June 4, 2009
Volume 2 - Issue 3
Editors:
Michael J. Missal
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
From the Editors
In the past several weeks, we have witnessed a series of extraordinary events in the
financial markets that will change and shape the markets and the financial industry
for years to come. In response to these events, K&L Gates has formed a crossdisciplinary Global Financial Markets Group that pulls together a number of our
firm’s practices, including securities, banking, investment management, hedge funds,
mortgage banking and consumer finance, broker-dealer, legislative, litigation,
government enforcement, commodities, derivatives, tax, creditors’ rights and
insurance coverage. In addition to representing clients on issues related to the
financial crisis, we will be publishing a regular newsletter that will report on
significant developments and provide an analysis of why those developments are
important. This is the inaugural issue and we hope that you find this newsletter
informative, unique and comprehensive. If there are others in your organization who
would like to obtain an electronic copy of the newsletter, please visit
www.klgates.com and click on Newsstand to register.
_______________________________
Michael J. Missal
Matt T. Morley
Brian A. Ochs
Mark D. Perlow
In this issue:
__________________________________________________________
Mark D. Perlow
mark.perlow@klgates.com
+1.415.249.1070
• Capital Markets Reforms
• Depository Institutions
• SEC
• Hedge Funds
• Mutual Funds
• UK – Executive Bonuses
• Mortgage Banking
• TALF
• CFTC
• International Arbitration
Capital Markets Reforms
Congress Launches Capital Markets Reforms
Daniel F. C. Crowley, Karishma Shah Page
In the days before adjourning for the week-long Memorial Day Recess, Congress
passed and President Barack Obama signed into law three significant pieces of
financial services legislation, kicking off what is likely to be the beginning of a
comprehensive capital markets reform effort. This piecemeal yet swift approach
suggests the manner in which Congress may proceed with financial services reforms
moving forward.
Congress Passes Bills on Fraud, Credit Cards, and Mortgages
•
Fraud Enforcement and Recovery Act. On May 20, 2009, President Obama
signed into law S. 386, the Fraud Enforcement and Recovery Act of 2009
(FERA; P.L. 111-21). The legislation, which the Senate approved on May 14 by
a voice vote and the House passed on May 18 by a 338-52 vote, provides federal
authorities with enhanced funding and expanded powers over a broad range of
financial crimes (see K&L Gates Alert Fraud Enforcement and Recovery Act of
2009; http://www.klgates.com/newsstand/Detail.aspx?publication=5665). In
addition, FERA establishes an independent Financial Crisis Inquiry
Commission, modeled after the Pecora Commission of the 1930s (see below and
Global Financial Markets
K&L Gates Alert A Congressional Investigation
of Wall Street Looms;
http://www.klgates.com/newsstand/Detail.aspx?
publication=5618).
•
•
Helping Families Save Their Homes Act. On
the same day, President Obama signed into law
S. 896, the Helping Families Save Their Homes
Act of 2009 (P.L. 111-22). The bill, which was
passed with broad bipartisan support in both the
House and the Senate on May 19, enhances the
Hope for Homeowners Program and provides
the Federal Housing Administration with the
authority to engage in foreclosure mitigation
programs (for more information about other
mortgage-related provisions in the bill, see K&L
Gates Alert New Disclosure Obligation Imposed
on Assignees;
http://www.klgates.com/newsstand/Detail.aspx?
publication=5659). In addition, the legislation
also increases FDIC and National Credit Union
Administration borrowing authority and extends
the increased $250,000 deposit insurance limit
to 2013.
Credit Cardholders’ Bill of Rights Act. The
same week, Congress passed and the President
signed H.R. 627, the Credit Cardholders’ Bill of
Rights Act of 2009 (P.L. 111-24). The
legislation, which was also passed with
significant bipartisan support in both chambers,
bans certain credit card company practices
including double-cycle billing and late fees on
issuer delayed crediting of payments, prohibits
certain changes in interest rates, and requires
expanded disclosure of credit card terms and
agreements.
Financial Crisis Inquiry Commission and
Capital Markets Reform
•
The Commission. As noted previously, S. 386
establishes an independent Financial Crisis
Inquiry Commission. The Commission will be
comprised of ten members. Senate Majority
Leader Harry Reid (D-NV) and Speaker of the
House Nancy Pelosi (D-CA) will each appoint
three members. Senate Minority Leader Mitch
McConnell (R-KY) and House Minority Leader
John Boehner (R-OH) will each appoint two
members.
•
Mandate. The Commission is charged with: (1)
investigating the causes of the financial and
economic crisis; and (2) examining the causes
of the collapse of each major financial
institution that failed or was likely to fail had it
not been for government assistance. The
Commission must submit a report with its
findings to Congress on December 15, 2010.
•
Relationship to Anticipated Regulatory
Reform. Despite the Commission’s December
2010 deadline, Congressional leaders and the
Obama Administration have indicated their
intention of moving forward with the capital
markets reform efforts. As such, rather than the
Commission’s findings informing reform
legislation, it is likely that financial services
reform legislation will move forward in parallel
with the Commission’s investigation.
Next on the Agenda
•
Structure of Financial Services Regulation.
Treasury Secretary Timothy Geithner, National
Economic Council Director Lawrence
Summers, and President’s Economic Recovery
Advisory Board Chairman Paul Volcker met on
May 19, 2009 to discuss restructuring of the
financial services regulatory framework.
Although the proposal is still under
development, Secretary Geithner is considering
expanding the role of the Federal Reserve to
include systemic risk regulation and creating a
single bank regulator through a merger of the
current responsibilities of the FDIC, Office of
the Comptroller of the Currency, and the Office
of Thrift Supervision, and a possible merger of
the SEC and the CFTC.
House Financial Services Chairman Barney
Frank (D-MA), an opponent of the single bank
regulator model, prefers a dual-track model, in
which a systemic risk regulator is established,
while the existing bank and securities regulators
continue prudential regulation. The House
Financial Services Committee has scheduled a
series of hearings on regulatory restructuring.
Chairman Frank is preparing two pieces of
legislation, one dealing with systemic risk and
the other dealing with the structure of the
regulatory agencies. He plans to have the
June 4, 2009
2
Global Financial Markets
Committee consider at least one of the bills by
the end of the month.
•
•
Derivatives Regulation. Over-the-Counter
(OTC) derivatives may be another area where
reform efforts begin to take shape. On May 13,
2009, in a letter ( read at
http://www.treas.gov/press/releases/tg129.htm)
sent to House and Senate leadership, Secretary
Geithner proposed a comprehensive framework
for the regulation of OTC derivatives (see K&L
Gates Alert Comprehensive Regulatory
Framework for OTC Derivatives Proposed as a
Prelude to Reform of the U.S. Financial System;
http://www.klgates.com/newsstand/Detail.aspx?
publication=5654). The proposal has been met
with support from Chairman Frank and House
Agriculture Committee Chairman Collin
Peterson (D-MN), who share jurisdiction over
OTC derivatives issues, signaling that
policymakers may be close to reaching a
consensus on the general features of the
regulatory structure. In addition, Senate
Agriculture, Nutrition, and Forestry Chairman
Tom Harkin (D-IA) plans to hold a hearing on
June 4, 2009 on OTC derivatives trading.
