Capital markets, derivatives, and the law : positivity and preparation [Third ed.] 9780190879631, 0190879637

Table of contents :
Cover
Capital Markets, Derivatives, and the Law
Copyright
Dedication
Contents
Acknowledgments
Preface
Introduction
1. The Financial Crisis: The Seeds of New Regulation
I. Origins of the Great Recession
II. Subprime Lending
III. Government-​Sponsored Entities
IV. Legislative Reforms
A. Multiple Guarantor Model
B. Multiple Insurer Model
2. The Liquidity Crisis and Government Reaction
I. Buildup to Crisis
II. Providing Liquidity and Stabilizing the Financial Markets
III. Regulatory Reaction at the Height of the Crisis
A. The Emergency Economic Stabilization Act
B. American Recovery and Reinvestment Act
IV. Dodd-​Frank
3. Dodd-​Frank and the Regulation of Depository Institutions Capital Requirements
I. The Volcker Rule and “Too Big to Fail”
II. Bank Holding Companies and Systemically Significant Nonbanks
III. Living Wills, Credit Exposure Reports, and Concentration Limits
IV. Other Prudential Standards
4. Using Financial Instruments
I. Goal-​Oriented Investing
A. Using Financial Instruments to Hedge Risk
B. Using Financial Instruments to Enhance Yield
C. The Economy’s Impact on Financial Instruments
II. Achieving Investment Goals
A. The Investor’s Perspective
B. Financial Instrument Objectives
III. Managing Risk
5. Financial Instruments and the Capital Markets
I. The Capital Markets
A. Primary versus Secondary Markets
B. Long-​Term versus Short-​Term Marketplaces
C. Case Study: The Auction Rate Securities (ARS) Market
II. Financial Instruments
A. Types of Financial Instruments
1. Equity-​Based Financial Instruments
2. Debt-​Based Financial Instruments
3. Derivatives
4. Cryptocurrency and Digital Assets
B. Distinction between Debt and Equity
C. Federal Regulation
III. The Role of the Attorney
A. Competent Representation
B. Duty to Advise Client
C. Drafting Financial Instruments
D. Regulatory Compliance
E. Opinion Letters
6. Bureau of Consumer Financial Protection
I. Structure
II. Roles and Function of the BCFP
A. The Bureau’s Regulatory Authority
B. The Bureau’s Supervisory Authority
C. The Bureau’s Enforcement Authority
III. Significant Changes in Financial Consumer Protection by the BCFP
A. The Judicial Review of BCFP’s Power
IV. BCFP under President Trump’s Administration
V. The Judicial BCFP Structures under President Trump’s Administration
A. Constitutionality of the Bureau
B. Single Directorship
VI. Ongoing Enforcement Action Status
A. Wells Fargo Case
7. Understanding Interest Rates and the Economy
I. Background
A. The Federal Reserve
B. The Federal Reserve Banking System
1. Composition
2. Purpose
3. Responsibilities
II. Economic Indicators and Interest Rates
A. Key Economic Statistics
1. Statistics
B. Monetary Policy Objectives
C. Inflation Targeting
III. Monetary Policy: The Financial Crisis and Beyond
IV. Quantitative Easing
A. Balance Sheet Normalization
B. Fiscal Considerations
V. FOMC Minutes
8. Asset Valuation
I. The Use of Interest Rates in Asset Valuation
II. Interest Rate Yield Curve
A. Types of Yield Curves
B. Why the Yield Curve May Be Flat or Inverted
1. Increase in Market Demand for Long-​Term Securities
2. Long-​Term Yield Affected by Federal Reserve Monetary Policy
9. United States Treasury Securities
I. Purpose and Goals
A. Risk-​Free Nature
B. Primary Dealers
II. Description of U.S. Treasury Securities
A. Types of Treasury Securities
1. Treasury Bills
2. Treasury Notes and Bonds
B. Pricing
1. Discounts and Premiums
2. Factors Affecting Yield
III. Bond Auctions and Price
A. Interruption of Supply: SEC v. Davis et al.
B. Manipulation of the Auction Process: United States v. Salomon Brothers
IV. Interest Rates
A. Fixed-​versus Floating-​Rate Securities
B. Treasury Inflation-​Protected Securities (TIPS)
V. STRIPS
A. Description
B. Valuation
C. Uses
D. Abuses: In the Matter of Orlando Joseph Jett
10. Debt Securities
I. Description
A. Features of Bonds
B. Types of Bonds
C. The Indenture
II. Bond-​Rating Agencies
A. Independence and Conflicts of Interest
B. Regulation of Bond-​Rating Agencies
III. Special Types of “Debt” Instruments
A. Repos
1. Description
2. Orange County Case Study
B. Mortgage-​Backed Securities
1. Mortgage-​Backed Bonds
2. Pass-​Through Securities
3. Collateralized Mortgage Obligations and Real Estate Mortgage Investment Conduits
4. Stripped Mortgage-​Backed Securities (SMBS)
5. Subprime Mortgage Crisis
IV. Securities Act Registration
A. Government Securities
B. Government Agency Securities
C. Municipal Securities
1. SEC Disclosure Requirements
2. MSRB Disclosure Requirements
D. Corporate Debt Securities
1. Securities Act Requirements
2. Trust Indenture Act Requirements
E. Private Placements of Debt Securities
11. Derivatives
I. Introduction
A. Description
B. Counterparty Credit Risk
C. Over-​the-​Counter versus Exchange-​Traded Derivatives
D. Exchange-​Traded versus OTC Derivatives
II. Shifting Risk
A. The Concept of Leverage
B. Basis Risk
C. Market Risk
D. Effective Tools of Risk Management
III. Types of Derivatives
A. Forwards
B. Futures
1. Reduction of Counterparty Risk
2. Suitability as Hedging Instruments
C. Distinction between Forwards and Futures
D. Foreign Exchange Forwards and Futures
E. Options
F. Swaps
1. Characteristics of Swaps
2. The ISDA Master Agreement
G. Credit Derivatives
Appendix CME Filing: Self-​Certification for the initial listing of the Bitcoin Futures Contract
12. Types of Swaps
I. “Plain Vanilla” Interest Rate Swaps
II. Currency Swaps
III. Credit-​Default Swaps
A. Purpose and Function
B. ISDA Master Agreement
C. Importance of Clearly Defined Terms
1. Credit Event
2. Reference Entity
D. Collateralized Debt Obligations
E. OTC Derivatives and the Financial Crisis
IV. The Move toward Regulatory Reform
A. The Central Clearing Model
B. The OTC Model
C. Confidence in the New Regulatory Regime: The Case of MF Global
13. Options
I. Characteristics of Options
II. How Options Work
A. Calls and Puts
1. Call Option
2. Put Option
B. Case Study: Levy v. Bessemer Trust
1. Facts
2. Theories of Liability in Levy
III. The Black-​Scholes Model and Option Pricing
A. Assumptions
B. Required Data
C. Volatility
1. Types of Volatility
2. Measures of Volatility
D. Authority of the Black-​Scholes Model
IV. Delta Hedging
A. Contracts That Are Economically Options
B. OTC versus Exchange-​Traded Options
C. Regulation of Options
V. Option Strategies
A. Synthetic Call
B. Covered Call
C. Collar
14. Regulation of Swaps
I. The Dodd-​Frank Regulatory Regime
A. Dodd-​Frank and Derivatives Trading
B. Jurisdiction and Registration
C. Clearing Requirements, Exchange Requirements, and the End-​User Exemption
D. Capital and Margin Requirements
E. Reporting Requirements
1. Commodity Position Limits
F. Futures Commission Merchants, Dodd-​Frank, and Regulation 1.25
1. Title VII Enforcement
2. Updated Enforcement Advisory on Self-​Reporting and Full Cooperation
3. Enforcement Actions for Data Reporting Violations
4. Action for Failure to Submit Accurate Large-​Trader Commodity Swap Reports
5. Increase of CFTC’s Enforcement Actions following the Change of CFTC Chairman
6. Reduction of Counterparty and Systemic Risk
a. Counterparty Risk
b. Systemic Risk
G. Rationale behind Exemptions and Exclusions
1. The End-​User Exemption
2. Physical Settlement Exclusion
3. Customization Exceptions
H. The Lincoln Rule
1. Futures Commission Merchants
I. Criticisms of Dodd-​Frank’s Derivatives Trading Provisions
1. Concentration of Systemic Risk in Clearinghouse and “Too Big to Fail”
2. Exceptions Swallowing the Rule: Incentivizing of Customization and De Minimis Exceptions
3. Lack of Global Harmonization
4. The Impact of the Change of U.S. Administration
5. The Change of CFTC Chairman
a. CFTC’s New Priorities
b. Improving SEF rules
c. Fixing Data Reporting
d. Achieving Cross-​Border Harmonization
e. Project KISS
6. Recent Actions of the CFTC and Announcements of Further Actions to Come
a. Amendment of Swap Trading Rules
b. Review of Swap Dealers De Minimis Threshold
c. Review of Position Limits
d. Improvement of Clearinghouse Stress Testing
7. Propositions of Reforms from the U.S. Treasury Report on Capital Markets
15. Securities Regulation
I. Regulatory Overview
A. The Securities and Exchange Commission
1. Jurisdiction
B. What Constitutes a Security
1. Stocks
2. Notes
3. Investment Contracts—​The Howey Test
a. Control and Splitting the Transaction
b. Prepurchase Efforts
c. State Regulation and the Hawaii Market Test
C. Sellers’ Representations
D. Consequences of Securities Violations
1. Preliminary Injunction
2. Disgorgement
3. Permanent Injunction
4. Antifraud Statutes
5. Attorney’s Potential Liability
E. Hedge Funds
1. Post-​crisis Hedge Fund Regulation
2. Other Regulations
II. Derivatives Regulation: The SEC after Dodd-​Frank
Appendix A: Implementing the Dodd-​Frank Wall Street Reform and Consumer Protection Act
Appendix B: Checklist for Stocks, Notes, and Investment Contracts
16. Suitability
I. The Suitability Doctrine
A. Suitability Duty
B. Scope and Applicability
C. Control and Enforceability
D. Investment Advisors
1. Rule: A Fiduciary Standard
E. Scope and Applicability
F. Control and Enforceability
G. Basis of the Suitability Doctrine
H. Special Circumstances
I. FINRA and Self-​Regulated Organizations (SROs)
1. Financial Industry Regulatory Authority Creation of the Agency
J. Rule: A Suitability and Know-​Your-​Customer Duty
K. Scope and Applicability
L. Control and Enforceability
M. NYSE Know-​Your-​Customer Rule
1. Consumer Financial Protection Bureau
2. Scope and Applicability
3. Control and Enforceability
4. Department of Labor
a. Employee Retirement Income Security Act
5. Scope and Applicability
a. The Antifraud Provisions of the Federal Securities Laws—​Section 10b Cause of Action
II. Futures and Options: Suitability
A. Commodity Futures Trading Commission Disclosure Rules
1. Commodity Futures Trading Commission
a. Commodity Exchange Act
b. Rule: A Suitability and Fair-​Dealing Duty
c. Scope and Applicability
d. Control and Enforceability
B. National Futures Association
1. Rule: Suitability and Know-​Your-​Customer Duty
a. Scope and Applicability
b. Control and Enforceability
C. CEA Antifraud Provision
D. Municipal Securities Rule-​Making Board
Appendix A: Various Suitability Rules and Diagrams of Applicability
Appendix B: Survey of Rules Adopted by the SEC under Dodd-​Frank​
17. The History of the CFTC
I. Role of the CFTC
II. Structure
III. Disciplinary Action
IV. Regulatory Background
A. Commodity Exchange Act (CEA) of 1936
B. Commodity Futures Modernization Act (CFMA) of 2000
C. Jurisdictional Disputes
D. The Commodity Futures Modernization Act
E. Exclusions
F. Forwards
G. Options
H. Futures
I. Regulatory Distinctions between Forwards and Futures
J. Swaps
K. Hybrid Instruments
L. Foreign Exchange Products
1. The Treasury Amendment
2. CFTC Reauthorization
Appendix A: Enforcement Case Study: CFTC v. Amaranth Advisors, LLC
Appendix B: Case Study: CFTC v. Zelener
Appendix C: Structure of CFTC
Appendix D: Case Study: CFTC v. Patrick McDonnell
18. Fiduciary Obligation to Manage Risk
I. Controlling Risk
A. Duty to Manage Risk
1. Risk Management for Financial and Non-​financial Institutions
B. Financial Risk
C. Quantifying Financial Risk
1. Value at Risk
2. Volatility Risk
3. Stress Testing
D. Portfolio Dynamics
II. Operational Risk Management
A. Directors’ and Officers’ Understanding of Financial Instruments
B. Risk Policy
C. Reporting Lines and Audit Techniques
D. Empowering Board Members
E. Reporting Structures
F. Information Flow
1. Daily Exception Report
2. Red Flags
G. Ethical Concerns
1. Compensation
2. Code of Conduct
3. Free Flow of Information
H. Flexibility
III. Executive Protection
A. Responsibility for Risk Management
B. Business Judgment Rule
C. Education at Financial Institutions
D. Disclosure under Sarbanes-​Oxley Act
1. Disclosures in Management’s Discussion and Analysis (MD&A)
2. Off-​Balance-​Sheet Transactions
Appendix A: Case Study: JPMorgan and the London Whale
19. Litigation Issues
I. Federal Securities Laws
A. The Retail Investor: Broker-​Dealers and Investment Advisers
B. Securities Exchange Act of 1934 Rule 10b-​5 Claim
C. Securities Act of 1933
D. Liability under the Commodity Exchange Act
1. Antifraud Provision
2. Disclosure
II. Common Law Theories
A. Breach of Fiduciary Duty
B. Common Law Fraud
C. Shingle Theory
D. Tort Theory
E. Contract Theory
III. State Blue Sky Laws
IV. Swaps Case Study
20. Synthesis and Conclusion
I. Synthesis
II. Structured Note Case Study: Securities and Exchange Commission v. Goldman, Sachs & Co. & Fabrice Tourre
III. Historical Example: Erlanger “Cotton” Bonds
IV. Range Notes
V. Internal Leverage and Market Risk
VI. Risks Involved
A. Interest Rate Risk
B. Liquidity Risk
C. Reinvestment Risk
D. OCC Warning
Index

Citation preview

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Capital Markets, Derivatives, and the Law

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Capital Markets, Derivatives, and the Law P OSI T I VI T Y AND P REPA RAT ION Third Edition

Alan N. Rechtschaffen

1 Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

1 Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trademark of Oxford University Press in the UK and certain other countries. Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America. © Alan N. Rechtschaffen 2019 First Edition published in 2009 Second Edition published in 2014 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by license, or under terms agreed with the appropriate reproduction rights organization. Inquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above. You must not circulate this work in any other form and you must impose this same condition on any acquirer. Library of Congress Cataloging-​in-​Publication Data Names: Rechtschaffen, Alan N., author. Title: Capital markets, derivatives, and the law : positivity and preparation / Alan N. Rechtschaffen. Description: Third edition. | New York : Oxford University Press, [2019] | Includes   bibliographical references and index. Identifiers: LCCN 2018048101 | ISBN 9780190879631 ((hardback) : alk. paper) Subjects: LCSH: Financial instruments—United States. | Derivative securities—   Law and legislation—United States. | Capital market—Law and legislation—United States. |   Securities industry—Law and legislation—United States. Classification: LCC KF1070 .R42 2019 | DDC 346.73/096—dc23 LC record available at https://lccn.loc.gov/2018048101 9 8 7 6 5 4 3 2 1 Printed by Sheridan Books, Inc., United States of America Note to Readers This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is based upon sources believed to be accurate and reliable and is intended to be current as of the time it was written. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Also, to confirm that the information has not been affected or changed by recent developments, traditional legal research techniques should be used, including checking primary sources where appropriate. (Based on the Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations.) You may order this or any other Oxford University Press publication by visiting the Oxford University Press website at www.oup.com.

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B’H Thank you for Miera, Ronit, Evie, Sarah, Emunah, my mother, my father, and my teachers. Thank you to Miera for more things than I could ever say. Thank you Josh, Tevi, Jason, and R. Green for your friendship. And thank you to my students who are an unstoppable source of inspiration and positivity. Alan Rechtschaffen

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Contents

Acknowledgments  xix Preface  xxiii Introduction  xxv 1. The Financial Crisis: The Seeds of New Regulation  1 I. Origins of the Great Recession  5 II. Subprime Lending  6 III. Government-​Sponsored Entities  6 IV. Legislative Reforms  9 A. Multiple Guarantor Model  10 B. Multiple Insurer Model  11 2. The Liquidity Crisis and Government Reaction  13 I. Buildup to Crisis  13 II. Providing Liquidity and Stabilizing the Financial Markets  18 III. Regulatory Reaction at the Height of the Crisis  19 A. The Emergency Economic Stabilization Act  19 B. American Recovery and Reinvestment Act  21 IV. Dodd-​Frank  23 3. Dodd-​Frank and the Regulation of Depository Institutions Capital Requirements  25 I. The Volcker Rule and “Too Big to Fail”  26 II. Bank Holding Companies and Systemically Significant Nonbanks  29 III. Living Wills, Credit Exposure Reports, and Concentration Limits  32 IV. Other Prudential Standards  35 vii

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4. Using Financial Instruments  37 I. Goal-​Oriented Investing  37 A. Using Financial Instruments to Hedge Risk  39 B. Using Financial Instruments to Enhance Yield  39 C. The Economy’s Impact on Financial Instruments  40 II. Achieving Investment Goals  41 A. The Investor’s Perspective  41 B. Financial Instrument Objectives  43 III. Managing Risk  45 5. Financial Instruments and the Capital Markets  47 I. The Capital Markets  48 A. Primary versus Secondary Markets  49 B. Long-​Term versus Short-​Term Marketplaces  50 C. Case Study: The Auction Rate Securities (ARS) Market  50 II. Financial Instruments  51 A. Types of Financial Instruments  51 1. Equity-​Based Financial Instruments  51 2. Debt-​Based Financial Instruments  52 3. Derivatives  53 4. Cryptocurrency and Digital Assets  54 B. Distinction between Debt and Equity  54 C. Federal Regulation  57 III. The Role of the Attorney  61 A. Competent Representation  61 B. Duty to Advise Client  61 C. Drafting Financial Instruments  62 D. Regulatory Compliance  62 E. Opinion Letters  63 6. Bureau of Consumer Financial Protection  65 I. Structure  66 II. Roles and Function of the BCFP  68 A. The Bureau’s Regulatory Authority  68 B. The Bureau’s Supervisory Authority  69 C. The Bureau’s Enforcement Authority  70 III. Significant Changes in Financial Consumer Protection by the BCFP  70 A. The Judicial Review of BCFP’s Power  71 IV. B CFP under President Trump’s Administration  73

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V. The Judicial BCFP Structures under President Trump’s Administration  77 A. Constitutionality of the Bureau  77 B. Single Directorship  77 VI. Ongoing Enforcement Action Status  78 A. Wells Fargo Case  78 7. Understanding Interest Rates and the Economy  81 I. Background  82 A. The Federal Reserve  82 B. The Federal Reserve Banking System  83 1. Composition  84 2. Purpose  84 3. Responsibilities  85 II. Economic Indicators and Interest Rates  86 A. Key Economic Statistics  86 1. Statistics  88 B. Monetary Policy Objectives  92 C. Inflation Targeting  95 III. Monetary Policy: The Financial Crisis and Beyond  96 IV. Quantitative Easing  97 A. Balance Sheet Normalization  104 B. Fiscal Considerations  106 V. FOMC Minutes  107 8. Asset Valuation  111 I. The Use of Interest Rates in Asset Valuation  111 II. Interest Rate Yield Curve  112 A. Types of Yield Curves  113 B. Why the Yield Curve May Be Flat or Inverted  117 1. Increase in Market Demand for Long-​Term Securities  117 2. Long-​Term Yield Affected by Federal Reserve Monetary Policy  118 9. United States Treasury Securities  121 I. Purpose and Goals  122 A. Risk-​Free Nature  123 B. Primary Dealers  124 II. Description of U.S. Treasury Securities  125 A. Types of Treasury Securities  125 1. Treasury Bills  125

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Contents 2. Treasury Notes and Bonds  126 B. Pricing  126 1. Discounts and Premiums  126 2. Factors Affecting Yield  127 III. Bond Auctions and Price  128 A. Interruption of Supply: SEC v. Davis et al.  129 B. Manipulation of the Auction Process: United States v. Salomon Brothers  130 IV. Interest Rates  132 A. Fixed-​versus Floating-​Rate Securities  132 B. Treasury Inflation-​Protected Securities (TIPS)  132 V. STRIPS  134 A. Description  134 B. Valuation  134 C. Uses  135 D. Abuses: In the Matter of Orlando Joseph Jett  136

10. Debt Securities  139





I. Description  140 A. Features of Bonds  140 B. Types of Bonds  141 C. The Indenture  142 II. Bond-​Rating Agencies  142 A. Independence and Conflicts of Interest  144 B. Regulation of Bond-​Rating Agencies  146 III. Special Types of “Debt” Instruments  146 A. Repos  146 1. Description  146 2. Orange County Case Study  147 B. Mortgage-​Backed Securities  149 1. Mortgage-​Backed Bonds  150 2. Pass-​Through Securities  150 3. Collateralized Mortgage Obligations and Real Estate Mortgage Investment Conduits  151 4. Stripped Mortgage-​Backed Securities (SMBS)  151 5. Subprime Mortgage Crisis  151 IV. Securities Act Registration  152 A. Government Securities  153 B. Government Agency Securities  153

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C. Municipal Securities  154 1. SEC Disclosure Requirements  154 2. MSRB Disclosure Requirements  154 D. Corporate Debt Securities  155 1. Securities Act Requirements  155 2. Trust Indenture Act Requirements  155 E. Private Placements of Debt Securities  156

11. Derivatives  157





I. Introduction  158 A. Description  158 B. Counterparty Credit Risk  158 C. Over-​the-​Counter versus Exchange-​Traded Derivatives  161 D. Exchange-​Traded versus OTC Derivatives  162 II. Shifting Risk  163 A. The Concept of Leverage  163 B. Basis Risk  164 C. Market Risk  164 D. Effective Tools of Risk Management  165 III. Types of Derivatives  165 A. Forwards  165 B. Futures  166 1. Reduction of Counterparty Risk  167 2. Suitability as Hedging Instruments  167 C. Distinction between Forwards and Futures  168 D. Foreign Exchange Forwards and Futures  169 E. Options  170 F. Swaps  172 1. Characteristics of Swaps  172 2. The ISDA Master Agreement  173 G. Credit Derivatives  174 Appendix CME Filing: Self-​Certification for the initial listing of the Bitcoin Futures Contract  176

12. Types of Swaps  199 I. “Plain Vanilla” Interest Rate Swaps  200 II. Currency Swaps  202 III. Credit-​Default Swaps  203 A. Purpose and Function  204



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Contents B. ISDA Master Agreement  206 C. Importance of Clearly Defined Terms  206 1. Credit Event  207 2. Reference Entity  209 D. Collateralized Debt Obligations  214 E. OTC Derivatives and the Financial Crisis  215 IV. The Move toward Regulatory Reform  220 A. The Central Clearing Model  221 B. The OTC Model  222 C. Confidence in the New Regulatory Regime: The Case of MF Global  223

