March 19, 2009
Volume 2 - Issue 2
Editors:
Michael J. Missal
From the Editors
We hope that you find this newsletter informative, unique and comprehensive. If
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http://www.klgates.com/practices/ServiceDetail.aspx?service=114&view=3.
michael.missal@klgates.com
+1.202.778.9302
Matt T. Morley
Michael J. Missal
Matt T. Morley
matt.morley@klgates.com
Brian A. Ochs
+1.202.778.9850
Mark D. Perlow
Brian A. Ochs
__________________________________________________________
brian.ochs@klgates.com
+1.202.778.9466
Mark D. Perlow
mark.perlow@klgates.com
+1.415.249.1070
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Financial Recovery Plan Update
Financial Stability Plan Begins to Take Shape
Daniel F. C. Crowley, Karishma Shah Page
On February 10, 2009, Treasury Secretary Timothy Geithner outlined the Obama
Administration’s plan to address the financial crisis. The Financial Stability Plan
(FSP; view at http://www.financialstability.gov/) represents a shift from the previous
Administration’s implementation of the Troubled Asset Relief Program (TARP),
which focused largely on capital injections into financial institutions under the
Capital Purchase Plan (CPP). In addition to continuing capital injections, the FSP
expands efforts to increase consumer and small business lending, will create a
public-private investment fund to purchase toxic assets from banks, and includes a
housing support and foreclosure mitigation component.
Capital Assistance Program
The Treasury Department will continue to make TARP equity investments in certain
financial institutions through the Capital Assistance Program (CAP; view at
http://www.treas.gov/press/releases/tg40.htm). Under CAP, the 19 largest banking
institutions with assets over $100 billion will be required to participate in a
coordinated supervisory forward-looking capital assessment (i.e., a “stress test”) to
determine whether the firm has the capital necessary to continue lending and to
absorb future losses. If Treasury determines that a firm has inadequate capital, it will
have six months to raise it privately, and if it does not succeed, it will be compelled
to take CAP funds. Banking institutions with consolidated assets of less than $100
billion will also be eligible for CAP funds. Eligibility is consistent with the criteria
and process established for CPP.
Capital provided under CAP will be in the form of cumulative mandatorily
convertible preferred stock and will carry a nine percent dividend yield. The security
will be convertible into common equity, at the issuer’s option, at a ten percent
Global Financial Markets
discount to the price prevailing prior to February 9,
2009; however, the security will automatically be
converted into common equity if it has not been
redeemed or converted after seven years. Treasury
will place its capital investments in a newly created
entity, the Financial Stability Trust, and will publicly
disclose its CAP investments on the Internet. At this
time, CAP is only available to publicly traded
qualifying financial institutions. The deadline for
applying is May 25, 2009.
Consumer and Small Business Lending
The FSP aims to increase consumer and small
business lending through a massive expansion of the
Term Asset-Backed Securities Loan Facility (TALF;
http://www.newyorkfed.org/markets/talf_docs.html)
from $200 billion to $1 trillion. The Treasury will
provide $100 billion in TARP funds to backstop the
Federal Reserve loan facility.
Under TALF, the Federal Reserve Bank of New
York (FRBNY) will provide non-recourse funding
to eligible borrowers owning eligible collateral.
Eligible collateral includes certain asset-backed
securities (ABS) that have at least two AAA ratings
and that have auto loans, student loans, credit card
loans, or small business loans as the underlying
credit exposure. The minimum TALF loan amount is
$10 million, and the loan will have a three-year term
and be subject to either a fixed or a floating interest
rate. In addition, the TALF loans will be subject to
haircuts ranging from five to 16 percent, depending
on the category of the ABS offered as collateral. For
additional details on TALF, see K&L Gates
Newsstand Alerts The Term Asset-Backed
Securities Loan Facility in Sharper Focus
(http://www.klgates.com/newsstand/Detail.aspx?pub
lication=5337) and The Term Asset-Backed
Securities Loan Facility Takes Form
(http://www.klgates.com/newsstand/Detail.aspx?pub
lication=5387). The initial round of loans will be
awarded on March 25, 2009; TALF terms and
conditions may be modified for subsequent rounds.
The Federal Reserve has indicated that ABS backed
by rental, commercial, and government vehicle fleet
leases and ABS backed by small ticket equipment,
heavy equipment, and agricultural equipment loans
and leases might be made eligible for the April
funding of the TALF.
In addition, Treasury and the Small Business
Administration (SBA) will launch the Small
Business and Community Lending Initiative.
Although details have not yet been announced,
initial plans indicate that the Initiative will finance
the purchase of AAA-rated SBA loans in an effort
to increase liquidity in secondary markets for small
business loans and increase SBA loan guarantees up
to 90 percent.
Public-Private Investment Fund
The FSP will also create a much-anticipated new
Public-Private Investment Fund (Fund) to purchase
toxic assets from banking institutions. The Fund
would make these purchases by providing
government capital and financing to leverage
purchases by private capital. In addition, the Fund
would rely on private sector buyers to price the
value of the assets. The initial scale of the Fund will
be $500 billion, but may be expanded up to $1
trillion. Treasury is expected to release details on
the operation of the Fund in the near future.
Homeowner Affordability and
Stability Plan
The FSP also includes a housing component, the
Homeowner Affordability and Stability Plan (Plan;
http://www.financialstability.gov/). The first pillar
of the Plan will support borrowers who have a solid
payment history but are unable to refinance their
mortgages because their current loan-to-value ratios
are above 80 percent due to a loss in home value.
The program would make 4 to 5 million of these
homeowners eligible to refinance their existing
Fannie Mae or Freddie Mac mortgages at today’s
low interest rates.
The second pillar of the Plan, the $75 billion
Homeowner Stability Initiative, creates a mortgage
modification program for at-risk homeowners that
have loans on owner-occupied properties with
unpaid balances up to $729,750. Loan servicers
must enter into a program agreement with Treasury
in order to participate. Participating loan servicers
must then apply a net present value (NPV) test on
each loan at risk of imminent default or at least 60
days delinquent, unless explicitly prohibited by
contract. If the NPV of the expected cash flow is
greater under a modification scenario, the servicer
must modify the loan such that the monthly
payment is no more than 31 percent of the
March 19, 2009
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borrower’s gross monthly income. In exchange for
the modification, the government will:
• Subsidize the lender or investor for the cost of
reducing monthly payments from 38 to 31
percent of gross monthly income;
• Provide servicers with a $1,000 payment for
each modification and an additional $1,000 per
year for loans that continue to perform; and
• Provide payments of $1,500 to lenders or
investors and $500 to servicers for modifications
made to borrowers that are current on their
payments.
Finally, Treasury will increase funding to Fannie
Mae and Freddie Mac through the purchase of
preferred stock. In order to fund this commitment,
Treasury will use $200 billion made available under
the Housing and Economic Recovery Act.
Additional Conditions
Increasingly, government assistance comes with
stricter terms and conditions. Firms receiving
assistance from the FSP will be subject to the
following conditions:
• Recipients will be required to submit lending
plans and monthly lending reports. This
information will be publicly disclosed on the
website financialstability.gov.
• Recipients will be required to commit to
participating in mortgage foreclosure mitigation
programs consistent with Treasury guidelines.
• Recipients will be restricted from paying
quarterly common dividend payments,
repurchasing privately-held shares, and pursuing
acquisitions until the government’s investment
is repaid.
• Recipients must comply with Treasury’s
guidelines on executive compensation
•
(http://www.ustreas.gov/press/releases/tg15.htm),
“say on pay” shareholder votes, and luxury
purchase disclosure.
Recipients are prohibited from certain lobbying
activities.
