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

By Anna Paglia and Mark R. Greer

The Committee of European Securities Regulators (“CESR”) published on April 19 a report  reviewing the good and poor practices on inducements (or compensation) exhibited by more than 150 regulated European investment firms (the “Report”).  The Report provides firms with a benchmark against current industry practices to measure their effectiveness in complying with the rules on inducements as stated in Article 19(1) of the Markets in Financial Instruments Directive (“MiFID”),  and in Article 26 of the MiFID implementing Directive 2006/73/EC (“Implementing Directive”).

To view the complete alert online, click here. 

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By: Philip J. Morgan and Neil Nick Robson

On 22 June 2010, the UK's new Chancellor of the Exchequer, George Osborne, delivered the new Government's “emergency” budget. Amongst a package of other measures, he announced a bank levy from 1 January 2011, and plans to carry out further work to tackle unacceptable bank bonuses, including a consideration of the costs and benefits of a “Financial Activities Tax” on bank profits and remuneration.

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By: Philip J. Morgan and Nicholas Brown

UK Chancellor of the Exchequer George Osborne yesterday announced the scrapping of the Financial Services Authority as part of a major shake-up of the regulation of financial services in the UK.

The FSA will be replaced by three new entities:

• a prudential regulator, which will be a subsidiary of the Bank of England, and will be responsible for oversight of UK-based retail lenders, investment banks, building societies and insurers, and regulation of capital requirements of financial institutions;

• a Consumer Protection and Markets Authority, responsible for the protection of consumers and day-to-day policing of financial firms; and
   
• a financial crime agency, incorporating the current financial crime powers of the FSA, the Serious Fraud Office and the Office of Fair Trading.
   

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By: Vanessa C. Edwards and Philip J. Morgan

In separate votes on 17 and 18 May, the European Parliament and the Council of Ministers (the two arms of the EU legislature) adopted their respective positions on the infamous Alternative Investment Fund Managers Directive (“the Directive”). The versions approved, however, differ significantly from each other, and the discussions will now move on to the so-called “Trialogue” procedure, involving the Parliament, the Council, and the European Commission, in an attempt to arrive at a final, definitive text acceptable to all three institutions. Although the Commission is not strictly part of the legislature, the new Internal Market Commissioner, Michel Barnier, is likely to have a significant influence in negotiating the final text given the differences between the two versions. It is hoped to have the Directive agreed in July, but this is widely regarded as over-ambitious.

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By: Philip J. Morgan

The UK remains at the forefront of international efforts to regulate bank pay practices. On 10th March 2010, the UK Treasury published draft new rules that, if they remain in their current form, will require the annual public disclosure by large banks and building societies of an "executives' remuneration report." See
http://www.hm-treasury.gov.uk/fin_bill_draftregulations.htm

The new rules would, amongst other things, require the annual disclosure of the number of employees within pay bands starting at £500,000 to £1,000,000. They would only apply to a bank (including any associated company providing services to the bank) with more than 1000 employees provided that the bank (either alone or together with its corporate group members where most of the group's activities are financial services activities) also has more than £100 billion of assets on its balance sheet.
 

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By: Kay A. Gordon, Dr. Wilhelm Hartung, Cary J. Meer, Philip J. Morgan, Mark D. Perlow, Neil Nick Robson, Richard Guidice, Jr

Changes in the regulatory approach to the short selling of listed securities have recently been announced in both the United States (U.S.) and the European Union (EU). In the U.S., rule amendments were recently adopted by the Securities and Exchange Commission that generally restrict market participants' ability to sell short listed securities whose price has dropped by at least 10% in a single day. In the EU, a new regulatory proposal would (to the extent adopted by the EU member states) require private disclosure of net short positions above a 0.2% threshold to the applicable regulator, and public disclosure to the market of such positions above a 0.5% threshold. We summarize in this alert what these changes entail and what each will mean for market participants.

To view the complete alert online, click here.
 

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Contacts: Diane E. Ambler, Michael J. Missal, Matt T. Morley, Mark D. Perlow

2009 brought a further transformation in the relationship between business and government. Regardless of political systems or philosophies, governments around the world became more dynamic and intrusive in response to the financial crisis.

This 2010 Annual Report, prepared by members of the K&L Gates Global Government Solutions initiative, contains concise articles that seek to forecast likely government actions and priorities regarding a broad spectrum of topics.

To view the report, click here.

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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: 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: 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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By: Claudia Harrison, Katie Hillier

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

2.  Update on Existing Measures

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

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

3.  New Measures

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

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

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

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

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

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

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

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By: Claudia Harrison, Katie Hillier

1. Introduction
 

Since the introduction of the stabilisation measures we reported in the previous edition of this newsletter, the global economic downturn has intensified, prompting the UK government to announce further efforts to combat financial instability and support economic recovery.  The new measures both extend and supplement the Special Liquidity Scheme, the Bank Recapitalisation Scheme and the Credit Guarantee Scheme described in the previous edition.  They do not have any immediate impact upon the draft legislation we reported previously.

2. Updates on Existing measures

2.1 Special Liquidity Scheme ("SLS") and Discount Window Facility
Upon the closure of the SLS at the end of this month, an alternative source of long-term liquidity will be provided under the discount window facility.  This is an existing facility provided by the Bank of England ("BoE") which ordinarily provides liquidity for periods not longer than 30 days and operates on similar principles to the SLS.  Under the new proposals, maturity periods of one year will be available with the aim of allowing banks to access longer-term liquidity support on demand.  The 30-day facility will continue to be available.

2.2 Credit Guarantee Scheme ("CGS")
The deadline for issuing debt to be guaranteed by this scheme is extended from 9 April 2009 to 31 December 2009.  All other aspects of the scheme will remain the same.

2.3 Bank Recapitalisation Scheme
Under this scheme, the UK government invested approximately £20bn in the Royal Bank of Scotland plc ("RBS").  The government is converting the £5bn of this stake that are held in preference shares into ordinary shares, thereby increasing its common holdings from 58% to nearly 70%.  This conversion will reduce by approximately £6bn the amount of preference dividends that RBS is required to pay each year to the UK government.  In return, RBS has committed to maintaining lending to large corporations, small businesses and homeowners at 2007 levels and to increase its lending activities by £6bn over the next year.  These commitments reflect the government's concern to protect the wider economy from the underlying lack of credit in the financial sector.

