Monthly Archives: August 2012

CFTC Proposes Clearing Exemption for Inter-Affiliate Swaps

Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP, and a former commissioner at the U.S. Securities and Exchange Commission. This post is based on a Davis Polk client memorandum, available here.

On August 16, 2012, the CFTC proposed rules that would permit affiliated swap counterparties to elect an exemption from mandatory swaps clearing, subject to various conditions. These conditions include reporting, documentation, risk management and other obligations, and, for swaps between financial entities, a requirement to provide variation margin. [1]

The Commodity Exchange Act requires swaps that have been designated by the CFTC as subject to mandatory clearing to be submitted for clearing to a designated clearing organization – unless a counterparty qualifies for an exemption from the clearing requirement. In proposing the inter-affiliate exemption from the clearing requirement, the CFTC recognized the risk management benefits and efficiencies that uncleared inter-affiliate swaps may provide for large financial and other organizations, but also noted its concerns about the “systemic risk repercussions” of uncleared inter-affiliate swaps. These concerns are reflected in the proposed conditions that would apply to affiliated counterparties seeking to rely on the exemption.

The CFTC’s proposed requirements for the use of the exemption are highly controversial. In particular, CFTC Commissioners Sommers and O’Malia voted against releasing the proposal because, in their view, the variation margin requirement is unwarranted. The comment period for the proposed rules will end 30 days after publication of the proposal in the Federal Register, which is expected to occur shortly.


Capital Adequacy Rules, Catastrophic Firm Failure, and Systemic Risk

The following post comes to us from Robert Jarrow, Professor of Finance at Cornell University.

In the paper, Capital Adequacy Rules, Catastrophic Firm Failure, and Systemic Risk, which was recently made publicly available on SSRN, I study capital adequacy rules based on Value-at-Risk (VaR), leverage ratios, and stress testing. VaR is the basis of Basel II, and all three approaches are proposed in Basel III.

Due to the 2007 credit crisis, the need for increased regulatory capital has been addressed by newly enacted legislation in the Dodd Frank Wall Street Reform and Consumer Protection Act, and the Basel III capital proposals. The existing and proposed capital adequacy rules are based on three methodologies: Value- at-Risk (VaR), maximum leverage ratios, and stress testing. The purpose of this paper is to analyze the impact of these three rules on the likelihood of financial institution catastrophic failure, and systemic risk in the economy.

A related literature on bank capital concerns the impact of capital regulation on bank risk taking behavior and the business cycle. Kahane (1977), Kim and Santomero (1988), Furlong and Keeley (1989), Rochet (1992), and Blum (1999) study models to determine if capital regulations decrease the risk of insolvency. The answer is yes and no, depending upon the bank’s objective function and market structure. This paper differs from this literature in two ways. First, I am concerned with the probability of catastrophic failure, keeping the probability of insolvency fixed at a level determined by the regulators. Second, with the exception of Kahane (1977), banks are not able to short assets in these models. Shorting assets enables banks to create large left-tail loss distributions and is consistent with current banking practice. An essential element of our model structure is that we allow financial institutions to short risky assets.


Money Market Fund Reform

Editor’s Note: Mary Schapiro is Chairman of the U.S. Securities and Exchange Commission. This post is based on a statement from Chairman Schapiro, available here. The views expressed in this post are those of Chairman Schapiro and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Three Commissioners, constituting a majority of the Commission, have informed me that they will not support a staff proposal to reform the structure of money market funds. The proposed structural reforms were intended to reduce their susceptibility to runs, protect retail investors and lessen the need for future taxpayer bailouts.

I — together with many other regulators and commentators from both political parties and various political philosophies — consider the structural reform of money markets one of the pieces of unfinished business from the financial crisis.

While as Commissioners, we each have our own views about the need to bolster money market funds, a proposal would have given the public the chance to weigh in with their views as well. However, because three Commissioners have now stated that they will not support the proposal and that it therefore cannot be published for public comment, there is no longer a need to formally call the matter to a vote at a public Commission meeting. Some Commissioners have instead suggested a concept release. We have been engaging for two and a half years on structural reform of money market funds. A concept release at this point does not advance the discussion. The public needs concrete proposals to react to.


Money Market Funds Need Further Study

Editor’s Note: Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on a statement from Commissioner Aguilar, available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Having reviewed the Chairman’s proposal on money market funds, it is clear to me that there is much to be investigated related to the cash management industry, as a whole, before a fruitful discussion can be initiated as to whether additional structural changes should be made to only one segment of the cash management industry — SEC-registered money market funds.

