Regulatory Update on Financial Reform AICPA PFP 11 Jan. 2011 Prof. William H. Byrnes & Prof. Stephen Polak International Tax & Financial Services Graduate Program
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The Wall Street Reform Act Topics To Be Covered Today1) Ethical standards for investment advice given by broker-dealers2) "Accredited investor" standard for private placements3) Mandatory securities agreement arbitration4) Jurisdiction over investment advisors5) Regulation of hedge funds and private equity funds6) Performance-Based Fees
The Wall Street Reform Act Topics To Be Covered Today7) Deposit insurance8) Study of state and federal regulation of financial planners9) Indexed annuities10) Creation of the Federal Insurance Office11) Surplus lines dealers12) Performance-Based Fees
Introduction to the Dodd-Frank Wall Street Reform and Consumer Protection ActThe Dodd-Frank Wall Street Reform and ConsumerProtection Act (Wall Street Reform Act), signed intolaw by President Obama on July 21, 2010.It was developed as a comprehensive response tothe financial crisis of 2007-2010.
What Did President Obama Say About the ActPresident Obama summarized its purpose shortlyafter signing, saying that:“For years, our financial sector was governed byantiquated and poorly enforced rules that allowedsome to game the system and take risks thatendangered the entire economy.”
Who Will Be AffectedAll financial professionals—including: Insurance producers, Investment advisors, Broker-dealers, and Others… will be forced by the Act to change the way theydo business. These changes a steep learning curveand extract significant compliance costs for mostprofessionals.
New Rules, Studies, Reports81 new studies will be conducted93 new reports will be completed, and520 rules will be created.
New AgenciesFederal Insurance Office subdivision of the Treasury Department;Consumer Financial Protection Bureau (CFPB), created by the Board of Governors of the Federal Reserve Office of Financial Protection for Older Americans Office of Financial Literacy,Financial Stability Oversight Counsel monitor systemic risks to the economy.
Biggest Change For Financial AdvisorsShift of regulatory authority … from the SEC to the state governments.Modification of the “accredited investor” standardMandatory securities arbitration clauses,performance-based fees,Bring most hedge fund (and other private fund) advisors under the SEC’s jurisdiction.
Biggest Change For Financial Advisors (cont.)Broker-dealers and their registered representatives will be the Act’s grant of authority to the SEC to apply a fiduciary standard to broker-dealers.
1. Ethical standards for investment advice given by broker-dealersThe Act grants the SEC the power to impose a fiduciary standard on broker-dealers and their authorized representatives.Under the fiduciary standard, broker- dealers would be required to put their clients interests ahead of their own interests, meaning that they would be required to act in their clients best interests and disclose any conflicts of interest.
2. "Accredited investor" standard for private placementsThe Act requires the SEC to evaluate the definition of "accredited investor,“ as it applies to individuals, and modify it as necessary "for the protection of investors, in the public interest, and in light of the economy.“ The SEC is given great latitude to define the term, except that the Act includes a specific provision requiring the SEC to revise the minimum net worth standard. This will reduce the number of investors who qualify as accredited investors.
3. Mandatory securities agreement arbitrationThe Act permits the SEC to prohibit or restrictmandatory securities arbitration agreements. – At present, contracts between brokers, dealers, and investment advisors and their clients often include arbitration clauses. – These arbitration clauses are typically upheld when challenged in the courts. – Pushing disputes out of arbitration and into the courts will drastically increase expenses for both sides of these disagreements.
4. Jurisdiction over investment advisorsStates, and not the SEC, are given jurisdiction over investment advisors who manage between $25 million & $100 million in assets.But investment advisors who are registered in 15 or more states are subject to SEC regulation regardless of the amount of their assets under management.Prior to the Act, advisors with $25 million or more in assets under management were subject to SEC regulation.
