0Federal District Court Enjoins Further Violations of Section 13 Ownership Reporting Requirements by Hedge Funds After Finding Scheme to Avoid Them
The U.S. District Court for the Southern District of New York (the “Court”) found for the plaintiff, a New York Stock Exchange traded corporation (the “Company”), against two hedge funds that had accumulated a significant economic position in the Company through the use of total return equity swaps (“TRSs”) based on the Company’s common stock, in a suit alleging violations of the position reporting requirements of Section 13(d) of the Securities Exchange Act of 1934, as amended (the “1934 Act”). The suit was filed in the midst of a proxy fight between the Company and the defendant hedge funds in which the latter were seeking, among other things, to elect their nominees to five of the twelve seats on the Company’s Board of Directors. Section 13(d) requires any person that acquires directly or indirectly the beneficial ownership of equity securities registered under the 1934 Act in excess of 5% of that class to make specified filings with the issuer and the SEC. Beneficial ownership under Section 13(d) is, in general terms, determined by whether a person has (1) voting power over the securities in question, which includes the power to vote, or to direct the voting of, those securities, and/or (2) investment power, which includes the power to dispose, or to direct the disposition of, those securities.
The Company’s Section 13(d) Allegations. The Company made two allegations related to Section 13(d) reporting: (1) that one of the defendants violated Section 13(d) by failing to disclose beneficial ownership of shares of the Company’s common stock represented by the TRSs, which when combined with Company shares the defendant had purchased directly would have brought its interest above the 5% threshold, and (2) that both defendants had failed to disclose the formation of a group under Section 13(d) in a timely manner. Section 13(d)(3) provides that when two or more persons act as a partnership, syndicate or other group for the purpose of acquiring, holding or disposing of securities of an issuer, that syndicate or group shall be deemed a person for purposes of Section 13(d) disclosure requirements. The Company contended that the defendants had been acting in concert to accumulate the Company’s common stock well before they ultimately filed a Schedule 13D that listed both direct holdings in the Company’s common stock and the Company stock underlying their TRS holdings, and thus their filing was not timely. The Company sought, among other things, an order (a) requiring corrective disclosure by the defendants, (b) voiding proxies defendants had obtained and (c) precluding defendants from voting their shares of the Company.
The TRS Holdings and Beneficial Ownership. In a TRS, the “short” party agrees to pay the “long” party cash flows based on the performance of an underlying reference asset in exchange for payment by the long party of interest at a negotiated rate on the agreed notional amount of the underlying reference asset, in this case an amount of Company common stock. A TRS does not grant the long party the right to vote the shares underlying the swap. The Court acknowledged there was no evidence that the defendant in question had explicit agreements with any of the counterparties regarding how the shares underlying the TRSs would be voted, but cited ways that the voting of those shares could be influenced to the defendant’s benefit. In addition, a TRS typically does not give the long party any right to direct the disposition of shares of the reference asset. The Court nevertheless found the bank counterparties to the TRSs would have been compelled as a practical matter to purchase shares of the Company’s common stock in order to hedge their exposures under the TRSs. The Court further observed that although they contemplate cash settlement, TRSs may be settled in kind. Ultimately, however, the Court declined to rule on the issue of whether the defendant in question had actual beneficial ownership within the meaning of Section 13(d) of the Company stock underlying its TRS holdings.
Instead, citing, among other things, (A) statements by the defendant’s CFO (although not specifically with reference to the Company) that one of the reasons for using swaps was to avoid disclosure to the market or the target company, (B) e-mails by defendant personnel emphasizing the importance of keeping TRS exposure to any one counterparty below the level where the counterparty’s purchase of Company stock to hedge the TRS position would cross the 5% Section 13(d) reporting threshold and (c) the fact that the defendant kept its direct investment in Company stock below the 5% threshold, the Court found that the defendant was deemed to have beneficial ownership by virtue of Rule 13d‑3(b) pursuant to the 1934 Act. Rule 13d‑3(b) provides in substance that a party that creates an arrangement to prevent the vesting of beneficial ownership as part of a plan or scheme to avoid the disclosure required had there been an outright purchase of the stock is deemed to be a beneficial owner of those shares.
