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

By:  Stephanie C. Robinson

The Obama Administration's Financial Regulatory Reform plan is progressing through Congress. Last week, the House Financial Services Committee voted to approve H.R. 3126, the bill that would create a Consumer Financial Protection Agency. As we reported in a prior publication, the agency would have extremely broad regulatory and enforcement authority over providers of consumer financial products and services, with the power to impose high penalties. See our Mortgage Banking & Consumer Financial Products alert, Million Dollar Baby: The Consumer Financial Protection Agency Act of 2009, for a complete discussion of the bill as introduced.

The committee spent the past couple of days considering and voting on dozens of proposed amendments to Chairman Barney Frank's (D-MA) original version of the bill. This alert highlights some of the issues we are being asked about most and what has changed since the bill's July 8, 2009 introduction.

To view the complete alert online, click here.

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By: Benoit N. Jacqmotte and Mark D. Perlow

On September 29 and 30, 2009, the Securities and Exchange Commission (SEC) held a roundtable on securities lending and short sales. On the first day, four panels of investor and industry representatives provided an overview of the securities lending market and discussed investor protection concerns, potential improvements to securities lending, and potential regulatory action in the area. On the second day, two panels addressed possible short sale pre-borrow requirements and additional short sale disclosure. This summary addresses the first-day roundtable on securities lending.

In a securities lending arrangement, the owner of securities lends out securities to market participants in exchange for a fee, upon posting of collateral (both of which, in the United States, usually take the form of cash). An institutional investor such as a mutual or pension fund will typically engage a custodial bank or other lending agent to handle the lending of securities to brokers and reinvestment of the collateral. Brokers borrow securities for a number of reasons, including for delivery of timely trade settlements and to lend to clients seeking to enter into short sales. In a short sale, a security is borrowed and sold in the market with the expectation that the security will be purchased later at a lower price (and returned to the lender), allowing the short seller to pocket the difference.

The commissioners and panelists generally agreed that securities lending is a critical component of proper market functioning because, among other reasons, such lending creates greater liquidity and enhances the ability to effect short sales (which in turn permit greater price discovery). With the intense scrutiny of short sales during the financial crisis and large losses suffered by certain institutional investors in their securities lending programs, the SEC has decided to shed light on and explore possible regulation in what SEC Chairman Mary Schapiro has called an “opaque” market.

Panel discussion focused on transaction price transparency, fee splits, cash reinvestment, proxy voting issues, the possible use of central counterparties and possible regulation. In general, while securities lending-related pricing information is available from various services, the price terms of loans tend to be individually negotiated between lending agents and brokers and depend in part on depth of information available to such parties. SEC staff members have previously expressed concern about the lack of transparency in both pricing and the supply of securities available for lending.

Net prices for borrowing securities are typically negotiated between parties and can range widely depending on such negotiations and market forces. For easy-to-borrow and highly liquid securities, lenders typically “rebate” to borrowers a substantial portion of the return they earn from reinvesting the cash collateral posted by a borrower. For hard-to-borrow securities, lenders can obtain a “negative rebate” from borrowers, in which borrowers must pay lenders a substantial rate of interest on the cash collateral for the right to borrow the relevant securities. This means that the effective cost of borrowing securities can range from a few basis points for easy-to-borrow securities to 20% and higher for hard-to-borrow securities.

Fee split arrangements between lenders and agents, under which an agent generally takes 10 to 50% of the net fees earned by a lender under its securities lending program, and the indemnification, termination and other provisions of these arrangements, appear to depend on the leverage and sophistication of the parties. Under these arrangements, securities lenders frequently delegate to their lending agents the task of reinvesting their cash collateral, usually pursuant to written guidelines in which the agent usually disclaims that it is acting as an investment adviser or manager. Given the fee splits between a lender and agent, an agent has an incentive to manage the reinvestment to yield the highest returns. Before the financial crisis, some agents reinvested securities lending cash collateral in instruments, for example in the securities of structured investment vehicles (or SIVs), that suffered from illiquidity and substantial losses during the financial crisis. Some lenders were unable to return collateral to borrowers who had returned loaned securities, and the decline in the value of these lenders’ cash collateral had to be marked to market, causing net asset value declines for these lenders.

