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09.30.2008 | Legal Update

Headlines

1.  Financial Rescue Legislation Rejected by House
2.  Treasury Department Insures Money Market Mutual Funds
3.  Federal Reserve Eases Rules to Encourage Investments in Banks
4.  SEC Suspends Short Sales in Securities Issued by Financial Institutions
5.  Massachusetts Issues Final Data Security Requirements
6.  Other Developments: ABCP Lending Facility and Call Report Changes

Full Reports

1.  Financial Rescue Legislation Rejected by House

The fate of the Emergency Economic Stabilization Act of 2008, the Treasury Department’s $700 billion proposal to stabilize the financial markets, remained uncertain as the House of Representatives voted down the bill on September 29 by a 228-205 margin.  The legislation would authorize, but not require, the Secretary of the Treasury to establish the Troubled Asset Relief Program (TARP) to purchase troubled assets from any financial institution including any bank or thrift institution.  “Troubled assets” would include, among other assets, whole residential and commercial mortgage loans issued before March 14, 2008, or any instruments that are based on or related to those types of loans (such as mortgage backed securities).  If there is a shortfall in the value of the assets in the TARP after 5 years, the bill would compel the President to submit a proposal to Congress to recoup from the “financial industry” an amount equal to the shortfall.  The bill does not define the term “financial industry.”  The legislation would also:

• Allow financial institutions to deduct losses on Fannie Mae and Freddie Mac preferred stock owned on September 6 or sold between January 1 and September 7 as ordinary income losses for tax purposes;
• Require the Secretary of the Treasury to consider how to assist undercapitalized institutions with under $1 billion in assets that were well capitalized or adequately capitalized as of June 30 but that suffered capital declines as a result of losses on Fannie Mae or Freddie Mac preferred stock;
• Allow the Securities and Exchange Commission to temporarily suspend mark-to-market accounting rules for any public company; and
• Require the Secretary of the Treasury to reimburse the Exchange Stabilization Fund for any funds that are used to guarantee investments in money market mutual funds (see report #2 below), and prohibit Treasury from using the Exchange Stabilization Fund again for the establishment of any future guarantee program for money market mutual funds.

Nutter Notes:  If the Secretary of the Treasury establishes the TARP, the bill would also require the Treasury Department to establish a Troubled Assets Insurance Financing Fund (Fund) to guarantee up to 100% of the payment of principal and interest on troubled assets on the books of participating financial institutions.  Financial institutions that opt to participate in the Fund would pay premiums established by the Secretary of the Treasury sufficient to create a reserve to meet anticipated claims.  Premiums would vary according to the credit risk associated with the troubled assets that would be guaranteed.  An institution that sells troubled assets to the TARP would be required to provide stock warrants or senior debt instruments to the government unless the institution has under $500 million in assets or sells less than $100 million in troubled assets to the government under the program.  The bill would require the Secretary of the Treasury to set limits on executive compensation and prohibit golden parachute payments to senior executives of institutions that sell troubled assets directly to the TARP rather than through market mechanisms or an auction process.  Golden parachutes would also be limited for institutions that sell over $300 million in troubled assets to the TARP through an auction.

2.  Treasury Department Insures Money Market Mutual Funds

The Treasury Department has established a program to insure the holdings of any eligible money market mutual fund that pays a fee to participate in the program.  Under the Temporary Guarantee Program for Money Market Funds, which began on September 29, the Treasury Department will guarantee repayment to investors of the full value of their principal investment in participating money market mutual funds as of the close of business on September 19.  All funds that are offered to the public and registered with the Securities and Exchange Commission under the Investment Company Act of 1940 will be eligible to participate in the guarantee program.  The guarantee will be triggered if a participating fund’s net asset value falls below $0.995 per share.  Funds with a net asset value below $0.995 per share as of the close of business on September 19 may not participate in the program.  Investments in money market mutual funds made after September 19 will not be federally insured.  The program will operate for an initial three-month term, after which the Secretary of the Treasury will review the need to extend the program.  The Secretary of the Treasury has the option to renew the program up to the close of business on September 18, 2009.

