The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”), which provides for comprehensive reform of the financial industry, was signed into law by President Obama on July 21, 2010. Certain aspects of the Act, as well as recent activity by the Basel Committee on Banking Supervision (“BCBS”) and the Securities and Exchange Commission (“SEC”), will affect securities lenders, borrowers and agents.
Dodd-Frank Wall Street Reform and Consumer Protection Act
The principal effects of the Act on securities lending industry participants are:
- Changes to the statutory regime governing insolvencies of significant broker-dealers and other financial institutions.
- Limitations on the ability of Federal Deposit Insurance Corporation (“FDIC”)-insured banks and their affiliates to sponsor, maintain and engage in transactions with cash collateral pools.
- Credit exposure limitations and additional capital requirements that may result in lower volumes of securities lending and repurchase agreement activity by affected banks and bank affiliates, both as principals and in indemnified agency securities lending programs.
- Enhanced limitations on transactions between affected banks and their affiliates, which may impact riskless principal or “conduit” lending and similar alternative lending programs.
- Changes to the federal securities laws that will result in additional disclosure in connection with securities lending.
The full implications of the Act will become more clear over time, as the Act calls for studies, reports and discretionary rulemaking by federal regulatory agencies. For a more comprehensive analysis of the Act, please see Goodwin Procter’s July 28, 2010 Financial Services Alert.
FDIC Liquidation Authority
The Act authorizes the Secretary of the Treasury to appoint the FDIC as receiver of a “covered financial company” if the Treasury Secretary determines, upon the recommendation of two-thirds of the Board of Governors of the Federal Reserve System (the “FRB”) and two-thirds of the FDIC Board (or, in the case of a broker-dealer, two-thirds of the FRB Governors and two-thirds of the SEC Commissioners, and in consultation with the FDIC), and in consultation with the President, that such company is in default or in danger of default, and such default and resolution under otherwise applicable law would have serious adverse effects on financial stability in the United States, as well as certain other specified findings (referred to as the “orderly liquidation authority”). The term “covered financial company” may include registered broker-dealers and certain insurance companies, but not insured depository institutions. At this point it cannot be predicted how frequently the Secretary of the Treasury will use this authority, but such authority is intended to be used only in very rare circumstances, and the U.S. Bankruptcy Code is expected to continue to be the primary path for liquidating a failing nonbank financial institution.
The FDIC’s powers as receiver under the orderly liquidation authority are substantially the same as its powers under the Federal Deposit Insurance Act (the “FDIA”) as receiver of an insured depository institution, with certain differences designed to harmonize the rules defining creditors’ rights with those contained in the U.S. Bankruptcy Code. In particular, the special treatment that the FDIA provides for “qualified financial contracts” (including securities loan agreements, repurchase agreements, forward contracts and swap agreements) is substantially similar under the orderly liquidation authority. Specifically:
- Subject to certain limitations in the case of defaults based on ipso facto clauses (i.e., defaults based on the insolvency, receivership or financial condition of a covered financial company), a counterparty to a qualified financial contract with a covered financial company may not be stayed or prohibited from exercising any rights to cause the termination, liquidation or acceleration of, or to offset or net out any obligations arising under or in connection with, a qualified financial contract, or from exercising any rights under any security agreement or other credit enhancement relating to the qualified financial contract.
- For a default based on an ipso facto clause, the counterparty would essentially be stayed from exercising its rights for one business day, during which time the FDIC would have the option of transferring all, but not less than all, of the qualified financial contracts with that particular counterparty and its affiliates to a single third-party financial institution. If the FDIC does transfer such contracts, the counterparty would not be permitted to exercise its rights to close out the contract except upon the occurrence of another default. It is not clear how the FDIC’s authority to transfer qualified financial contracts would be applied in the context of a liquidation of a broker-dealer participating in a bank’s agency lending program, where the bank acts as agent for multiple lenders, although the Act provides that any master agreement shall be treated as a single qualified financial contract. Any selective transfer of securities loans by the FDIC in the event of a broker counterparty’s insolvency could significantly affect a lending agent’s ability to offset or net obligations or to exercise cross-collateral rights.
- The Act prohibits the FDIC from avoiding any transfer of money or other property in connection with any qualified financial contract (absent actual intent to hinder, delay or defraud). Similarly, an otherwise enforceable and perfected security interest that collateralizes a qualified financial contract obligation may not be set aside unless the security interest was taken with actual intent to hinder, delay or defraud.
- The Act provides that “walkaway clauses” (in which a nondefaulting party benefits from a suspension or extinguishment of a payment obligation because of its status and without the need to exercise setoff or netting rights) are unenforceable.
The Act gives the FDIC the power to disaffirm or repudiate any contract or lease to which a covered financial company is a party if the FDIC determines that the contract would be burdensome and repudiation of the contract would promote the orderly administration of the company’s affairs. If the FDIC repudiates a qualified financial contract, damages to the counterparty would be deemed to include normal and reasonable costs of cover or other reasonable measures of damages typically applied in the industry to similar contracts.
