers under the National Banking Act. Divestiture ordered.

The court says that necessary just means convenient or useful in connection with the performance of one of the banks established activities pursuant to its expressed powers under the National Banking Act (NOT sine qua non).

Since Arnold Tours, the USSC has taken a more permissive view towards the OCC to authorize
activities beyond those specifically enumerated in 24 Seventh: NationsBank NA v. VALIC (USSC 1995) (note 2, page 133) WE expressly hold that the business of banking is not limited to the enumerated powers in section 24 Seventh and that the Comptroller therefore has discretion to authorize activities beyond those specifically enumerated.The exercise of the Comptrollers discretion, however, must be kept within reasonable bounds. And travel agencies are not reasonable. Seems like now 24 Seventh activities dont need to be grounded in enumerated powers. Also, more deference to OCC. Other OCC rulings have said: That banks can rent space to travel agencies and have the rent they receive be dependent on travel agencys profits. That Alabama chartered banks (in Alabama statute says that banks can own travel agencies) can form a travel agency subsidiary which would then lease space a branches of national banks that were held by the same BHC as the Alabama bank. OCC Interpretive Letter No. 399 (October 29, 1987). That banks can provide (sell to) a travel tour operator with the names and addresses of bank customers would receive tour and travel information, accompanied by a cover letter from the bank introducing them to the travel program. OCC Interpretive Letter No. 339 (May 16, 1985). That national banks can provide debt cancellation contracts based on disability or unemployment of the borrower. OCC Interpretive Letter, No. 640 (January 7, 1994). Equity & National banks have also been given some significant equity investment powers 24(7) generally prohibits national banks from owning stock, except as hereinafter provided or otherwise permitted by law. They may take equity kickers in loan transactions. 12 CFR 7.10006. National Banks have the authority to buy convertible securitiessecurities that are

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convertible into stockprovided that they are not convertible at the option of the issuer. Under 15 USCA 682(b), national banks have the power to invest up to 5% of their capital and surplus in small business investment companies (SBICs these provide equity and long term loans to small businesses). Activities of state chartered banks 12 USC 1831a(a) (1999)
After [December 19, 1991], an insured State bank may not engage as principal in any type of activity is not permissible for a national bank unless The FDIC has determined that the activity would pose no significant risk to the appropriate deposit insurance fund; and The state bank is, and continues to be, in compliance with applicable capital standards prescribed by the appropriate Federal banking agency.

Lending Limits
LOB 15% of capital + 10% for 100% RMC + 35% for 115% staple Limits not continuous Collateral continuous 375b / Reg O Insiders 375a / Reg O Executives D&O, 10+% shhs Higher of $25K or Board OK, same terms 2.5%, up to $500K 371c Affiliates covered transactions 10% for each, same terms 20% for all 100-130% tiered security no low-quality assets not bank-bank or sub

Limits on loans/extensions of credit to a single borrower Summary etc To one borrower (defined using common enterprise/direct benefit rules), a national bank can lend up to 15% of its unimpaired capital + unimpaired surplus. Additionally, the bank can lend that borrower another 10% if that 10% is fully secured by marketable collateral. If the value of the collateral securing the additional 10% falls below 100% of the value of the loan, the collateral must be brought up 100% within 30 days, or the collateral must be sold. Alternatively, a bank can lend one borrower 35%, if the loan is secured by collateral that is a readily marketable staple, but that loan must be over collateralized (collateral must be worth 115% of the loan). Aggregation of loans Loans or extensions of credit to one borrower will be attributed to another person and each person will be deemed a borrower (1) when proceeds of a loan or extension of credit are to be used for the direct benefit of the other person.or (2) when an common enterprise is deemed to exist between the persons. 12 CFR 32.5(a). Extension of credit 12 USCA 84(a) (1999)

(1) The total loans and extensions of credit by a national banking association to a person outstanding at one time and not fully secured, as determined in a manner consistent with paragraph (2) of this subsection, by collateral having a market value at least equal to the amount of the loan or extension of credit shall not exceed 15 per centum of the unimpaired capital and the unimpaired surplus of the association. (2) The total loans and extensions of credit by a national banking association to a person outstanding at one time and fully secured by readily marketable collateral having a market value, as determined by reliable and continuously available price quotations, at least equal to the amount of the funds

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outstanding shall not exceed 10 per centum of the unimpaired capital and unimpaired surplus of the association. . . . .

Basically 15% unsecured limit applies to national banks can lend another 10% if that additional 10% is fully secured by readily marketable collateral Capital and Surplus 12 CFR 32.2 (1999)

(b) Capital and Surplus means - (1) A banks Tier 1 and Tier 2 capital included in the banks risk based capital under the OCCs Minimum Capital ratios in Appendix A of part 3 of this chapter [see Supp. Pp. 178-179]; plus (2) The balance of a banks allowance for loan and lease losses not included in the banks Tier 2 capital, for purposes of the calculation of risk-based capital under part 3 of this chapter. (n) Readily marketable collateral means financial instruments and bullion that are salable under ordinary market conditions with reasonable promptness at a fair market value determined by quotations based upon actual transactions on an auction or similarly available daily bid and ask price market. (k) Loans and extensions of credit means a bank's direct or indirect advance of funds to or on behalf of a borrower based on an obligation of the borrower to repay the funds or repayable from specific property pledged by or on behalf of the borrower. (1) Loans or extensions of credit for purposes of 12 U.S.C. 84 and this part include (i) A contractual commitment to advance funds, as defined in paragraph (f) of this section; .... (f) Contractual commitment to advance funds. (1) The term includes a bank's obligation to . . . (iii) Advance funds under a qualifying commitment to lend, as defined in paragraph (m) of this section, . . . (m) Qualifying commitment to lend means a legally binding written commitment to lend that, when combined with all other outstanding loans and qualifying commitments to a borrower, was within the bank's lending limit when entered into, and has not been disqualified.

Definition of Readily Marketable collateral 12 CFR 32.3(n) (2004)

Extensions of Credit

Basically activities that present risks similar to those of a loan (such as standby letters of credit and personal property leases) are included in the definition of extension of credit. But note that purchases (with no obligation of repayment by the customer) are not extensions of credit (although they may be subject to other limits). A loan participation is both a purchase and a loan. Definition of Borrower 12 C.F.R. 32.2(a) (1999)
Borrower means a person who is named as a borrower or debtor in a loan or extension of credit, or any other person, including a drawer, endorser, or guarantor, who is deemed to be a borrower under the "direct benefit" or the "common enterprise" tests set forth in s 32.5. The proceeds of a loan or extension of credit to a borrower will be deemed to be used for the direct benefit of another person and will be attributed to the other person when the proceeds, or assets purchased with the proceeds, are transferred to another person, other than in a bona fide arm's length transaction where the proceeds are used to acquire property, goods, or services. A common enterprise will be deemed to exist and loans to separate borrowers will be aggregated: (1) When the expected source of repayment for each loan or extension of credit is the same for each borrower and neither borrower has another source of income from which the loan (together with the borrower's other obligations) may be fully repaid . . ;

The Direct Benefit Rule 12 C.F.R. 32.5(b) (1999)

Common Enterprise 12 C.F.R. 32.5(b) (1999)

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(2) When loans or extensions of credit are made- (i) To borrowers who are related directly or indirectly through common control, including where one borrower is directly or indirectly controlled by another borrower; and (ii) Substantial financial interdependence exists between or among the borrowers. Substantial financial interdependence is deemed to exist when 50 percent or more of one borrower's gross receipts or gross expenditures (on an annual basis) are derived from transactions with the other borrower.

Additional Basis of Common Enterprise 12 C.F.R. 32.5(c)(4) (1999)


When the OCC determines, based upon an evaluation of the facts and circumstances of particular transactions, that a common enterprise exists.

Problem 3.6 The bank makes a $2.2 million loan commitment to Dr. J and loans $750k to Mr. H secured by test tubes. Dr. J and Mr. H decide to go into business together and Dr. J draws $1.8 million of his loan and give some of the $ to Mr. H. Its okay for a bank to make a commitment over its lending limit as long as the bank doesnt fund over its limit when the time comes. Test tubes are not marketable collateral Most people would find these facts to constitute a common enterprise of direct benefit; thus the loans would be aggregated. Del Junco v. Conover (9th Cir. 1982 Loans were made to Fame (a company), the president of Fame and the Treasurer of Fame; Bank directors admitted that they knew that the loans to Fame and Fames president were being used for the benefit of Fame; the OCC found that lending officer knew that the loan to the Treasurer was being used for the benefit of Fame and that the proceeds of the loan were deposited directly into Fames account); Held that OCC was correct to hold directors of Bank personally liable for loans made to Fame Furniture, the president of Fame Furniture and the Treasurer of Fame furniture which in aggregate exceeded the banks lending limit for a single borrower. Note remedy of personal liability for bank directors who knowingly violate lending limits. Loans to Insiders Summary etc. Loans made to executive officers, directors, or principal shareholders (10% - shared owned by immediate family are included) and to the companies or political campaign funds they control must be made on substantially the same terms and involve the same risks of repayments as loans made to other borrowers. Additionally, loans to insiders above certain amounts must be approved by a majority of the banks board of directors (with the interested party abstaining from the vote). Banks are only allowed to make aggregate loans to insiders up to 100% of the institutions capital and surplus. Banks with less than $100 million in deposits, however, may make loans to insiders in amounts up to 200% of the institutions capital and surplus. 375b(5) if the they have a CAMEL rating of 1 or 2 and the banks board adopts a resolution certifying that the higher insider lending limit is needed to avoid restricting credit or to help the bank attract directors. Solves problem that directors of small local banks are likely to be local businessmen. Executive officers can receive loans in any otherwise permissible amount for the purpose of residential mortgages or education, and in any otherwise permissible amount for any other purpose if secured by a perfected security interest in governmental obligations or bank deposit accounts. Otherwise, loans to executive officers can be made only to the higher of $25,000 or 2.5% of bank capital and surplus, but not more than $100,000. 375(a), 12 CFR 215.5.

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Seems like banks can get around the prior board approval and more strict lending limit requirements for insider loans by entering into reciprocal arrangements with another bank where by the two banks lend to each others insiders. However the limits on making loans on more favorable terms or with greater risk of repayment still apply. 12 USC 1972(2). General Prohibitions of Regulation O, 12 CFR 215.4 (1997)

(a) Terms and creditworthiness. No member bank may extend credit to any insider of the bank or insider of its affiliates unless the extension of credit: (1) Is made on substantially the same terms (including interest rates and collateral) as . . . those prevailing at the time for comparable transactions by the bank with other persons . . . ; and (2) Does not involve more than the normal risk of repayment or present other unfavorable features. (b) Prior approval. (1) No member bank may extend credit . . . to any insider [above certain amounts] unless: (i) The extension of credit has been approved in advance by a majority of the entire board of directors of that bank; and (ii) The interested party has abstained from participating directly or indirectly in the voting.

Basically requires that banks dont favor insiders (substantive requirement of


substantially similar terms as loans to other similarly situated borrowers; procedural requirement of approval by disinterested board members). Note that the people most likely to populate the boards of small banks are local business people in that case it would be hard for those banks to abstain from lending to insiders. Insiders and Related Interests 12 C.F.R. 215.2 (1999)
(h) Insider means an executive officer, director, or principal shareholder, and includes any related interest of such a person (n) Related interest of a person means: (1) A company that is controlled by that person; or (2) A political or campaign committee that is controlled by that person or the funds or services of which will benefit that person. Principal shareholder means a person (other than an insured bank) that directly or indirectly, or acting through or in concert with one or more persons, owns, controls, or has the power to vote more than 10 percent of any class of voting securities of a member bank or company. Shares owned or controlled by a member of an individual's immediate family are considered to be [owned by the person.] (1) Control of a company or bank means that a person directly or indirectly, or acting through or in concert with 1 or more persons: (i) Owns, controls, or has the power to vote 25 percent or more of any class of voting securities of the company or bank; (ii) Controls in any manner the election of a majority of the directors . . .; or (iii) Has the power to exercise a controlling influence over the management or policies of the company or bank. (2) A person is presumed to have control, including the power to exercise a controlling influence over the management or policies, of a company or bank if: (i) The person is: (A) An executive officer or director of the company or bank; and (B) Directly or indirectly [controls] more than 10 percent of any class of voting securities of the company or bank . . . .

Definition of Principal Shareholder 12 C.F.R. 215.2(e) (1999)

Definition of Control 12 C.F.R. 215.2(c) (1999)

Special Rules for Executive Officers 12 C.F.R. 215.5 (1999)

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The following restrictions on extensions of credit by a member bank to any of its executive officers apply in addition to any restrictions on extensions of credit by a member bank to insiders of itself or its affiliates set forth elsewhere in this part. The restrictions of this section apply only to executive officers of the member bank and not to executive officers of its affiliates. (a) No member bank may extend credit to any of its executive officers, and no executive officer of a member bank shall borrow from or otherwise become indebted to the bank, except in the amounts, for the purposes, and upon the conditions specified in paragraphs (c) and (d) of this section. . . .

Problem 3-8. (p 150) May banks give special discounts for all employees? yes, so long as dont give special preference on loans [215.4] May bank loan to a daughter of bank director (related interest?)? Same loan but with directors guarantee? immediate family = living together; director pre-approval for loan, same terms as for other people [215.2(g), (h), (m), (n)] May bank lease out cars via a leasing company owned by director? leases are not loans/extensions of credit, so banking law doesnt apply (but maybe fid duty problem) Affiliates Summary etc

no more than 10% lent to any one affiliate no more than 20% lent to all affiliates all loans to affiliates must be fully collateralized

Definition of affiliate: companies controlled by bank, under common control with bank or sponsored and advised by the bank (such as a REIT), and any other company that that the FRB says has such a relationship with the bank (includes Financial Subsidiaries). Section 23A Rules, 12 USCA 371c(a) (1999)
A member bank and its subsidiaries may engage in a covered transaction with an affiliate only if- (A) in the case of any affiliate, the aggregate amount of covered transactions of the member bank and its subsidiaries will not exceed 10 per centum of the capital stock and surplus of the member bank; and (B) in the case of all affiliates, the aggregate amount of covered transactions of the member bank and its subsidiaries will not exceed 20 per centum of the capital stock and surplus of the member bank. (2) For the purpose of this section, any transaction by a member bank with any person shall be deemed to be a transaction with an affiliate to the extent that the proceeds of the transaction are used for the benefit of, or transferred to, that affiliate.

Note that while 371c and 371c-1 by its terms only applies to member banks, 1828(j)(1) provides that they apply to all FDIC Insured Banks. Definition of Covered Transactions 12 USC 371c(2004)
(7) the term "covered transaction" means with respect to an affiliate of a member bank (A) a loan or extension of credit to the affiliate; (B) a purchase of or an investment in securities issued by the affiliate; (C) a purchase of assets, including assets subject to an agreement to repurchase, from the affiliate, except such purchase of real and personal property as may be specifically exempted by the Board by order or regulation; (D) the acceptance of securities issued by the affiliate as collateral security for a loan or extension of credit to any person or company; or

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(E) the issuance of a guarantee, acceptance, or letter of credit, including an endorsement or standby letter of credit, on behalf of an affiliate;

Note that this doesnt include certain ordinary course transactions (e.g. employees of sears credit corp. using their credit cards). Basically reflects concern that value will be distributed out to affiliates and the assets on the balance sheet of the depository institution wont have their apparent value. In some sense this goes hand in hand with capital requirements. Collateralization requirements, 12 USCA 371c(c) (1999)
(1) Each loan . . . issued on behalf of, an affiliate . . . shall be secured at the time of the transaction by collateral having a market value equal to- (A) 100 per centum of the amount of such loan or extension of credit, guarantee, acceptance, or letter of credit, if the collateral is [government paper]. . . (B) 110 per centum of the amount of such loan or extension of credit, guarantee, acceptance, or letter of credit if the collateral is composed of obligations of any State or political subdivision of any State; (C) 120 per centum of the amount of such loan or extension of credit, guarantee, acceptance, or letter of credit if the collateral is composed of other debt instruments, including receivables; or (D) 130 per centum of the amount of such loan or extension of credit, guarantee, acceptance, or letter of credit if the collateral is composed of stock, leases, or other real or personal property.

Basically much more strict than general rule that only requires collateralization if the bank wants to go over its lending limits. Problem 3-9 Joan owns 70% of the common stock of JM Bank and 25% of the voting common stock of FN Holding Company, which owns 100% of FN Bank. Joan serves as a director of FN Bank. Are loans from FNB to JMB subject to affiliate lending requirements? 23A applies b/c FNB and JMB are under common control (even though Joans control of FNB is once removed). However, if Joan wanted to take out a personal loan, she would only be subject to insider requirements. Many banks dont even lend to affiliates (or only make really over secured loans) b/c the collateralization requirements are so serious). Section 23B, 12 USCA 371c-1(a) (1999)
A member bank and its subsidiaries may engage in any of the transactions described in paragraph (2) only - (A) on terms and under circumstances, including credit standards, that are substantially the same, or at least as favorable to such bank or its subsidiary, as those prevailing at the time for comparable transactions with or involving other nonaffiliated companies, or (B) in the absence of comparable transaction, on terms and under circumstances, including credit standards, that in good faith would be offered to, or would apply to, nonaffiliated companies.

Loan Participation Banks can maintain the risk reduction of the 84 lending limits, while still providing sufficient funds to meet the credit needs of the customer, Banco Espanol de Credito v. Security Pacific (2nd Cir. 1992 Institutional investors who had bought loan participation interests from Security Pacific sued SP, claiming that the loan participations were securities as defined by the 1933 Act and that SP had failed to disclose material facts in violation of 12(2)); Held that, applying the Reves family resemblance test, loan participations are analogous to bank issued commercial loans and are not securities. Reves test applied: (1) motivation (extension of credit), (2) distribution (sophisticated institutions), (3) public perception (sophisticated investors had notice), and (4) other risk reduction (OCC has regulations that cover loan participation).

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Deposits
Definition of Deposit, 12 USC 1831(l) (1995)
The term deposit means (1) the unpaid balance of money or its equivalent received or held by a bank . . . in the usual course of business and for which it has given or is obligated to give credit, either conditionally or unconditionally, to a commercial, checking, savings, time, or thrift account, or which is evidenced by its certificate of deposit, . . . , or a letter of credit or a traveler's check on which the bank . . . is primarily liable: Provided, That, without limiting the generality of the term "money or its equivalent", any such account or instrument must be regarded as evidencing the receipt of the equivalent of money when credited or issued in exchange for checks or drafts or for a promissory note upon which the person obtaining any such credit or instrument is primarily or secondarily liable, or for a charge against a deposit account . . . . FDIC Insurance Under 12 USCA 1821(a) the FDIC insures up to $100,000 of deposits held in the same capacity and the same right. The critical issue is whether various deposit accounts are in different categories of legal ownership, and so are entitled to separate deposit insurance within the $100,000 limits. Generally speaking the FDIC recognizes several distinct categories of ownership: Individual Joint These are insured separately from individual accounts A testamentary trust or revocable trust An irrevocable trust Retirement and employee benefit accounts Accounts held for another such as an executor, custodian, or fiduciary Accounts held for another are typically aggregated with the accounts of that other person. Business accounts Separate coverage for each entity engaged in independent activity but divisions of one corporation are not considered to be separate. Public unit accounts

Letters of Credit Documentary Letter of Credit Buyer gets letter of credit from bank; Buyer buys goods from Seller; Seller takes letter of credit to bank and gets payment for the goods. Short term financing allows parties who dont know each other to do business together. Bank has a security interest in the goods. These are not included in the banks lending limits. Standby Letter of Credit Seller cant got to the bank until Buyer breaks whatever contract the letter of credit is securing. Bank has no security interest to back up funds it disperses. These are riskier and are therefore are subject to lending limits. FDIC v. Philadelphia Gear Corp. (USSC 1986 Penn Square Bank issued a standby letter of credit for Orion in favor of PG; Orion issued a contingent promissory note in favor of Penn Square; Penn Square went into receivership and PG demanded presented drafts on the standby letter of credit claiming it should get paid up to the limit of deposit insurance); Held that a standby letter of credit backed by a contingent promissory note is not insured as a deposit by the FDIC because it does not entrust any noncontingent assets to the bank and the FDIC says so. consistent with Congress desire to protect the hard earnings of individuals by providing for federal deposit insurance. All that PG lost when Penn Square went into receivership was the ability to use Penn Square to reduce Philadelphia Gears risk that Philadelphia Gear wouldnt get paid for goods it delivered to Orion.

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Had Orion unconditionally entrusted Penn Square with fund in connection with a standard commercial letter of credit, then PGs claim would be covered by deposit insurance. Only state and local government depositors can have secured claims Rule on Security for Deposits, 12 USC 90 (1995)
. . . Any national banking association may, upon the deposit with it of any funds by any State or political subdivision thereof or any agency or other governmental instrumentality of one or more States or political subdivisions thereof, including any officer, employee, or agent thereof in his official capacity, give security for the safekeeping and prompt payment of the funds so deposited to the same extent and of the same kind as is authorized by the law of the State in which such association is located in the case of other banking institutions in the State.

Depositors are preferred in two ways: (1) $100,000 in FDI; (2) Preference in insolvency
Depositor Preference Provision, 12 USC 1821(d)(11)(A)(1995)
Subject to [certain restrictions], amounts realized from the liquidation or other resolution of any insured depository institution . . . shall be distributed to pay claims (other than secured claims to the extent of any such security) in the following order of priority: (i) Administrative expenses of the receiver. (ii) Any deposit liability of the institution. (iii) Any other general or senior liability of the institution (which is not a liability described in clause (iv) or (v)). (iv) Any obligation subordinated to depositors or general creditors (which is not an obligation described in clause (v)). (v) Any obligation to shareholders or members arising as a result of their status shareholders or members . . . .

Property held in trust accounts is not treated as part of the estate of the failed depository institution
(e.g. not available to creditors or depositors) and trust funds awaiting investment or distribution that are deposited wit the commercial side of the bank are required to be collateralized. 12 USC 92a, 12 CFR 9.8 and 9.10(b). Rights Under Qualified Financial Products, 12 USC 1821(e)(8)(A)(2000)
Subject to paragraph (10) of this subsection and notwithstanding any other provision of this chapter (other than subsection (d)(9) of this section and section 1823(e) of this title), any other Federal law, or the law of any State, no person shall be stayed or prohibited from exercising- (i) any right to cause the termination or liquidation of any qualified financial contract with an insured depository institution which arises upon the appointment of the Corporation as receiver for such institution at any time after such appointment; (ii) any right under any security arrangement relating to any contract or agreement described in clause (i); or (iii) any right to offset or net out any termination value, payment amount, or other transfer obligation arising under or in connection with 1 or more contracts and agreements described in clause (i), including any master agreement for such contracts or agreements.

Brokered Deposits Brokered deposits was a phenomenon that developed in the 1980s when restrictions on interest rates were lifted. I-Bankers would break up clients accounts in to accounts at several banks (under $100,000) so that clients multimillion $ deposits were insured. This created problems of moral hazard since depositors/brokers didnt care about the soundness of the institutions (b/c of FDI) and banks had incentives to engage in risky activities allowing them to offer higher interest rates to attract brokered deposits. FIDC tried to say that these brokered deposits were not covered by FID, but courts said they were on the language of the statute. As a result, the FDIC put forth rules limiting who can accept brokered deposits (only well capitalized institutions) and what interest rates can be paid on them. Rule on Brokered Deposits, 12 USC 1831f (1995)

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(a) In general. Maximum amount (now $100,000) An insured depository institution that is not well capitalized may not accept funds obtained, directly or indirectly, by or through any deposit broker for deposit into 1 or more deposit accounts. . . . (c) Waiver authority. The Corporation may, on a case-by-case basis and upon application by an insured depository institution which is adequately capitalized (but not well capitalized), waive the applicability of subsection (a) of this section upon a finding that the acceptance of such deposits does not constitute an unsafe or unsound practice . . . . (e) Any insured depository institution which, under subsection (c) . . . of this section, accepts funds obtained, directly or indirectly, by or through a deposit broker, may not pay a rate of interest on such funds which, at the time that such funds are accepted, significantly exceeds- (1) the rate paid on deposits of similar maturity in such institution's normal market area for deposits accepted in the institution's normal market area; or (2) the national rate paid on deposits of comparable maturity, as established by the Corporation, for deposits accepted outside the institution's normal market area.

Restriction on Interest Rate Paid, 12 USC 1831f (1995)

Federal Deposit Insurance FDIC Options Paper (2000; p. 179) identifies three fundamental areas for review: the process for pricing risk, funding insurance losses and setting coverage limits. FDIC Improvements Act of 1991 reforms: Prompt corrective action (allowing regulators to shut down banks not in compliance with capital regulations) Least cost resolutions Scaling back of too big to fail Introduction of risk based premiums Mandate to maintain adequate insurance funds Attachment C Overview of Risk Based Premium 2 Systems Capital Groups Well C Adequately C Under C Subgroups A-C largely based on CAMEL Ratings (1-5) Why 2 systems? CAMEL system discourages banks from engaging in risky activity by charging institutions who do higher premium. Continuing problems Continued existence of two separate funds Pricing system that creates inappropriate incentives and raises fairness issues. In 1999 only 7%of all banks paid premiums into the deposit insurance funds. Despite the uniform assessment ratings given to these 1A institutions, they do not all present uniform risks to the deposit insurance funds. Most banks and thrifts established since the recapitalization of the insurance funds have never paid for deposit insurance. Similarly, institutions that are rated 1A can grow their insured deposits without paying assessments. In a deteriorating financial environment, it will be necessary to raise assessment rates earlier or by a greater amount to make up for the dilution of the reserve ratio attributable to unfounded insured-deposit growth. Banks are forced to pay insurance premiums when they can least afford them. Because of current restrictions on pricing deposit insurance, most banks pay no insurance premiums

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when they are doing well, but pay high premiums when the industry is weak and banks are failing. Uncertainty for depositors as to the real value of FDIC coverage. Real value of $100,000 limit has eroded since its inception. How should losses be funded? Capped pre-payment This is what we have. Problem is that in a large crisis, funds will need more $ and banks will have to pay at a time when it will be hard for them to pay. Unlimited pre-payment Prior system Seems safer Mutual approach Dont pay anything but institution guarantee each other Post-funding Used in insurance industry nothing up front, but when there is a failure, the regulator goes to all the companies and asks for payment. Problem in a huge systematic crisis, it might be hard for banks to pay. Creates incentives for members in the industry to watch each other b/c bad behavior of others will come back to haunt them. May work better for state based insurance system where hits will be larger relative to the size/number of players. If the FDIC decides that a bank is too big to fail it can ask the presidents permission to bail it out. Note that this would result in a huge bill that would have to be funded post bail out.

Capital Adequacy
FDIC v. Bank of Coushatta (5th Cir. 1991 FDIC issued a capital directive for bank that had failed
to comply with forbearance plan; Bank failed to comply and FDIC obtained an ex parte order from the district court enforcing the capital directive; Bank appealed to 5th Cir. and claimed that the ex parte order violated its 5th Amendment Due Process Rights): Held that the FDICs decision to issue capital directives is not subject to judicial review because issuing capital directives is committed to agency (here FDIC) discretion by law; also the procedures, which do not involve a hearing before a neutral officer but do allow notice and ample opportunity to respond before a directive issues, do not violate the 5th Amendment under the Mathews test. 12 USCA 3903 required federal bank regulators to establish minimum levels of capital for banks and bank holding companies and empowers them to issue capital directives to individual banks. Administrative Procedures Act provides that Agency actions are subject to judicial review except when: Statutes preclude judicial review; or Agency action is committed to agency discretion by law. This occurs when the statute is draw so that a court would have no meaningful standard against which to judge the agencys exercise of discretion. In such a case, the statute can be taken to have committed the decision making to the agencys judgment absolutely. Demonstrates that the capital directive is a virtually unchecked regulatory tool. Note that this case arose before the current capital definitions and ratios were developed. United States v. Winstar (USSC 1996); Held that the agencies cannot constrain future acts of congress by contract, therefore the unmistakeability doctrine does not apply; US is liable to Winstar for breach of contract.

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Facts In the 1980s, thrifts were failing. To encourage well run and stable thrifts to acquire failing thrifts the Federal Home Loan Bank Board made agreements with the good thrifts that they could recognize supervisory good will towards their reserve requirements (an accounting forbearance) if they acquired one of these bad thrifts. In this environment, Winstar entered into an agreement with FSLIC where by it would acquire Windom Federal Savings and Loan and recognize supervisory good will as a capital asset which it would amortize over 35 years. In 1989 Congress enacted FIRREA which, among other things, eliminating accounting forbearances, set higher capital requirements and specifically excluded intangible assets such as good will from its definition of core capital. Unmistakability Doctrine: Contracts that limit the governments future exercise of regulatory authority are strongly disfavored and shall be recognized only rarely, and then only when the limitation on future regulatory authority is expressed in unmistakable terms. Doesnt apply here Federal agency contracts cant constrain future acts of congress, but government can be required to pay damages if future acts of congress make performance of contract between government impossible. Bank Board and FSLIC had authority to promise to permit respondents to count supervisory goodwill and capital credits towards regulatory capital and must pay respondents damages if that performance became impossible. Strange result? Contract doesnt bind congress, but binds govt to pay huge damages for the loss (10 or 20 billion $) resulting from change in law. Question of how to measure damages should s get lost proftis? FHLBB had the power to make deals, but not to spend $10-$20 billion. But b/c of the deal, congress had to spend $10-$20 billion when it changed the law. Higher capital requirements were not a risk. Had congress just said that goodwill should have a 150% risk rating, the court would have probably interpreted the contract as no giving rise to damages more minor. Capital deduction basically voids the contract. Generally Capital regulation received increasing attention over the last 15 years; maybe because of erosion of traditional restriction (e.g. activity restrictions). Prompt corrective action rules allow regulators to shut down banks that are not in compliance with these objective standards. In the late 1930s the banking regulators began to use a capital to asset (as opposed to capital to deposit) test. The change reflected the reality that banks sustained losses on their assets rather than on their deposits. Capital Ratios Leverage Requirement: Core (Tier 1) Capital greater than or equal to 3-5% of total assets Banks with a CAMEL rating of 1, must have a minimum leverage ratio of 3%. Banks with a rating of less than 1 must have 4-5% and perhaps more for banks with the worst ratings. The majority of banks must have 4-5%. Risk-based Requirement #1: Tier 1 capital greater than or equal to 4% of risk-weighted assets Risk-based Requirement #2: Total Tier 1 and Tier 2 greater than 8% of risk-weighted assets Definitions and Risk Weightings Minimum Capital Ratios, 12 C.F.R. 3.6 (2000)

(a) Risk-based capital ratio. All national banks must have and maintain the minimum risk-based capital ratio as set forth in appendix A (and, for certain banks, in appendix B). (b) Total assets leverage ratio. All national banks must have and maintain Tier 1 capital in an amount equal to at least 3.0 percent of adjusted total assets.