Nutter Notes:  Money market mutual funds with a net asset value per share greater than or equal to $0.9975 at the close of business on September 19, 2008, will be required to pay an upfront fee of 1 basis point per share outstanding.  Funds with a net asset value per share between $0.995 and below $0.9975 as of the cutoff date will be required to pay an upfront fee of 1.5 basis points per share outstanding.  The guarantee program only applies to money market mutual funds, as opposed to money market deposit accounts.  Money market mutual funds are mutual funds regulated by the Securities and Exchange Commission, which hold short-term debt investments such as government securities and short-term debt issued by public companies.  They are typically sold to investors by brokerage houses and mutual fund companies, and like any fund that is not a bank deposit, are not FDIC-insured.  Money market deposit accounts on the other hand are interest-bearing bank accounts that are FDIC-insured to the same extent as any other savings account.  The Treasury Department will make any payments required under the Temporary Guarantee Program for Money Market Funds from the Exchange Stabilization Fund which was established by the Gold Reserve Act of 1934 to deal in gold, foreign exchange, and other instruments of credit and securities to promote international financial stability.  The Treasury Department issued a press release on September 29 addressing “Frequently Asked Questions” about the program.

3.  Federal Reserve Eases Rules to Encourage Investments in Banks

The Federal Reserve, to encourage equity investments in banks, has issued a policy statement relaxing rules for determining whether an investor in a bank or bank holding company exercises a “controlling influence” over the banking organization which, as a general rule, would require the investor to register as a bank holding company and be regulated and supervised by the Federal Reserve under the federal Bank Holding Company Act.  A company is a “bank holding company” under that law if the company “controls” a bank or bank holding company.  The law provides that a company has “control” over a banking organization if (i) the company directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25% or more of any class of voting securities of the banking organization; (ii) the company controls in any manner the election of a majority of the directors or trustees of the banking organization; or (iii) the Federal Reserve determines, after notice and opportunity for a hearing, that the company directly or indirectly exercises a “controlling influence” over the management or policies of the banking organization.  The Policy Statement on Equity Investments in Banks and Bank Holding Companies issued on September 22 generally relaxes the Federal Reserve’s previously expressed views as to when a company exercises a “controlling influence” over a bank or bank holding company.

Nutter Notes:  In general, the Policy Statement indicates that a company that acquires a combination of voting and nonvoting shares that together represent up to 33% of the total equity of a bank or bank holding company would not be considered to have control of the banking organization, as long as the investing company does not own, hold, or vote 15% or more of any class of voting securities of the banking organization.  The Policy Statement would generally allow a company to acquire between 10% and 24.9% of the equity interest in a banking organization and appoint one member of the board of directors of the banking organization.  The Policy Statement further indicates that an investor that has up to two representatives on the board of directors of the banking organization is unlikely, absent other indicia of control, to be able to exercise a controlling influence over the banking organization when the investor’s aggregate director representation is proportionate to its total interest in the banking organization and does not exceed 25% of the voting members of the board, and another shareholder of the banking organization is a bank holding company that controls the banking organization under the Bank Holding Company Act.  The Policy Statement also provides that a noncontrolling minority investor generally may communicate with a banking organization’s management about, and advocate for changes in, any of the banking organization’s policies and operations.

4.  SEC Suspends Short Sales in Securities Issued by Financial Institutions

The Securities and Exchange Commission, acting in concert with the U.K. Financial Services Authority, announced an order temporarily prohibiting short selling of securities issued by financial institutions that, according to the SEC, is meant to protect the integrity and quality of the securities market and strengthen investor confidence.  The prohibition on short sales of financial institutions effective as of September 19 will apply to the securities of 799 financial companies identified in an appendix to the SEC’s order (SEC Release No. 34-58592).  The SEC stated that it banned short selling in the securities of financial institutions because the practice tends to drive the price of an issuer’s stock down.  The SEC said that there is an essential link between the stock price of a financial institution and public confidence in the institution.  The SEC’s emergency order, exercising its authority under Section 12(k)(2) of the Securities Exchange Act of 1934, will be effective until 11:59 p.m. ET on October 2, and the SEC may extend the order if it deems an extension necessary in the public interest and for the protection of investors, but will not extend the order for more than 30 calendar days in total.

Nutter Notes:  Short selling, a trading practice that allows investors to profit from the future decline of an issuer’s stock price, is ordinarily permissible and the SEC’s position is that short selling contributes to price efficiency and adds liquidity to the markets under normal conditions.  The SEC stated that unbridled short selling appears to be contributing to the recent, sudden price declines in the securities of financial institutions unrelated to the true value of those securities.  (The SEC also increased efforts recently to eliminate abuses associated with so-called “naked” short selling where the seller does not have stock available for delivery and intentionally fails to deliver within the standard three-day settlement period.)  The SEC’s order also temporarily requires that institutional money managers report their new short sales of certain publicly traded securities (money managers are already required to report their long positions in these securities), and temporarily eases restrictions on the ability of securities issuers to re-purchase their securities in an effort to help restore liquidity during the current period of market volatility.  The re-purchase order temporarily modifies the timing and volume conditions in the SEC’s Rule 10b-18, which provides a safe harbor for issuers from liability for stock price manipulation under the securities laws.

