Tuesday, August 31, 2010

Dodd-Frank Legislative History Reveals Great Importance of Treasury Study of GSEs

A Dodd-Frank mandated Treasury study on Fannie Mae and Freddie Mac is almost certain to be the first step in federal legislation to reform government-sponsored enterprises and the secondary mortgage market. The study, which must be submitted to Congress by the end of January 2011, was mandated by an amendment offered by Senator Chris Dodd, Chair of the Banking Committee, codified as section 1074, as the Senate was beating back an amendment offered by Senator John McCain that would have either ended the conservatorship of Fannie and Freddie or disbanded them with no reasonable alternative offered.

All that being said, there is a growing consensus that the 112th Congress must pass legislation reforming the GSEs. Senator Dodd said that everyone agrees that Congress must make that reform, but there is concern about how we get from the current structure to future arrangements without disrupting the overall housing finance system. Fannie, Freddie and the FHA together account for 96.5 percent of mortgage funding today, said the Banking Chair. (Cong. Record, May 11, 2010, S3507).

This is a tough study, said Sen. Dodd, and it must not paint over the situation. The study demands a report and a roadmap on how specifically Congress can do this in a time certain. It is not perfect. There is no magical reform . Congress wants Treasury to set forth scenarios on how to wind down and liquidate Fannie and Freddie; how to privatizen the two GSEs; how to breakup the GSEs into small companies; and other options that may be available.

Senator Dodd said that we should keep in mind that Congress created a strong new regulatory regime for Fannie Mae and Freddie Mac in 2008. Their regulator is maintaining strong oversight of these enterprises, he noted, while they continue to provide crucial assistance to the housing market. Longer term reform of Fannie and Freddie requires a thoughtful reconsideration of the structure of the whole housing finance system. This will require hearings about exactly what structure Congress wants to put in place to finance housing in the US. This will require hearings with many stakeholders and others involved in the serious discussions to determine what that system ought to be.

SEC-CFTC Roundtable Highlights Lynch Issues of Control and Governance in Crafting Dodd-Frank Derivatives Regulations

As the SEC and CFTC begin the momentous task of adopting regulations to implement the derivatives provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the conflict of interest and governance and control issues raised by Rep. Stephen Lynch (D-MA) throughout the legislative process will be a major part of regulatory consideration.

There was congressional concern throughout the process of passing Dodd-Frank that, with derivatives trading required to be conducted through clearinghouses, large financial institutions would own and control the clearinghouses and effectively set rules for their own derivatives deals. The Lynch Amendment in the bill the House passed last December would have prevented large financial institutions and major swap participants from taking over these new clearinghouses by imposing a 20-percent-voting-stake limitation on ownership interest in those institutions and the governance of the clearing and trading facilities.

The Lynch Amendment specifically provided that these restricted owners, which are defined as swap dealers, security-based swap dealers, major swap participants and major security-based swap participants, cannot own more than a 20 percent voting stake in derivatives-clearing organization, a swap-execution facility, or a board of trade. Further, the rules of the clearing organization, swap-execution facility and board of trade must provide that a majority of the directors cannot be associated with a restricted owner.

The Lynch Amendment was not in the final legislation. Instead, in provisions some at the roundtable called Lynch Lite, sections 726 and 765, the CFTC and SEC must adopt rules on conflicts of interest. Specifically, for example, the SEC may include numerical limits on the control of clearing agencies and security-based swap execution facilities. In addition, in a colloquy with Rep. Lynch on the day the House passed the conference bill, Financial Services Chair Barney Frank (D-MA) agreed that sections 726 and 765 of the Dodd-Frank Act require the SEC and CFTC to adopt rules eliminating the conflicts of interest arising from the control of clearing and trading facilities by entities such as swap dealers, security-based swap dealers, and major swap and security-based swap participants. SEC and CFTC adoption of strong conflict of interest rules on control and governance of clearing and trading facilities is mandatory. (Cong. Record, June 30, 2010, H5217).

At the roundtable, CFTC Director of Clearing and Intermediary Oversight Ananda Radhakkrishnan said that Dodd-Frank mandates clearing as many OTC derivatives as possible and bringing transparency to these products through the listing of them on exchanges and swaps execution facilities. The Commission has to make a determination as to whether a group of swaps has to be cleared. But if the Commission makes a determination that said this class of swaps has to be cleared but nobody wants to clear it, then it won't be cleared and it won't be traded. It is thus important to ensure that the governance structures take care of the conflicts of interest to make sure that the mandate of Congress is not blocked. Jay Kastner of the Swaps and Derivatives Market Association (SDMA) said this issue goes directly to the Lynch Light section 726 of Dodd-Frank (the SEC analog is section 765). If there is not proper governance, he said, some derivatives clearing organization may refuse to engage.

SDMA believes that the SEC and CFTC must ensure that the risk committees of these derivatives clearing organizations are transparent such that we know who the membership is and that decisions on whether to permit new clearing members and whether to permit new products to be listed are transparent and readily appraisable.

Heather Slavkin of the AFL-CIO said that, in addition to independence and transparency, it is important to have real experts on the boards of clearing facilities who understand the risks that exist within a clearinghouse and are prepared to perceive potential risks that may arise in the system down the road and address them. Similarly, former Fed Governor Kroszner said the best way to ensure that experts have input into risk management decisions is to establish a transparent process. It would also be valuable for principles to be outlined in advance of what types of contracts can come onto exchanges and how the decision process will be made. Because one of the goals of Dodd-Frank is a migration of some of these contracts onto essentially bigger platforms. Ms. Slavkin believes that providing a roadmap for how to do that will help to encourage market participants to restructure contracts to make them in a way that they will be more readily clearable.

According to CFTC Special Counsel Nancy Schnabel, the SEC and CFTC must figure out how to not inject systemic risk into the clearing and listing of swaps, but then balance that against the systemic risk that would exist if bilateral swaps are not cleared or listed because of certain incentives. SIFMA said that ultimately the risk managers of the clearinghouse are the ones who need to figure out how to manage these risks and manage these conflicts. SIFMA encouraged the CFTC and the SEC to reach out to those risk managers to get their direct views on how these risks and these conflicts are best managed. The primary purpose of Dodd-Frank is to reduce systemic risk, said SIFMA, and that risk will now be concentrated primarily in the clearing houses, and it is critical that the regulators get the risk management correct.

Echoing these sentiments, former Fed. Governor Randy. Kroszner said that the success of clearinghouses is because of their success in managing risks. The Commissions should refrain from forcing types of contracts that cannot be properly risk managed onto the exchanges by using certain criteria that will undermine risk management. They must be tough about risk management, he said, and sometimes that means setting very tough criteria that some institutions and individuals may not like. We are betting the system on the stability of these clearinghouses, emphasized the former Fed official, and thus the clearinghouses must be seen as bulletproof or as near to bulletproof as any private institution can be.

Monday, August 30, 2010

SEC-CFTC Roundtable on Dodd-Frank Derivatives Regulations Focuses on Governance and Risk Management

At the recent CFTC-SEC roundtable, CFTC Director of the Division of Clearing and Intermediary Oversight Radhakkrishnan said that Dodd-Frank mandates clearing as many OTC derivatives as possible and bringing transparency to these products through the listing of them on exchanges and swaps execution facilities. The Commission has to make a determination as to whether a group of swaps has to be cleared. But if the Commission makes a determination that said this class of swaps has to be cleared but nobody wants to clear it, and let's say nobody wants to clear it, then it won't be cleared and it won't be traded. It is thus important to ensure that the governance structures take care of the conflicts of interest to make sure that the mandate of Congress is not blocked. Mr. Kastner of SDMA said this issue goes directly to the Lynch Light section 726. If there is not proper governance, he said, some derivatives clearing organization may refuse to engage.

SDMA believes that the Commissions must ensure that the risk committees of these derivatives clearing organizations are transparent such that we know who the membership is and that decisions on whether to permit new clearing members and whether to permit new products to be listed are transparent and readily appraisable.

Ms. Slavkin of the AFL-CIO said that, in addition to independence and transparency, it is important to have real experts on the board who understand the risks that exist within a clearinghouse and are prepared to perceive potential risks that may arise in the system down the road and address them. Similarly, former Fed Governor Kroszner said the best way to ensure that experts have input into risk management decisions is to establish a transparent process. It would also be valuable for principles to be outlined in advance of what types of contracts can come onto exchanges and how the decision process will be made. Because one of the goals of Dodd-Frank is a migration of some of these contracts onto essentially bigger platforms. Ms. Slavkin believes that providing a roadmap for how to do that will help to encourage market participants to restructure contracts to make them in a way that they will be more readily clearable.

According to CFTC Special Counsel Schnabel, the Commissions must figure out how to not inject systemic risk into the clearing and listing of swaps, but then balance that against the systemic risk that would exist if bilateral swaps are not cleared or listed because of certain incentives. SIFMA said that ultimately the risk managers of the clearinghouse are the ones who need to figure out how to manage these risks and manage these conflicts. SIFMA encouraged the CFTC and the SEC to reach out to those risk managers to get their direct views on how these risks and these conflicts are best managed. The primary purpose of Dodd-Frank is to reduce systemic risk, said SIFMA, and that risk will now be concentrated primarily in the clearing houses, and it is critical that the regulators get the risk management correct.

Echoing these sentiments, Fed. Gov. Kroszner said that the success of clearinghouses is because of their success in managing risks. The Commissions should refrain from forcing types of contracts that cannot be properly risk managed onto the exchanges by using certain criteria that will undermine risk management. They must be tough about risk management, he said, and sometimes that means setting very tough criteria that some institutions and individuals may not like. We are betting the system on the stability of these clearinghouses, emphasized the former Fed official, and thus the clearinghouses must be seen as bulletproof or as near to bulletproof as any private institution can be.