Municipal Finance Regulation. Chairman
Frank recently circulated legislation related to
and held a hearing on municipal finance. The
four bills would: (1) standardize credit rating of
municipal bonds (H.R. 2549, Municipal Bond
Fairness Act;
http://frwebgate.access.gpo.gov/cgibin/getdoc.cgi?dbname=111_cong_bills&docid
=f:h2549ih.txt.pdf); (2) establish a federal
reinsurance program for municipal bond issuers
(H.R. 2589, Municipal Bond Insurance
Enhancement Act;
http://frwebgate.access.gpo.gov/cgibin/getdoc.cgi?dbname=111_cong_bills&docid
=f:h2589ih.txt.pdf); (3) create a credit liquidity
facility for municipal bond issuers (H.R. ____,
Municipal Bond Liquidity Enhancement Act;
http://www.house.gov/apps/list/press/financialsv
cs_dem/pressmfb05142009.shtml); and (4)
regulate financial advisors to municipalities (
H.R. ____, Municipal Financial Advisors
Regulation Act;
http://www.house.gov/apps/list/press/financialsv
cs_dem/pressmfb05142009.shtml). House
Financial Services Ranking Minority Member
Spencer Bachus (R-AL) has expressed
skepticism over the bills.
Committees with jurisdiction over financial services
issues have also recently held hearings on insurance
regulation, hedge fund registration, credit rating
agency reform, and federal government resolution
authority.
The K&L Gates Public Policy group is closely
monitoring these developments on behalf of the
firm’s policy clients.
______________________________
Depository Institutions
FDIC and OTS Approve
Private Equity Group’s
Acquisition of Failed Thrift,
But Guidelines for
Commercial Bank
Investments Remain
Unclear
Stanley V. Ragalevsky, Sean P. Mahoney
On May 20, 2009, the Office of Thrift Supervision
(“OTS”) and the Federal Deposit Insurance
Corporation (“FDIC”) approved the acquisition of a
failed thrift institution, BankUnited, FSB, by a
group of private equity investors. The FDIC, as
receiver of the failed institution, accepted the
private equity investors’ bid as the least cost
resolution of the failure. In approving the
transaction, the OTS permitted the transaction to be
structured in a way that allowed the constituent
members of the investor group to remain free of the
regulatory restrictions that apply to those who
control thrift institutions. The transaction thus offers
important precedent as to how purchases of failed
institutions may be accomplished by private equity
firms. It also highlights significant uncertainty
regarding private equity investments in commercial
banks.
Historically, investors in depository institutions and
their holding companies have sought to avoid
investments that would be considered “controlling”
under the federal banking laws. Control of a
depository institution, either directly or indirectly,
June 4, 2009
3
Global Financial Markets
can lead to limitations on the activities of the
controlling company, requirements to support
financially the subsidiary depository institution, and
also subject transactions between the depository
institution and the affiliates of the controlling
investor to certain restrictions. Moreover, investors
deemed to have “control” of a depository institution
generally must register as a bank, financial, or thrift
holding company, with ongoing regulation and
reporting requirements. These restrictions have
discouraged investment in banks and holding
companies at a time when these organizations
desperately need to attract additional capital. (See
also K&L Gates client Alert, Non-Controlling
Investments in Banking Institutions and Their
Holding Companies;
http://www.klgates.com/newsstand/Detail.aspx?publ
ication=4968)
In the BankUnited transaction, the investor group
formed two holding companies (a top-tier and an
intermediate-level entity) to acquire the bank’s
shares, and the holding companies applied for
regulatory approval as savings and loan holding
companies, which was required to permit them to
acquire control of the bank. At the same time, each
of the constituent investors – none of whom had
beneficial ownership of more than 25 percent of the
voting securities of either the holding companies or
the bank – disclaimed control of the bank by filing a
Rebuttal of Control Agreement, along with a rebuttal
of the presumption of control, with the OTS.
Significantly, the OTS accepted the investors’
position that the investor group members were not
acting in concert. By effectively determining that the
act of forming an investment vehicle to acquire
control of a bank was not concerted action, OTS
appears to have eased the way for private equity club
deals to acquire federal savings banks and statechartered savings banks that elect to be regulated by
the OTS.
In its press release announcing the resolution of the
BankUnited matter, the FDIC indicated that it would
publish guidance on eligibility for non-bank firms to
bid on failed banks and the terms and conditions for
such investments. Such guidance should prove
valuable to private equity firms wishing to bid on
failing banks.
Unfortunately, the structure approved in the
BankUnited deal, while approved for a savings and
loan holding company, may not translate to the
commercial bank sector. Commercial bank holding
companies are regulated by the Board of Governors
of the Federal Reserve System (the “Federal
Reserve”), which specifically declined to adopt
guidance on simultaneous minority investments in
depository institutions (i.e., “club” deals) in its
September 22, 2008 guidance on non-controlling
investments in banks. Thus, it remains unclear
whether the Federal Reserve would accept, as OTS
has, that investment firms could disclaim control
when forming a common investment vehicle. This
leaves significant uncertainty in the regulatory
framework applicable to private equity investments
in commercial banks. Also uncertain is the status of
the so-called “silo” structure whereby individual
investors in a private equity fund can invest in a
bank thereby avoiding the private equity fund from
taking control of the target bank. The Federal
Reserve appears to disfavor the silo structure, and
the Bank United order does not provide any
guidance to how the OTS and FDIC view it.
Unless and until the Federal Reserve issues
guidance on this issue or rules on a transaction
similar to the BankUnited deal, it will remain
unclear the extent to which groups of private equity
firms will be able to take over and recapitalize
failing commercial banks.
______________________________
SEC
SEC Chairman Schapiro
Defends Agency, Maps Out
Strategy for Revival
Mark D. Perlow
Congress, the media and the public have subjected
the SEC to harsh criticism in recent months,
charging that it failed to prevent the collapse of
Bear Stearns and Lehman Brothers and to detect the
long-running Ponzi scheme of Bernard Madoff.
While the accusations are somewhat unfair –
banking regulators failed to prevent the insolvency
of many large depository institutions, and the
Financial Industry Regulatory Authority also failed
to detect the Madoff fraud – these charges have
achieved considerable political traction, and many
recent proposals for regulatory reform would strip
authority from the SEC or merge it into a new or
June 4, 2009
4
Global Financial Markets
already existing regulatory agency, such as the
CFTC.
SEC Chairman Mary Schapiro, however, has made
clear that she intends to assert aggressively the
continuing importance and relevance of the agency.
In particular, in a recent speech, Chairman Schapiro
made the case for the SEC and its distinctive brand
of financial regulation. She stated her view that the
capital markets require a different type of regulation
than do financial institutions, one that is focused on
the protection of investors rather than on the safety
and soundness of key institutions. She argued that
investor protection requires an agency that is
independent and experienced in dealing with the
capital markets, an implicit criticism of banking
regulators as too closely tied to the banks they
regulate. She detailed the SEC’s past regulatory
achievements, including regulatory regimes that
have fostered successful exchanges, clearing
agencies, mutual funds, investment advisers and
broker-dealers, all of which (other than the largest
investment banks) have functioned without a
systemic failure during the current crisis. Although
she does not put it this way, she is arguing that if the
SEC did not exist, it would have to be invented.
Nonetheless, Chairman Schapiro admitted that the
SEC has not performed up to expectations recently,
and she mapped out the agency’s recent efforts to
revitalize itself. First and foremost, she emphasized
that the SEC’s enforcement program would be
tougher and more efficient. She signaled the SEC’s
intention to bring “meaningful cases that have the
greatest impact and send a strong message.” In an
effort to achieve these goals, the agency has
eliminated controversial procedures requiring the
staff to get pre-approval of the full Commission to
launch a formal investigation or to negotiate
settlements that include penalties. In addition, the
SEC will engage a consulting firm to help the
agency determine how best to sort through the
countless tips and complaints it receives each year.
The agency will also improve training and hire staff
analysts (who may not necessarily be lawyers) with
more financial industry experience. These reforms
will resonate with practitioners with experience of
the bureaucratic ways of the enforcement program.
Subjects of SEC investigations can expect to face an
even more relentless Division of Enforcement.
