Global Financial Market Watch : Global Financial Lawyer & Attorney : K&L Gates Law Firm : Government Enforcement, Investment Management

By: Daniel F. C. Crowley, Karishma Shah Page

On February 10, 2009, Treasury Secretary Timothy Geithner outlined the Obama Administration’s plan to address the financial crisis.  The Financial Stability Plan (FSP) represents a shift from the previous Administration’s implementation of the Troubled Asset Relief Program (TARP), which focused largely on capital injections into financial institutions under the Capital Purchase Plan (CPP).  In addition to continuing capital injections, the FSP expands efforts to increase consumer and small business lending, will create a public-private investment fund to purchase toxic assets from banks, and includes a housing support and foreclosure mitigation component. 

Capital Assistance Program
The Treasury Department will continue to make TARP equity investments in certain financial institutions through the Capital Assistance Program (CAP).  Under CAP, the 19 largest banking institutions with assets over $100 billion will be required to participate in a coordinated supervisory forward-looking capital assessment (i.e., a “stress test”) to determine whether the firm has the capital necessary to continue lending and to absorb future losses.  If Treasury determines that a firm has inadequate capital, it will have six months to raise it privately, and if it does not succeed, it will be compelled to take CAP funds.  Banking institutions with consolidated assets of less than $100 billion will also be eligible for CAP funds.  Eligibility is consistent with the criteria and process established for CPP. 

Capital provided under CAP will be in the form of cumulative mandatorily convertible preferred stock and will carry a nine percent dividend yield.  The security will be convertible into common equity, at the issuer’s option, at a ten percent discount to the price prevailing prior to February 9, 2009; however, the security will automatically be converted into common equity if it has not been redeemed or converted after seven years.  Treasury will place its capital investments in a newly created entity, the Financial Stability Trust, and will publicly disclose its CAP investments on the Internet.  At this time, CAP is only available to publicly traded qualifying financial institutions.  The deadline for applying is May 25, 2009.

Consumer and Small Business Lending
The FSP aims to increase consumer and small business lending through a massive expansion of the Term Asset-Backed Securities Loan Facility (TALF) from $200 billion to $1 trillion.  The Treasury will provide $100 billion in TARP funds to backstop the Federal Reserve loan facility. 

Under TALF, the Federal Reserve Bank of New York (FRBNY) will provide non-recourse funding to eligible borrowers owning eligible collateral.  Eligible collateral includes certain asset-backed securities (ABS) that have at least two AAA ratings and that have auto loans, student loans, credit card loans, or small business loans as the underlying credit exposure.  The minimum TALF loan amount is $10 million, and the loan will have a three-year term and be subject to either a fixed or a floating interest rate.  In addition, the TALF loans will be subject to haircuts ranging from five to 16 percent, depending on the category of the ABS offered as collateral.  For additional details on TALF, see K&L Gates Newsstand Alerts The Term Asset-Backed Securities Loan Facility in Sharper Focus and The Term Asset-Backed Securities Loan Facility Takes Form.  The initial round of loans will be awarded on March 25, 2009; TALF terms and conditions may be modified for subsequent rounds.  The Federal Reserve has indicated that ABS backed by rental, commercial, and government vehicle fleet leases and ABS backed by small ticket equipment, heavy equipment, and agricultural equipment loans and leases might be made eligible for the April funding of the TALF.

In addition, Treasury and the Small Business Administration (SBA) will launch the Small Business and Community Lending Initiative.  Although details have not yet been announced, initial plans indicate that the Initiative will finance the purchase of AAA-rated SBA loans in an effort to increase liquidity in secondary markets for small business loans and increase SBA loan guarantees up to 90 percent.

Public-Private Investment Fund
The FSP will also create a much-anticipated new Public-Private Investment Fund (Fund) to purchase toxic assets from banking institutions.  The Fund would make these purchases by providing government capital and financing to leverage purchases by private capital.  In addition, the Fund would rely on private sector buyers to price the value of the assets.  The initial scale of the Fund will be $500 billion, but may be expanded up to $1 trillion.  Treasury is expected to release details on the operation of the Fund in the near future.

Homeowner Affordability and Stability Plan
The FSP also includes a housing component, the Homeowner Affordability and Stability Plan (Plan).  The first pillar of the Plan will support borrowers who have a solid payment history but are unable to refinance their mortgages because their current loan-to-value ratios are above 80 percent due to a loss in home value.  The program would make 4 to 5 million of these homeowners eligible to refinance their existing Fannie Mae or Freddie Mac mortgages at today’s low interest rates.  

The second pillar of the Plan, the $75 billion Homeowner Stability Initiative, creates a mortgage modification program for at-risk homeowners that have loans on owner-occupied properties with unpaid balances up to $729,750.  Loan servicers must enter into a program agreement with Treasury in order to participate.  Participating loan servicers must then apply a net present value (NPV) test on each loan at risk of imminent default or at least 60 days delinquent, unless explicitly prohibited by contract.  If the NPV of the expected cash flow is greater under a modification scenario, the servicer must modify the loan such that the monthly payment is no more than 31 percent of the borrower’s gross monthly income.  In exchange for the modification, the government will:

• Subsidize the lender or investor for the cost of reducing monthly payments from 38 to 31 percent of gross monthly income;
• Provide servicers with a $1,000 payment for each modification and an additional $1,000 per year for loans that continue to perform; and
• Provide payments of $1,500 to lenders or investors and $500 to servicers for modifications made to borrowers that are current on their payments.

Finally, Treasury will increase funding to Fannie Mae and Freddie Mac through the purchase of preferred stock.  In order to fund this commitment, Treasury will use $200 billion made available under the Housing and Economic Recovery Act.

Additional Conditions
Increasingly, government assistance comes with stricter terms and conditions.  Firms receiving assistance from the FSP will be subject to the following conditions:

• Recipients will be required to submit lending plans and monthly lending reports.  This information will be publicly disclosed on the website financialstability.gov.
• Recipients will be required to commit to participating in mortgage foreclosure mitigation programs consistent with Treasury guidelines.
• Recipients will be restricted from paying quarterly common dividend payments, repurchasing privately-held shares, and pursuing acquisitions until the government’s investment is repaid.
• Recipients must comply with Treasury’s guidelines on executive compensation, “say on pay” shareholder votes, and luxury purchase disclosure.
• Recipients are prohibited from certain lobbying activities.

The FSP initiatives will continue to take shape in the coming months as details are released.  The K&L Gates public policy group is closely monitoring these developments on behalf of the firm’s policy clients.

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By: Laurence E. Platt, Kerri M. Smith

Using a trio of tools to triage those whom it realistically can seek to help, the federal government has stepped up its efforts to fight residential mortgage foreclosures.   Announcement of the details of the Obama Administration’s Making Home Affordable Program (“the Plan”) on March 4, 2009, makes clear that the federal government will rely on loan modifications, refinancings and cram downs to try to keep borrowers in their homes.  In addition, the recent passage of H.R. 1106, Helping Families Save Their Homes Act of 2009 (“H.R. 1106” or “the Bill”), by the House of Representatives, bolsters the Plan’s agenda by allowing bankruptcy judges unilaterally to modify mortgage loans, and providing a safe harbor against investor liability for servicers that make loan modifications subject to the Plan. 