The FSP initiatives will continue to take shape in the
coming months as details are released. The K&L
Gates public policy group is closely monitoring
these developments on behalf of the firm’s policy
clients.
______________________________
Mortgage Banking
Government Efforts to Prevent
Mortgage Foreclosures:
Modifications, Refinancings
and Cram Downs
Laurence E. Platt, Kerri M. Smith
Using a trio of tools to triage those whom it
realistically can seek to help, the federal
government has stepped up its efforts to fight
residential mortgage foreclosures. Announcement of
the details of the Obama Administration’s Making
Home Affordable Program (“the Plan”) on March 4,
2009, makes clear that the federal government will
rely on loan modifications, refinancings and cram
downs to try to keep borrowers in their homes. In
addition, the recent passage of H.R. 1106, Helping
Families Save Their Homes Act of 2009 (“H.R.
1106” or “the Bill”), by the House of
Representatives, bolsters the Plan’s agenda by
allowing bankruptcy judges unilaterally to modify
mortgage loans, and providing a safe harbor against
investor liability for servicers that make loan
modifications subject to the Plan.
While most elements of the Administration’s Plan
can proceed without Congressional approval, the
House Bill must be passed by the Senate to become
law. No one can tell in advance whether these antiforeclosure lifelines will work in an increasingly
deteriorating economy. While the individual
consumer who ultimately saves his or her home
from foreclosure will appreciate the effort, many
investors and unemployed borrowers are less
hopeful about these measures.
To view our complete alert online, click here:
http://www.klgates.com/newsstand/Detail.asp
x?publication=5389
______________________________
Madoff
Forfeiture of Madoff’s Assets:
Challenges for Victims
Richard A. Kirby , Rebecca L. Kline Dubill, Scott
P. Lindsay
On March 12, 2009, Bernard Madoff pleaded guilty
to 11 counts of a criminal information filed by the
U.S. Attorney’s Office for the Southern District of
March 19, 2009
3
Global Financial Markets
New York (“S.D.N.Y.”). The information seeks
forfeiture of all proceeds traceable to the
commission of Madoff’s fraud in an amount
“exceeding” $170 billion. Assuming that the
government can recover any additional assets
through the exercise of its criminal or civil forfeiture
powers, questions remain as to whether and how
those assets will be distributed to Madoff’s victims.
Two recent large-scale securities fraud cases,
Adelphia Communications Corp. and the Bayou
Group, illustrate how protracted this process can be
for victims.
Criminal forfeiture is a powerful tool that permits
the government to seize a defendant’s assets that
were used in, or were the fruits of, criminal activity.
The government also has civil forfeiture powers and
can seize property related to criminal activity even if
it does not belong to a convicted defendant.
Although as a separate matter the trustee appointed
by the Securities Investor Protection Corp. (“SIPC”)
in the Bernard L. Madoff Investment Securities,
LLC (“BMIS”) liquidation proceeding is also
seeking to recover BMIS assets, the full range of the
government’s forfeiture powers are broader than
those of the SIPC trustee and may result in
additional assets being recovered.
Typically, forfeited assets are distributed to crime
victims in one of two ways: (1) the petition for
remission process, in which victims apply for
remission from a victims’ fund administered by the
U.S. Department of Justice (“DOJ”); or (2)
restitution, in which the U.S. Attorney General
“restores” the forfeited assets to the court overseeing
the criminal cases, and the court distributes funds to
victims through an order of restitution.
In the Adelphia case, John and Timothy Rigas were
convicted in 2004 on various counts relating to their
looting of Adelphia’s corporate assets and forced to
forfeit significant personal assets, including their
Adelphia stock. In 2005, pursuant to a nonprosecution agreement, the company that the Rigas’
had controlled, Adelphia, agreed to repurchase this
forfeited stock for $715 million, which was paid into
a victims’ compensation fund. This victims’ fund is
administered by DOJ under the petition for
remission process and has faced substantial litigation
over its protocols. As a result, nearly nine years after
the fraud was revealed, no distributions from the
fund have yet been made to Adelphia’s creditors or
shareholders.
Bayou involved a $400 million Ponzi scheme. In
their plea allocutions, the Bayou principals agreed
to forfeit both personal and corporate assets,
including $100 million in Bayou funds, as well as
several dozen Bayou investment assets. The
S.D.N.Y. U.S. Attorney’s Office appointed a
receiver to collect and liquidate the assets so that
they could be restored to the court overseeing the
criminal proceedings for distribution to victims
through an order of restitution. Although the U.S.
Attorney’s Office obtained possession of the $100
million in cash and other investments as a part of
the preliminary forfeiture orders, it took almost
three years to distribute the forfeited assets to
victims. The restitution process was further
complicated and delayed due to litigation initiated
by former investors, who had been sued in the
Bayou bankruptcy on a clawback theory for return
of fictitious profits and principal. These former
investors succeeded in establishing themselves as
contingent victims for purposes of the restitution
fund.
If Adelphia and Bayou serve as a guide, it likely
could be years before Madoff’s victims receive any
distribution of property seized by the government
through the exercise of its forfeiture powers. This
may provide an opportunity — given the massive
scale of the fraud and the quasi-governmental nature
of SIPC — for the government to chart a different
course and use the established SIPC liquidation
proceeding to distribute any assets it seizes to
victims of Madoff’s scheme through a transfer of
forfeited assets to the SIPC trustee. Such a transfer
could expedite the ultimate distribution of funds to
Madoff’s victims and create certain efficiencies in
the processing of claims and the handling of
objections. While it remains to be seen whether the
government will be successful in identifying and
seizing assets not already under the control of the
SIPC trustee, it is not too soon to consider an
alternative paradigm to the government’s traditional
and slow-working forfeiture distribution
mechanisms.
______________________________
March 19, 2009
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Global Financial Markets
White Collar
Stanford Prosecutions Highlight
Difficult Issues Posed by
Company Counsel’s
Representation of Employees in
Government Investigations
Matt T. Morley, Michael D. Ricciuti
The triggering event for the SEC’s action against
Stanford International Bank, Ltd. and several of its
senior executives appears to have been the abrupt
public resignation of the company’s outside counsel.
This occurred the day after SEC testimony by one of
Stanford’s executives, Laura Pendergest-Holt. In
apparently making what is known as a “noisy
withdrawal,” counsel resigned and disavowed to the
SEC all prior statements made by them in the matter.
The SEC promptly filed an action against Stanford
and several executives, including Ms. PendergestHolt, who was also arrested on obstruction of justice
charges.
In connection with the SEC’s investigation,
company counsel had represented both the company
and Ms. Pendergest-Holt. According to press
reports, counsel told the SEC that he represented the
witness “insofar as she is an officer or director of
one of the Stanford-affiliated companies.” In many
cases, it is potentially more efficient for company
counsel to also represent individual officers and
directors in government investigations. But doing so
often poses serious risks for conflict. Although we
do not know, and may never know, what precisely
caused counsel to resign in the Stanford case, these
events serve as a reminder of the risks involved
where several parties share the same lawyers. In
such cases, parties need to consider in advance
whether separate counsel should be retained and, if
not, what will occur if a conflict subsequently arises.
When law enforcement officials first contact a
company, it may seem – and may be the case – that
the interests of individual employees are fully
aligned with those of their employer. In some cases,
at the outset of a criminal or SEC investigation,
when the facts and/or the scope and focus of the
probe may be unclear, corporate counsel may jointly
represent the corporation and its individual officers,
directors, and employees. Pursuant to Rule 1.13 of
the Model Rules of Professional Conduct, such joint
representation is permissible as long as it does not
involve a conflict of interest. For example, in the
event that an individual becomes a “subject” or
“target” of an investigation – that is, someone who
may be indicted as the result of a criminal probe –
joint representation of the company and any such
individual is not possible, and the employee will
need separate counsel. Other circumstances, such as
the discovery of additional facts, may also give rise
to conflicts of interest between the company and its
employees.
