November 17, 2008
Volume 1 - Issue 3
Editors:
Michael J. Missal
Revised TARP Strategy
michael.missal@klgates.com
Treasury Secretary Outlines Revised TARP Strategy
+1.202.778.9302
Anthony R.G. Nolan and Laurence E. Platt
Matt T. Morley
matt.morley@klgates.com
+1.202.778.9850
Brian A. Ochs
brian.ochs@klgates.com
+1.202.778.9466
Mark D. Perlow
mark.perlow@klgates.com
+1.415.249.1070
_________________________
In this issue:
• Revised TARP Strategy
• TARP/CPP Update
• The Obama Transition
• Lessons from Lehman Bankruptcy:
Centralized Cash Management
Causes Problems for Creditors
• FDIC Temporary Liquidity
Guarantee Program
• IRS Notice: Treatment of Losses in
Bank Mergers
On Wednesday, November 12, 2008, U.S. Treasury Secretary Henry M. Paulson, Jr.
delivered a significant speech outlining current issues regarding the implementation
of the financial rescue package authorized by the Emergency Economic Stabilization
Act of 2008 (“EESA”), and a revised strategy for the use of funds through the
Troubled Asset Relief Program (“TARP”) to address those issues. Please go to
http://www.treas.gov/press/releases/hp1265.htm for a link to Secretary Paulson’s
speech.
One of the key aspects of Secretary Paulson's speech was that the remaining funds
authorized by EESA will not be used to purchase illiquid mortgage-related assets,
but rather to pursue alternative strategies to refloat credit markets and to create new
mechanisms to facilitate price discovery for troubled assets. The Secretary’s remarks
seem to reflect a belief that it will be a losing battle to buy troubled mortgage assets
in the face of deteriorating economic circumstances that are likely to cause home
loan defaults to increase at a dramatic pace. This new approach appears to focus on
addressing circumstances that may cause consumers to default—such as the loss of
jobs—rather than on the effects of such defaults.
Secretary Paulson outlined three alternative strategies for the use of the remaining
funds authorized under the EESA:
•
Building additional capital in financial institutions, as has already been done
with more than $200 billion of the amounts authorized under EESA.
•
Supporting consumer access to credit outside the banking system.
•
Further mitigating mortgage foreclosures.
• State AG Initiatives
• German Financial Market Act
• Regulatory Implications of
Goldman Sachs and Morgan
Stanley Becoming Bank Holding
Companies
• Resolving Lehman Trade Fails
• "Veil Piercing" for MERS
Shareholders Rejected
• Insurance Coverage for Claims
Arising from the Credit Crisis
• NASAA Initiatives on Principal
Protected Notes
• No U.S. Court Jurisdiction for
"Foreign-Cubed" Class Action
• State and Local Measures to
Prevent Foreclosures
• Federal Loan Guarantees
• Discounts for Settlement Costs
Upheld Under RESPA
• Patents for Business Methods and
Software
• K&L Gates Events
Governmental efforts to support consumer access to credit outside the banking
system, the second strategy mentioned above, may have profound implications for
the securitization markets. In his remarks, Secretary Paulson spoke forcefully of the
need to resuscitate the securitization markets because of their importance as a source
of liquidity, not only to financial institutions, but also to consumers who necessarily
rely on credit. His speech suggests that the Treasury is prepared to take significant
steps to prime the pump for securitization activity, including a liquidity facility for
AAA-rated securitizations. This is an important statement of policy in light of the
views of many who have concluded that the securitization markets are permanently
dead, or that securitization is an inherently antisocial activity. Paradoxically, the
announcement of this strategy may actually end, for a time, the modest
thawing of the securitization markets that we have recently seen for certain asset
classes, as new issuances are delayed until the Treasury further elaborates its plans to
revive securitization markets. Issuers may be reluctant to go forward with
securitizations that might obtain better pricing in the near future if they may be
backed by a Treasury liquidity facility.
Global Financial Markets
The third strategy described by Secretary Paulson—
additional efforts to mitigate mortgage
foreclosures—may have important consequences for
the ongoing struggle among mortgage servicers,
borrowers, whole loan holders and investors in
mortgage-backed securities as to who will ultimately
bear the risk of loss inherent in loan modifications
that reduce borrower payments. While the issue is
difficult regardless of the type of loan or investor, it
is particularly complex in the case of loans pooled in
mortgage-backed securities. While servicers of
securitized mortgages have been modifying
mortgage loans in great numbers, there are
significant obstacles to expanding the scope of
modifications. Among these obstacles are investors’
reluctance to waive contractual rights in a manner
that arguably shifts a social cost to them where
modification costs more than foreclosure (even
where the outstanding loan balance arguably
represents principal that should never have been
extended in the first place). Another issue, evident in
the tepid reaction of consumer advocates to the
recently announced mortgage modification protocol,
revolves around disagreements over the extent to
which modification relief should be made available
to borrowers with similar loans but who are in
different economic circumstances, and the extent to
which relief should be made permanent.
The success of any program to expand mortgage
modifications will depend not only upon Treasury’s
ability to craft solutions that are perceived to be fair,
but also its ability to resolve some of the deeper
obstacles to broad loan modifications. Ordinarily,
most borrowers could be expected to resolve the
need for mortgage modifications by refinancing their
homes or selling them—neither of which may be
feasible given changes in the economic
circumstances of borrowers following loan closing,
declines in property values, and the drying up of
sources of credit for borrowers with anything other
than pristine credit histories. The solutions to these
problems go well beyond the authority and
capability of Treasury. Strategies for promoting
mortgage loan modifications may include the use of
TARP funds, but there simply is not enough money
for this tactic alone to have a material impact on a
nationwide basis.
The significance of Treasury’s shift in direction
should not be overstated, as it is likely to be quickly
overtaken by other events. However, it sets a new
direction for the financial recovery as the transition
to a new administration begins. Elements of the
previously announced asset purchase program may
come back in some form. More broadly, we remain
in the beginning stages of what may turn out to be a
massive shift of leverage from private balance
sheets to the public debt.
______________________________
TARP/CPP Update
TARP Capital Purchase
Program Update
Daniel F.C. Crowley and Karishma Shah Page
The U.S. Department of Treasury (“Treasury”)
continues to implement the Emergency Economic
Stabilization Act of 2008 (“EESA,” H.R. 1424, P.L.
110-343). Among other things, EESA authorized
the Secretary of the Treasury to establish a Troubled
Asset Relief Program (“TARP”) to purchase
troubled assets from financial institutions. Under
this authority, Treasury continues to develop the
Capital Purchase Program (“CPP”) to make equity
investments in banking institutions. However,
Treasury has recently indicated that it no longer
intends to purchase troubled assets as described
below.
On October 31, Treasury released additional CPP
documents for publicly traded financial institution
applicants, including a Securities Purchase
Agreement, Form of Letter Agreement, Certificate
of Designations, Form of Warrant, Term Sheet, and
SEC/FASB Letter on Warrant Accounting, available
at http://www.treas.gov/press/releases/hp1247.htm.
The documents contain terms and conditions and
make representations and warranties, to which a
CPP applicant must agree. As noted in the previous
issue, applications must be submitted by 5 p.m.
(EST), November 14, 2008.
In the same notice, Treasury stated it will be posting
a CPP application form and term sheet for private
and mutual banks in the future. In his testimony
(http://www.treas.gov/press/releases/hp1234.htm),
before the Senate Committee on Banking on
October 23, Interim Assistant Secretary for
Financial Stability Neel Kashkari noted that
Treasury is also developing a mortgage-backed
November 17, 2008
2
Global Financial Markets
securities program, whole loan purchase program,
and insurance program for troubled assets. On
November 10, following a speech in New York City
(http://www.treas.gov/press/releases/hp1262.htm),
Mr. Kashkari indicated that U.S. Treasury Secretary
Henry M. Paulson, Jr., will determine whether and
when to roll out these additional programs.
On November 10, the government announced
changes to the AIG bailout, available at
http://www.treas.gov/press/releases/hp1261.htm,
totaling $152.5 billion. Using its EESA authority,
Treasury will purchase $40 billion in senior
preferred stock from AIG. The Federal Reserve will
provide AIG with a $60 billion bridge loan, purchase
$22.5 billion of its mortgage-backed securities and
supply $30 billion to backstop the insurer’s credit
default swap agreements. Mr. Kashkari indicated
that the AIG deal was a “one-off” arrangement
rather than a broadening of the CPP beyond banking
institutions.
Treasury has also started to build its CPP
implementation group. The Department has named
James H. Lambright, former head of the ExportImport Bank, to serve as the interim Chief
Investment Officer
(http://www.treas.gov/press/releases/hp1232.htm).
Treasury has also posted a solicitation for financial
agents to provide asset management services for
CPP. Application guidelines are available at
http://www.treas.gov/press/releases/hp1260.htm; the
deadline for submission was 5 p.m. (EST),
November 13, 2008.
Of the $700 billion in funds authorized by EESA,
Treasury has thus far committed $250 billion to
banks. The President must certify the use of an
additional $100 billion and, for use of the remaining
$350 billion, submit a notice to Congress, which has
the ability to disapprove. On November 4, 2008, the
Treasury submitted its “First Tranche Report,”
http://www.treas.gov/initiatives/eesa/tranchereports.shtml, to Congress on the implementation of
the EESA. The report noted that “it is premature to
assess the impact of the CPP.” Preliminarily,
Treasury is “encouraged by recent signs of
improvement in the markets and in the confidence in
our financial institutions,” but Treasury also reported
that restoring liquidity to the long-term credit
markets remains a challenge.
On November 12, Secretary Paulson provided an
update on the implementation of EESA and
indicated that the Department has changed its
strategy, available at
http://www.treas.gov/press/releases/hp1265.htm.
Secretary Paulson stated that the Department has
abandoned efforts to purchase bad assets under
TARP, because the indirect purchase would delay
bank recapitalization. Instead, CPP equity purchases
would continue to be the central feature of
Treasury’s bailout efforts. Secretary Paulson noted
that the Department also will pursue two additional
strategies: strengthening the asset-backed
securitization market in order to support consumer
finance and expanding foreclosure mitigation.
(please see above article: Treasury Secretary
Outlines Revised TARP Strategy.)
Strategic shifts in the efforts to ameliorate the credit
crisis will presumably continue with the incoming
administration. Moreover, with the continued
instability of the financial markets, we believe that
we are in the beginning stages of what will
ultimately prove to be a massive shift of leverage
from private balance sheets to the public debt as
new programs are implemented.