5.  Massachusetts Issues Final Data Security Requirements

New rules established under Chapter 93H of the General Laws of Massachusetts by the Office of Consumer Affairs and Business Regulation (OCABR) will require banks and thrift institutions, along with other companies in Massachusetts, to develop and maintain comprehensive written information security programs.  The final Standards for the Protection of Personal Information of Residents of the Commonwealth (201 C.M.R. Part 17) were approved on September 22 and will take effect on January 1, 2009.  To satisfy the new regulations, an information security program must identify reasonably foreseeable risks to the security of all records containing personal information, limit the off-site transport of and wireless access to such records, and contain rules for disciplining individuals who violate the security program.  Data that is transmitted wirelessly, sent over the Internet, or saved on portable media such as laptops or flash drives must be encrypted under the new regulations.  Businesses must also prevent terminated employees from accessing records, verify that third-party service providers are capable of maintaining the required safeguards and contractually requiring them to take such measures, and limit the amount of personal information collected, the time that such information is retained and the employees who have access to such information.

Nutter Notes:  The data security regulations also require that every person that owns, licenses, stores or maintains personal information about Massachusetts residents, and electronically stores or transmits the information, must periodically monitor its networks and systems for unauthorized use of or access to personal information, maintain the most reasonably up-to-date system security software and firewall protection, provide appropriate education and training to employees, and restrict physical access to computerized records.  Although Chapter 93H directs OCABR to adopt regulations “consistent with the safeguards for protection of personal information set forth in the federal regulations by which the [business] is regulated,” the new regulations do not include an express exemption for federally-regulated institutions such as banks and thrift institutions.  While the Massachusetts legislature may have intended that an organization’s compliance with its applicable federal regulator’s data security requirements would satisfy the requirements of Chapter 93H, the new regulations appear to mandate more requirements and protective actions than federal banking law and current federal agency guidance require.

6.  Other Developments: ABCP Lending Facility and Call Report Changes

• Federal Reserve Provides Additional Liquidity for ABCP

The Federal Reserve established a lending facility on September 19 to finance the purchase, at amortized cost, of certain highly rated asset-backed commercial paper (ABCP) by banking organizations from money market mutual funds.  The Federal Reserve Bank of Boston will lend funds on a nonrecourse basis and the ABCP purchased must be used to secure the borrowing.

Nutter Notes:  The Federal Reserve also approved a temporary, limited exception from its leverage and risk-based capital rules and a temporary limited exception from sections 23A and 23B of the Federal Reserve Act to facilitate participation in the ABCP program.  The ABCP lending facility will expire on January 30, 2009 unless extended by the Federal Reserve.

• FFIEC Proposes Call Report Revisions

The Federal Financial Institutions Examination Council (FFIEC) has published several proposed revisions to the Call Report for comment.  The proposed reporting changes would take effect on a phased-in basis during 2009.  Comments may be sent to the Federal Reserve, the OCC or the FDIC by November 24.

Nutter Notes:  The proposed revisions apply, among other things, to the reporting of real estate construction and development loans with capitalized interest, commercial mortgage-backed securities and structured financial products.

Nutter Bank Report

Nutter Bank Report is a monthly electronic publication of the Banking and Financial Services Group of the law firm of Nutter McClennen & Fish LLP.  Chambers and Partners, the international law firm rating service, has ranked Nutter’s Banking and Financial Services practice among the top banking practices in the nation in the 2007 Chambers and Partners U.S. rankings.  The “well known and well-versed” Nutter team “excels” at corporate and regulatory banking advice, according to the 2007 Chambers Guide.  Visit the 2007 U.S. rankings at ChambersandPartners.com.  The Nutter Bank Report is edited by Matthew D. Hanaghan.  Assistance in the preparation of this issue was provided by Lisa M. Jentzen.  The information in this publication is not legal advice.  For further information, contact the practice co-chairs:

Kenneth F. Ehrlich  
kehrlich@nutter.com 
Tel: (617) 439-2989 

Michael K. Krebs
mkrebs@nutter.com
Tel: (617) 439-2288