2.4 Financial Services Authority ("FSA") on Capital Ratios
The FSA has given additional guidance on its expectations regarding capital ratios for banks.  No new requirements are currently being proposed, as the FSA considers that the recent recapitalisation exercise undertaken by certain banks has created a sufficient capital buffer to withstand losses and facilitate new lending.  The guidance introduces the concept of counter-cyclical measures so that during good years banks build a capital 'buffer' on which they can draw in harder times.  The Basel Committee is now working to develop this principle and it is possible that the regulatory framework may be adapted in the longer term.

2.5 Northern Rock
There has been concern that the timetable set by the government for Northern Rock to repay its loans was requiring it to reduce its mortgage lending too quickly.  This reduction was working against the government's desire to expand mortgage lending, and so the deadlines for repayment by Northern Rock have been extended.

3. New Measures

3.1 Additional credit guarantee scheme
As well as extending the deadline of the CGS, the government has proposed a new guarantee scheme, commencing in April 2009, for certain triple-A rated asset-backed securities.  Eligible securities may be backed by mortgages and corporate/consumer debt and must have transparent structures.  Eligibility for institutions will be by the same criteria as the CGS.  Further details on this proposal are expected in the next few months.

The rationale for this scheme is, in part, the need to maintain banks' mortgage lending capacity.  Typically, mortgage-backed securities have supported a third of mortgage lending in the UK, and the government hopes that a guarantee scheme which supports the market in these securities will help to maintain banks' capacity for such lending activity. 

3.2 Asset Purchase Facility
The UK government is allocating a fund of £50bn to be used by the BoE to purchase certain high-quality private sector assets, including corporate bonds, syndicated loans and asset-backed securities.  The programme will come into effect from 2 February 2009, and purchases will be funded by the issue of Treasury bills.  The BoE will be authorised to use this facility for monetary policy purposes such as meeting the inflation target.  Further details of how this facility will operate are expected before the end of January.

3.3 Asset Protection Scheme ("APS")
The UK government, for a fee, will provide banks with insurance against future credit losses on their riskiest assets.  The government will assess the likely performance of assets under consideration in order to set the level of probable loss and the fee to be charged.  The APS will then cover a substantial part of any loss sustained over and above this probable loss, i.e., the exceptional loss.  In addition, in order to incentivise participating institutions to minimise their losses, the institution will also have to bear a proportion (for example, 10%) of the exceptional loss.  The scheme is available to UK-incorporated authorised deposit takers with more than £25bn of eligible assets.  It intends to target the assets most affected by current economic conditions with a view to reducing uncertainty about the value of such assets.  In order to support wider economic recovery, participants will have to provide a commitment to the government to maintain lending to creditworthy borrowers in a commercial manner.  Further details of the scheme are expected to be issued by the end of February.

4. Conclusion
The theme running through this latest package of measures is an effort to limit the effect of the financial crisis on the wider economy.  In the aftermath of the collapse of a number of high street retailers, and as monthly unemployment increases reach levels last seen in 1991, this objective is understandable.  However, it remains to be seen whether on the high street are already beyond the reach of such protection.

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By: Robert V. Hadley,  Matt T. Morley

On 5 January 2009 the FSA imposed a penalty of £5.25 million on the insurance brokerage firm Aon Limited because the firm lacked adequate systems and controls to address the risk that third parties would make corrupt payments to assist Aon in winning business in overseas jurisdictions.  See http://www.fsa.gov.uk/pubs/final/aon.pdf.  The FSA’s Final Notice alleged that due to these failures, the firm had made sixty-six "suspicious payments" totalling more than US$5 million.  The Final Notice, which Aon consented to, states that the firm’s procedures failed to require adequate training of relevant personnel as to bribery and corruption risks, adequate due diligence prior to the retention of third party representatives, and appropriate monitoring of those relationships going forward.  In addition, Aon’s supervisory committees were not provided with adequate information or otherwise did not assess whether the firm’s corruption risks were being effectively managed.

The FSA’s action is particularly notable for several reasons.

• While the FSA is not directly empowered with jurisdiction over domestic or foreign corruption offenses, which are ordinarily the responsibility of the police or the Serious Fraud Office ("SFO"), the FSA has a specific statutory objective to prevent financial crime.  The Final Notice makes clear that Aon was fined for breaches of FSA Principle 3 ("A firm must take reasonable care to control its affairs responsibly, with adequate risk management systems").  Conceivably, the FSA could also act in such cases under Principle 1 ("a firm must conduct its business with integrity").  Of course, a firm is likely to more readily agree to a public statement of a systems and controls failure than to acting without integrity, but, for the FSA, the level of fine, the publicity, and the resulting deterrent value of the FSA action remains the same.
  
   
• Aon already had in place a policy that prohibited corrupt payments such as the ones that came to light.  Yet, as US law enforcement authorities have so often emphasized with regard to the US Foreign Corrupt Practices Act, a “paper program” is not enough, and firms must also take additional steps, such as training, due diligence, monitoring and auditing, in a meaningful effort to assure compliance.
  
   
• Aon promptly self-reported to the Serious and Organised Crime Agency ("SOCA") and the FSA its discovery of the questionable payments.  The firm went on to conduct its own internal review of its anti-bribery systems and controls, and all payments to third party representatives for the previous six years.  Aon implemented all recommendations resulting from this review, and took disciplinary action against personnel found to have been involved.  Aon co-operated fully with the FSA's investigation.  While these steps, and the cost involved, were taken into account by the FSA when assessing/agreeing the financial penalty imposed, the firm did not avoid sanctions.

Margaret Cole, the FSA's Director of Enforcement, said that the fine "sends a clear message to the UK financial services industry that it is completely unacceptable for firms to conduct business overseas without having in place acceptable anti-bribery and corruption systems and controls".  Ms. Cole added that the FSA "has an important role to play" in UK steps against overseas corruption.

