October 24, 2008
Volume 1 - Issue 2
TARP Capital Purchase Program
Editors:
As Treasury Implements EESA, Congress Prepares
for Significant Reform Legislation
Michael J. Missal
Daniel F. C. Crowley
michael.missal@klgates.com
+1.202.778.9302
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:
• TARP Capital Purchase Program
• Lehman CDS Auction Settlement
• FDIC Insurance Coverage
• Fair Value Accounting
• Credit Default Swaps — Criminal
Investigations
• SEC: Inspector General
• SEC: Attorney-Client Privilege
• FSA: New Chairman Lord Adair
Turner
The TARP Capital Purchase Program (CPP)
On October 3, 2008, the U.S. House of Representatives passed and President Bush
signed into law 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.
On October 14, 2008, Treasury announced the creation of the TARP Capital
Purchase Program (CPP), and issued an interim final rule on CPP executive
compensation and corporate governance standards. Treasury also issued executive
compensation notices with respect to two additional EESA programs that are
currently being developed by Treasury, the Troubled Asset Auction Program
(TAAP) and Programs for Systemically Significant Failing Institutions (PSSFI).
Through CPP, Treasury will provide $250 billion in equity capital under
standardized terms directly to certain U.S. financial institutions in the form of
preferred stock. The minimum subscription amount available to a participating
institution is 1 percent of risk-weighted assets. The maximum subscription amount
is the lesser of $25 billion or 3 percent of risk-weighted assets. Although the original
Treasury proposal did not contemplate this use of the TARP, the addition of the
phrase “any other financial instrument” by Congress provided Treasury with the
flexibility to inject equity capital directly into banks. Members of Congress largely
indicated their support for the CPP, as did the American Bankers Association.
• White Collar: Internal
Investigations
On October 20, Treasury issued application guidelines for the CPP which indicate
that all applications must be submitted to the appropriate Federal banking agency
(FBA) no later than 5 pm (EST), November 14, 2008.
• Investor Claims Against
Sovereign Governments
•
Application Guidelines for Capital Purchase Program
http://www.treas.gov/press/releases/reports/applicationguidelines.pdf
•
FAQs for Capital Purchase Program
http://www.treas.gov/press/releases/reports/faqcpp.pdf
• Breach of Contract
• CFTC
• Energy Businesses and Futures
Traders
• Loan Modifications
• Other Resources
• K&L Gates Events
To be eligible for the CPP, the applicant must ultimately receive Treasury approval.
According to Secretary Paulson, Treasury “will give considerable weight to” the
primary regulator’s recommendation. More detailed information, including
submission instructions, can be found at the applicable FBA website: www.fdic.gov,
www.federalreserve.gov, www.occ.treas.gov, or www.ots.treas.gov as the case may
be.
Global Financial Markets
In addition, the applicant must agree to certain terms
and conditions and make certain representations and
warranties described in various agreements available
on Treasury’s website: www.treas.gov. A detailed
investment agreement and associated documentation
will be posted soon. Among the conditions to
participation in the CPP is the requirement that, for
so long as the Treasury owns shares or warrants in
the applicant, certain senior officers of the applicant
meet executive compensation standards, which are
are explained on the Treasury website at
http://www.treas.gov/initiatives/eesa/executivecomp
ensation.shtml. With respect to the CCP, the
following standards apply: (a) limits on
compensation that exclude incentives for senior
executive officers (SEOs) of financial institutions to
take unnecessary and excessive risks that threaten
the value of the financial institution; (b) required
recovery of any bonus or incentive compensation
paid to an SEO based on statements of earnings,
gains or other criteria that are later proven to be
materially inaccurate; (c) prohibition on the financial
institution from making any golden parachute
payment to any SEO; and (d) agreement not to
deduct for tax purposes executive compensation in
excess of $500,000 for an SEO. Treasury did not
give much guidance as to what constitutes an
appropriate limit on incentives to take excessive
risks.
These conditions make a CPP investment less
attractive to a financial institution, which would find
itself with diluted equity and bound by stricter rules
on compensation than its competitors. In addition,
it was feared that capitalization by the Treasury
could carry the potential stigma that the firm cannot
attract financing on its own, leading to a potential
run on the bank. For these reasons, among others,
the Treasury essentially compelled nine of the
largest U.S. banks to accept investments under the
CPP program. It is not clear yet how much this
move will address other banks’ concerns or how
many smaller banks will participate. Also unclear is
whether the banks receiving CPP investments will
use the funds merely to shore up their capital bases
or, as is clearly Treasury’s intention, to serve as the
capital base for additional lending. To encourage
other banks to apply, the guidelines provide that
confidentiality may be requested with respect to
certain information, and Secretary Paulson has
indicated that Treasury will not announce any
applications that are withdrawn or denied.
Upcoming Congressional Hearings
As indicated in the last issue, we anticipate that
Congress will consider far-reaching reforms of the
financial services industry. As Treasury
implements EESA, numerous Congressional
committees continue to conduct oversight hearings
in order to lay the foundation for what will likely be
the most significant revisions to the nation’s
financial services laws since the Great Depression.
Among the hearings that have already occurred or
are currently scheduled are:
Future of Financial Services Industry Oversight
and Regulation
House Financial Services Committee
Date: Tuesday, Oct. 21, 10 a.m.
Location: 2128 Rayburn Bldg.
http://www.house.gov/apps/list/hearing/financialsvc
s_dem/hr102108.shtml
The Impact of the Financial Crisis on Workers’
Retirement Security
House Education and Labor Committee
Date: Wednesday, Oct. 22, 9:30 a.m.
Location: 1 Dr. Carlton B Goodlett Place, Room
250, San Francisco, Calif.
Witnesses: Shlomo Benartzi - professor, Anderson
School of Management, University of California at
Los Angeles
Mark Davis - partner, Kravitz Davis Sansone,
Encino, Calif.
Jacob S. Hacker - professor, University of
California at Berkeley
http://edlabor.house.gov/committee/schedule.shtml
Turmoil in the Financial Markets
House Oversight and Government Reform
Committee
•
Topic: Credit Rating Agencies and the
Financial Crisis
Date: Wednesday, Oct. 22, 10 a.m.
Location: 2154 Rayburn Bldg.
Witnesses: Deven Sharma - president, Standard
and Poor's
Raymond W. McDaniel - chairman and CEO,
Moody's Corp
October 24, 2008
2
Global Financial Markets
Stephen Joynt - president and CEO, Fitch
Ratings
•
Topic: The Role of Federal Regulators
Date: Thursday, Oct. 23, 10 a.m.
Location: 2154 Rayburn Bldg.
Witnesses: Alan Greenspan - former chairman,
Board of Governors, Federal Reserve System
John Snow - former secretary of the Treasury
Christopher Cox - chairman, Securities and
Exchange Commission
•
Topic: The Regulation of Hedge Funds
Date: Thursday, Nov. 13, 10 a.m.
Location: 2154 Rayburn Bldg
Note: Date changed to Nov. 13 from Oct. 16.
Witnesses: John Alfred Paulson - president,
Paulson and Co. Inc., George Soros - chairman,
Soros Fund Management LLC, Philip A.
Falcone - senior managing director, Harbinger
Capital Partners, James Simons - director,
Renaissance Technologies LLC, Kenneth C.
Griffin - CEO and managing director, Citadel
Investment Group
http://oversight.house.gov/
Turmoil in the U.S. Credit Markets: Examining
Recent Regulatory Responses
Senate Banking, Housing and Urban Affairs
Committee
Date: Thursday, Oct. 23, 10 a.m.
Location: 538 Dirksen Bldg.
http://banking.senate.gov/public/index.cfm?Fuseacti
on=Hearings.Detail&HearingID=3df09367-cf45438a-9c0f-7ebfec169719
The Public Policy & Law group is closely
monitoring these developments in order to provide
insights to and effective advocacy on behalf of firm
clients.
