February 22, 2024
As February comes to a close, join us for a comprehensive overview of the latest regulatory activities shaping the landscape of financial services in the latest issue of Cabinet News and Views. From combating discrimination in real estate practices to proposed rules on anti-money laundering compliance, stay informed and get ready to delve into the intricacies of financial regulation.
As always, your comments and questions are valued. Feel free to reach out to us anytime by dropping a note here.
Mercedes Tunstall and Alix Prentice
Partners and Co-Editors, Cabinet News and Views
As February already begins to wind down and all of us are wondering what we might have missed so far this year, here is a round-up of additional regulatory activities in financial services:
- CFPB Publishes Updated Supervisory Procedural Rule. On February 16th, the Consumer Financial Protection Bureau (“CFPB”) published an updated supervisory procedural rule that revises the process supervised institutions must follow when they want to appeal compliance ratings and exam findings. This is the second revision since the CFPB first issued this procedural rule in October 2012, with the last revision occurring in 2015. Effectively, the revised rule provides more flexibility for both the CFPB and the supervised entities. The CFPB now has the ability to pull “potential members of the appeals committee” broader pool that includes “any CFPB manager who did not participate in the underlying matter being appealed and who has relevant expertise.” Supervised entities may now appeal any compliance rating (i.e., not just negative ratings). Finally, the process now allows the appeal to be resolved in three ways – the existing options of upholding or rescinding the finding still hold, but now the appeal may be resolved by remanding the matter to the staff of the Department of Supervision for re-consideration. This rule became effective once it was published by the CFPB and while it does not resolve the persistent problem of the appeals process being an “echo chamber” for supervised institutions, the new resolution option offers a less black-and-white, we-win-and-they-lose path that could be useful.
- CFPB Tackles the Credit Card Industry. Across the credit score spectrum, the CFPB produced a report on February 16th showing that credit cards offered by community banks and credit unions have significantly lower rates than the rates the largest 25 credit card issuers in the United States charge. The difference is so stark that customers with cards from the smaller institutions “average savings of $400 to $500 a year” per $5000 of balance carried over on the credit card. Coming from the CFPB Office of Markets, the report remarked that “research has found high levels of concentration and evidence of practices that imply anti-competitive behavior in the consumer credit card market” and that such anti-competitive effects explain the higher interest rates at the bigger institutions. The Consumer Bankers Association resoundingly disagreed with the CFPB’s conclusion pointing out that “[t]here are more than 640 individual credit card products and nearly 4,000 banks today in this highly competitive marketplace. This may be the only time that anyone has pointed to a market with vastly different prices as an indication of competition problems.” In response to widespread criticism from the industry, the CFPB demonstrated that they are not concerned and published a blog post discussing additional market information and drawing additional conclusions on February 22nd. This time, the CFPB remarks that “credit cards have never been this expensive” and explains that the largest credit card issuers are charging higher annual percentage rates (“APRs”) because they “are reliant on revenue from interest charged to borrowers who revolve on their balances to drive overall profits.” That may not seem like new news, but the CFPB wrote an entire blog post to support that statement, and that should not be taken lightly.
- FDIC Creates Animated Timeline About Its History. On a cheerier note than most of the regulatory happenings that get reported on, the Federal Deposit Insurance Corporation (“FDIC”) created a new animated timeline about its history that is engaging and celebrates their 90th anniversary (which actually occurred June 16, 2023).
