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

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 Sean P. Mahoney and  Anthony R. G. Nolan

A possible rule change being considered by the Federal Deposit Insurance Corporation (“FDIC”) may make it difficult for banks and other securitization market participants to manage risks associated with FDIC conservatorship or receivership of sponsoring banks.  This troubling development warrants attention not only from banks, but also from other participants in bank securitization transactions including servicers, rating agencies, law firms and auditors.   

To view the complete alert online, click here.

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 By: Richard A. Kirby and R. James Mitchell

On December 9, 2009, almost one year to the day that Bernard L. Madoff was revealed to have perpetrated the largest Ponzi scheme in history, the SEC revealed its position with respect to the approach that it believes the Securities Investor Protection Corporation (“SIPC”) should take in defining the net equity of Madoff claimants.

The SIPC Trustee has previously taken the position that net equity for Madoff’s victims should be measured on a cash-in/cash-out basis, rather than using the stated values on account statements fabricated by Madoff. This measure of net equity rejects all claims filed by victims whose net withdrawals equaled or exceeded their principal investments.

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By: Daniel F. C. Crowley, Bruce J. Heiman, Karishma Shah Page, Collins R. Clark, Justin D. Holman

On December 11, the House of Representatives passed H.R. 4173, the “Wall Street Reform and Consumer Protection Act of 2009,” by a vote of 223 to 203. 27 Democrats voted against the bill and no Republicans voted in favor of the bill.

To view the complete alert online, click here.

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By: Lawrence B. Patent

Last month, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) issued two Joint Orders that (1) permit increased trading of futures contracts on volatility indices, and (2) expand the universe of security futures under the Commodity Exchange Act (CEA) and the Securities Exchange Act of 1934 (1934 Act). In both instances, the agencies worked together to find solutions to permit investors to trade a broader range of products, while retaining meaningful protections to investors in those markets. Given the prospect that regulatory reform will require greater cooperation between these two agencies, these Joint Orders suggest that the agencies can overcome any jurisdictional competition to act for the benefit of investors and the financial markets. 

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Matt T. Morley, Richard A. Kirby, and Andrew Edwin Porter

The Obama Administration has recently announced the formation of a task force designed to coordinate federal, state and local efforts to investigate and prosecute fraud and other financial misconduct. The Financial Fraud Enforcement Task Force (FFETF) expands and supplants an earlier task force created to combat corporate fraud in the wake of the Enron scandal.

While the simple reconstitution of a task force is unlikely to dramatically alter the law enforcement landscape, this development may be one part of a more sweeping set of changes that could result in considerable increases in the magnitude, focus and efficiency of efforts to pursue financial wrongdoing. 

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By: Daniel F. C. Crowley, Bruce J. Heiman, Karishma Shah Page, Collins R. Clark, Justin D. Holman

On December 2, the House Financial Services Committee passed final bills comprising the House version of the financial regulatory reform legislation. House Floor consideration is expected as early as the week of December 7. The Senate Banking Committee is also expected to begin marking up the discussion draft of the “Restoring American Financial Stability Act of 2009” the week of December 7.

To view the complete alert online, click here.

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By: Edward G. Eisert and Carolyn A. Jayne

I. Introduction.

On November 10, 2009, Senate Banking Committee Chairman Christopher Dodd introduced his discussion draft of the "Restoring American Financial Stability Act of 2009” (“RAFSA”). This draft of more than 1,100 pages in length consolidates the various components of the Administration’s regulatory reform proposals. Set forth below is an overview of those provisions of RAFSA that most directly affect investment advisers to funds that rely upon the exemptions from registration set forth in Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act of 1940 (collectively, “Private Funds”) and that materially differ from the provisions of HR 3818, the “Private Fund Investment Advisers Registration Act of 2009,” which would require certain private fund managers to register with and be regulated by the SEC, and HR 3817, the “Investor Protection Act of 2009,” passed by the House Financial Services Committee on October 27, 2009 and November 4, 2009, respectively. (For more information about the RAFSA in general, see K&L Gates alert Senator Dodd Releases Financial Reform Proposal: The Restoring American Financial Stability Act of 2009. For a discussion of the Obama Administration’s proposed legislation, see K&L Gates alert The Obama Administration’s Proposal for the Registration of Investment Advisers to Private Investment Funds: The Private Fund Investment Advisers Registration Act of 2009.)

A. Title IV of RAFSA - “Regulation of Advisers to Hedge Funds and Others.”

Private Equity Funds. Title IV provides a new exemption from registration for advisers to “Private Equity Funds,” a term to be defined by the SEC within six months after the enactment of the Act. Within the same time frame, the SEC also will be required to issue final rules regarding records to be maintained by such advisers and reports to be provided by such advisers to the SEC.

Venture Capital Funds and Family Offices. In addition, Title IV: (i) provides an exemption from registration for advisers to “Venture Capital Funds,” a term to be defined by the SEC within six months after the enactment of RAFSA; and (ii) provides a new exclusion from the definition of “investment adviser” under the Investment Advisers Act of 1940 (the “Advisers Act”) for a “Family Office,” a term to be defined by the SEC. Title IV does not include an exemption for midsized private funds (i.e., funds that have “assets under management in the United States of less than $150,000,000”) and does not impose any recordkeeping and reporting obligations on Venture Capital Funds as does HR 3818.

Financial Thresholds for Registration of an Adviser Under the Advisers Act and for an Accredited Investor. Also, RAFSA raises to $100 million the threshold for non-exempted investment advisers to be required to register with the SEC.

Title IV directs the SEC to increase the “financial threshold for an accredited investor,” as defined in Regulation D under the Securities Act of 1933, as amended, in an amount determined to be “appropriate and in the public interest, in light of price inflation . . .” and to adjust such threshold no less frequently than once every five years to “reflect the percentage increase in the cost of living.”

Independent Custodian. Title IV authorizes the SEC to promulgate rules requiring registered investment advisers to use an independent custodian to hold client assets.

Reports and Records. Title IV excludes a provision in HR 3818 requiring registered investment advisers to provide reports, records and other documents to “investors, prospective investors, counterparties, and creditors” as the SEC may prescribe as “necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.” At the same time, Title IV increases the required information to be filed in such records or reports to include valuation methodologies of the fund, types of assets held and side arrangements or side letters, whereby certain investors in a fund obtain more favorable rights or entitlements than other investors. However, off-balance sheet leverage, required to be filed with the SEC under HR 3818, is not required to be filed under Title IV. Title IV requires the SEC to report annually to Congress regarding how it has used the data collected thereunder “to monitor the markets for the protection of investors and the integrity of the markets.” Title IV also contemplates an agreement of confidentiality when information is provided to Congress.

Studies and Reports to Congress. Lastly, Title IV directs the Comptroller General of the United States to conduct studies and submit reports to Congress on three subjects: (i) the appropriate criteria for determining financial thresholds or other criteria needed to qualify as an “accredited investor” and eligibility to invest in “hedge funds (within one year of the enactment of RAFSA)”; (ii) the feasibility of forming a self-regulatory organization to oversee “hedge funds, private equity funds, and venture capital funds (within one year of the enactment of RAFSA)”; and (iii) the state of short selling in the stock market, with particular attention to the impact of recent rule changes and the incidence of the failure to deliver shares sold short (within two years of the enactment of RAFSA).

B. Title IX of RAFSA - “Investor Protections and Improvements to the Regulation of Securities.”

Fiduciary Standards of Broker-Dealers Providing Investment Advice. Title IX takes a different approach than HR 3817, the “Investor Protection Act,” to the issue presented by investment advisers and broker-dealers currently being subject to somewhat different duties to clients. As amended, HR 3817 provides that brokers, dealers, and advisers shall have the duty “to act in the best interest of the customer without regard to [compensation]” and that the standard of conduct for brokers and dealers “shall be no less stringent than” the standard for advisers under the Advisers Act. HR 3817 would retain the broker-dealer exclusion from the definition of investment adviser.

In contrast, Title IX would eliminate from the definition of “investment adviser” in the Advisers Act the categorical exception for a broker or dealer (without regard to whether any advice it provides is “incidental to the conduct of his business as a broker or dealer . . . ”). Title IX then would amend Section 206 of the Advisers Act to grant the SEC authority by rule to exempt any person or transaction, or any class of persons or transactions, from the prohibition under Section 206(3) thereof regarding principal transactions, if the SEC determines that such exemption is “for the protection of investors; and the adviser provides investors with adequate protections against conflicts of interest or principal transactions that are not in the best interests of the investors.”

Title IX also provides that “[n]othing in [Section 205 of the Advisers Act, which regulates the terms of investment advisory contracts] prohibits an investment adviser from entering into an investment advisory relationship that provides for the payment of an asset management fee or a commission.”

Lastly, Title IX would provide that it would be unlawful for an adviser “to fail to disclose to any client or prospective client any material limitation on the range of investment products about which the investment advisor gives advice . . . .”

Regulatory Oversight of Broker-Dealers. RAFSA also takes a different approach than HR 3817 to the oversight of certain advisers and broker-dealers. Currently, HR 3817 authorizes FINRA to oversee any investment adviser who has any legal or financial connection with a registered broker-dealer (although HFSC Chairman Frank has declared his intention to oppose this last-minute amendment to HR 3817 when presented to the full House). In contrast, by eliminating the exception for brokers or dealers under the definition of “investment adviser,” RAFSA appears to subject both advisers and broker-dealers to oversight by the SEC under the Advisers Act. In addition, as mentioned above, Title IV would require the Comptroller General to conduct a study of the feasibility of forming a self-regulatory organization to oversee hedge funds, private equity funds and venture capital funds.

II. Analysis.

A. The Definition of a “Hedge Fund.”

There is no statutory definition of a “hedge fund” and, as commonly used, the term “hedge funds” refers to private funds that follow a broad range of different investment strategies and employ leverage to greatly different degrees. If RAFSA is enacted in its present form, exemptions from registration will be provided to “venture capital funds” and “private equity funds” only. As a result of these provisions, and references to “hedge funds” in RAFSA, it appears that, by process of elimination, all other Private Funds might be deemed to be “hedge funds” unless the SEC also defines that term. Because of blurring of the lines between the hedge fund, private equity fund and other private fund industries, it is likely that the SEC will have difficulty in defining these terms and, accordingly, there is the not insignificant risk that the SEC will err on the side of overinclusiveness in requiring adviser registration.

B. Expanded Jurisdiction of State Regulation of Advisers.

If enacted in its present form, investment advisers that do not advise Venture Capital Funds or Private Equity Funds, would not come within one of the other narrow exemptions from registration under the Advisers Act, and have assets under management of less than $100 million would not be eligible to register with the SEC. Such advisers would be subject to regulation under the laws of the states in which they do business and, consequently, if they do business in more than one state might incur increased costs and be subject to increased regulatory burdens.

C. Treatment of Non-U.S. Domiciled Private Funds and Advisers.

Although much of the exemption provided for “foreign private advisers” is identical in both RAFSA and HR 3818, RAFSA includes one key revision to the definition of “foreign private adviser.” HR 3818 provides that a foreign private adviser must have fewer than 15 clients in the U.S. “during the preceding 12 months.” RAFSA provides no time frame for such calculation. Theoretically, non-U.S. domiciled advisers would be unable to rely upon this exemption under RAFSA after they have an aggregate of 15 U.S. clients over an unlimited period of time, regardless of whether such clients remain active clients.

RAFSA also modifies the definition of “Private Fund” in a manner that potentially is beneficial to U.S. and non-U.S. domiciled advisers to certain non-U.S. funds. RAFSA defines a “Private Fund” to be a fund that relies upon either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 and “either - (i) is organized or otherwise created under the laws of the United States or of a State; or (ii) has 10 percent or more of its outstanding securities owned by U.S. persons.” HR 3818 defines “Private Fund” to be any fund that relies upon either of those exemptions. Thus, RAFSA provides a limited exception from the definition of “Private Fund” for a fund organized in a non-U.S. jurisdiction if only a small percentage of its interests is held by “United States persons.”

Under RAFSA, non-U.S. domiciled advisers also would benefit to the same extent as U.S. domiciled advisers from the new exemptions from registration for advisers to “venture capital funds” and “private equity funds.”

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By: Daniel F. C. Crowley, Bruce J. Heiman, Karishma Shah Page, Collins R. Clark, Justin D. Holman

On November 10, 2009, Senate Banking Committee Chairman Christopher Dodd (D-CT) released a discussion draft of the "Restoring American Financial Stability Act of 2009." Chairman Dodd has been developing the Senate version of the regulatory reform package over several months. Until recently, the Chairman was working in conjunction with Ranking Member Richard Shelby (R-AL). However, Chairman Dodd recently decided to proceed only with the Democrats on the Committee.

At the time of this writing, the House Financial Services Committee is completing its markup of the House regulatory reform package. With the Senate and House taking different approaches in several respects, debate on significant aspects of the regulatory reform package will continue.

To view the complete alert online, click here.