_____________________________
Lehman CDS Auction Settlement
Lehman CDS Auction
Settlement: Credit Markets Take
a Deep Breath
Anthony R.G. Nolan and Gordon F. Peery
When Lehman Brothers Holdings Inc. ("Lehman")
filed for bankruptcy protection under Chapter 11 of
the United States Bankruptcy Code on September
15, 2008, a credit event occurred on over $400
billion notional amount of credit default swaps
(“CDS”) referencing Lehman obligations. The
notional amount of CDS referencing Lehman was
high because two distinct categories of players had
bought protection on Lehman. The first category
consisted of traders who used CDS to speculate on
Lehman’s credit spreads and the likelihood of
becoming a debtor in a bankruptcy case. The second
category consisted of counterparties to financial
contracts with Lehman or its subsidiaries, which
entered into CDS as a hedge against the risk that
Lehman would not be able to perform on
obligations owing to them. Protection sellers in
CDS referencing Lehman Brothers were, generally,
insurers, including monoline insurance companies,
hedge funds and special purpose entities engaged in
structured financings.
As with settlement of other CDS where the notional
amount exceeded the amount of deliverable
obligations that could readily be delivered in
physical settlement, the International Swaps and
Derivatives Association, Inc. (“ISDA”) established
an auction protocol (the “Protocol”) to offer market
participants an efficient way to address the
settlement issues relating to credit derivative
transactions referencing Lehman. The Protocol
offered institutions the ability to amend their
documentation for various credit derivatives
transactions in order to utilize an auction that took
place on October 10, 2008 to determine the final
price for certain CDS and other credit derivatives
referencing Lehman. Derivatives coming within the
Protocol are those transactions that were entered
into on or prior to September 15, 2008, terminate on
or after September 15, 2008, have a trade date on or
prior to October 10, 2008 and remain outstanding as
of October 21, 2008.
The auction that took place on October 10, 2008
created some consternation because the market
value of the deliverable obligations was valued at
approximately 9 percent of par, meaning that
protection sellers would realize a loss of
approximately 91 percent of the notional amount of
CDS, or over $364 billion in gross terms. In light of
the large notional amount of transactions to be
settled, the market looked forward with trepidation
to October 21, 2008, the date on which buyers of
October 24, 2008
3
Global Financial Markets
credit protection against Lehman were to receive
payments from protection sellers. News reports
indicated that banks may have been hoarding cash in
recent weeks to be in a position to make payments.
There was also speculation that significant
settlement failures by protection sellers could have a
potentially disastrous effect on market stability,
possibly resulting in other significant challenges to
the $55 trillion CDS market.
Credit market participants breathed a collective sigh
of relief when October 21, 2008 passed without
undue strain in the markets, as it turned out that the
$400 billion notional amount of Lehman CDS was
well in excess of the actual $6 billion of net Lehman
CDS settlement proceeds that changed hands on
October 21, 2008. The relatively small net amount
reflected the fact that many protection sellers had
been required to post collateral to secure their
payment obligations. As CDS referencing Lehman
fell in value, parties buying protection from
protection sellers made collateral calls, and
protection sellers had to post increasing amounts of
collateral, effectively meaning that assets to satisfy a
large portion of the settlement obligations had
already been segregated and made available to cover
Lehman CDS. It may have also reflected the fact
that many large institutions and hedge funds were on
both sides of Lehman CDS trades and were able to
net amounts owing to each other on Lehman CDS.
While the netting of positions and the offsetting of
amounts owed by posted collateral minimized the
market impact of the October 21, 2008 Lehman CDS
settlement under the terms of the Protocol, it may be
too early to break out the champagne because the
full effect of the $6 billion payday may not be
known until quarterly results are released. The net
Lehman CDS payout may very well still result in the
failure of many Lehman CDS protection sellers
which used leverage to fulfill their collateral posting
obligations. This is particularly true in the market for
synthetic collateralized debt obligations (“CDOs”),
where investors will bear losses for many
transactions that had significant exposure to
Lehman. Even though the obligations of synthetic
CDO issuers to their CDS counterparties are
supported by collateral, the market value loss of the
CDS is reflected in and borne by investors in the
CDOs through writedowns of principal. This may
lead to an expansion of the stresses recently seen in
the asset-backed CDO market to the corporate CDO
market, which until now has been relatively
unscathed. It is probable that the fallout of the
Lehman settlement will add to the pressure that has
been growing in Washington and in parts of Wall
Street for more effective regulation of the CDS
market.
_____________________________
FDIC Insurance Coverage
FDIC Insurance Coverage for
Securitization Servicing
Accounts Leaves Some
Investors in the Cold
Anthony R.G. Nolan and Drew A. Malakoff
On October 10, 2008, the FDIC adopted an interim
rule (the “Interim Rule”) that increases the standard
maximum deposit insurance amount from $100,000
to $250,000, in accordance with the Emergency
Economic Stabilization Act of 2008. Of particular
interest to securitization investors and servicers, the
Interim Rule also simplifies the deposit insurance
rules as they apply to mortgage servicing accounts.
By doing so, it increases certainty for investors
while enhancing liquidity for servicers of mortgage
assets.
Prior to the enactment of the Interim Rule, funds on
deposit in mortgage servicing accounts that
represented principal and interest received on the
underlying loans were insurable on a pass-through
basis to each investor or security holder of a
securitization or fund. The theory behind this
approach was that payments of principal and
interest on securitized mortgages were beneficially
owned by the investors in the related mortgagebacked securities. As a practical matter, however,
the FDIC’s prior approach to mortgage servicing
accounts created some ambiguity as to the ability of
individual investors to make a claim against the
FDIC for amounts in a servicing account held by a
depository institution that became subject to a
receivership or conservatorship, particularly as
securitizations became more complicated and
incorporated different tranches of bonds with
varying degrees of seniority or with specific rights
to sub-pools of assets.
October 24, 2008
4
Global Financial Markets
Under the FDIC’s prior approach, in order to
determine what portion of each investor’s interest in
the principal and interest payments deposited into a
mortgage servicing account was covered by FDIC
insurance, it was necessary to determine not only
which investors had not exceeded their respective
deposit insurance limits, but also which investors
should have been allocated the next dollar of
principal or interest based on the complex paydown
rules contained in the transaction documents. This
complex calculus, based on a deal’s distribution
waterfall and the percentage of the relevant security
each investor held, made it increasingly difficult to
determine which of the many investors in a
securitization vehicle had the rights to each dollar of
principal or interest. Moreover, given the size of
many of these transactions, it was also very likely
that individual investors would far exceed the
applicable insurance limit.
These considerations resulted in uncertainty among
securitization investors as to the extent to which
their allocated portions of loan payments would be
covered by deposit insurance. Consequently,
investors and rating agencies require that servicers
remit funds from servicing accounts to a trustee
account on a daily basis (or in some cases transfer
the servicing account to another institution)
whenever the servicers’ creditworthiness (as
measured by credit ratings) decline below certain
levels. This imposed a cost to depository institutions
in the form of reduced liquidity, which has become a
significant threat to the stability of financial markets
in the recent challenging market conditions.
The Interim Rule reconciles the needs of mortgagebacked security investors for security with the needs
of depository institutions for liquidity by changing
the basis for insuring accounts in mortgage servicing
accounts and, in many cases, increasing the amount
actually covered in each such account. Because the
Interim Rule makes it easier to determine what
portion of payments beneficially owned by
securitization investors are covered by FDIC deposit
insurance, investors and rating agencies will be more
likely to permit depository institutions that maintain
mortgage servicing accounts to commingle amounts
received on mortgage loans for longer periods, thus
enhancing their liquidity. For this reason, the Interim
Rule is a welcome development for depository
institutions and investors participating in the
mortgage securitization market. However, the
Interim Rule as currently drafted — to cover only
mortgage servicing accounts — does not go far
enough in that it does not address these concerns as
they arise in the securitization of non-mortgage
related assets.
