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.

Firm Advice: Your Weekly Update

On December 3rd, the SEC approved FINRA Rule 5123, which requires firms that sell a security in a private placement to file with FINRA a copy of any private placement memorandum, term sheet or other offering document used by the firm within fifteen days of the sale. The Rule provides for limited exemptions. FINRA also issued “frequently asked questions” regarding the substantive and procedural requirements of the filings. Morrison & Foerster has summary of these requirements and exemptions in a recent News Bulletin.

On December 6, 2012, the SEC lifted the two-year-old moratorium on active exchange-traded funds’ (“ETF”) use of derivatives. The news came during a speech by Norm Champ, the SEC’s Director of the Division of Investment Management. During the moratorium, the SEC would only approve ETFs that represented that they did not make any investments in options, futures, or swaps. In a recent Legal Update, Dechert discusses the implications and limitations of the proposal.

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.

Firm Advice: Your Weekly Update

Federal Reserve Governor, Daniel Tarullo, recently discussed an upcoming proposal to alter the regulation of foreign banks in the U.S. The proposal would require large foreign banks to establish “a separately capitalized top-tier U.S. intermediate holding company.” The holding company would be “required independently to meet all U.S. capital and liquidity requirements as well as other enhanced prudential standards required by the Dodd-Frank Act.” In a recent Client Memorandum, Davis Polk suggests that the proposal “could have profound negative consequences” for both foreign banks in the U.S. and U.S. banks abroad by adding “fuel to the growing trend toward regionalization of global banking.” The proposal is still under consideration and more details are anticipated “in the coming weeks.”

The Dodd-Frank Act amended the Commodities Exchange Act to require clearing of certain swaps through a derivatives clearing organization. This includes fixed-to-floating swaps, basis swaps, forward rate agreements, and overnight index swaps. The CFTC recently issued final rules to implement this requirement and issued two no-action letters “that provide time-limited relief from the clearing requirement for certain swaps.” In a recent Legal Alert, Bingham McCutchen details the requirements, the timing of their implementation, and safe harbors provided by the no-action letters.

In a recent Corporate Finance Alert, Skadden provides guidance on how to avoid prohibited communications when contemplating a securities offering. Section 5 of the Securities Act prohibits “activities intended to stimulate interest in a securities offering prior to the filing of registration statement.” Violations of this prohibition are commonly referred to as “gun jumping.” The Alert outlines the types and timing of permitted and prohibited communications, as well as suggestions for a company policy on relevant social media communications.

Saudi Arabia’s Real-Estate Finance Laws

In July 2012, Saudi Arabia witnessed the official launch of the real-estate finance industry as part of the country’s economic financial development plans.  To promote the local competition between banking and other financial sectors, and the economy’s overall global competitiveness, non-banking corporations may now finance real estate in Saudi Arabia.

The Real Estate Development Fund (“REDF”) is the country’s main provider of housing finance.  REDF was unable to meet the rapidly increasing demand, while other real estate financing was limited due to absence of a well-structured regulatory framework.  For example, the industry lacked effective land registries and foreclosure regulations for properties in default.  Individual real estate financing was done against the transfer of title deeds rather than as an official mortgage.  In addition, lenders have been conservative with their loan standards, resulting in a low mortgage penetration rates.

Making mortgages available to public will address the imbalances occurring in the market with supply twisted to the high end.  The new Saudi laws tackle the chronic shortage of home ownership, particularly in the affordable middle- and lower-end markets.  More financing opportunities are needed, even though additional time may be required for the market to safely adopt such laws.

These laws are tools to open safe and continuous investment channels.  They encourage national economy leaders to diversify income sources and create job opportunities and investments in the country.  They also satisfy growing demands for appropriate and safe housing offers.  These steps aim to develop mechanisms that preserve homeownership rights, while stimulating financial institutions to lend more frequently, reduce the cost of mortgage financing and provide differentiated products for multiple segments of society.

