Lisa L. Jacobs (www.practicallaw.com/4-384-8625) and Carl B. McCarthy (www.practicallaw.com/7-384-8624)
As a result of the ongoing credit crisis, governments across the world have taken, and continue to take, a variety of extraordinary measures to protect the financial sector and prevent a more severe recession (to read more about the various measures taken to date by governments around the world, click here).
One of these measures has been the Temporary Liquidity Guarantee Program (TLGP) of the US Federal Depositary Insurance Corporation (FDIC), under which senior unsecured debt issued between 14 October 2008 and 30 June 2009 by eligible participating entities will be fully and unconditionally guaranteed by the FDIC until 30 June 2012.
On 24 November 2008, the Securities and Exchange Commission (SEC) stated that such debt will be considered to have been guaranteed by an instrumentality of the United States. Accordingly, the debt may be issued without SEC registration under Section 3(a)(2) of the Securities Act of 1933, as amended (Securities Act). As a result, issuances of TLGP-guaranteed debt will not have to be made under an effective registration statement, and will not be subject to certain laws regarding disclosure liability (such as Section 11 of the Securities Act).
Offerings may, however, also be made under an effective registration statement and many issuers have chosen to do so.
Issuers should be aware that public offerings of FDIC-guaranteed debt in Europe (for example, under a global offering or an offering limited to Europe) will be subject to the Prospectus Directive (Directive 2003/71/EC). This requires the publication of a prospectus where securities are offered to the public and/or admitted to trading in Europe. No exemptions are available from these requirements in respect of non-equity securities guaranteed by a non-EEA country or an agency or instrumentality of a non-EEA country (such as the FDIC).
As a result, unless the issuance, offer and sale by an issuer of FDIC-guaranteed debt in Europe is limited to "qualified investors" within the meaning of the Prospectus Directive, or is conducted according to other applicable exemptions under it, appropriate sovereign disclosure with respect to the guarantor must be prepared and included in the relevant prospectus. This would include the requirement to include audited historical financial information of the guarantor (which would raise issues as neither the FDIC nor the US Federal Government makes such financial statements available). Issuers may seek a derogation from some of these requirements from the relevant authority from which approval is being sought, but these will be considered on a case-by-case basis.
In practice, however, the authors expect offers and sales of such securities to be conducted under available exemptions from the prospectus requirements set out in the Prospectus Directive.
Herbert S. Washer (www.practicallaw.com/9-384-8623) and Christopher R. Fenton (www.practicallaw.com/1-384-8622)
Recently, a growing number of foreign companies have been hauled into US courts to defend themselves against allegations of securities fraud brought by foreign investors who purchased shares on foreign exchanges. These cases (often referred to as "foreign-cubed" class actions) have raised important questions about whether US courts have jurisdiction over such suits.
Although courts have been divided on this issue, the recent decision by the US Court of Appeals for the Second Circuit in Morrison v National Australia Bank Ltd., 547 F.3d 167 (2d Cir. 2008) (Morrison) should be viewed as a significant victory for foreign defendants.
In Morrison, the Second Circuit was asked to decide whether US courts had jurisdiction over a case involving alleged misrepresentations made in financial statements compiled and disseminated by National Australia Bank (NAB) (an Australian financial institution) in Australia that were based, in part, on numbers reported to it by HomeSide Lendings, Inc., a wholly-owned subsidiary based in the US. Although NAB's ordinary shares trade only on foreign exchanges, its American depository receipts trade on the New York Stock Exchange.
The Second Circuit dismissed the case against NAB on the ground that it could not exercise jurisdiction under these circumstances. Although unwilling to rule out the possibility that US courts could ever exercise jurisdiction over a foreign-cubed case, the Second Circuit explained that it would only be appropriate to do so in very limited circumstances where the "conduct [that] comprises the heart of the alleged fraud" occurred within the US.
That test was not satisfied in Morrison because:
NAB's financial statements were prepared at, and issued from, its foreign headquarters in Australia.
The wrongful conduct that occurred in the US did not directly cause the claimants' losses.
The misreported numbers had to first pass through NAB before reaching investors.
Morrison is significant because, like NAB, most foreign companies prepare and issue their financial statements from outside the US and, under the Second Circuit's standard, would likely not be subject to class actions brought by a worldwide class of investors alleging securities fraud under the anti-fraud provisions of the US securities laws. Although the Second Circuit's decision is only binding on federal courts in New York, Connecticut and Vermont, the Court's reputation as a leading authority on securities law makes it quite possible that other courts in the US will soon follow its precedent.
Linda E. Rappaport (www.practicallaw.com/0-384-8627) and Amy B. Gitlitz (www.practicallaw.com/2-384-8626)
Executive compensation programmes of financial institutions participating in the US Treasury Department's Troubled Assets Relief Program (TARP) must exclude incentives for senior executives to take "unnecessary and excessive risks" that threaten the value of the institution.