- OCC Proposes Revised Rule on Bank Mergers. On January 29th, the Office of the Comptroller of the Currency (“OCC”) published a proposed rule seeking to revise practices related to its review of bank mergers under the Bank Mergers Act (“BMA”). Basically, the OCC proposes to remove certain provisions that presently allow for expedited or streamlined review of bank mergers, and to include an appendix to the rule that is comprised of a policy statement “that would discuss general principles the OCC uses in its review of applications under the BMA and discuss the OCC’s consideration of the financial stability, financial and managerial resources and future prospects, and convenience and needs factors.” The proposed Appendix to the rule lists out 13 qualities that applications that are generally approved tend to have, including having strong overall ratings as well as strong ratings regarding the Community Reinvestment Act and consumer compliance. Then, the Appendix walks through how the OCC looks at the effect of the proposed application on financial stability for the institutions and the marketplace; describes the balancing test used to ensure an approved application results in financial stability; explains how the OCC approaches considerations relating to financial and managerial resources; and discusses its viewpoint on considering the “probably effects of the proposed business combination on the community to be served”, seeking to ensure that community convenience will not be severely impacted and that community needs will continue to be addressed. Finally, the Appendix discusses various additional factors that could apply in individual situations related to financial resources, managerial risks, and future prospects. Comments are due on April 15, 2024, and regardless of how the comments lead to changes in the final rule, the publication of the Appendix provides useful transparency today and will likely remain largely unchanged.
- SEC Annual Report to Congress on Credit Agencies. On February 16th, the Securities and Exchange Commission (“SEC”) issued its annual staff report to Congress regarding credit agencies, or National Recognized Statistical Rating Organizations (“NRSROs”). The SEC is required to examine credit agencies annually and the report identified the following potential risks as areas of focus for exams in the next year: 1) Looking more closely at how NRSROs monitor low-rated companies in the wake of higher interest rates for debt service payments; 2) Also as a result of higher interest rates, reviewing NRSRO surveillance of collateralized loan obligations (“CLOs”) and securitizations backed by consumer assets and auto loans; 3) Focusing upon how securitizations in the rental income market have been rated; and 4) Ensuring that credit agencies are documenting their use of artificial intelligence and other technologies to produce models, but also how those technologies are used for analytical tools, with a particular focus on whether NRSROs make appropriate distinctions between the approval and use of these technologies when used for models versus when they are used for analytical tools.
- SEC Approves FINRA Rule Regarding Post-Trade Transparency In Treasury Markets. On February 7th, the SEC issued a statement discussing its approval of a rule proposed by the Financial Industry Regulation Agency (“FINRA”) that supports post-trade transparency, such that trades in Treasury markets will be available for review on a trade-by-trade basis, rather than on an aggregated basis. As Chairman Gensler remarks, this rule seeks to “align Treasury post-trade transparency with what we’ve come to benefit from in corporate, municipal, and mortgage markets.”
- FTC Sends ECOA Letter to CFPB. Before the CFPB was in operation, the Federal Trade Commission (“FTC”) submitted an annual report on its activities involving the Equal Credit Opportunity Act (“ECOA”) to Congress every year, but now the FTC submits its report to the CFPB, which it did on February 16th. The report covers three areas the FTC focused on with respect to “fair lending” in 2023, including enforcement efforts, research and policy development and consumer and business education. One of the leading pieces of the research and policy development portion of the FTC’s ECOA work was the joint statement issued with the CFPB, Department of Justice and the Equal Employment Opportunity Commission describing principles for enforcement actions intended to ensure that artificial intelligence being used by companies and financial institutions does not lead to discrimination in the marketplace due to “outcomes [skewed] by unrepresentative or imbalanced datasets, datasets that incorporate historical bias, or datasets that contain other errors.”