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(c) Additional leverage ratio requirement . . . .

Note that currently some banks have a different calculation for risk ratios than the one described here. Tier One Capital, 12 C.F.R. 3 App. A (1998)
A national bank's qualifying capital base consists of two types of capital-- core (Tier 1) and supplementary (Tier 2). (a) Tier 1 Capital. The following elements comprise a national bank's Tier 1 capital: (1) Common stockholders' equity; (2) Noncumulative perpetual preferred stock and related surplus; and (3) Minority interests in the equity accounts of consolidated subsidiaries. (b) The following elements comprise a national bank's Tier (1) Allowance for loan and lease losses, up to a maximum of 1.25% of risk- weighted assets, . . . subject to the transition rules . (2) Cumulative perpetual preferred stock, long-term preferred stock, convertible preferred stock, and any related surplus, without limit, if the issuing national bank has the option to defer payment of dividends on these instruments . . . . (3) Hybrid capital instruments, without limit. . . . . (4) Term subordinated debt instruments, and intermediate-term preferred stock and related surplus are included in Tier 2 capital, but only to a maximum of 50% of Tier 1 capital . . .

Tier Two Capital, 12 C.F.R. 3 App. A (1995)

Risk-Weightings of On-Balance Sheet Assets, 12 C.F.R. 3 Appendix A, Section 3(a) (2004) (1) 0% risk weight.

(i) Cash, including domestic and foreign currency owned and held in all offices of a national bank
or in transit. Any foreign currency held by a national bank should be converted into U.S. dollar equivalents. (ii) Deposit reserves and other balances at Federal Reserve Banks. (iii) Securities issued by, and other direct claims on, the United States Government or its agencies, or the central government of an OECD country. (iv) That portion of assets directly and unconditionally guaranteed by the United States Government or its agencies, or the central government of an OECD country. [FN9] (For the treatment of privately-issued mortgage-backed securities where the underlying pool is comprised solely of mortgage-related securities issued by GNMA, see infra note 10.) (v) That portion of local currency claims on or unconditionally guaranteed by central governments of non-OECD countries, to the extent the bank has local currency liabilities in that country. . . . (vi) Gold bullion held in the bank's own vaults or in another bank's vaults on an allocated basis, to the extent it is backed by gold bullion liabilities. (vii) The book value of paid-in Federal Reserve Bank stock. (viii) That portion of assets and off-balance sheet transactions . . .collateralized by cash or securities issued or directly and unconditionally guaranteed by the United States Government or its agencies, or the central government of an OECD country

(2) 20% risk weight.

(i) All claims on depository institutions incorporated in an OECD country, and all assets backed
by the full faith and credit of depository institutions incorporated in an OECD country. This includes the credit equivalent amount of participations in commitments and standby letters of credit sold to other depository institutions incorporated in an OECD country, but only if the originating bank remains liable to the customer or beneficiary for the full amount of the commitment or standby letter of credit. Also included in this category are the credit equivalent amounts of risk participations in bankers' acceptances conveyed to other depository institutions incorporated in an OECD country. However, bank-issued securities that qualify as capital of the issuing bank are not included in this risk category, but are assigned to the 100% risk category of section 3(a)(4) of this appendix A.

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(ii) Claims on, or guaranteed by depository institutions, other than the central bank, incorporated

in a non-OECD country, with a residual maturity of one year or less. (iii) Cash items in the process of collection. (iv) That portion of assets collateralized by cash or by securities issued or directly and unconditionally guaranteed by the United States Government or its agencies, or the central government of an OECD country, that does not qualify for the zero percent riskweight category. . . (ix) Claims representing general obligations of any public-sector entity in an OECD country, and that portion of any claims guaranteed by any such public-sector entity. In the U.S., these obligations must meet the requirements of 12 CFR 1.2(b). [e.g. municipal securities].

(3) 50% risk weight.

(i) Revenue obligations of any public-sector entity in an OECD country for which the underlying
obligor is the public-sector entity, but which are repayable solely from the revenues generated by the project financed through the issuance of the obligations. (ii) The credit equivalent amount of derivative contracts, calculated in accordance with section 3(b)(5) of this Appendix A, that do not qualify for inclusion in a lower risk category. (iii) Loans secured by first mortgages on one-to-four family residential properties, either owneroccupied or rented, provided that such loans are not otherwise 90 days or more past due, or on nonaccrual or restructured. It is presumed that such loans will meet prudent underwriting standards. If a bank holds a first lien and junior lien on a one-to-four family residential property and no other party holds an intervening lien, the transaction is treated as a single loan secured by a first lien for the purposes of both determining the loan-to-value ratio and assigning a risk weight to the transaction. Furthermore, residential property loans made for the purpose of construction financing are assigned to the 100% risk category of section 3(a)(4) of this appendix A; however, these loans may be included in the 50% risk category of this section 3(a)(3) of this appendix A if they are subject to a legally binding sales contract and satisfy the requirements of section 3(a)(3) (iv) of this appendix A. (iv) Loans to residential real estate builders for one-to-four family residential property construction, if the bank obtains sufficient documentation demonstrating that the buyer of the home intends to purchase the home (i.e., a legally binding written sales contract) and has the ability to obtain a mortgage loan sufficient to purchase the home (i.e., a firm written commitment for permanent financing of the home upon completion), subject to the following additional criteria: . . . (4) 100% risk weight. All other assets not specified above, . . .including: (i) Claims on or guaranteed by depository institutions incorporated in a non- OECD country, as well as claims on the central bank of a non-OECD country, with a residual maturity exceeding one year. (ii) All non-local currency claims on non-OECD central governments, as well as local currency claims on non-OECD central governments that are not included in section 3(a)(1)(v) of this appendix A.<Text of subsection (a)(4)(iii) effective until Sept. 30, 2004.> (iii) Any classes of a mortgage-backed security that can absorb more than their pro rata share of the principal loss without the whole issue being in default, e.g., subordinated classes or residual interests, regardless of the issuer or guarantor.

Full Leverage Requirements, 12 CFR 3.6 (2000)


(b) Total assets leverage ratio. All national banks must have and maintain Tier 1 capital in an amount equal to at least 3.0 percent of adjusted total assets. (c) Additional leverage ratio requirement. An institution operating at or near the level in paragraph (b) of this section should have well-diversified risks, including no undue interest rate risk exposure; excellent control systems; good earnings; high asset quality; high liquidity; and well managed on-and off-balance sheet activities; and in general be considered a strong banking organization, rated composite 1 under the Uniform Financial Institutions Rating System (CAMELS) rating system of banks. For all but the most highly-rated banks meeting the conditions

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set forth in this paragraph (c), the minimum Tier 1 leverage ratio is 4 percent. In all cases, banking institutions should hold capital commensurate with the level and nature of all risks.

Definition of adjusted total assets


(a) Adjusted total assets means the average total assets figure required to be computed for and stated in a bank's most recent quarterly Consolidated Report of Condition and Income (Call Report) minus end-of-quarter intangible assets, deferred tax assets, and credit-enhancing interestonly strips, that are deducted from Tier 1 capital, and minus nonfinancial equity investments for which a Tier 1 capital deduction is required pursuant to section 2(c)(5) of appendix A of this part 3. The OCC reserves the right to require a bank to compute and maintain its capital ratios on the basis of actual, rather than average, total assets when necessary to carry out the purposes of this part. 12 C.F.R 3.2 (2004) (definitions).

Note that the leverage test is based on a calculation of total assets look at the call report. Doesnt include most off balance sheet transactions. Subtract intangible assets that are deducted from tier 1 capital. Activities of State-Chartered Banks, 12 U.S.C. 1831d(a) (1999)
After [Dec. 19, 1991], an insured State bank may not engage as principal in any type of activity that is not permissible for a national bank unless- (1) the Corporation has determined that the activity would pose no significant risk to the appropriate deposit insurance fund; and (2) the State bank is, and continues to be, in compliance with applicable capital standards prescribed by the appropriate Federal banking agency.

Special Rules for big banks (1996 Basel Adjustments) with large trading positions
Minimum Capital Ratios, 12 C.F.R. 3.6 (2000)
(a) Risk-based capital ratio. All national banks must have and maintain the minimum risk-based capital ratio as set forth in appendix A (and, for certain banks, in appendix B). (b) Total assets leverage ratio. All national banks must have and maintain Tier 1 capital in an amount equal to at least 3.0 percent of adjusted total assets. (c) Additional leverage ratio requirement . . . . (a) Purpose. The purpose of this appendix is to ensure that banks with significant exposure to market risk maintain adequate capital to support that exposure. [FN1] This appendix supplements and adjusts the risk-based capital ratio calculations under appendix A of this part with respect to those banks. [FN1] This appendix is based on a framework developed jointly by supervisory authorities from the countries represented on the Basle Committee on Banking Supervision and endorsed by the Group of Ten Central Bank Governors. The framework is described in a Basle Committee paper entitled "Amendment to the Capital Accord to Incorporate Market Risk," January 1996. (b) Applicability. (1) This appendix applies to any national bank whose trading activity (on a worldwide consolidated basis) equals: (i) 10 percent or more of total assets; or (ii) $1 billion or more. (2) The OCC may apply this appendix to any national bank if the OCC deems it necessary or appropriate for safe and sound banking practices. (3) The OCC may exclude a national bank otherwise meeting the criteria of paragraph (b)(1) of this section from coverage under this appendix if it determines the bank meets such criteria as a consequence of accounting, operational, or similar considerations, and the OCC deems it consistent with safe and sound banking practices. (c) Scope. The capital requirements of this appendix support market risk associated with a bank's covered positions.

Market Risk Adjustment, Section One of Appendix B to Part 3 (2000)

Market Risk Adjustment Cont., Section One of Appendix B to Part 3 (2000)

Banks that are not well capitalized are restricted in their activities Capital Category Rules, 12 USC 1831o (1999)

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(A) Well capitalized: An insured depository institution is "well capitalized" if it significantly exceeds the required minimum level for each relevant capital measure. (B) Adequately capitalized: An . . . institution is "adequately capitalized" if it meets the required minimum level for each relevant (C) Undercapitalized: An . . . institution is "undercapitalized" if it fails to meet [any] required minimum level . . . (D) Significantly undercapitalized: An . . . institution is "significantly undercapitalized" if it is significantly below [any] required minimum (E) Critically undercapitalized: An . . . institution is "critically undercapitalized" if it fails to meet any level specified under subsection (c)(3)(A) of this section. (a) In general. An insured depository institution that is not well capitalized may not accept funds obtained, directly or indirectly, by or through any deposit broker for deposit into 1 or more deposit accounts. . . . (c) Waiver authority. The Corporation may, on a case-bycase basis and upon application by an insured depository institution which is adequately capitalized (but not well capitalized), waive the applicability of subsection (a) of this section upon a finding that the acceptance of such deposits does not constitute an unsafe or unsound practice . . . . (k) (1) In general. Notwithstanding subsection (a), a financial holding company may engage in any activity, and may acquire and retain the shares of any company engaged in any activity, that the Board, in accordance with paragraph (2), determines (by regulation or order)- (A) to be financial in nature or incidental to such financial activity; or (B) is complementary to a financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally.

Rule on Brokered Deposits, 12 U.S.C. 1831f (1995)

Activities that are Financial in Nature, Section 4(k) of the BHCA (new)

Conditions for Engaging in Expanded Financial Activities, Section 4(l) of the BHCA as amended by GLB Act

(1) IN GENERAL.--Notwithstanding subsection (k), (n), or (o), a bank holding company may not engage in any activity, or directly or indirectly acquire or retain shares of any company engaged in any activity, under subsection (k), (n), or (o), other than activities permissible for any bank holding company under subsection (c)(8), unless- (A) all of the depository institution subsidiaries of the bank holding company are well capitalized; (B) all of the depository institution subsidiaries of the bank holding company are well managed; and (C) the bank holding company has filed with the Board- (i) a declaration that the company elects to be a financial holding company to engage in activities or acquire and retain shares of a company that were not permissible for a bank holding company to engage in or acquire before the enactment of the Gramm-Leach-Bliley Act; and (ii) a certification that the company meets the requirements of subparagraphs (A) and (B). (1) Monitoring required (2) Capital restoration plan required (3) Asset growth restricted (4) Prior approval required for acquisitions, branching, and new lines of business (5) Discretionary safeguards The appropriate Federal banking agency may, with respect to any undercapitalized insured depository institution, take actions described in any subparagraph of subsection (f)(2) of this section if the agency determines that those actions are necessary to carry out the purpose of this section. (1) This subsection shall apply with respect to any insured depository institution that--

PCA Provisions for Undercapitalized Institutions, 12 U.S.C.A. 1831o(e)(1) (1999)


PCA Procedures for Significantly Undercapitalized Institutions, 12 U.S.C.A. 131(o)(f) (1999)

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(A) is significantly undercapitalized; or (B) is undercapitalized and- (i) fails to submit an acceptable capital restoration plan . . . or (ii) fails in any material respect to implement a plan . . . (2) Specific actions authorized (A) Requiring recapitalization; (B) Restricting transactions with affiliates; (C) Restricting interest rates paid; (D) Restricting asset growth; (E) Restricting activities; (F) Improving management; (G) Prohibiting deposits from correspondent banks;(H) Requiring prior approval for capital distributions by bank holding company; (I) Requiring divestitures ... . The appropriate Federal banking agency shall, not later than 90 days after an insured depository institution becomes critically undercapitalized- (i) appoint a receiver (or, with the concurrence of the Corporation, a conservator) for the institution; or (ii) take such other action as the agency determines, with the concurrence of the Corporation, would better achieve the purpose of this section, after documenting why the action would better achieve that purpose.

Rules for Critically Undercapitalized Institutions, 12 U.S.C.A. 1831o(h)(3) (1999)

What can banks do to improve the capitalization? Sell loan participations Go out and raise capital (sell stock) Sell loans pay off deposits shrink down in size What if the bank were to sell loans on a recourse basis? Loans sold on recourse bases dont count as being sold Sell with limited commitment to take 25% back? Still wouldnt work but maybe with 5% it would. Sale of loans with standard reps and warranties maybe okay even though the bank does retain some liability. Alternative Approaches to Capital Standards Historical Approaches Ad hoc capital levels pre-1983 1983: ILSA Rules (6% - Bank of Coushatta) 1988: Basel Accords (8% risk-weighted; Problems 3-20, 3-21) 1991: FDICIA/PCA (10% risk-weighted: well-capitalized) enshrined risk capital rules; linked capital to commands from congress to regulators on how to deal with problem institutions to be well capitalized today means higher capital: 10% risk-weighted and being well capitalized means you get lots of benefits 1999: Basel Reform Proposal Basel II Proposed Reform of the Basel Accord (see www.bis.org) for details) What are the Reforms proposed in 1999? 1) move away from current system (specific categories tied to easily observable characteristics of loans) to privatized system where credit rating agencies will provide info to determine capital 2) use bank models for capturing the various types of risk (an interesting way to regulate: ask the regulated entities what they think); force banks to create a generally accepted model of how risky their balance sheet is, force them to test model against reality and tweak it why: capture more risk than current model, and reduce perverse effects New Credit classifications:

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More grades risk for commercial loans 20% for highly rated borrowers 100% for medium rated borrowers 150% for low-rated borrowers 100% for unrated borrowers Similar rules for sovereign risk Allowance for internal Rating Systems? More distinctions based on internal information, or Internal models akin to market risk models (This was chosen) Critiques of Basel II System may be more accurate, but still not right. Doesnt deal with portfolio risk (only risk from individual assets and off balance sheet stuff). Use of private rating companies to rate borrowers maybe problematic. Rating agencies have been criticized for not reacting fast enough and catering to companies (who pay to be rated). Now they could start to cater towards banks b/c banks will pressure rating agencies to rate their borrowers favorably. New more lenient agencies may crop up. May need accreditation process for rating agencies. SEC does have some sort of process for this. Privatization of a regulatory function does that make sense? Law already uses them e.g. qualification for certain trusts relies on these private ratings. Disadvantages banks/borrowers in countries w/ less developed credit rating industry. Unrated get lower risk rated than low rated doesnt necessarily make sense. Many countries may have very few rated borrowers wont really help developing country banks. Wisdom of reliance on internal model? Appropriateness of a Multi-Tier System? 3 Categories Credit Standard Internal Market Risk Operational Risk risks not associated with credit or market risk. E.g. employee unilaterally bets the portfolio on Singapore. Standard Advanced management approach This system is complex. May benefit large sophisticated bank, but small banks will be stuck with standardized approach (as opposed to internal or AMA). How does this effect competitive equality? These standards were largely developed by developed countries (US, Europe, Japan). Basel II Implementations Basel II Proposal US Position Majority of Banks Credit Risk: More elaborate categories using Retain Basel I credit risk ratings. Operational Risk: Standardized approach based on gross income.

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Sophisticated international Banks

Credit Risk: Internal ratings approaches with Specific advanced approached back testing. required for certain banks (about Operational Risk: Advanced management 10) and permitted for others with approach applied at group level and allocated appropriate infrastructure (about to subsidiaries. 10). Controversial seen as US unilateralism. May be technically in compliance with Basel b/c Basel Accords applies to international banks, and those banks will be in compliance. Concerns Foreign banks using basic system in home country may be required to use advanced approach in US. May need to set up really expensive model for US branch. Operational risk can be calculated on a group-wide basis FED has said that this may leave too little operational risk capital allocated to US branch, so US will require individual calculation. Alternative Approach: Shadow committee report (March 2, 2000) Mark to Market accounting Conversion of book values Some intangible assets included Off-balance sheet conversions Higher leverage requirement (10%) No risk ratings risk ratings are not necessarily reflective of true risk; allow banks to game the system, while not necessarily reducing risk (e.g. by loaning $ to risky banks). No distinction between tier 1 and tier 2 capital artificial distinction. Mandatory subordinate debt Characteristics Minimum term of one year If debt isnt readily traded, must re-issue periodically Banks wont love the idea of being forced to access the capital market every 6 months or so. Subordinate to other debt and deposits FDIC cant bail it out Issued in large denominations (like over $100,000) Basically uses the market; Basel II use credit rating agencies Benefits B/c mandatory subordinated debt is not backed up with FDIC insurance, investors will have incentive to monitor. Banks who disclose less will have to pay more for their subordinate debt (encourage disclosure). Banks who make risky investments will have to pay more for their subordinate debt. Puts pressure on regulators to act visible standard for when banks are getting more risky (interest rates on bonds go up). Criticisms How good is the market at detecting bank problems? Bank examiners have special information from their periodic examinations. For publicly traded banks, couldnt regulators get the same information from just watching the equity market. Shadow committee argues that subordinated debt is better Cheaper to issue

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Subordinated debt holders have incentives aligned with regulators if bank starts to go down downside risk of loss; no possibility of up-side gain from potentially profitable risky investments. NB: this is pretty radical. Basically the debate is between Basel I and Basel II. No serious move to implement this. Consolidated Capital Requirements for Financial Conglomerates (Jacksons article) Application of capital standards to holding companies. When a company has a controlling interest in a bank, it is going to be subject to the BHCA. After GHB, financial holding companies can hold insurance companies, depository institutions, and securities firms all at once. These subsidiaries are all subject to their own system of regulation. What do you do when you have a holding company sitting on top of more than one type of company subject to HC regulation? Functional regulation e.g. securities firms affiliates are regulated by the SEC, Insurance Company Affiliates are regulated by state insurance agencies. But what about affiliates that dont fit into one category or anther? Streamlining Provisions (Fed Lite) Self-Declaration of Qualified FHC Status Ex Post Review versus Ex Ante Approval Prior Approval Not Required for Most Activities Streamlined Anti-Trust Review (sort of) Exceptions for: Approval of New Activities (Financial in Nature) Acquisitions of Banks Complementary Activities Reasons for Change Reduction of Concern Over Risks from HC Affiliations Accommodation of Other Sectors of the Industry Fed will look at unregulated affiliates and depository institutions, but not at other regulated subsidiaries (e.g. insurance companies and securities firms) which have their own regulators. Traditional solution for thinly capitalized financial institutions Depository institutions Bank capital rules Basel Insurance companies Insurance capital rules Complicated b/c factors that determine risk are complicated. Hard to incorporate into unitary capital requirement for all financial institutions. Securities firms Broker-Dealer Capital Rules Unregulated affiliate Talk of moving capital requirements to HC level Concern that not regulating capital at the HC level will lead HCs to move their risky activities to their unregulated affiliates as much as possible. Problem capital rules for various companies are very different; which rule do you apply? Some say that we should just have a composite capital requirement for HC (add up capital requirements for various subsidiaries). But what about the unregulated affiliate?

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Maybe this is overkill this structure allows for diversification and diversification is supposed to reduce risk. Perhaps the additive approach to capital is overkill. But maybe the HC structure is more risky if securities firm gets in to trouble, reputation concerns may cause runs on all the financial subsidiaries. Also, the larger the institution (e.g. Citicorp) the larger the cost to society of failure. Maybe not just an additive capital requirement, but an additional capital surcharge once the HC (and its subsidiaries) reach a certain size. Basel II suggests that we stop the capital regulation of HCs at the financial HC level (e.g. if auto manufacturing company owns a FHC, dont create capital requirements for auto manufacturer). Hard to do HC capital regulation now that HCs dont just hold banks and entities related to banking. Aberration from general corporate rule of limited liability when in HC context, depository institution subsidiary fails, can it call on the assets of the securities firm subsidiary? Conglomerates dont like this. Insurance regulators dont like the idea that a bank regulator might be able to grab resources that the insurance regulator was planning to have made available to it.

Community Reinvestment Act


Community Reinvestment Act, 12 USC 2901
(a) The Congress finds that - (1) regulated financial institutions are required by law to demonstrate that their deposit facilities serve the convenience and needs of the communities in which they are chartered to do business. (2) the convenience and needs of communities include the need for credit services as well as deposit services; and (3) regulated financial institutions have continuing and affirmative obligation to help meet the credit needs of the local communities in which they are chartered.

Basically a gloss on convenience and needs that looks at service of the credit needs of the community and (as opposed to looking at whether the market can support more banks) does NOT got to safety and soundness. The CRA by its terms does not seem to apply to race and gender; rather it is based largely on geography (anti-redlining) and individual economic status. CRA continued 12 USC 2903

(a) In connection with its examination of a financial institution, the appropriate Federal financial supervisory agency shall - (1) assess the institutions record of meeting the credit needs of its entire community, including lowand moderate-income neighborhoods, consistent with safe and sound operation of such institutions; and .(2) take such record into account in its evaluation of an application for a deposit facility by such institution. NB: This is the only penalty for non-compliance (hard to acquire new banks); only applies to depository institutions.

Conditions for Engaging in Expanded Financial Activities Continued Section 4(l) of the BHCA as
amended by the GLB Act
(2) CRA Requirement Notwithstanding subsection (k) or (n) of the sectionthe appropriate Federal banking agency shall prohibit a financial holding company or any insured depository institution from (A) commencing any new activity under subsection (k) or (n) of this section.; (B) directly or indirectly acquiring control of a company engaged in any activity under subsection (k) or (n) of this section;

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if any insured depository institution subsidiary of such financial holding company, or the insured depository institution or any of its insured depository institution affiliates, has received in its most recent examination under the Community Reinvestment Act of 1977, a rating of less than satisfactory record of meeting community credit needs.

Tests Three prong test to determine CRA rating for most banks Lending test (mortgages, small business, small farm and consumer loans) Most important test b/c banks must receive at least low satisfactory under that test before it can receive an overall rating of satisfactory or higher. Service test (accessibility) Investment test (responsiveness to credit an community development needs). Streamlined tests for wholesale banks, small banks (less than $250 million in assets) Pre-approved strategic plans. One way to look at it is you have an obligation to give something back to the community from which you take deposits. This expectation doesnt exist with respect to securities firms e.g. fidelity holds your IRA but you dont expect it to give back the community (and CRA doesnt apply). But note that securities firms do not have a history of redlining. Enforcement Periodic examination in which CRA rating is assigned Public disclosure of CRA ratings Periodic enforcement in the form of denial of applications for expansion So basically banks can avoid compliance by not expanding. Factors to Consider Under BHC in approving their acquisition of new banks
(1) The Board shall not approve [in an application to purchase a bank under section 3 of the BHCA]- (A) any acquisition . . . which would result in a monopoly, or which would be in furtherance of any combination or conspiracy to monopolize or to attempt to monopolize the business of banking in any part of the United States. . . (2) In every case, the Board shall take into consideration the financial and managerial resources and future prospects of the company or companies and the banks concerned, and the convenience and needs of the community to be served

In re Gore-Bronson Bancorp, 78 Fed. Res. Bull. (1992 - BHC is applying to acquire a new bank.
Fed looks at the CRA rating of the depository institutions that the BHC controls and finds that they are below satisfactory. BHC says it has a plan in place to make CRA ratings better); Fed says that thats not good enough. When looking at an institutions application for expansion of facilities, in terms of CRA, future plans should only be taken into account where the applying institution has an otherwise satisfactory CRA rating, the problems with the CRA dont indicate conic institutional deficiencies or a pattern of CRA deficiencies, and the applicant takes immediate and effective action to address identified deficiencies in the CRA performance of its banks. NB that these are tinny banks and the Fed came down HARD on them. If there were problems with Fleet/BOA, there would be likely big commitments for the future and the expansion would be approved. Studies of Lending Discrimination (Evans & Segal. Pp. 218 Redlining Studies of Neighborhoods (Atlanta Study): Evidence of differences in lending levels But problems with Unit of observation (e.g. banks might only redline 1 block, so looking at the neighborhood as a whole would not show redlining; also, if only 2 banks redline, looking at all the banks that serve the community together wont show redlining).

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Omitted variables (e.g. variables correlated with location or race). Lack of demand side controls Accept/Reject Studies (Munnell study of Boston) Evidence that race is a significant factor in rejection rates Effect reduced, but generally survives refinement of data But omitted variable problems and problems with informal screening (e.g. before official process from which a rejection could result starts there is some screening potential applicants. Maybe sophisticated but unqualified applicants never got to the point where they could be rejected, where as unsophisticated unqualified applicants did. Default studies Redlining Studies of Neighborhoods (Atlanta study): Evidence of Differences in Lending Levels But: Problems with unit of observation & omitted variables & lack of demand side controls Accept/Reject Studies (Munnell study of Boston) Evidence that race is a significance factor in rejection rates Effect reduced, but generally survives refinement of data But: omitted variable problems & informal screening Default Studies (Becker): Absence of evidence of lower default rates in targeted groups But: Discrimination in foreclosure possible, and technical problems Overall Performance Studies (In progress) What if studies suggest CRA detracts from overall performance? What if studies suggest CRA improves overall performance? Findings (effect of CRA) Aggregate Mortgage lending was up in 1990s, but growth was consistent with underlying economic factors. Composition of lending does appear to have changed somewhat in favor of lower-income borrowers and minority groups. Unclear whether CRA caused these changes. Implications of CRA Evidence (ambiguous) of benefits fro CRA Effective in light of costs? Alternative approaches

Financial Privacy and Other Consumer Protections


Complaint in Hatch v. US Bank National Association (complaint from Attorney General of
Minnesota 1999) US Bank National Association would sell its customers private information (including SS#s, credit card numbers, occupation, bankruptcy score, average account balance etc.) to MemberWorks. MemberWorks would then call the customers and try to sell them stuff (in this case dental insurance); MemberWorks would call people up and tell them that they needed to sign up for the service before they could be sent information, but then they could cancel before 30 days and not be billed (otherwise they would be billed either on their credit card or through direct debit from their account). Attorney General claimed

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Violation of Electronic Funds Transfer Act (need prior written authorization for debt from bank here just oral authorization was used). Consumer Fraud US Bank said that it would keep its customers info private and just share with affiliates. MemberWorks was not an affiliate. Violation of Fair Credit Reporting Act Either US bank is acting as a credit rating agency (assembling and transmitting credit reports that re at least in part obtained from other sources) and not complying with the law, or US bank is obtaining credit reports on its customers and not using them in compliance with the law (failing to certify the purpose for which the information is obtained from the credit rating agency). This matter was settled: US Bancorp agreed to pay $3 million dollars to charity and to provide notice of its privacy policy to customers on an annual basis. Statutes Notice and Opt Out Rules, Section 502 of the CLB Act, 15 USC 6801 (2004)

(a) Except as otherwise provided in this subtitle, a financial institution may not, directly or through any affiliate, disclose to a nonaffiliated third party any nonpublic personal information, unless such financial institution provides or has provided to the consumer a notice that complies with section 503. (b)(1) IN GENERAL.--A financial institution may not disclose nonpublic personal information to a nonaffiliated third party unless- (A) such financial institution clearly and conspicuously discloses to the consumer, in writing or in electronic form or other form permitted by the regulations prescribed under section 504, that such information may be disclosed to such third party; (B) the consumer is given the opportunity, before the time that such information is initially disclosed, to direct that such information not be disclosed to such third party; and (C) the consumer is given an explanation of how the consumer can exercise that nondisclosure option.