Florida Adopts Review of Dealer, Issuer-Dealer, Associated Person and Investment Adviser Applicants' Law Enforcement Records

The law enforcement records of applicants for dealer, issuer-dealer, associated person and investment adviser registration who have been found guilty of, or who have pled guilty or nolo contendere to, certain crimes will be reviewed by the Office of Financial Regulation to determine their eligibility to register in Florida. Applicants will be disqualified from registration for certain periods based upon criminal convictions, pleas of nolo contendere, or pleas of guilt, whether or not there was an adjudication. Class A crimes (felonies) involving fraud, dishonesty or any other acts of moral turpitude will disqualify applicants from associated person registration for 15 years while Class B crimes (misdemeanors) will disqualify applicants from registration for five years. Disqualification periods may be extended for applicants having committed multiple Class A or B crimes but can also be reduced with mitigating factors. Applicants have the burden to prove they're entitled to register when their disqualifying periods expire.

For more information, please see http://www.flofr.com

SEC-CFTC Roundtable Illuminates Major Issues in Implementing Derivatives Provisions of Dodd-Frank

An SEC-CFTC roundtable on implementing the derivatives provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act discussed the very important and difficult issues of access to derivatives clearing organizations, clearinghouses, and security-based and non-security based swap execution facilities. There are also significant governance, risk management, and conflict of interest issues surrounding the clearing of OTC derivatives. Dodd-Frank mandates that the SEC and CFTC adopt regulations implementing the derivative provisions of Title VII. The roundtable was co-chaired by Robert Cook, SEC Director of Trading and Markets and Ananda Radhakrishnan, CFTC Director of Clearing and Intermediary Oversight. The roundtable was also composed of SEC and CFTC staffers, industry representative and former Federal Reserve Board Governor Randy Kroszner.

Governor Kroszner said that, in determining what derivatives are eligible for clearing, the SEC and CFTC should consider giving strong incentives through capital requirements and collateral requirements, but not necessarily mandating each individual product. The Commissions will be struggling with the heart of the issues that clearinghouses have been struggling with since they started to function as the guarantors of contracts, he noted, and that is getting the balance right between having access and having enough clearing members, making sure there is enough trading and drawing things off the exchange, but also ensuring that those members have the wherewithal to withstand the shocks to make the clearinghouse something that will reduce systemic risk and reduce interconnectedness rather than increase it.

More specifically, Mr. Radhakrishnan, CFTC Director of Clearing and Intermediary Oversight, noted the importance of finding the balance between open access, fair access and the desire for sound risk management. If you have a clearinghouse that is dominated by a group of people, he asked, does that achieve the objective of fair and open access. It is also important to avoid conflict of interest while at the same time ensuring that all decisions are being made by the clearinghouse according to its risk management.

Mr. Kroszner said that the law is very clear on what should prevail, and that is open access, fair, open, unfettered access, and transparency. Risk management is better done in a default scenario if there are more members participating in an auction. And to say, for example, that a Swaps and Derivatives Market Association (SDMA) member firm that clears a large amount of treasuries is somehow ineligible or unqualified to be a member of a clearinghouse is not addressing the issues properly. The former Fed Governor also pointed out that Section 731 of the Dodd-Frank Act discusses this issue in a different way in regards to conflicts of interest. Section 731 requires that banks establish structural and institutional safeguards and supervisory barriers and informational partitions between those who trade and those who provide clearing services in what they call in the SDMAs "the Chinese Wall provision." This is a very good provision, emphasized Gov. Kroszner, because it goes directly to the issue of the conflict between trading and clearing.

Currently, annually, there is estimated to be about $300 to $500 million made clearing, and there are between $400 and $60 billion being made trading. So, in the former Fed official’s view, this discussion of clearing and access to clearing is really just a proxy about access to trading, because that is where the revenues are. And the law is clear, he reiterated, open access is the fundamental principle.

Robert Cook, SEC Director of Trading and Markets, sees a growing consensus favoring open access to swap execution facilities, both security-based and non-security-based. In his view, the main issues are how to ensure that open access happens and what are the potential conflicts that the SEC and CFTC need to anticipate and prevent in order to ensure that there is open access. Under the statute, the SEC and CFTC are meant to consider potential rules governing ownership and voting and control of a swap execution facility by particular types of parties in order to ensure that outcome. Given the goal of open access, the SEC official asked what types of conflicts do the Commissions need to try to anticipate and prevent. He also asked if the Commissions should treat particular parties mentioned in Dodd-Frank, such as bank holding companies differently or the same.

Responding to Mr. Cook, Jason Kastner, SDMA Vice Chair, noted that if you look at the progress of the legislation into the final hours there was the notion that a swap execution facility may operate by any means of interstate commerce. A previous version of the bill required electronic trading, he said, and so the issue is can you trade swaps with ``two paper cups and a string and carrier pigeons’’, or is it required that they be on an electronic screen. And another issue is whether there should be a request for quote model or should there be a fully disintermediated market where anybody can join any bid and offer and anybody can participate in an open way. He pointed out that the goal of Dodd-Frank is to promote the trading of swaps on swap execution facilities and to promote pre-trade price transparency. The only way that you can have pre- trade price transparency is if it is on a screen and everyone can see it ahead of time, he said. Thus, he urged the Commissions to consider this when they are thinking about the definition of the swap execution facility and rule construction and electronic versus carrier pigeon and when the SEC and CFTC think about requests for quote versus disintermediated market.

Heather. Slavkin of the AFL-CIO said that another issue arising in this context is the question of the timeliness of information received by various players in the market. She understands that the SEC has probably been looking at the issue of collocation with regard to the exchanges, and sees this as a potential issue that could arise as well in the context of the swap execution facilities. Thus, she urged the Commissions to consider who is getting what information, when they are receiving it, and what they can do with that information once they receive it.

Former Fed Governor Kroszner emphasized the importance of getting risk management right, because there are now very strong incentives to get things onto the platforms making everyone interconnected to the clearinghouse. So, in order to avoid the kind of crises that we saw, the clearinghouse has to be seen as very strong, he said, seen as basically bulletproof so that an individual member going down will not cause the sort of cascading concerns we saw in late 2008. And so it is crucial that members have the right incentives for risk management. It may be difficult when two types of members on the exchange might have different incentives to get their approaches to risk management right, you could have some institutions that have very little capital because they might be willing to take more risks and want the exchange or the central clearer to take more risks than otherwise.

A number of people have made the point, noted Gov. Kroszner, that the idea behind migrating these things onto central clearing platforms and potentially on exchanges is to try to reduce those risks since you've got to think about the incentives that people with different amounts of capital might have for ensuring good risk management. This goes to the historic struggle of clearinghouses and exchanges trying to get more things onto the exchange, but also making sure that the risks can be managed by the exchange or by the clearinghouse.

James Hill speaking for SIFMA, said that the industry has been focused very much on what happens when a member defaults and you have to unwind the portfolio or inject more capital into the clearinghouse. But the related piece is who can inject risk into the clearinghouse. So, the clearing members, in addition to contributing capital to the clearinghouse and margin, they interact with their customers and put trades into the clearinghouse. And because the FCM ultimately has a risk to its customer, if its customer defaults, the FCM has to carefully risk manage the amount of trades it takes from any one customer and put into the clearinghouse. And so not only do you have to be worried about someone's ability to fund the clearinghouse in a default scenario, noted SIFMA, but you have to be concerned and focused on their ability to risk manage their customer relationships so that they don't put trades into the clearinghouse that could otherwise destabilize the clearinghouse. So, it's not just a wind-down that you have to be concerned about, observed SIFMA, but also the injection of risk into the clearinghouse.

In the view of Jonathan Short of ICE, if you get the governance of the clearinghouse right, a lot of these problems will go away. Risk management is paramount, he emphasized. The reason there is a mandate for clearing in Dodd-Frank is to make the financial system more stable, and, while there are conflicts that have to be dealt with, Mr. Short has never heard the Dodd-Frank Act described as legislation aimed at simply promoting competition among financial institutions. That really wasn't the gist of what Congress was doing here, he added, and, while all of these things need to be considered and balanced, if you create a system that allows too much risk or unmanageable risk to come into the clearinghouse we are going to be right back in front of Congress again with hearings and major problems.

Haimera Workie, SEC Deputy Associate Director, Trading and Markets, said that the Dodd-Frank asks the Commissions to think about restrictions with respect to swap participants, major swap participants, bank holding companies and nonbank financial institutions. When the Commissions are thinking about conflicts and potential restrictions, asked the SEC official, how should they think about them, either collectively within that group, or individually within those subgroups. Mr. Kastner referred the SEC and CFTC staffs to Section 726, which deals with rulemaking on conflicts of interest, what he called Lynch Light, and for the Commissions to consider certain ownership and control restrictions in DCOs. The SDMA strongly supports restrictions on ownership and restrictions on control in DCOs, and the reason why is because if you have a club which is closed and which controls not only what goes into the clearinghouse but who can become a member of it, it does not address the issues of too big to fail and too interconnected to fail. Thus, he strongly suggested that as the Commissions consider the implementation of Section 726, they move forward and impose restrictions because, if they do not, there is a real risk that we are going to end up right back where we started again.

Nancy Schnabel, CFTC Special Counsel in the Division of Clearing and Intermediary Oversight, has heard concerns about the potential tying of execution and clearing. It seems as if the circumstances surrounding clearing now may be slightly different than what have previously happened when LCH was first formed, noted special counsel, for instance by the interdealer banks. There are issues of incentives and conflicts of interest connected to eligibility of clearing.

It is SIFMA’s view that, and Dodd-Frank appears to require this, that clearinghouses be agnostic as to where they accept trades from, so clearinghouses should be open to any swap execution facility. SIFMA believes that there will be multiple SEFs in the marketplace from multiple products, and the clearinghouses should accept trades from multiple SEFs which is consistent with Dodd-Frank’s goal of increasing clearing.

Similarly, SIFMA believes that SEFs should be clearing agnostic as well, meaning that an SEF should be set up to allow the people using the facility to choose which clearinghouse they want to go to. So that clearinghouses should be agnostic and the SEFs, themselves, should be agnostic. SIFMA emphasized that this will ensure that the maximum amount of clearing that can occur will in fact occur.