These lenders, who had traditionally viewed the reinvestment of cash collateral as a low-risk business for a small reward, were caught flat-footed with substantial losses and liabilities. Some panelists suggested that such lenders placed undue reliance on their agents to make investment decisions or may not have fully understood the risks involved with these reinvestment programs. According to some panelists, while mutual funds tended to have the capacity and staff sophistication to “shop” among and negotiate these terms with different agents, other lenders, including smaller pension funds, did not have the capacity and expertise to negotiate in the same manner and may have been more susceptible to losses and liabilities under these arrangements. These panelists urged the SEC to consider requiring agents to make greater disclosures to all lenders regarding the range of instruments in which cash collateral may be reinvested and the risks inherent in such programs.

Panelists discussed the potential use of non-cash collateral in the securities lending process, noting that the posting of certain securities as collateral for the borrowing of securities is widely used in Europe. Some panelists suggested that the buildup of cash balances in securities lenders’ accounts caused volatility in lenders’ portfolios because the reinvestment of this collateral drove earnings during good economic periods and led to losses during bad periods. However, other panelists cautioned that while the use of other securities as collateral for securities lending (including short-term government debt securities) could mitigate some of these risks, the use of securities as collateral could introduce other risks, including correlation (or lack thereof) between the market risk of the collateral and that of underlying loaned securities.

Under securities lending arrangements, the borrower of securities generally becomes the record owner of the securities for proxy voting purposes if it owns the securities on the relevant record date. The interests of the short seller may not be aligned with those of the “long” holders of a company’s securities, including the lender: for instance, the short seller might want to vote against accepting a tender offer at a premium to the market price, since the offer would drive up the stock’s price and cause a loss in value in the seller’s short position.

Panelists discussed the record-keeping, conflicts of interests and other issues surrounding such proxy voting issues. Some panelists urged securities lenders to pay more attention to proxy voting to make sure they are able to maintain voting rights, by recalling loaned securities or otherwise, to give input on corporate action in line with their interests as “long” holders. Panelists representing both lenders and broker-dealers agreed that lenders appeared to face no difficulties or adverse consequences from recalling their loaned securities, such as being penalized by broker-dealers by losing future securities lending opportunities, and that lenders could address many of these issues by considering their proxy voting and related goals and adopting policies and procedures to give them effect.

Panelists also considered whether there should be central counterparties for securities lending, both to enhance price discovery for securities lending and to address counterparty risk. Several panelists asserted that, because price discovery was available to many lenders and their agents through pricing services, and since the collateral for borrowed securities was generally made in cash in an amount exceeding the price of the relevant security, the incremental value of using central counterparties would be minimal. Other panelists stated that the expanded use of central counterparties would have a positive impact on risk management and the transparency of the pricing and liquidity of securities lending.

Several panelists also urged the SEC to crack down on unregistered finders seeking to locate securities on behalf of broker-dealers for borrowing purposes, especially from retail owners of securities. According to these panelists, retail investors were particularly susceptible to misapprehending the risks, terms and consequences of lending securities in their portfolios. Richard Ketchum, chief executive of Financial Industry Regulatory Authority, stated that the organization is considering the adoption of rules designed to require broker-dealers to better disclose to their customers the risks and consequences of securities lending.

In her closing remarks, Chairman Schapiro stressed the SEC’s commitment to review the securities lending market’s benefits and pitfalls and to assess whether changes should be made in the regulation of the market. The SEC is accepting comments regarding issues addressed in the roundtable until October 30, 2009.
 

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By: Daniel F. C. Crowley, Karishma Shah Page and Collins R. Clark

Congress continues to move forward expeditiously on the financial services regulatory reform effort. Over the past several weeks, House Financial Services Committee Chairman Barney Frank (D-MA), in conjunction with other key committee members, has released additional legislative proposals building on the Obama Financial Regulatory Reform plan, while Senate Banking Committee Chairman Chris Dodd (D-CT) and Ranking Member Richard Shelby (R-AL) develop a separate regulatory reform package. At the same time, these Committees have kept up a remarkably ambitious hearing schedule. This update provides an overview of significant recent developments, as well as the outlook moving forward.