Indeed, in the internal investigation context, where
company counsel represents only the company,
employees are ordinarily provided with “Upjohn”
warnings, making clear counsel is acting solely for
the company, and that while the interview may be
subject to the attorney-client privilege, the company
and not the employee controls whether to assert that
privilege. Employees are told that the company
remains free to waive the privilege and disclose the
substance of the interview to third parties, including
the government, as part of its effort to cooperate.
Where company counsel also represents an
employee, however, the Upjohn warning doesn’t fit,
because counsel also has attorney-client
relationships both with the company and with the
employee, and the employee’s confidences cannot
be revealed without his or her consent. If the
interests of the company and the employee diverge,
a number of critical issues will promptly arise.
Counsel will generally be unable to represent both
the company and the employee, and a change in
representation will be required. Will the individual
be required to get separate counsel? If that occurs,
will company counsel remain free to represent the
company? If so, what will happen to the
employee’s confidences that have been shared with
company counsel? Will the company be free to use
that information as it chooses? Will the company
be able to disclose this information to the
government? The failure to resolve these questions
in advance can harm both the company and the
individual involved and thus, in a joint
representation, it is wise to reach a clear and
common understanding from the outset as to what
will happen if the parties develop conflicting
interests or objectives.
March 19, 2009
5
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These questions take on even greater significance
given that, in recent years, it has become
increasingly common for the SEC to cooperate
closely with criminal authorities. Documents and
witness statements may be shared with criminal
prosecutors without notice to the company or its
employees – and in the current environment, one
should assume that almost any SEC investigation
involves criminal charges. Indeed, press reports
indicate that, at the beginning of Ms. PendergestHolt’s SEC testimony, counsel tried without success
to learn whether there was a parallel criminal
investigation in the matter.
No single solution to these issues can fit every
situation, but there are a variety of ways to address
these issues. At a minimum, where counsel will
represent multiple interests, the engagement letter
should spell out the parties’ agreement as to what
will happen in the event of a conflict. Sometimes,
individuals may decide to retain “shadow” counsel,
who are fully involved in providing advice and
preparing for testimony, but who may not make a
public appearance in the matter. In other
circumstances, separate counsel may be the best
choice. One thing remains clear – those who become
the focus of attention by government authorities
need to consider these issues at the very start.
______________________________
CFTC
CFTC Nominee Calls for
Increased Regulation of
Derivatives
Lawrence B. Patent
Introduction
Gary Gensler, President Obama’s nominee for
Chairman of the Commodity Futures Trading
Commission (CFTC), testified at his confirmation
hearing before the Senate Committee on Agriculture,
Nutrition, and Forestry (the “Agriculture
Committee”) on February 25, 2009; the Agriculture
Committee approved his nomination on March 16.
In his opening statement, he mentioned four
priorities that he would pursue if confirmed by the
full Senate: (1) vigorous enforcement to prevent
fraud and manipulation in futures and options
markets; (2) position limits across all markets and
platforms where there is a finite supply of the
underlying commodity; (3) generally requiring the
clearing and exchange trading of derivative
instruments, and direct regulation of derivatives
dealers; and (4) working with regulators around the
globe to protect Americans impacted by world
financial markets. The first and last of these goals
are often cited by nominees to federal regulatory
positions, and they are to be expected. The
remainder of this article will focus upon his other
goals, those concerning position limits and
enhanced regulation of derivatives, which represent
a departure from the current regulatory framework
yet are in keeping with recent legislative initiatives.
Trading and Clearing of Derivatives
Mr. Gensler’s statements at his confirmation
hearing are consistent with some of the recent bills
before Congress addressing regulation of
derivatives and the energy markets. Mr. Gensler did
acknowledge that his current views may not be
consistent with positions that he took as a senior
official in the Treasury Department under President
Clinton in the late 1990s, leading up to the passage
of the Commodity Futures Modernization Act of
2000 (CFMA). The CFMA provided greater legal
certainty for trading in financial and energy swaps
by exempting those instruments (and certain related
markets) from regulation by the CFTC or the
Securities and Exchange Commission (SEC). Mr.
Gensler stated that his views have since “evolved”
and that there should have been more aggressive
regulation of derivatives to protect the American
public. Thus, Mr. Gensler’s current views are
generally compatible with the regulatory direction
of the provisions of H.R. 977, the “Derivatives
Markets Transparency and Accountability Act of
2009,” addressing over-the-counter (“OTC”)
commodity derivatives. That bill was approved by
voice vote of the House Committee on Agriculture
on February 12, 2009 (and the subject of a prior
K&L Gates Alert; view at
http://www.klgates.com/newsstand/Detail.aspx?pub
lication=5327). H.R. 977 would generally require
the clearing of all swap transactions, but would
leave open the possibility of reporting certain swap
transactions to the CFTC if a clearing organization
did not want to clear them.
S. 272, the “Derivatives Integrity Act of 2009,”
which was introduced by Senator Harkin (D-Iowa)
March 19, 2009
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Global Financial Markets
on January 15, 2009, goes beyond H.R. 977’s
requirement for clearing to require that all swaps be
traded exclusively on CFTC-regulated exchanges.
That provision would effectively eliminate all OTC
transactions in commodity derivatives. Senator
Harkin, who is Chairman of the Agriculture
Committee, tried to press Mr. Gensler during the
confirmation hearing to support the thrust of his bill.
Although Mr. Gensler indicated that he generally
supported the concept of the greater transparency
that would be provided by exchange trading and
clearing of swaps, he resisted committing to support
exchange trading of all swaps with no exceptions.
Mr. Gensler recognized that there could be cases
where customized transactions would not fit readily
into an exchange-traded, clearinghouse framework,
and exceptions might be necessary to accommodate
such instruments. Senator Harkin expressed the view
that it would be too easy to vary a particular term of
a contract so that it could be labeled as “customized”
rather than standardized and thereby permit such
instruments to evade the exchange-trading
requirement.
Regulation of Financial Swap Dealers
Mr. Gensler did express support for another facet of
S. 272 -- the regulation of financial swap dealers
(H.R. 977 does not provide for such regulation). Mr.
Gensler stated that the entities involved in financial
swap transactions needed to be subject to minimum
financial, business conduct and reporting
requirements. He stated that it was not enough for
other affiliates of a swap dealer or its corporate
parent holding company to be subject to regulation
by the CFTC or the SEC; rather, in his view, the
entity that is a party to financial swap transactions
must itself be subject to minimum financial,
business conduct and reporting requirements. Mr.
Gensler indicated that the new requirements would
apply to the 15 or 20 swap dealers that are involved
in the vast majority of such transactions. Such a
policy reversal would certainly be a large step away
from the exemptive framework for swaps under the
CFMA.
when it was introduced last year was to impose
speculative limits on energy-related futures and
options, because trading in those products has been
blamed by many as contributing heavily to the runup in gasoline prices last summer (although that
view is disputed by the CFTC’s Office of Chief
Economist and several other studies). In addition,
Mr. Gensler expressed support for the regulation of
OTC trading of energy and metals in the same
manner as agricultural swaps. Agricultural swaps
currently trade in accordance with CFTC
regulations that date back almost 20 years, rather
than pursuant to statutory exemptions, which in the
case of energy and metals can fully exclude them
from the reach of the CFTC. Accordingly,
regulating OTC trading in energy and metals in the
same manner as agricultural commodities would
confer more power to the CFTC to impose
restrictions on such trading. It appears that Mr.
