On April 19, 2012, the United States Bankruptcy Court for the Southern District of New York granted in part a motion to dismiss claims asserted by Lehman Brothers Holdings Inc. (together with its debtor-affiliates, “Lehman”) against JPMorgan Chase Bank, N.A (“JPMorgan”). [1] The claims at issue arose from JPMorgan’s efforts in the months leading up to Lehman’s bankruptcy to mitigate its exposure as Lehman’s primary clearing bank by requiring Lehman to post a significant amount of additional collateral and expand the scope of the obligations secured by that collateral. Lehman and its creditors’ committee challenged these transactions under the avoidance provisions of the Bankruptcy Code and asserted other causes of action, including common law claims for unjust enrichment and invalidation of the contractual amendments that improved JPMorgan’s position.

The decision applies the safe harbor protections of Section 546(e) to dismiss Lehman’s preference and constructive fraud claims. However, the court rejected JPMorgan’s efforts to apply Section 546(e) more broadly, allowing Lehman’s parallel common law claims to proceed even where they are based on similar allegations. The decision also applies a relaxed pleading standard to Lehman’s claims for actual fraud, under which it found that Lehman had adequately alleged facts to state a claim under Section 548(a)(1)(A). The decision thus provides support for a literal application of the safe harbor protections to dismiss certain claims at the pleading stage. However, the decision also suggests that even where a transaction falls within the scope of Section 546(e), artful pleading may permit plaintiffs to survive a motion to dismiss. The decision thus underscores the importance of considering potential litigation risks and costs when analyzing transactions with distressed counterparties.

…continue reading: Lehman Bankruptcy Court Interprets Safe Harbor Protections

Regulation is the most important factor influencing strategic change at financial institutions and is the second largest threat – after economic uncertainty – to growth prospects, according to PwC’s Annual Global CEO Survey [1]. The survey, which is in its fifteenth consecutive year, canvassed CEOs at over 250 financial institutions in 42 countries late last year and provides a good barometer on market sentiment. The significance of regulation as a change driver in the financial sector has grown steadily since the recent crisis. Based on PwC’s face-to-face interviews with CEOs of some of the world’s largest financial institutions, it is clear, though, that it is not simply regulatory change, but regulatory complexity and uncertainty that are really dampening confidence in growth.

Upgrading the European Union (EU) prudential regime for banks in line with the Basel III proposals is an excellent example of both regulatory complexity and uncertainty. In July 2011, the European Commission [2] released two proposals to introduce the new regime. The bulk of the existing EU prudential regime, with the amendments necessary to introduce Basel III, is recast into a regulation – the Capital Requirements Regulation (CRR) – amongst other things to support the parallel EU goal of harmonising and deepening the internal market through a single rule book. In addition, a Directive – Capital Requirements Directive IV (CRD IV) – sets out requirements in a limited number of areas where Member State discretion is still necessary, for example in relation to corporate governance.

…continue reading: Regulatory Complexity and Uncertainty: The Capital Requirements Directive IV

As widely reported in the press, seizures of banks and thrifts by regulatory authorities began to subside in 2011. Throughout the year, 92 institutions were seized compared with 157 in 2010 and 140 in 2009. In contrast, Federal Deposit Insurance Corporation professional liability lawsuits targeting failed financial institutions began to increase in 2011. These are lawsuits in which the FDIC, as receiver for failed financial institutions, brings professional liability claims against directors and officers of those institutions and against other related parties, such as accounting firms, law firms, appraisal firms, or mortgage brokers.

Overview

From July 2, 2010, through January 27, 2012, the FDIC filed 21 lawsuits related to 20 failed institutions (two of the 21 lawsuits were associated with IndyMac Bank, F.S.B). Of the 21 lawsuits, two were filed in 2010, 16 in 2011, and three in January 2012. Aggregate damages claimed in the complaints totaled $1.98 billion.

…continue reading: FDIC Lawsuits Targeting Failed Financial Institutions

The aftermath of the recent acquisition of Lyondell by Basell provides a striking example of the risk that directors face if they approve a cash merger financed in substantial part through borrowing and the target then fails. The deal was characterized as an “absolute home run” by Lyondell’s financial advisor. [1] But less than thirteen months after the closing of the merger in December 2007, Lyondell filed for bankruptcy. A litigation trust established by the bankruptcy court to marshal the debtor’s assets has sued Lyondell’s former directors, seeking damages on the theory that the merger, while beneficial to Lyondell’s shareholders, unlawfully mistreated Lyondell’s creditors by causing the company to become insolvent. [2] The case is pending. To add to the directors’ problems, the excess directors’ and officers’ insurance carrier has declined coverage on several grounds, among them that, because the litigation trust stands in Lyondell’s shoes, this is an “insured v. insured” matter not covered by the D&O policy. [3]

…continue reading: Protecting Directors When Firms Fail Post-Merger

On December 16, 2011, the Internal Revenue Service (the “IRS”) and Treasury Department issued final and proposed regulations (“the Final Regulations” and “the Proposed Regulations,” respectively) that generally provide rules for the proper timing of the valuation of consideration offered in respect of a reorganization, for purposes of satisfying the “continuity of interest” requirement for tax-free reorganizations. The Final Regulations issue in finalized form rules previously described in temporary regulations, which allow in certain circumstances for the valuation of consideration on the date prior to the signing of a merger agreement, known as the “signing date” rule, with some additional clarification.