13. Options  231







I. Characteristics of Options  232 II. How Options Work  233 A. Calls and Puts  234 1. Call Option  234 2. Put Option  235 B. Case Study: Levy v. Bessemer Trust  235 1. Facts  235 2. Theories of Liability in Levy  236 III. The Black-​Scholes Model and Option Pricing  238 A. Assumptions  238 B. Required Data  238 C. Volatility  239 1. Types of Volatility  239 2. Measures of Volatility  240 D. Authority of the Black-​Scholes Model  241 IV. Delta Hedging  242 A. Contracts That Are Economically Options  244 B. OTC versus Exchange-​Traded Options  245 C. Regulation of Options  246 V. Option Strategies  247 A. Synthetic Call  248 B. Covered Call  248 C. Collar  248

14. Regulation of Swaps  249

I. The Dodd-​Frank Regulatory Regime  250 A. Dodd-​Frank and Derivatives Trading  250 B. Jurisdiction and Registration  252

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C. Clearing Requirements, Exchange Requirements, and the End-​User Exemption  254 D. Capital and Margin Requirements  259 E. Reporting Requirements  260 1. Commodity Position Limits  261 F. Futures Commission Merchants, Dodd-​Frank, and Regulation 1.25  262 1. Title VII Enforcement  263 2. Updated Enforcement Advisory on Self-​Reporting and Full Cooperation  263 3. Enforcement Actions for Data Reporting Violations  265 4. Action for Failure to Submit Accurate Large-​Trader Commodity Swap Reports  266 5. Increase of CFTC’s Enforcement Actions following the Change of CFTC Chairman  267 6. Reduction of Counterparty and Systemic Risk  267 a. Counterparty Risk  268 b. Systemic Risk  270 G. Rationale behind Exemptions and Exclusions  271 1. The End-​User Exemption  271 2. Physical Settlement Exclusion  273 3. Customization Exceptions  273 H. The Lincoln Rule  274 1. Futures Commission Merchants  275 I. Criticisms of Dodd-​Frank’s Derivatives Trading Provisions  276 1. Concentration of Systemic Risk in Clearinghouse and “Too Big to Fail”  276 2. Exceptions Swallowing the Rule: Incentivizing of Customization and De Minimis Exceptions  277 3. Lack of Global Harmonization  278 4. The Impact of the Change of U.S. Administration  279 5. The Change of CFTC Chairman  279 a. CFTC’s New Priorities  280 b. Improving SEF rules  280 c. Fixing Data Reporting  280 d. Achieving Cross-​Border Harmonization  281 e. Project KISS  281 6. Recent Actions of the CFTC and Announcements of Further Actions to Come  282 a. Amendment of Swap Trading Rules  282 b. Review of Swap Dealers De Minimis Threshold  283

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Contents c. Review of Position Limits  283 d. Improvement of Clearinghouse Stress Testing  283 7. Propositions of Reforms from the U.S. Treasury Report on Capital Markets  284

15. Securities Regulation  287







I. Regulatory Overview  288 A. The Securities and Exchange Commission  288 1. Jurisdiction  288 B. What Constitutes a Security  290 1. Stocks  290 2. Notes  292 3. Investment Contracts—​The Howey Test  298 a. Control and Splitting the Transaction  304 b. Prepurchase Efforts  307 c. State Regulation and the Hawaii Market Test  308 C. Sellers’ Representations  310 D. Consequences of Securities Violations  311 1. Preliminary Injunction  312 2. Disgorgement  313 3. Permanent Injunction  313 4. Antifraud Statutes  314 5. Attorney’s Potential Liability  314 E. Hedge Funds  315 1. Post-​crisis Hedge Fund Regulation  319 2. Other Regulations  320 II. Derivatives Regulation: The SEC after Dodd-​Frank  321 Appendix A: Implementing the Dodd-​Frank Wall Street Reform and Consumer Protection Act  323 Appendix B: Checklist for Stocks, Notes, and Investment Contracts  323

16. Suitability  325

I. The Suitability Doctrine  326 A. Suitability Duty  326 B. Scope and Applicability  327 C. Control and Enforceability  327 D. Investment Advisors  328 1. Rule: A Fiduciary Standard  328 E. Scope and Applicability  329

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F. Control and Enforceability  330 G. Basis of the Suitability Doctrine  331 H. Special Circumstances  333 I. FINRA and Self-​Regulated Organizations (SROs)  334 1. Financial Industry Regulatory Authority Creation of the Agency  334 J. Rule: A Suitability and Know-​Your-​Customer Duty  335 K. Scope and Applicability  336 L. Control and Enforceability  337 M. NYSE Know-​Your-​Customer Rule  337 1. Consumer Financial Protection Bureau  339 2. Scope and Applicability  340 3. Control and Enforceability  341 4. Department of Labor  342 a. Employee Retirement Income Security Act  342 5. Scope and Applicability  343 a. The Antifraud Provisions of the Federal Securities Laws—​Section 10b Cause of Action  343 II. Futures and Options: Suitability  345 A. Commodity Futures Trading Commission Disclosure Rules  345 1. Commodity Futures Trading Commission  345 a. Commodity Exchange Act  345 b. Rule: A Suitability and Fair-​Dealing Duty  346 c. Scope and Applicability  348 d. Control and Enforceability  348 B. National Futures Association  349 1. Rule: Suitability and Know-​Your-​Customer Duty  349 a. Scope and Applicability  350 b. Control and Enforceability  350 C. CEA Antifraud Provision  351 D. Municipal Securities Rule-​Making Board  351 Appendix A: Various Suitability Rules and Diagrams of Applicability  352 Appendix B: Survey of Rules Adopted by the SEC under Dodd-​Frank​  360

17. The History of the CFTC  367

I. Role of the CFTC  369 II. Structure  369 III. Disciplinary Action  370 IV. Regulatory Background  371 A. Commodity Exchange Act (CEA) of 1936  371

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Contents B. Commodity Futures Modernization Act (CFMA) of 2000  372 C. Jurisdictional Disputes  373 D. The Commodity Futures Modernization Act  373 E. Exclusions  374 F. Forwards  375 G. Options  376 H. Futures  376 I. Regulatory Distinctions between Forwards and Futures  378 J. Swaps  381 K. Hybrid Instruments  383 L. Foreign Exchange Products  384 1. The Treasury Amendment  384 2. CFTC Reauthorization  385 Appendix A: Enforcement Case Study: CFTC v. Amaranth Advisors, LLC  388 Appendix B: Case Study: CFTC v. Zelener  391 Appendix C: Structure of CFTC  393 Appendix D: Case Study: CFTC v. Patrick McDonnell  394

18. Fiduciary Obligation to Manage Risk  397











I. Controlling Risk  398 A. Duty to Manage Risk  398 1. Risk Management for Financial and Non-​financial Institutions  400 B. Financial Risk  401 C. Quantifying Financial Risk  402 1. Value at Risk  402 2. Volatility Risk  403 3. Stress Testing  403 D. Portfolio Dynamics  405 II. Operational Risk Management  405 A. Directors’ and Officers’ Understanding of Financial Instruments  406 B. Risk Policy  407 C. Reporting Lines and Audit Techniques  408 D. Empowering Board Members  409 E. Reporting Structures  410 F. Information Flow  411 1. Daily Exception Report  411 2. Red Flags  412 G. Ethical Concerns  412

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1. Compensation  412 2. Code of Conduct  413 3. Free Flow of Information  414 H. Flexibility  414 III. Executive Protection  414 A. Responsibility for Risk Management  415 B. Business Judgment Rule  415 C. Education at Financial Institutions  416 D. Disclosure under Sarbanes-​Oxley Act  416 1. Disclosures in Management’s Discussion and Analysis (MD&A)  416 2. Off-​Balance-​Sheet Transactions  417 Appendix A: Case Study: JPMorgan and the London Whale  419

19. Litigation Issues  423



I. Federal Securities Laws  424 A. The Retail Investor: Broker-​Dealers and Investment Advisers  424 B. Securities Exchange Act of 1934 Rule 10b-​5 Claim  426 C. Securities Act of 1933  428 D. Liability under the Commodity Exchange Act  430 1. Antifraud Provision  430 2. Disclosure  431 II. Common Law Theories  432 A. Breach of Fiduciary Duty  435 B. Common Law Fraud  438 C. Shingle Theory  438 D. Tort Theory  439 E. Contract Theory  439 III. State Blue Sky Laws  439 IV. Swaps Case Study  440



20. Synthesis and Conclusion  443 I. Synthesis  443 II. Structured Note Case Study: Securities and Exchange Commission v. Goldman, Sachs & Co. & Fabrice Tourre  445 III. Historical Example: Erlanger “Cotton” Bonds  447 IV. Range Notes  450 V. Internal Leverage and Market Risk  452 VI. Risks Involved  455

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Contents A. Interest Rate Risk  455 B. Liquidity Risk  455 C. Reinvestment Risk  456 D. OCC Warning  456

Index  459

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Acknowledgments

Capital Markets, Derivatives and the Law: Positivity and Preparation explains complex financial and legal information in a way that is easy to grasp. While regulation is rapidly evolving, understanding the building blocks of capital market trading activities is valuable far beyond a survey of the latest legal structures. For more than twenty years, I have taught students at New York University School of Law and at Fordham University. A number of my finest students helped me write and update this book to describe innovation, regulation, and capitulation within the global economy. We would like to thank each of them for their contribution, and acknowledge their fine work: Ying-​Tien Chen earned both Bachelor’s and Master’s degrees at National Taiwan University and works as an attorney in Taiwan. Tina’s knowledge of the law is broad, having worked internationally in civil, criminal, and domestic relations litigation, including real estate and contract disputes, breach of fiduciary duty claims, fraud, and family law. Melanie de Marnix, who contributed portions relating to suitability and standards of care, attended NYU Law School after having been an attorney for five years in Brussels, specializing in corporate and finance law. Her experience in advising clients in the Belgian public markets gave her valuable insight into European surveillance authorities and their expected standards of care.

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Michael Jaroslawicz earned his JD in 2018 from NYU Law School. While at NYU, he was my teaching assistant and demonstrated depth and understanding in conveying information to others. He simultaneously earned his MBA in 2018 from NYU Stern School of Business, specializing in financial instruments and markets, quantitative finance, and economics. In 2014, he received his BA in economics, magna cum laude, from Yeshiva University. Maria Khan worked as an attorney in India and the United Arab Emirates, advising on corporate and commercial law, banking and financial law, secondary market transactions, and syndicated financing of aircraft, vessels, and mega-​infrastructure projects. Her experience advising clients from India, Singapore, the United Arab Emirates, the European Union, and the United States gives her a unique perspective in global capital markets and regulations. Giovanni Patti holds an LLM in corporate law from NYU Law School and a PhD in corporate law from the University of Roma Tor Vergata. He served as a graduate editor of the NYU Journal of Law & Business and as a research assistant at the NYU Pollack Center for Law & Business and at the University of Roma Tre. Alexandre Reignier attended the University of Law of Nancy in France and NYU Law School. He will start his legal career at Cleary Gottlieb Steen & Hamilton, in Paris, with a practice focusing on corporate and financial transactions. Melanie Simon interned with the capital markets practices of Allen & Overy and White & Case in Paris. She graduated from the banking and financial law master's degree program at Paris II—​Pantheon-​Assas University. She won the Spitz & Poulle prize for best student in financial services (regulatory) before coming to NYU Law School. Masahiro Suzuki works as an attorney at Nagashima Ohno & Tsunematsu in Tokyo, specializing in capital market, structured finance, real estate, banking and financial law. He attended Kyoto University and NYU Law School. Vinca Vinenska contributed a portion relating to the passage covering the current state of the Consumer Financial Protection Bureau. She worked as an attorney at Hiswara Bunjamin & Tandjung, in association with Herbert Smith Freehills in Jakarta, Indonesia, for more than four years, specializing in capital market law, corporate law, mergers and acquisitions, banking, and financial law. In 2018, she received an LLM from NYU Law School in corporation law. Prachi Tadsare was an incredible help with writing and editing sections of this book. Prachi works as a legal consultant in the Operations Policy Group of the World Bank in Washington, DC, advising on operational issues in finance, specifically in the areas of fragility, conflict, and violence. She received an LLM

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from NYU Law School after completing her legal education in India. As a student in my class on financial instruments at NYU, Prachi researched capital markets and disruptive technologies, some aspects of which we are excited to incorporate into this edition of the book. Much of the fine work from former students for the second edition of this book survives in this latest iteration. I wish to once again thank, acknowledge, and send my personal regards to: Andraz Jadek, who, at the time of the second edition, worked as an attorney in Ljubljana, Slovenia, specializing in corporate and commercial law, mergers and acquisitions, venture capital, securities regulation, banking, and financial law. His experience advising clients from the European Union and the United States, among them large financial institutions, gave him a unique perspective on U.S. capital markets and regulation. Richard Kim, who contributed portions relating to the passage of Dodd-​ Frank and the regulatory developments that ensued. He attended Binghamton University and NYU Law School. While at NYU he was a student in my seminar on financial instruments. Grant Munyon, who graduated Phi Beta Kappa and with honors from Stanford University with a B.A. in international relations. He graduated in May 2013 from NYU Law School, where he acted as a notes editor for the Journal of Law and Business and participated in the Children’s Rights Clinic. Omar Radawi, who attended Princeton University and majored in the Woodrow Wilson School of Public and International Affairs. After Princeton, Omar earned a master’s degree in international political economy from the London School of Economics and a J.D. from NYU Law School. His academic background proved invaluable in doing research for this work. Daniel Wolf, who received his B.A. in economics from the Johns Hopkins University and earned his J.D. (magna cum laude, Order of the Coif ) from NYU Law School. His ability to synthesize regulation and economic reality helped me immensely as we reviewed new legislation and the evolution of the capital markets. And to the students who participated in the first edition, we once again express our gratitude: Colin Addy, Boriana A. Anguelova, Andrew Arons, Alice Dullaghan, Steven Eichorn, Lee J. Goldberg, David E. Gravelle, Sarah Hayes, Robert A. Johnston, Jim Kelly, Michael Kuzmicz, Benchen Li, Gabriel Mass, Katie McDonald, Robert Pierson, Jr., Justin Quinn, Joshua Riezman, Adam J. Tarkan, and Marshall Yuan.

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Preface

This book provides the basic knowledge necessary to understand the financial markets. Much of the work contained in this treatise is adapted from outstanding research by others. Under my guidance, a group of some of my finest students assembled cases and commentary to explain the capital markets and their evolving regulation. The structure of this work is based predominantly on the lectures of the author. However, where a regulator, judge, government official or economist describes a financial instrument or a situation better than the author might have, that commentary has been included in its entirety (or paraphrased for editorial consistency) without regard to political affiliation or philosophic disposition. In synthesizing materials such as the speeches of the Chairman of the Board of Governors of the Federal Reserve System, leading judicial rulings, and government sources from disparate administrations, the book is designed to immerse the reader in the structure and regulatory history of the capital markets. This treatise offers real-​world examples of how financial instruments actually work. The outline and methodology is unique. The treatise is designed to cover the functioning of the markets and the various applicable regulatory regimes. The subject matter cuts across a number of legal disciplines, including securities, corporate finance, banking, financial institutions, and commodities. Cases describe the subject matter and demonstrate to the reader the functioning of the capital

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markets. The pedagogical approach is to describe financial instruments in a way that everyone can understand. As capital market events evolve, it is impossible to freeze time. The treatise seeks to serve as a foundation for understanding world economic events as they unfold. This book covers the basic issues affecting capital markets trading, regulation, litigation, risk management, and internal controls. It further outlines the basic knowledge that every participant in the capital markets should have of the complexity of the role of the Federal Reserve in U.S. capital markets, the use of financial instruments to manage risk and to enhance yield, and the steps regulators take to address systemic vulnerabilities.

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After one of the greatest periods of economic turmoil in American history, the capital markets are enthusiastically embracing positivity. Indeed, the idea that America is on the road to economic “Great”ness is seen in positive economic data and domestic stock prices. Major sources of new-​found confidence include a change in the global “animal spirits,” increased liquidity, and a domestic unemployment rate that is approaching record lows. Importantly, regulatory constructs specifically designed to address some of the causes of the great crisis also allowed investors to gain resolve after a potentially apocalyptic time in economic history. President Trump’s administration clearly embraces a limited regulatory approach. This is a powerful juxtaposition to the crisis-​era actions of President Obama, who signed the Dodd-​Frank Act into law. Dodd-​Frank was designed to reduce systemic risks in the financial and banking sectors through enhanced regulatory control, transactional accountability, and transparency. Under President Trump these regulations have come under increased scrutiny. Secretary of the Treasury Steven Mnuchin explained: “The U.S. has experienced slow economic growth for far too long . . . we examined the capital markets system to identify regulations that are standing in the way of economic growth and capital formation . . . By streamlining the regulatory

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system, we can make the U.S. capital markets a true source of economic growth which will harness American ingenuity and allow small businesses to grow.”1 In this period of positivity, it is important to reassess the effectiveness of crisis-​era legislation to prevent systemic risk in the future. The overwhelming goal of Dodd-​ Frank was to address the causes of the financial crisis. While there may have been many early warning signs and lessons about frailties within the system that could have prevented the events of 2008, Dodd-​Frank attempted to fill in the gaps that existed at the time of the genesis of the Great Recession. The vulnerabilities that came to the fore in 2008 serve as powerful guideposts for the evolution of regulation for generations to come. As markets respond to monetary and fiscal policy that has enhanced economies around the globe, regulators and legislators continue to devote an enormous amount of attention to ensuring that we have robust financial systems that promote responsible risk-​taking and efficient allocation of resources. Despite success, financial stability cannot be taken for granted. While some financial vulnerability is cyclical in nature, rising and falling over time, others are structural, stemming from longer-​term forces shaping the nature of credit intermediation.2 Much of the regulation that has evolved in the wake of the financial crisis focuses on four areas of vulnerability that came to the fore during the financial crisis:3 1. Macroeconomic Imbalances In the context of the financial crisis, macroeconomic imbalances resulted when low interest rates forced investors to create instruments to enhance yield. Foreign investors sent large flows of cash into America seeking higher returns. Such an inflow of cash created financial bubbles as investors abandoned traditional risk–​reward analysis in pursuit of disproportional benefit. One area in particular that attracted foreign and domestic investment was real estate. Capitalizing on this “yield chasing,” financial engineers created products that were highly leveraged and often opaque in terms of pricing structure. 2. Unrestrained Entities Entities such as Fannie Mae and Freddie Mac encouraged investment in real estate by creating inexpensive financing opportunities for home investors by purchasing and 1 Treasury Releases Second Report On The Administration’s Core Principles Of Financial Regulation 10/6/2017 available at https://www.treasury.gov/press-center/press-releases/Pages/sm0173.aspx (last visited February 24, 2019). 2 See: An Assessment of Financial Stability in the United States, June 27, 2017 Vice Chairman Stanley Fischer available at https://​www.federalreserve.gov/​newsevents/​speech/​fischer20170627a.htm. 3 Ken Raisler, head of the derivatives group at Sullivan and Cromwell, LLP joined me in a class at New York University School of Law in identifying four key areas leading to the financial crisis.

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aggregating mortgages to increase liquidity. Increased liquidity drove the market for real estate higher. As the real estate market rose, financial engineers structured real estate–​related investments linked to the underlying mortgages. These instruments were often detached from the underlying asset except in the sense that a small move in the price of the underlying real estate would have far-​reaching effects on the economy beyond the initial home price. At the same time, entities not sponsored by the government such as American International Group (AIG) sold insurance look-​alike products (derivatives) that made investors overly confident in taking on risk. Emboldened by the idea that AIG would take the loss in the event of financial default, investors took risks with little consideration of the repercussions of a decline in asset prices that might impact the insuring entity and might actually lead to counterparty failure when AIG was called upon to pay under the terms of its agreements. As there were no capital requirements for entities such as AIG to engage in this financial engineering, there were no safeguards in place to address the counterparty risk inherent in its contracts. These derivatives contracts looked like tools that could virtually eliminate the risks of an investment. 3. Complex Products Complex financial instruments, such as derivatives, allowed investors to speculate on contingencies without regulatory or capital restraint. Key to appreciating how derivatives and other financial instruments contributed and arguably caused the financial crisis is looking at how they concentrate risk, and how prior to the crisis they were used to shift risk to systemically important institutions. The derivatives instrument itself is not inherently problematic. The risk inherent in a derivative contract can be misunderstood, and its use might be misapplied. Valuing models in complex transactions can prove useless when the world operates in new and unpredictable ways. The derivatives market knows no bounds—​a contract whose value fluctuates based on an asset can represent a notional value far in excess of the total amount of the asset that actually exists. Derivatives, therefore, created systemic leverage impacting the entire banking system. 4. Regulators Regulatory constructs did not evolve as rapidly as the capital markets. As a result, the fragmented regulatory construct of the pre-​crisis area allowed transactions and entities to slip through the cracks.

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In addition, there was no formal regulatory process for the oversight of the unwinding of systemically important institutions. When the time came and all the coins came up heads, there was no one regulator to oversee the orderly liquidation of systemically important market players. In summing up the vulnerabilities that existed at the time of the crisis, Ben Bernanke, the crisis-​era Chairman of the Federal Reserve, observed:4 The . . . private sector vulnerabilities include‌the excessive debt taken on perhaps because of the period of the Great Moderation . . . the banks’ inability to monitor their own risks, excessive reliance on short-​term funding . . . and increased use of exotic financial instruments like credit default swaps and others that concentrated risk in particular companies or in particular markets. The public sector had its own vulnerabilities including gaps in a regulatory structure. Important firms and markets did not have adequate oversight. Where there was adequate oversight at least in law, sometimes the supervisors and regulators didn’t do a good enough job. For example, there wasn’t enough attention paid to enforcing banks to do a better job of monitoring and managing their risks. And finally, an important gap that we’ve really begun to look at since the crisis is that with individual agencies looking at different parts of the system, there was not enough attention being paid to the stability of the financial system taken as a whole. . . . [A]‌nother important public sector vulnerability . . . were the so called government-​sponsored enterprises Fannie Mae and Freddie Mac. . . . In particular, the GSEs, Fannie and Freddie, when they sell their mortgage-​backed securities, they provide guarantees against credit loss. So if mortgages go bad, Fannie and Freddie make the investor whole. Now, Fannie and Freddie were permitted to operate within adequate capital. So in particular, they were at risk in a bad situation where there were a lot of mortgage losses. They didn’t have enough capital to pay off, make good those guarantees that they have promised . . . What made the situation even somewhat worse was that Fannie and Freddie besides selling these mortgage-​backed securities to investors, they also purchased on their own account large amounts of mortgage-​backed securities, both their own and some that were issued by the private sector. So they made profits from holding those mortgages, but again, that created an additional [danger] to the extent that those mortgages were not insured or protected, they were vulnerable to losses and again, without enough capital they were at 4 Ben S. Bernanke, The Federal Reserve and the Financial Crisis, The Federal Reserve's Response to the Financial Crisis, Lecture 3, George Washington University School of Business (Mar. 27, 2012), available at http://​www. federalreserve.gov/​newsevents/​files/​chairman-​bernanke-​lecture3-​20120327.pdf.