With regard to members of the clearinghouse, SIFMA believes that anybody who has the capital and the expertise to evaluate risk should be allowed to be a member. But in terms of whether or not those clearing members should have a say in what gets cleared, the key is that the clearing members themselves are the ones who capitalize the clearinghouse. Thus, with respect to all the OTC derivatives clearinghouses, the clearing members have the overwhelming preponderance of capital in the entity. So, for example, XYZ clearinghouse, the clearing members may have put in $5 billion. The clearinghouse itself probably has about $20 to $50 million. So the overwhelming preponderance of capital in the clearinghouse is put up by the clearing members.

In evaluating what trades should be cleared, advised SIFMA, a balance must be struck between the goal of increasing clearing and risk management. You don't want to put trades in the clearinghouse that can't be appropriately risk-managed. So if you put trades in the clearinghouse that are illiquid and can't be valued properly, reasoned SIFMA, what will happen is when a clearing member defaults, there will be insufficient collateral with respect to that trade because it wasn't properly valued in the clearinghouse, and the surviving clearing members will be stressed from an economic perspective in
taking positions the value of which cannot be readily ascertained. Thus, SIFMA told the Commissions that it is critical that only trades that can be appropriately risk-managed be put into the clearinghouse.

SIFMA anticipates that most of the clearinghouses will look to their clearing members to help them valuate which trades are appropriate from a clearing perspective, which is consistent with the economic incentives because the clearing members are the ones who have the overwhelming preponderance of the capital in the clearinghouse. Noting that it is the clearing members that have their capital at risk, SIFMA urged the Commissions to give them a say in helping the clearinghouse evaluate which trades are acceptable for clearing and which trades are too risky or can't be valued, or are too illiquid or not standardized and, therefore, should not be cleared.

A colloquy between Ms. Schnabel, CFTC special counsel, and Mr. Hill of SIFMA revealed that, when SIFMA speaks of the capital of the clearing members that is at risk, it speaks of the default fund and not margin. Ms. Schnabel noted that margin is thus still the first line of defense, and that can be provided by customers as well. SIFMA agreed, but added that, when a clearing member is defaulting and markets are illiquid, if the margin is insufficient, then you look to the default fund to make sure the clearinghouse stays solvent.

Sunday, August 29, 2010

Volcker Board Proposes Changes in Taxation of Investment Funds as Part of Reforming Federal Tax Code

A report issued by the Volcker Tax Advisory Board proposes the reform of mutual fund and carried interest taxation within the scope of a broad simplification of how the Internal Revenue Code taxes capital gains. The report comes against the backdrop of pending but stalled legislation that would reform the carried interest taxation of hedge fund and other asset managers. The Board is chaired by former Fed Chair Paul Volcker and includes former SEC Chair William Donaldson. The Volcker Board, officially the President’s Economic Recovery Advisory Board, has a mandate to simplify and reform the federal tax code.

Capital gains are taxed at the individual level at special rates which depend on factors like the type of income or type of asset, the holding period of the asset, and other accounting rules. Long-term capital gains and qualified stock dividends are taxed separately from other income. A source of complexity arises when a capital gain has occurred and thus when taxes are due. An exchange of property, such as a sale, generally is a taxable transaction, for example, you pay the tax when you sell an asset. However, several provisions allow taxes on capital gains income to be deferred or for the gain to be calculated differently, said the Volcker Board, adding complexity and providing incentives for socially unproductive tax planning. For example, present law provides that *no gain or loss is recognized if property held for productive use in a trade or business or for investment purposes is exchanged for like-kind property (a Section 1031 exchange).

Another area of concern is the taxation of carried interest. The manager or general partner of a hedge fund or investment fund typically receives two types of compensation: a management fee and a percentage of profits generated by the investments called a carried interest. The management fee is taxed as ordinary income, but the carried interest is generally taxed at the lower capital gains tax rate to the extent that the underlying investment has generated long-term capital gains eligible for the lower rate. Many tax experts consider some or all of the carried interest as compensation for managers’ services, and therefore argue that some or all of this compensation should be taxed as ordinary earned income, as is performance-based pay in other professions.

The Volcker Board proposes harmonizing the rules and tax rates for long-term capital gains. Preferential rates would be eliminated. Investors in mutual funds currently have the choice of using several different methods of computing their basis for purposes of computing capital gain. They can choose the average cost basis method, the first-in, first-out method or the specific identification of shares method. Specific identification
is the most taxpayer friendly as it allows selling those shares that have the highest cost and thus the lowest capital gain first. First-in, first-out is generally least taxpayer friendly as the oldest shares are more likely to have been purchased when stock prices were lower, resulting in a larger taxable gain. The average cost method would generally be in between these two methods. With new reporting of basis requirements in effect, however, this creates the potential for confusion and errors if taxpayers use a different method than used by the mutual fund.

The Volcker Board believes that requiring standardization using the average cost method for all shares in a particular mutual fund account would provide the greatest simplification and be a compromise among the methods available. Taxpayers would still have some flexibility as separate accounts would be treated separately. As a transition measure, this could be mandatory only for new shares purchased after date of enactment
(or alternatively starting at the beginning of that calendar year). This option would also
help improve compliance as over time all mutual-fund gain information would be computed and reported by mutual funds. The Board conceded that one disadvantages would be that some mutual fund investors would face higher effective tax rates on their mutual fund investments.

The small business stock exclusion in Section 1202 of the Code has a highly complex set of requirements that must be met throughout the holding period of a shareholder who hopes to benefit from the exclusion. The complex requirements are designed to prevent abuse of this generous provision. In addition, the Small Business Investment Act has been repealed, and there are now only a few small grandfathered Specialized Small Business Investment Companies (SSBICs). Because capital gains tax rates have declined substantially and the excluded gains are taxed as a preference under the AMT, reasoned the Board, there is almost no benefit from these exclusions.

Both the small business stock exclusion and the rollover of qualified small business stock gains have suffered from compliance issues because of limited reporting requirements and enforcement by the IRS. The IRS does not receive third-party information on eligibility of stock owners of potentially qualified small business stock, making the provision difficult to enforce. The rollover provision has also been criticized because of the short six-month holding period, which mainly benefits insiders and traders rather than long-term investors. This provision has been described as a tax benefit allowing a zero capital gains tax, but some small business investors do not re-invest their gains in replacement-qualified small business stock.

The President proposed a zero percent capital gains rate on equity investments in small businesses and a 75 percent exclusion was enacted for investments in 2009 and 2010 as part the American Recovery and Reinvestment Act. Some simplification could be achieved by allowing the 100 percent exclusion for stock purchases starting in 2009 and changing the prior 50 percent exclusion off ordinary income tax rates to a 25 percent exclusion off capital gains rates.

This simplification would retain the extra incentive for qualifying small business investments and result in similar effective tax rates while greatly simplifying the tax calculations. The alternative of repealing these special small business provisions for pre-2009 investments would still provide these investments with the benefits of the general preferential rate for long-term capital gains. Whatever option is chosen, improved reporting is required to help prevent abuse of this provision.

The Board also suggested that the rollover of gains from qualified small business stock (Section 1044) into an investment in another qualified small business stock could be repealed or reformed by lengthening the holding period from six months to at least one year. In the Board’s view, the short six-month holding period requirement is inconsistent with the patient capital rationale for special small business stock incentives.

Saturday, August 28, 2010

Keeping the Dream Alive

I once heard Alabama federal district judge (later named to the 11th Circuit Court of Appeals) Frank Johnson Jr. caution people not to think that federal judges decide momentous civil rights cases every day. Most of the work of federal judges, he said, consists of interpreting arcane federal regulations and US code provisions. Frank Johnson Jr. was the federal judge in the Rosa Parks case, which changed the history of the South and the entire US. So, every once in a while, I have to leave the arcane world of securities regulation to mention something more momentous.
Today is the anniversary of Dr. Martin Luther King Jr.’s ``I have a dream speech’’. It envisions a world and a South where, in Dr. King’s words, `` one day on the red hills of Georgia the sons of former slaves and the sons of former slave owners will be able to sit down together at the table of brotherhood.’’

There is a New South today, and there are many to thank for it, President Jimmy Carter, Senator Claude Pepper of Florida, and dare I mention Governor and later Senator Terry Sanford of North Carolina, yes I do dare because he was a great man also.

But if the New South has a father, it has to be Dr. King. When I drive past the new gleaming auto plants and Seimens plants in South Carolina and Georgia and see the sign announcing a new $1 billion VW plant in Tennessee, I think how Dr. King made it all possible. Yes, he did. Because no global company, not Nissan not BMW not Seimens, would ever have come and built large new plants in a segregated South. That would never have happened, and that is the God’s truth.
So, on the anniversary of ``I have a dream’’ let us pause to honor Dr. King. Tomorrow, we return to the arcane world of securities regulation.

Friday, August 27, 2010

Hong Kong Securities Regulator Calls for Internationally Harmonized Hedge Fund Regulation

A senior official of the Hong Kong Securities and Futures Commission emphasized that the regulation of hedge funds must be globally harmonized in order to prevent regulatory arbitrage and protectionist entry barriers. In remarks at a seminar, SFC Executive Director Alexa Lam said that large financial firms are internationally active, operating through affiliates in many countries, and financial markets themselves are increasingly linked. Thus, regulators must minimize scope for arbitrage between different regulatory requirements and ensure that data is able to be analyzed at the appropriate level when assessing matters such as systemic risk.

The challenges are numerous. Once regulatory gaps are identified and measures are being considered to address them, said the Executive Director, regulators must weigh the cost or regulatory burden against the benefit sought, and determine the best way to achieve the main objective. Regulators will have to take into account not just universal but local and regional needs or market characteristics, she continued, and also the time-sensitivity of a given matter at issue. And there will be issues and measures that have implications at a global level and others that by their nature have a more localized effect. With hedge funds and other alternative investment funds, the international issues involve requirements for registration and operations, reporting, and other transparency measures. Some of the measures being proposed target hedge funds in particular.