There are at least two important messages being sent by the FSA by its action against Aon.  First and most clearly, the case makes clear that the FSA expects regulated firms to have effective anti-corruption compliance measures in place – not simply a policy prohibiting corrupt payments, but coordinated efforts to require training of relevant personnel; due diligence on agents and other intermediaries acting on the firm’s behalf; monitoring and auditing compliance with the policy; and disciplinary action where violations of the policy occur.  Firms that fail to take these steps face potential sanctions under Principle 3.

Beyond this, the Aon case sets the precedent that in the eyes of the FSA regulated firms are required to self-report potential overseas corruption violations to the FSA.   FSA Principle 11 provides that "a firm must deal with its regulators in an open and cooperative way and must disclose to the FSA appropriately anything relating to the firm of which the FSA would expect notice."  We know the FSA's position from the Aon case, notwithstanding the FSA’s lack of criminal jurisdiction over such conduct, and that such matters are discloseable under Principle 11 also follows from the fact that firms are authorised by the FSA and individuals are approved by the FSA on the basis of their being "fit and proper." 

Disclosure of such matters may also be driven by the obligation of persons in the regulated sector (very broadly the financial services industry) to inform the SOCA where there is a suspicion of money laundering under the Proceeds of Crime Act 2002.   UK prosecutors regard any revenue from a contract obtained through a corrupt payment or offer of payment as the proceeds of crime, so that possession or any dealing with such funds is potentially a money laundering offence. Accordingly, the risk of a failure to disclose an offence or the need to set up a defence of SOCA's consent by disclosure to SOCA arises in almost every case where there is a suspicion of corruption. Once the need or obligation to make a report to SOCA is triggered, a regulated firm would be taking a serious risk by not also disclosing to the FSA under Principle 11. 

Overseas corruption is a hot topic in England and Wales, and the SFO has also taken recent steps to increase enforcement activity, increasing its manpower dedicated to looking at these matters by over 50% in 2008.  Last year saw the first UK convictions for overseas corruption, with the conviction of the head of the British company CBRN in connection with security services contracts in Uganda (see: http://www.guardian.co.uk/uk/2008/sep/23/ukcrime.law).  The SFO also reached a settlement with the construction company Balfour Beatty, in which that company admitted to historic accounting irregularities in some of its African operations.  Balfour Beatty paid a civil fine of £2.5million and was not subjected to criminal prosecution.  This case can be seen as a model for the SFO’s efforts to create a culture of self-reporting and to increase deterrence in the overseas corruption field.  In this way, the SFO can be seen to be taking enforcement steps without running the risk of a failed prosecution.

Both the SFO’s settlement with Balfour Beatty and the FSA's approach to Aon bear a strong resemblance to efforts by the US Securities and Exchange Commission and the US Department of Justice to pursue violations of their anticorruption statute, the US Foreign Corrupt Practices Act.  The great majority of such cases are resolved by violators consenting to the entry of court orders finding legal violations and imposing significant financial penalties as well as disgorgement of profits, as in the recent case involving Siemens AG and the imposition of more than $1 billion in fines.  As in the Siemens case, a further condition of these kinds of settlements is the creation of remedial programmes and the installment of external monitors, at the company’s considerable expense, empowered to review the firm's anti-corruption programmes for several years and report back to law enforcement authorities.  Self-reporting of potential violations is also encouraged by US authorities, who state that the consequences of violations will be less severe for those who come forward voluntarily. 

It remains to be seen whether the SFO’s resolution of the Balfour Beatty case will provide a model for future cases, but in the financial services arena, the die seems to have been cast by the Aon case by the rather straightforward application of the FSA’s Principles to require regulated firms to implement anti-corruption compliance programs.

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By: Sarah Turpin, Jane Harte-Lovelace

The credit crunch has already given rise to numerous third party claims against financial institutions in the US, primarily by disgruntled investors and shareholders.   While the "tsunami" of litigation predicted by many lawyers has not yet arrived in the UK, the collapse of Lehman Brothers and the scandal involving Bernard Madoff's $50 billion Ponzi scheme raises the prospect of similar claims (and related investigations) emerging.   In these circumstances, companies are well advised to consider the state of their insurance coverage, particularly under Professional Indemnity/Errors & Omissions and Directors & Officers' Liability policies.  In particular, companies should pay close attention to the importance of well-drafted claims notification provisions in their insurance policies.  Companies should also be alert to the need for prompt notification to their insurers in the event of a claim or circumstances that may give rise to a claim. 

Below is a checklist of some practical points to consider in connection with insurance placed in the London market and governed by English law, although many of the points have equal application in other jurisdictions, particularly the US. 

• Check the policy provisions relating to claims notification and consider whether there is any scope for improvement.   The English Court of Appeal recently criticised the claims notification provisions in a Professional Indemnity policy as "a patchwork of provisions, which have no doubt been largely drawn from other policies but do not all fit well together".
  
   
• Make sure that any notice of claims and of circumstances is given in a timely manner.  The notice provision will normally stipulate the period within which notice has to be given and this can vary from a specified time period to "immediately" or "as soon as practicable".  Failure to comply could prove fatal if the clause is a condition precedent to the insurer's liability under the policy.
  
   
• Don't assume that the absence of the words "condition precedent" means that the notice provision will not be construed as such.  Harsh as it may seem, the English (and US) courts may hold that the requirement to give valid notice is a condition precedent even though not described as such in the policy.  English courts may allow insurers to deny liability for breach of a condition precedent, even if they have not suffered any prejudice as a result.  The position is similar in the US where, in contrast to comprehensive general liability policies, some US courts have not required an insurer to demonstrate any prejudice resulting from untimely notice under a claims-made policy.
  
   
• Set up and maintain proper internal lines of communication to ensure early identification of any errors or problems which may require notification.  This is especially relevant to businesses with global operations, particularly those based in jurisdictions where less importance is placed on the need for early notification.  In these circumstances, it may prove particularly beneficial to limit the requirement to notify to those claims or circumstances which are known to the group risk manager or general counsel.
  
   
• Make sure the notice of any circumstance is sufficiently detailed.  Some policies require detailed particulars to be given, including the identity of any potential claimants and the types of claim anticipated.  The insurer may seek to deny cover if it considers that inadequate details have been given.
  
