The High Court in London has held that clients of insolvent UK brokers are entitled to a claim based on the value of their open positions as at the date of entry into administration or liquidation, rather than based on the value actually realised when those positions are closed. The “hindsight” principle – that where assets are later actually valued, actual values should be used – is not applicable.

Background

Under the client money and client asset rules contained in the CASS 7 and 7A sourcebooks of the UK Financial Services Authority (the “FSA”) Handbook (the “client money rules”), brokers are required to segregate money received from or held for their clients and will hold such funds pursuant to a statutory trust. In the event of the broker entering administration or liquidation, client money is segregated from the broker’s property and is distributed to clients on a pari passu basis (meaning “pro rata”).

The client money rules have been the subject of protracted litigation and judicial criticism in various cases due to their lack of clarity and even drafting errors. A number of issues regarding the client money rules were resolved by the UK Supreme Court in February 2012 in the litigation arising out of the Lehman insolvency, and have been discussed in a previous client publication. [1] The client money rules have also been amended in various ways and are currently subject to a consultation process for more wholesale amendment. [2]

On 31 October 2011, investment broker MF Global UK Limited became the first investment company to enter the special administration regime under the Investment Bank Special Administration Regulations 2011. It held client money as well as many open derivative positions for clients.

…continue reading: The “Hindsight” Principle and Clients of Insolvent UK Brokers

Schulte Roth & Zabel is pleased to present Distressed Investing M&A, published in association with mergermarket and Debtwire. Based on a series of interviews with investment bankers, private equity practitioners and hedge fund investors in the US, this report examines the market for distressed assets at home and abroad.

Economic uncertainty brought on by the looming US “fiscal cliff” have placed companies in difficult situations where many are forced to sell assets and restructure operations and debt in order to avoid a court mandated sale further down the line. The value gained and time saved by selling assets prior to in-court restructuring and liquidation is signaled by the respondents’ shift toward dealmaking early and out-of-court.

Outside of the US, the eurozone crisis and macroeconomic concerns in the emerging markets are having a similar effect. While some are waiting for a solution to the sovereign debt crisis, distressed investors are geared to take advantage of attractively-priced assets within the region. Hyperinflation remains a concern for the markets in Latin America and India, while economic growth has slowed in Brazil and China. Both are likely to create distressed opportunities over the next 12 months.

Respondents cite the energy sector as likely to be the most active for distressed M&A in the next year. Low natural gas prices in the US are hitting the bottom line and companies are feeling the strain. Additionally, inflation concerns in Asia may expose manufacturing companies, who respondents describe as “losing the battle” against prices.

In addition to the above findings, this report provides insight into pricing, litigation, club deals, and various other issues concerning the distressed M&A community. We hope you find this study informative and useful, and as always we welcome your feedback.

…continue reading: 2012 Distressed Investing M&A Report

My recent article “The SEC and the Financial Industry: Evidence from Enforcement Against Broker-Dealers,” just published at the Business Lawyer (Vol. 67, p. 679, May 2012), provides an empirical account of the agency’s enforcement record against investment banks and brokerage houses in the period right before the 2007-2008 crisis. At the time, the SEC was the target of severe criticism from diverse quarters, ranging from scholarly commentators to the popular press and Congress. This article provides a systematic examination of the SEC enforcement record up to April 2007 and finds that defendants associated with big firms fared better in SEC enforcement actions, as compared to defendants associated smaller firms.

As this data suggests, the SEC faces three key decisions when formulating an enforcement action. One decision concerns whether to focus on the violations of individual employees of financial institutions, pursue the corporate entity that employs them, or charge them both. In two well-publicized rulings, Judge Rakoff chastised the SEC’s decision to direct its action exclusively against the firm and avoid individual liability. The article reveals that actions against big broker-dealers were more likely to target solely the corporate entity, without any further action against either frontline employees or high-level supervisors. More specifically, 40 percent of all actions against broker-dealers involved exclusively corporate liability, compared to just 10 percent for smaller firms.

…continue reading: Evidence from SEC Enforcement Against Broker-Dealers

If timing is everything, this is not an auspicious time to argue against the Volcker Rule, given the recent London trading and investment misadventures of JPMorgan Chase. Predictably, there has been a hue and cry over this situation, and the bank regulators will be under heavy political pressure to toughen the Volcker Rule. In turn, the regulatory agencies probably will stiffen the Volcker Rule’s implementing regulations when they are adopted later this year (perhaps). For that reason, now is a good time to take a critical look at the Volcker Rule’s utility in improving regulatory oversight and preventing future financial crises.

