Lending Law Report : Corporate Finance Lawyer & Attorney : Reed Smith Law Firm : Lending Transactions, Secured Investments

It's now been several months since Dodd-Frank was enacted, and the regulators have been busy.  There have been several proposed rules sent out for comment, and various agencies have produced studies, reports and final rules. 

All this activity would be too much for most of us to keep up with, but my colleague Michael Bleier, former general counsel of Mellon Bank and now a partner in our financial services regulatory practice here at Reed Smith, has been keeping a close eye on the developments in this area.  He's put together a handy summary of all the rulemaking.   If you've been following the developments in this area - or if you haven't been but want a chance to catch up now - you'll want to check it out.

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I've just finished reading Andrew Ross Sorkin's excellent book Too Big To Fail (Penguin, 2009).  If you haven't read it yet, put it on your list, because this one is really worth it.  The book tells the gripping tale of the financial crisis, beginning with the downward slide of Bear Stearns and Lehman and continuing through to adoption of the TARP program.   With particular focus on Tim Geithner, then President of the Federal Reserve Bank of New York, and Hank Paulson, then Secretary of the Treasury, who - along with many others in government and the private sector - worked tirelessly to try to fix a seemingly unending parade of problems, Sorkin captures the intensity of the times and offers insights into why things happened the way they did.   It's a real page-turner, and suprisingly so given that the primary elements of the story are already well known.

As we now try to figure out how to deal with the Dodd-Frank Act (pdf) and its potential impact on financial institutions, it's helpful to look back at what happened in 2008, as described in Sorkin's book.  It's striking to see how similar certain provisions of the Act (and the language used in the congressional committee's report about the Act) are to the ideas expressed by people in government during the crisis itself. 

In particular, concerns about moral hazard (the idea that undue risk-taking is promoted when managers and shareholders know they can be insulated from negative consequences) and about the real need for an alternative to the bankruptcy process for large financial institutions, were often voiced.  As quoted in Sorkin's book, both Paulson and Ben Bernanke, Chairman of the Federal Reserve, expressed on multiple occasions the need for the government to have authority to resolve or wind-down complex financial institutions outside of bankruptcy.  Bernanke also spoke of the need to mitigate moral hazard  "by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors."

And sure enough, in adopting Dodd-Frank, Congress explained that the "too big to fail" provisions address both of these issues front and center.  The Act provides for "orderly liquidation authority" if the Secretary of the Treasury (in consultation with the President,  and with the wrritten recommendation of two additional  federal regulators) finds that liquidation is necessary to mitigate "serious adverse effects on financial stability" in the nation.  The liquidation is to be carried out in a manner that "minimizes moral hazard," with costs being borne first by shareholders and unsecured creditors -- and protecting taxpayers from these losses.

Several other provisions of Dodd-Frank can find their beginnings in the events of 2008 as well --  short sales, hedge fund regulation, derivatives, rating agencies, etc.  Turns out that Sorkin's book, though likely not intended for this purpose, provides a fascinating background story and explanation for much of the content of the Dodd-Frank Act.

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My law partners Sandra Poe (of Reed Smith's New York office) and Alicia Powell (from Pittsburgh), along with other colleagues, wrote the following summary of the Private Fund Investment Advisers Registration Act of 2010.  As part of the larger Dodd-Frank financial reform legislation, this Act significantly changes the rules for funds.  If you manage a hedge fund or private equity fund, or work with (or make loans to) these funds, you'll want to know about these new rules.  Of course, this is just one of many important changes affecting the financial industry -- we'll have a lot more to say about other aspects of Dodd-Frank in future posts. 

In the Private Fund Investment Advisers Registration Act of 2010, Congress adopted changes to the Investment Advisers Act of 1940 that greatly increase the chances that managers of hedge funds or private equity funds will now have to register as investment advisers.  Advisers who are required to register will have about a year to do so -- until July 21, 2011.  Widely covered in the news as “hedge fund registration” requirements, these amendments actually primarily affect the status of the fund managers, rather than the funds themselves.

What Will Change

Currently, advisers that have fewer than 15 clients generally are exempt from
registration.  Advisers that manage private funds can count each fund as a single client.  Most private equity and hedge fund managers have been entitled to rely on this exemption.  The law change eliminates this so-called “private adviser exemption” in its entirety, and provides that the SEC will replace it with a much narrower exemption for advisers with assets under management of less than $150 million, and who exclusively advise private funds (as defined in the Act).   As a result, private fund advisers with $150 million or more in assets under management will be required to register with the SEC.  Private fund advisers falling beneath the $150 million threshold must determine whether they are required to register with the securities regulators in one or more states (we note that all states other than Wyoming have some sort of registration requirements).