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By: Daniel F. C. Crowley, Bruce J. Heiman, Karishma Shah Page, Collins R. Clark, Justin D. Holman

Over the past several weeks, Congress has accelerated the financial regulatory reform effort, which will dramatically restructure the legislative and regulatory framework that governs the financial services industry. Late last week, House Financial Services Committee Chairman Barney Frank (D-MA) announced that the Committee will complete its markup of the financial regulatory reform bills by November 20.

As the House approaches Floor consideration of the regulatory reform package, the Senate is getting underway with its parallel effort. On November 10, Senate Banking Committee Chairman Chris Dodd (D-CT), who until recently had been working in conjunction with Ranking Member Richard Shelby (R-GA), released a discussion draft in the form of a single large bill. 

To view the complete alert online, click here.

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By: Lawrence B. Patent, Mary C. Moynihan

On October 16, 2009, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) issued “A Joint Report of the SEC and the CFTC on Harmonization of Regulation” (Report). The Report was issued in response to a request in the Administration White Paper on Financial Regulatory Reform.

The Report contains 20 recommendations. This Alert will focus upon the recommendations in the Report that may be of greatest interest to investment advisers: (1) the potential “uniform” standards of “fiduciary” duties for persons providing investment and commodity trading advice for securities and futures; (2) aiding and abetting liability under the Securities Act and the Investment Company Act; and (3) aligning the reporting requirements for private funds. The Alert also discusses the other recommendations, some of which may indicate enhanced opportunities for portfolio margining across markets and the prospect of greater clarity and expedited judicial review of new products that straddle jurisdictional lines. 

To view the complete alert online, click here.

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By: Stephen J. Crimmins, Nicholas S. Hodge, Melissa S. Holmes, Thomas F. Joyce, Beth R. Kramer, Richard A. Kirby, Mary C. Moynihan, Megan B. Munafo, Gwendolyn A. Williamson, Roger S. Wise

The Fall 2009 Edition of K&L Gates' Investment Management newsletter is offered as a timely aid in addressing the myriad regulatory issues confronting the investment management industry. Watch for future issues discussing up-to-the-minute developments and trends in the industry.

To view the complete newsletter, please click here.

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By:  Stephanie C. Robinson

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

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

To view the complete alert online, click here.

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

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

To view the complete alert online, click here.

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By: Richard A. Kirby and Melissa S. Holmes

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

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

FINRA Reforms. 

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

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

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

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

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

SEC Enforcement Reforms. 

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

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

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

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

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

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

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

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

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By: Lawrence B. Patent

In testimony relating to“cap-and-trade” legislation currently pending in Congress, the Chairman of the Commodity Futures Trading Commission (CFTC), Gary Gensler, has urged that his agency be designated as the primary regulator of carbon trading, with authority over both cash transactions and derivative instruments. In a prepared statement for his September 9, 2009 testimony before the U.S. Senate Committee on Agriculture, Nutrition and Forestry, Chairman Gensler advocated CFTC regulation of both the trading of futures contracts in emission allowances and offset credits for greenhouse gases (GHG), and the cash market transactions in those allowances and credits. At the same time, Chairman Gensler recognized the need for the involvement of other agencies, such as the Environmental Protection Agency (EPA), in the “cap” part of cap-and-trade, to oversee related functions such as the allocation of GHG emission allowances, the establishment of standards for allowances and credits, and the maintenance of a central registry for such instruments. CFTC regulation would include oversight of the trade execution system, oversight of the clearing of trades, and protection against fraud, manipulation and other abuses. Chairman Gensler called for prompt reporting of all transactions in both GHG emissions cash and futures markets, and for a central registry of all transactions, to be updated on at least a daily basis.

Chairman Gensler’s testimony follows introduction by Senator Feinstein of S. 1399, the Carbon Market Oversight Act of 2009, which would grant the CFTC authority over both GHG emission allowances and offset credits, and derivatives thereon. Currently, the CFTC has authority only over futures transactions in derivative instruments, but not over cash transactions in the products underlying those derivatives. If enacted, S. 1399 would, for the first time, extend CFTC jurisdiction to a cash market – that is, the market for GHG emission allowances and credits that will arise under any cap-and-trade scheme – with the power to adopt and enforce rules for cash market transactions in those products. 

Among the rules that the CFTC would be likely to impose on those cash markets would be standardization of contracts and centralized trading and clearing.The CFTC takes the view that derivative instruments should, to the extent possible, be defined by standardized contracts, and traded and cleared centrally. Chairman Gensler envisions a similar regime for GHG emission allowances and offset credits, urging that they should be traded only on centralized marketplaces, rather than on an off-exchange basis through ISDA or other documentation. 

Chairman Gensler advocated that the CFTC is the appropriate regulator of the trading of GHG emission allowances and offset credits because of its experience and expertise in regulating markets involving derivatives on similar instruments. He noted that the CFTC already oversees the trading and clearing of derivative contracts based on sulfur dioxide, nitrogen oxide and carbon dioxide allowances and offsets. Chairman Gensler also argued that carbon markets have similarities to several different markets that fall within the CFTC’s regulatory authority because, like agricultural commodities, there will be a yearly “crop” and important programmatic regulations governing the nature of the product, and because emission allowances and offset credits will be government-issued, similar to Treasury-issued debt instruments. Chairman Gensler further pointed out that the CFTC recently issued a proposed determination to classify the Carbon Financial Instrument contract traded on the Chicago Climate Exchange as a significant price discovery contract, which, if finalized, would give the CFTC full oversight authority over the contract and additional experience regulating cash emissions contracts. 74 Fed. Reg. 42052 (Aug. 20, 2009). Certain commenters responding to the CFTC’s request for comment on the proposed determination, however, have questioned the CFTC’s assertion of jurisdiction in that matter. See Letter from R. Trabue Bland, Director of Regulatory Affairs and Assistant General Counsel, IntercontinentalExchange, to David Stawick, Secretary, CFTC, Sept. 4, 2009. 

CFTC regulation of GHG emission allowances and offset credits is by no means certain, and Congress has some difficult choices to make. The cap-and-trade bill that passed the House of Representatives earlier this year, the American Clean Energy and Security Act of 2009 (H.R. 2454), would give such jurisdiction to the Federal Energy Regulatory Commission (FERC), with CFTC jurisdiction limited to derivatives trading in those instruments. See Title III, Subtitle D of that bill, beginning at page 1027 thereof. In this regard, the House bill is consistent with the existing cap-and-trade program involving sulfur dioxide emissions that was begun almost two decades ago under the administration of the EPA, which maintains jurisdiction over the cash market trading in sulfur dioxide emissions trading to this day, pursuant to 42 U.S.C. § 7651b and regulations promulgated thereunder. 

Competing regulatory jurisdiction over the energy space is not new. The CFTC and the FERC recently engaged in a jurisdictional dispute over which agency should pursue allegations of manipulation of the NYMEX natural gas futures market by Amaranth Advisors, with both the CFTC and the FERC ultimately settling separate actions against the company on the same day, August 12, 2009, which included a total civil monetary penalty due to the U.S. Treasury in the amount of $7.5 million, and continuing to pursue separate actions against Brian Hunter, who was the lead trader in natural gas products for Amaranth. Earlier this year, the CFTC sought unsuccessfully to persuade the Federal Trade Commission not to adopt regulations that the CFTC saw as impinging upon its exclusive jurisdiction over regulated energy futures markets. 74 Fed. Reg. 40685 (Aug. 12, 2009).

Historically, the CFTC has taken the position that the Commodity Exchange Act expressly vests it with exclusive regulatory and civil enforcement jurisdiction over all transactions in regulated futures and option contracts and the markets in them. Such exclusive jurisdiction, it has argued, assures that participants and intermediaries in those markets will be governed by a comprehensive set of statutory and regulatory standards and requirements administered by a single regulator, and that these markets will not be subjected to multiple different and potentially conflicting statutory and regulatory standards, interpretations and enforcers. 

Yet while the CFTC has not hesitated to use its enforcement powers against those who it alleges seek to use cash market transactions to attempt to manipulate cash and futures commodity prices, the CFTC has not previously sought to regulate cash markets for energy, agricultural or financial products. Any such CFTC regulatory authority, however, would appear to overlap with other agencies’ existing jurisdiction over related products, because the CFTC’s exclusive jurisdiction under the Commodity Exchange Act extends only to exchange-traded futures and option contracts. A regulatory framework where the CFTC has general authority over cash markets may be problematic, given the potential for legal uncertainty and increased costs for market participants as they seek to comply with multiple and potentially inconsistent federal regulations. Beyond this, these legislative debates may also embolden other agencies to seek to expand their own respective jurisdictions, so as to reach into the CFTC’s traditional jurisdiction over derivatives.

The CFTC already has a robust agenda to address, including possible federal position limits on energy futures trading, reporting to Congress on efforts to harmonize its regulatory framework with that of the SEC, and helping to shape the evolving regulatory program for what have been off-exchange derivatives that were exempt from federal regulation. This is an ambitious agenda that will likely require the CFTC to develop additional resources for its implementation. Its proposed new authority over GHG emission allowances and offset credits adds to the list and, from a jurisdictional perspective, may be the most complicated item of all.

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By: Diane E. Ambler, Philip M. Cedar, Daniel F. C. Crowley, Vanessa C. Edwards, Edward G. Eisert, David H. Jones, Steven M. Kaplan, Sean P. Mahoney, J. Matthew Mangan, Philip J. Morgan, Mary C. Moynihan, Anthony R.G. Nolan, Clair E. Pagnano, Lawrence B. Patent, Karishma Shah Page

Since June 17, 2009, when the Obama Administration unveiled its financial regulatory reform plan, there has been a flurry of executive branch and legislative branch activity.  The frenetic pace of the reform effort is expected to resume in the fall, as Congress works to resolve the many highly controversial issues presented by the plan.  The traditional August Congressional recess now underway provides an opportunity to take stock of this historic capital markets reform effort.  This alert provides an overview of the most significant developments so far, as well as the outlook moving forward.

To view the complete alert online, click here.

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By: Rebecca H. Laird, Edward G. Eisert, Stanley V. Ragalevsky, Sean P. Mahoney, Daniel F. C. Crowley, Collins R. Clark

On July 22 and 23, 2009, the U.S. Department of Treasury released nine legislative proposals affecting banking institutions and their holding companies.  The various parts of this proposed legislation interact in a manner that, if enacted, will change the banking industry’s playing field in unprecedented ways.  These changes aim to end regulatory arbitrage and minimize systemic risk.

To view the complete alert online, click here.

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By: Gordon F. Peery, Lawrence B. Patent, Anthony R.G. Nolan

 Activity in the U.S. House of Representatives in late July 2009 gave the financial services industry a glimpse of legislative initiatives that, if enacted into law, may dramatically transform the over-the-counter (“OTC”) derivatives market. Congress will debate the aggressive legislative initiatives detailed in this Alert soon after it reconvenes following its August recess. The initiatives go hand-in-hand with the rest of the Obama Administration’s Financial Regulatory Reform mandates. In order to understand the importance of the July 2009 initiatives, it is first necessary to briefly review industry, regulatory and legislative efforts to reform the OTC derivatives market earlier this year.

To view the complete alert online, click here.

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

In the days before adjourning for the week-long Memorial Day Recess, Congress passed and President Barack Obama signed into law three significant pieces of financial services legislation, kicking off what is likely to be the beginning of a comprehensive capital markets reform effort. This piecemeal yet swift approach suggests the manner in which Congress may proceed with financial services reforms moving forward.

Congress Passes Bills on Fraud, Credit Cards, and Mortgages

• Fraud Enforcement and Recovery Act. On May 20, 2009, President Obama signed into law S. 386, the Fraud Enforcement and Recovery Act of 2009 (FERA; P.L. 111-21). The legislation, which the Senate approved on May 14 by a voice vote and the House passed on May 18 by a 338-52 vote, provides federal authorities with enhanced funding and expanded powers over a broad range of financial crimes (see K&L Gates Alert Fraud Enforcement and Recovery Act of 2009). In addition, FERA establishes an independent Financial Crisis Inquiry Commission, modeled after the Pecora Commission of the 1930s (see below and K&L Gates Alert A Congressional Investigation of Wall Street Looms).
• Helping Families Save Their Homes Act. On the same day, President Obama signed into law S. 896, the Helping Families Save Their Homes Act of 2009 (P.L. 111-22). The bill, which was passed with broad bipartisan support in both the House and the Senate on May 19, enhances the Hope for Homeowners Program and provides the Federal Housing Administration with the authority to engage in foreclosure mitigation programs (for more information about other mortgage-related provisions in the bill, see K&L Gates Alert New Disclosure Obligation Imposed on Assignees ). In addition, the legislation also increases FDIC and National Credit Union Administration borrowing authority and extends the increased $250,000 deposit insurance limit to 2013.  
• Credit Cardholders’ Bill of Rights Act. The same week, Congress passed and the President signed H.R. 627, the Credit Cardholders’ Bill of Rights Act of 2009 (P.L. 111-24). The legislation, which was also passed with significant bipartisan support in both chambers, bans certain credit card company practices including double-cycle billing and late fees on issuer delayed crediting of payments, prohibits certain changes in interest rates, and requires expanded disclosure of credit card terms and agreements.

