Op-Ed: All Against One – Judge Rakoff’s Lonely Crusade

Since November 28,2011 Judge S. Rakoff of the Federal District Court in Manhattan has been the man of the hour. His refusal to approve a $285 million settlement of the Securities and Exchange Commission (SEC) with Citigroup Global Markets has attracted the attention of all parties involved in alike cases pursued by the SEC. It is not the disapproval itself but rather the reasoning that causes the SEC and future defendants to fear the effectiveness of settlements.


Out, Out Brief Candle: European Union Competition Commission Blocks NYSE Euronext-Deutsche Boerse Merger

As reported by the Network last month, the proposed merger between NYSE Euronext and Deutsche Boerse (DB) was in jeopardy as Juan Alumnia, head of the European Union’s Competition Commission, publicly stated that he would recommend prohibiting the deal from going forward. On February 1, the commission officially blocked the proposed merger that would have created the world’s largest exchange operator. As a result of the decision, NYSE Euronext announced that “both companies have agreed to a mutual termination of the business combination agreement originally signed by the companies on February 15, 2011.”


SEC Issues Controversial Rule Regulating Asset-Backed Securities

The SEC will soon put the finishing touches on a rule stemming from one of the most infamous cases of fraud from the 2007-08 financial crisis. The new rule prohibits certain material conflicts of interest between those who create or distribute asset-backed securities (ABS), including synthetic ABS, and the investors in the ABS. This proposal takes direct aim at a transaction that, within the securities industry, has become a symbol of greed and profiteering: Goldman Sachs’s Abacus transaction.

Abacus 2007-AC1 (“Abacus 2007” or “Abacus”) was an investment vehicle designed to fail. It was created in February 2007 at the request of John Paulson, the hedge fund manager who made billions of dollars during the recession by shorting subprime mortgage-backed securities (MBS). Paulson selected the pieces of toxic subprime MBS that he wanted to short which were then packaged together and sold by Goldman to its clients, including German bank IKB and Dutch bank ABN Amro. The buyers were not aware that Paulson selected Abacus’s underlying portfolio; in fact, these banks were led to believe that an independent third party selected the mortgages. The Abacus 2007 transaction resulted in massive losses for IKB and ABN Amro, while Paulsen profited from the investment vehicle’s demise to the tune of over $1 billion.


Banking Supervision: Capital Conservatism

The broad supervisory standards and guidelines issued by the Basel Committee on Banking Supervision (‘the Committee’) have greatly influenced the manner in which Banks are organized in various jurisdictions. The Committee claims that the main culprit behind the current financial crisis is excessive leverage assumed by banks both on and off the balance sheet. The latest in the series of proposed changes propounded by the Committee is Basel III, which seeks to restructure banks like shock absorbers rather than transmitters of financial risk.

The Federal Reserve Bank (‘Federal Reserve’) has responded to Basel III by asking bank holding companies (‘BHCs’) to submit comprehensive capital plans over the next 24 months. It is noteworthy that BHCs are required to notify the Federal Reserve of any change in their capital structure under Section 224.5(b) of Regulation Y issued under section 5(b) of the Bank Holding Company Act of 1956. Basel III, which has been designed conservatively, creates a framework whereby banking companies are to maintain higher common equity ratios, institute tougher stress tests for liquidity, and enhance market discipline and disclosure, among other things. Furthermore, trading positions will be subject to more stringent review, as the Federal Reserve believes that such changes are in the spirit of financial reform initiated by the Dodd-Frank Act.


SOPA Dope: Where Does Online Piracy Reform Go From Here?

It’s fair to say that cool heads did not entirely prevail in the entertainment industry’s war with Silicon Valley over new legislation aimed at curbing foreign online piracy.  Terms like “rogue websites,” “end of the internet,” and “the Great Firewall” are only a sampling of the high-octane rhetoric that colored the public discussion of “SOPA,” the Stop Online Piracy Act, and its Senate analog, the PROTECT IP Act, or “PIPA.”

Critics charged that the SOPA/PIPA regime would enable arbitrary censorship, impose an enormous burden on tech firms, and would be ineffective against the more swashbuckling of web ‘pirates’.  On the other hand, content owners argued that the hemorrhage of profits would not abate without the ability to block or de-fund foreign ‘pirate’ sites.

The unanticipated attention to SOPA was no accident – its opponents are uniquely positioned to amplify a message.  As Reddit, Google, Wikipedia, and perhaps most critically the “Cheezburger” network (famous for hilarious pictures of cats) assembled a “blackout” protest, it appeared that the content industry had been taken a bit by surprise at the ability of web firms to ignite buzz over regulation of the Internet.


Double Taxing to Fix a Loophole: The Tax Treatment of Stock Options

What is a tax loophole? According to a recent front page story in the New York Times, a loophole is simply an area of the tax code, which if changed, would increase government revenue. But isn’t a loophole more?  Berkeley Law Tax Professor Mark Gergen thinks so.