In a speech on 21 October 2008, Securities and Exchange Commission (SEC) Director John White addressed the potential implications of these executive compensation provisions for public companies that do not participate in TARP. In particular, Director White suggested that, while not yet legally required, it might be prudent for all compensation committees to consider the "risks an executive might be incentivised to take" when establishing incentive compensation arrangements.
Perform a risk analysis. If they are not doing so already, compensation committees should consider examining whether the executive compensation programmes encourage excessive or unnecessary risk-taking in the context of the company's business. This exercise should include a periodic review of the design and operation of the programmes with the company's risk officers and compensation advisors to assess whether the performance goals foster long-term value creation. Conditioning bonuses or other incentive rewards on extraordinary short-term growth or on one particular financial target may have the unintended consequence of encouraging executives to ignore longer-term risks that would, in hindsight, compromise attainment of the stated target.
Compensation committees should also look to whether incentive programmes inherently encourage risk-taking by allowing executives to cash out based on short-term profits that may not be sustainable in subsequent years or by offering executives unlimited or highly leveraged upside potential, with limited or no downside risk. By insulating the executive from the threat of the downside, the executive may be incentivised to assume more risk to reap the upside benefits.
Modify compensation programmes. Some suggestions that, depending on a company's situation, might mitigate the risk of encouraging executives to take unwarranted risks include the following:
Hold through retirement requirements. Require executives to hold a percentage of the shares acquired from stock options, restricted shares and other equity awards for a specified period following termination of employment.
Symmetrical incentive-based compensation. Adopt a symmetrical incentive compensation programme under which amounts awarded for performance in one performance cycle remain at risk and can be "clawed back" based on poor performance in a later year or performance cycle. (This would supplement claw backs that many companies already have in place for compensation awarded based on fraud or misconduct.)
Balance performance target mix. Balance financial-based targets with qualitative performance and operations measures, and consider using more than one financial target as the criteria for payment of incentives.
Balance compensation instruments. To balance risks to the company and the executive:
consider payment of incentive compensation in a mixture of current and deferred instruments; and
balance equity compensation between stock options and full-value shares.
Discretionary performance criteria. Providing the compensation committee the authority to adjust bonuses on the basis of subjective factors or its judgment concerning the quality of earnings or performance of the executive allows for re-calculations of incentive compensation if unexpected or unintended events occur.
Director White has strongly suggested that all companies whose compensation committees engage in a risk analysis consider describing this analysis in their proxy statements. Director White was explicit that, to the extent that risk analysis is or becomes a "material part of a company's compensation policies or decisions", discussion in the CD&A is required under the SEC's existing rules.
For more information, see:
Nathan J. Greene (www.practicallaw.com/1-384-8542) and Gretchen D. Liersaph (www.practicallaw.com/8-384-8628)
Many businesses include risk disclosure that they are subject to the risk of changed regulations, but relatively few actually experience a sudden prohibition on core activities. In 2008, investment firms that relied on short selling both to speculate in the markets and hedge other positions saw just such an emergency prohibition by US and UK regulators on shorting financial stocks.
These prohibitions accompanied efforts around the world to clamp down on short selling (to read more about these, click here). Other restrictions included strict new disclosure and reporting requirements. For example, certain institutional managers must prepare and file with the Securities and Exchange Commission (SEC) a weekly, non-public disclosure statement, on the newly-created Form SH, disclosing short positions (to read more about this, click here).
The US prohibitions, now lifted, are notable because they represent a regulatory u-turn, following the SEC's June 2007 repeal of the 70-year-old "uptick rule" (which generally prevented selling short many US stocks except at a price higher than the last reported sale price, or at the last reported sale price if that price is itself higher than the preceding sale price).
Moreover, there is a move afoot for another u-turn, with legislation proposed in Congress to re-establish the uptick rule. The bill (H.R. 302) is sponsored by a senior Democratic member of the House Financial Services Committee and is a follow-up to a failed bill with the same goal introduced in July 2008. It could have fresh traction, however, given the newly seated Congress, the sharp declines in the markets over the autumn of 2008, and criticism of the SEC studies that were cited by the agency in support of its repeal of the old rule. Those studies centred on pilot programs that lifted the uptick restrictions on a limited number of stocks and have been called both too narrow in scope and, given that they tested the waters at a time of steadily rising stock prices and low market volatility, ill-timed. President Barack Obama's newly-appointed SEC Chair likewise supports a re-examination of the decision to repeal the rule.
Going forward, regulation of short selling may remain in flux as regulators continue to gather information to determine the best course of action. Just recently the UK Parliament's Treasury Committee held hearings to question prominent hedge fund managers about the industry's role in the declining values of UK banks. Among the topics discussed was the role of short selling, a hot topic in the UK press following a recent profit of Paulson & Co of at least GB£270 million from the short sale of Royal Bank of Scotland (RBS) stock before its rapid decline in value.
Meanwhile, many short sellers seem to have adapted handily to the panoply of newly-imposed restrictions. Short-biased hedge funds are reported to have gained 34% on average in 2008, compared to a decline of 39% in the Standard & Poor's 500 Stock Index. That said, at least one noted short seller, David Rocker and his firm Copper River Management, shut down last year, with some of the firm's difficulties attributed to the ban on shorting financial stocks.
