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: Phillip J. Kardis II,  Vincent J. Pisano, Douglas J. Ellis

On December 16, 2009, the Securities and Exchange Commission (the “SEC”) adopted amendments (the “Amendments”) to its executive compensation and corporate governance disclosure requirements. The Amendments are effective on February 28, 2010. Accordingly, many public companies face significant new disclosure requirements for the 2010 proxy season.

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: David H. Jones and Andrew V. Petersen

It was no ordinary day. On 25 November 2009, the Dubai government announced through its Supreme Fiscal Committee (SFC) that its Dubai Financial Support Fund (DFSF) would spearhead the restructuring of Dubai World’s financial obligations. The resulting tsunami sent shockwaves through the world markets, as it raised doubts over the Gulf Emirate's ability to meet its financial obligations. Investors with interests in Dubai and its debt market were exposed. Or were they?

As the dust settled, it became clear that Dubai World was seeking to restructure just $26 billion (€17bn, £16bn) out of a total debt of $60 billion.  As a first step in the restructuring process, Dubai World and its subsidiaries, Nakheel PJSC (“Nakheel”) and Limitless LLC (“Limitless”), the real estate developer and investor famous for projects such as the spectacular Palm Jumeirah, requested their creditors agree to a “standstill” on repayments and an extension of a near-term maturity until at least 30 May 2010. The most urgent problem facing Dubai World is a $3.52 billion sukuk (the world’s biggest), an Islamic financial instrument, issued by Nakheel, and maturing on 14 December 2009 along with its two other outstanding sukuk, with a par value of $1.75 billion. To complicate matters further, the sukuk is guaranteed by Dubai World. With this requested restructuring, the legal system of the United Arab Emirates ("UAE") faced an unprecedented test. This Alert provides an overview of what this development means to those with exposure to Dubai World and Nakheel debt, by examining the applicable Islamic financing concepts and the regional legal uncertainty, the question of what creditors should do as well as outlining possible implications for investors and buyers interested in taking advantage of the opportunities that may arise.

To read 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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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: 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: Benoit N. Jacqmotte and Mark D. Perlow

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

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

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

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

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

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

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

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

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

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

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

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

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

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By: 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: 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: Anthony R.G. Nolan

The Term Asset-Backed Securities Liquidity Facility (“TALF”) was announced in February 2009 and first implemented in the following month. As an emergency lending facility established by the Federal Reserve Bank of New York (the “New York Fed”) pursuant to Section 13(3) of the Federal Reserve Act, TALF provides non-recourse term financing for the purchase of highly rated asset-backed and mortgage-backed securities at attractive rates. Although it is backed by a $200 billion credit facility from the Treasury, it is not considered a TARP program subject to the Emergency Economic Stimulus Act of 2009 (“EESA”). However, because of the involvement of the New York Fed in the program as well as its close association with TARP, prospective borrowers have had to weigh the political risks of their involvement and the extent to which governmental authorities could access information about their activities and their investors. 

In the first three subscriptions that occurred in March, April and May 2009, TALF borrowings financed approximately $16 billion in newly issued asset-backed securities, facilitating over $24 billion in issuance of asset-backed securities. After a slow start, and considerable hesitation by investors over participating in the April subscription owing to political and other risks, the TALF program appears to have come into its own in the May subscription, with approximately $10.5 billion of TALF subscriptions facilitating the issuance of approximately $13.5 billion of TALF eligible securities. Subscriptions for the June funding appear to be on track to increase substantially from the May subscription level.

The acceleration of TALF subscriptions reflects several factors. These include

• expansion of the scope of asset classes eligible for TALF funding;
• clarification by the New York Fed and the Treasury that private TALF participants are not (without more) subject to the executive compensation restrictions of the EESA;
• increased experience with the TALF subscription process and the streamlining of TALF borrowing logistics, which increased the comfort level of investors and others with the program; and
• the sense that TALF was a constructive force in the markets for asset-backed securities and consumer credit.

These considerations acted to counter prospective participants’ concerns about political risk, which appeared to have come to a peak following the disclosure in March 2009 that employees of AIG Financial Products had been paid $165 million in retention bonuses after the company had received TARP funds. However, recent political and legislative developments may make it more likely that Congress will obtain information about TALF investment funds and their investors through audits of the New York Fed or of TALF borrowers by the Government Accountability Office (“GAO”).  This concern may dampen the willingness of funds to borrow under TALF to the extent that spreads on TALF-eligible ABS continue to compress to a point where perceived risks outweigh rewards.

The contractual path of transparency is familiar to participants in the TALF borrowing process. Section 11.1 of the TALF Master Loan and Security Agreement (the “MLSA”) authorizes the Federal Reserve Board (the “Board”) to obtain reports or statements that it reasonably requests with respect to the borrowing and the collateral. Section 11.3 of the MLSA also authorizes the New York Fed to obtain “know-your-customer” (“KYC”) information submitted by a borrower to the primary dealer acting as its agent for TALF borrowings.

Primary dealers have recently been expanding the scope of KYC diligence required for TALF investment funds to “look through” the fund to get information about investors who own (directly or indirectly) 10% or more of a class of securities in the fund.  The extent of the look-through varies among dealers, with different formulations covering direct, intermediate and/or ultimate owners of the borrower. KYC information is typically given to dealers under confidentiality restrictions, and the MLSA obligates the New York Fed to comply with any confidentiality restrictions.  However, the New York Fed is permitted to disclose any information it receives to oversight bodies (including Congress) to the extent required by applicable law or regulations or by subpoena.  Once so disclosed, information given in confidence may become publicly available.  Therefore, the scope of KYC disclosure that TALF investment funds make to their primary dealers could be a crucial issue for direct and indirect investors in those funds.

The increasing level of KYC diligence has coincided with expressions of concern by the Office of the Special Inspector General for the Troubled Asset Relief Program, in its April report to Congress, that a look-through is appropriate to ensure that TALF not be used to leverage proceeds of crime. Even though TALF is not a TARP program, policymakers and enforcement agencies have been concerned about moral hazard implications of non-recourse TALF borrowings (at a 6-1 leverage ratio) by public-private investment funds established under the Treasury’s Public-Private Investment Program (“PPIP”). This moral hazard arises from the potential of such leverage to dilute the risk of loss of private equity investors in PPIP funds even beyond the dilution implicit in the Treasury’s co-investments in the equity of those vehicles. To the extent that private parties have limited “skin in the game,” they may have disincentives to conduct appropriate due diligence on financed assets or establish a fair price, which could harm a fundamental taxpayer protection in the design of TALF and PPIP by potentially exposing the public purse, as represented by the New York Fed and the Treasury, to a heightened risk of loss.

Recent legislative developments may also be providing a separate avenue to disclosure of information about investors in TALF funds.  Section 8.01(d) of the enrolled version of Senate bill S.896 (Helping Families Save Their Homes Act of 2009) permits the GAO to conduct audits, including onsite examinations, of any action taken by the Board under the authorizing legislation for TALF “with respect to a single and specific partnership or corporation.”  Section 8.01(c) of that bill provides that it may obtain access to any entity receiving TALF funding in connection with such audits.  A separate bill introduced in the House of Representatives, H.R.1207 (Federal Reserve Transparency Act of 2009), provides for a report to Congress with respect to GAO audits of the Board.  It appears that sponsors of this legislation conceive of it as a basis for Congress to obtain information with respect to TALF borrowers and their investors.

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

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

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

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

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

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

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

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By: Matt T. Morley, Michael D. Ricciuti

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

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

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

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

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

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

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

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By: 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: Clare Tanner, Paul F. Donahue

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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By: Claudia Harrison, Katie Hillier

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

2.  Update on Existing Measures

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

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

3.  New Measures

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

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

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

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

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

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

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

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By: David N. Jonson

The North American Securities Administrators Association ("NASAA") started the new year off with an ambitious agenda at its annual Winter Enforcement Conference on January 8-11, in Coronado, California.  The conference, which is open only to state, federal and FINRA enforcement attorneys and investigators, featured panels on Enforcement Trends, Enforcement Best Practices, Broker-Dealer Sales Tactics, and Enforcement Implications of the Financial Crisis.  The attendees also met to discuss strategy and tactics in six specialized NASAA enforcement groups: Enforcement Technology, Enforcement Trends, Special Project Development and Coordination, Attorney Investigator Training, Litigation Forum, and Enforcement Zones.