The New Rules

• Registration on Form ADV — To register, advisers must complete Form ADV, which requires substantial disclosures to the SEC and to the adviser’s clients. Form ADV must be updated at least annually and, with respect to certain key information, at the time of certain changes in the reported information.
• Disclosures to Adviser’s Clients — “Part II” of Form ADV, or the “brochure,” calls for substantial narrative description of the adviser’s business, products, management, material adverse financial or disciplinary matters, conflicts of interest and policies designed to address conflicts of interest.  Advisers are required to deliver their brochure to advisory clients annually. The brochure is often used as a means of conveying other required disclosures such as privacy policies.
• Adoption of a Comprehensive Compliance Program — Registered advisers must adopt written policies and procedures designed to prevent violation of the Act and its rules. Such written policies must be reviewed at least annually for adequacy and effective implementation, and a chief compliance officer must be appointed to oversee their administration.
• Adoption of an Anti-Insider Trading Policy — A policy must be designed to ensure that material, non-public information is not misused in violation of the Act or the U.S. Securities Exchange Act of 1934 (the “1934 Act”), and may entail (i) circulating a written policy to all employees, (ii) employee training programs, (iii) creating physical and organizational information barriers, (iv) maintaining restricted lists, watch lists, and rumor lists, and (v) maintaining a procedure for monitoring client and personal trades.
• Adoption of Code of Ethics and Personal Trading Policy for Access Persons — Access persons must report their personal securities holdings and transactions.  Some access persons must also obtain pre-clearance before participating in, and may be barred from investing in, initial public offerings and limited offerings.
• Subject to SEC Examination Authority — The SEC conducts periodic examinations of registered advisers.  You'll want to stay abreast of “hot topics” and periodic SEC staff
  statements about the focus of the SEC’s examination program.
• Substantial Recordkeeping Obligations — The Act imposes requirements with respect to
  adviser records substantiating the basis of performance claims and other records reflecting
  the relationship between the adviser and its clients.  New legislation would add to these
  records for each private fund under management.  These records include AUM, the use of
  leverage, counterparty credit risk exposure, trading and investment positions, valuation policies, side arrangements or side letters, trading practices, and any other subjects that the SEC, in consultation with the Financial Stability Oversight Council, deems necessary for the public interest, investor protection or the assessment of systemic risk.
• Compliance with Anti-Fraud Laws — The Act generally prohibits an investment adviser from
  employing a “device, scheme or artifice” to defraud clients or engaging in a “transaction, practice or course of business” that operates as a “fraud or deceit” on clients. The Act’s anti-fraud provisions also prohibit certain securities transactions absent disclosure to clients, as well as any “act, practice or course of business which is fraudulent, deceptive or manipulative.” Rules under the Act extend these protections to investors in the adviser’s private funds. In addition to the antifraud provisions of the Act, you may also be subject to the anti-fraud and manipulation provisions of the other federal securities laws, such as section 17(a) of the U.S. Securities Act of 1933, as amended, and Rule 10b-5 under the Securities Exchange Act of 1934, as amended.
• Custody Rules — The Act imposes specific measures registered advisers must take to safeguard client assets over which the adviser has, or is deemed to have, custody. These steps include maintenance of client assets with a “qualified custodian” and submission to an annual surprise examination by an independent public accounting firm (or the issuance of annual audited financial statements by private funds advised by the adviser). 

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Now that the Dodd Frank Act is expected to be enacted, attention turns to how this legislation will affect the financial services industry.  Will it fundamentally change the industry in the same way that Glass-Steagall, the FDIC Act, and the groundbreaking securities laws did during the Depression era?  With more than 200 rulemakings still to be issued, countless research studies to be conducted, and a Financial Stability Oversight Council to be formed, the bill’s enactment alone will not provide all of the answers.  

Reed Smith is planning to conduct a series of teleseminars about the new bill, with the first session on Tuesday, July 20, at 12 pm Eastern.  A panel of regulatory authorities and former general counsel will provide a summary of the legislation and discuss the following topics: 

• Will this law be the game-changer everyone expects?  What will the impact be for the financial services industry?
• What impact will the financial reform legislation have on banks and investors outside the United States?
• Who will be the new regulators?  Who will be among the newly regulated?
• Has the legislation addressed the issue of "too big to fail"?

Michael Bleier, former general counsel of Mellon and now a partner in our regulatory practice, will moderate the panel.  Panelists will include William Mutterperl, former vice chairman of PNC, Jacqui Hatfield, a partner in Reed Smith's financial services regulatory practice, and Reed Smith partners Stephen Keen and Andrew Cross from our investment management practice. 