The Proposed Regulations would expand the signing date rule and would allow for the use of an average share price under certain circumstances. Specifically, under the Proposed Regulations, for purposes of determining whether the “continuity of interest” requirement is satisfied:

…continue reading: Measuring Continuity of Interest in Reorganizations

In our paper, The Risk-Shifting Hypothesis: Evidence from Sub-Prime Organizations, which was recently presented at Harvard, we provide evidence consistent with risk-shifting in the lending behavior of a large subprime mortgage originator (New Century Financial Corporation) starting in 2004. This change follows the monetary policy tightening implemented by the Fed in the spring of 2004, which resulted in an adverse shock to the large portfolio of loans New Century was holding for investment. New Century reacted to this shock by massively resorting to deferred amortization loan contracts (“interest-only” loans).

Financial institutions, when in distress, may take excessive risk. Because they do not bear the losses in case of failure, shareholders of distressed banks have a natural preference for risky lending, fueling asset bubbles, banking crises and prolonged recessions. Our goal in this paper is to provide direct evidence of risk shifting in a large financial institution. To this end, we use the internal records of a major subprime originator, New Century Financial Corporation (NC). NC is a good candidate to study risk-shifting: in 2004, its payout ratio went up from 5% to 90%, consistent with textbook asset substitution. Against this background, our project-level (loan-level) data allows us to accurately characterize the distortion in risk preferences induced by financial distress.

…continue reading: The Risk-Shifting Hypothesis

In the paper, The Case Against the Dodd-Frank Act’s Living Wills: Contingency Planning Following the Financial Crisis, forthcoming in the Berkeley Business Law Journal, I focus on the Dodd-Frank Act’s “living will” requirement that mandates that systemically important financial institutions (SIFIs) develop business strategic analyses, and submit plans for reorganization or resolution of their operations to regulators. The goal of this regulation is to mitigate risks to the financial stability of the US and encourage last-resort planning – in order to enable a rapid and efficient response in the event of an emergency – for multinational financial institutions that are so large that their insolvency could shake the entire financial system and the economy. Nearly everyone believes that living wills are just about the perfect solution to the problems highlighted in the recent financial crisis; regulators from all over the world strongly support the concept and have been advocating for its implementation. Nevertheless, I argue that this solution is ill-designed to address the too-big-to-fail problem, and that living wills are not the silver bullet that regulators seem to think they are. My paper shows that there are a lot of open issues concerning living wills, and that there are real questions as to how effective they can be.

…continue reading: The Case Against the Dodd-Frank Act’s Living Wills

The UK Financial Services Authority (“FSA”) confirmed on 31 Oct. 2011 that MF Global UK Limited (“MF Global UK”) will be subject to the new Special Administration Regime (“SAR”). [1] This is the first time that the new regime, set out in The Investment Bank Special Administration Regulations 2011 (“SAR Regulations”) [2] has been invoked.

Background

The SAR Regulations were made under the powers set out in Sections 233 and 234 of the Banking Act 2009. They came into effect on Feb. 8, 2011 and are supplemented by The Investment Bank Special Administration (England and Wales) Rules 2011 [3] (“SAR Rules”) which came into force on 30 June 2011.

The purpose of the new SAR is to address perceived deficiencies in the UK insolvency regime in the case of the collapse of an investment bank and highlighted by the collapse of Lehman Brothers in 2008 such as: [4]

• Ascertaining which assets are client assets and which firm assets;
• Interpreting the effect of, and the interrelationship between, various contracts and master agreements such as prime brokerage agreements, futures agreements, stock lending agreements and ISDA master agreements;
• Establishing the extent of any right of use; and
• Determining and allocating any shortfalls in client omnibus accounts.

…continue reading: UK Special Administration Regime

Recently, the United States District Court for the Southern District of New York ruled that the trustee for Bernard L. Madoff Investment Securities lacks authority to pursue common-law damages claims belonging to the investors in Madoff’s Ponzi scheme.  Based on that ruling, the court dismissed claims against JPMorgan and UBS seeking to hold the banks liable for customer losses resulting from Madoff’s scheme.  Picard v. JPMorgan Chase & Co., No. 11 civ. 913 (S.D.N.Y. Nov. 1, 2011) (McMahon, J).

It is a longstanding principle of bankruptcy law that a trustee, as successor to the debtor, may not bring claims that belong to creditors.  It is also well-established that, where the debtor has defrauded its creditors, the trustee — who stands in the debtor’s shoes — cannot recover from third parties for wrongdoing that the debtor itself took part in.

In attempting to escape these principles, the Madoff trustee argued that the Securities Investor Protection Act (SIPA), which governs the liquidation of broker dealers, provides a SIPA trustee with broader powers than an ordinary bankruptcy trustee, including the power to bring claims belonging to creditors (in this case, Madoff’s former customers).  The Madoff trustee purported to have such standing as a “bailee” of customer property.  The trustee also argued that section 544(a) of the Bankruptcy Code, which grants a trustee rights of a hypothetical creditor that extends credit to the debtor at the time of its bankruptcy, permits a trustee to assert damages claims that belong to actual creditors.

…continue reading: Can Madoff Trustee Go After the Banks?

A major step in the prevention of future financial bailouts has been taken by Federal bank supervisors with the adoption on October 17 and September 13 of final joint regulations requiring a resolution plan (or “living will”) for the largest financial institutions active in the United States. Preparation of these plans will constitute a major undertaking for the institutions with consequences and ramifications that will continue to evolve over time. The following provides the background of the new regulations, the requirements that the regulations impose, tips for compliance, and possible difficulties to be faced as the process unfolds.

The Federal Deposit Insurance Corporation (the “FDIC”) and the Board of Governors of the Federal Reserve System (the “Federal Reserve”) approved final resolution-plan regulations for the largest financial groups operating in the United States on September 13 and October 17, respectively. The FDIC also approved a final interim regulation requiring plans of FDIC-insured institutions with $50 billion or more in total assets. Both sets of requirements follow from previously issued proposals but include important clarifications and additional accommodations to the financial industry.

…continue reading: Final “Living Wills” Requirements for Large Financial Institutions