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Firm Advice: Your Weekly Update

Recently, the DOJ and SEC issued A Resource Guide to the U.S. Foreign Corrupt Practices Act. The FCPA prohibits U.S. persons and businesses and all companies listed on U.S. stock exchanges from making corrupt payments to foreign official to obtain or retain business. The FCPA also mandates that these companies maintain accurate books and a system of internal accounting controls. The goal of the Resource Guide is to help companies “abide by the law, detect and prevent FCPA violations, and implement effective compliance programs.” The Resource Guide explains the intricacies of which companies are subject to the law and the types of transactions are likely to violate the law. In a recent Client Alert, Latham & Watkins provides a summary of the Resource Guide and the nine most relevant and important areas. The Client Alert is available for download here.

The Fiscal Cliff is looming in 2013, and with it is the specter of increased taxes. Both the cliff itself and any potential compromise are likely to include increased marginal tax rates and capital gains taxes.  While some people may wish to accelerate income into 2012 to avoid the increased taxes, Section 409A of the Internal Revenue Code severely limits the “ability of employers and employees to change the time of payment for most types of compensation.” In a recent Client Alert, Skadden presents “Strategies for Accelerating Incoming into 2012,” focusing on methods of accelerating income that avoid the limitations of 409A.

The U.S. Secretary of the Treasury recently exempted foreign exchange swaps from certain regulations under the Commodity Exchange Act. These swaps will not be subject to central clearing, margin or exchange trading requirements.  In a recent Client Alert, Mayer Brown explains the qualifications for foreign exchange swaps and the consequences of their exemption.

Some Claims in DOJ Lawsuit Against Wells Fargo Potentially Precluded by Mortgage Settlement

Prior to filing its recent lawsuit against Bank of America, as discussed here, the United States Attorney for the Southern District of New York announced last month it had filed suit against another major U.S. bank for alleged reckless underwriting and false representations made during the sub-prime mortgage crisis—this time, against the largest American home lender, San Francisco-based Wells Fargo, N.A.

Filed in conjunction with the U.S. Department of Housing and Urban Development (“HUD”), the suit seeks treble damages and civil penalties for violations of the False Claims Act and the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”). Wells Fargo faces a range of charges including a breach of fiduciary duty, unjust enrichment, and false certifications to HUD, as well as charges under the False Claims Act of knowingly or recklessly making false claims regarding its FHA loans and making false statements in support of those claims.

Wells Fargo insists that the current lawsuit is barred by its five billion dollar settlement over its foreclosure practices in April, arguing that the new claims fall into the categories of claims released per the settlement—servicing, foreclosure, and origination liability claims. The settlement does allow the government and borrowers to preserve claims that include criminal prosecutions, claims relating to securitization of mortgage loans, claims of discrimination in lending practices, and individual or class action claims brought by homeowners and investors.

Most pertinently, the settlement did not preclude the new charges if the prosecution can prove the bank knowingly lied to the FHA about specific loans meeting the program’s eligibility requirements. However, Wells Fargo firmly maintains that the government can only prosecute individual loans under this exception, meaning many of the new charges would nonetheless be prevented.

The defense has submitted a filing to U.S. District Judge Rosemary Collyer, who presided over the settlement, in an effort to block the government from pursuing the new charges. It remains to be seen whether Judge Collyer will take any action to block the new suit.

This lawsuit comes amid several other suits against the nation’s largest lenders, including Bank of America, as the government seeks damages for the banks’ roles in the subprime mortgage crisis.

A New Method of Disclosing Executive Compensation

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) has changed the landscape of executive compensation in the United States in favor of greater disclosure.  Dodd-Frank requires publicly traded companies to disclose “information that shows the relationship between executive compensation actually paid and the financial performance of the [company].”  15 U.S.C. § 78n(i).  Investors can discern what was actually paid to executives and the financial performance of the company in the proxy statement by looking to their company’s “Compensation Discussion and Analysis” and “Summary Compensation Table.”