If you'd like to attend this program, just click here to register. 

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The last two weeks have brought new plans for regulation of financial institutions and financial markets, in both the US and the UK.   The global trend toward increased regulation of finance is bound to have significant effects on lending institutions over the next few months and years.

On May 20, the US Senate passed S. 3217, an extensive set of banking and financial regulatory reform legislation.   This bill covers such areas as proprietary trading by banks, enhanced consumer protection (including creation of a new consumer financial protection agency), trading of over-the-counter derivatives, and many other things.  Next steps will include trying to reconcile the content of this bill with the somewhat different version of a financial reform bill passed earlier by the House of Representatives, before the legislation moves forward to be signed by the President.  To find out more about how this legislation might affect you, take a look at this summary of the Senate bill's contents prepared by my partner Christopher Rissetto and others.

Meanwhile, across the pond, UK regulators are gearing up to further tighten the rules affecting financial markets.  Similar to some initiatives in the US, the focus in the UK is on reforming over-the-counter derivative markets, strengthening global standards for clearing houses (including improving handling of defaults in the clearing and settlement system), increased transparency in non-equity markets, and oversight of credit rating agencies.  Here's a helpful guide to the UK proposals, along with some commentary from my partner Jacqui Hatfield, who leads Reed Smith's Financial Services Advisory Group from our office in London.

For those in the US, enjoy the Memorial Day weekend and the unofficial start of summer!

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Are you using social media?   I'd be surprised if you weren't . . . and if you're part of a financial institution subject to FINRA (the Financial Industry Regulatory Authority), you'll want to know about a new notice that just went into effect about use of social media. 

On January 25, 2010, FINRA issued a regulatory notice (pdf download) giving guidance on how the FINRA rules apply to social media sites that are sponsored by financial firms and their registered representatives.   My partners Chris Bennett and Amy Greer have written a report summarizing the relevant parts of the notice and explaining how the rules can affect you.  For example, you still have to comply with the normal recordkeeping requirements when using social media -- and this can be a real challenge, since the requirements were set up before social media gained widespread use.  The FINRA notice includes a dicussion of some requirements for adopting a system for supervision and review of social media communications.   And there is new guidance about how the rules apply to the content that you post.

To learn more about the issues you can encounter when using social media for business - in any industry - take a look at this full-length write-up (pdf download).

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What's going on in the derivatives market these days?  There's lots of talk about regulation -- who, how, when, and what.  

My partners in our derivatives practice have written a summary of the three proposals for regulatory reform of the OTC derivatives market that are currently under consideration by Congress.  Key themes of these proposals include mandatory clearing, exchange trading, capital requirements, margin requirements, position limits, and disclosure and reporting obligations.  The Commodities and Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC) will be required to establish the specific rules. 

If you're a swap dealer or "major swap participant" (as defined in the proposals), you'll want to watch these developments closely.

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This post was written by Colleen McDonald, a partner in the Financial Industry Group here at Reed Smith.

The FDIC has given banks a temporary reprieve from the impact on their securitizations of the recent changes in GAAP, until March 31, 2010. By then, the FDIC has promised new securitization rules.

The FDIC has stated (pdf) that it will issue new rules for bank securitizations in December 2009, which rules will likely impose mandatory structural changes to bank securitizations including credit risk retention, increased disclosures to investors, and more flexibility for servicers of securitized debt. There will be a comment period before the revised rules go into effect, during which time interested parties will be invited to provide comments and feedback to the FDIC on the proposals.

The FDIC's action under the Interim Rule (Fed. Reg. Vol. 74. No. 220, Nov. 17, 2209) extends the current safe harbor for bank securitizations contained in the "Securitization Rule" (12 CFR 360.0) until March 31, 2010, thereby giving banks the ability to securitize without considering whether the recent GAAP accounting changes in FAS 166 and 167 (the "New GAAP Rules") affect their securitizations during the interim period. We've prepared a separate report on the content of these recent changes to GAAP.

Under the "Securitization Rule", the FDIC clarified its authority as receiver or conservator to reclaim as property of a bank any financial assets transferred by the bank in connection with a securitization did not apply to a sale which met all conditions for sale accounting treatment under GAAP. The New GAAP Rules may affect whether an issuing entity has to be consolidated on the bank's balance sheet for financial reporting purposes. Given the changes in the accounting treatment, securitizations would not likely meet all conditions for sale accounting treatment. As a result, the safe harbor provision of the Securitization Rule may not apply to the transfer.