Hedge fund managers carrying on business in Hong Kong are subject to the Commission’s regulatory regime and are required to be licensed. Once licensed, they are subject to SFC supervision. To improve the transparency of Hong Kong’s hedge fund industry, the Commission has conducted surveys of Hong Kong-licensed hedge fund managers in recent years. Together with other IOSCO members, the SFC is also participating in the collection of information from hedge funds pursuant to the framework developed by IOSCO to facilitate assessment of systemic risk.

The Executive Director noted that the SFC has been carrying out joint inspections with the SEC both in the US and in Hong Kong of hedge fund managers who are both licensed in Hong Kong and registered with the SEC. Thus, while other jurisdictions are putting in place a licensing and supervision regime covering hedge fund managers, the SFC has regulatory supervision over those hedge fund managers who operate in Hong Kong. One of the areas of focus of the G-20 and the Financial Stability Board is on systemically important non-banks, such as hedge funds. The SFC official pledged to follow the global regulatory developments in the alternative investment fund area closely to ensure that the SFC regime continues to meet international standards.

The SFC is particularly concerned with the proposed EU Alternative Investment Fund Managers Directive relating to the marketing in the EU, or sale to EU investors, of hedge funds managed by non-EU managers or located in non-EU countries. Much has already been said about this aspect of the draft Directive, and its terms are still being debated, but the SFC fears that it has the potential to restrict substantially the universe of these types of funds available to EU investors. In the Executive Director’s view, this could be detrimental not just to the managers and the funds concerned but also to the EU investor base.

One version of the Directive, which is currently moving towards legislative enactment, would sharply limit the access of European professional and institutional investors to legitimate investment opportunities from non-EU hedge funds. In an earlier letter to EU finance ministers, Treasury Secretary Tim Geithner called on the European Union to participate in a globally coordinated approach toward financial regulatory reform and resist protectionist-driven initiatives in the proposed Alternative Investment Fund Manager Directive. Specifically, he asked that EU legislation regulating hedge funds not discriminate against US and other third country hedge funds not based in the EU.

Thursday, August 26, 2010

Dodd-Frank Volcker Provisions Sponsor Explains GSE Permission

The Volcker provisions of the Dodd-Frank Act authorize banks and non-bank financial companies to purchase or sell government obligations, including government-sponsored enterprise (GSE), obligations. According to Senator Jeff Merkley, a co-author of the provisions, Dodd-Frank does this on the grounds that such products are used as low-risk, short-term liquidity positions and as low-risk collateral in a wide range of transactions, and so are appropriately retained in a trading account.

Allowing trading in a broad range of GSE obligations is also meant to recognize a market reality that removing the use of these securities as liquidity and collateral positions would have significant market implications, including negative implications for the housing and farm credit markets. By authorizing trading in GSE obligations, noted Sen. Merkley, the language is not meant to imply a view as to GSE operations or structure over the long-term, and permits regulators to add restrictions on this permitted activity as necessary to prevent high-risk proprietary trading activities. When GSE reform occurs, Congress expects that these provisions will be adjusted accordingly. Moreover, as is the case with all permitted activities under Section 619, regulators are expected to apply additional capital restrictions as necessary to account for the risks of the trading activities. (Cong. Record, July 15, 2010. p. S5895).

A consensus is growing that GSE reform legislation will happen next year in the 112th Congress.

Wednesday, August 25, 2010

SEC Adopts Proxy Access for Significant Long-Term Shareholders

Armed with specific congressional authorization, the SEC has adopted shareholder proxy access, which is shorthand for a framework of rules under which a shareholder may require the company to include in its proxy statement and proxy card a person nominated by the shareholder, and not by the board, for election to the board. This effort finds itself resting on an historical bedrock principle of federal securities regulation, which is that the proxy rules seek to improve the corporate proxy process so that it functions, as nearly as possible, as a replacement for an actual in-person meeting of shareholders. The Dodd-Frank Wall Street Reform and Consumer Protection Act authorized the SEC to implement shareholder access to management’s proxy card to nominate directors for election to the board.

In the SEC’s view, to refine the proxy process so that it replicates, as nearly as possible, the annual meeting is particularly important given that the proxy process has become the primary way for shareholders to learn about the matters to be decided by the shareholders and to make their views known to company management. The proxy access rules are intended to remove impediments so shareholders may more effectively exercise their rights under state law to nominate and elect directors at meetings of shareholders. As far back as 1943, then SEC Chairman Ganson Purcell testified before Congress that the rights that the SEC is endeavoring to assure to the stockholders are those rights that they have traditionally had under state law.

Under new Exchange Act Rule 14a-11, companies would be required to include a shareholder nominee or nominees for director in company proxy materials if the shareholder meets certain conditions, and if the shareholders are not otherwise prohibited by applicable state or foreign law or a company’s governing documents from nominating a candidate for election as a director.

Shareholders would be eligible to have their nominee included on management’s proxy card if they own at least 3 percent of the total voting power of the company’s securities that are entitled to be voted on the election of directors at the annual meeting, shareholders would be able to aggregate holdings to meet this threshold, and have held their shares for at least three years. The shareholders would be required to continue to own at least the required amount of securities through the date of the meeting at which directors are elected. However, shareholders would not be eligible to use the rule if they are holding the securities for the purpose of changing control of the company, or to gain a number of seats on the board of directors that exceeds the number of nominees a company could be required to include under Rule 14a-11.

The proxy access rule would apply to all Exchange Act reporting companies, including investment companies, other than companies whose only public securities are debt securities. Smaller reporting companies would be subject to the rule, but it would not apply to them until after a three-year phase in period. Foreign companies that come within the definition of “foreign private issuer” are not subject to the SEC’s proxy rules and would not be subject to these new rules. Foreign companies that do not qualify as foreign private issuers would be subject to the rules.

A shareholder would be able to include no more than one nominee, or a number of nominees that represents up to 25 percent of the company’s board of directors, whichever is greater. For example, if the board is comprised of three members, one shareholder nominee could be included in the proxy materials. If the board is comprised of eight members, up to two shareholder nominees could be included in the proxy materials.

The nominee’s candidacy or, if elected, board membership must not violate applicable laws and regulations. The shareholder’s nominee for director must also satisfy objective independence standards of the applicable national securities exchange or national securities association. Neither the nominating shareholder nor the director nominee may have a direct or indirect agreement with the company regarding the nomination of the nominee. But there would be no restrictions on the relationship between the nominating shareholder and the nominee.

The nominating shareholder would be required to file with the SEC and submit to the company a new Schedule 14N, which would be publicly available on EDGAR. The Schedule 14N would require, among other things, disclosure of the amount and percentage of the voting power of the securities owned by the nominating shareholder, the length of ownership, and a statement that the nominating shareholder intends to continue to hold the securities through the date of the meeting. The disclosure provided in Schedule 14N would identify the nominee or nominees, would include biographical information about the nominees, and would include a description of the nature and extent of the relationships between the nominating shareholder and nominees and the company. In addition, Schedule 14N would require several certifications relating to eligibility and the accuracy of the information provided. A nominating shareholder could also include a statement of support for its nominee in the Schedule 14N.

The company would include in its proxy materials disclosure concerning the nominating shareholder, as well as the shareholder nominee or nominees, that is similar to the disclosure currently required in a contested election. As is the case when directors nominate candidates, the nominating shareholder or group would be liable for any false or misleading statements it makes about the nomination, regardless of whether the statements are included in the company’s proxy materials. A company will not be responsible for information provided by the shareholder and then reproduced in the company’s proxy materials.

For Rule 14a-11, shareholders must submit nominees no later than 120 days before the anniversary date of the mailing of the company’s proxy statement in the prior year. Shareholders will be able to submit nominees for inclusion in the next year’s proxy statement if the 120 day deadline falls on or after the effective date of the rules. For example, if the rules become effective on Nov. 1, 2010, Rule 14a-11 generally would be available at companies that mailed their proxy statement for their last annual meeting no earlier than March 1, 2010.

The SEC also amended Exchange Act Rule 14a-8(i)(8) requiring companies to include in their proxy materials shareholder proposals seeking to establish a procedure in the company’s governing documents for the inclusion of shareholder director nominees in company proxy materials. Currently, Rule 14a-8(i)(8) permits companies to exclude shareholder proposals that relate to elections. Under the amendment, this so-called election exclusion would be narrowed, thereby allowing in the proxy materials more shareholder proposals regarding elections.

Specifically, shareholder proposals by qualifying shareholders that seek to establish a procedure in the company’s governing documents for the inclusion of shareholder director nominees in company proxy materials would not be excludable under amended Rule 14a-8(i)(8). A company would not be required to include in its proxy materials a shareholder proposal that seeks to limit the availability of Rule 14a-11.

The Council of Institutional Investors and others maintain that the current federal proxy rules for the election of directors are flawed because they prohibit shareholders from placing the names of their own director candidates on proxy cards. Rather, in the United States, unlike most of Europe, the only way that shareowners can run their own candidates is by waging a full-blown election contest and printing and mailing their own proxy cards to shareowners. For most investors, that is onerous and prohibitively expensive.Shareholder proxy access is viewed as a sound corporate governance imperative. In the Council’s view, a measured right of access will invigorate board elections and make boards more responsive to shareowners, more thoughtful about whom they nominate to serve as directors and more vigilant in their oversight of companies. The

Consistent with good governance, the SEC is focused on removing burdens that the federal proxy process currently places on the ability of shareholders to exercise their basic rights to nominate and elect directors. The Commission believes that shareholder proxy access will facilitate shareholders’ ability to participate more fully in the debates surrounding the issues. To the extent shareholders have the right to nominate directors at meetings of shareholders, the federal proxy rules should not impose unnecessary barriers to the exercise of this right. Proxy access is consistent with investor protection, noted the SEC, since investors are best protected when they can exercise the rights they have as shareholders without unnecessary obstacles imposed by the federal proxy rules.

