Capital Markets

Week in Review: The Administration on Wall Street

The Obama Administration has continued its aggressive prosecution of suspect players in the financial meltdown that shaped most of the President’s first term.

Four mortgage insurers, including an AIG subsidiary, have agreed to a $15 million settlement over allegations of improper ‘kickbacks’ paid to lenders for more than a decade.  The Consumer Financial Protection Bureau made the announcement today.  Its director, Richard Cordray, charged, “We believe these mortgage insurance companies funneled millions of dollars to mortgage lenders for well over a decade.”  For more, see the NYTimesand WSJ.

Also today, the U.S. Department of Justice filed a fraud suit against Golden First Mortgage Corp, alleging the company and its CEO “repeatedly lied” to the government.  The complaint claims that Golden First rushed paperwork through internally, although the company certified (to HUD and the FHA) that proper due diligence had been conducted.  According to the government, Golden First used three employees to process 100-200 loans per month—predictably leading to “extraordinarily high” default rates as high as 60% in 2007.  For more, see Thomson Reuters.

On a related note, district court Judge Victor Marrero (S.D.N.Y.) indicated that he may not accept a “neither admit nor deny” provision in SAC Capital Advisor’s insider trading settlement.  At a hearing last week, he made a point unlikely to encounter much resistance:  “There is something counterintuitive and incongruous in a party agreeing to settle a case for $600 million that might cost $1 million to defend and litigate if it truly did nothing wrong.”  Judge Marrero is not the first to question these clauses – commonly demanded by corporate litigants – but his remarks demonstrate a growing judicial skepticism with the practice.  For more, see BusinessweekReuters, and The New Yorker.

The Week in Review: Major Suits and Proposed Legislation

The director of the U.S. Consumer Financial Protection Bureau may be facing a challenge the constitutionality of his “recess appointment,” following a January 25 ruling by the D.C. Circuit Court of Appeals.  In that case, the court held three of President Obama’s appointments to the NLRB were unconstitutional.  The party challenging director Richard Cordray’s status would likely argue that the opinion applies to him as well, as he was appointed via the same process.  For more, see Bloomberg.

The Justice Department has sued Anheuser-Busch InBev in Washington D.C. district court, attempting to block the company’s proposed $20.1 billion merger with Modelo.  The head of the DOJ’s antitrust division, William J. Baer, said the deal would reduce competition in the American beer industry, as InBev would control 46 percent of the country’s annual sales.  “Even small price increases could lead to significant harm,” Baer said.  For more, see the NYTimes.

The Commodity Futures Trading Commission is drafting rules for “swaps,” under the directive of the Dodd-Frank financial markets overhaul.  The stakes are high, as the complex instruments account for eight-ninths of the derivatives market—and Wall Street banks have been jockeying to frame the proposals as too burdensome for their respective industries.  For more, see Reuters.

Capitol Hill may again take up a system of voluntary cybersecurity standards.  According to a new Senate Commerce Committee report, there is strong support among Fortune 500 companies.  U.S. Senator Jay Rockefeller (D., W.Va.) has spearheaded the effort, and his data suggests differing perspectives from industry leaders and the U.S. Chamber of Commerce.  Sen. Rockefeller hopes to pass a bill this year.  For more, see the Wall Street Journal.

Firm Advice: Your Weekly Update

While much attention has been paid to increasing taxes on high-income earners as a result of the fiscal cliff compromise (the American Taxpayer Relief Act of 2012), less attention has been paid to the compromise’s corporate tax provisions. In a recent Tax Department Update, Latham & Watkins summarizes the effects of the compromise on both individuals and businesses. The Update also covers the compromise’s effects for various energy-related credits, including the extension of a tax credit for qualified wind facilities. The Update is available for download here.