   
• Make sure the notice of any circumstance is sufficiently broad to cover all potential claims regarded as real risks.   The policy will usually contain a “deeming” provision to the effect that any claim arising from a circumstance notified to insurers will be deemed to have been made within the policy period.  However, if the notice is not sufficiently broad and additional claims materialise which have no causal connection with the circumstance originally notified, then the deeming provision may not apply and the policy will not respond.
  
   
• Don't be economical with the truth!  A preliminary notice couched in vague terms — perhaps to avoid the prospect of higher premiums at renewal — may be held inadequate for claims notification purposes.  There is, however, a balance to be drawn between being too vague and too specific:  a notification which is too specific may enable insurers to limit their liability if the claim expands into something much wider than suggested in the original notification.
  
   
• If the matter is subject to further investigation and/or dependent upon future developments, make this clear and update the notification as further information comes to light. 
  
   
• Review and update the notification prior to renewal.
  
   
• Make sure notification is given to all insurers (including Lloyd's Underwriters and Co-Insurers).  The policy will normally provide an address where notices must be sent.  Some policies provide for notice to be sent to a broker or solicitor but, unless they are authorised by the insurers to act as their agents for claims notification purposes, they merely act as a conduit, and it is vital to ensure that the notice is actually received by the relevant insurers.  Notice to the broker or solicitor may not in itself be sufficient.
  
   
• Make sure notification is also given to any excess layer insurers, where there is any possibility that the claim will impact on those layers.  The excess layer policies may not necessarily have the same notice provisions as the primary layer, and notice to the primary layer insurers alone is unlikely to be sufficient.  This could prove catastrophic for high-value claims where the excess layer insurance may prove essential.

Whatever the jurisdiction, but certainly in England and the US, it is vital that policyholders take a proactive approach to claims notification.   Early advice both prior to and at the time of notification could prove invaluable. 

Please contact Jane Harte-Lovelace (020 7360 8280 or jane.harte-lovelace@klgates.com) or Sarah Turpin (020 7360 8285 or sarah.turpin@klgates.com ) if you would like further information.

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By: Claudia Harrison, Katie Hillier

1. Introduction

At the start of 2008, few people predicted the dramatic financial events of the past year.  Governments have rallied to stabilise financial systems which have been severely shaken and remain wary of further possible aftershocks.  This article considers the stabilisation measures already implemented by the British government and the draft legislation for a permanent statutory regime to deal with failing banks.

2. Measures already implemented

2.1 Special Liquidity Scheme ("SLS")
The Bank of England (the "BoE") summarises the SLS as a scheme enabling banks "to swap temporarily assets that are currently illiquid in exchange for UK treasury bills".   In fact, the BoE lends treasury bills in return for security over 'swapped' assets.  It is limited by eligibility restrictions for both institutions (only those eligible to subscribe to BoE standing facilities) and assets (only those backed by residential mortgages or credit card debt).  Despite these limitations, it has proved so popular that both its availability period and its value have been extended. 

A key feature of the SLS is that the risk associated with the 'swapped' assets remains with participants.   The public sector would only be exposed if a bank failed to return its treasury bills at maturity and the value of the assets it had pledged as security fell short of the value of the bills borrowed.  The use of a margin or 'haircut', intended to ensure that the value of security assets is always greater than the value of the bills, reduces this risk. 

2.2  Bank Recapitalisation Fund ("BRF")
The government has made available up to £50bn for equity share capital investments in certain UK banks.   The overriding objective of the BRF is to ensure that banks maintain capital positions which support market confidence in them.  The foundations of such confidence include banks having sufficient capital to absorb losses and to continue normal commercial lending.  So far, Lloyds TSB, Halifax Bank of Scotland and Royal Bank of Scotland are participating in the BRF.  Others intend to increase capital through normal commercial measures.  Naturally, banks wish to minimise any government shareholding to ensure independence and avoid the stigma of public ownership.  However, if the poor uptake of RBS's recent share placing is any indication, the amount needed from the government may be higher than anticipated.  Predictions suggest that the banking system may need capital investment of at least £100bn before confidence in it recovers. 

2.3 Credit Guarantee Scheme
This scheme aims to encourage wholesale lending by issuing government guarantees in respect of certain debt instruments issued by eligible institutions.   In theory, if a bank is backed by a government guarantee, other banks will be less reluctant to lend to it.  Wholesale funds will start to move more readily and LIBOR will fall as confidence between banks is restored.  However, the scheme's eligibility conditions, both for participants and instruments, limit its scope so that it may only boost confidence in institutions least in need of such support. 

3.  Permanent Statutory Regime

3.1 Banking Bill 2008 (the "Bill")
The Bill, published in October, is the government's proposal introducing for the first time a permanent statutory regime for dealing with troubled banks.  This replaces emergency legislation passed earlier this year, which expires in February 2009.  It proposes a 'Special Resolution Regime', conferring various powers upon the tripartite authorities - the UK government, Financial Services Authority (the "FSA") and BoE.  These powers include three 'stabilisation options' (to be used to rescue a failing bank), a bank insolvency procedure ("BIP") and a bank administration procedure ("BAP").

(a)  Stabilisation options
These options restate and reinforce the authorities' powers under the emergency  legislation.  They are triggered if a bank fails to meet the conditions of its FSA authorisation (normally because of a failure to maintain adequate resources to conduct its business, in the FSA's opinion).  The options are to transfer all or part of the shares or business of a failing bank to either (i) a private sector purchaser, (ii) a 'bridge bank' (a BoE subsidiary), or (iii) temporary public ownership.

(b) BIP and BAP
The FSA already has statutory authority to apply for an administration order or petition for the winding up of a bank. The Bill extends this power so that, where certain conditions are met, any of the authorities can apply for a failing bank to be placed in BIP and the BoE can apply for a failing bank to be placed in BAP. These procedures follow the same structure as existing insolvency and administration regimes, with different 'officeholders' objectives. Ordinarily, a liquidator's objective is to realise an insolvent company's assets for distribution to creditors. A bank liquidator's primary objective is to ensure that eligible depositors receive compensation speedily or have accounts transferred to an alternative institution. Similarly, an administrator has three objectives, in order of priority: first to rescue the company as a going concern, secondly to achieve a better result for the company's creditors as a whole than would be likely if the company were wound up, or, if neither of the first two are possible, to realise assets to make distributions to secured creditors. In contrast, BAP will be used to oversee the operation of the 'residue' of any bank, following a partial property transfer under the stabilisation options referred to above. Consequently, a bank administrator's primary objective is to facilitate such transfer to the bridge bank or private purchaser.