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risk. Now an important trigger . . . wasn’t just the house price boom and bust but it was the mortgage products and practices that went along with the house price movements that was particularly damaging. The result of the vulnerabilities of the pre-​crisis economy led to the undoing of the American capital markets. Credit froze, markets tumbled, and institutions failed. Today we are in a post-​crisis world where there is increasing focus on how to moderate the initiatives that were taken to save an economy on the brink of collapse. The new regulatory order was designed to resurrect confidence in the system and to prevent future crises. But President Trump has made the observation that in this post-​crisis period, overregulation stymies growth. The financial crisis not only created new regulation but also laid the groundwork for revolutionary technologies like cryptocurrency, robo-​advisors, and artificial intelligence designed to undermine our historic reliance on humans’ ability to make decisions. Bitcoin, for instance, mocked the centralized federal reserve banking system and fiat currency system it sought to replace. The Bitcoin genesis block contained the explicit political message: “The Times 03/​Jan/​2009 Chancellor on brink of second bailout for banks.”5 Unfortunately, even with history as a guide and computer driven decentralization, humans are still capable of creating macroeconomic imbalances, mistakes, and misfits. The stories we will tell our grandchildren and the fortunes to be made or lost in the years to come will be based on our ability to adapt to realities as they present themselves. No legislation or regulatory authority can replace prudence and thoughtful analysis in seeing what tomorrow might bring—​even if decisions are masked by the latest technologies. With the backdrop of fortified markets and economies, America is experiencing a period of growth, “full” employment, and increasing asset prices. Confidence and investment have greatly improved the U.S. economy. Indeed, the Trump Administration has taken to stimulate growth by cutting taxes and decreasing regulatory burdens. Policies and pro-​growth perception have enhanced spending and investment; even trade wars are yet to substantially dampen current economic enthusiasm—​but enthusiasm itself can increase risk. A positive outlook should not be maintained at the expense of prudent policy to manage systemic vulnerabilities. It is incumbent on government to be sensitive to remaining flexible to react to events of unexpected shock that will, no doubt, occur in the years and decades to come. Enhanced regulation has done much to 5 An Abridged History of Bitcoin available at https://archive.nytimes.com/www.nytimes.com/interactive/ technology/bitcoin-timeline.html (last visited February 24, 2019).

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address vulnerabilities and shore up market confidence. These gains should not be compromised. Prudence requires a fundamental understanding of market innovation and vulnerabilities within the context of positivity to prepare for the inevitable challenges that lie ahead. To that end, we present this description of capital markets, derivatives, and the law. Alan N. Rechtschaffen May 2019

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1 The Financial Crisis

THE SEEDS OF NEW REGUL ATION



I. II. III. IV.



Origins of the Great Recession  5 Subprime Lending  6 Government-​Sponsored Entities  6 Legislative Reforms  9 A. Multiple Guarantor Model  10 B. Multiple Insurer Model  11

on November 8, 2016 Donald Trump was elected the 45th president of the United States. After many years of financial crisis, and several years of modest recovery, the American electorate chose a president advocating less regulation as a means to greater growth. The reaction of the stock market the night that the votes were cast was quite dramatic. The stock market futures sold off dramatically and then, over the next 48 hours, recovered to levels that would remain the low price for years to come. It seems the markets bought into the notion that light touch regulation and a focus on business would be better for the American economy. The idea of less regulation was anchored in a notion that part of what was holding back domestic growth was an overreaction by regulators to the global financial

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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Capital Markets, Derivatives, and the Law

crisis. Indeed, beyond the financial realm, candidate Trump declared that regulatory burden stymies growth across a multitude of industries. President Trump makes clear that deregulation is a focus of his administration. He declared, “We’re here . . . to cut the red tape of regulation. For many decades, an ever-​growing maze of regulations, rules, restrictions have cost our country trillions and trillions of dollars, millions of jobs, countless American factories, and devastated many industries.”1 In Executive Order 13789, identifying and reducing regulatory tax burdens, he expressed the view that “numerous tax regulations issued over the last several years have effectively increased tax burdens, impeded economic growth, and saddled American businesses with onerous fines, complicated forms, and frustration.”2 This viewpoint is consistent with his view of financial regulation under the Dodd–​Frank Act that “regulation is stealth taxation.”3 President Trump established a set of core principles to be used to regulate the U.S. financial system via Executive Order 13772. These principles are to (1) empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth; (2) prevent taxpayer-​ funded bailouts; (3) foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry; (4) enable American companies to be competitive with foreign firms in domestic and foreign markets; (5) advance American interests in international financial regulatory negotiations and meetings; (6) make regulation efficient and effective, while ensuring that it is appropriately tailored; and (7) restore public accountability within the federal financial regulatory agencies, while rationalizing the federal financial regulatory framework.4 In operationalizing Executive Order 13772, the Treasury Department provides a review of the financial system through a series of reports covering: • The depository system, including banks, savings associations, and credit unions of all sizes, types, and regulatory charters; • Capital markets: debt, equity, commodities and derivatives markets, central clearing, and other operational functions;

1 Remarks by President Trump on Deregulation (December 14, 2017), https://​www.whitehouse.gov/​briefings-​ statements/​remarks-​president-​trump-​deregulation/​. 2 Exec. Order No. 13,789, 82 Fed. Reg. 19317 (Apr. 26, 2017). 3 Supra note 1. 4 Exec. Order No. 13,258, 82 Fed. Reg. 9965 (Feb. 8, 2017).

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• The asset management and insurance industries and retail and institutional investment products and vehicles; and • Nonbank financial institutions, financial technology, and financial innovation (unpublished). The events driving financial markets to the precipice of collapse during the global financial meltdown gave rise to a regulatory framework that may have been a rational response to a market in free fall. The Trump administration seeks to restrain that regulatory burden now that the economy is recovered. Beginning in 2007, the world witnessed dramatic events affecting the global economy. Failures in individual markets and institutions rapidly devolved into global financial recession. Financial markets and regulators the world over scrambled to navigate systemic imbalances and avoid stagnation as unemployment, debt crises, and recessions fostered political, social, and economic unrest. In response, the United States passed a host of legislative acts that completely reshaped the regulatory landscape. Since the darkest days of the financial crisis we have seen an unemployment rate that has more than halved and economic growth that has more than doubled. We are near or beyond full employment.5 As an emergency measure, it is certainly plausible that the slew of crisis reactionary regulation contributed to order and confidence in the financial markets. Their utility, now that the economy is quite robust, is less clear. To better understand the current state of financial market regulation, it is necessary to review the systemic vulnerabilities that led to the Great Recession. The financial crisis arose in large part as a result of “the complexity and sophistication of . . . financial institutions and instruments and the remarkable degree of global financial integration that allows financial shocks to be transmitted around the world at the speed of light.”6 As the financial markets evolved up until the crisis, financial instruments took on dynamic and sophisticated structures allowing returns to investors, contingent on variables other than credit. For example, mortgage-​backed bonds, backed by the cash flow of underlying mortgages, were particularly vulnerable to the macroeconomic imbalances that existed at the onset of the crisis.

5 Monetary Policy Report, Board of Governors of the Federal Reserve System (Feb. 23, 2018), at https://​www. federalreserve.gov/​monetarypolicy/​files/​20180223_​mprfullreport.pdf. 6 Ben S. Bernanke, Stabilizing the Financial Markets and the Economy, Address at the Economic Club of New York (Oct. 15, 2008), http://​www.federalreserve.gov/​newsevents/​speech/​bernanke20081016a.htm.

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Capital Markets, Derivatives, and the Law

Adair Turner, chairman of the U.K.’s Financial Services Authority during the crisis,7 explained that “[a]‌‌t the core of the crisis was an interplay between macroeconomic imbalances which have become particularly prevalent over the last 10–​15 years [prior to the crisis] and financial market developments which have been going on for 30 years but which accelerated over the last ten under the influence of the macro imbalances.”8 Chairman Turner explained that very large current account surpluses piling up in the oil exporting countries and corresponding deficits in the United States and other countries led to a dramatic “reduction in real risk free rates of interest to historically low levels.”9 Two effects of extremely low interest rates were “[a] rapid growth of credit extension . . . particularly but not exclusively for residential mortgages . . . and . . . a ferocious search for yield.”10 In part, as a result of low interest rates and legislative incentives to own a home, the U.S. real estate market saw enormous gains in the decades leading up to the crisis. When the real estate market reversed, it carried securitized debt with it. Prices of securities that were purchased to enhance yield tumbled, and the dramatic reversal proved devastating for market participants who created and invested in mortgage-​ linked debt. As a result of the implosion of the real estate and credit markets, companies such as Lehman declined from positions of financial supremacy to illiquidity in a matter of days. Firms that took on the credit default risk of others, such as American International Group (AIG), were subsequently devastated. In 2019, the U.S. economy is viewed by many as wholly recovered from the economic impact of the crisis. At the time of the writing of this work, the U.S. stock market is trading at record highs, having erased all the losses of the crisis period and then some. Indeed, the Federal Open Market Committee (FOMC) in commenting on the accomplishments of the economy recently observed: Information received since the Federal Open Market Committee met in March indicates that the labor market has continued to strengthen and that economic activity has been rising at a moderate rate. Job gains have been strong, on average, in recent months, and the unemployment rate has stayed low. Recent data suggest that growth of household spending moderated from its strong fourth-​quarter pace, while business fixed investment continued to grow 7 The Financial Services Authority (FSA) is an independent non governmental body in the United Kingdom, given statutory powers by the Financial Services and Markets Act 2000. The U.K. Treasury appoints the FSA Board. The FSA is accountable to Treasury Ministers and through them to Parliament. It is operationally independent of government and is funded entirely by the firms it regulates. 8 Adair Turner, chairman of the FSA, The Economist’s Inaugural City Lecture ( Jan. 21, 2009). 9 Id. 10 Id.

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strongly. On a 12-​month basis, both overall inflation and inflation for items other than food and energy have moved close to 2 percent. Market-​based measures of inflation compensation remain low; survey-​based measures of longer-​ term inflation expectations are little changed, on balance.11 While the economy may be approaching full recovery and robust growth, the long-​ lasting effects of the crisis continue to be felt throughout the global regulatory systems, and it remains to be seen what the impact will be of a reduction in those constructs. I. Origins of the Great Recession After years of robust growth in the American real estate markets, prices began to decline in the second half of 2007. The decline in real estate prices had a direct impact on the prices of financial instruments linked to the mortgages on those properties. In addition, the prices and market for instruments deriving their values directly or synthetically from mortgages rapidly declined. Systemically important financial institutions owned these securities, while others such as AIG “insured” the financial health of the security holders. Mortgage-​backed securities are financial instruments that derive their cash flow and/​or value from pools of mortgages; they include mortgage-​backed bonds. The ripple effect caused by a downdraft in the value of mortgage-​backed securities resulted in diminished liquidity at financial institutions and systemic threats to the broader capital markets. The undertow created by mortgage foreclosures and deficiencies rocked the financial world and changed the essential functioning of financial institutions in the global economy. Ben S. Bernanke, the chairman of the Board of Governors of the Federal Reserve System at the time, explained that: Large inflows of capital into the United States and other countries stimulated a reaching for yield, an underpricing of risk, excessive leverage and the development of complex and opaque financial instruments that seemed to work well during the credit boom but have been shown to be fragile under stress. The unwinding of these developments, including a sharp deleveraging and a headlong retreat from credit risk, led to highly strained conditions in financial markets and a tightening of credit that has hamstrung economic growth.12 11 https://​www.federalreserve.gov/​newsevents/​pressreleases/​monetary20180502a.htm (last visited May 30, 2018). 12 Id.

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Capital Markets, Derivatives, and the Law

II. Subprime Lending In 2007 and 2008, the high levels of delinquencies, defaults, and foreclosures among subprime borrowers led to the undoing of the broader capital markets, the shock waves of which were felt throughout the global economy. The effects of mortgage lending on the broader capital markets demonstrate both how global banking systems and international economies are increasingly interconnected and the effect that a unique capital market disruption has on the broader U.S. economy. Today more than ever before, improvements in communication and financial innovation have increased the effects of market disruptions anywhere in the world on the global capital marketplace. The rise in real estate prices in the 10 years prior to the crisis was encouraged, in large part, by low interest rates facilitating the purchase of homes and investment properties, mortgage brokers on commission, and federal policies encouraging home ownership. This increase in real estate activity, combined with easy access to funding, allowed borrowers to access equity contained in their homes and allowed speculators to make investments in property that would never have been possible without the availability of cheap money. Borrowers take on debt for many purposes including the funding of long-​term purchases such as a home. In the years leading up to the mortgage meltdown, banks aggressively pumped capital into the economy by making loans, advantaging themselves of the spreads between the rates at which banks borrow money and the mortgage rates they charge their customers. Cash was readily available to banks to lend to their customers, since the loans they created were resold in the form of mortgage-​ backed securities. The concept of financing mortgages by issuing securities backed by the revenue stream generated from those mortgages was not new. Indeed, the federal government sponsored the establishment of several enterprises specifically designed to provide liquidity to banks participating in the mortgage markets.

III. Government-​Sponsored Entities There are several entities that are sponsored by the federal government to refinance mortgages. Federal agencies are direct arms of the U.S. government, while federally sponsored agencies were historically privately owned and publicly chartered organizations that were created by acts of Congress to support a specific public purpose (also referred to as government-​sponsored entities or GSEs). Until the

7



The Financial Crisis

7

changes resulting from the crisis, several executive branches had overseen GSEs. The Department of Housing and Urban Development (HUD) monitored the activities of Fannie Mae and Freddie Mac.13 During the financial crisis, the Housing and Economic Recovery Act of 2008 (HERA) established the Federal Housing Finance Agency (FHFA) as the overseer of Fannie Mae, Freddie Mac (the Enterprises), and the Federal Home Loan Bank System (which includes the 11 Federal Home Loan Banks and the Office of Finance). Since 2008, FHFA has also served as conservator of Fannie Mae and Freddie Mac.14 In 2008, Fannie Mae and Freddie Mac experienced large losses related to the plummeting real estate market in the United States. As a result, the U.S. government placed these two leading mortgage lenders into conservatorship. This action blurred the distinction between government and government agency beyond an implicit guaranty for survivorship. This action was taken to avoid unacceptably large dislocations in the mortgage markets and the economy as a whole. The U.S. Treasury, drawing on authorities granted by Congress, made financial support available to the housing agencies. As the recovery unfolded, we witnessed a recovering credit market and a more robust mortgage lending market. As housing prices recovered, Fannie Mae and Freddie Mac returned to profitability after teetering on the edge of collapse. In May 2013, Fannie Mae announced a record profit and the return of $59.4 billion to the government that bailed it out: WASHINGTON, DC—​Fannie Mae (FNMA/​OTC) reported pre-​tax income of $8.1 billion for the first quarter of 2013, compared with pre-​tax income of $2.7 billion in the first quarter of 2012 and pre-​tax income of $7.6 billion in the fourth quarter of 2012. Fannie Mae’s pre-​tax income for the first quarter of 2013 was the largest quarterly pre-​tax income in the company’s history. The improvement in the company’s results in the first quarter of 2013 compared with the first quarter of 2012 was due primarily to strong credit results driven by an increase in home prices, including higher average sales prices on Fannie Mae-​owned properties, a decline in the number of delinquent loans and the company’s resolution agreement with Bank of America. Including Fannie Mae’s release of the valuation allowance on its deferred tax assets, the company reported quarterly net income of $58.7 billion for the first quarter of 2013. Fannie Mae reported comprehensive income of $59.3 billion in the first

Federal Housing Enterprises Financial Safety and Soundness Act of 1992. Fannie Mae and Freddie Mac are subject to supervision by a newly created regulator within HUD, called the Office of Federal Housing Enterprise Oversight (OFHEO). 14 https://​www.fhfa.gov/​AboutUs (last visited June 30, 2018). 13

8

8

Capital Markets, Derivatives, and the Law

quarter of 2013, compared with comprehensive income of $3.1 billion for the first quarter of 2012. As a result of actions to strengthen its financial performance and continued improvement in the housing market, Fannie Mae’s financial results have improved significantly over the past five quarters. Based on analysis of all relevant factors, Fannie Mae determined that release of the valuation allowance on its deferred tax assets was appropriate under generally accepted accounting principles (“GAAP”), which resulted in a benefit for federal income taxes of $50.6 billion. The release of the valuation allowance in addition to operating income and comprehensive income for the first quarter of 2013 will result in a dividend payment to taxpayers of $59.4 billion in the second quarter of 2013.15 In August 2012, before the announcement of record profits, Treasury and FHFA amended the Senior Preferred Stock Purchase Agreements (the so-​called “Third Amendment”) that facilitated the bailout of Fannie Mae and Freddie Mac during the height of the crisis to include significantly more favorable terms for the government. In addition to requiring a faster wind-​down of their portfolios, the 10 percent fixed-​ rate dividend that was to be paid to the government on “bailout” contributions was replaced with a variable structure directing all net income earned by the Agencies to be paid to the Treasury. According to the FHFA, “replacing the current fixed dividend in the agreements with a variable dividend based on net worth helps ensure stability, fully captures financial benefits for taxpayers, and eliminates the need for Fannie Mae and Freddie Mac to borrow from the Treasury Department to pay dividends.”16 While the Treasury continues, at the time of the writing of this book, to collect profits from the GSEs, the shareholders of the GSEs are restless about the dividend distribution scheme, which does not allow them to receive any dividend return on their GSE investments. The Third Amendment has resulted in approximately 20 lawsuits by various classes of shareholders in the GSEs. These litigations all spring from the same set of facts and have taken a number of different approaches to attacking the validity of the Third Amendment.17 The Appellate Court held that HERA’s Succession Clause18 allowed FHFA to succeed to all rights, titles, powers, and privileges of the GSEs’ shareholders as Press Release, Fannie Mae (May 9, 2013), available at http://​www.fanniemae.com/​resources/​file/​ir/​pdf/​ quarterly-​annual-​results/​2013/​q12013_​release.pdf. 16 https://​www.fhfa.gov/​conservatorship/​pages/​senior-​preferred-​stock-​purchase-​agreements.aspx (last visited June 28, 2018). 17 Altering the Deal: The Importance of GSE Shareholder Litigation, 19 N.C. Banking Inst. 109. 18 HERA, 12 U.S.C. 4617(b)(2)(A)(i). 15

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The Financial Crisis

9

conservator and barred plaintiffs from bringing a derivative claim on behalf of the GSEs during a conservatorship. In rejecting petitioners’ assertion that the Succession Clause included a “manifest conflict of interest” exception that permitted shareholders to sue on behalf of the enterprises to challenge FHFA’s decisions, the Appellate Court recognized a limited conflict-​of-​interest exception in interpreting an analogous FIRREA provision, and declined to extend that rationale to HERA. However, the Appellate Court held that stockholders retained the right to bring direct claims against FHFA during a conservatorship, and subsequently determined that plaintiffs’ breach-​of-​contract claims were direct and remanded the issue to the District Court for further proceedings, the only relief the plaintiffs secured in their appeal. The plaintiff shareholders’ appealed to the Supreme Court of United States for the reversal of the order passed by the Appellate Court by filing a petition for a writ of certiorari in January 2018. The Supreme Court declined the plaintiff shareholders’ petition. IV. Legislative Reforms GSEs enjoy lower operating and funding costs, a line-​of-​credit with the U.S. Treasury and issue debt and mortgage-​backed securities at lower yields than comparable corporate entities due to their government-​sponsored status. The credit rating of many GSEs is AA+. The credit spread between GSEs and Treasury securities is small. While the mortgages purchased by Fannie Mae and Freddie Mac are not “government-​insured,” a perception had always existed that they “carry an implicit government guarantee [because] the companies are so large that the government would never let them fail.”19 The biggest criticism for bailout of GSEs was the notion of privatization of gains and socialization of losses. The use of $400 billion of taxpayers’ money to bailout private GSEs was a hot topic in the legislature. In order to shape the post-​crisis world, the regulatory focus has shifted to the taxpayer protections with respect to government sponsored entities especially in the light of GSE’s federal government conservatorship. Equity holders initially suffered under federal conservatorship. However, in 2013, as investors considered the robust profits at the agency, the future of GSEs generally, and the potential outcome of shareholder lawsuits, the stock of Fannie Mae rose from 25 cents to over three dollars. As of this writing the shares are trading at about $1.50.

Ally Coll Steele, Fannie, Freddie, and Fairness: Judicial Review of Federal Conservators, 53 Harv. J. on Legislation 417, 420. 19

10

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Capital Markets, Derivatives, and the Law

Bondholders immediately benefited from the federal government’s new and active role in overseeing Fannie Mae and Freddie Mac. Indeed, after Fannie Mae and Freddie Mac were placed into federal conservatorship, investors’ moral obligation inference seems to have been well placed as credit spreads tightened in the wake of government intervention into the ownership and operation of these entities. GSEs were created to ensure adequate credit flows. They were deemed necessary because of the types of loans they facilitated. The aggregate amount of GSE loans is in the trillions of dollars. Much of the loans outstanding represent growth in the issuance of mortgage-​backed securities by home-​lending GSEs. Mortgage-​backed securities are supported by mortgages the GSE purchases. Fannie Mae and Freddie Mac also purchase loans from banks and repackage the loans into debt securities called residential mortgage-​backed securities (collateralized mortgage obligations or CMOs). The GSEs enhanced liquidity by affording homeowners the opportunity to borrow money to spend in the economy. There is a long line of housing finance reforms proposals made by various policymakers since the financial crisis of 2008. At their core these policies differ on two conceptual issues: (1) whether to keep the GSEs or dissolve them, and (2) whether we continue affording federal guarantee to refinancing agencies. The best way to analyze the legislative reforms surrounding the housing finance market would be to examine two different models that propose different solutions for these questions.20 One of the models is the Corker-​Warner “multiple guarantor model” (“Multiple Guarantor Model”) and the second is DeMarco-​Bright-​Hensarling “multiple issuer model” (“Multiple Insurer Model”). A. Multiple Guarantor Model

The model proposes the creation of additional market competition and dissolution of the GSEs. The new system would allow new guarantor firms (“Guarantor Firms”) to purchase mortgages from originators and then bundle them into mortgage backed securities (MBS). The qualified MBS shall have a federal guarantee that can only be invoked where private capital arranged by Guarantor Firms takes considerable losses. The model also proposes the creation of a single government agency, the Federal Mortgage Insurance Corporation (FMIC) that would, among other things, provide a common securitization platform, develop standard form risk-​sharing mechanisms, expand access to credit, impose disclosure requirements 20 Eric Kaplan, Michael A. Stegman, Phillip Swagel & Theodore W. Tozer, Bringing Housing Finance Reform over the Finish Line, Milken Institute ( Jan. 2018), available at http://​assets1b.milkeninstitute.org/​assets/​ Publication/​Viewpoint/​PDF/​FINAL-​Housing-​Finance-​Reform-​Proposals-​to-​Legislation-​2.pdf.