Gensler would not slow down efforts to increase the
regulatory scrutiny of energy derivatives.
Relief Requests
Legislation regulating derivatives and imposing new
speculative limits will likely take several months to
finalize. Mr. Gensler also noted during his
testimony two areas of CFTC procedures that he
would want to review that may not require any
additional legislative action (although H.R. 977
would mandate that CFTC conduct such a review).
Mr. Gensler indicated that he wants to review any
exemptions granted from hedging restrictions and
position limits in the past 20 years by the CFTC,
and that he also wants to review the “no-action”
letter process, which is used, among other purposes,
to grant exemptions for foreign energy markets. Mr.
Gensler indicated that some decisions on requests
for no-action relief could remain at the staff level,
but he implied that certain matters previously
handled by staff should be considered by the
Commissioners. The overall message from Mr.
Gensler is clear: his regime as Chairman of the
CFTC will tend towards greater regulation and
stricter scrutiny of requests for exemption or noaction relief.
______________________________
Position Limits
Mr. Gensler also indicated his support for H.R.
977’s objective of establishing position limits for
physically deliverable commodities that have a finite
supply. Part of the original purpose of H.R. 977
March 19, 2009
7
Global Financial Markets
SEC
Compliance with TARP
Executive Compensation
Restrictions Subject to SEC
Enforcement
Brian A. Ochs
A little-noticed recent amendment to the Emergency
Economic Stabilization Act of 2008, 12 U.S.C.
§5221 (“EESA”), may provide the Securities and
Exchange Commission (“SEC”) with a prominent
role in enforcing the executive compensation and
corporate governance requirements under the
Treasury Department’s Troubled Asset Relief
Program (“TARP”). The amendment, which was
signed into law on February 17 as part of the
American Recovery and Reinvestment Act of 2009
(the “Recovery Act”) (Pub. L. No. 111-5), requires
the chief executive officer and chief financial officer
(or their equivalents) of any public company that
receives TARP funds to certify compliance with
EESA’s executive compensation and corporate
governance restrictions as part of the company’s
annual SEC filing. Much like the required officer
certifications regarding internal controls and
disclosure controls that have been part of the legal
landscape since the enactment of the SarbanesOxley Act of 2002, the effect of the EESA
certification requirement is to focus personal
responsibility for EESA compliance on CEOs and
CFOs, with the potential for securities fraud or other
charges to be brought by the SEC in the event of
false certifications.
EESA and the Treasury Department’s
Interim Rules on Executive Compensation
As originally enacted, section 111(b) of EESA
directed that any financial institution that sells
troubled assets to the Treasury Department must
meet certain standards of executive compensation
and corporate governance. These standards included:
(1) eliminating incentives for senior executives to
take unnecessary and excessive risks that threaten
the financial value of the institution; (2) a
“clawback” provision for the recovery by the
institution of any bonus or incentive compensation
paid to a senior executive officer based on financial
statements or other criteria that are later proven to be
materially inaccurate; and (3) a prohibition on
“golden parachute” payments to senior executive
officers. (Generally, “senior executives” means the
five highest paid officers of the company.)
In October 2008 and January 2009, the Treasury
Department announced rules to implement the
executive compensation requirements of section 111
for participants in the TARP Capital Purchase
Program (“CPP”). (The Treasury Department
separately provided guidance for certain other
TARP programs.) Among other things, the January
rule required the principal executive officer of each
participating financial institution to certify to
TARP’s Chief Compliance Officer that the
institution was in compliance with the executive
compensation requirements set forth in EESA. The
Treasury Department further noted in the January
rule that a false certification could subject the
certifier to federal criminal penalties for false
statements under 18 U.S.C. §1001. See CPP
Executive Compensation Final Rule (Jan. 16, 2009),
http://www.treas.gov/press/releases/reports/tarp%20
_executive%20compensation%20ifr%20jan%20200
9.pdf.
The Recovery Act Amendments
The Recovery Act (Section 7001) expanded the
significance of these provisions in several important
respects. First, it directs the Secretary of the
Treasury to impose new and expanded executive
compensation and corporate governance standards
on all recipients of TARP funds. In addition to the
restrictions found in the original section 111, these
standards must bar payment of any bonus, retention
award, or incentive compensation during the period
that a TARP obligation is outstanding (except for
payments made in restricted stock comprising no
more than one-third of the individual’s total
compensation, and not fully vesting during the
period that the obligation is outstanding), and must
prohibit any compensation plan that would
encourage earnings manipulation. The number of
employees to which the new compensation
limitations apply varies by provision, in many cases
going beyond the original five “senior executive
officers” to as many as the next 20 most highly
compensated officers. In addition, the Recovery Act
amendments require SEC registrants that receive
TARP funds to establish a board compensation
committee, comprised entirely of independent
directors, and also require boards of directors to
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implement company-wide policies regarding
excessive or luxury expenditures.
Section 7001 of the Recovery Act also requires the
CEO and CFO (or their equivalents) of each
recipient of TARP funds that has publicly traded
securities to “provide a written certification of
compliance by the TARP recipient with the
requirements of this section … together with annual
filings required under the securities laws….”
(Certifications are to be provided to the Secretary of
the Treasury if the entity receiving TARP funds is
not a publicly traded company.) The SEC has
determined that it will not give effect to the
certification requirement until the Secretary of the
Treasury establishes standards to implement section
7001 of the Recovery Act. This approach follows the
views expressed by Senator Christopher Dodd, the
author of the executive compensation provisions of
the Recovery Act, in a February 20 letter to SEC
Chairwoman Mary Schapiro.
Analysis
The requirement that CEO and CFO certifications be
filed with a TARP recipient’s annual report to the
SEC will unambiguously subject public companies
that receive TARP funds and their executives to
SEC scrutiny and potential enforcement action for
failure to comply with EESA’s executive
compensation and corporate governance
requirements. This is because any material false
statement in an SEC filing may be charged as a
securities fraud or other securities violation,
depending on the actor’s level of intent. In the
current environment, regulators are likely to view a
certification that an entity receiving TARP funds is
in compliance with requirements concerning
executive compensation and corporate governance
as being material to investors. In particularly
egregious cases, criminal prosecution for securities
fraud could also result.
Further, because the CEO and CFO will each be
considered the “maker” of statements in the EESA
certifications, these executives could be exposed to
personal liability under the securities laws for
compliance failures that result in false certifications.
Since the passage of the Sarbanes-Oxley Act, most
companies have instituted formal procedures such as
compliance checklists, sub-certifications by
managers with line responsibilities, and disclosure
committee reviews, to support the CEO and CFO
certifications required by that Act. Entities that
receive TARP funds will need to consider
implementing similar structured processes to
support the CEO’s and CFO’s annual certifications
under EESA.
______________________________
Damage Calculations
Damages Theories for Financial
Institutions Injured by Changes
in Government Regulation
David T. Case, Brendon P. Fowler
With the nearly unparalleled upheaval in world
financial markets and the resulting impact on the
nation’s financial institutions, many entities have
either gone bankrupt or become subject to
increasing levels of Government intervention,
regulation, and oversight. The Government also
continues to consider actions to address “toxic”
assets and to stimulate financial activity. While
Government action may ultimately lead the way to
financial recovery for the broad economy, in some
instances the Government may take actions, such as
changing federal regulatory schemes and related
contracts, that nonetheless inflict harm on individual
companies. In those situations, developments in a
series of cases relating to an earlier financial crisis
may provide guidance in navigating the risks of
increased Government regulation and oversight, and
the measure of any damages that might be
recovered.