3.2 Comment

In general the Bill has been welcomed, but there is widespread concern about certain of its provisions.  This has led to calls for more consultation time to ensure that haste does not lead to measures which, instead of improving stability in financial markets, actually undermine it further.

• The Bill is primarily designed to limit the instability caused by failing banks by establishing an orderly regime for dealing with them.  However, some consider that instability is an inevitable consequence of the failure of large financial institutions, and that stability will only be protected by tighter regulation which reduces the inherent risk of such failure.  A consultation document on regulation regarding liquidity risk management and supervision is expected from the FSA in 2009.  Critics suggest that the FSA's measures and the Bill should be developed concurrently.
  
   
• The Bill's stabilising effect is limited because it does not apply to foreign or investment banks, two categories with a significant impact on market conditions.
  
   
• In the context of a partial property transfer, the transferee may be able to 'cherry pick' the highest quality assets, disproportionately reducing assets available for residual creditors and undermining rights of set-off against other transactions with the same counterparty.  Any such interference in creditors' rights or the ability to override contractual provisions could seriously damage confidence in UK financial markets and in particular London's competitiveness as an international financial centre.  The government is consulting on secondary legislation to address this issue.
  
   
• There could be problems regarding transparency in how the authorities' powers are used.   For example, it is proposed that the BoE should no longer have to disclose details of its emergency lending operations.  The aim is to prevent the media-fuelled panic which occurs when news of a bank's financial difficulties breaks.  However, it could lead to a more general sense of uncertainty as opposed to instability concentrated around the institutions which are the source of it. 

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By: Wilhelm Hartung, Oliver M. Kern

The German government has enacted significant new measures to stabilize German financial markets.  These efforts seek to restore trust in the financial system and to revive the business interaction among financial institutions and other market participants.

Central to these measures is the creation of a €100 billion fund to support troubled financial institutions, called the Financial Market Stabilisation Fund ("SoFFin") (www.soffin.de).  SoFFin has been authorized to operate through December 31, 2009, after which date, under current legislation, it will be dissolved.

SoFFin is directed toward financial market participants headquartered in Germany.  Among the types of institutions eligible for assistance are banks and credit institutions, investment management companies, operators of securities and futures exchanges, as well as some specific affiliates of such companies, including parent companies of public law state banks (Landesbanken) (e.g., BayernLB Holding AG, Landesbank Berlin AG) (all together referred to hereinafter as "Financial Sector Enterprises").

SoFFin is authorized to provide the following types of financial assistance to Financial Sector Enterprises:

• €20 billion to make payments under guarantees issued for the benefit of Financial Sector Enterprises.   SoFFin may issue up to €400 billion in such guarantees. 
  
   
• €80 billion to (a) acquire participations in Financial Sector Enterprises or (b) assume risk positions held by such companies.

Guarantees.   Guarantees have been designated as the preferred method for SoFFin to use in seeking to stabilize the markets.  The hope is that recipients can use such assistance to overcome short-term liquidity problems and seek to recapitalize themselves on the market.  SoFFin may provide standard first-demand guarantees in connection with obligations of 3 years or less that are created between October 18, 2008 and December 31, 2009.  Guarantees may also be issued to single purpose entities which have assumed risk positions of Financial Sector Enterprises.  

Recipients of these guarantees will be required to pay fair market rates for the guarantee, and be required to meet certain minimum capital requirements.   If adequate capital resources are not available, the Financial Sector Enterprises may apply for recapitalization assistance from SoFFin.               

Acquisitions of Risk Positions.   SoFFin may also determine to assist Financial Sector Enterprises by acquiring certain risk positions, including, but not limited to, receivables, securities, derivative financial instruments and rights and obligations under loan commitments. Ordinarily, no Financial Sector Enterprises may receive more than €5 billion of this type of assistance, and recipients may be required to repurchase such risk positions as SoFFin determines to be appropriate. 

Recapitalizations.   Where the national interest requires it, and where no reasonable alternatives exist, SoFFin may acquire equity interests of up to €10 billion in any Financial Sector Enterprises seeking such assistance.  New regulations have been put into place to SoFFin’s participation in a recapitalization by easing requirements under German corporate, capital markets, and commercial law. 

Recipients of assistance under any of these measures must meet certain preconditions, which vary according to the form of assistance provided.   Recipients may be required to cease certain types of business transactions, to restrict compensation of individual employees to €500,000 or less, and to suspend dividend payments to anyone other than SoFFin. 

In addition to legal changes to facilitate the recapitalization of market participants by SoFFin, amendments have been made to the Banking Act (Kreditwesengesetz, KWG), to the Insurance Supervision Act, and to the German federal insolvency law (modifying the definition of over indebtedness (Überschuldung)). 

While the European Commission (“EC”) has generally approved, under EC treaty state aid rules, the German assistance measures, EC authorities have in one instance already questioned whether guarantees provided to one company met EC requirements because they may not have been granted at fair market value. According to publicly available sources, further investigations are pending.

There has been one further development of note for companies subject to IFRS accounting standards.  In October 2008, the International Accounting Standards Board issued amendments to IAS 39 and IFRS 7 which were endorsed by the EC by regulation (Commission Regulation No. 1004/2008 of October 15, 2008). These amendments, which are effective retroactively to July 1, 2008, allow certain reclassifications of non-derivative financial assets out of the "Fair Value through Profit or Loss" category and also allow the reclassification of financial assets from the "Available for Sale" category to the "Loans and Receivables" category in particular circumstances.  A number of companies have taken advantage of these provisions.  In one widely reported example, Deutsche Bank’s third quarter report  notes that, due to reclassifications allowed by these amendments, the company increased income before income tax by €825 million. 