Michael H. Torkin (www.practicallaw.com/3-384-8621) and Solomon J. Noh (www.practicallaw.com/5-384-8620)
The recent failure of Lehman Brothers Inc. (LBI) has provided, and continues to provide, valuable insight into how large-scale insolvency proceedings of broker-dealers are administered. Insolvent broker-dealers cannot reorganize under the US Bankruptcy Code. Instead, they must usually liquidate under the Securities Investor Protection Act of 1970, as amended (SIPA) (see box, Insolvency proceedings for broker-dealers).
Although broker-dealer liquidations under SIPA have taken place in the past, no prior case had even remotely resembled the magnitude of the LBI SIPA proceeding, nor had any attracted as much public scrutiny. As a result, many professionals and advisors with no prior experience of broker-dealer insolvencies were forced to familiarize themselves quickly with SIPA.
Although a SIPA proceeding resembles in many ways a liquidation under Chapter 7 of the US Bankruptcy Code, one aspect of the LBI case that caught many by surprise was the temporary restriction against the ability to foreclose on securities collateral. On the commencement of a SIPA proceeding, creditors with claims against the debtor broker-dealer generally are stayed from taking any direct actions against it that might negatively impact the value of the its estate, such as exercising any setoff or foreclosure rights.
This general restriction is subject to a safe harbor provision permitting creditors to both:
Liquidate, terminate and/or accelerate their securities contracts, commodity contracts, forward contracts, repurchase agreements or swap agreements with the debtor.
Exercise any setoff or foreclosure rights arising in connection with such financial contracts.
The stay under SIPA, as well as this financial contracts exception, closely resemble the automatic stay and the safe harbor provisions contained in the US Bankruptcy Code. The safe harbor under SIPA, however, contains one significant caveat that the Bankruptcy Code does not: the ability of counterparties to financial contracts to foreclose on any securities collateral posted by the debtor broker-dealer (whether under a securities lending arrangement or a repurchase agreement) can be prohibited for a period of time, effectively, at the Securities Investor Protection Corporation's (SIPC) (see box, Insolvency proceedings for broker-dealers) discretion.
Indeed, the order that was entered commencing the LBI SIPA proceeding prohibited the foreclosure on any securities collateral posted by LBI for a period of 21 days following the date of the order (see box, Duration of the SIPC's prohibition on counterparty foreclosure on securities collateral).
This 21-day prohibition was not anticipated by many of LBI's counterparties who had intended to foreclose on LBI's securities collateral immediately on the commencement of LBI's SIPA case. As a result, those counterparties in many cases were exposed to an additional 21 days of market risk in relation to those securities.
By contrast, those who were aware, in advance, of this temporary prohibition were able to substantially limit this exposure by taking advantage of an option that the SIPC historically has offered up. In response to various concerns expressed by market participants, the SIPC in the past has indicated that it expects to consent to the lifting of the temporary prohibition with respect to the applicant if a secured counterparty submits within the restricted period a "good faith affidavit" attesting both that:
It owns, or has a security interest, in the applicable securities.
It is unaware of any fraud with respect to the underlying transaction.
Many of the counterparties who were aware of this option had prepared "good faith affidavits" in advance of LBI's SIPA case and submitted them to SIPC promptly after the commencement of the proceeding. In response, the SIPC in many instances promptly lifted the stay to permit the foreclosure of securities. In fact, certain clients of Shearman & Sterling LLP had the stay lifted within three days of the commencement of the SIPA case.
Based on this experience, practitioners would be well-advised in the future to prepare for any apparently imminent broker-dealer liquidation proceeding by compiling, before the case commences, good faith affidavits with respect to any securities collateral their clients may hold in respect of any qualifying financial contracts with the broker-dealer, so that they may be submitted shortly after the SIPA case commences. The time which it takes to prepare such materials may be short, but such efforts are likely to prove worthwhile.
Insolvency proceedings for broker-dealers
Insolvent broker-dealers technically can be liquidated under Chapter 7 of the US Bankruptcy Code. However, at the election of the Securities Investor Protection Corporation (SIPC) (a non-profit corporation formed to administer SIPA), a SIPA proceeding can be commenced, even if a Chapter 7 liquidation is then pending. In such cases the SIPA proceeding supersedes the Chapter 7 proceeding. The SIPC typically elects to commence a SIPA proceeding in respect of an insolvent broker-dealer, which is the reason broker-dealer liquidations normally are administered under SIPA. |
Duration of the SIPC's prohibition on counterparty foreclosure on securities collateral
The 21-day duration of this restriction is not expressly provided for under SIPA; rather, it was what the SIPC in the past had implemented in their discretion. In the subsequent SIPA proceeding of Bernard L. Madoff Investments Securities LLC (Madoff), it became clear that the SIPC will not necessarily limit the duration of the securities collateral foreclosure prohibition to 21 days. Immediately before the initial 21-day period expired, the SIPC petitioned the court presiding over the Madoff case to extend the prohibition indefinitely, and the court granted its request. |