During the Great Depression, forty percent of the
nation’s home mortgages went into default, and
1,700 of the nation’s approximately 12,000 savings
institutions failed. This led to significant
Government oversight of the savings and loan, or
"thrift" industry, in the form of the Federal Home
Loan Bank Board and the Federal Savings and Loan
Insurance Corporation, as well as the passage of
numerous laws such as the Home Owners’ Loan Act
of 1933. This regulatory regime remained in place
until the financial crisis of the late 1970s and early
1980s, when, in order to retain deposits, thrifts were
compelled to offer interest rates to depositors that
exceeded the stream of income from the thrifts’
long-term, low-rate mortgages. Over 400 thrift
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institutions failed by 1983, and by the mid-1980s, it
became clear that Government regulatory efforts to
resolve the crisis were not succeeding. As a result,
Congress enacted the Financial Institutions Reform,
Recovery, and Enforcement Act of 1989
(“FIRREA”), which resulted in regulations that
imposed more stringent capital standards on thrifts.
Many thrifts, particularly ones that had acquired
failed thrifts under agreements with the Government,
were immediately thrown out of compliance with
regulatory capital requirements and became subject
to seizure by thrift regulators.
A number of thrifts adversely affected by the new
regulations sued the Government, alleging that the
passage of FIRREA breached the contracts under
which the thrifts had previously agreed to acquire
other failed institutions. In United States v. Winstar
Corporation, 518 U.S. 839, 843 (1996), the Supreme
Court held that where the Government entered into
contracts with regulated financial institutions,
promising to provide particular regulatory treatment
in exchange for the assumption of liabilities, the risk
of regulatory change fell to the Government, even
though Congress subsequently changed the law and
barred the Government from honoring its
agreements. Following this ruling, the United States
Court of Federal Claims and the United States Court
of Appeals for the Federal Circuit addressed a series
of cases where the allegations were that the
Government had indeed breached its contractual
obligations to various thrifts through the passage of
FIRREA. This group of cases, which is often
denoted as the “Winstar-related cases,” may provide
significant guidance for any cases that derive from
the present crisis.
recover in the Winstar-related context.
Nevertheless, a recent Winstar-related decision by
the United States Court of Appeals for the Federal
Circuit (“Federal Circuit”) upheld the trial court’s
acceptance of a lost profits theory that established,
by way of expert testimony and models, that the
Government’s implementation of FIRREA caused
lost profit damages to the affected thrift. See First
Federal Sav. and Loan Ass’n of Rochester v. United
States, 290 Fed. Appx. 349, 2008 WL 3822567
(Fed. Cir. 2008). The injured thrift established with
reasonable certainty its lost profits of $85 million to
the satisfaction of the courts, and the Federal Circuit
upheld the trial court’s reliance on plaintiff’s
damages expert, and the projections of the growth
(and profits) the thrift would have experienced
absent the Government breach. Id. at 357.
As a general matter, damages in the Winstar-related
cases are based on one of three damages theories:
expectancy damages, reliance damages, or
restitution damages.
Reliance damages, often sought or pled in the
alternative to expectation damages, are intended to
address harm resulting from the thrift’s change of
position in reliance on its contract with the
Government. The underlying principle in reliance
damages is that a party who relies on another
party’s contractual promise is entitled to damages
for any losses actually sustained as a result of the
breach of that promise. Glendale Federal Bank v.
United States, 239 F.3d 1374, 1382 (Fed. Cir.
2001). In Glendale, the Federal Circuit affirmed the
use of a reliance damage calculation because “for
purposes of measuring the losses sustained … as a
result of the Government’s breach, reliance
damages provide a firmer and more rational basis”
than the alternative theories argued by the parties in
that case. Id. at 1383. Reliance damages can include
both pre- and post-breach activities and costs by the
thrift, and have been described as the “ideal” theory
for “wounded bank” damages. Glendale Federal
Bank v. United States, 378 F.3d 1308, 1313 (Fed.
Cir. 2004) (upholding trial court’s award of $381
million).
Expectancy, or “lost profit” damages, protect a
bank’s expectation interest by seeking to put that
institution in as good a position as it would have
been had the institution’s contract with the
Government been fully performed, without also
providing plaintiff with a windfall. If successful, this
theory for recovery typically produces the largest
quantum of damages for an injured bank, but lost
profits have historically been difficult to prove and
Restitution damages may be sought when proof of
lost profits or reliance damages fails. The idea
behind restitution is to restore the non-breaching
party to the position he would have been in had
there never been a contract to breach. Specifically, a
restitution theory seeks to recover any benefit that
the non-breaching party may have given to the
breaching party, but such damages should not be
awarded if the award would result in a windfall to
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the non-breaching party. See Southwest Investment
Co., Inv. v. United States, 63 Fed. Cl. 182, 197 (Fed.
Cl. 2004). Accordingly, an institution must carefully
consider whether benefits conferred on the
Government might nonetheless be offset fully by
benefits received from the Government, as “the nonbreaching party is not entitled, through the award of
damages, to achieve a position superior to the one it
would reasonably have occupied had the breach not
occurred.” Glendale Federal Bank v. United States,
239 F.3d 1374, 1382 (Fed. Cir. 2001). In addition,
restitution can be a challenging theory to pursue, for
while a party may often be able to show benefits
given to the Government, establishing an actual
dollar value conferred can be difficult. Id. at 1382
(under theory that thrift assumed risk and relieved
Government of liabilities for a period of time in
which the Government was able to deal with other
failing thrifts, the value of Government’s time was
more than zero but there is no proof of what in fact it
was worth). Where a specific dollar amount is
clearly established, however, restitution may be
awarded. See 1st Home Liquidating Trust v. United
States, 76 Fed. Cl. 731, 744 (Fed. Cl. 2007).
In sum, the numerous Winstar-related decisions
provide a body of law for institutions faced with a
rapidly changing bank regulatory environment and
possible breaches by the Government with respect to
current contracts. Familiarity with the types of
damages theories and models employed by past
thrift litigants against the Government may help
today’s institutions develop a viable remedy if they
are harmed by Government action.
______________________________
Arbitration
Arbitration of Disputes Arising
from the Financial Crisis
Clare Tanner, Paul F. Donahue
The current turmoil in financial markets has led to
an increase in disputes involving financial
institutions. Parties may have entered into
transactions in better times with little consideration
given to the forum in which future disputes would
play out. In today’s far more challenging
circumstances, the choice of forum may be central to
the satisfactory resolution of disputes.
In some areas, it is common for disputes involving
financial institutions to be resolved through
arbitration. The Financial Industry Regulatory
Authority (FINRA) is the largest self-regulatory
organization, i.e., non-governmental regulator, for
all securities firms doing business in the United
States. (FINRA’s rulemaking, however, is subject to
approval by the Securities and Exchange
Commission (SEC).) Both individual and
institutional customers can require a FINRA
member to arbitrate disputes. Indeed, most, if not
all, securities broker/dealers will refuse to do
business with customers who do not agree to
arbitrate disputes. Disputes between FINRA
members may also be submitted to arbitration.
The financial crisis has resulted in a dramatic
increase in the number of cases referred to FINRA
arbitration. In 2007, slightly more than 3,000
arbitration cases were filed. In 2008, the number
was almost 5,000 and the upward trend has only
increased in 2009. The number of cases filed in
January 2009 was double that of a year earlier.