State securities regulators, who have regulated the securities industry since before federal securities laws and the SEC were created by Congress during the New Deal, have always been mindful of the erosion of their regulatory power by federal initiatives advocated by both the SEC and the securities industry itself.  Although the securities industry's clout in Washington today is arguably at its weakest level in decades, the states are also aware that any new financial services regulatory scheme from Washington could still result in a diminution of state authority.  Accordingly, even though recent multi-state regulatory enforcement actions in the areas of research analyst conflict of interests and auction rate securities have been widely viewed as successful by investors, consumer groups and some influential members of Congress, the states clearly do not intend to stray too far from the kitchen while a new regulatory pie is being baked.

To continue demonstrating their value during this time of regulatory change, state securities regulators will continue to focus on local cases with a common national theme (e.g. , auction rate securities and senior citizen issues).   However, since the states have also detected an unprecedented number of registered representatives departing broker-dealers to form smaller, state-registered investment advisory firms, the states have also indicated that they will dramatically increase the number of proactive examinations, investigations and enforcement actions against such firms. 

There are several reasons for the states' increased interest in these new investment advisers.   As an overarching factor, the effects of the Madoff matter cannot be understated.  No state securities regulator, many of whom serve at the pleasure of statewide elected officials, wants to have to explain how or why they missed clues or leads that, if properly investigated, would have shut down a would-be Madoff in their jurisdiction.  Therefore, future state examinations and investigations — regardless of whether or not a whistleblower provides a roadmap of where to look — will be far more thorough than in the past.  As a result, subjects of these inquiries should expect to find that responding to such matters will involve considerably more time and expense than they may have grown accustomed to in prior years. 

Second, state regulators are very concerned that since the majority of the new advisers may not be accustomed to handling compliance and other administrative details themselves, and because adequate compliance takes time and money and may be less of a priority than client development, state regulators theorize that these advisers are more likely to be deficient in carrying out such duties.  Some states will even be taking the unusual step of conducting introductory examinations of newly registered advisory firms. 

Third, some regulators believe that most of the representatives who left broker-dealers to form their own advisory firms may not have been in the upper echelon (or "top producers") at their former firms, and now, under pressure to pay their own way, may be more desperate to generate business through questionable advice or investment opportunities that they would not have attempted to solicit while at their prior firms.   (Interestingly, some state regulators — especially those who considered the term "top producer" to be questionable when viewed from the client's perspective — took a more charitable view of the motives of the lower-producing representatives who recently became state-registered advisers.) 

State securities regulators have identified new, state-registered investment advisers as the latest "at risk" group who will bear the brunt of their regulatory and investigative scrutiny.   Given the deterrent effect and favorable publicity that can be generated from taking strong enforcement actions, the states can also be expected to continue availing themselves of the full array of media outlets on both the local and national level.

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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: Lawrence B. Patent

The Treasury Department’s Office of Foreign Assets Control (OFAC) administers and enforces economic and trade sanctions against targeted foreign countries and designated persons.  OFAC issued guidance dated November 5, 2008, to assist securities and futures firms in fulfilling their OFAC obligations when accepting new clients and evaluating client transactions.  OFAC’s guidance applies to investment advisers (IAs), securities broker-dealers (BDs), futures commission merchants (FCMs), introducing brokers in commodity interests, commodity pool operators (CPOs) and commodity trading advisors (CTAs).  OFAC’s guidance is important in three areas:

• Although another arm of the Treasury Department, the Financial Crimes Enforcement Network (FinCEN), recently withdrew as outdated proposals published in 2002 and 2003 that would have required IAs, CPOs, CTAs and hedge funds to establish anti-money laundering (AML) programs under the Bank Secrecy Act (BSA), OFAC’s guidance notes that all U.S. persons, including securities and futures firms, are subject to the requirements of OFAC.
  
   
• OFAC, unlike FinCEN’s approach under the BSA, requires that a BD or an FCM look through the intermediary to the underlying beneficial owners of an omnibus account for purposes of complying with OFAC requirements.
  
   
• Although FinCEN permits clearing firms and introducing or executing firms to rely upon each other for performing certain AML functions, OFAC’s guidance states that it does not permit businesses to reallocate their legal liability to a third party with regard to statutes that OFAC administers – thus, if a securities or futures firm delegates OFAC compliance functions to others, the securities or futures firm, as well as the third party, could be held liable for any OFAC violations caused by the third party’s negligence.

OFAC’s guidance, which was issued almost immediately after FinCEN withdrew its outdated AML proposals, appears designed to remind all financial intermediaries of their obligations under OFAC, which is certainly a less well-known regulatory program compared to the AML programs administered by FinCEN.  The OFAC guidance also makes clear that OFAC has less concern than FinCEN about duplicative regulation, and OFAC, unlike FinCEN, does not accept the concept that different intermediaries perform certain roles in financial market transactions that should permit delegation of responsibility.  Despite OFAC’s statement that “[a] strong OFAC compliance program [will be] similar to . . . a brokerage firm’s Customer Identification Program,” in fact OFAC expects more of BDs and FCMs where omnibus accounts and certain other intermediaries are involved than does FinCEN.

OFAC Account Opening Requirements
A new customer’s identity should be verified before an account is opened or within a reasonable time period after account opening.  Securities and futures firms should screen the new customer against OFAC’s Specially Designated Nationals and Blocked Persons list, known as the SDN list and accessible at www.treas.gov/offices/enforcement/ofac/sdn/index.shtml, and applicable OFAC sanctions programs.  OFAC advises that firms should use risk-based factors to assess risks posed by each customer and transaction, asking questions such as:

• Is the customer regulated by a federal functional regulator, widely known, or listed on an exchange?
• Has the firm had any previous experience with the customer or does it have prior knowledge about the customer?
• Is the firm facilitating a U.S. person’s investment in a foreign issuer or other company that conducts business in a sanctioned country?
• Is the customer located in a high-risk foreign jurisdiction that is considered to be poorly regulated or in a known offshore banking or secrecy haven?
• Is the customer located or does it maintain accounts in countries where local privacy laws, regulations, or provisions prevent or limit the collection of client identification or beneficial ownership information?

Periodic checks of “non-accountholders,” such as beneficiaries, guarantors or principals, may also be necessary, depending upon each firm’s specific risk profile.

Documenting OFAC Compliance
Securities and futures firms should maintain adequate documentation of the results of their screening against the SDN list and applicable OFAC sanctions programs.   In the event of a potential OFAC violation, both the adequacy of a company’s transaction processing system and its overall OFAC compliance program are taken into consideration when determining the severity of possible enforcement action. 

FinCEN Withdrawal of Proposed AML Rules for IAs, CPOs, CTAs and Hedge Funds
As noted above, in late October FinCEN withdrew rules proposed over five years ago that would have required IAs, CPOs, CTAs and hedge funds to adopt AML programs.  In issuing these withdrawal notices, FinCEN noted that it would not adopt such rules in the future without providing interested parties an additional opportunity to comment upon proposals.  FinCEN’s withdrawal appears to be based on the principle that AML programs for IAs, CPOs, CTAs and hedge funds are not necessary because their customer accounts are carried by and their transactions are executed through other financial institutions, BDs and FCMs that do have AML programs.  FinCEN noted that it has concluded major rulemakings concerning BSA compliance by BDs and FCMs since it proposed the now-withdrawn proposals related to IAs, CPOs, CTAs and hedge funds that have confirmed the adequacy of their AML protections.  OFAC’s guidance also focuses more upon the responsibility of BDs and FCMs and does not permit those entities to avoid liability under OFAC programs by pointing to introducing firms or firms engaged only in the transaction-execution process.

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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: Richard S. Miller, Robert T. Honeywell, Jeffrey N. Rich

The Lehman Brothers bankruptcy sometimes seems to have exhausted the list of “biggest ever” superlatives: Biggest ever bankruptcy filing in the United States ($639 billion in assets).  “By far the largest securities broker-dealer liquidation ever attempted,” according to the trustee overseeing the liquidation of Lehman’s U.S. broker-dealer.  His British counterpart, overseeing the insolvency of Lehman’s London operations, told the press, “Enron and BCCI were large and complex but not on this scale.”  The Lehman collapse has been tied to the fall of the investment banking model, to continuing uncertainty in financial markets, and to the current turmoil in the global  economy itself. 

A less-discussed theme of the Lehman bankruptcy is the strain it is revealing between the efficiencies of global corporate cash management and the legal regimes governing creditor claims.   When the cash literally stops flowing, creditors and investors naturally ask, “Where’s my money?”  The Lehman insolvency has revealed, like many of the largest corporate bankruptcies in recent years, that this can be an extremely difficult question to answer. 

