As covered in an Ad Hoc LRA earlier this month, the Financial Stability Oversight Council (FSOC) issued its long-awaited study and recommendations to the federal banking agencies regarding implementation of the Volcker Rule. The study recognized the concern that separate account products could be included in the definitions of “hedge fund” and “private equity fund” because they are offered in reliance on the same registration exemptions under the Investment Company Act. The study recommended that the banking agencies consider the issue carefully so as not to preclude certain insurance products that Congress may not have intended to fall under the Volcker Rule. The study also suggested that the agencies monitor fund flows between banks and insurance companies to guard against “gaming” the Volcker Rule with innovative products like BOLI or the use of separate accounts. The federal banking agencies have nine months, or until October 18, to issue implementation guidance. We expect the preliminary agency proposals to include a public comment period and will closely track these as they are released.
The final text of the Basel III package has been released, and its significance in the U.S. will depend on how the banking agencies implement it in light of regulations required under the Dodd-Frank Act. Basel III not only requires higher capital ratios and capital buffers, but also applies stricter definitions and adjustments to the components of capital. The Dodd-Frank Act has a number of provisions that conflict with Basel III. For example, there is uncertainty as to how Basel III will interact with the Collins Amendment, which requires banking agencies to prescribe minimum leverage capital requirements and minimum risk-based capital requirements on a consolidated basis for banks and bank holding companies. Another important difference relates to the role of rating agencies. Basel III’s framework for risk-weighting certain types of securities relies heavily on credit rating agencies’ published ratings. However, the Dodd-Frank Act requires U.S. regulatory agencies to remove all references to credit ratings of securities from their rules. U.S. agencies are evaluating alternatives to the use of ratings agencies. Some think this is overkill since the Dodd-Frank Act also requires the SEC to impose a number of requirements on credit rating agencies which must be adopted by July 21, 2011. Click here for a brief overview of Basel III by law firm Mayer Brown.
On January 21, the SEC staff delivered to Congress a study pursuant to Section 913 of the Dodd-Frank Act. Currently, investment advisors operate under a fiduciary standard and are required to serve the best interests of the client. On the other hand, broker-dealers are required to deal fairly with their clients under antifraud provisions of federal securities law and self regulatory organization (SRO) rules. Broker-dealers have a suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the interests of its customer. The study recommended a fiduciary standard, no less stringent than currently applied to investment advisors under the Investment Advisors Act, be applied uniformly to both broker-dealers and investment advisors. There is no statutory deadline to implement rulemaking from the study. SEC commissioners Kathleen Casey (R) and Troy Paredes (R) have expressed their opposition to the study stating that, as currently drafted, the study failed to fulfill the statutory mandate to evaluate the effectiveness of the existing legal or regulatory standard of care. The statement further provided that the study prescribed the uniform fiduciary standard without articulating the problems the new standard would alleviate and did not “adequately recognize the risk that its recommendations could adversely impact investors.”
Industry trade groups including the National Association of Insurance and Financial Advisors (NAIFA) and the Association of Advanced Life Underwriting (AALU) have voiced opposition to the proposal; both have issued statements praising the positions put forth by Casey and Paredes. MBSA strongly disagrees with those opposing the study’s findings and conclusions. We fully support adoption of a single, fiduciary standard.
President Obama called on lawmakers to simplify the tax system and cut the corporate tax rate during his State of the Union address. The top marginal corporate tax rate is 35 percent. Reportedly, each percentage-point reduction to the tax rate could cost $8 billion or more a year in foregone revenue to the Treasury. While there seems to be a consensus that the US corporate tax rate should be lowered, there is disagreement on how to fund a rate cut. Obama seeks to cut the rate without adding to the deficit by closing corporate loopholes. This approach may result in some businesses paying higher taxes depending on whether tax rates are lowered enough to offset lost tax breaks. The revenue-neutral approach creates a political hurdle since Republican leaders have made it clear that they do not support an increase in taxes. Also, it is expected that some businesses would rally against eliminating corporate tax deductions. Such an ambitious initiative appears likely to require an extended period of time to produce an actual bill. Nevertheless, we will be tracking this closely given that COLI/BOLI could very well land on the list of targeted corporate tax loopholes.
