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September 2008

Published by RR Donnelley
Editorial Content by LegalWorks
Blake A. Bell, Editor in Chief

In This Issue:

LEGISLATION:: Emergency Economic Stabilization Act of 2008
On September 20, 2008, the U.S. Department of Treasury responded to the current economic crisis by proposing draft legislation to allow it to purchase up to $700 billion in troubled mortgage-related assets. Senator Christopher Dodd and Rep. Barney Frank drafted alternative bills that would impose more stringent oversight on the Treasury Department’s implementation of the rescue plan and require financial institutions participating in the plan to agree to certain concessions.

Following various legislative initiatives and maneuvers, on September 28, 2008, a new version of the rescue plan legislation, referred to for the first time as the Emergency Economic Stabilization Act of 2008, was released with the support of the Secretary of the Treasury and Congressional leaders of both parties.

On Monday, September 29, 2008, the House of Representatives rejected the Emergency Economic Stabilization Act of 2008 by a vote of 205 to 228. On Wednesday, October 1, 2008, the Emergency Economic Stabilization Act of 2008 was introduced in the Senate. Because a bill involving raising revenue is constitutionally required to originate in the House of Representatives, the Senate introduced the act as an amendment to the Mental Health Parity and Addiction Equity Act of 2008 and also included the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, the Energy Improvement and Extension Act of 2008, and the Heartland Disaster Tax Relief Act of 2008. The Emergency Economic Stabilization Act of 2008 portion of the Senate bill is largely identical to the bill previously presented to the House of Representatives, but includes a temporary increase in the limit on FDIC deposit insurance to $250,000 and includes minor revisions to the provisions concerning executive compensation and the purchase of warrants from participating financial institutions.

On October 1, 2008, the Senate voted to include the Emergency Economic Stabilization Act of 2008 in the bill and then passed the bill, each by a vote of 74 to 25. On Friday, October 3, 2008, the House of Representatives passed the bill by a vote of 263 to 171, and the President signed the bill into law.

The Department of the Treasury has fast-tracked efforts to implement the new law. Treasury Secretary Henry Paulson has tapped 35-year-old Neel Kashkari, a Treasury Assistant Secretary for International Affairs and a former Goldman Sachs banker, to serve as interim head of Treasury's new Office of Financial Stability to implement the purchase of bad loans and distressed securities from the nation's financial institutions.

On Monday, October 6, the Treasury asked companies to submit bids for running a system to enable the Treasury to acquire such debt and securities no later than October 8. The Treasury has said that it will select winners on Friday, October 10 from among those who submit bids by October 8. The Treasury reportedly will retain multiple investment managers to manage various classes of assets that the government chooses to purchase under the new law.



SEC I: : SEC Issues Wide-Ranging Set of Emergency Orders, Guidance and Statements Banning Short-Sales of Securities of Financial Institutions; Ban Expired on October 8

SEC Emergency Actions

SEC Press Releases

Testimony of SEC Chairman

Market Participant Guidance Issued by SEC

EDGAR Filer Materials and Guidance

Shortly after the collapse of Lehman Brothers as the current economic crisis deepened in mid-September, the U.S. Securities and Exchange Commission began entering a series of orders, guidance and public statements as part of an emergency ban on short-sales of hundreds of financial institutions. (The links above provide access to more than two dozen such items issued by the Commission between September 18 and October 3). As negotiations continued over the proposed Emergency Economic Stabilization Act of 2008, the Commission was forced to enter a series of orders extending protections provided in its earlier orders.

With the enactment of the Emergency Economic Stabilization Act of 2008, the Commission's ban on short sales was permitted to expire. On October 3, the Division of Markets and Trading issued a notice affirming that the emergency ban would be lifted on October 8 at 11:59 p.m.

The Commission's extraordinary actions covered a wide-range of conduct such as the following:

  • Temporary prohibition of short selling in financial companies.
  • Temporary requirement that institutional money managers report to the SEC their new short sales of certain publicly traded securities.
  • Temporary easing of restrictions on the ability of securities issuers to repurchase their securities.
The Commission's most recent orders and guidance also involved the strengthening of its earlier ban on naked short selling and increasing the penalties against naked short selling. Each of these actions continue in force following expiration of the Commission's emergency orders. These actions include the following:

  • Hard T+3 close-out requirement for naked short selling; penalties for violation include prohibition of further short sales without mandatory pre-borrow. The Commission adopted, on an emergency basis, a new rule requiring that short sellers and their broker-dealers deliver securities by the settlement date (three days after the sale transaction date, or T+3) and imposing penalties for failure to do so. If a short sale violates this close-out requirement, then any broker-dealer acting on the short seller's behalf will be prohibited from further short sales in the same security unless the shares are not only located but also pre-borrowed. The prohibition on the broker-dealer's activity applies not only to short sales for the particular naked short seller, but to all short sales for any customer. The emergency order will be extended, and will now expire at 11:59 p.m. ET on Oct. 17, 2008, but the Commission intends that the order will continue in effect beyond that date without interruption in the form of an interim final rule. The Commission will seek comments on all aspects of the anticipated rulemaking.
  • Repeal of exception for options market makers from short selling close-out provisions in Regulation SHO. This exception had permitted options market makers to maintain fail positions indefinitely. It was repealed effective at 12:01 a.m. ET on Sept. 18, 2008, through a final rule to eliminate the options market maker exception from the close-out requirement of Rule 203(b)(3) in Regulation SHO.
  • Rule 10b-21 naked short selling anti-fraud rule. The new rule, which became effective at 12:01 a.m. ET on Sept. 18, 2008, covers short sellers who deceive broker-dealers or any other market participants about their intention or ability to deliver securities in time for settlement. The rule makes clear that such persons are violating the law when they fail to deliver.


SEC II:: SEC's Office of the Chief Accountant and FASB Staff Issue "Clarifications" Intended to Ease Fair Value Accounting Standards

On September 30, the SEC's Office of the Chief Accountant and the Financial Accounting Standards Board released a set of "clarifications" intended to ease fair market accounting standards to take pressure off of financial institutions hurt by the ongoing credit crisis. The guidance addressed five areas, noted below (together with the Commission's guidance on each).

Can management's internal assumptions (e.g., expected cash flows) be used to measure fair value when relevant market evidence does not exist?

  • Yes. When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable. Statement 157 discusses a range of information and valuation techniques that a reasonable preparer might use to estimate fair value when relevant market data may be unavailable, which may be the case during this period of market uncertainty. This can, in appropriate circumstances, include expected cash flows from an asset. Further, in some cases using unobservable inputs (level 3) might be more appropriate than using observable inputs (level 2); for example, when significant adjustments are required to available observable inputs it may be appropriate to utilize an estimate based primarily on unobservable inputs. The determination of fair value often requires significant judgment. In some cases, multiple inputs from different sources may collectively provide the best evidence of fair value. In these cases expected cash flows would be considered alongside other relevant information. The weighting of the inputs in the fair value estimate will depend on the extent to which they provide information about the value of an asset or liability and are relevant in developing a reasonable estimate.
How should the use of "market" quotes (e.g., broker quotes or information from a pricing service) be considered when assessing the mix of information available to measure fair value?

  • Broker quotes may be an input when measuring fair value, but are not necessarily determinative if an active market does not exist for the security. In a liquid market, a broker quote should reflect market information from actual transactions. However, when markets are less active, brokers may rely more on models with inputs based on the information available only to the broker. In weighing a broker quote as an input to fair value, an entity should place less reliance on quotes that do not reflect the result of market transactions. Further, the nature of the quote (e.g. whether the quote is an indicative price or a binding offer) should be considered when weighing the available evidence.
Are transactions that are determined to be disorderly representative of fair value? When is a distressed (disorderly) sale indicative of fair value?

  • The results of disorderly transactions are not determinative when measuring fair value. The concept of a fair value measurement assumes an orderly transaction between market participants. An orderly transaction is one that involves market participants that are willing to transact and allows for adequate exposure to the market. Distressed or forced liquidation sales are not orderly transactions, and thus the fact that a transaction is distressed or forced should be considered when weighing the available evidence. Determining whether a particular transaction is forced or disorderly requires judgment.
Can transactions in an inactive market affect fair value measurements?
  • Yes. A quoted market price in an active market for the identical asset is most representative of fair value and thus is required to be used (generally without adjustment). Transactions in inactive markets may be inputs when measuring fair value, but would likely not be determinative. If they are orderly, transactions should be considered in management's estimate of fair value. However, if prices in an inactive market do not reflect current prices for the same or similar assets, adjustments may be necessary to arrive at fair value.

    A significant increase in the spread between the amount sellers are "asking" and the price that buyers are "bidding," or the presence of a relatively small number of "bidding" parties, are indicators that should be considered in determining whether a market is inactive. The determination of whether a market is active or not requires judgment.
What factors should be considered in determining whether an investment is other-than-temporarily impaired?

  • In general, the greater the decline in value, the greater the period of time until anticipated recovery, and the longer the period of time that a decline has existed, the greater the level of evidence necessary to reach a conclusion that an other-than-temporary decline has not occurred.

    Determining whether impairment is other-than-temporary is a matter that often requires the exercise of reasonable judgment based upon the specific facts and circumstances of each investment. This includes an assessment of the nature of the underlying investment (for example, whether the security is debt, equity or a hybrid) which may have an impact on a holder's ability to assess the probability of recovery.