To view the complete alert online, click here.

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By: Richard A. Kirby and Melissa S. Holmes

Last week, FINRA released a report by the 2009 Special Review Committee that examines in detail the failure of FINRA’s examination program to detect the Stanford and Madoff frauds (the FINRA Report). The Special Committee recommends a series of reforms to FINRA examinations for adoption by FINRA management and its board, including items that would require SEC approval and – with respect to jurisdiction over registered investment advisers - Congressional action. These reforms would significantly expand FINRA’s enforcement and regulatory reach beyond its current mandate. 

The FINRA Report follows on the heels of the final recommendations of the SEC Inspector General for reforming the agency’s Division of Enforcement operations (the SEC Report), which grew out of his earlier scathing critique of the SEC’s failures to identify the Madoff fraud. The Director of Enforcement has agreed to adopt and implement all of the SEC Report’s recommendations. While many of the proposed FINRA reforms outlined in the FINRA Report would take time to implement (if they are implemented at all), the immediate changes to the respective examination and enforcement programs of FINRA and the SEC triggered by these reviews are being felt by financial services firms immediately and they will need to react to these changes.

FINRA Reforms. 

A. The FINRA Report concludes that FINRA should seek authority from Congress to regulate activities under the Investment Advisers Act. It suggests that if FINRA had this authority, it may have discovered Madoff’s Ponzi scheme through its regular examination process after he registered as an investment adviser in 2006. The SEC has not taken a public position on this proposal. The current Obama Financial Regulatory Reform does not contemplate an SRO regulatory structure for investment advisers, nor do any of the current proposals being considered by House Financial Services Chairman Barney Frank or Senate Banking Chairman Chris Dodd. Please see recent Blog posting called "House and Senate Take Expedited But Divergent Approaches to Financial Regulatory Reform Plan." It would be surprising if this jurisdictional reach by FINRA gets traction in the present Congress. 

B. The FINRA Report also recommends that FINRA seek SEC authority to broaden its authority to examine not only outside business activities of associated persons of members, but also affiliates of member firms. This expansion of FINRA’s regulatory reach would give it broader investigative powers than the SEC itself. It remains to be seen how the SEC will react to this proposal.

C. The FINRA Report notes that FINRA staff declined to pursue inquiries into complaints about Stanford’s high-pressure sales of CDs issued by its off-shore Antigua bank affiliate because of a concern that the CDs were not securities. This decision apparently was made by non-attorneys and contrary to the specific position of the SEC Fort Worth Regional Office on the issue, and was taken without fully informed consultation with FINRA General Counsel. The FINRA staff’s surprisingly and well-documented timid view of its jurisdictional limits, which appear to have had a material impact on its failure to pursue complaints related to Stanford, provides an interesting contrast to the Special Committee’s recommendation of a much more expanded and robust jurisdictional scope for FINRA going forward.

D. One recommendation from the FINRA Report that FINRA itself can implement is the proposal to increase FINRA’s fraud detection capacity and to focus more heavily on so-called “cause” examinations. The shift to an examination program focused primarily on items triggered for cause, however, would transform the examination staff to an adjunct of the FINRA enforcement division. Assuming this recommendation is adopted by the FINRA board, it could require members and associated persons to prepare for and approach future examinations with a much more guarded approach. Management will need to promptly assess the allegations that trigger the cause examination and independently determine whether the cause determination is warranted and, if so, whether remedial action is appropriate.

E. The FINRA Report notes that it is standard practice of FINRA not to defer to another regulatory agency’s parallel enforcement efforts, unless there is an express request to defer made by the SEC or other agency. This statement will come as a surprise to many practitioners who have successfully persuaded FINRA to defer its own review of an enforcement matter on burdensomeness grounds where there is a parallel SEC or DOJ investigation into the same conduct. It remains to be seen how this newly announced FINRA policy will be applied in practice. 