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By: Edward G. Eisert, Megan B. Munafo

Hedge funds are under intense scrutiny as a result of the global financial crisis and the most comprehensive review of the financial industry regulatory framework in 70 years. Until recently, most legislators and regulators believed that the hedge fund regulatory regime was adequate, taking into account reliance on the oversight of hedge fund financial counterparties, such as prime brokers. However, in the current environment, anxiety has grown that hedge funds could pose a systemic risk to the global financial system due, in part, to: (i) the large amount of assets managed through hedge funds; (ii) the use of leverage by hedge funds; (iii) the relative lack of transparency concerning their operations; and (iv) the limited power of regulators to examine their managers and the funds themselves.

Although hedge funds have been a focus of regulatory reform in the past, global initiatives have accelerated in 2009. In the wake of the April 2009 G-20 meeting held in London, two sets of initiatives are anticipated to significantly reshape the regulation of hedge funds: (i) the draft Directive on Alternative Investment Fund Managers (“AIFMs”) issued by the European Commission; and (ii) legislative developments in the United States.

Draft Directive Issued by the European Commission
On April 29, 2009, the European Commission proposed legislation designed to impose the first European-wide regulation of alternative investment capital pools, including hedge funds, in an effort to reduce systemic risk and harmonize regulation in the European Union (“EU”). The proposed Directive on Alternative Investment Fund Managers (the “AIFM Directive”) would require EU-domiciled managers of hedge funds and other alternative capital pools with assets under management of more than €100 million, or €500 million where the funds have “no leverage” and a “lock-up period” of five years or more, to be “authorized” by their home Member State and report regularly on the main investments of the fund, its performance and risks. In addition, AIFMs would be subject to ongoing regulation relating to minimum capital, risk management and audit arrangements. (Directive of Alternative Investment Fund Managers (AIFMs): Frequently Asked Questions, Memo/09/211, 29/04/2009).

The AIFM Directive would not regulate the fund itself, its fees, or its investment objectives. Rather, the AIFM Directive provides that: (i) only AIFMs established in the EU can provide their services in the EU; and (ii) only funds domiciled in the EU can be marketed by authorized AIFMs in the EU. Nonetheless, in order to allow offshore funds to continue to be offered in the EU, the AIFM Directive would provide an “EU Passport” for the marketing of such funds that comply with “stringent requirements in regulations, supervision and cooperation, including on tax matters.” The AIFM Directive would impose for the first time capital requirements on AIFMs and limits on fund leverage, and it would also establish business conduct principles such as fair dealing and detailed rules regarding independent valuation and disclosures to investors and reporting to regulators. The AIFM Directive would also institute reporting requirements regarding controlling interests in fund portfolio companies. In order to allow time for the development of rules allowing for the marketing of “third country funds,” for a period of three years after the effectiveness of the AIFM Directive, third country funds could continue to be sold in the EU, subject to individual Member State approval. In light of the strong critical reaction by various organizations in the alternative investment industry, and the requirement that the AIFM Directive is subject to approval by the European Council and the European Parliament, it is not likely to become effective until at least 2011. For more information on the proposed Directive, please see the K&L Gates Alert “European Commission Proposes Regulation of Alternative Investment Fund Managers.”

U.S. Legislative Developments
In the first quarter of 2009, several bills were introduced in the U.S. Congress that would require hedge fund managers and “large” hedge funds to register with the U.S. Securities and Exchange Commission (“SEC”), comply with information reporting and other requirements, and subject them to further study. One, the “Hedge Fund Transparency Act,” would limit the availability of the exemptions from registration under the Investment Company Act of 1940 relied upon by hedge funds to those with assets under management of less than $50 million. (S. 344, 111 th Cong. (2009)). Another, the “Hedge Fund Adviser Registration Act of 2009,” would eliminate the “private adviser exemption” under the Investment Advisers Act of 1940 (the “Advisers Act”), commonly relied upon by hedge fund managers, with the effect of requiring virtually all hedge fund managers to register with the SEC under the Advisers Act. (H.R. 711, 111th Cong. (2009)). Although its precise terms have not yet been defined, following the G-20 meeting in April and the increased focus on a global systemic risk regulator, a broad legislative proposal is anticipated in 2009 that will include a requirement that private fund managers be registered under the Advisers Act. The Obama Administration has also proposed that the SEC be authorized to obtain, among other things, hedge fund portfolio holdings information from fund managers in order to report on potential systemic risks to a newly designated systemic risk regulator.

In May 2009, in testimony at a hearing held before the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, the Managed Funds Association (the “MFA”) announced its support for the mandatory registration of investment advisers (including advisers to private pools of capital) with the SEC under the Advisers Act. The MFA is an organization comprised of professionals from hedge funds, funds of funds, managed futures funds and industry service providers. The proposed framework supported by the MFA goes beyond recent proposals, which only sought to require the largest fund advisers to be registered, and would subject the vast majority of investment advisers to the registration requirements of the Advisers Act. The MFA’s position signals that leading hedge fund managers have accepted that there will be increased regulation and are trying to shape it rather than fight it.

Also of far-reaching impact, the President’s Budget Outline for fiscal year 2010 includes provisions for the taxation as ordinary income of the “incentive allocation” or “override” received by the managers of U.S.-domiciled hedge funds. As proposed, the “Stop Tax Haven Abuse Act” would “restrict the use of offshore tax havens and abusive tax shelters to inappropriately avoid federal taxation, and for other purposes.” (S. 506, 111 th Cong. (2009); H.R. 2136, 110 th Cong. (2007)). At the same time, the Treasury has reaffirmed the value of private pools of capital to the financial system in its proposals for Public-Private Investment Funds.

Moving Forward
As these various initiatives progress, it appears that not only will private investment fund managers, wherever domiciled, become subject to more intense U.S. regulatory scrutiny, but U.S.-domiciled managers will become subject to EU regulatory scrutiny, at least insofar as they manage European-based funds or market funds in Europe. An active, substantive dialogue between the private sector and global regulators will be necessary in order to promote the development of regulatory reforms that are measured and that contribute to the restoration of financial market stability without unduly restricting the ability of hedge funds to meet the needs of investors.

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By: Mary C. Moynihan, Diane E. Ambler

Although mutual funds have not been implicated as a cause of the financial crisis, many investors have experienced the crisis most directly through the plummeting value of their mutual fund investments. As Washington moves to address the myriad issues arising from the crisis, the mutual fund industry should expect to see changes that will directly affect how funds—and their advisers, distributors and custodians—do business. Changes of particular interest to the mutual fund industry are discussed below.

Change to Primary Regulator for Registration of Mutual Funds, Broker-Dealers and Advisers
Lawmakers are considering several configurations for a new regulatory regime. These include consolidation of the SEC with the CFTC—although Barney Frank, the powerful chair of the House Financial Services Committee, has expressed doubts as to whether such consolidation will happen. Another idea involves the creation of a financial products safety commission. Whether that proposal will take hold is unclear, although key Democrats in the Senate and House have submitted a bill to create the commission. Even if it were created, the White House is reported to support a plan under which the new financial products safety commission would focus on consumer products such as mortgages and credit cards, but would not have jurisdiction over securities (and therefore mutual funds), which would instead be regulated by the new agency resulting from a merger of the SEC and CFTC. Because the proposals are likely to trigger a turf war in Congress and among the affected agencies, it is still too early to predict the outcome. Lawmakers are also still waiting for final proposals from the Obama administration.

Money Market Funds
Money market funds have drawn closer regulatory scrutiny since the Reserve Primary Fund broke the buck in September, spurring large-scale redemptions from money market funds with large institutional investor bases and a guarantee program from the U.S. Treasury. While the Group of 30 proposed earlier this year that funds that maintain a stable $1 NAV be regulated as special purpose banks, this proposal does not seem to have gained traction. However, a consensus has developed on the need to tighten the rules governing money market funds’ portfolio assets’ credit quality, maturity and liquidity. The first detailed proposal came in March from a task force convened by the Investment Company Institute, which included proposals to (1) impose daily and weekly minimum liquidity requirements; (2) stress test the portfolio; (3) tighten portfolio maturity limits; (4) raise credit quality standards on portfolio investments; (5) address client concentration risks; (6) disclose portfolio investments monthly; (7) require additional risk disclosures; (8) authorize suspending redemptions for several days for failing funds; and (9) establish a nonpublic reporting scheme to regulators for all money market investors. The SEC has not yet produced a detailed proposal. However, SEC Chair Mary Schapiro has made clear that the SEC will propose tougher rules later this month that will “extend beyond” the ICI task force proposals. The staff is examining the credit quality, maturity and liquidity provisions currently applicable to money market funds and considering whether more fundamental changes are needed, including floating rate net asset values for money market funds.

“Proxy Access” and “Say on Pay”
In May, the SEC proposed a new “proxy access” rule that would set a tiered system under which shareholders may nominate candidates for election to boards of directors. For example, for companies with a market cap of $700 million or more, shareholders owning at least 1% of the voting securities would be eligible to nominate directors. By some estimates, this could increase by three or four times the number of contested director elections that funds must evaluate in exercising proxies. In addition, funds themselves would be subject to the proposed rule, which would allow shareholders to nominate fund directors. Finally, funds with ownership positions in excess of the thresholds would need to determine whether they should be proposing director candidates for portfolio companies. These proposals would transform a fund’s traditional analysis of “buy vs. sell” and force new decision-making concerning voting and management. Also in May, Senators Charles Schumer and Maria Cantwell introduced a “shareholder bill of rights” that would require non-binding shareholder votes on how executives are paid. The bill is not likely to pass in its current form but, particularly in view of the action taken earlier this year by the House to limit compensation of recipients of TARP money, any reform package is likely to include some corporate governance component.

Emerging Best Practices Relating to Risk Management
Many fund advisers and boards are examining whether the events of the past year suggest that they need additional risk monitoring programs to evaluate risk elements in the portfolio and the adviser’s organization. There is no “one size fits all” answer to the risk management puzzle, and the precise actions that a fund family and its board should take with respect to risk assessment are highly subjective and based on many different factors, including the nature of the fund family’s investments, experience with risk, organizational structure, and nature of investors. Nonetheless, the SEC has indicated that risk will be a central concern, suggesting that advisers may need to develop a more robust approach to risk management and that fund boards may wish to consider creating a risk management oversight committee or adding responsibility for risk oversight to an existing committee, such as compliance or investment performance.

Target Date Funds
In a May speech to the Mutual Fund Directors Forum, SEC Chair Schapiro stated that the SEC is closely examining target date funds due to concerns with performance of the funds during the market decline. As these funds approach their “target” date, their asset allocations should move toward a more conservative allocation, often referred to as a fund's “glide path.” Some funds may have established more aggressive glide paths based on the assumption that investors would continue to maintain their investments, and partially live off the proceeds following retirement. This could be particularly problematic for a target date fund underlying a college investment plan, since those investors would need to access their investment at or near the fund’s target date. Chairman Schapiro stated that the SEC staff would be closely reviewing target date funds’ disclosure about their glide paths and asset allocations, examining whether the same target date funds underlie both retirement and college savings plans and considering whether the target dates in some funds’ names are misleading. Chairman Schapiro also challenged fund directors to review their funds’ allocations between asset classes.

Custody of Client Assets by Investment Advisers
Following the Madoff scandal, the SEC has moved swiftly to propose new rules governing the custody of client funds held by all registered investment advisers. The proposed rules would require advisers to undergo an annual surprise examination by an independent public accountant to verify client assets. In the case of assets that are not maintained by an independent qualified custodian, the rules would require a “SAS-70” report from an independent public accountant registered with and inspected by PCAOB that includes an opinion covering controls over custody of client assets. The proposed rules would not apply to custody of assets held by mutual funds, but would affect advisers with respect to other classes of client funds.

When the dust settles, the investment management landscape will undoubtedly be much changed. Mutual funds will likely be subject to new rules, regulated by a reconstituted regulator, and, especially if hedge funds and other unregulated entities face more regulation, will encounter a new competitive environment. Industry participants should closely monitor these developments and may wish to provide input into policy choices that will have direct implications for them and their investors.

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By: Steven M. Kaplan, Kerri M. Smith

The consumer credit industry has been subject to legislative and regulatory changes occurring at a dizzying velocity.

On May 22, 2009, the Credit Card Accountability Responsibility and Disclosure Act of 2009 became law, amending the Truth in Lending Act (“TILA”) to establish fair and transparent practices relating to the extension of open-end consumer credit plans and gift cards. TILA also was amended in the Helping Families Save Their Homes Act of 2009, signed two days prior. Further, on that May 20, 2009 date, President Obama issued a Memorandum for the Heads of Executive Departments and Agencies directing federal agencies to take appropriate action if preemption regulations do not meet certain requirements, which could affect almost every segment of the consumer finance industry.