Part of the problem is that most corporate cash management systems involve one corporate entity moving cash on behalf of its affiliates, but reflecting their interests primarily through intercompany claims.   This has obvious operational efficiencies, but when “the music stops” upon a bankruptcy filing, the cash is held by the entity with legal title to it (i.e., in its accounts).  Creditors of the entity holding the cash have an immediate enforcement advantage – the money is there – while creditors of its affiliates have to chase it down, possibly across jurisdictional boundaries.  The Lehman bankruptcy is the latest example. 

Like most large companies, Lehman operated a centralized cash management system that had one entity – in this case the holding company – operate as the “central banker” for the numerous Lehman entities.   According to court filings, the holding company generally swept excess cash into its own U.S. and foreign operating accounts and used it to fund expenses of subsidiaries.  The degree to which subsidiaries were integrated into the system varied.  For example, unregulated subsidiaries had their excess cash swept on a daily basis to the holding company’s operating accounts, while regulated subsidiaries (generally broker-dealers) transferred cash to the holding company less frequently, to pay down intercompany loans for prior advances.  Some subsidiaries managed their own cash and disbursements independently (e.g., Lehman Brothers Commercial Bank).  Others had some of their collections deposited into the accounts of other subsidiaries.  For example, the regulated U.S. broker-dealer (Lehman Brothers Inc. (“LBI”)) received collections from some derivatives, futures and foreign exchange transactions of Lehman Brothers Commercial Corporation, Lehman Brothers Special Financing Inc., and Lehman Brothers International (Europe) (“LBIE”).  As to disbursements for expenses, the holding company acted as “paymaster” for most of Lehman’s European operations, while the regulated U.S. broker-dealer (LBI) acted as “paymaster” for most U.S. operations. 

A centralized cash management system such as Lehman’s may make utter sense pre-bankruptcy, but can produce legal nightmares afterward.  For one, the sheer number of transactions can make untangling intercompany claims based on those transactions a herculean task.  Lehman reported that the portion of its business related to the sale of derivatives alone involved approximately 1,500,000 transactions with approximately 8,000 counterparties.  It is now faced, in the post-bankruptcy setting, with sorting these out with a radically reduced staff, going from more than 13,000 employees to about 140.  Lehman’s London office recently lost over half of its legal staff.   Its current U.S. management, led by an outside restructuring firm, is reportedly focused on preserving its information systems and retaining employees, and estimates being able to respond to creditor inquiries in 45-60 days.  Impatient creditors in the U.S. case have filed motions for their own investigations and for the appointment of an examiner and for an independent trustee to replace Lehman’s remaining officers and directors.  Its UK insolvency administrators reported difficulty determining the UK companies’ assets, partly due to difficulties getting information from other asset custodians around the world, and that “it will take many years to finally resolve the inter-company and third-party claims.”

A review of Lehman’s cash management system also shows that numerous legal and regulatory regimes are now at play that may affect intercompany claims and, as a result, creditors’ ultimate recoveries.   The holding company that acted as the “central bank” is now subject to the U.S. Chapter 11 case, along with 16 subsidiaries; LBI is subject to a separate liquidation proceeding supervised by the Securities Investor Protection Corporation; LBIE and three other British entities are in a UK administration proceeding; other foreign subsidiaries are subject to insolvency proceedings in their own jurisdictions (for example, in Hong Kong, Australia, Singapore, Japan, The Netherlands, France and Germany); and various Lehman entities and funds are still “non-debtors,” not having yet filed a formal insolvency proceeding and thus continuing to be subject to whatever laws govern the entities and their various contracts. 

From an insolvency perspective, this means that a creditor or investor evaluating its recovery prospects must:

1. first determine which entity or entities it did business with, both directly and through guaranties, cross-collateralization, setoff and netting rights; then
2. determine which assets (including collateral) are available for recovery and which courts and regulators may have jurisdiction over those assets (including a possible stay or injunction prohibiting enforcement or foreclosure); then
3. file claims in the relevant insolvency proceedings prior to the applicable deadlines (subject to considering the risks of submitting to jurisdiction), exercise any voting and participation rights available to creditors (for example, attending creditors’ meetings and voting on a plan of reorganization), and possibly take other enforcement action (for example, a motion to modify any stay against foreclosure or other litigation); then
4. monitor the relevant insolvency proceedings, to determine the timing and amount of creditor recoveries.

The multiplicity of bankruptcy regimes now governing Lehman means that each Lehman entity is now considered a separate “bankruptcy estate” – i.e.,   a separate group of assets and creditors – and each is now vying with the other bankruptcy estates for a piece of the Lehman group’s remaining assets.    Intercompany claims are often the main vehicle through which these separate bankruptcy estates try to recover assets for themselves.  Anyone who has lived through other large corporate bankruptcies (e.g., Adelphia, Global Crossing, Refco) knows that intercompany litigation can be the most complex, intractable and even unresolvable feature of the insolvency proceeding.  Some cases feature creditors attempting to “substantively consolidate” all of the companies by collapsing all of the different bankruptcy estates into one, eliminating intercompany claims in the process, but other creditors naturally, and fiercely, resist.  Some creditors will of course benefit from corporate separateness by preserving their respective debtor-companies’ assets for themselves. 

Creditors and investors of the “asset-weak” companies try to reach through corporate boundaries by any and all means.   If they are unsuccessful, their recoveries can be much lower than their counterpart creditors at other entities in the corporate tree, in what is ostensibly the “same company.”  A typical pattern is that lenders and investors at one level (for example, stockholders and bondholders of the holding company) assert that they financed the operations of the subsidiaries and should recover accordingly; conversely, creditors of the subsidiaries assert that holding company creditors were aware of their “structural subordination” and have to live with the consequences. 

Hence, the (often furious) litigation that attends many complex corporate bankruptcies and is now gathering steam in the Lehman cases.   In addition to the multiple insolvency proceedings around the world, there are now securities class actions and criminal investigations, all of which will presumably take years to resolve.  One of the well-publicized complaints is from creditors of Lehman’s UK entities, who claim that several billion dollars was swept into Lehman’s U.S. accounts on the eve of its Chapter 11 filing.  These creditors are now faced with trying to claw back cash that once flowed easily within “Lehman Brothers” and is suddenly beyond their reach due to legal boundaries that became very real, and difficult to pierce, upon Lehman’s bankruptcy filing. 

This is one of the difficult lessons that is learned repeatedly in corporate bankruptcies but is especially potent for companies with global operations.   At a court hearing, one of Lehman’s lawyers explained its cash management system as “cash moves around with great velocity.”  This can be profitable for creditors in good times yet very dangerous in others.  Creditors should be aware of the benefits and risks of centralized cash management – specifically, of exactly which entities they have claims against, and where those entities’ cash and other assets are – so that they can understand and be prepared for the consequences in the event, “the music stops.” 

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By: Paul F. Hancock

State attorneys general aspire to be the primary protectors of consumers. The housing collapse provided new opportunities for them to flex their muscles and seek a role in the development of solutions.  Federal preemption remains a controversial issue, but the threat of preemption has only caused state attorneys general to be more aggressive in the areas where they have legal authority.   Recently elected attorneys general have pledged to focus attention on the housing and financial markets, and we can reasonably expect attorneys general, as a group, to push the limits of their authority in addressing the issues.  Some examples of their actions in recent months are described below.

Auction-Rate Securities
Allegations of deception have provided a basis for attorney general involvement in auction-rate securities markets.  New York Attorney General Cuomo reached agreement with twelve financial institutions on claims that they “sold auction-rate securities as safe, cash-equivalent products, when in fact they faced increasing liquidity risk.”  The institutions agreed to buy back the securities from certain customers, generally individuals and foundations, and otherwise provide restitution to “individual investors who were fraudulently sold auction-rate securities.”  Cuomo says that the settlements “returned over $50 billion back to investors’ hands.”  Similar settlements were reached by attorneys general in Massachusetts and Michigan.

Mortgage Fraud
Attorneys general have identified mortgage fraud, particularly inflated appraisals, as a major contributor to the housing crisis.  The Florida Attorney General sued ten companies and fifteen individuals that defrauded lenders by recruiting “straw buyers'” with good credit and conspiring with realtors to artificially inflate purchase prices.  Other states have filed similar claims.