Schapiro also summarized some of the key elements
of the SEC’s current pipeline of cases, making clear
the agency’s intent to bring “message” cases – 150
hedge fund investigations, two dozen municipal
securities investigations, and 50 cases involving
credit default swaps (“CDS”), collateralized debt
obligations and other derivatives. Recently
announced enforcement actions have filled out this
story further: the SEC has brought several dozen
cases against alleged Ponzi schemes; the first
insider trading case based on transactions in CDS; a
case alleging manipulation of a municipal securities
market; a case alleging that an investment adviser
did not have adequate procedures to protect against
conflicts of interest in its proxy voting procedures;
an action against the manager of a money market
fund that broke the buck for allegedly inadequate
disclosures; and a case against executives of a
subprime lender for allegedly misleading investors
about the riskiness of its loan portfolio.
As Schapiro pointed out, the SEC also has a full
rule-making agenda. In April, it proposed
reinstating the short-sale uptick rule (or some
variant on it); in May, it proposed a revamp of the
client asset custody regime for registered investment
advisers, including proposals to require surprise
audits and independent compliance reviews, with
the clear intent to prevent another Madoff. The SEC
has also issued a controversial proposal to provide
public company and investment company
shareholders with access to the company’s proxy
statement both to nominate a short slate of directors
and to propose amendments to company nomination
process bylaws. Schapiro’s willingness to take up
this topic, which has been considered in various
forms almost since the creation of the SEC and
vigorously opposed by many industry groups,
reflects her determination to restore the agency’s
reputation with the public by picking a high-profile
fight. Later this month, the SEC will propose new
rules on money market funds, and is considering an
expansion of the municipal pay-to-play rules and
municipal securities disclosure, new rules regulating
hedge funds, and seeking authority over
whistleblower actions.
The Obama Administration has stated that it wants
to see Congress pass a financial regulatory bill by
the end of the year, and the chairs of the relevant
Congressional committees have agreed to this
timetable. The SEC is on a mission to demonstrate
its importance and competence before the serious
legislative sausage-making begins in the fall, all
June 4, 2009
5
Global Financial Markets
against the backdrop of deep public disillusionment
with the financial sector. As one aspect of that
campaign, subjects of SEC investigations and
examinations, and industries targeted in SEC
rulemaking proposals, should expect a tougher fight
than at any time in recent memory.
______________________________
Hedge Funds
Reshaping the Global
Hedge Fund Industry
Edward G. Eisert, Megan B. Munafo
Hedge funds are under intense scrutiny as a result of
the global financial crisis and the most
comprehensive review of the financial industry
regulatory framework in 70 years. Until recently,
most legislators and regulators believed that the
hedge fund regulatory regime was adequate, taking
into account reliance on the oversight of hedge fund
financial counterparties, such as prime brokers.
However, in the current environment, anxiety has
grown that hedge funds could pose a systemic risk to
the global financial system due, in part, to: (i) the
large amount of assets managed through hedge
funds; (ii) the use of leverage by hedge funds; (iii)
the relative lack of transparency concerning their
operations; and (iv) the limited power of regulators
to examine their managers and the funds themselves.
Although hedge funds have been a focus of
regulatory reform in the past, global initiatives have
accelerated in 2009. In the wake of the April 2009
G-20 meeting held in London, two sets of initiatives
are anticipated to significantly reshape the regulation
of hedge funds: (i) the draft Directive on Alternative
Investment Fund Managers (“AIFMs”) issued by the
European Commission; and (ii) legislative
developments in the United States.
Draft Directive Issued by the European
Commission
On April 29, 2009, the European Commission
proposed legislation designed to impose the first
European-wide regulation of alternative investment
capital pools, including hedge funds, in an effort to
reduce systemic risk and harmonize regulation in the
European Union (“EU”). The proposed Directive on
Alternative Investment Fund Managers (the “AIFM
Directive”) would require EU-domiciled managers
of hedge funds and other alternative capital pools
with assets under management of more than €100
million, or €500 million where the funds have “no
leverage” and a “lock-up period” of five years or
more, to be “authorized” by their home Member
State and report regularly on the main investments
of the fund, its performance and risks. In addition,
AIFMs would be subject to ongoing regulation
relating to minimum capital, risk management and
audit arrangements. (Directive of Alternative
Investment Fund Managers (AIFMs): Frequently
Asked Questions, Memo/09/211, 29/04/2009).
The AIFM Directive would not regulate the fund
itself, its fees, or its investment objectives. Rather,
the AIFM Directive provides that: (i) only AIFMs
established in the EU can provide their services in
the EU; and (ii) only funds domiciled in the EU can
be marketed by authorized AIFMs in the EU.
Nonetheless, in order to allow offshore funds to
continue to be offered in the EU, the AIFM
Directive would provide an “EU Passport” for the
marketing of such funds that comply with “stringent
requirements in regulations, supervision and
cooperation, including on tax matters.” The AIFM
Directive would impose for the first time capital
requirements on AIFMs and limits on fund leverage,
and it would also establish business conduct
principles such as fair dealing and detailed rules
regarding independent valuation and disclosures to
investors and reporting to regulators. The AIFM
Directive would also institute reporting
requirements regarding controlling interests in fund
portfolio companies. In order to allow time for the
development of rules allowing for the marketing of
“third country funds,” for a period of three years
after the effectiveness of the AIFM Directive, third
country funds could continue to be sold in the EU,
subject to individual Member State approval. In
light of the strong critical reaction by various
organizations in the alternative investment industry,
and the requirement that the AIFM Directive is
subject to approval by the European Council and the
European Parliament, it is not likely to become
effective until at least 2011. For more information
on the proposed Directive, please see the K&L
Gates Alert European Commission Proposes
Regulation of Alternative Investment Fund
Managers;
June 4, 2009
6
Global Financial Markets
http://www.klgates.com/newsstand/Detail.aspx?publ
ication=5678/.
U.S. Legislative Developments
In the first quarter of 2009, several bills were
introduced in the U.S. Congress that would require
hedge fund managers and “large” hedge funds to
register with the U.S. Securities and Exchange
Commission (“SEC”), comply with information
reporting and other requirements, and subject them
to further study. One, the “Hedge Fund
Transparency Act,” would limit the availability of
the exemptions from registration under the
Investment Company Act of 1940 relied upon by
hedge funds to those with assets under management
of less than $50 million. (S. 344, 111 th Cong.
(2009)). Another, the “Hedge Fund Adviser
Registration Act of 2009,” would eliminate the
“private adviser exemption” under the Investment
Advisers Act of 1940 (the “Advisers Act”),
commonly relied upon by hedge fund managers,
with the effect of requiring virtually all hedge fund
managers to register with the SEC under the
Advisers Act. (H.R. 711, 111th Cong. (2009)).
Although its precise terms have not yet been
defined, following the G-20 meeting in April and the
increased focus on a global systemic risk regulator, a
broad legislative proposal is anticipated in 2009 that
will include a requirement that private fund
managers be registered under the Advisers Act. The
Obama Administration has also proposed that the
SEC be authorized to obtain, among other things,
hedge fund portfolio holdings information from fund
managers in order to report on potential systemic
risks to a newly designated systemic risk regulator.
In May 2009, in testimony at a hearing held before
the House Financial Services Subcommittee on
Capital Markets, Insurance, and Government
Sponsored Enterprises, the Managed Funds
Association (the “MFA”) announced its support for
the mandatory registration of investment advisers
(including advisers to private pools of capital) with
the SEC under the Advisers Act. The MFA is an
organization comprised of professionals from hedge
funds, funds of funds, managed futures funds and
industry service providers. The proposed framework
supported by the MFA goes beyond recent
proposals, which only sought to require the largest
fund advisers to be registered, and would subject the
vast majority of investment advisers to the
registration requirements of the Advisers Act. The
MFA’s position signals that leading hedge fund
managers have accepted that there will be increased
regulation and are trying to shape it rather than fight
it.
