Lawbitrage

Lawbitrage Links 1/14/13

Statement By Commissioner Scott D. O’Malia - Approving Portfolio Margining of Swaps and Security Based Swaps in 4d(f) Accounts (CFTC)

Court of Appeals Affirms Validity of New York Choice-of-Law Provisions (JD Supra)

Wall Street Returns to Property CDOs in Yield Hunt (Bloomberg)

Financial Technology Start-Ups: Can They Compete? (Mondato)

Bruce Brittain on hedge fund due diligence given the "new normal." (PIMCO)

Researchers Risk Insider Trading (The Scientist via Securities Docket)

BOE Proposes Power to Target Risks in Mortgages, Derivatives (Bloomberg via Derivalert.org)

CFTC Follows SEC in Permitting Offsets for Cleared CDS at ICE (Dow Jones Newswires)

FINRA Proposes to Tighten Definition of "Public Arbitrator" (Securities Law Prof)

Brazilian states break financing mould (Reuters)

Hedge Fund "Sharks Going After' Paulson: (HITC Business)

Comptroller Curry discusses 2013 opportunities and challenges (OCC.gov)

Financial Industry Revolving Door Set to Spin Even Faster

The practice of government regulators and other officials regularly finding employment in the financial sector, and vice versa, is widely criticized for creating a system of favoritism. For example, in advocating for financial reform, Sheila Bair, the former chairperson of the Federal Deposit Insurance Corporation, hypothetically asks the presidential candidates the following question in a recent Forbes column:

WILL YOU END THE REVOLVING DOOR? The spectacle of senior regulators moving into and out of industry has undermined public confidence in our regulatory system. Will you commit to appointing individuals at the Treasury Department and regulatory agencies who will be independent and promise never to work for the industry they regulate? People who want to use regulatory positions as stepping stones to more lucrative employment in the private sector have no place in government.

Underlying Bair's claims is anecdotal evidence. This includes a 2010 report by the Securities and Exchange Commission (SEC) Inspector General about an SEC official that led an investigation against short seller David Einhorn at the behest of Allied Capital (the target of the short) who thereafter went to work for a law firm that obtained Allied Capital as a client. The revolving door criticism is also supported by data such as that compiled by the Project on Government Oversight, which found "that 219 former SEC employees filed 789 statements between 2006 and 2010 announcing their intent to appear before the SEC or communicate with its staff on behalf of private clients."

But despite the anecdotal evidence and criticism by former high-ranking government officials such as Bair, it is unlikely that the revolving door will end any time soon. In fact, the revolving door is most likely going to increase due to the increasing demand for specialized legal expertise in the financial services field.

The growing demand for expertise is being driven by the rise of potential sources of legal claims against financial institutions. A recent story in the Economist noted the multiple sources of government and civil claims, including numerous financial regulators (and departments within them), state attorney generals, and private litigants. Potential legal liability is on the rise not only due to the the increasing number and aggressiveness of regulatory agencies and departments, but also due to the failure of settlements to stop new lawsuits from being brought. 

The growing demand for legal expertise is also being fueled by financial regulatory reform, which is creating rules that are both numerous and complex. Firms are responding by increasing legal and compliance staff, and also by making regulatory compliance a part of the company's overall approach to risk management. A March 2012 survey shows a clear upward trend in the last four years in compliance hiring by financial firms:

As the law and potential sources of liability become more extensive and complex, the value of industry expertise to government, and the value of government expertise to industry, will only increase. And along with this dynamic we should expect the financial industry revolving door to spin even faster.

But whether a faster revolving door is a reason for concern is an open issue. A recent empirical study of the impact of the revolving door found that it probably isn't the problem implied by Bair. The study suggests that in the securities industry lawyers in government demonstrate their value to potential private employers by being more aggressive, not less.

FINRA, Fines, and Investor Expectations

FINRA, the U.S. financial industry's self-regulatory organization (SRO) for broker-dealers, was dealt a blow yesterday by the appellate court decision in Fiero v. FINRA that ruled it did not have the power to enforce fines against its members in court. The court based its conclusion on the lack of a specific grant of power to FINRA in the Securities and Exchange Act (Exchange Act) and FINRA's failure to properly file a proposed rule change with the Securities and Exchange Commission (SEC) in 1990.