While most elements of the Administration’s Plan can proceed without Congressional approval, the House Bill must be passed by the Senate to become law.  No one can tell in advance whether these anti-foreclosure lifelines will work in an increasingly deteriorating economy.  While the individual consumer who ultimately saves his or her home from foreclosure will appreciate the effort, many investors and unemployed borrowers are less hopeful about these measures.

To view our complete alert online, click here.

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By: Richard A. Kirby, Rebecca L. Kline Dubill, Scott P. Lindsay

On March 12, 2009, Bernard Madoff pleaded guilty to 11 counts of a criminal information filed by the U.S. Attorney’s Office for the Southern District of New York (“S.D.N.Y.”).  The information seeks forfeiture of all proceeds traceable to the commission of Madoff’s fraud in an amount “exceeding” $170 billion.  Assuming that the government can recover any additional assets through the exercise of its criminal or civil forfeiture powers, questions remain as to whether and how those assets will be distributed to Madoff’s victims.  Two recent large-scale securities fraud cases, Adelphia Communications Corp. and the Bayou Group, illustrate how protracted this process can be for victims.

Criminal forfeiture is a powerful tool that permits the government to seize a defendant’s assets that were used in, or were the fruits of, criminal activity.   The government also has civil forfeiture powers and can seize property related to criminal activity even if it does not belong to a convicted defendant.  Although as a separate matter the trustee appointed by the Securities Investor Protection Corp. (“SIPC”) in the Bernard L. Madoff Investment Securities, LLC (“BMIS”) liquidation proceeding is also seeking to recover BMIS assets, the full range of the government’s forfeiture powers are broader than those of the SIPC trustee and may result in additional assets being recovered. 

Typically, forfeited assets are distributed to crime victims in one of two ways: (1) the petition for remission process, in which victims apply for remission from a victims’ fund administered by the U.S. Department of Justice (“DOJ”); or (2) restitution, in which the U.S. Attorney General “restores” the forfeited assets to the court overseeing the criminal cases, and the court distributes funds to victims through an order of restitution. 

In the Adelphia case, John and Timothy Rigas were convicted in 2004 on various counts relating to their looting of Adelphia’s corporate assets and forced to forfeit significant personal assets, including their Adelphia stock.   In 2005, pursuant to a non-prosecution agreement, the company that the Rigas’ had controlled, Adelphia, agreed to repurchase this forfeited stock for $715 million, which was paid into a victims’ compensation fund.  This victims’ fund is administered by DOJ under the petition for remission process and has faced substantial litigation over its protocols.  As a result, nearly nine years after the fraud was revealed, no distributions from the fund have yet been made to Adelphia’s creditors or shareholders. 

Bayou involved a $400 million Ponzi scheme.   In their plea allocutions, the Bayou principals agreed to forfeit both personal and corporate assets, including $100 million in Bayou funds, as well as several dozen Bayou investment assets.  The S.D.N.Y. U.S. Attorney’s Office appointed a receiver to collect and liquidate the assets so that they could be restored to the court overseeing the criminal proceedings for distribution to victims through an order of restitution.  Although the U.S. Attorney’s Office obtained possession of the $100 million in cash and other investments as a part of the preliminary forfeiture orders, it took almost three years to distribute the forfeited assets to victims.  The restitution process was further complicated and delayed due to litigation initiated by former investors, who had been sued in the Bayou bankruptcy on a clawback theory for return of fictitious profits and principal.  These former investors succeeded in establishing themselves as contingent victims for purposes of the restitution fund. 

If Adelphia and Bayou serve as a guide, it likely could be years before Madoff’s victims receive any distribution of property seized by the government through the exercise of its forfeiture powers.   This may provide an opportunity — given the massive scale of the fraud and the quasi-governmental nature of SIPC — for the government to chart a different course and use the established SIPC liquidation proceeding to distribute any assets it seizes to victims of Madoff’s scheme through a transfer of forfeited assets to the SIPC trustee.  Such a transfer could expedite the ultimate distribution of funds to Madoff’s victims and create certain efficiencies in the processing of claims and the handling of objections.  While it remains to be seen whether the government will be successful in identifying and seizing assets not already under the control of the SIPC trustee, it is not too soon to consider an alternative paradigm to the government’s traditional and slow-working forfeiture distribution mechanisms. 

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By: Matt T. Morley, Michael D. Ricciuti

The triggering event for the SEC’s action against Stanford International Bank, Ltd. and several of its senior executives appears to have been the abrupt public resignation of the company’s outside counsel.  This occurred the day after SEC testimony by one of Stanford’s executives, Laura Pendergest-Holt.  In apparently making what is known as a “noisy withdrawal,” counsel resigned and disavowed to the SEC all prior statements made by them in the matter.  The SEC promptly filed an action against Stanford and several executives, including Ms. Pendergest-Holt, who was also arrested on obstruction of justice charges.

In connection with the SEC’s investigation, company counsel had represented both the company and Ms. Pendergest-Holt.  According to press reports, counsel told the SEC that he represented the witness “insofar as she is an officer or director of one of the Stanford-affiliated companies.”  In many cases, it is potentially more efficient for company counsel to also represent individual officers and directors in government investigations.  But doing so often poses serious risks for conflict.  Although we do not know, and may never know, what precisely caused counsel to resign in the Stanford case, these events serve as a reminder of the risks involved where several parties share the same lawyers.  In such cases, parties need to consider in advance whether separate counsel should be retained and, if not, what will occur if a conflict subsequently arises.

When law enforcement officials first contact a company, it may seem – and may be the case – that the interests of individual employees are fully aligned with those of their employer. In some cases, at the outset of a criminal or SEC investigation, when the facts and/or the scope and focus of the probe may be unclear, corporate counsel may jointly represent the corporation and its individual officers, directors, and employees.  Pursuant to Rule 1.13 of the Model Rules of Professional Conduct, such joint representation is permissible as long as it does not involve a conflict of interest.  For example, in the event that an individual becomes a “subject” or “target” of an investigation – that is, someone who may be indicted as the result of a criminal probe – joint representation of the company and any such individual is not possible, and the employee will need separate counsel.  Other circumstances, such as the discovery of additional facts, may also give rise to conflicts of interest between the company and its employees.

Indeed, in the internal investigation context, where company counsel represents only the company, employees are ordinarily provided with “Upjohn” warnings, making clear counsel is acting solely for the company, and that while the interview may be subject to the attorney-client privilege, the company and not the employee controls whether to assert that privilege.   Employees are told that the company remains free to waive the privilege and disclose the substance of the interview to third parties, including the government, as part of its effort to cooperate. 