SEC Enforcement Reforms. 

While the SEC IG proposed myriad reforms regarding training and oversight at the SEC, financial services firms are most likely to be affected by reforms relating to the staffing and handling of complaints as well as a proposed more targeted focus of examinations. 

A. A new Office of Market Intelligence will be created within the Enforcement Division to coordinate the process of reviewing and evaluating tips and complaints. In addition, SEC Chairman Mary Schapiro is seeking Congressional authority to reward whistleblowers with financial incentives.

B. The SEC will work to deploy adequately qualified staff with experience tailored to the matters at issue in a specific investigation. The Office of Compliance Inspections and Examinations (OCIE) hopes to fill new “Senior Specialized Examiner” positions with professionals with experience in areas such as valuation, sales and forensic accounting. Dealing with such specialized professionals could result in a streamlining and acceleration of the enforcement investigation and examination process for financial services firms. Whether this results in a fairer process for these firms remains to be seen.

C. Finally, the Enforcement Division will institute a more rigorous and systematized process for the planning, oversight and management of the investigation process, including the processes for both opening and closing investigations. Although more targeted investigations may lighten the burden on financial services firms in some respects, OCIE, like FINRA, intends to increase its focus on “cause” investigations. This focus raises the same concerns as it does with FINRA’s shift in emphasis and puts greater burdens on financial services firms to more carefully prepare for and respond to issues raised in examinations and investigations. It will also increase the need for management to conduct its own independent review of the matter under scrutiny.

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

As Congress increasingly focuses its attention on the Obama Financial Regulatory Reform (FRR) plan, the biggest change of late has to do with timing. For months, most observers have expected the House Financial Services Committee to consider the Obama proposals piecemeal, with Senate consideration following House approval. Now it is clear that the House and Senate are moving forward simultaneously, but on divergent paths. House Financial Services Committee Chairman Barney Frank (D-MA) is championing and improving the Administration proposals, and plans to move legislation to the House Floor this fall in five basic pieces (Consumer Financial Protection Agency, OTC derivatives, systemic risk, National Banking Supervisor, investor protection). These pieces reflect the groupings of the various proposals as introduced by the Administration (e.g., “systemic risk” includes the Financial Services Oversight Council, Tier 1 Financial Holding Companies, and securitization). Senate Banking Committee Chairman Chris Dodd (D-CT) has his own ideas in key areas, many of which go further than the Obama plan. Chairman Dodd currently plans to bring a single, omnibus reform bill to the Senate Floor. Short updates on the major FRR provisions follow:

1. The Financial Services Oversight Council (FSOC) - The FSOC is one of the simplest aspects of the FRR and therefore almost certain to occur. It is basically the successor to the current President’s Working Group on Capital Markets, with a dedicated staff at the Treasury Department and the addition of the heads of the FDIC, and the new Consumer Financial Protection Agency and the National Bank Supervisor. A key question is what role the FSOC will play with respect to systemic risk. If Chairman Dodd has his way, it will assume some of the functions contemplated for the Federal Reserve in the Obama/Frank plan.
2. Tier 1 Financial Holding Companies (FHCs) - As expected, serious questions have been raised about the Fed’s capacity to provide consolidated supervision of large, integrated financial institutions. There is a growing political backlash to what some view as overreaching to position the Federal Reserve as the primary systemic risk regulator. The fact that large non-depository institutions could be regulated as Tier 1 FHCs is reminding many on the Hill that they really do not trust the Federal Reserve, and that the role of a central bank may be somewhat inconsistent with such a prominent regulatory function.
3. National Bank Supervisor - As many expected, the Administration’s effort to squeeze all federally chartered financial institutions into the bank model is falling short. The thrift charter appears likely to be preserved, industrial loan companies (ILCs) grandfathered, and credit card lenders will not be deemed banks. Given the failure to close the other Bank Holding Company Act “non-bank loopholes,” many also see no reason to abolish the exception for non-depository trust companies. Nonetheless, Chairman Dodd has said the Administration proposal does not go far enough and would like to see further consolidation among the banking regulators. Chairman Frank favors preserving the dual state and federal banking systems. The outcome is uncertain.
4. Securitization - This remains a four-letter word for the time being. It is currently disfavored and, certainly, the days of passing along 100% of the default risk to investors are over. In short, keeping originators’ “skin in the game” remains a primary objective of Chairman Frank and other key policy makers.
5. The Consumer Financial Protection Agency (CFPA) - In the interest of co-opting business interests, Congressional Oversight Panel Chairwoman Elizabeth Warren, who first proposed the CFPA, has been thrown under the proverbial bus. Chairman Frank recently circulated an updated CFPA bill. In its current form, the bill exempts non-financial companies and jettisons requirements for “plain vanilla” products. As such, Chairman Frank has made it much harder for even some Republicans to oppose the CFPA. Indeed, banks may even conclude that subjecting their competitors (e.g., non-depository mortgage originators, payday lenders, etc.) to the same regulatory burdens they have faced for years might be worthwhile after all. 
6. Private Fund Investment Advisor Registration Act - As currently drafted, the Obama plan would require the registration and regulation of virtually all private fund managers, including hedge funds, private equity funds, sovereign wealth funds, and even family investment pools. Much of the alternative fund industry seems to have embraced “reform” in hopes of being favorably positioned in the rulemaking process. Alas, such a strategy failed convincingly in the context of Sarbanes-Oxley.
7. Resolution authority - There has been much discussion about how to unwind systemically significant failing institutions. Chairman Frank has referred to such powers as a “death sentence.” The FDIC resolution powers regarding banks will be expanded, probably extended to Treasury, and the SEC will be given similar responsibility with regard to the regulated entities within its purview. As an aside, requiring Treasury to sign off on Federal Reserve uses of authority under FRA section 13(3) is (discount) window dressing, since Treasury is de facto fulfilling that role now.
8. OTC derivatives - In the wake of AIG and its credit default swaps, there is a clear consensus around centralized clearing of all derivatives, and a majority preference for exchange trading of standardized contracts. On August 11, the Administration introduced its OTC derivatives proposal as the “final piece” of its legislative proposals. However, there are a number of competing proposals, including S. 1691, which was recently introduced by Senate Securities Subcommittee Chairman Jack Reed (D-RI). All of these proposals would provide strong regulation of all major participants in the OTC derivative markets, and would create new anti-fraud and market manipulation enforcement powers.
9. Credit rating agencies - House Financial Services Capital Markets Subcommittee Chairman Paul Kanjorski (D-PA) recently circulated a discussion draft that builds on the Obama proposal to have the SEC comprehensively regulate Nationally Recognized Statistical Ratings Organizations (NRSROs), and would impose information sharing requirements, as well as “collective liability” on the entire industry for a monetary judgment against any NRSRO relating to a credit rating. It is difficult to imagine that this provision will survive, but it clearly reflects a great deal of consternation about the industry (see pp. 30-31).
10. Executive compensation - Shareholder say-on-pay proxy votes and compensation committee independence are soon to become part of the ever-expanding corporate governance montage.
11. Insurance - While the insurance industry appears to have escaped the CFPA, there will be a new Office of National Insurance at Treasury that will aggregate state insurance data. Together with the FSOC, and Tier 1 FHC supervision by the Fed, the insurance industry may end up wishing it had reached consensus on a federal charter. Stay tuned for more in the next Congress.

Finally, with both the House and Senate moving forward quickly, the timetable for successfully advocating changes in much of the legislation will likely be truncated. Ultimately, the differences between the House and Senate versions will be reconciled in conference committee, a process largely shielded from public scrutiny (or influence). Please see the K&L Gates alert Eye of the Storm: A Summer Recess Assessment of the Capital Markets Reform Effort for a comprehensive overview of the Obama plan. In addition, detailed analysis on many of the Obama proposals may be found on http://www.globalfinancialmarketwatch.com/.

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