5. Regulation of hedge funds and private equity fundsHedge funds and private equity firms with > $150 million in assets under management have to register as investment advisors with the SECPrivate funds advisors that are exempted from registration by the SEC because they have < $150 million in assets under management will still be subject to enhanced recordkeeping requirements.These records must be kept open to inspection by the SEC.
6. Advisor disclosuresThe SEC is required by the Act to study investor access to information about advisors’ professional backgrounds, including "disciplinary actions, regulatory, judicial, and arbitration proceedings, and other information."The SEC is required to implement its recommendations within 18 months of completing the study.
7. Deposit insuranceThe Act permanently extends the FDICs $250,000 guarantee for deposits at banks, thrifts, and credit unions.The FDIC guarantee was previously $100,000 per institution, but the guarantee was temporarily raised to $250,000 during the financial crisis.
8. Study of state and federal regulation of financial plannersThe GAO is required to study the adequacy of state and federal regulations designed to protect investors from persons who hold themselves out as financial planners "through the use of misleading titles, designations, or marketing materials.
9. Indexed annuitiesThe Act conclusively settles the question of whether indexed annuities are securities subject to the SECs jurisdiction by excluding indexed annuities from the definition of "security."
10. Creation of the Federal Insurance OfficeInsurance regulation has generally been left to the states; however, the Wall Street Reform Act may foreshadow future Federal oversight of the industry.The Act creates the Federal Insurance Office within the Treasury. – The Office will monitor all components of the insurance industry excluding the health, crop, and long-term care sectors.
11. Surplus lines dealersThe Act streamlines the regulation of surplus lines insurance by making the insureds home state the sole regulator and tax collector in surplus lines transactions.
12. Performance-Based FeesThe Act reduces the pool of clients who can becharged performance-based fees. – Currently, “qualified clients” can be charged performance fees if they have at least $750,000 in funds under management, or a net worth of over $1,500,000. – The Reform Act requires that the SEC adjust these funds under management and net worth threshold amounts to account for inflation starting on July 21. 2011, and then index them for inflation every five years thereafter.
What You Don’t Know Yet Might Hurt You: ABroker’s Duties Under the Financial Reform ActChanging Standards – Broker-dealers are presently subject to a suitability standard under which a broker-dealer must reasonably believe that his or her advice is suitable to the client’s financial situation. – The Act permits the SEC to step-up broker-dealers’ duties to their clients to a fiduciary standard on par with the standard applied to financial advisors. Under the fiduciary standard, broker-dealers would be required to put their client’s interests ahead of their own interests.
Fiduciary Duty Standard Current bifurcated standard IAs v. BDs BDs = suitability standard “reasonably believe” that advice is suitable to the financial situation “an adequate and reasonable basis” for recommendations “reasonable efforts” to obtain information about the financial status not required to disclose COI
Fiduciary Duty Standard universally apply IAs standard broker-dealers / reps Insurance agents caught act in clients’ best interests disclose any conflicts of interest not factor commissions into advice disclose if limited range of financial products
Consultants to Employee Benefits Plans to be Classified as FiduciariesThe Department of Labor is looking to significantly broaden the definition of who is a fiduciary when giving investment advice to employee benefit plans and plan participants.Many plan consultants who previously escaped classification as fiduciaries will soon be subject to the conflict of interest and self-dealing rules that are applied to plan fiduciaries, creating a compliance nightmare for those advisors.
The Proposed Regulations greatly expand the types of activities that can result in fiduciary statusRendering advice, appraisals, or fairness opinions concerning the value of securities or other property;Making recommendations as to the advisability of investing in, purchasing, holding, or selling securities or other property; orGiving advice or recommendations as to the management of securities or other property.
Wall Street Reform Act Re-Defines “Accredited Investor”The definition of “accredited investor” includes both high-net-worth individuals and institutional investors. Individuals are qualified as accredited investors if they satisfied either a yearly income standard or a net-worth standard.The Wall Street Reform Act amends the net-worth standard, although it leaves the income standard alone.