Foreclosures
The State Foreclosure Prevention Working Group released its third report on mortgage foreclosures at the end of September, contending that 80 percent of delinquent borrowers are not receiving meaningful foreclosure relief.  Although the Group’s collaboration with servicers is described as cooperative, a stronger stick is laying in wait.  After a number of states announced a settlement with Bank of America regarding the Countrywide portfolio that centers on loan modification, on October 7, the Group sent a letter to sixteen subprime servicers stating: “We urge you in the strongest possible terms to adopt a comprehensive, streamlined, and effective loan modification program as soon as possible.”  The implicit threat of prosecution is clear.

State attorneys general investigated and prosecuted deceptive conduct by foreclosure rescue companies.  This issue is a neat fit for traditional attorney general enforcement and is a priority in many states.

Loan Origination
The settlement with Bank of America regarding the Countrywide portfolio continues a trend of aggressive state attorney general action regarding home mortgage lending practices.  The attorneys general already have extracted major business changes in the lending industry through lawsuits and compelled settlements.  The monetary value of the attorney general settlements with Household ($484 million) and Ameriquest ($295 million), as well as the extensive loan modification relief obtained from Countrywide, certainly overshadow any action by federal agencies.  The only real question is which firm will be the next target – perhaps one of the sixteen servicers that received the October 7 letter, or the originators of the loans that they are servicing.

2008 Attorney General Elections
Eleven seats were up for election and the announced plans of the winners indicate a continued, and perhaps increased, focus on mortgage and financial markets. 

Chris Koster, newly elected in Missouri, and Richard Cordray, newly elected in Ohio, focused their campaigns on credit and foreclosure issues.  Other well-known attorneys general who already enjoy a strong reputation in seeking mortgage reform and foreclosure relief – such as Roy Cooper in North Carolina and Rob McKenna in Washington – were reelected.  Mark Shurtleff was reelected in Utah, as was Darrell McGraw in West Virginia; they have prioritized mortgage fraud and other credit-related issues.

First-term attorneys general were elected in Indiana (Greg Zoeller), Montana (Steve Bullock) and Oregon (John Kroger), and incumbents were reelected in Pennsylvania (Tom Corbett) and Vermont (William Sorrell).   All emphasized the importance of consumer protection in seeking office.

Conclusion
The states want a place at the remedial table.   Some offer an olive branch of cooperative efforts to work through the present crisis.  Others are more aggressive from the start.  But if conditions do not improve quickly, it can be expected that many states will join forces to compel reform, based on claims that consumers and investors were deceived or otherwise were victims of unfair practices of loan originators, servicers or secondary market participants.

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By: David N. Jonson

Recent pronouncements from the North American Securities Administrators Association ("NASAA") indicate that its members (state and Canadian provincial securities regulators) are fielding so many investor inquiries and complaints regarding Principal Protected Notes ("PPNs") that NASAA is considering the formation of a multistate investigative task force to investigate how PPNs were offered and sold.  Such a task force would likely be similar to the one that NASAA created earlier this year to investigate auction rate securities.

A PPN is a type of structured investment product designed to provide a return of principal investment at maturity (typically 3-8 years), plus the potential to earn additional returns that are tied to the performance of an equity or commodity index.  Accordingly, PPNs tend to attract investors who are risk-averse and long-term oriented, and who seek a guaranteed return of their principal investment.

In order to preserve principal and offer a degree of upside potential, PPNs are comprised of two components.  A portion of the principal is used to purchase a zero coupon bond with a face value equal to the full principal amount at maturity, assuring that the original amount invested will be returned, so long as the bond's issuer does not default during the life of the PPN.  The remainder of the principal amount is invested in options on an underlying index with the same expiration date as the PPNs maturity date.  The two primary risks of investing in PPNs are the credit risk of the issuer and the lack of liquidity, since PPNs are designed to be held until maturity.  The total size of the PPN market is estimated to be approximately $35 billion.

In the wake of the insolvency of some PPN issuers, state regulators have been contacted with allegations that the risks of these investments were misrepresented or that PPNs were sold to investors for whom they were unsuitable.  Given the volatility of today's financial markets and the speed with which bad news travels, investors in PPNs of solvent issuers have also expressed concerns about the safety of their investments.

Several key dynamics will influence whether NASAA's Board of Directors and Enforcement Section decide to create a PPN task force.  First, state securities regulators view themselves as the "local cops on the beat," and thus, the first line of defense in protecting investors.  If the number of investor complaints is significant enough, NASAA and its members will act quickly, as they did most recently in connection with NASAA’s auction rate securities task force, which took the leading regulatory role away from the SEC and FINRA.  Second, if one of the more active state securities regulators, such as the New York Attorney General or Massachusetts Secretary of State, takes early action, NASAA will be sure to organize a more widespread group of states to join the fray.  Third, although there is now a pro-regulation environment in Washington, NASAA and its members have historically been mindful of and concerned about any efforts to pre-empt the states from asserting their regulatory authority.  By acting quickly and decisively on the heels of their successful auction rate task force, NASAA members would be taking advantage of another opportunity to reemphasize the importance of the states' role in the securities regulatory arena.  We are continuing to monitor the situation through our NASAA contacts, and will report any material developments in the future.

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By: Michael J. King

Proclaiming that “we are an American court, not the world’s court,” the U.S Court of Appeals for the Second Circuit recently rejected an effort to extend U.S. jurisdiction over foreign securities transactions. The decision in Morrison v. National Australia Bank Ltd., – F.3d –, 2008 WL 4660742 (2d Cir. Oct. 23, 2008), arose in a so-called “foreign-cubed” securities class action case: an action brought by foreign investors, in foreign securities, purchased on a foreign securities exchange. Morrison, the first such case considered by the Second Circuit, offers a measure of reassurance to foreign issuers and investors who might otherwise avoid even tangential connections with U.S. capital markets due to fear of the U.S. legal system.

Australian investors sought to bring a class action suit in the U.S. District Court for the Southern District of New York against National Australia Bank (“NAB”) and others, alleging securities fraud under U.S. law in connection with purchases of NAB securities on an Australian securities exchange. According to the plaintiffs, NAB’s subsidiary, HomeSide Lending, Inc. (“HomeSide”), a U.S. mortgage service provider, used improper accounting methods that overstated the value of its mortgage servicing rights (“MSR”). These improper accounting methods led NAB to write down $2 billion in the value of HomeSide’s MSR in 2001, resulting in significant declines in the price of NAB’s securities. Plaintiffs alleged that the defendants made false and misleading statements concerning HomeSide’s operations and its contributions to NAB’s financial health in filings with the SEC, foreign securities exchanges, in statements to the press, and in corporate documents.

Since it was confronted with allegations of securities fraud involving foreign securities transactions, the district court looked to the “effects” and the “conduct” tests developed by the Second Circuit for deciding whether to exercise jurisdiction over such suits. Morrison v. National Australia Bank Ltd., -- F. Supp. 2d--, 2006 WL 3844465 (S.D.N.Y. 2006). Under the effects test, a district court may exercise jurisdiction over foreign plaintiffs where the alleged illegal activity causes a “substantial effect” on U.S. investors or markets. Under the conduct test, a district court may exercise jurisdiction if a defendant’s conduct in the United States was more than “merely preparatory” to the fraud, and particular acts or culpable failures to act within the United States “directly caused” losses to foreign investors abroad.

The district court quickly concluded that the effects test did not support exercise of subject matter jurisdiction since the alleged fraud had very little, if any, effect in the U.S. markets. Moving to the conduct test analysis, the district court concluded that HomeSide’s alleged misconduct in the United States was immaterial to a securities fraud claim given the much more significant extra territorial conduct of NAB. Thus, the district court found that the foreign actions, not the domestic actions, “directly caused” the alleged harm in this case and dismissed the complaint.

On appeal, the appellants relied solely on the “conduct” component of the conduct and effects tests in support of their jurisdictional argument. Reviewing prior precedent, the Second Circuit reaffirmed that pursuant to “the ‘conduct’ component, subject matter jurisdiction exists if activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused losses to investors abroad . . .. Our determination of whether American activities ‘directly’ caused losses to foreigners depends on what and how much was done in the United States and on what and how much was done abroad.” Morrison, 2008 WL 4660742, at *4. The Second Circuit then reviewed the comparative significance of the conduct in the United States with those actions that occurred abroad and concluded that actions of NAB in Australia were significantly more central to the alleged fraud and more directly responsible for the harm to investors than the alleged manipulative accounting by HomeSide in the United States. In reaching its decision, the Second Circuit stressed that the responsibilities of NAB’s Australian headquarters included overseeing its own and its subsidiaries’ operations, and reporting to shareholders and to the financial community. The court also emphasized that NAB, not HomeSide, was the issuer of the securities and therefore was responsible for the public statements and filings and for relations with its investors. The Second Circuit also noted the absence of any allegation of harm to U.S. investors or markets and the lengthy chain of causation between HomeSide’s contribution to the misstatements and harm to investors. Based upon the totality of this analysis, the court concluded that it lacked subject matter jurisdiction and affirmed the dismissal. Id. at *7 & 8.