Tuesday, August 24, 2010

Dodd-Frank Legislative History Reveals What is Expected of SEC and CFTC REgarding Block Trades

Block trades are transactions involving a very large number of shares or dollar amount of a particular security or commodity and which transactions could move the market price for the security or contract, and are very common in the securities and futures markets. Block trades, which are normally arranged privately off exchange, are subject to certain minimum size requirements and time delayed reporting. Dodd-Frank authorizes the SEC and CFTC to establish what constitutes a block trade or large notional swap transaction for particular contracts and commodities as well as an appropriate time delay in reporting such transaction to the public.

Congress expects the SEC and CFTC to distinguish between different types of swaps based on the commodity involved, size of the market, term of the contract and liquidity in that contract and related contracts, i.e; for instance the size/dollar amount of what constitutes a block trade in 10-year interest rate swap, 2-year dollar/euro swap, 5-year CDS, 3-year gold swap, or a 1-year unleaded gasoline
swap are all going to be different. (Cong. Record, July 15, 2010, S5921).

While Congress expects the SEC and CFTC to distinguish between particular contracts and markets, said Senator Lincoln, the guiding principal in setting appropriate block trade levels should be that the vast majority of swap transactions should be exposed to the public market through exchange trading. With respect to delays in public reporting of block trades, Congress expects the SEC and CFTC to keep the reporting delays as short as possible. (Cong. Record, July 15, 2010, S5922).

Sen. Lincoln Explains Derivatives Clearing Provisions of Dodd-Frank

The mandatory clearing and trading of swaps and security-based swaps, along with real-time price reporting, is at the heart of swaps market reform. Under the Act, swaps and security-based swaps determined to be subject to the mandatory clearing requirement by the SEC and CFTC would also be required to be traded on a designated contract market, a national securities exchange, or new swap execution facilities or security-based swap execution facilities.

To avoid any conflict of interests, the CFTC and SEC will make a determination as to what swaps must be cleared following certain statutory factors. It is expected that the standardized, plain vanilla, high volume swaps contracts, which according to the Treasury Department are about 90 percent of the $600 trillion swaps market, will be subject to mandatory clearing. Derivatives clearing organizations and clearing agencies are required to submit all swaps and security-based swaps for review and mandatory clearing determination by the SEC and CFTC. It will also be unlawful for any entity to enter into a swap without submitting it for clearing if that swap has been determined to be required to clear. Congress understands that approximately 1,200 swaps and security-based swaps contracts are currently listed by CFTC-registered clearing houses and SEC-registered clearing agencies for clearing. Under the Dodd-Frank Act these 1,200 swaps and security-based swaps already listed for clearing are deemed submitted to the SEC and CFTC for review upon the date of enactment.

Senator Blanche Lincoln expects the SEC and CFTC, which are already familiar with these 1,200 swap and security-based swap contracts, to work within the 90-day time frame they are provided to identify which of the current 1,200 swap and security-based swap agreements should be subject to mandatory clearing requirements. The SEC and CFTC may also identify and review swaps and security-based swaps which are not submitted for clearinghouse or clearing agency listing and determine that they are or should be subject to mandatory clearing requirement. Senior members of the Senate Agriculture Committee consider this to be an important provision because it removes the ability for the clearinghouse or clearing agency to block a mandatory clearing determination. (Cong. Record, July 15, 2010, S5921).

Sunday, August 22, 2010

SIFMA Provides Best Practices on Dodd-Frank Provision Requiring Broker Notification of Short-Sales

The Dodd-Frank Act, Sec, 929X, requires brokers to provide notice to their customers that they may elect not to allow their fully paid securities to be used in connection with short sales. And a broker using a customer’s securities in connection with short sales must provide notice to its customer that the broker may receive compensation in connection with lending the customer’s securities. Section 929X appears to be self-operating, noted SIFMA, since it provides that the SEC may prescribe the form, content, time and manner of delivery of any such notice.

SIFMA has outlined some best practices for compliance with the notice requirements of Section 929X, which are based on discussions with various SIFMA members, as well as discussions with the staff in the SEC Division of Trading and Markets. Pursuant to Rule 15c3-3 under the Securities Exchange Act , brokers are generally prohibited from borrowing a customer’s fully-paid securities unless they enter into a separate written agreement with the customer that contains the provisions set forth under Rule 15c3-3(b)(3).

Therefore, according to SIFMA, to comply with the notice requirements of Section 929X, brokers should consider reviewing their disclosures to existing customers with brokerage accounts with whom they have entered into a fully-paid lending agreement pursuant to Rule 15c3-3(b)(3), and make any necessary adjustments to such disclosures before engaging in any new borrows with such customers. More specifically, brokers should consider the extent to which their disclosures provide notice to such customers that fully-paid securities they lend to the broker-dealer may be used in connection with short sales, and that the broker-dealer may receive compensation in connection with the use of the customer’s fully-paid securities.

In addition to ensuring that this disclosure is included in disclosures to existing customers with brokerage accounts with whom the broker-dealer has entered into a fully-paid lending agreement pursuant to Rule 15c3-3(b)(3), continued SIFMA, broker-dealers should also consider the fact that the language of Section 929X does not specifically reference that this disclosure only applies to fully-paid securities. Brokers should therefore consider the extent to which such disclosure should also be sent to margin customers whose securities may be rehypothecated. While firms may choose different mechanisms to disseminate this information to such margin customers, SIFMA suggested that one approach could be to include such notice in the course of standard information provided to existing margin customers in the next available cycle, for example as part of information provided in a customer statement or otherwise, as well as through amendments to agreements for future margin customers.

Friday, August 20, 2010

Sen. Collins Explains Intent of Dodd-Frank Leverage Requirements

According to Senator of Susan Collins, author of Section 171, it is the intent of Section 171(b)(7) to require the federal banking agencies, subject to the recommendations of the Financial Stability Oversight Council, to develop capital requirements applicable to insured depository institutions, depository institution holding companies, and nonbank financial companies supervised by the Federal Reserve Board that are engaged in activities that are subject to heightened standards under Section 120 of the Act.

However, a colloquy between Senator Collins and Senator Shaheen, in which Senator Dodd concurred, revealed that Section 171(b)(7) does not to create any inference that minimum capital requirements are the appropriate standard or safeguard for the Council to recommend to be applied to any non-bank financial company that is not subject to Fed supervision with respect to any Section 120 activity. Rather, the Council has full discretion not to recommend the application of capital requirements to any such non-bank financial firm engaged in any such activity. While minimum capital rules can shield public and private stakeholders from risks posed by material distress that could arise from firms engaging in certain activities, noted Senator Collins, minimum capital rules may not be an appropriate tool to apply under all circumstances. (Cong. Record, July 15, 2010, S5903).

Dodd-Lincoln Colloquy Says US Branches of Foreign Banks Treated the Same under Bank Push Out Provisions

In the rush to complete the House-Senate conference on the Dodd-Frank Act, there was a significant oversight made in finalizing section 716 as it relates to the treatment of uninsured U.S. branches of foreign banks. Under section 716, insured depository institutions must push out all swaps and security-based swaps activities except for specifically enumerated activities, such as hedging and other similar risk mitigating activities directly related to the insured depository institution’s activities.

Under the U.S. policy of national treatment, which has been part of U.S. law since the International Banking Act of 1978, uninsured U.S. branches of foreign banks are authorized to engage in the same activities as insured depository institutions. While these U.S. branches of foreign banks do not have deposits insured by the FDIC, they are registered and regulated by a federal banking regulator, they have access to the Federal Reserve discount window, and other Federal Reserve credit facilities. A number of these U.S. branches of foreign banks will be swap entities under section 716 and title VII of Dodd-Frank. Due to the fact that the section 716 safe harbor only applies to insured depository institutions it means that U.S. branches of foreign banks will be forced to push out all their swaps activities. According to a colloquy between Senator Dodd and Senator Lincoln, this result was not intended. U.S. branches of foreign banks should be subject to the same swap desk push out requirements as insured depository institutions under section 716.

U.S. branches of foreign banks should, and are willing to, meet the push out requirements of section 716 as if they were insured depository institutions. Senator Dodd agreed that uninsured U.S. branches of foreign banks are included in the safe harbor of section 716 and should be treated the same as insured depository institutions under the provisions of section 716, including the safe harbor language. (Cong. Record, July 15, 2010, pp. S5903-5904).

Sen. Lincoln Says that Dodd-Frank Bank Push Out Provision Includes Mini-Volcker Rule

The bank push out provisions of Section 716 of the Dodd-Frank Act essentialy require banks to divest types of derivatives activities considered to carry the greatest risk, while allowing banks to retain the majority of thier low-risk derivatives activities on behalf of customers.

According to Senator Blanche Lincoln, author of the provision, a mini-Volcker rule was incorporated into Section 716. Banks, their affiliates and their bank holding companies would be prohibited from engaging in proprietary trading in derivatives. This provision would prohibit
banks and bank holding companies, or any affiliate, from proprietary trading in swaps as well as other derivatives. This was an important expansion and linking of the Lincoln Rule in Section 716 with the Volcker Rule in Section 619 of Dodd-Frank. (Cong. Record, July 15, 2010, S5922).

Section 716’s effective date is two years from the effective date of the title, with the possibility of a one year extension by the appropriate federal banking agency. Senator Lincoln said that the appropriate federal banking agencies should be looking at the affected banks and evaluating the appropriate length of time which a bank should receive in connection with its push out. Under the revised Section 716, she noted, banks do not have a right to a 24 month phase-in for the push out of the impermissible swap activities. The appropriate federal banking agencies should be evaluating the particular banks and their circumstances under the statutory factors to determine the appropriate time frame for the push out. (Cong. Record, July 15, 2010, S5922).

Thursday, August 19, 2010

Delaware Supreme Court Orders Defunct Hedge Fund to Provide Names and Addresses of Limited Partners to Fund Investor

The Delaware Supreme Court has ruled that a limited partner of a defunct hedge fund had the right to obtain a list of the names and addresses of its fellow limited partners and that federal privacy regulations did not preempt this right. Thus, the en banc Court affirmed a Chancery Court order to the hedge fund to produce the list. (Parkcentral Global, L.P. v. Brown Investment Management, L.P., Del Supreme Court, CA No. 5248, August 12, 2010).