The Act directs the FRB, in consultation with the Administrative Office of the United States Courts, to conduct a study on a number of issues related to the resolution of financial companies, including whether amendments should be made to the Bankruptcy Code, the FDIA and other insolvency laws “to address the manner in which qualified financial contracts of financial companies are treated.” The results of this study could affect the special treatment currently afforded to qualified financial contracts under the various U.S. insolvency regimes. The Act also directs the newly established Financial Stability Oversight Council (the “Council”) to conduct a study to consider whether applying a haircut to the rights of a secured creditor could improve market discipline and protect taxpayers. Imposing haircuts on collateral rights in the context of securities lending could materially affect lenders’ willingness to make loans and/or increase the potential indemnification obligations of lending agents.
The orderly liquidation authority under the Act also includes special provisions for covered broker-dealers. Upon its appointment as receiver for any covered broker-dealer, the FDIC is required to appoint the Securities Investor Protection Corporation (“SIPC”) as the trustee to liquidate the covered broker-dealer and any of its assets or liabilities that the FDIC does not transfer to a bridge financial company in a liquidation proceeding under the Securities Investor Protection Act (“SIPA”). Except as otherwise provided in the Act, SIPC would have the same powers and duties with respect to such remaining assets and liabilities that it would otherwise have under SIPA. However, the rights and obligations of any party to a qualified financial contract with a covered broker-dealer would be governed by the Act provisions discussed above, and not any provisions of SIPA.
At least two recent U.S. bankruptcy court cases, Lehman Brothers1 and SemCrude,2 have imposed limits on the ability of a creditor to exercise rights to set off its obligations to the debtor against obligations of the debtor to the creditor or its related parties. These cases have created some uncertainty regarding the application of master netting arrangements between lenders and borrowers, particularly in the context of bank-sponsored agency programs that include multiple lenders. In determining the enforceability of netting arrangements, the FDIC is not bound by bankruptcy court decisions, and might not reach the same conclusions as those cases. Moreover, certain differences between the language of the Act and that of the U.S. Bankruptcy Code make clear that the FDIC would be required to give full effect to netting agreements without regard to mutuality or similar doctrines.
The Act requires the primary federal financial regulatory agencies (the banking agencies, the SEC and the Commodity Futures Trading Commission (the “CFTC”)) to jointly prescribe regulations requiring that financial companies maintain such records with respect to qualified financial contracts (including market valuations) that the primary federal financial regulatory agencies determine to be necessary or appropriate in order to assist the FDIC as receiver for a covered financial company in being able to exercise its rights and fulfill its obligations under the Act.
The Volcker Rule
The so-called “Volcker Rule,” contained in Title VI of the Act, generally prohibits FDIC-insured banks and their affiliates from sponsoring any fund that would be an investment company, as defined in the Investment Company Act of 1940 (the “1940 Act”), but for section 3(c)(1) or 3(c)(7) of the 1940 Act, or such other funds as the appropriate federal banking agencies, the SEC and the CFTC may specify by rulemaking. The term “sponsor” includes serving as a general partner, managing member or trustee, and the rule therefore would effectively prohibit covered lending agents from establishing or maintaining funds for the reinvestment of cash collateral. The Act contains an exemption for a banking entity where the banking entity provides bona fide trust, fiduciary or investment advisory services, and the fund is organized and offered only in connection with the provision of bona fide trust, fiduciary or investment advisory services and only to persons that are customers of such services of the banking entity.
We would generally expect that lending agents sponsoring cash collateral pools will be able to qualify for this exemption, although there are additional conditions to the exemption, including that the banking entity may not enter into any transaction with the fund that would be a “covered transaction” under Section 23A of the Federal Reserve Act (“Section 23A”), other than (as yet unspecified) prime brokerage transactions under certain circumstances. Thus, lending agents may be limited in their ability to extend credit to their sponsored cash collateral pools, purchase securities or other assets from such pools, or engage in foreign exchange trading with such pools, among other activities. One practical result of the Volcker Rule may be the push-out of general partner, managing member or trustee responsibilities from the lending agent to an unaffiliated bank or other sponsor.
The effectiveness of the Volcker Rule is subject to additional study and other future action by the Council and the federal banking agencies, but as a general matter banking entities likely must be in full compliance with the rule no earlier than July 21, 2014 (unless final regulations are promulgated before July 21, 2012, in which case the relevant date would be two years after such final regulations are issued).
