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

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). In addition, FERA establishes an independent Financial Crisis Inquiry Commission, modeled after the Pecora Commission of the 1930s (see below and K&L Gates Alert A Congressional Investigation of Wall Street Looms).
• 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 ). 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.

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By: 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, 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).

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 state-chartered 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.

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By: 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 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 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.

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By: 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.”

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 European-based 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.

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By: 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 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, Broker-Dealers 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 non-binding 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.

Emerging Best Practices Relating to Risk Management
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.

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.

Custody of Client Assets by Investment Advisers
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.

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.

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By: 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 arise out of employer reaction to this paradigm shift in the financial markets.

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.

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 have been hit, again the employee is likely to have a strong claim for the recovery of this sum.

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.

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 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 pre-estimate 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 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.

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By: 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.

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 short-term 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.

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By: 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 asset-backed 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 (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 Public-Private 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.  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.

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By: Lawrence B. Patent, Charles R. Mills

Recent rule proposals 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 exchange-traded transactions. In the same release, the CFTC requested comment on whether to increase the minimum adjusted net capital for firms dually-registered 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 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 dually-registered 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 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 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 less-well-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.

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By: 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 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.

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 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.

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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By: Philip J. Morgan, Anna Paglia, Neil Nick Robson, Cary J. Meer, Mark D. Perlow

On 29 April 2009, the European Commission (the "Commission") of the European Union ("EU") published its much-anticipated "Proposal for a Directive of the European Parliament and of the Council on Alternative Investment Fund Managers" (the "Proposal" and the "Directive"). The Commission has indicated its desire to spearhead the world regulatory response to the current financial crisis, with the Proposal forming part of an ambitious Commission programme to extend appropriate regulation and oversight to all activities that the Commission considers present and/or create significant risks. 

To view the complete alert online, click here.

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