The Interim Rule provides that for securitizations and participations for which transfers were made or interests were issued before March 31, 2010, the FDIC will not exercise its statutory authority and reclaim as property of the institution any transferred financial assets notwithstanding that such transfer does not satisfy all conditions for sale accounting treatment under the New GAAP Rules for reporting periods after November 15, 2009, if such transfer satisfied the conditions for sale accounting treatment set forth by GAAP in effect for reporting periods before November 15, 2009. The FDIC has requested comments on all aspects of the Interim Rule, which must be received by January 4, 2010.

Of course, not all issuers are banks. Non-depository institutions will continue to have to deal with the impact of the GAAP changes on their securitization structures.

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A new set of FASB rules may impact whether a securitization is treated as a "true sale" and whether companies with financial assets will have to consolidate their special purpose entities on their balance sheets.   For banks, the new rules may also mean that there will be additional capital requirements, to cover their conduits.  The Wall Street Journal has reported (subscription-based content) that the cost of securitization will likely go up as a result of this change, and that it could create a "logjam" in the securitization market, further slowing market recovery.  My partners Michael Brown and Colleen McDonald have written a report on the proposed changes -- if the securitization market affects you, you'll want to check it out.  

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In our prior posts on this topic, we focused on what your loan agreements might say about how to deal with a defaulting lender.  In this post,  we'll talk about what happens when a member of your bank group goes into default because it is taken over by the FDIC.  Special rules apply in that case.

Automatic Stay.  The Federal Deposit Insurance Act  provides for an "automatic stay" whenever a lender is taken over by the FDIC.  In part, the statute says that no one may "exercise any right or power to terminate, accelerate, or declare a default under any contract" that the failed institution is a party to, for a period of 90 days after appointment of the FDIC as receiver (45 days, if it is a conservatorship).  

My colleagues Colleen McDonald and Nikki Kolhoff have explained (pdf) that this means you can't do anything that would affect the contractual rights of the defaulting lender, if such action is based solely on the insolvency or FDIC takeover.  So, for example, you can still amend your loan documents, but you have to invite the defaulting lender to vote, and the amendment can't affect the rights of the defaulting lender without that lender's consent.  According to McDonald, the bottom line here is "if you are going to amend your loan agreement, make sure you do it correctly."  She points out that both the "D'Oench Dhume doctrine" (D'Oench, Duhme & Co. v. FDIC, 315 U.S. 447 (1942)) and 12 U.S.C. Section 1823(e) impose specific requirements on modifications of loans involving financial institutions taken over by the FDIC.  Contracts that don't meet the requirements can be avoided altogether by the FDIC - so it's worth taking the time to make sure those requirements are met.

In addition, even if the loan agreement would otherwise permit you to stop sharing payments with a defaulting lender, if the lender is taken over by the FDIC, you'll still have to share all principal and interest payments with it -- at least, to the extent of the obligations it has previously funded.  (As discussed in our prior post, the loan documents should ordinarily prohibit the defaulting lender from sharing in principal and interest payments relating to advances it did not fund.) 

As a practical matter, the automatic stay can create significant problems for a bank group, particularly if the defaulting lender is the administrative agent for the credit facility.  Since the agent manages the funding and payment processes, and often holds the borrower's bank accounts and controls other collateral for the loan, an FDIC takeover could bring everything to a halt - at least temporarily.  

McDonald recommends that to help protect against these problems, the loan agreement should include the right to declare the lender in default early -- before FDIC takeover.  This would allow the bank group to take action before the automatic stay kicks in.  For example, if the agent in a syndicated loan goes into default (pre-FDIC takeover), its rights as agent could be terminated and assigned to a successor, and all the collateral could be transferred to the new agent -- thus permitting the credit facility to function pretty much as usual through the FDIC takeover.  McDonald suggests including a definition of  "Impaired Agent" in the loan agreement that would include an agent that fails to make payments or fund loans required under the loan documents, or that rescinds or repudiates a loan document.

Exceptions.  There are other sections of the Federal Deposit Insurance Act that provide exceptions to the automatic stay, including an exception for when the FDIC as conservator/receiver fails to comply with otherwise enforceable provisions in the loan agreement.  Sometimes these exceptions can provide relief for the bank group, though their full effect is as yet untested.   I have a feeling we'll get the chance to test some of these provisions over the next few months.