Where company counsel also represents an employee, however, the Upjohn warning doesn’t fit, because counsel also has attorney-client relationships both with the company and with the employee, and the employee’s confidences cannot be revealed without his or her consent.   If the interests of the company and the employee diverge, a number of critical issues will promptly arise.  Counsel will generally be unable to represent both the company and the employee, and a change in representation will be required.  Will the individual be required to get separate counsel?  If that occurs, will company counsel remain free to represent the company?  If so, what will happen to the employee’s confidences that have been shared with company counsel?  Will the company be free to use that information as it chooses?  Will the company be able to disclose this information to the government?  The failure to resolve these questions in advance can harm both the company and the individual involved and thus, in a joint representation, it is wise to reach a clear and common understanding from the outset as to what will happen if the parties develop conflicting interests or objectives. 

These questions take on even greater significance given that, in recent years, it has become increasingly common for the SEC to cooperate closely with criminal authorities.  Documents and witness statements may be shared with criminal prosecutors without notice to the company or its employees – and in the current environment, one should assume that almost any SEC investigation involves criminal charges.  Indeed, press reports indicate that, at the beginning of Ms. Pendergest-Holt’s SEC testimony, counsel tried without success to learn whether there was a parallel criminal investigation in the matter.

No single solution to these issues can fit every situation, but there are a variety of ways to address these issues.  At a minimum, where counsel will represent multiple interests, the engagement letter should spell out the parties’ agreement as to what will happen in the event of a conflict.  Sometimes, individuals may decide to retain “shadow” counsel, who are fully involved in providing advice and preparing for testimony, but who may not make a public appearance in the matter.  In other circumstances, separate counsel may be the best choice.  One thing remains clear – those who become the focus of attention by government authorities need to consider these issues at the very start.

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By: Lawrence B. Patent

Introduction
Gary Gensler, President Obama’s nominee for Chairman of the Commodity Futures Trading Commission (CFTC), testified at his confirmation hearing before the Senate Committee on Agriculture, Nutrition, and Forestry (the “Agriculture Committee”) on February 25, 2009; the Agriculture Committee approved his nomination on March 16.  In his opening statement, he mentioned four priorities that he would pursue if confirmed by the full Senate:  (1) vigorous enforcement to prevent fraud and manipulation in futures and options markets; (2) position limits across all markets and platforms where there is a finite supply of the underlying commodity; (3) generally requiring the clearing and exchange trading of derivative instruments, and direct regulation of derivatives dealers; and (4) working with regulators around the globe to protect Americans impacted by world financial markets.  The first and last of these goals are often cited by nominees to federal regulatory positions, and they are to be expected.  The remainder of this article will focus upon his other goals, those concerning position limits and enhanced regulation of derivatives, which represent a departure from the current regulatory framework yet are in keeping with recent legislative initiatives.

Trading and Clearing of Derivatives
Mr. Gensler’s statements at his confirmation hearing are consistent with some of the recent bills before Congress addressing regulation of derivatives and the energy markets.   Mr. Gensler did acknowledge that his current views may not be consistent with positions that he took as a senior official in the Treasury Department under President Clinton in the late 1990s, leading up to the passage of the Commodity Futures Modernization Act of 2000 (CFMA).  The CFMA provided greater legal certainty for trading in financial and energy swaps by exempting those instruments (and certain related markets) from regulation by the CFTC or the Securities and Exchange Commission (SEC).  Mr. Gensler stated that his views have since “evolved” and that there should have been more aggressive regulation of derivatives to protect the American public.  Thus, Mr. Gensler’s current views are generally compatible with the regulatory direction of the provisions of H.R. 977, the “Derivatives Markets Transparency and Accountability Act of 2009,” addressing over-the-counter (“OTC”) commodity derivatives.  That bill was approved by voice vote of the House Committee on Agriculture on February 12, 2009 (and the subject of a prior K&L Gates Alert).  H.R. 977 would generally require the clearing of all swap transactions, but would leave open the possibility of reporting certain swap transactions to the CFTC if a clearing organization did not want to clear them. 

S. 272, the “Derivatives Integrity Act of 2009,” which was introduced by Senator Harkin (D-Iowa) on January 15, 2009, goes beyond H.R. 977’s requirement for clearing to require that all swaps be traded exclusively on CFTC-regulated exchanges.  That provision would effectively eliminate all OTC transactions in commodity derivatives.  Senator Harkin, who is Chairman of the Agriculture Committee, tried to press Mr. Gensler during the confirmation hearing to support the thrust of his bill.  Although Mr. Gensler indicated that he generally supported the concept of the greater transparency that would be provided by exchange trading and clearing of swaps, he resisted committing to support exchange trading of all swaps with no exceptions.  Mr. Gensler recognized that there could be cases where customized transactions would not fit readily into an exchange-traded, clearinghouse framework, and exceptions might be necessary to accommodate such instruments.  Senator Harkin expressed the view that it would be too easy to vary a particular term of a contract so that it could be labeled as “customized” rather than standardized and thereby permit such instruments to evade the exchange-trading requirement.

Regulation of Financial Swap Dealers
Mr. Gensler did express support for another facet of S. 272 -- the regulation of financial swap dealers (H.R. 977 does not provide for such regulation).  Mr. Gensler stated that the entities involved in financial swap transactions needed to be subject to minimum financial, business conduct and reporting requirements.  He stated that it was not enough for other affiliates of a swap dealer or its corporate parent holding company to be subject to regulation by the CFTC or the SEC; rather, in his view, the entity that is a party to financial swap transactions must itself be subject to minimum financial, business conduct and reporting requirements.  Mr. Gensler indicated that the new requirements would apply to the 15 or 20 swap dealers that are involved in the vast majority of such transactions.  Such a policy reversal would certainly be a large step away from the exemptive framework for swaps under the CFMA.

Position Limits
Mr. Gensler also indicated his support for H.R. 977’s objective of establishing position limits for physically deliverable commodities that have a finite supply.  Part of the original purpose of H.R. 977 when it was introduced last year was to impose speculative limits on energy-related futures and options, because trading in those products has been blamed by many as contributing heavily to the run-up in gasoline prices last summer (although that view is disputed by the CFTC’s Office of Chief Economist and several other studies).  In addition, Mr. Gensler expressed support for the regulation of OTC trading of energy and metals in the same manner as agricultural swaps.  Agricultural swaps currently trade in accordance with CFTC regulations that date back almost 20 years, rather than pursuant to statutory exemptions, which in the case of energy and metals can fully exclude them from the reach of the CFTC.  Accordingly, regulating OTC trading in energy and metals in the same manner as agricultural commodities would confer more power to the CFTC to impose restrictions on such trading.  It appears that Mr. Gensler would not slow down efforts to increase the regulatory scrutiny of energy derivatives.