The K&L Gates Public Policy & Law group
consists of senior, bipartisan policy professionals
who are closely monitoring these developments in
order to provide insights to and effective advocacy
on behalf of firm clients.
http://www.klgates.com/newsstand/Detail.aspx?pub
lication=5052
______________________________
The Obama Transition
The Obama Transition and the
110th Congress
Daniel F.C. Crowley and Karishma Shah Page
The U.S. Department of Treasury (“Treasury”) is
conferring with the Obama transition team, led by
former Clinton Chief of Staff John Podesta, on
policy decisions in order to ensure continuity
between administrations. The transition team has
also turned its attention to selecting the next
Treasury Secretary. The new Secretary is likely to
November 17, 2008
3
Global Financial Markets
have been involved in the development of programs
under the Emergency Economic Stabilization Act of
2008 (EESA, H.R. 1424, P.L. 110-343). Possible
choices include New York Federal Reserve
President Timothy Geithner, Federal Deposit
Insurance Commission Chairwoman Sheila Bair,
former Federal Reserve Chairman Paul Volcker, and
former Treasury Secretaries Larry Summers and
Robert Rubin.
President Bush
(http://www.whitehouse.gov/news/releases/2008/10/
20081022.html) hosted the G-20 summit
(http://www.g20.org/G20) on November 15 in
Washington, D.C. to discuss a globally coordinated
response to the financial crisis. European Union
leaders have urged the President to join them in
devising international regulatory measures to govern
the banking industry. In his remarks on November
12, U.S. Treasury Secretary Henry M. Paulson, Jr.
underscored the importance of reaching a consensus
on a broad-based reform agenda during the meeting.
Although President-elect Obama was not expected
to formally participate, some delegates were
planning to engage with him while in Washington,
D.C.
Congress is scheduled to reconvene for one week,
beginning November 17. House Speaker Nancy
Pelosi (D-CA) and Senate Majority Leader Harry
Reid (D-NV) would like to pass a stimulus package,
but the Majority Leader has said there may not be
enough support. President-elect Obama has stated
that if a bill does not pass in the lame-duck session,
he will make it his first order of business upon being
sworn in. The stimulus bill may be a vehicle for
legislative directives relative to the Troubled Asset
Relief Program (“TARP”) , especially in the area of
preventing mortgage foreclosures. The FDIC has
proposed using $50 billion of TARP funds for a loan
modification and guarantee program. Senate
Banking Committee Chairman Christopher Dodd
(D-CT),
http://dodd.senate.gov/index.php?q=node/4616, and
House Financial Services Committee Chairman
Barney Frank (D-MA),
http://www.house.gov/apps/list/press/financialsvcs_
dem/press102008.shtml, are supportive of the
proposal.
As expected, congressional oversight of EESA
implementation has continued apace. On October
24, Senators Charles Schumer (D-NY), Jack Reed
(D-RI), and Robert Menendez (D-NJ) wrote a letter,
http://menendez.senate.gov/newsroom/record.cfm?i
d=304512, recommending Treasury adopt
guidelines to ensure that institutions use bailout
funds to restart lending activities rather than
acquisitions or dividends. On October 29, House
Speaker Nancy Pelosi and Senate Majority Leader
Harry Reid sent a letter,
http://speaker.house.gov/newsroom/pressreleases?id
=0876, urging Treasury to strengthen the interim
final rules on executive compensation for CPP
institutions. In addition, the following congressional
hearings have recently taken place or are planned to
take place:
Private Sector Cooperation with Mortgage
Modifications
Wed., Nov. 12, 10:00 a.m., 2128 Rayburn Bldg.
House Financial Services Committee
http://www.house.gov/apps/list/hearing/financialsvc
s_dem/hr111208.shtml
Regulation of Hedge Funds
Thurs., Nov. 13, 10:00 a.m., 2154 Rayburn Bldg.
House Oversight and Government Reform
Committee
http://oversight.house.gov/
Oversight of Emergency Economic Stabilization
Act
Thurs., Nov. 13, 10:00 a.m., 538 Dirksen Bldg.
Senate Banking Committee
http://banking.senate.gov/public/index.cfm?Fuseacti
on=Hearings.Detail&HearingID=1d38de7d-67db4614-965b-edf5749f1fa3
Is Treasury Using Bailout Funds for Foreclosure
Prevention, as Congress Intended?
Fri., Nov. 14, 10:00 a.m., 2154 Rayburn Bldg.
House Oversight and Government Reform
Committee’s Subcommittee on Domestic Policy
http://oversight.house.gov/story.asp?ID=2276
Troubled Asset Purchase Program Oversight
Tues., Nov. 18, 10:00 a.m., 2128 Rayburn Bldg.
House Financial Services Committee
http://www.house.gov/apps/list/hearing/financialsvc
s_dem/hr11102008.shtml
November 17, 2008
4
Global Financial Markets
Collapse of Fannie Mae and Freddie Mac
Tues, Dec. 9, 10:00 a.m., 2154 Rayburn Bldg.
House Oversight and Government Reform
Committee
http://oversight.house.gov/schedule.asp
Congress is preparing to consider comprehensive
financial services reform legislation early next year.
Senator Schumer, a member of both the Senate
Finance and Banking Committees, has outlined six
principles that he believes should guide the
deliberations:
1. A key focus should be on controlling systemic
risk and ensuring stability.
2. The regulatory structure should be unified under
a single regulatory authority, or at a minimum,
simplified.
3. Complex financial instruments should be subject
to regulation under clear regulatory authority.
4. Global financial markets require globally
coordinated solutions.
5. Increased transparency should be a central goal.
6. The laissez-faire view of regulation must come
to an end.
For more details on the impact of the recent election
on current and future policy initiatives relating to the
financial services industry, please see the recent
K&L Gates Public Policy and Law Alert, “Financial
Services Reform: What Comes Next?”
(http://www.klgates.com/newsstand/Detail.aspx?pub
lication=5052).
The K&L Gates Public Policy & Law group consists
of senior, bipartisan policy professionals who are
closely monitoring these developments in order to
provide insights to and effective advocacy on behalf
of firm clients.
______________________________
Lessons from Lehman Bankruptcy:
Centralized Cash Management Causes
Problems for Creditors
Lessons of the Lehman Brothers
Bankruptcy: Global Cash
Management v. Legal
Provincialism
Richard S. Miller, Robert T.
Honeywell and Jeffrey N. Rich
The Lehman Brothers bankruptcy sometimes seems
to have exhausted the list of “biggest ever”
superlatives: Biggest ever bankruptcy filing in the
United States ($639 billion in assets). “By far the
largest securities broker-dealer liquidation ever
attempted,” according to the trustee overseeing the
liquidation of Lehman’s U.S. broker-dealer. His
British counterpart, overseeing the insolvency of
Lehman’s London operations, told the press, “Enron
and BCCI were large and complex but not on this
scale.” The Lehman collapse has been tied to the
fall of the investment banking model, to continuing
uncertainty in financial markets, and to the current
turmoil in the global economy itself.
A less-discussed theme of the Lehman bankruptcy
is the strain it is revealing between the efficiencies
of global corporate cash management and the legal
regimes governing creditor claims. When the cash
literally stops flowing, creditors and investors
naturally ask, “Where’s my money?” The Lehman
insolvency has revealed, like many of the largest
corporate bankruptcies in recent years, that this can
be an extremely difficult question to answer.
Part of the problem is that most corporate cash
management systems involve one corporate entity
moving cash on behalf of its affiliates, but reflecting
their interests primarily through intercompany
claims. This has obvious operational efficiencies,
but when “the music stops” upon a bankruptcy
filing, the cash is held by the entity with legal title
to it (i.e., in its accounts). Creditors of the entity
holding the cash have an immediate enforcement
advantage – the money is there – while creditors of
its affiliates have to chase it down, possibly across
jurisdictional boundaries. The Lehman bankruptcy
is the latest example.
November 17, 2008
5
Global Financial Markets
Like most large companies, Lehman operated a
centralized cash management system that had one
entity – in this case the holding company – operate
as the “central banker” for the numerous Lehman
entities. According to court filings, the holding
company generally swept excess cash into its own
U.S. and foreign operating accounts and used it to
fund expenses of subsidiaries. The degree to which
subsidiaries were integrated into the system varied.
For example, unregulated subsidiaries had their
excess cash swept on a daily basis to the holding
company’s operating accounts, while regulated
subsidiaries (generally broker-dealers) transferred
cash to the holding company less frequently, to pay
down intercompany loans for prior advances. Some
subsidiaries managed their own cash and
disbursements independently (e.g., Lehman Brothers
Commercial Bank). Others had some of their
collections deposited into the accounts of other
subsidiaries. For example, the regulated U.S.
broker-dealer (Lehman Brothers Inc. (“LBI”))
received collections from some derivatives, futures
and foreign exchange transactions of Lehman
Brothers Commercial Corporation, Lehman Brothers
Special Financing Inc., and Lehman Brothers
International (Europe) (“LBIE”). As to
disbursements for expenses, the holding company
acted as “paymaster” for most of Lehman’s
European operations, while the regulated U.S.
broker-dealer (LBI) acted as “paymaster” for most
U.S. operations.
A centralized cash management system such as
Lehman’s may make utter sense pre-bankruptcy, but
can produce legal nightmares afterward. For one,
the sheer number of transactions can make
untangling intercompany claims based on those
transactions a herculean task. Lehman reported that
the portion of its business related to the sale of
derivatives alone involved approximately 1,500,000
transactions with approximately 8,000
counterparties. It is now faced, in the postbankruptcy setting, with sorting these out with a
radically reduced staff, going from more than 13,000
employees to about 140. Lehman’s London office
recently lost over half of its legal staff. Its current
U.S. management, led by an outside restructuring
firm, is reportedly focused on preserving its
information systems and retaining employees, and
estimates being able to respond to creditor inquiries
in 45-60 days. Impatient creditors in the U.S. case
have filed motions for their own investigations and
for the appointment of an examiner and for an
independent trustee to replace Lehman’s remaining
officers and directors. Its UK insolvency
administrators reported difficulty determining the
UK companies’ assets, partly due to difficulties
getting information from other asset custodians
around the world, and that “it will take many years
to finally resolve the inter-company and third-party
claims.”