"Accredited investor" standard for private placements1982 $1m standard of all assets = 1.87% of pop$200/$300 married threshold will remain for now2011-14: $1m asset threshold excluding homeEvaluate income threshold2015: must raise asset threshold> 2.5m? net investments (2006 proposal)Investor pool will return to 1.3% of pop.
Wall Street Reform Act Re-Defines “Accredited Investor” (cont.)The Act amends the net-worth standard, although it leaves the income standard alone.Under the income standard an individual with: – Annual income of $200,000 in each of the two most recent years, or – Married couple with an annual income of $300,000 in each of the two most recent years, is an accredited investor. – Net worth rule excludes an investor’s principal – residence from the net worth calculation.
Fewer Clients Qualify for Performance-Based Fees The Wall Street Reform Act reduces the pool of clients who can be charged performance-based fees. The Act requires that the SEC adjust these funds under management and net worth threshold amounts to account for inflation starting on July 21. 2011, and then index them for inflation every five years thereafter. Any adjustment to the qualified clients test will reduce the pool of clients who can be charged performance-based fees.
“Qualified Clients" standard for performance based fees1996: $750K managed or net worth $1.5MJuly 21, 2011 must be adjusted for inflationMinimum required adjustment - $100KProbably $1M managed / $2M net worthEvery five years re-indexed for inflation
Mandatory Securities Arbitration Clauses on the Chopping BlockThe Act expressly gives the SEC the power to prohibit or restrict mandatory securities arbitration agreements.Although securities arbitration would still be permitted if the SEC decides to act, arbitration would likely be used only at the client’s option, effectively shifting the choice of whether to arbitrate from financial professionals to their clients.
Hedge Fund Must Now Register with the SEC Under the New Wall Street Reform ActWho Must Register? – The Act requires advisors to hedge funds and private equity funds with > $150 million in assets under management to register as investment advisors with the SEC. – Managers with assets under management of between $25 million and $150 million will be required to register with state regulators. – Those with < $25 million in assets under management are exempt from the federal registration requirement, but may be subject to registration requirements under state law. Private Advisor Exemption Under the Advisors Act
Registration Exemptions Under the Wall Street Reform Act1. Mid-Sized Private Fund Advisors—An advisor who acts solely as advisor to private funds and who has less than $150 million in assets under management2. Venture Capital Fund Advisors—Advisors who act as advisors only for venture capital funds3. Foreign Private Advisors—Foreign private advisors, if they (1) do not have a place of business in the U.S., (2) have fewer than 15 U.S. clients and investors in private funds advised by the advisor, (3) have assets under management of less than $25 million (4) do not hold themselves out as an investment advisor in the U.S., and (5) do not act as advisors to any registered investment companies or business development companies
Registration Exemptions Under the Wall Street Reform Act1. Family Offices—Advisors to family offices, although the term “family office” is left undefined by the Act2. Commodity Trading Advisors—Advisors registered with the Commodity Futures Trading Commission, if they do not give advice about securities, and3. Small Business Investment Company Advisors— Advisors who exclusively advise small business investment companies.
Registration Exemptions Under the Wall Street Reform Act (cont.)These records must be kept open to inspection bythe SEC. Information required to be kept by privateadvisors includes:The amount of assets under management and use of leverage, including off-balance sheet leverageCounterparty credit risk exposureTrading and investment positions
Registration Exemptions Under the Wall Street Reform Act (cont.)1. Trading and investment positions2. Valuation policies and practices of the fund3. Types of assets held4. Side arrangements or side letters, whereby certain investors in a fund obtain more5. Favorable rights or entitlements than other investors6. Trading practices, and7. Other information that is appropriate in the public interest and for the protection of8. Investors and for the assessment of systemic risk.
Confidentiality ProtectionsProprietary information provided by funds to the SECunder the Act is not subject to Freedom ofInformation Act requests. Proprietary informationincludes non-public information about: – Investment and trading strategies; – Analytical and research methodologies; – Computer hardware and software that hold intellectual property; and – Other information deemed proprietary by the SEC.
