Monthly Archives: April 2013

Becoming the Fifth Branch

M. Todd Henderson is Professor of Law and Aaron Director Teaching Scholar at the University of Chicago Law School, and William A. Birdthistle is Associate Professor of Law and Freehling Scholar at Chicago-Kent College of Law.

In our article Becoming the Fifth Branch, we argue that financial self-regulation has changed dramatically and problematically in the past few years. Financial self-regulatory organizations (SROs), such as FINRA and the Chicago Mercantile Exchange’s regulatory arm, are transforming from “self-regulatory” into “quasi-governmental” organizations. We believe this evolution, moreover, may become a serious problem for the stability and efficiency of our financial system.

To SEC Commissioner Daniel Gallagher’s question, “Is FINRA becoming a ‘deputy SEC?,’” we fear the answer is “yes.” We describe an array of forces that we believe may be driving this change, explain the implications of the loss of true self-regulation, and offer some options for restoring a healthier regulatory balance.

SROs are the primary legislators, regulators, and officers on the beat who monitor our financial system. While corporate theorists tend to focus on Congressional legislation and agency rulemaking, self-regulation is the form of financial governance that most directly governs the daily activities of our financial firms. Nearly one hundred and fifty years before the creation of federal and state securities authorities, the financial industry established its own self-regulatory organizations. The growth of private regulation was initially designed to fill a regulatory void that left brokers unable to signal quality and investors reluctant to participate in the market confidence.

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Swap Trading in the New Regulatory World

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 discusses a Davis Polk memorandum, available here; an accompanying timeline is available here.

As a result of the Dodd-Frank Act, the over-the-counter derivatives markets have become subject to significant new regulatory oversight. As the markets respond to these new regulations, the menu of derivatives instruments available to asset managers, and the costs associated with those instruments, will change significantly. As the first new swap rules have come into effect in the past several months, market participants have started to identify risks and costs, as well as new opportunities, arising from this new regulatory landscape.

This memorandum and the accompanying timeline is designed to provide asset managers, and those interested in the activities of asset managers, with background information on key aspects of the swap regulatory regime that may impact their derivatives trading activities. The memorandum highlights practical considerations and potential opportunities for asset managers, as they assess the impact these regulations will have on their trading activities.

In the short term, asset managers should be sure to:

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The New Market in Debt Governance

The following post comes to us from Yesha Yadav of Vanderbilt Law School.

Scholars have traditionally assumed that lenders that protect themselves using credit derivatives like credit default swaps (CDS) have limited interest in debt governance. The rationale behind this proposition seems straight-forward. Lenders that have bought credit protection should have little incentive to invest in monitoring and disciplining a borrower where they know they will be repaid under the CDS. Indeed, scholars argue, lenders that have purchased CDS protection have considerable interest in seeing a borrower fail. When this happens, they can easily and cheaply exit their investment by triggering repayment on the CDS.

This paper, the New Market in Debt Governance, recently made available on SSRN, challenges this consensus and proposes a new theory of governance in the context of credit derivatives trading. While scholars have traditionally focused on lenders that protect themselves using CDS, they overlook the role of financial firms that sell this credit protection and thereby assume economic risk on the underlying borrower. These protection sellers take on the risk of a borrower defaulting, but possess no legal tools with which they can discipline the borrower to stave off default. As a result, unlike ordinary lenders, protection sellers have no direct means to control a borrower’s risk-taking. They possess no legal powers to influence how much leverage a borrower takes on, its use of collateral, cash reserves or its acquisitions and enterprise strategy. Given this precarious position, it follows that protection sellers possess powerful incentives to seek out ways to influence how a borrower company is run to better control how risky it is allowed to become.

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A New Playbook Part 2 — Global Securities Enforcement Stepping Up

The following post comes to us from Paul A. Ferrillo, counsel at Weil, Gotshal & Manges LLP specializing in complex securities and business litigation, and is based on an article by Mr. Ferrillo, Robert F. Carangelo, and Hannah Field-Lowes. [1]

About a year ago, we published A New Playbook for Global Securities Litigation and Regulation, in which we detailed dramatic changes in the global securities regulatory and litigation arena driven by various factors, including not only the financial crisis of 2007-2008, but also changes in tolerance in the United States to litigation brought by foreign investors against public companies listed on non-U.S. exchanges.

One year later, the regulatory environment continues to revamp with new rules being issued constantly in the United States to conform to the legislative mandates set forth in the Dodd Frank Act. The United Kingdom and European Union also seek to reinforce previous global initiatives to reform and strengthen the Pan-European financial markets.

What is more ever-present, however, is the marked increase in global enforcement activities by regulators in the United Kingdom, Canada, and the European Union, which are attempts to give teeth to the global financial reforms each jurisdiction felt necessary to potentially prevent a “repeat” of the financial crisis. This article seeks to address the increase in global securities enforcement activity and concludes that continued cooperation and coordination in enforcement activities will be required to seamlessly address the desire to strengthen global regulatory initiatives aimed at harmonizing and centralizing international securities regulation to create safer, more fundamentally sound financial markets for investors.

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