In addition to addressing for the first time the issues presented in a foreign-cubed class action case, the Second Circuit’s decision is significant because the court refused to replace the conduct test analysis with proposed alternative formulations for determining subject matter jurisdiction. Appellees and certain of the amici urged the court to adopt a bright-line rule that, in foreign-cubed cases, domestic conduct should never be enough and subject matter jurisdiction cannot be established where the conduct in question has no effect in the United States or on U.S. investors. The court flatly rejected this proposal. The court also rejected the SEC’s proposed alternative standard proffered in its amicus brief that the “antifraud provisions of the securities laws [should] apply to transnational frauds that result exclusively or principally in overseas losses if the conduct in the United States is material to the fraud’s success and forms a substantial component of the fraudulent scheme.” The court’s implicit rejection of the SEC’s materiality test – the decision does not even address it – is particularly important because the materiality standard would likely permit more cases alleging transnational frauds to stay in U.S. courts. For example, the SEC amicus brief urged that, under the materiality test, jurisdiction existed in Morrison.

The decision provides needed stability in an area of the law that is important to non-U.S. companies considering investing in the United States who are concerned about the risks and burdens of U.S. class action lawsuits, existing foreign investors in the United States with similar concerns, and the financial markets and intermediaries that service such investors and potential investors. At a time when the U.S. plaintiff’s bar is taking deliberate steps to cultivate foreign claimants for U.S. class action suits, these protections are welcome. Although the conduct and effects tests are very fact specific, the Second Circuit’s decision to adhere to these tests when considering subject matter jurisdiction in transnational fraud cases provides a reliable framework for disposing of cases at a preliminary stage. This is particularly important to firms concerned about exposure to class actions, where attendant disruptions and defense costs alone can prove very burdensome, even where defendants have fully complied with the law.

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By Anthony R.G. Nolan and Gordon F. Peery

When Lehman Brothers Holdings Inc. ("Lehman") filed for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code on September 15, 2008, a credit event occurred on over $400 billion notional amount of credit default swaps (“CDS”) referencing Lehman obligations. The notional amount of CDS referencing Lehman was high because two distinct categories of players had bought protection on Lehman. The first category consisted of traders who used CDS to speculate on Lehman’s credit spreads and the likelihood of becoming a debtor in a bankruptcy case. The second category consisted of counterparties to financial contracts with Lehman or its subsidiaries, which entered into CDS as a hedge against the risk that Lehman would not be able to perform on obligations owing to them. Protection sellers in CDS referencing Lehman Brothers were, generally, insurers, including monoline insurance companies, hedge funds and special purpose entities engaged in structured financings.

As with settlement of other CDS where the notional amount exceeded the amount of deliverable obligations that could readily be delivered in physical settlement, the International Swaps and Derivatives Association, Inc. (“ISDA”) established an auction protocol (the “Protocol”) to offer market participants an efficient way to address the settlement issues relating to credit derivative transactions referencing Lehman. The Protocol offered institutions the ability to amend their documentation for various credit derivatives transactions in order to utilize an auction that took place on October 10, 2008 to determine the final price for certain CDS and other credit derivatives referencing Lehman. Derivatives coming within the Protocol are those transactions that were entered into on or prior to September 15, 2008, terminate on or after September 15, 2008, have a trade date on or prior to October 10, 2008 and remain outstanding as of October 21, 2008.

The auction that took place on October 10, 2008 created some consternation because the market value of the deliverable obligations was valued at approximately 9 percent of par, meaning that protection sellers would realize a loss of approximately 91 percent of the notional amount of CDS, or over $364 billion in gross terms. In light of the large notional amount of transactions to be settled, the market looked forward with trepidation to October 21, 2008, the date on which buyers of credit protection against Lehman were to receive payments from protection sellers. News reports indicated that banks may have been hoarding cash in recent weeks to be in a position to make payments. There was also speculation that significant settlement failures by protection sellers could have a potentially disastrous effect on market stability, possibly resulting in other significant challenges to the $55 trillion CDS market.

Credit market participants breathed a collective sigh of relief when October 21, 2008 passed without undue strain in the markets, as it turned out that the $400 billion notional amount of Lehman CDS was well in excess of the actual $6 billion of net Lehman CDS settlement proceeds that changed hands on October 21, 2008. The relatively small net amount reflected the fact that many protection sellers had been required to post collateral to secure their payment obligations. As CDS referencing Lehman fell in value, parties buying protection from protection sellers made collateral calls, and protection sellers had to post increasing amounts of collateral, effectively meaning that assets to satisfy a large portion of the settlement obligations had already been segregated and made available to cover Lehman CDS. It may have also reflected the fact that many large institutions and hedge funds were on both sides of Lehman CDS trades and were able to net amounts owing to each other on Lehman CDS.

While the netting of positions and the offsetting of amounts owed by posted collateral minimized the market impact of the October 21, 2008 Lehman CDS settlement under the terms of the Protocol, it may be too early to break out the champagne because the full effect of the $6 billion payday may not be known until quarterly results are released. The net Lehman CDS payout may very well still result in the failure of many Lehman CDS protection sellers which used leverage to fulfill their collateral posting obligations. This is particularly true in the market for synthetic collateralized debt obligations (“CDOs”), where investors will bear losses for many transactions that had significant exposure to Lehman. Even though the obligations of synthetic CDO issuers to their CDS counterparties are supported by collateral, the market value loss of the CDS is reflected in and borne by investors in the CDOs through writedowns of principal. This may lead to an expansion of the stresses recently seen in the asset-backed CDO market to the corporate CDO market, which until now has been relatively unscathed. It is probable that the fallout of the Lehman settlement will add to the pressure that has been growing in Washington and in parts of Wall Street for more effective regulation of the CDS market.

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By Irene C. Freidel and Anthony R.G. Nolan

The U.S. Attorney’s Office in Manhattan and the New York Attorney General’s Office confirmed last week that they have launched a joint investigation into operation of the largely unregulated $55 trillion dollar market for credit default swaps (“CDS”).

CDS are synthetic risk transfer devices whereby, in exchange for a premium, one party (the seller) agrees to make a payment to the other (the buyer) to protect the buyer from credit risk of one or more reference entities following the occurrence of a bankruptcy or other credit event with respect to such reference entity. Following the occurrence of a credit event, the buyer is entitled to receive a cash payment to compensate it for the decline in market value of selected obligations of the reference entity. Therefore, the value of a CDS to the buyer fluctuates with changes in the reference entity’s financial strength, increasing as the reference entity’s creditworthiness deteriorates and decreasing as the reference entity becomes more financially stable.

Since 2005, the CDS market has become very large and liquid, with an estimated $62 trillion notional amount of CDS outstanding globally in 2007. The growth of the CDS market has been premised to a great extent on light regulation of CDS transactions under commodities laws, securities laws, and insurance law. Most CDS are “security-based swap agreements” that are excluded in large part from SEC jurisdiction, although they are subject to antifraud and antimanipulation provisions of the U.S. federal securities laws.

The current investigation represents an expansion of existing investigations by federal and New York State authorities into whether short-selling activity resulted in manipulation of the price of bonds and shares of financial services institutions. The purpose of the current effort is to determine whether investors manipulated the prices (or credit spreads) of CDS in uncompleted transactions that were nonetheless reported to data providers. Credit spreads for CDS affect the prices of the debt obligations issued by entities referenced in the CDS because those spreads are considered to be leading indicators of perceived financial stability of the reference entity. Thus, efforts to manipulate CDS pricing could benefit short sellers of financial obligations issued by the reference entities, who would benefit from a decline in the value of those obligations occasioned by fears that the reference entity might be under financial stress.

Collaboration of the two enforcement offices suggests that the investigation will be significant and wide-ranging in scope, and includes the possibility that U.S. Attorney Michael Garcia will seek information from foreign sources. To date, subpoenas have been issued by New York’s Attorney General Andrew Cuomo to a variety of large financial institutions, including stock exchanges, hedge funds, and several entities that are involved in the credit default swap trade process: Depository Trust Clearing Corp., Markit, and Bloomberg LP. Whether the investigation will result in any prosecutions is as yet unknown. The effort reflects a new aggressiveness in the use of antimanipulation enforcement jurisdiction to the derivatives market.