An award handed down by a FINRA tribunal last
month, arising from transactions in auction rate
securities, illustrates the enormous magnitude of
disputes arising from the financial crisis and the
speed with which they can be resolved through
arbitration. The FINRA tribunal ordered Credit
Suisse Securities USA LLC, a brokerage unit of the
Swiss bank, to pay $400 million to its customer
STMicroelectronics NV, a European semiconductor
maker. STMicroelectronics claimed it had
authorized Credit Suisse to make investments in
top-rated securities backed by U.S. Government
guaranteed student loans, but instead the funds were
invested in collateralized debt obligations some of
which were backed by sub-prime mortgages. The
entire process including 28 hearing sessions over
two months took just under a year. Any court
proceeding would undoubtedly have taken far
longer. Nonetheless, STMicroelectronics, according
to the award, incurred more than $4 million in legal
fees during that time.
While FINRA members can be compelled to
arbitrate customer disputes and most require their
customers to agree to arbitrate disputes, other
financial institutions have traditionally been
reluctant to commit to arbitration and have preferred
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to submit disputes to national courts. Some of the
risks and benefits associated with arbitration as a
means of resolving disputes involving financial
institutions can be illustrated by reference to
FINRA’s procedures.
Confidentiality
As is common with arbitration, FINRA arbitrations
are confidential. The evidence submitted and
procedural and substantive hearings are not open to
the public. Although FINRA arbitral awards are
made public, that is the exception, not the rule for
most arbitrations unless the parties agree otherwise.
FINRA awards are not necessarily fully reasoned
and may simply amount to a requirement that one
party pay as was the case in the STMicroelectronics
case. Under a recent rule approved by the SEC,
however, beginning next month, if both parties
request it, FINRA arbitrators will have to give an
“explained decision,” i.e., “a fact based award
stating the general reasons for the decision” but
which need not include legal authorities or damage
calculations.
Confidentiality can be a significant attraction of
arbitration as it avoids both financial institutions and
their institutional clients airing their dirty laundry in
public. In current markets, disputes may give rise to
a damaging loss of confidence in the financial
institution. Equally, even if sophisticated
institutional customers feel they have been misled by
a financial institution, they may wish to avoid public
allegations that they share some responsibility or
may not want detailed aspects of their financial
dealings laid open to public scrutiny. In disputes
between sophisticated commercial enterprises, the
risk of adverse publicity is seldom limited to one
party.
Arbitration will not be appropriate where a financial
institution seeks to establish a legal precedent that
will be publicly available. Only a court ruling can
provide that and, of course, it can be a double-edged
sword.
The Tribunal
FINRA’s arbitration rules for customer disputes
generally provide for a three-person tribunal with
one “industry member” and two independent
members. Under a rule change effective at the end of
this month the size of cases to be decided by a single
arbitrator will increase to $100,000. Three-arbitrator
panels are intended to provide both industry
knowledge and experience while also protecting the
customer’s interests, but some have criticised such
panels as too industry friendly. Under a pilot
program now underway for 400 cases, several
securities firms have agreed to have panels made up
of three independent arbitrators. FINRA’s approach
may not be appropriate in all cases and, for
example, the arbitration rules of the London-based
City Disputes Panel provide that the tribunal will
usually consist of a legally qualified chairman and
two experienced financial services practitioners.
Given the complex and technical nature of modern
financial products, there may be a significant
advantage in decisions being reached by tribunals
with necessary expert knowledge. Both financial
institutions and their institutional customers may
prefer such a tribunal to the vagaries of a jury trial
in the U.S. The speed at which law and market
practice change are such that, even in jurisdictions
where disputes may come before an experienced
judge, a tribunal made up of industry experts may
still be preferable.
Procedure
Recent rule changes have sharply curtailed the
ability to obtain a summary determination of a
dispute in FINRA arbitrations. The loss of the
opportunity of having a frivolous claim dismissed at
an early stage may be unattractive for respondents
and correspondingly attractive for claimants in those
jurisdictions where summary determination is only
available to a claimant. However, expedited
procedures are available by agreement between the
parties in both FINRA arbitrations and in other
arbitral rules. Equally, the absence of, or restrictions
on, wide-ranging discovery exercises and pre-trial
depositions found in FINRA and other arbitral rules
may mean that, even without a summary
determination, arbitration is still more attractive
than litigation through national courts.
Finality
The ability to challenge an arbitration award is
usually strictly limited and FINRA arbitration is no
exception. The attraction of a final award is that the
cost and risk associated with any given dispute can
be more easily judged. The prospect of a defaulting
party endlessly prolonging the proceedings while
attempting to protect assets against enforcement is
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greatly diminished as is the prospect of a successful
party deciding to settle simply to end the
bloodletting.
Enforcement
Many financial transactions will have an
international element, as illustrated by the
STMicroelectronics case. A party may be reluctant
to commence proceedings in the home court of the
other party fearing “home advantage.” Even if the
parties agree to resolve disputes in the courts of a
neutral state, many national courts will not permit
parties to “manufacture” jurisdiction and simply will
not hear such cases. Even when they do, the
successful party still faces the cost and difficulty of
enforcing that judgment in another country.
Arbitration awards made in a country which is a
party to the 1958 New York Convention on the
Recognition and Enforcement of Foreign Arbitral
Awards can be enforced in any other Convention
State, by the local court giving effect to the award as
if it were a court judgment. This is subject to
limited, mostly due process, exceptions.
Conclusion
Arbitration is not a panacea - as with litigation
through the courts, expense and delay can be
features of arbitration - but there are advantages for
disputes between financial institutions or between
financial institutions and their institutional clients,
particularly where there is an international element.
Even parties who did not commit to arbitration at the
outset may still agree, after a dispute has arisen, that
arbitration is a more suitable dispute resolution
mechanism. A failure to consider arbitration may
leave parties at a disadvantage and, of course, it is
always best to make the decision at the outset,
before disputes arise
______________________________
UK Banking
UK Banking Stabilisation
Measures – March 2009 Update
Claudia Harrison, Katie Hillier
1.
INTRODUCTION
Since our reports in the December 2008 and January
2009 editions of this newsletter, the UK government
has released further details on several initiatives
intended to combat the current economic downturn,
and a number of UK based banks have announced
their participation in the initiatives. In addition, the
Banking Act 2009 received royal assent on 12
February 2009.
2.
UPDATE ON EXISTING MEASURES
2.1
Special Liquidity Scheme ("SLS")
This scheme, which enabled banks to borrow liquid
UK treasury bills in return for security over their
illiquid assets, closed on 30 January 2009. The Bank
of England ("BoE") have confirmed that use of the
scheme was considerable: 32 institutions borrowed
£185bn in return for £287bn of collateral, mainly
residential mortgage-backed securities and
residential mortgage covered bonds.
2.2
Bank Recapitalisation Scheme
On 7 March 2009, following recent falls in Lloyds
Banking Group's share price and the release of
Halifax Bank of Scotland's 2008 results, the UK
government announced that its £4bn of preference
shares in the Lloyds Banking Group will be
converted into ordinary shares, which could
increase the government's holding in the bank from
43.5% to 65%.
3.
NEW MEASURES
3.1
Asset Purchase Facility ("APF")
This commercial paper facility has been operational
since 13 February 2009, and the BoE is in the
process of consulting in relation to facilities to
purchase corporate bonds, paper issued under the
Credit Guarantee Scheme (under which the UK
government issued guarantees in respect of certain
debt instruments), syndicated loans and assetbacked securities created in viable securitisation
structures. Further, on 5 March 2009 the UK
government authorised the BoE to use the APF for
monetary policy purposes (including quantitative
easing), giving permission to finance asset
purchases using central bank reserves. UK
government debt, purchased in the secondary
markets, has been added to the list of eligible assets,
and purchases up to £150bn have been authorised,
although at least £50bn of this should still be used
to purchase private sector assets, as initially
intended.
