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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The U.S. Department of Treasury (“Treasury”) continues to implement the Emergency Economic Stabilization Act of 2008 (“EESA,” H.R. 1424, P.L. 110-343, click GPO’s PDF Display for EESA text). Among other things, EESA authorized the Secretary of the Treasury to establish a Troubled Asset Relief Program (“TARP”) to purchase troubled assets from financial institutions. Under this authority, Treasury continues to develop the Capital Purchase Program (“CPP”) to make equity investments in banking institutions. However, Treasury has recently indicated that it no longer intends to purchase troubled assets as described below.

On October 31, Treasury released additional CPP documents for publicly traded financial institution applicants, including a Securities Purchase Agreement, Form of Letter Agreement, Certificate of Designations, Form of Warrant, Term Sheet, and SEC/FASB Letter on Warrant Accounting. The documents contain terms and conditions and make representations and warranties, to which a CPP applicant must agree. As noted in the previous issue, applications must be submitted by 5 p.m. (EST), November 14, 2008.

In the same notice, Treasury stated it will be posting a CPP application form and term sheet for private and mutual banks in the future. In his testimony before the Senate Committee on Banking on October 23, Interim Assistant Secretary for Financial Stability Neel Kashkari noted that Treasury is also developing a mortgage-backed securities program, whole loan purchase program, and insurance program for troubled assets. On November 10, following a speech in New York City, Mr. Kashkari indicated that U.S. Treasury Secretary Henry M. Paulson, Jr., will determine whether and when to roll out these additional programs.

On November 10, the government announced changes to the AIG bailout totaling $152.5 billion. Using its EESA authority, Treasury will purchase $40 billion in senior preferred stock from AIG. The Federal Reserve will provide AIG with a $60 billion bridge loan, purchase $22.5 billion of its mortgage-backed securities and supply $30 billion to backstop the insurer’s credit default swap agreements. Mr. Kashkari indicated that the AIG deal was a “one-off” arrangement rather than a broadening of the CPP beyond banking institutions.

Treasury has also started to build its CPP implementation group. The Department has named James H. Lambright, former head of the Export-Import Bank, to serve as the interim Chief Investment Officer. Treasury has also posted a solicitation for financial agents to provide asset management services for CPP. Application guidelines are available at http://www.treas.gov/press/releases/hp1260.htm; the deadline for submission was 5 p.m. (EST), November 13, 2008.

Of the $700 billion in funds authorized by EESA, Treasury has thus far committed $250 billion to banks. The President must certify the use of an additional $100 billion and, for use of the remaining $350 billion, submit a notice to Congress, which has the ability to disapprove. On November 4, 2008, the Treasury submitted its “First Tranche Report” to Congress on the implementation of the EESA. The report noted that “it is premature to assess the impact of the CPP.” Preliminarily, Treasury is “encouraged by recent signs of improvement in the markets and in the confidence in our financial institutions,” but Treasury also reported that restoring liquidity to the long-term credit markets remains a challenge.

On November 12, Secretary Paulson provided an update on the implementation of EESA and indicated that the Department has changed its strategy. Secretary Paulson stated that the Department has abandoned efforts to purchase bad assets under TARP, because the indirect purchase would delay bank recapitalization. Instead, CPP equity purchases would continue to be the central feature of Treasury’s bailout efforts. Secretary Paulson noted that the Department also will pursue two additional strategies: strengthening the asset-backed securitization market in order to support consumer finance and expanding foreclosure mitigation.  (Treasury Secretary Outlines Revised TARP Strategy.)

Strategic shifts in the efforts to ameliorate the credit crisis will presumably continue with the incoming administration. Moreover, with the continued instability of the financial markets, we believe that we are in the beginning stages of what will ultimately prove to be a massive shift of leverage from private balance sheets to the public debt as new programs are implemented.

The K&L Gates Public Policy & Law group consists of senior, bipartisan policy professionals who are closely monitoring these developments in order to provide insights to and effective advocacy on behalf of firm clients. http://www.klgates.com/newsstand/Detail.aspx?publication=5052

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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By: Laurence E. Platt

Press reports claim that the Federal Deposit Insurance Corporation and the U.S. Department of Treasury (“Treasury”) are close to announcing a plan pursuant to which the federal government will guarantee the timely repayment of principal and interest on modified eligible residential mortgage loans held by private parties pursuant to the Emergency Economic Stabilization Act of 2008 (“EESA”).  Such a plan might conflict with legal and accounting rules for mortgage-backed securities, raises questions about its relationship to other recent federal initiatives, requires Treasury to develop an actuarially sound, self-funded mortgage insurance program, and calls for loan holders to make principal write-downs they might not be willing to make.  Because of these issues, we are not convinced that the proposal will morph into a real program. As events unfold, we want to take the opportunity to highlight certain issues for which you should watch if a home loan guarantee program actually is promulgated by Treasury. These issues are addressed in the article, “EESA: No Guarantees of Federal Loan Guarantees.” They include the following:

1. What residential mortgage loans will be eligible for loan guarantees?
   
    
2. What is the difference between an FHA-insured, refinancing mortgage loan under the HOPE for Homeowners Program (“HOPE Program”), which Congress created earlier this year as part of the Housing and Economic Recovery Act of 2008, and a Treasury-guaranteed modified loan?
   