1



The Financial Crisis

11

in collaboration with the Securities Exchange Commission (SEC), provide insurance on principal and interest for qualified MBS when Guarantor Firms suffer catastrophic losses, and charge fees in exchange for providing this insurance. All resources and functions of FHFA would be transferred to FMIC. Once fully functional, the GSEs charters will be repealed, except that provisions of the charters will continue to apply with respect to mortgage-​backed securities guaranteed by the GSEs, as well as outstanding debt obligations, bonds, debentures, notes, and other similar instruments, and the full faith and credit of the U.S. government would continue to apply to them. The idea behind the model appears to increase competition in the market so that the status of Fannie Mae and Freddie Mac can be reduced as systemically important and also reduce the scope of the federal guarantee. The deficiencies of the model revolve around the federal guarantee that it proposes. The model would make the implicit federal guarantee into an explicit one. Considering the explicit federal guarantee, the model also flusters on the design of capital loss of the Guarantor Firms that would trigger the federal guarantees and pricing of the guarantees.21 A separate issue triggered by the model is the introduction of competition in the refinancing market. With too many Guarantor Firms and high level of competition we might end up in a similar situation as the housing bubble of 2008. B. Multiple Insurer Model

The model proposes to end the receivership and reconstruct the GSEs (Fannie Mae, Freddie Mac, and Ginnie Mae22) by amending their charters and dissolving their investment portfolio. The GSEs will be turned into lender-​owned mutuals. They would continue to provide credit enhancement by syndicating mortgage credit risk through a variety of credit risk transfer structures and provide access to small and mid-​sized lenders to sell mortgages for cash. Other than being approved by the FHFA as a credit enhancer, the GSEs would no longer have any government role. Ginnie Mae would be reconstructed to become a stand-​alone government entity providing guarantees on MBS issued by newly reconstituted GSEs. FHFA shall continue to exist and would regulate the securitization and the quantity and quality of private capital with respect to government guarantee. FHFA

David Scharfstein & Phillip Swagel, Legislative Approaches to Housing Reform, p. 7, (2016), available at http://​ assets1b.milkeninstitute.org/​a ssets/​Publication/​V iewpoint/​P DF/​L egislative-​Approaches-​to-​Housing-​ Finance-​Reform-​Oct16.pdf. 22 For the purpose of this chapter we will only focus on Fannie Mae and Freddie Mac. 21

12

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Capital Markets, Derivatives, and the Law

would also be responsible for setting standards for private credit enhancement and overseeing the winding down of the conservatorships, including managing the outstanding securities issued by Fannie Mae and Freddie Mac backed by the Treasury. The model, like in the case of multiple guarantor model, promotes standardization across the housing finance market with regard to disclosure requirements and market systems. A major concern with the proposal is whether such mutual ownership of potentially systemic financial institutions can survive a financial crisis such as the one in 2008. Just like the Multiple Guarantor Model, this model is unclear on the pricing of government guarantees by Ginnie Mae and the extent to which it can or should take risk, to avoid looking increasingly like the previous GSEs. On January 16, 2018, FHFA Director Mel Watt provided his views on housing finance reforms in a letter and supporting report23 to the Senate Banking Committee chairman, Mike Crapo, and Senator Sherrod Brown. Both the previous models recommend the retention of FHFA, but FHFA leans more toward the Multiple Guarantor Model. Watt’s term as FHFA director ended on January 6, 2019. As of the writing of this book, the FHFA is led by Comptroller of the Currency Joseph Otting, who was picked by President Donald Trump to serve as acting director of the FHFA while Mark Calabria, the President’s nominee for permanent Director awaits Senate confirmation.

23 See Federal Housing Finance Agency Perspectives on Housing Finance Reform ( Jan. 16, 2018), available at http://​ nlihc.org/​sites/​default/​files/​FHFA_​011618_​Letter_​Crapo-​Brown_​Housing-​Finance-​Reform_​011718.pdf and http://​nlihc.org/​sites/​default/​files/​FHFA_​Housing-​Finance-​Reform-​Perspective_​011718.

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2 The Liquidity Crisis and Government Reaction





I. Buildup to Crisis  13 II. Providing Liquidity and Stabilizing the Financial Markets  18 III. Regulatory Reaction at the Height of the Crisis  19 A. The Emergency Economic Stabilization Act  19 B. American Recovery and Reinvestment Act  21 IV. Dodd-​Frank  23

I. Buildup to Crisis Purchasing a home is an extremely interest-​rate sensitive decision. The ability to buy a home is often contingent on the debt available to the homebuyer and the interest rate of that debt. Banks provide debt financing by analyzing the ratio of household net worth to income. A declining interest rate environment affords homeowners the opportunity to initiate or refinance mortgages at lower rates. By fixing a long-​term mortgage rate, homeowners are insulated from rising rates.1 1 Ben S. Bernanke, The Economic Outlook and Monetary Policy, Address at the Bond Market Association Annual Meeting (Apr. 22, 2004). Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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Capital Markets, Derivatives, and the Law

Mortgage-​backed pass-​through securities are created when mortgages are pooled together and sold as undivided interests to investors. Usually, the mortgages in the pool have the same loan type, similar maturities, and similar loan interest rates.2 Leading up to the financial crisis, a number of Wall Street brokerage firms, including the former Bear Stearns, created private-​label mortgage-​backed securities to help lenders fund more purchases of real estate. The securities were backed by mortgages from subprime borrowers, and when these borrowers were unable to meet the demands set by the mortgage pools, the securities derived from these mortgage pools became worthless. In circumstances where mortgagors continued to meet their obligations, the securities’ value may have suffered as firms simply did not know how to value them in the face of a changed economic environment. Mortgage-​ backed security issuance was so lucrative and ubiquitous that a glut of mortgage-​ derived securities wound up on the balance sheets of a number of the leading Wall Street firms. As the securities’ value declined, the liquidity of the securities declined as well, thus leading to a liquidity crisis. So severe was this liquidity crisis that the Federal Reserve (the Fed) took the aggressive step of facilitating a buyout of Bear Stearns by J.P. Morgan to prevent the collapse of the Wall Street powerhouse. In Chairman Bernanke’s speech describing the buildup to the liquidity crisis and the steps the Federal Reserve took to shore up the system in facilitating the acquisition of Bear Stearns,3 he confirmed the Federal Reserve’s role in providing liquidity to a banking system in a crisis. The duty of the central bank is to respond to a sharp increase in the demand for cash or equivalents by private creditors. The way to respond to a crisis in liquidity is for the central bank to lend freely.4 Chairman Bernanke commented that liquidity risks are always present for institutions—​banks and nonbanks alike—​that finance illiquid assets with short-​ term liabilities. However, mortgage lenders, commercial and investment banks, and structured investment vehicles experienced great difficulty in rolling over commercial paper backed by subprime and other mortgages. Furthermore, a loss of confidence in credit ratings led to a sharp contraction in the asset-​backed commercial paper market as short-​term investors withdrew their funds. Some financial institutions even experienced pressures in rolling over maturing repurchase agreements (repos).

2 Federal Reserve System, Trading and Capital-​Markets Activities Manual § 4110.1 (Board of Governors of the Federal Reserve System, 1998). 3 Ben S. Bernanke, Liquidity Provision by the Federal Reserve, Address at the Federal Reserve Bank of Atlanta Financial Markets Conference (May 13, 2008), via satellite. Bernanke presented identical remarks to the Risk Transfer Mechanisms and Financial Stability Workshop, Basel, Switzerland, on May 29, 2008 (via videoconference). See http://​www.federalreserve.gov/​newsevents/​speech/​bernanke20080513.htm for the complete text of the remarks. 4 Id.

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Liquidity Crisis and Government Reaction

15

This was despite the fact that repos were traditionally regarded as virtually risk-​free instruments and thus largely immune to the type of rollover or withdrawal risks associated with short-​term unsecured obligations. Markets can be severely disrupted when investors feel pressure to sell the underlying collateral in illiquid markets. Such forced asset sales can set up a particularly adverse dynamic: a dynamic in which further substantial price declines fan investor concerns about counterparty credit risk, which then feed back in the form of intensifying funding pressures. These “fire sales,” forced by sharp increases in investors’ liquidity preferences, can drive asset prices below their fundamental value at significant cost to the financial system and the economy.5 This explains the basic logic of the central bank’s prescription for crisis management: A central bank may be able to eliminate, or at least attenuate, adverse outcomes by making cash loans secured by borrowers’ illiquid but sound assets. Thus, borrowers can avoid selling securities into an illiquid market and the potential for economic damage—​arising, for example, from the unavailability of credit for productive purposes or the inefficient liquidation of long-​term investments—​is substantially reduced.6 This solution, though simple in theory, is far more complicated in practice. The central bank must “distinguish between institutions whose liquidity pressures stem primarily from a breakdown in financial market functioning and those whose problems fundamentally derive from underlying concerns about their solvency.”7 Moreover, “[c]‌‌entral banks provide liquidity through a variety of mechanisms, including open market operations and direct credit extension through standing lending facilities. The choice of tools in a crisis depends on the circumstances as well as on specific institutional factors.”8 Central banks in other countries have tools available to them that the Federal Reserve does not. “[T]he Federal Reserve has had to innovate in large part to achieve what other central banks have been able to effect through existing tools.”9 Because crises may involve large financial institutions operating across international borders and in multiple currencies, central banks must work closely together.10 Id. 6 Id. 7 Id. 8 Id. 9 Id. 10 Id. 5

16

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Capital Markets, Derivatives, and the Law

Traditionally, the Federal Reserve has used open market operations to manage the aggregate level of reserves in the banking system and thereby control the federal funds rate.11 The discount window has served as a source of reserves “when conditions in the federal funds market tighten significantly or when individual depository institutions experience short-​term funding pressures.”12 However, this traditional framework for providing liquidity proved inadequate during the recent crisis. This was in part due to the reluctance of depository institutions to use the discount window as a source of funding because of a perceived stigma arising “primarily from banks’ concerns that market participants will draw adverse inferences about the banks’ financial condition if their borrowing from the Federal Reserve were to become known.”13 The Federal Reserve took steps to make discount window borrowing more attractive by narrowing the spread of the primary credit rate over the target federal funds rate and by permitting depositories to borrow for as long as 90 days, renewable at their discretion so long as they remain in sound financial condition. Although these actions had some success in increasing depository institutions’ willingness to borrow, new ways of providing liquidity were necessary. In December 2007, the Federal Reserve introduced the Term Auction Facility (TAF); through which predetermined amounts of discount window credit is auctioned every two weeks to eligible borrowers for terms of 28 days. “The TAF, apparently because of its competitive auction format and the certainty that a large amount of credit would be made available, appears to have overcome the stigma problem to a significant degree.”14 In addition, the Federal Reserve expanded its ability to supply liquidity to primary dealers by initiating as part of its open-​market operations a series of single-​tranche repurchase transactions with terms of roughly 28 days and totaling up to $100 billion. The Federal Reserve also introduced the Term Securities Lending Facility (TSLF), which let primary dealers exchange less-​liquid securities for Treasury securities for terms of 28 days at an auction-​determined fee. (TSLF was closed on February 1, 2010.) The list of securities eligible for such transactions includes all AAA/​Aaa-​ rated asset-​backed securities.15 In mid-​March 2008, Bear Stearns, then a prominent investment bank, “advised the Federal Reserve and other government agencies that its liquidity position had significantly deteriorated and that it would be forced to file for bankruptcy the next

Id. 12 Id. 13 Id. 14 Id. 15 Id. 11

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Liquidity Crisis and Government Reaction

17

day unless alternative sources of funds became available.”16 In order to prevent a much broader liquidity crisis in the overall financial markets, the Federal Reserve “use[d]‌‌ its emergency lending authorities under the Federal Reserve Act to avoid a disorderly closure of Bear. Accordingly, the Federal Reserve, in close consultation with the Treasury Department, agreed to provide short-​term funding to Bear Stearns through J.P. Morgan-​Chase. Over the following weekend, JP Morgan-​Chase agreed to purchase Bear Stearns and assumed the company’s financial obligations.”17 In addition, the Federal Reserve used its emergency authorities to create the Primary Dealer Credit Facility (PDCF), which let primary dealers borrow at the same rate as depository institutions at the discount window, and have borrowings secured by a broad range of investment-​grade securities. The PDCF, which expired on February 1, 2010, provided primary dealers with a liquidity backstop similar to the discount window for depository institutions in generally sound financial condition. The provision of liquidity by a central bank can help mitigate a financial crisis, but it raises the issue of “moral hazard.” [S]‌‌pecifically, if market participants come to believe that the Federal Reserve or other central banks will take such measures whenever financial stress develops, financial institutions and their creditors . . . have less incentive to pursue suitable strategies for managing liquidity risk and more incentive to take such risks. . . . [T]he problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis. . . . [Institutions must] have “adequate processes in place to measure and manage risk, importantly including liquidity risk. . . .” In particular, future liq­ uidity planning will have to take into account the possibility of a sudden loss of substantial amounts of secured financing. . . . [I]‌‌f financial institutions and investors draw appropriate lessons from the recent experience about the need for strong liquidity risk management practices, the frequency and severity of future crises should be significantly reduced.18 By late 2008, short-​term interest rates reached an effective rate of 0 percent, hindering the Federal Reserve’s ability to stimulate growth through additional cuts in the federal funds rate.

16 Id. 17 Id. 18 Id.

18

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Capital Markets, Derivatives, and the Law

In October 2008, President George W. Bush created the Troubled Asset Relief Program (TARP) to strengthen the financial sector in the early stages of the financial crisis. To complement TARP’s effort to increase available funds for commercial banks, in November 2008 the Fed initiated a monetary policy known as “quantitative easing.” Quantitative easing means the central bank purchases financial assets from private institutions, thereby injecting a predetermined quantity of money into the economy, increasing the excess reserves of commercial banks, and decreasing the supply of the assets purchased. This decreased supply raises the price of those assets, which decreases their yield.19 II. Providing Liquidity and Stabilizing the Financial Markets The Federal Reserve provided large amounts of liquidity to the financial system to cushion the effects of tight conditions in short-​term funding markets. In order to reduce the downside risks to growth emanating from the tightening of credit, the Fed significantly lowered its target for the federal funds rate in a series of moves that began in September 2007.20 Chairman Bernanke described the events leading up to increasing Fed intervention to prevent systemic failure. He explained notwithstanding efforts at increasing liquidity, the financial crisis intensified over the summer of 2008: [A]‌s mortgage-​related assets deteriorated further, economic growth slowed and uncertainty about the financial and economic outlook increased. As investors and creditors lost confidence in the ability of certain firms to meet their obligations, their access to capital markets as well as to short-​term funding markets became increasingly impaired and their stock prices fell sharply.21 The investment bank Lehman Brothers and the insurance company AIG experienced this dynamic and were unable to weather the storm:22 (B)oth companies were large, complex and deeply embedded in the American financial system.

Larry Elliot, Business Glossary, Quantitative Easing, Guardian, Jan. 8, 2009, http://​www.guardian.co.uk/​ business/​2008/​oct/​14/​businessglossary. For a complete discussion of the steps the Federal Reserve has taken to improve the economy after 2009, see ­chapter 4. 20 Bernanke, supra note 1. 21 Id. 22 Id. 19

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Liquidity Crisis and Government Reaction

19

Private-​sector solutions were not forthcoming for either entity. A public-​sector solution for Lehman proved infeasible as well, “as the firm could not post sufficient collateral to provide reasonable assurance that a loan from the Federal Reserve would be repaid and the Treasury did not have the authority to absorb billions of dollars of expected losses to facilitate Lehman’s acquisition by another firm. Consequently, little could be done except to attempt to ameliorate the effects of Lehman’s failure on the financial system.”23 According to Bernanke, “in the case of AIG, the Federal Reserve and the Treasury judged that a disorderly failure would have severely threatened global financial stability and the performance of the U.S. economy.”24 The Federal Reserve granted emergency credit to AIG because it felt the credit would be adequately secured by AIG’s assets, but “ensured that the terms of the credit extended to AIG imposed significant costs and constraints on the firm’s owners, managers and creditors.25 “AIG’s difficulties and Lehman’s failure, along with growing concerns about the U.S. economy and other economies, contributed to extraordinarily turbulent conditions in global financial markets [during the fall of 2008]. Equity prices fell sharply. . . . The cost of short-​term credit, where . . . available, jumped for virtually all firms and liq­ uidity dried up in many markets.”26 The flow of credit to households, businesses, and state and local governments was severely restricted and posed a significant threat to economic growth.27 III. Regulatory Reaction at the Height of the Crisis A. The Emergency Economic Stabilization Act At the height of the crisis, the expansion of Federal Reserve lending helped financial firms cope with reduced access to their usual sources of funding and thus supported their lending to non-​financial firms and households. However, the intensification of the financial crisis during the late summer of 2008 made it clear that a more powerful, comprehensive approach involving the fiscal authorities was needed.28 On October 3, 2008, after a previously failed attempt at legislation, Congress passed and President George W. Bush signed the Emergency Economic Stabilization Act (EESA).29 The Act provides important new tools for addressing the distress in financial markets 23 Id. 24 Id. 25 Id. 26 Id. 27 Id. 28 Id. 29 Pub. L. No. 110–​343 (H.R. 1424).

20

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Capital Markets, Derivatives, and the Law

and thereby mitigates the risks to the economy. The Act allows the Treasury to buy troubled assets, provide guarantees, and inject capital to strengthen the balance sheets of financial institutions.30 TARP, authorized by the legislation, allowed the Treasury, under the supervision of an oversight board, to undertake two highly complementary activities: (1) using TARP funds to help recapitalize the banking system by purchasing nonvoting equity in financial institutions, and (2) using some of the resources provided under the bill to purchase troubled assets from banks and other financial institutions, in most cases using market-​based mechanisms. Media attention surrounding the passage of the bill focused on mortgage-​related assets, including mortgage-​backed securities and whole loans, but the law provides flexibility regarding the types of assets that can be purchased as needed to promote financial stability. The Act defines a “troubled asset” as follows: The term “purchase of troubled assets” means—​ (A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and (B) Any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress.31

The flexibility resulting from the definition of “troubled asset” under the Act enabled the Treasury to purchase preferred equity of banks directly from the banks. Although TARP is evolving into direct government involvement in the banking activities of privately owned financial institutions, the manifest goal of the Act was to provide equity capital to the banking system, thereby helping credit flow more freely, thus supporting economic growth.32 The funds allocated to the TARP program were not simple expenditures, but rather involved acquisitions of assets or equity positions, which the Treasury could

See Bernanke, supra note 1. 31 Pub. L. No. 110-​343, § 3, 122 Stat. 3766 (Oct. 3, 2008). 32 Id. Furthermore, the Act itself describes its purpose as “provid[ing] authority for the Federal Government to purchase and insure certain types of troubled assets for the purposes of providing stability to and preventing disruption in the economy and financial system and protecting taxpayers.” 30

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Liquidity Crisis and Government Reaction

21

then sell or redeem down the road. Indeed, according to the U.S. Treasury, “those programs have also earned a significant profit for taxpayers. Treasury invested a total of $245 billion and has already [as of December 18, 2012] recovered $268 billion through repayments, dividends, and other income—​representing a $23 billion positive return for taxpayers to date.”33 Though, more significantly, the economic benefit of these programs was the impact they had on financial market stability in a time of crisis. Chairman Bernanke explained at the time that if TARP is successful in promoting financial stability and, consequently, in supporting stronger economic growth and job creation, it will have proved itself a very good investment indeed, to everyone’s benefit.34 The EESA also raised the limit on deposit insurance from $100,000 to $250,000 per account.35 In addition, the Federal Deposit Insurance Corporation (FDIC) put forth a plan to provide a broad range of guaranties of the liabilities of FDIC-​insured depository institutions, including their associated holding companies. The costs of the FDIC guaranties are covered by fees and assessments on the banking system and are not incurred directly by taxpayers.36 The effort taken by Congress in enacting the EESA was a critical first step in stabilizing the capital markets. Economic recovery depends greatly on when and to what extent financial and credit markets return to more normal functioning.37 Vital to improving the broader economy is the restoration of consumer and investor confidence, not limited to the credit and financial markets. B. American Recovery and Reinvestment Act

As the EESA recapitalized banking institutions and stabilized financial markets in an effort to encourage economic growth and job creation, Congress took additional steps to stem economic contraction. A dramatic decline in jobs and rapid growth in the unemployment rate, both more severe than in any other recession since World War II,38 threatened the recovery.

http://​www.treasury.gov/​connect/​blog/​Pages/​An-​Update-​on-​the-​Wind-​Down-​of-​TARP’s-​Bank-​Programs. aspx (last visited Aug. 2, 2018). 34 Supra note 1. 35 Id. 36 Id. 37 Id. 38 Ben S. Bernanke, On the Outlook for the Economy and Policy, Address at the Economic Club of New York (Nov. 16, 2009), available at http://​www.federalreserve.gov/​newsevents/​speech/​bernanke20091116a.htm (last visited December 1, 2018). 33

2

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In December 2007, just before the official beginning of the recession, the national unemployment rate rested at 5 percent, a level it had not exceeded for the previous 30 months.39 In the previous decade, the unemployment rate had crept over 6 percent only for a period of seven months in 2003.40 However, over the next two years the unemployment rate climbed quickly and steadily to over 10 percent and the U.S. economy lost approximately 8 million private sector jobs.41 In 2009, workers who did manage to retain their jobs found that their hours were being reduced. This created an environment in which the number of workers seeking full-​time employment without success doubled, while the average workweek for production and nonsupervisory workers fell to 33 hours, the lowest level in the postwar period.42 Such data suggested that the excess labor supply was greater even than that recorded by the unemployment numbers. Additionally, the glut of available workers allowed businesses to hire all the workers necessary without needing to increase wages. In some instances businesses were even able to hire workers at a decreased wage level. The combination of slow wage gains and a decrease in hours worked depressed labor income, which in turn restrained household spending.43 Chairman Bernanke noted in a 2009 speech: “The best thing we can say about the labor market right now is that it may be getting worse more slowly.”44 In response to rising unemployment and general economic stagnation, President Barack Obama signed the American Recovery and Reinvestment Act (ARRA) on February 17, 2009.45 Hailing it as a “beginning to what we need to do to create jobs for Americans scrambling in the wake of layoffs . . . paving the way to long term growth and prosperity.”46 The Act appropriated funds for “job preservation and creation, infrastructure investment, energy efficiency and science, unemployment assistance and State and local fiscal stabilization.”47 At a cost of $831 billion paid out between 2009 and 2019, with 90 percent of the budgetary impact realized by December 2011,48 the Act’s primary purpose was to Bureau of Labor Statistics, Spotlight on Statistics, The Recession of 2007–​2009 (Feb. 2012). 40 Id. 41 Bernanke, supra note 38. 42 Id. 43 Id. 44 Id. 45 Pub. Law No. 111-​5 (H.R. 1). 46 Barack Obama, Remarks by the President and the Vice President at the Signing of the American Recovery and Reinvestment Act, Denver Museum of Nature and Science (Feb. 17, 2009). 47 Pub. Law No. 111-​5 (H.R. 1). 48 Congressional Budget Office, Estimated Impact of the American Recovery and Reinvestment Act on Employ­ ment and Economic Output from October 2011 through December 2011 (Feb. 22, 2012), http://​www.cbo.gov/​ publication/​43013. 39

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create new jobs and save old ones through wide-​ranging direct spending initiatives that constitute “the most sweeping economic recovery package in our history.”49 Since 2011 the U.S. economy has improved dramatically. In 2019 President Trump is establishing a lighter regulatory touch, the economy is growing and employment has been restored to pre-​crisis levels. Indeed, across sectors, unemployment rates have reached historic lows. Under President Trump, Congress passed sweeping tax reductions that may have put the recovery initiated under the prior administration into a full throttle forward drive. Whatever the political realities, the facts are incontrovertible that the financial crisis, as of 2018, is behind us, yet the regulatory reforms that arose in reaction to the crisis survive. IV. Dodd-​Frank On July 21, 2010, President Obama signed the Wall Street Reform and Consumer Protection Act (WSRCPA),50 widely known as the “Dodd-​Frank Act,” a massive piece of financial legislation encompassing a wide range of reforms intended to stabilize financial markets through enhanced oversight, reduction of risk, and improved consumer protection. Its 2,200 pages direct enactment of over 200 new or expanded regulations by federal agencies.51 A guiding concern for the entire Act was the broad systemic fragility exposed by the crisis. Between the end of the Great Depression and the early 2000s, the financial system weathered numerous shocks and crashes without significant damaging spillover into the economy, as the Fed provided a liquidity safety net.52 In 2007 and 2008, however, this self-​stabilization capacity failed spectacularly. In written testimony delivered to the House Financial Services Committee in September 2009, then treasury secretary Timothy F. Geithner commented, “The job of the financial system . . . is to efficiently allocate savings and risk. Last fall, our financial system failed to do its job and came precariously close to failing altogether.”53 Against this background, regulators sought to combine effective and unifying umbrella