A review of Lehman’s cash management system
also shows that numerous legal and regulatory
regimes are now at play that may affect
intercompany claims and, as a result, creditors’
ultimate recoveries. The holding company that
acted as the “central bank” is now subject to the
U.S. Chapter 11 case, along with 16 subsidiaries;
LBI is subject to a separate liquidation proceeding
supervised by the Securities Investor Protection
Corporation; LBIE and three other British entities
are in a UK administration proceeding; other
foreign subsidiaries are subject to insolvency
proceedings in their own jurisdictions (for example,
in Hong Kong, Australia, Singapore, Japan, The
Netherlands, France and Germany); and various
Lehman entities and funds are still “non-debtors,”
not having yet filed a formal insolvency proceeding
and thus continuing to be subject to whatever laws
govern the entities and their various contracts.
From an insolvency perspective, this means that a
creditor or investor evaluating its recovery prospects
must:
a. first determine which entity or entities it
did business with, both directly and through
guaranties, cross-collateralization, setoff
and netting rights; then
b. determine which assets (including
collateral) are available for recovery and
which courts and regulators may have
jurisdiction over those assets (including a
possible stay or injunction prohibiting
enforcement or foreclosure); then
c. file claims in the relevant insolvency
proceedings prior to the applicable
deadlines (subject to considering the risks
of submitting to jurisdiction), exercise any
voting and participation rights available to
creditors (for example, attending creditors’
meetings and voting on a plan of
November 17, 2008
6
Global Financial Markets
reorganization), and possibly take other
enforcement action (for example, a motion
to modify any stay against foreclosure or
other litigation); then
d. monitor the relevant insolvency
proceedings, to determine the timing and
amount of creditor recoveries.
The multiplicity of bankruptcy regimes now
governing Lehman means that each Lehman entity is
now considered a separate “bankruptcy estate” – i.e.,
a separate group of assets and creditors – and each
is now vying with the other bankruptcy estates for a
piece of the Lehman group’s remaining assets.
Intercompany claims are often the main vehicle
through which these separate bankruptcy estates try
to recover assets for themselves. Anyone who has
lived through other large corporate bankruptcies
(e.g., Adelphia, Global Crossing, Refco) knows that
intercompany litigation can be the most complex,
intractable and even unresolvable feature of the
insolvency proceeding. Some cases feature creditors
attempting to “substantively consolidate” all of the
companies by collapsing all of the different
bankruptcy estates into one, eliminating
intercompany claims in the process, but other
creditors naturally, and fiercely, resist. Some
creditors will of course benefit from corporate
separateness by preserving their respective debtorcompanies’ assets for themselves.
take years to resolve. One of the well-publicized
complaints is from creditors of Lehman’s UK
entities, who claim that several billion dollars was
swept into Lehman’s U.S. accounts on the eve of its
Chapter 11 filing. These creditors are now faced
with trying to claw back cash that once flowed
easily within “Lehman Brothers” and is suddenly
beyond their reach due to legal boundaries that
became very real, and difficult to pierce, upon
Lehman’s bankruptcy filing.
Creditors and investors of the “asset-weak”
companies try to reach through corporate boundaries
by any and all means. If they are unsuccessful, their
recoveries can be much lower than their counterpart
creditors at other entities in the corporate tree, in
what is ostensibly the “same company.” A typical
pattern is that lenders and investors at one level (for
example, stockholders and bondholders of the
holding company) assert that they financed the
operations of the subsidiaries and should recover
accordingly; conversely, creditors of the subsidiaries
assert that holding company creditors were aware of
their “structural subordination” and have to live with
the consequences.
Temporary Liquidity
Guarantee Program
Hence, the (often furious) litigation that attends
many complex corporate bankruptcies and is now
gathering steam in the Lehman cases. In addition to
the multiple insolvency proceedings around the
world, there are now securities class actions and
criminal investigations, all of which will presumably
This is one of the difficult lessons that is learned
repeatedly in corporate bankruptcies but is
especially potent for companies with global
operations. At a court hearing, one of Lehman’s
lawyers explained its cash management system as
“cash moves around with great velocity.” This can
be profitable for creditors in good times yet very
dangerous in others. Creditors should be aware of
the benefits and risks of centralized cash
management – specifically, of exactly which entities
they have claims against, and where those entities’
cash and other assets are – so that they can
understand and be prepared for the consequences in
the event, “the music stops
______________________________
FDIC Temporary Liquidity Guarantee
Program
Stanley V. Ragalevsky and Sean P. Mahoney
Federal Deposit Insurance Corporation (“FDIC”)insured depository institutions, bank holding
companies, financial holding companies and certain
thrift holding companies have until December 5,
2008 to decide whether to participate in the FDIC’s
Temporary Liquidity Guarantee Program
(“TLGP”). FDIC established the TLGP as of
October 14, 2008 after determining that rapid and
substantial outflows of uninsured deposits from
banks threatened the stability of our financial
system. The purpose of the TLGP is to preserve
public confidence and encourage liquidity in the
banking system. Participation by FDIC-insured
institutions is voluntary.
The TLGP has two components: an FDIC guaranty
of certain senior unsecured debt ("Debt Guarantee
November 17, 2008
7
Global Financial Markets
Program") and unlimited FDIC deposit insurance
coverage for non-interest bearing transaction
accounts through 2009 ("Transaction Account
Guarantee Program"). Under the Debt Guarantee
Program, covered debt in an amount up to 125
percent of the senior unsecured debt of a
participating institution outstanding on September
30, 2008 that matures no later than June 30, 2009
will be guaranteed by FDIC, for an annual fee of
seventy-five basis points of the covered amount.
Covered senior unsecured debt includes commercial
paper and unsecured borrowings from Federal
Reserve Banks but excludes derivatives, deposits in
foreign currency, and convertible debt. If investors
in an institution's unsecured debt do not insist upon
the FDIC guaranty, the cost of the Debt Guarantee
Program may not be a worthwhile expense.
The Transaction Account Guarantee Program
supplements existing FDIC insurance with
temporary, unlimited deposit insurance coverage on
non-interest bearing transaction accounts such as
demand deposit accounts, payroll and other
processing accounts, certain custodial accounts for
loan servicing or similar activities and non-interest
bearing savings accounts into which funds from
transaction accounts are swept. Institutions that
participate in the Transaction Account Guarantee
Program will be assessed an annual premium in an
amount equal to 0.10 percent of covered transaction
account balances in excess of standard FDIC
coverages.
Although it is theoretically voluntary, participation
in the Transaction Account Guarantee Program may
effectively be mandatory for most banks that depend
upon commercial demand deposit accounts for
funding. The market may simply demand this
coverage. This may not be the case for institutions
with specialized balance sheets or business models.
Institutions have until 11:59 p.m. (EST) on
December 5, 2008 to opt out of participation in the
Debt Guarantee Program or Transaction Account
Guarantee Program. For institutions that do not opt
out, the TLGP is scheduled to expire on December
31, 2009, although senior unsecured debt guaranteed
under the TLGP will remain guaranteed until the
later of maturity or June 30, 2012. Each institution
will be required to disclose whether or not it is
participating in the Transaction Account Guarantee
Program. If an institution participates in the Debt
Guarantee Program, it will have to disclose to
investors in a commercially reasonable manner
whether or not the debt instrument being offered is
guaranteed under the TLGP.
______________________________
IRS Notice: Treatment of Losses in Bank
Mergers
IRS: Little Noticed Notice
Unlocks Losses in Bank Mergers
Roger S. Wise
Notice 2008-83, quietly issued by the Internal
Revenue Service (“IRS”) on September 30, 2008,
removes significant limitations that would otherwise
apply to a category of tax losses upon a change of
control involving a bank. The notice’s brevity – its
operative section contains a single sentence –
should not obscure the profound impact that it may
have on merger and acquisition activity involving
banks.
Section 382 of the Internal Revenue Code of 1986,
as amended (the “Code”), was originally enacted to
prevent “trafficking” in loss corporations. Congress
was concerned about transactions where one
corporation would acquire a target corporation –
perhaps even one that had disposed of its historic
business – solely to utilize the target’s loss
carryforwards. Under current law, when a
corporation undergoes an “ownership change,”
Section 382 limits the amount of income that may
be offset with historic losses. This limit is generally
equal to the value of the loss corporation at the time
of the ownership change multiplied by the longterm tax-exempt rate, a rate which is published
monthly by the IRS. In essence, this limitation
gives the acquiring corporation the benefit of the
target’s losses only to the extent of the benefit it
would have received if it had instead made an
investment in tax-exempt bonds.
An ownership change generally occurs when there
is a more than 50 percentage point change in the
ownership of the loss corporation by 5 percent
shareholders during the three-year period ending on
the testing date. An ownership change can arise if
shares of a target corporation are acquired from
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Global Financial Markets
existing shareholders, or if a new equity investment
is made in the target.
The rules described above deal with losses that have
already been recognized. Section 382(h) of the
Code extends these limitations to certain built-in
losses – i.e., losses existing at the time of an
ownership change that are not recognized until later.
If a corporation has a net unrealized built-in loss
(“NUBIL”) at the time of an ownership change and
meets certain other conditions, any deductions
relating to the recognition of those NUBILs during
the following 5 years will be subject to the
limitations described above. Certain deductions
during the 5-year period that are attributable to
periods before the ownership change may also be
treated similarly.
Under the new IRS notice, the rules on NUBILs do
not apply “to any deduction properly allowed after
an ownership change . . . to a bank with respect to
losses on loans or bad debts (including any
deduction for a reasonable addition to a reserve for
bad debts).” This simple statement appears designed
to encourage mergers with, and investments in,
troubled banks, by permitted loss deductions arising
from bad debts held by the banks. By removing a
significant limitation that would otherwise apply to
these losses, the notice in effect creates a tax asset
that would otherwise not be available.
A bank is defined in Section 581 of the Code as a
bank or trust company incorporated and doing
business under the laws of the United States
(including laws relating to the District of Columbia)
or of any state, which among other things is subject
by law to supervision and examination by State,
Territorial, or Federal authority having supervision
over banking institutions, and also includes a
domestic building and loan association.
The long-term impact of the notice is difficult to
predict, but it had an almost immediate impact on
the takeover of Wachovia, in that the bid by Wells
Fargo – which came shortly after the release of the
notice, when an offer by Citibank was nearly
finalized – appears to have been encouraged by the
change in tax law.
The notice was effective upon issuance and may be
relied upon unless and until additional guidance is
issued.