Also of far-reaching impact, the President’s Budget
Outline for fiscal year 2010 includes provisions for
the taxation as ordinary income of the “incentive
allocation” or “override” received by the managers
of U.S.-domiciled hedge funds. As proposed, the
“Stop Tax Haven Abuse Act” would “restrict the
use of offshore tax havens and abusive tax shelters
to inappropriately avoid federal taxation, and for
other purposes.” (S. 506, 111 th Cong. (2009); H.R.
2136, 110 th Cong. (2007)). At the same time, the
Treasury has reaffirmed the value of private pools
of capital to the financial system in its proposals for
Public-Private Investment Funds.
Moving Forward
As these various initiatives progress, it appears that
not only will private investment fund managers,
wherever domiciled, become subject to more
intense U.S. regulatory scrutiny, but U.S.-domiciled
managers will become subject to EU regulatory
scrutiny, at least insofar as they manage Europeanbased funds or market funds in Europe. An active,
substantive dialogue between the private sector and
global regulators will be necessary in order to
promote the development of regulatory reforms that
are measured and that contribute to the restoration
of financial market stability without unduly
restricting the ability of hedge funds to meet the
needs of investors.
______________________________
Mutual Funds
Regulatory Reform and the
Mutual Fund Industry
Mary C. Moynihan, Diane E. Ambler
Although mutual funds have not been implicated as
a cause of the financial crisis, many investors have
experienced the crisis most directly through the
plummeting value of their mutual fund investments.
As Washington moves to address the myriad issues
arising from the crisis, the mutual fund industry
should expect to see changes that will directly affect
June 4, 2009
7
Global Financial Markets
how funds—and their advisers, distributors and
custodians—do business. Changes of particular
interest to the mutual fund industry are discussed
below.
Change to Primary Regulator for
Registration of Mutual Funds, BrokerDealers and Advisers
Lawmakers are considering several configurations
for a new regulatory regime. These include
consolidation of the SEC with the CFTC—although
Barney Frank, the powerful chair of the House
Financial Services Committee, has expressed doubts
as to whether such consolidation will happen.
Another idea involves the creation of a financial
products safety commission. Whether that proposal
will take hold is unclear, although key Democrats in
the Senate and House have submitted a bill to create
the commission. Even if it were created, the White
House is reported to support a plan under which the
new financial products safety commission would
focus on consumer products such as mortgages and
credit cards, but would not have jurisdiction over
securities (and therefore mutual funds), which would
instead be regulated by the new agency resulting
from a merger of the SEC and CFTC. Because the
proposals are likely to trigger a turf war in Congress
and among the affected agencies, it is still too early
to predict the outcome. Lawmakers are also still
waiting for final proposals from the Obama
administration.
Money Market Funds
Money market funds have drawn closer regulatory
scrutiny since the Reserve Primary Fund broke the
buck in September, spurring large-scale redemptions
from money market funds with large institutional
investor bases and a guarantee program from the
U.S. Treasury. While the Group of 30 proposed
earlier this year that funds that maintain a stable $1
NAV be regulated as special purpose banks, this
proposal does not seem to have gained traction.
However, a consensus has developed on the need to
tighten the rules governing money market funds’
portfolio assets’ credit quality, maturity and
liquidity. The first detailed proposal came in March
from a task force convened by the Investment
Company Institute, which included proposals to (1)
impose daily and weekly minimum liquidity
requirements; (2) stress test the portfolio; (3) tighten
portfolio maturity limits; (4) raise credit quality
standards on portfolio investments; (5) address
client concentration risks; (6) disclose portfolio
investments monthly; (7) require additional risk
disclosures; (8) authorize suspending redemptions
for several days for failing funds; and (9) establish a
nonpublic reporting scheme to regulators for all
money market investors. The SEC has not yet
produced a detailed proposal. However, SEC Chair
Mary Schapiro has made clear that the SEC will
propose tougher rules later this month that will
“extend beyond” the ICI task force proposals. The
staff is examining the credit quality, maturity and
liquidity provisions currently applicable to money
market funds and considering whether more
fundamental changes are needed, including floating
rate net asset values for money market funds.
“Proxy Access” and “Say on Pay”
In May, the SEC proposed a new “proxy access”
rule that would set a tiered system under which
shareholders may nominate candidates for election
to boards of directors. For example, for companies
with a market cap of $700 million or more,
shareholders owning at least 1% of the voting
securities would be eligible to nominate directors.
By some estimates, this could increase by three or
four times the number of contested director
elections that funds must evaluate in exercising
proxies. In addition, funds themselves would be
subject to the proposed rule, which would allow
shareholders to nominate fund directors. Finally,
funds with ownership positions in excess of the
thresholds would need to determine whether they
should be proposing director candidates for
portfolio companies. These proposals would
transform a fund’s traditional analysis of “buy vs.
sell” and force new decision-making concerning
voting and management. Also in May, Senators
Charles Schumer and Maria Cantwell introduced a
“shareholder bill of rights” that would require nonbinding shareholder votes on how executives are
paid. The bill is not likely to pass in its current form
but, particularly in view of the action taken earlier
this year by the House to limit compensation of
recipients of TARP money, any reform package is
likely to include some corporate governance
component.
June 4, 2009
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Global Financial Markets
Emerging Best Practices Relating to Risk
Management
Custody of Client Assets by Investment
Advisers
Many fund advisers and boards are examining
whether the events of the past year suggest that they
need additional risk monitoring programs to evaluate
risk elements in the portfolio and the adviser’s
organization. There is no “one size fits all” answer
to the risk management puzzle, and the precise
actions that a fund family and its board should take
with respect to risk assessment are highly subjective
and based on many different factors, including the
nature of the fund family’s investments, experience
with risk, organizational structure, and nature of
investors. Nonetheless, the SEC has indicated that
risk will be a central concern, suggesting that
advisers may need to develop a more robust
approach to risk management and that fund boards
may wish to consider creating a risk management
oversight committee or adding responsibility for risk
oversight to an existing committee, such as
compliance or investment performance.
Following the Madoff scandal, the SEC has moved
swiftly to propose new rules governing the custody
of client funds held by all registered investment
advisers. The proposed rules would require advisers
to undergo an annual surprise examination by an
independent public accountant to verify client
assets. In the case of assets that are not maintained
by an independent qualified custodian, the rules
would require a “SAS-70” report from an
independent public accountant registered with and
inspected by PCAOB that includes an opinion
covering controls over custody of client assets. The
proposed rules would not apply to custody of assets
held by mutual funds, but would affect advisers
with respect to other classes of client funds.
Target Date Funds
In a May speech to the Mutual Fund Directors
Forum, SEC Chair Schapiro stated that the SEC is
closely examining target date funds due to concerns
with performance of the funds during the market
decline. As these funds approach their “target” date,
their asset allocations should move toward a more
conservative allocation, often referred to as a fund's
“glide path.” Some funds may have established more
aggressive glide paths based on the assumption that
investors would continue to maintain their
investments, and partially live off the proceeds
following retirement. This could be particularly
problematic for a target date fund underlying a
college investment plan, since those investors would
need to access their investment at or near the fund’s
target date. Chairman Schapiro stated that the SEC
staff would be closely reviewing target date funds’
disclosure about their glide paths and asset
allocations, examining whether the same target date
funds underlie both retirement and college savings
plans and considering whether the target dates in
some funds’ names are misleading. Chairman
Schapiro also challenged fund directors to review
their funds’ allocations between asset classes.
When the dust settles, the investment management
landscape will undoubtedly be much changed.