The cash management industry is a large industry that includes many pooled vehicles exempted from registration and largely excluded from regulatory oversight. There are larger macro questions and concerns about the cash management industry as a whole that must be considered before a specific slice of that industry — money market funds — is fundamentally altered. To move forward without this foundation is to risk serious and damaging consequences in contravention of the Commission’s mission.

I am, and continue to be, supportive of the Commission putting forward a thoughtful and deliberative concept release that asks serious and probing questions about the cash management industry as a whole to diagnose its frailties and assess where reforms are required. This release should include all pooled cash management mechanisms so that the Commission is knowledgeable about how trillions of dollars are managed and understands how this money is able to move from the regulated, transparent money market fund market to the opaque, unregulated markets.


Delaware Case Raises Question About Structuring Director Compensation

Arthur H. Kohn is a partner at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum by Mr. Kohn, Janet Fisher and Samuel Bryant. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

A recent opinion of the Delaware Chancery Court, Seinfeld v. Slager, [1] addresses the legal standard applicable to directors’ decisions about their own pay under Delaware law, an important topic as to which there is little prior law. In an opinion by Vice Chancellor Glasscock, the Court held that a derivative claim alleging that directors breached their fiduciary duties by granting themselves excessive compensation survived a motion to dismiss. [2] In so concluding, the Court also found that the directors’ action did not have the protection of the business judgment rule and was instead subject to “entire fairness” review.

The Court’s decision to require “entire fairness” review means that the claim of excessive compensation could proceed to a full evidentiary trial on the merits. Under Delaware law, a court will not second-guess business judgments of directors if the directors acted in good faith, exercised due care and were not conflicted in the matter. When the business judgment rule does not apply, the judgments may be subject to heightened scrutiny under the entire fairness standard. To meet this standard, the directors must demonstrate that both the process undertaken by directors and the amount of their compensation are fair to the company.


Handling a Corporate Crisis

Matteo Tonello is managing director of corporate leadership at the Conference Board. This post is based on an issue of the Conference Board’s Director Notes series by John F. Savarese, partner in the Litigation Department at Wachtell, Lipton, Rosen & Katz. This Director Note was based on an article written by Mr. Savarese; the full version, including footnotes, is available here.

The ongoing fallout from the 2008 financial crisis has generated a host of unprecedented challenges for broker-dealer, investment banking, investment advisory, and other financial services firms. Last year alone, the industry was hit with wave upon wave of criminal prosecutions, regulatory enforcement proceedings, and parallel private civil actions. In fiscal year 2011, U.S. Attorneys’ offices nationwide collected $6.5 billion in criminal and civil actions, and the U.S. Securities and Exchange Commission commenced 735 enforcement actions and obtained over $2.8 billion in penalties and disgorgement. Many of the more high-profile matters also triggered congressional hearings as well as massive adverse press attention and publicity.

The securities and financial services industry has been a key focus of government attention. As announced by President Obama in his January 2012 State of the Union address, the U.S. Department of Justice has formed a new unit within the Financial Fraud Enforcement Task Force—the Residential Mortgage-Backed Securities Working Group. The group will consist of at least 55 DOJ lawyers, analysts, agents, and investigators from across the country and will be chaired by the heads of the DOJ’s civil and criminal divisions, the U.S. Attorney from Colorado, SEC enforcement head Robert Khuzami, and New York Attorney General Eric Schneiderman. It will focus on investigating those responsible for misconduct contributing to the financial crisis through the pooling and sale of residential mortgage-backed securities. The unit has already sent subpoenas to 11 financial institutions.

Officials have also said that this new unit would most likely focus on Wall Street firms, big banks, and other entities that the public believes have avoided scrutiny for their role in the housing crisis.


The Evolving Importance of Banks and Securities Markets

The following post comes to us from Asli Demirgüç-Kunt, Director of Development Policy in the World Bank’s Development Economics Vice Presidency (DEC) and Chief Economist of the Financial and Private Sector Network (FPD), Erik Feyen, Senior Financial Economist in the Policy Unit of the World Bank’s Financial and Private Sector Development Vice Presidency (FPD), and Ross Levine, Willis H. Booth Chair in Banking and Finance at the University of California, Berkeley.