_____________________________
Fair Value Accounting
SEC and FASB Relax Fair Value
Rules; Controversy Continues
Edward G. Eisert and Mark D. Perlow
On September 30, the Office of the Chief
Accountant of the Securities and Exchange
Commission (“SEC”) and the Staff of the Financial
Accounting Standards Board (“FASB Staff”) issued
guidance on the determination of “fair value” under
FAS 157 (the “FAS 157 Guidance”), addressing the
use of internal assumptions, the use of broker
quotes, and transactions in disorderly or inactive
markets to measure fair value. On October 10 , the
FASB published a FASB Staff Position (“FSP”)
intended to clarify the application of the FAS 157
Guidance. FAS 157, which became effective in
November 2007, defines “fair value” as the price
that would be obtained in an orderly transaction
between market participants in the principal or most
advantageous market.
The FSP provides an illustrative example to
demonstrate how the fair value of a financial asset
might be determined when there is a “disorderly” or
“inactive” market and the basis on which a
determination could be made that a market is, in
fact, "inactive." Although the FSP provides helpful
commentary on the FAS 157 Guidance, it does not
eliminate the need for investors and auditors to
make difficult judgment calls.
The FAS 157 Guidance and the FSP were issued in
response to a campaign by the banking industry,
based on the argument that the emphasis under FAS
157 on “fair market” valuations for financial assets
was forcing banks to write down performing assets
to “fire sale” or distressed prices, compelling them
to sell more assets to raise capital, and thereby
depressing prices further in a downward spiral.
Conversely, many supporters of FAS 157, including
investors’ groups, have expressed the view that
October 24, 2008
5
Global Financial Markets
current market values provide a more accurate
picture of the health of financial institutions than
values based on cost or cash flow models. The SEC
rarely involves itself in FASB policy-making, and
the SEC’s action is clearly an attempt to reach a
compromise between the two positions: it relaxed
the interpretation of some of FAS 157’s market
valuation provisions, but did not suspend market
valuation, as some have requested.
The compromise has not appeased either side in the
debate. Some in the industry continue to believe that
the FAS 157 Guidance and the FSP do not go far
enough. On October 13, in a letter to Chairman Cox
of the SEC (the “October 13 Letter”), the American
Bankers Association (“ABA”) commented that
FASB’s fair value standard “needs serious work,”
that it “is always going to create a downward bias on
values” and requested the SEC “to use its statutory
authority to step in and override the guidance issued
by FASB.”
http://www.aba.com/aba/documents/press/ChrmnCo
xLtr.101308.pdf. Two specific issues highlighted by
the October 13 Letter are the requirement in the FSP
that “liquidity risk from the buyer’s perspective” be
included in cash flow calculations that can be used
to determine fair value and that the FSP did not
address “other than temporary impairment” in an
illiquid market. In addition, a number of members of
Congress have been making public statements
calling upon the SEC to suspend mark-to-market
accounting, thereby politicizing the issue.
Apparently in response to the October 13 Letter and
Congressional pressure, on October 15, in a joint
letter to Chairman Cox, the Center for Audit
Quality, the Consumer Federation of America, the
CFA Institute and the Council of Institutional
Investors “expressed grave concern regarding recent
calls for the SEC to override [the FAS 157
Guidance] that would effectively suspend fair value
or mark-to-market accounting.”
http://www.thecaq.org/newsroom/pdfs/SECJointLett
er2008-10-15.pdf. The joint letter did not
specifically mention the October 13 Letter or
address the specific issues it raised.
detrimental impact on the crisis, while auditor and
investor groups believe that the crisis was not
caused by fair value accounting and that, in fact,
FAS 157 has been helpful in exposing problems.
In time-honored Washington fashion, this
controversy is now being simultaneously addressed
and avoided through a study group. The Emergency
Economic Stabilization Act mandates that the SEC
“in consultation with the [Federal Reserve Board
and the Secretary of the Treasury] shall conduct a
study on mark-to-market accounting standards as
provided in [FAS 157], as such standards are
applicable to financial institutions, including
depository institutions.” The SEC is required to
submit a report of such study (the “SEC Study”) no
later than January 2, 2009 (that is, after the election,
but before the new Congress takes office), including
“such administrative and legislative
recommendations as the [SEC] determines
appropriate.”
Work on the SEC Study has commenced and the
SEC has announced that it is scheduling public
roundtables to obtain input from “investors,
accountants, standard setters, business leaders, and
other interested parties.”
With the preparation of third quarter financial
statements now in process, presumably in reliance
on the FAS 157 Guidance and the FSP, and the SEC
Study underway, with further public input to be
provided, it appears likely that any further
regulatory action on these issues will be deferred
until 2009, when it will unquestionably be a subject
for further debate during the upcoming effort by
Congress to reform financial regulation.
We will continue to provide updates on these
important issues as events unfold.
_____________________________
Underlying these positions is a basic disagreement
as to the role that the adoption of FAS 157 has
played in the liquidity and credit crisis. The ABA
believes that FAS 157 has had a significant
October 24, 2008
6
Global Financial Markets
Credit Default Swaps — Criminal
Investigations
Joint Federal-State Credit Default
Swap Investigation
is Launched
Irene C. Freidel and Anthony R.G. Nolan
The U.S. Attorney’s Office in Manhattan and the
New York Attorney General’s Office confirmed last
week that they have launched a joint investigation
into operation of the largely unregulated $55 trillion
dollar market for credit default swaps (“CDS”).
CDS are synthetic risk transfer devices whereby, in
exchange for a premium, one party (the seller)
agrees to make a payment to the other (the buyer) to
protect the buyer from credit risk of one or more
reference entities following the occurrence of a
bankruptcy or other credit event with respect to such
reference entity. Following the occurrence of a
credit event, the buyer is entitled to receive a cash
payment to compensate it for the decline in market
value of selected obligations of the reference entity.
Therefore, the value of a CDS to the buyer fluctuates
with changes in the reference entity’s financial
strength, increasing as the reference entity’s
creditworthiness deteriorates and decreasing as the
reference entity becomes more financially stable.
Since 2005, the CDS market has become very large
and liquid, with an estimated $62 trillion notional
amount of CDS outstanding globally in 2007. The
growth of the CDS market has been premised to a
great extent on light regulation of CDS transactions
under commodities laws, securities laws, and
insurance law. Most CDS are “security-based swap
agreements” that are excluded in large part from
SEC jurisdiction, although they are subject to
antifraud and antimanipulation provisions of the
U.S. federal securities laws.
The current investigation represents an expansion of
existing investigations by federal and New York
State authorities into whether short-selling activity
resulted in manipulation of the price of bonds and
shares of financial services institutions. The purpose
of the current effort is to determine whether
investors manipulated the prices (or credit spreads)
of CDS in uncompleted transactions that were
nonetheless reported to data providers. Credit
spreads for CDS affect the prices of the debt
obligations issued by entities referenced in the CDS
because those spreads are considered to be leading
indicators of perceived financial stability of the
reference entity. Thus, efforts to manipulate CDS
pricing could benefit short sellers of financial
obligations issued by the reference entities, who
would benefit from a decline in the value of those
obligations occasioned by fears that the reference
entity might be under financial stress.
Collaboration of the two enforcement offices
suggests that the investigation will be significant
and wide-ranging in scope, and includes the
possibility that U.S. Attorney Michael Garcia will
seek information from foreign sources. To date,
subpoenas have been issued by New York’s
Attorney General Andrew Cuomo to a variety of
large financial institutions, including stock
exchanges, hedge funds, and several entities that are
involved in the credit default swap trade process:
Depository Trust Clearing Corp., Markit, and
Bloomberg LP. Whether the investigation will result
in any prosecutions is as yet unknown. The effort
reflects a new aggressiveness in the use of
antimanipulation enforcement jurisdiction to the
derivatives market.
