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

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

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

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

To view the report, click here.

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By: Sean P. Mahoney

As 2010 begins, the FDIC has indicated that private equity investors will face increased challenges in making investments in failed institutions, as certain approaches to making such investments without becoming subject to onerous FDIC requirements will not be approved.

In August 2009, the FDIC issued its “Statement of Policy on Qualifications for Failed Bank Acquisitions” (the “Policy Statement,” issued August 26, 2009 and available here), which generally subjects private investors in failed institutions to, among other things, increased capital requirements at the bank level, limits on transactions with their affiliates, prohibitions on silo ownership structures, and mandatory holding periods. The Policy Statement contained exceptions to its applicability, and many investors have been structuring their transactions to take advantage of these exceptions.
 

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By Sean P. Mahoney and  Anthony R. G. Nolan

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

To view the complete alert online, click here.

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

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

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

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

On 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 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: Sean P. Mahoney

After a few high-profile investments in banking organizations by private equity firms, the FDIC appears to be rethinking its policies on new entrants into the banking industry. This trend is evidenced by two recent FDIC pronouncements indicating the regulator’s increased scrutiny of certain private equity acquisitions and more strict limitations on the business activities of certain newly created banks.

The FDIC’s Final Statement of Policy on Qualifications for Failed Bank Acquisitions (the “Policy Statement”) (issued August 26, 2009 and available here), relates only to acquisitions of failed banks by private equity firms, including acquisitions made through the use of a new charter from any regulator. Although the Policy Statement generally does not extend to transactions outside the context of FDIC conservatorship or receivership, it may also extend to so-called “inflatable charters” or small banks acquired to facilitate the acquisition of failed institutions. Nevertheless, it contains a number of burdensome provisions that apply only to the acquisition of failed banks by private equity firms, but not to other acquirers. These provisions include:

• a requirement to maintain the bank’s Tier 1 common equity ratio at 10% or more for three years following the acquisition;
• prohibitions on the acquired bank extending loans to any of its private equity investors or any entity in which any such investor owns 10% of the equity;
• a prohibition on silo ownership structures (e.g., structures with parallel ownership between the bank and a private equity fund); and
• a requirement that the private equity investor commit to hold its investment in the bank for three years or more.

At the same time, the Policy Statement may create artificial barriers to entry and competitive imbalances among private equity firms, as the FDIC reserved authority to exempt from the Policy Statement investors that have held investments in banks that retain one of the two highest examination ratings for a period of seven or more years. In other words, certain experienced bank investors may not be subject to the more stringent standards contained in the Policy Statement.

The FDIC also recently issued “Enhanced Supervisory Procedures for Newly Insured FDIC-Supervised Depository Institutions,” FIL-50-2009 (the “Enhanced Supervisory Procedures”) (issued August 28, 2009 and available here). The Enhanced Supervisory Procedures impose increased regulation upon investors who enter the banking industry for the first time by forming new state-chartered banks. The Enhanced Supervisory Procedures apply only to de novo FDIC-insured state banks, and not to de novo national banks or federal savings banks. 

While all de novo banks are required to conduct their first three years of operations within the bounds of a business plan submitted to regulators as part of the chartering process (during which time they are subject to more frequent examinations), the Enhanced Supervisory Procedures expand that period to seven years for newly formed state banks that have the FDIC as a primary regulator.

Although the Policy Statement and Enhanced Supervisory Procedures do create new barriers, they also provide a regulator-sanctioned framework for private equity firms to bid on failed institutions. It remains to be seen whether such barriers are significant enough to deter private equity investors.

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

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

To view the complete alert online, click here.

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

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

To view the complete alert online, click here.

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By: Stanley V. Ragalevsky, Sean P. Mahoney

On May 20, 2009, the Office of Thrift Supervision (“OTS”) and the Federal Deposit Insurance Corporation (“FDIC”) approved the acquisition of a failed thrift institution, BankUnited, FSB, by a group of private equity investors. The FDIC, as receiver of the failed institution, accepted the private equity investors’ bid as the least cost resolution of the failure. In approving the transaction, the OTS permitted the transaction to be structured in a way that allowed the constituent members of the investor group to remain free of the regulatory restrictions that apply to those who control thrift institutions. The transaction thus offers important precedent as to how purchases of failed institutions may be accomplished by private equity firms. It also highlights significant uncertainty regarding private equity investments in commercial banks.