As part of the Dodd-Frank Act’s requirement for regulated and centralized derivatives trading, many nonfinancial companies that use derivatives may be required to register with the CFTC. However, there is an exception for a “nonfinancial end user.” In general, to qualify as a non-financial end user, the company must not be a swap dealer, major swap participant or other “financial entity.” Additionally, the derivatives must be used as for commercial, rather than investment, purposes. WilmerHale’s recent Corporate and Futures and Derivatives Alert provides a thorough explanation of the application of this exception for nonfinancial companies.

Gibson Dunn recently hosted its ninth-annual webcast, “Challenges in Compliance and Corporate Governance.” Corporate Counsel viewed the webcast and derived seven takeaways for 2013.  Among these lessons is that firms should broaden their focus. Between the SEC’s regulations on conflict minerals and sanctions on Iran, broad-based compliance efforts are necessary.  Another lesson is that firms should not forget the compliance tone in the middle. While many compliance officers focus on setting the tone for upper management, it is often middle managers who receive tips and should be trained on proper compliance procedures.  Check out the other takeaways here.

 

Firm Advice: Your Weekly Update

Late last year, the Federal Reserve issued guidance on its new framework for supervising large financial institutions.  The Federal Reserve’s primary objectives will be to increase the resiliency of financial institutions, and to reduce the impact of an institution’s failure on the broader economy.   Changes include a greater emphasis on recovery and orderly resolution planning as required by Dodd-Frank.  In a recent publication, Sullivan & Cromwell reviews the specifics of the recent changes and explains how their implementation may differ from the previous regulatory framework.

The expectation that courts will recognize and enforce the insolvency proceedings of foreign courts is essential to certainty and predictability of cross-border transactions.  This is especially important where the two nations’ bankruptcy laws materially differ.  Three recent decisions in the U.S. and U.K. call into question whether such an expectation is reasonable.  In one of the cases, the Fifth Circuit held unenforceable a $3.4 billion restructuring plan approved by a Mexican court as “manifestly contrary to the public policy of the United States.”  The Fifth Circuit took issue with the Mexican court’s decision that shareholders receive $500 million in value while higher-ranking creditors receive only 40 percent of their claims.  In a recent client alert, DLA Piper explains the implications of these decisions for certainty and predictability of cross-border transactions.

The U.S. District Court for the District of Columbia recently dismissed a lawsuit challenging recent amendments to CFTC Rule 4.5. With limited exceptions, the amendments require registration by investment companies that trade in futures, options, and commodities. The plaintiffs, the Investment Company Institute and the U.S. Chamber of Commerce, argued the amendments were arbitrary and capricious in violation of the Administrative Procedure Act and that the CFTC failed to perform adequate cost-benefit analysis. In rejecting these arguments, the court found that the link between unregulated derivatives and the financial crisis provided an adequate basis for the amendments. In a recent Client Alert, Ropes & Gray explains the court’s reasoning and the decision’s implications for registered investment companies.

Forthcoming in California Law Review: “From Independence to Politics in Financial Regulation” by Stavros Gadinis.

Berkeley Law Professor Stavros Gadinis’s latest article, “From Independence to Politics in Financial Regulation,” is forthcoming in the California Law Review.  Professor Gadinis’s work focuses on the intersections between finance and government regulation.  This particular paper takes a global look at how governments reformed their “independent” financial regulatory agencies by making them more politically accountable after the 2007-08 financial crisis.

We at the Network found this article particularly interesting because it focuses on the fundamental—and often taken for granted—relationship between administrative law and business law.  In the United States, “agency independence has long been the hallmark of financial regulation.”  In fact, most governmental financial regulation occurs within the “headless fourth branch,” i.e., independent administrative agencies like the Federal Reserve (“the Fed”), Federal Deposit Insurance Corporation (“FDIC”), and Securities and Exchange Commission (“SEC”).

Historically, these governmental entities, corporations, boards, and commissions often have been insulated from direct democratic forces.  The theory is that, free from “generalist” whims and electoral politics, agency independence allows neutral “subject matter experts” to focus their particular skill and knowledge on the specialized problems they were commissioned to solve. Further, independent agencies bring the country long-term stability and uniformity.  Whereas elected politicians, so the theory goes, are often biased towards short-term goals to capture votes in the next electoral cycle.