______________________________
State AG Initiatives
State Attorneys General –
A Force to be Reckoned With
Paul F. Hancock
State attorneys general aspire to be the primary
protectors of consumers. The housing collapse
provided new opportunities for them to flex their
muscles and seek a role in the development of
solutions. Federal preemption remains a
controversial issue, but the threat of preemption has
only caused state attorneys general to be more
aggressive in the areas where they have legal
authority. Recently elected attorneys general have
pledged to focus attention on the housing and
financial markets, and we can reasonably expect
attorneys general, as a group, to push the limits of
their authority in addressing the issues. Some
examples of their actions in recent months are
described below.
Auction-Rate Securities
Allegations of deception have provided a basis for
attorney general involvement in auction-rate
securities markets. New York Attorney General
Cuomo reached agreement with twelve financial
institutions on claims that they “sold auction-rate
securities as safe, cash-equivalent products, when in
fact they faced increasing liquidity risk.” The
institutions agreed to buy back the securities from
certain customers, generally individuals and
foundations, and otherwise provide restitution to
“individual investors who were fraudulently sold
auction-rate securities.” Cuomo says that the
settlements “returned over $50 billion back to
investors’ hands.” Similar settlements were reached
by attorneys general in Massachusetts and
Michigan.
Mortgage Fraud
Attorneys general have identified mortgage fraud,
particularly inflated appraisals, as a major
contributor to the housing crisis. The Florida
Attorney General sued ten companies and fifteen
individuals that defrauded lenders by recruiting
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Global Financial Markets
“straw buyers'” with good credit and conspiring with
realtors to artificially inflate purchase prices. Other
states have filed similar claims.
Foreclosures
The State Foreclosure Prevention Working Group
released its third report on mortgage foreclosures at
the end of September, contending that 80 percent of
delinquent borrowers are not receiving meaningful
foreclosure relief. Although the Group’s
collaboration with servicers is described as
cooperative, a stronger stick is laying in wait. After
a number of states announced a settlement with
Bank of America regarding the Countrywide
portfolio that centers on loan modification, on
October 7, the Group sent a letter to sixteen
subprime servicers stating: “We urge you in the
strongest possible terms to adopt a comprehensive,
streamlined, and effective loan modification
program as soon as possible.” The implicit threat of
prosecution is clear.
State attorneys general investigated and prosecuted
deceptive conduct by foreclosure rescue companies.
This issue is a neat fit for traditional attorney general
enforcement and is a priority in many states.
Loan Origination
The settlement with Bank of America regarding the
Countrywide portfolio continues a trend of
aggressive state attorney general action regarding
home mortgage lending practices. The attorneys
general already have extracted major business
changes in the lending industry through lawsuits and
compelled settlements. The monetary value of the
attorney general settlements with Household ($484
million) and Ameriquest ($295 million), as well as
the extensive loan modification relief obtained from
Countrywide, certainly overshadow any action by
federal agencies. The only real question is which
firm will be the next target – perhaps one of the
sixteen servicers that received the October 7 letter,
or the originators of the loans that they are servicing.
2008 Attorney General Elections
Eleven seats were up for election and the announced
plans of the winners indicate a continued, and
perhaps increased, focus on mortgage and financial
markets.
Chris Koster, newly elected in Missouri, and
Richard Cordray, newly elected in Ohio, focused
their campaigns on credit and foreclosure issues.
Other well-known attorneys general who already
enjoy a strong reputation in seeking mortgage
reform and foreclosure relief – such as Roy Cooper
in North Carolina and Rob McKenna in Washington
– were reelected. Mark Shurtleff was reelected in
Utah, as was Darrell McGraw in West Virginia;
they have prioritized mortgage fraud and other
credit-related issues.
First-term attorneys general were elected in Indiana
(Greg Zoeller), Montana (Steve Bullock) and
Oregon (John Kroger), and incumbents were
reelected in Pennsylvania (Tom Corbett) and
Vermont (William Sorrell). All emphasized the
importance of consumer protection in seeking
office.
Conclusion
The states want a place at the remedial table. Some
offer an olive branch of cooperative efforts to work
through the present crisis. Others are more
aggressive from the start. But if conditions do not
improve quickly, it can be expected that many states
will join forces to compel reform, based on claims
that consumers and investors were deceived or
otherwise were victims of unfair practices of loan
originators, servicers or secondary market
participants.
______________________________
German Financial Market Act
German Measures to Address
the Financial Crisis
Wilhelm Hartung and Oliver M. Kern
The German government has enacted significant
new measures to stabilize German financial
markets. These efforts seek to restore trust in the
financial system and to revive the business
interaction among financial institutions and other
market participants.
Central to these measures is the creation of a €100
billion fund to support troubled financial
institutions, called the Financial Market
Stabilisation Fund ("SoFFin") (www.soffin.de).
SoFFin has been authorized to operate through
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10
Global Financial Markets
December 31, 2009, after which date, under current
legislation, it will be dissolved.
SoFFin is directed toward financial market
participants headquartered in Germany. Among the
types of institutions eligible for assistance are banks
and credit institutions, investment management
companies, operators of securities and futures
exchanges, as well as some specific affiliates of such
companies, including parent companies of public
law state banks (Landesbanken) (e.g., BayernLB
Holding AG, Landesbank Berlin AG) (all together
referred to hereinafter as "Financial Sector
Enterprises").
SoFFin is authorized to provide the following types
of financial assistance to Financial Sector
Enterprises:
• €20 billion to make payments under guarantees
issued for the benefit of Financial Sector
Enterprises. SoFFin may issue up to €400
billion in such guarantees.
•
€80 billion to (a) acquire participations in
Financial Sector Enterprises or (b) assume risk
positions held by such companies.
Guarantees. Guarantees have been designated as
the preferred method for SoFFin to use in seeking to
stabilize the markets. The hope is that recipients can
use such assistance to overcome short-term liquidity
problems and seek to recapitalize themselves on the
market. SoFFin may provide standard first-demand
guarantees in connection with obligations of 3 years
or less that are created between October 18, 2008
and December 31, 2009. Guarantees may also be
issued to single purpose entities which have assumed
risk positions of Financial Sector Enterprises.
Recipients of these guarantees will be required to
pay fair market rates for the guarantee, and be
required to meet certain minimum capital
requirements. If adequate capital resources are not
available, the Financial Sector Enterprises may
apply for recapitalization assistance from SoFFin.
Acquisitions of Risk Positions. SoFFin may also
determine to assist Financial Sector Enterprises by
acquiring certain risk positions, including, but not
limited to, receivables, securities, derivative
financial instruments and rights and obligations
under loan commitments. Ordinarily, no Financial
Sector Enterprises may receive more than €5 billion
of this type of assistance, and recipients may be
required to repurchase such risk positions as SoFFin
determines to be appropriate.
Recapitalizations. Where the national interest
requires it, and where no reasonable alternatives
exist, SoFFin may acquire equity interests of up to
€10 billion in any Financial Sector Enterprises
seeking such assistance. New regulations have been
put into place to SoFFin’s participation in a
recapitalization by easing requirements under
German corporate, capital markets, and commercial
law.
Recipients of assistance under any of these
measures must meet certain preconditions, which
vary according to the form of assistance provided.
Recipients may be required to cease certain types
of business transactions, to restrict compensation of
individual employees to €500,000 or less, and to
suspend dividend payments to anyone other than
SoFFin.
In addition to legal changes to facilitate the
recapitalization of market participants by SoFFin,
amendments have been made to the Banking Act
(Kreditwesengesetz, KWG), to the Insurance
Supervision Act, and to the German federal
insolvency law (modifying the definition of over
indebtedness (Überschuldung)).
While the European Commission (“EC”) has
generally approved, under EC treaty state aid rules,
the German assistance measures, EC authorities
have in one instance already questioned whether
guarantees provided to one company met EC
requirements because they may not have been
granted at fair market value. According to publicly
available sources, further investigations are
pending.
There has been one further development of note for
companies subject to IFRS accounting standards. In
October 2008, the International Accounting
Standards Board issued amendments to IAS 39 and
IFRS 7 which were endorsed by the EC by
regulation (Commission Regulation No. 1004/2008
of October 15, 2008). These amendments, which are
effective retroactively to July 1, 2008, allow certain
reclassifications of non-derivative financial assets
November 17, 2008
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Global Financial Markets
out of the "Fair Value through Profit or Loss"
category and also allow the reclassification of
financial assets from the "Available for Sale"
category to the "Loans and Receivables" category in
particular circumstances. A number of companies
have taken advantage of these provisions. In one
widely reported example, Deutsche Bank’s third
quarter report (http://annualreport.deutschebank.com/2008/q3/notes/basisofpreparationunaudite
d.html) notes that, due to reclassifications allowed
by these amendments, the company increased
income before income tax by €825 million.
______________________________
Regulatory Implications of Goldman
Sachs and Morgan Stanley Becoming
Bank Holding Companies
Regulatory Implications of
Goldman Sachs and Morgan
Stanley Becoming Financial
Holding Companies
Rebecca H. Laird and Edward G. Eisert
On September 22, 2008, in simultaneous actions, the
Federal Reserve Board (“FRB”) announced that it
had approved the joint application of The Goldman
Sachs Group, Inc. and Goldman Sachs Bank USA
Holdings LLC (collectively, “Goldman Sachs”), and
the joint application of Morgan Stanley, Morgan
Stanley Capital Management LLC and Morgan
Stanley Domestic Holdings, Inc. (collectively,
“Morgan Stanley”), to become bank holding
companies. Each company already owned an
institution insured by the Federal Deposit Insurance
Corporation (“FDIC”) (a Utah industrial loan
company), which was converted into a commercial
bank with full deposit taking and lending powers.
Though initially bank holding companies, Goldman
Sachs and Morgan Stanley have each stated their
intention to become a “financial holding company,”
i.e., a company that is permitted under the Bank
Holding Company Act of 1956 to engage in
activities that are “financial in nature,” including
securities underwriting, merchant banking, and
insurance underwriting and sales (“FHC”).
Set forth below are answers to a number of
frequently asked questions about the regulatory
implications of an investment banking firm, such as
Goldman Sachs or Morgan Stanley, becoming an
FHC:
1. What are the minimum capital and liquidity
requirements for a company to become an
FHC? The FHC’s bank must be “wellcapitalized” on a consolidated basis, which
means that the bank must maintain a “total riskbased capital ratio” of 10.0 percent or greater
and the bank must maintain a “Tier 1 risk-based
capital ratio” of 6.0 percent or greater. The
“total risk-based capital ratio” is the ratio of
total capital to assets, which are calculated on a
risk-weighted basis. The “Tier 1 risk-based
capital ratio” is the ratio of Tier 1 capital –
basically common and perpetual preferred stock
and surplus minus goodwill and intangibles – to
total assets, which are calculated on a riskweighted basis. In addition, the bank’s leverage
ratio, which is the ratio of capital to total assets
(which are not calculated on a risk-weighted
basis), cannot be less than 3.0 percent. The
FRB has stated that at least 100 to 200 basis
points above the 3.0 percent leverage ratio is
required of all but the very strongest banking
organizations. There are no express liquidity
requirements in the regulations.