By November 2008, the hedge fund had suffered large losses that wiped out investors’ capital. As a result, this limited partner lost its entire investment. The hedge fund is no longer in any active business and has no business plan. The limited partner sought the information in an effort to contact other limited partners in order to investigate claims of the fund general partner’s mismanagement or breaches of fiduciary duty.

The Court noted that the partnership agreement expressly grants limited partners the right to access a list of the names and addresses of each partner. The limited partner complied with all the procedural requirements which entitled it to the list of names and addresses, said the Court, and the general partner may not eliminate that right through unilaterally issued privacy notices.

The full Court also rejected the fund’s assertion that federal regulations pre-empt Delaware law and prohibit disclosure of the shareholder list. The Gramm-Leach-Bliley Act of 1999 provides privacy protections for customers of financial institutions. Pursuant to the Act, the SEC, CFTC, and FTC adopted rules designed to protect individuals’ privacy interests. Under these privacy regulations, a financial institution may not disclose any nonpublic personal information about a consumer to a non-affiliated third party unless the individual has been provided notice and the opportunity to opt out of the disclosure.

The privacy regulations do not pre-empt Delaware law in this instance, noted the Court, nor do the federal statute or regulations apply to the partner list. The federal agencies did not express a clear intent to pre-empt state law. Rather, to comply with state law, they included an exception to the notice and opt out requirements when a financial institution discloses non-public personal information. For example, the FTC’s regulations provide an exception to comply with federal, state, or local laws. Disclosure of the list of the limited partners’ names and addresses to another limited partners falls within that exception, said the Supreme Court, because the Delaware Code requires it.

Finally, the Court rejected the hedge fund’s contention that the partnership agreement allowed it to keep the list of names and addresses confidential because it believed in good faith that disclosure would damage the fund. The Court found that the fund did not demonstrate that it had a good faith belief that providing a list of names and addresses would harm the fund. In that context, the Court noted that the hedge fund does not actively conduct business and thus has no business to damage. Disclosure of the names and addresses of the partners may harm the general partner’s reputation and it may limit certain individuals’ ability to gain investors in future funds, said the Court, but it will not damage the fund.

Wednesday, August 18, 2010

Key Senators Urge the SEC to Adopt Regulations Enhancing Off-Balance Sheet Disclosures

Six key Democratic Senators have urged the SEC to use its existing authority under Sarbanes-Oxley to require that companies write detailed descriptions of all their off-balance sheet activities in their annual Form 10-K reports and not just descriptions of those activities that are reasonably likely to affect the firm’s financial condition, as the regulations currently state. In a letter to SEC Chair Mary Schapiro, the senators also urged the Commission to require companies to explicitly justify why they have not brought those liabilities onto the balance sheet. As regulators implement the Dodd-Frank Wall Street Reform and Consumer Protection Act, noted the senators, the complete disclosure of all off-balance sheet activities is particularly crucial for the largest and most interconnected companies, including both banks and non-banks. Without such disclosure, they emphasized, it will be almost impossible for regulators to set appropriate capital and leverage requirements under Dodd-Frank and for investors and counterparties to make wise decisions about where to put their money.

Moreover, the senators urge the SEC to encourage the FASB to improve financial reporting rules for all types of off-balance sheet activities and to monitor FASB’s efforts to prohibit off-balance sheet financing. The letter to the SEC Chair was signed by Senators Robert Menendez, Ted Kaufman, Barbara Boxer, Diane Feinstein, Carl Levin, and Sherrod Brown.

The Sarbanes-Oxley Act authorized the SEC to require reporting of off-balance sheet activities. While the SEC did issue rules on off-balance sheet activity pursuant to Sarbanes-Oxley, noted the senators, they are troubled that, despite these rules, widespread off-balance sheet accounting arrangements allowed large financial firms to hide trillions of dollars in obligations from investors, creditors, and regulators. As Frank Partnoy and former SEC Chief Accountant Lynn Turner wrote in a recent report, noted the senators, abusive off-balance sheet accounting was a major cause of the financial crisis. The report indicates that these abuses triggered a daisy chain of dysfunctional decision-making by removing transparency from investors, markets, and regulators. Off-balance sheet accounting facilitated the spread of the bad loans, securitizations, and derivative transactions that brought the financial system to the brink of collapse.

For example, said the senators, Citigroup reportedly kept $1.1 trillion worth of assets off its books in various financing vehicles and trusts that were used to handle mortgage-backed securities and issue short-term debt. In addition, State Street shareholders saw their investment value drop by 60% in a single day when hidden off-balance sheet conduits sustained heavy losses under credit turmoil in January 2009. Neither of these companies adequately disclosed the risks posed by their off-balance sheet activities to investors. Had they done so, said the senators, investors and creditors might have made better decisions.

The senators also urged the SEC to pay particular attention to the large market for repurchase agreements. They are concerned by both the risks of using short-term funding for longer-term holdings and that firms may be engaging in these transactions with the intent to hide their true debt and risk levels. As an example of such, they cited Lehman Brothers use of the Repo 105 transaction as particularly troubling. According to the Lehman Brothers Examiner’s Report, Lehman took advantage of accounting rules to temporarily book a loan as a sale, and by carefully timing this transaction just before the release of its quarterly financial report, Lehman was able to deceive the public and regulators into thinking it was much better capitalized than it actually was.

The federal bankruptcy court examiner concluded that there were colorable claims against Lehman’s outside auditor for its failure to question and challenge improper or inadequate disclosures in Lehman’s financial statements. Similarly, the examiner found colorable claims against the Lehman senior officers who oversaw and certified the firm’s misleading financial statements. Further, although repo transactions engaged in by the firm may not have been inherently improper, the examiner found a colorable claim that their sole function as employed by Lehman was balance sheet manipulation. On September 15, 2008, as the financial crisis roiled, Lehman Brothers Holdings, Inc. sought Chapter 11 protection in the largest bankruptcy proceeding ever filed.

In order to prevent this from happening in the future, the senators urged the SEC to require disclosure of period end and daily average leverage ratios in quarterly and annual reports. This would provide useful information to investors and creditors to assist their decision-making processes. Rather than relying on carefully-staged quarterly and annual snapshots, said the senators, investors and creditors should have access to a complete real-life picture of a company’s financial situation.

The SEC was founded on the premise that when investors and creditors have full and accurate information about companies’ finances, they can allocate capital effectively. But when companies use accounting gimmicks to mislead investors and creditors, capital markets malfunction. As the financial markets attempt to recover from the latest meltdown, the senators want the SEC, in addition to aggressively investigating and prosecuting past misconduct, tol put in place new rules that will make it harder for companies to mislead investors and creditors in the future.

Tuesday, August 17, 2010

Citing Express and Pervasive SEC Enforcement Powers, Ninth Circuit Rejects Implied Private Right of Action for Sec. 13(a) of Investment Company Act

A Ninth Circuit panel ruled that there is no implied private cause of action to enforce the provisions of Section 13(a) of the Investment Company Act, which requires an investment company to obtain shareholder approval before deviating from the investment policies contained in the company’s SEC-filed registration statement. Neither the language of Section 13(a) nor its legislative history, nor the structure of the Investment Company Act of 1940 reflect any congressional intent to either create or recognize a previously established private right of action under the statute. Rather, the panel emphasized that the job of enforcement remains exclusively with the SEC by express command of the 1940 Act itself. The appeals court followed the modern trend in the federal courts of denying the existence of implied private rights of action under the 1940 Act. (Northstar Financial Advisors, Inc. v. Schwab Investments, CA-9, No. 09-16347, Aug. 12, 2010).

The action involved claims by investors that a large investment trust operating a series of mutual funds deviated from the investment policies set forth in its registration statement to the detriment of the fund’s shareholders and in violation of Section 13(a). The court first analyzed whether Section13(a)’s language and structure contains an implied private right of action. The panel concluded that there is no language in 13(a) that would imply Congress intended to allow private enforcement of the statute’s requirements. There is no “rights-creating language.”

More broadly, the panel next held that the structure of the 1940 Act suggests no congressional intent to allow private enforcement. The Act specifically authorizes SEC enforcement of the 1940 Act, said the court, and Congress created an express private right of action against investment advisors for breach of certain fiduciary duties in § 36(b). The panel said that Congress did not intend to imply a private right to enforce other sections of the 1940 Act because the very structure of the Act does not indicate that Congress intended to create an implied private right to enforce the individual provisions of the Act.

Congress expressly authorized the SEC to enforce all of the provisions of the Act by granting the Commission broad authority to investigate suspected violations; initiate actions in federal court for injunctive relief or civil penalties; and create exemptions from compliance with any ICA provision, consistent with the statutory purpose and the public interest. In the panel’s view, this thorough delegation of authority to the SEC to enforce the ICA strongly suggests Congress intended to preclude other methods of enforcement.

Because the statutory scheme of the 1940 Act provides for thorough SEC enforcement of the Act’s provisions, including Section 13(a), reasoned the panel, it is highly improbable that Congress absentmindedly forgot to mention an intended private action. Moreover, it is evident from the text of the 1940 Act that Congress knew how to create a private right of action to enforce a particular section of the Act when it wished to do so. In Section 30(f) of the original 1940 Act (now codified at 15 U.S.C. § 80a-29(h), Congress expressly authorized private suits for damages against insiders of closed-end investment companies who make short-swing profits.

Congress created a second express private right of action in 1970 when it added Section 36(b) to the ICA, which allows shareholders to sue an investment company’s advisor and its affiliates for breach of certain fiduciary duties relating to management fees. According to the court, Congress’s enactment of these two express private rights of action elsewhere in the ICA, without the enactment of a corresponding express private right of action to enforce Section 13(a), indicates that Congress did not, by its silence, intend a private right of action to enforce Section 13(a).