    
3. Will loan holders permanently write down the existing indebtedness by the amount necessary to qualify for a loan guarantee?
   
    
4. Given the write-downs that it will take to qualify an existing loan for a HOPE Program refinancing or a federal loan guarantee, why not just sell the loans to Treasury under the recently enacted Troubled Asset Relief Program (“TARP”)?
   
    
5. Does a federal loan guarantee provide a comparative advantage to loan holders over the HOPE Program or TARP?
   
    
6. How will Treasury ensure that the insurance premiums are sufficient to meet the statutory standard of actuarial soundness?

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By Daniel F. C. Crowley

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

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

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

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

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

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

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

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

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

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

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

Turmoil in the Financial Markets
House Oversight and Government Reform Committee

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

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

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

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By Anthony R.G. Nolan and Drew A. Malakoff

On October 10, 2008, the FDIC adopted an interim rule (the “Interim Rule”) that increases the standard maximum deposit insurance amount from $100,000 to $250,000, in accordance with the Emergency Economic Stabilization Act of 2008. Of particular interest to securitization investors and servicers, the Interim Rule also simplifies the deposit insurance rules as they apply to mortgage servicing accounts. By doing so, it increases certainty for investors while enhancing liquidity for servicers of mortgage assets.

Prior to the enactment of the Interim Rule, funds on deposit in mortgage servicing accounts that represented principal and interest received on the underlying loans were insurable on a pass-through basis to each investor or security holder of a securitization or fund. The theory behind this approach was that payments of principal and interest on securitized mortgages were beneficially owned by the investors in the related mortgage-backed securities. As a practical matter, however, the FDIC’s prior approach to mortgage servicing accounts created some ambiguity as to the ability of individual investors to make a claim against the FDIC for amounts in a servicing account held by a depository institution that became subject to a receivership or conservatorship, particularly as securitizations became more complicated and incorporated different tranches of bonds with varying degrees of seniority or with specific rights to sub-pools of assets.

Under the FDIC’s prior approach, in order to determine what portion of each investor’s interest in the principal and interest payments deposited into a mortgage servicing account was covered by FDIC insurance, it was necessary to determine not only which investors had not exceeded their respective deposit insurance limits, but also which investors should have been allocated the next dollar of principal or interest based on the complex paydown rules contained in the transaction documents. This complex calculus, based on a deal’s distribution waterfall and the percentage of the relevant security each investor held, made it increasingly difficult to determine which of the many investors in a securitization vehicle had the rights to each dollar of principal or interest. Moreover, given the size of many of these transactions, it was also very likely that individual investors would far exceed the applicable insurance limit.

These considerations resulted in uncertainty among securitization investors as to the extent to which their allocated portions of loan payments would be covered by deposit insurance. Consequently, investors and rating agencies require that servicers remit funds from servicing accounts to a trustee account on a daily basis (or in some cases transfer the servicing account to another institution) whenever the servicers’ creditworthiness (as measured by credit ratings) decline below certain levels. This imposed a cost to depository institutions in the form of reduced liquidity, which has become a significant threat to the stability of financial markets in the recent challenging market conditions.

The Interim Rule reconciles the needs of mortgage-backed security investors for security with the needs of depository institutions for liquidity by changing the basis for insuring accounts in mortgage servicing accounts and, in many cases, increasing the amount actually covered in each such account. Because the Interim Rule makes it easier to determine what portion of payments beneficially owned by securitization investors are covered by FDIC deposit insurance, investors and rating agencies will be more likely to permit depository institutions that maintain mortgage servicing accounts to commingle amounts received on mortgage loans for longer periods, thus enhancing their liquidity. For this reason, the Interim Rule is a welcome development for depository institutions and investors participating in the mortgage securitization market. However, the Interim Rule as currently drafted — to cover only mortgage servicing accounts — does not go far enough in that it does not address these concerns as they arise in the securitization of non-mortgage related assets.

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By Laurence E. Platt

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

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

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

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

The Act

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

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

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

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

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

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

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

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

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

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By: Arthur C. Delibert 

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

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

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

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

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

There have also been extraordinary actions from the regulators:

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

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

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

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

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By: 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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