Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News November 7, 2005 Issue

IM Staff Provides Guidance on Foreign Banks’ Investment Company Status

A foreign bank doesnít necessarily have to meet the long-accepted 20 percent deposits test to qualify for the foreign bank exception under Investment Company Act Rule 3a-6.

Thatís the upshot of a recent interpretative letter issued by the SECís Division of Investment Management to the law firm of Seward and Kissel, which had written in on behalf of its unnamed foreign bank clients. The letter addressed the issue of when a foreign bank will be deemed to be "substantially engaged" in commercial banking activities and therefore not subject to investment company regulation when offering securities in the United States.

Hereís the problem the law firm was trying to fix: banks easily fall into the assets and income tests of investment company status under the ICA. In recognition that banks are not investment companies, the ICA contains an exception for domestic banks. Foreign banks got their own exception in 1991, in the form of Rule 3a-6. That rule states that a foreign bank that is regulated as such in its home jurisdiction isnít an investment company for purposes of the ICA, provided the bank is engaged substantially in commercial banking activity. That, in turn, is defined as extending credit and accepting deposits, as customary for commercial banks in their home countries.

Rule 3a-6 was designed to put foreign banks on a level playing field with domestic banks. However, Seward and Kissel told the Division that some lawyersí interpretations of the rule were having the opposite effect. Members of the bar, said the firm, had opined that a bank is "engaged substantially" in commercial banking if 20 percent of the bankís activities involve accepting deposits. Since U.S. banks arenít subject to the "substantially" test, those opinions could put foreign banks and U.S. banks on uneven footing if foreign banks had to meet a 20 percent deposit test and U.S. banks did not, the law firm said.

The firm proposed an alternative: a 10 percent test, to apply to deposit-taking and credit extension activities in the aggregate. The staff, however, did not adopt a numeric threshold, based on the fact that the Commission did not go that route when it first adopted the rule. "In looking through the regulatory history, we couldnít really find a good basis to support that view fully," said IM chief counsel Douglas Scheidt, speaking at last monthís ALI-ABA conference.

While the staff decided not to provide a specific numeric threshold, it did provide additional guidance. To meet the "substantial" standard in Rule 3a-6, the staff said that it would expect a foreign bank:

  • to be authorized to accept demand and other types of deposits and to extend commercial and other types of credit;
  • to hold itself out as engaging in, and to engage in, each of those activities on a continuous basis, including actively soliciting depositors and borrowers;
  • to engage in both deposit taking and credit extension at a level sufficient to require separate identification of each in publicly disseminated reports and regulatory filings describing the bankís activities; and
  • to engage in either deposit taking or credit extension as one of the bankís principal activities.

The staff noted that these factors did not constitute the definative test of what it means to be "engaged substantially" in commercial banking, and that other facts and circumstances may cause a foreign bank to fall within the exclusion.

"The early returns with respect to that letter are clearly positive," said Scheidtís co-panelist, Shearman and Sterling partner Barry Barbash. "Those lawyers who had difficulty . . . [in giving] opinions with respect to foreign banksí ability to rely on the rule . . . find the letter much clearer than whatís out there and a useful guidepost," he said. "I think you get kudos for that one."

Barbash added that the notion that the Chief Counselís office had looked at an exemptive rule "was also well received." Barbash noted that some of the exemptive rules "are old" and "donít always work all that easily." He suggested that Scheidtís office consider providing interpretative guidance on other exemptions, such as ICA Section 3(c)(5)(C), which provides an exclusion for entities that invest primarily in mortgage-related interests and real estate. That area, he said, is viewed by many as a "hot alternative" to "straight investment management."

Scheidt noted that the Chief Counselís Office hasnít issued a letter of significance in the 3(c)(5)(C) area "in quite some time." However, he added, "we know and have heard that there are different types of instruments and perhaps different ways of looking at those issues today. We are receptive to entertaining requests and providing guidance in that area."