Obama, supra note 46, 50 Pub. Law No. 111-​203 (H.R. 4173). 51 Robert A.G. Monks & Nell Minow, Corporate Governance 394 (5th ed. 2011). 52 Congressional Research Service, Dodd-​Frank Wall Street Reform and Consumer Protection Act: Issues and Summary ( July 29, 2010), www.llsdc.org/​attachments/​files/​232/​CRS-​R41350.pdf. 53 House Financial Services Committee, Financial Regulatory Reform (Sept. 23, 2009) (written testimony of Timothy F. Geithner), available at http://​www.derivsource.com/​articles/​treasury-​secretary-​ timothy-​f-​geithner-​written-​testimony-​house-​financial-​services-​committee-​. 49

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regulation with reform sensitive to the myriad sectors, participants, and products involved in the financial markets.54 The Act created the Financial Stability Oversight Council (FSOC) to expose regulatory gaps, oversight failures, and inconsistent application of regulatory standards resulting from the sheer number of federal and state agencies responsible for monitoring the financial markets. The Council is charged with identifying systemically vital financial firms to the Fed, which can then impose stricter oversight to minimize the risk those firms pose to the overall health of the system. This oversight includes implementation of “short-​term debt limits, a 10% liability concentration limit, counterparty exposure set at 25% of total capital, risk-​based capital requirements, annual stress tests and leverage limits.”55 The Act also creates numerous support agencies, including the Consumer Financial Protection Bureau and the Office of Financial Research, to assist the Council in fulfilling its mandate to monitor the financial markets, coordinate information sharing among agencies, promote market discipline, recommend supervisory priorities, and evaluate the market’s integrity, competitiveness, and efficiency. The Council annually reports its findings to Congress.56 Dodd-​Frank also addresses an enormous range of policy concerns related to the financial markets. It established the Consumer Financial Protection Bureau to improve consumer protections related to the offering of loans and other financial products; encourages transparency and accountability by requiring centralized clearing and exchange trading of many over-​the-​counter financial instruments, such as derivatives; imposes capital and leverage requirements in an effort to avoid “too big to fail” bailouts; ensures enforcement of financial laws already on the books; reforms corporate governance and executive compensation; and expands regulatory authority over credit ratings agencies that came under increased scrutiny due to alleged ratings failures, particularly of mortgage-​backed securities.57

Congressional Research Service, Dodd-​Frank, supra note 52. 55 Id. 56 Morrison & Foerster, The Dodd Frank Act: A Cheat Sheet, MoFo.com (2010), available at http://​media. mofo.com/​files/​uploads/​Images/​SummaryDoddFrankAct.pdf. 57 Congressional Research Service, Dodd-​Frank, supra note 52. 54

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Frank and the Regulation of Depository Institutions 3 Dodd-​ Capital Requirements



I. II. III. IV.

The Volcker Rule and “Too Big to Fail”  26 Bank Holding Companies and Systemically Significant Nonbanks  29 Living Wills, Credit Exposure Reports, and Concentration Limits  32 Other Prudential Standards  35

Implementation of Dodd-​F rank has been a dynamic and expensive process, as agencies follow through on congressionally mandated rule making and market participants alter behavior in response to a new regulatory regime. The legislation had dramatic effects on the operation and stability of the financial markets in the years since its passage and will continue to play a vital role in the capital markets. Capital requirements are a critical facet of Dodd-​Frank. These requirements are designed to reduce systemic risk. Dodd-​Frank states: The appropriate Federal banking agencies shall establish minimum leverage [and risk-​based] capital requirements on a consolidated basis for insured depository institutions, depository institution holding companies, and nonbank financial companies supervised by the Board of Governors. The minimum leverage [and risk-​based] capital requirements established under this paragraph shall not be less than the generally applicable leverage [and risk-​based] capital Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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requirements, which shall serve as a floor for any capital requirements that the agency may require, nor quantitatively lower than the generally applicable leverage [and risk-​based] capital requirements that were in effect for insured depository institutions as of the date of enactment of this Act.1 In addition to establishing new capital and leverage requirements for banks, Bank Holding Companies (BHCs), and Systemically Significant Nonbanks (SSNBs), Dodd-​Frank also mandates that these requirements be “countercyclical, so that the amount of capital required to be maintained by a company increases in times of economic expansion and decreases in times of economic contraction.”2 I. The Volcker Rule and “Too Big to Fail” The Volcker Rule, named after former chairman of the Federal Reserve Bank Paul Volcker, combats systemic risk posed by “too big to fail” institutions by instituting two significant restrictions: “banking entities”3 may not (1) engage in proprietary trading, or (2) have any equity, partnership, or other ownership interest in a hedge fund or private equity fund, subject to certain exceptions.4 The rule took effect on July 21, 2012, though covered entities were given two years to conform to the rule’s restrictions.5 The Volcker Rule aims to prevent banks “from making risky market bets while accepting taxpayer-​insured deposits.”6 It prevents banks from engaging in risky market bets with their own accounts and limits their relationships with hedge funds and other private funds. According to Paul Volcker, a ban on proprietary trading by bank holding companies is necessary because “Proprietary trading of financial instruments . . . does not justify the taxpayer subsidy implicit in routine access to Federal Reserve credit, deposit insurance or emergency support.”7 Senator Jeffery Merkley, the senator who

1 D.F.A. § 171(b). 2 D.F.A. § 616(a), (b), (c). 3 Dodd-​Frank defines “banking entity” as any depository institution insured by the FDIC, or any of that institution’s affiliates, subsidiaries, or parents, not including limited purpose trust companies. § 619(h). 4 D.F.A. § 619(a). 5 Press Release, Board of Governors of the Federal Reserve System, Volcker Rule Conformance Period Clarified (Apr. 19, 2012), available at http://​www.federalreserve.gov/​newsevents/​press/​bcreg/​20120419a.htm. 6 CNBC, U.S. Regulators Are Examining Wall Street’s “Volcker Rule” Wish List (Feb. 28, 2018). 7 Comment Letter from Paul Volcker to the OCC, Board of Fed Governors, FDIC, SEC, and CFTC, Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds (Feb. 13, 2012), available at http://​www.valuewalk.com/​2012/​02/​volcker-​files-​ comment-​letter-​against-​yes-​the-​volcker-​rule/​.

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introduced the Volcker Rule as an amendment to Dodd-​Frank, argued that the ban on proprietary trading reduces systemic risk by separating commercial banking from hedge funds and private equity firms: Put simply, the Volcker Rule takes deposit-​taking, loan-​making banks out of the hedge fund business. While hedge funds have their place in capital allocation, that place is not in commercial loan-​making banks subsidized by FDIC insurance and the Fed discount window. The reason is simple: our banking system and our economy do better if the periodic bad bets of hedge funds blow up only the hedge funds and not our lending system that fuels economic growth and job creation.8 In the immediate aftermath of Dodd-​Frank becoming law, many investment banks wound down their proprietary trading arms.9 This occurred even before a group of federal agencies10 issued proposed regulations (“the Joint Rule”) on November 7, 2011, seeking to implement Dodd-​Frank’s ban on proprietary trading.11 The plain language of the statute itself made it clear that proprietary trading arms had to be wound down. Nonetheless, the notice-​and-​comment period was open until February 15, 2012, and the final regulations were supposed to have been promulgated by July 21, 2012.12 During the notice-​and-​comment period, the agencies received roughly 17,000 comments and letters regarding all aspects of the Joint Rule.13 In addition, the statute called on the Financial Stability Oversight Council to issue a study with recommendations to the agencies on how best to craft the regulations. The study was released by the FSOC in January 2011.14 Senator Jeffrey Merkley, Defending a Strong Volcker Rule, The Harvard Law School Forum on Corporate Governance and Financial Regulations ( Jan. 31, 2012), available at http://​blogs.law.harvard.edu/​corpgov/​ 2012/​01/​31/​defending-​a-​strong-​volcker-​rule/​#more-​25210. 9 For example, Goldman Sachs wound down its large Principal Strategies desk in 2010, and began winding down its smaller Global Macro Proprietary Trading group in 2011. Other large banks, such as Morgan Stanley, J.P. Morgan & Chase, and Bank of America, have also taken action to wind down their proprietary trading arms. 10 The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (“the Board”), Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC), and the Commodities Futures Trading Commission (CFTC), adopt rules necessary to carry out the Volcker Rule’s mandate. 11 The Joint Rule at 68846. 12 Id. 13 Craig Torres, Bernanke Says Dodd Frank’s Volcker Rule Won’t Be Ready by July 21 Deadline, Bloomberg, Feb. 29, 2012, available at http://​www.bloomberg.com/​news/​2012-​02-​29/​bernanke-​says-​dodd-​frank-​s-​volcker-​ rule-​won-​t-​be-​ready-​by-​july-​21-​deadline.html. 14 Study and Recommendations on Prohibitions on Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds ( Jan. 2011), The Financial Stability and Oversight Council, available at http://​ www.google.com/​url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CCgQFjAA&url=http%3A 8

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Fed Vice Chairman for Supervision, Randal Quarles, said “the Volcker Rule is an example of a complex regulation that is not working well.”15 For each analyzed part of the rule, the quality of the rule itself is challenged because the “one-​size fits all” approach16 has put too many requirements on companies that didn’t deserve this level of protection. In addition to this global approach, the ambiguity of the definitions of the terms used in the rule combined with regulators’ broad authority to interpret and modify the statute has led to an “unworkable and ineffective rule.”17 As a result, the rule has not solved the initial problem of preventing financial institutions to invest depositors’ money into speculative activities. Rather, it has reduced liq­ uidity especially in the market for corporate debt instruments, and inhibited capital formation.18 On February 3, 2017, President Trump issued an executive order19 that established the policy of his administration to regulate the U.S. financial system in a manner consistent with a set of “Core Principles.” In line with the motto “make America great again,” one of the principles is “empowering American investors and enhancing the competitiveness of American companies.” It gives the Treasury the authority to restructure major provisions of Dodd-​Frank, and it directs the Treasury secretary to make sure existing laws align with administration goals. In response to the executive order, the U.S. Treasury Department issued several reports. One of them, focusing on banks, recommends several modifications to the Volcker Rule.20 Although the Treasury report seeks to reduce the cost and burden of compliance on banks, it cannot be viewed as a new deregulation movement. Rather the recommendations of the Treasury are viewed as “too little too late” as impacted banks have already spent significant time and resources over the last four years to alter their business models to meet the rule’s requirements.21 However, on February 27, 2018, Fed Chairman Jerome Powell said before Congress: “We’re taking a fresh look at the Volcker rule.” Taking these recommendations into consideration, the

%2F%2Fwww.treasury.gov%2Finitiatives%2Fdocuments%2Fvolcker%2520sec%2520%2520619%2520study %2520final%25201%252018%252011%2520rg.pdf&ei=y46dT5uCFube0QG9i_​nsDg&usg=AFQjCNFprW_​ SWB_​HwbLSVI4pkfgDRP2HAA&sig2=arAXa9wCwLwZoCvs-​W6-​_​w. [hereinafter “The FSOC Study”]. 15 Mar. 5, 2018—​The Institute of International Bankers conference 16 PWC, July 2017—​Volcker Rule: Under review until further notice 17 Charles A. Piasio, It’s Complicated: Why the Volcker Rule Is Unworkable, 43 Seton Hall L. Rev. 737 (May 2013). 18 U.S. Department of the Treasury, Report, A Financial System That Creates Economic Opportunities—​Banks and Credit Unions ( June 2017). 19 Executive Order 13772, Feb. 3, 2017. 20 U.S. Department of the Treasury, A Financial System That Creates Economic Opportunities Banks and Credit Unions, June 2017. 21 Id.

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Senate passed the Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCPA) on March 14, 2018, seeking to amend the Dodd-​Frank Act and consequently the Volcker Rule.22 II. Bank Holding Companies and Systemically Significant Nonbanks During the financial crisis and the widespread government bailouts it entailed, “too big to fail” became a common term to describe implicit and explicit government guarantees of firms deemed integral to the U.S. economy because the firms’ failure would threaten economic collapse. The term also referred to the moral hazard of creditors supplying capital to these firms with the expectation of government protection. By not facing any downside to their investment, creditors were incentivized to fund these institutions regardless of potential losses, mispricing risk, and the inefficient allocation of capital. Title I of the Dodd-​Frank Act broadly addresses financial stability concerns through the establishment of two new government agencies tasked with monitoring the financial system and through the creation of prudential standards intended to mitigate systemic risk. A brief overview of Title I’s major provisions as they relate to banking regulation and the designation of systemically significant bank holding companies23 and nonbank financial companies will provide the context for the prudential standards that apply to these entities. Title I creates the Federal Stability Oversight Council (FSOC), a council of regulators consisting of 10 voting members24 and 5 nonvoting members.25 The Council meets at least once every three months, with most issues decided by simple majority voting.26 The FSOC is responsible for a host of regulatory mandates related 22 S.2155. 23 Any company that has control over a bank or over a company that is a bank holding company. See Bank Holding Company Act of 1956, 12 U.S.C. § 1841(a). Examples include Bank of America, JPMorgan Chase, Citigroup, and Goldman Sachs. 24 The 10 voting members are: the Secretary of the Treasury, who serves as Chairperson; the Chairman of the Board of Governors; the Comptroller of the Currency; the Director of the Bureau of Consumer Financial Protection; the Chairman of the SEC; the Chairperson of the Federal Deposit Insurance Corporation; the Chairperson of the Commodity Futures Trading Commission; the Director of the Federal Housing Finance Agency; the Chairman of the National Credit Union Administration; and an independent member appointed by the president who has expertise in the field of insurance and serves a six-​year term. D.F.A. § 111(b)(1), D.F.A. § 111(c)(1). 25 The five nonvoting members are: the Director of the Office of Financial Research, the Director of the Federal Insurance Office, a State Insurance Commissioner (two-​year term), a State Banking Supervisor (two-​year term), and a State Securities Commissioner (two-​year term). D.F.A. § 111(b)(2), D.F.A. § 111(c)(1). 26 D.F.A. § 111(f ). Some actions require a two-​thirds vote and an affirmative vote by the Chairperson.

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to the risks posed by large, interconnected banks and bank holding companies, both domestic and foreign. Among other tasks, the FSOC collects information and facilitates information sharing and coordination among various regulatory entities, monitors domestic and international proposals and developments, advises Congress, and identifies regulatory gaps.27 All bank holding companies with total consolidated assets of at least $50 billion are considered systemically significant and are thus subject to prudential standards administered by the Fed, though, the FSOC and the Federal Reserve Board (FRB) may exercise discretion in applying stricter standards to bank holding companies of all asset levels, based on an assessment of riskiness, complexity, size of the company, and other relevant factors.28 The FSOC can also determine if nonbanks are systemically significant. An assessment that a nonbank might be systemically significant triggers supervision by the Federal Reserve’s Board of Governors.29 A nonbank financial company must be “predominantly engaged” in financial activities in order to be subject to heightened prudential standards and FRB supervision. To be “Predominantly engaged” means that 85 percent or more of the company’s consolidated annual gross revenues or assets come from activities of a financial nature30 and from the ownership of an insured depository institution, if applicable.31 However, meeting this threshold is not sufficient for a nonbank to be labeled systemically significant. The Act requires a two-​thirds majority vote, including an affirmative vote by the Chairperson, after a determination of the potential impact of the company’s material financial distress on the financial stability of the United States.32 Relevant factors to the determination include the company’s leverage, off-​balance sheet exposure, transactions and relationships with other nonbank companies and BHCs, importance of the company as a source of credit and liquidity in the United States, degree to which the company is already regulated, and various other items.33

D.F.A. § 112(a). 28 D.F.A. § 115(a), (b). Foreign banks and foreign bank holding companies are likewise treated as systemic bank holding companies (as defined in the Bank Holding Company Act of 1956) by Dodd-​Frank when their consolidated assets are valued at $50 billion or more. Id.; see D.F.A. § 102(a). 29 D.F.A. § 112(a). 30 Bank Holding Company Act of 1956 § 4(k). 31 D.F.A. § 102(a). 32 D.F.A. § 113(a). The FSOC may likewise determine that a foreign nonbank financial company should be subject to FRB supervision by a two-​thirds majority vote after an assessment of the company’s systemic significance based on a range of factors similar to those considered for a domestic nonbank financial company. D.F.A. § 113(b). The foreign company should be organized under the laws of a country other than the United States and should be predominantly engaged in activities of a financial nature. D.F.A. § 102(a). 33 D.F.A. § 113(a). 27

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A U.S. nonbank financial company that is notified of its possible designation as systemically significant has 30 days to contest the proposed designation and request a hearing.34 Though, the Council maintains final determination power.35 The FSOC may further require systemically risky bank holding companies or nonbanks to submit reports36 that clarify the company’s financial state and its capacity to undermine the stability of financial markets.37 All information received by the Council is kept confidential.38 Title I also establishes the Office of Financial Research (OFR) under the umbrella of the Treasury Department. A presidential appointee who is confirmed by the Senate directs the OFR,39 which is funded by payments from systemically significant bank holding companies and nonbank financial companies.40 It includes a Data Center and a Research Analysis center that collect, analyze, and monitor data related to systemic risk and provide it on an as necessary basis to the FSOC and other regulatory agencies.41 The OFR may also subpoena financial companies to obtain the information it requires to fulfill its mandate.42 Dodd-​Frank grants the Federal Reserve Board broad authority to supervise and impose a range of prudential standards on large bank holding companies (total consolidated assets of $50 billion or more) and systemically significant nonbanks.43 The standards must be more stringent than those applicable to bank holding companies and nonbank financial companies that pose less of a risk to financial stability and must increase in stringency based on (1) the same factors used by the FSOC to determine whether a particular institution is systemically significant, (2) the question of whether the company owns an insured depository institution, (3) the company’s nonfinancial activities and affiliations, and (4) any other factors the FRB believes relevant.44 The FRB may apply different prudential standards to a category of companies or to companies individually, taking into account capital structure, complexity, and other risk-​related factors.45 In determining standards for a foreign BHC or nonbank, the FRB must give “due regard” to the principle of

D.F.A. § 113(e). 35 Id. 36 D.F.A. § 112(d). 37 D.F.A. § 116(a). 38 D.F.A. § 112(d). 39 D.F.A. § 152(b). 40 D.F.A. § 155(d). 41 D.F.A. § 154(a), (b). 42 D.F.A. § 154(b). 43 D.F.A. § 165(a). 44 Id. 45 Id. 34

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national treatment and equality of competitive opportunity, and take into account the extent to which the foreign company is subject to comparable home country standards.46 III. Living Wills, Credit Exposure Reports, and Concentration Limits BHCs and nonbanks under FRB supervision must periodically submit a resolution plan, colloquially known as a living will, to the FRB, the FSOC, and the FDIC that describes the rapid and orderly resolution of the company in the event of material financial distress or failure.47 The plan must include information about the protection of any depository institutions affiliated with the company from any risks arising from the company’s nonbank subsidiaries; descriptions of the company’s assets, ownership structure, liabilities, and contractual obligations; identification of counterparties, guarantees, and collateral pledges; and any other information the FRB or FDIC demands by rule.48 On October 17, 2011, the FRB and FDIC published final regulations for Dodd-​ Frank’s living will requirement that apply to “covered companies.” According to the Federal Reserve: The final rule requires bank holding companies with assets of $50 billion or more and nonbank financial firms designated by the Financial Stability Oversight Council for supervision by the Board to annually submit resolution plans to the Board and the Federal Deposit Insurance Corporation. Each plan will describe the company’s strategy for rapid and orderly resolution in bankruptcy during times of financial distress. A resolution plan must include a strategic analysis of the plan’s components, a description of the range of specific actions the company proposes to take in resolution, and a description of the company’s organizational structure, material entities, interconnections and interdependencies, and management information systems. Under the final rule, companies will submit their initial resolution plans on a staggered basis. The first group of companies, generally those with $250 billion or more in non-​bank assets, must submit their initial plans on or before July 1, 2012; the second group, generally those with $100 billion or more, but

46 D.F.A. § 165(b) 47 D.F.A. § 165(d). The supervised entity must also submit a credit exposure report to the same agencies. Id. 48 Id.

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less than $250 billion, in total non-​bank assets, must submit their initial plans on or before July 1, 2013; and the remaining companies, generally those subject to the rule with less than $100 billion in total non-​bank assets, must submit their initial plans on or before December 31, 2013.49 If the FRB and FDIC determine that the submitted living will would not result in an orderly resolution of the company under Chapter 11 of the Bankruptcy Code, the company is notified and given a period of time to re-​ evaluate and resubmit the proposal with revisions.50 Failure to do so can trigger imposition of stringent capital and liquidity requirements and/​or operational restrictions.51 If the company then does not resubmit an acceptable living will within two years and fails during that time, the FRB and FDIC can order divestiture of certain assets or operations to facilitate orderly resolution.52 FRB-​supervised entities must also satisfy concentration requirements intended to limit a systemically significant BHC’s or non-​bank’s credit exposure to another company, so that the failure of the other company will not in turn bring down the BHC or SSNB.53 No FRB-​supervised entity may have credit exposure to an unaffiliated company that exceeds 25 percent of the capital stock and surplus of the BHC or SSNB.54 These requirements apply to any transaction between a FRB-​supervised company and an entity where the proceeds of the transaction are used for the benefit of, or transferred to, the company.55 Section 165 of the Dodd-​Frank Act requires the Federal Reserve Board to adopt enhanced capital standards, including supervisory stress tests, company-​run stress tests, and enhanced risk-​based and leverage capital requirements, for bank holding companies with total consolidated assets of $50 billion or more. The Board’s supervisory stress test known as the Comprehensive Capital Analysis and Review (CCAR) evaluates whether firms have sufficient capital to continue operations throughout times of economic and financial stress using firm-​provided data and a common set of scenarios, models, and assumptions. The Fed’s stress tests are the binding constraint 49 Dec. 13, 2013, http://​www.federalreserve.gov/​newsevents/​press/​bcreg/​20111017a.htm. 50 D.F.A. § 165(d). 51 Id. 52 Id. 53 Credit exposure includes all extensions of credit, repurchase, and reverse repurchase agreements; securities lending and borrowing agreements to the extent they create credit risk; guarantees and letters of credit; purchases of or investments in securities; counterparty credit exposure in connection with derivatives transactions between an unaffiliated company and the FRB-​supervised entity; or any similar transactions that the FRB deems a credit exposure. D.F.A. § 165(e). 54 Id. 55 Id.