NB: Function regulation as opposed to entity regulation; applies to all financial institutions, but who will enforce for unregulated entities? Definition of Financial Institution, Section 509 of the GLB Act (3)(A) IN GENERAL.--The term "financial institution" means any institution the business of which is engaging in financial activities as described in section 4(k) of the Bank Holding Company Act of 1956. Activities that are Financial in Nature, Section 4(k) of the BHCA (new) (k) (1) In general. Notwithstanding subsection (a), a financial holding company may engage in any activity, and may acquire and retain the shares of any company engaged in any activity, that the Board, in accordance with paragraph (2), determines (by regulation or order)- (A) to be financial in nature or incidental to such financial activity; or (B) is complementary to a financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. Exceptions Credit approvals (need to share information for customers to get approvals) Corporate transactions (e.g. in the course of M&A due diligence) Examinations by regulators Joint marketing arrangements (e.g. if US Bank had joint marketed with MemberWroks, that would be okay) State law is preempted but states can make stricter regulations Relationship to State Law, Section 507

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(a) IN GENERAL.--This subtitle and the amendments made by this subtitle shall not be construed
as superseding, altering, or affecting any statute, regulation, order, or interpretation in effect in any State, except to the extent that such statute, regulation, order, or interpretation is inconsistent with the provisions of this subtitle, and then only to the extent of the inconsistency. (b) GREATER PROTECTION UNDER STATE LAW.For purposes of this section, a State statute, regulation, order, or interpretation is not inconsistent with the provisions of this subtitle if the protection such statute, regulation, order, or interpretation affords any person is greater than the protection provided under this subtitle and the amendments made by this subtitle, as determined by the Federal Trade Commission, after consultation with the agency or authority with jurisdiction under section 505(a) of either the person that initiated the complaint or that is the subject of the complaint, on its own motion or upon the petition of any interested party. (e) GENERAL EXCEPTIONS.--Subsections (a) and (b) shall not prohibit the disclosure of nonpublic personal information . . . (5) to the extent specifically permitted or required under other provisions of law and in accordance with the Right to Financial Privacy Act of 1978, to law enforcement agencies (including a Federal functional regulator, the Secretary of the Treasury with respect to subchapter II of chapter 53 of title 31, United States Code, and chapter 2 of title I of Public Law 91-508 (18 U.S.C. 1951-1959), a State insurance authority, or the Federal Trade Commission), self-regulatory organizations, or for an investigation on a matter related to public safety;

Relevance of G-L-B Act, See Section 502(e) of the Act

Which more approximates what consumers would want, opt in or opt out? Studies indicate that in opt in states 10% opt in, in opt out states 10% opt out.

RESPA Logic of RESPA: Congress wanted to prevent kickbacks (referral fees) paid by Title Insurance Appraisers to Broker or Settlement attorney. Law requires that all fees be disclosed. Statutory Provisions of RESPA Section 8(a) of RESPA prohibits providers of settlement services from paying referral fees and kickbacks, as follows: No person shall give and no person shall accept any fee, kickback, or thing of value pursuant to any agreement or understanding, oral or otherwise, that business incident to or a part of a real estate settlement service involving a federally related mortgage loan shall be referred to any person. Section 8(c)(2), however, exempts from those prohibitions the payment of compensation for goods or services which are actually provided: Nothing in this section shall be construed as prohibiting ... the payment to any person of a bona fide salary or compensation or other payment for goods or facilities actually furnished or for services actually performed.... Maybury v. Colonial Mortgage Co. (MD Ala. 2001); Held that the correct test to be used is the Culpepper test and servicing rights are not a good so defendants motion for summary judgment is denied. Facts Mortgage broker (La Rue) originates mortgages for lenders and serves as an intermediary btw the lender and the borrower. Plaintiff hired La Rue to secure a mortgage for her. Loan was closed using lenders (defendants) funds. Defendant receives an assignment of the note and the mortgage. Loan Correspondent Agreement provides for the payment to La Rue of a yield differential, also know as a yield spread premium (difference btw what borrower agreed to and what lender agreed to). La Rue got $900 origination fee at closing. Also at closing, the borrower learned of the $2,010.09 yield spread premium she was paying to La Rue.

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Plaintiff claims that the YSP is a kickback which is prohibited under RESPA and that Defendant violated RESPA by failing to disclose the YSP prior to closing. Defendant is moving for summary judgment claiming that they paid the $ to La Rue for the servicing rights on the loans and that this falls with in exception for payment of goods and services. Two tests of Section 8 Culpepper (preferred by plaintiffs) ; Is the payment in exchange for goods and services rendered? No per se liability Yes was the payment so excessive that partmay constitute a prohibited referral fee? HUD Policy Whether goods were actually furnished or services were actually performed for the compensation paid? No per se liability Yes Were the payments reasonably related to the value of the goods an services rendered. How are they different? Culpepper requires a closer nexus between the payment and the goods and services rendered. Here, La Rue would have done the same thing whether or not the loan was above par (at par no YSP). Under HUD you will always end up in the reasonableness inquiry. Culpepper easier to certify a class. Plaintiff also made disclosure claims which the court dismissed because the plaintiff did not refer to any RESPA statutory provision from which the claims arose and 12 USC 2604(c) offers no private right of action. Additional Comments on YSPs In the end the HUD test prevailed. And no class Actions. Turns out La Rue is Colonials (the defendant lenders) agent. Does it really matter whether La Rue gets its fee as a flat fee or from the spread? YSPs were so widely used. HUD forms had a place to disclose YSP. Blowing up the mortgage broker with billion dollar law suits seems extreme. Generally mortgage brokers served a good function for borrowers increased market efficiencies. Today the majority of loans are originated through mortgage brokers. Trilateral dilemma Theoretical and Empirical Interlude The consumer going to a market professional to find a financial service provider and the market professional having a lot of financial service providers to choose from is a reoccurring transaction. Trilateral dilemma. 401(k) Plans and Excessive Fees Plan providers offer benefits to corporate sponsors for choosing them. Why might the market not work Consumers rely on mortgage brokers; Primary attention is on purchasing the house/getting mortgage. No one chooses an employer based on the level of fees company pays to 401(k) provider. Incident of Yield Spread Premiums Table

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80-90% of loans had YSP; largest source of compensation. Origination fees were higher where there were no YSP, but total compensation was around $900 lower on average.

Money Laundering
Laundering of monetary instruments, 18 U.S.C. 1956 (2004)
(a)(1) Whoever, knowing that the property involved in a financial transaction represents the proceeds of some form of unlawful activity, conducts or attempts to conduct such a financial transaction which in fact involves the proceeds of specified unlawful activity (A) (i) with the intent to promote the carrying on of specified unlawful activity; or (ii) with intent to engage in conduct constituting a violation of section 7201 or 7206 of the Internal Revenue Code of 1986; or (B) knowing that the transaction is designed in whole or in part- (i) to conceal or disguise the nature, the location, the source, the ownership, or the control of the proceeds of specified unlawful activity; or (ii) to avoid a transaction reporting requirement under State or Federal law, shall be sentenced to a fine of not more than $500,000 or twice the value of the property involved in the transaction, whichever is greater, or imprisonment for not more than twenty years, or both. (7) The term "specified unlawful activity" means- (A) any act or activity constituting an offense listed in section 1961(1) of this title except an act which is indictable under subchapter II of chapter 53 of title 31; (B) with respect to a financial transaction occurring in whole or in part in the United States, an offense against a foreign nation involving- (i) the manufacture, importation, sale, or distribution of a controlled substance (as such term is defined for the purposes of the Controlled Substances Act); (ii) murder, kidnapping, robbery, extortion, destruction of property by means of explosive or fire, or a crime of violence (as defined in section 16); (iii) fraud, or any scheme or attempt to defraud, by or against a foreign bank (as defined in paragraph 7 of section 1(b) of the International Banking Act of 1978)); [FN2] (iv) bribery of a public official, or the misappropriation, theft, or embezzlement of public funds by or for the benefit of a public official; (v) smuggling or export control violations involving- (I) an item controlled on the United States Munitions List established under section 38 of the Arms Export Control Act (22 U.S.C. 2778); or

Definition of Specified Unlawful Activity

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(II) an item controlled under regulations under the Export Administration Regulations (15 C.F.R. Parts 730-774); or (vi) an offense with respect to which the United States would be obligated by a multilateral treaty, either to extradite the alleged offender or to submit the case for prosecution, if the offender were found within the territory of the United States;. .

Records And Reports On Monetary Instruments Transactions, 31 U.S.C. 5311 (2000)


Declaration of purpose It is the purpose of this subchapter (except section 5315) to require certain reports or records where they have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings. (a) General. (1) Every bank shall file with the Treasury Department, to the extent and in the manner required by this section, a report of any suspicious transaction relevant to a possible violation of law or regulation. A bank may also file with the Treasury Department by using the Suspicious Activity Report specified in paragraph (b)(1) of this section or otherwise, a report of any suspicious transaction that it believes is relevant to the possible violation of any law or regulation but whose reporting is not required by this section. (4) Transactions aggregating $5,000 or more that involve potential money laundering or violate the Bank Secrecy Act. Any transaction. . . conducted or attempted by, at or through the national bank and involving or aggregating $5,000 or more in funds or other assets, if the bank knows, suspects, or has reason to suspect that: (i) The transaction involves funds derived from illegal activities or is intended or conducted in order to hide or disguise funds or assets derived from illegal activities (including, without limitation, the ownership, nature, source, location, or control of such funds or assets) as part of a plan to violate or evade any law or regulation or to avoid any transaction reporting requirement under Federal law; (ii) The transaction is designed to evade any regulations promulgated under the Bank Secrecy Act; or (iii) The transaction has no business or apparent lawful purpose or is not the sort in which the particular customer would normally be expected to engage, and the institution knows of no reasonable explanation for the transaction after examining the available facts, including the background and possible purpose of the transaction. (c) As used in this section- (4) the term "financial transaction" means (A) a transaction which in any way or degree affects interstate or foreign commerce (i) involving the movement of funds by wire or other means or (ii) involving one or more monetary instruments, or (iii) involving the transfer of title to any real property, vehicle, vessel, or aircraft, or (B) a transaction involving the use of a financial institution which is engaged in, or the activities of which affect, interstate or foreign commerce in any way or degree;. No person shall for the purpose of evading the reporting requirements of section 5313(a) or 5325 or any regulation prescribed under any such section- (1) cause or attempt to cause a domestic financial institution to fail to file a report required under section 5313(a) or 5325 or any regulation prescribed under any such section; (2) cause or attempt to cause a domestic financial institution to file a report required under section 5313(a) or 5325 or any regulation prescribed under any such section that contains a material omission or misstatement of fact; or (3) structure or assist in structuring, or attempt to structure or assist in structuring any transaction with one or more domestic financial institutions.

Reports by banks of suspicious transactions, 12 C.F.R. 103.18 (2000)

SAR Rules for National Banks, 12 C.F.R. 21.11 (2001)

Key Definitions

Structuring transactions to evade reporting requirement prohibited, 31 U.S.C. 5324 (2000)

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Regulation of Organization Structure


Introduction to Organizational Structure
Holding Company

Issues:
Basic Definitions, etc. Limitations on Activities - HC affiliates - Bank subsidiaries

Bank

Affiliate

Bank Subsidiaries Non-Banking Subsidiaries

Geographic Expansion of Banks History Historic restrictions on intrastate and interstate banking have been based on concerns about both concentration of economic power and a desire to focus bank activities on the development of local economies and close attention to local borrowers. But today, it is fair to say that if there is a public policy concern about local savings being drained from communities, the danger is as much related to non-bank financial institutions, such as securities firms and mutual funds with 800 telephone numbers, as it is to the steady growth of interstate banking. Until 1994, the geographic limits in 12 USC 36 provided that national bank branches could be located only within the state where the bank was head quartered, and only where statechartered banks were authorized to locate branches (today all but a few states allow branches state wide). Definition of a Branch etc Possible 3 prong test: a facility must engage in core activities (accept deposits, cash checks, make loans); be established by the bank; and provide the bank with a competitive advantage in obtaining customers Statutory Definition, 12 USC 36(j) The term branch as used in this section shall be held to include any branch bank, branch office, branch agency, additional office, or any branch place of business located in any StateAt which deposits are received, or checks paid, or money lent. First National Bank in Plant City v. Dickinson (USSC 1969); Held that armored truck that went to customers premises and both delivered cash in exchange for checks and accepted checks for deposit is not a branch; drop box which armored truck picked up from was a branch to spite contract between bank and customer providing that funds were not deemed to be deposited until they were delivered to the bank. Private contracts do not control the location of accepting deposits for the purpose of federal law. The facilities gave the national bank a competitive advantage in attracting customers and providing the functional equivalent of deposit taking in a place away from authorized office locations. Clarke v. Securities Industry Association (USSC 1987); Held that facilities of a national bank which offered only discount brokerage services are not branches. Competitive equality is only necessary in regard to core functions, not every incidental service.

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St. Louis County National Bank v. Mercantile Trust Co. (8th Cir. 1976); Held that the three activities listed in 36(j) are not the only indicia of branch banking, and that an office offering trust services is a branch. ATMs It used to be that ATMs (accept deposits, cash checks, make loans by dispensing $ against prearranged lines of credit) were considered branches, but sometimes not if the bank doesnt own them. Now: 12 USC 36(j) The term branch as used in this section does not include an ATM or a remote service unit. Interstate Branching Summary of Changes of the Reigle-Neal Act of 1994 Effective June 1, 1997, national banks can merger with banks in any other state provided that the state has not opted out obey enacting a law which expressly prohibits such branching. If a state opts out, state or national banks with that state as their home state are prohibited from interstate branching AND out-of-state banks are prohibited from branching into that state. If a state does nothing, national chartered banks will be able to branch across state lines but the state chartered banks in that state will not be able to. So to remain competitive, it seems like the state will either have to opt out (and no one can branch in or out) or pass enabling legislation allowing banks chartered by that state to engage in interstate branching like the nationally chartered banks in that state. The approval criteria for interstate mergers and branching are essentially identical to those for interstate banking (BHCs owning banks in more than one state). Concentration limits - merger will NOT be approved if: The bank and its affiliates will control more than 10% of the total amount of insured deposits in the US The bank had any presence in the state before the merger and after the merger the bank would control 30% or more of the insured deposit in the state (states can raise or lower this 30% limit). Other methodologies require express state approval; two examples of activities that would require such express approvals are as follows: De novo branching of a bank with no facilities in the home state. Acquisition of one or more select branches from an existing bank in the host state. Approval of interstate merger transactions authorized, 12 USC 1831u(a) (2004)
(1) In general. Beginning on June 1, 1997, the responsible agency may approve a merger transaction under section 1828(c) of this title between insured banks with different home States, without regard to whether such transaction is prohibited under the law of any State. (2) State election to prohibit interstate merger transactions. (A) In general. Notwithstanding paragraph (1), a merger transaction may not be approved pursuant to paragraph (1) if the transaction involves a bank the home State of which has enacted a law after September 29, 1994, and before June 1, 1997, that (i) applies equally to all out-of-State banks; and (ii) expressly prohibits merger transactions involving out-of-State banks. . . . . (3) State election to permit early interstate merger transactions. (A) In general. A merger transaction may be approved pursuant to paragraph (1) before June 1, 1997, if the home State of each bank involved in the transaction has in effect, as of the date of the approval of such transaction, a law that (i) applies equally to all out-of-State banks; and

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(ii) expressly permits interstate merger transactions with all out-of-State banks. Applicable State Laws

Preservation of State Age Laws, 12 USC 1831u(a)(5) (2004)


(A) In general. The responsible agency may not approve an application pursuant to paragraph (1) that would have the effect of permitting an out-of-State bank or out-of-State bank holding company to acquire a bank in a host State that has not been in existence for the minimum period of time, if any, specified in the statutory law of the host State. (B) Special rule for State age laws specifying a period of more than 5 years. Notwithstanding subparagraph (A), the responsible agency may approve a merger transaction pursuant to paragraph (1) involving the acquisition of a bank that has been in existence at least 5 years without regard to any longer minimum period of time specified in a statutory law of the host State.

Basically banks cant acquire banks that havent been in existence for the minimum amount of time set by the host state or 5 years, whichever is shorter. Law applicable to national bank branches 12 USC 36(f)(1) (2004)

(A) In general. The laws of the host State regarding community reinvestment, consumer
protection, fair lending, and establishment of intrastate branches shall apply to any branch in the host State of an out-of-State national bank to the same extent as such State laws apply to a branch of a bank chartered by that State, except- (i) when Federal law preempts the application of such State laws to a national bank; or (ii) when the Comptroller of the Currency determines that the application of such State laws would have a discriminatory effect on the branch in comparison with the effect the application of such State laws would have with respect to branches of a bank chartered by the host State.

Riegle-Neal Amendments Act of 1997 (amending 12 USC 1831a(j)

(1) APPLICATION OF HOST STATE LAW.--The laws of a host State, including laws regarding
community reinvestment, consumer protection, fair lending, and establishment of intrastate branches, shall apply to any branch in the host State of an out-of-State State bank to the same extent as such State laws apply to a branch in the host State of an out-of-State national bank. To the extent host State law is inapplicable to a branch of an outof- State State bank in such host State pursuant to the preceding sentence, home State law shall apply to such branch. (2) ACTIVITIES OF BRANCHES.--An insured State bank that establishes a branch in a host State may conduct any activity at such branch that is permissible under the laws of the home State of such bank, to the extent such activity is permissible either for a bank chartered by the host State (subject to the restrictions in this section) or for a branch in the host State of an out-of- State national bank.

Problem for competitive equality: Wachovia said that federal law applies to federal banks. Now under this law, for state banks engaged in intrastate branching, the host state laws apply with respect to these 4 issues and home state laws apply for everything else. But for federal banks, the OCC regulates everything and mostly only federal law applies (but even if state law applies which it does to the aforementioned 4 areas OCC applies the law). Bank Holding Companies The BHCA both regulates geographical expansion of BHCs and creates a series of portfolioshaping restrictions. Note that as ordinary companies, BHCs themselves cannot engage in banking. Just as national banks are prohibited by 24(7) of the National Banking Act from owning general commercial enterprises, so 1843 of the BHCA prohibits general commercial enterprises from owning banks. Section 1843, however, does allow BHCs to control subsidiaries engaged in certain types of activities, particularly those that are closely related to banking and proper and incident thereto. Basic BHC Approval Rules, 12 USC 1842(a)(1999)
It shall be unlawful, except with the prior approval of the Board, (1) for any action to be taken that causes any company to become a bank holding company;

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(2) for any action to be taken that causes a bank to become a subsidiary of a bank holding company; (3) for any bank holding company to acquire . . . more than 5 per centum of the voting shares of such bank; (4) for any bank holding company . . . to acquire all or substantially all of the assets of a bank; or (5) for any bank holding company to merge or consolidate with any other bank holding company.

Definition of Bank Holding Company, 12 U.S.C.A. 1841(a) (1999)

(1) Except as provided in paragraph (5) of this subsection, a "bank holding company" means any company which has control over any bank or over any company that is or becomes a bank holding company by virtue of this chapter. .... (5) Notwithstanding any other provision of this subsection- (A) No bank and no company owning or controlling voting shares of a bank is a bank holding company by virtue of its ownership or control of shares in a fiduciary capacity, except as provided in paragraphs (2) and (3) of subsection (g) of this section. "Company" means any corporation, partnership, business trust, association, or similar organization, or any other trust unless by its terms it must terminate within twenty-five years or not later than twentyone years and ten months after the death of individuals living on the effective date of the trust but shall not include any corporation the majority of the shares of which are owned by the United States or by any State.

BHCA Definition of Company, 12 U.S.C.A. 1841(b) (1999)

Note that the definition gives the FRB some leeway in defining a company e.g. 5
linked partnerships each owning 5% of a banks voting securities may or may not constitute a company that controls. BHCA Definition of Control, 12 U.S.C. 1841(a)(2) (1999)
Any company has control over a bank or over any company if- (A) the company directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 per centum or more of any class of voting securities of the bank or company; (B) the company controls in any manner the election of a majority of the directors or trustees of the bank or company; or (C) the Board determines, after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the bank or company. Individuals who own banks are not BHCS The BHCA is silent with respect to the acquisition of banks by individuals but the Change in Control Bank Act, 12 USCA 1817(j) allows the appropriate federal regulator to disapprove the acquisition of an insured depository institution by a person or group of persons. However, the act does not limit the ownership of other commercial enterprises by individuals who also own banks; only companies are limited in their affiliations under the BHCA.

In re Sumitomo Bank, 73 Fed. Res. Bull 24 (1987) Facts: Sumitomo, a Japanese bank, was considering acquiring an interest in Goldman Sachs. This raised a BHC issue, not b/c Sumitomo was going to gain control of Goldman Sachs, but because Sumitomo already had control over a California bank. B/c GS engaged in activities impermissible for a company controlled by BHCs, the Fed reviewed. Ultimately the Fed required Sumitomo to alter its proposal before it would say that its interest in GS would not give rise to a controlled affiliate. Original Proposal $500 million investment in limited partnership equity and subordinated debt (more than 25 percent of capital)

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Representation on Board Equal Voting Interest in Joint Venture in London plus 12.5 interest in Tokyo venture Increased Business Relationships Joint Training Programs What changes did the Board require and why? Even though some of the 25% investment was going to be in debt, the FRB required that it not acquire more than 24.9% of the outstanding equity of GS. Board was concerned about combination of equity and extensive business relationships Sumitomo proposed the following changes and the fed agreed to the investment Sumitomo would only acquire 24.9% of GS equity. No board representation; no voting on management officials or other directing of GS policy No increased business relationships (stay on arms length non-exclusive basis) No former Sumitomo employees will be trainees of GS except as approved by the FRB. NB: Since GLB, bank holding companies are permitted to control companies such as GS. Board of Governors v. DLG Financial Corp. 29 F. 3d 993 (5th Cir. 1994); Held that DLG became a BHC when it purchased two promissory notes secured by a pledge of bank stock, the security agreement provided that if the notes defaulted, the security note holder could exercise all the voting rights of the pledged stock and the notes actually went in to default before the their purchase. The non-Bank Bank Phenomenon What is a Bank? Having a bank charter or engaging in the business of banking does not make an entity a bank under the BHCA. An entity can be a bank for the purpose of state or federal banking laws, but not for the purpose of the BHCA.

Prior to 1987, the definition for Bank under the BHCA permitted the creation of nonbank banks (institutions with national or state bank charters that engaged in deposit taking, credit granting and credit exchange but did not make commercial loans, or perhaps, do make commercial loans but did not take demand deposits). Old BHC Definition of Bank, 12 USCA 1841(c)(1)(B) (1986) repealed in 1987
[T]he term "bank" means . . . [a]n institution organized under the laws of the United States [or] any State . . . which both - (i) accepts demand deposits or deposits that the depositor may withdraw by check or similar means for payment to third parties or others; and (ii) is engaged in the business of making commercial loans.

Basically the conjunctive nature of this law allowed companies to get away with a lot. GE could control a non-bank bank.

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The FRB believed that non-bank banks posed three dangers to the national banking system: (1) by being outside the reach of many banking regulations, non-bank banks had a significant competitive advantage; (2) the proliferation of non-bank banks threatened the structure established by congress for limiting the affiliation of banking and commercial enterprises; and (3) the interstate acquisition of multiple non-state banks undermined the statutory proscriptions on interstate banking absent specific legislative authority. Board of Governors v. Dimension Financial Corp. (USSC 1986- Dimension tried to set up a non-bank bank in every state); Held that the plain language of the BHCA did not support the FRBs regulations proscribing Dimensions activities. Note: this case prompted Congress to change the law. But ownership of non-bank banks by approximately 160 commercial enterprises was grandfathered in, with a few restrictions on their activities. BHC Definition of Bank, 12 USCA 1841(c)(1999) (current law) includes all FDIC insured entities
(1) [T]he term "bank" means any of the following: (A) An insured bank as defined in section 3(h) of the Federal Deposit Insurance Act . . . . (B) An institution organized under the laws of the United States [or] any State . . . which both - (i) accepts demand deposits or deposits that the depositor may withdraw by check or similar means for payment to third parties or others; and (ii) is engaged in the business of making commercial loans. (2) The term "bank" does not include any of the following: (A) A foreign bank [with limited branches in the U.S.] (B) An insured [thrift] . . . . (F) [A credit card institution] [No] company which becomes . . . a bank holding company on the date of such enactment [enacted Dec. 31, 1970], [shall] retain direct or indirect ownership or control of any voting shares of any company which is not a bank or bank holding company or engage in any activities other than (A) those of banking or of managing or controlling banks and other subsidiaries authorized under this Act or of furnishing services to or performing services for its subsidiaries, and (B) those permitted under paragraph (8) of subsection (c) of this section subject to all the conditions specified in such paragraph or in any order or regulation issued by the Board under such paragraph . . . . [A BHCA may acquire] - (4) shares held or acquired by a bank in good faith in a fiduciary capacity, except where such shares are held under a trust that constitutes a company . . . . (5) shares which are of the kinds and amounts eligible for investment by national banking associations . . . . (6) shares of any company which do not include more than 5 per centum of the outstanding voting shares of such company;

BHCA Acquisitions of Non-Banks, 12 U.S.C. 1843(a) (1999)

Permissible BHCA Investments, 12 U.S.C. 1843(c) (1999)

Geographical Restrictions on BHCs Non-bank subsidiaries Federal banking law has historically show substantial deference to state law in regulating the geographical expansion of banks, thus allowing the states to burden interstate commerce. But federal law is silent as to the geographical expansion of nonbank

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subsidiaries and affiliates of banks, thus providing BHCs with the protection of the dormant Commerce Clause in limiting the power of states to regulate their expansion. Lewis v. BT Investment (USSC 1980 BT (a BHC) decided to seek approval to have its Delaware incorporated investment management subsidiary operate in Florida; A Florida statute prohibited an out of state BHC from owning any investment advisor company operating in Florida); Held that the Florida statute violates the dormant commerce clause and the BHCA does not save the statute through either 1842(d), regulating interstate bank acquisitions, or 1846 permitting states to regulate BHCs in a nondiscriminatory manner more restrictive than the BHCA itself. While under the DCC states do retain authority to regulate matters of legitimate local concern, even if they affect interstate commerce, there is no police power justification for the level of discrimination caused by the Florida statute. 1846 only preserves as states authority to enact limitations on BHCs as a class (but note must be ALL BHCs; cant discriminate) but does not authorize states to control the approval or disapproval of a particular BHC transaction. After Lewis, out of state BHCs were free to establish any non-bank subsidiary subject only to the regulatory powers of the state requiring registration fees substantially similar to those of corporations. Bank subsidiaries Interstate Banking and Branching Efficiency Act of 1994 Effective September 29, 1995, BHCs have the power to make interstate acquisitions of banks located anywhere in the US without regard to state laws that might purport to limit such acquisitions. 12 USC 1842(d). While states cant opt out, they can require that a target bank be in existence for five years before it can be acquired by an out-of-state BHC. Also, states can maintain laws concerning community reinvestment, fair lending, intrastate branching, and consumer protection, as long as such laws do not discriminate against out-of-state institutions. The FRB can approve an application for an acquisition of a bank by a BHC that is adequately capitalized and adequately managed subject tot the 10% national and 30% state insured deposits concentration limits and CRA consideration. Activities of Bank Holding Companies The Closely Related to Banking Test Section 4(c)(8) of the BHCA, 12 U.S.C. 1843(c)(8) (1999)

[A BHCA may acquire] the shares of any company the activities of which the Board after due
notice and opportunity for hearing has determined (by order or regulation) to be so [i] closely related to banking or managing or controlling banks as to be [ii] a proper incident thereto, but for purposes of this subsection it is not closely related to banking or managing or controlling banks for a bank holding company to provide insurance as a principal, agent, or broker except [for certain limited exceptions]. In determining whether a particular activity is a proper incident to banking the Board shall consider whether its performance by . . . a holding company can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interests, or unsound banking practices.