Mutual funds will likely be subject to new rules,
regulated by a reconstituted regulator, and,
especially if hedge funds and other unregulated
entities face more regulation, will encounter a new
competitive environment. Industry participants
should closely monitor these developments and may
wish to provide input into policy choices that will
have direct implications for them and their
investors.
______________________________
UK - Executive Bonuses
“The Days of Big Bonuses
are Over …”
Daniel Wise
So said Gordon Brown in the immediate aftermath
of the economic crisis that shook the City in
October of last year. This sentiment has been
echoed by the Treasury Committee’s report
published on 15 May which stated that “bonus
driven remuneration structures led to a lethal
combination of reckless and excessive risk taking.”
As the recession begins to deepen in the UK,
unemployment continues to rise and city financiers
lick their wounds following a record low bonus
round this year, a web of employment law issues
June 4, 2009
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Global Financial Markets
arise out of employer reaction to this paradigm shift
in the financial markets.
have been hit, again the employee is likely to have a
strong claim for the recovery of this sum.
Primary among these are issues as to the legality of
City employers’ attempts to slash bonus awards or
recoup payments already received, and how to shape
the bonus elements of remuneration structures in
senior level service contracts to reflect changes in
the expectations of both employers and employees in
an environment that has grown intolerant of the fat
cat/big bonus City culture.
Thus where banks have bowed to commercial
pressure to reduce bonuses as a result of a disastrous
bonus year and a pessimistic financial forecast for
2009, the Courts may well rule against them, given
the case law in recent years in favour of an
employee’s contractual entitlement to certain levels
of bonus payment irrespective of the economic
climate and/or the strength of the particular bank’s
financial position.
Bonus Litigation
Hundreds of staff members at Dresdner Kleinwort
have lodged claims to recover tens of millions of
pounds in unpaid bonuses resulting from the
decision of its new owner, Commerzbank, to slash
compensation payouts. A raft of similar claims are
expected against other financial institutions as
employers come under increased commercial
pressure to reduce or eliminate bonus payments,
particularly in circumstances where organisations
are now effectively Government run.
Depending on the specific employer bonus structure,
the legal ramifications of trimming such bonus
payments may be significant. Many employers will
have established contractual obligations to certain
levels of bonus payment in recent years, either
through custom and practice, or as a part of
negotiated service agreements to attract particular
stars in the financial community. For example, many
banks in recent years have introduced a “Golden
Hello” scheme to new joiners, guaranteeing a
minimum level of bonus for all or a portion of their
first bonus year, regardless of performance during
that period. These payments are designed to
compensate new recruits for the bonus they have lost
leaving their previous employer midway through a
bonus year. A refusal to honour such a contractual
provision will almost certainly be unlawful.
Another common trend that has developed in the
City in recent years has been to link bonuses to
performance targets, creating an irreducible
contractual entitlement once these personal
performance targets are hit, irrespective of the
bank’s overall performance. These targets are often
short term, and often paid out in lump sum cash
awards. Despite the current climate and the potential
difficulties banks are now facing, if such bonuses are
not paid in circumstances where performance targets
When addressing the restructure of bonus schemes
for future years, many UK employment lawyers
caution against changing too much too quickly,
although in the current economic climate many
financial institutions will have no choice. For
example, adoption of the recent FSA Code’s
principles and replacing what was previously a
contractual bonus structure with deferred bonus
scheme, may cause wholesale team moves to
competing institutions along with a raft of
constructive unfair dismissal claims from departing
employees arising out of the bank’s breach of its
implied duty of trust and confidence. However, the
financial landscape will also be a major factor in
assessing the commercial risk of these claims being
brought. If either the majority of other banks are
unwilling to take on new recruits or are adopting
similar schemes for their employees, there will be
little practicable risk of this legal consequence.
Repaying a Bonus
The clarion call through both the press and in
political circles for high-profile, senior-level
executives to repay bonuses which have already
been awarded also throws up some interesting
issues for UK employment lawyers. One individual
who bowed to public pressure and repaid a
substantial bonus is Michael Fingleton, chief
executive of Irish Nationwide, who in March of this
year voluntarily returned his €1 million bonus
awarded for 2008. In his statement to the press at
the time. Mr. Fingleton was at pains to point out
that the bonus was “a contractual and binding
agreement... which [he] was legally entitled to
receive….” His move came in response to both
political and commercial pressure, rather than as a
consequence of any legal obligation to do so. This is
of course correct. In circumstances of this kind,
particularly where payment of the bonus is pursuant
June 4, 2009
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Global Financial Markets
to a contractual entitlement, any employer’s
remedies against senior executives to compel
repayment are limited, unless specific contractual
provision has been made for this within the service
agreement. In circumstances of alleged regulatory
breach by a financial institution, employers are in a
much weaker position in the UK than in the US,
where the Sarbanes-Oxley Act of 2002 requires
certain levels of senior executives to repay incentive
based remuneration in specific instances of
securities law breaches.
Making provision for a contractual term forcing
repayment in these circumstances is now an issue
that many UK banks are grappling with. The move
to include such a term is not without its difficulties.
Firstly, the UK law on penalty clauses will cause
such a contractual provision to be unenforceable if it
provides for repayment of a bonus as a result of a
breach of contract and the repayment is deemed to
be a penalty. In determining this, a Court will
consider whether the payment is a genuine preestimate of the loss suffered by the bank arising out
of the breach or simply a penalty. If it is the latter,
the clause will be unenforceable. However, case law
on this subject suggests that where there is a bona
fide attempt to pre-estimate loss, such a clause may
be upheld, despite the fact that the figures differ
from the actual loss caused.
Secondly, the purpose behind the clause must be to
compensate the employer rather than to act as a
deterrent. It is often the case in a financial context
that breach by a senior executive could lead to
substantial monetary losses, and in circumstances
where such losses far exceed the amount required to
be repaid by the director it will be easy for the
employee to suggest the repayment was not to
compensate the bank, but to act as a deterrent.
Whilst it is possible to put together a sliding scale of
repayment which is directly linked to loss flowing
from the breach, persuading a senior executive to
sign up to such a clause may well be an
unsurpassable hurdle to any subsequent challenge.
Thirdly, proving that the breach occurred is often a
practical difficulty in consequent litigation,
particularly in the context of complex financial
dealing structures where a Court is asked to
determine the reasonableness of a decision arrived at
based on complex assessments of commercial risk.
This hurdle can often make such a clause
unworkable.
An alternative approach to clauses of this kind is to
avoid any linkage with a breach of contract by
connecting a repayment obligation to external
measures of some kind. These alternative
contractual terms are commonly known as “no
fault” repayment agreements. These provisions
eliminate the risk of being struck down as a penalty
clause, and can provide the employer with the
ability to require repayment in various different
circumstances, including when the bank itself has
performed particularly badly in any given year.
Whilst it is important that such clauses are drafted
to ensure that sufficient clarity exists to allow them
to be enforceable, other than this drafting hurdle
such a clause can be relatively effective.
Employers generally have not previously used such
clauses due to a concern that such a provision in a
bank’s standard service agreement may deter strong
senior executives from joining. However, depending
on the mood of the general public going forward,
both in the US and the UK, as well as an increased
scarcity of positions at a senior level, banks may
well find themselves in much stronger negotiating
positions when drafting senior level service
agreements.
Some of the suggested models for recovering all or
a portion of a bonus already paid without linking
this repayment request to contractual breach have
been discussed in the context of clawback
provisions which are also referred to in the FSA
Code. The three common types of clause are as
follows:
•
Clawbacks due to over-estimated
performance - Such a clause can be used when
a bonus is linked directly to performance
conditions or performance is one of the criteria
taken into account when awarding a
discretionary payment. The clawback provision
will be operative where the performance criteria
were initially thought to be satisfied but later
turned out to have been overstated. This clause
will be effective provided it is exercised
objectively and reasonably.