In fact, the Volcker Rule continues to exist in a parallel universe that has little relation either to the recent financial crisis, the functional realities of the modern financial markets, or to the ongoing efforts to strengthen our financial system. Nothing that JPMorgan Chase, or any other too-big-to-fail bank, has or has not done changes that essential fact. Here is why:

…continue reading: The Parallel Universe of the Volcker Rule

The Federal Reserve issued a statement last week clarifying that it will interpret the Volcker Rule to afford banking entities the full two-year period provided by the statute to conform their activities and investments to the Rule’s prohibitions and restrictions. The financial services industry should welcome this alternative to curtailing trading and investment activities earlier than the statute on its face would have required, but inevitably some questions remain. The Federal Reserve still has not given any indication whether it may extend this period. As compliance activities progress and we gain greater insight into the effect of the Rule on the economy, the public may seek even clearer guidance on this aspect of the Federal Reserve’s discretion.

Statute

The Volcker Rule added a new section 13 (“Section 13”) to the Bank Holding Company Act of 1956 imposing prohibitions and requirements on a banking entity that engages in proprietary trading and has investments in or certain relationships with a hedge fund or private equity fund. [1] The Rule also provides that a non-bank financial company supervised by the Federal Reserve that engages in proprietary trading or makes hedge fund investments must comply with certain other requirements, including supplemental capital requirements or quantitative limitations. [2] The Rule takes effect on the earlier of two years after the date of its enactment, July 21, 2012, or 12 months after the date of issuance of rules implementing that section. Because the Agencies did not issue implementing rules by July 21, 2011, the effective date will be July 21, 2012.

…continue reading: Federal Reserve Clarifies Deadline for Volcker Rule Compliance

The governance structure of a firm can influence any number of its policies and actions, sometimes to the benefit and sometimes to the detriment of shareholders. Among the many studies of these relationships, numerous ones investigate the link between firm governance and corporate investment; however, the findings are inconclusive. Some studies report results suggesting poor governance associates with excessive investment (over-investment or empire-building), while others suggest the opposite (poorly governed managers may prefer the “quiet life”).

In our paper, The Influence of Governance on Investment: Evidence from a Hazard Model, forthcoming in the Journal of Financial Economics, we revisit the question of how governance affects corporate investment behavior in an attempt to reconcile these conflicting findings. Unlike prior studies we use a hazard framework, wherein we study how governance influences the time between large investment expenditures. This empirical approach helps alleviate some of the concerns with the methods of prior studies and also provides an unexplored perspective. In this framework, we find that governance does influence the time between major investments (investment spikes). Poor governance associates with shorter periods between spikes than that for firms with stronger governance. We further show that this relation is due to poorly governed firms over-investing, rather than stronger governance firms under-investing.

…continue reading: The Influence of Governance on Investment

On September 12, 2011, the Obama administration submitted statutory language for the proposed American Jobs Act to Congress. The Administration’s proposal contains a number of revenue offsets, including an updated proposal to tax carried interest as ordinary income. The carried interest proposal is similar to and based on earlier versions of the proposed legislation that have passed the House of Representatives a number of times over the past several years, but have not passed the Senate. The Administration’s proposal, however, makes some significant changes as compared to earlier versions.

In General. The legislation continues to recharacterize carried interest income and gain as ordinary income, and would apply to interests in traditional hedge funds, private equity funds, venture capital funds, and real estate funds that were the focus of the original legislation. It would also continue to treat gain on the sale of such interests as ordinary income.

…continue reading: Proposed American Jobs Act Would Tax Carried Interest Tax as Ordinary Income

In our paper, The Impact of Common Advisors on Mergers and Acquisitions, which was recently made publicly available on SSRN, we examine the conflict of interest that an investment bank faces when advising both the target and acquirer in a merger or acquisition (M&A) by investigating how common advisors affect deal outcomes.

When the New York Stock Exchange merged with Archipelago Holdings, Inc. in 2004, Goldman Sachs served as the lead M&A advisor to both sides of the deal. Goldman’s dual role was fraught with obvious conflicts of interest. The rationale given was that the bank, as the former underwriter of Archipelago’s IPO, had valuable insights about the potential synergies from the merger.

Whether a common M&A advisor has an adverse effect on one or both sides of a deal is unclear a priori, for two reasons. First, the advisor may be deterred from exploiting its clients by potential litigation costs, damage to its reputation, and the repeat nature of the business. Second, as considerable empirical evidence suggests, market participants may consider financial intermediaries’ conflicts of interest when making their own decisions.