The Federal Financial Institutions Examination Council (“FFIEC”) published a statement on February 12, 2024 regarding “principles for the examination of supervised [institutions’] residential property appraisal and [valuation] practices to: (i) mitigate risks that may arise due to potential discrimination or bias in those practices, and (ii) promote credible valuations.” The FFIEC made the statement because “[d]eficiencies in real estate valuations, including those due to valuation discrimination or bias, can lead to increased safety and soundness risks, as well as consumer harm and have an adverse impact on borrowers and their communities” and such deficiencies have been acknowledged by the FFIEC’s member entities, including the Federal Reserve, the Office of the Comptroller of the Currency (“OCC”) and the National Credit Union Association (“NCUA”). In fact, on February 13, 2024, acting Comptroller Michael Hsu remarked to a fourth hearing by the FFIEC’s Appraisal Subcommittee on appraisal bias that, “Thanks to a housing shortage and soaring home prices, Americans who own their homes have seen a nearly $12 trillion increase in housing wealth since 2020. While these homeowners may rejoice, many minority homebuyers still face daunting hurdles and endure a widening racial wealth gap . . . [And a]ppraisals are integral to underwriting residential real estate lending: they are the ‘value’ part of the ‘loan-to-value’ measure. By rooting out bias in the appraisal system, we can expand homeownership and wealth creation opportunities to all Americans.”
Accordingly, the FFIEC has encouraged examiners charged with supervisory financial institutions to evaluate appraisal practices and trends on the basis of both consumer protection grounds and safety and soundness grounds. Specifically on the consumer protection front, the statement reminds examiners that several laws are in place to address patterns and practices of discrimination and bias in real estate appraisals, including the Equal Credit Opportunity Act and Regulation B, the Truth In Lending Act and Regulation Z, the Federal Trade Commission’s Section 5 prohibitions against unfair or deceptive acts or practices, and the Consumer Financial Protection Bureau’s own prohibitions against unfair, abusive or deceptive acts or practices under the Consumer Financial Protection Act. Examiners focused on the consumer protection aspects of appraisal bias and discrimination should therefore pay particular attention to board and senior management oversight of the compliance management systems (“CMS”) as well as to third-party risk management, as well as to ensure that the CMS consists of robust policies and procedures, training, monitoring, auditing and review of consumer complaints.
On the safety and soundness front, examiners are reminded that in addition to the consumer protection laws, “Title XI of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and the implementing federal appraisal regulations include several requirements to promote the reliability of appraisals in federally related transactions.” Thus, the risks attendant to potential valuation discrimination and bias should take into account consumer protection concerns, appropriate training protocols and third-party risk management, but also all of the following: 1) consideration of the materiality of residential real estate lending and related credit risks in relation to the institution’s overall lending activities, size, complexity, and risk profile; 2) assessment of the institution’s policies, processes, staff organization and resources, control systems, and management information systems for residential real estate collateral valuations, as well as the institution’s ability to identify and resolve incidences of potential valuation discrimination or bias; 3) evaluation of the institution’s practices for selecting, retaining, and overseeing independent, qualified, and competent individuals (and applicable valuation models) that have the ability to render unbiased and credible opinions of collateral value; and 4) assessment of the institution’s valuation review function for identifying potentially discriminatory or biased valuation results.
Of particular note is the statement’s encouragement that institutions establish a formal valuation review program designed to minimize findings regarding potential valuation discrimination or bias, consistent with the Interagency Appraisal and Evaluation Guidelines.
On February 15, the U.S. Treasury’s Financial Crimes Enforcement Network (“FinCEN”), published a proposed rule that would define specified investment advisers as “financial institutions” required to implement anti-money laundering (“AML”) compliance programs.
The proposed rule would apply to investment advisers registered with the Securities and Exchange Commission (“SEC”) and investment advisers that report to the SEC as exempt reporting advisors. It would require covered investment advisers to implement an AML compliance program that includes:
- Policies, procedures, and internal controls reasonably designed to prevent money laundering, terrorist financing, and other illicit financial activities;
- Diligence to understand the nature and purpose of customer relationships in order to develop a customer risk profile;
- Ongoing monitoring to identify and report suspicious activity;
- Ongoing training for personnel;
- A designated person responsible for implementing and monitoring the AML compliance program; and
- Independent testing of the AML compliance program for compliance with the Bank Secrecy Act (“BSA”).