Legislative History Clarifies Dodd-Frank Derivatives End User Exemption

The Dodd-Frank Act derivatives end user exemption gives commetcial end users the option, but not the obligation, to clear or not clear their swaps and security-based swaps that have been determined to be required to clear, as long as those swaps are being used to hedge or mitigate commercial risk. Senator Blanche Lincoln has noted that this option is solely the end users’ right. If the end user opts to clear a swap, the end user also has the right to choose the clearing house where the swap will be cleared. Further, the end user has the right, but not the obligation, to force clearing of any swap or security-based swap which is listed for clearing by a clearing house or clearing agency but which is not subject to mandatory clearing requirement. Again the end user has the right to choose the clearing house or clearing agency where the swap or security-based swap will be cleared. The option to clear is meant to empower end users and address the disparity in market power between the end users and the swap dealers. (Cong. Record, July 15, 2010, S5921).

Under the Act, specified financial entities are prohibited from using the end user exemption. While most large financial entities are not eligible to use the end user exemption for standardized swaps entered into with third parties, it would be appropriate for the SEC and CFTC to exempt from mandatory clearing and trading inter-affiliate swap transactions between wholly-owned affiliates of a financial entity. Congress also believes that small financial entities, such as banks, credit unions and farm credit institutions below $10 billion in assets, and possibly larger entities, will be permitted to utilize the end user clearing exemption with approval from the SEC and CFTC. The Act also includes an anti-evasion provision which provides the CFTC and SEC with authority to review and take action against entities which abuse the end user exemption. (Cong. Record, July 15, 2010, S5921).

A colloquy between Senator Susan Collin and Senator Chris Dodd revealed that it is the intent of Congress that an end user does not become a swap dealer by virtue of using an affiliate to hedge its own commercial risk. Thus, end users that execute swaps through an affiliate should not be deemed to be swap dealers under Dodd-Frank just because they hedge their risks through affiliates. (Cong. Record, July 15, 2010, p. S5907).

Washington State Proposes Dodd-Frank Accredited Investor Definition

Washington State's "accredited investor" definition was proposed for amendment to exclude to the value of an investor's primary residence from the $1 million net worth calculation to reflect the modification in the federal "accredited investor" definition under the Dodd-Frank Act.

Monday, August 16, 2010

Dodd-Frank Sets Process for SEC and CFTC to Resolve Jurisdictional Status of Novel Derivatives Products

The Dodd-Frank Act establishes a new process for the CFTC and SEC to resolve the status of novel derivative products. In the past, said Senator Blanche Lincoln, these types of novel and innovative products have gotten caught up in protracted jurisdictional disputes between the agencies, resulting in delays in bringing products to market and placing U.S. firms and exchanges at a competitive disadvantage to their overseas counterparts. (Cong. Record, July 15, 2010, S5923).

In their Joint Harmonization Report of October 2009, the SEC and CFTC recommended legislation to provide legal certainty with respect to novel derivative product listings, either by a legal determination about the nature of a product or through the use of the agencies’ respective exemptive authorities.

According to Senator Lincoln, Dodd-Frank implements these recommendations by establishing a process that requires public accountability by ensuring that jurisdictional disputes are resolved at the Commission rather than staff level, and within a firm time frame. Specifically, either the SEC or the CFTC can request that the other one make a legal determination whether a particular product is a security under SEC jurisdiction or a futures contract or commodity option under CFTC jurisdiction; or grant an exemption with respect to the product. An agency receiving such a request from the other agency is to act on it within 120 days. (Cong. Record, July 15, 2010, S5923).

Dodd-Frank also provides for an expedited judicial review process for a legal determination where the agency making the request disagrees with the other’s determination. The Act also ensures that if either agency grants an exemption, the product will be subject to the other’s jurisdiction, so there will be no regulatory gaps. For example, the Commodity Exchange Act is amended to clarify that the CFTC has jurisdiction over options on securities and security indexes that are exempted by the SEC.

Senator Lincoln strongly urged the SEC and CFTC to work together under these new provisions to alleviate the ills that they themselves have identified. The SEC and CFTCs should make liberal use of their exemptive authorities to avoid spending taxpayer resources on legal fights over whether these novel derivative products are securities or futures, and to permit these important new products to trade in either or both a CFTC- or SEC-regulated environment. (Cong. Record, July 15, 2010, S5923).

Senator Levin Explains Intent of Dodd-Frank Conflict of Interest Provision for Firms Profiting from Failure of Securities They Packaged

The intent of Section 621 of the Dodd-Frank Act is to prohibit underwriters, sponsors, and others who assemble asset-backed securities, from packaging and selling those securities and profiting from the securities’ failures. Given the unique control that firms packaging and selling asset-backed securities have over transactions involving those securities, Section 621 of Dodd-Frank protects purchasers by prohibiting those firms from engaging in transactions involving or resulting in material conflicts of interest. The conflicts of interest provision under Section 621 arises directly from the hearings and findings of the Senate Permanent Subcommittee on Investigations, which dramatically showed how some firms were creating financial products, selling those products to their customers, and betting against those same products.

Senator Carl Levin, the principal author of Section 621, likened this practice to selling someone a car with no brakes and then taking out a life insurance policy on the purchaser. In the asset-backed securities context, the sponsors and underwriters of the asset-backed securities are the parties who select and understand the underlying assets, and who are best positioned to design a security to succeed or fail. They, like the mechanic servicing a car, would know if the vehicle has been designed to fail. And so they must be prevented from securing handsome rewards for designing and selling malfunctioning vehicles that undermine the asset-backed securities markets. It is for that reason that Congress prohibited those entities from engaging in transactions that would involve or result in material conflicts of interest with the purchasers of their products (Cong. Record, July 15, 2010, S5901)

However, Section 621 is not intended to limit the ability of an underwriter to support the value of a security in the aftermarket by providing liquidity and a ready two-sided market for it. Nor does it restrict a firm from creating a synthetic asset-backed security, which inherently contains both long and short positions with respect to securities it previously created, so long as the firm does not take the short position. But a firm that underwrites an asset-backed security would run afoul of the provision if it also takes the short position in a synthetic asset-backed security that references the same assets it created. In such an instance, noted Senator Levin, even a disclosure to the purchaser of the underlying asset-backed security that the underwriter has or might in the future bet against the security will not cure the material conflict of interest. (Cong. Record, July 15, 2010, S5899).

While a strong prohibition on material conflicts of interest is central to Section 621, Congress recognized that underwriters are often asked to support issuances of asset-backed securities in the aftermarket by providing liquidity to the initial purchasers, which may mean buying and selling the securities for some time. That activity is consistent with the goal of supporting the offering, is not likely to pose a material conflict, and thus Congress was comfortable in excluding it from the general prohibition. Similarly, market conditions change over time and may lead an underwriter to wish to sell the securities it holds. That is also not likely to pose a conflict. But Senator Levin cautioned federal regulators to act diligently to ensure that an underwriter is not making bets against the very financial products that it assembled and sold. (Cong. Record, July 15, 2010, S5901)

Disclosure has a role in relation to conflicts of interest. But in the view of Congress, disclosure alone may not cure these types of conflicts in all cases. Indeed, while a meaningful disclosure may alleviate the appearance of a material conflict of interest in some circumstances, in others, such as if the disclosures cannot be made to the appropriate party or because the disclosure is not sufficiently meaningful, disclosure is likely insufficient.

The intent of Congress is to provide regulators with the authority and strong directive to stop the egregious practices, and not to allow for regulators to enable them to continue behind the fig leaf of vague, technically worded, fine print disclosures. These provisions must be interpreted strictly, and regulators are directed to use their authority to act decisively to protect critical financial infrastructure from the risks and conflicts inherent in allowing banking entities and other large financial firms to engage in high risk proprietary trading and investing in hedge funds and private equity funds. (Cong. Record, July 15, 2010, S5901). In the end, Congress believes that the SEC has sufficient authority to define the contours of the rules in such a way as to remove the vast majority of conflicts of interest from these transactions, while also protecting the healthy functioning of the capital markets. (Cong. Record, July 15, 2010, S5899).

Sunday, August 15, 2010

Senator Lincoln Details Protections for Retail Commodities Customers in Dodd-Frank Act

Section 742 of the Dodd-Frank Act includes several important provisions to enhance the protections afforded to customers in retail commodity transactions. Senator Lincoln highlighted such provisions. First, Section 742 clarifies the prohibition on off-exchange retail futures contracts that has been at the heart of the Commodity Exchange Act throughout its history.

In recent years, there have been instances of fraudsters using what are known as rolling spot contracts with retail customers in order to evade the CFTC’s jurisdiction over futures contracts. These contracts function just like futures, but the Seventh Circuit in the 2004 CFTC v. Zelener case, based on the wording of the contract documents, held them to be spot contracts outside of CFTC jurisdiction. The CFTC Reauthorization Act of 2008, which was enacted as part of that year’s Farm Bill, clarified that such transactions in foreign currency are subject to CFTC anti-fraud authority. It left open the possibility, however, that such Zelener-type contracts could still escape CFTC jurisdiction if used for other commodities such as energy and metals. Section 742 corrects this by extending the Farm Bill’s ‘‘Zelener fraud fix’’ to retail off exchange transactions in all commodities.

Further, a transaction with a retail customer that meets the leverage and other requirements set forth in Section 742 is subject not only to the anti-fraud provisions of CEA Section 4b (which is the case for foreign currency), but also to the on-exchange trading requirement of CEA Section 4(a), as if’ the transaction was a futures contract. As a result, such transactions are unlawful, and may not be intermediated by any person, unless they are conducted on or subject to the rules of a designated contract market subject to the full array of regulatory requirements applicable to on-exchange futures under the CEA. Retail off-exchange transactions in foreign currency will continue to be covered by the ‘‘Zelener fraud fix’’ enacted in the Farm Bill. Further, cash or spot contracts, forward contracts, securities, and certain banking products are excluded from this provision in Section 742, just as they were excluded in the Farm Bill. Section 742 also addresses the risk of regulatory arbitrage with respect to retail foreign currency transactions.