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Global Financial Markets
3.2
Asset Protection Scheme
Under this scheme, the UK government will 'insure'
banks against losses on their riskiest assets. Both the
Royal Bank of Scotland ("RBS") and the Lloyds
Banking Group have announced their intentions to
participate in this scheme, in respect of assets
totalling £325bn and £260bn respectively. RBS will
pay a £6.5bn fee and bear a first loss of up to
£19.5bn, with Lloyds Banking Group paying a fee of
£15.6bn and bearing a first loss of up to £25bn. In
order to support wider economic recovery, RBS and
Lloyds have given lending commitments for 2009 of
£25bn and £14bn respectively. In response to
political and popular pressure, the UK government
has also secured assurances relating to remuneration
policies in these banks. What such assurances
amount to is not yet known. Lloyds, for example,
has agreed to review its remuneration policies and
implement changes needed to ensure its policies
comply with the Financial Services Authority's
(“FSA”) guidance in this area. Whether this will
produce substantive changes to policies remains to
be seen.
4.
BANKING ACT 2009 (THE "ACT")
The Act is in substantially the same form as the bill
which was presented to parliament last October (and
referred to in the December edition of this
newsletter); however some important amendments
were made as the bill progressed through the
legislative process and are incorporated in the
legislation, which was passed on 12 February 2009.
4.1
Reverse Transfers
Under the Act, the Treasury or the BoE (as
applicable) can order that shares or property of a
bank which have been transferred to a bridge bank
or into temporary public ownership be transferred
back to the seller even if the shares or property have
been subject to subsequent onward transfers. This
flexibility was introduced as the UK government
considered the time and information available prior
to taking over a failing bank may not be sufficient to
allow detailed due diligence of every part of the
bank's business.
failing banks under the special resolution regime
have been triggered. Once under public ownership,
the Treasury will have the same powers in respect
of the parent company (and the banks within its
group) as it would have in respect of the bank itself,
including the ability to make forward and reverse
transfers as well as appoint, remove and vary the
service contracts of directors.
4.3
Investment Banks
The Treasury may now adopt regulations to modify
the application of insolvency law to, or establish a
new insolvency procedure for, investment banks.
The Treasury can specify whether an institution is
considered an investment bank for the purposes of
such regulations, provided that it holds client assets
and is authorised under Financial Services and
Markets Act of 2000 to carry out a "regulated
activity".
5.
CONCLUSION
The UK government hopes that the combination of
purchasing assets together with providing
guarantees and insurance will free up the credit
markets for commercial and retail lending. They are
also attempting to deal with recent bonus and
transparency issues by setting compliance with
remuneration and disclosure policies as conditions
to participation in certain schemes. Whilst the
statutory regulatory regime introduced under the
Act has been hailed as the biggest shake up of the
industry in a decade, it grants the UK government
significant powers in relation to troubled banks
which many commentators consider unnecessary
and enables support which is given to the banks to
be kept secret. With the UK government now
having majority stakes in two major high street
banks, other global banks such as HSBC seeking to
raise large amounts of capital through their existing
shareholders, and reports that the level of national
debt is equal to GDP, the jury is out on whether
these latest measures will achieve their aim of
improving market trust and confidence.
______________________________
4.2
Parent Companies
Following consultation with the FSA and the BoE,
the Treasury may now take a UK-incorporated
parent company of a bank into temporary public
ownership, provided that the powers for dealing with
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Class Action – Certification Standards
Putting the Rigor in Rigorous:
The Third Circuit Clarifies
Plaintiffs’ Burden of Proof in
Seeking Class Certification
R. Bruce Allensworth, Andrew C. Glass, David D.
Christensen
A recent decision of the Third Circuit Court of
Appeals significantly bolsters the standard of proof
that plaintiffs must satisfy in motions for class
certification under Rule 23 of the Federal Rules of
Civil Procedure (“Rule 23”). In In re Hydrogen
Peroxide Antitrust Litigation, 552 F.3d 305 (3d Cir.
2008, as amended Jan. 16, 2009), the Third Circuit
emphasized that the broad discretion district courts
have to control the class certification process does
not “soften the rule” that each requirement of Rule
23 must be satisfied. Class certification is a critical
stage of any class action because it is the point at
which the court decides whether the action may
proceed on a classwide basis rather than simply as
an individual case. Rule 23(a) requires plaintiffs to
demonstrate, in part, that there are questions of fact
or law common to the class, and Rule 23(b)(3)
requires plaintiffs to establish, in part, that those
common questions predominate over questions
affecting only individual members. Because the
class certification decision is often the defining
moment of a class action – one that can signal the
“death knell” for plaintiffs or place “unwarranted
pressure” on defendants to settle meritless claims –
the Third Circuit instructed that district courts must
engage in a “thorough examination of the factual
and legal allegations” raised by the action. Further,
because In re Hydrogen Peroxide was authored by
Third Circuit Chief Judge Anthony J. Scirica, who
as chair of the Standing Committee on Rules of
Practice and Procedure oversaw extensive revisions
to Rule 23, the decision is likely to impact federal
courts’ class action jurisprudence nationwide.
With its decision, the Third Circuit clarified three
aspects central to the class certification process,
discussed in turn below.
A Mere “Threshold Showing” of
Predominance Does Not Satisfy Rule 23
In certifying a Rule 23(b)(3) class, which is a class
that seeks primarily money damages, the district
court stated that “[s]o long as plaintiffs demonstrate
their intention to prove a significant portion of their
case through factual evidence and legal arguments
common to all class members, that will now
suffice.” Id. at 321. The district court further stated
that “plaintiffs need only make a threshold
showing” that common questions predominate over
individual ones. Id. The Third Circuit ruled,
however, that neither plaintiffs’ expressed intentions
nor a mere threshold showing could satisfy Rule 23.
Reversing the district court, the Third Circuit held
that plaintiffs must actually set forth evidentiary
proof, rather than a promise to do so at some future
point, that class certification is warranted under
Rule 23. In addition, the court ruled that plaintiffs
must establish the Rule 23 requirements by a
preponderance of the evidence. In other words,
plaintiffs must demonstrate that the “evidence more
likely than not establishes each fact necessary to
meet the requirements of Rule 23.” Id. at 320. The
Third Circuit criticized the district court for
adopting a “lenient” burden, or presumption of
deference, for the party seeking certification.
Courts Must Resolve Relevant Factual
and Legal Disputes When Ruling on Class
Certification Motions
In re Hydrogen Peroxide requires district courts to
resolve all factual or legal disputes that would affect
the court’s certification decision. This may even
require an analysis of the merits of the case at the
class certification stage to determine whether
certification is appropriate. An analysis of the
substantive elements of plaintiffs’ claims may also
be necessary to evaluate whether plaintiffs have set
forth a feasible trial plan where one is required by a
court, namely one showing that the claims are
susceptible to proof on a classwide basis. Plaintiffs’
assurances that they intend or plan to devise a
feasible trial plan at some future point do not meet
their burden.
Courts Must Weigh Expert Testimony
In conjunction with ruling that district courts must
consider all relevant evidence necessary to decide
class certification, the Third Circuit emphasized that
this ruling encompasses consideration of expert
testimony. The court rejected the district court’s
assumption that it could not weigh the parties’
competing expert testimony in deciding whether to
certify a class. Accordingly, under In re Hydrogen
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Peroxide, where expert testimony is necessary to the
class certification decision, a district court must
resolve disputes between competing expert
testimony. Furthermore, neither credibility issues
nor concern for addressing the merits of a case can
impede the rigorous analysis required to resolve
such disputes.
