Firm Advice: Implementing Dodd-Frank

The comment period recently expired on the Federal Reserve’s proposal to require foreign banking organizations with at least $50 billion in global assets and $10 billion in U.S assets to form an intermediate holding company for most of their U.S. assets.  The proposal is part of the Board’s implementation of Sections 165 and 166 of the Dodd-Frank Act. In a recent Client Alert, Gibson Dunn advises that “the IHC requirement likely exceeds the Board’s legal authority in implementing Sections 165 and 166 of Dodd-Frank, has the tendency to increase, rather than reduce, financial instability in the United States and globally, threatens other adverse effects, and does not effectively respond to the developments that the Board perceives in the U.S. operations of FBOs and in international banking regulation generally.” Gibson Dunn explains why here.

On April 10th, the White House released its proposed budget, which contained significant new tax proposals. While often general, the budget laid out specific proposals for: 1) the Buffet Rule, 2) marking to market of derivatives, and 3) alternative treatment for debt purchased on the secondary market. Skadden’s recent Client Alert explains the various proposals and both their foreign and domestic tax implications.

Class Action Complaint Alleges Conspiracy to Fix CDS Market

A group of institutional investors recently filed a class action complaint against some of the world’s largest banks alleging a conspiracy fix prices and monopolize the market for Credit Default Swaps (“CDS”) in violation of the Sherman Act § 1.  Defendants include Bank of America, Barclays, Citibank, and Goldman Sachs.   The complaint also names the International Swaps and Derivatives Association (“ISDA”), a financial trade association, which the complaint alleges is controlled by the defendant banks.  The plaintiffs are claiming potentially billions of dollars in damages.

A credit default swap is a method of transferring the risk of default for a financial instrument.  The purchaser pays a fixed payment to the seller in exchange for the promise to pay off the underlying debt in the event of a default.  The complaint alleges that because of the CDS market structure is unregulated and over the counter, every transaction must be with one of the defendant banks.

The complaint characterizes the CDS market as “starkly divided” between the defendant banks “who control and distort the market” and the plaintiffs “who, in order to participate in the market, must abide their distortions.”  The complaint alleges that this is the result of an opaque trading environment in which the defendant banks manipulate the bid-ask spreads through their negotiations with individual traders.  These manipulations cost the plaintiffs billions of dollars, says the complaint.  Plaintiffs allege that several of their attempts to create and regulated exchange were rebuffed by defendants.

Both the DOJ and the European Commission have been conducting their own investigations into these activities.  In March, the EU indicated that “ISDA may have been involved in a coordinated effort of investment banks to delay or prevent exchanges from entering the credit derivatives business.”

Federal Reserve FBO Proposal: Will Comments on the Intermediate Holding Company Requirement Be Heeded?

[Editor’s Note:  The following post is a Gibson, Dunn & Crutcher LLP Publication, authored by its Financial Institutions Practice Group.]

The comment period has now closed on the controversial proposed rule (FBO Proposal) of the Board of Governors of the Federal Reserve System (Board) implementing Sections 165 and 166 of the Dodd-Frank Act (Dodd-Frank) for foreign banking organizations (FBOs) and foreign nonbank financial companies supervised by the Board.  If the FBO Proposal becomes final in the manner proposed, it will mark a sea change in the regulation of the U.S. operations of FBOs, by requiring FBOs with $50 billion or more in total global consolidated assets and $10 billion or more in total U.S. nonbranch assets to form an intermediate holding company (IHC) for almost all of their U.S. subsidiaries.  In our view, the IHC requirement likely exceeds the Board’s legal authority in implementing Sections 165 and 166 of Dodd-Frank, has the tendency to increase, rather than reduce, financial instability in the United States and globally, threatens other adverse effects, and does not effectively respond to the developments that the Board perceives in the U.S. operations of FBOs and in international banking regulation generally.


Professor Paulus Speaks on Sovereign Debt Restructuring

On April 17, legal practitioners, bankers, scholars, and students met at the Federal Reserve Bank of San Francisco to discuss recent developments in sovereign debt restructuring.  Sovereign debt restructurings date to at least 300 B.C. and are a practical fact of life in today’s global economy.  Recent developments in the realm of sovereign debt restructurings include Greece’s recent restructuring, the Second Circuit’s potentially destabilizing decision in NML Capital v. Argentina, and the seemingly perpetual Eurozone debt crisis.