Historically, investors in depository institutions and their holding companies have sought to avoid investments that would be considered “controlling” under the federal banking laws. Control of a depository institution, either directly or indirectly, can lead to limitations on the activities of the controlling company, requirements to support financially the subsidiary depository institution, and also subject transactions between the depository institution and the affiliates of the controlling investor to certain restrictions. Moreover, investors deemed to have “control” of a depository institution generally must register as a bank, financial, or thrift holding company, with ongoing regulation and reporting requirements. These restrictions have discouraged investment in banks and holding companies at a time when these organizations desperately need to attract additional capital. (See also K&L Gates client alert, Non-Controlling Investments in Banking Institutions and Their Holding Companies).

In the BankUnited transaction, the investor group formed two holding companies (a top-tier and an intermediate-level entity) to acquire the bank’s shares, and the holding companies applied for regulatory approval as savings and loan holding companies, which was required to permit them to acquire control of the bank. At the same time, each of the constituent investors – none of whom had beneficial ownership of more than 25 percent of the voting securities of either the holding companies or the bank – disclaimed control of the bank by filing a Rebuttal of Control Agreement, along with a rebuttal of the presumption of control, with the OTS. Significantly, the OTS accepted the investors’ position that the investor group members were not acting in concert. By effectively determining that the act of forming an investment vehicle to acquire control of a bank was not concerted action, OTS appears to have eased the way for private equity club deals to acquire federal savings banks and state-chartered savings banks that elect to be regulated by the OTS.

In its press release announcing the resolution of the BankUnited matter, the FDIC indicated that it would publish guidance on eligibility for non-bank firms to bid on failed banks and the terms and conditions for such investments. Such guidance should prove valuable to private equity firms wishing to bid on failing banks.

Unfortunately, the structure approved in the BankUnited deal, while approved for a savings and loan holding company, may not translate to the commercial bank sector. Commercial bank holding companies are regulated by the Board of Governors of the Federal Reserve System (the “Federal Reserve”), which specifically declined to adopt guidance on simultaneous minority investments in depository institutions (i.e., “club” deals) in its September 22, 2008 guidance on non-controlling investments in banks. Thus, it remains unclear whether the Federal Reserve would accept, as OTS has, that investment firms could disclaim control when forming a common investment vehicle. This leaves significant uncertainty in the regulatory framework applicable to private equity investments in commercial banks. Also uncertain is the status of the so-called “silo” structure whereby individual investors in a private equity fund can invest in a bank thereby avoiding the private equity fund from taking control of the target bank. The Federal Reserve appears to disfavor the silo structure, and the Bank United order does not provide any guidance to how the OTS and FDIC view it.

Unless and until the Federal Reserve issues guidance on this issue or rules on a transaction similar to the BankUnited deal, it will remain unclear the extent to which groups of private equity firms will be able to take over and recapitalize failing commercial banks.

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By: Laurence E. Platt, Kerri M. Smith

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

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

To view our complete alert online, click here.

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By: Stanley V. Ragalevsky, Sean P. Mahoney

Federal Deposit Insurance Corporation (“FDIC”)-insured depository institutions, bank holding companies, financial holding companies and certain thrift holding companies have until December 5, 2008 to decide whether to participate in the FDIC’s Temporary Liquidity Guarantee Program (“TLGP”).   FDIC established the TLGP as of October 14, 2008 after determining that rapid and substantial outflows of uninsured deposits from banks threatened the stability of our financial system.  The purpose of the TLGP is to preserve public confidence and encourage liquidity in the banking system.  Participation by FDIC-insured institutions is voluntary. 

The TLGP has two components:   an FDIC guaranty of certain senior unsecured debt ("Debt Guarantee Program") and unlimited FDIC deposit insurance coverage for non-interest bearing transaction accounts through 2009 ("Transaction Account Guarantee Program").  Under the Debt Guarantee Program, covered debt in an amount up to 125 percent of the senior unsecured debt of a participating institution outstanding on September 30, 2008 that matures no later than June 30, 2009 will be guaranteed by FDIC, for an annual fee of seventy-five basis points of the covered amount.  Covered senior unsecured debt includes commercial paper and unsecured borrowings from Federal Reserve Banks but excludes derivatives, deposits in foreign currency, and convertible debt.  If investors in an institution's unsecured debt do not insist upon the FDIC guaranty, the cost of the Debt Guarantee Program may not be a worthwhile expense. 

The Transaction Account Guarantee Program supplements existing FDIC insurance with temporary, unlimited deposit insurance coverage on non-interest bearing transaction accounts such as demand deposit accounts, payroll and other processing accounts, certain custodial accounts for loan servicing or similar activities and non-interest bearing savings accounts into which funds from transaction accounts are swept.   Institutions that participate in the Transaction Account Guarantee Program will be assessed an annual premium in an amount equal to 0.10 percent of covered transaction account balances in excess of standard FDIC coverages. 