The requirement for disclosure of pay and performance, coupled with the new ability for shareholders to have a “say on pay” has resulted in increased scrutiny from shareholders.  The new “say on pay” regime has allowed shareholders to have a non-binding vote on executive compensation.  Even though this vote is non-binding, Boards of Directors are paying attention to potential negative feedback from shareholders.

Because of “say on pay” voting, proxy advisory firms such as Glass Lewis and Institutional Shareholder Services have become more relevant.  These firms advise investors whether to vote yes or no on a company’s executive compensation provisions.  Because of this new scrutiny, companies are more likely to take actions to ensure they receive a recommended vote of “yes” from these proxy advisory firms.  If executive compensation payments appear excessive, the likelihood of a shareholders being advised to vote against executive compensation plans increases.

Therefore, many companies have begun to precede the Summary Compensation table in the proxy report with a “Realized Pay” or “Realized Compensation” table.  This additional disclosure reveals the compensation actually realized in the years shown by the named executives according to their W-2 forms.  The rationale often given for the additional disclosure is that the numbers in the Summary Compensation table do not show exact figures, but instead show figures for the “fair value” of shares/options awarded.  These fair values are based on accounting principles and models that estimate the potential worth of awards, instead of exact earned amounts.  For example, the most recent proxy statement for Hewlett-Packard Company states that in 2011, Catherine Lesjak, R. Todd Bradley, and Vyomesh Joshi realized $2.8 million, $3.0 million, and $2.7 million, respectively.  The Summary Compensation table states their 2011 compensation as $11.0 million, $10.7 million, and $9.8 million.  These numbers are strikingly different.  The realized pay table and the summary compensation table present different data; they are not perfect substitutes for one another.  The Realized Pay table shows the money the executive took home in a given year.  The Summary Compensation Table shows the salary, bonus, and the equity awards the company granted in a given year (not the equity awards that vested or were cashed-in in a given year).

We are still waiting for guidance from the Securities Exchange Commission on the definition of executive compensation “actually paid.”  In the meantime, it is reasonable to expect companies to continue to move in the direction of disclosing realized pay.

CME Files Lawsuit Against the Commodities Futures Trading Commission

On November 8th, U.S. exchange operator CME Group filed a lawsuit against the Commodities Futures Trading Commission (CFTC) in the United States District Court for the District of Columbia, asking for an injunction to prevent the CFTC from requiring CME Group to report private data to a third party. In the lawsuit, CME Group alleged that the regulator overstepped its authority under the Dodd-Frank Act by requiring CME Group to report non-public swaps transactions data to CFTC-certified Swap Data Repositories (SDRs), which is in turn released to federal regulators to be used to monitor the market.  (more…)

Netflix, Good Governance and Poison Pills

In response to Carl Icahn’s recent trading activities, the board of directors of Netflix, Inc. has approved a shareholder rights plan (the “Plan”), commonly referred to as a “poison pill.”  The Plan allows Netflix shareholders to buy newly issued shares at a discount, diluting the Company’s shares and making a potential takeover more expensive and less attractive for potential buyers.

The Board approved the Plan in response to a takeover threat by Carl Icahn, an activist shareholder who currently owns 9.98% of the Common Shares.  Icahn is not attempting to purchase the Company outright; rather, it appears he is attempting to attract other buyers who would buy Netflix at a premium.  Instituting a shareholder rights plan is a common defensive tactic taken by boards of directors to thwart corporate takeovers.

Pursuant to the terms of the Plan, the Company has declared a dividend distribution of one right (each a “Right”) for each issued and outstanding common share of the Company.  Each Right entitles the holder thereof to purchase one one-thousandth of a series A preferred share.  The Plan is “flip-in,” whereby Netflix shareholders can exercise the Rights following the public announcement that a shareholder has acquired beneficial ownership of 10% or more of the Company’s common shares.

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