Federal regulators have also been active. For example, the Federal Trade Commission initiated rulemaking proceedings on June 1, 2009 to address unfair and deceptive practices in the mortgage industry, as required by Congress’ 2009 Omnibus Appropriations Act. Concurrently, the federal financial institution regulatory agencies are issuing proposed rules requiring mortgage loan originators who are employees of agency-regulated institutions to meet the registration requirements of the Secure and Fair Enforcement for Mortgage Licensing Act of 2008.

While the industry scrambles to come to grips with the array of new requirements, two of the issues garnering much attention are the residential mortgage loan servicer safe harbor and the new TILA disclosure obligations on purchasers of residential mortgage loans, found in the Helping Families Save Their Homes Act of 2009 (“the Act”).

The servicer safe harbor, as discussed in section 201 of the Act, provides that a mortgage loan servicer will be shielded from liability from any party to whom it owes a duty “to maximize the net present value,” based solely on its implementation of a “qualified loss mitigation plan” (“QLMP”), so long as that QLMP is deemed to be in the best interest of all investors or other parties. The Act determines that a servicer acts in the best interest of all investors (again, when it has an express duty to maximize net present value) if it makes a QLMP where: (1) default has occurred, is imminent, or reasonably foreseeable, as those terms are defined in the Department of Treasury’s Home Affordable Modification Plan guidelines (“HAMP”); (2) the property is occupied by the debtor as a primary residence; and (3) the servicer reasonably determines, consistent with HAMP, that a QLMP for a particular property or a class of properties will result in greater principal recovery than foreclosure of that property. Further, the Act defines a QLMP as a plan described or authorized by the HAMP, or a refinancing under the federal Hope for Homeowners program. It may surprise some, but the new servicer safe harbor contains no express provisions regarding the superseding of contractual restrictions. The ambiguity is even more pronounced when compared to the House’s safe harbor provision in H.R. 1106, which was not enacted into law, but which did contain such express provisions.

Meanwhile, the Act also provides that purchasers of residential mortgage loans have affirmative disclosure obligations to consumers, and subjects them to civil liability if they fail to comply. The statute provides that it is effective upon enactment, which means that the first disclosures are required by Friday, June 19, 2009. One of the fundamental questions regarding this obligation, however, is which purchasers are subject to this new disclosure obligation.

Section 404 of the Act amends TILA to provide that “a creditor that purchases or is assigned a mortgage loan must notify the borrower in writing of a sale or transfer of his or her mortgage loan, not later than 30 days after the transaction’s completion.”  The notice must include the following information:

• the identity, address, and telephone number of the new creditor;
• the transfer date;
• how to reach an agent or party having authority to act on behalf of the new creditor;
• the location of the place where transfer of ownership of the debt is recorded; and
• any other relevant information regarding the new creditor.

The Act’s use of the term “creditor” to describe the “new owner” conflicts with TILA’s preexisting definition of creditor as the one to whom the loan was “originally payable.” This conflict in statutory terms makes it very difficult for the mortgage industry to know who must comply with the new law. Additionally, there are several other ambiguities contained in the new disclosure requirement, including whether the obligation should apply to so-called short-term transfers and the specific information that must be included in the disclosure.

Some might say that in the policy makers’ wish to enact legislation, clarity was compromised. Thus, we hope that future laws and regulations will be clearer than those recently enacted. If federal policymakers continue regulating at this fast pace, credit industry participants may need to swap their beach reading for copies of the Federal Register and the Congressional Record.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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By: Laurence E. Platt, Kerri M. Smith

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

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

To view our complete alert online, click here.

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By: Lawrence B. Patent

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

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

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

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

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

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

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By: Brian A. Ochs

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

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

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

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

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

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

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

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By: David T. Case, Brendon P. Fowler 

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

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

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

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

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

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

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

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

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By: Mark D. Perlow

On January 15, 2009, Mary L. Schapiro, President Obama’s nominee to chair the U.S. Securities and Exchange Commission (“Commission”), testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs (“Committee”) in a hearing to consider whether to recommend her nomination to the full Senate.  Her appointment was confirmed by the Committee and the Senate on January 22.  During her confirmation hearing, Ms. Schapiro outlined her priorities for the days ahead.

Ms. Schapiro stated that her “first and foremost” priority will be to “move aggressively to reinvigorate enforcement at the SEC” — an implicit repudiation of the direction that SEC enforcement has taken under Chairman Christopher Cox.  Under Mr. Cox, the size of the enforcement staff has declined in recent years, and the Commission has instituted additional layers of review for the approval of an investigation.  In addition, it issued guidance that limited the circumstances under which monetary penalties can be imposed upon corporations, noting that in many cases penalties have the effect of harming the corporation’s innocent shareholders.  The SEC also instituted a pilot program requiring the Commission’s pre-approval for the enforcement staff to negotiate monetary penalties in settlements, with the Commission first approving an acceptable range for the penalties.  Critics contend that these measures have hamstrung and demoralized the enforcement staff, while defenders argue that they have restored balance to an overly aggressive program.  In either case, Ms. Schapiro’s chairmanship most likey will result in more aggressive enforcement.

Second, Ms. Schapiro articulated her vision of the SEC’s mission as the “investor’s advocate,” focused on “investor protection, transparency, accountability and disclosure.”  She expressed a desire to preserve these missions in the coming regulatory overhaul, which seems to concede that the SEC would serve as a regulator of business conduct but not as a prudential regulator of safety and soundness.  The U.S. Treasury’s Blueprint for a Modernized Financial Regulatory Structure, proposed in March 2008, advocated consolidating the many federal financial regulators into three – a market stability regulator, a prudential regulator, and a business conduct regulator, and this broad vision (if not the specifics of the Treasury’s proposals) has gained currency among the Congressional leadership.  Ms. Schapiro may have thus signalled that she will not fight to regain what the SEC has already in fact lost, the power to impose capital, liquidity and other prudential standards on systemically important broker-dealers.  Indeed, she implicitly endorsed regulatory consolidation when she expressed her view that one reason why regulators did not uncover the alleged Madoff fraud was the current “stovepiped” approach to regulation.  Nonetheless, she pointed out to a largely sympathetic Committee that the SEC’s core functions — examinations of investment companies and advisers and securities firms, regulation of corporate disclosure, exchange regulation and oversight — need to be preserved in any combined agency.

Ms. Schapiro also said that the SEC’s approach to regulating credit rating agencies should be reconsidered.  These firms have garnered much criticism for allegedly allowing their standards to slip in overrating many of the asset-backed securities that now clog the balance sheets of financial institutions.  In particular, the business model of these firms has come under attack:  because the issuer of the security pays the rating agency, critics, including the SEC itself, have alleged that this conflict of interest compromised the independence and methods of the ratings agencies.  Ms. Schapiro said that two ideas in particular merit attention – first, requiring that the rating agencies receive their compensation from small transaction or listing fees rather than from the issuers of securities, and second, establishing a dedicated regulator with powers modelled after those of the Public Company Accounting Oversight Board to set standards and conduct comprehensive examinations.

Ms. Schapiro also advocated mandatory SEC registration and regulation of hedge fund managers.  While she acknowledged that the SEC does not currently have this authority, since the agency’s effort to impose a hedge fund registration rule was struck down by the DC Circuit Court of Appeals, Ms. Schapiro recognized that Congress will likely soon expressly grant the SEC this authority.  Ms. Schapiro said that the agency will begin working on proposals that will govern hedge fund disclosures and provide for “better and stronger checks and balances.”  Even before Congress enacts any legislation, such rules could be applied to hedge fund managers currently registered with the SEC.

Ms. Schapiro indicated that the SEC would move forward with shareholder proxy access, an issue with a long and contested history.  In 2004, then-SEC Chairman William Donaldson prompted the Commission to propose a complicated rule that would have allowed shareholders that crossed certain ownership percentage and longevity thresholds to place a limited number of director nominees on an issuer’s own proxy.  However, business groups strongly opposed the rule, and Donaldson stepped down before it could be adopted.  In 2007, pressured by a Second Circuit Court of Appeals ruling that questioned the SEC staff’s interpretation of the SEC proxy rules, the Commission under Chairman Cox adopted a rule permitting issuers to omit access proposals from their proxy materials, which engendered opposition from some institutional shareholders’ groups.  Ms. Schapiro pointed out that many other leading non-U.S. markets mandate proxy access, and she stated her preference for “the U.S. to enter that club.”  However, she signalled that she would not force through a proposal, only that she was going to immediately begin discussing with other Commissioners a proxy access proposal along Donaldson’s lines.

Ms. Schapiro testified that she will re-evaluate the SEC’s current path towards the adoption of International Financial Reporting Standards (“IFRS”), thereby moving away from U.S. Generally Accepted Accounting Principles.  Chairman Cox made the globalization of capital markets a theme of his tenure, and he pushed the SEC to adopt a “roadmap” to the adoption of IFRS, subject to the completion of certain “milestones.”  Ms. Schapiro stated that she would not be bound by this roadmap, and indeed she expressed concerns that make clear that the SEC will move slowly on the issue.  In particular, she questioned the independence of the International Accounting Standards Board, which governs IFRS, and pointed out that the Sarbanes-Oxley Act requires U.S. public companies to operate under standards promulgated by an independent authority.  She also noted that conversion to IFRS would be extremely expensive and thus more burdensome during a recession, and her comments indicated concerns that IFRS, which are principles-based (rather than rules-based, as is U.S. GAAP), were not detailed enough to be effective.  Each of these concerns mirrors public criticisms of IFRS by opponents of their U.S. adoption.

She similarly indicated that the SEC will reconsider whether to grant “mutual recognition” to other countries’ securities exchanges and broker-dealers.  One of Chairman Cox’s initiatives on globalization, mutual recognition would recognize that certain countries have market regulatory schemes equal in effectiveness to that of the U.S.  Exchanges in these countries would be allowed direct access to U.S. customers, and their broker-dealers would be permitted to operate in the U.S. and transact with U.S. customers, in each case without registration with or regulation by the SEC.  Advocates of mutual recognition argue that it would eliminate unnecessary obstacles to international investing, whereas critics argue that mutual recognition would eliminate the superior investor protections under the U.S. regulatory regime.  Ms. Schapiro sided with the critics and questioned whether mutual recognition was “headed in the right direction.”

Finally, Ms. Schapiro testified that she will rebuild the SEC’s Office of Risk Assessment (“ORA”) and that she wants risk assessment to “permeate everything the SEC does.”  In particular, she pointed out that, given the limited number of SEC examiners, risk assessment would enable them to focus on the issues of greatest importance.  Chairman Donaldson created ORA in response to the market timing and late trading scandals in the mutual fund industry in 2003-2004, but Chairman Cox gave it less emphasis and fewer resources.  It is worth remembering that Chairman Donaldson created ORA in part to organize and give direction to a profusion of industry-wide, issue-focused but partially redundant “sweep” examinations that were burdening the fund and brokerage industries and wasting SEC staff resources.  Ms. Schapiro seemed to be signalling that ORA will perform a similar disciplining function, but it remains to be seen whether it will also inaugurate another era of large-scale sweep examinations.

Ms. Schapiro’s testimony indicates both that she has a clear idea where she wants to lead the SEC and that she is skilled at building political support for her agenda.   As a result, the securities and investment industries are almost certainly facing an era of tougher SEC enforcement and revitalized examinations, while the internationalization of SEC rules will be made a lower priority.  The SEC will also seek to increase the regulation of hedge funds and credit rating agencies.  While the extent of any regulatory reform is still unknown, these initiatives reflect the views of the large majority in Congress that these regulatory regimes need fixing and leave aside broader questions as to the need for a qualitative change of the SEC’s mission. 

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

Congress failed to block release of the second $350 billion tranche of the $700 billion Troubled Asset Relief Program (“TARP”), which was created by the Emergency Economic Stabilization Act of 2008 (EESA; P.L. 110-343; H.R. 1424).  The use of these funds was subject to Congressional disapproval by joint resolution enacted within 15 calendar days after the Treasury Department certified its intention to use the funds.  On January 12, the Bush Administration, at the request of then President-elect Obama, formally sought release of the second $350 billion tranche.  The Senate effectively approved the funds when it defeated S.J. Res. 5, a Republican resolution to disapprove the funds, by a vote of 52-42 on January 15.   Notably, on January 22, the House approved the companion resolution, H.J. Res. 3, which would have rejected the release of the TARP funds, by a vote of 270-155.

The House vote was largely symbolic, but it does reflect Congress’ strong dissatisfaction with TARP implementation to date.  On January 21, the House passed H.R. 384, the TARP Reform and Accountability Act of 2009, by a vote of 266-160.  Introduced by House Financial Services Chairman Barney Frank (D-MA), H.R. 384, as amended, would place numerous conditions on the TARP program and its beneficiaries, such as:

• Setting conditions on TARP recipients, including executive compensation restrictions, providing the Treasury Secretary with the authority to apply new executive compensation restrictions retroactively to TARP beneficiaries;
• Requiring reporting, data collection, and analysis of use of TARP funds;
• Authorizing Treasury to place observers in board meetings of “assisted organizations” (a newly defined term);
• Increasing the size of the Financial Stability Oversight Board and providing the Board with the authority to overturn any policy determination made by the Treasury Secretary by a 2/3 vote; and
• Requiring the Treasury Secretary to commit at least $100 billion, but not less than $40 billion, to foreclosure mitigation.