Two pronged test (1) Whether a given activity is closely related to banking; and general inquiry which may be articulated in the form of regulations applicable to all BHCs

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(2) Whether allowance of an activity in a particular instance constitutes a proper incident thereto; Case-specific; evaluates the merits of a particular BHC engaging in a particular nonbanking activity. National Courier Association v. Board of Governors of the Federal Reserve System (DC Cir. 1975 FRB approved a BHC going into the courier business (described below); courier service proceed sued to challenge the FRBs ruling on the closely related issue); Held that under the test put forth by the court, the BHC could carry banking material and financially related data processing material, but could NOT carry on general courier services, even where such services were unsolicited and not otherwise available. National Courier Activities [C]ourier or high speed transportation services for -- the internal operations of the holding company and its subsidiaries; checks, commercial papers, documents, and written instruments . . . as are exchanged among banks and banking institutions; audit and accounting media of a banking or financial nature and other business records and documents used in processing such media; and [N]on-financially-related material upon the specific, unsolicited request of a third party when courier services are not otherwise reasonably available . . . . Basically banks would do a sort of FedEx service in conjunction with the couriering they do anyway for their banking business. Court made it clear that even a strong showing of public benefit would not make this activity proper. Only if such services had been reasonably necessary to the conduct of a closely related activity would they have been found permissible. Three pong test for closely related (interpretation of BHCA 4(8)(c) Have the banks traditionally provided the service? Are the services so operationally or functionally similar to something that banks have traditionally done as to equip them particularly well to provide the proposed service? Are the services in question are so integrally related to the services traditionally provided by banks that they must be provide in specialized form? Bank was found to be able to do the courier stuff that was closely related to their banking business, but not the organ transport. Citibank was later found to be able to sell limited equipment in connection with their banking business. Regulation Y Some Permissible Activities (closely related to banking) for BHCs under Regulation Y (activities BHCs can perform inside the US). Credit bureau services Collection agency services Leasing personal or real property Financial and investment advisory activities. Including serving as an Investment Advisor, as defined in section 2(a)(2) of the ICA of 1940. Agency transactional services for customer investments. Including securities brokerage, if the securities brokerage activities are restricted to buying and selling securities solely as agent for the account of customers and do not include securities underwriting or dealing. Acting as a futures commission merchant. Underwriting and dealing in government obligations and money market instruments.

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Engaging as principal in foreign exchange and derivatives transactions. Buying and selling bullion. Management consulting on any matter to unaffiliated depository institutions, or any financial, economic, accounting, or audit matter to any other company. Data Processing (there must be limit on this?) Other Activities under BHCA 4(c)(8) The FRB has generally issued denials of authority to operate travel agencies and armored car service under BHCA 4(c)(8). Insurance As of 1982, BHCA 4(c)(8) contains language to the effect that most insurance activities are not closely related to banking under 4(c)(8). By the end of the 1990s Regulation in fact placed greater restrictions on BHCs than those applicable to national and state banks. Regulation Y does allow insurance agency activity conducted out of a so-called town of 5000 as well as issuance of credit insurance policies in connection with the extension of a loan by the BHC or any of its subsidiaries. Regulation K provides an even broader list of activities which BHCs can engage in outside of the US. Its statutory authority is BHCA 4(c)(13). Standard is of a financial or banking nature which is broader than closely related to banking. Activities permitted under Regulation K that are not permitted in the US under BHCA 4(c)(8) include: underwriting life insurance; underwriting securities; and operating a travel agency in connection with the provision of financial services abroad. Banks/BHCs & Insurance pre-GLB In 1982 4(c)(8) of the BHCA was amended to provide that providing insurance as a principal, agent, or broker, subject to certain exceptions, was not closely related to banking (e.g. BHCs could not engage in it). Regulation Y does allow insurance agency activity conducted out of a so-called town of 5000 as well as issuance of credit insurance policies in connection with the extension of a loan by the BHC or any of its subsidiaries. Banks had greater ability to engage in the insurance business. Banks in towns of 5,000 in habitants could act as insurance agents Section 92 of the National Bank Act (interpreted in Saxon v. Georgeia Independent Insurance Agents, 399) [A]ny [national banking] association located and doing business in any place the population of which does not exceed five thousand inhabitants, as shown by the last preceding decennial census, may, under such rules and regulations as may be prescribed by the Comptroller of the Currency, act as agent for any . . . insurance company authorized by the authorities of the State in which said bank is located to do business in said state . . . Citicorp (2d Cir. 1991 DE passed a law allowing banks to engage in insurance; banks; Citibank set up a subsidiary that mostly banking and a little insurance underwriting); Held that this is okay. In response to this congress changed the law to prevent state banks from engaging in this and other activities as principals (can still do things that states allow as agents). FDICIA Restrictions on Insured State Banks. Section 24 of the FDIA

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(a) [A]n insured State bank may not engage as principal in any type of activity that is not
permissible for a national bank unless - (1) The [FDIC] has determined that the activity would pose no significant risk to the appropriate deposit insurance fund; and (2) the State bank is, and continues to be, in compliance with applicable capital standards prescribed by the appropriate Federal banking agency. (b) Notwithstanding subsection (a), an insured State bank may not engage in insurance underwriting except to the extent that activity is permissible for national banks.

I.I.A.A. v. Ludwig, 997 F2d 958 (DC Cir. 1993); Held that bank operating out of a town of 5,000 can sell insurance nation wide. A]ny [national bank] located and doing business in any place the population of which does not exceed five thousand inhabitants, as shown by the last preceding decennial census, may, under such rules and regulations as may be prescribed by the Comptroller of the Currency, act as agent for any . . . insurance company authorized by the authorities of the State in which said bank is located to do business in said state . . Nations Bank v. Valic, 115 S. Ct. 810 (1995): Held that banks can sell variable annuities since these are not insurance. GLB basically pushed insurance up to the QFHC affiliate level by allowing QFHC affiliates to be insurance companies (more liberal than activities previously allowed for banks and therefore for bank operating subsidiaries) and specifically prohibiting financial subsidiaries of banks from underwriting insurance or selling annuities. Leading up to GLB: Insurance Companies were getting into securities Depository Institutions were getting into insurance: (FNB v. Taylor: debt cancellation contract) Depository Institutions trying to get into securities: variable annuities, section 20 subs before GLB, B-Ds Securities Industry getting into banking activities: a) mutual funds set up by B-D making inroads on traditional savings b) MMMF functioning same as checking account c) commercial lending eroding asset side of bank balance sheet d) asset-backed securitization (take normal loans, sell into securities markets) The Gram-Leach-Bliley Act (GLB) GLB repealed 10 and 32 of Glass Steagall and created a new category of BHC the Qualified Financial Holding Company which are permitted to engage in activities which are (1) financial in nature, (2) incidental to such financial activity or (3) complementary to such financial activity. 20 of GS (repealed by GLB)

No member bank shall be affiliated in any mannerwith any corporationengaged principally in


the issue, flotation, underwriting, public sale, or distribution at wholesale or retailof stocks, bonds, debenture, notes, or other securities. (emphasis added).

Pre-GLB FRB interpretations of the phrase principally engaged (less than 25%) enabled BHCs to establish securities underwriting affiliates, though these affiliates remained subject to a complex set of restrictions. 32 of GS (repealed by GLB) reinforced the separation of between banks and firms principally engaged in securities activities by prohibiting such firms from sharing common directors. QFHCs can engage in activities that are (1) financial in nature, (2) incidental to such financial activity or (3) complementary to such financial activity.

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(1) IN GENERAL -[A] financial holding company may engage in any activity, and may acquire and retain the shares of any company engaged in activity, that the Board, in accordance with paragraph (2), determines (by regulation or order (A) to be financial in nature or incidental to such financial activity; or (B) is complementary to a financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. (4) ACTIVITIES THAT ARE FINANCIAL IN NATURE.For purposes of this subsection, the following activities shall be considered to be financial in nature: (A) Lending, exchanging, transferring, investing for others, or safeguarding money or securities. (B) Insuring, guaranteeing, or indemnifying against loss, harm, damage, illness, disability, or death, or providing and issuing annuities, and acting as principal, agent, or broker for purposes of the foregoing, in any State. (C) Providing financial, investment, or economic advisory services, including advising an investment company (as defined in section 3 of the Investment Company Act of 1940). (D) Issuing or selling instruments representing interests in pools of assets permissible for a bank to hold directly. (E) Underwriting, dealing in, or making a market in securities. (5) ACTIONS REQUIRED.- "(A) IN GENERAL.--The Board shall, by regulation or order, define, consistent with the purposes of this Act, the activities described in subparagraph (B) as financial in nature, and the extent to which such activities are financial in nature or incidental to a financial activity. "(B) ACTIVITIES.--The activities described in this subparagraph are as follows: "(i) Lending, exchanging, transferring, investing for others, or safeguarding financial assets other than money or securities. "(ii) Providing any device or other instrumentality for transferring money or other financial assets. "(iii) Arranging, effecting, or facilitating financial transactions for the account of third parties.

FHCs may petition to have additional activities added to the list of activities that are considered financial in nature or incidental. Both the FRB and the Treasury have authority to propose that the list of such activities be expanded and gives each the authority to veto such expansion. The following are the factors to be taken into account when expanding the list:
(3) FACTORS TO BE CONSIDERED.--In determining whether an activity is financial in nature or incidental to a financial activity, the Board shall take into account (A) the purposes of this Act and the Gramm-Leach-Bliley Act; (B) changes or reasonably expected changes in the marketplace in which financial holding companies compete; (C) changes or reasonably expected changes in the technology for delivering financial services; and (D) whether such activity is necessary or appropriate to allow a financial holding company and the affiliates of a financial holding company to- (i) compete effectively with any company seeking to provide financial services in the United States; (ii) efficiently deliver information and services that are financial in nature through the use of technological means, including any application necessary to protect the security or efficacy of systems for the transmission of data or financial transactions; and (iii) offer customers any available or emerging technological means for using financial services or for the document imaging of data.

With respect to activities falling under GLBs complementary heading, however, the FRB has sole power of approval. 12 USC 1843(j)(1)(A). Note that the notion that these activities are complementary in nature suggests that they are not financial in nature.

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In order for a BHC to qualify to be a QFHC, all of its depository institution subsidiaries must be well managed, well capitalized and have CRA ratings of satisfactory or over and the BHC must file an application with the FRB declaring itself to be a QFHC and certifying that it meets the aforementioned requirements.
(1) IN GENERAL.-- . . . [A] bank holding company may not engage in [expanded activities authorized under the G-L-B Act] other than activities permissible for any bank holding company under subsection (c)(8), unless- (A) all of the depository institution subsidiaries of the bank holding company are well capitalized; (B) all of the depository institution subsidiaries of the bank holding company are well managed; and (C) the bank holding company has filed with the Board- (i) a declaration that the company elects to be a financial holding company to engage in activities or acquire and retain shares of a company that were not permissible for a bank holding company to engage in or acquire before the enactment of the Gramm-Leach-Bliley Act; and (ii) a certification that the company meets the requirements of subparagraphs (A) and (B). (2) CRA REQUIREMENT. . . . [T]he appropriate Federal banking agency shall prohibit a financial holding company or any insured depository institution from- (A) commencing any new [expanded authority under certain provisions of the G-L-B Act] . . . ; or (B) directly or indirectly acquiring control of a company engaged in any [expanded authority under certain provisions the G-L-B Act] . . . by an affiliate already engaged in activities under any such provision); if any insured depository institution subsidiary of such financial holding company, or the insured depository institution or any of its insured depository institution affiliates, has received in its most recent examination under the Community Reinvestment Act of 1977, a rating of less than "satisfactory record of meeting community credit needs".

If a QFHC later falls short of the statutory requirements, it must divest accordingly (m) Provisions Applicable To Financial Holding Companies That Fail To Meet Certain Requirements.- (1) IN GENERAL.--If the Board finds that- (A) a financial holding company is engaged, directly or indirectly, in any activity under subsection (k), (n), or (o), other than activities that are permissible for a bank holding company under subsection (c)(8); and (B) such financial holding company is not in compliance with the requirements of subsection (l)(1); the Board shall give notice to the financial holding company to that effect, describing the conditions giving rise to the notice. . . . . [various procedures & potentially divestiture of banks] BHCs that do not become QFHCs may continue to take advantage of the BHC regulatory structure (including all grants of authority under section 4(c)(8) that existed as of the date of the GLBAs enactment). Following the date of enactment, the FRB is no longer allowed to designate further activities as closely related to banking. The FRB may, however, alter the conditions that govern activities that were previously found to be closely related to banking. Financial Subsidiaries of Banks Financial subsidiaries (created by GLB) of banks are more restricted in their activities than financial affiliates and are subject to more restrictive regulation. For example unlike FHC affiliates, financial subsidiaries of banks can NOT engage in activities that are complementary to financial activity. Additionally, financial subsidiaries are expressly forbidden from engaging in insurance underwriting, real estate development and ordinary course insurance portfolio investment. They are also prohibited from engaging in merchant banking activities for at least five years after GLBAs November 1999 date of enactment. Because financial subsidiaries are subject to more restrictions affiliates have become the

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preferred route to expanding bank activities. Note that financial subsidiaries of Banks are regulated primarily by the OCC where as FHC affiliates are regulated by the FRB (sometimes one or the other can be more/less restrictive in certain situations). However in the case of FHC affiliates that are subject to another functional regulator (e.g. if the affiliate is a securities firm regulated by the SEC), the FRB must show deference to the primary functional regulator. Note under GLBA that Bank operating subsidiaries that do not qualify as financial subsidiaries are restricted to the same activities the parent bank is allowed to engage in. Basic Rules on Financial Subsidiaries, 12 U.S.C. 24a(a) (2000)
(1) IN GENERAL.--Subject to paragraph (2), a national bank may control a financial subsidiary, or hold an interest in a financial subsidiary. (2) CONDITIONS AND REQUIREMENTS.--A national bank may control a financial subsidiary, or hold an interest in a financial subsidiary, only if- (A) the financial subsidiary engages only in- (i) activities that are financial in nature or incidental to a financial activity pursuant to subsection (b); and (ii) activities that are permitted for national banks to engage in directly (subject to the same terms and conditions that govern the conduct of the activities by a national bank) . . "(B) the activities engaged in by the financial subsidiary as a principal do not include-(i) insuring, guaranteeing, or indemnifying against loss, harm, damage, illness, disability, or death (except to the extent permitted under section 302 or 303(c) of the Gramm-Leach-Bliley Act) or providing or issuing annuities the income of which is subject to tax treatment under section 72 of the Internal Revenue Code of 1986; (ii) real estate development or real estate investment activities, unless otherwise expressly authorized by law; or (iii) any activity permitted in subparagraph (H) or (I) of section 4(k)(4) of the Bank Holding Company Act of 1956, except activities described in section 4(k)(4)(H) that may be permitted in accordance with section 122 of the Gramm-Leach-Bliley Act . . . (2) CONDITIONS AND REQUIREMENTS A national bank may control a financial subsidiary . . . only if . . . . (C) the national bank and each depository institution affiliate of the national bank are well capitalized and well managed; (D) the aggregate consolidated total assets of all financial subsidiaries of the national bank do not exceed the lesser of (i) 45 percent of the consolidated total assets of the parent bank; or (ii) $50,000,000,000; (E) except as provided in paragraph (4), the national bank meets any applicable rating or other requirement set forth in paragraph (3); and (F) the national bank has received the approval of the Comptroller of the Currency for the financial subsidiary to engage in such activities, which approval shall be based solely upon the factors set forth in this section. (3) RATING OR COMPARABLE REQUIREMENT.- (A) IN GENERAL.--A national bank meets the requirements of this paragraph if- (i) the bank is 1 of the 50 largest insured banks and has not fewer than 1 issue of outstanding eligible debt that is currently rated within the 3 highest investment grade rating categories by a nationally recognized statistical rating organization; or (ii) the bank is 1 of the second 50 largest insured banks and meets the criteria set forth in clause (i) or such other criteria as the Secretary of the Treasury and the Board of Governors of

Limitations on FS Activities, 12 U.S.C. 24a(a)(1) (2000)

More Requirements for Financial Subsidiaries, 12 U.S.C. 24a(a)(2) (2000)

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the Federal Reserve System may jointly establish by regulation and determine to be comparable to and consistent with the purposes of the rating required in clause (i). (4) FINANCIAL AGENCY SUBSIDIARY.--The requirement in paragraph (2)(E) shall not apply with respect to the ownership or control of a financial subsidiary that engages in activities described in subsection (b)(1) solely as agent and not directly or indirectly as principal. "(c) CAPITAL DEDUCTION.- "(1) CAPITAL DEDUCTION REQUIRED.--In determining compliance with applicable capital standards- "(A) the aggregate amount of the outstanding equity investment, including retained earnings, of a national bank in all financial subsidiaries shall be deducted from the assets and tangible equity of the national bank; and "(B) the assets and liabilities of the financial subsidiaries shall not be consolidated with those of the national bank. "(2) FINANCIAL STATEMENT DISCLOSURE OF CAPITAL DEDUCTION.--Any published financial statement of a national bank that controls a financial subsidiary shall, in addition to providing information prepared in accordance with generally accepted accounting principles, separately present financial information for the bank in the manner provided in paragraph (1).

Yet More Requirements, 12 U.S.C. 24a(c) (2000)

Basically bank takes a capital deduction for any investment in a financial subsidiary. So if subsidiary goes under, bank is still okay for capital. And Still More Requirements, 12 U.S.C. 24a(d) (2000)
"(d) SAFEGUARDS FOR THE BANK.--A national bank that establishes or maintains a financial subsidiary shall assure that- "(1) the procedures of the national bank for identifying and managing financial and operational risks within the national bank and the financial subsidiary adequately protect the national bank from such risks; "(2) the national bank has, for the protection of the bank, reasonable policies and procedures to preserve the separate corporate identity and limited liability of the national bank and the financial subsidiaries of the national bank; and "(3) the national bank is in compliance with this section. "(e) RULES RELATING TO BANKS WITH FINANCIAL SUBSIDIARIES.- "(1) FINANCIAL SUBSIDIARY DEFINED.--For purposes of this section and section 23B, the term 'financial subsidiary' means any company that is a subsidiary of a bank that would be a financial subsidiary of a national bank under section 5136A of the Revised Statutes of the United States. "(2) FINANCIAL SUBSIDIARY TREATED AS AN AFFILIATE.--For purposes of applying this section and section 23B, and notwithstanding subsection (b)(2) of this section or section 23B(d)(1), a financial subsidiary of a bank- "(A) shall be deemed to be an affiliate of the bank; and "(B) shall not be deemed to be a subsidiary of the bank.

Amendments to Sections 23A & 23B, See Section 121(b) of G-L-B Act

State banks Note that GLB allows state bank subsidiaries to take advantage of the powers available not national bank financial subsidiaries, if state law so authorizes. The qualification rules applicable to national bank financial subsidiaries are relaxed somewhat as applied to state bank subsidiaries seeking comparable power. In particular, the size limits and debt rated requirements do not apply. 12 USC 1831w. E-commerce FRB Proposed Rule on E-commerce & Fin. In Nature

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1. Act as finder Incidental or Financial in Nature 2. Operating an electronic marketplace 3. Purchasing access arrangements 4. Conducting non-financial data processing Closely Related but Will Relax Conditions 5. Data collection 6. Providing web and portal services Complementary 7. Advisory and consulting services 8. Owning communications linkages 9. Developing new technologies Complementary but with ownership limits 10. Electronic marketing Restrictions under Fed Proposal: Investments limited to 5% of capital: Revenues limited to 45% of total assets: Revenues of affiliate must be at least 20% financial: Investment in new technology companies limited: Up to 25% of voting shares non-controlling [4(c)(8) limits] With other large investors Cross-marketing OK
Banking & Commerce after GLB Grandfather Authority x Authority to Retain Limited Non-financial Activities and Affiliations, 12 USC 1843(n) (2004)
(1) IN GENERAL.--Notwithstanding subsection (a), a company that is not a bank holding company or a foreign bank (as defined in section 1(b)(7) of the International Banking Act of 1978) and becomes a financial holding company after the date of the enactment of the Gramm-Leach-Bliley Act may continue to engage in any activity and retain direct or indirect ownership or control of shares of a company engaged in any activity if (A) the holding company lawfully was engaged in the activity or held the shares of such company on September 30, 1999; (B) the holding company is predominantly engaged in financial activities as defined in paragraph (2); and (C) the company engaged in such activity continues to engage only in the same activities that such company conducted on September 30, 1999, and other activities permissible under this Act. (2) PREDOMINANTLY FINANCIAL.For purposes of this subsection, a company is predominantly engaged in financial activities if the annual gross revenues derived by the holding company and all subsidiaries of the holding company (excluding revenues derived from subsidiary depository institutions), on a consolidated basis, from engaging in activities that are financial in nature or are incidental to a financial activity under subsection (k) represent at least 85 percent of the consolidated annual gross revenues of the company. (7) SUNSET OF GRANDFATHER.--A financial holding company engaged in any activity, or retaining direct or indirect ownership or control of shares of a company, pursuant to this subsection, shall terminate such activity and divest ownership or control of the shares of such company before the end of the 10- year period beginning on the date of the enactment of the Gramm-Leach-Bliley Act. The Board may, upon application by a financial holding company, extend such 10-year period by a period not to exceed an additional 5 years if such extension would not be detrimental to the public interest.

Unitary Thrift Holding Company Loop hole Background

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Initial S&L Holding Company Act passed in 1967 An Increasingly Important Exemption The Politics of Thrift Holding Companies Closing of the Thrift Industry Loophole (Unitary Savings and Loan Loophole)
(9) PREVENTION OF NEW AFFILIATIONS BETWEEN S&L HOLDING COMPANIES AND COMMERCIAL FIRMS.- (A) IN GENERAL.--Notwithstanding paragraph (3), no company may directly or indirectly, including through any merger, consolidation, or other type of business combination, acquire control of a savings association after May 4, 1999, unless the company is engaged, directly or indirectly (including through a subsidiary other than a savings association), only in activities that are permitted- (i) under paragraph (1)(C) or (2) of this subsection [a limited number of financial activities]; or (ii) for financial holding companies under section 4(k) of the Bank

Holding Company Act of 1956. Banks can keep their thrifts, but they cant buy new ones and OCCs destroy the exemption. 12 U.S.C. 1831a(d) (2000)
(d) Subsidiaries of insured State banks (1) In general After the end of the 1-year period beginning on December 19, 1991, a subsidiary of an insured State bank may not engage as principal in any type of activity that is not permissible for a subsidiary of a national bank unless- (A) the Corporation has determined that the activity poses no significant risk to the appropriate deposit insurance fund; and (B) the bank is, and continues to be, in compliance with applicable capital standards prescribed by the appropriate Federal banking agency.

Subsidiaries of State-Chartered Banks, 12 U.S.C. 1831w (2000) [aka Section 46 of the


FDIA]
(a) In general. An insured State bank may control or hold an interest in a subsidiary that engages in activities as principal that would only be permissible for a national bank to conduct through a financial subsidiary if- (1) the State bank and each insured depository institution affiliate of the State bank are well capitalized (after the capital deduction required by paragraph (2)); (2) the State bank complies with the capital deduction and financial statement disclosure requirements in section 24a(c) of this title; (3) the State bank complies with the financial and operational safeguards required by section 24a(d) of this title; and (4) the State bank complies with the amendments to sections 371c and 371c-1 of this title made by section 121(b) of the Gramm-Leach-Bliley Act. (b) Preservation of existing subsidiaries Notwithstanding subsection (a), an insured State bank may retain control of a subsidiary, or retain an interest in a subsidiary, that the State bank lawfully controlled or acquired before November 12, 1999, and conduct through such subsidiary any activities lawfully conducted in such subsidiary as of such date. **** (d) Preservation of authority (1) Federal Deposit Insurance Act No provision of this section shall be construed as superseding the authority of the Federal Deposit Insurance Corporation to review subsidiary activities under section 1831a of this title. (d) Subsidiaries of insured State banks

12 U.S.C. 1831a(d) (2000)

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(1) In general --After the end of the 1-year period beginning on December 19, 1991, a subsidiary of an insured State bank may not engage as principal in any type of activity that is not permissible for a subsidiary of a national bank unless- (A) the Corporation has determined that the activity poses no significant risk to the appropriate deposit insurance fund; and (B) the bank is, and continues to be, in compliance with applicable capital standards prescribed by the appropriate Federal banking agency.

Merchant Banking Provision of G-L-B, 12 U.S.C. 1843(k)(4) (2004) Merchant banking is the buying of equity positions in companies as a financial investment; Tightly regulated, but basically banks can make such investments if they dont get too involved.
(H) Directly or indirectly acquiring or controlling, whether as principal, on behalf of 1 or more entities . . . engaged in any activity not authorized pursuant to this section if (i) the shares, assets, or ownership interests are not acquired or held by a depository institution or subsidiary of a depository institution; (ii) such shares, assets, or ownership interests are acquired and held by- (I) a securities affiliate or an affiliate thereof; or (II) an affiliate of an insurance company described in subparagraph (I)(ii) . . .; (iii) such shares, assets, or ownership interests are held for a period of time to enable the sale or disposition thereof on a reasonable basis . . .; and (iv) during the period such shares, assets, or ownership interests are held, the bank holding company does not routinely manage or operate such company or entity except as may be necessary or required to obtain a reasonable return on investment upon resale or disposition.

Additional Rules Under, New Section 4(n)(5) of the BHCA (5) CROSS MARKETING RESTRICTIONS APPLICABLE TO COMMERCIAL

ACTIVITIES.- (A) IN GENERAL.--A depository institution controlled by a financial holding company shall not- (i) offer or market, directly or through any arrangement, any product or service of a company whose activities are conducted or whose shares are owned or controlled by the financial holding company pursuant to this subsection or subparagraph (H) or (I) of subsection (k)(4); or (ii) permit any of its products or services to be offered or marketed, directly or through any arrangement, by or through any company described in clause (i). . . . (6) TRANSACTIONS WITH NONFINANCIAL AFFILIATES.A depository institution controlled by a financial holding company may not engage in a covered transaction (as defined in section 23A(b)(7) of the Federal Reserve Act) with any affiliate controlled by the company pursuant to this subsection.

Who Won in Gramm-Leach-Bliley? FRB v. Treasury (OCC): Fed won: ended up being regulator at top of food chain: regulates the top entity (BHC) most non-banking activities are going to be pursued through non-bank affiliates which do not have a bank supervisor, just the Fed so organizations will choose to put activities in Fed-oriented, Fed-supervised things rather than OCC-supervised banks Federal Authorities v. State Authorities: federal government is displacing state authority BHC and non-bank affiliates are the attractive place to put stuff; not much competing role for state banks Banks v. Thrifts: banks will now be more attractive than savings banks (pre-GLB, there were fewer distinctions between savings banks and commercial banks)

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Banking v. Insurance v. Securities: insurance has been pushed out of banks: have been pushed out to non-bank 4(k) subs and thus are fully subject to state insurance regulation

functional regulation: the regulators who are best at regulating a function should do it The Separation of Banking and Commerce: watering down restrictions may lead to removal of separation altogether.

Capital Requirements for Financial Conglomerates If banks or BHCs are given expanded powers outside the bank, and deposit insurance and other safety nests for banks are statutorily limited to avoid government insurance of the non-core, risk taking activities of non-bank affiliates, one unresolved issue is whether a bank can effectively be insulated from the activities of its non-bank affiliates. It is possible that the use of one name by the conglomerate or effective cross selling or advertising on the part of the BHC would cause the public, and possibly the courts, to limit the corporate separateness of banks and their non-bank affiliates under certain circumstances. Tendency of management to centralize decision making power and resource allocation in the parent bank or BHC. If the activities of the non-bank affiliate are more profitable, the critical lending activity of the bank and its general safety may be less important to the parent. Also conflicts of interest may arise bank which is an affiliate of an automobile company will probably not want to make loans to other automobile companies or their suppliers. The ramifications of larger organizations failing are more dire than those of smaller organizations failing Could use firewalls to assuage these problems of centralized decision making and maintaining corporate separateness, but this may create economic efficiencies and frustrate desire to operate as a coherent whole. Also, history has shown that theirs is an irresistible incentive for management to bring the total resources of the financial conglomerate as a whole to bear to prevent failure Source of strength doctrine BHCs should have sufficient managerial and financial resources to assist their banks subsidiaries should they get into trouble. BHC should use those resources to assist troubled bank subsidiaries. FIRREA (1989) Cross-guarantee provision allows the FDIC to make a direct assessment on BHC commonly controlled banks whenever the FDIC incurs losses as the result of the failure of another federally insured depository institution within the same BHC system. Note that this provision does not reach BHC resources invested in non-bank affiliates or the BHC itself. FDICA (1991) The legislation imposes a series of supervisory restrictions on any depository institution that fails to meet its capital requirement. The institution is to submit a capital restoration, including a guarantee (limited to the lesser of 5% of the subs total assets or the amount necessary to bring its undercapitalized sub back into compliance) from its parent holding company that the capital restoration plan will be achieved. The BHC can also choose to cut its losses (e.g. not guarantee) and allow the regulators to apply their other supervisory enforcement powers, such as closure of the institution. Departure from traditional rules of limited liability Advantage that the transfer frontline supervisory responsibility from government agencies to BHCs and BHCs are likely to be more familiar with the risks of their depository institutions (and their organizations as a whole) and can monitor those risks at substantially lower costs than government agencies can.

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Insurance Companies
Introduction to Insurance Regulation
History Colonial times through civil war Slower growth than banks; skeletal regulatory structure at state level Paul v. Virginia (USSC 1868 Virginia adopted some rules that made it difficult for out of state insurance companies to make use of local agentsdesigned to keep northern insurance companies out after civil war; A bunch of insurance companies challenged on the grounds that it violated the interstate commerce clause); Held that insurance wasnt included in interstate commerce. Insurance was a local contract. As a result congress was prevented from regulating insurance (since its not part of interstate commerce). This is why banking went the way of the fed govt and insurance is all state regulation. Following this case there was fear that securities laws would meet the same fate. If you read the 1933 Act, every other word is interstate commerce. Crisis if the Turn of the Century Assertion of Federal Authority United States v. South Eastern Underwriters Association (USSC 1944 SEUA was found to have violated federal antitrust laws, but district court said that federal antitrust laws did not apply since insurance was not commerce); Held that fire insurance transactions across state lines constitutes interstate commerce. Overruled Paul. Congress responded by enacting legislation which basically maintained the status quo of state regulation of insurance. McCarran-Ferguson Act turns off the dormant commerce clause Declaration of Policy, 15 USCA 1011 (1999)

The Congress hereby declares that the continued regulation and taxation by the several
States of the business of insurance is in the public interest, and that silence on the part of the Congress shall not be construed to impose any barrier to the regulation or taxation of such business by the several States.