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By Brian A. Ochs

Significant disruptions in the market invariably lead to an increase in SEC enforcement activity, as regulators seek to determine whether those negative events resulted from violations of the federal securities laws. The aggressiveness of the SEC’s efforts in this regard will likely be further enhanced by two new reports from the SEC’s Inspector General (“IG”), H. David Kotz, that are highly critical of the Enforcement Division’s prior conduct of investigations involving major Wall Street firms. In each report, the IG raised questions about the Enforcement staff’s appearance of impartiality and recommended that disciplinary action be taken against the staff members involved, including the Director of the Enforcement Division and the head of the SEC’s Miami Regional Office.

The Enforcement Division has publicly, and in strong terms, contested the findings of at least one of the IG’s reports. Nonetheless, the IG’s charges of lax enforcement and the appearance of favorable treatment for major participants in the financial services industry seem certain to result in an even tougher and more difficult enforcement environment in the context of the SEC’s response to the current financial crisis.

Aguirre termination. The first report, issued on September 30, stemmed from charges by a former SEC Enforcement staff attorney, Gary Aguirre, that his supervisors gave improper preferential treatment to Morgan Stanley Chairman and CEO John Mack, and terminated Aguirre’s employment, when Aguirre sought to take Mack’s testimony as a possible tipper in an insider trading investigation involving hedge fund Pequot Capital Management. See “Re-Investigation of Claims by Gary Aguirre of Improper Preferential Treatment and Retaliatory Termination,” SEC Office of Inspector General (Sept. 30, 2008), available at http://finance.senate.gov/press/Gpress/2008/prg100708.pdf. An initial IG investigation in 2005, conducted by the current IG’s predecessor, exonerated the Enforcement staff. Congress held hearings, and in August 2007, the Senate Finance and Judiciary Committees issued a report critical of the Enforcement Division’s conduct of the Pequot investigation, and faulting the IG for failing to conduct a credible investigation into Aguirre’s charges. Following the Senate report, the IG retired, and Kotz was appointed as the SEC’s new IG in December 2007.

Importantly, the Kotz re-investigation did not find that Mack received any favorable treatment regarding the taking of his testimony. The IG received testimony from numerous past and present Enforcement officials that Enforcement cases are not affected by political considerations or the prominence of particular individuals. The IG also found that there had been reasonable strategic reasons for delaying Mack’s testimony.

Notwithstanding these findings, the IG went on to conclude that Enforcement staff supervisors had “conducted themselves in a manner that raised serious questions about the impartiality and fairness of the Pequot investigation.” Further, the IG determined that “there was a connection between the decision to terminate Aguirre and his seeking to take Mack’s testimony,” and that Enforcement “allowed inappropriate reasons to factor into its decision to terminate him.” The IG went on to directly criticize Enforcement Director Linda Thomsen and recommended that the SEC Chairman take disciplinary action against her for disclosing non-public information about the evidence against Mack to counsel for Morgan Stanley’s board of directors. In response to a request for information (because Morgan Stanley’s board was considering hiring Mack as CEO), Thomsen told the board’s counsel that the investigation had uncovered “smoke,” but no “fire,” concerning Mack.

Bear Stearns Investigation. In a second report, the IG found that the Director of the SEC’s Miami Regional Office had “failed to administer his statutory obligations and responsibilities to vigorously enforce compliance with [applicable] securities laws” in connection with an investigation into Bear Stearns’ role in valuing certain collateralized bond obligations and collateralized loan obligations that a client purchased from Bear Stearns. See “Failure to Vigorously Enforce Action Against W. Holding and Bear Stearns at the Miami Regional Office,” SEC Office of Inspector General (Sept. 30, 2008). The report was prepared in response to a request from Senator Charles Grassley (R. Iowa), ranking member of the Senate Finance Committee, seeking information as to why the SEC had closed the investigation without any enforcement action.

According to the IG’s report, the head of the Miami office “abruptly” closed the investigation in 2007 after the staff had made progress negotiating several settlements. Further, the IG found that the fact that two of the defense counsel involved in the case were longtime friends of the head of the Miami office created an “appearance, to some, that they may have received favorable treatment.” While acknowledging that there was “no evidence of a direct connection between the relationship … and the decision to close the investigation,” the IG found the appearance of a conflict “disturbing,” noting that it “could potentially damage the reputation of the Commission.” (This finding of the IG seems particularly ill-considered, given that a large portion of the defense bar consists of attorneys who have previously served on the SEC staff. To suggest an apparent conflict of interest merely because defense attorneys may deal with former friends and colleagues on the SEC staff is to risk depriving clients of the best and most experienced counsel of their choice, a position that the SEC itself has never asserted.)

The IG went on to fault the Miami office staff for not coordinating its investigation with the Department of Justice, which was investigating a similar matter involving another Bear Stearns employee. The IG found that “[a] significant opportunity to coordinate with the U.S. Attorney’s Office and uncover evidence of a systematic problem at Bear Stearns was also lost through neglect.” The IG recommended that the SEC Chairman take disciplinary action against the Director of the Miami office.

In a strongly worded response, the Enforcement Division characterized the IG’s report as “misleading,” filled with “speculation and innuendo,” as ignoring testimony showing that the decision to close the investigation was a sound one, and failing to comply with the IG’s “fundamental obligation to conduct a fair and impartial fact-finding.”

Likely impact of the IG reports. Against the backdrop of existing criticisms of the SEC for regulatory failures that contributed to the current financial crisis, the IG’s reports may provide the impetus for a period of unusually difficult, contentious, and highly critical oversight of the SEC’s enforcement function. Regardless of whether the IG’s conclusions in these cases were sound, the IG’s reports are likely to fuel critics in Congress and elsewhere who seek to contend that the Enforcement Division has failed in its responsibility to pursue aggressively misconduct at large banking firms.

To cite just one such example, Sen. Grassley has commented that the IG’s report on the Bear Stearns investigation provides “yet another example of the lack of vigorous enforcement at the SEC,” and “demonstrates the culture of deference at the SEC in dealing with big players on Wall Street.” http://finance.senate.gov/press/Gpress/2008/prg101008.pdf. Similarly, on October 21, Sen. Grassley wrote to SEC Chairman Cox concerning anonymous allegations he has received that, during the negotiations earlier this year that led to JP Morgan Chase’s (“JPMC”) takeover of Bear Stearns, Enforcement Director Thomsen disclosed information concerning the status of various investigations involving Bear Stearns to JPMC’s General Counsel, Stephen Cutler, who preceded Ms. Thomsen as Director of the Enforcement Division. Sen. Grassley wrote to Chairman Cox that “Such conduct would reinforce the appearance that Enforcement decisions, and disclosures of information about them, are sometimes based not on the merits, but rather on access to senior officials by influential representatives of power brokers on Wall Street. In light of these allegations and the ongoing financial crisis, there has never been a more critical time to take swift action to restore confidence in the SEC Enforcement Division.” http://finance.senate.gov/press/Gpress/2008/prg102108.pdf.

The SEC’s Enforcement Division and the Commission thus are likely to feel pressure to demonstrate heightened aggressiveness and firmness in future investigations and enforcement actions, particularly where major participants in the financial services sector are involved. The Enforcement staff will likely seek even more rapid progress in priority investigations than in the past, and may curtail opportunities for meaningful deliberation and dialogue that have historically proven beneficial both to the staff and to the subjects of complex investigations. While the staff will undoubtedly maintain its high standards of professionalism, it would be unsurprising if there is less flexibility and less willingness to entertain sound arguments regarding factual and legal defenses in an environment where staff members may be concerned that any concessions they make may subject them to criticism or even disciplinary action if they are perceived to be insufficiently vigorous in their enforcement of the securities laws.

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By Brian A. Ochs

On October 6, the Securities and Exchange Commission (“SEC”) posted on its web site the first-ever SEC Enforcement Manual. (See http://www.sec.gov/divisions/enforce/enforcementmanual.pdf.) The publication of the manual reflects the first time that the SEC has committed to writing, in a single document, the various policies and procedures that govern investigations conducted by its Division of Enforcement. According to press accounts, the manual was prepared in response to a report issued in August 2007 by the Senate Judiciary and Finance Committees that criticized the SEC for its handling of an insider trading investigation involving hedge fund Pequot Capital Management (see separate article in this newsletter), and recommended that the SEC adopt a consistent set of procedures similar to the U.S. Attorneys Manual.