When scholars speak of “independence” from political influence, they largely mean from the President’s removal power.  It has long been settled that Congress may “under certain circumstances, create independent agencies run by principal officers appointed by the President, whom the President may not remove at will but only for good cause.”  Free Enter. Fund v. Pub. Co. Accounting Oversight Bd., 561 U.S. __ (2010) (slip op. at 2).

However, too much independence can become a problem.  For example, in Free Enterprise Fund the Supreme Court held that a dual for-cause removal scheme Congress set up in the Sarbanes-Oxley Act was ultra vires of the Constitution’s separation of powers.  The Act placed members of the Public Company Accounting Oversight Board (“PCAOB”) under the SEC’s control, removable only for cause.  In turn, SEC commissioners were only removable by the President for-cause.  This novel structure, Chief Justice Roberts held, prevented the President from discharging his duty to “ensure that the laws are faithfully executed—as well as the public’s ability to pass judgment on his efforts.”

The anxiety that motivated Chief Justice Robert’s opinion in Free Enterprise Fund could partly be described as a fear of Congressional aggrandizement at the expense of the Chief Executive.  But it could also be described as a distrust of the growing independence of democratically unaccountable bureaucrats—the same distrust that Professor Gadinis comments on in his most recent article.

Professor Gadinis argues that a coalescence of unique atmospheric factors post the 2007-08 crisis led to a global shift from financial regulatory independence toward greater political accountability.  According to Professor Gadinis’s argument, those factors include (1) pervasive failures across multiple agencies charged with financial regulation, (2) failure of the market to self-correct, (3) fear of agency capture, (4) unprecedented voter interest, and (5) welcomed political assistance.

Professor Gadinis’s empirical data supports his premise in the United States, France, Germany, Australia, Belgium, Spain, Denmark, the United Kingdom and Ireland.  Only a few countries surveyed did not evince an increase in political accountability, and that was because they either already had a highly politically accountable system or were in the process of working out legislation.  In the United States, for example, one way this shift materialized was through the Dodd-Frank Act.  Significantly, the move toward political accountability did not take the traditional route, e.g., Appointment and Removal powers.  Instead, Congress sought to retain independent subject matter expertise, but at the same time make the Secretary of Treasury—who is directly accountable to the President—the final arbiter of agency decisions, rather than the agency head.

The upshot of all of this is that the administrative financial regulatory system in the United States, and likely worldwide has seen a paradigm shift.  While this shift can simply be seen as moving independent agencies back within the traditional executive agency structure, it is important to remain cognizant of the hazards of too much political influence.  After all, the benefits of the independence model are also the downsides of the political model.  Professor Gadinis discusses how, in the bailout context, considerations of electoral timing, adverse public opinion detached from economic reality, and opportunities for massive political contributions could improperly influence political actors.  Only time will tell where the line will be drawn in this canonical administrative law paradox.

Make sure to read the final version of the article in the California Law Review. The abstract is available after the jump. (more…)

Firm Advice: Your Weekly Update

Regulation FD mandates that issuers disclose material nonpublic information through “a Form 8-K, or by another method… reasonably designed to effect broad, non-exclusionary distribution of the information to the public.”  As the SEC’s recent investigation of Netflix shows, a disclosure by the CEO of such information on Facebook likely is insufficient.  In a similar incident earlier this year, Francesca’s Holding Corp. terminated its CFO after he tweeted, “Board meeting. Good numbers = Happy Board.”  This incident, however, did not result in an SEC investigation.  Despite these and other similar incidents, the SEC has provided no guidance on the applicability of Regulation FD to social networking.  In a recent Client Alert, Weil, Gotshal & Manges makes the case for additional guidance and explains how the SEC’s 2008 guidance on corporate website disclosures could be applied to social media.