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By Robert V. Hadley and Philip J. Morgan

Last week, two leading UK newspapers reported interviews with the new Chairman of the FSA, Lord Adair Turner, in which he is said to have warned that the days of “soft-touch regulation” are over. He also spoke of the FSA’s plans to pump more resources, and to recruit high quality people from the private sector at considerable expense, into the regulation of systemically important institutions.

Earlier last week FSA Chief Executive Hector Sants struck a slightly different tone when he noted that the concept of “heightened supervision” - jargon for an FSA enhanced regulatory regime for banks where failure appears possible - was a last resort. He also said that the term “heightened supervision” was a colloquialism that reflects the fact that the FSA adopts a risk-based approach. Certain risks now being clear it is appropriate, and consistent with the FSA’s stated and historic approach, and nothing new, for supervision in relation to such risks to be “heightened.”

The new Chairman is plainly looking to stamp his authority in a very public way. Interviews with national newspapers are not a common occurrence for leaders at the FSA. And “light-touch regulation” has long been a mantra of FSA leaders, Mr Sants included. But does Lord Turner's intervention last week signal a real change of direction for the FSA?

Risk-based regulation, which continues to be at the heart of the FSA’s approach, and light-touch regulation run hand in hand - a business that presents a limited risk to the FSA’s statutory objectives can be regulated in a less hands-on fashion than higher risk businesses the failure of which may have systemic consequences. We suspect therefore that many people regulated by the FSA will notice little difference with the tougher stance signalled by Lord Turner.

On the other hand, it is clear that the FSA is currently far more focused, as a matter of necessity, on issues that can have consequences for the stability of the financial system as a whole. Lord Turner mentioned in particular FSA work in three areas:

(i) the capital adequacy regime for banks - in relation to which he noted that the current regime seems to encourage the banks to lend too much in the boom times and too little when times get tough;

(ii) liquidity - where the focus would be on whether the business model of financial institutions was solid enough in bad times as well as good; and

(iii) pay - although Lord Turner was clear that this area plays second fiddle to capital adequacy and liquidity

Also, it would appear that under Lord Turner's watch the FSA will be taking a renewed close look at the risks posed by hedge funds. For example, it was reported that he thinks that hedge funds, up to now beneficiaries of “light-touch regulation” in the UK, could evolve to pose a systemic risk, much as the Wall Street banks did during the past few decades.

The truth, it seems to us, is that whilst the FSA is set to get tougher with high-impact, systemically important firms, notably significant banks and insurance companies, much of the rest of the FSA’s work will probably carry on as before, at least for a while. Lord Turner himself summed up the balancing act as follows:

“There is no doubt the touch will be heavier… We have to make sure that it is intelligent and focussed on where the risks really are.”

It does remain interesting, though, that the new Chairman, unlike the last, does not seem minded to defend the concept of “light-touch regulation,” even choosing to refer to it by the more pejorative “soft-touch regulation.” It remains to be seen whether Mr. Sants will adjust his tone to be more in keeping with his new boss’s tough talking.

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By Marcus M. Birch and Ian Meredith

Over recent weeks, governments on both sides of the Atlantic have intervened in the affairs of banks and other financial institutions in a quite unprecedented manner.

The government-initiated rescues have had an undoubted impact on private investors. Some announcements of planned action have been followed by sharp falls in share values; many shareholders have seen their holdings diluted by the creation of new preference shares in some cases held by the state; and there has been an absence of shareholder consultation and instances of unequal treatment (the U.S. government stepped in to save AIG from bankruptcy, but allowed Lehman Brothers to fail, and the U.K. government is procuring a merger between LloydsTSB and HBOS but has chosen to nationalise Northern Rock and Bradford & Bingley).

These and other issues raise the prospect of a wave of investor-state claims against governments based on the impact of the rescue packages. Many of the countries concerned have bilateral or multilateral investment treaties (known as BITs or MITs) in place intended to protect foreign investors from discrimination, unfair expropriation, and other state action. Unlike most international treaties, these investment treaties typically create a direct right of action on the part of investors that are nationals of one country against the other state party to the treaty. Such claims are typically administered by the International Centre for the Settlement of Investment Disputes (ICSID) or before bodies such as the International Chamber of Commerce (ICC), the London Court of International Arbitration (LCIA) or the Stockholm Chamber of Commerce (SCC).

Past economic crises have been the catalyst for a series of investor-state claims. More than 40 out of the 140 cases currently pending before ICSID arise out of the Argentinean government's responses to the financial crisis of 2001-2002. Those cases provide a guide to the types of measures that can ground an investment treaty claim and the defences that are likely to be relied on by a state. Foreign investors claimed compensation from the Argentinean state arising out of a variety of measures including the devaluation of the peso, the pesification of debt and the freezing of bank accounts. Many claims remain ongoing. Argentina has relied on two principal defences. One was the presence in the relevant BIT of a non-precluded measures (NPM) clause that limited the applicability of investor protections in exceptional circumstances, including the protection of essential security and the maintenance of public order. The second was the customary international law defence of necessity. Although all the tribunals to date have accepted that both defences can apply to measures taken to avert financial crises, most tribunals (notably those in the cases involving CMS, Enron and Sempra Energy) have interpreted those defences strictly and have awarded compensation to the claimant investor. Other tribunals, notably in the cases involving LG&E Energy Corp. and Continental Casualty, have recognised that the intent of the state parties to the treaties was to strike a bargain between increased investor protection and state policy flexibility, and accorded deference to a government's freedom of choice in regard to the methods used to avert a financial disaster.

It is of course too soon to assess precisely which states will face claims arising out of the current crisis and what kind of measures will generate claims. The scale of the economic crisis and the number of potential claims may cause governments to agree on a new structured process for the administration of claims, possibly including the establishment of a specialised tribunal or series of tribunals along similar lines as the U.S.-Iran Claims Tribunal. It is understood that intergovernmental discussions are already underway in this respect.

Whether claims are brought under the auspices of ICSID, before the ICC, LCIA or SCC or by means of a special tribunal established for the purpose, each case will of course turn on its facts and the interpretation of the relevant treaty, the measures adopted, and their precise financial impact on the individual claimants. The position is further complicated by the absence of a strict doctrine of precedent in treaty-based claims.