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on bank capital requirement. Because banks have to keep large amounts of capital in case of an emergency (stress) situation, they are prevented from using this money. Accordingly, Fed’s stress tests affect banks’ lending. The stress tests require banks to prove they could survive extreme adverse scenarios while still complying with global capital requirements. The aim of capital requirements is to protect the banks themselves, their customers, the government, and the economy, by making sure that banks hold enough capital to ensure continuation of a safe and efficient market. However, two main problems are highlighted by the banking industry. First, they highlight that the Fed’s adverse scenarios are extreme. There is no open consultation with experts, industry or the general public as to whether these scenarios are plausible.56 The second problem pointed out is that the Fed’s stress tests depend on government financial models to predict bank losses. Since these models are never held up to the public scrutiny, the banking industry said there is no way to know whether they are accurate or well-​justified.57 As a result, the Fed’s stress tests restrain banks in lending and the economy in growing. In January 2017, the Federal Reserve Board adopted a rule to reduce the burden associated with the qualitative aspects of CCAR for less complex firms. Under this rule, firms that are not identified as GSIBs and that have average total consolidated assets of $50 billion or more but less than $250 billion, and total nonbank assets of less than $75 billion (large and noncomplex firms) are no longer subject to the provisions of the capital plan rule whereby the Board may object to a firm’s capital plan on the basis of qualitative deficiencies in the firm’s capital planning process.58 Additionally, in December 2017, the Board released a package of proposals that would increase the transparency of the supervisory stress test.59 The Treasury report recommends focusing on banking entities with at least $10 billion in trading assets and liabilities on a consolidated basis, rather than the current application to all banking entities with over $50 billion in total consolidated assets.60 The Treasury wants to tailor compliance programs and eliminates metrics not necessary for effective supervision.61 In April 2018, the Board of Governors of the Federal Reserve issued a notice of proposed rulemaking that would integrate the Board’s regulatory capital rule and the Board’s CCAR and stress test rules in order to simplify the capital regime applicable 56 Is It Time to Roll Back U.S. Bank Regulation?, Fin. Times, Mar. 1, 2018 57 Id. 58 81 Federal Register 9308 (Feb. 3, 2017). 59 82 Federal Register 59529 (Dec. 15, 2017). 60 12 C.F.R. 248.20(c). 61 U.S. Treasury Report, A Financial System That Creates Economic Opportunities: Banks and Credit Unions.

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to firms subject to the capital plan rule.62 It would introduce a “stress capital buffer,” or SCB, which would in part integrate the forward-​looking stress test results with the Board’s non-​ stress capital requirements. The result would produce capital requirements for large banking organization that are firm-​specific and risk-​sensitive. This is not at all the capital requirement relief the banks expected. Rather, the proposal creates a new, adjustable buffer that has a floor of 2.5 percent but that could go higher based on how much capital a bank loses in the hypothetical stress scenario.63 IV. Other Prudential Standards Certain other requirements increase transparency and regulate risk management by BHCs and SSNBs. Dodd-​Frank grants authority to the FRB to require public disclosures to facilitate market assessment of the company’s risk profile and capitalization,64 and each BHC that is a public company and has consolidated assets of more than $10 billion will be required to establish a risk committee for oversight of the company’s risk management practices that includes one risk expert.65 At the FRB’s discretion, BHCs with less than $10 billion of assets may be required to establish a risk committee as well.66 Dodd-​Frank also imposes new limitations on mergers and acquisitions involving large BHCs and SSNBs. Such a company may not acquire, directly or indirectly, ownership or control of any voting shares of any company, other than an insured depository institution, that is engaged in financial activities under 4(k) of the Bank Holding Company Act and has consolidated assets of $10 billion or more, without prior notice to the FRB.67 In reviewing a proposed transaction, the FRB will consider the extent to which the merger or acquisition would create larger or more concentrated risks to the financial system.68 The U.S. economy is on a positive path. The “Great Recession” and financial crisis of the first decade of this century may offer lessons on how to shore up the global economic system going forward. The unanswered question is whether the lessons of the financial crisis will stand the test of time. Board of Governors of the Federal Reserve Board, Proposed Rule Regarding the Stress Buffer Requirements (Apr. 5, 2018). 63 Aaron Back, The Fed’s New Rules Are a Letdown for Wall Street (Apr. 11, 2018), https://​www.wsj.com/​articles/​ the-​feds-​new-​rules-​are-​a-​letdown-​for-​wall-​street-​1523462199. 64 D.F.A. § 165(f ). 65 D.F.A. § 165(h). 66 Id. 67 D.F.A. § 163(b). 68 Id. 62

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4 Using Financial Instruments

I. Goal-​Oriented Investing  37 A. Using Financial Instruments to Hedge Risk  39 B. Using Financial Instruments to Enhance Yield  39 C. The Economy’s Impact on Financial Instruments  40 II. Achieving Investment Goals  41 A. The Investor’s Perspective  41 B. Financial Instrument Objectives  43 III. Managing Risk  45

I. Goal-​Oriented Investing The capital markets represent the opportunity for an enterprise to access capital to maintain its level of business activity. Therefore, ensuring the stability of the capital markets and preventing systemic failure are paramount concerns of the Federal Reserve (the Fed) and other financial market regulators. By shoring up the capital

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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markets, the Fed furthers its legislated goals of fostering an environment with maximum sustainable growth, minimum unemployment, and reasonable inflation.1 Access to the capital markets is facilitated through the use of financial instruments that allow risk to be negotiated among market participants. Fundamentally, a corporation needs capital to run its daily operations or to pay for future endeavors. A corporation can use financial instruments to raise that capital by issuing either debt or equity instruments.2 However, a corporation can use financial instruments for more than simply acquiring capital, as they can be used to achieve two other main goals: hedging risk and enhancing yield. Financial instruments can serve two objectives: (1) providing price stability in an unpredictable financial market, or (2) benefiting investors from price movements.3 To carry out the first objective, corporations can use financial instruments to hedge against adverse moves in financial or commodity prices.4 In furtherance of the second objective, corporations seeking profit from financial market moves (also known as “yield enhancement”) can engineer financial instruments that are susceptible to dramatic increases in value when an underlying asset changes in value.5 Derivatives are risk-​shifting agreements, the value of which is derived from an underlying asset, index, or other investment. Derivatives can be used to facilitate both of these objectives. There are four categories of derivatives: forwards, futures, options, and swaps.6 Derivatives can be structured into complex financial instruments whose pricing is based on optionality and rocket science. However, the basic structure of derivatives can be quite simple. In structuring derivative instruments designed to shift risk from one party who is less willing or able to assume that risk to another who is more willing or able to assume that risk, market participants are able to utilize derivatives to maximize enterprise goals. Derivatives can be used to “facilitate identification, isolation and separate management of fundamental risks.”7 Entities can employ derivatives to achieve various goals of cash flow, interest rate, and currency liquidity.8

1 See Federal Reserve Act § 2a, 12 U.S.C. § 225a as added by act of November 16, 1977 (91 Stat. 1387) and amended by acts of Oct. 27, 1978 (92 Stat. 1897); Aug. 23, 1988 (102 Stat. 1375); and Dec. 27, 2000 (114 Stat. 3028). 2 See ­chapter 2, Sec. II.A., supra. 3 See Proctor & Gamble Co. v. Bankers Trust Co, 925 F. Supp. 1270, 1275–​76 (S.D. Ohio 1996). Citing Henry Hu, Hedging Expectations: “Derivative Reality” and the Law of Finance of the Corporate Objective, 73 Texas L. Rev. 985 (1995). 4 Id. at 1275. 5 Id. at 1275–​76. 6 Derivatives are discussed in detail in ­chapter 8, infra. 7 Thomas C. Singher, Regulating Derivatives: Does Transnational Regulatory Cooperation Offer a Viable Alternative to Congressional Action?, 18 Fordham Int’l L.J. 1397, 1405 (1995). 8 Id.

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It is a fundamental premise, however, that although financial instruments can be used to generate profits, they are also accompanied by risk, and risk and reward are inversely proportional. Attorneys who help to engineer such financial instruments must recognize and prepare for such risks.9 When using financial instruments to achieve goals, a corporation must be aware of several considerations: the value of the asset underlying the financial instrument, duties or obligations the corporation owes to the other party to the contract, the implications and “worse case scenario” of the performance of the financial instrument, the risk of the transaction, and how the specific transaction can achieve the corporation’s goals. A. Using Financial Instruments to Hedge Risk

Although derivatives have been vilified because of losses attributed to their misuse, in actuality they are neither good nor bad. They are tools of managing risk that can be used appropriately, or, indeed, misused. When used appropriately, they can be effective hedges against unwanted risk, thereby isolating the risk an enterprise would like to sustain. A hedge is a transaction or position designed to mitigate the risk of other financial exposure.10 Hedgers trade to shift the risk of an unfavorable event to a counterparty that is better able or more willing to carry that risk. The value of the contract being used to hedge a position will move in an opposite direction from the underlying asset being hedged. Hedging in effect balances a negative position with a positive one and lowers the overall risk. Derivatives such as forwards, futures, and options can be used to hedge a transaction.11 B. Using Financial Instruments to Enhance Yield

Derivatives can also be used as a tool for enhancing yield, or making money. By assuming a counterparty’s unwanted risk, market participants are afforded the opportunity to benefit from the reward attendant to that risk. The assumption of risk to enhance yield by speculating on the outcome of a contingent event allows market participants to achieve returns that might otherwise be impossible. The main contrary position to a hedge is speculation. The Fed defines speculation as: “The practice of buying or selling stocks, commodities, land, or other types of assets hoping to

See, e.g., In re BT Sec. Corp., Securities Act Release No. 33-​7124, Exchange Act Release No. 34-​35136 (Dec. 22, 1994), http://​www.sec.gov/​litigation/​admin/​337304.txt. 10 Oxford Dictionary of Finance and Banking 194 ( John Smullen & Nicholas Hand eds., 3d ed. 2005). 11 See ­chapter 8, infra. 9

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take advantage of an expected rise or fall in price.”12 Speculation is taking a greater risk in exchange for a possible greater return on the investment. Derivatives can also be used for speculative purposes. For instance, consider a fund that might want to speculate that the price of gold will rise. The fund can accomplish this by buying a so-​called forward position in gold. A forward is a class of derivatives that can be as simple in structure as a purchaser obligating himself to take delivery of an underlying commodity at some date in the future. The terms of that contract for delivery may require little or no good faith deposit; the contract is therefore highly leveraged. The seller of the contract has shifted the risk of the price of gold falling from themselves to their counterparty, the fund.13 If price of gold rises, the forward contract will increase in value, as that contract derives its value from the price of the physical metal. C. The Economy’s Impact on Financial Instruments

In the words of the legendary investor Warren Buffett, “(a)fter all, you only find out who is swimming naked when the tide goes out.”14 Many entities that appeared to be models of excellence quickly became insolvent when markets collapsed; the confidence placed in some of these institutions was, indeed, misplaced. It is for this reason that the Fed began stress-​testing banks in 2009 in an attempt to shore up confidence in the surviving financial institutions. During the financial crisis, the crisis in confidence affecting the capital markets was, in part, due to fears regarding the credit worthiness and, indeed, the trustworthiness of counterparties. Because many financial instruments require counterparties to live up to their end of the bargain, if the counterparties are unwilling or unable to do so, the transactions are meaningless. Financial instruments have two components in terms of their utility to shift risk or enhance yield: (1) the counterparties’ ability to meet their obligations under the terms of the financial instrument, and (2) the underlying asset, the thing of value upon which the obligations of the financial instrument depend. The valuation of the underlying asset, and therefore the value of the financial instrument, is dependent on numerous economic factors, including prevailing interest rates, which are the rates for borrowing money.15 It is important to clarify here

https://​www.federalreserveeducation.org/​glossary/​ (last visited Aug 12, 2018). 13 See ­chapter 8. 14 See Berkshire Hathaway 2001 annual report, available at http://​www.berkshirehathaway.com/​2001ar/​ 2001letter.html (last visited Aug. 3, 2018). 15 See https://​www.federalreserveeducation.org/​glossary/​ (last visited Aug. 12, 2018). 12

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that the underlying asset need not necessarily be a physical possession. Currencies for example, derive their value because of their designation in the market as legal tender. Similarly, other newer assets, such as virtual currencies and tokens based on such “crypto-​currencies,” derive their value due to an agreement among market participants based on ongoing economic factors.16 Prevailing interest rates directly affect decisions to hedge a risk or to speculate in order to enhance yield. What may be a prudent business decision at one point in time may seem otherwise when interest rates change. Because of the highly leveraged nature of financial instruments incorporating derivative components, a severe market capital market disruption, such as the events of 2008, has a profound effect on the financial stability of enterprises throughout the broader economy. II. Achieving Investment Goals Firms that use financial instruments are classified by their market objectives. End users trade primarily to satisfy their own production, investment, or distribution needs. This can be accomplished by entering into derivatives contracts with the expectation of taking or making delivery. End users can use financial instruments aggressively to add strategic profits or enhance yield by virtue of their trading strategy. Speculators trade with the specific intention of making profits from market movement. In its simplest form, speculating involves buying something cheap and selling it dear. For example, buying crude oil futures with the expectation of a slowdown in oil production and a corresponding price rise. Speculators hope to take advantage of an expected rise or fall in price. A. The Investor’s Perspective

The same financial instrument can be used both to hedge a risk and to speculate, depending on the party’s perspective. For example, a forward contract, which is an agreement for delivery of an asset or commodity at some future date at a price agreed upon at the time the contract is made,17 can be used to either speculate or hedge a risk.18 A manufacturer who wishes to ensure availability of a raw material at a given price can hedge against the risks of fluctuating prices by entering into a forward Aaron Brown, How to Make Sense of Cryptocurrency Valuations (Apr. 17, 2018), https://​www.bloomberg.com/​ view/​articles/​2018-​04-​17/​how-​to-​make-​sense-​of-​cryptocurrency-​valuations. 17 Oxford Dictionary of Finance and Banking, supra note 10, at 168. 18 U.S. Commodity Futures Trading Commission, The Economic Purpose of Futures Markets and How They Work, http://​www.cftc.gov/​ConsumerProtection/​EducationCenter/​economicpurpose (last visited Aug. 3, 2018). 16

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contract, thereby agreeing to buy the raw material at a set price and ensuring its availability. The party selling the raw material is also hedging by guaranteeing against declining commodity prices. For example, consider a forward contract made between a wheat farmer and a cereal manufacturer regarding the future delivery of a set amount of wheat; the parties agree on a price and a delivery date. Because a forward contract has terms, offer, acceptance, and consideration, it is a contract. Because the value of that contract will be affected by the changing value of the underlying item (i.e., wheat), the contract is a derivative. It also meets the functional definition of a derivative because it shifts the risk of an increase or decrease in the price of the underlying item from the seller to the buyer of the forward contract. In terms of hedging risk, consider the wheat farmer who is concerned about a decline in wheat prices. By entering into a forward contract with a counterparty such as a cereal manufacturer, the wheat farmer has shifted the risk of declining wheat prices to the buyer of the contract. If wheat rises in price over the six-​month life of the forward contract, the farmer will not benefit from an increase in the underlying price of wheat. A forward contract for wheat for $6 per bushel, deliverable in six months, will give the wheat farmer $6 for one bushel of wheat six months from now even if the market price for one bushel of wheat six months from now is more or less than $6. On the purchase side of the contract, the cereal manufacturer is establishing a wheat price of $6 regardless of where prices actually are in six months. The cereal manufacturer has contracted to purchase wheat for $6 even if the market price for one bushel of wheat six months from now is much higher. Thus, in this example, both parties can use a forward contract to hedge against the future price of wheat moving in an unfavorable direction. The same forward contract protects the wheat farmer from a drop in wheat prices and protects the cereal manufacturer from an increase in wheat prices. In terms of speculating, a third party can purchase a wheat forward contract, hoping to profit from an increase in wheat prices. The speculator exchanges capital for the risk of an increasing wheat price. In contrast to the wheat farmer and the cereal manufacturer, who each have a specific risk that is being hedged using the wheat forward contract, the speculator has entered into a contract for wheat so that he might sell that contract or the physical wheat at a later date for a higher price. The speculator makes a profit on the forward contract when, in the future, the price of wheat increases and the forward contract (a contract for cheaper wheat) becomes more valuable to a purchaser of wheat, for example, the cereal manufacturer. If the contract allows for novation (the substitution of a new obligation for the old one) the speculator can sell that contract to the cereal manufacturer at a profit. The speculator holding the forward contract can sell the forward contract to the cereal

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manufacturer for some price higher than he originally paid for the contract, and the cereal manufacturer can lock in the purchase price of the wheat it needs. Thus, the manufacturer’s interest in hedging against increasing wheat prices coincides with the speculator’s interest in benefiting when wheat prices rise. As forward contracts are privately negotiated financial instruments, it is essential that the terms reflect the objectives of both parties to the transaction. For example, in this case the wheat speculator will want to allow for novation in order to be able to extinguish his obligations to take delivery under the terms of the contract. In the alternative, the wheat speculator might ask for a forward contract structured as a cash-​settled financial instrument, where changes in value are reflected in cash flows, rather than requiring actual delivery of the underlying commodity. B. Financial Instrument Objectives

The Financial Accounting Standards Board (FASB) requires corporations to disclose the objectives for holding and issuing hedging instruments.19 It is interesting to note the different ways financial instruments are intended to be used, and the appropriateness of a specific and stated objective. For instance, in Fadem v. Ford Motor Co.,20 the Southern District of New York found that Ford did not misrepresent to shareholders its purpose for entering into palladium forward and futures contracts because Ford adequately stated its purpose for entering into such contracts.21 Ford entered into palladium forward and futures contracts while prices were at a historic high; the price eventually settled and Ford sustained a loss on the contracts. However, in both of its 1999 and 2000 10-​K filings, Ford stated that it entered into such contracts “to offset [Ford’s/​our] exposure to the potential change in prices mainly for various nonferrous metals [used in manufacturing automotive components].”22 Thus, by identifying a risk and describing the management of that risk through the financial instruments it used, Ford adequately disclosed its objective for entering into the derivative financial instruments. In In re Ashanti Goldfields Securities Litigation,23 the Eastern District of New York denied in part a motion to dismiss a securities fraud complaint because shareholders sufficiently alleged facts that could support the claim that statements made by Ashanti regarding its use of gold futures were misleading.24 Ashanti was See generally FASB Statement 133, http://​www.fasb.org/​st/​summary/​stsum133.shtml (last visited Aug. 3, 2018). 20 352 F. Supp. 2d 501 (S.D.N.Y. 2005). 21 Id. at 508; Ford entered into such contracts “to lock in palladium supply at fixed prices.” 22 Id. at 507. 23 184 F. Supp. 2d 247 (E.D.N.Y. 2002). 24 Id. at 258. 19

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in the business of mining and processing gold and regularly entered into gold futures contracts to protect itself from price fluctuation in gold. After gold prices rose dramatically, the value of Ashanti’s futures contracts dropped from $290 million to negative $570 million.25 The shareholders alleged that Ashanti misled them when Ashanti said it entered into the contracts for hedging purposes rather than speculation because Ashanti failed to fully disclose the extent of risk exposure to the rise in gold prices.26 Although Ashanti’s actions could be used to hedge, the court noted the difference between hedging and speculating as one of magnitude risk/​reward: “[a hedger’s] primary financial interest is in the profit to be earned from the production or processing of the commodity. Those who seek financial gain by taking positions in the futures market generally are called ‘speculators’ or ‘investors.’ ”27 Because speculation takes on more risk than merely hedging, Ashanti misled shareholders by not fully disclosing the extent of its risk exposure from its derivative financial instruments. In Nationwide Life Insurance Co. v. St. Clair Mobile Home Parks LLC,28 the Eastern District of Missouri held that a client was not liable for “hedge losses” sustained by Nationwide when the client failed to close on a commercial loan because the client was not fully informed of Nationwide’s hedging activity.29 The court noted that it was standard industry practice for a commercial mortgage company to enter into a mirror-​image ancillary agreement with a third party to act as a hedge on any capital market loans it extended.30 It was also standard industry practice to execute a hedge-​ loss agreement with any parties seeking a commercial loan, such that the borrower would be liable for any hedge losses sustained as a result of the borrower’s failure to close on the loan.31 Nationwide, however, did not execute such an agreement with St. Clair.32 After Nationwide and St. Clair agreed on terms for a mortgage application, Nationwide entered into a hedging arrangement with a third party. Subsequently, interest rates rose unfavorably for St. Clair, the closing was postponed repeatedly, and Nationwide eventually canceled the application.33 Nationwide sought recovery for losses on the hedge it placed.34 The court examined the language of the application and found Id. at 250. 26 Id. at 262 (discussing that Ashanti gave no warning of the extent of potential risks). 27 Id. at 254. 28 2006 WL 3313786 (E.D. Mo. Nov. 14, 2006). 29 Id. at *1. 30 Id. at *2. 31 Id. 32 Id. 33 Id. at *9. 34 Id. at *10. 25

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no unambiguous language stipulating that St. Clair would be liable for any hedging losses.35 Thus, Nationwide could not recover its hedge losses because it did not clearly disclose and inform its client of its hedging activity. III. Managing  Risk Many financial instruments that are not labeled derivatives may contain a derivative component and function, that is, to shift risk (hedge) or to enhance yield to further corporate objectives. For example, when an oil company contracts to deliver fuel to a customer at a fixed price and the customer retains contract termination rights, that contract termination right is effectively an embedded derivative that may be classified as an “option.”36 It is therefore necessary to understand the risk components of any financial instrument or contract. Risk must be measured and managed comprehensively. That is, once the risk of a particular financial instrument is isolated and quantified, the holistic risk management focus should be on the dynamics of the investments in the context of an entire portfolio. Focusing on one instrument in a vacuum, thereby ignoring the interplay among various instruments can be costly if one financial instrument’s ability to achieve its objective is offset by another financial instrument. Past crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios that would have been revealed if the portfolio had been stress-​tested and analyzed in a more comprehensive manner.37 Financial engineering can create derivative instruments that combine risks in very complex ways. Upon analysis, traditional cash instruments that appear simple may actually have greater risk than the complex instruments that are labeled derivatives. Placing financial instruments into pigeonholes, without adequately acknowledging their true underlying risks or economic functions, can create disincentives for prudent risk management and often lead to disastrous results. Two instruments that have different names (e.g., options and swaps) and entirely different treatment under existing legal and regulatory frameworks might have identical financial, credit, liquidity, or operational risks.

35 Id. at *12. 36 See ­chapter 11, infra, for a complete discussion of derivatives. 37 See ­chapter 18, infra, for a complete discussion of risk management.

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Derivatives are by definition leveraged. For instance, if a speculator enters into a contract to purchase 5,000 bushels of wheat at a fixed price of $6 a bushel six months hence, absent specific terms to the contrary, no margin is posted as a good faith deposit to ensure performance of the contract. Therefore, the speculator has put up $0 to control a contract that’s notional or underlying value is $30,000 ($6 times 5,000 bushels). The assumption of risk or the control of assets far in excess of the capital invested is the definition of leverage. When privately negotiated, over-​the-​counter derivatives may be illiquid and therefore pose unique risks to portfolio managers and corporate fiduciaries. It should also be noted that in entering into an over-​the-​ counter-​derivatives contract, the counterparties take on the credit risk that the other side of the contract will be unwilling or unable to meet its obligations under the contract when those obligations come due. However, derivatives are neither good nor bad in and of themselves. The enterprise’s overall business objective is the most important factor in determining the derivative’s efficacy and value to the enterprise. Thus, derivatives can prove invaluable as a tool of risk management, but, if misused, can increase a firm’s risks dramatically.38

38 See In re County of Orange v. Fuji Sec., Inc., 31 F. Supp. 2d 768 (C.D. Cal. 1998), for an illustration of the magnitude of leverage that can be achieved by entering into a series of derivatives based on debt-​instruments and the disastrous results that can ensue.