Modernizing Mutual Fund Taxation: Registered Investment Company Modernization ActPass through of foreign tax credits and tax-exempt interest—The RICM Act permits qualified funds of funds to pass foreign tax credits and tax-exempt interest on to investors.Eliminate preferential dividend rules—The RICM Act eliminates the preferential dividend rules for publically offered RICs. Note, however, that securities laws still govern when a publically offered RIC is allowed to pay preference dividends.
Modernizing Mutual Fund Taxation: Registered Investment Company Modernization ActRepeal of the nine year limit on loss carry forwards—The RICM Act allows a RIC to carry its losses forward indefinitely.Net capital losses excluded from earnings and profits—Under the RICM Act, earnings and profits of a registered investment company cannot be reduced by any amount that is not deductible for tax purposes.
Wall Street Reform Act Mandates Study of Financial Planning Industry The federal government is taking the first steps toward regulating financial planners. Advisors who are also Certified Financial Planners may ultimately face a second layer of federal regulation.
Wall Street Reform Act Mandates Study of Financial Planning IndustryFINRA Positions Itself to Oversee Advisers: – The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed earlier this year, mandates an SEC study of its investment advisor examinations and whether delegation of advisor regulation to an SRO would improve examinations.
New FINRA Rule Restricts Brokers’ Outside Business Activities Brokers will face new restrictions on outside businesses under FINRA Rule 3270, which is set to go into effect December 15, 2010. The rule will limit brokers’ investment advisory and insurance business by requiring brokers to provide their broker-dealers with prior written notice of their outside business activities.
New FINRA Rule Restricts Brokers’ Outside Business ActivitiesUnder the new rule, once a broker-dealer receives notice ofa brokers outside business, the broker-dealer will berequired to determine whether the outside business activitywill: – Interfere with or otherwise compromise the registered person’s responsibilities to the member and/or the member’s customers, or – Viewed by customers or the public as part of the member’s business based upon, among other factors, the nature of the proposed activity and the manner in which it will be offered.
Enhanced Disclosures RequirementsThe Wall Street Reform Act lays the groundwork forincreased advisor and broker-dealer disclosurerequirements: – The Act requires the SEC to conduct a study looking for ways to improve investor access to information about advisors’ professional backgrounds. – The Act gives the SEC broad powers to institute disclosure requirements for broker-dealers.
New York Life Insurance Commission DisclosuresBeginning January 1, 2011 life insurance brokers inthe Big Apple will be disclosing commissions toconsumers. New York is one of the first states thatare mandating life insurance commission details tobe disclosed to clients.
New York Life Insurance Commission DisclosuresUnder New York Insurance law an insuranceproducer selling or renewing an insurance contractmust disclose the following information to thepurchaser orally or in writing not later thanapplication for the insurance contract or therenewal: – Whether the insurance producer represents the purchaser or the insurer for purposes of the sale
New York Life Insurance Commission Disclosures (cont.)– The insurance producer will receive compensation from the selling insurer based on the insurance contract the producer sells;– The compensation insurers pay to insurance producers may vary depending on a number of factors, including the insurance contract and the insurer that the purchaser selects, the volume of business the producer provides to the insurer or the profitability of the insurance contracts that the producer provides to the insurer; and
New York Life Insurance Commission Disclosures (cont.)– The purchaser may obtain information about the compensation expected to be received by the producer for the sale and for any alternative quotes obtained by the producer by requesting such information from the producer.
New York Life Insurance Commission Disclosures (cont.)If a purchaser of a life insurance contract requests more information about the producer’s compensation prior to the issuance of the insurance contract, the producer is required to disclose the following information to the purchaser in a prominent writing no later than the issuance of the insurance contract, (except that if time is of the essence to issue the insurance contract, then within five business days).