2. How would an investment banking firm have to
restructure its business if it were to become an
FHC? An FHC is permitted to engage in
activities that are “financial in nature,”
including securities activities, insurance
activities, and other financial services activities,
such as merchant banking and private equity
investing, and may do so in addition to owning
banks under a single corporate umbrella. To
the extent an activity of an investment banking
firm is not “financial in nature” and is not in
compliance with applicable regulations, the
firm would have two years in which to divest
the activity, which the FRB may extend for
three one-year periods.
3. What discretionary powers does the FRB have
over an FHC? The FRB is vested with broad
supervisory powers and enforcement tools with
which to oversee FHCs. The FRB has the
power to conduct examinations, not just at the
bank level, but at the holding company and
affiliate level. The FRB conducts examinations
on a regular basis at each supervised institution
and maintains offices at, and continuously
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Global Financial Markets
monitors the activities of, the largest holding
companies. In addition to its general
rulemaking authority, the FRB also imposes
reporting requirements, restricts activities,
imposes operational and managerial standards,
and may bring enforcement actions to maintain
the “safety and soundness” of the companies it
regulates. The FRB also has the authority to
require undercapitalized FHCs to take “prompt
corrective action” to raise additional capital or
find a merger partner.
The jurisdiction of the FRB does not supplant
the jurisdiction of other federal banking
regulators (such as the FDIC) over the banks
owned by the FHC, or state banking regulators
over such banks organized under state law.
Perhaps most importantly from the investment
banking perspective, the SEC remains the
primary federal regulator of any registered
broker-dealer and investment adviser controlled
by the FHC, and the Commodity Futures
Trading Commission remains the primary
federal regulator of any registered commodity
trading advisor, commodity pool operator and
futures commission merchant controlled by the
FHC. However, the FRB retains ultimate
supervisory authority.
This multifaceted regulatory regime has farreaching and significant consequences for new
FHCs, including the regulatory compliance
programs that are required and the manner in
which regulatory examinations and deficiencies
are addressed. For example, historically, the
FRB and other bank regulators have been
viewed as “prudential” regulators that apply a
more “principles based,” collaborative approach
to supervision, which is often handled behind
closed doors on a confidential basis, as opposed
to federal and state securities regulators that are
generally viewed as more public-action,
enforcement-based regulators.
What are the rules on capital for separate
subsidiaries of FHCs and how does the FRB regulate
transfers of funds from subsidiaries? In general, the
FRB wants the FHC to be a source of strength to the
bank; it does not want the bank to be used to support
the FHC. Consequently, the FRB will generally not
allow funds to flow from the bank to the FHC to
support its debt, pay dividends or fund general
operations, unless there is clearly no detriment to
the bank in doing so.
______________________________
Resolving Lehman Trade Fails
Resolving Lehman Trade Fails
Gordon F. Peery
Prior to September 15, 2008, portfolio managers
placed thousands of trades with brokers at Lehman
Brothers Inc. (“LBI”) in New York City. These
trades, many of which were subsequently
transferred for settlement to LBI affiliates
throughout the world, eventually failed to settle last
month (and are referenced in settlement parlance as
“trade fails”) as a result of the worldwide collapse
of Lehman Brothers and the landmark civil
proceedings that followed on at least three
continents. The circuitous routes taken by these
trades prior to settlement failure and the legal and
business implications along the way demonstrate the
complexity of the global system of modern finance
and the need for qualified legal counsel.
As of this time, two sets of authoritative statements
have been issued with regard to certain trade fails
involving LBI.
•
SIPC Protocol and LBI Trustee Statement.
The Securities Investor Protection Corporation
(“SIPC”), on September 26, 2008, published a
protocol for closing certain open trades (“SIPC
Protocol”). The LBI bankruptcy trustee (the
“LBI Trustee”) issued a related clarifying
statement (“LBI Trustee Statement”).
•
SIFMA RMBS Protocol. The Securities
Industry and Financial Markets Association
(“SIFMA”), on October 9, 2008, published
Protocol 08-02 for resolving certain outstanding
agency mortgage-backed security trades with
LBI (the “SIFMA RMBS Protocol”).
In light of the foregoing developments, the short
and long term tasks for handling related Lehman
trade fails are as follows:
1. Understand the relevant players, law and
timing. With the assistance of qualified legal
counsel in the appropriate jurisdiction, the first
step is to identify
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13
Global Financial Markets
a.
the relevant trades and the Lehman entity
that is properly deemed to be the
counterparty,
b. the particular court/trustee/administrator
that will have authority to resolve issues
relating to the trades, and
c. the time periods under the relevant
protocols for securing rights and performing
obligations.
Missing deadlines for filing claims in proceedings
may result in the loss of important rights, including
the right to recover losses.
2. Determine whether any contractual
obligations are subject to a stay. Counsel’s
early efforts should focus on establishing a
legal, contractual obligation that is enforceable
in light of applicable insolvency proceedings.
Prime brokerage agreements often set forth
remedies for trade fails and, so long as the
transactions are not stayed by a Chapter 11
proceeding, stayed in a SIPC proceeding, or UK
or other administration, contractual rights may
be pursued with the advice of counsel and in
accordance with applicable settlement protocols.
3. Interface with the relevant trustee or
administrator. Perhaps the most important
step throughout the process is properly
interfacing with the appropriate trustee or
administrator in a timely manner. In many
cases the trustee, legal counsel representing the
trustee—or both—will communicate important
milestones, deadlines and, in some cases,
settlement protocols.
More generally, with respect to trades involving
non-LBI counterparties, affected parties would be
well advised to reexamine their current forms of
trade documentation. Agreements should include
terms that are consistent with current market
practice, the law and the global arrangements
relating to trade execution and settlement. While
the extraordinary efforts to resolve LBI trade fails
seem likely to yield favorable solutions, many of
these issues may arise in other situations today and
in the future.
______________________________
“Veil Piercing” for MERS Shareholders
Rejected
Delaware Court Rejects “Veil
Piercing” Claims Against MERS
Shareholders: Dismisses
Shareholders From Lawsuit
Irene C. Freidel and Gregory N. Blase
A federal court in Delaware recently held that
shareholders of Mortgage Electronic Registration
Systems, Inc. (“MERS”) – some of the country’s
largest mortgage lenders – could not be held liable
for the alleged activities of MERS. Trevino et al. v.
Merscorp., Inc., et al., No. 1:07-cv-00568-JJF (D.
Del.). MERS was created in 1996 by the real estate
finance industry to eliminate the need to prepare and
record assignments when trading residential and
commercial mortgage loans. MERS’s chief
business purpose is to simplify and streamline the
manner in which mortgage ownership and servicing
rights are originated, sold and tracked. Recently, in
light of its visibility in connection with mortgage
defaults and foreclosures, MERS and its
shareholders have come under attack by plaintiffs’
class action lawyers. The court’s decision resulted
in the dismissal from the putative class action of
MERS shareholders Citigroup, Inc., Countrywide
Financial Corp., Fannie Mae, Freddie Mac, GMACRFC Holding Company, LLC, HSBC Finance
Corporation, JPMorgan Chase & Co., Washington
Mutual Bank, and Wells Fargo & Company (the
“shareholder defendants”).
In their complaint, plaintiffs alleged that MERS
overcharged them and a class of similarly situated
individuals for costs arising out of proceedings to
enforce mortgage instruments, including
foreclosures. Plaintiffs asserted that MERS’s
alleged actions constituted breach of contract, unjust
enrichment, and breach of the duty of good faith and
fair dealing.
Plaintiffs sought to hold the shareholder defendants
liable for the alleged actions of MERS through the
theory of “piercing the corporate veil.”
Specifically, plaintiffs contended that because of its
alleged “diminutive size and meager asset base,”
MERS is undercapitalized and would be unable to
pay on any judgment that plaintiffs and the putative
class may eventually obtain. Plaintiffs contended
November 17, 2008
14
Global Financial Markets
that these facts stated the basis for their request to
pierce MERS’s corporate veil and to hold the
shareholder defendants liable for MERS’s alleged
wrongdoing.
The shareholder defendants moved to dismiss the
complaint arguing, among other things, that there
was no allegation that MERS was set up for the
purpose of committing fraud or some other injustice
to borrowers, that MERS was established for a
legitimate business purpose, and that its shareholders
– all competitors in the marketplace – could not be
considered a “single functioning entity” for veilpiercing purposes. The court agreed, finding in
part, that plaintiffs had failed to allege an overall
element of injustice. The court noted that the
plaintiffs’ only substantive factual allegation in
support of their claim against the shareholders was
that MERS was undercapitalized. But the court held
that a shortage of capital is not a per se reason to
pierce the veil. This is particularly the case where
there is no allegation that the alleged
undercapitalization was undertaken to defraud a
corporation’s creditors. The court noted plaintiffs’
acknowledgment that MERS was established for a
legitimate business reason, i.e., to “create a
secondary mortgage market, internally administer
the buying and selling of mortgages, and to simplify
the administration of home mortgages.”
Insurance Coverage for Claims Arising
from the Credit Crisis
Finally, the court found that plaintiffs had failed to
allege any unfairness sufficient to ignore MERS’s
corporate form. Specifically, while plaintiffs alleged
that MERS was created to facilitate its shareholders’
business interests and to limit their liability, neither
of these factors shows unfairness, unless the attempt
to limit liability was undertaken in order to avoid
responsibility for a specific tort or class of torts.The
Trevino decision is significant because it spared
MERS’s shareholders from potential exposure to
consumer class actions on the now rejected theory of
indirect liability. MERS is integral to the successful
functioning of the secondary mortgage market.
Plaintiffs’ discredited legal theory, if not rejected by
the court, could have exposed MERS shareholders to
liability for the actions of third party investors and
servicers, causing further stress to the already
embattled mortgage market.
______________________________
Given this expanding crisis, many corporations (as
well as their officers and directors) will be forced to
incur substantial sums to defend such claims, to
settle such claims, and/or to pay judgments. In
many cases, insured companies and their officers
and directors should be entitled to coverage for such
costs under their Directors’ and Officers’ (“D&O”)
liability policies. While this article focuses on
D&O coverage, policyholders also should consider
the potential for coverage under other policies, such
as Errors and Omissions liability policies and
Fiduciary liability policies.
