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

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

To view the complete alert online, click here.

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

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

To view the complete alert online, click here.

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

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

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

To view the complete alert online, click here.

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

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

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

To view the complete alert online, click here.

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

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

To view the complete alert online, click here.

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

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

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

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

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By: Lawrence B. Patent

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

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

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

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

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

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

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

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

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

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

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

To view the complete alert online, click here.

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By: Lawrence B. Patent

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

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

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

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

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

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

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By: 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 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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