…continue reading: The Impact of Common Advisors on Mergers and Acquisitions

With the explosion in natural resource prices and trade surpluses, the corresponding
increase in the size and investing profile of sovereign wealth funds (SWFs), and the unprecedented stress on the global financial system, SWFs have faced substantial and increasing political and popular suspicion and pressure from the international community to address concerns that their investment decisions may be motivated by political, rather than economic, considerations. (See our December 2007 and June 2008 memos.) In a much-anticipated response, on October 11, a group of 26 nations with SWFs (the “International Working Group”) unveiled a set of 24 non-binding best practices, known as the “Santiago Principles,” designed to safeguard the operational independence of SWFs from political influences, promote greater transparency and accountability, and enhance internal investment and management frameworks, thereby encouraging continued political and popular acceptance of SWF investment in the developed world.

Intended to demonstrate that SWFs are soundly established and that investment decisions will be made on an economic and financial basis, the Santiago Principles address three broad areas of concern regarding SWFs: (i) their legal structure and relationship with the state, policy and investment objectives, and degree of coordination with their sovereign’s macroeconomic policies; (ii) their institutional structure and governance mechanisms; and (iii) their investment and risk management framework. While much will turn on how SWFs actually implement these aspirational guidelines (and it is worth noting that all of the principles are well caveated and subject to home country laws, regulations, requirements and obligations), the Santiago Principles may help reduce political influence in SWF investing and encourage the flow of sovereign wealth across borders.

Notably, the Santiago Principles provide for public disclosure of an SWF’s legal relationship with state bodies, general investment policies and goals, details of funding, withdrawal and spending arrangements, and audited financial information compliant with international or national auditing standards. In addition, the guidelines call for public disclosure of relevant financial information to demonstrate the SWF’s economic and financial orientation. Preferred governance frameworks would establish clear divisions of responsibilities to facilitate the operational independence of the SWF, and governing bodies would be appointed in accordance with defined procedures and with adequate authority to function in an independent manner. Disclosure regarding the SWF’s approach to exercising ownership and voting rights is provided for as is an explicit prohibition on seeking or taking advantage of privileged information or inappropriate influence by the broader government in competing with private entities. The Santiago Principles also make explicit that SWFs will comply with applicable recipient country regulatory and disclosure requirements. Of course, the capacity of the Santiago Principles to allay concerns about the transparency of SWF operations and objectives and their investment motivations will ultimately depend on the level and robustness of each SWF’s compliance with the letter and spirit of these voluntary guidelines.

…continue reading: Sovereign Wealth Funds Adopt Voluntary Best Practices

One of the features of the current financial crisis is the comparative lack of comment from the bulk of the market participants. Certain high profile investors such as George Soros and Warren Buffett have been widely quoted, but might not be regarded as typical industry participants. We also have the recent testimony by some of the major figures of failed institutions given to the Congressional Committee on Oversight and Government Reform. But a more broadly based view of what the financial services is thinking seems to be lacking thus far. This might be due to the hectic times that the markets have recently witnessed, or else a desire to keep heads down at a time when the industry is under fire.

In response to this, the recently formed finance professionals’ think tank, Network for Sustainable Financial Markets, in partnership with AQ Research, has launched a global survey of investment sector professionals. The goal is to ensure the voice of ordinary investment professionals is heard in the debate about the future of financial markets, not just about today’s debate but also about the underlying dynamics which affect both the crisis response but also the longer-term rehabilitation.

The Network includes some of the world’s most high-profile sustainable investment supporters, including corporate governance expert Dr Robert Eccles from the Harvard Business School, Professor Keith Ambachstheer, Director of Rotman International Centre for Pension Management, University of Toronto and world renowned expert on pensions and Professor Frank Partnoy, one of the world’s leading experts on the complexities of modern finance and financial market regulation.

We believe that an evidence based approach is important. It is clear that we are already entering a period of intense and fundamental debate about the future of the financial services industry, how it is regulated and its role in economic life. Concerned industry participants should be want their voice to be heard, particularly as they will be most affected by the future restrictions.

The survey asks investment professionals for their opinion on fundamental questions on the causes, cures and consequences of the credit crisis.

The survey, which is completed anonymously, can be found here. It will close on 31 October 2008. We estimate that it will take approximately 15 minutes to complete. The results will be extensively reported in financial media and will also be available to participants.

The organizers invite you to complete the survey and forward it to contacts you may have who are investment professionals.