The decision is important to the extent FINRA directly or implicitly relies on the judicial system to enforce its fines rather than on the self-interest of its members to pay any fines as a condition of not being barred from the industry. The decision is also important to the extent investors and customers rely on FINRA to be able to pursue fines against parties that no longer seek to remain in the industry. If they do rely heavily on FINRA's authority to enforce fines in court, it may make sense for FINRA to obtain the power to do so by properly filing a rule change with the SEC; that is, one that goes through the full notice and comment process.

Perhaps the most important aspect of Fiero, however, is the impact it may have on future investment adviser regulation. Pending new legislation, FINRA or some other SRO is likely to begin to oversee hedge funds and other investment advisers, consistent with the SEC's recommendation and admission that it lacks the resources to effectively oversee advisers. Whatever SRO does end up overseeing investment advisers, investors should know in advance whether the SRO has the legal authority to enforce fines against advisers in court so that they can tailor their reliance on the SRO to do so accordingly. Based on Fiero, the new adviser SRO will not be able to enforce fines in court absent a legislative or regulatory grant of power.

More Cost-Benefit Analysis is Coming to Financial Regulation

Last week saw introduction of the Financial Regulatory Responsibility Act (FRRA) of 2011 by Senator Richard Shelby (R-AL). Based on its summary, the new bill would mandate greater and more consistent use of economic analysis in financial regulation, require a reexamination of existing regulations and new ones every five years, and prohibit regulators from finalizing rules for which the costs exceed the benefits. The bill would also create a new Chief Economist Council to coordinate the cost-benefit analyses of financial regulators. 

The FRRA comes amid a growing wave of attention by policymakers on the use of cost-benefit analysis in the regulatory process. On the very same day the FRRA was introduced, a bipartisan group of lawmakers also proposed the Regulatory Accountability Act of 2011, which would require even more extensive use cost-benefit analysis throughout the entire spectrum of federal rulemaking. The FRRA is in part a response to examinations earlier this year of each financial regulator's use of cost-benefit analysis.* Senator Shelby and other lawmakers viewed the results of these examinations as demonstrating that cost-benefit analysis in financial regulation left much to be desired for lacking depth and consistency and failing to focus on broad costs such as on employment and economic growth. The growing importance of cost-benefit analysis was also highlighted earlier this year when the DC Court of Appeals overturned the Securities and Exchange Commission's Dodd-Frank shareholder proxy access rules due to the court's opinion that the agency's cost-benefit analysis was faulty.

Throughout 2011, a focus on the burdens of regulation and the need to maintain flexibility in light of economic analysis and changing circumstances have been a hallmark of the Obama Administration's approach to regulation. Two executive orders (from January and July) highlight the principles of this approach, which also requires a retroactive cost-benefit assessment of existing regulation as seen in the FRRA.

It is too early to tell whether the FRRA will have widespread support by Congressional lawmakers. However, given that it embeds into law the Obama Administration's principles of regulatory analysis, and a bipartisan group of legislators introduced a different law on the same day that would even more forcefully enshrine cost-benefit analysis into the entire regulatory system, it is very likely that some piece of legislation will soon be able to obtain enough votes and require far more extensive cost-benefit analysis in financial regulation.

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*The examinations for each agency were undertaken by their respective offices of inspector general and the reports are located at the following links for each agency: the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Office of the Comptroller of the Currency and Treasury Department, and the Securities and Exchange Commission.

SEC Proposal Would Likely Prohibit Controversial Synthetic CDOs

On September 19, 2011, the Securities and Exchange Commission (SEC) released its proposed rule to prevent conflicts of interest in certain asset-backed securities (ABS) transactions (securitizations). The proposal comes just a week after news reports that the SEC widened its investigation into securitizations in which the underwriter or sponsor of the deal, or a third party hedge fund with influence over selecting the assets underlying the securitization, took a short position such that it stood to gain if the deal's investors lost. In case there was any doubt that the proposal was motivated to prohibit transactions such as the now notorious Abacus 2007-AC1 synthetic collateralized debt obligation (CDO) sponsored by Goldman Sachs at the behest of hedge manager John Paulson, the proposal expressly cites to such deals as indicative of "the existence and potential effects of conflicts of interest" in securitizations.

This post summarizes the SEC's 118-page proposed rule and makes some preliminary observations.