In large measure the Enforcement Manual does not break new ground, but instead describes practices that have been commonly understood for years. Notably, however, the Enforcement Manual does include the first comprehensive, written statement by the SEC on its view of the relationship between “cooperation” in an investigation and the assertion of attorney-client or attorney work product privileges. After years of controversy over this issue in the post-Enron era, during which parties often felt pressured by government investigators to waive privilege in order to receive full credit for cooperation, the Enforcement Manual makes clear that waiver is neither necessary nor expected. The manual’s key statements on this topic include:

• “As a matter of public policy, the SEC wants to encourage individuals, corporate officers, and employees to consult counsel about potential violations of the securities laws.”
  
   
• “The staff should not ask a party to waive the attorney-client or work product privileges, and is directed not to do so.” (Emphasis in original.) (This express direction is significant given that, as recently as last year, Enforcement Director Linda Thomsen acknowledged in a speech that waivers were still sometimes being requested – albeit “judiciously.”)
  
   
• “The voluntary disclosure of information need not include a waiver of privilege to be an effective form of cooperation, as long as all relevant facts are disclosed.”
  
   
• “Waiver of a privilege is not a pre-requisite to obtaining credit for cooperation. A party’s assertion of a legitimate privilege will not negatively affect their claim to credit for cooperation. The appropriate inquiry in this regard is whether, notwithstanding a legitimate claim of privilege, the party has disclosed all relevant underlying facts within its knowledge.”

With its emphasis on obtaining underlying facts, rather than on waivers of privilege, and in its direction that the SEC Staff should not seek waivers, the Enforcement Manual follows the path of the Department of Justice’s recent “Filip Memorandum,” which prohibits federal prosecutors from requesting privilege waivers (see “DOJ Issues New Guidance That Retreats From Aggressive Policies Followed in White Collar Cases,” K&L Gates White Collar Crime/Criminal Defense Alert (Sept. 24, 2008)).

Although senior Enforcement Division officials stated in the past that waiver of privilege was not required in order to obtain credit for cooperation, they had also indicated that the voluntary decision to waive privilege would receive enhanced credit, and some SEC enforcement orders reflected this approach. Among others, former SEC Commissioner Paul Atkins had been a vocal critic of the practice of holding out privilege waiver as a “plus factor” in determining credit for cooperation.

Although it remains to be seen how the Enforcement Manual is applied in practice, the manual does not suggest that any “plus factor” calculus will be used in future cases. Instead, the manual emphasizes that waiver of privileges is not necessary to “effective cooperation.”

As the SEC expands and increases the pace of its investigations into possible wrongdoing in relation to the crisis in the financial sector, these provisions of the Enforcement Manual will hopefully bring clarity and consistency to Enforcement Division practices when parties seek to cooperate while still preserving attorney-client and work product privileges. This should provide important protections to companies (in particular those that conduct internal investigations), as well as to their officers and employees, as compared with the environment of a few years ago, when waivers of privilege were often viewed as necessary to receiving full credit for cooperation.

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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: Kay A. Gordon, Mark D. Perlow 

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

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

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

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

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

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By: Brian A. Ochs

On September 19, 2008, the SEC announced a “sweeping expansion” of its ongoing investigation into possible market manipulation in connection with short selling in the securities of financial institutions. (LINK)  The investigation is focused on broker-dealers, hedge fund managers, and institutional investors with significant trading activity in financial issuers and with positions in credit default swaps.

As part of the investigation, the SEC is invoking its authority under section 21(a) of the Securities Exchange Act of 1934 to require certain information in the form of sworn, written statements.   According to published reports, the first of these demands was sent out on September 22 to more than two dozen hedge fund managers, requiring information relating to AIG, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Washington Mutual.  The SEC seldom invokes its section 21(a) power in enforcement investigations — usually opting to subpoena documents and testimony instead — and the fact that the Commission is doing so in this instance indicates the speed and seriousness with which the SEC plans to pursue these investigations.

The SEC’s expanded investigation promises heightened scrutiny of two issues which have been the subject of enforcement focus since early this year: the dissemination of false rumors to the marketplace as part of short selling schemes and abusive “naked” short selling.

• False rumors and short selling
  
  
  • Last April, the SEC brought its first case alleging that a trader engaged in market manipulation by selling a company’s stock short at the same time that he intentionally disseminated a false rumor that had a depressing effect on the stock price. See SEC v. Paul S. Berliner (April 24, 2008). (LINK)  Other investigations are in progress, as well as an industry-wide sweep examination undertaken in conjunction with FINRA and the NYSE, that is focused on whether broker-dealers and investment advisers have reasonable controls and procedures to prevent the intentional creation or dissemination of false information. (LINK)
    
     
  • Given the prevalence of rumors of all types in the investment community, and how quickly rumors can spread, a key challenge to the SEC in any investigation will be to determine who is responsible for disseminating false rumors and whether those persons acted intentionally and with knowledge that the rumors were false. 
    
     
  • At the same time, the SEC’s focus on firm procedures indicates that the SEC will be looking to bring enforcement actions not only against individuals who are responsible for creating or disseminating false rumors, but also against any broker-dealers or investment advisers in the rumor chain that the SEC determines had lax oversight. 
    
     
  • Complicating matters is the fact that, on September 18, New York Attorney General Andrew Cuomo announced his own investigation into allegations of short selling in financial securities based upon false information. NYAG involvement not only increases pressure on the SEC to bring cases in this area, but is also a direct and formidable threat to the individuals and entities under scrutiny. Unlike SEC Enforcement staff, New York’s Assistant Attorneys General have considerably fewer levels of bureaucracy to wind through before they can bring a case - as they have repeatedly demonstrated in matters involving market timers, insurance brokers, lenders, ratings agencies, and purveyors of auction-rate securities, to name a few. Contrary to popular belief, Section 352 et seq. of NY General Business Law (aka the “Martin Act”) is not without its jurisdictional limitations and defenses, but it is nonetheless a potent starting point for the NYAG. Subpoenas issued thereunder must be handled with considerable caution.
    
     
• “Naked” short selling
  
  
  • SEC Chairman Christopher Cox has observed that naked short selling can “turbocharge” false rumor/manipulation schemes. (LINK) 
    
    
    • Generally, the SEC defines naked short selling as “abusive” when the seller does not have shares available for delivery and intentionally fails to deliver stock within the standard three-day settlement cycle.
      
       
  • On September 18, 2008, the SEC adopted Rule 10b-21, which had been proposed in March 2008 to address the problem of short sellers who deceive broker-dealers or others about their intention or ability to deliver securities in time for settlement. (LINK) The rule formed part of the SEC’s response, in the current financial crisis, to concerns about possible false rumors and abusive naked short selling of financial institutions and other issuers. 
    
     
    • Rule 10b-21 prohibits any person from submitting an order to sell an equity “if such person deceives a broker or dealer, a participant of a registered clearing agency, or a purchaser about its intention or ability to deliver the security on or before the settlement date, and such person fails to deliver the security on or before the settlement date.” (LINK)
      
       
    • In adopting the rule, the SEC noted that while, in its view, naked short selling as part of a manipulative scheme was already prohibited under general antifraud provisions, Rule 10b-21 is intended to highlight the specific fraud liability of persons who deceive other participants about their intention or ability to deliver securities in time for settlement.

Of course, when short selling is facilitated by deceptive practices – such as intentionally spreading false rumors or misleading other participants about an intention to deliver stock – there is little doubt that the SEC can bring a case for securities fraud.   Another example of deceptive practices might be the use of nominee accounts or similar efforts to disguise the identity of the short seller.  But what if short selling is done in the open, with no accompanying acts of deception, albeit in large amounts and with the intent to drive a company’s stock price down? 

• The SEC takes the position that even open trading, when done for a manipulative purpose (so-called “open market manipulation”), is fraudulent.   See, e.g., SEC v. Masri, 523 F. Supp. 2d 361 (S.D.N.Y. 2007).  Thus, the Division of Trading and Markets has cautioned that “short sales effected to manipulate the price of a stock are prohibited” as an “abusive” short sale practices. (LINK)
  
   
• Courts have taken varying positions on whether “open market manipulation,” without other deceptive conduct, can give rise to a cause of action.   However, in a recent opinion dealing with aggressive short selling by purchasers of “toxic convertible” securities, the U.S. Court of Appeals for the Second Circuit held that “short selling – even in high volumes – is not, by itself manipulative.  … To be actionable as a manipulative act, short selling must be willfully combined with something more to create a false impression of how market participants value a security.”  ATSI Communications, Inc. v. Wolfson, 493 F.3d 87 (2d Cir. 2007).