_____________________________
SEC: Inspector General
SEC Inspector General Finds
Staff Misconduct in
Investigations of Wall Street
Firms. Reports Will Increase
Pressure on SEC to “Get Tough”
Brian A. Ochs
Significant disruptions in the market invariably lead
to an increase in SEC enforcement activity, as
regulators seek to determine whether those negative
events resulted from violations of the federal
securities laws. The aggressiveness of the SEC’s
efforts in this regard will likely be further enhanced
by two new reports from the SEC’s Inspector
General (“IG”), H. David Kotz, that are highly
critical of the Enforcement Division’s prior conduct
of investigations involving major Wall Street firms.
In each report, the IG raised questions about the
October 24, 2008
7
Global Financial Markets
Enforcement staff’s appearance of impartiality and
recommended that disciplinary action be taken
against the staff members involved, including the
Director of the Enforcement Division and the head
of the SEC’s Miami Regional Office.
The Enforcement Division has publicly, and in
strong terms, contested the findings of at least one of
the IG’s reports. Nonetheless, the IG’s charges of
lax enforcement and the appearance of favorable
treatment for major participants in the financial
services industry seem certain to result in an even
tougher and more difficult enforcement environment
in the context of the SEC’s response to the current
financial crisis.
Aguirre termination. The first report, issued on
September 30, stemmed from charges by a former
SEC Enforcement staff attorney, Gary Aguirre, that
his supervisors gave improper preferential treatment
to Morgan Stanley Chairman and CEO John Mack,
and terminated Aguirre’s employment, when
Aguirre sought to take Mack’s testimony as a
possible tipper in an insider trading investigation
involving hedge fund Pequot Capital Management.
See “Re-Investigation of Claims by Gary Aguirre of
Improper Preferential Treatment and Retaliatory
Termination,” SEC Office of Inspector General
(Sept. 30, 2008), available at
http://finance.senate.gov/press/Gpress/2008/prg1007
08.pdf. An initial IG investigation in 2005,
conducted by the current IG’s predecessor,
exonerated the Enforcement staff. Congress held
hearings, and in August 2007, the Senate Finance
and Judiciary Committees issued a report critical of
the Enforcement Division’s conduct of the Pequot
investigation, and faulting the IG for failing to
conduct a credible investigation into Aguirre’s
charges. Following the Senate report, the IG retired,
and Kotz was appointed as the SEC’s new IG in
December 2007.
Importantly, the Kotz re-investigation did not find
that Mack received any favorable treatment
regarding the taking of his testimony. The IG
received testimony from numerous past and present
Enforcement officials that Enforcement cases are not
affected by political considerations or the
prominence of particular individuals. The IG also
found that there had been reasonable strategic
reasons for delaying Mack’s testimony.
Notwithstanding these findings, the IG went on to
conclude that Enforcement staff supervisors had
“conducted themselves in a manner that raised
serious questions about the impartiality and fairness
of the Pequot investigation.” Further, the IG
determined that “there was a connection between
the decision to terminate Aguirre and his seeking to
take Mack’s testimony,” and that Enforcement
“allowed inappropriate reasons to factor into its
decision to terminate him.” The IG went on to
directly criticize Enforcement Director Linda
Thomsen and recommended that the SEC Chairman
take disciplinary action against her for disclosing
non-public information about the evidence against
Mack to counsel for Morgan Stanley’s board of
directors. In response to a request for information
(because Morgan Stanley’s board was considering
hiring Mack as CEO), Thomsen told the board’s
counsel that the investigation had uncovered
“smoke,” but no “fire,” concerning Mack.
Bear Stearns Investigation. In a second report, the
IG found that the Director of the SEC’s Miami
Regional Office had “failed to administer his
statutory obligations and responsibilities to
vigorously enforce compliance with [applicable]
securities laws” in connection with an investigation
into Bear Stearns’ role in valuing certain
collateralized bond obligations and collateralized
loan obligations that a client purchased from Bear
Stearns. See “Failure to Vigorously Enforce Action
Against W. Holding and Bear Stearns at the Miami
Regional Office,” SEC Office of Inspector General
(Sept. 30, 2008). The report was prepared in
response to a request from Senator Charles Grassley
(R. Iowa), ranking member of the Senate Finance
Committee, seeking information as to why the SEC
had closed the investigation without any
enforcement action.
According to the IG’s report, the head of the Miami
office “abruptly” closed the investigation in 2007
after the staff had made progress negotiating several
settlements. Further, the IG found that the fact that
two of the defense counsel involved in the case
were longtime friends of the head of the Miami
office created an “appearance, to some, that they
may have received favorable treatment.” While
acknowledging that there was “no evidence of a
direct connection between the relationship … and
October 24, 2008
8
Global Financial Markets
the decision to close the investigation,” the IG found
the appearance of a conflict “disturbing,” noting that
it “could potentially damage the reputation of the
Commission.” (This finding of the IG seems
particularly ill-considered, given that a large portion
of the defense bar consists of attorneys who have
previously served on the SEC staff. To suggest an
apparent conflict of interest merely because defense
attorneys may deal with former friends and
colleagues on the SEC staff is to risk depriving
clients of the best and most experienced counsel of
their choice, a position that the SEC itself has never
asserted.)
The IG went on to fault the Miami office staff for
not coordinating its investigation with the
Department of Justice, which was investigating a
similar matter involving another Bear Stearns
employee. The IG found that “[a] significant
opportunity to coordinate with the U.S. Attorney’s
Office and uncover evidence of a systematic
problem at Bear Stearns was also lost through
neglect.” The IG recommended that the SEC
Chairman take disciplinary action against the
Director of the Miami office.
In a strongly worded response, the Enforcement
Division characterized the IG’s report as
“misleading,” filled with “speculation and
innuendo,” as ignoring testimony showing that the
decision to close the investigation was a sound one,
and failing to comply with the IG’s “fundamental
obligation to conduct a fair and impartial factfinding.”
Likely impact of the IG reports. Against the
backdrop of existing criticisms of the SEC for
regulatory failures that contributed to the current
financial crisis, the IG’s reports may provide the
impetus for a period of unusually difficult,
contentious, and highly critical oversight of the
SEC’s enforcement function. Regardless of whether
the IG’s conclusions in these cases were sound, the
IG’s reports are likely to fuel critics in Congress and
elsewhere who seek to contend that the Enforcement
Division has failed in its responsibility to pursue
aggressively misconduct at large banking firms.
To cite just one such example, Sen. Grassley has
commented that the IG’s report on the Bear Stearns
investigation provides “yet another example of the
lack of vigorous enforcement at the SEC,” and
“demonstrates the culture of deference at the SEC in
dealing with big players on Wall Street.”
http://finance.senate.gov/press/Gpress/2008/prg101
008.pdf. Similarly, on October 21, Sen. Grassley
wrote to SEC Chairman Cox concerning anonymous
allegations he has received that, during the
negotiations earlier this year that led to JP Morgan
Chase’s (“JPMC”) takeover of Bear Stearns,
Enforcement Director Thomsen disclosed
information concerning the status of various
investigations involving Bear Stearns to JPMC’s
General Counsel, Stephen Cutler, who preceded Ms.
Thomsen as Director of the Enforcement Division.
Sen. Grassley wrote to Chairman Cox that “Such
conduct would reinforce the appearance that
Enforcement decisions, and disclosures of
information about them, are sometimes based not on
the merits, but rather on access to senior officials by
influential representatives of power brokers on Wall
Street. In light of these allegations and the ongoing
financial crisis, there has never been a more critical
time to take swift action to restore confidence in the
SEC Enforcement Division.”
http://finance.senate.gov/press/Gpress/2008/prg102
108.pdf.