UBS has agreed to pay a total of $1.5 Billion to regulators in the U.S., U.K., and Switzerland to resolve claims that it manipulated LIBOR.  The fine includes $1.2 Billion to the DOJ and CFTC.  The remainder will be paid to U.K. and Swiss regulators.  As part of the U.S. agreement, UBS must “take steps to ensure the integrity and reliability of UBS’s future benchmark interest rate submissions” and have its Japanese subsidiary plead guilty to one count of wire fraud.  The DOJ also filed a criminal complaint against two former UBS traders.  In a recent Client Alert, Goodwin Proctor has a full summary of the actions and links to the complaint and settlement agreements.

Fiscal year 2012 was significant for criminal cartel enforcement in the U.S.  The DOJ extracted $1.1 billion in fines, more than double that of 2011.  The average prison sentence for individuals also increased to 28 months from 17 months.  The banner year for the DOJ included investigations of 1) a five-year conspiracy to fix the prices of LCD panels, 2) an international conspiracy to fix LIBOR, and 3) a conspiracy among automotive part manufacturers, which has become the broadest antitrust investigation in U.S. history.  In the recently published U.S. Chapter of “Cartels: Enforcement, Appeals & Damages Actions,” Skadden succinctly explains U.S. antitrust laws regarding cartel enforcement and summarizes their application in 2012.

Firm Advice: Your Weekly Update

In a recent Client Alert, Wilson Sonsini reviews the 2012 proxy season, finding it “evolutionary, rather than revolutionary.” In the second year of the say-on-pay requirement, shareholder support for executive compensation averaged about 90 percent. Only three percent of say-on-pay proposals failed to garner the necessary majority of shareholder votes. Moreover, proxy access shareholder proposals—proposals by large shareholders to include their director nominees in the company’s proxy statement—enjoyed modest success in 2012. The Alert provides in-depth analysis of these results and recommendations for 2013.

A jury in Los Angeles recently found three former officers of the failed IndyMac Bank liable for $168 million in losses. The suit, brought by the FDIC, sought damages resulting from construction loan losses by the bank’s Homebuilder Division. In a recent Client Alert, Manatt analyzes the result and provides “lessons learned” from the jurors’ quick decision. Among other lessons, the firm suggests that officers are likely to be held to a higher standard than are directors when they actually approve the loans, especially in California where courts have consistently refused to extend the business judgment rule beyond directors.

The CFTC recently published a series of no-action letters, providing for: 1) a limited exemption for swap dealers from the prohibition against association with certain persons subject to statutory disqualification, 2) an exemption for swap dealers from the requirement to disclose counterparties when the entity has a reasonable belief that the disclosure would violate foreign laws, and 3) a limited exemption for certain futures commission merchants from the requirement that the chief compliance officer certify the annual report. In a recent Financial Alert, Goodwin Proctors has a full summary of these no-action relief letters, as well as an update on other regulatory news.

 

SEC Adopts Rules On Clearing House Standards

The Securities and Exchange Commission recently adopted a new, stricter rule governing risk management and operation standards for registered clearing activities.  This new Rule, 17 Ad-22, will become effective 60 days after its publication in the Federal Register.

The Rule requires registered clearing agencies that perform central counterparty services to establish, maintain and enforce written policies and procedures reasonably designed to limit their exposure. At minimum, they must measure their credit exposure at least once per day and maintain margin requirements to limit their credit exposure to participants, using risk-based models and parameters. The procedures must be reviewed monthly, and the models must be validated annually.

The Rule is an attempt “to ensure that clearing agencies will be able to fulfill their responsibilities in the multi-trillion dollar derivatives market and more traditional securities market.”  It is part of an effort to promote financial stability by improving accountability and transparency in the financial system. It was adopted in accordance with the Dodd-Frank Act, which gave the SEC greater authority to establish standards for clearinghouses.

In general, clearing agencies act as middlemen to the parties in a securities transaction. They play a crucial role in the securities markets by ensuring the successful completion of operations and avoiding the risk of a defaulting operator.  In addition, they ensure transactions are settled on time and on the agreed-upon terms.