•
Clawbacks for negative developments - This
provision is triggered by certain specified
negative developments occurring within a set
period after the bonus is paid. The negative
June 4, 2009
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Global Financial Markets
development should be something which is not
personally linked to the employee but rather an
objective development such as the bank
announcing a major loss.
•
Clawbacks for unrecognised breach at the
time of payments - This form of provision is
not as safe legally given its close nexus to the
penalty clause principle. However, case law
suggests that such a clawback provision which
becomes operative when an employer discovers
serious breach by the employee (which occurred
prior to payment of a bonus) may well be
enforceable, and will not be struck down as an
unenforceable penalty clause.
The extent to which some or all of these contractual
measures will become commonplace will in a large
part be shaped by global trends, and in particular the
US’s reaction. Now that the world’s key financial
centres are so closely aligned, it would be foolhardy
to approach these sorts of issues as isolated domestic
problems, and any reaction and/or solution will
almost inevitably follow the tide of global opinion.
______________________________
Mortgage Banking
No Lazy Days of Summer
for the Consumer Credit
Industry
Steven M. Kaplan, Kerri M. Smith
The consumer credit industry has been subject to
legislative and regulatory changes occurring at a
dizzying velocity.
On May 22, 2009, the Credit Card Accountability
Responsibility and Disclosure Act of 2009 became
law, amending the Truth in Lending Act (“TILA”) to
establish fair and transparent practices relating to the
extension of open-end consumer credit plans and gift
cards. TILA also was amended in the Helping
Families Save Their Homes Act of 2009, signed two
days prior. Further, on that May 20, 2009 date,
President Obama issued a Memorandum for the
Heads of Executive Departments and Agencies
directing federal agencies to take appropriate action
if preemption regulations do not meet certain
requirements, which could affect almost every
segment of the consumer finance industry.
Federal regulators have also been active. For
example, the Federal Trade Commission initiated
rulemaking proceedings on June 1, 2009 to address
unfair and deceptive practices in the mortgage
industry, as required by Congress’ 2009 Omnibus
Appropriations Act. Concurrently, the federal
financial institution regulatory agencies are issuing
proposed rules requiring mortgage loan originators
who are employees of agency-regulated institutions
to meet the registration requirements of the Secure
and Fair Enforcement for Mortgage Licensing Act
of 2008.
While the industry scrambles to come to grips with
the array of new requirements, two of the issues
garnering much attention are the residential
mortgage loan servicer safe harbor and the new
TILA disclosure obligations on purchasers of
residential mortgage loans, found in the Helping
Families Save Their Homes Act of 2009 (“the
Act”).
The servicer safe harbor, as discussed in section 201
of the Act, provides that a mortgage loan servicer
will be shielded from liability from any party to
whom it owes a duty “to maximize the net present
value,” based solely on its implementation of a
“qualified loss mitigation plan” (“QLMP”), so long
as that QLMP is deemed to be in the best interest of
all investors or other parties. The Act determines
that a servicer acts in the best interest of all
investors (again, when it has an express duty to
maximize net present value) if it makes a QLMP
where: (1) default has occurred, is imminent, or
reasonably foreseeable, as those terms are defined in
the Department of Treasury’s Home Affordable
Modification Plan guidelines (“HAMP”); (2) the
property is occupied by the debtor as a primary
residence; and (3) the servicer reasonably
determines, consistent with HAMP, that a QLMP
for a particular property or a class of properties will
result in greater principal recovery than foreclosure
of that property. Further, the Act defines a QLMP as
a plan described or authorized by the HAMP, or a
refinancing under the federal Hope for Homeowners
program. It may surprise some, but the new servicer
safe harbor contains no express provisions regarding
the superseding of contractual restrictions. The
ambiguity is even more pronounced when compared
to the House’s safe harbor provision in H.R. 1106,
which was not enacted into law, but which did
contain such express provisions.
June 4, 2009
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Global Financial Markets
Meanwhile, the Act also provides that purchasers of
residential mortgage loans have affirmative disclosure
obligations to consumers, and subjects them to civil
liability if they fail to comply. The statute provides
that it is effective upon enactment, which means that
the first disclosures are required by Friday, June 19,
2009. One of the fundamental questions regarding
this obligation, however, is which purchasers are
subject to this new disclosure obligation.
Section 404 of the Act amends TILA to provide that
“a creditor that purchases or is assigned a mortgage
loan must notify the borrower in writing of a sale or
transfer of his or her mortgage loan, not later than 30
days after the transaction’s completion.” The notice
must include the following information:
•
the identity, address, and telephone number of
the new creditor;
•
the transfer date;
•
how to reach an agent or party having authority
to act on behalf of the new creditor;
•
the location of the place where transfer of
ownership of the debt is recorded; and
•
any other relevant information regarding the
new creditor.
The Act’s use of the term “creditor” to describe the
“new owner” conflicts with TILA’s preexisting
definition of creditor as the one to whom the loan was
“originally payable.” This conflict in statutory terms
makes it very difficult for the mortgage industry to
know who must comply with the new law.
Additionally, there are several other ambiguities
contained in the new disclosure requirement, including
whether the obligation should apply to so-called shortterm transfers and the specific information that must be
included in the disclosure.
Some might say that in the policy makers’ wish to
enact legislation, clarity was compromised. Thus, we
hope that future laws and regulations will be clearer
than those recently enacted. If federal policymakers
continue regulating at this fast pace, credit industry
participants may need to swap their beach reading
for copies of the Federal Register and the
Congressional Record.
______________________________
TALF
TALF Investments:
Progress and Political Risk
Anthony R.G. Nolan
The Term Asset-Backed Securities Liquidity
Facility (“TALF”) was announced in February 2009
and first implemented in the following month. As an
emergency lending facility established by the
Federal Reserve Bank of New York (the “New York
Fed”) pursuant to Section 13(3) of the Federal
Reserve Act, TALF provides non-recourse term
financing for the purchase of highly rated assetbacked and mortgage-backed securities at attractive
rates. Although it is backed by a $200 billion credit
facility from the Treasury, it is not considered a
TARP program subject to the Emergency Economic
Stimulus Act of 2009 (“EESA”). However, because
of the involvement of the New York Fed in the
program as well as its close association with TARP,
prospective borrowers have had to weigh the
political risks of their involvement and the extent to
which governmental authorities could access
information about their activities and their
investors.
In the first three subscriptions that occurred in
March, April and May 2009, TALF borrowings
financed approximately $16 billion in newly issued
asset-backed securities, facilitating over $24 billion
in issuance of asset-backed securities. After a slow
start, and considerable hesitation by investors over
participating in the April subscription owing to
political and other risks, the TALF program appears
to have come into its own in the May subscription,
with approximately $10.5 billion of TALF
subscriptions facilitating the issuance of
approximately $13.5 billion of TALF eligible
securities. Subscriptions for the June funding appear
to be on track to increase substantially from the
May subscription level.
The acceleration of TALF subscriptions reflects
several factors. These include
•
expansion of the scope of asset classes eligible
for TALF funding;
•
clarification by the New York Fed and the
Treasury that private TALF participants are not
June 4, 2009
13
Global Financial Markets
(without more) subject to the executive
compensation restrictions of the EESA;
•
increased experience with the TALF
subscription process and the streamlining of
TALF borrowing logistics, which increased the
comfort level of investors and others with the
program; and
•
the sense that TALF was a constructive force in
the markets for asset-backed securities and
consumer credit.
