Regulatory Update on Financial Reform

Prof. William H. Byrnes &Prof. Stephen Polak

International Tax & Financial Services Graduate Program

AICPA PFP11 Jan. 2011

wbyrnes@tjsl.edu Tel: (619) 374-6955spolak@tjsl.edu Tel: (802) 338-7009

www.profwilliambyrnes.com

Master of Science of Laws (non-lawyers)Master of Laws (lawyers)

Doctor of Science of Laws (lawyers and non-lawyers)

International Tax, Financial Services, Wealth Management, Compliance, Risk Management,

Financial Instruments, Financial Crimes

www.advisorfyi.com

The Wall Street Reform ActTopics To Be Covered Today

1) Ethical standards for investment advice given by broker-dealers

2) "Accredited investor" standard for private placements

3) Mandatory securities agreement arbitration4) Jurisdiction over investment advisors5) Regulation of hedge funds and private equity

funds6) Performance-Based Fees

The Wall Street Reform ActTopics To Be Covered Today

7) 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 Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Wall Street Reform Act), signed into law by President Obama on July 21, 2010.

It was developed as a comprehensive response to the financial crisis of 2007-2010.

What Did President Obama Say About the Act

President Obama summarized its purpose shortly after signing, saying that:

“For years, our financial sector was governed by antiquated and poorly enforced rules that allowed some to game the system and take risks that endangered the entire economy.”

Who Will Be Affected

All financial professionals—including:Insurance producers,Investment advisors,Broker-dealers, andOthers

… will be forced by the Act to change the way they do business. These changes a steep learning curve and extract significant compliance costs for most professionals.

New Rules, Studies, Reports

81 new studies will be conducted93 new reports will be completed, and520 rules will be created.

New Agencies

Federal Insurance Officesubdivision of the Treasury Department;

Consumer Financial Protection Bureau (CFPB), created by the Board of Governors of the Federal ReserveOffice of Financial Protection for Older AmericansOffice of Financial Literacy,

Financial Stability Oversight Counselmonitor systemic risks to the economy.

Biggest Change For Financial Advisors

Shift 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-dealers

The 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 client's 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 placements

The 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 arbitration

The Act permits the SEC to prohibit or restrict mandatory 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 advisors

States, 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 funds

Hedge funds and private equity firms with > $150 million in assets under management have to register as investment advisors with the SEC

Private 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 disclosures

The 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 insurance

The Act permanently extends the FDIC's $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 planners

The 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 annuities

The Act conclusively settles the question of whether indexed annuities are securities subject to the SEC's jurisdiction by excluding indexed annuities from the definition of "security."

10. Creation of the Federal Insurance Office

Insurance 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 dealers

The Act streamlines the regulation of surplus lines insurance by making the insured's home state the sole regulator and tax collector in surplus lines transactions.

12. Performance-Based Fees

The Act reduces the pool of clients who can be charged 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: A Broker’s Duties Under the Financial Reform Act

Changing 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 StandardCurrent bifurcated standard IAs v. BDsBDs = 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 interestsdisclose any conflicts of interestnot factor commissions into advicedisclose if limited range of financial products

Consultants to Employee Benefits Plans to be Classified as Fiduciaries

The 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 status

Rendering 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; or

Giving 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 placements

1982 $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 forPerformance-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 fees

1996: $750K managed or net worth $1.5M

July 21, 2011 must be adjusted for inflationMinimum required adjustment - $100KProbably $1M managed / $2M net worth

Every five years re-indexed for inflation

Mandatory Securities Arbitration Clauseson the Chopping Block

The 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 Act

Who 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 ExemptionsUnder the Wall Street Reform Act

1. 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 management

2. Venture Capital Fund Advisors—Advisors who act as advisors only for venture capital funds

3. 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 ExemptionsUnder the Wall Street Reform Act

1. Family Offices—Advisors to family offices, although the term “family office” is left undefined by the Act

2. Commodity Trading Advisors—Advisors registered with the Commodity Futures Trading Commission, if they do not give advice about securities, and

3. Small Business Investment Company Advisors—Advisors who exclusively advise small business investment companies.

Registration ExemptionsUnder the Wall Street Reform Act (cont.)

These records must be kept open to inspection by the SEC. Information required to be kept by private advisors includes:

The amount of assets under management and use of leverage, including off-balance sheet leverage

Counterparty credit risk exposureTrading and investment positions

Registration ExemptionsUnder 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 Protections

Proprietary information provided by funds to the SEC under the Act is not subject to Freedom of Information Act requests. Proprietary information includes 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 Act

Pass 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 Act

Repeal 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 Industry

FINRA 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 Activities

Under the new rule, once a broker-dealer receives notice of a broker's outside business, the broker-dealer will be required to determine whether the outside business activity will:

– 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 Requirements

The Wall Street Reform Act lays the groundwork for increased advisor and broker-dealer disclosure requirements:

– 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 Disclosures

Beginning January 1, 2011 life insurance brokers in the Big Apple will be disclosing commissions to consumers. New York is one of the first states that are mandating life insurance commission details to be disclosed to clients.

New York Life Insurance Commission Disclosures

Under New York Insurance law an insurance producer selling or renewing an insurance contract must disclose the following information to the purchaser orally or in writing not later than application for the insurance contract or the renewal:

– 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 the producer’s compensation after issuance of the insurance contract but less than three years after issuance, the insurance producer shall disclose to the purchaser in a prominent writing the information as discussed in the above 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 Fire

The 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 STOLI

Although 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 CaseIs a Big Win for Insurers

An 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 Dropsin a Gathering Storm

Some 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 Options

In 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 Insurance

After 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 Annuities

There are clear examples of annuity products that fall on each 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 $250,000

In order for an account to be treated as a trust account, it has 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 Office

The FIO is not a regulatory or supervisory body, but will serve 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 Program4. Monitoring minority and other underserved

communities’ access to affordable insurance

The Federal Insurance Office

4. Make recommendations to the Financial Stability Oversight Committee (also created

5. by the Act) that particular insurers be supervised as a nonbank financial company by the Federal Reserve

6. Coordinate the Federal response to international insurance related matters, and

7. Negotiate international trade agreement that preempt inconsistent state regulations.

IRS Guidance Provides Safe Harbor for Policies Maturing After Age 100

The Service will not treat a policy as a MEC or otherwise deny its tax status as a life insurance contract if the contract satisfies the requirements of the safe harbor.

The Tax Code treats a contract as a life insurance policy if it either:

― 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 Policies

MassMutual Financial Group representatives recently sent a letter to Treasury Department officials proposing an alternative to the valuation methods required for taxpayers who want to take a charitable contribution deduction on their income taxes for a donated life insurance policy. The letter 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 BuyGuaranteed Living Benefits Riders

Annuities customers purchased GLB riders87 percent of the time when the riders were available.

Questions