The proposed rule would not require covered investment advisors to immediately implement a Customer Identification Program (“CIP”) Rule (e.g., 31 C.F.R. 1023.220), or comply with FinCEN’s Customer Due Diligence (“CDD”) Rule (31 C.F.R. 1010.230), which requires certain financial institutions to identify the individual beneficial owners of entities. Instead, FinCEN plans to impose CIP obligations as part of a joint rulemaking with the SEC, and beneficial ownership obligations after FinCEN completes a separate rulemaking to conform the CDD Rule with the requirements of the Corporate Transparency Act (31 C.F.R. 1010.380). Nonetheless, covered investment advisers would need to collect information about customers in order to develop a customer risk profile and for the purpose of effectively monitoring customer conduct to identify suspicious activity.
FinCEN proposes to delegate its examination authority to the SEC, as it has done for broker-dealers and mutual funds. Although many investment advisors already implement some form of an AML compliance program, whether voluntarily, as a contractual obligation, or due to the advisor’s affiliation with another regulated financial institution, covered investment advisors would need to review those programs to assess whether they meet the requirements of the proposed rule. Notably, investment advisors would not need to apply an AML compliance program to mutual fund customers, because mutual funds are subject to separate AML program requirements under the BSA and its implementing regulations.
As “financial institutions,” covered investment advisors would also be subject to additional reporting and compliance obligations, including:
- Compliance with the Travel Rule (31 C.F.R. 1010.410(e)) and related recordkeeping requirements;
- Filing currency transaction reports for cash transactions exceeding $10,000;
- Enhanced due diligence requirements for private bank accounts and correspondent accounts for foreign financial institutions;
- Special measures that the U.S. Treasury imposes under Section 311 of the USA PATRIOT Act; and
- Information sharing rules under sections 314(a) and 314(b) of the USA PATRIOT Act.
FinCEN issued a similar proposed rule in 2015, but never finalized it. The 2015 proposed rule has now been formally withdrawn.
FinCEN has set a deadline of April 15, 2024 for the submission of comments on the proposed rule.
On February 16, 2024, the Financial Crimes Enforcement Network (“FinCEN”) issued a proposed rule addressing “Anti-Money Laundering Regulations for Residential Real Estate Transfers.” The proposed rule would, among other things, require certain persons involved in real estate closings to maintain records regarding non-financed residential real estate transfers and to submit “streamlined SARs” (suspicious activity reports), called Real Estate Reports, to FinCEN. “The persons subject to these reporting and recordkeeping requirements would be deemed reporting persons for purposes of the proposed rule and . . . [t]he information required to be reported in the Real Estate Report would identify the reporting person, the legal entity or trust to which the residential real property is transferred, the beneficial owners of that transferee entity or transferee trust, the person that transfers the residential real property, and the property being transferred, along with certain transactional information about the transfer.”
As FinCEN describes in the Federal Register notice including the proposed rule, the Bank Secrecy Act has generally required that real estate transaction information falls within the categories of transactions that are subject to appropriate money laundering controls since 1970. However, “for many years, FinCEN has exempted such persons from comprehensive regulation under the BSA and has issued a series of time-limited and geographically focused ‘geographic targeting orders’ (“GTOs”) to the real estate sector in lieu of more comprehensive regulation.” In particular, in 2016, FinCEN specifically extended a Residential Real Estate GTO to “require title insurance companies to file reports and maintain records concerning non-financed purchases of residential real estate above a certain price threshold by certain legal entities in select metropolitan areas.” As a result of that 2016 GTO, the information received has indicated to FinCEN that more comprehensive regulation is necessary, when it comes to non-financed real estate transactions. The goal of this permanent rule would be to “connect non-financed residential real property purchases by certain legal entities with the true beneficial owners making the purchases, thereby decreasing the ability of criminals to hide their identities while laundering money through real estate.”