Although it is theoretically voluntary, participation in the Transaction Account Guarantee Program may effectively be mandatory for most banks that depend upon commercial demand deposit accounts for funding.   The market may simply demand this coverage.  This may not be the case for institutions with specialized balance sheets or business models. 

Institutions have until 11:59 p.m. (EST) on December 5, 2008 to opt out of participation in the Debt Guarantee Program or Transaction Account Guarantee Program.   For institutions that do not opt out, the TLGP is scheduled to expire on December 31, 2009, although senior unsecured debt guaranteed under the TLGP will remain guaranteed until the later of maturity or June 30, 2012.  Each institution will be required to disclose whether or not it is participating in the Transaction Account Guarantee Program.  If an institution participates in the Debt Guarantee Program, it will have to disclose to investors in a commercially reasonable manner whether or not the debt instrument being offered is guaranteed under the TLGP.

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By: Rebecca H. Laird, Edward G. Eisert

On September 22, 2008, in simultaneous actions, the Federal Reserve Board (“FRB”) announced that it had approved the joint application of The Goldman Sachs Group, Inc. and Goldman Sachs Bank USA Holdings LLC (collectively, “Goldman Sachs”), and the joint application of Morgan Stanley, Morgan Stanley Capital Management LLC and Morgan Stanley Domestic Holdings, Inc. (collectively, “Morgan Stanley”), to become bank holding companies.   Each company already owned an institution insured by the Federal Deposit Insurance Corporation (“FDIC”) (a Utah industrial loan company), which was converted into a commercial bank with full deposit taking and lending powers.   Though initially bank holding companies, Goldman Sachs and Morgan Stanley have each stated their intention to become a “financial holding company,” i.e., a company that is permitted under the Bank Holding Company Act of 1956 to engage in activities that are “financial in nature,” including securities underwriting, merchant banking, and insurance underwriting and sales (“FHC”). 

Set forth below are answers to a number of frequently asked questions about the regulatory implications of an investment banking firm, such as Goldman Sachs or Morgan Stanley, becoming an FHC:

1. What are the minimum capital and liquidity requirements for a company to become an FHC?  The FHC’s bank must be “well-capitalized” on a consolidated basis, which means that the bank must maintain a “total risk-based capital ratio” of 10.0 percent or greater and the bank must maintain a “Tier 1 risk-based capital ratio” of 6.0 percent or greater.  The “total risk-based capital ratio” is the ratio of total capital to assets, which are calculated on a risk-weighted basis.  The “Tier 1 risk-based capital ratio” is the ratio of Tier 1 capital – basically common and perpetual preferred stock and surplus minus goodwill and intangibles – to total assets, which are calculated on a risk-weighted basis.  In addition, the bank’s leverage ratio, which is the ratio of capital to total assets (which are not calculated on a risk-weighted basis), cannot be less than 3.0 percent.  The FRB has stated that at least 100 to 200 basis points above the 3.0 percent leverage ratio is required of all but the very strongest banking organizations.  There are no express liquidity requirements in the regulations.
   
    
2. How would an investment banking firm have to restructure its business if it were to become an FHC?  An FHC is permitted to engage in activities that are “financial in nature,” including securities activities, insurance activities, and other financial services activities, such as merchant banking and private equity investing, and may do so in addition to owning banks under a single corporate umbrella.  To the extent an activity of an investment banking firm is not “financial in nature” and is not in compliance with applicable regulations, the firm would have two years in which to divest the activity, which the FRB may extend for three one-year periods.
   
    
3. What discretionary powers does the FRB have over an FHC?  The FRB is vested with broad supervisory powers and enforcement tools with which to oversee FHCs.  The FRB has the power to conduct examinations, not just at the bank level, but at the holding company and affiliate level.  The FRB conducts examinations on a regular basis at each supervised institution and maintains offices at, and continuously monitors the activities of, the largest holding companies.  In addition to its general rulemaking authority, the FRB also imposes reporting requirements, restricts activities, imposes operational and managerial standards, and may bring enforcement actions to maintain the “safety and soundness” of the companies it regulates.  The FRB also has the authority to require undercapitalized FHCs to take “prompt corrective action” to raise additional capital or find a merger partner.
   