Explicitly or substantively discriminatory measures will provide the most obvious target. This would include measures such as the proposal by the Icelandic government to guarantee only those deposits in its banks held by Icelandic citizens or companies, which proposal was shelved following international diplomatic efforts. Yet as the Argentina cases show, macroeconomic policy instruments may also give rise to significant claims where they can be proved to have harmed non-national investors. This could include the obtaining of ownership or control of financial institutions, the dilution of shareholdings, and the triggering of stock value declines. In such cases, the approach taken by ICSID tribunals to NPM clauses in the relevant BITs and to the defence of necessity will be of central importance. Since this economic crisis is global rather than local, but each government faces unique challenges in its own economy, it is to be expected that the deferential approach taken in LG&E Energy Corp. and Continental Casualty will gain ground.

Individual or institutional investors who have been adversely affected by state actions during the current crisis should consider the possibility of mounting a claim under a relevant treaty made between a country to which they can claim nationality and the country in which their affected investment was located.

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By: Kay A. Gordon, Mark D. Perlow 

In response to the recent extraordinary events in the U.S. and worldwide markets, during the past two weeks the Securities and Exchange Commission (“SEC”) adopted a series of emergency regulatory measures regarding short sales of securities.  First, on September 17 and 18, 2008, the SEC issued orders temporarily banning short sales in certain financial stocks and requiring certain institutional money managers to report their new short sales of certain publicly traded securities on new Form SH (collectively, the “Emergency Orders”).  The SEC also amended Regulation SHO and Rule 10b-18 under the Securities Exchange Act of 1934 to prohibit “naked” short selling—the short sale of securities that one has not already borrowed—and adopted a new antifraud rule, Rule 10b-21, aimed at manipulative and deceptive practices in short selling.  In addition, the SEC chairman announced enforcement initiatives aimed at preventing “naked” and “manipulative” short selling.   The SEC has taken these actions in the hope that they would help to restore fair and orderly markets and curtail declines in securities prices.  On October 1, the SEC extended all of these emergency measures until October 17.  However, the ban on selling certain financial stocks provided that it would expire after the effectiveness of the EESA.  Therefore, the ban expires on Wednesday October 8 at 11:59 p.m.

On September 21, the SEC amended the Emergency Orders to expand (1) the list of issuers in whose securities the SEC has temporarily banned short selling, (2) the scope and duration of certain market maker exceptions, and (3) the types of securities exempted.  The SEC also stated that institutional investment managers’ short sale disclosures would be non-public for two weeks after filing. The SEC adopted these amendments to address the current and anticipated technical and operational issues raised by the Emergency Orders, as well as to coordinate with similar actions restricting short sales by foreign regulators.

In addition to the actions of the SEC, the U.K. Financial Services Authority and the French, German, Australian and many other regulators have adopted similar restrictions on short selling and, in certain cases, increased short selling disclosure requirements in an effort to restore market integrity and stability in these extreme market conditions.  Consequently, the policy level response to the perceived threat and the uncertainty generated by naked short selling was global, if not globally coordinated, in practice making it difficult for any manager to engage in forum shopping.

Many financial institutions, lawmakers and regulators have supported the SEC’s ban and limits on short sales, based on their concern that short sellers have contributed to the current market turmoil by spreading false information and using manipulative trading tactics.   In contrast, many hedge fund managers and other investors have objected to these measures, suggesting that risk management failures and poor business strategies are to blame for the current market instability.  They have argued that short selling provides liquidity and an important price discovery mechanism in the market and that the inability of managers to engage in short selling with respect to certain securities may adversely affect the markets both in the long and short terms.  Critics of the ban also point out that a temporary SEC order banning naked short selling in July failed to prevent the decline of stock prices while it was in effect.

The increased disclosure obligations have also given rise to concerns that managers will have to disclose proprietary methods and that companies whose securities are being sold short would retaliate against these managers when the managers’ short positions are publicly released.   The short selling ban may have also been particularly damaging to certain quantitative funds, which  were left unable to implement their disclosed and intended strategies.  In addition, short sellers were also constrained on another front:  many institutional investors that lend portfolio stock holdings have been recalling their stock, and some have suspended their stock lending programs altogether, which has made it harder or more expensive to borrow certain stocks.   Some industry participants believe that short sellers will adjust to the ban by switching to other instruments that are not subject to the ban, e.g., single stock futures and options, whose price movements will ultimately be reflected in the prices of the affected stocks.

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By: Edward Smith

On September 15, 2008, Lehman Brothers and its UK subsidiaries — Lehman Brothers International (Europe), Lehman Brothers Ltd, LB Holdings PLC, and LB UK RE Holdings Ltd — declared bankruptcy.  On the same day, partners in PricewaterhouseCoopers LLP were appointed joint administrators of the UK entities.

The administrators' role will be to wind down the UK Lehman companies in an orderly manner. Administration is a procedure intended to either rescue an insolvent company or to realise a better value from its assets than on a liquidation. To do so, the administrators will take over the running and management of the companies. Administration introduces a statutory moratorium, or stay. This means that no action can be taken or continued against the companies or their property, without the consent of the administrators or the leave of the Court.  Importantly, contractual set-off and close-out netting provisions will not be affected by the moratorium.

Administration does not, in itself, terminate contracts to which the Lehman entity is party. However, contracts may contain automatic insolvency termination clauses which permit the counterparty to terminate the contract on insolvency or the appointment of an administrator.

Many of Lehman’s prime brokerage clients have tried to terminate their prime brokerage agreements ("PB Agreements") in order to crystallise their position and gain some certainty. However, the standard Lehman documentation is one-sided and, in many cases, does not permit the client to terminate on Lehman insolvency or default. Equally, the close-out provisions may favour the Lehman entity — the client may not be entitled to exercise set-off unless and until all amounts owing to the Lehman entity have been settled.