It is not clear whether the Senate will act on the legislation.  However, a recent letter from National Economic Council Director Lawrence Summers to House Speaker Nancy Pelosi (D-CA) and Senate Majority Leader Harry Reid (D-NV) indicates that the Obama Administration has agreed in principle to many of the provisions contained in the legislation.  Key elements of the plan include:

• Placing conditions on TARP recipients, including limits on executive compensation, dividend payments, stock repurchases, and acquisitions of healthy financial companies;
• Requiring reporting on and analysis of TARP funds use;
• Extending credit to consumers, homeowners, small businesses, and local governments; and
• Developing a foreclosure mitigation program, including a possible change to bankruptcy laws.

A number of new TARP programs have been developed to address the continuing credit market crisis.   After Congressional negotiations stalled in December, President Bush announced an auto bailout package, consisting of a $17.4 billion short-term bridge loan to General Motors and Chrysler.  The loan is contingent on the auto companies showing that they are financially viable by March 31, 2009 and also contains conditions allowing the government to block transactions over $100 million, restricting dividends, and limiting executive compensation.  Subsequently, Treasury announced a $6 billion package to GMAC and a $1.5 billion loan to Chrysler Financial under the newly created Automotive Industry Financing Program. 

On January 2, the Treasury Department released guidelines for the Targeted Investment Program (“TIP”).  TIP was used by the Federal Reserve and Treasury in the Citigroup package announced in November.  On January 16, Treasury, the Federal Reserve, and the FDIC announced assistance to Bank of America.  In addition to a $118 billion loan guarantee, the deal includes a $20 billion preferred stock purchase through TIP, and requires that Bank of America comply with enhanced executive compensation restrictions and implement a mortgage loan modification program.

On January 14, the Treasury Department issued Capital Purchase Program (“CPP”) application guidelines for subchapter S corporation banks; applications are due on February 13, 2009.   Unlike other CPP programs that provide government support through preferred stock purchases, CPP support for S Corporations will come through the issuance of subordinated debt at a rate of 7.75 percent for the first five years and 13.8 percent thereafter. 

Finally, discussions continue on broader financial service industry reforms.   On January 15, the Group of Thirty (“G30”) issued a report entitled Financial Reform: A Framework for Financial Stability.  The G30 Working Group on Financial Reform that issued the report is chaired by former Federal Reserve Chairman Paul Volcker, one of President Obama’s economic advisors and Chairman of the President’s Economic Recovery Advisory Board.  Mr. Volcker has stated that he will make the recommendations to President Obama and that the report is “a reasonable indication of the direction in which we might go.” 

The G30 report recommends a massive, globally coordinated restructuring of the legislative and regulatory system that governs the financial services industry.  Building on the momentum created by other recent proposals, such as the Treasury Department Blueprint for a Modernized Financial Regulatory Structure, the Group of 20 Financial Markets and the World Economy Summit Declaration, and the Government Accountability Office Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System, the G30 report’s core recommendations include:

• Requiring that all systemically significant financial institutions be subject to prudential oversight;
• Improving the effectiveness of prudential regulation by increasing international coordination and enhancing resources available to regulators and central banks;
• Strengthening institutional policies and standards, with a particular focus on governance, risk management, capital, liquidity, credit and counterparty exposure, and leverage; and
• Increasing transparency and realigning risks associated with financial markets and products.

A detailed analysis of the G30 report is provided in our recent alert, Group of Thirty Issues Roadmap for Financial Reforms.

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

Treasury has committed the first $350 billion tranche of the $700 billion provided by Congress for the Troubled Asset Relief Program (TARP), which was created by the Emergency Economic Stabilization Act of 2008 (EESA).  The remaining $350 billion is subject to Congressional disapproval by joint resolution enacted within 15 calendar days after Treasury certifies its intention to use those funds.  Outgoing Treasury Secretary Paulson has seemingly been reluctant to utilize this second tranche of TARP funds because of considerable Legislative Branch resistance to the Capital Purchase Program (CPP), as described below.  However, after auto industry bailout negotiations stalled in the Senate, it now appears that the White House and Treasury may be assessing whether to commit additional TARP funds for a short-term bridge loan in order to prevent a bankruptcy filing by a major domestic automaker before President-elect Obama is inaugurated.  There is speculation that Congress may choose not to exercise its disapproval authority as part of a deal to help the auto industry. 

Most of the first tranche of TARP funds was used to purchase preferred stock in banking institutions, including as part of the massive Citigroup bailout.  As the program has matured, Treasury and the Federal Reserve have become increasingly inventive in addressing the continuing credit market crisis.  For example, on November 25, Treasury allocated $20 billion in TARP funds to back a $200 billion Term Asset-Backed Securities Loan Facility (TALF) established by the Federal Reserve to increase liquidity in the consumer credit market.  The underlying credit exposures of eligible TALF securities initially must be newly or recently originated auto loans, student loans, credit card loans or small business loans guaranteed by the U.S. Small Business Administration.  The facility may be expanded over time and eligible asset classes may be expanded later to include other assets, such as commercial mortgage-backed securities, non-agency residential mortgage-backed securities or other asset classes. 

At a hearing on December 10, House Financial Services Committee Chairman Barney Frank (D-MA) stated that Treasury should not request use of the second tranche of TARP funds without addressing foreclosure mitigation and oversight issues.   Chairman Frank’s statement reflects mounting Legislative Branch criticisms of Treasury’s implementation of TARP.  The Government Accountability Office released a report on December 2 concluding that Treasury has yet to address critical oversight and compliance issues.  The Congressional Oversight Panel (COP), a TARP oversight panel created by EESA, also released its first report on December 10, questioning Treasury’s strategy and oversight.  COP members include Chair Elizabeth Warren (Professor, Harvard Law School), Congressman Jeb Hensarling (R-TX), Richard Neiman (Superintendent of Banks, New York Banking Department), and Damon Silvers (Associate Counsel, AFL-CIO).  Congress has held a series of hearings on these matters, as well as Treasury’s decision to abandon efforts to purchase or guarantee troubled assets and instead focus on equity injections into banking institutions (see the previous issue of the Global Financial Markets Newsletter).

Congress is considering measures to strengthen oversight of TARP.  On December 10, the Senate passed S. 3731, the Special Inspector General for the Troubled Asset Relief Program Act of 2008, by unanimous consent.  The bill clarifies that the Special Inspector General (SIG) has the authority to investigate all actions taken under EESA (including the CPP); provides the SIG with temporary fast-track hiring authority and funds to set up his office; and requires Treasury to take actions to address deficiencies identified by the SIG.  The Senate confirmed Neil Barofsky as the SIG on December 8.

Also on December 10, the House adopted an amendment to the auto industry bailout bill, H.R. 7321, to address the criticism that TARP participants are not using funds to provide loans and increase credit market liquidity.   Adopted 403-0, the amendment would require TARP participants to report their lending activities quarterly.  Both the H.R. 7321 amendment and S. 3731, however, have yet to be considered by the other chamber.  With the end of the session fast approaching, it is not clear whether there will be further action on either measure before Congress adjourns for the year.  Similar legislation may be reintroduced next year.  Other possible provisions could include directing Treasury to require participating institutions to use bailout funds to restart lending; or limitations on the use of funds for acquisitions, dividends, or executive compensation.

Chairman Frank has also indicated interest in pursuing legislation that strengthens foreclosure mitigation efforts.  Such legislation could take several forms.  First, Congress could mandate that Treasury purchase or guarantee troubled assets as it initially contemplated in creating TARP.  Second, Congress could direct Treasury to allocate a portion of the bailout funds to a loan modification and guarantee program, such as the $24 billion program recently proposed by the FDIC to guarantee 2.2 million modified loans.  The FDIC plan would reduce mortgage payments to 31% of income, based on reductions in the applicable interest rate, extension of the loan term, and forbearance of principal.  In exchange, servicers would get $1,000 for each modification and the government would share up to 50% of the re-default loss.  Third, Congress could expand the Hope for Homeowners program (P.L. 110-289), under which the original lender takes a write-down on the loan and the borrower then refinances to a government-backed loan.  Fourth, Congress could provide mortgage-backed security servicers with the legal authority to modify loans and indemnification from investor lawsuits.

Finally, as anticipated in previous newsletters, discussions continue on broader financial service industry reforms.  Notably, COP Chair Elizabeth Warren recently called for the creation of a Financial Product Safety Commission, akin to the Consumer Product Safety Commission, that would regulate financial services products.  On November 14, the G-20 ministers agreed to begin work on a coordinated response to the financial crisis.  At present, the ministers are developing specific recommendations for the next summit, which is scheduled for April 2009.  The bipartisan professionals in the K&L Gates Public Policy and Law Group are monitoring all such proposals for the benefit of firm clients.

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

The U.S. Department of Treasury (“Treasury”) is conferring with the Obama transition team, led by former Clinton Chief of Staff John Podesta, on policy decisions in order to ensure continuity between administrations. The transition team has also turned its attention to selecting the next Treasury Secretary. The new Secretary is likely to have been involved in the development of programs under the Emergency Economic Stabilization Act of 2008 (EESA, H.R. 1424, P.L. 110-343, click GPO’s PDF Display for EESA text). Possible choices include New York Federal Reserve President Timothy Geithner, Federal Deposit Insurance Commission Chairwoman Sheila Bair, former Federal Reserve Chairman Paul Volcker, and former Treasury Secretaries Larry Summers and Robert Rubin.

President Bush hosted the G-20 summit on November 15 in Washington, D.C. to discuss a globally coordinated response to the financial crisis. European Union leaders have urged the President to join them in devising international regulatory measures to govern the banking industry. In his remarks on November 12, U.S. Treasury Secretary Henry M. Paulson, Jr. underscored the importance of reaching a consensus on a broad-based reform agenda during the meeting. Although President-elect Obama was not expected to formally participate, some delegates were planning to engage with him while in Washington, D.C.

Congress is scheduled to reconvene for one week, beginning November 17. House Speaker Nancy Pelosi (D-CA) and Senate Majority Leader Harry Reid (D-NV) would like to pass a stimulus package, but the Majority Leader has said there may not be enough support. President-elect Obama has stated that if a bill does not pass in the lame-duck session, he will make it his first order of business upon being sworn in. The stimulus bill may be a vehicle for legislative directives relative to the Troubled Asset Relief Program (“TARP”) , especially in the area of preventing mortgage foreclosures. The FDIC has proposed using $50 billion of TARP funds for a loan modification and guarantee program. Senate Banking Committee Chairman Christopher Dodd (D-CT) and House Financial Services Committee Chairman Barney Frank (D-MA) are supportive of the proposal.

As expected, congressional oversight of EESA implementation has continued apace. On October 24, Senators Charles Schumer (D-NY), Jack Reed (D-RI), and Robert Menendez (D-NJ) wrote a letter recommending Treasury adopt guidelines to ensure that institutions use bailout funds to restart lending activities rather than acquisitions or dividends. On October 29, House Speaker Nancy Pelosi and Senate Majority Leader Harry Reid sent a letter urging Treasury to strengthen the interim final rules on executive compensation for CPP institutions. In addition, the following congressional hearings have recently taken place or are planned to take place:

Private Sector Cooperation with Mortgage Modifications
Wed., Nov. 12, 10:00 a.m., 2128 Rayburn Bldg.
House Financial Services Committee

Regulation of Hedge Funds
Thurs., Nov. 13, 10:00 a.m., 2154 Rayburn Bldg.
House Oversight and Government Reform Committee

Oversight of Emergency Economic Stabilization Act
Thurs., Nov. 13, 10:00 a.m., 538 Dirksen Bldg.
Senate Banking Committee

Is Treasury Using Bailout Funds for Foreclosure Prevention, as Congress Intended?
Fri., Nov. 14, 10:00 a.m., 2154 Rayburn Bldg.
House Oversight and Government Reform Committee’s Subcommittee on Domestic Policy

Troubled Asset Purchase Program Oversight
Tues., Nov. 18, 10:00 a.m., 2128 Rayburn Bldg.
House Financial Services Committee

Collapse of Fannie Mae and Freddie Mac
Tues, Dec. 9, 10:00 a.m., 2154 Rayburn Bldg. 
House Oversight and Government Reform Committee

Congress is preparing to consider comprehensive financial services reform legislation early next year. Senator Schumer, a member of both the Senate Finance and Banking Committees, has outlined six principles that he believes should guide the deliberations:

1. A key focus should be on controlling systemic risk and ensuring stability.
2. The regulatory structure should be unified under a single regulatory authority, or at a minimum, simplified.
3. Complex financial instruments should be subject to regulation under clear regulatory authority.
4. Global financial markets require globally coordinated solutions.
5. Increased transparency should be a central goal.
6. The laissez-faire view of regulation must come to an end.