Relief Requests
Legislation regulating derivatives and imposing new speculative limits will likely take several months to finalize.  Mr. Gensler also noted during his testimony two areas of CFTC procedures that he would want to review that may not require any additional legislative action (although H.R. 977 would mandate that CFTC conduct such a review).  Mr. Gensler indicated that he wants to review any exemptions granted from hedging restrictions and position limits in the past 20 years by the CFTC, and that he also wants to review the “no-action” letter process, which is used, among other purposes, to grant exemptions for foreign energy markets.  Mr. Gensler indicated that some decisions on requests for no-action relief could remain at the staff level, but he implied that certain matters previously handled by staff should be considered by the Commissioners.  The overall message from Mr. Gensler is clear:  his regime as Chairman of the CFTC will tend towards greater regulation and stricter scrutiny of requests for exemption or no-action relief.

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By: Brian A. Ochs

A little-noticed recent amendment to the Emergency Economic Stabilization Act of 2008, 12 U.S.C. §5221 (“EESA”), may provide the Securities and Exchange Commission (“SEC”) with a prominent role in enforcing the executive compensation and corporate governance requirements under the Treasury Department’s Troubled Asset Relief Program (“TARP”).  The amendment, which was signed into law on February 17 as part of the American Recovery and Reinvestment Act of 2009 (the “Recovery Act”) (Pub. L. No. 111-5), requires the chief executive officer and chief financial officer (or their equivalents) of any public company that receives TARP funds to certify compliance with EESA’s executive compensation and corporate governance restrictions as part of the company’s annual SEC filing.  Much like the required officer certifications regarding internal controls and disclosure controls that have been part of the legal landscape since the enactment of the Sarbanes-Oxley Act of 2002, the effect of the EESA certification requirement is to focus personal responsibility for EESA compliance on CEOs and CFOs, with the potential for securities fraud or other charges to be brought by the SEC in the event of false certifications.

EESA and the Treasury Department’s Interim Rules on Executive Compensation
As originally enacted, section 111(b) of EESA directed that any financial institution that sells troubled assets to the Treasury Department must meet certain standards of executive compensation and corporate governance.  These standards included: (1) eliminating incentives for senior executives to take unnecessary and excessive risks that threaten the financial value of the institution; (2) a “clawback” provision for the recovery by the institution of any bonus or incentive compensation paid to a senior executive officer based on financial statements or other criteria that are later proven to be materially inaccurate; and (3) a prohibition on “golden parachute” payments to senior executive officers.  (Generally, “senior executives” means the five highest paid officers of the company.)

In October 2008 and January 2009, the Treasury Department announced rules to implement the executive compensation requirements of section 111 for participants in the TARP Capital Purchase Program (“CPP”).   (The Treasury Department separately provided guidance for certain other TARP programs.)  Among other things, the January rule required the principal executive officer of each participating financial institution to certify to TARP’s Chief Compliance Officer that the institution was in compliance with the executive compensation requirements set forth in EESA.  The Treasury Department further noted in the January rule that a false certification could subject the certifier to federal criminal penalties for false statements under 18 U.S.C. §1001.  See CPP Executive Compensation Final Rule (Jan. 16, 2009). 

The Recovery Act Amendments
The Recovery Act (Section 7001) expanded the significance of these provisions in several important respects.  First, it directs the Secretary of the Treasury to impose new and expanded executive compensation and corporate governance standards on all recipients of TARP funds.   In addition to the restrictions found in the original section 111, these standards must bar payment of any bonus, retention award, or incentive compensation during the period that a TARP obligation is outstanding (except for payments made in restricted stock comprising no more than one-third of the individual’s total compensation, and not fully vesting during the period that the obligation is outstanding), and must prohibit any compensation plan that would encourage earnings manipulation.  The number of employees to which the new compensation limitations apply varies by provision, in many cases going beyond the original five “senior executive officers” to as many as the next 20 most highly compensated officers.  In addition, the Recovery Act amendments require SEC registrants that receive TARP funds to establish a board compensation committee, comprised entirely of independent directors, and also require boards of directors to implement company-wide policies regarding excessive or luxury expenditures.

Section 7001 of the Recovery Act also requires the CEO and CFO (or their equivalents) of each recipient of TARP funds that has publicly traded securities to “provide a written certification of compliance by the TARP recipient with the requirements of this section … together with annual filings required under the securities laws….”  (Certifications are to be provided to the Secretary of the Treasury if the entity receiving TARP funds is not a publicly traded company.)  The SEC has determined that it will not give effect to the certification requirement until the Secretary of the Treasury establishes standards to implement section 7001 of the Recovery Act.  This approach follows the views expressed by Senator Christopher Dodd, the author of the executive compensation provisions of the Recovery Act, in a February 20 letter to SEC Chairwoman Mary Schapiro.

Analysis
The requirement that CEO and CFO certifications be filed with a TARP recipient’s annual report to the SEC will unambiguously subject public companies that receive TARP funds and their executives to SEC scrutiny and potential enforcement action for failure to comply with EESA’s executive compensation and corporate governance requirements.  This is because any material false statement in an SEC filing may be charged as a securities fraud or other securities violation, depending on the actor’s level of intent.  In the current environment, regulators are likely to view a certification that an entity receiving TARP funds is in compliance with requirements concerning executive compensation and corporate governance as being material to investors.  In particularly egregious cases, criminal prosecution for securities fraud could also result.

Further, because the CEO and CFO will each be considered the “maker” of statements in the EESA certifications, these executives could be exposed to personal liability under the securities laws for compliance failures that result in false certifications.  Since the passage of the Sarbanes-Oxley Act, most companies have instituted formal procedures such as compliance checklists, sub-certifications by managers with line responsibilities, and disclosure committee reviews, to support the CEO and CFO certifications required by that Act.  Entities that receive TARP funds will need to consider implementing similar structured processes to support the CEO’s and CFO’s annual certifications under EESA.
 

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By: David T. Case, Brendon P. Fowler 

With the nearly unparalleled upheaval in world financial markets and the resulting impact on the nation’s financial institutions, many entities have either gone bankrupt or become subject to increasing levels of Government intervention, regulation, and oversight.   The Government also continues to consider actions to address “toxic” assets and to stimulate financial activity.  While Government action may ultimately lead the way to financial recovery for the broad economy, in some instances the Government may take actions, such as changing federal regulatory schemes and related contracts, that nonetheless inflict harm on individual companies.  In those situations, developments in a series of cases relating to an earlier financial crisis may provide guidance in navigating the risks of increased Government regulation and oversight, and the measure of any damages that might be recovered. 

During the Great Depression, forty percent of the nation’s home mortgages went into default, and 1,700 of the nation’s approximately 12,000 savings institutions failed.   This led to significant Government oversight of the savings and loan, or "thrift" industry, in the form of the Federal Home Loan Bank Board and the Federal Savings and Loan Insurance Corporation, as well as the passage of numerous laws such as the Home Owners’ Loan Act of 1933.  This regulatory regime remained in place until the financial crisis of the late 1970s and early 1980s, when, in order to retain deposits, thrifts were compelled to offer interest rates to depositors that exceeded the stream of income from the thrifts’ long-term, low-rate mortgages.  Over 400 thrift institutions failed by 1983, and by the mid-1980s, it became clear that Government regulatory efforts to resolve the crisis were not succeeding.  As a result, Congress enacted the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), which resulted in regulations that imposed more stringent capital standards on thrifts.  Many thrifts, particularly ones that had acquired failed thrifts under agreements with the Government, were immediately thrown out of compliance with regulatory capital requirements and became subject to seizure by thrift regulators. 