Insurance Coverage for Claims
Arising from the Credit Crisis:
Policyholders Should Take Steps
to Preserve Their Rights to
Coverage for Lawsuits and
Investigations
Gregory S. Wright
I. Introduction
In 2007, the subprime mortgage crisis triggered a
wave of litigation and regulatory action involving
not only the lenders that sold subprime mortgages,
but also the issuers, underwriters, and other
financial institutions that participated in the
securitization of the mortgages and the sale of
securities backed by the subprime loans. The credit
crisis of the last few months has exacerbated (and
likely will continue to exacerbate) this wave of
litigation and regulatory action, not only by
increasing the number of claims, but also by
expanding the universe of targets to include
companies and individuals that were not directly
involved in the sale or securitization of subprime
loans.
It should be noted that the terms of D&O policies
vary widely. In addition, one should assume that
insurers will assert all available defenses to such
claims based on the specific policy language and
facts at issue. Given the potential for coverage,
policyholders facing claims and investigations
should carefully review their D&O policies and
should take appropriate steps in order to maximize
their potential insurance recoveries.
November 17, 2008
15
Global Financial Markets
II. Credit Crisis Litigation and Investigations
The subprime mortgage crisis, and the ensuing credit
crisis, has produced a wide array of claims, lawsuits,
and government investigations. Companies and
individuals in a rapidly expanding list of industries
have been impacted. Many of the claims at issue
target individuals who are commonly insured under
D&O policies (e.g., individual directors and
officers), as well as the target entity itself, and allege
conduct that often potentially triggers coverage
under D&O policies, such as alleged misstatements
in public filings, negligent misrepresentations,
and/or breaches of fiduciary duties. Merely to
illustrate, this wave of litigation and investigations
includes the following types of current claims, all of
which potentially may trigger coverage under D&O
policies:
•
Lawsuits by shareholders against lenders and
certain directors and officers alleging (in part)
that defendants made false and misleading
statements to the public about subprime lending
activities.
•
Lawsuits by shareholders against investment
banks and certain directors and officers alleging
misstatements about the value of and risks
associated with subprime-backed assets.
•
Lawsuits by investors against financial
institutions and certain directors and officers
alleging that the defendants that sold them
mortgage-backed securities misrepresented the
risks associated with such securities.
•
Class action lawsuits against failed banks,
related holding companies, and related officers
and directors, alleging that the defendants
misled investors about the financial status of the
bank, violated securities laws, committed fraud,
made negligent misrepresentations, etc.
•
Class action lawsuit on behalf of preferred
shareholders of Fannie Mae and Lehman
Brothers alleging false statements by named
officers and directors in connection with the
offerings.
•
Class action lawsuits against companies not
directly involved in the subprime area (such as
Constellation Energy), as well as their directors
and officers, alleging failure to make
appropriate disclosures about exposures arising
from credit problems of trading partners (e.g.,
Lehman Brothers).
•
Class action lawsuits and regulatory
investigations against companies concerning
auction rate securities. The lawsuits allege in
general that the companies failed to make
appropriate disclosures about the risks
associated with auction rate securities. Some
(but not all) of the lawsuits name individual
directors and officers. While most of the
lawsuits have been filed on behalf of the
purchasers of the auction rate securities, at least
one lawsuit was filed on behalf of shareholders
of the entity (Merrill Lynch) that sold the
auction rate securities to other investors. See
also M. King, SEC and FINRA Focusing on
Individuals in Auction Rate Securities
Investigation, available at
http://www.klgates.com/newsstand/Detail.aspx?
publication=4966.
•
SEC investigations into possible market
manipulation in connection with short selling in
the securities of financial institutions. See B.
Ochs, Manipulation Tied to Short Selling a Top
Enforcement Priority, available at
http://www.klgates.com/newsstand/Detail.aspx?
publication=4966.
•
FBI and DOJ criminal investigations regarding
accounting, disclosure, and corporate
governance matters. See M. Ricciuti, DOJ
Opens Criminal Investigations under New
Guidelines for Prosecuting Corporate
Entities, available at
http://www.klgates.com/newsstand/Detail.aspx?
publication=4966.
III. Potential Coverage under D&O Policies
In general, D&O policies afford coverage for
“Claims” against an “Insured” alleging “Wrongful
Acts” that result in a covered “Loss.” The
availability of coverage turns on the definitions of
such terms (which vary widely), other policy terms
and conditions, and the nature of the specific
allegations in the claim at issue.
Claim. D&O policies generally afford coverage
for “claims.” All (or virtually all) D&O policies
include “lawsuits” within the definition of “claim,”
but coverage for regulatory or criminal
November 17, 2008
16
Global Financial Markets
investigations varies widely. For example, certain
D&O policies define “claim” to include SEC
investigations commenced by the service of a
subpoena on an insured person or criminal
proceedings commenced by the return of an
indictment, information, or similar document. Other
D&O policies cover a broader array of informal
investigations, while other policies limit coverage to
investigations commenced by a “formal order” of
investigation. In any event, given the broad array of
policy language available in the market, insureds
should not wait for lawsuits to be filed before
analyzing the potential for coverage.
Entity Coverage. In addition to covering claims
against insured directors and officers, many D&O
policies afford coverage for claims against the
insured entity itself (for example, many D&O
policies cover so-called “Securities Claims” filed
against the insured entity, including class action
securities lawsuits). The inclusion of “entity
coverage” in D&O policies often helps insurers and
policyholders avoid disputes on how to allocate
defense costs and/or settlement payments among
covered individuals and the entity itself.
Loss. The definition of “loss” in D&O policies
varies widely. For example, some policies expressly
cover fines, penalties, multiplied damages, and
punitive damages, when permitted by law. Some
D&O policies do not. In addition, insurers and
policyholders frequently litigate (and courts recently
have reached conflicting opinions on) the
availability of coverage for so-called
“disgorgement,” “restitution,” and/or for losses paid
pursuant to Section 11 of the Securities Act of 1933.
See, e.g., Bank of America Corp. v. SR International
Business Ins. Co., 2007 WL 4480057 (N.C. Super.
2007) (holding that settlement of Section 11 claim
may be covered under D&O policy).
Conduct Exclusions. Insurers also may seek to
rely on various exclusions in the relevant policy to
deny coverage for subprime-related claims. For
example, insurers may seek to rely on so-called
conduct exclusions, which bar coverage for certain
claims relating to criminal or fraudulent activity or
for claims alleging that the insured received a profit
to which he or she was not legally entitled. Again, it
should be noted that the terms of these exclusions
vary widely. Some exclusions arguably bar
coverage when the excluded conduct is merely
alleged. However, in most policies, the exclusions
do not apply unless the insurer meets its burden of
proving that the excluded conduct “in fact” occurred
or unless the excluded conduct is established via a
“final adjudication.” When the policy at issue
includes the “in fact” test or “final adjudication”
test, insureds are often entitled to coverage for
defense costs and/or settlements that are made
without any finding or admission with respect to the
excluded conduct. In addition, many D&O policies
contain severability provisions that prevent the
insurer from imputing the knowledge or conduct of
one insured to other insureds, which in effect
preserves coverage for the “innocent insureds”
and/or the company itself.
Defense Issues. In many D&O policies, the insurer
is not obligated to defend a claim, but rather is
required to reimburse the policyholder’s defense
costs. Nevertheless, certain D&O policies state that
the policyholder should not incur defense costs or
settle a claim without the consent of the insurer. In
addition, certain D&O policies require the
policyholder to obtain the insurer’s consent with
respect to the selection of defense counsel (such
consent not to be unreasonably withheld). To avoid
potential insurer defenses, policyholders may wish
to consider taking steps to address any conditions in
the policy related to defense and/or cooperation
with the insurer.
Rescission Issues. In response to claims alleging
misleading statements in a public filing, insurers
often attempt to rescind the policy at issue entirely
to the extent the public filing at issue was attached
to or incorporated by reference into the insured’s
“application” for coverage. State law on this
defense varies widely, but most courts impose a
high burden of proof on insurers to demonstrate
(among other things) that the alleged
misrepresentation was material and that the insurer
in fact relied on the alleged misrepresentation when
it decided to issue the policy. In addition, many
current D&O policies make coverage nonrescindable for certain types of claims or certain
insureds. Further, many D&O policies contain strict
severability clauses that limit the insurer’s right to
rescind to only those individuals that had specific
knowledge of the misstated facts.
November 17, 2008
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Global Financial Markets
Renewal Issues. As noted above, the terms of
D&O policies vary widely. Further, insureds and
insurers frequently negotiate certain terms of
coverage during the renewal process. With proper
planning, insureds potentially may obtain coverageenhancing changes to standard policy forms that
may be outcome-determinative when a claim is
filed. Insureds frequently retain outside coverage
counsel to review their D&O policies and participate
in this renewal process.
IV. Conclusion
D&O policies offer a potentially valuable resource
for policyholders facing claims arising from the
subprime crisis and related credit crisis.
Policyholders should take steps now to preserve
their rights to coverage.
______________________________
NASAA Initiatives on Principal Protected
Notes
State Securities Regulators - On
the Warpath Against Principal
Protected Notes?
David N. Jonson
Recent pronouncements from the North American
Securities Administrators Association ("NASAA")
indicate that its members (state and Canadian
provincial securities regulators) are fielding so many
investor inquiries and complaints regarding Principal
Protected Notes ("PPNs") that NASAA is
considering the formation of a multistate
investigative task force to investigate how PPNs
were offered and sold. Such a task force would
likely be similar to the one that NASAA created
earlier this year to investigate auction rate securities.
A PPN is a type of structured investment product
designed to provide a return of principal investment
at maturity (typically 3-8 years), plus the potential to
earn additional returns that are tied to the
performance of an equity or commodity index.
Accordingly, PPNs tend to attract investors who are
risk-averse and long-term oriented, and who seek a
guaranteed return of their principal investment.
In order to preserve principal and offer a degree of
upside potential, PPNs are comprised of two
components. A portion of the principal is used to
purchase a zero coupon bond with a face value
equal to the full principal amount at maturity,
assuring that the original amount invested will be
returned, so long as the bond's issuer does not
default during the life of the PPN. The remainder of
the principal amount is invested in options on an
underlying index with the same expiration date as
the PPNs maturity date. The two primary risks of
investing in PPNs are the credit risk of the issuer
and the lack of liquidity, since PPNs are designed to
be held until maturity. The total size of the PPN
market is estimated to be approximately $35 billion.