In many cases PB clients have transferred collateral (in the form of cash or securities) to the Lehman entity. Many of the PB Agreements that we have reviewed provide that title to collateral passes to the Lehman entity and permits the Lehman entity to charge, transfer or sell the collateral. Any requirement to treat the collateral as "client money", in accordance with FSA rules, has usually been waived. In such cases, it is likely that the client has given up its proprietary rights in the collateral. Instead it will only have an unsecured claim in the administration for delivery of collateral “equivalent” to the original collateral. The value of the client's unsecured claim will depend on how much money is ultimately available for distribution. In some circumstances clients may be entitled to lodge a claim for compensation with a statutory fund. However, the tests for eligible applicants are prescriptive and the maximum amount of compensation is relatively small. 

As a result, many PB clients have found that their assets are tied up at a Lehman entity and can only be claimed through the administration process.  If, however, a Lehman entity has provided custodial services to a PB client, the client has a priority claim on those assets, and steps can and should be taken to contact the administrators to procure the return of the client’s assets.

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By: Philip J. Morgan, Robert V. Hadley

A hallmark of enforcement by the U.K. Financial Services Authority (the “FSA”) in 2008 has been the effort to establish that abusive behavior is likely to trigger severe personal consequences - so-called “credible deterrence.”  The FSA is now spreading the message that it is “getting tough” and intends to increase its focus on deterrence through enforcement action.

The FSA has been saying for some time that it intends to boost credible deterrence and engage senior management in particular in relation to its strategic priorities of combating market abuse and insider dealing by three strategies: higher financial penalties; greater focus on enforcement actions against individuals rather than or as well as firms; and the prosecution of criminal cases.  Yet many have wondered when the rhetoric would be matched by action.  In all of 2007 the FSA imposed just one fine for abuse-related activity.  By the start of 2008 the FSA had brought one successful criminal prosecution since its establishment under the current regulatory regime on 1 December 2001.  It had prosecuted nobody for the criminal offence of insider dealing.

Now, things appear to be starting to change. The FSA has said that in order to achieve its aim of credible deterrence it must prosecute “a steady stream” of criminal cases.  Thus, in January of this year the FSA launched its first criminal prosecution for insider dealing against two individuals, one of whom was an in-house counsel.  In July it commenced two more prosecutions, one against a former Cazenove partner. There are said to be several others in the pipeline.

Also, on July 29, 2008, an extensive dawn raid operation was mounted on various addresses by the FSA under search warrants.  Eight individuals were arrested. The FSA said that this was in connection with “a major ongoing investigation into insider dealing rings.” The FSA does not comment on ongoing investigations, but this was a further clear demonstration of intent.

Individuals, and especially senior management and others in the regulated sector, can be in no doubt that there is at least some risk of criminal prosecution for insider dealing and other market manipulation offences. The risk is not merely of financial penalty imposed on their firm, or even on them personally.  Certainly no one can any longer say that the FSA has never prosecuted anyone for such activities.  The FSA’s aim is that any person with access to inside information or other opportunity to abuse the market should believe that these criminal cases are the first of its “steady stream,” and to think clearly that that is not where they wish to swim.

The FSA also will point to other recent actions as evidence of its new, more aggressive posture toward enforcement.

In the past two months, the FSA fined Credit Suisse £5.6 million for the mismarking of certain positions resulting in an overstatement in published accounts corrected some eight days later, and fined a GE Money mortgage brokerage operation £1.1 million for defective systems and controls leading to its not accounting correctly for customer funds, so that, for example, mortgages were overpaid on redemption and clients’ money was not applied to their mortgage accounts promptly or accurately (both fines imposed after the FSA acknowledged the full cooperation of the firms and after applying the 30 percent reduction for settling at an early stage of the enforcement process).  These cases are examples of the higher financial penalties that the FSA intends to seek.

The FSA fined Land of Leather Limited in May in relation to inadequate systems and controls to prevent the sale of Payment Protection Insurance which was unsuitable for customers’ needs, but will stress that it also fined the company’s Chief Executive £14,000 (after a 30 percent early settlement reduction) in respect of the same matter. This shows the FSA’s willingness to pursue senior management on the basis of senior management’s responsibility for a firm’s regulatory compliance.

Similarly the FSA extracted an undertaking from Mr. Steven Harrison, an investment manager at a hedge fund, effectively that he stay out of the financial services industry for 12 months (in addition to a financial penalty of £52,500 - after the 30 percent early settlement reduction).  The allegation was market abuse in the sense of instructing colleagues to purchase certain bonds while in possession of inside information.  The final notice acknowledges that Mr. Harrison’s conduct was not deliberate in the sense that he did not consider at the time that he had inside information, but the FSA’s position was that he should have recognized that fact.  The FSA thus intends to promote deterrence not only by fining individuals, but also by affecting their continued ability to earn their livelihood in the financial services sector.

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By: Philip J. Morgan

In general, a person seeking to acquire a stake of 10% or more in an EU credit institution, securities firm or insurance firm has to obtain prior approval from the relevant local regulator.  However, the current EU directives mandating the relevant approvals process permit Member States to impose additional requirements over those in the relevant directives.  This has left scope for national regulators to adopt protectionist practices such as making unreasonable requests for information during the approvals process, refusing applications or imposing conditions on grounds unrelated to the purpose of the underlying directives.

This problem, which has impeded cross border acquisitions across Europe contrary to the aims of the EU Financial Services Action Plan, is now being addressed by the Acquisitions Directive (2007/44/EC) (the “Directive”) which is required to be brought into law in EU Member States by 21 March 2009.  The Directive's aim is to facilitate and encourage cross border acquisitions by increasing certainty, clarity and transparency, and Member States are not permitted to impose rules additional to those in the Directive.

The Directive seeks to harmonise the supervisory approvals process by setting out the entire procedure to be applied by regulatory authorities including fixing deadlines, limiting the ability of regulators to "stop the clock" by asking questions, and clearly laying down uniform prudential criteria for the assessment (which are the only criteria that may be applied).

In the UK, the adoption of the new rules is not currently expected to make any very material changes to the current "change in control" regime, although there will be a slight shortening of about a week of the period, currently 3 months,  within which the Financial Services Authority must make its decision.

Harmonisation of the rules across the EU should, however, mean that anyone, including those from outside the EU, looking to acquire European financial firms may find that task somewhat more straightforward.  This might be expected to trigger, or at least facilitate, a new wave of consolidation in the European banking, insurance and securities industries.

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