Professor Christoph Paulus, Director of the Institute for Interdisciplinary Restructuring (Berlin) and graduate of Berkeley School of Law (LLM ’84), presented his framework for creating a Eurozone sovereign debt restructuring mechanism (SDRM).  The IMF proposed an international SDRM in the early 2000s, but the plan lost out to market driven approaches.  Market driven approaches to sovereign debt restructuring include the use of Collective Action Clauses (CACs) in debt contracts, which allow a qualified majority of bondholders to change the terms of the contracts to effectuate a restructuring. 

Professor Paulus’s proposed Europe-centered SDRM envisions a “resolvency” proceeding for sovereigns – a more optimistic and palatable vision of restructuring than an “insolvency” proceeding.  The proposal includes three key requirements: (1) the inclusion of a resolvency clause in bond contracts that would trigger resolvency proceedings under certain circumstances; (2) the creation of a resolvency court overseen by a president who would in turn select 30–40 elder statespersons to serve as judges in potential resolvency proceedings, and; (3) the development of the resolvency court rules of procedure.  The envisioned resolvency process is roughly comparable to insolvency proceedings under most country’s corporate laws and would be intended to promote orderly negotiations between sovereigns and bondholders.

Following Professor Paulus’s presentation, Professor Barry Eichengreen facilitated a lively discussion detailing the limitations and virtues of an institutional approach as compared to market driven approaches, including CACs.  Professor Eichengreen described the moral hazard argument against the creation of an SDRM – that such an institution could make it too easy for sovereigns to write down their debt.  Nonetheless, Professor Eichengreen pointed out that the moral hazard argument now cuts the other way out of concerns that sovereigns borrow too much, and the market for sovereign debt requires greater discipline.  The group also considered Contingent Convertibles (CoCos), an additional market driven approach, as a means to facilitate smooth sovereign debt restructurings.  CoCos would convert sovereign debt to equity on the occurrence of certain measurable conditions, such as sustaining a particular GDP.

The ideas and issues raised at the Federal Reserve Bank provided a useful framework for understanding the potential of a Europe-centered SDRM to facilitate sovereign debt restructurings in the future.  Limitations and questions remain. There are hurdles to applying resolvency clauses in non-European jurisdictions. Certification is required for ensuring the legitimacy of the elder statespersons who would serve as judges. Methodological questions remain about calculating accurately the effect of an SDRM on liquidity in the bond market, and an account of the insufficiency of market-based solutions (especially CACs) to shore up the argument that an SDRM is in fact needed. Indeed, these ideas are still being developed and stakeholders are not in consensus about the best way forward.

Experience from the Anti-Monopoly Law Decision in China – Part II

[Editor’s note:  This post continues yesterday’s article, found here.]

3.2. Methodology and Assumptions

This “legal discount” test provides how much Coca Cola may lose in the acquisition of Huiyuan Juice if the application were rejected because of improper enforcement of law.

The potential loss Coca Cola suffered was the potential net income of the Huiyuan Juice for fiscal year 2009, the first year of operation if the transaction were approved.

It was difficult to predict whether the profit of the new company would increase because it was a component of the Coca Cola (by economies of scale, for example) or decrease (as actually occurred with Huiyuan in year 2010). We assumed that the annual profit of the new company was stable.

It was not sufficient that we merely estimated the profit if Coca Cola successfully purchased Huiyuan, because Coca Cola’s funding does not exist in a vacuum, i.e., Coca Cola would not be required to pay for the costs of funding, whether dividends to shareholders or interest expense to creditors, if it did not spend the USD24 billion for the deal.

Thus, potential income should be divided by the weighted average cost of capital (WACC) of Coca Cola.

Because legal risk is variable case by case, the analysis only examines the highest level of loss caused by uncertainty in the rule of law in the Chinese legal environment. This assumption also matches the conservatism in accounting principle, which suggests that expenses should be over-estimated at their highest possibility when the amount is not certain.

To reflect the possibility of judicial intervention, the discount should be multiplied by 1/67, which reflects the highest legal risk.