The SEC’s Enforcement Division and the
Commission thus are likely to feel pressure to
demonstrate heightened aggressiveness and
firmness in future investigations and enforcement
actions, particularly where major participants in the
financial services sector are involved. The
Enforcement staff will likely seek even more rapid
progress in priority investigations than in the past,
and may curtail opportunities for meaningful
deliberation and dialogue that have historically
proven beneficial both to the staff and to the
subjects of complex investigations. While the staff
will undoubtedly maintain its high standards of
professionalism, it would be unsurprising if there is
less flexibility and less willingness to entertain
sound arguments regarding factual and legal
defenses in an environment where staff members
may be concerned that any concessions they make
may subject them to criticism or even disciplinary
action if they are perceived to be insufficiently
vigorous in their enforcement of the securities laws.
_____________________________
October 24, 2008
9
Global Financial Markets
Linda Thomsen acknowledged in a speech that
waivers were still sometimes being requested –
albeit “judiciously.”)
SEC: Attorney-Client Privilege
New SEC Enforcement Manual
Directs Staff Not to Seek Waivers
of Attorney-Client Privilege
•
“The voluntary disclosure of information need
not include a waiver of privilege to be an
effective form of cooperation, as long as all
relevant facts are disclosed.”
•
“Waiver of a privilege is not a pre-requisite to
obtaining credit for cooperation. A party’s
assertion of a legitimate privilege will not
negatively affect their claim to credit for
cooperation. The appropriate inquiry in this
regard is whether, notwithstanding a legitimate
claim of privilege, the party has disclosed all
relevant underlying facts within its knowledge.”
Brian A. Ochs
On October 6, the Securities and Exchange
Commission (“SEC”) posted on its web site the firstever SEC Enforcement Manual. (See
http://www.sec.gov/divisions/enforce/enforcementm
anual.pdf.) The publication of the manual reflects
the first time that the SEC has committed to writing,
in a single document, the various policies and
procedures that govern investigations conducted by
its Division of Enforcement. According to press
accounts, the manual was prepared in response to a
report issued in August 2007 by the Senate Judiciary
and Finance Committees that criticized the SEC for
its handling of an insider trading investigation
involving hedge fund Pequot Capital Management
(see separate article in this newsletter), and
recommended that the SEC adopt a consistent set of
procedures similar to the U.S. Attorneys Manual.
In large measure the Enforcement Manual does not
break new ground, but instead describes practices
that have been commonly understood for years.
Notably, however, the Enforcement Manual does
include the first comprehensive, written statement by
the SEC on its view of the relationship between
“cooperation” in an investigation and the assertion
of attorney-client or attorney work product
privileges. After years of controversy over this issue
in the post-Enron era, during which parties often felt
pressured by government investigators to waive
privilege in order to receive full credit for
cooperation, the Enforcement Manual makes clear
that waiver is neither necessary nor expected. The
manual’s key statements on this topic include:
•
“As a matter of public policy, the SEC wants to
encourage individuals, corporate officers, and
employees to consult counsel about potential
violations of the securities laws.”
•
“The staff should not ask a party to waive the
attorney-client or work product privileges, and
is directed not to do so.” (Emphasis in original.)
(This express direction is significant given that,
as recently as last year, Enforcement Director
With its emphasis on obtaining underlying facts,
rather than on waivers of privilege, and in its
direction that the SEC Staff should not seek
waivers, the Enforcement Manual follows the path
of the Department of Justice’s recent “Filip
Memorandum,” which prohibits federal prosecutors
from requesting privilege waivers (see “DOJ Issues
New Guidance That Retreats From Aggressive
Policies Followed in White Collar Cases,” K&L
Gates White Collar Crime/Criminal Defense Alert
(Sept. 24, 2008),
http://www.klgates.com/newsstand/Detail.aspx?pub
lication=4929).
Although senior Enforcement Division officials
stated in the past that waiver of privilege was not
required in order to obtain credit for cooperation,
they had also indicated that the voluntary decision
to waive privilege would receive enhanced credit,
and some SEC enforcement orders reflected this
approach. Among others, former SEC
Commissioner Paul Atkins had been a vocal critic
of the practice of holding out privilege waiver as a
“plus factor” in determining credit for cooperation.
Although it remains to be seen how the
Enforcement Manual is applied in practice, the
manual does not suggest that any “plus factor”
calculus will be used in future cases. Instead, the
manual emphasizes that waiver of privileges is not
necessary to “effective cooperation.”
As the SEC expands and increases the pace of its
investigations into possible wrongdoing in relation
to the crisis in the financial sector, these provisions
October 24, 2008
10
Global Financial Markets
of the Enforcement Manual will hopefully bring
clarity and consistency to Enforcement Division
practices when parties seek to cooperate while still
preserving attorney-client and work product
privileges. This should provide important
protections to companies (in particular those that
conduct internal investigations), as well as to their
officers and employees, as compared with the
environment of a few years ago, when waivers of
privilege were often viewed as necessary to
receiving full credit for cooperation.
_____________________________
FSA: New Chairman Lord Adair Turner
An End to Light Touch
Regulation in the UK?
Robert V. Hadley and Philip J. Morgan
Last week, two leading UK newspapers reported
interviews with the new Chairman of the FSA, Lord
Adair Turner, in which he is said to have warned
that the days of “soft-touch regulation” are over. He
also spoke of the FSA’s plans to pump more
resources, and to recruit high quality people from the
private sector at considerable expense, into the
regulation of systemically important institutions.
Earlier last week FSA Chief Executive Hector Sants
struck a slightly different tone when he noted that
the concept of “heightened supervision” - jargon for
an FSA enhanced regulatory regime for banks where
failure appears possible - was a last resort. He also
said that the term “heightened supervision” was a
colloquialism that reflects the fact that the FSA
adopts a risk-based approach. Certain risks now
being clear it is appropriate, and consistent with the
FSA’s stated and historic approach, and nothing
new, for supervision in relation to such risks to be
“heightened.”
The new Chairman is plainly looking to stamp his
authority in a very public way. Interviews with
national newspapers are not a common occurrence
for leaders at the FSA. And “light-touch regulation”
has long been a mantra of FSA leaders, Mr Sants
included. But does Lord Turner's intervention last
week signal a real change of direction for the FSA?
Risk-based regulation, which continues to be at the
heart of the FSA’s approach, and light-touch
regulation run hand in hand - a business that
presents a limited risk to the FSA’s statutory
objectives can be regulated in a less hands-on
fashion than higher risk businesses the failure of
which may have systemic consequences. We
suspect therefore that many people regulated by the
FSA will notice little difference with the tougher
stance signalled by Lord Turner.
On the other hand, it is clear that the FSA is
currently far more focused, as a matter of necessity,
on issues that can have consequences for the
stability of the financial system as a whole. Lord
Turner mentioned in particular FSA work in three
areas:
(i) the capital adequacy regime for banks - in
relation to which he noted that the current regime
seems to encourage the banks to lend too much in
the boom times and too little when times get tough;
(ii) liquidity - where the focus would be on whether
the business model of financial institutions was
solid enough in bad times as well as good; and
(iii) pay - although Lord Turner was clear that this
area plays second fiddle to capital adequacy and
liquidity
Also, it would appear that under Lord Turner's
watch the FSA will be taking a renewed close look
at the risks posed by hedge funds. For example, it
was reported that he thinks that hedge funds, up to
now beneficiaries of “light-touch regulation” in the
UK, could evolve to pose a systemic risk, much as
the Wall Street banks did during the past few
decades.
The truth, it seems to us, is that whilst the FSA is
set to get tougher with high-impact, systemically
important firms, notably significant banks and
insurance companies, much of the rest of the FSA’s
work will probably carry on as before, at least for a
while. Lord Turner himself summed up the
balancing act as follows:
“There is no doubt the touch will be heavier… We
have to make sure that it is intelligent and focussed
on where the risks really are.”
October 24, 2008
11
Global Financial Markets
It does remain interesting, though, that the new
Chairman, unlike the last, does not seem minded to
defend the concept of “light-touch regulation,” even
choosing to refer to it by the more pejorative “softtouch regulation.” It remains to be seen whether Mr.