    Existing U.S. GAAP does not provide "bright lines" or "safe harbors" in making a judgment about other-than-temporary impairments. However, "rules of thumb" that consider the nature of the underlying investment can be useful tools for management and auditors in identifying securities that warrant a higher level of evaluation.

    To assist in making this judgment, SAB Topic 5M1 provides a number of factors that should be considered. These factors are not all inclusive of the potential factors that may be considered individually, or in combination with other factors, when considering whether an other-than-temporary impairment exists. Factors to consider include the following:
    • The length of the time and the extent to which the market value has been less than cost;
    • The financial condition and near-term prospects of the issuer, including any specific events, which may influence the operations of the issuer such as changes in technology that impair the earnings potential of the investment or the discontinuation of a segment of the business that may affect the future earnings potential; or
    • The intent and ability of the holder to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.
All available information should be considered in estimating the anticipated recovery period.



SEC III: SEC Announces End of the Consolidated Supervised Entities Program Saying "Voluntary Regulation Does Not Work"

In a classic case of closing the barn door after the horse has bolted, on September 26 the SEC issued a statement announcing the end of the so-called CSE Program (the Consolidated Supervised Entities Program). Under that program, created in 2004, global investment bank conglomerates that lack a supervisor under the law were permitted voluntarily to submit to regulation. The announcement followed immediately on the heels of a report issued by the Inspector General of the SEC strongly criticizing the Commission's supervision of Bear Stearns under the CSE.

The SEC Chairman announced that the CSE program was a failure. In a brief statement, Chairman Cox said, among many other things:

"The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act, it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.

Because of the lack of explicit statutory authority for the Commission to require these investment bank holding companies to report their capital, maintain liquidity, or submit to leverage requirements, the Commission in 2004 created a voluntary program, the Consolidated Supervised Entities program, in an effort to fill this regulatory gap.

As I have reported to the Congress multiple times in recent months, the CSE program was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily. The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE program, and weakened its effectiveness.

The Inspector General of the SEC today released a report on the CSE program's supervision of Bear Stearns, and that report validates and echoes the concerns I have expressed to Congress. The report's major findings are ultimately derivative of the lack of specific legal authority for the SEC or any other agency to act as the regulator of these large investment bank holding companies.

With each of the major investment banks that had been part of the CSE program being reconstituted within a bank holding company, they will all be subject to statutory supervision by the Federal Reserve. Under the Bank Holding Company Act, the Federal Reserve has robust statutory authority to impose and enforce supervisory requirements on those entities. Thus, there is not currently a regulatory gap in this area."



NY DEP'T OF INSURANCE: NY State Department of Insurance Will Regulate Certain Credit-Default Swaps

On September 22, New York Governor David Paterson announced what he termed a "plan to limit harm to markets from damaging speculation". Under that plan, New York will -- among other things -- regulate part of the $62 Trillion credit-default swap market. In connection with Governor Paterson's announcement, the State of New York Insurance Department issued Circular Letter No. 19 (2008). In short, the Department of Insurance reversed its earlier position and issued guidelines declaring that some credit-derivative swap contracts are "insurance and therefore subject to state regulation". Rules covering New York buyers and sellers will go into effect in January 2009 and will apply to swaps bought by investors who also own the actual bonds or loans referenced by the swaps.

In 2000, the New York Insurance Department declared that such contracts are not a form of insurance. Consequently, the market has received little or no regulatory oversight even as it grew into a $62 trillion behemoth once described by Warren Buffett of Berkshire Hathaway as "financial weapons of mass destruction".

Still, the move by New York to rein in some part of the CDS market has puzzled some experts. In effect, the regulations would require banks or institutions that sell covered credit-default swaps to investors who want to protect their bond or loan holdings would have to apply for a license to be an insurance company and would become subject to all regulations applicable to insurance companies.



TREASURY I: U.S. Treasury Announces Temporary Guarantee Program for Money Market Funds

In mid-September, the Reserve Fund -- a large money market fund -- experienced the unthinkable. It "broke the buck" leading to a panic that caused a run on the fund as well as runs on numerous other money market funds as investors lost confidence and began to redeem their money market investments.

On September 29, 2008, the U.S. Department of the Treasury stepped in to stop the run. It opened a "Temporary Guarantee Program for Money Market Funds". Under the Guarantee Program, the Treasury Department will guarantee the share price of participating money market funds that seek to maintain a stable net asset value of $1.00 per share, subject to certain conditions and limitations.

The Guarantee Program provides coverage to shareholders for amounts that they held in participating money market funds as of the close of business on September 19, 2008. While the program protects the accounts of investors, each money market fund makes the decision to sign-up for the program. Investors cannot sign-up for the program individually. Funds should apply by October 8, 2008 for the program using the forms on the program webpage: http://www.treas.gov/offices/domestic-finance/key-initiatives/money-market-fund.shtml.