Impact on Class Action Defense
The Third Circuit decision is likely to impact federal
courts’ class action jurisprudence nationwide. As
noted, Chief Judge Scirica served from 1998 to 2003
as chair of the Standing Committee on Rules of
Practice and Procedure. In this role, the Chief Judge
oversaw extensive revisions to Rule 23, which
revisions support conducting a rigorous analysis of
each class certification motion.
For class action defendants, In re Hydrogen
Peroxide heralds a welcomed bolstering of the
standard of proof that plaintiffs must satisfy. Other
aspects of the decision will also likely benefit class
action defendants, including the emphasis on courts
understanding how the merits of class claims
intersect with class certification and the role expert
testimony can play in defeating class certification.
______________________________
Class Action – Fairness Act
when trying to establish that a case meets the CAFA
jurisdictional prerequisites. For instance, CAFA
requires a defendant to show that the amount-incontroversy placed at issue by a plaintiff’s claims
exceeds $5,000,000 on a classwide basis. The
federal circuit courts warn that speculative
assertions, unsupported by evidence, will not suffice
to meet this jurisdictional burden. Rather, courts
exhort defendants to carefully develop the
evidentiary support necessary to demonstrate that a
plaintiff’s claims have placed more than $5,000,000
at issue.
In Amoche, the plaintiffs brought suit in state court
on behalf of New Hampshire consumers who
allegedly had not received refunds purportedly
owed to them on credit insurance policies purchased
in connection with auto loans. After certifying a
class of New Hampshire consumers, the state court
allowed the plaintiffs to amend their complaint to
propose an expanded class of consumers from other
states. On the basis of the proposed expanded class,
the defendant removed the case from state court to
federal district court under CAFA, and the plaintiffs
moved to send the case back to state court. Finding
that the defendant’s assertions concerning the
amount-in-controversy were speculative, the district
court granted the plaintiffs’ request.
R. Bruce Allensworth, Andrew C. Glass, David D.
Christensen
On appeal, the First Circuit held that a removing
defendant must establish CAFA jurisdiction by a
“reasonable probability.” Id. at *7. The First Circuit
found that the Amoche defendant had not
demonstrated to a “reasonable probability” that the
alleged damages exceeded the $5,000,000 amountin-controversy threshold and affirmed the district
court’s order sending the case back to state court.
In its recent decision, Amoche v. Guarantee Trust
Life Insurance Co., --- F.3d ----, 2009 WL 350898
(1st Cir. Feb. 13, 2009), the First Circuit Court of
Appeals joined a growing number of federal courts
that have articulated defendants’ jurisdictional
burden under the Class Action Fairness Act
(“CAFA”). CAFA allows defendants to remove a
class action matter from state court to federal court if
the matter meets certain jurisdictional prerequisites.
Eight federal circuits have now ruled that defendants
must establish the existence of those prerequisites, at
the very least, by a “reasonable probability” or by a
preponderance of the evidence. The Amoche opinion
highlights potential pitfalls that defendants may face
The defendant had submitted a declaration that the
New Hampshire class involved approximately
$450,000 in damages, and argued, by extrapolating
the New Hampshire amount to the thirteen states
named in the amended complaint, that the
$5,000,000 jurisdictional minimum was satisfied.
The defendant, however, did not provide a basis for
that extrapolation. The court suggested that the
defendant might have met its burden through
introducing information regarding its market share
and revenues in states other than New Hampshire.
Because the defendant failed to account for
differences in its business practices among the
“With Reasonable Probability:”
The First Circuit Defines
Defendants’ CAFA
Jurisdictional Burden
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Global Financial Markets
relevant states, the First Circuit found it could not
rely on the defendant’s assertions that the class
members’ claims exceeded $5,000,000 in the
aggregate.
While CAFA is a powerful procedural device that
makes it easier for defendants to litigate class
actions in federal court rather than state court, the
Amoche opinion highlights the demands federal
courts are placing on defendants to carefully develop
the evidentiary support necessary to sustain removal,
including addressing such areas as the number of
potential class members and the alleged value of
those members’ claims. Fortunately, as the First
Circuit held, the remand of a class action does not
necessarily foreclose subsequent attempts to remove
the action under CAFA. Indeed, “[s]uccessive
attempts at removal are permissible where the
grounds for removal become apparent only later in
the litigation.” Id. at *11.
______________________________
Class Action – Waivers
The Enforceability of Class
Action Waivers in Arbitration
Agreements: The Third Circuit
Court of Appeals Signs on to
the Majority Trend
Irene C. Freidel, Robert W. Sparkes, III
In addressing the enforceability of class action
waiver provisions included in mandatory arbitration
agreements, the majority of state and federal courts
have followed a two-pronged, fact-intensive test that
will operate to invalidate a class action waiver
where: 1) the party to be bound did not have a
meaningful opportunity to negotiate or reject the
arbitration agreement portion of a contract (i.e., the
agreement is one of adhesion); and 2) if enforced,
the waiver would effectively eliminate a party’s
right to seek redress because the expected recovery
is not large enough to justify the risks and costs of
individual litigation. In practice, most courts
employing this analysis have found class action
waivers in consumer finance related agreements to
be unconscionable, and thus unenforceable, under
applicable state and federal law.
The Third Circuit Court of Appeals, however,
appeared to reject the majority trend in its 2007
opinion in Gay v. CreditInform, 511 F.3d 369, 378
(3d Cir. 2007). In Gay, the Third Circuit panel
upheld a mandatory arbitration clause in an
agreement between a consumer and a credit repair
organization, which clause required individual
arbitration of all disputes arising out of the
agreement. The Third Circuit panel held that the
right to proceed on a class-wide basis was merely a
procedural right and was therefore waivable. The
court refused to consider whether the consumer
would have a meaningful opportunity to recover if
she were barred from pursuing the claim as a class
action. Instead, the court ruled that the arbitration
provision was not, on its face, so unreasonable that
it could be considered unconscionable under state
law. Any further inquiry into the effect of the
provision, according to the Third Circuit panel
(albeit in dicta), would violate the Federal
Arbitration Act’s (“FAA”) prohibition on state laws
which restrict or burden the enforcement of
agreements to arbitrate. In so holding, the Third
Circuit panel did not discuss the apparently contrary
holdings in other federal circuits.
On February 24, 2009, a different three-judge panel
of the Third Circuit, in Homa v. American Express
Company, ---F.3d---, 2009 WL 440912 (3d Cir.
Feb. 24, 2009), found that a class action waiver
included in a mandatory arbitration provision in a
consumer credit card agreement was
unconscionable under New Jersey state law. The
Third Circuit held that New Jersey had a
fundamental public policy against enforcing class
action waivers in the context of “a low-value
consumer credit suit.” As such, the court held that
“if the claims at issue are of such a low value as
effectively to preclude relief if decided individually,
then, under [New Jersey law] the class-arbitration
waiver is unconscionable.” Id. at *7.
The Third Circuit’s opinion in Homa suggests that
the Third Circuit may be prepared to fall in line with
the majority of state and federal courts in addressing
class action waivers in arbitration agreements. This
development will likely not bode well for consumer
finance and consumer credit entities that seek to
include such class action waivers in their various
consumer agreements. On the other hand, the Homa
court’s reliance on New Jersey state law – law not at
March 19, 2009
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Global Financial Markets
issue in the Gay case – may not signify any change
in the Third Circuit’s approach to class action
waivers, but may merely stand as evidence of one
court interpreting and applying two different states’
laws in similar situations. The fluidity and
importance of this area of the law, however, suggest
that we will not have to wait long for the next court
ruling to more fully direct the analysis and the Third
Circuit’s approach to class action waivers in
arbitration agreements.
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