Group Formation under Section 13(d)(3). In analyzing the question of whether the defendants had timely disclosed that they were acting in concert, i.e., as a group, with respect to their acquisition of Company stock, the Court made extensive findings regarding the longstanding prior relationship between the two defendants, the admitted exchanges of views and information between the two regarding the Company, the patterns of share purchases by one of the defendants immediately following meetings between its personnel and the managing partner and partner of the other defendant leading that defendant’s efforts with respect to the Company and the two defendants’ parallel proxy fight preparations. On this basis, the Court found that the defendants had formed a group approximately ten months prior to the filing of their Schedule 13D.Relief Granted. Addressing the remedies that it deemed relevant to the Section 13(d) violations it had found, the Court permanently enjoined the defendant hedge funds from further Section 13(d) violations, but bowing to precedent in the Second Circuit, did not grant the Company’s request that the hedge funds be precluded from voting the stock of the Company that they acquired between the time of group formation as found by the Court and the time the defendants made their Schedule 13D filing. The court indicated that any penalties for the defendants’ violations of Section 13(d) would have to be the result of SEC or DOJ action. (CSX Corp. v. Children’s Investment Fund Management (UK), 08 Cir. 2764 (LAK) (S.D.N.Y. June 11, 2008).)
0FDIC Issues Guidance on Managing Third-Party Risk
The FDIC issued a Financial Institution Letter (FIL-44-2008, the “Letter”) in which it provided guidance to financial institutions (“FIs” and each an “FI”) concerning managing third-party risk. In the Letter, the FDIC stressed that an FI’s Board of Directors and senior management are responsible for identifying and controlling risks arising from third-party relationships to the same extent as if the activity were handled directly by the FI itself. The Letter states that FIs should make certain that appropriate procedures are in place to monitor and control the risks, and that these procedures should take into account the complexity, magnitude and risk potential of the third-party relationship. In addition, the Letter states that the FI should not rely exclusively on indemnification agreements with the third party to protect the FI.
Third-party arrangements, including outsourcing agreements, can lower costs for and increase the expertise available to the FI, but can potentially pose a broad panoply of risks. The Letter discusses strategic risks, reputational risks, operational risks, transaction risks, credit risks, compliance risks and other risks that can be created by FIs’ third-party relationships.
The FDIC then provides guidance concerning various aspects of the risk management process, including: (1) risk assessment; (2) due diligence in selecting a third party; (3) contract structuring and review; and (4) oversight of the third-party relationship and adequate quality control over products and services provided by the FI through third-party vendors.The Letter states that in supervising and examining an FI’s handling of third-party relationships, the FDIC will focus upon the FI management’s “record and process of assessing, measuring, monitoring and controlling risks associated with” an FI’s significant third-party relationships. The FDIC also reminds FIs that under Section 7 of The Bank Services Company Act, an FI must notify its primary federal banking regulator in writing when it enters into an agreement with a third party pursuant to which the third party will provide certain types of services to the FI, including “check and deposit sorting and posting, computation and posting of interest and other credits and charges, preparation and mailing of checks, statements, notices and similar items, or any other clerical, bookkeeping, accounting, statistical, or similar functions.” Furthermore, the FDIC alerts banks that future compliance examinations may focus on the failure of banks to manage third-party relationship risks, and that corrective actions, including enforcement actions, may be pursued for deficiencies related to third-party relationships that pose a safety and soundness or compliance management concern or result in violations of applicable laws or regulations.
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0Financial Crimes Enforcement Network Issues Guidance on “Money Services Businesses” for Purposes of the Bank Secrecy Act
In the past month, the U.S. Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) issued two rulings as to whether different card-related entities constitute “money services businesses” (“MSB”) for purposes of the Bank Secrecy Act (“BSA”).