Sants will adjust his tone to be more in keeping with
his new boss’s tough talking.
_____________________________
White Collar: Internal Investigations
DOJ’S Resource Crunch Offers
Strategic Options for
Corporations in White Collar
Cases
Michael D. Ricciuti, Clarence H. Brown and
Leanne E. Hartmann
With the advent of the credit crisis, the Department
of Justice (DOJ) – and particularly the Federal
Bureau of Investigation (FBI) and the United States
Attorneys’ Offices – is faced with a daunting
challenge at a time of decreasing budgets and
strained resources. DOJ’s resource shortage presents
an enhanced strategic opportunity to corporations
who suspect that they are at risk for investigation or
prosecution for criminal activity – or have been
victimized by it. In brief, sometimes the distinction
between a criminally culpable company and one that
has been victimized is in the eyes of the beholder.
Emphasizing the latter status serves as an
opportunity.
Background. After the events of September 11,
2001, DOJ and the FBI made national security their
top priority, but with a more refined focus. No
longer was it enough for DOJ to investigate and
prosecute terrorists. Instead, DOJ now seeks to
prevent acts of terrorism – a far more difficult task
than merely prosecuting terrorism, which are among
the most challenging criminal cases. Unsurprisingly,
to fulfill this aggressive mission, a huge portion of
the resources of the FBI and DOJ were redeployed
to fight terrorism. Now, with the massive credit
crisis to contend with, DOJ and FBI have opened a
series of financial investigations, reportedly
involving Freddie Mac, Fannie Mae, Lehman
Brothers, and AIG, among approximately 1,500
others. Reports indicate that the FBI plans to double
the number of agents focusing on financial crime,
but also make clear that the FBI has hundreds fewer
agents focused on this work than it did during the
financial crisis involving savings and loans in the
1980s. It will be extremely challenging for the
government to find the resources to handle these
new complex and difficult cases.
Internal Investigations: Defensive Use. As
discussed in the previous Global Financial Markets
Group newsletter, the government has wide
authority to bring charges in the corporate criminal
context, but its own policies restrict its power to do
so. In brief, a corporation may be criminally liable
for the conduct (or omissions) of its agents
committed within the scope of their duties and
intended, at least in part, to benefit the corporation.
This means that, as a matter of law, the crimes of
any employee in the organization, regardless of his
or her position on the organization chart, may be
attributable to the company and the company could
thus be charged criminally for them. DOJ has the
discretion to bring a criminal case against the
company under these circumstances – or not to do
so. Whether DOJ exercises its discretion not to
charge a company depends upon its analysis of the
factors under DOJ’s Principles of Federal
Prosecution of Business Organizations (“the
Principles”). The Principles put a premium on a
company’s cooperation in helping DOJ investigate
the alleged crime – exactly the type of cooperation
DOJ sorely needs now that it is facing a global
financial crisis and its own resource shortage.
Revised this past August, the Principles recognize
that corporate crime is more difficult to investigate
than crimes committed by individuals. As the
Principles note:
In investigating wrongdoing by or within a
corporation, a prosecutor is likely to encounter
several obstacles resulting from the nature of the
corporation itself. It will often be difficult to
determine which individual took which action on
behalf of the corporation. Lines of authority and
responsibility may be shared among operating
divisions or departments, and records and personnel
may be spread throughout the United States or even
among several countries. Where the criminal
conduct continued over an extended period of time,
the culpable or knowledgeable personnel may have
October 24, 2008
12
Global Financial Markets
been promoted, transferred or fired, or they may
have quit or retired.
Because of these difficulties, the Principles
acknowledge that “a corporation’s cooperation may
be critical in identifying potentially relevant actors
and locating relevant evidence, among other things,
and in doing so expeditiously.” (For more
information regarding the Principles, see the United
States Attorney’s Manual, Title 9, Chapter 9-28.700
et seq.)
From a defensive perspective, then, the company
may seek to curry favor from DOJ and avoid being
criminally charged through its cooperation. In
cooperating under the Principles, a company with a
good track record of compliance seeks, in essence,
to demonstrate to the government that it should not
be charged criminally on the basis of an employee’s
criminal acts because that employee’s activities are
inconsistent with the company’s otherwise positive
compliance record, among other factors. Typically,
conducting an independent internal investigation is a
critical initial element in the company seeking credit
for cooperation. Through an investigation of itself,
the company discovers the relevant facts and – if it
chooses to do so – can provide DOJ with a roadmap
of the potential case from it. From DOJ’s
perspective, cooperation credit is awarded where the
corporation “timely disclosed the relevant facts
about the putative misconduct” – and can result in
DOJ not seeking to prosecute an otherwise well-run,
compliant company because of its cooperation,
among other factors.
There are significant risks to providing this
cooperation. For instance, preparing an internal
investigation develops a factual record which private
litigants may later use to assert claims against the
company and its officers and directors. Even so,
with DOJ in short supply of agents to perform
detailed investigations, providing this cooperation
may be at a premium for the government – and may
earn companies significant consideration when DOJ
decides whether to bring criminal charges against
the corporation. With an internal investigation in
hand, companies can also often reap other benefits,
such as identifying personnel who should be
terminated for misconduct and deficient systems and
procedures that need improvement, preparing earlier
for shareholder and third-party litigation, and
permitting the company to more effectively assist its
board members, officers and employees in
preparing for and giving testimony.
Internal Investigations: Offensive Use. There is
also an offensive aspect to the use of internal
investigations that is often overlooked. A company
that suffers from the criminal conduct of an
employee may be a defendant in a resulting
prosecution – but may also be a victim of the
wayward employee’s criminal acts. The company’s
status as a victim is a fact on which the government
does not always focus. A company thus should
consider whether to use an internal investigation to
proactively prod the United States Attorney’s Office
to bring a criminal case against the employee
wrongdoer. When the government is strapped for
resources, it will often look favorably on a
completed investigation that shows readily provable
criminal wrongdoing, which will increase the
likelihood that the government will take the case
and prosecute it. Offensive use of the internal
investigation accomplishes at least three goals:
First, it makes it clear to DOJ that the company
should not be viewed as a potential defendant but
rather as a victim, and, as such, is entitled to
victim’s rights, to include the right to restitution
from the employee. In a fraud case, where an
employee has made off with company funds, a court
in sentencing a convicted employee wrongdoer is
empowered to order restitution as an element of the
criminal judgment – forcing the employee to repay
the company through a restitution order enforced by
the Probation Department, U.S. Attorney’s Office,
and the Court. Such an order saves the company
from pursuing repayment from the employee civilly,
often an expensive and fruitless endeavor.
Second, seeking prosecution from the government is
often relatively inexpensive. Once the internal
investigation is done by the company, and the
government accepts the case for prosecution, it is
the government that bears the costs of the
prosecution. The company only needs to cooperate
with the government, typically far cheaper than
defending itself and its employees in a criminal
probe.
Third, a prosecution of a criminal employee sends a
very clear message to other employees and to the
October 24, 2008
13
Global Financial Markets
government that the company will not tolerate
criminal wrongdoing and will take very aggressive
action against those who violate the rules. There can
be no clearer zero-tolerance approach for criminal
activity.
Conclusion. With DOJ facing a likely crush of new
financial crimes cases, companies with potential
exposure need to consider their options strategically.
One important option is a credible, independent
internal investigation done early and proactively,
which can provide the company with both defensive
and offensive benefits.
_____________________________
Investor Claims Against Sovereign
Governments
Bank Rescues, Nationalisation
and Stock Value Losses: What
Prospects for Foreign Investors
to Bring Claims Against
Sovereign Governments?
Marcus M. Birch and Ian Meredith
Over recent weeks, governments on both sides of the
Atlantic have intervened in the affairs of banks and
other financial institutions in a quite unprecedented
manner.