In the wake of the insolvency of some PPN issuers,
state regulators have been contacted with allegations
that the risks of these investments were
misrepresented or that PPNs were sold to investors
for whom they were unsuitable. Given the volatility
of today's financial markets and the speed with
which bad news travels, investors in PPNs of
solvent issuers have also expressed concerns about
the safety of their investments.
Several key dynamics will influence whether
NASAA's Board of Directors and Enforcement
Section decide to create a PPN task force. First,
state securities regulators view themselves as the
"local cops on the beat," and thus, the first line of
defense in protecting investors. If the number of
investor complaints is significant enough, NASAA
and its members will act quickly, as they did most
recently in connection with NASAA’s auction rate
securities task force, which took the leading
regulatory role away from the SEC and FINRA.
Second, if one of the more active state securities
regulators, such as the New York Attorney General
or Massachusetts Secretary of State, takes early
action, NASAA will be sure to organize a more
widespread group of states to join the fray. Third,
although there is now a pro-regulation environment
in Washington, NASAA and its members have
historically been mindful of and concerned about
any efforts to pre-empt the states from asserting
their regulatory authority. By acting quickly and
decisively on the heels of their successful auction
rate task force, NASAA members would be taking
advantage of another opportunity to reemphasize the
importance of the states' role in the securities
regulatory arena. We are continuing to monitor the
situation through our NASAA contacts, and will
report any material developments in the future.
November 17, 2008
18
Global Financial Markets
______________________________
No U.S. Court Jurisdiction for “ForeignCubed” Class Action
Second Circuit Dismisses Its
First “Foreign-Cubed” Securities
Action for Lack of Jurisdiction
Michael J. King
Proclaiming that “we are an American court, not the
world’s court,” the U.S Court of Appeals for the
Second Circuit recently rejected an effort to extend
U.S. jurisdiction over foreign securities transactions.
The decision in Morrison v. National Australia Bank
Ltd., – F.3d –, 2008 WL 4660742 (2d Cir. Oct. 23,
2008), arose in a so-called “foreign-cubed”
securities class action case: an action brought by
foreign investors, in foreign securities, purchased on
a foreign securities exchange. Morrison, the first
such case considered by the Second Circuit, offers a
measure of reassurance to foreign issuers and
investors who might otherwise avoid even tangential
connections with U.S. capital markets due to fear of
the U.S. legal system.
Australian investors sought to bring a class action
suit in the U.S. District Court for the Southern
District of New York against National Australia
Bank (“NAB”) and others, alleging securities fraud
under U.S. law in connection with purchases of
NAB securities on an Australian securities
exchange. According to the plaintiffs, NAB’s
subsidiary, HomeSide Lending, Inc. (“HomeSide”),
a U.S. mortgage service provider, used improper
accounting methods that overstated the value of its
mortgage servicing rights (“MSR”). These improper
accounting methods led NAB to write down $2
billion in the value of HomeSide’s MSR in 2001,
resulting in significant declines in the price of
NAB’s securities. Plaintiffs alleged that the
defendants made false and misleading statements
concerning HomeSide’s operations and its
contributions to NAB’s financial health in filings
with the SEC, foreign securities exchanges, in
statements to the press, and in corporate documents.
Since it was confronted with allegations of securities
fraud involving foreign securities transactions, the
district court looked to the “effects” and the
“conduct” tests developed by the Second Circuit for
deciding whether to exercise jurisdiction over such
suits. Morrison v. National Australia Bank Ltd., -F. Supp. 2d--, 2006 WL 3844465 (S.D.N.Y. 2006).
Under the effects test, a district court may exercise
jurisdiction over foreign plaintiffs where the alleged
illegal activity causes a “substantial effect” on U.S.
investors or markets. Under the conduct test, a
district court may exercise jurisdiction if a
defendant’s conduct in the United States was more
than “merely preparatory” to the fraud, and
particular acts or culpable failures to act within the
United States “directly caused” losses to foreign
investors abroad.
The district court quickly concluded that the effects
test did not support exercise of subject matter
jurisdiction since the alleged fraud had very little, if
any, effect in the U.S. markets. Moving to the
conduct test analysis, the district court concluded
that HomeSide’s alleged misconduct in the United
States was immaterial to a securities fraud claim
given the much more significant extra territorial
conduct of NAB. Thus, the district court found that
the foreign actions, not the domestic actions,
“directly caused” the alleged harm in this case and
dismissed the complaint.
On appeal, the appellants relied solely on the
“conduct” component of the conduct and effects
tests in support of their jurisdictional argument.
Reviewing prior precedent, the Second Circuit
reaffirmed that pursuant to “the ‘conduct’
component, subject matter jurisdiction exists if
activities in this country were more than merely
preparatory to a fraud and culpable acts or
omissions occurring here directly caused losses to
investors abroad . . .. Our determination of whether
American activities ‘directly’ caused losses to
foreigners depends on what and how much was
done in the United States and on what and how
much was done abroad.” Morrison, 2008 WL
4660742, at *4. The Second Circuit then reviewed
the comparative significance of the conduct in the
United States with those actions that occurred
abroad and concluded that actions of NAB in
Australia were significantly more central to the
alleged fraud and more directly responsible for the
harm to investors than the alleged manipulative
accounting by HomeSide in the United States. In
reaching its decision, the Second Circuit stressed
that the responsibilities of NAB’s Australian
November 17, 2008
19
Global Financial Markets
headquarters included overseeing its own and its
subsidiaries’ operations, and reporting to
shareholders and to the financial community. The
court also emphasized that NAB, not HomeSide,
was the issuer of the securities and therefore was
responsible for the public statements and filings and
for relations with its investors. The Second Circuit
also noted the absence of any allegation of harm to
U.S. investors or markets and the lengthy chain of
causation between HomeSide’s contribution to the
misstatements and harm to investors. Based upon the
totality of this analysis, the court concluded that it
lacked subject matter jurisdiction and affirmed the
dismissal. Id. at *7 & 8.
In addition to addressing for the first time the issues
presented in a foreign-cubed class action case, the
Second Circuit’s decision is significant because the
court refused to replace the conduct test analysis
with proposed alternative formulations for
determining subject matter jurisdiction. Appellees
and certain of the amici urged the court to adopt a
bright-line rule that, in foreign-cubed cases,
domestic conduct should never be enough and
subject matter jurisdiction cannot be established
where the conduct in question has no effect in the
United States or on U.S. investors. The court flatly
rejected this proposal. The court also rejected the
SEC’s proposed alternative standard proffered in its
amicus brief that the “antifraud provisions of the
securities laws [should] apply to transnational frauds
that result exclusively or principally in overseas
losses if the conduct in the United States is material
to the fraud’s success and forms a substantial
component of the fraudulent scheme.” The court’s
implicit rejection of the SEC’s materiality test – the
decision does not even address it – is particularly
important because the materiality standard would
likely permit more cases alleging transnational
frauds to stay in U.S. courts. For example, the SEC
amicus brief urged that, under the materiality test,
jurisdiction existed in Morrison.
The decision provides needed stability in an area of
the law that is important to non-U.S. companies
considering investing in the United States who are
concerned about the risks and burdens of U.S. class
action lawsuits, existing foreign investors in the
United States with similar concerns, and the
financial markets and intermediaries that service
such investors and potential investors. At a time
when the U.S. plaintiff’s bar is taking deliberate
steps to cultivate foreign claimants for U.S. class
action suits, these protections are welcome.
Although the conduct and effects tests are very fact
specific, the Second Circuit’s decision to adhere to
these tests when considering subject matter
jurisdiction in transnational fraud cases provides a
reliable framework for disposing of cases at a
preliminary stage. This is particularly important to
firms concerned about exposure to class actions,
where attendant disruptions and defense costs alone
can prove very burdensome, even where defendants
have fully complied with the law.
______________________________
State and Local Measures to Prevent
Foreclosures
Make My Day: States Dare
Servicers to Foreclose
Nanci L. Weissgold
Approximately 7.3 million American homeowners
are expected to default on their mortgages between
2008 and 2010, and 4.3 million of those are
expected to lose their homes. Taking the response to
the ongoing foreclosure crisis into their own hands,
in recent months a number of states and local
governments have enacted measures to protect their
home-owning constituents. These measures impose
notice and other practice requirements on mortgage
loan servicers, create new rights for homeowners,
and encourage the parties to communicate and to
attempt to work out alternatives to foreclosure.
Through such measures, states are doing what they
can to stop foreclosures in their tracks or make it so
burdensome to foreclose that generous loan
modifications look better and better.
Although their impact cannot yet be measured, what
is clear is that the numerous measures that state and
local governments have enacted are impacting the
way that mortgage lenders and loan servicers
conduct their business. These measures require
lenders and servicers not only to keep up to date on
legislative changes, but also (in many cases) to
adjust their business practices to comply with new
statutory requirements. At a minimum, many of
these measures effectively extend the time frame for
bringing a foreclosure action; they may also add
procedural requirements to the process. The article
November 17, 2008
20
Global Financial Markets
“Make My Day: States Dare Servicers to Foreclose,”
available at
http://www.klgates.com/newsstand/Detail.aspx?publ
ication=5040, uses examples of each type of new
measure to explore that impact.
______________________________
Federal Loan Guarantees
EESA: No Guarantees of Federal
Loan Guarantees
Laurence E. Platt
Press reports claim that the Federal Deposit
Insurance Corporation and the U.S. Department of
Treasury (“Treasury”) are close to announcing a
plan pursuant to which the federal government will
guarantee the timely repayment of principal and
interest on modified eligible residential mortgage
loans held by private parties pursuant to the
Emergency Economic Stabilization Act of 2008
(“EESA”). Such a plan might conflict with legal
and accounting rules for mortgage-backed securities,
raises questions about its relationship to other recent
federal initiatives, requires Treasury to develop an
actuarially sound, self-funded mortgage insurance
program, and calls for loan holders to make principal
write-downs they might not be willing to make.
Because of these issues, we are not convinced that
the proposal will morph into a real program. As
events unfold, we want to take the opportunity to
highlight certain issues for which you should watch
if a home loan guarantee program actually is
promulgated by Treasury. These issues are
addressed in the article, “EESA: No Guarantees of
Federal Loan Guarantees,” available at
http://www.klgates.com/newsstand/Detail.aspx?publ
ication=5039. They include the following:
1. What residential mortgage loans will be eligible
for loan guarantees?