The rule is similar to the Supervisory Capital Assessment Program, publicly described as the bank “stress tests.”  This examination, conducted by the Federal Reserve System, measured the financial strength of the nation’s 19 largest financial institutions.  The stress tests measured whether banks had enough capital to weather a downturn with enough funds to continue lending.  Like the new Rule, the stress tests were intended to reduce uncertainty surrounding the financial system, while building up transparency and investor confidence.

Under the new Rule, clearing agencies will have to maintain sufficient financial resources to withstand, at a minimum, a default by the participant group to which it has the largest exposure in extreme (but plausible) market conditions.  In addition, the clearing agencies will now be required to calculate and maintain a record of the financial resources that would be needed in the event of a participant default.  Clearing agencies must perform the calculation quarterly, or at any time upon the SEC’s request, and must post on their websites annual audited financial statements within 60 days of fiscal year-end.

The Rule also requires clearing agencies to implement membership standards for central counterparties reasonably designed to: 1) provide membership opportunities to persons who are not dealers or security-based swap dealers, 2) not require minimum portfolio size or transaction volume. Those who have a $50 million portfolio should also be able to obtain membership, provided they comply with other reasonable membership standards.

Proprietary Data Feeds and the SEC’s Regulatory Approach to High Frequency Trading

Earlier this year the Securities Exchange Commission (“SEC”) levied its first monetary fine against an exchange as part of a $5 million dollar settlement against the New York Stock Exchange (“NYSE”).  The SEC found that the NYSE delivered stock-price quotes and other data to subscribers of so called proprietary data feeds seconds before transmitting the same data to the broader market.  This gave certain traders an improper head start to act on important market information.  Proprietary data feeds had been a favorite resource of high frequency trading (“HFT”) firms whose business model depends on split-second informational advantages.  The SEC’s attack on proprietary feeds represents an episode in the struggle to regulate HFT.

HFT firms use computer-based algorithms and ultra-fast processing speed to steer daily trading activity.  They derive profits by obtaining information about the market and executing trades much faster than non-HFT competitors.  Typically, HFT firms would have to wait for public disclosure of market data before trading on such information because U.S. exchanges are required to submit market data to a centralized network for public dissemination.  However, proprietary feeds, like the ones offered by NYSE, allowed firms direct access to information a few seconds before public disclosure.  According to Gibson Dunn Partner Barry Goldsmith, permitting access to these NYSE feeds gave HFT firms “potentially unfair advantages.”

Some critics go further than Goldsmith and question whether HFT should be allowed at all.  These critics argue that HFT creates two-tiered markets where firms with fast computers trade ahead of market orders to the detriment of all other investors.  Even without the NYSE feeds, HFT firms use sophisticated infrastructure to routinely access market data before non-HFT firms. Some strategies include issuing thousands of “immediate or cancel” orders and dark pool pinging.  Furthermore, proliferation of HFT practices has been recognized as a cause of the 2010 “Flash Crash” and other market embarrassments like the Knight Capital “Trading Glitch.”

Despite evidence of HFT’s negative impact on markets, the practice does have support.  HFT’s proponents claim that the practice has positive effects.  Cameron Smith, General Counsel for Quantlab Financial, argues that HFT increases liquidity by increasing trading volumes, thus making it easier to find buyers and sellers of securities. This increased liquidity also lowers trading costs by reducing risk for market makers.  Accordingly, Smith believes that HFT firms should not be inhibited by regulation.

The SEC appears content with an intermediate position, allowing HFT firms certain privileges, like server collocation, while directly attacking certain methods it deems as abusive informational advantages, like flash trading and utilization direct data feeds.  Though the NYSE settlement and fines may curb the aggressive marketing of data feeds to HFT, unbalanced informational advantages for HFT and market failure risks still remain.  The SEC must make difficult decisions in considering what types of advantages it will allow to HFT.  As European regulators move to halt HFT completely, it remains to be seen whether the SEC will change its regulatory approach.