Effectively, the proposed rule would require that at least one person involved in the real estate transaction would have to submit the Real Estate Report. And, that one person would not need to exercise any discretion regarding whether to file the Real Estate Report (unlike when traditional SARs are filed) and the proposed rule would not require confidentiality to be maintained by any of the persons involved in the filing of the Real Estate Report (again, unlike the confidentiality covered institutions must maintain regarding whether they have filed a SAR). While there is a hierarchy in terms of which person would, under the rule, be obligated to submit the Real Estate Report, the parties may also sign a “designation agreement” that would designate a particular person identified in the hierarchy as being the reporting person. Primarily, that person should be “the person listed as the closing or settlement agent on a settlement (or closing) statement.” If there is no agent on the closing statement, then the person that has prepared the closing statement should submit the Real Estate Report. If there is no closing statement, then the person that underwrites the title policy should submit the Real Estate Report. And, if there is no title policy underwritten, then reporting should be done by the “person that disburses the greatest amount of funds in connection with residential real property transfer”, meaning disbursement from an escrow account, a trust account or from a lawyer’s trust account, but excluding direct transfers between transferees. If there is no person disbursing on behalf of the transferees, then the person who prepares an evaluation of the title should submit the Real Estate Report. And, if all else fails, then the person that prepares the deed for the transaction should submit the Real Estate Report. This so-called “reporting cascade” is designed to “capture both sales of residential real estate and non-sale transfers of residential real estate . . . to ensure uniform coverage of non-financed transfers and to ensure that nominees do not purchase homes for criminal actors and then transfer the title on free of charge to a legal entity or trust.”
There are three elements that determine whether a transaction is a “reportable transaction”:
1) Is the kind of property involved in the transaction covered by the rule?
2) Is any transferee considered a “transferee entity” or “transferee trust”?
3) Is the transaction not covered by any of the following exceptions?
- Transaction is financed;
- Transaction is low-risk because it involves an easement, death, divorce or bankruptcy; or
- Transaction involves transfer directly to an individual person.
In terms of the transactions that would be subject to being reported through the Real Estate Report, FinCEN cast an intentionally broad net. “The proposed rule is meant to broadly capture residential real property such as single-family houses, townhouses, condominiums, and cooperatives, as well as apartment buildings designed for one to four families. These properties would be captured even if there is also a commercial element to the property, such as a single-family residence that is located above a commercial enterprise.” Further, many kinds of land-only transactions would be reportable.
In terms of the types of transferees involved, as mentioned, any transfer directly to an individual, even if that transfer was not financed and was not deemed to be low-risk, would not result in a reportable transaction. But, if the transferee is any person other than an individual and that transfer is not financed or is not low-risk, then the transfer would most likely be deemed a reportable transaction. The definition of “transferee entity” generally means “any person other than a transferee trust or an individual.” The definition of “transferee trust” generally means “any legal arrangement created when a person . . . places assets under the control of a trustee for the benefit of one or more persons . . . or for a specified purpose, as well as any legal arrangement similar in structure or function[,] whether formed under the laws of the United States or a foreign jurisdiction.” There are specific exemptions to both of these transferee definitions, including statutory trusts and trusts that are securities reporting issuers, and for the most part, FinCEN points to protocols described in its rules under the Corporate Transparency Act (“CTA”), especially its Beneficial Ownership Reporting Rule, as being applicable to defining which entities and trusts may or may not be exempt from these transferee definitions. Having said that, the inclusion of most trusts involved in non-financed transactions is especially interesting.
In addition to the proposed rule provisions, FinCEN lists no less than 50 questions for comment from interested parties. These questions include everything from how likely “designation agreements” are likely to be used to concerns that may arise in transactions that are partially non-financed to whether concerns relating to non-financed real estate transactions extend to commercial real estate, as well. Comments are due to FinCEN on or before April 16, 2024.