A number of thrifts adversely affected by the new regulations sued the Government, alleging that the passage of FIRREA breached the contracts under which the thrifts had previously agreed to acquire other failed institutions.  In United States v. Winstar Corporation, 518 U.S. 839, 843 (1996), the Supreme Court held that where the Government entered into contracts with regulated financial institutions, promising to provide particular regulatory treatment in exchange for the assumption of liabilities, the risk of regulatory change fell to the Government, even though Congress subsequently changed the law and barred the Government from honoring its agreements.  Following this ruling, the United States Court of Federal Claims and the United States Court of Appeals for the Federal Circuit addressed a series of cases where the allegations were that the Government had indeed breached its contractual obligations to various thrifts through the passage of FIRREA.  This group of cases, which is often denoted as the “Winstar-related cases,” may provide significant guidance for any cases that derive from the present crisis.

As a general matter, damages in the Winstar-related cases are based on one of three damages theories:   expectancy damages, reliance damages, or restitution damages. 

Expectancy, or “lost profit” damages, protect a bank’s expectation interest by seeking to put that institution in as good a position as it would have been had the institution’s contract with the Government been fully performed, without also providing plaintiff with a windfall.   If successful, this theory for recovery typically produces the largest quantum of damages for an injured bank, but lost profits have historically been difficult to prove and recover in the Winstar-related context.  Nevertheless, a recent Winstar-related decision by the United States Court of Appeals for the Federal Circuit (“Federal Circuit”) upheld the trial court’s acceptance of a lost profits theory that established, by way of expert testimony and models, that the Government’s implementation of FIRREA caused lost profit damages to the affected thrift.  See First Federal Sav. and Loan Ass’n of Rochester v. United States, 290 Fed. Appx. 349, 2008 WL 3822567 (Fed. Cir. 2008).  The injured thrift established with reasonable certainty its lost profits of $85 million to the satisfaction of the courts, and the Federal Circuit upheld the trial court’s reliance on plaintiff’s damages expert, and the projections of the growth (and profits) the thrift would have experienced absent the Government breach.  Id. at 357.

Reliance damages, often sought or pled in the alternative to expectation damages, are intended to address harm resulting from the thrift’s change of position in reliance on its contract with the Government.   The underlying principle in reliance damages is that a party who relies on another party’s contractual promise is entitled to damages for any losses actually sustained as a result of the breach of that promise.  Glendale Federal Bank v. United States, 239 F.3d 1374, 1382 (Fed. Cir. 2001).  In Glendale, the Federal Circuit affirmed the use of a reliance damage calculation because “for purposes of measuring the losses sustained … as a result of the Government’s breach, reliance damages provide a firmer and more rational basis” than the alternative theories argued by the parties in that case.  Id. at 1383.  Reliance damages can include both pre- and post-breach activities and costs by the thrift, and have been described as the “ideal” theory for “wounded bank” damages.  Glendale Federal Bank v. United States, 378 F.3d 1308, 1313 (Fed. Cir. 2004) (upholding trial court’s award of $381 million).

Restitution damages may be sought when proof of lost profits or reliance damages fails.  The idea behind restitution is to restore the non-breaching party to the position he would have been in had there never been a contract to breach.  Specifically, a restitution theory seeks to recover any benefit that the non-breaching party may have given to the breaching party, but such damages should not be awarded if the award would result in a windfall to the non-breaching party.  See Southwest Investment Co., Inv. v. United States, 63 Fed. Cl. 182, 197 (Fed. Cl. 2004).  Accordingly, an institution must carefully consider whether benefits conferred on the Government might nonetheless be offset fully by benefits received from the Government, as “the non-breaching party is not entitled, through the award of damages, to achieve a position superior to the one it would reasonably have occupied had the breach not occurred.”  Glendale Federal Bank v. United States, 239 F.3d 1374, 1382 (Fed. Cir. 2001).  In addition, restitution can be a challenging theory to pursue, for while a party may often be able to show benefits given to the Government, establishing an actual dollar value conferred can be difficult.  Id. at 1382 (under theory that thrift assumed risk and relieved Government of liabilities for a period of time in which the Government was able to deal with other failing thrifts, the value of Government’s time was more than zero but there is no proof of what in fact it was worth).  Where a specific dollar amount is clearly established, however, restitution may be awarded.  See 1^st Home Liquidating Trust v. United States, 76 Fed. Cl. 731, 744 (Fed. Cl. 2007).

In sum, the numerous Winstar-related decisions provide a body of law for institutions faced with a rapidly changing bank regulatory environment and possible breaches by the Government with respect to current contracts.  Familiarity with the types of damages theories and models employed by past thrift litigants against the Government may help today’s institutions develop a viable remedy if they are harmed by Government action.

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By: Clare Tanner, Paul F. Donahue

The current turmoil in financial markets has led to an increase in disputes involving financial institutions.   Parties may have entered into transactions in better times with little consideration given to the forum in which future disputes would play out.  In today’s far more challenging circumstances, the choice of forum may be central to the satisfactory resolution of disputes. 

In some areas, it is common for disputes involving financial institutions to be resolved through arbitration.  The Financial Industry Regulatory Authority (FINRA) is the largest self-regulatory organization, i.e., non-governmental regulator, for all securities firms doing business in the United States.  (FINRA’s rulemaking, however, is subject to approval by the Securities and Exchange Commission (SEC).)  Both individual and institutional customers can require a FINRA member to arbitrate disputes.  Indeed, most, if not all, securities broker/dealers will refuse to do business with customers who do not agree to arbitrate disputes.  Disputes between FINRA members may also be submitted to arbitration.

The financial crisis has resulted in a dramatic increase in the number of cases referred to FINRA arbitration.   In 2007, slightly more than 3,000 arbitration cases were filed.  In 2008, the number was almost 5,000 and the upward trend has only increased in 2009.  The number of cases filed in January 2009 was double that of a year earlier. 

An award handed down by a FINRA tribunal last month, arising from transactions in auction rate securities, illustrates the enormous magnitude of disputes arising from the financial crisis and the speed with which they can be resolved through arbitration.  The FINRA tribunal ordered Credit Suisse Securities USA LLC, a brokerage unit of the Swiss bank, to pay $400 million to its customer STMicroelectronics NV, a European semiconductor maker.  STMicroelectronics claimed it had authorized Credit Suisse to make investments in top-rated securities backed by U.S. Government guaranteed student loans, but instead the funds were invested in collateralized debt obligations some of which were backed by sub-prime mortgages.  The entire process including 28 hearing sessions over two months took just under a year.  Any court proceeding would undoubtedly have taken far longer.  Nonetheless, STMicroelectronics, according to the award, incurred more than $4 million in legal fees during that time.