The potential return on the project resulting from the assumptions made above is that made for USD24 billion in investment funds.


Experience from the Anti-Monopoly Law Decision in China – Part I

1. Introduction – Reasons of Estimating Cost of Legal Risks

The general public typically has a positive view of liberty, democracy, and a reliable legal system. For their part, analysts are likely to take the legal system for granted because they have a positive view of the rule of law and are able to construct airtight arguments explaining why a reliable legal environment is important for investors.

However, simply stating that having the rule of law is always better than not having it may not be sufficient. Scholars rarely evaluate the magnitude of the positive effect of the rule of law. Certain studies may consider that legal risk increases costs at the operating level, such as the risk of suffering litigation expenses, but these studies have not analyzed how legal risk may cause investment loss.

Additionally, scholars may attempt to show that the rule of law is not a foundational concern for investors by developing models based on the interaction between governments and investors; however, these studies may miss the mark when investors hesitate to enter the market because of the perception of an unfair legal environment or when the same model is applied to a variety of industries.

In reality, it is not easy to calculate accurate figures of profit or loss resulting from the stability of the legal environment for an entire society, but a test estimating a rough ceiling of loss that might be caused by the improper application of the rule of law in a particular circumstance might be a valuable indicator for investors.

Robert Hahn et al. suggest a cost-and-benefit approach to examine the enactment of regulations; they apply it to the question of whether legislators should prohibit drivers from using cellphones while driving in 2001 and 2007.

Subject to assumptions and adjustments, such an approach might provide investors with a general idea about how much the application of the rule of law affects profitability by applying the analysis to judicial matters.


SEC Signals Investigators’ Priorities

The National Examination Program (the “NEP”) has published its examination priorities of areas perceived to have heightened risk in order to support the SEC’s market-wide regulation. While the examination priorities do not represent SEC regulations, they are reflective of SEC staff investigators’ priorities for the upcoming year based on registrants’ communications with regulators, market data, and other general information. The priorities focus on areas perceived to have heightened risk.

The NEP initially looked at market-wide priorities including fraud prevention, conflicts of interest, corporate governance and technology-related issues. On the technology front, the NEP emphasized the need to ensure that new technology helps maintain “transparent, stable markets” and “do[es] not give inappropriate advantages to some market participants over others.” The NEP indicated that it “may conduct examinations on governance and supervision of information technology systems for topics such as operational capability, market access, and information security, including risks of system outages, and data integrity compromises that may adversely affect investor confidence.”

The priorities then addressed four distinct program areas. First, the Investment Adviser-Investment Company (IA-IC) Exam Program will focus on the safety of assets, marketing and performance, conflicts of interest related to compensation arrangements and allocation of investment opportunities, and fund governance. The concentration on fund governance is “a key component in assessing risk during any investment examination” and will ensure that advisers are making accurate disclosures to fund boards and directors with their reviews “in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability.” The policy topics for the IA-IC program will include money market funds, compliance with exemptive orders, and compliance with the pay to play rule.

The Broker-Deal (B-D) Exam Program takes into account the risks and activities associated with individual broker-dealers (or firms), including sales practices and fraud, trading risks, weak anti-money laundering programs, and capital risks. With capital risks, the program “intends to conduct exams of clearing firms with multiple correspondents engaging in high frequency/high volume trading” and will focus on “clearing firms internal controls for managing intraday liquidity risk, as well as assessing intraday net capital and other financial risks.” The B-D program will center on the policy topics of the JOBS act and other regulatory requirements.


DOJ’s Antitrust Division Reverses Policy on Individual Carve-Outs in Company Plea Agreements

[Editor’s Note:  The following is a Wilson Sonsini Goodrich & Rosati Client Alert.]

On Friday, April 12, 2013, the Antitrust Division of the United States Department of Justice announced a reversal in policy relating to its negotiations with companies that plead guilty of criminal antitrust violations.  The new policy significantly affects how the Antitrust Division will approach the plea negotiation process and enforce the criminal antitrust laws.