In our recent NBER working paper, The Evolving Importance of Banks and Securities Markets, we evaluate empirically the changing importance of banks and securities markets as economies develop. In particular, we focus on assessing whether economies increase their demand for the types of services provided by securities markets relative to the services provided by banks as countries grow. To empirically test whether the economic development “returns” to improvements to both bank and securities market development change as economies grow, we use data on 72 countries over the period from 1980 through 2008 and aggregate the data in 5-year averages (data permitting), so that we have a maximum of six observations per country. We use several measures of bank and securities market development, including standard indicators such as bank credit to the private sector as a share of gross domestic product (GDP), the value of stock market transactions relative to GDP, and the capitalization of equity and private domestic bond markets relative to GDP.


From the Shareholders’ Spring to the Autumn of Activism

John Olson is a founding partner of Gibson, Dunn & Crutcher’s Washington, D.C. office and a visiting professor at the Georgetown Law Center. This post is based on a Gibson Dunn alert by Selina S. Sagayam; the full version, including footnotes, is available here.

This alert discusses some of the recent regulatory developments and debate in the UK and at EU level which may have an impact on institutional investors (asset managers and asset owners) and public companies and takes a look at some examples of investor activism in these jurisdictions.

I. Shareholder Spring — Recent Examples of Activism

The UK press has had a field day over the past 12 months with news of shareholder challenges or activism. In the run up to the AGM season in the spring, barely a day went by without report of shareholders flexing their muscles by taking on the boards of listed companies — the discussions and debates which typically had gone on behind closed boardroom doors had escaped into the public arena.

The issues that boards have been called up on have varied from corporate governance (with a particular focus on the highly emotive board remuneration issues), to influencing corporate events (acquisitions, disposals, takeovers) to more fundamental challenges on corporate and business strategy with a view to unlocking value for shareholders.


Mid-Year Securities Litigation Update

The following post comes to us from Robert F. Serio, head partner in the New York office of Gibson, Dunn & Crutcher and co-chair of the Securities Litigation Practice Group. This post is based on a Gibson Dunn client alert, available here.

The first half of 2012 has not seen the series of landmark Supreme Court decisions that were handed down in 2011, but it has been a significant period as lower courts apply these decisions in different areas and in a number of different contexts. And the Supreme Court did decide one case–Credit Suisse Securities (USA) LLC v. Simmonds, 132 S. Ct. 1414 (2012)–relating to the statute of limitations under Section 16 of the Securities and Exchange Act of 1934, and granted review in two other cases–Amgen, Inc. v. Connecticut Retirement Plans & Trust Funds and Comcast Corp. v. Behrend–that are likely to result in watershed rulings on the issue of class certification in securities class actions.

Securities litigation filing trends remain generally steady in the face of these developments, with securities class action filings increasing only slightly in the first half of 2012, and the filings against particular sectors staying roughly similar to last year, with filings against financial industry companies at their lowest level since 2008. One particularly noteworthy development is that not a single securities class action filing thus far in 2012 has named an accounting firm as a defendant, possibly as a result of the Supreme Court’s rejection of aiding and abetting liability under the securities laws, emphatically reinforced last year in Janus Capital Group Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2012) (in which Gibson Dunn represented Janus).

Some of the most significant case law and legislative developments in the first half of 2012 are summarized below.


Financial Regulation in General Equilibrium

Anil K. Kashyap is the Edward Eagle Brown Professor of Economics and Finance at the University of Chicago Booth School of Business.

In our recent NBER working paper, Financial Regulation in General Equilibrium, my co-authors (Charles Goodhart of the London School of Economics, Dimitrios P. Tsomocos of the University of Oxford, and Alexandros Vardoulakis of the Banque de France) and I explore how different types of financial regulation could combat many of the phenomena that were observed in the financial crisis of 2007 to 2009. The primary contribution is the introduction of a model that includes both a banking system and a “shadow banking system” that each help households finance their expenditures. Households sometimes choose to default on their loans, and when they do this triggers forced selling by the shadow banks. Because the forced selling comes when net worth of potential buyers is low, the ensuing price dynamics can be described as a fire sale. The presence of the banking and shadow banking system, and the possibility that their interaction can create fire sales distinguishes our analysis from previous studies.

The model builds on past work by Tsomocos (2003) and Goodhart, Tsomocos and Vardoulakis (2010) and uses many of the same ingredients as their general equilibrium model. In particular, the model includes two periods and allows for heterogeneous agents who borrow and lend to each other through financial intermediaries. When the borrowers default, the intermediaries suffer losses and tighten lending standards to future borrowers. Thus, the model also includes a possible credit crunch.


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