While FINRA members can be compelled to arbitrate customer disputes and most require their customers to agree to arbitrate disputes, other financial institutions have traditionally been reluctant to commit to arbitration and have preferred to submit disputes to national courts.   Some of the risks and benefits associated with arbitration as a means of resolving disputes involving financial institutions can be illustrated by reference to FINRA’s procedures. 

Confidentiality
As is common with arbitration, FINRA arbitrations are confidential.   The evidence submitted and procedural and substantive hearings are not open to the public.  Although FINRA arbitral awards are made public, that is the exception, not the rule for most arbitrations unless the parties agree otherwise.  FINRA awards are not necessarily fully reasoned and may simply amount to a requirement that one party pay as was the case in the STMicroelectronics case.  Under a recent rule approved by the SEC, however, beginning next month, if both parties request it, FINRA arbitrators will have to give an “explained decision,” i.e., “a fact based award stating the general reasons for the decision” but which need not include legal authorities or damage calculations.

Confidentiality can be a significant attraction of arbitration as it avoids both financial institutions and their institutional clients airing their dirty laundry in public.   In current markets, disputes may give rise to a damaging loss of confidence in the financial institution.  Equally, even if sophisticated institutional customers feel they have been misled by a financial institution, they may wish to avoid public allegations that they share some responsibility or may not want detailed aspects of their financial dealings laid open to public scrutiny.  In disputes between sophisticated commercial enterprises, the risk of adverse publicity is seldom limited to one party. 

Arbitration will not be appropriate where a financial institution seeks to establish a legal precedent that will be publicly available.  Only a court ruling can provide that and, of course, it can be a double-edged sword.

The Tribunal
FINRA’s arbitration rules for customer disputes generally provide for a three-person tribunal with one “industry member” and two independent members.  Under a rule change effective at the end of this month the size of cases to be decided by a single arbitrator will increase to $100,000.  Three-arbitrator panels are intended to provide both industry knowledge and experience while also protecting the customer’s interests, but some have criticised such panels as too industry friendly.  Under a pilot program now underway for 400 cases, several securities firms have agreed to have panels made up of three independent arbitrators.  FINRA’s approach may not be appropriate in all cases and, for example, the arbitration rules of the London-based City Disputes Panel provide that the tribunal will usually consist of a legally qualified chairman and two experienced financial services practitioners.

Given the complex and technical nature of modern financial products, there may be a significant advantage in decisions being reached by tribunals with necessary expert knowledge.   Both financial institutions and their institutional customers may prefer such a tribunal to the vagaries of a jury trial in the U.S.  The speed at which law and market practice change are such that, even in jurisdictions where disputes may come before an experienced judge, a tribunal made up of industry experts may still be preferable.  

Procedure
Recent rule changes have sharply curtailed the ability to obtain a summary determination of a dispute in FINRA arbitrations.   The loss of the opportunity of having a frivolous claim dismissed at an early stage may be unattractive for respondents and correspondingly attractive for claimants in those jurisdictions where summary determination is only available to a claimant.  However, expedited procedures are available by agreement between the parties in both FINRA arbitrations and in other arbitral rules.  Equally, the absence of, or restrictions on, wide-ranging discovery exercises and pre-trial depositions found in FINRA and other arbitral rules may mean that, even without a summary determination, arbitration is still more attractive than litigation through national courts.

Finality
The ability to challenge an arbitration award is usually strictly limited and FINRA arbitration is no exception.   The attraction of a final award is that the cost and risk associated with any given dispute can be more easily judged.  The prospect of a defaulting party endlessly prolonging the proceedings while attempting to protect assets against enforcement is greatly diminished as is the prospect of a successful party deciding to settle simply to end the bloodletting.  

Enforcement
Many financial transactions will have an international element, as illustrated by the STMicroelectronics case.   A party may be reluctant to commence proceedings in the home court of the other party fearing “home advantage.”  Even if the parties agree to resolve disputes in the courts of a neutral state, many national courts will not permit parties to “manufacture” jurisdiction and simply will not hear such cases.  Even when they do, the successful party still faces the cost and difficulty of enforcing that judgment in another country. 

Arbitration awards made in a country which is a party to the 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards can be enforced in any other Convention State, by the local court giving effect to the award as if it were a court judgment.  This is subject to limited, mostly due process, exceptions.

Conclusion
Arbitration is not a panacea — as with litigation through the courts, expense and delay can be features of arbitration — but there are advantages for disputes between financial institutions or between financial institutions and their institutional clients, particularly where there is an international element.   Even parties who did not commit to arbitration at the outset may still agree, after a dispute has arisen, that arbitration is a more suitable dispute resolution mechanism.  A failure to consider arbitration may leave parties at a disadvantage and, of course, it is always best to make the decision at the outset, before disputes arise.

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By: Claudia Harrison, Katie Hillier

1. Introduction
Since our reports in the December 2008 and January 2009 editions of this newsletter, the UK government has released further details on several initiatives intended to combat the current economic downturn, and a number of UK based banks have announced their participation in the initiatives.   In addition, the Banking Act 2009 received royal assent on 12 February 2009.

2.  Update on Existing Measures

2.1 Special Liquidity Scheme ("SLS")
This scheme, which enabled banks to borrow liquid UK treasury bills in return for security over their illiquid assets, closed on 30 January 2009.   The Bank of England ("BoE") have confirmed that use of the scheme was considerable: 32 institutions borrowed £185bn in return for £287bn of collateral, mainly residential mortgage-backed securities and residential mortgage covered bonds. 

2.2 Bank Recapitalisation Scheme
On 7 March 2009, following recent falls in Lloyds Banking Group's share price and the release of Halifax Bank of Scotland's 2008 results, the UK government announced that its £4bn of preference shares in the Lloyds Banking Group will be converted into ordinary shares, which could increase the government's holding in the bank from 43.5% to 65%.

3.  New Measures

3.1 Asset Purchase Facility ("APF")
This commercial paper facility has been operational since 13 February 2009, and the BoE is in the process of consulting in relation to facilities to purchase corporate bonds, paper issued under the Credit Guarantee Scheme (under which the UK government issued guarantees in respect of certain debt instruments), syndicated loans and asset-backed securities created in viable securitisation structures.  Further, on 5 March 2009 the UK government authorised the BoE to use the APF for monetary policy purposes (including quantitative easing), giving permission to finance asset purchases using central bank reserves.  UK government debt, purchased in the secondary markets, has been added to the list of eligible assets, and purchases up to £150bn have been authorised, although at least £50bn of this should still be used to purchase private sector assets, as initially intended.