Limitations on Credit Exposure
The Act establishes a framework designed to improve the financial stability of bank holding companies with total consolidated assets equal to or greater than $50 billion and significant nonbank financial companies (collectively referred to as “systemically significant financial companies”), in part by providing for more stringent standards of conduct for those companies.3 The new standards will include counterparty concentration and lending limits that may restrict the ability of systemically significant financial company lending agents to offer indemnified agency programs. Specifically:
- The Act requires the FRB to issue regulations prohibiting a systemically significant financial company from having credit exposure to any non-affiliate in excess of 25% of the capital stock and surplus of the company, or such lower amount as the FRB may determine to be necessary to mitigate risks to financial stability. For this purpose, credit exposure would include repurchase and reverse repurchase agreements and securities borrowing and lending transactions “to the extent that such transactions create credit exposure.” We expect the FRB’s rulemaking to clarify that credit exposure should be measured on a net basis, taking into account collateral held and also, potentially, master netting arrangements. These regulations would not become effective earlier than July 21, 2013.
- The Act permits, but does not require, the FRB to issue regulations prescribing limits on the amount of short-term debt (including off-balance sheet exposures) that may be accumulated by any systemically significant financial company. Any such limit must be based on the short-term debt of the company as a percentage of capital stock and surplus of the company or on such other measure as the FRB considers appropriate. For this purpose, short-term debt means liabilities with short-dated maturities that the FRB identifies by regulation. We expect that indemnified securities borrowing and lending transactions, as well as repurchase and reverse repurchase agreements, will qualify as short-term debt for this purpose.
- The Act provides that in determining their capital requirements, systemically significant financial companies must take into account any off-balance sheet exposures, which would include indemnities relating to agency securities loans. Both existing risk-based capital rules and Basel II4 already require banks to account for these types of exposures.
- The Act amends the lending limits of all national banks to require that a bank include in the single borrower limitation any credit exposure arising from a derivative transaction, repurchase agreement, reverse repurchase agreement, securities lending transaction or securities borrowing transaction. The Act further provides that an insured state bank may engage in derivatives transactions that give rise to credit exposure only if applicable state law takes such credit exposure into account for purposes of state lending limits.
Leverage and Risk Based Capital
The Act will impose on bank holding companies (including intermediate holding companies of foreign banking organizations), thrift holding companies and systemically significant nonbank financial companies the same leverage and risk-based capital standards applicable to insured depository institutions, with currently applicable leverage and risk-based capital standards serving as the floor going forward. Credit exposures resulting from indemnities, guarantees, overdraft facilities and similar services provided by nonbank affiliates with respect to a bank’s agency lending program will be subject to these new requirements. Moreover, additional capital requirements may be imposed under Basel III, as discussed below.
The Act also requires, subject to recommendations from the Council, that the federal banking agencies develop capital requirements to address the risks posed both to financial institutions and to other public and private stakeholders of engaging in “significant volumes of activity” in securities borrowing and lending and repurchase and reverse repurchase agreements. The Act does not specify what qualifies as “significant volumes of activity” and also does not specify when these additional capital requirements must be implemented.
Transactions with Affiliates
The Act provides for enhanced restrictions on transactions between banks and their affiliates, which may, among other things, impact riskless principal or “conduit” lending and similar alternative lending programs. Among other changes, the Act:
- Revises the definition of “covered transaction” under Section 23A to provide that a repurchase agreement will give rise to an extension of credit rather than a purchase of assets. As a result of this change, repurchase agreements between a covered bank and its affiliates will be subject to the ongoing collateral requirements of Section 23A and the FRB’s Regulation W relating to credit transactions. An additional consequence of this change is that a bank could potentially avail itself of an exemption from the requirements of Section 23A for loans or extensions of credit to an affiliate fully secured by certain types of collateral, which exemption is not available for asset purchase transactions. However, exemptions related to asset purchase transactions, such as the exemption for purchasing liquid assets for which there is a readily identifiable and publicly available published market quotation, will likely no longer apply to these types of repurchase agreement transactions.
- Revises the definition of “covered transaction” under Section 23A to include securities borrowing and lending transactions with an affiliate to the extent the transaction creates a credit exposure to the affiliate. This change, along with the expansion of a related exemption for transactions fully secured by certain types of collateral, appears to simply codify existing law and interpretive positions of the FRB.
- Authorizes the FRB to issue regulations and interpretations addressing the manner in which a netting agreement may be taken into account in determining the amount of a covered transaction between a bank and its affiliates, including the extent to which netting agreements may be taken into account in determining whether a covered transaction is fully secured.
- Expands the definition of “affiliate” to include any investment fund advised by a bank or its affiliates.
- Provides that low quality assets and securities or other debt obligations are not acceptable as collateral for a credit exposure to an affiliate resulting from a securities borrowing or lending transaction.
The changes to Section 23A and Regulation W will become effective sometime between July 21, 2012 and January 21, 2013.