Under the CEA, several types of regulated entities can provide retail foreign currency trading platforms, among them, broker-dealers, banks, futures commission merchants, and the category of retail foreign exchange dealers that was recognized by Congress in the Farm Bill in 2008. Section 742 requires that the agencies regulating these entities have comparable regulations in place before their regulated entities are allowed to offer retail foreign currency trading. According to Senator Lincoln, this will ensure that all domestic retail foreign currency trading is subject to similar protections.

Finally, Section 742 also addresses a situation where domestic retail foreign currency
firms were apparently moving their activities offshore in order to avoid regulations required by the National Futures Association. It removes foreign financial institutions as an acceptable counterparty for off-exchange retail foreign currency transactions under section 2(c) of the CEA. Foreign financial institutions seeking to offer them to retail customers within the United States will now have to offer such contracts through one of the other legal mechanisms available under the CEA for accessing U.S. retail customers. (Cong. Record, July 15, 2010, S59124).

Friday, August 13, 2010

Senator Merkley Explains the Workings of Dodd-Frank Volcker Rule Banning Bank Sponsoring of Hedge Funds

Sections 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act codifies the Volcker Rules and broadly prohibits bank proprietary trading and bank sponsoring of hedge funds, while nevertheless permitting certain activities that may technically fall within the definition of proprietary trading but which are, in fact, safer, client-oriented financial services. Senator Jeff Merkley, a principal author of Section 619 explained how these provisions will work. Section 619 establishes the basic principle that a banking entity must not engage in proprietary trading or acquire or retain ownership interests in or sponsor a hedge fund or private equity fund, unless otherwise provided in the section.

Congress found it appropriate for the Volcker provisions to restrict investing in or sponsoring hedge funds and private equity funds Clearly, reasoned Senator Merkley, if a financial firm were able to structure its proprietary positions simply as an investment in a hedge fund or private equity fund, the prohibition on proprietary trading would be easily avoided, and the risks to the firm and its subsidiaries and affiliates would continue. A financial institution that sponsors or manages a hedge fund or private equity fund also incurs significant risk even when it does not invest in the fund it manages or sponsors. . (Cong. Record, July 15, 2010, p. S5895).

Although piercing the corporate veil between a fund and its sponsoring entity may be difficult, said Senator Merkley, recent history demonstrates that a financial firm will often feel compelled by reputational demands and relationship preservation concerns to bail out clients in a failed fund that it managed or sponsored, rather than risk litigation or lost business. Knowledge of such concerns creates a moral hazard among clients, attracting investment into managed or sponsored funds on the assumption that the sponsoring bank or systemically significant firm will rescue them if markets turn south, as was done by a number of firms during the 2008 crisis. That is why setting limits on involvement in hedge funds and private equity funds is critical to protecting against risks arising from asset management services. (Cong. Record, July 15, 2010, p. S5895).

Dodd-Frank sets forth a broad definition of hedge fund and private equity fund, not distinguishing between the two. The definition includes any company that would be an investment company under the Investment Company Act, but is excluded from such coverage by the provisions of sections 3(c)(1) or 3(c)(7). Although market practice in many cases distinguishes between hedge funds, which tend to be trading vehicles, and private equity funds, which tend to own entire companies, both types of funds can engage in high risk activities and it is exceedingly difficult to limit those risks by focusing on only one type of entity.

Section 619 also permits a banking entity to engage in risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other
holdings of the entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings. According to Senator Merkley, this activity is permitted because its sole purpose is to lower risk.

While this is intended to permit banking entities to utilize their trading accounts to hedge, said Senator Merkley, the phrase in connection with and related to individual or aggregated positions was added to the final version in the conference report in order to ensure that the hedge applied to specific, identifiable assets, whether it be on an individual or aggregate basis. Moreover, hedges must be to reduce specific risks to the banking entity arising from these positions. This formulation is meant to focus banking entities on traditional hedges and prevent proprietary speculation under the guise of general hedging. For example, for a bank with a significant set of loans to a foreign country, a foreign exchange swap may be an appropriate hedging strategy.

On the other hand, purchasing commodity futures to hedge inflation risks that may generally impact the banking entity may be nothing more than proprietary trading under another name. Distinguishing between true hedges and covert proprietary trades may be one of the more challenging areas for regulators, and will require clear identification by financial firms of the specific assets and risks being hedged, research and analysis of market best practices, and reasonable regulatory judgment calls. (Cong. Record, July 15, 2010, p. S5896). Congress believes that vigorous and robust regulatory oversight of this issue will be essential to the prevent hedging from being used as a loophole in the ban on proprietary trading.

Section 619 provides exceptions to the prohibition on investing in hedge funds or private
equity funds, if such investments advance a public welfare purpose. It permits investments in small business investment companies, which are a form of regulated venture capital fund in which banks have a long history of successful participation. It also permits investments of the type permitted under the paragraph of the National Bank Act enabling banks to invest in a range of low-income community development and other projects. It also specifically mentions tax credits for historical building rehabilitation administered by the National Park Service, but is flexible enough to permit the regulators to include other similar low risk investments with a public welfare purpose.

Section 619 also permits firms to organize and offer hedge funds or private equity funds as an asset management service to clients. According to Senator Merkley, it is important to remember that nothing in Section 619 otherwise prohibits a bank from serving as an investment adviser to an independent hedge fund or private equity fund. Yet, to serve in that capacity, a number of criteria must be met. First, the firm must be doing so pursuant to its provision of bona fide trust, fiduciary, or investment advisory services to customers. Given the fiduciary obligations that come with such services, these requirements ensure that banking entities are properly engaged in responsible forms of asset management, which should tamp down on the risks taken by the relevant fund. Second, the section provides strong protections against a firm bailing out its funds by prohibiting banks from entering into lending or similar transactions with related funds, and prohibiting them from directly or indirectly guaranteeing, assuming, or otherwise insuring the obligations or performance of the hedge fund or private equity fund.

To prevent banking entities from engaging in backdoor bailouts of their invested funds, the section extends to the hedge funds and private equity funds in which such hedge funds and private equity funds invest. Third, to prevent a bank from having an incentive to bailout its funds and also to limit conflicts of interest, the section restricts directors and employees of a bank from being invested in hedge funds and private equity fund organized and offered by the bank, except for directors or employees directly engaged in offering investment advisory or other services to the hedge fund or private equity fund. Fund managers can have ‘‘skin in the game’’ for the hedge fund or private equity fund they run, but to prevent the bank from running its general employee compensation through the hedge fund or private equity fund, other management and employees may not.

Fourth, by stating that a firm may not organize and offer a hedge fund or private equity fund with the firm’s name on it, the section further restores market discipline and supports the restriction on firms bailing out funds on the grounds of reputational risk. Similarly, it ensures that investors recognize that the funds are subject to market discipline by requiring that funds provide prominent disclosure that any losses of a hedge fund or private equity fund are borne by investors and not by the firm, and the firm must also comply with any other restrictions to ensure that investors do not rely on the firm, including any of its affiliates or subsidiaries, for a bailout.

Fifth, the firm or its affiliates cannot make or maintain an investment interest in the fund, except in compliance with the limited fund seeding and alignment of interest provisions provided in the section. This provision allows a firm, for the limited purpose of maintaining an investment management business, to seed a new fund or make and maintain a de minimis co-investment in a hedge fund or private equity fund to align the interests of the fund managers and the clients, subject to several conditions. As a general rule, firms taking advantage of this provision should maintain only small seed funds, likely to be $5 to $10 million or less. Large funds or funds that are not effectively marketed to investors would be evasions of the restrictions of this section. Similarly, co-investments designed to align the firm with its clients must not be excessive, and should not allow for firms to evade the intent of the restrictions of this section.

These ‘‘de minimis’’ investments are to be greatly disfavored, emphasized Senator Merkley, and are subject to several significant restrictions. First, a firm may only have, in the aggregate, an immaterial amount of capital in such funds, but in no circumstance may such positions aggregate to more than 3 percent of the firm’s Tier 1 capital. Second, by one year after the date of establishment for any fund, the firm must have not more than a 3 percent ownership interest. Third, investments in hedge funds and private equity funds must be deducted on, at a minimum, a one-to-one basis from capital. As the leverage of a fund increases, the capital charges must be increased to reflect the greater risk of loss. This is specifically intended to discourage these high-risk investments, and should be used to limit these investments to the size only necessary to facilitate asset management businesses for clients. (Cong. Record, July 15, 2010, S5897).

Section 619 allows a very limited exception for the provision of limited services under the rubric of prime brokerage between a bank and a third party advised fund in which the fund managed, sponsored, or advised by the bank has taken an ownership interest. Essentially, it was argued that a bank should not be prohibited, under proper restrictions, from providing limited services to unaffiliated funds, but in which its own advised fund may invest. Accordingly, the exception is intended to only cover third-party funds, and should not be used as a means of evading the general prohibition. Put simply, a firm may not create tiered structures and rely upon the narrow exception to provide these types of services to funds for which it serves as investment advisor. Further, in recognition of the risks that are created by allowing for these services to unaffiliated funds, several additional criteria must also be met for the bank to take advantage of this exception. S5898

For example, banks are prohibited from bailing out funds they manage, sponsor, or advise, as well as funds in which those funds invest. The permitted services provisions are intended to permit banks to maintain certain limited prime brokerage service relationships with unaffiliated funds in which a fund-of-funds that they manage invests, said Senator Merkley, but are not intended to permit fund-of-fund structures to be used to weaken or undermine the prohibition on bailouts. Given the risk that a banking entity may want to bail out a failing fund directly or its investors, the permitted services exception must be implemented in a narrow, well-defined, and arms-length manner and regulators are not empowered to create loopholes allowing high-risk activities like leveraged securities lending or repurchase agreements. (Cong. Record, July 15, 2010, S5901. While Congress implements a number of legal restrictions designed to ensure that prime brokerage activities are not used to bail out a fund, Congress expects the regulators will nevertheless need to be vigilant.

On top of the flat prohibitions on bailouts, the statute requires the chief executive officer of firms taking advantage of this limited prime brokerage services exception to also certify that these services are not used directly or indirectly to bail out a fund advised by the firm. (Cong. Record, July 15, 2010, S5898).