New York Life Insurance Commission Disclosures (cont.) A description of the nature, amount and source of any compensation to be received by the producer or any parent, subsidiary or affiliate based in whole or in part on the sale; A description of any alternative quotes obtained by the producer, including the coverage, premium and compensation that the insurance producer or any parent, subsidiary or affiliate would have received based in whole or in part on any such alternative quotes;
New York Life Insurance Commission Disclosures (cont.) A description of any material ownership interest the insurance producer or any parent, subsidiary or affiliate has in the insurer issuing the insurance contract or any parent, subsidiary or affiliate; A description of any material ownership interest the insurer issuing the insurance contract or any parent, subsidiary or affiliates has in the insurance producer or any parent,subsidiary or affiliate; and
New York Life Insurance Commission Disclosures (cont.)A statement whether the insurance producer is prohibited by law from altering the amount of compensation received from the insurer for the sale.If the purchaser requests more information about theproducer’s compensation after issuance of the insurancecontract but less than three years after issuance, theinsurance producer shall disclose to the purchaser in aprominent writing the information as discussed in theabove paragraph within thirty days.
The Department of Labor Releases Final 401(k) Disclosure Rules They mandate that plans provide adequate disclosures about the plan and about investment options under the plan, including information about: – The plan’s identification and general operational characteristics, – Administrative expenses, and – Individual expenses. Disclosures must be made on the basis of the plan’s most recent, available information.
NCOIL Adopts Beneficiaries Bill of Rights as Retained Asset Accounts under FireThe National Conference of Insurance Legislators (NCOIL) Executive Committee has adopted the model Beneficiaries’ Bill of Rights—which would restrict the insurance industry practice of using retained asset accounts (RAAs) to pay policy death benefits. The model would require “appropriate disclosure” when benefits will be issued through an RAA.
New York Court of Appeals Upholds STOLI Arrangement Under Pre-2010 Law– In a big win for STOLI promoters, the Court of Appeals of New York—the state’s highest court—held that New York’s insurable interest law was not violated when an insured purchased a life insurance policy and immediately assigned the policy to a third party who did not have an insurable interest in the insured’s life.
2010 New York Statute Prohibiting STOLIAlthough STOLI investors won the day in Kramer, New York is no longer a safe haven for such transactions. In 2009, the New York State Legislature passed life settlements legislation that prohibits STOLI policies like those at issue in this case. The New York statute that became effective May 18, 2010, would prohibit immediate policy assignments as described in the Kramer case.
Recent Delaware STOLI Case Is a Big Win for InsurersAn insurer recently won a major victory when the U.S. District Court for Delaware voided a life insurance policy that was purchased as part of a STOLI transaction. The case—Principal Life Insurance Co. v. Lawrence Rucker 2007 Insurance Trust—is significant because the court voided the policy for lack of an insurable interest based on the finding of insured’s intent to sell, even though the insured had not identified a particular purchaser for the policy at the time it was issued.
STOLI to STOA: First Drops in a Gathering StormSome STOA variants are simply avant-garde STOLI, replacing life insurance with annuity death benefits. In this breed of STOA, investors pay an individual to serve as annuitant on a variable annuity contract that includes a guaranteed minimum death benefit.The annuitant is typically a person with a short life expectancy, such as the terminally ill.On the death of the annuitant, the guaranteed minimum death benefit is paid to the investor.
NCOIL Adopts Model Act Requiring Insurers to Inform Consumers of Settlement OptionsIn a contentious move, the National Conference of Insurance Legislators (NCOIL) executive committee voted unanimously to adopt the Life Insurance Consumer Disclosure Model Act, (Model Act), which requires life insurance carriers to notify policy owners of settlement options when the policy owner is considering surrendering the policy or when the policy is set to lapse.