These considerations acted to counter prospective
participants’ concerns about political risk, which
appeared to have come to a peak following the
disclosure in March 2009 that employees of AIG
Financial Products had been paid $165 million in
retention bonuses after the company had received
TARP funds. However, recent political and
legislative developments may make it more likely
that Congress will obtain information about TALF
investment funds and their investors through audits
of the New York Fed or of TALF borrowers by the
Government Accountability Office (“GAO”). This
concern may dampen the willingness of funds to
borrow under TALF to the extent that spreads on
TALF-eligible ABS continue to compress to a point
where perceived risks outweigh rewards.
The contractual path of transparency is familiar to
participants in the TALF borrowing process. Section
11.1 of the TALF Master Loan and Security
Agreement (the “MLSA”) authorizes the Federal
Reserve Board (the “Board”) to obtain reports or
statements that it reasonably requests with respect to
the borrowing and the collateral. Section 11.3 of the
MLSA also authorizes the New York Fed to obtain
“know-your-customer” (“KYC”) information
submitted by a borrower to the primary dealer acting
as its agent for TALF borrowings.
Primary dealers have recently been expanding the
scope of KYC diligence required for TALF
investment funds to “look through” the fund to get
information about investors who own (directly or
indirectly) 10% or more of a class of securities in the
fund. The extent of the look-through varies among
dealers, with different formulations covering direct,
intermediate and/or ultimate owners of the borrower.
KYC information is typically given to dealers under
confidentiality restrictions, and the MLSA obligates
the New York Fed to comply with any
confidentiality restrictions. However, the New York
Fed is permitted to disclose any information it
receives to oversight bodies (including Congress) to
the extent required by applicable law or regulations
or by subpoena. Once so disclosed, information
given in confidence may become publicly
available. Therefore, the scope of KYC disclosure
that TALF investment funds make to their primary
dealers could be a crucial issue for direct and
indirect investors in those funds.
The increasing level of KYC diligence has
coincided with expressions of concern by the Office
of the Special Inspector General for the Troubled
Asset Relief Program, in its April report to
Congress, that a look-through is appropriate to
ensure that TALF not be used to leverage proceeds
of crime. Even though TALF is not a TARP
program, policymakers and enforcement agencies
have been concerned about moral hazard
implications of non-recourse TALF borrowings (at a
6-1 leverage ratio) by public-private investment
funds established under the Treasury’s PublicPrivate Investment Program (“PPIP”). This moral
hazard arises from the potential of such leverage to
dilute the risk of loss of private equity investors in
PPIP funds even beyond the dilution implicit in the
Treasury’s co-investments in the equity of those
vehicles. To the extent that private parties have
limited “skin in the game,” they may have
disincentives to conduct appropriate due diligence
on financed assets or establish a fair price, which
could harm a fundamental taxpayer protection in the
design of TALF and PPIP by potentially exposing
the public purse, as represented by the New York
Fed and the Treasury, to a heightened risk of loss.
Recent legislative developments may also be
providing a separate avenue to disclosure of
information about investors in TALF funds.
Section 8.01(d) of the enrolled version of Senate bill
S.896 (Helping Families Save Their Homes Act of
2009) permits the GAO to conduct audits, including
onsite examinations, of any action taken by the
Board under the authorizing legislation for TALF
“with respect to a single and specific partnership or
corporation.” Section 8.01(c) of that bill provides
that it may obtain access to any entity receiving
TALF funding in connection with such audits. A
separate bill introduced in the House of
Representatives, H.R.1207 (Federal Reserve
Transparency Act of 2009), provides for a report to
Congress with respect to GAO audits of the Board.
June 4, 2009
14
Global Financial Markets
It appears that sponsors of this legislation conceive
of it as a basis for Congress to obtain information
with respect to TALF borrowers and their investors.
______________________________
CFTC
New CFTC Proposals
Address New FCM Capital
Requirements for Cleared
OTC Transactions, and New
Investment Restrictions for
Customer Margin Funds
Lawrence B. Patent, Charles R. Mills
Recent rule proposals (read at
http://www.cftc.gov/stellent/groups/public/@lrfeder
alregister/documents/file/e9-10459a.pdf) of the
Commodity Futures Trading Commission ("CFTC")
continue the agency’s interest in securing a stronger
regulatory grip on over-the-counter ("OTC")
derivatives and protection of customer deposits of
futures margin. While it is not surprising that the
CFTC would consider such amendments in light of
recent economic conditions, the proposals could
have the effect of further decreasing the number of
future commission merchants ("FCMs"), as well as
leading to less-well-capitalized FCMs, and resulting
in reduced liquidity in the system just as clearing of
OTC derivatives becomes more prevalent.
The proposals would mandate that an FCM’s
minimum capital requirements treat cleared OTC
transactions in a manner equivalent to exchangetraded transactions. In the same release, the CFTC
requested comment on whether to increase the
minimum adjusted net capital for firms duallyregistered as FCMs and securities broker-dealers
("BDs") to equal the combined (aggregate) net
capital requirements of the CFTC and the Securities
and Exchange Commission ("SEC"). Currently,
these dually-registered firms need only maintain the
greater of the amounts required by the CFTC or
SEC.
In the October 24, 2008 issue of this Newsletter, we
reported on a CFTC interpretation published on
October 2, 2008, which states that, in an FCM
bankruptcy, claims related to OTC contracts cleared
by a derivatives clearing organization ("DCO") will
be entitled to the same preferential treatment as
claims that are based upon exchange-traded futures
contracts. The CFTC’s rule proposals published
May 7, 2009 provide that an FCM’s required
adjusted net capital include an amount equal to ten
percent of the maintenance margin level of
customer and non-customer cleared OTC derivative
positions. FCMs also would be required to take the
same haircuts on proprietary cleared OTC derivative
positions that are required for exchange-traded
futures and options: 100 percent of maintenance
margin if the FCM is a member of the clearing
organization, and 150 percent if the FCM is not a
member.
Incorporating Cleared OTC Positions Into
Minimum Financial Requirements
The proposed amendments would apply to OTC
derivatives, including credit default swaps, that are
submitted for clearing on any (1) U.S. DCO, (2)
non-U.S. clearing organization permitted to clear
such transactions under the laws of the relevant
jurisdiction, (3) multilateral clearing organization
authorized under Section 409 of the Federal Deposit
Insurance Corporation Improvement Act, which
could also be non-U.S., or (4) securities clearing
organization. The CFTC stated that it is proposing
these amendments because DCOs have become
significant clearers of OTC derivatives and that this
development has increased the risk exposure of
FCMs in a manner not currently reflected in CFTC
regulations. The proposed amendments, however,
would extend to OTC derivatives beyond those
cleared by DCOs and held in segregated customer
accounts, and thereby include OTC derivatives
other than those whose holders are to be accorded
preferential treatment in the event of the FCM’s
bankruptcy.
The idea underlying the CFTC’s proposal – that
enhanced capital requirements might be thought to
provide greater customer and systemic protections
against the risk of defaults by FCMs – must be
examined and weighed against the fact that higher
financial requirements for FCMs in a poor economy
could reduce the number of FCMs participating in
clearing OTC transactions, thereby reducing
liquidity and concentrating systemic risk among
fewer market participants. The CFTC’s proposals
might also provide an incentive for FCMs not to
submit OTC positions for clearing if the capital
June 4, 2009
15
Global Financial Markets
impact would be too severe, and may also cause
customers to avoid clearing as well if clearing fees
would be increased.
Minimum Capital Requirements for
FCM/BDs
Although the CFTC did not propose a specific
amendment to its regulations concerning the
minimum adjusted net capital required for duallyregistered FCM/BDs, it solicited comments on
whether to change that level from the greater of to
the sum of the amounts required by CFTC and SEC.