On January 27, the Financial Crisis Inquiry Commission released its report on the causes of the financial crisis. The report concluded that the crisis was avoidable and was caused by widespread failures in financial regulation, dramatic breakdown in corporate governance, excessive borrowing and risk, and systemic breaches in accountability and ethics among other causes. All four Republican members of the 10-member commission dissented. One dissent criticized the report for being unbalanced and having incorrect conclusions “by focusing too narrowly on U.S. regulatory policy and supervision, ignoring international parallels, emphasizing only arguments for greater regulation, failing to prioritize the causes, and failing to distinguish sufficiently between causes and effects….” The Commission interviewed over 700 witnesses and held 19 days of public hearings. The operations of the Commission will conclude on February 13.
As we have been reporting the past few months, the Financial Stability Oversight Committee (FSOC) was tasked by the Dodd-Frank Act (the Act) to conduct a study and provide recommendations to the federal banking agencies on the implementation of Section 619 of the Act, commonly referred to as the Volcker Rule. Following a meeting on January 18, the FSOC released a number of documents including its Volcker Rule Study, a report on the concentration limit on large financial companies, and proposed rulemaking regarding the Federal Reserve Board’s authority to supervise certain nonbank financial companies.
Overall, we think the Volcker Rule Study and recommendations are encouraging. Key concerns as submitted by the insurance and banking industries are specifically recognized. Recommendations would empower agencies to undertake strong corrective action if necessary, but agencies are also directed to be mindful not to overstep the intended scope and purpose of the Volcker Rule. Click here for the Volcker Rule Study and the notice of proposed rulemaking
Relevant commentary within the Volcker Rule Study regarding insurance, including investment activities of insurance companies (within general account and separate account) and BOLI are made in the section “The Accommodation of the Business of Insurance” (beginning on pg.71). Below, we have excerpted some key FSOC comments/recommendations:
Limitations on Qualified Activity
Under the Volcker Rule, activity for the general account is permitted if the appropriate federal banking agencies, after consultation with the Council and the relevant state insurance commissioners, have not jointly determined that such investment laws, regulations and written guidance are insufficient to protect the safety and soundness of the banking entity, or of the financial stability of the United States.
Should the appropriate federal banking agencies, after consultation with the Council and the relevant state insurance commissioners, jointly determine, that a particular state’s insurance company investment laws, regulations and guidance – or some aspects thereof – are insufficient to protect the safety and soundness of a banking entity or the financial stability of the United States, the activity of all regulated insurance companies domiciled in that particular state could be affected.
Separate Account Assets
Some commenters argued that the assets in these accounts are held for the benefit of particular customers, and therefore, investments tied to these separate accounts should be considered “permitted activity” under [the BHC Act]. Agencies should consider how insurance companies invest separately on behalf of customers.
Other Issues Related to the Business of Insurance
The Volcker Rule may apply to banking entities‘ investment in insurance products.
Some commenters also expressed concerns that some separate account products could be included in the definitions of “hedge fund” and “private equity fund” not by virtue of their being “other similar funds,” but because the definition includes funds required to be registered under the Investment Company Act, but for the exclusions under Sections 3(c)(1) or 3(c)(7). Agencies should examine this carefully so as not to preclude certain insurance products that may not have been intended to be limited by the Volcker Rule. One approach may be for Agencies to design, by rule, a process by which insurance companies can request an interpretative determination of whether particular separate accounts and products qualify under the definition of hedge or private equity fund. Another would be to determine whether the activity promotes the safety and soundness of the banking entity under [the BHC Act].
Finally and in general, the appropriate Agencies should carefully monitor fund flows between banking entities and insurance companies, to guard against “gaming” the Volcker Rule, whether it is through innovative insurance products and financial instruments, like Bank Owned Life Insurance, or use of separate accounts.
Agencies should work with the state insurance agencies in monitoring activity of bank affiliate insurance companies and captive insurers. To the extent such products become vehicles to enable impermissible activity, Agencies should consider procedures for designating such financial instruments [as proprietary trading under the BHC Act].