2. What is the difference between an FHA-insured,
refinancing mortgage loan under the HOPE for
Homeowners Program (“HOPE Program”),
which Congress created earlier this year as part
of the Housing and Economic Recovery Act of
2008, and a Treasury-guaranteed modified loan?
3. Will loan holders permanently write down the
existing indebtedness by the amount necessary
to qualify for a loan guarantee?
4. Given the write-downs that it will take to
qualify an existing loan for a HOPE Program
refinancing or a federal loan guarantee, why not
just sell the loans to Treasury under the recently
enacted Troubled Asset Relief Program
(“TARP”)?
5. Does a federal loan guarantee provide a
comparative advantage to loan holders over the
HOPE Program or TARP?
6. How will Treasury ensure that the insurance
premiums are sufficient to meet the statutory
standard of actuarial soundness?
______________________________
Discounts for Settlement Costs Upheld
Under RESPA
Eleventh Circuit Rejects
Challenge to Optional Discounts
under RESPA
Phillip L. Schulman, R. Bruce Allensworth,
Andrew C. Glass and David D. Christensen
Through a spate of lawsuits, the plaintiffs’ class
action bar has sought to articulate a novel theory of
liability under the Real Estate Settlement
Procedures Act (“RESPA”), 12 U.S.C. § 2601, et
seq. Specifically, the plaintiffs’ bar has brought
RESPA Section 8 claims against home builders and
their affiliates who offer optional discounts on
settlement costs if home buyers choose to use the
affiliates’ services. In conflict with RESPA’s goal
of lowering settlement costs, plaintiffs’ lawsuits
challenge the ability of home builders, as well as of
affiliated mortgage lenders, title insurance
companies, and other settlement service providers,
to offer meaningful discounts to consumers.
Becoming the first federal appellate court to
consider the issue, the U.S. Court of Appeals for the
Eleventh Circuit recently rejected plaintiffs’ theory.
See Spicer v. The Ryland Group, Inc., Appeal No.
07-15426, 2008 WL 4276909 (11th Cir. Sept. 16,
2008) (per curiam), aff’g 523 F. Supp. 2d 1356
(N.D. Ga. 2007).
Plaintiff Tanya Spicer sued The Ryland Group, Inc.
(“Ryland”) and its affiliate Ryland Mortgage
Company (“Ryland Mortgage”), alleging that
defendants violated RESPA Section 8 through
offering an optional settlement costs discount if
November 17, 2008
21
Global Financial Markets
Spicer chose to use Ryland Mortgage to finance the
purchase of her home from Ryland. 523 F. Supp. 2d
at 1358-59. Spicer attempted to articulate a theory of
“economic coercion” in support of her claim. In
particular, Spicer argued that because the amount of
the discount allegedly was too great to pass up, she
had “no viable economic option but to use the
affiliated lender.” Id. at 1361.
RESPA Section 8 prohibits kickbacks in exchange
for the referral of, and unearned fees received in
connection with, real estate settlement services. The
statute, however, provides a qualified exemption
from Section 8 liability to affiliated business
arrangements. Specifically, 12 U.S.C. § 2607(c)(4)
provides that the referral of settlement services to an
affiliated service provider is permitted if: (a) the
existence of the affiliated business arrangement is
disclosed to the person referred; (b) the person
referred is not required to use any particular
settlement service provider; and (c) the only thing of
value that is received from the arrangement is the
return on the ownership interest. Regulation X,
promulgated by the Department of Housing and
Urban Development to implement RESPA, permits
affiliated service providers to offer “discounts or
rebates to consumers for the purchase of multiple
settlement services.” 24 C.F.R. § 3500.2. Such
discounts do not constitute an impermissible
“required use” if the discounts are “optional to the
purchaser” and are “true discount[s] below the prices
that are otherwise generally available, and must not
be made up by higher costs elsewhere in the
settlement process.”
consensus among federal courts that offering
optional discounts on settlement costs if home
buyers choose to use affiliates’ services does not
violate RESPA. Changes to Regulation X’s
definition of “required use” effective in January
2009, however, may alter the landscape for home
builders and their affiliates.
Phillip L. Schulman, R. Bruce Allensworth, Andrew
C. Glass, and David D. Christensen of K&L Gates
LLP represented The Ryland Group, Inc. and
Ryland Mortgage Company.
______________________________
Patents for Business Methods and
Software
In Re Bilski and Patents for
Business Methods and Software
Stephen C. Glazier
Following the plain language of RESPA and
Regulation X, the Spicer district court held that
offering optional discounts on settlement costs if
home buyers choose to use affiliates’ services does
not violate RESPA or Regulation X. 523 F. Supp. 2d
at 1362. The court specifically rejected Spicer’s
claim that offering an optional settlement costs
discount amounted to “economic coercion.” After
briefing and oral argument, the Eleventh Circuit
affirmed, adopting the district court opinion as
“well-reasoned.” Spicer, 2008 WL 4276909, at *1.
On October 30, 2008, in an en banc decision,
the U.S. Court of Appeals for the Federal Circuit
handed down the In re Bilski decision. This was a
much-awaited decision that addressed the question
of what subject matter may be considered for
patentability in software, financial services,
business methods and telecom services. After citing
the Supreme Court precedent in Gottschalk v.
Benson, 409 U.S. 63 (1972), Parker v. Flook, 437
U.S. 584 (1978), and Diamond v. Diehr, 450 U.S.
175 (1981), the Federal Circuit, in stating the
“definitive test” provided by the Supreme Court for
determining whether a “process” may be considered
for patentability under Section 101 of the Patent
Statute, said that process is “surely patent-eligible
if: 1) it is tied to a particular machine or apparatus,
or 2) it transforms a particular article into a different
state or thing.” This test is referred to as the
“machine or transformation” test. (Patent eligibility
under Section 101 is only the first hurdle to issuing
a valid and enforceable patent. If a patent
application claims patent eligible subject matter
under Section 101, then the patent must still be
novel under Section 102, and non-obvious under
Section 103.)
The federal district court decisions to date have
rejected the “economic coercion” theory of required
use, and the Eleventh Circuit’s affirmation of the
dismissal of the Spicer matter reinforces the
The Bilski decision rejects other tests previously
adopted by the Federal Circuit for potentially
patentable subject matter under Section 101,
specifically rejecting the test in State Street Bank &
November 17, 2008
22
Global Financial Markets
Trust Company v. Signature Financial Group, 149
F.3d 1368 (Fed. Cir. 1998), and AT&T Corp. v.
Excel Communications, Inc., 172 F.3d 1352 (Fed.
Cir. 1998), which states that the potentially
patentable methods of software or business methods
must “produce a useful concrete and tangible result.”
After stating the machine or transformation test, the
court goes on to state that “certain considerations are
applicable to analysis under either branch [of this
test]. First, as illustrated in Benson, the use of a
specific machine or transformation of an article must
impose meaningful limits on the claim scope to
impart patent-eligibility. Second, the involvement
of the machine or transformation in the claim
process must not merely be insignificant extrasolution activity.”
The court goes on to say that it may in the future
further refine the machine or transformation test. In
particular, it may further carve out special rules for
patent eligibility where the machine in question is a
“computer”; however, the court specifically leaves
this further development of case law for possible
future action. Specifically, the court says “issues
specific to the machine implementation part of the
test are not to be decided today. We leave to future
cases the elaboration of the precise contours of
machine implementation as well as the answers to
particular questions such as whether and when
recitation of a computer suffices to tie a process
claim to a particular machine.” Further, the court
says “we agree that future developments in the
technology and the sciences may present difficult
challenges to the machine or transformation test,
such as the widespread use of computers and the
advent of the Internet has become the challenge in
the past decade.” The court further states “and we
certainly do not rule out the possibility that this court
may in the future refine or augment the test or how it
is applied. At present, however, and certainly for
the present case, we see no need for such a departure
and reaffirm that the machine or the transformation
test is properly applied as the governing test for
determining patent eligibility of a process under
Section 101.” The term “machine” is commonly
used in the practice and includes computers and
programmed apparatus.
machine or physical transformation of matters;
however, the no-technology, purely “mental step
only” invention has never been a large percentage of
the U.S. patent portfolio. And, apparently, all
software embodied inventions may be drafted to be
tied to a machine.
For existing patents and patent applications, Bilski
might suggest an opportunity to audit current
portfolios of interest for possible modification of
pending claims in patent applications, and to audit
issued patents to modify issued claims in issued
patents, where reissues are possible to more
precisely comply with the Bilski test.
Further, case law should be monitored for possible
further refinements in the application of the Bilski
test. Specific issues, such as possible modification
of the machine requirement where the machine is a
computer, should be watched for.
As for planning business patent strategies, we can
expect, until any further case law development in
this area, continued growth in the population of
software and computerized business method patent
applications and issued patents, and in related
enforcement and transactions. However, as is
always the case in the development of case law, we
must keep alert for the next shoe to drop.
______________________________
The new Bilski test will be a problem for that small
percentage of business method patents and patent
applications that cannot be drafted to include any
November 17, 2008
23
Global Financial Markets
K&L Gates Events
Global Crisis, Change,
Perspective: A Look at Today's
International Real Estate Finance
and Investment Markets
December 2, 2008
Local time in all locations
New York, Boston, Charlotte and Raleigh
http://www.klgates.com/events/Detail.aspx?event=1832
12:00 p.m. Lunch begins
12:30 p.m. - 2:00 p.m. Panel discussion and Q&A
London
http://www.klgates.com/events/Detail.aspx?event=1826
5:00 p.m. Registration
5:30 p.m. - 6:30 p.m. Panel discussion and Q&A
6:30 p.m. Cocktail reception
K&L Gates comprises approximately 1,700 lawyers in 28 offices located in North America, Europe and Asia, and represents capital markets
participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector
entities. For more information, please visit www.klgates.com.
K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and
maintaining offices throughout the U.S., in Berlin, in Beijing (K&L Gates LLP Beijing Representative Office), and in Shanghai (K&L Gates LLP
Shanghai Representative Office); a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining our London
and Paris offices; a Taiwan general partnership (K&L Gates) which practices from our Taipei office; and a Hong Kong general partnership (K&L
Gates, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices
are located. A list of the partners in each entity is available for inspection at any K&L Gates office.
This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon
in regard to any particular facts or circumstances without first consulting a lawyer.
©2008 K&L Gates LLP. All Rights Reserved.
November 17, 2008
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