NCOIL Adopts Model Act Requiring Insurers to Inform Consumers of Settlement Options Not all policy owners have a right to disclosure about settlements under the Model Act. The disclosure requirement applies only where the insured is sixty years old or older or “is known by the insurer to be terminally ill or chronically ill” and The policy owner requests the surrender, in whole or in part, of a policy. The policy owner requests an accelerated death benefit under a policy. The insurer sends notice to the policy owner that the policy may lapse.
Indexed Annuities: Still InsuranceAfter a series of contradictory indicators from the SEC and the courts, Congress finally settled the question of whether fixed indexed annuities (FIAs) are securities or insurance products.The Dodd-Frank Wall Street Reform and Consumer Protection Act—signed into law by President Obama on July 21, 2010—conclusively excludes FIAs from regulation as securities by the Securities and Exchange Commission (SEC).
Classification of AnnuitiesThere are clear examples of annuity products that fall oneach end of the spectrum. ― Variable annuities—which shift most or all of the investment risk to the purchaser and away from the insurance company—are the obvious case of a product that falls on the “investment” side of the spectrum. ― Fixed annuities—which guarantee the purchaser’s return, shifting almost all investment risk to the insurance company—are the clearest example of a product falling on the insurance side of the spectrum.
FDIC Guarantee Increased to $250,000In order for an account to be treated as a trust account, ithas to satisfy the following requirements: ― The account title must include a designator signifying it’s held in a trust relationship. Payable on death (POD), in trust for (ITF), and as trustee for (ITF) satisfy this requirement. ― Beneficiaries must be named in either deposit account records or identified in the trust document, if any. ― To be eligible for the guarantee, a beneficiary must be either a living person or an IRS qualified charity or non-profit.
The Federal Insurance OfficeThe FIO is not a regulatory or supervisory body, but willserve the following functions: 1. Gathering information about the insurance industry, conducting studies on the industry, and generating reports for Congress and Executive Branch 2. Locating regulatory gaps and other issues in the insurance industry that may contribute to systemic risk 3. Administering the Terrorism Risk Insurance Program 4. Monitoring minority and other underserved communities’ access to affordable insurance
The Federal Insurance Office4. Make recommendations to the Financial Stability Oversight Committee (also created5. by the Act) that particular insurers be supervised as a nonbank financial company by the Federal Reserve6. Coordinate the Federal response to international insurance related matters, and7. Negotiate international trade agreement that preempt inconsistent state regulations.
IRS Guidance Provides Safe Harbor for Policies Maturing After Age 100The Service will not treat a policy as a MEC or otherwisedeny its tax status as a life insurance contract if the contractsatisfies the requirements of the safe harbor.The Tax Code treats a contract as a life insurance policy if iteither: ― Satisfies the cash value accumulation test or ― Satisfies both the Code’s guideline premium requirements and falls within the Code’s cash value corridor.
Vigorous Debate over Qualified Appraisal Standard for Valuation of Donated PoliciesMassMutual Financial Group representatives recently sent aletter to Treasury Department officials proposing analternative to the valuation methods required for taxpayerswho want to take a charitable contribution deduction ontheir income taxes for a donated life insurance policy. Theletter makes two proposals: ― That the qualified appraisal requirement for sizeable charitable donation be satisfied by an issuing carrier’s statement of the policy’s value, and ― That the Treasury apply existing IRS valuation safe harbors when valuing a policy for charitable donation purposes.
Can Term Life Coupled with a Mutual Fund Investment Replace a Variable Universal Life Policy? The first distinction between the mutual fund strategy and VUL is found in the insurance component of each option. Because term insurance provides coverage in the mutual fund strategy, the insurance coverage will be time limited to ten, fifteen, twenty, or thirty years. Unlike term insurance, VUL is permanent insurance, meaning that a VUL policy will stay in force until the policy matures—usually after the insured’s 100th birthday. Permanent vs. Term Insurance Fees Investment Options Income Tax Differences
More Consumers Buy Guaranteed Living Benefits RidersAnnuities customers purchased GLB riders87 percent of the time when the riders wereavailable.