Regulation by State law and Certain Federal Laws, 15 USCA 1012 (1999)
(a) State regulation. The business of insurance, and every person engaged therein, shall be subject to the laws of the several States which relate to the regulation or taxation of such business. (b) Federal regulation. No Act of Congress shall be construed to invalidate, impair, or supersede any law enacted by any State for the purpose of regulating the business of insurance, or which imposes a fee or tax upon such business, unless such Act specifically relates to the business of insurance: Provided, That after June 30, 1948, the [Sherman Act, the Clayton Act, and the FTC Act] shall be applicable to the business of insurance to the extent that such business is not regulated by State law.

Suspension of certain Federal laws, 15 USCA 1013 (1999) This provision related directly to the situation in SEUA making SEUAs behavior impermissible
(a) Until June 30, 1948, the [Sherman Act and certain other federal antitrust laws] shall not apply to the business of insurance or to acts in the conduct thereof. (b) Nothing contained in this Act shall render the said Sherman Act inapplicable to any agreement to boycott, coerce, or intimidate, or act of boycott, coercion, or intimidation.

Following McCarran-Ferguson

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As a result of MF, it became important for states wishing to avoid application of federal antitrust statutes to pass laws regulating rates. Most states eventually passed an Unfair Trade Practices Act to block application of the Federal Trade Commission Act. Overview of Insurance Regulation Most state insurance codes exempt certain organizations or transactions from all or part of the regulatory rules. Typical cases are government insurance funds, charitable organizations, employee pension plans (for which federal law has displaced state regulation), and certain small mutual aid societies. Familiar Features Licensing procedures Insurance companies (and brokers and reinsurers etc.) must be licensed. However in most states unlicensed insurers are permitted to underwrite surplus lines of insurance (those lines of insurance unavailable through the normal insurance market). The contracts for such insurance usually must be made by specially licensed brokers who affirm that the coverage could not be obtained in the regular market, who assume the responsibility for paying the applicable premium tax, and who are expected to satisfy themselves that the insurers selected are financially sound. Restrictions on other businesses Most states prohibit insurance companies from engaging in any other business not reasonably related to its insurance business. Nonlife, insurers, however have long been permitted to hold controlling interests in unrelated businesses as part of their investments, and modern holding company laws permit them to have affiliates for a generously defined range of related activities; some states permit affiliates for any lawful purpose. In addition, GLB permits a QFHC to hold an insurance company along with other financial affiliates (e.g. a bank and a securities firm). Portfolio restrictions and supervisory and oversight Less than for banks All states required newly formed domestic insurance companies to have a certain minimum amount of paid-in capital, or in the case of a mutual, of surplus, which must be maintained at the prescribed level at all times. In practice, regulators can and do take action against troubled insurers before they fall below the minimum standard, but such actions are subject to legal challenges and regulators must convince a court that an insurer is in unsafe condition. NIAC has adopted model minimum risk based capital requirements for the various different types of insurers. A few state require foreign insurers (e.g. those domiciled in another US state) to have a higher amount of capital or surplus. American insurance commissioners have a large assortment of enforcement powers, whose simple existence and deterrent effect make it possible for the commissioner in most cases to secure compliance with his suggestions without having to resort to enforcement measures. The enforcement measures that are used most often include civil penalties or forfeitures and suspension or revocation of license. Reporting requirements Specialized Liquidation Procedures The insurance business is exempted form federal bankruptcy law. Difficulty of coordinating between jurisdictions means there is no guarantee that all the assets of an insolvent insurer will be pooled and distributed equitably among its insureds and other creditors.

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Most states have insolvency guarantee funds. Most states have separate funds for life and
non-life. Most states limit coverage of property/casualty claims and death benefits to $300,000; and Health insurance claims and cash values on life insurance policies and annuities are typically limited to $100,000. With the exception of NYs property/casualty guarantee fund, assessments are made after an insolvency occurs to cover the claims of the insolvent insurer. T The burden of the guarantee fund assessments are ultimately shared by: all policy holder through their insurance rates; taxpayers because of state premium tax offsets (in some states) and deductions for federal income taxes; and owners of insurers. New Features of Regulation State oversight & interstate cooperation (NAIC) x Rate regulation In life and accident and health insurance, there is no direct rate regulation but state standard accident and health policy laws normally give the commissioner the power to disapprove policy forms if in his judgment the promised benefits are not reasonable in relation to the premiums charged. 4 possible legal regimes for setting rates Open competition File and use Prior approval by company Prior approval for all companies States have been particularly active in regulating automobile insurance. Massachusetts has the most compressive rate regulation system. For some lines of insurance, market competition is considered to be sufficient for regulating rates. Line of Business regulation/Regulation by class x Specialized rules/systems of regulation for different types of insurance Life and Non-life are usually separated. Agents, Reinsures, etc. all have regulatory structures Consumer protections (not really new, but done differently) States generally have an approval process whereby contract forms must be submitted for approval before they are used. Advertising and solicitation by insurers and observation of principles of fair trade have long been subject to surveillance both by state insurance departments and to a lesser extent by the Federal Trade Commission. Fairness to policy holders Aequum et Bonum Dont want policy holders to have to pay more than the insurance is worth, but dont want insurers to undercharge b/c in the end, insolvent insurers also hurts policy holders. Contra proferentem ambiguities in the contract are interpreted against the writer of the contract (so in favor of the policy holder).

What is Insurance?
State ex rel. Duffy v. Western Auto Supply (Ohio 1938 company owned retailers which sold tiers
with guarantees against defects in material and workmanship and "against blowouts, cuts, bruises, rim-cuts, under-inflation, wheels out of alignment, faulty brakes or other road hazards that may render the tire unfit for further service (except fire and theft)."); Held that this is insurance.

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A warranty promises indemnity against defects in the article sold, while insurance indemnifies against loss or damage resulting from perils outside of and unrelated to defects in the article itself. Each [warranty form] constitutes an undertaking to indemnify against failure from any cause except fire or thefts and therefore covers loss or damage resulting from any and every hazard of travel, not excepting negligence of the automobile driver or another. It is substantially an unconditional promise of indemnity, and that is insurance. Prepaid Dental Services, Inc. v. Day (Utah 1980 - PDS proposed to offer a dental plan under which people pay a single plan and get access to a group of dentists; plan pays group of dentists a retainer; dentists provide services and if they dont, plan pays patients performance bond); Held that this is not insurance (specifically not an HMO); PDS is not undertaking to pay any benefit upon the happening of any contingency (e.g. there is a risk that the participants will need more dental care than anticipated, but dentists in the plan get paid no matter what (based on number of people in plan), so essentially this risk is on the dentists). Nowhere in the HMO Act do we find a provision that an HMO must provide dental services. It seems anomalous then that an organization which provides dental services must also offer medical and hospital services in order to operate Result oriented? There is still a risk of dentists not performing. Performance bonds dont normally exempt plans from insurance regulation. Seems like court might not have wanted to call this an HMO because if it had to provide the services required by an HMO, it probably wouldnt be able to continue and overall the plan seems beneficial. First National Bank of Eastern Arkansas v. Taylor (8th Cir. 1990 For an extra fee bank offers protection whereby if the customer dies, their estate doesnt have to pay back the loan; OCC says this is incidental to banking under 24 seventh); Held that this is not insurance, its banking. Moral of the story when federal banking laws and state insurance laws overlap, federal banking laws preempt. Not clear if this makes sense since offering insurance involves complex calculations of risk and perhaps insurance regulators would regulate better. Having found that the national Bank Act authorizes national banks to offer debt cancellation contracts as incidental to baking, we find in favor of FNB under the principle of federal preemption. Because national banks are considered federal instrumentalities states may neither prohibit or unduly restrict their activities. Because debt cancellation contracts are within the incidental powers granted by the National Bank Act, they do not constitute the business of insurance [which is exempted from most federal regulation that does not directly refer to insurance] under the McCarren-Ferguson Act. The court makes a strange distinction between insurance contracts which require something to be paid, and scenario under which debt is simply extinguished.

Interpretation of Insurance Contracts


State Farm Mutual Automobile Insurance Co. v. Moore (Pa Super Ct. 1988 Brain Stuck had a
car accident; the Car was owned by Charles Royer and insured by Ohio Casualty; On the night of the Accident Leigh Ann Royer (daughter) had the car; she and Brian and friends had visited several bars; At some point in the night Leigh Ann let Brian drive her car; Brian did not have a licenses; He got into an accident; Brains family had a no fault insurance policy with State Farm; OC claimed that its policy did not cover Brain b/c he wasnt a licensed driver; SF claimed that its policy only provided excess coverage (e.g. $ above what OC policy pays)); Held that under the principles of contra proferentem, OC pays. OCs policy stated we do not provide Liability Coverage.for any person using a vehicle without a reasonable belief that the person is entitled to do so.

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Could be interpreted to mean that a person can reasonably believe he is entitled to use a car once he has obtained the owners permission. Contra proferentem Where a provision of a policy is ambiguous, the policy provision is to be construed in favor of the insured and against the insurer, the drafter of the agreement. Insurable interests Cant insure something in which you dont have an interest Johnson v. Alstate Insurance Co. (Okla App. Ct. 1993 Johnsons were married; in the divorce, Mr. got the house subject to its mortgage; Mr. then went bankrupt leaving Mrs. liable on the mortgage; Mrs. took out insurance on the house; the house burned down and Mrs. filed a claim for the value of the house, but not its contents; the insurance policy contained language limiting the maximum claim to the insureds interest in the property): Held that Mrs. insureable interest was the amount owed on the mortgage and NOT the value of the house. Policy against wagering contracts in the form of insurance and against fostering effort to destroy the insured property in an effort to profit from it. Insurance agents dont have a continuing duty to keep up with developments in insurance and inform their customers of new developments that might help them (lower standard than is applicable in the securities industry). Murphy v. Kuhn (NY 1997 - Insured had asked agent about getting maximum possible coverage when he first opened his policy. He later got in an accident and the insurance didnt cover the whole thing. He sued his insurance agent for not keeping him apprised of new developments in insurance that might have afforded him more coverage); Held that the insurance agent is not liable. It is well settled that agents have no continuing duty to advise, guide or direct a client to obtain additional coverage. Insureds are in a better position to know their personal assets and abilities to protect themselves more so than general insurance agents or brokers unless the later are informed and asked to advise and act.

The Regulation of Insurance Company Insolvency


Executive Life Insurance Company: A Case Study ELIC was a well known insurer in the 1980s. CEO Freddie Carr was close to Michael Milken and bought a lot of junk bonds. Over 50% of assets were Junk bonds (6.2 billion) Other assets were about 4 million in marketable securities. Liabilities were primarily GICs (Guaranteed Insurance Contracts). GICs were annuities at maturity get principle plus guaranteed interest. Sold as a substitute for bank deposits. Muni GICs annuities bought by municipalities with money raised from municipal bonds. S&L crisis; 1989 Thrifts were told to liquidate junk bonds. This brought down the value of junk bonds (ELICs primary assets) considerably. California state regulator shut ELIC operation down & Sent letters to policy holders. 1st Letter State regulator sent out letters informing insured parties saying that the would get 80 or 90 cents on the dollar and anyone with an annuity of $100K or less will be covered by NOLGA (made of state guarantee funds from the 50 states each fund covers the resident of its state and NOLGA coordinates). Then Commercial National Bank v. Superior Court (Cal. 1993) Muni GICs wanted to be class 5 (along with the other GICs) other CIC; Court held that Muni GICs and GICs were to be classified together (class 5).

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Doesnt matter that bondholders bought their bonds on the secondary market at below face value; the Muni GIC holders were the indenture trustees of the bonds and not the bond holders. Insurance commission wanted to value as of the shut down (low point) and Muni GICs wanted to value as of a later date when assets were more valuable. Court held in favor of Munis. nd 2 Letter Court has said that the Muni GICs were class 5 along with the other GICs (as opposed to class 6 as the insurance commissioner had originally thought). Therefore the class original 5 GICs are getting less than had been indicated in the first letter. 2 groups hurt: Those with GICs over $100,000 NOLGA (b/c they need to pay up to $100,000 to the extent that the assets of the liquidated company dont cover). Highlights of Insolvency Regulation Insurance companies have solvency proceedings administered on the state level (no bankruptcy). HQ state acts as receiver and through NOLGA, the individual states guarantee funds administer payments to the residents of their respective cases. For banks the FDIC does both functions. National banks have national regulation, but different offices regulate different aspects of banking. Reserve board for holding company regulation OCC for charters FDIC for deposit insurance In insurance law, the state insurance commissions serve all functions, but there are 50 state insurance commissions. This and other failures have caused some to question the efficacy of state based guarantee funds/regulation. A failure in one state can cause the guarantee funds of several funds to have to pay. Movement for federal charters for insurance companies State guarantee situation cobbled together in strange way as ELIC shows (e.g. at one point some state guarantee funds were going to pay and some were refusing to b/c there was no life insurance component as defined under their statutes). Easier for insurance companies to maneuver. Probably insurance companies would be able to choose state or federal charters and have holding companies which held both. Maybe federal charter with state guarantee funds? Maybe federal guarantee fund which could either apply to all insurance companies or only federally chartered insurance companies. Guarantee Funds Since 1974. PBGC (pension benefit guarantee corporation) has guaranteed annuities given to workers in employer sponsored pension plans, taking these instruments out of the insurance guarantee fund system. In Insurance the funds for failures are raised after the fact (by contrast to the banking system where the funds are raised in advance). Also, the insurance assessments arent done nationally, they are done on a state by state basis. Also, the insurance assessments arent charged to all insurers in the effected states either all life insurance or all health insurance etc. Also, often assessments can only be a certain percentage of premiums collected. Idea that insurance companies will watch their neighbors b/c they know that the risky business of a neighbor might mean that they end up having to pay.

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There is a considerable variation in the amount of guarantees offered in different states (e.g. California = $100,000; Pennsylvania = $300,000). In addition there are variations as to what insurance the state guarantee funds will cover. Arizona Life & Disability Guarantee Fund v. Honeywell (Arz 1997) (Finding that ELIC GICs held by a pension fund in trust for its beneficiaries were not annuities because they were not contingent on the continuance of human life and therefore not entitled to insurance fund payment); overturned on a appeal by the Arizona Supreme Court which found that although the GICs themselves were not life contingent, they were part of an investment plan and therefore they incorporate the plan, subject to all of the plans conditions. NAIC Accreditation Program (pages 498-06) Content A series of model acts that are supposed to be adopted by all the jurisdictions. Enforcement Adopting these model acts is the ticket to doing business outside of the state. After January 1, 1994, accredited sates were supposed to refuse to accept examinations from unaccredited states, thereby forcing insurance companies from unaccredited states to submit to additional examinations. Is it likely to be successful Hard to enforce against big insurance states Unaccredited states, such as New York, adopted retaliatory legislation threatening to reject regulatory examinations of insurance companies domiciled in states that rejected examinations from the legislating state. Threats of this sort dissuaded most jurisdictions from enforcing the accreditations sanctions. Additionally insurance companies discovered a loophole by submitting themselves to zone examinations, in which regulatory authorities from several states participated, a company domiciled in an unaccredited jurisdiction could claim that it was examined by an accredited jurisdiction if at least one accredited jurisdiction participated in the examination. Ultimately the states did come through and accept the program Attempt to Regulate Licensing of Agents Federal government threatened to takeover licensing of agents unless the states stepped up. The states did step up so federal regulation didnt come to pass.

Insurance Rates and Risk Classification


Generally Most states have laws that provide that rates shall not be excessive, in adequate or unfairly discriminatory. In life and accident and health insurance, there is no direct rate regulation but state standard accident and health policy laws normally give the commissioner the power to disapprove policy forms if in his judgment the promised benefits are not reasonable in relation to the premiums charged. 4 possible legal regimes for setting rates Open competition File and use Prior approval by company Prior approval for all companies States have been particularly active in regulating automobile insurance. Massachusetts has the most compressive rate regulation system.

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For some lines of insurance, market competition is considered to be sufficient for regulating rates. Automobile Insurers Bureau v. Commissioner of Insurance (Mass. 1995 Judicial review of Massachusetts Commissioner of Insurance decision effecting an overall reduction in private passenger car insurance of 6.1% in light of a new mandatory seat belt law); Held that while the effect of the seatbelt law was not yet known (too new) the commissioners decision was justified by the logic of the model it used, the available data, and the absence of evidence to the contrary. Test = whether rates have reasonable support in evidence Insurance commissioner has brad authority to set rates Calfarm Insurance v. Deukmejian (Cal. 1989): Held that the part of the referendum allowing rate increases where the insurer is substantially threatened with insolvency would allow the government to impose confiscatory rates and thus is unconstitutional The rest is okay. . Facial challenge to Proposition 103 referendum reducing insurance rates by 20% passed. Before 11/89, relief from 20 percent reduction only if insurer is substantially threatened with insolvency. This is confiscatory on its face because If an insurer had a substantial net worth, or significant income from sources unregulated by proposition 103, it might be able to sustain substantial and continuing losses on regulated insurance without danger of insolvency. In such a case the continued solvency of the insurer could not suffice to demonstrate that the regulated rate constitutes a fair return. But note that while suggestive (certainly there must be some distance between insolvency and a fair rate of return), this leaves the question open of what would happen if the insolvency condition just applied to the part of the insurance company that was regulated by proposition 103. After 11/89, increase with Commissioners prior approval unless rates are excessive, inadequate, unfair discriminatory or otherwise in violation of the initiative. Thereafter, rates increase with prior approval Permissible factors limited to driving record, number of miles driven, years of driving experience, and other factors approved by the Commissioner. Termination of insurance policies for only for cause. Cause = nonpayment of premiums, fraud or significant increase in risk This does not violate the constitutional prohibition on impairing the obligation on contracts since insurance is a highly regulated industry so insurers should expect to be regulated AND insurers can always discontinue their business in California. Confiscatory = denies owners a reasonable return on their property. To justify a measure which deprives persons of a fair return, however, an emergency would have to be a temporary situation of such enormity that all individuals might reasonably be required to make sacrifices for the common weal. In re Twin City Fire Insurance Co. (N.J. 1992 - Twin cities wants to get out of NJ b/c its tiered of being hit with these taxes designed to subsidize the residual market. Hartford fire owns twin cities and other affiliates which operate in NJ. NJ law says that if an insurance company leaves, the state, all its affiliates have to surrender their licenses to practice in NJ within 5 years. Also, any withdrawing company must seek replacement carrier for its policies and cannot withdraw from the market until all of its policies have been placed with other carriers or have expired; Sort of withdrawal tax.); Held no due process violation; no unconstitutional taking of property. Regulatory interest in retention of private-passenger insurers is more than adequate to sustain the forfeiture condition against a substantive due process challenge.

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We consider [the forfeiture condition] to be more in the nature of a regulatory limit on Twin Citys right to abandon its responsibilities in the private passenger automobile market than a taking of its affiliates property for public use. Risk Classifications Trade off between efficiency and fairness Promoting efficiency through risk classification sometimes requires sacrificing other values. The burdens of inaccuracy may be unevenly distributed; risk classes may be based on variables not within the control of insureds; and certain variables may have unacceptable social or moral connotations. 4 categories of criticisms of risk classifications accuracy-equity concerns control-causality concerns (use variables that arent under the control of the insureds?) use of suspect variables Unraveling in one insurer offers the unisex rate and others offer the lower womens rate and the higher mens rate, mostly men will take the unisex rate. redistributional polices Florida State Department of Insurance v. Insurance Service Office (Fla. Dist. Ct. App. 1983 Florida statute said no insurer shall, with respect to premiums charged for automobile insurance, unfairly discriminate solely on the basis of age, sex, marital status or scholastic achievement; In implementing this law the Florida DoI adopted a rule prohibiting the continued use of age, sex, marital status, and scholastic achievement as automobile insurance rating factors); Held that the adoption of this rule is an invalid exercise of delegated legislative authority. Statute doesnt prohibit consideration of these factors, it just prohibits unfair discrimination based on these factors. the evidence below overwhelmingly shows these factors are actuarially sound. We conclude, therefore, that even under the alternative theory advanced by the department, the statues do not authorize a blanket prohibition against use of these factors. Problem if there were a test to determine whether you would get a particular disease, insurance against this incurrence would become impossible (e.g. those with no chance of getting it wouldnt buy the insurance so no risk spreading). Even if the insurance company couldnt use the test, if the test were available to the general population, only those who would get the disease would buy the insurance (adverse selection problem). Health insurance (outside of employer sponsored plans) suffer from this problem to some extent. Only those who think they might need it buy it and thus it is very expensive. Employment based life insurance and annuities are priced on a gender neutral basis (Title VII); However other aspects of insurance are regulated on a state level and states can choose what criteria they want to permit.

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The Securities Industry


Introduction to the Securities industry
History of broker dealer regulation Early regulation and Blue Sky Laws Late 19th Century public securities market began to develop. Big projects (e.g. RR) needed capital Wealthy class had $ to invest New telecommunications made marketing easier Growing middle class meant that issuers began to issue bonds in smaller denominations. Early 20th Century During the first 3 decades of the 20th Century saw and expansion in retail security business 1st world war was financed through liberty bonds. Blue Sky Laws developed by the 1920s name came from the idea that offerors would sell everything but the blue sky. First securities litigations mostly based on common law fraud and deceit. Crash of 1929 and New Deal Legislation Pecora Hearings revealed infirmities in the securities market Disclosure problems Market manipulation Conflicts of interest 2 views Brandies wrote a book with the famous idea that disclosure was the best regulator Hard core new dealers thought that the federal government should be more active in reviewing the quality and appropriateness of publicly traded securities. Securities Act of 1933 was passed Initially administered by FTC; SEC was created by 1934 Exchange Act Securities Exchange Act of 1934 & the creation of the Securities and Exchange Commission Addresses the exchanges. Rather than directly regulating the exchanges, the 1934 Act called upon the exchanges themselves to register with the SEC and make rules regulating and oversee their members. Also imposed disclosure requirements for issuers with securities traded in public markets (exchanges/OTC). SROs (exchanges and NASD) were created. Quasi governmental, but also influenced by private interest. NYSE was seen to be a problem, but too big to do away with, so 1934 Act co-opted it. Joe Kennedy (Known market manipulator and father of JFK) was the first head of the SEC. Amendments of 1938 and Creation of NASD Two types of public securities markets Exchanges physical location; people trade in person. OTC market no physical location; network of broker/dealers and daily quotes. 1934 Act didnt effectively reach the OTC, although some of its fraud rules probably extended to participants in the OTC market. Required securities dealers engaged in the OTC to align themselves with an SRO. The only SRO that ever came to be was NASD.

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Modern Era Reforms in 1970 and 1975 1970 amendments created the Securities Investor Protection Corporation (SPIC). Provides coverage for up to $500,000 in losses for an individual account, not more than $100,000 of which may be in cash balances (does not cover bad investments or fraud or manipulation by brokers only covers BD loosing /misapplying your assets). 1975 Amendments were designed to increase competition in the trading markets and to develop a more unified national market system. Realignment of Federal-State Authority in the 1990s National Securities Market Improvement Act of 1996 partially repealed the traditional join federal-state oversight. In particular, the Act added 15(h) to the 1934 Act, which invalidates all state or local laws that establish capital, custody, margin, financial responsibility, record keeping, bonding, or financial or operational reporting requirements for brokers, dealers, municipal securities dealers, government securities brokers, or government securities dealers that differ from, or are in addition to the requirements of the 1934 Act. Apparently left unaffected by this new provision are state anti-fraud rules and other common law remedies. Overview of Broker-Dealer Regulation Federal, State, and SRO Emphasis on individual qualification to be come a broker dealer Need to file form BD with SRO, which passes it on to the SEC along with other biographical and financial information. Principals and employees engaged in investment banking and securities business must pass an exam. Portfolio-Shaping Rules Capital Requirements, Record-Keeping, Continuing Education etc. Not many other balance sheet restrictions No geographic restrictions No direct limitations on types of investments or liabilities Limited public insurance & receivership (SIPC) Protects investors from brokers absconding with their $; does NOT provide protections simply from bad investments Supervisory Oversight Emphasis on Open-ended obligations Multiple venues for Discipline Substantial Private Rights of Action

Definition of Broker Dealers


Registration and Regulation ( 15 of the 1934 Act)

(a)(1) It shall be unlawful for any broker or dealer which is either a person other than a natural person or a natural person not associated with a broker or dealer . . . (other than such a broker or deal whose business is exclusively intrastate and who does not make sure of any facility of a national securities exchange) to [enter interstate commerce] to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security . . . , unless such broker or dealer is registered in accordance with subsection (b) of this section.

Basically says broker dealers cant be involved in securities transactions unless they are registered. Original Definitions of 1934 Act (amended in 1999 now much longer, but not much different)

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Under 3(a)(4) of the 1934 Act, a broker is defined to be any person engaged in the business of effecting transactions in securities for the account of others, but does not include a bank. Section 3(b)(5) offers a similar definition for a dealer as any person engaged in the business of buying and selling securities for his own account, though a broker or otherwise, but does not include a bank, or any person insofar as he buys or sells securities for his own account, either individually or in some fiduciary capacity, but not as part of a regular business. Why not regulate banks as broker-dealers? Enacted in the wake of Glass-Stegal saying that banks couldnt engaged in securities business (or so congress thought). It turns out that the Glass-Stegal prohibitions on banks engaging in the securities business was eroded overtime. In 1999 the rule was changed to say that if a bank does too much securities stuff, the rules applying to broker dealers will apply. Old-Stone Corp. SEC No-Action Letter (Granted November 20, 1984) Old Stone Corp owned Old Stone Bank FSB which owned OSSC. In connection with approval of a reorganization of Old Stone, the FDIC made certain capital requirements. Old Stone Corp wanted to offer and sell notes though three of its subsidiaries (Old Stone Bank FSB, Perpetual Savings and Loan Association, and Guild Loan & Investment Co.) thus avoiding the use of an underwriter without those subsidiaries having to register as brokers and without meeting broker capital requirements. For technical reasons, the bank exemption is not available to Old Stone. Rule 3a4-1is a safe harbor that is designed for issuers selling their own securities. Old Stones proposed transaction, however, is in technical non-compliance with the safe harbor b/c the safe harbor is no available to associated persons of a broker-dealer. OSSC is a broker dealer, but will not be participating in the offering. Other favorable aspects of the transaction Sale is in response to higher capital to assets ratio imposed by SEC No future offers of this type are anticipated No persons associated with OSSC will participate in the offering Those participating in the offering will be regular, full time employees and not compensated on a commission basis. OSSC deals with institutional and not retail investors and deals in govt securities. No action letters are technically not representative of the SEC but the opinion of the enforcement staff. Theoretically the SEC could still go after someone who gets a no action letter. Lincoln Savings and Loan SEC enforcement resulted firm LSL selling bonds from its holding company, ACC, to customers without disclosing ACCs bad financial condition.

The Obligations of Broker Dealers


Broker Dealers v. Investment Advisors Note that the duties that attach when BDs give advice stem from their status as BDs. Just giving investment advice, without more, doesnt make someone a BD, although they may be regulated under the Investment Advisors Act of 1940. IAA provides lighter regulation and has no SRO overlay. Also, USSC has only allowed limited private rights of action under the Investment Advisors Act. Although some BDs are also registered under the Investment Advisors Act, the Act itself includes an exemption for BDs whos performance of advisory services is solely incidental to the conduct of [their business as broker dealers] and who receive no special compensation there from. IAA 202(a)(11)(C).