The Times story attacked the way corporations are taxed on the stock options they issue as compensation to employees. It was part of the “But Nobody Pays That” series, which explored “efforts by businesses to lower their taxes and the debate over how to improve the tax system.” Generally, under Section 83(a) of the I.R.C., stock options are taxed when the employee exercises the option by purchasing stock. Once exercised, the employee pays taxes on the difference between the exercise price and the market price as if it were regular income. At the same time, pursuant to Section 83(h) of the I.R.C., the company then deducts as an expense the amount claimed as income by the employee, lowering its income tax liability. According to the article, this deduction loophole has allowed the likes of Google, Goldman Sachs and Apple to drastically reduce their tax liability. The article was not the first place this has been pointed out either. In July 2011, Senator Carl Levin (D-MI) attempted to end this deduction by introducing the “Ending Excessive Corporate Deductions for Stock Options Act.”


Second Circuit Holds that Calculations of Goodwill and Loan Loss Reserves Constitute Opinions; FASB Goes a Step Further to Insulate Yearly Declarations Regarding Goodwill Impairment

On August 23rd the Second Circuit affirmed a lower court’s dismissal of a suit alleging securities fraud in Fait v. Regions Financial. The plaintiffs, securities holders of Regions, asserted that Regions violated Section 11 and 12 of the Securities Act of 1933 by making material misstatements with regard to goodwill and loan loss reserves in its 2007 10k and 2008 10Q. However the Second Circuit held that the plaintiffs failed to plead a claim under Sections 11 and 12 because calculations of goodwill and loan loss reserves were issues of opinion, not fact, and the plaintiffs did not plead any facts that demonstrated that the officers of Regions knew, at the time the filings were made, that the calculations were incorrect.

In the years prior to 2008, Regions had acquired several businesses that derived a substantial portion of their profits from mortgage-backed securities. In February 2006, Regions reported goodwill (calculated as the difference between the purchase price and the net fair value of a target’s assets) as $11.5 billion and declared its loan loss reserves were $555 million. These amounts remained relatively constant through the first three quarters of 2008. In January 2009, when the company released its fourth quarter 10Q, goodwill decreased by roughly 50% to $5.5 billion and its loan loss reserves doubled to $1.15 billion. For perspective, Lehman Brothers, Bear Sterns, and Washington Mutual had all gone under, and Congress had initiated the Toxic Asset Relief Program (“TARP”) more than three months before Regions recognized any impairment to its goodwill or declared any increase in loan loss reserves.


On the Passing of 14(a)-11 and Shareholder Nominations in BOD Elections

On July 22, 2011 the D.C. Circuit struck down an SEC regulation (Rule 14(a)-11) that would have required publicly traded companies to allow qualified shareholders to propose nominations in Board of Directors (BOD) elections. The court held that the SEC failed to perform a required cost/benefit analysis of the new provision, as mandated under Section 3(f) of the Exchange Act and Section 2(c) of the Investment Company Act of 1940. Consequently, Rule 14(a)-11 was declared invalid and unenforceable.

Before the SEC proposed the final version of 14(a)-11, Delaware preemptively proposed and implemented its own law regarding shareholder nominations for BOD elections: DGCL 112. A critical difference between the Delaware law and the SEC proposal is that DGCL 112 does not require that Delaware corporations allow qualified shareholders to nominate candidates in BOD elections, but rather provides that qualified shareholders can be given the authority to nominate candidates if such a provision is adopted in the company’s bylaws. Additionally, Section 112 does not make shareholder nominations of BOD members the default rule, as the procedure must be proactively adopted in the bylaws. Rule 14(a)-11 would have made it mandatory for all publicly traded companies to allow qualified shareholders to nominate candidates in BOD elections (and would have superseded DGCL 112, but for being struck down).


The Largest Exchange Operator That May Never Be

On January 10th, 2012, it was reported that European Competition commissioner Joaquin Alumnia would recommend blocking the proposed merger between NYSE Euronext and Deutsche Boerse by the European Union’s Competition Commission at its February 1st meeting. For 11 months, NYSE’s Duncan Niederauer and Deutsche Boerse’s Reto Francioni have been trying to quell Mr. Alumnia’s concern that such a merger would give the resulting exchange control over approximately 90% of Europe’s traded derivatives. If allowed to proceed, the merger would create the world’s largest stock exchange operator.


Volcker Rule Update #2: Comment Period Extended; Analysis of the Hedging Exemption

The deadline for submitting comments regarding the proposed regulations implementing the Volcker Rule has been extended from January 13 to February 13. As we noted in our previous update on the Volcker Rule, the timeline was already very tight if regulators intended to meet the implementation deadline of July 2012, and this postponement only makes that timeline even tighter and less feasible.

Putting this logistical problem to a side, one major provision in the proposal we have yet to discuss in-depth is the exemption provided in the Volcker Rule for risk-mitigating hedging transactions. The current proposal would allow banks to maintain, purchase, or sell hedging positions with commercial deposits provided that these positions arise from and are related to specific risks involved in the bank’s other legitimate positions, contracts, or holdings. These other risks include market risk, counterparty/credit risk, currency/foreign exchange risk, and interest rate risk (among others). Additionally, the hedged positions taken by the bank must be “reasonably correlated” (or, to be more precise, reasonably negatively correlated) with the risks purportedly being mitigated.