Financial Services Alert - September 14, 2010

The Basel Committee on Banking Supervision (the “Basel Committee”) announced that the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee, agreed on new, higher capital standards for banking organizations at its meeting on September 12, 2010.  The President of the European Central Bank and Chairman of the Group of Governors and Heads of Supervision, Jean-Claude Trichet, noted that “the agreements reached today are a fundamental strengthening of global capital standards,” and that “their contribution to long term financial stability and growth will be substantial.”

The new standards will include a minimum common equity requirement of 4.5% (compared to the current requirement of 2%).  The phase-in period for this requirement will begin on January 1, 2013, with full implementation effective January 1, 2015.  The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments, will increase from 4% to 6% over the same period.  The total capital requirement will remain at the existing level of 8%, and therefore will not need to be phased in.

In addition, banking organizations will be required to hold an additional capital conservation buffer of 2.5% to withstand periods of stress, bringing the total common equity requirements to 7% upon full implementation.  This capital conservation buffer will be phased in between January 1, 2016 and January 1, 2019.  While banking organizations that fail to meet the buffer would not be forced to raise additional capital, they would be subject to greater constraints on dividends, share buy-backs and bonuses the closer their regulatory capital ratios approach the minimum requirement.

Furthermore, a countercyclical capital buffer of between 0% and 2.5% of common equity or other fully loss absorbing capital will be implemented “according to national circumstances.”  This buffer, which would be introduced as an extension of the capital conservation buffer range, may be implemented differently in each country and will “only be in effect when there is excess credit growth that is resulting in a system wide build up of risk.”

The Basel Committee also announced that existing public sector capital injections will be grandfathered until January 1, 2018, while capital instruments that no longer qualify as non‑common equity Tier 1 capital or Tier 2 capital will be phased out over a 10-year period beginning on January 1, 2013.  In addition, instruments with an incentive to be redeemed will be phased out at their effective maturity date.  Moreover, while capital instruments that no longer qualify as common equity Tier 1 will be excluded from common equity Tier 1 as of January 1, 2013, instruments meeting all of the following three conditions will be phased out over the same 10-year period: (1) they are issued by a non-joint stock company; (2) they are treated as equity under the prevailing accounting standards; and (3) they receive unlimited recognition as part of Tier 1 capital under current national banking law.

In addition, the Basel Committee announced that regulatory adjustments, including deductions of amounts above the aggregate 15% limit for investments in financial institutions, mortgage servicing rights and deferred tax assets, will be subject to a transition period beginning on January 1, 2014, with full implementation effective on January 1, 2018.

The Basel Committee noted that “systemically important” banks should have “loss absorbing capacity beyond the standards” announced, and left open the possibility that such “systemically important” banks may be subject to stricter capital rules.

The FRB, the OCC and the FDIC issued a release supporting the new capital standards discussed above, calling the agreement “a significant step forward in reducing the incidence and severity of future financial crises, providing for a more stable banking system that is less prone to excess risk-taking.”

The Alert will continue to follow these issues closely.

On September 1, 2010, an Alabama bankruptcy judge issued opinion refusing to allow the FDIC to demand $905 million as a priority claim (the “Demand”) in the Chapter 11 bankruptcy case of a failed bank holding company The Colonial Bancgroup, Inc. (“Colonial”).  In re The Colonial Bancgroup Inc., Case No. 09-32303 (Bankr. M.D. Ala., September 1, 2010).  As part of a broad, aggressive effort by the FDIC to minimize the costs of bank failures, the FDIC filed the Demand because Colonial had signed several agreements with the FDIC, including a memorandum of understanding, a stipulation and consent to the issuance of a cease and desist order and a separate agreement under Section 4(m)(2) of the Bank Holding Company Act (the “Agreements”), pursuant to which Colonial pledged to use “good faith efforts” to “assist” its bank subsidiary and, specifically, to try to ensure that such subsidiary had adequate capital reserves.  After the failure of the subsidiary bank, the FDIC filed the Demand in Colonial’s bankruptcy reorganization to cover the losses to the Federal Deposit Insurance Fund.

The Court held that the specific language of the Agreements between Colonial and the FDIC did not create enforceable promises by Colonial to infuse additional capital into the subsidiary bank and that none of the Agreements amounted to a formal, enforceable capital maintenance agreement.  However, the Court did not preclude the possibility that agreements with stronger language could be enforceable in bankruptcy courts.  Nonetheless, the Court noted that even if Colonial had made an enforceable commitment to maintain the capital of its subsidiary bank, such commitment would not be entitled to a priority claim under Section 365(o) the Bankruptcy Code because the failed subsidiary bank was not operating on the date Colonial filed for bankruptcy protection.

CFTC Commissioner Scott D. O'Malia issued a statement in which he indicated that the CFTC should move forward on a petition by the National Futures Association (“NFA”) proposing amendments to the exclusion provided under CFTC Regulation 4.5 (“Reg. 4.5”) from the definition of the term “commodity pool operator” for persons who would otherwise be regulated as such by the CFTC.  The NFA’s proposal is designed to foreclose reliance on the Reg. 4.5 exclusion by “commodity mutual funds,” pooled investment vehicles registered under the Investment Company Act of 1940, as amended, that are marketed as commodities futures investments to retail investors, among others.  The NFA’s proposed amendments would restore conditions that prior to 2003 were imposed on registered investment companies that relied upon Reg. 4.5.  Under the NFA’s proposal, a registered investment company seeking to rely on Reg. 4.5 would have to represent that it “(1) will not be, and has not been, marketing participations to the public as or in a commodity pool or otherwise as or in a vehicle for trading in the commodity futures or commodity options markets; and (2) will use commodity futures or commodity options contracts solely for bona fide hedging purposes and, with respect to positions held for non-bona fide hedging purposes the aggregate initial margin and premiums required to establish such positions will not exceed five percent of the liquidation value of the qualifying entity’s portfolio, after taking into account unrealized profits and unrealized losses on any such contracts it has entered into.”

The CFTC issued a release proposing changes to its regulations that will codify relief from certain disclosure, reporting and recordkeeping requirements for commodity pool operators (“CPOs”) whose commodity pool units of participation are publicly offered and listed for trading on a national securities exchange (“Commodity ETFs”).  Like securities based ETFs, Commodity ETFs seek to track the performance of a specific commodity index or alternatively, actively trade commodity interests without regard to an index or benchmark.  The CFTC has previously provided exemptive relief on a case by case basis to Commodity ETFs subject to compliance with conditions like those in proposed amendments.  Actively managed Commodity ETFs must have independent directors or trustees in order to meet exchange listing standards that implement audit committee independence requirements mandated in SEC Rule 10A-3 under the Securities Exchange Act of 1934 adopted pursuant to the Sarbanes-Oxley Act of 2002.  The proposed amendments would provide an exemption from the requirement that a director or trustee of a Commodity ETF able to rely on the relief described above must register as a CPO; the exemption would be available to a director or trustee who served solely for the purpose of complying with the audit committee requirements of Rule 10A-3. 

Comments on the CFTC’s proposal must be received on or before October 25, 2010.