3.2 Asset Protection Scheme
Under this scheme, the UK government will 'insure' banks against losses on their riskiest assets.  Both the Royal Bank of Scotland ("RBS") and the Lloyds Banking Group have announced their intentions to participate in this scheme, in respect of assets totalling £325bn and £260bn respectively.  RBS will pay a £6.5bn fee and bear a first loss of up to £19.5bn, with Lloyds Banking Group paying a fee of £15.6bn and bearing a first loss of up to £25bn.  In order to support wider economic recovery, RBS and Lloyds have given lending commitments for 2009 of £25bn and £14bn respectively.  In response to political and popular pressure, the UK government has also secured assurances relating to remuneration policies in these banks.  What such assurances amount to is not yet known.  Lloyds, for example, has agreed to review its remuneration policies and implement changes needed to ensure its policies comply with the Financial Services Authority's (“FSA”) guidance in this area.  Whether this will produce substantive changes to policies remains to be seen. 

4. Banking Act 2009 (The "Act")
The Act is in substantially the same form as the bill which was presented to parliament last October (and referred to in the December edition of this newsletter); however some important amendments were made as the bill progressed through the legislative process and are incorporated in the legislation, which was passed on 12 February 2009. 

4.1 Reverse Transfers
Under the Act, the Treasury or the BoE (as applicable) can order that shares or property of a bank which have been transferred to a bridge bank or into temporary public ownership be transferred back to the seller even if the shares or property have been subject to subsequent onward transfers.   This flexibility was introduced as the UK government considered the time and information available prior to taking over a failing bank may not be sufficient to allow detailed due diligence of every part of the bank's business. 

4.2 Parent Companies
Following consultation with the FSA and the BoE, the Treasury may now take a UK-incorporated parent company of a bank into temporary public ownership, provided that the powers for dealing with failing banks under the special resolution regime have been triggered. Once under public ownership, the Treasury will have the same powers in respect of the parent company (and the banks within its group) as it would have in respect of the bank itself, including the ability to make forward and reverse transfers as well as appoint, remove and vary the service contracts of directors. 

4.3 Investment Banks
The Treasury may now adopt regulations to modify the application of insolvency law to, or establish a new insolvency procedure for, investment banks.   The Treasury can specify whether an institution is considered an investment bank for the purposes of such regulations, provided that it holds client assets and is authorised under Financial Services and Markets Act of 2000 to carry out a "regulated activity".

5. Conclusion
The UK government hopes that the combination of purchasing assets together with providing guarantees and insurance will free up the credit markets for commercial and retail lending.  They are also attempting to deal with recent bonus and transparency issues by setting compliance with remuneration and disclosure policies as conditions to participation in certain schemes.  Whilst the statutory regulatory regime introduced under the Act has been hailed as the biggest shake up of the industry in a decade, it grants the UK government significant powers in relation to troubled banks which many commentators consider unnecessary and enables support which is given to the banks to be kept secret.   With the UK government now having majority stakes in two major high street banks, other global banks such as HSBC seeking to raise large amounts of capital through their existing shareholders, and reports that the level of national debt is equal to GDP, the jury is out on whether these latest measures will achieve their aim of improving market trust and confidence.

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By: R. Bruce Allensworth, Andrew C. Glass, David D. Christensen

A recent decision of the Third Circuit Court of Appeals significantly bolsters the standard of proof that plaintiffs must satisfy in motions for class certification under Rule 23 of the Federal Rules of Civil Procedure (“Rule 23”).  In In re Hydrogen Peroxide Antitrust Litigation, 552 F.3d 305 (3d Cir. 2008, as amended Jan. 16, 2009), the Third Circuit emphasized that the broad discretion district courts have to control the class certification process does not “soften the rule” that each requirement of Rule 23 must be satisfied.  Class certification is a critical stage of any class action because it is the point at which the court decides whether the action may proceed on a classwide basis rather than simply as an individual case.  Rule 23(a) requires plaintiffs to demonstrate, in part, that there are questions of fact or law common to the class, and Rule 23(b)(3) requires plaintiffs to establish, in part, that those common questions predominate over questions affecting only individual members.  Because the class certification decision is often the defining moment of a class action – one that can signal the “death knell” for plaintiffs or place “unwarranted pressure” on defendants to settle meritless claims – the Third Circuit instructed that district courts must engage in a “thorough examination of the factual and legal allegations” raised by the action.  Further, because In re Hydrogen Peroxide was authored by Third Circuit Chief Judge Anthony J. Scirica, who as chair of the Standing Committee on Rules of Practice and Procedure oversaw extensive revisions to Rule 23, the decision is likely to impact federal courts’ class action jurisprudence nationwide.

With its decision, the Third Circuit clarified three aspects central to the class certification process, discussed in turn below. 

A Mere “Threshold Showing” of Predominance Does Not Satisfy Rule 23
In certifying a Rule 23(b)(3) class, which is a class that seeks primarily money damages, the district court stated that “[s]o long as plaintiffs demonstrate their intention to prove a significant portion of their case through factual evidence and legal arguments common to all class members, that will now suffice.”  Id. at 321.  The district court further stated that “plaintiffs need only make a threshold showing” that common questions predominate over individual ones.  Id.  The Third Circuit ruled, however, that neither plaintiffs’ expressed intentions nor a mere threshold showing could satisfy Rule 23.  Reversing the district court, the Third Circuit held that plaintiffs must actually set forth evidentiary proof, rather than a promise to do so at some future point, that class certification is warranted under Rule 23.  In addition, the court ruled that plaintiffs must establish the Rule 23 requirements by a preponderance of the evidence.  In other words, plaintiffs must demonstrate that the “evidence more likely than not establishes each fact necessary to meet the requirements of Rule 23.”  Id. at 320.  The Third Circuit criticized the district court for adopting a “lenient” burden, or presumption of deference, for the party seeking certification.

Courts Must Resolve Relevant Factual and Legal Disputes When Ruling on Class Certification Motions
In re Hydrogen Peroxide requires district courts to resolve all factual or legal disputes that would affect the court’s certification decision.  This may even require an analysis of the merits of the case at the class certification stage to determine whether certification is appropriate.  An analysis of the substantive elements of plaintiffs’ claims may also be necessary to evaluate whether plaintiffs have set forth a feasible trial plan where one is required by a court, namely one showing that the claims are susceptible to proof on a classwide basis.  Plaintiffs’ assurances that they intend or plan to devise a feasible trial plan at some future point do not meet their burden. 

Courts Must Weigh Expert Testimony
In conjunction with ruling that district courts must consider all relevant evidence necessary to decide class certification, the Third Circuit emphasized that this ruling encompasses consideration of expert testimony.  The court rejected the district court’s assumption that it could not weigh the parties’ competing expert testimony in deciding whether to certify a class.  Accordingly, under In re Hydrogen Peroxide, where expert testimony is necessary to the class certification decision, a district court must resolve disputes between competing expert testimony.  Furthermore, neither credibility issues nor concern for addressing the merits of a case can impede the rigorous analysis required to resolve such disputes.