FEDERAL RESERVE: Fed Allows Goldman Sachs and Morgan Stanley to Form Bank Holding Companies

On September 22, the last two major standalone investment banks on Wall Street decided to convert themselves into bank holding companies in a move that many have said closes a chapter in the history of U.S. finance. The move was widely viewed as a way to help bolster the capital of the two institutions by enabling them to attract additional retail consumer deposits and to operate commercial banking franchises. Nevertheless, by converting in such a fashion, both firms now must accept much more stringent regulation intended to limit risk-taking and increase capital cushions.

News accounts immediately labeled the moves as "the end of Wall Street as we know it". Some, however, viewed the moves as necessary following record declines in the shares of both institutions in the previous week and the downward spiral in the shares of financial institutions generally.

As part of the conversion process, Morgan Stanley will convert its Utah industrial bank to a national bank and will become subject to supervision of the Federal Reserve. The Firm also will be regulated by the Federal Deposit Insurance Corporation, which will continue to insure deposits at Morgan Stanley Bank to the maximum extent allowed by the FDIC.

In the case of Goldman Sachs, its conversion creates the fourth largest bank holding company which, of course, likewise will be regulated by the Federal Reserve. Goldman Sachs already had two active deposit taking institutions – Goldman Sachs Bank USA and Goldman Sachs Bank Europe PLC – which, together, hold more than $20 billion in customer deposits. The firm will move assets from a number of strategic businesses, including its lending businesses, into GS Bank USA. With over $150 billion in assets, GS Bank USA will become one of the ten largest banks in the United States.



PRACTICAL GUIDANCE: Courtesy of RealCorporateLawyer.com

RealCorporateLawyer.com provides its readers with free access to a very large collection of law firm memoranda providing practical guidance on current hot topics. Readers are encouraged to visit the frequently-updated "Emerging Legal Issues" area of the home page for such current memoranda, as well as the Expert Analysis: SEC Reform Portal section containing hundreds of other such memoranda. Recent additions include:

Also, don’t forget that RR Donnelley offers a selection of reference publications of interest to corporate counsel.



COMINGS AND GOINGS: Who's Doing and Saying What and Where?

On October 7, the Commission announced that former Congressional Budge Office Director and White House budget advisor Dr. Dan L. Crippen has been named Senior Advisor to the Chairman. See U.S. Securities and Exchange Commission, Former CBO Director Dan Crippen Named Senior Advisor to Chairman, News Release 2008-245 (Oct. 7, 2008). On October 6, the SEC announced that James L. Eastman has been named Chief Counsel and Associate Director in the Commission's Division of Trading and Markets. See U.S. Securities and Exchange Commission, Jim Eastman Named Chief Counsel in Division of Trading and Markets, News Release 2008-240 (Oct. 6, 2008). The Commission also named James Clarkson as its Acting Regional Director of the New York Regional Office responsible for enforcement actions and performance of compliance inspections in the region on October 3. See U.S. Securities and Exchange Commission, James Clarkson Named Acting Regional Director of SEC's New York Regional Office, News Release 2008-236 (Oct. 3, 2008). The announcement followed the Commission's September 11 announcement that Mark K. Schonfeld was leaving as Director of the New York Regional Office to re-enter private practice. See U.S. Securities and Exchange Commission, Mark K. Schonfeld, Director of New York Regional Office, Leaving After 12 Years of Service at SEC, News Release 2008-194 (Sep. 11, 2008). On September 10, the Commission announced the promotion of Michael Dicke to Associate Regional Director for Enforcement in the SEC's San Francisco Regional Office. See U.S. Securities and Exchange Commission, Michael Dicke Named Associate Regional Director for Enforcement in SEC's San Francisco Regional Office, News Release 2008-192 (Sep. 10, 2008). The SEC named Paul A. Beswick as its Deputy Chief Accountant for Professional Practice in the Commission's Office of the Chief Accountant on September 3. See U.S. Securities and Exchange Commission, Paul Beswick Named Deputy Chief Accountant for Professional Practice in SEC Office of the Chief Accountant, News Release 2008-188 (Sep. 3, 2008).

The credit crisis seems to have curbed the Commission's speaking engagements during September. SEC Chairman Christopher Cox delivered remarks on "Protecting Senior Investors in Today's Markets" at a Senior Summit held in Washington D.C. on September 22. The Director of the Commission's Office of Compliance Inspections and Examinations, Lori Richards, spoke at the Southwest Securities Enforcement Conference in Fort Worth, Texas on September 9 regarding "Why Does Fraud Occur and What Can Deter or Prevent it?".



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