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5 Financial Instruments and the Capital Markets

I. The Capital Markets  48 A. Primary versus Secondary Markets  49 B. Long-​Term versus Short-​Term Marketplaces  50 C. Case Study: The Auction Rate Securities (ARS) Market  50 II. Financial Instruments  51 A. Types of Financial Instruments  51 1. Equity-​Based Financial Instruments  51 2. Debt-​Based Financial Instruments  52 3. Derivatives  53 4. Cryptocurrency and Digital Assets  54 B. Distinction between Debt and Equity  54 C. Federal Regulation  57 III. The Role of the Attorney  61 A. Competent Representation  61 B. Duty to Advise Client  61 C. Drafting Financial Instruments  62 D. Regulatory Compliance  62 E. Opinion Letters  63

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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I. The Capital Markets Although the lessons of the financial crisis have encouraged new legislation, it is unclear whether the steps taken to shore up the capital markets will prevent future crises. Indeed, Kevin Warsh, a former member of the Board of Governors of the Federal Reserve System, made an important observation about the financial crisis. Warsh commented that “if you have seen one financial crisis, you have seen one financial crisis.”1 At the very least, central banks and market participants are now more aware of the speed at which a problem in one part of the world can be transferred to healthy markets across the globe, and the speed at which a seemingly discrete problem can create a global systemic threat. New innovations, the speed of information and transaction flow, and structured financial instruments can increase the resiliency of world markets, but they can also increase the speed at which problems are transferred from market to market. Indeed technology and the speed of computer trading was the major cause of the so-​called “Flash Crash” when “[o]‌‌n May 6, 2010, the prices of many U.S.-​based equity products experienced an extraordinarily rapid decline and recovery. That afternoon, major equity indices in both the futures and securities markets, each already down over 4% from their prior-​day close, suddenly plummeted a further 5–​6% in a matter of minutes before rebounding almost as quickly.”2 Notwithstanding the frailties of the capital markets, access to capital remains a vital part of global economic growth. Capital market participation allows companies to use financial instruments as a means of accessing capital, managing risk, and making money. The capital markets provide a marketplace where persons with financial capacity can meet persons who have needs for long-​term or short-​term capital. The capital markets also provide a means for shifting risk from one party who is less willing or able to retain a financial risk to another party who is more willing or able to take on that risk. Issuers, underwriters, regulators, and investors have a stake in the capital markets. There are two ways that corporations access capital: issuing equity or issuing debt. These two means of accessing capital can be structured in complex and discreet ways, furthering the simple goal of raising money. Equity issuers are generally private enterprises seeking venture participation in return for capital to expand operations

1 Kevin Warsh, Q & A Session at New York University School of Law Global Economic Policy Forum 2008 (Apr. 11, 2008). 2 http://​www.sec.gov/​news/​studies/​2010/​marketevents-​report.pdf (last visited Aug. 3, 2018).

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or to buy out enterprise owners. (Although in the case of preferred equity, that participation may be limited to a preferred dividend.) Debt issuers can be private enterprises or sovereigns, municipalities or agencies seeking capital by borrowing money and retaining their equity interest. Underwriters are typically investment banks that sell the securities to investors and thereby earn a fee in return. From an issuer’s perspective, issuing debt means borrowing money from the investor. The issuer retains an obligation to pay back the principal at maturity and often the interest payments periodically as promulgated by the indenture. Issuing equity means selling an ownership interest to the investors. The issuer sometimes will pay periodic dividends to the common stockholders over and above dividends paid to preferred shareholders.3 Entities borrow and lend funds in the capital markets. Entities, such as banks, corporations, and individuals, participate in the capital markets by trading financial instruments. Financial instruments generally are contractual agreements between parties regarding something of value. They are the primary vehicle used to achieve two primary financial objectives: (1) making money, or (2) protecting the money already earned, in other words, hedging risk. The type and specific structure of a particular financial instrument determines the magnitude of risk it poses or benefit it provides to the entity using it. Thus, in the example of a corporation, it is of paramount importance for the managers responsible for the financial instruments to understand the impact those financial instruments have on the corporation. A. Primary versus Secondary Markets

The capital markets provide a forum for issuers and investors to meet to negotiate financial instruments. Within the context of the capital markets there are two subsidiary component markets reflecting whether an investor is purchasing a financial instrument directly from an issuer or its underwriter (the primary market), or from another investor who may or may not have purchased the instrument from the original issuer (the secondary market). It is conceptually similar to buying something new or used. It is important to consider that although some “used” items may be worth less than “new” ones, the “used” item may be something that has become scarce or rare (that is, more in demand or less in supply than when it was originally created). The item purchased “used” in the secondary market may, indeed, be worth significantly more than it was at creation or issue.

3 See Sec. II.B, infra.

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The primary market is the marketplace in which newly issued financial instruments are bought and sold. The basic parties in the primary market are: (1) the issuer, and (2) a purchaser. The secondary market is the marketplace in which financial instruments are resold to other parties. The secondary market provides liquidity because it allows holders to resell their financial instruments. An example of the distinction between the primary and secondary markets is where a private company decides to go public. When Google chose to access capital, it did so by issuing equity in a Dutch auction initial public offering (IPO). It issued stock in the primary market at the highest price possible to meet the demands of all potential investors. The proceeds minus a small underwriting fee went to Google’s coffers to use for corporate activities. The investors can sell their shares at a later date in the secondary market to other investors and will make a profit or incur a loss depending on the price of those shares in the secondary market. B. Long-​T erm versus Short-​T erm Marketplaces

The financial markets are also categorized into marketplaces for short-​ term obligations and long-​term obligations. The money market is the marketplace for obligations lasting less than one year. The capital market is the marketplace for corporate equity and debt obligations lasting longer than one year.4 These categories are subordinate to the notion of the primary and secondary market categories. For example, IPO shares are issued and sold in the primary capital market and then later resold in the secondary capital market. Treasury bills, which last one year or less, are issued and sold in the primary money market and are then later resold in the secondary money market. The prospectus, indenture, or contractual agreement governing a financial instrument outlines its duration. C. Case Study: The Auction Rate Securities (ARS) Market

Auction rate securities (ARS) are generally long-​term or perpetual debt instruments. The rate paid for capital is negotiated at a weekly auction. At that auction, the issuer is bound to pay the lowest rate at which all sellers might liquidate their positions in the security. Historically, because of the auction process, investors treated these instruments as short-​term investment alternatives, relying on the historical liquidity provided by the marketplace.

4 See the U.S. Federal Reserve website, https://​www.federalreserveeducation.org/​glossary/​ (last visited Aug. 6, 2018).

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Unfortunately, investors ignored the reality (or arguably were not informed of the reality) that these instruments had extremely long durations, with a possibility that no bidder would be available when the investor needed his or her money. Because of the 2008 liquidity crisis in the banking industry, many auction participants were unwilling or unable to continue to bid in the ARS market. Most auctions, therefore, “failed.” When an auction fails, the investor is locked into the instrument until the auction process resumes. Most often this default interest rate is not attractive given the illiquidity of the instrument. Many issuers retired their auction rate securities to fend off irate investors who claim to have been duped into purchasing long-​term securities despite the investor’s short-​term risk appetite. Furthermore, a number of the underwriters of these securities have settled with state attorneys general and have agreed to return cash to investors.5 II. Financial Instruments A financial instrument is a contract involving a financial obligation.6 Like all contracts, financial instruments grant a contractual right to one counterparty, impose a contractual obligation on the other counterparty, and must be supported by consideration. Thus, financial instruments are agreements to exchange something of value in return for something of value. A simple example of such an exchange is a loan—​a lender provides the borrower an initial sum of money and in return the borrower pays the lender portions of the principal and interest over time. A. Types of Financial Instruments 1. Equity-​Based Financial Instruments

The classic equity-​based financial instrument is common stock, or simply, equity. The issuer carves out a piece of its equity and sells it to the purchaser. The purchaser, or shareholder, is a person who owns stock in a company and is eligible to share in profits and losses, the same as a shareholder.7 Equities can be tiered, giving some stock, such as “preferred stock,” preference over other stock, such as “common stock.” Although preferred

5 See Press Release, Office of the Attorney General of the State of New York (Aug. 15, 2008), available at http://​ www.oag.state.ny.us/​media_​center/​2008/​aug/​aug15a_​08.html. 6 Oxford Dictionary of Finance and Banking 154 ( John Smullen & Nicholas Hand eds., 3d ed. 2005). 7 See U.S. Federal Reserve, https://​www.federalreserveeducation.org/​glossary/​ (last visited Aug. 12, 2018). Equity is defined as “ownership interest in an asset after liabilities are deducted;” Stockholder is defined as “a person who owns stock in a company and is eligible to share in profits and losses; same as shareholder.”

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stocks often include valuable rights that make those shares more valuable than common stocks, such as entitlement to a dividend,8 they may not represent an ownership interest in the corporation, if despite their designation as “equity,” they are functionally equivalent to a debt instrument, meaning that they are issued as a means of accessing capital but, under their terms, do not represent any ownership interest in the company. 2. Debt-​Based Financial Instruments The classic debt-​based financial instrument is the bond. A bond is an IOU issued by a borrower to a lender.9 Bonds can be issued by sovereign entities (countries, states, or municipalities), or by corporations. These financial instruments are essentially loans that contain terms regarding interest payments and the repayment of principal. Short-​term debt obligations (obligations for one year or less) include: U.S. Treasury bills, commercial paper, certificates of deposit (CDs), repurchase agreements (repos), and federal funds. U.S. Treasury bills are federal government debt obligations that issue with maturities of 3, 6, or 12 months. Commercial paper is short-​term debt issued by corporations in lieu of taking out a loan from a bank. CDs are short-​term debt obligations issued by banks, although some CDs can have maturities of longer than one year. A repo is an agreement in which one party sells assets to another party with the understanding that the initial party will buy back the assets at a later date. Federal funds are the overnight loans banks lend to each other and are kept on deposit at the Federal Reserve Bank. Because of the extent to which companies rely on borrowing short-​term capital and because of the chilling effect on the economy of a disruption of that market, in February 2009, the U.S. government secured certain short-​term corporate debt under the Temporary Liquidity Guarantee Program. The Federal Deposit Insurance Corporation (FDIC) created this program to strengthen confidence in and encourage liquidity in the banking system by guaranteeing newly issued senior unsecured debt of banks, thrifts, and certain holding companies and by providing full coverage of non–​interest-​bearing deposit transaction accounts, regardless of dollar amount.10 The FDIC is an independent agency created by Congress that maintains the stability of and public confidence in the nation’s financial system, in part by insuring deposits at financial institutions. According to the FDIC: The FDIC adopted the Temporary Liquidity Guarantee Program on October 13th because of disruptions in the credit market, particularly the interbank lending See, e.g., In re Nanovation Tech., Inc., 364 B.R. 308, 347 (N.D.Ill., 2007). For a list of nuanced examples of equity instruments, see Glenn G. Munn, F.L. Garcia & Charles J. Woelfel, The St. James Encyclopedia of Banking and Finance 401 (9th ed. 1991). 9 See Oxford Dictionary of Finance and Banking, supra note 6, at 46. 10 http://​www.fdic.gov/​regulations/​resources/​TLGP/​index.html (last visited Aug. 3, 2018). 8

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market, which reduced banks’ liquidity and impaired their ability to lend. The goal of the TLGP is to decrease the cost of bank funding so that bank lending to consumers and businesses will normalize. The industry funded program does not rely on the taxpayer or the deposit insurance fund to achieve its goals.11 As opposed to short-​term obligations, long-​term debt obligations are for longer than one year and include corporate bonds, U.S. Treasury notes and bonds, and municipal bonds. Corporate bonds are bonds issued by corporations and typically pay interest twice a year. U.S. Treasury notes are federal government-​issued bonds lasting between 1 and 10 years. U.S. Treasury bonds last longer than one year. Municipal bonds are bonds issued by either the state or local governments, and the interest paid out is usually free of federal income tax. 3. Derivatives In addition to straightforward equity or debt agreements, entities can use another form of financial instrument called a derivative, to advance corporate goals in the capital markets. Derivatives are so called because they derive their value from another asset index or other investment. Derivatives are contractual agreements that obligate parties to exchange assets or cash flows.12 A derivative transaction is “a bilateral contract or payments exchange agreement whose value derives . . . from the value of an underlying asset or underlying reference rate or index.” Derivatives transactions may be based on the value of foreign currency, U.S. Treasury bonds, stock indices, or interest rates. Market forces, such as movements in interest rates, are the determinants of these underlying financial instruments. Within the broad panoply of derivatives transactions are numerous innovative financial instruments whose objectives may include a hedge against market risks, management of assets and liabilities, or lowering of funding costs; derivatives may also be used as speculation for profit.13 The U.S. Treasury distinguishes between two categories of derivatives: (1) privately negotiated agreements, called over-​the-​counter derivatives; and (2) standardized agreements, called exchange-​ traded derivatives.14

11 http://​www.fdic.gov/​news/​news/​press/​2008/​pr08122.html (last visited Aug. 3, 2018). 12 Procter & Gamble Co. v. Bankers Trust Co., 925 F. Supp. 1270, 1275 (S.D. Ohio 1996), Blue Sky L. Rep. (CCH) P74108, Comm. Fut. L. Rep. (CCH) P26700, Fed. Sec. L. Rep. (CCH) P99229 (citing Global Derivatives Study Group of the Group of Thirty, Derivatives: Practices and Principles 28 (1993)). 13 Id., citing Thomas Singher, Regulating Derivatives: Does Transnational Regulatory Cooperation Offer a Viable Alternative to Congressional Action?, 18 Fordham Int’l. Law J. 1405–​06 (1995). 14 U.S. Treasury website, http://​www.treasury.gov/​resource-​center/​faqs/​Markets/​Pages/​derivatives.aspx (last visited February 28, 2019).

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Generally, derivatives are highly leveraged because they require little or no good faith deposit to secure the parties’ obligations under the contract. There are four categories of derivatives: forwards, futures, options, and swaps.15 4. Cryptocurrency and Digital Assets “Crypto”currency16 is electronic money. With cryptocurrencies, community members repose value in a digital asset (like a string of numbers). Virtual currency exhibits many of the same characteristics as real money. Unlike fiat currency, where a central government declares that the currency has value, it is the community that recognizes the legitimacy of the digital asset as a means of being used as acceptable “tender.”17 There are three ways to obtain cryptocurrency—“mining” for new ones (solving a complicated digital mathematical puzzle to generate “new money”), buying through a cryptocurrency exchange, and accepting cryptocurrency for goods and services. These digital assets have value because they are limited in supply and because a broadly distributed ledger can not be counterfeited. The blockchain is one type of distributed ledger. Distributed ledgers use independent computers (referred to as nodes) to record, share, and synchronize transactions in their respective electronic ledgers (instead of keeping data centralized as in a traditional ledger). This distributed ledger technology (“DLT”) is of most interest to players in the financial markets as it might be used as a means of recording and settling a broad range of transactions. B. Distinction between Debt and Equity

The distinction between debt-​based and equity-​based financial instruments is an important one. One court noted that the distinction is one of investor intention: “Generally, shareholders place their money ‘at the risk of the business’ while lenders seek a more reliable return.”18 Whether a security is equity-​based or debt-​based affects whether the

15 See ­chapter 8, infra, for a detailed discussion of derivatives. 16 For a comprehensive discussion of Bitcoin see the Appendix to Chapter 11. 17 The basic definition of legal tender is that it must be a medium of exchange that is recognized by a legal system to be valid for meeting a financial obligation. The U.S. currently does not recognize virtual currencies such as bitcoin as legal tender. Under 12 U.S. Code § 411, the Federal Reserve has the authority to issue Federal Reserve notes, and under 12 U.S.C.A. § 418, the Treasury Department “in order to furnish suitable notes for circulation . . . shall cause plates and dies to be engraved” and print numbered quantities. The Secretary of the Treasury has the authority to “mint and issue coins.” As a result, cryptocurrencies remain well outside this legal apparatus. 18 Slappey Drive Indus. Park v. United States, 561 F.2d 572, 581 (5th Cir. 1977): “Contributors of capital undertake the risk because of the potential return, in the form of profits and enhanced value, on their underlying

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purchaser is guaranteed a return on his or her investment, whether the instrument is subordinate to other instruments in the case of bankruptcy, and whether the instrument receives favorable tax treatment.19 Moreover, the implications of issuing or buying equity-​based financial instruments differ from those of debt-​based financial instruments. When a corporation raises capital, it can do so by either issuing equity or debt. A corporation is not required to make distributions on equity shares it issues to shareholders, but must repay principal and interest to debt holders. Also, in the event of bankruptcy, equity claims are subordinate to debt claims. With regard to tax treatment, the type of instrument will determine the deductibility of interest paid, taxability of the return of principal, and the recognition of gain or loss upon exchange of property. Thus an entity must be cognizant of the implications of using equity-​based versus debt-​based financial instruments. However, determining whether a financial instrument is equity-​based or debt-​ based is not always easy, and the denomination of a financial instrument by the parties as one or the other is not always controlling. In Fin Hay Realty v. United States,20 the Third Circuit applied an objective economic reality test to distinguish between debt and equity.21 The issue in the case was whether funds paid by shareholders to a close corporation were “additional contributions to capital or loans on which the corporation’s payment of interest was deductible under [the Internal Revenue Service (IRS) Code].”22 Two shareholders had created Fin Hay Realty with capital contributions in exchange for stock and additional contributions in exchange for “unsecured promissory note[s]‌‌ payable on demand and bearing [6 percent interest].”23 Years later and after the deaths of the original shareholders, the IRS disallowed the corporation from deducting interest paid on the so-​called loans.24 Although other courts and commentators had analyzed several factors to be considered in distinguishing debt from equity,25 the court settled on an objective

investment. Lenders, on the other hand, undertake a degree of risk because of the expectancy of timely repayment with interest” (noting different risks associated with equity-instruments and debt-instruments). 19 See generally Richard A. Booth, Financing the Corporation § 1:5 (2007). 20 398 F.2d 694 (3d Cir. 1968). 21 Id. at 697. 22 Id. at 694–​95. 23 Id. at 695. The shareholders made subsequent additional contributions in exchange for “six per cent demand promissory notes.” 24 Id. at 696. 25 Id. (stating that factors for distinguishing debt and equity include: “(1) the intent of the parties; (2) the identity between creditors and shareholders; (3) the extent of participation in management by the holder of the instrument; (4) the ability of the corporation to obtain funds from outside sources; (5) the ‘thinness’ of the capital structure in relation to debt; (6) the risk involved; (7) the formal indicia of the arrangement; (8) the relative position of the obligees as to other creditors regarding the payment of interest and principal; (9) the voting

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economic reality test.26 The court considered the additional contributions as capital contributions because they did not dilute the shareholders’ equity interests and were not called during the shareholders’ lifetimes.27 The shareholders were in the position to structure contributions to receive the most favorable tax treatment without truly subjecting the corporation to the consequences of taking on debt.28 Thus, the economic reality of the contributions was that they were capital contributions, or equity, rather than loans, or debt. Courts also focus on the interpretation of the contract between the issuer and holders to determine if the financial instrument is debt or equity. In Slappey Drive Industrial Park v. United States,29 the Fifth Circuit identified several factors to be considered in interpreting whether a financial instrument is debt or equity.30 One of the issues in the case was whether certain transfers of property by shareholders to close corporations in exchange for financial instruments should be classified as debt or equity for tax purposes.31 A representative transaction involved the transfer of land by one shareholder to the close corporation in exchange for a note from the corporation for “$65,000 five-​year 3% installment[s]‌.”32 The case involved several similar transactions by the same individuals; notably, the corporation did not meet the terms of repayment for any of the transactions. The court held the transactions should be considered equity transactions because the shareholders failed to insist on timely repayment,33 the shareholders sought payment only when the corporation(s) had “plenty of cash,”34 the proceeds went toward purchasing “capital assets,”35 and power of the holder of the instrument; (10) the provision of a fixed rate of interest; (11) a contingency on the obligation to repay; (12) the source of the interest payments; (13) the presence or absence of a fixed maturity date; (14) a provision for redemption by the corporation; (15) a provision for redemption at the option of the holder; and (16) the timing of the advance with reference to the organization of the corporation.”) 26 Id. at 697. 27 Id. at 697–​98. 28 See id. 29 561 F.2d, 572 (5th Cir. 1977). 30 Id. at 582 (5th Cir. 1977) (listing factors for distinguishing debt and equity: ”(1) the names given to the certificates evidencing the indebtedness; (2) the presence or absence of a fixed maturity date; (3) the source of payments; (4) the right to enforce payment of principal and interest; (5) participation in management flowing as a result; (6) the status of the contribution in relation to regular corporate creditors; (7) the intent of the parties; (8) ’thin’ or adequate capitalization; (9) identity of interest between creditor and stockholder; (10) source of interest payments; (11) the ability of the corporation to obtain loans from outside lending institutions; (12) the extent to which the advance was used to acquire capital assets; and (13) the failure of the debtor to repay on the due date or to seek a postponement.”) (citing Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972)). 31 Id. at 580. 32 Id. at 577. 33 Id. at 582. (“When a corporate contributor seeks no interest, it becomes abundantly clear that the compensation he seeks is that of an equity interest: a share of the profits or an increase in the value of his shareholdings.”) 34 Id. at 582–​83 (stating that the intent to withdraw money only when the corporations were flush with cash was evidence that shareholders intended to treat the transactions as equity transactions rather than debt transactions). 35 Id. at 583.