The government-initiated rescues have had an
undoubted impact on private investors. Some
announcements of planned action have been
followed by sharp falls in share values; many
shareholders have seen their holdings diluted by the
creation of new preference shares in some cases held
by the state; and there has been an absence of
shareholder consultation and instances of unequal
treatment (the U.S. government stepped in to save
AIG from bankruptcy, but allowed Lehman Brothers
to fail, and the U.K. government is procuring a
merger between LloydsTSB and HBOS but has
chosen to nationalise Northern Rock and Bradford &
Bingley).
These and other issues raise the prospect of a wave
of investor-state claims against governments based
on the impact of the rescue packages. Many of the
countries concerned have bilateral or multilateral
investment treaties (known as BITs or MITs) in
place intended to protect foreign investors from
discrimination, unfair expropriation, and other state
action. Unlike most international treaties, these
investment treaties typically create a direct right of
action on the part of investors that are nationals of
one country against the other state party to the
treaty. Such claims are typically administered by the
International Centre for the Settlement of
Investment Disputes (ICSID) or before bodies such
as the International Chamber of Commerce (ICC),
the London Court of International Arbitration
(LCIA) or the Stockholm Chamber of Commerce
(SCC).
Past economic crises have been the catalyst for a
series of investor-state claims. More than 40 out of
the 140 cases currently pending before ICSID arise
out of the Argentinean government's responses to
the financial crisis of 2001-2002. Those cases
provide a guide to the types of measures that can
ground an investment treaty claim and the defences
that are likely to be relied on by a state. Foreign
investors claimed compensation from the
Argentinean state arising out of a variety of
measures including the devaluation of the peso, the
pesification of debt and the freezing of bank
accounts. Many claims remain ongoing. Argentina
has relied on two principal defences. One was the
presence in the relevant BIT of a non-precluded
measures (NPM) clause that limited the
applicability of investor protections in exceptional
circumstances, including the protection of essential
security and the maintenance of public order. The
second was the customary international law defence
of necessity. Although all the tribunals to date have
accepted that both defences can apply to measures
taken to avert financial crises, most tribunals
(notably those in the cases involving CMS, Enron
and Sempra Energy) have interpreted those defences
strictly and have awarded compensation to the
claimant investor. Other tribunals, notably in the
cases involving LG&E Energy Corp. and
Continental Casualty, have recognised that the
intent of the state parties to the treaties was to strike
a bargain between increased investor protection and
state policy flexibility, and accorded deference to a
government's freedom of choice in regard to the
methods used to avert a financial disaster.
It is of course too soon to assess precisely which
states will face claims arising out of the current
October 24, 2008
14
Global Financial Markets
crisis and what kind of measures will generate
claims. The scale of the economic crisis and the
number of potential claims may cause governments
to agree on a new structured process for the
administration of claims, possibly including the
establishment of a specialised tribunal or series of
tribunals along similar lines as the U.S.-Iran Claims
Tribunal. It is understood that intergovernmental
discussions are already underway in this respect.
Whether claims are brought under the auspices of
ICSID, before the ICC, LCIA or SCC or by means
of a special tribunal established for the purpose, each
case will of course turn on its facts and the
interpretation of the relevant treaty, the measures
adopted, and their precise financial impact on the
individual claimants. The position is further
complicated by the absence of a strict doctrine of
precedent in treaty-based claims.
Explicitly or substantively discriminatory measures
will provide the most obvious target. This would
include measures such as the proposal by the
Icelandic government to guarantee only those
deposits in its banks held by Icelandic citizens or
companies, which proposal was shelved following
international diplomatic efforts. Yet as the Argentina
cases show, macroeconomic policy instruments may
also give rise to significant claims where they can be
proved to have harmed non-national investors. This
could include the obtaining of ownership or control
of financial institutions, the dilution of
shareholdings, and the triggering of stock value
declines. In such cases, the approach taken by ICSID
tribunals to NPM clauses in the relevant BITs and to
the defence of necessity will be of central
importance. Since this economic crisis is global
rather than local, but each government faces unique
challenges in its own economy, it is to be expected
that the deferential approach taken in LG&E Energy
Corp. and Continental Casualty will gain ground.
Individual or institutional investors who have been
adversely affected by state actions during the current
crisis should consider the possibility of mounting a
claim under a relevant treaty made between a
country to which they can claim nationality and the
country in which their affected investment was
located.
_____________________________
Breach of Contract
Litigation: Financial Institutions
Have Remedies for a Breach of
Contract by the Federal
Government
David T. Case
The evolving efforts of the U.S. Government to
address the turmoil in the financial markets echo in
many respects Government actions to address the
“crisis” in the savings and loan industry in the
1980s. As a consequence, the litigation against the
Government resulting from the regulatory reform of
the savings and loan industry provides a useful
template in the event that the current reforms cause
the Government to breach promises of specific
regulatory treatment. In particular, under the
previous litigation, the Government has been held
liable for breach of contract, and substantial
damages have been awarded, including damages for
lost profits.
Looking back to the 1980s, regulators were faced
with the possibility of widespread failure by savings
and loans, along with a corresponding threat to the
deposit insurance funds and potentially enormous
liquidation costs. Many early efforts to solve the
savings and loan crisis resulted in contracts between
savings and loans and the Government in which the
Government promised specific treatment under
pertinent regulations. The Federal Savings and Loan
Insurance Corporation (“FSLIC”) entered into
varying forms of such agreements, either as a means
of directly avoiding seizure of failing institutions, or
indirectly avoiding such seizures by encouraging
healthy thrifts to acquire failing institutions.
Subsequent efforts to resolve the savings and loan
crisis culminated in the passage and implementation
of the Financial Institutions Reform, Recovery and
Enforcement Act of 1989 (“FIRREA”), and in
implementing the provisions of that law, the
Government breached many of its earlier promises.
These breaches caused a wave of claims against the
Government, and one critical lesson from the tumult
is that contracts with the Government for specific
regulatory treatment are enforceable, and the
Government will be liable for damages caused by its
breach of contract. The U.S. Supreme Court has
October 24, 2008
15
Global Financial Markets
held that, where the Government entered into
contracts with regulated financial institutions,
promising to provide financial institutions with
“particular regulatory treatment in exchange for their
assumption of liabilities that threatened to produce
claims against the Government as insurer,” the risk
of regulatory change fell to the Government, even
though “Congress subsequently changed the relevant
law, and thereby barred the Government from
specifically honoring its agreements.” United States
v. Winstar, 518 U.S. 839, 843 (1996).
The application of these principles was recently
affirmed in a case presenting a scenario remarkably
reminiscent of current Government attempts to
address the turmoil in the financial markets: First
Federal Savings and Loan Association of Rochester
v. United States, 76 Fed. Cl. 106 (2007), aff’d 2008
U.S. App. Lexis 17331 (Aug. 13, 2008). Four failing
savings and loans were merged into First Federal,
and the Government provided financial assistance to
the institution, replaced senior management, selected
members of the Board of Directors, and exercised
substantial control over First Federal’s operations.
First Federal later claimed that the Government had
breached its contract with First Federal by failing to
honor its agreement to allow First Federal to operate
at reduced capital levels. The contract had been
agreed to between First Federal and FSLIC as part of
a reorganization of First Federal, and the agreement
was intended to permit the Association to return to
financial health as an alternative to seizure,
following a lengthy period of insolvency, and to
save FSLIC the costs of liquidating the Association.
Following this 1986 agreement, First Federal’s
business prospered until 1989, when Congress
passed FIRREA, nullifying all contracts between the
FSLIC and thrift institutions to the extent that those
contracts relaxed regulatory capital requirements for
specific thrift institutions.
Finding liability against the Government, the court
awarded First Federal $85 million in damages,
primarily for lost profits, plus attorney’s fees and
costs. The award was recently affirmed by the
United States Court of Appeals for the Federal
Circuit. First Federal, 2008 U.S. App. Lexis 17331
(Aug. 13, 2008).