Changes to the Federal Securities Laws
The Act amends the Securities Exchange Act of 1934 (the “1934 Act”) to prohibit “manipulative” short sales of securities and directs the SEC to promulgate rules to implement this prohibition. The term “manipulative” is not defined. To avoid potential liability for aiding and abetting a violation of this prohibition, a securities lender should consider obtaining sufficient contractual or other assurances from the borrower that it is not borrowing the securities for the purpose of engaging in a manipulative short sale.
The Act requires registered brokers and dealers to notify customers that they may elect not to allow their fully paid securities to be used in connection with short sales. If a broker or dealer uses a customer’s securities in connection with short sales, the broker or dealer must notify its customer that the broker or dealer may receive compensation in connection with lending the customer’s securities. The SEC is authorized to prescribe the form, content, time and manner of delivery of any such notice. Given the SEC staff’s view that a person lending securities to a broker-dealer is a customer of the broker-dealer, registered broker-dealers should consider enhancing the disclosures contained in their borrowing agreements, as well as their customer agreements, and may become subject to specific requirements if and when the SEC promulgates rules regarding such disclosures.
The Act also requires the SEC to promulgate rules no later than July 21, 2012 that are designed to increase the transparency of information available to brokers, dealers and investors with respect to the loan or borrowing of securities. Furthermore, the Act amends Section 10 of the 1934 Act to prohibit effecting a loan or borrowing of securities in contravention of any applicable SEC rules and regulations. This provision does not limit the authority of the federal banking agencies to prescribe rules regarding the loan or borrowing of securities.
In addition, the Act requires the SEC to promulgate rules providing for monthly public disclosure of short sales by institutional investment managers subject to Section 13(f) of the 1934 Act. The Act also requires the SEC to complete a study by July 21, 2011 on the reporting of short sale positions in real time to the public or only to the SEC and the Financial Industry Regulatory Authority. Additional disclosure of short-selling activity may affect the demand for loans of securities.
Additional Developments Relating to Regulatory Capital
At the same time as new provisions are taking effect under the Act and the regulations and studies it mandates are being pursued, the continued implementation of Basel II in the United States is occurring. In addition, the BCBS continues to develop the Basel III proposals. One such Basel III proposal is the introduction of a global leverage ratio to help contain the build up of excessive leverage in the banking system. This proposal differs from the leverage ratio generally applicable to U.S. banking institutions in that it will likely require a lending agent that indemnifies its clients against counterparty default to take into account assets resulting from repo style transactions (which include repurchase and reverse repurchase transactions and securities borrowing and securities lending transactions) in determining its leverage ratio. The current proposal would not permit netting of repo style transactions when calculating the leverage ratio, although the BCBS has stated that it will assess the impact of applying regulatory netting rules. The BCBS has also stated that it expects to base the leverage ratio on a new definition of Tier 1 capital, although it will also track the impact of using total capital and tangible common equity.
The Basel III proposals also include provisions intended to enhance the capital requirements for counterparty credit risk exposures arising from derivatives, repurchase transactions and securities financing activities. Repo style transactions will also likely be covered by expected Basel III proposals to build capital buffers and reduce pro-cyclicality. The BCBS is expected to finalize Basel III by the end of 2010, but compliance with the Basel III requirements will generally be subject to grandfathering arrangements and phase-in measures that will extend until at least the end of 2012, and in at least some circumstances as late as 2018.
SEC Concept Release on the U.S. Proxy System
Also separate from developments arising as a result of the Act, on July 14, 2010, the SEC issued a concept release on the U.S. proxy system that seeks public comment on how the SEC’s current rules might be revised to promote greater efficiency and transparency in the system and enhance the accuracy and integrity of the shareholder vote. Among the areas discussed in the release is the securities loan recall process. In a typical securities loan, the right to vote the loaned securities is transferred along with title to the securities. If a lender wishes to vote the loaned securities, it must recall them from the lender.
The release points out that proxy statements are typically mailed out after the record date, and therefore an institutional lender that wishes to vote proxies must learn what matters will be presented to shareholders sufficiently in advance of the record date so as to be able to recall the securities in time to vote them. The release asks “whether decisions to recall loaned securities in connection with shareholder votes might be more timely and better informed.” The release notes that potential methods for addressing this issue include requiring issuers to report to their self-regulatory organizations, and those self-regulatory organizations to publish, the proposed meeting agenda in advance of the record date, or requiring issuers to disclose the meeting agenda publicly, through a Form 8-K filing or otherwise. The release asks institutional securities lenders to provide the SEC staff with data regarding the recall of loaned securities by lenders for the purpose of voting the securities.
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Goodwin Procter’s securities lending specialists will continue to follow regulatory developments and consider their specific application in the context of the securities lending industry. We will provide additional targeted updates on material developments, and the firm’s Financial Services Group will continue to report on financial industry developments in our weekly Financial Services Alert. To discuss the implementation of these changes to your business, please contact your regular Goodwin Procter attorney.