   The jurisdiction of the FRB does not supplant the jurisdiction of other federal banking regulators (such as the FDIC) over the banks owned by the FHC, or state banking regulators over such banks organized under state law.  Perhaps most importantly from the investment banking perspective, the SEC remains the primary federal regulator of any registered broker-dealer and investment adviser controlled by the FHC, and the Commodity Futures Trading Commission remains the primary federal regulator of any registered commodity trading advisor, commodity pool operator and futures commission merchant controlled by the FHC.  However, the FRB retains ultimate supervisory authority.
   
   This multifaceted regulatory regime has far-reaching and significant consequences for new FHCs, including the regulatory compliance programs that are required and the manner in which regulatory examinations and deficiencies are addressed.   For example, historically, the FRB and other bank regulators have been viewed as “prudential” regulators that apply a more “principles based,” collaborative approach to supervision, which is often handled behind closed doors on a confidential basis, as opposed to federal and state securities regulators that are generally viewed as more public-action, enforcement-based regulators. 
   
    
4. What are the rules on capital for separate subsidiaries of FHCs and how does the FRB regulate transfers of funds from subsidiaries?  In general, the FRB wants the FHC to be a source of strength to the bank; it does not want the bank to be used to support the FHC.  Consequently, the FRB will generally not allow funds to flow from the bank to the FHC to support its debt, pay dividends or fund general operations, unless there is clearly no detriment to the bank in doing so.

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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 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 David T. Case

The evolving efforts of the U.S. Government to address the turmoil in the financial markets echo in many respects Government actions to address the “crisis” in the savings and loan industry in the 1980s. As a consequence, the litigation against the Government resulting from the regulatory reform of the savings and loan industry provides a useful template in the event that the current reforms cause the Government to breach promises of specific regulatory treatment. In particular, under the previous litigation, the Government has been held liable for breach of contract, and substantial damages have been awarded, including damages for lost profits.

Looking back to the 1980s, regulators were faced with the possibility of widespread failure by savings and loans, along with a corresponding threat to the deposit insurance funds and potentially enormous liquidation costs. Many early efforts to solve the savings and loan crisis resulted in contracts between savings and loans and the Government in which the Government promised specific treatment under pertinent regulations. The Federal Savings and Loan Insurance Corporation (“FSLIC”) entered into varying forms of such agreements, either as a means of directly avoiding seizure of failing institutions, or indirectly avoiding such seizures by encouraging healthy thrifts to acquire failing institutions.

Subsequent efforts to resolve the savings and loan crisis culminated in the passage and implementation of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), and in implementing the provisions of that law, the Government breached many of its earlier promises. These breaches caused a wave of claims against the Government, and one critical lesson from the tumult is that contracts with the Government for specific regulatory treatment are enforceable, and the Government will be liable for damages caused by its breach of contract. The U.S. Supreme Court has held that, where the Government entered into contracts with regulated financial institutions, promising to provide financial institutions with “particular regulatory treatment in exchange for their assumption of liabilities that threatened to produce claims against the Government as insurer,” the risk of regulatory change fell to the Government, even though “Congress subsequently changed the relevant law, and thereby barred the Government from specifically honoring its agreements.” United States v. Winstar, 518 U.S. 839, 843 (1996).

The application of these principles was recently affirmed in a case presenting a scenario remarkably reminiscent of current Government attempts to address the turmoil in the financial markets: First Federal Savings and Loan Association of Rochester v. United States, 76 Fed. Cl. 106 (2007), aff’d 2008 U.S. App. Lexis 17331 (Aug. 13, 2008). Four failing savings and loans were merged into First Federal, and the Government provided financial assistance to the institution, replaced senior management, selected members of the Board of Directors, and exercised substantial control over First Federal’s operations.

First Federal later claimed that the Government had breached its contract with First Federal by failing to honor its agreement to allow First Federal to operate at reduced capital levels. The contract had been agreed to between First Federal and FSLIC as part of a reorganization of First Federal, and the agreement was intended to permit the Association to return to financial health as an alternative to seizure, following a lengthy period of insolvency, and to save FSLIC the costs of liquidating the Association. Following this 1986 agreement, First Federal’s business prospered until 1989, when Congress passed FIRREA, nullifying all contracts between the FSLIC and thrift institutions to the extent that those contracts relaxed regulatory capital requirements for specific thrift institutions.

Finding liability against the Government, the court awarded First Federal $85 million in damages, primarily for lost profits, plus attorney’s fees and costs. The award was recently affirmed by the United States Court of Appeals for the Federal Circuit. First Federal, 2008 U.S. App. Lexis 17331 (Aug. 13, 2008).

First Federal provides a roadmap for claims that arise as a result of the Government’s breach of contract, and if a financial institution believes it has such a claim against the Government, counsel should be consulted to evaluate appropriate steps to preserve and perfect the claim.

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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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