For more details on the impact of the recent election on current and future policy initiatives relating to the financial services industry, please see the recent K&L Gates Public Policy and Law Alert, “Financial Services Reform: What Comes Next?”

The K&L Gates Public Policy & Law group consists of senior, bipartisan policy professionals who are closely monitoring these developments in order to provide insights to and effective advocacy on behalf of firm clients.

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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 Daniel F. C. Crowley

The TARP Capital Purchase Program (CPP)
On October 3, 2008, the U.S. House of Representatives passed and President Bush signed into law the Emergency Economic Stabilization Act of 2008 (EESA, H.R. 1424, P.L. 110-343, click  GPO's PDF Display for the text of EESA).  Among other things, EESA authorized the Secretary of the Treasury to establish a Troubled Asset Relief Program (TARP) to purchase troubled assets from financial institutions.

On October 14, 2008, Treasury announced the creation of the TARP Capital Purchase Program (CPP), and issued an interim final rule on CPP executive compensation and corporate governance standards.  Treasury also issued executive compensation notices with respect to two additional EESA programs that are currently being developed by Treasury, the Troubled Asset Auction Program (TAAP) and Programs for Systemically Significant Failing Institutions (PSSFI). 

Through CPP, Treasury will provide $250 billion in equity capital under standardized terms directly to certain U.S. financial institutions in the form of preferred stock.  The minimum subscription amount available to a participating institution is 1 percent of risk-weighted assets.  The maximum subscription amount is the lesser of $25 billion or 3 percent of risk-weighted assets.  Although the original Treasury proposal did not contemplate this use of the TARP, the addition of the phrase “any other financial instrument” by Congress provided Treasury with the flexibility to inject equity capital directly into banks.  Members of Congress largely indicated their support for the CPP, as did the American Bankers Association.

On October 20, Treasury issued application guidelines for the CPP which indicate that all applications must be submitted to the appropriate Federal banking agency (FBA) no later than 5 pm (EST), November 14, 2008.

• Application Guidelines for Capital Purchase Program
• FAQs for Capital Purchase Program

To be eligible for the CPP, the applicant must ultimately receive Treasury approval.   According to Secretary Paulson, Treasury “will give considerable weight to” the primary regulator’s recommendation.  More detailed information, including submission instructions, can be found at the applicable FBA website: www.fdic.gov, www.federalreserve.gov, www.occ.treas.gov, or www.ots.treas.gov as the case may be.

In addition, the applicant must agree to certain terms and conditions and make certain representations and warranties described in various agreements available on Treasury’s website:  www.treas.gov.  A detailed investment agreement and associated documentation will be posted soon.  Among the conditions to participation in the CPP is the requirement that, for so long as the Treasury owns shares or warrants in the applicant, certain senior officers of the applicant meet executive compensation standards, which are explained on the Treasury website  here.  With respect to the CCP, the following standards apply: (a) limits on compensation that exclude incentives for senior executive officers (SEOs) of financial institutions to take unnecessary and excessive risks that threaten the value of the financial institution; (b) required recovery of any bonus or incentive compensation paid to an SEO based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (c) prohibition on the financial institution from making any golden parachute payment to any SEO; and (d) agreement not to deduct for tax purposes executive compensation in excess of $500,000 for an SEO.  Treasury did not give much guidance as to what constitutes an appropriate limit on incentives to take excessive risks.

These conditions make a CPP investment less attractive to a financial institution, which would find itself with diluted equity and bound by stricter rules on compensation than its competitors.   In addition, it was feared that capitalization by the Treasury could carry the potential stigma that the firm cannot attract financing on its own, leading to a potential run on the bank.  For these reasons, among others, the Treasury essentially compelled nine of the largest U.S. banks to accept investments under the CPP program.  It is not clear yet how much this move will address other banks’ concerns or how many smaller banks will participate.  Also unclear is whether the banks receiving CPP investments will use the funds merely to shore up their capital bases or, as is clearly Treasury’s intention, to serve as the capital base for additional lending.  To encourage other banks to apply, the guidelines provide that confidentiality may be requested with respect to certain information, and Secretary Paulson has indicated that Treasury will not announce any applications that are withdrawn or denied.

Upcoming Congressional Hearings
As indicated in the last issue, we anticipate that Congress will consider far-reaching reforms of the financial services industry.  As Treasury implements EESA, numerous Congressional committees continue to conduct oversight hearings in order to lay the foundation for what will likely be the most significant revisions to the nation’s financial services laws since the Great Depression.  Among the hearings that have already occurred or are currently scheduled are:

Future of Financial Services Industry Oversight and Regulation
House Financial Services Committee
Date: Tuesday, Oct. 21, 10 a.m.
Location: 2128 Rayburn Bldg.
http://www.house.gov/apps/list/hearing/financialsvcs_dem/hr102108.shtml

The Impact of the Financial Crisis on Workers’ Retirement Security
House Education and Labor Committee
Date: Wednesday, Oct. 22, 9:30 a.m.
Location: 1 Dr. Carlton B Goodlett Place, Room 250, San Francisco, Calif.
Witnesses: Shlomo Benartzi - professor, Anderson School of Management, University of California at Los Angeles
Mark Davis - partner, Kravitz Davis Sansone, Encino, Calif.
Jacob S. Hacker - professor, University of California at Berkeley
http://edlabor.house.gov/committee/schedule.shtml

Turmoil in the Financial Markets
House Oversight and Government Reform Committee

• Topic: Credit Rating Agencies and the Financial Crisis
  Date: Wednesday, Oct. 22, 10 a.m.
  Location: 2154 Rayburn Bldg.
  Witnesses: Deven Sharma - president, Standard and Poor's
  Raymond W. McDaniel - chairman and CEO, Moody's Corp
  Stephen Joynt - president and CEO, Fitch Ratings
  
   
• Topic: The Role of Federal Regulators
  Date: Thursday, Oct. 23, 10 a.m.
  Location: 2154 Rayburn Bldg.
  Witnesses: Alan Greenspan - former chairman, Board of Governors, Federal Reserve System
  John Snow - former secretary of the Treasury
  Christopher Cox - chairman, Securities and Exchange Commission
  
   
• Topic: The Regulation of Hedge Funds
  Date: Thursday, Nov. 13, 10 a.m.
  Location: 2154 Rayburn Bldg
  Note: Date changed to Nov. 13 from Oct. 16.
  Witnesses: John Alfred Paulson - president, Paulson and Co. Inc., George Soros - chairman, Soros Fund Management LLC, Philip A. Falcone - senior managing director, Harbinger Capital Partners, James Simons - director, Renaissance Technologies LLC, Kenneth C. Griffin - CEO and managing director, Citadel Investment Group
  http://oversight.house.gov/

Turmoil in the U.S. Credit Markets: Examining Recent Regulatory Responses 
Senate Banking, Housing and Urban Affairs Committee
Date: Thursday, Oct. 23, 10 a.m.
Location: 538 Dirksen Bldg.
More information

The Public Policy & Law group is closely monitoring these developments in order to provide insights to and effective advocacy on behalf of firm clients.

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By Laurence E. Platt

A critical question to be answered concerning the Emergency Economic Stabilization Act of 2008 (“EESA”) is who will bear the cost of loan modifications. There are great pressures on the federal, state and local governments to keep defaulting borrowers in their homes. However, loan servicers and holders, who did not originate the loans but have a financial interest in them, could suffer significant costs if the government forces certain loan modifications. Both loan holders and loan servicers generally support the government's strategic objective of home retention. However, EESA leaves open the issue of when should a borrower be eligible for a loan modification that exceeds the cost of foreclosure? Click here to read a recent alert that describes the requirements for loan modifications under EESA and compares and contrasts these requirements with the pronouncement of the FDIC and the actions of state attorneys general. To read the full alert, please click here.

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By:  Daniel F. C. Crowley, Patrick G. Heck

Recent Policy Responses
The recent public policy responses to the credit crisis have been geared toward restoring liquidity in the credit markets, enhancing transparency, and prohibiting certain trading practices.   Foremost among these measures has been H.R. 1424, the Emergency Economic Stabilization Act of 2008   (“EESA” or “the Act”), in response to the Department of the Treasury’s (“Treasury”) request for authority to spend up to $700 billion to purchase illiquid assets.  The Act is intended to improve the capital positions of financial institutions and allow them to once again extend credit.  Other stop-gap measures by the regulatory agencies, as discussed elsewhere in this newsletter, have been geared toward reducing volatility and restoring orderly markets.

EESA, which was passed by the House and signed by President Bush on Friday, October 3, 2008, authorizes up to $700 billion for the Treasury for a troubled asset relief program (TARP) to purchase, and a Troubled Assets Insurance Financing Fund to insure, illiquid financial instruments. The Act allows Treasury to immediately use $250 billion, with an additional $100 billion if the president certifies such a need. The president would have to provide a written request for the remaining $350 billion, which could be subject to expedited congressional approval.

The Act

• Creates the Financial Stability Oversight Board, comprised of the Fed Chairman, the Secretaries of Treasury and HUD, the FHFA Director, and the SEC Chairman.
• Creates various reporting and oversight requirements.
• Waives FAR and provides for streamlined contracting procedures.
• Establishes a Congressional Oversight Panel in the legislative branch to “review the current state of the financial markets and the regulatory system.”
• Places limits on senior executive compensation for some participating financial institutions.
• Requires Treasury to develop programs to reduce foreclosures and encourage lenders to modify mortgage terms.
• Prohibits use of the Exchange Stabilization Fund for future money market guarantee programs.
• Authorizes the SEC to suspend mark-to-market accounting (FAS 157).
• Increases the federal budget debt ceiling to $11.315 trillion.
• Temporarily increases the FDIC insurance limit from $100,000 to $250,000.

The text of the Act and a section-by-section analysis may be found on the House Financial Services Committee website: http://financialservices.house.gov/.  

EESA Tax Provisions
EESA also contains a number of important tax provisions that have not received a great deal of attention. There are three tax provisions related to the rescue plan:

1. Extension of exclusion of income from discharge of qualified principal residence indebtedness.  Generally, when homeowners have parts of their mortgages forgiven, they immediately owe income taxes on the amount of indebtedness forgiven.   To prevent homeowners from facing higher tax bills, the housing relief bill passed by Congress earlier this year allowed homeowners caught up in the mortgage crisis to avoid paying tax on forgiven mortgage debts through 2009.  EESA will extend through 2012 the housing bill provision that forgives income from the cancellation of indebtedness.  The proposal does not extend the relief to home equity loans.  The Joint Committee on Taxation estimates that this provision will cost $362 million over ten years. 
   
    
2. Gain or loss from sale or exchange of certain preferred stock.  Federal law limits the allowable investments for banks, and many community banks therefore invested in Fannie Mae and Freddie Mac preferred stock – which became worthless when the government bailed out those companies.  EESA includes a proposal to allow financial institutions or financial institution holding companies to treat their Fannie and Freddie losses as ordinary losses. Applying to any preferred stock that was owned on September 6, 2008 or sold between January 1 and September 6, 2008, this provision will allow banks to claim the book benefit of the loss on their tax returns, therefore reducing the need to obtain additional capital from the FDIC or investors.  Policy makers believe that this proposal should also prevent some community banks from becoming insolvent.  The Joint Committee on Taxation estimates that this provision will cost $3.045 billion over ten years, with $2.7 billion of the cost occurring in 2009. 
   
    
3. Special rules for tax treatment of executive compensation of employers participating in the troubled assets relief program.  The EESA contains non-tax measures aimed at limiting executive compensation and “golden parachute” severance packages overall for companies and executives participating in the buyout.  Additionally, EESA modifies the tax treatment of executive compensation and severance packages.  The deductibility of executive compensation for companies participating in the troubled asset relief program will be cut in half – from the $1 million level in current law – to $500,000.  Performance-based compensation is included in the $500,000 limitation.  Companies will also lose deductions currently available for excessively large severance packages.  Executives receiving severance packages will continue to face a 20 percent excise tax on payments once they reach an excessive threshold, and that tax will now be due if the executive leaves for reasons other than a standard retirement for which they are eligible – not just if the company changes hands, as in current law.  The Joint Committee on Taxation estimates that the amount of revenue gain from these provisions is indeterminate as it will depend on how the underlying troubled asset program is implemented.     

In addition, the Act extends dozens of expired or expiring tax provisions (the so-called “tax extender package”), including the Alternative Minimum Tax and disaster relief, energy tax incentives and a host of other provisions.  Several of these provisions might be of interest to the financial services community.  For example, the package includes: 1) broker reporting of a customer’s basis in securities transactions; 2) an extension of tax-free distributions from IRAs to certain public charities through 2009; 3) an extension of the exception under Subpart F for active financing income through 2009; 4) an extension of the look-through treatment of payments between related CFCs under foreign personal holding company income rules; and 5) the modification of the tax treatment of offshore nonqualified deferred compensation for certain tax indifferent parties.  The package does not include a further delay in the implementation of the worldwide interest allocation rules.