The Council of the European Union has confirmed that it has adopted changes to EU trading rules in the Markets in Financial Instruments Regulation (“MiFIR”) and the Markets in Financial Instruments Directive (“MiFID II”) on:
- A consolidated tape: the new rules establish an EU-level consolidated tape (“CT”) centralising market data from across multiple platforms and enabling investors to access up-to-date information on price, volume and time of trades. Note that in the UK, rules for the CT for bonds are largely finalised with an expectation that operations will start in the second half of 2025. An update on next steps for an equities CT in the UK is expected later this year.
- A ban on payment for order flow (“PFOF“): while the practice of brokers receiving payments for sending client orders through to particular trading platforms with which the brokers had an agreement is now generally banned, Member States that have up to now allowed PFOF may continue to do so provided that it is only provided to clients in that Member State. The practice must, however, be phased out by 30 June 2026.
Once the texts are published in the Official Journal of the EU, they will enter into force 20 days after publication and apply immediately when they are changes to MiFIR while Member States will have 18 months to bring into force changes to MiFID II.
The UK’s Prudential Regulation Authority (“PRA”) has reported on the conclusions of a review of its ring-fencing rules conducted during the course of 2023. While the report concludes that most rules are ‘performing satisfactorily’ and remain an important support for the statutory regime (which is not the remit of the PRA), there are areas where improvements are indicated.
Background
Ring-fencing was one of the measures brought in post the financial crisis of 2008-2009 and which requires banks performing the ‘core activities’ involved in accepting deposits to place those activities into ring-fenced banks (“RFBs”) in order to protect them from contagion from non-ring-fenced activities and from the wider financial system. RFBs are required to be legally separate from activities performed in one or more non-RFBs within the same consolidation group, and to be isolated in a way such that the actions or insolvency of those non-RFBs cannot affect the continuity of the RFB’s core activities. In addition, certain activities and customers are prohibited for RFBs.
Potential Areas for Improvement
- Governance arrangements: RFB rules on governance are intended to ensure that RFBs can, as far as reasonably practicable, function within a consolidation group while maintaining appropriate independence. While the PRA considers that the rules in this regard on board membership, remuneration policy, HR policy and risk policies function well, the outcome of this review is that the PRA is considering a more flexible approach to granting waivers or modifications over longer time periods and applying some rules at sub-group level rather than to each individual subsidiary.
- Continuity of provision of services: PRA rules in this area are designed to ensure that the RFB can continue to rely on important, business-critical services in the event of a failure or other adverse development in group non-RFBs. While the PRA is required to ensure that RFBs do not depend on services that would no longer be available if another member of its group became insolvent, it does consider that there are options to modify the way its rule that requires RFBs to receive services from group entities that are ‘permitted suppliers’ (ring-fenced affiliates or entities whose only business is to provide services or facilities) functions in order to achieve greater flexibility.
- The arm’s-length rules and intragroup arrangements: The arm’s-length rule requires RFBs to treat transactions with and exposures to non-RFBs in the same group in the same way as dealings with a third party and put in place governance, monitoring , reporting and dispute resolution processes. Intragroup arrangements rules cover a diverse range of topics, including own funds requirements, distributions to group entities, dependencies for income, netting arrangements and shared collateral. The PRA’s review concludes that these are functioning as intended in their current form, but will consult on the frequency of the required review of arm’s-length policies (currently annual).
- Use of financial market infrastructure and exceptions policies: In certain circumstances, RFBs are permitted to gain some exposure to non-retail financial products, such as derivatives to hedge their own risk. Rules intended to ensure that RFBs remain protected from the riskier aspects of the financial system when doing so include rules on the use of central counterparties and securities depositories, internal policies to ensure differentiation of permitted transactions from prohibited transactions, and on the process RFBs can use to apply for indirect use of Inter-Bank Payment Systems. Again, the PRA concludes that the rules are fit for purpose and remain appropriate.
- Data reports and notifications: The PRA requires specific reporting on ring-fencing in order to supervise compliance and conduct its reviews. While the PRA’s review concludes that these reports remain necessary, it will consider certain adjustments to templates.