First, the Antitrust Division announced that it would no longer publicly disclose the names of individuals excluded (or “carved out”) from the non-prosecution provision of company plea agreements.  This provision protects the company and its employees from further prosecution under the antitrust laws for the conduct at issue (a core benefit for companies entering into the plea), but some employees typically are carved out from this protection.  Prior to the announcement last week, the Antitrust Division had a long-standing practice of disclosing the names of these carve-out employees in the plea agreement, a practice that some have called a “perp walk.”  The division now has put an end to this practice, recognizing that “[a]bsent some significant justification, it is ordinarily not appropriate to publicly identify uncharged third-party wrongdoers.”

Second, the Antitrust Division announced that it no longer would carve out individuals from pleas merely for not cooperating in its investigation.  Instead, the division will carve out only those individuals who are “potential targets” of the investigation (i.e., only those whom the division has reason to believe were engaged in the criminal conduct at issue and targets for potential prosecution).  Prior to the announcement, the Antitrust Division had a long-standing practice of carving out from the non-prosecution protection of a plea agreement two categories of individuals:  (1) those the division has reason to believe were involved in criminal wrongdoing (i.e., potential targets) and (2) those who are uncooperative in its investigation or are difficult to find or contact.  Under the new policy, the division will limit the carve-outs to the first category of individuals.  The Assistant Attorney General of the Antitrust Division, Bill Baer, elaborated publicly, stating:  “I reached the conclusion that . . . focusing on the group of people who are potentially targets of the investigation, potentially liable, [and] can be charged [] was a better way of defining our carve-out groups.”

To read the rest of the WSGR Article, click here.

Upheaval in the Sovereign Debt Market: The Argentinean Story (Part 2)

[Editor’s Note:  This article is a continuation of yesterday’s post.]

Ripple Effects in Restructuring Sovereign Debt:

Although the ruling in NML Capital v. Argentina only binds the Second Circuit, the sovereign debt market will feel the ripples of the district court and Second Circuit’s rulings, especially because of New York’s prominence as a financial center and because many sovereign debt contracts are governed by New York law.  The exact effects of the courts’ decisions are hard to discern until the dust settles.  For instance, following the courts’ decisions, bond issuers have included a warning of the uncertainty surrounding the meaning and interpretation of the pari passu clause in bond offering brochures.  Paraguay, one of many sovereigns to include warnings in its offering information, has notified investors of the following:

“In ongoing litigation in federal courts in New York captioned NML Capital, LTD. v. Republic of Argentina, the U.S. Court of Appeals for the Second Circuit has ruled that ranking clause in bonds issued by Argentina prevents Argentina from making payments in respect of the bonds unless it makes pro rata payments in respect of defaulted debt that ranks pari passu with the performing bonds.  The judgment has been appealed.

“We cannot predict when or in what form a final appellate decisions will be granted. Depending on the scope of the final decision, a final decision what requires ratable payments could potentially hinder or impede future sovereign debt restructuring and distress debt management unless sovereign issuers obtain the requisite creditor consents under their debt pursuant to a collective action clause such as the collective action clause contained in the Bonds, if applicable, or otherwise. . .  [We] cannot predict whether or in what manner the courts will resolve the dispute or how any such judgment will be applied or implemented.”

Historically, the restructuring of bonds involves negotiations between the external creditors and the sovereign. Deals struck during negotiations are not always able to placate all participants–resulting in holdout creditors.  Additionally, some creditors sell their bonds at a discount in the secondary market to vulture funds, purchasers of distressed securities who seek full payment of the bonds.  Holdout bondholders, including vulture funds, have the option to seek legal recourse and compel full payment.  Conventionally, sovereigns may not formally subordinate payments due to holdout bondholders when issuing newly restructured bonds but may instead delay payments on the nonrestructured bonds while intending to or actually paying on restructured bonds.  Under the Second Circuit’s broad interpretation of the pari passu clause, a sovereign’s informal subordination of bond payments to holdout bondholders may result in a contractual default under the pari passu clause.