Finally, in addition to the various tax provisions listed above, the package contains a provision that would lower the tax preparer standard for undisclosed positions from “more likely than not” to “substantial authority” (the same standard that currently applies to taxpayers) with the exception for tax shelters (reportable transactions to which section 6662A applies). 

The Long View
In the slightly longer term, these unprecedented market events will likely lead to the most significant revisions to the legal and regulatory framework for financial services since the Great Depression. 

• Revamping the structure of financial services regulation.   Beginning in January 2009, the 111^th Congress will consider comprehensive legislation to restructure the regulation of financial services.  A primary consideration will be the respective roles of the Treasury, the Federal Reserve Board, the SEC and the CFTC with respect to oversight of the capital markets.  Some of the proposals under consideration were outlined in the Treasury’s March 2008 “Blueprint for a Modernized Financial Regulatory Structure.”
  
   
• Regulation of previously unregulated products and entities. Current discussions also include new reporting and other regulatory requirements for a broad array of financial products and market participants that have, until now, been subject to relatively little regulation, including commodities, derivatives, hedge funds and sovereign wealth funds.  Some products that currently trade over-the-counter may soon be required to trade on exchanges and, more generally, all market participants with the potential to impact the economy will almost certainly be under increased scrutiny.
  
   
• Among the other issues that will likely be considered as part of this comprehensive reform effort are:
  • Credit rating agency reforms,
  • Enhanced government agency enforcement authorities, and
  • Recommendations of the Congressional Oversight Panel created by EESA. 
    
     
• Tax. With respect to federal tax issues relating to investments, determination of the appropriate tax rates on capital gains and dividends and the appropriate tax treatment of derivatives, as well as retirement savings incentives, will receive considerable attention.
  
   
• Retirement Plans. Finally, there will almost certainly be a renewal of efforts to increase disclosure with respect to defined contribution plan fees. 

Our Public Policy & Law group is closely monitoring these developments in order to provide insights to and effective advocacy on behalf of firm clients.

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By: Arthur C. Delibert 

Recent turmoil in the securities markets, affecting financial companies in particular, has imposed unprecedented stress on money market funds, as some institutional investors have sought to liquefy their holdings at the very moment that many money funds have found it difficult to raise cash.  These pressures have resulted in some extraordinary market and regulatory events.  Illustrative of the pressures facing the industry and regulators:

• On September 16, The Primary Fund, a money market series of The Reserve Fund, announced that it had “broken the dollar” – i.e., that the mark-to-market value of its portfolio assets had fallen below $0.995 per share. (LINK)  In fact, the fund said, its per-share net asset value had fallen to 97 cents, primarily from holding paper issued by Lehman Brothers, which had filed for bankruptcy on September 15.  This is only the second time a registered money fund has broken the dollar, the last such event having occurred in 1994. (Reserve has subsequently reported that the assets available may be higher than 97 cents per share.)
  
  Subsequently, Ameriprise Financial Services filed suit against The Reserve Fund and its manager, alleging that certain large investors had been tipped off about the Fund’s impending problem, allowing those investors to remove their money before the NAV was reduced.
  
   
• On September 18, Putnam Investments announced that it was suspending sales of its institutional Putnam Prime Money Market Fund and would liquidate the fund.  Within days, Putnam and Federated Investors, Inc. announced that Federated Prime Obligations Fund would acquire the assets of the Putnam money fund and that all shareholders would receive shares of the Federated fund worth $1.00 per share.

In the face of these pressures, many money funds have resorted to extraordinary measures:

• Many funds have drawn on lines of credit previously arranged through their custodian banks and others.  The Federal Reserve made extra cash available to these banks to fund the loans.
  
   
• Some funds have made use of their authority under Section 22 of the 1940 Act to withhold payment on redemption orders for up to seven days, rather than the same-day or overnight payment offered in fund prospectuses “under normal circumstances.”  Such extensions can be difficult for customers, who expect to have prompt access to assets held in money funds.
  
   
• Other funds have used authority reserved in their prospectuses to pay redemptions through the in-kind distribution of portfolio securities.  These distributions potentially raise two questions under the 1940 Act:

1. Funds may have filed with the SEC irrevocable elections under Section 18 of the 1940 Act, allowing them to make redemptions in kind for shareholders seeking redemptions in excess of $250,000 or 1% of the fund’s net assets, whichever is less, in any 90 day period, but committing them to pay lesser redemptions in cash.  Such filings have become less common since 1996, meaning that some funds have greater flexibility in this area.
2. Redemptions paid in kind to shareholders that are affiliates of the fund because they hold 5% or more of the fund’s outstanding securities may raise questions under Section 17 of the 1940 Act, which restricts principal transactions with affiliates.  Funds can rely on a 1999 no-action letter issued by the SEC staff, which permits in-kind payments to affiliates provided the fund’s board either approves the transaction or has adopted certain procedures to assure the fairness of such distributions. 

There have also been extraordinary actions from the regulators:

• Some money funds have sought permission from the SEC under Section 22(e) of the 1940 Act to suspend redemptions.   On September 22, the SEC issued an order (effective as of September 17) authorizing two Reserve Funds to suspend redemptions for an indefinite period, while they engage in an orderly liquidation. (LINK)
  
   
• On September 19, the Federal Reserve temporarily exempted member banks from provisions of the Federal Reserve Act to permit the banks to purchase asset-backed commercial paper from affiliated money market funds. (LINK)
  
  On September 25, the SEC staff issued a no-action letter permitting such purchases. Such purchases by fund affiliates would normally raise issues under Section 17 of the 1940 Act.  Rule 17a-9 permits fund affiliates to purchase securities from money market funds if they are no longer “eligible securities” under Rule 2a-7 – i.e., if they have deteriorated in quality. The no-action letter permits such purchases even if the security is still eligible. 
  
   
• On September 19, the Treasury announced a program of money market fund insurance.   Funds wishing to apply for the insurance must do so by Wednesday, October 8.  (LINK)

According to the announcement, Treasury is establishing this program under existing authority, using the $50 billion Exchange Stabilization Fund.  Treasury’s authority may be limited somewhat by the Economic Stabilization Act which, as of this writing, is still under consideration by Congress.  The insurance initially will be available for a period of three months, at which point Treasury may renew it for a total period of up to a year, but participating funds would be required to pay an additional fee.

The insurance applies only to assets in a fund on September 19, the day the program was announced.  This limit was apparently adopted at the urging of the banking industry, which was concerned that if money fund insurance were available for unlimited amounts of new assets flowing into the funds, large deposits would flee the banks. The program is available only to funds registered under both the 1933 Act and the 1940 Act.

Funds wishing to apply to the program must obtain approval of their boards of directors, as the application requires that the board, including a majority of independent directors, determine that “entering into” the Guarantee Agreement, as well as “fulfillment of its obligations …  are in the best interests of the Fund and its shareholders.”  Fund boards must take into consideration a number of factors before entering into such an Agreement.

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By: Edward G. Eisert, Rebecca H. Laird

On September 22, 2008, the Board of Governors of the Federal Reserve issued a new policy statement on equity investments in banks and bank holding companies (the “Policy Statement”).  The Policy Statement was widely seen as a response to complaints by private equity firms seeking to make recapitalizing equity investments in troubled banks that the existing guidelines posed too great a risk of subjecting them to regulation as bank holding companies.  In certain respects, the Policy Statement liberalizes and clarifies the guidelines that the Federal Reserve has applied since 1982 in determining whether a company controls a bank, bank holding company, or whether a bank or bank holding company controls another company such as a non-banking firm. At the same time, the Policy Statement reemphasizes the Federal Reserve’s belief that whether an investor has a controlling influence over a banking organization or a non-banking firm depends on all of the facts and circumstances of each case.

The primary indicia of control addressed in the Policy Statement are:  (1) director representation (one and, in some cases, two directors, would be permissible); (2) total equity (in some cases up to one-third of total equity would be permissible); (3) the extent and subject matter of consultation with management (for example, advocacy regarding strategic decisions is permitted, but not “if accompanied by explicit or implicit threats to dispose of shares in the banking organization or to sponsor a proxy solicitation as a condition of action or non-action by the banking organization or management”); (4) business relationships (relationships are permitted that are “quantitatively limited and qualitatively nonmaterial, particularly in situations where an investor’s voting securities percentage in the banking organization [is] closer to 10 percent than 25 percent”); and (5) and the existence of covenants granting the investor approval or veto rights with respect to strategic decisions and management (“covenants that substantially limit the discretion of a banking organization’s management over policies and decisions suggest the exercise of a controlling influence”).

Despite its helpful guidance, the Policy Statement does not eliminate the concerns of private equity firms and other investors that wish to take larger equity stakes in, and have greater influence over, banking organizations than permitted under the prior guidance.  For example, without more, there is a significant risk that a minority investor could be deemed to control a banking organization if it holds the largest percentage of equity, particularly if its combined ownership of voting and non-voting stock exceeds twenty-five percent.  Private equity firms also must consider whether the greater latitude provided by the Policy Statement does, in fact, provide sufficient comfort (absent consultation with the Federal Reserve) for them to increase their targeted equity stake and board representation in a banking organization, particularly if their investment programs contemplate having significant influence over corporate strategies and material business decisions.

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By: Charles R. Mills, Lawrence B. Patent

Responding to Congressional pressure to improve the transparency of futures market activity of swap dealers and index traders, the CFTC will be issuing rule proposals that could, among other things, increase swap dealers’ futures trading reporting obligations and impose new terms for them to qualify for exemptions from regulatory limits on the number of futures positions they may hold.  The proposals are intended to effectuate recommendations contained in a CFTC staff report released September 11, 2008, including the following:

• CFTC to separately report swap dealer futures position.   The CFTC issues a weekly Commitments of Traders Report, which provides a breakdown of each Tuesday’s open interest for futures markets in which 20 or more traders hold futures positions required to be reported by CFTC rules.  This information is currently sorted into categories of “commercial” and “non-commercial” traders, with swap dealers’ futures transactions included in the “commercial” category.  The anticipated rule proposal would for the first time report swap dealers under a separate “swap dealer” classification.
  
   
• Swap dealers may be required to report client information.   One of the provocative, albeit still opaque aspects, of the rulemaking will be to propose the creation of a supplemental CFTC market report that will disclose information regarding the particular types of trading by the swap dealers’ counterparties.
  
  
  • The staff describes the contemplated report as one designed to “look through from swap dealers to their clients and identify the types and amounts of trading occurring through these intermediaries, including index trading.”  Details about the scope, content and source of information for the supplemental report must await the CFTC’s proposing release, but the descriptions in the staff report suggest that swap dealers may be required to gather and report discrete information about the relationship between the swap transactions and the counterparties’ futures market positions.
    
     
  • This could put swap dealers in the perhaps undesirable position of requiring clients to disclose to them otherwise sensitive, confidential proprietary trading information that clients would not otherwise disclose.   It also would create a seemingly incongruous regimen that makes entering into swap transactions that otherwise are fully excluded from the reach of the Commodity Exchange Act a triggering event for gathering and reporting on clients’ futures market positions, at least on an aggregate basis.
    
     
• Changes to the hedge exemption for swap dealers.   The CFTC also instructed the staff to develop an advance notice of proposed rulemaking to solicit comments on whether the current exemption from regulatory limits on the number of open futures contracts a trader may hold that is accorded to hedge positions should be eliminated for swap dealers and replaced with something different.  The CFTC will solicit comment regarding whether exemption from position limits for swap dealers should be governed by a new “risk management” exemption that would require a swap dealer to agree to:

1. report to the CFTC and applicable self-regulatory organizations whenever certain “non-commercial” swap clients reach certain position levels in related exchange-traded futures contracts and/or
2. certify that none of a swap dealer’s “non-commercial” swap clients exceed specified position limits in related exchange-traded contracts.

This proposal, too, could be problematic for swap dealers by making them the “cop on the block” to police their clients’ futures positions, even when the swap dealer does not carry those positions for the client and does not otherwise have independent access to the information. 

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The United States Court of Appeals for the Second Circuit held that the National Bank Act (“NBA”) limits the ability of states to regulate tax preparers that facilitate tax refund anticipation loans (“RALs”) for national banks.  The decision in Pacific Capital Bank, N.A. v. Blumenthal is of particular interest to any federally regulated lender (national bank, federal savings association, or operating subsidiary of either) that relies on third party agents (including brokers) to source loans or other bank products.

At issue was a Connecticut statute that capped interest rates on RALs.  National banks were exempt from the law by its terms (and federal law would have preempted it for national banks anyway), but the Connecticut Attorney General concluded in a legal opinion that a tax preparer or other party that facilitated an RAL with an interest rate in excess of the statutory cap violated the statute, even if the lender was a national bank.

The court held that federal law preempted the interest rate limitation for facilitators of RALs made by national banks, at least in connection with RALs made through the arrangement at issue in the case, finding that “the natural effect” of enforcing the interest rate limits against facilitators that assist national banks offering RALs “would . . . be either to prevent a facilitator from assisting such national banks with respect to RALs or to cause it to refuse such assistance unless the national banks agreed to forgo their NBA-permitted rates and limit themselves to the lower rates specified by” the Connecticut law.   The court concluded that “[i]f a state statute subjects non-bank entities to punishment for acting as agents for national banks with respect to a particular NBA-authorized activity and thereby significantly interferes with national banks’ ability to carry on that activity, the state statute does not escape preemption on the theory that, on its face, it regulates only non-bank entities.”