Given the Second Circuit precedent, in any future cases directed at aggressive short selling, the SEC will likely seek to allege other deceptive conduct in addition to short sales.   However, in light of the SEC’s need to demonstrate a strong response to the current crisis, the Commission can also be expected to press its theory that short selling, even if unaccompanied by any other deceptive practices, is unlawful if done for the purpose of depressing a company’s stock.

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By: Gordon F. Peery

When Fannie Mae and Freddie Mac were placed into conservatorship on September 7, 2008, several leading dealers uncontroversially agreed that a bankruptcy credit event had occurred on credit derivative transactions referencing either of those institutions.  The occurrence of a credit event gave protection buyers the right to settle the transaction in exchange for a payment to compensate it for the loss of market value of specified deliverable obligations of the reference entity.  As it has done in the case of previous credit events on widely traded reference entities, the International Swaps and Derivatives Association (“ISDA”) has introduced an auction protocol to facilitate settlement of transactions by providing for cash settlement as an alternative to physical settlement.

A controversy arose over whether the principal-only component of debt securities issued by Fannie Mae and Freddie Mac (“PO Strips”) should be included in the list of deliverable obligations that could be valued for purposes of settlement.   This was an important issue for transaction counterparties because the buyer of protection on a credit default swap has no obligation to mitigate loss and is entitled to select the qualifying obligations that are “cheapest to deliver,” i.e., that have fallen most in value.  Unusually for a reference entity’s obligations following a credit event, most Fannie Mae and Freddie Mac debt obligations traded at or above par after the credit event occurred when it became clear that the United States would guarantee all debt securities of Fannie Mae and Freddie Mac on an equal basis.

Protection buyers would have benefited from the inclusion of PO Strips in the list of deliverable obligations because those obligations continued to trade below par following the credit event, reflecting that the market value of stripped securities depends not only on the issuer’s perceived creditworthiness but also on broader market factors such as interest rates and inflation.   On cash settlement of a credit derivative transaction, a protection buyer would have been entitled to receive a payment equal to the difference between the notional amount of the transaction and the market value of the PO Strip selected for valuation.  ISDA’s board of directors concluded that Fannie Mae and Freddie Mac PO Strips cannot be delivered in settlement of credit derivative transactions because they do not technically constitute “borrowed money” as defined in the 2003 Credit Derivatives Definitions.  This conclusion is based in part on the fact that as a stripped security a PO Strip represents only part of a repayment obligation, and is also based on the conclusion that a PO Strip is not issued as a “bond” or “note” by the relevant issuer but is rather a product of the book-entry rules for obligations of each GSE in book-entry form on the Federal Reserve Banks’ book-entry system because the stripping of debt securities into interest and principal components occurs after their “issuance.”

Insurance Regulatory Developments Affecting Credit Derivatives
On September 22, 2008, the New York State Department of Insurance issued Circular Letter No. 19, which sets forth best practices for financial guarantee insurers.  Circular Letter No. 19 announced new guidelines that, for the first time, will establish that some credit default swaps that have previously not been subject to state regulation as insurance products will be deemed to constitute “the doing of an insurance business” within the meaning of Section 1101 of the New York Insurance Law.  The new guidelines, which will be effective January 1, 2009, establish that a credit default swap will be considered an insurance contract when the buyer owns or is reasonably expected to own the reference obligation.  In essence, a party who owns the reference obligation for a credit default swap will be presumed to have entered into the transaction in order to obtain indemnification for loss on that obligation.  Under the new guidance, credit default swaps would be subject to regulation and will be issuable only by entities licensed to conduct insurance business.  The guidance does not extend to so-called “naked swaps,” which are not insurance and cannot be regulated by state insurance authorities.

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By: Edward Smith

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

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

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

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

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

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

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By: David N. Jonson

In mid-September, the North American Securities Administrators Association (“NASAA”) held its 91st Annual Conference in Las Vegas. Securities regulators, industry experts and political commentators appeared on several panels before almost 400 attendees and discussed topics ranging from risk/reward analysis to how the next administration will regulate the financial services industry to the future of global financial services. 

The general consensus of these panelists was that the financial services industry and federal regulators had failed on a number of levels, and for a number of reasons, to understand and manage the increasing amounts of risk being taken by market participants who had been driven to excesses by unduly focusing on short-term profits and compensation rather than long-term value creation. Panelists repeatedly blamed federal financial and securities regulators for failing to exercise their authority over the financial services industry. 

State securities regulators, however, largely escaped the panelists’ criticism because they had quickly coordinated their enforcement efforts and reached settlements in matters of national import, such as Auction Rate Securities, which traditionally would have been spearheaded by federal regulators such as the SEC.  By demonstrating their value and proactivity at the very same time that federal regulators have been considered to be lacking, the states have all but ensured themselves a place at the table as a new financial regulatory scheme is crafted in the coming months.  Flush with their recent successes, state securities regulators can be expected to be more assertive in 2009 and beyond in matters of national importance, such as annuities, brokered CDs, reverse mortgage schemes and virtually any investment promotion affecting America’s increasing population of senior citizens.  As NASAA’s president Fred Joseph said in his inaugural speech, invoking The Blues Brothers, “We can’t be stopped.  We’re on a mission.”

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By: Michael J. King

In testimony before the House Financial Services Committee (“Committee”) on September 18, 2008, Linda Thomsen, Director of the SEC’s Enforcement Division, and Susan Merrill, FINRA Executive Vice-President and Chief of Enforcement, said that they were investigating individuals in connection with the sale of auction rate securities (“ARS”) and that they would bring enforcement actions against individuals if their ongoing investigations revealed misconduct.  Their prepared remarks may be found here and here.  Their complete testimony may be viewed here.  Committee Chairman Barney Frank convened the hearing in order to examine the continuing crisis in the market for ARS and to explore potential resolutions.

In August, the SEC announced preliminary settlements in principle with four broker-dealers (Citigroup, UBS, Wachovia, and Merrill Lynch) that will make available more than $40 billion in liquidity to purchasers of ARS.  Specific charges were not announced, but they will relate to alleged misrepresentations concerning safety and liquidity in the sale of ARS.  During the September 18 testimony, Ms. Merrill announced that FINRA had also entered into agreements in principle with five broker-dealers to settle charges related to the sale of ARS, pursuant to which the firms would offer to repurchase up to $1.8 billion of ARS from individual investors and some institutions.  FINRA charged the firms with supervisory violations and with using advertising and marketing materials that did not provide a sound basis for evaluating the purchase of ARS.  FINRA’s Press Release describing the agreements in principle in more detail can be read here.  Both the SEC and FINRA are continuing to investigate conduct at the settling firms and at other firms as well.  According to FINRA’s Press Release, 50 additional investigations have been opened and more are expected.

None of the SEC or FINRA actions announced to date have named any individuals. However, in response to Committee member questions about individual misconduct and accountability, Ms. Merrill stated that FINRA was investigating individual brokers and implied that they could be suspended or barred from the industry if FINRA found that they engaged in misrepresentations or suitability violations in connection with the sale of ARS.  In response to separate questions, Ms. Thomsen also said that the SEC’s investigations were ongoing and to the extent that individuals were involved in “bad behavior,” the SEC will pursue actions against them to the extent that they can “establish cases.”

Given the testimony of Ms. Thomsen and Ms. Merrill, and FINRA’s announcement that more investigations will be opened, even firms that are not currently the subject of regulatory inquiries should closely examine the conduct of individuals if the firm has sold a significant amount of ARS.  Although, so far, FINRA has only charged violations of advertising and supervision rules, sales practice violations can provide a separate basis for liability for the firm, and, of course, the individual salesperson.  Since the potential sanctions identified by Ms. Merrill are severe, firms will certainly want to know if they have salespersons who could face such sanctions.

Any firm that discovers clear misconduct in connection with ARS sales should consider disciplining the employee and making the customer whole, regardless of whether they are currently subject to regulatory scrutiny.   If there is a regulatory investigation, individuals may need separate counsel and the firm should review its indemnification and professional liability policies.  Firms should also review their compliance and supervisory procedures with regard to sales practices and make enhancements when appropriate.  Firms that have closely examined their employees’ activities, taken corrective and remedial action when necessary, and upgraded their compliance and supervisory procedures will be in a better position to deal with regulators whether they are currently involved in a regulatory investigation or become subject to one. 

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By: Philip J. Morgan

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

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

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

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

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

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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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