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One area where the IAA is more stringent: Section 205(a)(1) generally prohibits the use of performance based fees for most small investors. Three basic functions of broker dealers Broker-agent Dealer-principal (underwriter or trading for their own account) Advisor Distinctive features of Broker Dealer regulation: Focus on individual accountability Emphasis on protection through disclosure Statutes Anti-Fraud in Sale of Securities, Section 17(a) of the 1933 Act It shall be unlawful for any person in the offer or sale of any securities . . . directly or indirectly- (1) to employ any device, scheme, or artifice to defraud, or (2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser. Manipulation by Broker Dealers Section 15(c)(1)(A) of 1934 x No broker or dealer shalleffect any transaction in, or to induce or attempt to induce the purchase or sale of any security (other than commercial paper, bankers acceptances, or commercial bills) otherwise than on a national securities exchange of which it is a member by means of any manipulative, deceptive, or other fraudulent device or contrivance. Section 10(b) of 1934 Act Gives the SEC rule making authority. Most important rule is 10-b(5) which looks a lot like 17(a). Charles Hughes & Co. v. SEC (Hughes I) (2d Cir. 1943 - SEC revoked broker-dealers (dealer/advisors) registration because they were selling securities at substantially above market prices saying that they were marvelous buys and beyond the usual. The customers were primarily single women or widows who knew little about the securities market.); Held [e]ven considering petitioner as a principal in a simple vendor-purchaser transaction (and there is doubt whether petitioner was not acting as a broker-agent for the purchasers, in which case all undisclosed profits would be forfeited), it was under a special duty not to take advantage of its customers ignorance of market conditions. Revocation upheld. An OTC firm which actively solicits customers and then sells them securities at prices as far above the market as were those which the petitioner charged here must be deemed to commit a fraud. Under 17(a) the SEC has consistently held that a dealer cannot charge prices not reasonably related to the prevailing market price without disclosing that fact. Note: Different than rule in goods market. Coop doesnt have to disclose mark-up for books that they sell. Are we regulating the substance of the transaction or imposing disclosure duties? Unresolved in this case. Shingle theory when a securities firm hangs out its shingle to do business it implicitly represents that it will deal fairly with the public. Hughes v. SEC (Hughes 2) (DC Cir. 1949 SEC revoked Arleen W. Hughes (dealer/advisor) registration of a broker dealer; Arleen sells stocks and provides research/advice to her clients; she

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charges a slightly higher than usual transaction fee; She never disclosed the price she paid for the securities, their market price of any bid ask prices for the securities.); Held that Arleen, as a fiduciary, did not satisfy minimum disclosure requirements; revocation upheld. Waiver 120 of 175 of Arleens clients filed an amicus brief on behalf of Arleen saying that they understand their agreement with Arlene and the capacity under which she dealt with them. The court says that such statements are not grounds for overturning the decision by the SEC. In memorandum of agreement between Arleen and her clients it said Company, when acting as investment adviser, shall act as Principal in every such transaction, except as otherwise agreed, and that in any event and Arleen said that she always stood ready to provide any further information which her customers desired The court says this is not enough. Churning Mihara v. Dean Witter & Co. (9th Cir. 1980 Mihara filed this action under 10(b)-5 against Dean Witter for churning; Dispute as to what Mirahas expressed objectives to his broker-dealer were (e.g. he said conservative investment goals and the broker-dealer said growth); Between January 1971 and July 1973 the account was turned 14 times; 9.3 of the times were in 1971); Held that Dean Witter and its account executive, George Gracias (broker/advisor) churned. When a securities broker engages in excessive trading in disregard of his customers investment objectives for the purpose of generating commission business, the customer may hold the broker liable for churning in violation of 10b-5. 3 elements of churning from Hetch v. Harris Upham & Co. (9th Cir. 1970) Excessive trading in light of the objectives of the customer No set number but commentators have suggested that an annual rate of over 6 reflects excessive trading. Broker must exercise control over the customers account The account need not be a discretionary account to satisfy this prong. The requisite degree of control is met when the client routinely follows the representation of the broker. Scienter (necessary for 10b-5) The brokers conduct reflects at best a wreckless disregard for the clients investment concerns, and, at worst, an outright scheme to defraud the client. Reckless conduct constitutes a scienter. Opinion refers to the NASD know your customer rule; while courts have declined to infor private rights of action under SRO rules, these rules do create important background norms for cases such as this one. Mihara is a high-water mark for churning cases. Recently there has been a move to de-emphasize the first element (suitability) especially with respect to institutional investors. Damages in churning cases hotly contested issue; usually limited to amount of excess commissions, but more recently some courts have allowed recovery for losses suffered on a churned portfolio. 10b-5 10b-5 oddities Mihara complained about the handling of his account but kept trading. Why? Idea that if people loose money, they can trump up claims then sue; but scienter requirement blunts this effect some. Is it right to create a private right of action where people will be motivated to sue just b/c they lost money?

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Santa Fe v. Green (USSC 1977); With respect to issuers, 10(b)-5 actions have to be based on deception (informational deficiencies) rather than simple unfairness or breach of fiduciary duty. Enrnst & Ernst v. Hochfelder (USSC 1976); Violations of rule 10b-5 must entail intentional misconduct, not merely negligence (scienter). Duty to Investigate: Broker/dealers have a duty to become educated about the securities being recommended to customers Hanly v. SEC (2d Cir. 1969 5 securities salesmen sold shares of Sonics to their customers and in the process of doing so made overly optimistic comments and failed to disclose negative information that was or would have been available to them upon reasonable investigation; SEC order issued sanctions under 10(b), 17(a) and 15(c)(1), barring 4 BDs from association with any other BD for live and suspending 1 for 6 months; Held that SECs sanctions are upheld. Where the salesman lacks essential information about a security, he should disclose this as well as the risks which arise form his lack of information. A salesman may not rely blindly upon the issuer for information concerning a company, although the degree of independent investigation which must be made by a securities dealer will vary in each case. Securities issued by smaller companies of recent origin obviously require more thorough investigation. The sophistication of the customers was irrelevant the BDs had a duty to investigate.

Note that the SEC brought the Hanly action under 10(b), 17(a) and 15(c)(1). Could investors have brought this under 10b-5? Probably not The implied warranty in this case may not be as rigidly enforced in a civil action. Judge (Timbers) has a view of the SEC as expert agency and is dubious about motivations for the private bar; thinks it should be harder for private bar to bring actions. Also not clear that there is scienter (but scienter wasnt required yet). Not clear that these brokers got any special compensation from pushing this stock in particular. There testimony suggests they just hoped it would take off and make them look good to their customers. Compare sanctions Merrill Lynch The BDs in Hanly received very harsh sanction (4 were barred for life; 1 six months suspension). In a similar SEC enforcement action Merrill Lynch received sanctions that were considerably less harsh (censure; fine of up to $1.6 million to compensate customers; review practices; adopt new guide lines; strengthen trading program; no effort made to delicense the firm). Is differential treatment of large firms appropriate? Hanly Small firm with majority of sales force engaging in behavior seems more like an endemic problem. Merrill larger number but smaller percentage of sales force infected. Merrill has a reputation to protect. Merrill also agreed to review its practices and strengthen its training program need more resources to agree to these potentially useful measures. Merrill was a settled case; Hanly was litigated. Rule 15c2-11 specifies the financial information that broker dealer must possess before it can publish a quotation for a security. No Scalping: Duty to disclose holdings/before & after dealings in recommended securities Sec v. Capital Gains Research (USSC 1963 CG (an Investment Advisor and NOT a BD) would buy stocks then send out its news letter (to about 5000 subscribers who paid $18 per year for it) recommending it as a long term hold. When there was a run up in price following the recommendation, GC would sell. CG would not disclose this to their customers. This is known as scalping. Is scalping fraud or deceit with in the meaning of the Investment Advisors Act of 1940); Held that SECs mild prophylactic of requiring a fiduciary to

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disclose to his clients, not all security holdings, but only his dealings in recommended securities just before and after the issuance of his recommendation is upheld. Now this duty is codified. The Obligation to Supervise In Re. John H. Gutfreund (SEC 1992 Salomon scandal from late 1980s/early 90s. Involved the market for govt securities and a dealership network called primary dealers. PDs make bids on US govt securities at auction (form of IPO) and then resell them into the secondary market. Salomon was a PD. Mozer put in bids for other fictitious purchase in addition to Salomons actual bids and was able to corner the market in government securities. Gutfreund and other senior executives become aware that Mozer is doing this before the government does, but they dont really do anything (tell him this could be bad for his career etc). SEC imposed sanctions for failure to supervise (all 3 were ordered to pay penalties CEO was barred for life and president and vice Chairman were suspended for 6 and 3 months respectively). 1934 Exchange Act 15(b)(4)(E) authorizes the Commission to impose sanction against a broker-dealer if the firm has: failed reasonably to supervise, with a view to preventing violations [of federal Securities Laws], another person who commits such a violation, if such person is subject to supervision. 1934 Exchange Act 15(b)(6) incorporates 15(b)(4)(E) by reference and authorizes the Commission to impose sanctions for deficient supervision on individuals associated with broker-dealers. Even where the knowledge of supervisors is limited to red flags or suggestions of irregularity, they cannot discharge their supervisory obligations simply by relying on the unverified representations of employees.[T]here must be adequate follow-up and review when a firms own procedures detect irregularities or unusual trading activity Note that in Getfreund the defendants discussed the matter with the firms chief legal officer, Feuerstein who posited that Mozers actions were criminal and recommended that they be reported to the government. In the opinion, the SEC scolds Feuerstein for not informing the Compliance Department, which it said was his responsibility. However, the SEC lets Feuerstein off because he was not a direct supervisor of Mozer at the time of the false bid then goes on to say [b]ecause we believe this is an appropriate opportunity to amplify our views on the supervisory responsibilities of legal and compliance officers in Feuersteins position, we have not named him as a respondent in this proceeding. Instead we are issuing this report of investigation concerning the responsibilities imposed by Section 15(b)(4)(E) of the Exchange Act under the circumstances of this case. In the future, those in Feuersteins position may face sanctions for failing to prevent violations of this sort. Broker-Dealers as Market-Makers and Underwriters

Chasins v. Smith, Barney (2d Cir. 1970 - Smith Barney (acting as a broker-dealer principal and
advisor) sold Chasin certain securities without revealing that the firm was a market maker/underwriter in those securities (but did reveal that it was acting as a principal)); Held that failure to inform the customer of SBs possible conflict of interest, in that it was a market maker in the securities which it strongly recommended for purchase by him, was an omission of material fact in violation of Rule 10b-5. Knowledge of the additional fact market making by Smith, Barneycould well influence the decision of a client in Chasins position, depending on the broker-dealers undertaking to analyze and advise, whether to follow its recommendation to buy the securities; disclosure of the fact would indicate the possibility of adverse interest which might be relflected in Smith, Barneys recommendations. Smith Barney could well be caught in either a short position or a long

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position in a security, because of erroneous judgment of supply and demand at given levels. If over supplied, it may be to the interest of the market maker to attempt to unload its securities on his retail clients. The SEC is presently engaged in consideration of the advisability of rules on disclosure for market making. But couldnt a reply to this be so what, the SEC hasnt put out a rule yet to spite having promulgated other detailed disclosure rules. Where is the source of SBs duty to disclose? Friendlys dissent This potential adverse interest exists in any transaction between a buyer and a principal (e.g. the principal may recommend the securities b/c they wan to unload them. Its widely recognized that the best price can be obtained by dealing directly with market makers (commission to an intermediary can be avoided). The fears concerning the ability of market makers to set an arbitrary price are inapplicable here where there were several market makers for the stocks in question. In re Alstead, Dempsey & Co. (SEC 1984 Alstead, a broker-dealer was accused of charging its retail customers excessive mark-ups. This case raises questions concerning the proper pricing practices of an integrated dealer, a market-maker who simultaneously makes a wholesale market in an over the counter security while selling the same security retail.); Held that Alstead marked up starting from an illusory market price, thus charging excessive markets. Mark-ups of more than 10% over the prevailing market price are fraudulent in the sale of equity securities. The question here is what is the prevailing market price? Pink sheet price and prices charged to retail customer not legitimate market price here where Alstead controlled the market for these stocks. The court also notes that even its sails to retail customers were at prices consistently below its wholesale offering price. Where there is no independent competitive market for the securities being sold, the prevailing market price is either The amount the registrant was willing to pay other dealers for shares of the security it purchased from them; or The amount the registrant received when it sold the shares to other dealers. Illustrates that market makers are not treated like normal broker-dealers Pagel v. SEC (9th Cir. 1986 Pagel was the principal underwriter for FilmTecs IPO. In the days following the offering Pagel drove the price of the FilmTec shares up (by buying up the shares. On March 21, 1980, with a bonus the firm gave to him, the president of Pagel purchased 32,000 shares of FilmTech from the firm, apparently its entire inventory, at a price of 7. The sale enabled Pagel, Inc. to realize a $180,000 tax loss at the close of its fiscal year, offsetting the firms trading profits; SEC imposed sanctions on Pagels president (and sole stockholder) and executive vice president, fining them and barring them for life for violations under 10(b) & 17(a) and under Rule 10b-5); Held that SEC could have reasonably believed that the manipulation was intentional and reasonably concluded that the protection of the public interest required the sanctions it imposed; sanctions upheld. Pagel was accused of Manipulating the price of FT in the initial 8 days following the offering Manipulating the price of FT stock in March 1980 to secure significant tax and investment benefits Purchasing FT stock within the period of distribution Failing to maintain records identifying the beneficial ownership of nominee accounts through which Pagel (the president) and Markus traded.

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This is an example of a boiler room operation market manipulation to generate interest in security. Rapidly rising prices in the absence of any demand are well-known symptoms of unlawful market operations. Penny Stock Regulations The SEC responded to the problem (exemplified by Pagel) of firms obtaining control over the market for shares of small, thinly traded companies and then promoting those shares to unsophisticated customers at prices that bear little relation to underlying values by adopting Penny Stock regulations (Rule 15g-1 of the 1934 Act). Rule 15g-1 Prior to selling a Designated Security to a customer, broker must: Obtain personal financial information on client Determine suitability of security Deliver a disclosure document to client This stops it from being done in one phone call. Receive a signed acknowledgment of disclosure Equities are Designated Securities (DS) unless: Traded on an Exchange or NASDAQ Issuer has more than $2 million in assets Exempt transactions Stocks with price of more than $5 per share Transactions with established customers Transactions the Broker does not initiate Transactions by broker who is not a market maker in the DS and with less than 5% of business in all DS in previous 12 months. Note that this rule is easy to circumvent charge more than $5; accumulate established customers etc. Manipulation of Securities Prices, Section 9(a)(2) of the 1934 Act
It shall be unlawful for any person, directly or indirectly, by the use of the mails or any means or instrumentality of interstate commerce, or of any facility of any national securities exchange, or for any member of a national securities exchange. (2) To effect, alone or with one or more other persons, a series of transactions in any security registered on a national securities exchange creating actual or apparent active trading in such security or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.

The Dilemma of Broker-Dealer Regulation Let investors fend for themselves (caveat emptor) v. create legal rights How much can you rely on the market The market for securities IF the prices are correct maybe you can But All markets take some time to adjust Sometimes BDs control the market (Alstead & Pagel) Two products: the security and the intermediation service (markup cases & churning cases). Market for BDs Over time good firms will develop a reputation Theres market for reputation (Hanly v. Merrill)

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But Always new firms. Firms might take advantage of being at the end of their life cycle Theres a sucker born every minute But how much of your regulatory system to you want to devote to this principal.

Arbitration of Disputes

Shearson/American Express v. McMahon (USSC 1987) Held that enforcement of an arbitration agreement between customer and broker-dealer does not effect a waiver of compliance with any provision under 29(a). Federal Arbitration Act (1924) establishes federal policy favoring arbitration. The burden is on the party opposing arbitration to show that Congress intended to preclude a waiver of judicial remedy for the statutory rights at issue. The court says that arbitration and the perception of arbitration has changed since Wilco (a case saying arbitration agreements could not bind parties with 1933 Act claims). The SROs have established extensive rules with respect to arbitration. Rodriguez de Luijas v. Shearson/American Express, Inc. (USSC 1989) extended McMahons holding to claims arising under the 1933 Act. But note that standard class actions for material misrepresentations against issuers and those involved in IPOs are NOT subject to arbitration. Still in federal courts. Can brokers insist as a condition of doing business with customers that they sign arbitration agreements? SEC has not said no. Policy Evaluation Benefits of arbitration Cheaper Quiet Problems with arbitration Doesnt create president (e.g. clarifications of the law). Where is there better justice Arbitration is less likely to yield large awards, but more likely to yield some award b/c arbitrators are more sensitive to smaller deviations from industry practice. Arbitration is quiet so it reduces the potentially beneficial effect of the treat of reputation harm that comes with the threat of litigation.

Financial Obligations of Broker Dealers


Not really covered in class.
There are Net Capital Rules and Reporting Requirements Haberman, Capital Requirements of Commercial and Investment Banks Banks get Haircuts for asset types based on Risks Securities firms take deductions from net capital for illiquid assets (such as loans thats why its fatal for a bank to be deemed a broker dealer). Hinkle Northwest, Inc. v. SEC (9th Cir. 1981 HN used a S&L customers credit to do reverse repo (type of securities transaction), but was to be the owner of the securities in question and the transaction was to be concealed from the S&L (but not its treasurer who got a cut) ); Held that HN was the actual owner of the securities and that the SEC sanctions were justifiable. Rules HN violated:

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Reporting Obligations: must report transaction on financial statements. FOCUS reports of 17a-11. Capital Rules: wanted to make it look like customer (Franklin) was taking the risk, as opposed to themselves, because were below net capital requirements. Rule 15c3-1.

Analyst Conflicts of the Late 1990s


Background Problem of Capital Gains Research has been solved legal requirements from the USSC opinion have been implemented. Disclosure of holdings required. Also Chinese walls to prevent disclosure of non-public information from investment banking departments of firms. Preventing insider trading. Increased Prominence of (sell side) Analysts in Full Service Firms Technology & Internet Expertise Certain IB firms were known for being good at taking companies (especially tech and internet companies) public. They had customers who were interested in the stock. They could make a market in the securities after the IPO. In retrospect it wasnt clear that it was just a question of expertise. Tilt towards buy recommendations Very few sell recommendations. Evidence of inconsistent internal assessment Internal assessments (buy side reports) were not as favorable as those being published by the (sell side) analysts Recommendations were tied on compensation arrangements that turned on underwriting profits. Investigations and Prosecutions by New York Attorney General Spitzer Very substantial settlements Rule making on Research Analyst Conflicts Procedural points These are NASD & NYSE proposed rules Substance of Rules Supervision & Communication with Research Departments Separation of Research and IB departments. IBers cant supervise research analysts. Limitations on Analyst Compensation Arrangements Research analysts cant get bonuses based just on underwriting business, but can get compensation based on success of business overall (including underwriting business). Weak. Quiet period For 5 days after IPO, research analysts cant introduce new reports on the securities. More restrictions on Analysts personal trading Stricter disclosure on holdings in recommended firms More information about analysts ratings (price charts, % of buys, etc.) Compliance officers Can you really solve these problems with disclosure and structural reforms? Even if you get rid of formal lines of communication between researchers and IBers and say that researchers pay cant be directly tied to underwriting work, everyone understands that its good

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for business to get underwriting work and that a sell recommendation 2 weeks after an IPO is not good for business. Maybe a change in corporate form would be helpful? e.g. structurally separate IBs from BDs.

Self Regulatory Organizations


The End of Fixed Commissions Gordon v. NYSE (USSC 1975 Class action; small investors suing NYSE, AMEX and two member firms of the exchange alleging that the system of fixed commissions used by the exchanges for transactions less than $500,000 violated 1&2 of the Sherman Act. Historically BD commission rates had been fixed by the SEC. As of May 1, 1975 (after the date this suit was filed), the SEC, by order, has abolished fixed rates. New legislation, enacted into law June 5, 1975, codified this result, although still permitting the SEC some discretion to re-impose fixed rates if warranted. Price fixing is usually considered an unreasonable restraint on trade and thus impermissible under federal anti-trust law); Held that the SECs ability to fix commissions does not violate federal anti-trust law. Silver test for anti-trust immunity repeal of the antitrust laws is to be regarded as implied only if necessary to make the Securities Exchange Act work, and even then only to the minimum extent necessary. The Securities Exchange Act was intended by Congress to leave the supervision of the fixing of reasonable rates of commission to the SEC. Interposition of antitrust laws, which would bar fixed commissions rates as per se violations of the Sherman Act in the face of positive SEC action, would preclude and prevent the operation of the Exchange Act as intended by Congress and as effectuated through SEC regulatory activity. Implied repeal of the antitrust laws is, in fact, necessary to make the Exchange Act work as it was intended. Note price fixing case: In May of 1994, private class action law suit was filed charging marketmaking firms with colluding to maintain artificially wide spreads in 1,659 NASDQ stocks over a five-year period. Though representatives of the defendant firms denied that their market making practices were unlawful, most of the defendants had, by year end 1997, agreed to settlements totaling more than $1 billion, reportedly the largest of such recoveries in the history of state or federal anti-trust laws. Whats wrong with fixed commissions? May charge customers too much NYSE prices advance the interests of their members and not customers Inefficiencies Subsidy may allow inefficient BDs to continue to exist. Potential for fragmentation of markets. Why have fixed commissions? Fear of destructive competition Fear of discount brokerages that just execute orders and dont give information/advice Problem just b/c bds are charging more, doesnt meant that they are putting the $ into research. Could be putting the $ into big bonuses. Fear that only large firms would survive (economies of scale) Incentive for NYSE members to bring trades to NYSE b/c thats where they will get the fixed commissions (no fragmentation more efficient market). What happened? Fix commissions came to an end. Discount (online) brokerages popped up (first Schwab, then e-trade). Schwab was just execution no advice.

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Small brokerages did go under (competition from Schwab and E-trade). Post-Gordon Developments Reforms of 1975 End of fixed commissions Emergence of discount brokerage houses Restructuring of the brokerage industry Substantial decline in the cost of trading National Market System (NMS): New 11A of the 1934 Act Gave the SEC the mandate to establish a National Market System (NMS) Goals outlined by congress: (1) create a level playing field for completion among various market participants; (2) increase dissemination of price quotes; (3) increase efficiency of the market; and (4) ensure best execution. Such a system would reduce the NYSE monopoly Development of Several Inter Market Links Consolidation Quotations Inter-Market Trading links Intermarket Trading System (ITS) electronically links eight national exchanges and NASD. It provides brokers on the floor of any participating exchange with a means of executing a trade in any of the other markets, thus allowing the broker or specialist to execute their transaction at the best displayed price. Consolidated tape (trade reporting) Continuing Anti-Trust Scrutiny of (NASDAQ) Odd-Eights Controversy 1990s study by financial economist that looked at market making behavior of NASDAQ market makers. Market makers quoted on the 1/8ths. But strangely if you look at the quotes, they are almost always on the 1/4ths. Not as many odd eights as one would expect. Collusion to create bigger spreads? Telephone calls recorded of MMs telling each other to stop quoting on odd eighths. Over the last 20 years competitions across trading markets has increased substantially (the NYSE is no longer the dominant force it once was). Questions remain, however, over whether the fragmentation of markets is necessarily a good thing. Some of the new markets, such as the proprietary trading systems, are only available to large institutional investors. Is this consistent with the SECs over reaching policy of protecting investors? Questions of how to regulate the new markets: The SEC does not consider proprietary trading systems to be exchanges for the purposes of the 1934 Act, and thus subjects them to a substantially less burdensome regulatory structure as compared to that imposed on the New York Stock Exchange and other traditional markets. Should all markets be regulated in the same way? Or, does the limited function of proprietary trading systems warrant more lenient supervision? NASD Settlement, Exchange Act Release (Aug. 8, 1996) Findings of Fact In adequate Oversight of Market-Makers By 1990 the NASD was aware of information suggesting that its members were engaging in misconduct which had potentially anticompetitive implications and could be detrimental to the interests of Investors. This information included (a) facts and

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circumstances evidencing a convention among dealers to quote only on even eights; (b) evidence of spreads and dealer quotations being artificially inflexible with market makers having little incentive to narrow them; and (c) facts indicating that some market makers retaliated against other market makers who attempted to improve upon quotations otherwise prevailing in the market. The NASD failed to take appropriate action to thoroughly investigate these problems and take effective regulatory action. Failure to Enforce Firm Quote Rule Various Trade Reporting Violations Market-Makers Failing to report transactions on a timely and accurate basis NASD processed the applications of certain members in a manner inconsistent with its rules. Found that regulatory function of NASD needed to be made independent/walled off. NASD was censured and ordered to comply with the following undertakings (among others): At least 50% of Board of Governors need to be independent public and non-industry To provide that NASDR have primary responsibility for regulation and full access to records of the Nasdaq market. To institute the participation of professional hearing officers (who shall be attorneys with appropriate experience and training) to preside over disciplinary proceedings. To provide for the autonomy and independence of the regulatory staff of the NASD and its subsidiaries such that the staff, subject only to the supervision of the Board of Governors of NASD and the Board of Directors of NASDR and Nasdaq has sole discretion over who to prosecute and membership applications and prepares rule interpretations and is generally insulated from the commercial interests of its members and the Nasdaq market. The District Business conduct Committees and the Market Surveillance Committee should not have any involvement in deciding whether to institute disciplinary proceedings or passing on new members. To ensure the existence of a substantial independent internal audit staff which reviews all aspects of the NASD and reports directly to an audit committee of the NASD Board of Governors. SRO Rule Making Generally markets get to make their own rules (including listing standards), subject to SEC approval. 19 of the 1934 Exchange Act Section 19(b)(2) SEC Power to Review Proposed SRO Rules:
The commission shall approve a proposed rule change of a self regulatory-organization if it finds that such proposed rule change is consistent with the requirements of this chapter and the rules and regulations thereunder applicable to such organizations. The Commission shall disprove a proposed rule change of a SRO if it does not make such a finding.

Section 19(c) SEC Power to Amend SRO Rules

The Commission, by rule, may abrogate, add to, and delete from (hereinafter in this subsection
collectively referred to as "amend") the rules of a self-regulatory organization (other than a registered clearing agency) [1] as the Commission deems necessary or appropriate to insure the fair administration of the selfregulatory organization, [2] to conform its rules to requirements of this chapter and the rules and regulations thereunder applicable to such organization, or [3]otherwise in furtherance of the purposes of [the Exchange Act].

National Market System, Section 11A(a) of the 1934 Act (1) The congress finds that
(A) The securities markets are an important asset which much be preserved and strengthened. (B) New data processing and communications techniques create the opportunity for more efficient and effective market operations.

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(C) It is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure. (i) economically efficient execution of securities transactions; (ii) fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets. (iii) the availability to brokers, dealers, and investors of information with respect to quotations for and transactions in securities; (iv) the practicability of brokers executing investors orders in the best market, and (v) an opportunity, consistent with the provisions of clauses (i) and (iv) of this subparagraph, for investors orders to be executed without the participation of a dealer. (D) The linking of all markets for qualified securities through communication and data processing facilities will foster efficiency, enhance competition, increase the information available to brokers, dealers, and investors, facilitate the offsetting of investors orders, and contribute to best execution of such orders.

Business Roundtable v. SEC (DC Cir. 1990 GM announced that it was going to issue a second class of stock with vote per share. NYSE listing standards included a one vote per share for common stock rule; Eventually the NYSE filed a proposal with the SEC to relax its own rule. The SEC did not approve the rule change and instead it adopted Rule 19c-4, barring SROs from listing stock of a corporation that takes any corporate action with the effect of nullifying, restricting or disparately reducing the per share voting rights of [existing common stockholders]. The rule prohibits such disenfranchisement even where approved by a shareholder vote conducted on one share/one vote principles); Held that the adoption of Rule 19c-4 is beyond the SECs power since it interferes with the internal affairs of the corporation. Internal affairs doctrine As the Supreme Court has said, corporations are creatures of state regulation, and investors commit their funds to corporate directors on the understanding that, except where federal law expressly requires certain responsibilities of directors with respect to stockholders, state law ill govern the internal affairs of the corporation. SEC says that allowing managers to exploit shareholders through dual classes is unfair competition and exchanges couldnt resist b/c big issuers would go to other markets court says this is not the type of competitive failure that the SEC was charged with protecting against. The types of subject the SEC can put forth rules on include: the hours of operation of any type of quotation system, trading halts, what and how information is displayed and qualifications for the securities to be included on any tape or within any quotation system.. Basically the SEC regulates the markets; The states regulate the corporations In the years since the Roundtable decision was decided, the debate over dual class stock has shifted back to the SROs, which have voluntarily adopted restrictions similar to those that Rule 19c-4 would have mandated. Does this development mean that SEC intervention was unnecessary? ER-TRADE Problem (Hypo) Website offers online trading; provides information about high tech companies and hosts a chat room. Customers sued. Hanley Recommendations have to be truthful and have reasonable foundation. But what if ER had disclaimer just a chat room; not the views of ER. Obviously would be a problem if ER employees were going into the chat room and making optimistic statements about stocks sold on website. Hard to say. What would be an ideal rule?

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No employees of ER can enter chat room. Need disclaimer (just a chat room; not the views of ER) Maybe need to have people sign up before entering chat room (so you can be more sure that they are not ER employees or related to ER employees) SEC put out some vague guidance that neither prohibited nor sanctioned these chat rooms. Most firms have shied away from chat rooms burden is high; to risky. Note that if strict suitability requirements were to be enforced, then almost no info can be posted on website. Limit Orders Limit Order v. Market Order Limit orders X shares, but only if at a certain price Market orders X shares (at market price) In re E.F. Hutton & Co. (SEC 1988 -Manning puts in a limit order (sell 5000 Genex at 17 1/8). At the time the order was put in, the inside bid was at 17 (brokers buy) and the inside ask (brokers sell) was at 17 1/8. EF Hutton was a market maker. Sometime after the order was given to them, but before the floor dropped out of the stock, they executed some sales for their own account at 17 and 17. Manning filed a complaint with the NASD. EF Hutton says they only had an obligation to execute at inside bid when the 17 1/8 price became available. Just because they were a market maker doesnt mean that they had a duty to execute at the wholesale price. This is an appeal before the SEC); Held that EF has a duty to execute at wholesale price a head of its trades, but its not clear whether the duty can be abrogated by disclosing that it will just execute at the inside bid like any other broker dealer and not at the wholesale price available to market makers. Even though there was no rule specifically mandating such a disclosure Manning was entitled to expect that industry practice would comport with fiduciary principles and that conflicts of interest would be disclosed. Grundfests dissent I writeto emphasis that: (1) a broker-dealers obligation to a customer depends on the facts and circumstances of the relationship; (2) Mr. Manning was a sophisticated customer; (3) the NASDs own general counsel provided evidence that the industry practice regarding limit orders is not uniform. Manning spent 10 years at Merrill Lynch and now manages his own investment firm. While the existence of a duty to disclose the lack of a limit order priority depends on the facts involved, established custom and usages is one of those facts. As the concurring opinion makes clear, the duty at issue in this case is based on the customers expectation that his broker-dealer will monitor the market and obtain execution when the market reaches the limit order price. But the market never reached the limit order price. Thus, by Chair Ruders own formulation, the customers expectation was never frustrated. New Limit Order Rule, Section 11Ac-1-4 Under the 1934 Act Background Aftermath of the Manning Case Disclosure v. Market Structure Rule Elements of the Rule Order Exposure Requires market-makers to display the price and size of customer limit orders when those orders represent buying and selling interests that is at a better price than the market makers public quote. Benefits

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increased quote competition improved execution Because many markets and market makers offer automatic execution of small orders at the best displayed quotes, the display of limit orders that improve the best displayed quotes can result in improved executions for these orders. Other possible solutions the SEC could have come up with: Enhanced transparency Disclosure disclose that customer limit orders will only be executed if they match the retail quotes. Fiduciary duties customer limit orders come first. Payment for Order Flow Payment for order flow is the practice of payments (hidden kick-backs) to brokers by market makers and regional specialist. Some argue that these payments distort broker incentives so that their choices diverge from what would best serve customers. Trilateral dilemma: Financial intermediary makes a decision for a customer with a third party. Often, there is a side payment from the third party to the financial intermediary. Examples: Yield spread premium, mutual fund industry; payment for order flow. Recurring theme; a problem that regulation tries to address. As bad as they seem? Either a bribe, or a means of lowering the cost to the customer. Hypo Investor goes to BD and says he wants to buy 100 shares of IBM at market. NYSE Offer =117 Ask = 117.4 OTC Market Maker says well match NYSE prices and if BD places order with them, the OTCMM pays the BD a payment for order flow. Is this a problem? Should this discount be passed on to the customer? But if the order was executed on the NYSE, the customer wouldnt get the discount then either. Are there benefits a quick guarantee of price. May take longer (and expose customer to more market risk) to execute on NYSE. SEC said this is okay, but you need to disclose. Hypo Suppose a Broker-Dealer Offered the Following Services: the firm would execute transactions for customers at the NBBO plus at the end of each quarter the broker-dealer would pay (to each customer) rebate equal to the average price improvements plus 5% at the NYSE or whatever market had the best price improvement. Any problem here? This seems better because it transfers value to the investor. Is everyone just free-riding of the NYSE? In volatile times, specialists at NYSE still have to trade. Some of these other alternative trading systems have been known to not respond to bids/sells in volatile time. The alternative trading systems are regulated in a lighter manner than exchanges. They are regulated as broker dealers. Hard for NYSE to compete for price since NYSE has more responsibilities and overhead as SROs. NYSE provides price discovery, issuer supervision, liquidity in times of crisis, information services. Should other markets be regulated as exchanges?