Impact on Class Action Defense
The Third Circuit decision is likely to impact federal courts’ class action jurisprudence nationwide.   As noted, Chief Judge Scirica served from 1998 to 2003 as chair of the Standing Committee on Rules of Practice and Procedure.  In this role, the Chief Judge oversaw extensive revisions to Rule 23, which revisions support conducting a rigorous analysis of each class certification motion. 

For class action defendants, In re Hydrogen Peroxide heralds a welcomed bolstering of the standard of proof that plaintiffs must satisfy.  Other aspects of the decision will also likely benefit class action defendants, including the emphasis on courts understanding how the merits of class claims intersect with class certification and the role expert testimony can play in defeating class certification.

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By: R. Bruce Allensworth, Andrew C. Glass, David D. Christensen

In its recent decision, Amoche v. Guarantee Trust Life Insurance Co., --- F.3d ----, 2009 WL 350898 (1st Cir. Feb. 13, 2009), the First Circuit Court of Appeals joined a growing number of federal courts that have articulated defendants’ jurisdictional burden under the Class Action Fairness Act (“CAFA”).  CAFA allows defendants to remove a class action matter from state court to federal court if the matter meets certain jurisdictional prerequisites.  Eight federal circuits have now ruled that defendants must establish the existence of those prerequisites, at the very least, by a “reasonable probability” or by a preponderance of the evidence.  The Amoche opinion highlights potential pitfalls that defendants may face when trying to establish that a case meets the CAFA jurisdictional prerequisites.  For instance, CAFA requires a defendant to show that the amount-in-controversy placed at issue by a plaintiff’s claims exceeds $5,000,000 on a classwide basis.  The federal circuit courts warn that speculative assertions, unsupported by evidence, will not suffice to meet this jurisdictional burden.  Rather, courts exhort defendants to carefully develop the evidentiary support necessary to demonstrate that a plaintiff’s claims have placed more than $5,000,000 at issue.

In Amoche, the plaintiffs brought suit in state court on behalf of New Hampshire consumers who allegedly had not received refunds purportedly owed to them on credit insurance policies purchased in connection with auto loans.   After certifying a class of New Hampshire consumers, the state court allowed the plaintiffs to amend their complaint to propose an expanded class of consumers from other states.  On the basis of the proposed expanded class, the defendant removed the case from state court to federal district court under CAFA, and the plaintiffs moved to send the case back to state court.  Finding that the defendant’s assertions concerning the amount-in-controversy were speculative, the district court granted the plaintiffs’ request. 

On appeal, the First Circuit held that a removing defendant must establish CAFA jurisdiction by a “reasonable probability.”    Id. at *7.  The First Circuit found that the Amoche defendant had not demonstrated to a “reasonable probability” that the alleged damages exceeded the $5,000,000 amount-in-controversy threshold and affirmed the district court’s order sending the case back to state court. 

The defendant had submitted a declaration that the New Hampshire class involved approximately $450,000 in damages, and argued, by extrapolating the New Hampshire amount to the thirteen states named in the amended complaint, that the $5,000,000 jurisdictional minimum was satisfied.  The defendant, however, did not provide a basis for that extrapolation.  The court suggested that the defendant might have met its burden through introducing information regarding its market share and revenues in states other than New Hampshire.  Because the defendant failed to account for differences in its business practices among the relevant states, the First Circuit found it could not rely on the defendant’s assertions that the class members’ claims exceeded $5,000,000 in the aggregate.

While CAFA is a powerful procedural device that makes it easier for defendants to litigate class actions in federal court rather than state court, the Amoche opinion highlights the demands federal courts are placing on defendants to carefully develop the evidentiary support necessary to sustain removal, including addressing such areas as the number of potential class members and the alleged value of those members’ claims.  Fortunately, as the First Circuit held, the remand of a class action does not necessarily foreclose subsequent attempts to remove the action under CAFA.  Indeed, “[s]uccessive attempts at removal are permissible where the grounds for removal become apparent only later in the litigation.”  Id. at *11. 
 

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By: Irene C. Freidel,  Robert W. Sparkes, III

In addressing the enforceability of class action waiver provisions included in mandatory arbitration agreements, the majority of state and federal courts have followed a two-pronged, fact-intensive test that will operate to invalidate a class action waiver where: 1) the party to be bound did not have a meaningful opportunity to negotiate or reject the arbitration agreement portion of a contract (i.e., the agreement is one of adhesion); and 2) if enforced, the waiver would effectively eliminate a party’s right to seek redress because the expected recovery is not large enough to justify the risks and costs of individual litigation.   In practice, most courts employing this analysis have found class action waivers in consumer finance related agreements to be unconscionable, and thus unenforceable, under applicable state and federal law. 

The Third Circuit Court of Appeals, however, appeared to reject the majority trend in its 2007 opinion in Gay v. CreditInform, 511 F.3d 369, 378 (3d Cir. 2007).   In Gay, the Third Circuit panel upheld a mandatory arbitration clause in an agreement between a consumer and a credit repair organization, which clause required individual arbitration of all disputes arising out of the agreement.  The Third Circuit panel held that the right to proceed on a class-wide basis was merely a procedural right and was therefore waivable.  The court refused to consider whether the consumer would have a meaningful opportunity to recover if she were barred from pursuing the claim as a class action.  Instead, the court ruled that the arbitration provision was not, on its face, so unreasonable that it could be considered unconscionable under state law.  Any further inquiry into the effect of the provision, according to the Third Circuit panel (albeit in dicta), would violate the Federal Arbitration Act’s (“FAA”) prohibition on state laws which restrict or burden the enforcement of agreements to arbitrate.  In so holding, the Third Circuit panel did not discuss the apparently contrary holdings in other federal circuits. 

On February 24, 2009, a different three-judge panel of the Third Circuit, in Homa v. American Express Company, ---F.3d---, 2009 WL 440912 (3d Cir. Feb. 24, 2009), found that a class action waiver included in a mandatory arbitration provision in a consumer credit card agreement was unconscionable under New Jersey state law.  The Third Circuit held that New Jersey had a fundamental public policy against enforcing class action waivers in the context of “a low-value consumer credit suit.”  As such, the court held that “if the claims at issue are of such a low value as effectively to preclude relief if decided individually, then, under [New Jersey law] the class-arbitration waiver is unconscionable.” Id. at *7.    

The Third Circuit’s opinion in Homa suggests that the Third Circuit may be prepared to fall in line with the majority of state and federal courts in addressing class action waivers in arbitration agreements.  This development will likely not bode well for consumer finance and consumer credit entities that seek to include such class action waivers in their various consumer agreements.  On the other hand, the Homa court’s reliance on New Jersey state law – law not at issue in the Gay case – may not signify any change in the Third Circuit’s approach to class action waivers, but may merely stand as evidence of one court interpreting and applying two different states’ laws in similar situations.  The fluidity and importance of this area of the law, however, suggest that we will not have to wait long for the next court ruling to more fully direct the analysis and the Third Circuit’s approach to class action waivers in arbitration agreements.

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