The courts’ rulings have injected a new level of risk into the sovereign debt markets.  The pro rata payment requirements ordered by the district court and recently affirmed by the Second Circuit make it more difficult for sovereigns to restructure external debt contracts with pari passu clauses that parallel the language of the pari passu clause in the FAA.  Fundamentally, the courts’ rulings have provided external creditors with additional means of recourse against sovereigns, especially those able to satisfy payment obligations but who refuse to do so.  Because of the absence of an international bankruptcy regime, holdout bondholders have limited recourse against a defaulting sovereign.  The primary incentive for a sovereign to pay holdout bondholders is to maintain the sovereign’s access to international capital markets and, to a lesser degree, to avoid “harassment” from holdout bondholders.  The courts’ broad interpretation of the pari passu clause, however, has provided holdout bondholders with additional leverage to argue for full payment on distressed securities.

The increased protection for creditors comes at a cost to those bondholders willing to restructure bond payments.  The holdout bondholders will free ride on the bondholders who accept the haircut on the original bonds.  The Argentinian restructure dealt with the freeriding problem through a law prohibiting higher payments to holdout bondholders.  The courts’ rulings, however, hold that such a law violates the FAA’s pari passu clause.

If courts carry over the Second Circuit’s interpretation of the pari passu clause to corporate bonds, the consequences may be more pronounced.  A broad interpretation of pari passu clause under corporate bonds may result in a perverse incentive for creditors.  Such an interpretation incentivizes creditors to refuse to allow an insolvent business to make ordinary business payments in order to gain bargaining power against other creditors.  This may result in a premature dissolution of the business.  Consequently, creditors may not be able to support debtor’s business if just one creditor objects.

The possible blowback because of a broad interpretation to the pari passu clause has not convinced all sovereigns to drop the “payor” language in pari passu clauses in its bond contracts.  Professor Mitu Gulati, a Duke Law professor, has compiled a list of sovereign bond offerings that show no significant changes from the boilerplate pari passu clause used in Argentina’s FAA.  The list of countries includes Ivory Coast, Serbia, Mongolia, Costa Rica and Ukraine.  Some have speculated that sovereigns may feel safe because the clause only becomes important if the economy implodes–a small, tail-end risk for some, because the sovereign does not want to be associated with novelty by changing the pari passu clause and because the collective action clauses in the sovereign’s bond contracts are sufficiently strong.  Others argue that collective action clauses will not prevent the holdout issue seen in NML Capital v. Argentina.  English law governs the bond contracts of Ukraine and Serbia.  English courts have not adopted the views of the U.S. courts and it remains to be seen how this ruling will affect them.


It is unclear how the ruling in NML Capital v. Argentina will affect the sovereign debt market.  Recent sovereign debt offerings have noted the risk and uncertainty surrounding the Second Circuit’s rulings, though many sovereign bond contracts preserve the boilerplate pari passu language used in Argentina’s bond contract.  What is clear is that there is a real risk that Argentina will default on bonds issued under the FAA as a result of this decision.

Upheaval in the Sovereign Debt Market: The Argentinean Story (Part 1)

On October 26, sovereign debt markets felt the shock of the Second Circuit’s ruling in the ongoing case of NML Capital v. Argentina.  The court rejected a narrow interpretation of the pari passu clause advanced by Argentina.  Under the narrow interpretation, a sovereign violates the pari passu clause if it formally or legally subordinates debt; instead, the court adopted a broader interpretation of the clause, holding that the clause prevents making payments to creditors of restructured notes and holding out creditors.  In addition to interpreting the pari passu clause broadly, the court also upheld a novel injunction issued by the district court requiring ratable payments for holdout bondholders of the 2005 and 2010 Argentinian debt swaps.  

This article will first describe the events leading up to the Second Circuit’s ruling in NML Capital v. Argentina.  The next section will focus on the legal conclusions of the Southern District of New York (“S.D.N.Y”) and the Second Circuit.  Finally, this article will provide high-level analysis of the fallout of the Second Circuit’s ruling.

The 2005 and 2010 Haircut:

The Argentinian bond saga begins in 1994, when Argentina began originating debt securities under the Fiscal Agency Agreement (the agreement will hereafter be referred to as “FAA” and debt instruments created by the FAA as the “Bonds”).  The Bonds had a coupon rate ranging from 9.75 percent to 15.5 percent and maturity ranging from April 2005 to September 2031.  The FAA contained a pari passu clause, standard in international sovereign bond agreements.  Simply stated, a pari passu clause places all bondholders on equal footing–that is, protects bond payment obligations from subordination.