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The U.S. Department of Energy has a new program to guarantee loans to support the development of renewable energy projects.   Lenders who meet the DOE's requirements for eligibility have been invited to submit applications for partial guarantees from the DOE for the financing of projects that will generate electricity or thermal energy, using commercial technology.   The loans must be structured as traditional senior secured indebtedness, and the guaranteed amount will vary but is capped at 80% of the principal amount of the loan.   The guarantees offered by the DOE are expected to support up to as much as $4-8 billion in lending to eligible projects.   If you'd like to learn more about this program, my partners Ellen Bastier and Ferd Convery from Reed Smith's energy practice group have written a helpful summary of the program.   

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This post was written by Joel Schaider, a partner in the Financial Industry Group here at Reed Smith.

With failed financial institutions approaching record numbers, the Federal Deposit Insurance Corporation (“FDIC”) has been required to step in and seize the assets of these institutions.  The single largest categories of assets held by a failed financial institution are its performing and non-performing loans.  These loans are in the process of being sold to the public in bulk through a sealed bid process.

How to Find Information on Loan Sales  

The FDIC’s website contains information on current loans which are available for bid.  The loans of each failed institution are grouped into pools by loan type (e.g. commercial and industrial, consumer, residential, agriculture).  The website contains a list of offering announcements which are currently available for bid including the name of the financial institution which originally held the loans, the number of loans in each pool, a general description of the loan type, a description of the nature of the collateral securing the loans, the location of the collateral and the percentages of seasoned performing and non-performing loans in each group.  There are also key dates listed for the commencement of due diligence and the due date for the submission of a bid.

Additional information on loan sales may be obtained from two loan sales advisors (First Financial Network and DebtX) who the FDIC has retained to manage the sales process. The offering announcement for each loan sale will identify the sales advisor who has been assigned to manage the particular sale. 

How the Sale Process Works

• Purchaser Qualification.   The first step in the sale process to for the purchaser to become qualified.  First Financial and DebtX have established similar qualification requirements, however, it is advisable for the purchaser to qualify with both advisors.  Once the qualification requirements have been met, purchasers will be given passwords and access instructions to the loan due diligence and other information pertaining to a particular loan sale.
   
• Timing.  Generally, the period of time involved in bidding and purchasing a group of loans from the FDIC is approximately 6 to 8 weeks from the time the offering is first announced. The initial period of due diligence is typically 4 to 5 weeks in length with the bids to be submitted on a specified date after the expiration of the due diligence period. Generally, it takes two weeks for the bid to be awarded. The closing would then occur within a short period after the bid is awarded.
   
• Due Diligence.   The FDIC makes no representations or warranties in connection with the purchase of any loans and all of the risk of loss associated with the loans are passed to the purchaser upon closing.  The rights and remedies available to the purchaser are solely contained in the underlying loan documents and the associated collateral.  Therefore, a review of the loan files including the collateral is a critical element which must be completed prior to the submission of a bid. 
  
  The due diligence process may vary depending on the size and characteristic of the loans contained in each portfolio. Larger-sized commercial loans may require greater scrutiny than smaller consumer loans. However, a large number of consumer loans, for example, may contain defective terms which could affect the enforceability of all the loans in the portfolio. The loan files may be missing signed documents or important pieces of collateral. Experienced counsel needs to be involved in order to conduct due diligence in an efficient and effective manner.
  
  The due diligence files are obtained through the financial advisor assigned to the particular sale. The files are typically available on a secured website, on a separate hard drive (which may be purchased) or in a physical location.
   
• Bid Submission.  Upon completion of due diligence, an interested purchaser needs to submit a bid.  An initial deposit of $100,000 is required from each bidder to be sent by wire transfer at the time of bid submission.  The deposit is fully refundable, without interest, if the purchaser’s bid is not accepted.  If the purchaser’s bid is accepted, a final deposit equal to 10% of the purchase price of the loan portfolio, less the amount of the initial deposit, is required to be deposited within one business day following the bid award.
   
• Closing.  Closing occurs on a specified date within a short period of time after the bid is accepted by mail or in person at a place designated by the sales advisor.  The balance of the purchase price is due at the time of closing. All loan documentation such as notes, collateral documents and loan files will be delivered to the purchaser within a reasonable time after closing.

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While we engage in debate about how to reform our own financial markets here in the US, similar activities are going on in other parts of the world.  There's a new government proposal in the UK that includes plans to strengthen their regulatory entities, focusing on managing "high impact" institutions, increasing market transparency, improving consumer protection and education, and enhancing market access.  Though our goals may be similar in the US, under this proposal the means for getting there would be somewhat different.  

The UK proposal adds an interesting perspective to the ongoing international discussion on this vital topic.   If you're interested in learning more, my partner Jacqui Hatfield in the London office here at Reed Smith has written a helpful summary of the UK proposal. 

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