Last week, FinCEN determined (in FIN-2008-R006) that a firm that has developed a virtual credit card product is an MSB. As FinCEN explained, the firm issues a one-time-only “virtual” credit card to consumers who may use the card to effect a pre-set on-line transaction, after which the card reverts to a zero balance that cannot be re-loaded. The virtual card allows a consumer to protect his or her personal and financial information from disclosure to on-line merchants.
In analyzing whether the firm’s virtual card program fit within the definition of an MSB, FinCEN noted that the MSB definition does not encompass entities that transmit funds as an integral part of a transaction “other than the funds transmission itself.” FinCEN found that the virtual card company’s financial privacy purposes do not constitute a transaction separate from the funds transmission itself because the need for protection of the consumer’s personal and financial information only arises in connection with the funds transmission. FinCEN thus determined that the firm is engaged in the business of offering secure money transmission, “rather than security to which money transmission is ancillary,” which makes the firm an MSB.In a separate ruling issued last month (FIN-2008-R005), FinCEN clarified that certain merchants and ATMs participating in a prepaid card re-load program are not MSBs for BSA purposes. FinCEN reached this determination despite the fact that these merchants and ATMs would serve as locations where customers could add value to re-loadable cards. In so holding, FinCEN cited numerous factors, including that the merchants and ATMs would serve only as the physical point in the reload process where the card is presented to transmit data to a bank. By contrast, FinCEN observed, the banks involved in the card program “control and conduct the actual transaction that results in the adding of value to the re-loadable card.” From FinCEN’s perspective, the acceptance and transmission of funds by merchants and ATMs is an integral part of the execution and settlement of a transaction other than the funds transmission itself, namely the sale and re-load of stored value cards.
0Division of Supervision and Consumer Protection of the FDIC Publishes Article on Transparency in the Structured Finance Market
The Division of Supervision and Consumer Protection of the FDIC published an article entitled “Enhancing Transparency in the Structured Finance Market” in its journal Supervisory Insights, Vol. 5 Issue 1, Summer 2008, page 4. This article, authored by Bobby R. Bean, Chief, Policy Section, Division of Supervision and Consumer Protection, details in specific terms some disclosure concerns with complex structured securities and summarizes actions the author believes would improve transparency. Below are some of the recommendations included in the article:
Investors, regulators and other interested parties need to focus attention on the lack of liquidity in most structured finance offerings and work toward improving pricing disclosure. Regulators should encourage market participants to openly share trading information about Asset Backed Securities (ABS) and Collateralized Debt Obligations (CDOs), such as daily volumes, bid/ask spreads, consensus prices, and price ranges and report this information to pricing services.
Regulators need to reevaluate the supervisory treatment of ABSs and CDOs that are not liquid and do not trade on active secondary markets to ensure that the risks associated with these securities are adequately captured in the examination process and in capital regulation. Bank management must have a thorough understanding of the terms and structural features of the structured finance products that they hold for investment.
Banking regulators should consider other approaches in concert with the review of securities registration and disclosure enhancements. For instance, banking regulators should consider whether the capital treatment of structured finance products could be conditioned on the granularity and the quality of information provided in prospectuses and offering circulars, even if the bank is considered to be a qualified institutional buyer.
The SEC should review the quality and granularity of information provided on the rating agencies’ public web sites. Rating agencies should be strongly encouraged to provide information on all aspects of a rated transaction, including loan-level information on the underlying collateral. Surveillance reports should be issued regularly and should note any material changes to the composition of the securitization vehicle.
Regulators also will need access to more granular information as part of the Basel II implementation process. Under the Internal Assessment Approach and the Supervisory Formula, regulators will need to have loan- and portfolio-level information to evaluate the appropriateness of the capital requirements. The regulators should begin a dialogue with the rating agencies to determine if enhancements to the transparency of the ratings process could also provide value to Basel II implementation efforts.
- Credit ratings should not be used as a substitute for pre-purchase due diligence or as a proxy for ongoing risk monitoring for banks with positions in complex securities. Banks should understand that the loss expectations associated with the rating scales used by credit rating agencies for various types of debt (corporate bonds, structured finance investments, and municipal debt) can differ.
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