The CFTC explained that it was soliciting comments
on this issue because, in the event of liquidation, an
FCM/BD’s assets would be available to satisfy any
unsecured claims of creditors, including any
unsecured claims of futures and securities
customers. Requiring that an FCM/BD maintain the
sum of the CFTC and SEC minimums would, in the
CFTC’s view, reflect more fully the scope of
customer business and increase the “equity available
to satisfy . . . unsecured claims of customers.”
The CFTC proposal presumes that, if capital
requirements are increased, enterprises would
continue to organize themselves so that futures and
securities business is conducted through a single
entity. Currently, a BD may decide that it makes
sense to operate its futures business through the
same legal entity, because such business is normally
smaller than its securities business, and where that is
the case, such a structure does not increase its
minimum capital requirement (i.e., under the
“greater of” formulation, the SEC minimum will
exceed the CFTC minimum and the futures business
can be done “for free”). However, if that is no longer
the case, and a dually-registered firm would
experience an increase in its minimum capital
requirement, the BD may decide to establish a
subsidiary or affiliate that would be registered as an
FCM with a relatively modest amount of capital as
compared to that maintained by FCM/BDs. If so,
and if the separate FCM were forced to liquidate in
bankruptcy, there would likely be fewer assets
available to satisfy unsecured creditor claims,
including unsecured customer claims, than would be
the case if the firm were an FCM/BD. A change
from the “greater of” standard to a “sum of”
requirement could therefore result in fewer assets
available to creditors in a bankruptcy.
Comments on the proposal are due by July 6, 2009.
Investment of Customer Funds
The CFTC also recently issued an advance notice of
proposed rulemaking (read at
http://www.cftc.gov/stellent/groups/public/@lrfeder
alregister/documents/file/e9-12020a.pdf) concerning
the investment of customer funds, which was
published in the Federal Register on May 22, 2009.
The Commodity Exchange Act ("CEAct") specifies
that customer funds related to futures and options
traded on a U.S. contract market may be invested by
FCMs and DCOs only in U.S. government
securities and municipal securities. Nevertheless,
beginning in 2000, the CFTC used its general
exemptive authority under Section 4(c) of the
CEAct to permit the investment of customer funds
in other instruments, including government
sponsored enterprise securities, bank certificates of
deposit, commercial paper, corporate notes, general
obligations of a sovereign nation, and interests in
money market mutual funds ("MMMFs").
Investment of funds of U.S.-located customers
related to futures trading on non-U.S. exchanges is
governed by CFTC Regulation 30.7, which does not
limit the type of investment of such funds, but
requires that an FCM maintain records that include
a description of the obligations in which such
investments were made.
CFTC Regulation 1.25, which governs the
investment of customer funds related to trades made
on U.S. contract markets, contains a general
prudential standard that all permitted investments be
“consistent with the objectives of preserving
principal and maintaining liquidity.” The CFTC has
been mindful of how important the earnings on
investment of customer funds are to the net income
of FCMs and thus had been open during the earlier
part of this decade to an expansion of permissible
investments. The CFTC noted that FCMs have
managed the investment of customer funds and
Regulation 30.7 funds responsibly during the recent
economic downturn. However, the CFTC cited the
market events of the past year, notably the failures
of certain government sponsored enterprises,
difficulties encountered by certain MMMFs in
honoring redemption requests, illiquidity of certain
adjustable rate securities, and turmoil in the credit
ratings industry, as challenges to many of the
fundamental assumptions regarding investment of
customer funds. Although the CFTC in its advance
notice states that it “welcomes comments . . . in
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Global Financial Markets
support of any new instruments that might qualify as
permitted investments,” the general tenor of the
notice is directed towards soliciting comments
concerning retaining, rescinding, or modifying
existing authority. It would appear that the
expansion of permissible investments is over.
The CFTC also is soliciting comment about applying
the standards of Regulation 1.25 to Regulation 30.7,
so that investment of customer funds related to
trades on non-U.S. exchanges would be subject to
the same limits applicable to funds related to trades
on U.S. contract markets.
Any new restrictions on the investment of customer
funds are likely to further squeeze the bottom line of
FCMs, and contribute to a further contraction in the
number of FCMs, which has been cut almost in half
over the last 14 years (from 255 in August 1995 to
134 as of the end of 2008).
Comments are due by July 21, 2009.
Conclusion
It is not surprising that the CFTC would consider
amendments to its regulations governing minimum
capital requirements and the investment of customer
funds following recent economic conditions. The
proposals and requests for comment referred to
above, however, could have the effect of further
decreasing the number of FCMs, leading to lesswell-capitalized FCMs, and resulting in a diminution
of liquidity in the system just as clearing of OTC
derivatives becomes more prevalent and desired, and
even mandatory.
______________________________
International Arbitration
Treasury and Budget
Minister of Luxembourg
Calls for Arbitration of
Madoff Claims
Ian Meredith, Sean Kelsey
For investors, advisors, liquidators and institutions
contemplating their exposure, or potential exposure,
to the European dimensions of Bernard Madoff's
Ponzi scheme, there have been notable recent
developments in one of the key European centres of
the funds industry, where the unwinding of the
Madoff scandal has recently intersected with a
significant current trend in international commercial
dispute resolution.
Many of the Madoff-related claims in Europe are
being brought in Luxembourg, estimated to be
Europe’s largest funds centre. Prominent among
these are suits seeking compensation and access to
documents from Luxembourg units of UBS AG
(“UBS”), custodian bank for two Madoff feeder
funds, Access International Advisors LLC’s
LuxAlpha Sicav-American Selection and
Luxembourg Investment Fund. More than twenty
suits have been dealt with to date, according to
reports. Luxembourg’s Treasury and Budget
Minister, Luc Frieden, anticipates “dozens” more,
and some commentators suggest they could run into
the hundreds.
On April 28, Mr. Frieden urged custodian
banks, fund liquidators, investors and all other
parties to Madoff-related lawsuits in Luxembourg to
agree to settle their differences by resort to
international arbitration. Mr. Frieden believes that
international arbitration - possibly seated in London
or Paris - would provide a more appropriate, and a
quicker solution than pursuit of such claims through
the Luxembourg courts. Mr. Frieden also stated that
he believed such an approach would be “in the best
interest of the fund industry.”
Any solution along these lines would require the
agreement of UBS, and might involve provisions
permitting claimants to opt in (rather than requiring
them to opt out). In some respects, Mr. Frieden’s
proposal chimes with the increasing availability of
representative or “class” action as a tool for dispute
resolution in a number of jurisdictions around the
world, and indeed the uses to which that tool is
already being put in connection with Madoff-related
claims. In the United States, where class action
litigation has been long established, investors are
pursuing a variety of such claims against a host of
feeder funds and advisors. In the arbitration context,
class arbitrations have existed in the United States
for over 25 years, and the American Arbitration
Association has had rules for their conduct since
2003. At least one New York law firm is reportedly
filing a number of Madoff-related group
arbitrations. International class arbitration has been
gaining in prominence more recently, and several
international class arbitrations seated in the United
June 4, 2009
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Global Financial Markets
States are currently known to exist. Enforcement,
under the New York Convention, of awards
resulting from international class arbitrations has,
however, the potential to create issues, particularly if
parties seek to enforce against assets located in
jurisdictions less familiar with the class concept.
to assess the validity of their claims for
compensation. This would appear to hold out at
least the possibility that claimants may be willing to
pursue class-based lawsuits by way of international
class arbitration if they, and UBS, perceive any
advantages in doing so.
In a separate development, on April 24, a
Luxembourg court selected a handful of “test cases”
from more than fifty Madoff-related lawsuits that
have been filed against UBS by individual investors
We will look to provide a more detailed analysis of
the disputes landscape flowing from recent
upheavals in the capital markets in a future edition
of this newsletter.
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