The court’s reasoning could extend past the RAL context to other situations where states try to regulate parties that arrange loans for federally regulated lenders.   For example, this decision calls into question whether recently enacted state laws that prohibit mortgage brokers from arranging loans that do not meet certain underwriting standards could be applied to brokers when they are arranging loans for federally regulated lenders.

HUD/VA/GSE Developments

Moratorium on Risk-Based Premiums for FHA-Insured Loans
In July 2008, HUD shifted its mortgage insurance premium structure to a risk-based structure based on a combination of borrower credit scores and loan-to-value ratios.   In response to the FHA Modernization provisions of the Housing and Economic Recovery Act of 2008, however, HUD is now required to implement a one-year moratorium on its new risk-based premium structure.  HUD recently released Mortgagee Letter 2008-22, which, effective October 1, 2008, rescinds the Department’s risk-based premium guidance and sets forth new requirements for up-front and annual mortgage insurance premiums for FHA-insured loans.  The Mortgagee Letter also provides guidance with regard to the use of borrower credit scores to assess a borrower’s credit risk.  For instance, FHA has determined that borrowers with decision credit scores below 500 and with loan-to-value ratios at or above 90 percent are not eligible for FHA-insured mortgage financing.  Such a provision appears to be HUD’s attempt to salvage some parts of its now-rescinded risk-based premium insurance program. (LINK)  

Borrower Downpayment Requirement Increases for FHA-Insured Loans
Until the recent enactment of the Housing and Economic Recovery Act of 2008, FHA guidelines required borrowers to make a 3% cash investment in the transaction, which could include a downpayment and borrower-paid closing costs.   This requirement will change effective January 1, 2009, and HUD recently released Mortgagee Letter 2008-23 to provide guidance to mortgage lenders regarding these changes.  Notably, for all new FHA case number assignments on or after January 1, 2009, the Mortgagee Letter advises that a borrower must make a 3.5% cash downpayment, and closing costs may not be used to meet the minimum amount.  Moreover, given the 3.5% downpayment requirement, the appropriate loan-to-value ratio for all purchase-money mortgages will be 96.5%.  Thus, to determine the maximum mortgage amount for which FHA borrowers are eligible, lenders will be required to apply the 96.5% figure to the lesser of either (i) the appraiser’s estimate of value; or (ii) the contract sales price for the property (minus any required adjustments, such as seller concessions above 6% of the sales price). (LINK) 

Broker Advisors No Longer Permitted in HECM Transactions
The Housing and Economic Recovery Act of 2008 also enacted provisions affecting Home Equity Conversion Mortgages (“HECM”), which are FHA-insured reverse mortgage loans.   One such provision requires that all parties that participate in the origination of HECM loans must be approved by HUD. 

While this language itself does not appear to be groundbreaking, its effect is sure to change the way many HECM loans are currently originated - namely, with the assistance of non-approved advisors.   In response to the Housing and Economic Recovery Act of 2008’s HECM requirements, HUD recently issued Mortgagee Letter 2008-24, which effectively outlaws the use of non-FHA-approved advisors in connection with HECM transactions.  It does so by rescinding Mortgagee Letter 2008-14, which HUD issued in May 2008.  Beginning with case number assignments made on or after October 1, 2008, only FHA-approved mortgagees may participate and be compensated for the origination of HECM loans.  As a result, the use and compensation of “advisors” in connection with the origination of HECM loans may no longer be permissible. (LINK)

Freddie Mac Underscores Requirements Related to Quality Control Reviews
On September 4, 2008, Freddie Mac released an Industry Letter to its approved sellers and servicers as a reminder of Freddie Mac’s requirements related to post-funding quality control underwriting reviews.   Notably, the Industry Letter highlighted many of the timing requirements imposed on seller/servicers.  For instance, if a loan is selected for a post-funding quality control review, the seller/servicer must submit the requested loan file to Freddie Mac within 15 days of Freddie Mac’s request.  If Freddie Mac discovers any underwriting deficiencies with the loan, the seller/servicer has 30 days from the date of Freddie Mac’s request to take remedial action.  Similarly, if Freddie Mac requires repurchase of a loan following a post-funding quality control review, the seller/servicer must appeal the action or else remit the repurchase funds within 30 days from the date of Freddie Mac’s letter requiring repurchase.  Freddie Mac emphasizes in the Industry Letter that these requirements are not new ones.  Rather, given the unprecedented times in the mortgage market, Freddie Mac expects to increase its quality control efforts. (LINK)  

State Developments

Illinois Imposes Default and Foreclosure Reporting Requirements on Servicers
Many state regulators, such as those in New York and North Carolina, have begun imposing reporting requirements on mortgage servicers so that they can get a handle on the severity of loan delinquencies, defaults, and foreclosures, and perhaps an early warning before those borrowers get into trouble.   With little prior notice, Illinois regulators joined those states, announcing new biannual reporting obligations on loan servicers.  In addition to asking for statistical information about modifications, the reporting form asks servicers to provide narrative descriptions of such things as the servicers’ proactive loss mitigation steps, “including calls and mailings to borrowers" and "participation at community outreach events.”  The first of these reports is due this week.

• Default & Foreclosure Report - Filing Deadline: Oct. 1, 2008 
  
   
• Loan Servicer Questionnaire - Due: Sept. 30, 2008

Massachusetts Applies Community Investment Regulations to Mortgage Lenders and Brokers
Community-type reinvestment provisions are common fare for depository institutions, but that has not been true for non-depository lenders, such as mortgage lenders and brokers.   That has now changed in Massachusetts, where community investment regulations applicable to mortgage lenders and mortgage brokers became effective on September 5, 2008.  The regulations implement a new provision of that state’s licensing law, which was passed as part of the state’s response to the foreclosure crisis. 

The statute and implementing regulations subject Massachusetts mortgage lenders and brokers to standards that are very similar to those set forth in the federal Community Reinvestment Act of 1977 (“CRA”).   Mortgage lenders and mortgage brokers will be assessed on their record of meeting the mortgage credit needs of borrowers in Massachusetts, including low- and moderate-income neighborhoods and individuals.  The assessment will be based upon a lending test and a service test — but not an investment test — that are similar to those applicable to banks.  A licensee’s community investment rating will affect the procedures for it to obtain approvals of any applications, including license renewals, establishment or renewal of any branch, and mergers and acquisitions. 

The consequences of a poor record under the new regulations for a mortgage lender may be far greater than a poor CRA record for a bank.   A poor record could possibly result in non-renewal of a license, which would force a mortgage lender to cease lending operations in Massachusetts. (LINK)

While the federal government continues to struggle with the foreclosure crisis, states are adopting a variety of approaches to slow down foreclosures in their communities.  New Jersey is the latest to join the ranks of more than ten other jurisdictions that have enacted such laws during 2008, but the New Jersey law takes a novel approach by extending the introductory rate of an adjustable rate mortgage for 3 years. 

Effective September 15, 2008, AB 2780, the Save New Jersey Homes Act of 2008  applies to certain borrowers with adjustable rate mortgages who have received a foreclosure notice with respect to their principal residence and whose introductory rate or rate reset terms meet defined criteria. To be eligible for this three-year rate relief and the statutory suspension of foreclosure proceedings, the borrower must, among other things, certify that he or she does not have sufficient income to pay the monthly payments after the rate resets, and agree to repay all deferred interest at the time the mortgage is paid off. The Save New Jersey Homes Act of 2008 requires creditors to send written notices containing prescribed language and carries significant penalties for willful violations of its terms. (LINK)

State Foreclosure Prevention Working Group Issues Data Report #3
The State Foreclosure Prevention Working Group, a multi-state group made up of state attorneys general and state banking regulators, recently issued its third report on the performance of subprime mortgage servicing, calling the evidence “profoundly disappointing.” 

Over the past year, the Working Group has been collecting data from servicers on a monthly basis.   Their latest report finds:

• that the majority of seriously delinquent borrowers are not on track for any loss mitigation,
• the use of short sales is increasing while loan modifications are on the decline,
• 20% of loan modifications made in the past year are currently delinquent, and
• foreclosure rates remain high. 

According to the Working Group, “[s]ervicers appear to have reached the ‘low hanging fruit’ of subprime loans facing interest rate resets, while not developing effective approaches to address the bulk of subprime loans which are in default before interest rate resets.” This has led to property value declines and additional losses on mortgage loan foreclosures, according to the report.   Given the number of ARM loans facing reset over the next two years, the Working Group predicts another wave of preventable foreclosures.

With the exact terms of a federal bailout plan uncertain at the time of this writing, this report may fuel a more aggressive implementation of a foreclosure mitigation program at the federal level should a bailout plan be enacted.   A copy of the report is available here.

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By: Edward G. Eisert

On September 19, 2008, the Securities and Exchange Commission issued Release No. 33-8957 (the “Release”), adopting final rules implementing significant changes to its regulation of cross-border business combinations and rights offerings by foreign private issuers (the “Cross-Border Rules”).   The Cross-Border Rules, adopted after eight years of experience with the current cross-border exemptions, are intended to encourage offerors and issuers in cross-border business combinations and in rights offerings by foreign private issuers to permit U.S. security holders to participate in these transactions in the same manner as other holders.  The Cross-Border Rules address certain recurring issues and unintended consequences of the existing exemptions that have impeded their usefulness.   

The Release also adopts revisions to the beneficial ownership reporting rules under Sections 13(d) and 13(g) of the Securities Exchange Act of 1934 (the “Exchange Act”) to permit non-U.S. entities similar to U.S. brokers, dealers, banks, investment companies, investment advisers and employee benefit plans to use the short form Schedule 13G thereunder to report beneficial ownership of U.S. registered securities, if certain conditions are met (the “Beneficial Ownership Reporting Rules” and, together with the Cross-Border Rules, the “Final Rules”). Reporting beneficial ownership on Schedule 13G is materially less burdensome than reporting beneficial ownership on Schedule 13D under the Exchange Act, as would be required, absent exemptive order or “no-action” relief. 

Generally speaking, each set of the Final Rules represents an expansion and refinement of current exemptions and “no-action” positions, and in some areas, would codify relief previously granted only on an individual basis.  The codification of various interpretive positions of the SEC staff makes such relief available as a matter of right, thereby reducing associated burdens and costs.  The Final Rules were adopted substantially as proposed.

Although the Final Rules benefit both global investment managers and foreign private issuers, their thrust is primarily to benefit U.S. investors in foreign private issuers and non-U.S. institutional investors in U.S. registered securities.  First, from the U.S. investment manager’s perspective, the Cross-Border Rules should lessen the burden on foreign private issuers to include U.S. holders in tender offers, exchange offers and business combinations.  As a consequence, U.S. holders should be more likely to receive the same treatment as other holders in such transactions and, in turn, this should lessen a concern for U.S. persons investing in foreign private issuers.  Second, from the non-U.S. investment manager’s perspective, the Beneficial Ownership Reporting Rules should reduce the administrative burden of holding U.S. registered equity securities.

The specific changes adopted in the Final Rules are complex and a detailed discussion of them is beyond the scope of this article.  For a more complete discussion of these issues, see  Eisert and Berkeley, Global Investment Managers Benefit Under Revisions to Cross-Border Regulation of Business Transactions and Beneficial Ownership Reporting Rules, 15 The Investment Lawyer 9 (2008).

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By: Edward G. Eisert

On September 15, 2008, the Second Circuit Court of Appeals issued a Summary Order in the case brought by CSX Corporation (“CSX”) against The Children’s Investment Fund Management (UK) LLP and 3G Fund L.P. that affirmed the decision of the Southern District of New York not to enjoin the voting of the CSX shares acquired by the defendants in their proxy fight with CSX management.  Stating that an opinion would follow, the Second Circuit did not rule on the other issues of the case that are of great significance to the financial community — particularly the treatment of total return swaps (“TRSs”) under the Securities Exchange Act of 1934 (the “Exchange Act”).

The June 11 decision of the District Court found that through the undisclosed use of TRSs, the defendants had violated Section 13(d) of the Exchange Act and the rules thereunder and enjoined further violations thereof, dismissed all counterclaims, but held that it was “foreclosed” under controlling Second Circuit precedent from enjoining defendants from voting the shares they had acquired from the date of the violation to the trial date.

Thus, the decision of the District Court has called into question a basic expectation of the equity derivatives market:  that the long party to a TRS does not acquire beneficial ownership of the referenced securities under the TRS for purposes of Section 13(d), absent a supplemental arrangement outside of the TRS that provides a contractual right to vote or dispose of such securities.

The opinion of the Second Circuit is being anxiously awaited by the financial community, particularly in light of the current market turmoil.  For a detailed discussion of the decision of the District Court see the K&L Gates June 2008 Alert.

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