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Guice v. Charles Schwab & Co. (N.Y. 1996 payment for order flow case; Customer says payment for order flow violates common law fiduciary duties; BD says under the supremacy clause, Rule 10b-10 trumps common law agency principles (fiduciary duties) with respect to payment for order flow); Held that 10b-10 pre-empts common law agency standards of disclosure; cant sue BD for a disclosure based violation of fiduciary duties when SEC rule on disclosure relating to disclosure in this situation has been followed. Rule 10b-10 (adopted by SEC in 1977) required that on a customers confirmation statement the broker-dealer disclose whether any remuneration [other than the amount received from the customer and certain specified sources] has been or will be received and that the source and amount of such other remuneration will be furnished upon written request. Later the SEC considered adopting a more stringent rule, but then basically decided to stick with the original rule. It is uncontested that the defendants (Schwab and Fidelity) complied with Rule 10b-10. Upon the basis of the legislative history of the 1975 amendments to the Securities Exchange Act and the history of SECs implementing regulations applicable to order flow payment disclosure, we are convinced that permitting the courts of each State to enforce the foregoing common-law agency standards of disclosure on the practice of order flow payments in civil damage actions would unavoidably result in serious interference with the accomplishment and execution of the full purposes and objectives of Congress, in enacting the 1975 amendments, and would directly conflict with SEC regulations limiting the disclosure requirements regarding receipt of order flow payments to less exacting, post-transaction information on customer confirmation statements and disclosure of general policies of the broker on initial and annual customers account statements.

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Investment Companies
Introduction
Investment Act of 1940 Specific Requirements/Provisions Registration with SEC. Disclosure Instead of adopting activity-limiting rules applied to banks and insurance companies; ICA adopts regulation similar to BDs, mainly disclosure requirements. Capitalization Restrictions restrictions on leverage (debt) and capital structure. Open ended companies cannot issue senior securities, but closed end companies can issue debt and preferred stock if they meet certain requirements. Thus mutual funds are entirely funded by shareholders equity. Self-Dealing Prohibitions Prohibitions on many direct transactions with affiliated persons. Portfolio Restrictions diversification requirements; Tax code provides certain portfolio requirements for conduit treatment. Investment companies cannot acquire more than 3% of a diversified company or 5% of a non-diversified company. Some risky investments are prohibited (e.g. buying securities on the margin and, with some exceptions, various investments in other firms in the financial services industry. Independent directors old rules said 40%; new rules say majority. SEC has rule making authority and power to exempt any person, security or transaction from any provision of the Act. Structure of the Investment Advisers Act (IAA) complementary Act focused on the regulation of investment advisers. Important provisions: (1) registration of all advisers with SEC; (2) prohibitions against performance-based compensation, such as that based on capital gains in a clients account; (3) special anti-fraud rules. Exemptions for those who: (1) give investment advice that is peripheral to their business (e.g. lawyers giving legal advice that happens to have value as investment advice). (2) have less than $25 million under management (presumption that those people will be regulated at the state level. If you have over $30 million you must register. Grey area between $25 and $30. (3) advise fewer than 15 clients, none of which is an Investment Company. Classification of Investment Companies Face Certificate v. Unit Investment v. Management Companies Close-end v. open-end (e.g. mutual funds) Note that closed-end are not mutual funds; mutual funds must have continuous redemption at NAV. Money market mutual funds v. other mutual funds Money market mutual funds are bank like; other mutual funds hold stock etc. Structure of a Mutual Fund Distributor (like an underwriter) distributes shares through several broker dealers who sell them to investors. Shareholders equity is used to buy a portfolio of securities which is managed by an advisor. Board oversees.

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Company like fidelity will then commonly own both the advisor and the distributor. The company will then hire a board of directors.

Definition of Investment Company


SEC v. Fifth Avenue Coach Lines (2d cir. 1970 Firth Avenue had a wholly owned subsidiary
called Surface Transit, which in turn had a wholly owned subsidiary called Westchester Street transportation Company. All three companies operated bus lines. In 1962 the City of NY by condemnation acquired all of the bus lines of Fifth and Surface, but did not takeover Westchester. In 1966, Fifth finally received $11.5 million from NYC for the condemnation. Over time Fifth then used the $ to invest in a bunch of different companies. According to management, Fifth was looking around for Fifth to buy control of other companies); Held that by June 30, 1967, when 55% of Fifths assets were investment securities, Fifth had become an investment company (e.g. had met the 40% and engaged primarily in requirements of (3)(a)(3) of the ICA of 1940). Statement in the companies annual report that the company plans to make investments with the $ it receives from the city are predictions and are too general in nature to justify a finding that they amounted to such a holding out or proposing that Fifth would engage primarily in the business of investing as to require the conclusion that Fifth became an investment company immediately when the funds received. The court does not believe that merely putting ones money in the bank, even though one thereby obtains some interest, is in and of itself investing, reinvesting or trading in securities within the meaning of 3(a)(1) of the Act. The statute does not recognize an exception for the business that the defendants claim Fifth is and was engaged in, i.e., the business of acquiring control of other companies. There must come a time when a corporation initially possessed of cash and no real business, by spending its cash becomes engaged in a business of some sort. That time had come by June 30, 1967. At that time 55% of Fifths assets were investment securities. Definition of Investment Company, Section 3(a) of the 1940 Act
[I]nvestment company means any issuer which (1) holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities; (2) is engaged or proposed to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or (3) is engaged in or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuers total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

Is this definition too broad? Picks up banks and insurance companies, but they are later exempted out. Doesnt pick up Harvard b/c even if Harvard meets the asset tests, its not an issuer. Exemptions from the IC Definition, Section 3(b) of the 1940 Act
Notwithstanding paragraph (3) of subsection (a) of this section, none of the following persons is an investment company within the meaning of this subchapter: (1) Any issuer primarily engaged, directly or through a wholly-owned subsidiary or subsidiaries, in a business or businesses other than that of investing, reinvesting, owning, holding, or trading in securities. (2) Any issuer which the Commission, upon application by such issuer, finds and by order declares to be primarily engaged in a business or businesses other than that of investing, reinvesting, owning, holding, or trading in securities either directly or (A) through majority-owned subsidiaries or (B) through controlled companies conducting similar types of businesses.

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Further Exemptions, Section 3(c) of the 1940 Act

(1) Any issuer whose outstanding securities (other than short term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. (2) Any person primarily engaged in the business of underwriting and distributing securities issued by other persons, selling securities to customers, and acting as broker. . . (3) Any bank or insurance company . . . or any receiver, conservator, liquidator, liquidating agent, or similar official or person thereof or therefor; or any common trust fund or similar fund maintained by a bank exclusively for the collective investment and reinvestment of moneys contributed thereto by the bank in its capacity as a trustee . . . (7)(A) Any issuer, the outstanding securities of which are owed exclusively by persons who, at the time of acquisition of such securities are qualified purchasers [$5 million in assets] and which is not making and does not at the time propose to make a public offering of such securities. [A Qualified purchaser means a person who owns not less that $5 million in investments, as defined by the Commission. See Section 2(a)(51) of the 1940 Act.]

Example of a potentially contravening use of an exception under Section 3(c): Berkshire Hathaway (Warren Buffet) is not a registered investment company because the investment assets are located in an insurance company registered in Nebraska which has almost no insurance business. Policy reasons for exemptions 100 person/no public solicitation exemption assumes that there will be more personal solicitations (giving investors an opportunity to ask questions etc.) from people with a lot of $ (e.g. if only 100 people are investing, only makes sense to solicit people with a lot of $). $5 million in investments we assume that these people know what they are doing. CMA Accounts Opinion of the Attorney General of the State of Oregon (February 11, 1981 Merrill Lynch is offering a Cash Management (CMA) account; Participants have 3 linked accounts: a brokerage account, a money market mutual fund (or in some cases a choice of three money funds) (on which checks can be draw), and a Visa. When investors write checks or use Visa, money is taken out of the money market mutual fund or borrowed on margin on the brokerage account; Free credit cash balances in the securities account are automatically invested in the money market mutual fund at least weekly, or can be withdrawn by the participant at anytime. Participation in the CMA program requires a minimum investment of $20,000 and disclosures are made to the effect that it is not a bank account; In Oregon, only banks can take deposits. Is the CMA Account banking?); Held that neither the money market shares nor the free credit balances are deposits. Money market mutual fund shares are equity interests providing capital gains and losses to the investor. The free credit balances are a by product of securities investment activity and contractually committed to automatic investment in the money market mutual funds. They are not deposits, but even if they were, they are deposited pending investmentsin securities. Business of Banking, Oregon Revised Statutes 706.005.4 Banking business means the business of soliciting, receiving or accepting money or its equivalent on deposit as a regular business whether the deposit is made subject to check or is evidence by a certificate of deposit, a pass book or other writing, but does not include: (a) Depositing money or its equivalent in escrow or with an agent, pending investments in . . . securities for or on account of a principal . . . .

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Fiduciary Duties and the Role of Directors


Extracting value from trading in portfolio securities Collateral Payments Directing commission give-ups from BDs who execute portfolio trades to BDs that distribute fund shares (now obsolete since the end of fixed commissions) Moses v. Burgin (1st Cir. 1971 FMRC (advisor of Fidelity Fund, Inc.) is under common control with Crosby. Crosby (underwriter) distributes shares through retail broker-dealers. The portfolio securities in the mutual fund are traded mostly on the NYSE. In this fixed commission environment, anti-rebate rules prevent brokers from refunding cash to the customers. Here, on the Funds instructions, at Managements behest, the so called customerdirected give ups (portion of commissions from brokers who traded the portfolio securities) were paid over to brokers who sold shares of the Fund acquired from Crosby to the public, in proportion to their successes, in order to stimulate sales. Moses (plaintiff) claims that these practices resulted in the loss of valuable brokerage commissions that could have been recaptured for the benefit of the fund); Held that here there was a possible conflict of interest between managements interests and those of the fund and that management violated its fiduciary duties by not disclosing relevant information/options to the (unaffiliated) directors and allowing them to participate in the decisions surrounding this matter and is liable under 36. No violation for unaffiliated directors since they did not know of the possibility of recapture. Customer directed give ups are inherently in the nature of a refund or rebate to the customer. Customer directed give-ups are to be distinguished from broker-directed giveups, a long recognized practice whereby two or more brokers who have shared in the work divide the commission between themselves. Defendants claimed that recapture would have been illegal so no need to disclose the possibility to unaffiliated directors; Court says that its not clear whether recapture would have been illegal and directors should have had a say in the issue. Tannenbaum v. Zeller (2d Cir. 1977 another recapture case; this time the adviser was getting research from the brokers who did transactions in portfolio securities); Held that neither the funds adviser or its directors violated their fiduciary duties under 36 by deciding to forgo recapture because the independent directors (1) were not dominated or unduly influenced by the investment adviser; (2) were fully informed by the adviser and interested directors of the possibility of recapture and the alternative uses of brokerage; and (3) fully aware of this information, reached a reasonable business decision to forgo recapture. . 36 does not impose an absolute duty to recapture. However, proxy statements were false and misleading under 14a-9 because they failed to disclose material facts as to the opportunities to recapture portfolio brokerage commissions for the benefit of the Fund, the methods available for such recapture, and the boards decision to forgo recapture. Transfer research services from BD that executes portfolio trades to fund advisor (soft dollar arrangements) Soft-Dollar Provision, Section 28(e)(1) of the 1934 Act

No person . . . in the exercise of investment discretion with respect to an account shall be deemed
to have acted unlawfully or to have breached a fiduciary duty under State or Federal law unless expressly provided to the contrary by a law enacted by the Congress or any State . . . solely by reason of his having caused the account to pay a . . . broker . . . an amount of commission for effecting a securities transaction in excess of the amount of commission another . . . broker . . . would have charged for effecting that transaction, if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided by . . . broker . . . viewed in terms of either that particular transaction or his overall responsibilities with respect to the accounts as to which he exercises investment discretion.

What does this mean?

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Brokerage houses would give research to customers in exchange for business This is okay as long as appropriate disclosures are made. Dilemma for advisors can I buy research for the same group I get brokerage services from? Issue advisors need the research, but supposedly this need is priced into their advisory fee. Note rule says that payment needs to be reasonable but does NOT say that there needs to be an offsetting subtraction to advisory free. Can you throw in equipment (e.g. special computers to access research)? Sometimes yes. Directed Brokerage choosing broker dealer to execute portfolio trades based on which BD sells the most fund shares (now prohibited) Note that this looks similar to Moses instead of the distributing brokers getting money, they are getting business. It seems to still be okay to have distributor of fund shares execute trades for portfolios. But the part of the fund organization that picks BD to execute portfolio trades must be separate (Chinese wall) from the distribution part. Charge Fund a 12b-1 Fees to compensate BDs that distribute Fund Shares Rule 12b-1 Fees (b)[A mutual fund may make payments to its distributor] . . .provided, That any payments made by such company in connection with such distribution are made pursuant to a written plan describing all material aspects of the proposed financing of distribution and that all agreements with any person relating to implementation of the plan are in writing, and further provided, That: (1) Such plan has been approved by a vote of at least a majority of the [shareholders]; (2) Such plan, together with any related agreements, has been approved by a vote of the [independent members of the ] board of directors of such company . . .and (3) Such plan or agreement provides, in substance, [for termination at will] . . . (c) A registered open-end management investment company may rely on the provisions of paragraph (b) of this section only if selection and nomination of those directors who are not interested persons of such company are committed to the discretion of such disinterested directors . . . . [New amendments provide for a ban on directed brokerage] Why is this allowed? Idea that it is good for shareholders for the Fund to be a certain size. If it shrinks too small, then management fees (calculated as as a percentage of fund assets) might have to be raised. Scandals of September 2003 3 problems Late Trading placing orders after 4:00pm based on new information that the broker then puts through as if they had been placed before 4:00pm. Hard 4:00pm rule Transfer agent for the funds shares (not broker executing trade) needs to receive all orders by 4:00pm. In practice this means that customers will have to wrap up their trading earlier than 4. May disadvantage wet coat customers. Put together a good enough auditing technique so that you can tell whether the order came in at 3:59 or 4:01 enforce penalties. Other forms of back testing (and force suspicious companies to move to a hard 4). Stale Price Trading placing orders late in the day (close to 4:00pm) at NAV based on a closing price from 11:00AM (in the case of London Exchange trades assets for example).

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New NAV rule Some type of Fair NAV rule that deviates from normal NAV under certain circumstances. Market Timing High volume short term trading in mutual fund shares. Proposed solutions. Costly for the fund. 2% redemption charge (that goes to the fund) on shares redeemed within five days of purchase. Mutual Funds should make more specific disclosures as to what it considers to be market timing and what it will do about it. Transfer of Advisory Contracts Rules Governing Advisory Contracts, Section 15(a) of the 1940 Act
It shall be unlawful for any person to serve or act as investment adviser of a . . . investment company, except pursuant to a written contract, which . . . has been approved by the vote of a majority of the outstanding voting securities . . . , and (1) precisely describes all compensation to be paid thereunder; (2) shall continue in effect for a period more than two years from the date of its execution, only so long as such continuance is specifically approved at least annually by the board of directors or by vote of a majority of the outstanding voting securities . . . ; (3) provides, in substance, that it may be terminated at any time, without the payment of any penalty, by the board of directors of such registered company or by vote of a majority of the outstanding voting securities . . . ; and (4) provides, in substance, for its automatic termination in the event of its assignment.

Rosenfeld v. Black (overruled by statute) (2d Cir. 1971 Lazard managed a mutual fund, but in contrast to most open ended funds, it did not engage in a continuous offering of its securities (instead redemptions were intended to be offset by an additional offering in the future). However, developments in the mutual fund industry accelerated the shrinkage and Lazard decided that the funds interest would be better served by continuous offering. However, Lazard did not have the organizional structure to do this. Lazard decided to sell the fund to Moodys. As part of the sale, Lazard and Moodys entered into a contract where by Lazard received 75,000 fund shares in exchange for certain consulting services. The proxy statement to shareholders described the agreement including a description of the 75,000 shares as $1 par (no mention that the market price was $37). Plaintiffs claimed that the 75,000 shares was not just for consulting services, but for the sale of Lazards position as advisor, and as such it violated the common law principle prohibiting the sale of fiduciary office. Lazard claims that it complied with 15s requirements (majority approval by stockholders) in connection with the transfer of its advisory conflicts so it cant be sued for breach of common law fiduciary duty principles); Held that 15 does not provide an exclusive protection to an investment company when there is a change in advisory office. Common law fiduciary principles apply. Whether there proxy was materially misleading is an issue of fact which should not have been determined on a motion for summary judgment. Stands for the proposition that statutory compliance does not provide complete defense to common law fiduciary duty violations claims. Why is the situation in Rosenfeld objectionable? Idea that Moodys isnt just taking a loss on the 75,000 shares. It will extract that value from the fund. But what about BoA buying Fleet? Different? In BoA/Fleet the shareholders of Fleet (the entity being sold) got the value. Rosenfeld wouldnt have objected to the fund shareholders getting the 75,000 shares. But in a bank context, there are depositors. Is BOA going to depositor raise fees to cover this?

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We dont want to discourage equity investments in banks (by making them illiquid cant sell). But what about mutual funds? Maybe we dont need to give this extra encouragement to mutual fund organizers. New Rules on Transfer of Advisory Contracts, Section 15(f)(1) of the 1940 Act (overruled Rosenfeld v. Black)

An investment adviser . . . of a registered investment company may receive any amount or benefit in connection with a sale of securities of, or a sale of any other interest in, such investment adviser which results in an assignment of an investment advisory contract with such company . . . , if (A) for a period of three years after the time of such action, at least 75 per centum of the members of the board of directors of such registered company or such corporate trustee (or successor thereto, by reorganization or otherwise) are not (i) interested persons of the investment adviser of such company . . . . , or (ii) interested persons of the predecessor investment adviser . . . ; and (B) there is not imposed an unfair burden on such company as a result of such transaction or any express or implied terms, conditions, or understandings applicable thereto.

Note: Overruled Rosenfled v. Black; Okay to receive $ for transfer of advisory contract. Note that this independent director protection is similar to approach taken by 12-b1. Saying you cant sell (or cant get $) might be an unreasonably high burden. No protection would be troublesome. Is 15(f)(1) enough? Problem 3-5 (ICM) in the book details a hypo based on a real situation. An investment advisor was faced with the choice of selling its advisory business to one buyer who was offering a lot of money, but whos track record was not so great OR to another buyer who offered no money but had a great track record and lower advisory fees. The advisor went with the buyer offering $ and the SEC chose not to intervene. 15 doesnt seem to have been too effective here. Advisory Fees Obligations of Investment Advisors Section 36(b) of the 1940 Act
[T]he investment adviser . . . shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by [a] registered investment company or by the security holders thereof. An action may be brought under this subsection by the Commission, or by a security holder of such registered investment company on behalf of such company . . . With respect to any such action the following provisions shall apply: (1) It shall not be necessary to allege or prove that any defendant engaged in personal misconduct, and the plaintiff shall have the burden of proving a breach of fiduciary duty. (2) In any such action approval by the board of directors of such investment company . . . shall be given such consideration by the court as is deemed appropriate under all the circumstances. (3) No such action shall be brought or maintained against any person other than the recipient of such compensation or payments, and no damages or other relief shall be granted against any person other than the recipient of such compensation or payments.

Krinsk v. Fund Asset Management (2d Cir. 1989 CMA participant is suing derivatively claiming, among other things, that the advisory fees Merrill Lynch was receiving were excessive); Court goes through Gartenberg factors and determines the fee is not excessive. Gartenberg test for reasonable advisors fee. Look at: (1) Quality of service (2) Profitability to advisor (12b-1 plan fees; other costs profitability measures) (3) Fall-out benefits (Court rejects the idea that this should include all securities commissions and margin revenues from CMA accounts, even if the benefits would have come to Merrill Lynch absent the existence of the Fund (or the CMA program).

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(4) Economies of Scale (Plaintiff has the burden to prove that these exist) (5) Comparative Expense Ratios and Advisory Fees (compare with other similar funds) (6) Trustees approval (e.g. were directors/trustees qualified and well informed?)
Note that none of the factors take into account the amount paid to take over the advisory position The Gartenberg test is usually understood to mean that a well advised fund has a fair amount of latitude in what they can charge and not be subject to sanctions under 36(b). New Disclosures Regarding Approval of Investment Contracts Disclosure Enhancements (note that these seem to be basically more explicit disclosure re: Gartenberg factors. Selection of Advisor & Fees Specific Factors Considered Comparison of Fees & Services Evaluation of Factors Concern: Mutual fund fees, as a percentage of assets invested, have not unambiguously declined in recent years, notwithstanding the fact that the industry has grown dramatically and would appear likely to enjoy substantial economies of scale. An Interlude to the economics of mutual funds. Gross Returns on assets Interest & dividends on portfolio securities Capital appreciation or loss (realized and unrealized) MINUS Commissions paid to Brokerage (see fix commission/Section 28(e)/directed brokerage arrangements; value of gifts?) Various Kinds of Fees Basic management fee Rule 12b -1 distribution fees Other expenses Commissions on Sale of Fund Shares Load v. No -load funds Variations on loads: front loaded, back loaded, etc. EQUALS Net Return on Investment (Not Adjusted for income tax consequences for shareholders) The Role of Independent Directors Strougo v. Scudder, Stevens (SDNY 1997 Closed-end mutual fund (no continuous offering); stock traded like any other corporation; can trade below NAV) is traded on NYSE. Advisor (Scudder) is being paid as a percentage of the funds assets, which are diminishing. Fund decides to issue rights to all of its shareholders allowing them to buy additional shares. The Subscription Price was 30.19% below the funds NAV and resulted in per share NAV being reduced by $1.88. Strougo sued directors and Scudder (advisor) directly claiming breaches of fiduciary duty under 36(a) and common law principles. Claims, among other things, that the offer was coercive (either buy more shares or be diluted; Held: Strougo can only sue derivatively. A complaint, that, like this one, alleges no injury to shareholders distinct from diminution of share value does not state a cause of action that can be brought directly in a class action. An injury shared by all the shareholders of a corporation cannot be personal to each shareholder.

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Minority shareholders being screwed by majority have been allowed to sue directly, but
this is not a situation of a group of shareholders being treated disproportionately. All shareholders were treated equally and could prevent disproportionate dilution by exercising their rights to purchase the newly issued shares. In his derivative claims, Strugo is not required to make a demand of directors or shareholders because such a demand would be futile. Under MD law, there must be a minimum of two independent directors to form a committee to consider a demand. Here there is only one director who is both independent (under the ICA) and does not hold multiple directorships on Scudder funds. Note that this level of independence is not required of independent directors under the 1940 Act. Note that following this decision, MD companies threatened to reincorporate elsewhere and legislature changed the statute. The shareholder demand is futile if shareholders would either have to replace the board or ask the board to sue itself. SEC Final Rule on Corporate Governance (might be withdrawn) Background (current rule) Statutory requirement of 40% independent directors (disinterested) More stringent in some cases: 15(f) for Transfer of Advisory Contracts. Structure of new rule Operates through Amendment of exemptions (e.g. 12b-1) (see note 9). Cant take advantage of the exemptions (e.g. cant get 12b-1 fees) if fund doesnt meet these new requirements. However, in fact basically all funds rely on these exemptions, so basically all funds will need to follow these new rules. Elements: Board composition (usually 75%; 66% if only 3 board members) Independent Chair Annual Self-Assessment Separate Sessions of Independent Directors Independent Staff Recordkeeping Grounds for dissent Outside chair might just mean less knowledgeable chair. SEC is being required to do study on the effects of independent chair Just recently raised requirements to a majority Benefits have not been quantified, nor have costs Discussion predicts costs and benefits but doesnt do much real analysis. But maybe its not about cost-benefit analysis; its about reduction of conflicts. But the only reason we want to reduce conflicts is b/c we think it will reduce costs (benefit) the shareholders; if these new requirements are not going to do this, then whats the point? Other recently enacted reforms may prove sufficient See Business Roundtable Chamber of commerce case has the SEC gone beyond its authority? The statute already tells us how many independent directors to have (40% except 50% or 75% in certain cases); the SEC has exempted authority and they can set the requirements for the exemptions. But almost all funds rely on these exemptions and everyone knows it. So does this rule raise the effective requirement for everyone to 75% without statutory authority?

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Mutual Fund Disclosure


Two trends Put as much information out there as possible Slim down disclosure document into a single page which people might read Investment Company Disclosure Concept Release on Risk What Problem is the Release Addressing? Attention to return as opposed to risk Rule on disclosing return in uniform way across funds; but not enough said about risk (just as relevant) Tendency for people to look for funds with the highest returns without regard for risks Tenancy of funds to make higher risk investments to generate higher returns Problems in the MMMF Subsector/Orange County, etc. Existing performance standards require only broad categories What solutions does this release suggest? Quantitative measures based on past fund performance Simple variance v. Beta v. Jensens Alpha v. Sharpe Ratio Complicated ratios showing risk; Will investors understand? Alternative One: Focus on actual current portfolio of fund Alternative Two: Employ more popular understanding of risk In polls people said that they wanted bar graphs that showed fund performance over time. Thats what is required now. These two trends have Reforms to disclosures of 12b-1 fees (fund assets used to BDs that distribute Fund Shares) Problems of multiple classes of fee structures Class A: 5.75% FESC (front end service charge commission); 0.25% 12b-1 Fee; no CDSC Class B: No FESC; 1% 12b-1 fee; 4%/3%/2% CDSC (contingent deferred sales charge you pay a lot of you withdraw your funds quickly and less and less as time goes on). Which class is better for the investor depends on the particular investor (depends on holding period). Which class is better for the distributor? Inverse of what is good for the investor (e.g. investor wants to choose the class that minimizes fees; distributor wants to maximize his own profits). So the people who are advising the investor on these subjects have inverse interests to the investor. What is the best way to address this problem? Prohibition on 12b-1 fees? Requirement that the fees be deducted from investor account? (brining fees to investors attention). Retention of 12-b1 fees but better disclosure (table comparing the effect of fees over time). Some Dilemmas of Disclosure Policy Comprehensive v. Summary Information Value from Additional Information (e.g. on risk or portfolio managers) The more information, the fewer readers How many factors can consumers consider Is analytical precision an appropriate goal? Can we rely on market forces if investor cant understand disclosure? Maybe New investors will follow good performance Can we depend on third party services (e.g. rating services) to digest disclosure?

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Should we care about those who dont help themselves? Why do we treat mutual funds differently than ordinary stock? Different treatment: portfolio restrictions (mutual funds = no debt; diversification); no dual class securities; special disclosures; independence requirements for directors. Mutual funds managers particular susceptible to malfeasance Assets consist of relatively liquid investment assets Good for the rest of the capital markets Jacksons paper comparing individual returns on stock Not that much variation in the annual returns of stock market funds over a ten year period. Credit to regulatory structure.