First Federal provides a roadmap for claims that
arise as a result of the Government’s breach of
contract, and if a financial institution believes it has
such a claim against the Government, counsel
should be consulted to evaluate appropriate steps to
preserve and perfect the claim.
_____________________________
CFTC
CFTC Grants Parties to OTC
Contracts Same Preference as
Exchange-Traded Futures
Customers in FCM Bankruptcy
Charles R. Mills and Lawrence B. Patent
The CFTC on October 2, 2008 published an
interpretative statement
(http://www.cftc.gov/stellent/groups/public/@lrfede
ralregister/documents/file/e8-23277a.pdf) providing
that claims in the case of a futures commission
merchant’s (FCM) bankruptcy related to over-thecounter (OTC) contracts that are not executed or
traded on a designated contract market, yet are
submitted for clearing through an FCM to a
derivatives clearing organization (DCO), will be
entitled to the same preferential treatment as
customers whose claims are based solely upon
exchange-traded futures contracts. The significance
of the “customer” designation is that customers in a
commodity broker bankruptcy are entitled to
priority over all other claims except for those
necessary for the administration of the bankrupt
estate. This CFTC statement provides greater
certainty that a party's commodity broker or FCM is
now reduced as a credit risk even if only OTC
contracts are involved, and is yet another example
of the convergence of the OTC and exchange-traded
worlds.
OTC parties treated like exchange-traded futures
customers. To qualify for preferential treatment in
an FCM bankruptcy, the person with the claim
based upon the OTC contract must be considered to
be a “customer” under the Bankruptcy Code and
CFTC regulations thereunder, Part 190. A person
will be considered to be the FCM’s customer if its
claim arises out of a “commodity contract.” The
CFTC interpretative statement says that OTC
contracts that are “cleared-only” contracts are
October 24, 2008
16
Global Financial Markets
contracts for the purchase or sale of a commodity for
future delivery within the meaning of the
Bankruptcy Code and thus qualify as “commodity
contracts,” making a party thereto a customer. The
statement notes that, although the creation and
trading of the OTC contracts is outside CFTC
jurisdiction, the clearing of these products by FCMs
and DCOs is within CFTC jurisdiction.
Alternative theory achieves the same result. The
CFTC statement also presents an alternative method
of finding that a party to a cleared-only OTC
contract is an FCM’s customer, even if the OTC
contract is not held to be a commodity contract. If
the party has both cleared-only and exchange-traded
futures contracts in its account with the FCM, the
entirety of the account owner’s assets in that account
serves as performance bond for each of the
exchange-traded and OTC contracts pursuant to
CFTC orders issued under Section 4d(a)(2) of the
Commodity Exchange Act. Thus, a claim for those
assets in bankruptcy constitutes a claim “on account
of a commodity contract made, received, acquired,
or held by or through [an FCM] in the ordinary
course of [the FCM’s] business as [an FCM] from or
for the commodity futures account of such entity,”
which qualifies a person with such a claim as a
customer of the FCM under the Bankruptcy Code.
The CFTC statement further notes that the nature of
futures trading makes it unwise to provide different
treatment for an account that is currently portfolio
margined among OTC and exchange-traded
contracts and one that was at one time or is intended
to be so in the future. There is no requirement that
the customer’s assets are margining commodity
contracts on the day that the bankruptcy petition is
filed and all assets contained in the account are
properly included in the customer’s net equity for
purposes of making a claim.
Risk mitigation. The CFTC interpretative statement
provides that parties to OTC contracts that clear,
have cleared or intend to clear such transactions
through an FCM’s Section 4d account at a DCO will
be protected in the event of the FCM’s bankruptcy to
the same extent as a customer of the FCM whose
only transactions were exchange-traded futures.
Although the DCO guarantee does not run directly
to the customers of the clearing members, because of
the way the system operates, no customer of a
clearing member FCM has suffered financial loss
due to the FCM's failure during the history of the
Commodity Exchange Act, which dates to 1936.
The segregation of funds system protects a customer
from an FCM stealing its funds; the DCO guarantee
protects from default by the other side of the trade.
The treatment of an OTC contract party like any
other customer if the FCM goes bankrupt will serve
to protect the OTC party from fellow customers of
the FCM, which have caused FCM bankruptcies in
the past, when a fellow customer of the FCM
defaults in such a massive way that the FCM
becomes insolvent.
_____________________________
Energy Businesses and Futures Traders
Proposed FTC Anti-Manipulation
Rule Could Affect Energy
Businesses and Futures Traders
Charles R. Mills and Lawrence B. Patent
Energy businesses and traders in energy futures
markets should be aware that the Federal Trade
Commission (FTC), acting under authority granted
in last year’s energy bill, proposed a new antimanipulation rule in August that would prohibit the
use of manipulative or deceptive devices or
contrivances in wholesale crude oil, gasoline or
petroleum distillate markets. The FTC states in the
Federal Register notice announcing the proposals
that its rules in this area are modeled on SEC Rule
10b-5. The FTC thus would become part of the
posse of federal agencies searching for villains to
blame for the run-up in energy prices earlier this
year. The FTC is taking this action despite the fact
that, in response to its Advance Notice of Proposed
Rulemaking in this area, even very few consumer
commenters supported an FTC anti-manipulation
rule.
No safe harbor for futures traders. Despite
comments on an Advance Notice of Proposed
Rulemaking that a safe harbor provision or other
explicit exemption for the futures markets is
necessary to avoid overlap with CFTC (Commodity
Futures Trading Commission) jurisdiction over
futures markets, the FTC does not believe that a safe
harbor or exemption is warranted. Although the
FTC points to its prior practice of coordinating
enforcement efforts with other agencies, the CFTC
October 24, 2008
17
Global Financial Markets
has continued to urge the FTC to reconsider its
opposition to a carve-out of the futures markets from
the FTC’s rule. The extended comment period on the
FTC’s proposed rule closed on October 17, 2008,
and the FTC has scheduled a public workshop on the
proposals for November 6, 2008.
Are three heads better than one? Energy businesses
and futures traders may need to be mindful of the
FTC in addition to the CFTC and the Federal Energy
Regulatory Commission (FERC). The CFTC and
FERC continue to debate their respective
jurisdictions over energy futures markets, which has
been highlighted by the agencies separately bringing
competing enforcement actions against the nowdefunct hedge fund Amaranth Advisors, LLC with
respect to its trading in the natural gas futures
market.
_____________________________
Loan Modifications
Will the Federal Government
Force Innocent Parties to Bear
the Cost of Loan Modifications?
Laurence E. Platt
A critical question to be answered concerning the
Emergency Economic Stabilization Act of 2008
(“EESA”) is who will bear the cost of loan
modifications. There are great pressures on the
federal, state and local governments to keep
defaulting borrowers in their homes. However, loan
servicers and holders, who did not originate the
loans but have a financial interest in them, could
suffer significant costs if the government forces
certain loan modifications. Both loan holders and
loan servicers generally support the government's
strategic objective of home retention. However,
EESA leaves open the issue of when should a
borrower be eligible for a loan modification that
exceeds the cost of foreclosure? Click here to read a
recent alert that describes the requirements for loan
modifications under EESA and compares and
contrasts these requirements with the
pronouncement of the FDIC and the actions of state
attorneys general. To read the full alert, please click
go to
http://www.klgates.com/newsstand/Detail.aspx?pub
lication=4988.
_____________________________
K&L Gates Events
How to Prepare for an SEC
Examination
October 29 and November 12, 19, 2008
Local time in all locations:
8:00 - 8:30 a.m. Registration & Breakfast
8:30 - 10:30 a.m. Program
Boston, San Francisco, New York, Washington,
D.C.
Webinar Registration Link
http://www.klgates.com/events/Registration.aspx?e
vent=1762
Live Registration Link
http://www.klgates.com/FCWSite/event_forms/regi
stration_SEC_examination_10-1108.asp
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.
October 24, 2008
18