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Additional Topics Covered In Class


Hedge Funds
Hedge funds are not Investment Companies Regulated under the Investment Company Act of 1940 thanks to exemptions contained in the Act relating to the number (low) and nature (high net worth) of investors. Long-Term Capital Management Long-Term Capital Management was a thinly capitalized hedge fund which held financial assts and liabilities (to BD affiliates and unregulated firms and banks and securities firms). Between January and September of 1988 LTCM lost almost 90% of its capital. LTCM had some very large positions in some risky markets, so when those markets dried up, it was very difficult for LTCM to liquidate their assets at the prices they had projected. In September 1998 the FRB determined that rapid liquidation of LTCMs trading positions and related positions of other market participants might pose a significant threat to the already unsettled global financial market. FRB went to banks and securities firms said it would be okay with them lending to LTCM; banks lend to LTCM and we never found out what happened when a firm dumps billions of dollars of stocks and bonds on the market. LTCM was not and Investment Company registered under the 1940 Act. There are exemptions from the 1940 Act for funds with less than 100 investors or an unlimited number of qualified investors. Theory that these investors are sophisticated investors that will impose market discipline. LTCM investors had not realized how potentially disruptive LTCMs large trading positions could be. GAO Report Regulatory approach, which focused on the condition of individual institutions, did not sufficiently consider systemic threats that can arise from non-regulated entities such as LTCM. Lack of authority over certain affiliates of securities and futures firms limits the ability of the SEC and the CFTC to identify the kind of systemic risk that LTCM posed. Many of the transactions that allowed LTCM to become so leveraged were with these unregulated affiliates. Currently the SEC and the CFTC can require certain disclosures regarding these affiliates but cannot set capital requirements and do not have enforcement powers with respect to these affiliates. GAO Reports that the SEC and the CFTC are giving increased powers with respect to these affiliates (like Fed has for BHCs). Federal financial regulators need to develop ways to better coordinate oversight activities that cross traditional regulatory and industry boundaries catch problems like LTCM earlier in the future. Systemic Risk Concept of Systemic Risk Why regulate to prevent? Impact on parties in Second-Tier Privity E.g. when Continental Illinois got in to trouble it was found that it held deposits of other banks and its failure would affect other banks. Impact of complex systems in which troubled institutions participate E.g. payments; perhaps derivatives Failed institutions effect depositors which effect creditors of the depositor. Precipitation of financial panics and self defeating behavior

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Irrational runs Rapid dispositions of assets (LTCM? If LTCM had had to sell all of its assets, the market would have been forced down). Other disruptions or discontinuities in important economic functions E.g. too big to fail Citibank Failure in market with only one financial institution Changing Face of Systemic Risk Declining Prominence of Depository Institutions Failures havent caused panics Regulatory solutions to some paths to systemic risk Less potential to disrupt economic functions Potential for Systemic Risk in Other Areas New complex systems to transmit systemic risk (derivatives market) Potential for Liquidity crisis in other areas Investment companies Stock markets Systemic Risks from Unregulated Sectors Long-Term Credit Management (Hedge Funds) 1997 Asian Crises SECs Hedge Fund Proposal Background Hedge funds are not regulated like mutual funds (which unlike hedge funds are regulated under the Investment Company Act of 1940) are thanks to the exemptions contained in the 1940 Act relating to the number (low) and nature (high net worth) of investors. The SECs proposed rule doesnt propose to regulate hedge funds under the Investment Company Act of 1940. Instead it proposes to regulate certain hedge fund advisors under the Investment Advisers Act of 1940. Currently such advisers are exempt from the registration requirements of the IAA, but not the anti-fraud provisions. SECs Concerns Growth in Hedge Fund Industry (approaching $3 trillion under management); LTCM had suggested that size could eventually be a problem. Treatment of Hedge Fund Clients Interactions between hedge funds and the mutual fund industry Hedge funds using their financial power to extract special benefits at the expense of mutual funds (e.g. late trading). Proposed rule Proposed rule 203(b)(3) would require investment advisers to count each owner of a private fund as a client for the purposes of determining the availability of the private adviser exemption of section 203(b)(3) of the Act. As a result, an adviser to a private fund which is defined by the rule, could no longer rely on the private adviser exemption if the adviser, during the course of the preceding 12 months, advised a private fund that had more than 14 investors. And an advisor who advised individual clients directly would have to count those clients together with the investors in any private fund it advised in determining its total number of clients. Amended rule 203(b)(3)-1 would clarify that investment advisers may not count (private investment funds) hedge funds as single clients under that safe harbor (although other legal organizations e.g. a bank may still be counted as a single client). Amend Rule 204-2 to provide relief from record keeping requirement of Advisers act for hedge funds.

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Amend Rule 205-3 to avoid requiring hedge funds too divest investors to meet requirements that investment advisers can only charge performance fees to qualified clients (but hedge funds will have to comply going forward). Compensation Rules for Registered Advisers, Section 205 of the Advisers Act of 1940 No investment adviser, unless exempt from registration pursuant to section 203(b) of the Advisers Act, shall make use of the mails or any means or instrumentality of interstate commerce, directly or indirectly, to enter into, extend, or renew any investment advisory contract, or in any way to perform any investment advisory contract entered into, extended, or renewed on or after November 1, 1940, if such contract (1) provides for compensation to the investment adviser on the basis of a share of capital gains upon or capital appreciation o f the funds or any portion of the funds of the client; (2) fails to provide, in substance, that no assignment of such contract shall be made by the investment adviser without the consent of the other party to the contract; or (3) fails to provide, in substance, that the investment adviser, if a partnership, will notify the other party to the contract of any change in the membership of such partnership within a reasonable time after such change. Regulatory Allowance of Performance Fees, 17 CFR 275.205-3 (2004) General. The provisions of section 205(a)(1) of the Act will not be deemed to prohibit an investment adviser from entering into, performing, renewing or extending an investment advisory contract that provides for compensation to the investment adviser on the basis of a share of the capital gains upon, or the capital appreciation of, the funds, or any portion of the funds, of a client, Provided, that the client entering into the contract subject to this section is a qualified client [$1.5 million worth or $750K investment], as defined in paragraph (d)(1) of this section. [Look trough to investors in Private Investment Companies (those exempt under 3(c)(1) (less than 100 investors) of the 1940 Act; not needed for 3(c)(7) exemption with $5 million net worth requirement]. New Definition of Clients Under Proposed Rule
(a) For purposes of section 203(b)(3) of the Act [private exemption], you must count the shareholders, limited partners, members, other security holders or beneficiaries (any of which are referred to hereinafter as an "owner") of a private fund as clients. (b) If you provide investment advisory services to a private fund in which an investment company registered under the Investment Company Act of 1940 is, directly or indirectly, an owner, you must count the owners of that investment company as clients for purposes of section 203(b)(3) of the Act. (c) If both you and the private fund have your principal offices and places of business outside the United States, you may treat the private fund as your client for all other purposes under the Act, other than sections 206(1) and 206(2). A private fund is a company: (i) That would be an investment company under section 3(a) of the Investment Company Act of 1940, but for the exception provided from that definition by either section 3(c)(1) or section 3(c)(7) of such Act; (ii) That permits its owners to redeem any portion of their ownership interests within two years of the purchase of such interests; and

Definition of Private Fund Under Proposed Rule

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(iii) Interests in which are or have been offered based on the investment advisory skills, ability or expertise of the investment adviser. (2) Notwithstanding paragraph (d)(1) of this section, a company is not a private fund if it permits its owners to redeem their ownership interests within two years of the purchase of such interests only in the case of: (i) Events you find after reasonable inquiry to be extraordinary and unforeseeable at the time the interest was issued; and (ii) Interests acquired with reinvested dividends. (3) Notwithstanding paragraph (d)(1) of this section, a company is not a private fund if it has its principal office and place of business outside the United States, makes a public offering of its securities in a country other than the United States, and is regulated as a public investment company under the laws of the country other than the United States.

Dissent Its not appropriate to pick and choose when to look through. Designed to prevent fraud, but the registered advisers appear in fraud cases as much as the unregistered. We can get most of the disclosure required by the IA A from new money laundering laws. Such reforms will push hedge funds toward retailization Did the SEC get it right? Not clear that private fund structure is better for investors, so if hedge funds restructure to meet that definition, could disadvantage hedge fund investors. How do you deal with offshore migration? The SEC wants to regulate offshore funds that US residents invest in but NOT offshore investors (e.g. a fund could require all investors to set up Netherlands partnerships and as many of them as they wanted could invest). What about offshore investors who move on shore? Regulation of offshore activities can cause conflict with local laws. This got a lot of resistance from the industry, but a variety of hedge fund advisers are registered already (good for business; have other clients etc.). Maybe not that costly to comply? Designed to prevent fraud, but the registered advisers appear in fraud cases as much as the unregistered. Will this eliminate or curtail retailization (selling risky hedge fund investments to small investors)? Now these hedge fund advisers can advertise (since they are registered). But retailization might be curtailed by performance fees can only charge performance based fees if you have only qualified clients.

Brokerage Activities of Banks


Banks v. Affiliates: How do regulations for affiliates and banks themselves differ?
Affiliates Starting in the 1980s, 20 affiliates could have securities activities that constituted up to 25% of their business. In 1999 GLB Act said affiliates of QFHCs could engage in basically any financial activity (including securities business). National Banks Unlike affiliates, national banks can engage in the business of banking and do things incidental thereto. They cant do any underwriting equity trading for their own account, but they can do a limited amount for customers.

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National Bank Powers, 12 U.S.C. 24(Seventh (1999)


[A national bank shall have the power to]. . . . Seventh. To exercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes according to the provisions of this title. The business of dealing in securities and stock by the association shall be limited to purchasing and selling such securities and stock without recourse, solely upon the order, and for the account of, customers, and in no case for its own account . ..

Section 16 of the Glass-Steagall Act, 12 U.S.C. 24(Seventh) (1999) (not effected by GLB)

The business of dealing in securities and stock by [a national banking association] shall be limited
to purchasing and selling such securities and stock without recourse, solely upon the order, and for the account of, customers, and in no case for its own account, and the association shall not underwrite the issue of securities or stock; Provided That the association may purchase for its own account investment securities under such limitations and restrictions as the Comptroller of the Currency may by regulation proscribe. . . . The limitations and restrictions herein contained as to dealing in, underwriting and purchasing for its own account, investment securities shall not apply to obligations of the United States, or general obligations of any State

Glass Stegal also says that securities firms cant take deposits (continues after GLB under GLB only affiliates can do these things). Section 21 of the Glass-Steagall Act, 12 U.S.C. 378(a)(1) (1999)
[I]t shall be unlawful . . . [f]or any person, firm, corporation, association, business trust, or other similar organization, engaged in the business of issuing, underwriting, selling, or distributing, at wholesale or retail, or through syndicate participation, stocks, bonds, debentures, notes, or other securities, to engage at the same time to any extent whatever in the business of receiving deposits . . . . Provided, That the provisions of this paragraph shall not prohibit national banks or State banks . . . from dealing in, underwriting, purchasing, and selling investment securities, or issuing securities, to the extent permitted to national banking associations by the provisions of section 24 of [title 12] . . . . Provided Further, That nothing in this paragraph shall be construed as affecting in any way such right as any bank . . . may otherwise possess to sell without recourse or agreement to repurchase, obligations evidencing loans on real estate . . .

I.C.I. v Camp (USSC 1970 Bank put together collective investment vehicle (trust) and let customers hold interests in this trust which would then invest in securities. OCC said okay. Bank tried to say that this is just a trust account and bank has always had trust accounts. Small client trust accounts were always pooled. Investment Company Institute said that this was a violation of GS b/c the bank was underwriting securities); Held that this is too risky; not something banks were designed to do. Justice Blackmun dissented saying that banks had trusts; trusts invested in securities; this was just a new form of trusts. SIA v. Board (USSC 1984); Held that its okay for banks to purchase commercial paper, but not to underwrite it (e.g. offer it publicly). American Bankers Association v. Securities Exchange Commission (DC Cir. 1986); Held that banks acting as broker dealers (e.g. discount brokerages) are NOT Broker Dealers and

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are to be regulated by bank regulators and NOT the SEC; 1934 Act definition of broker dealers explicitly excludes banks. Note that being deemed a Broker Dealer is fatal for a bank since Broker Dealers have 100% capital requirements (capital deductions) for illiquid assets (e.g. loans). This is an example of Entity regulation winning out over Functional regulation SECs redefining of bank (not a bank if profits from BD activity or publicly solicit brokerage business) through rule 3a-9 was impermissible since the statute had already defined bank. Basically the SEC was saying banks can use the exemption for activities that banks have traditionally been allowed to do, but not for things that the OCC authorized later. Argument that when it wrote the definition of Bank in 1934 it didnt understand that GS did not prohibit banks from engaging in discount brokerage activity fails for lack of evidence. But note that if it had been an affiliate or a subsidiary (as opposed to the chartered entity) doing the discount brokerage, the exemption for banks would not apply and SEC would regulate. New law (GLB) since ABA v. SEC changes the result somewhat, pushing brokerage activities out of the banks and into affiliates See Sections 201 & 202 of the GLB, Amending section 3(a)(4) and 3(a)(5) of the 1934 Act Banks are exempt from the definition of broker only if the brokerage activities are limited to: Third party brokerage arrangements [contracting out] Trust, Permissible Securities activities, Sweep Accounts, Safekeeping and custodial services [traditional activities; recall Justice Blackmuns dissent in Camp] De minimus exception The bank effects, other than in transactions referred to in clauses (i) through (x), not more than 500 transactions in securities in any calendar year, and such transactions are not effected by an employee of the bank who is also an employee of the broker or dealer. Exemption for private Securities Offerings
`(vii) - The bank- `(I) effects sales as part of a primary offering of securities not involving a public offering, pursuant to section 3(b), 4(2), or 4(6) of the Securities Act of 1933 or the rules and regulations issued thereunder; `(II) at any time after the date that is 1 year after the date o f the enactment of the Gramm-Leach-Bliley Act, is not affiliated with a broker or dealer that has been registered for more than 1 year in accordance with this Act, and engages in dealing, market making, or underwriting activities, other than with respect to exempted securities; and `(III) if the bank is not affiliated with a broker or dealer, does not effect any primary offering described in subclause (I) the aggregate amount of which exceeds 25 percent of the capital of t he bank, except that the limitation of this subclause shall not apply with respect to any sale of government securities or municipal securities. (ix) IDENTIFIED BANKING PRODUCTS- The bank effects transactions in identified banking products as defined in section 206 of the Gramm-Leach-Bliley Act. Section 206: For purposes of paragraphs (4) and (5) of section 3(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a) (4), (5)), the term `identified banking product' means--

Boundary Problems

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(1) a deposit account, savings account, certificate of deposit, or other deposit instrument issued by a bank; (2) a banker's acceptance; .... (4) a debit account at a bank arising from a credit car or similar arrangement. (5) a participation in a loan which the bank or an affiliate of the bank (other than a broker or dealer) funds, participates in, or owns that is sold- (A) to qualified investors; or (B) to other persons that- (i) have the opportunity to review and assess any material information, including information regarding the borrower's credit worthiness; and (ii) based on such factors as financial sophistication, net worth, and knowledge and experience in financial matters, have the capability to evaluate the information available, as determined under generally applicable banking standards or guidelines; or (6) any swap agreement, including credit and equity swaps, except that an equity swap that is sold directly to any person other than a qualified investor (as defined in section 3(a)(54) of the Securities Act of 1934) shall not be treated as an identified banking product.

Proposed Regulation B & SEC Comment Letter Regulation B is designed to interpret when banks need to worry about registration. Statutory Definition of Exempt Trust Activities, Section 3(a)(4)(B)(ii) of the 1934 Act.
Exception for certain bank activities: A bank shall not be considered to be a broker because the bank engages in any one or more of the following activities under the conditions described: .... (ii) Trust activities: The bank effects transactions in a trustee capacity, or effects transactions in a fiduciary capacity in its trust department or other department that is regularly examined by bank examiners for compliance with fiduciary principles and standards, and (I) is chiefly compensated for such transactions, consistent with fiduciary principles and standards, on the basis of an administration or annual fee (payable on a monthly, quarterly, or other basis), a percentage of assets under management, or a flat or capped per order processing fee equal to not more than the cost incurred by the bank in connection with executing securities transactions for trustee an d fiduciary customers, or any combination of such fees; and (II) does not publicly solicit brokerage business, other than by advertising that it effects transactions in securities in conjunction with advertising its other trust activities.

Note that this exemption is similar to the rule 3(a)(9) that the SEC had tried to put forth
earlier (its okay to do brokerage in connection with trust activities if you are paid in the traditional way). Comment Letter to the SEC from the Banking Agencies Banking agencies say that the SECs interpretation will create great costs and problems for bank trust departments. In a sense the banking industry lost b/c the definition of broker-dealer was amended to include some banks; but the banking industry did get a bunch of exemptions; however, the SEC can interpret the statute and they have come up with a pretty restrictive definition of Trust Activities. This may end up pushing trust activities out into subsidiaries and affiliates.

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Securities v. Insurance
Annuities Generally
Variable Annuities contract whereby investors pay premiums and their return depends on the performance of a portfolio of assets. Fixed Annuities contract whereby investor pays premiums and gets a fixed rate of return. Regulatory Treatment of Variable Annuities VALIC v. SEC (USSC 1959 VALIC was an insurance company that basically only offered variable annuities; SEC said that basically this was a mutual fund and that VALIC needed to register under the 1940 ICA/1933 Sec. Act and make filings under 1934 Exchange Act); Held that the variable annuity has no element of fixed return and assumes no true risk in the insurance sense, so they were not excepted from security regulation coverage by Section 3(a)(8) of the 1933 Act (Douglas conclusory). The result is that variable annuities are securities and insurance companies have to have registered broker dealers working with them to sell them. Exemptions for Insurance Products, Section 3(a)(8) Of the 1933 Act exempting insurance and annuity contracts from 1933 Act regulation.
Except as hereinafter expressly provided, the provisions of this subchapter shall not apply to any of the following classes of securities: .... (8) Any insurance or endowment policy or annuity contract or optional annuity contract, issued by a corporation subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State or Territory of the United States or the District of Columbia . . . .

Justice Brennan concurring (functional) When congress passed [the federal securities laws], no State Insurance Commissioner wasEngaged in the sort of regulationThat Congress thought would be appropriate for the protection of people entrusting their money to others to be invested on an equity basis. There is no reasonto make an exemption of forms of investment to which [the federal securities] regulation which would not be relevant to them all. Justice Harlan, dissenting (deferential/formal) Congress intendedbona fide experiments in the insurance fieldbe classed within the federal exemption of insurance, and not within the federal regulation of securities. Prudential Insurance v. SEC (Prudential decides to set up variable annuities (as a small part of its insurance business). Should prudential be regulated as a 1940 Act company? (not an issue in VALIC since VALIC basically didnt have any actual insurance business)); Held that the definition of company under the 1940 Act doesnt just include legal entities; it includes variable annuity divisions within insurance companies. Definition of Investment Company, Section 3(a) of the 1940 Act
''[I]nvestment company'' means any issuer which (1) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities; (2) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or (3) is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer's total assets (exclusive of Government securities and cash items) on an unconsolidated basis. Further Exemptions, Section (3)(c) of the 1940 Act

Further Exemptions, Section 3(c) of the 1940 Act

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[N]one of the following persons is an investment company within the meaning of this subchapter: (1) Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. . . . (2) Any person primarily engaged in the business of underwriting and distributing securities issued by other persons, selling securities to customers, and acting as broker . . . (3) Any bank or insurance company . . . or any receiver, conservator, liquidator, liquidating agent, or similar official or person thereof or therefor; or any common trust fund or similar fund maintained by a bank exclusively for the collective investment and reinvestment of moneys contributed thereto by the bank in its capacity as a trustee . . . ''Company'' means a corporation, a partnership, an association, a joint-stock company, a trust, a fund, or any organized group of persons whether incorporated or not; or any receiver, trustee in a case under title 11 or similar official or any liquidating agent for any of the foregoing, in his capacity as such.

Definition of Company, Section 2(a)(8) of the 1940 Act

Summary Insurance companies can be authorized to underwrite variable annuities under state law. SEC exerts jurisdiction under federal securities laws (VALIC). 1940 Act also applies under ectoplasm theory (Prudential).

Insurance v. Banking
Summary Under GLB national banks themselves can do anything that they the OCC said they could in 1999 (provided court has not overruled) including: Sell insurance nation wide from towns of 5,000 or less (I.I.lA.A. v. Ludwig) Sell contracts providing for the extinguishing of debt upon a borrowers death (First National Bank of Eastern Arkansas v. Taylor) Sell annuities from anywhere (Nations Bank v. VALIC) However, also under GLB while state insurance regulators are limited in how they can restrict the activities of national banks, they do regulate any insurance activities of banks (functional regulation). This may cause banks to push their activities out into QFHC affiliates where possible. QFHC affiliates are not limited their insurance activities. Insurance affiliates are regulated by state regulators (functional regulation). Citicorp (Family Guardian) (2d Cir. 1991 DE passed a law allowing banks to engage in insurance; banks; Citibank set up a subsidiary that mostly banking and a little insurance underwriting); Held that this is okay. In response to this case congress changed the law to say that state banks basically cant engage as a principal in activities that banks cant engage in unless they get approval. FDICA Restrictions on Insured State Banks, Section 24 FDICA (Note the distinction between principal and agent. State banks can still be travel agents etc if state says okay)

(a) [A]n insured State bank may not engage as principal in any type of activity that is not
permissible for a national bank unless - (1) The [FDIC] has determined that the activity would pose no significant risk to the appropriate deposit insurance fund; and (2) the State bank is, and continues to be, in compliance with applicable capital standards prescribed by the appropriate Federal banking agency. (b) Notwithstanding subsection (a), an insured State bank may not engage in insurance underwriting except to the extent that activity is permissible for national banks.

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I.I.lA.A. v. Ludwig (DC Cir 1993); Held that 92 of the National Banking Act allows banks located
in towns with 5,000 or less people can sell insurance nationwide. Text of Section 92 of the National Banking Act:

A]ny [national bank] located and doing business in any place the population of which does not
exceed five thousand inhabitants, as shown by the last preceding decennial census, may, under such rules and regulations as may be prescribed by the Comptroller of the Currency, act as agent for any . . . insurance company authorized by the authorities of the State in which said bank is located to do business in said state . . . .

Big loophole can sell insurance (as agent; cant underwrite) nationwide
from a bank located in a town of 5,000. Nations Bank v. VALIC (1995 OCC okays Nations Bank (national bank) selling variable and fixed annuities from a town of OVER 5000; VALIC sues doesnt want the competition); Held that annuities (fixed or variable) are not insurance; defer to OCCs judgment that annuities are investment products the sale of which is incidental to banking. WE expressly hold that the business of banking is not limited to the enumerated powers in section 24 Seventh and that the Comptroller therefore has discretion to authorize activities beyond those specifically enumerated.The exercise of the Comptrollers discretion, however, must be kept within reasonable bounds. And travel agencies are not reasonable. Doesnt overrule Arnold Tours (no travel agents), but puts for a more lenient test for the business of banking. Meaning is contextual, just b/c states consider annuities to be insurance, doesnt meant that they are insurance for the purpose of federal banking laws. National Bank Powers, 12 U.S.C. 24(Seventh (1999)

[A national bank shall have the power to]. . . . Seventh. To exercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes according to the provisions of this title.

Barnett Bank v. Nelson (USSC 1996 FL law precluded insurance agents in the state from
affiliating with banks except for banks which are not affilates/subsidiaries of bank holding companies and are located in a town of less than 5,000): Held that National Banking Act pre-empts state laws and allows national banks to sell insurance (nationwide) from towns of under 5000. Issue many states had laws that said that state insurance agents werent allowed to affiliate with banks or banks of a certain side. Does the NBA preempt the state anti-affiliation rules under ordinary preemption principles? [Yes.] Congress would not want States to forbid, or to impair significantly, the exercise of a power that Congress explicitly granted. To say this is not to deprive States of the power to regulate national banks, where (unlike here) doing so does not significantly prevent or significantly interfere with the national banks exercise of its powers. Interpretation of 92 which says that national banks can sell insurance from towns of under 5,000.

A]ny [national bank] located and doing business in any place the population of which does not exceed five thousand inhabitants, as shown by the last preceding decennial census, may, under such rules and regulations as may be prescribed by the Comptroller of the Currency, act as agent for any . . . insurance company authorized by the authorities of the State in which said bank is located to do business in said state . . . .

Some state regulation would probably be okay, but not constricting the expressed powers of national banks.

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MCCarran-Ferguson Act Federal law will not pre-empt a state statute enacted for the purpose of regulating the business of insurance unless the federal statute specifically relates to the business of insurance. McCarran-Ferguson Act. Section 92 expressly says that national banks can sell insurance from towns of 5000. Therefore MFs special preemption rule doesnt apply. First National Bank of Eastern Arkansas v. Taylor (8th Cir. 1990 For an extra fee bank offers protection where by if the customer dies, they dont have to pay back the loan. The OCC said that this was an activity incidental to banking under 12 USC 24(7). Arkansas Insurance department says this amounts to credit life insurance); Held that this credit insurance is not insurance; its banking. Perhaps this was decided wrong for MCCarran-Ferguson purposes no statute specifically relating covering this just the OCC saying its incidental to banking. Now under GLB, state insurance regulators cant prevent national banks from doing anything that federal law or the OCC says they can do, HOWEVER the insurance activities of national banks are now functionally regulated by the states. GLB Functional Regulation of Insurance, Section 301 GLB Act, 15 USC 6712 (2004)
The insurance activities of any person (including a national bank exercising its power to act as agent under the eleventh undesignated paragraph of section 13 of the Federal Reserve Act) shall be functionally regulated by the States, subject to section 104.

Insurance Underwriting of National Banks, Section 302 of GBL Act, 15 USC 6712 (2004) Banks can underwrite what OCC said they could underwrite as of January 1, 1999, but NOT annuities or title insurance.

(a) IN GENERAL.--Except as provided in section 303 [establishing special rules for title insurance], a national bank and the subsidiaries of a national bank may not provide insurance in a State as principal except that this prohibition shall not apply to authorized products. (b) AUTHORIZED PRODUCTS.--For the purposes of this section, a product is authorized if- (1) as of January 1, 1999, the Comptroller of the Currency had determined in writing that national banks may provide such product as principal, or national banks were in fact lawfully providing such product as principal; (2) no court of relevant jurisdiction had, by final judgment, overturned a determination of the Comptroller of the Currency that national banks may provide such product as principal; and (3) the product is not title insurance, or an annuity contract the income of which is subject to tax treatment under section 72 of the Internal Revenue Code of 1986. (c) DEFINITION.--For purposes of this section, the term "insurance" means- (1) any product regulated as insurance as of January 1, 1999, in accordance with the relevant State insurance law, in the State in which the product is provided; (2) any product first offered after January 1, 1999, which- (A) a State insurance regulator determines shall be regulated as insurance in the State in which the product is provided . . ; and (B) is not a product or service of a bank that is- (i) a deposit product; (ii) a loan, discount, letter of credit, or other extension of credit; (iii) a trust or other fiduciary service; (iv) a qualified financial contract (as defined in or determined pursuant to section 11(e) (8)(D)(i) of the Federal Deposit Insurance Act); or (v) a financial guaranty, except . . . ; or (3) any annuity contract, the income on which is subject to tax treatment under section 72 of the Internal Revenue Code of 1986.

Disputes Regarding Insurance, Section 304 of GLB Act, 18 U.S.C. 6714 (2004) - Now no agency gets deference with respect to what is insurance (v. what is banking); chevron turned off; banks decide denovo.

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In the case of a regulatory conflict between a State insurance regulator and a Federal regulator regarding insurance issues, including whether a State law, rule, regulation, order, or interpretation regarding any insurance sales or solicitation activity is properly treated as preempted under Federal law, the Federal or State regulator may seek expedited judicial review of such determination by the United States Court of Appeals . . . [The judicial resolution of such disputes shall be] based on [the courts] review on the merits of all questions presented under State and federal law, including the nature of the product or activity and the history and purpose of its regulation under State and federal law, without unequal deference. (a) STATE REGULATION OF THE BUSINESS OF INSURANCE. --The Act entitled "An Act to express the intent of Congress with reference to the regulation of the business of insurance" and approved March 9, 1945 (15 U.S.C. 1011 et seq.) (commonly referred to as the " McCarran -Ferguson Act") remains the law of the United States. (b) MANDATORY INSURANCE LICENSING REQUIREMENTS.--No person shall engage in the business of insurance in a State as principal or agent unless such person is licensed as required by the appropriate insurance regulator of such State in accordance with the relevant State insurance law, subject to subsections (c), (d), and (e). (c) AFFILIATIONS. (1) IN GENERAL. --Except as provided in paragraph (2), no State may , by statute, regulation, order, interpretation, or other action, prevent or restrict a depository institution, or an affiliate thereof, from being affiliated directly or indirectly or associated with any person, as authorized or permitted by this Act or any other provision of Federal law. (1) IN GENERAL. --Except as provided in paragraph (3), and except with respect to insurance sales, solicitation, and cross marketing activities, which shall be governed by paragraph (2), no State may, by statute, regulation, order, interpretation, or other action, prevent or restrict a depository institution or an affiliate thereof from engaging directly or indirectly, either by itself or in conjunction with an affiliate, or any other person, in any activity authorized or permitted under this Act and the amendments made by this Act. (2) INSURANCE SALES. (A) IN GENERAL. --In accordance with the legal standards for preemption set forth in the decision of the Supreme Court of the United States in Barnett Bank of Marion County N.A. v. Nelson (S Ct. 1996), no State may, by statute, regulation, order, interpretation, or other action, prevent or significantly interfere with the ability of a depository institution , or an affiliate thereof, to engage, directly or indirectly, either by itself or in conjunction with an affiliate or any other person, in any insurance sales, solicitation, or cross marketing activity. (B) CERTAIN STATE LAWS PRESERVED.--Notwithstanding subparagraph (A), a State may impose any of the following restrictions, or restrictions that are substantially the same as but no more burdensome or restrictive than those in each of the following clauses:

Operation of State Law, Section 104 of GLB Act, 15 U.S.C. 6701 (2004)

Operation of State Law, Section 104(d) of GLB Act, 15 U.S.C. 6701 (2004)

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