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the “proportionality” of the shareholder’s equity interest equaled the shareholder’s debt interests.36 Thus, by examining the contract and the behavior of the parties with respect to the contract, the court determined the transactions should be treated like equity transactions rather than debt transactions. The Financial Accounting Standards Board (FASB) has issued guidelines for discerning equity from debt.37 In a posting of project updates, FASB identified three approaches to the problem. The approach favored by FASB is the so-​called Basic Ownership Approach, under which a basic ownership instrument is considered equity. A basic ownership instrument is one that “(1) is the most subordinated interest in an entity and (2) entitles the holder to a share of the entity’s net assets after all higher priority claims have been satisfied.” All other financial instruments, such as “forward contracts, options and convertible debt,” are to be classified either as assets or liabilities. Claims against an entity’s assets are either (1) liabilities, or debt, if they reduce the net assets; or (2) assets if they increase the net assets available to the owner of the entity.38 The second approach is the Ownership-​Settlement Approach, which classifies financial instruments according to the return and settlement requirements. This approach considers as equity: (1) basic ownership instruments, (2) other perpetual instruments, such as preferred shares, and (3) indirect ownership instruments “settled by issuing related basic ownership instruments.”39 All other financial instruments are classified as either assets or liabilities. The third approach is the Reassessed Expected Outcome, or REO Approach, which considers financial instruments as equity or non-​equity depending on the direction of movement of fair value of the financial instrument compared to the direction of movement of fair value of the basic ownership instrument. The basic theme of each approach is that FASB categorizes financial instruments as either (1) equity, or (2) non-​equity; and non-​equity as either an asset or a liability (i.e., debt). C. Federal Regulation

Financial instruments are subject to significant regulatory oversight. There are several governmental agencies that oversee financial instruments, including the Id. at 583–​84. 37 FASB website, http://​www.fasb.org/​fi_​with_​characteristics_​of_​equity.shtml (last visited Aug. 3, 2018). 38 Id. The U.S. Federal Reserve defines liabilities as “money an individual or organization owes; same as debt.” Federal Reserve Publication, Financial Fundamentals from the Fed, available at https://​www. federalreserveeducation.org/​~/​media/​documents/​financial-​fundamentals/​creditlesson2.pdf ?la= (last visited Aug. 3, 2018). 39 Id. Indirect ownership instruments are (1) not perpetual, (2) have terms that link the value of the instrument to the “fair value of the basic ownership instrument,” and (3) do not have contingent provisions linked to either the market price of anything other than the basic ownership instrument or an unrelated price index. Id. 36

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Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Additionally, the Federal Reserve (the Fed) exerts regulatory authority over certain derivatives, transactions, banks, and systemically significant entities. Depending on how a transaction is structured and who is a party to it, a transaction may be subject to regulation by one or more of these agencies. As of the beginning of 2019 in the United States, Congress has yet to authorize a system to regulate virtual currency. As the CFTC recently admitted, U.S. law does not provide for “direct, comprehensive U.S. regulation of virtual currencies. To the contrary a multi-regulatory approach is being used.”40 While the CFTC and other regulatory bodies claim concurrent regulatory power over cryptocurrencies in certain settings, this jurisdiction is more or less incomplete. Moreover, the current laws also limit the reach of these agencies to virtual currency platforms operating only within the U.S. As the CFTC chair noted in written testimony: In 2015, the CFTC determined that virtual currencies, such as Bitcoin, met the definition of “commodity” under the CEA. Nevertheless, the CFTC does NOT have regulatory jurisdiction under the CEA over markets or platforms conducting cash or “spot” transactions in virtual currencies or other commodities or over participants on such platforms. More specifically, the CFTC does not have authority to conduct regulatory oversight over spot virtual currency platforms or other cash commodities, including imposing registration requirements, surveillance and monitoring, transaction reporting, compliance with personnel conduct standards, customer education, capital adequacy, trading system safeguards, cyber security examinations or other requirements. In fact, current law does not provide any U.S. Federal regulator with such regulatory oversight authority over spot virtual currency platforms operating in the United States or abroad.41 New markets and the regulatory landscape have evolved greatly since 2008. DoddFrank42 establishes jurisdiction over derivatives by bestowing regulatory authority over swaps to the CFTC and giving the SEC authority over security-based swaps; both commissions will have authority over mixed swaps, which are swaps with both commodities and securities features. In Dodd-Frank, amending the Commodity Commodity Futures Trading Comm’n v. McDonnell, 18-CV-361, at *9 (E.D.N.Y. Mar. 6, 2018). 41 Written Testimony of Chairman J. Christopher Giancarlo before the Senate Banking Committee, Washington, D.C., Feb. 6, 2018, available at: https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo37 (last visited Feb. 28, 2019). 42 Dodd–Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111–203, H.R. 4173) 2010. 40

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Exchange Act (CEA), a swap is broadly defined in the first instance and includes a list of “commonly known” swaps such as credit default swaps, currency swaps, and total return swaps that are explicitly subject to its provisions. However, the Act provides an exclusion for “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled.” It is clear that the exclusion applies only to the sale of physical commodities contracts, such as oil and grains, which expect to be settled with the underlying commodity; all other swaps are subject to CFTC oversight. A “security-based swap,” as defined in the Securities Exchange Act of 1934, encompasses swaps that are based on an index, a single security or loan, or the occurrence or non-occurrence of an event of an issuer or group of issuers if that event affects the finances of the issuer. As both the swap and security-based swap definitions are extensive, many derivative instruments that were previously unregulated by the SEC and the CFTC by virtue of the Commodity Futures Modernization Act of 2000 (CFMA), as well as derivative instruments not yet in existence, will now be subject to regulatory oversight. In addition to regulating the derivatives products themselves, the Act forces certain entities to register with the CFTC or the SEC. First, “swap dealers” and “security-based swap dealers” must register with the CFTC and SEC respectively by filing an application with the respective commission. A swap dealer is any person who (1) “holds itself out as a dealer in swaps,” (2) is a market maker; (3) enters into swaps for its own account with counterparties “regularly,” or (4) is known as a dealer or market maker. The Act includes a de minimis exception to the swap dealer determination, to be promulgated by the CFTC. A security-based swap dealer is similarly defined, but also encompasses those entities that deal in security-based swaps; this also has a de minimis exception. Along with registration, these persons are subject to margin, capital, and business conduct requirements, as mandated by the Act. In addition, Dodd-Frank created the Bureau of Consumer Financial Protection (BCFP) to consolidate most federal consumer financial protection authority in one place.43 Title X of Dodd-Frank describes the creation of the BCFP: There is established in the Federal Reserve System, an independent bureau to be known as the “Bureau of Consumer Financial Protection,” which shall regulate the offering and provision of consumer financial products or services under the Federal consumer financial laws.44

http://​www.consumerfinance.gov/​the-​bureau/​creatingthebureau/​ (last visited Aug. 3, 2018). 44 12 U.S.C. 5491, sec. 1011 (2012). 43

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Dodd-Frank lists a broad range of products in which the BFCP will seek to protect consumers: purpose, objectives, and functions: SEC. 1021. PURPOSE, OBJECTIVES, AND FUNCTIONS. 12 USC 5511. (a) PURPOSE—​The Bureau shall seek to implement and, where applicable, enforce Federal consumer financial law consistently for the purpose of ensuring that all consumers have access to markets for consumer financial products and services and that markets for consumer financial products and services are fair, transparent, and competitive. (b) OBJECTIVES—​The Bureau is authorized to exercise its authorities under Federal consumer financial law for the purposes of ensuring that, with respect to consumer financial products and services—​ (1) consumers are provided with timely and understandable information to make responsible decisions about financial transactions; (2) consumers are protected from unfair, deceptive, or abusive acts and practices and from discrimination; (3) outdated, unnecessary, or unduly burdensome regulations are regularly identified and addressed in order to reduce unwarranted regulatory burdens; (4) Federal consumer financial law is enforced consistently, without regard to the status of a person as a depository institution, in order to promote fair competition; and (5) markets for consumer financial products and services operate transparently and efficiently to facilitate access and innovation. (c) FUNCTIONS—​The primary functions of the Bureau are—​ (1) conducting financial education programs; (2) collecting, investigating, and responding to consumer complaints; (3) collecting, researching, monitoring, and publishing information relevant to the functioning of markets for consumer financial products and services to identify risks to consumers and the proper functioning of such markets; (4) subject to sections 1024 through 1026, supervising covered persons for compliance with Federal consumer financial law, and taking appropriate enforcement action to address violations of Federal consumer financial law; (5) issuing rules, orders, and guidance implementing Federal consumer financial law; and (6) performing such support activities as may be necessary or useful to facilitate the other functions of the Bureau.

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(d) Federal Regulation of Swaps In August 2014, the CFPB released a consumer advisory warning consumers of the risk of cryptocurrencies.45 The mosaic of Federal regulation continues to evolve with new products and administration enforcement initiatives. The changes keep market participants and attorneys actively engaged in understanding the applicability of the rules. III. The Role of the Attorney A. Competent Representation A thorough understanding of the structure and implications of various financial instruments is essential for the attorney who deals in these matters. The American Bar Association’s Model Rules of Professional Responsibility require that an attorney be competent to handle any matter in which the attorney accepts representation. “A lawyer shall provide competent representation to a client. Competent representation requires the legal knowledge, skill, thoroughness and preparation reasonably necessary for the representation.”46 Furthermore, “competent handling of a particular matter includes inquiry into and analysis of the factual and legal elements of the problem and use of methods and procedures meeting the standards of competent practitioners.”47 Thus the attorney has a legal and ethical obligation to understand the financial concepts that underlie the transactions on which he or she is working. If those transactions involve complicated financial structures and complex financial instruments, the attorney must acquire a working knowledge of them. B. Duty to Advise Client

The attorney, as in-​house or outside counsel, has a duty to advise the corporate directors of the risks associated with various financial instruments. Corporate directors can be held liable for failing to exercise due care with regard to financial instruments if their decisions cause the corporation to suffer a loss. For example, in Brane v. Roth,48 the shareholders of a grain cooperative sued the directors when the co-​op lost money as a result of an unhedged grain position. The directors had relied on an accountant who suggested hedging the company’s market exposure to grain. https://www.consumerfinance.gov/about-us/newsroom/cfpb-warns-consumers-about-bitcoin/ (last visited February 28, 2019). 46 ABA Model Rule 1.1. 47 ABA Model Rule 1.1 comment [5]‌‌. 48 Brane v. Roth, 590 N.E. 587 (Ind. App. 1992). 45

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The directors hired a manager to implement a hedging strategy, but neglected to oversee the manager or his implementation of the hedging strategy. The manager, inexperienced in hedging, hedged only a small percentage of the co-​op’s total grain exposure; only $20,000 of grain sales was hedged despite the fact that the company had over $7,000,000 of potential exposure. As a result, the co-​op suffered a substantial loss on the unhedged position.49 The court found that the directors had breached their fiduciary duties and were liable for the cooperative’s losses. The court reasoned that the directors breached their duty to their shareholders by hiring a manager inexperienced in hedging, failing to maintain reasonable supervision over him, and failing to acquire knowledge of the basic fundamentals of hedging to be able to properly supervise the manager.50 In effect, the court was saying that the directors had an affirmative duty to become knowledgeable enough with regard to hedging strategy to be able to make an informed decision about whether to follow such a strategy. It is clear, therefore, that the attorney who advises such directors must advise their client of the need to become knowledgeable with regards to the financial operation of the company. C. Drafting Financial Instruments

It is the responsibility of the attorney to draft legal documents that will meet the business needs of the client. Where financial instruments are involved, the attorney must thoroughly understand the basis of those instruments in order to draft a document that will maximize the benefits to the client and minimize the client’s liability. The attorney must recognize the structure of the instrument and be cognizant of any tax and other financial implications. Although many financial transactions use standardized agreements as their basis,51 the attorney must be able to understand those agreements and have sufficient knowledge to be able to adapt them to the client’s individual needs. D. Regulatory Compliance

The attorney must be familiar with the various regulatory agencies that impose disclosure, registration, and other requirements on the issuers of financial instruments.52

49 See ­chapter 8, infra, for a complete discussion of hedging. 50 Brane, 590 N.E. at 589. 51 See, e.g., International Swaps and Derivatives (ISDA) Master Agreement, discussed in ­chapter 9, infra. 52 See Sec. B, supra and ­chapter 7, infra.

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It is the responsibility of the attorney to draft such public disclosure documents and to advise the client on how best to comply with the requirements of all applicable laws. Plaintiffs who have sued corporations alleging fraud in the issuance of securities53 have alleged that the attorneys advising those clients “aided and abetted” the clients in violating those laws.54 Courts have held lawyers potentially liable if a plaintiff can show, in addition to a violation of the law, that the lawyer knew of the violation and provided “substantial assistance” to the primary party with regard to the violation.55 Therefore, to avoid potential liability, the attorney must understand the underlying structure of any transaction and comply with any applicable disclosure, registration, and other requirements. E. Opinion Letters

Attorneys involved in financial transactions often issue opinion letters to their clients regarding the implications of those transactions. These letters provide conclusions regarding legal issues and are often for the benefit of third parties entering into a transaction.56 An attorney for a securities issuer “assumes a duty to provide complete and non-​misleading information with respect to subjects on which he undertakes to speak [in an opinion letter].”57 In Mehaffy, Rider, Windholz & Wilson v. Central Bank Denver, N.A.,58 the court held that an attorney who prepares such a letter could be held liable to a third party for any material misrepresentation contained in that letter. This is particularly important in transactions involving where lawyers may be called on to advise on the creation of new financial instruments involving disruptive technologies. Thus, the attorney has an affirmative duty to fully understand and accurately describe financial instruments in order to avoid personal liability as well.

E.g., under SEC Rule 10b-​5, discussed infra in ­chapter 12. 54 22 Am. Jur. Proof of Facts 3d 559 § 5 (2007). 55 Id. 56 Steven L. Schwarcz, The Public Responsibility of Structured Finance Lawyers, Working Paper (2006), 7 n.6. 57 Rubin v. Schottenstein, Zox & Dunn, 143 F.3d 263, 268 (6th Cir. 1998). 58 892 P.2d 230, 236–​37 (Colo. 1995). 53

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6 Bureau of Consumer Financial Protection

I. Structure  66 II. Roles and Function of the BCFP  68 A. The Bureau’s Regulatory Authority  68 B. The Bureau’s Supervisory Authority  69 C. The Bureau’s Enforcement Authority  70 III. Significant Changes in Financial Consumer Protection by the BCFP  70 A. The Judicial Review of BCFP’s Power  71 IV. BCFP under President Trump’s Administration  73 V. The Judicial BCFP Structures under President Trump’s Administration  77 A. Constitutionality of the Bureau  77 B. Single Directorship  77 VI. Ongoing Enforcement Action Status  78 A. Wells Fargo Case  78

Under Dodd-​F rank’s Title X, the Consumer Financial Protection Act of 2010 (CFPA), Congress established an independent Bureau of Consumer Financial Protection in the Federal Reserve System1 (CFPB, BCFP or “the

1 12 U.S.C. § 5491(a). Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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Bureau”).2 The BCFP is tasked with protecting consumer interests in financial markets. Specifically, the Bureau aims to ensure that all customers have access to markets for consumer financial products and services in a fair, transparent, and competitive way.3 The CFPA authorizes the Bureau to uniformly regulate, supervise and enforce the provisions of consumer financial products or services under federal consumer financial law.4 Federal consumer financial law5 includes 18 enumerated consumer laws,6 the provisions of the CFPA itself, such as the prohibition of “an unfair, deceptive, or abusive act or practice” (UDAAP)7, and any rule or order prescribed by the Bureau, except for the Federal Trade Commission Act.8 I. Structure The Bureau is led by the Director, who is appointed by the president and approved by the Senate.9 The Director serves for a term of five years, and can only be removed by the president for inefficiency, neglect of duty, or malfeasance in office (“the for-​cause removal protection”).10 The Director is authorized to appoint the Deputy Director, who serves as acting Director in the absence or unavailability of the Director.11 The

2 Originally, the Bureau embraced the non-​legislated name of Consumer Financial Protection Bureau or CFPB. Notwithstanding the fact that the name in the Dodd-​Frank Act was “The Bureau of Consumer Financial Protection.” President Trump’s Acting Bureau Director quickly changed the name to the one mandated by the legislation. Throughout this chapter references to the Bureau will use CFPB and BCFP interchangeably unless the events referenced took place prior to the name change by Acting Director Mulvaney. 3 12 U.S.C. § 5511(a). 4 12 U.S.C. § 5491(a). 5 12 U.S.C. § 5481(14). 6 12 U.S.C. § 5481(12). The 18 enumerated consumer laws include: the Alternative Mortgage Transaction Parity Act of 1982; the Consumer Leasing Act of 1976; the Electronic Fund Transfer Act, except with respect to section 920 of that Act; the Equal Credit Opportunity Act; the Fair Credit Billing Act; the Fair Credit Reporting Act, except with respect to sections 615(e) and 628 of that Act; the Home Owners Protection Act of 1998; the Fair Debt Collection Practices Act; (I) subsections (b) through (f ) of section 43 of the Federal Deposit Insurance Act; sections 502 through 509 of the Gramm-​Leach-​Bliley Act except for section 505 as it applies to section 501(b); the Home Mortgage Disclosure Act of 1975; the Home Ownership and Equity Protection Act of 1994; the Real Estate Settlement Procedures Act of 1974; the S.A.F.E. Mortgage Licensing Act of 2008; the Truth in Lending Act; the Truth in Savings Act; section 626 of the Omnibus Appropriations Act, 2009; and the Interstate Land Sales Full Disclosure Act. 7 12 U.S.C. § 5531. 8 12 U.S C. § 5481(14). 9 12 U.S.C. § 5491(b). 10 12 U.S.C. § 5491(c). 11 12 U.S.C. § 5491(b).

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Federal Reserve Board may not intervene in any matter or proceeding before the Director, including examinations or enforcement actions.12 The Bureau may establish the rules of appointments and supervisions of its employees.13 The Director may fix the number of, and appoint and direct, all employees of the Bureau.14 The Federal Reserve Board has no appointing or dismissal rights of the Bureau’s personnel.15 Since its establishment, the single director structure in the Bureau has become the subject of one of the highlighted political debates in the United States. Consumer advocates argue that the single directorship structure would guarantee the independ­ ence of the agency. This is seen as necessary to overcome any potential insinuation from the industry players and heavy-​handed political interference by Congress and the White House, especially where there were concerns about deregulatory ambitions from the Republican Party. On the other hand, the pro-​financial industry and the Republican Party have intensely argued that the single director structure in the Bureau should instead be revised to have better checks on the Bureau’s authority and greater political control.16 The Bureau’s budgeting is excluded from the congressional appropriation process as it exists within the Federal Reserve Board. This allows it to be independent for budgeting purposes. Additionally, it has been granted independent agency status, where the Bureau could generate a higher pay scale for their employees, and be exempted from the regular Office of Management and Budget’s cost-​benefit analysis.17 Even though the Bureau is in the Fed, it has complete regulatory independence from the Board of Governors of the Federal Reserve.18 However, there are some restrictions that apply to the Bureau’s actions. The Bureau is subject to be bound by its statutory authorities and the Administrative Procedure Act (APA), the Small Business Regulatory Enforcement Fairness Act of 1996 (SBREFA), and the veto review by the Financial Stability Oversight Council.19

12 U.S.C. § 5492(c). 13 12 U.S.C. § 5492(a)(7), (8). 14 12 U.S.C. § 5493(a). 15 12 U.S.C. § 5492(c)(2)(B). 16 Adam J. Levitin. The Consumer Financial Protection Bureau: An Introduction, 32 Rev. Banking & Fin. L. 321, 339 (2013). 17 Id. at 339–​40. See also, 12 U.S.C. § 5497(a)(2)(A), 5491(a), 5941(b)(4), 5493(a)(2), 5512(b)(2)(A) (Supp. IV 2010). 18 12 U.S.C. § 1012 (c)(2) (Supp. IV 2010). 19 Levitin, supra note 16, at 341. 12

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II. Roles and Function of the BCFP The BCFP has the power to enforce federal consumer financial law to promote fair competition and increasing market transparency in line with its mandate under the Dodd-​Frank Act to ensure protection of financial customers from harmful practices.20 Congress mandated the Bureau with six essential functions to achieve its mission:21 1) conducting financial education programs; 2) collecting, investigating, and responding to consumer complaints; 3) collecting, researching, monitoring, and publishing information relevant to the functioning of markets for consumer financial products and services to identify risks to consumers and the proper functioning of such market; 4) supervising covered persons for compliance with federal consumer financial law, and taking appropriate enforcement action to address violations of federal consumer financial law; 5) issuing rules, orders, and guidance implementing federal consumer financial law; and 6) performing such support activities as may be necessary or useful to facilitate the other functions of the Bureau. From July 2011 onward the Bureau took over responsibilities from seven other existing federal government agencies responsible for consumer protection.22 A. The Bureau’s Regulatory Authority

The Bureau is authorized to administer, enforce, and implement the provisions of the federal consumer financial law.23 The Director may prescribe rules and issue orders and guidance to administer and carry out the federal consumer financial laws.24

12 U.S.C. § 5511(a)–​(b) (Supp. IV 2010). 21 Id. § 5511(c). 22 The seven existing agencies that transferred their certain responsibilities to the BCFP are the Federal Reserve Board of Governors, the Federal Deposit Insurance Corporation, the Federal Trade Commission, the National Credit Union Administration, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Department of Housing and Urban Development. 23 12 U.S.C. § 5512(a). 24 12 U.S.C. § 5512(b)(1). 20

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In prescribing a rule, the Bureau is supposed to consider the potential benefits and costs to consumers and covered persons. This includes the potential reduction of access by consumers to consumer financial products or services resulting from such rule, the impact of proposed rules on covered persons, and the impact on consumers in rural areas.25 B. The Bureau’s Supervisory Authority

BCFP has supervisory jurisdiction over the following financial entities: (1) non-​ depository institutions and individuals who provide mortgage-​related products or service, payday and private student loans, as well as large participants of other consumer financial products or services markets defined by BCFP, plus the service providers of all above;26 (2) large insured depository institutions and credit unions in excess of $10 billion in total assets as well as their affiliates and service providers;27 and (3) other small depository institutions that are not covered by 12 U.S. Code § 5515.28 To fulfill its supervisory authority, the BCFP may examine the supervised entities.29 The examination process generally involves collecting information, going on-​site to observe, conducting interviews with internal staffs, and producing the examination reports.30 If negative results are found, depending on the degree of harm to the customers and the severity of the problem type, it may lead to the supervised entity’s self-​correction or further enforcement actions by BCFP.31 Through its oversight function, the Bureau aims to monitor the potential risk of the consumer harm caused by the malpractice of financial institutions based on the collected data as well as to enforce the federal consumer protection law with consistent standards.32

12 U.S.C. § 5512(b)(2). 26 12 U.S.C. § 5514. 27 12 U.S.C. § 5515. 28 12 U.S.C. § 5516. 29 12 U.S.C. §§ 5514(b), 5515(b), & 5516(c). 30 CFPB, CFPB Supervision and Examination Process Overview, 5–​6 (Oct. 2012), https://​s3.amazonaws.com/​ files.consumerfinance.gov/​f/​documents/​032017_​cfpb_​examination-​process-​overview_​supervision-​and-​ examination-​manual.pdf. 31 Id. 32 12 U.S.C. §§ 5514–​5515. 25

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C. The Bureau’s Enforcement Authority

An enforcement action of the Bureau may be initiated by a supervisory examination or an enforcement investigation. The methods of conducting an investigation include issuing subpoenas or civil investigative demands for testimony or material documents relevant to violations of the federal consumer financial law.33 Once the Bureau finds any violations of federal consumer financial law, it may bring administrative enforcement proceedings34 or civil actions in federal district court.35 The Bureau may seek any appropriate legal or equitable relief with respect to a violation of federal consumer protection law, including rescission or reformation of contracts, refund of money or return of real property, restitution, disgorgement or compensation for unjust enrichment, payment of damages or other monetary relief, public notification regarding the violation, and civil money penalties.36 The CFPA also establishes the Consumer Financial Civil Penalty Fund (“Civil Penalty Fund”) in the Federal Reserve. When the Bureau obtains a civil penalty for victims under federal consumer financial laws, it should deposit the collected amount into the Civil Penalty Fund.37 III. Significant Changes in Financial Consumer Protection by the BCFP Since its establishment, the Bureau has issued several final rules concerning mortgage lending, prepaid cards, and other financial products. The Bureau has legislated several final rules concerning residential mortgage lending which begins in 2013.38 The new rules on mortgage lending focus on renovation for the new origination, notification, disclosure requirements, and implementation of additional limitation on fees and charges that might be increased from estimates provided by the lenders. In October 2015, the Bureau had finalized the amendment for Regulation C: the implementing rule for the Home Mortgage Disclosure Act.39 The amendment,

12 U.S.C. § 5562. 34 12 U.S.C. § 5563. 35 12 U.S.C. § 5564. 36 12 U.S.C. § 5565. 37 12 U.S.C. § 5497(d). 38 2014 CFPB Dodd-​Frank Mortgage Rules Readiness Guide Version 3.0. https://​files.consumerfinance.gov/​f/​ 201409_​cfpb_​readiness-​g uide_​mortgage-​implementation.pdf (last visited Mar. 18, 2018). 39 New Rule Summary: Home Mortgage Disclosure (Regulation C). https://​files.consumerfinance.gov/​f/​ 201510_​cfpb_​hmda-​executive-​summary.pdf (last visited Mar. 10, 2018). 33

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which became effective in January 2018, results in a significant expansion of the data points that will be required from lenders to be collected by the Bureau. On October 2016, the Bureau had also amended the rules regarding consumer protections for prepaid accounts.40 These rules provided that a prepaid card is subject to similar consumer protections as those provided by more traditional debit and credit cards, such as fraud protection and expanded access to account information. In 2017, the Bureau issued a final rule governing payday loans. Explaining the background of the issuance of the rules, Director Cordray stated, “too often, borrowers who need quick cash end up trapped in loans they can’t afford. The rule’s common-​ sense ability-​to-​repay protections prevent lenders from succeeding by setting up borrowers to fail.”41 In January 2018, the Bureau issued a statement announcing their plan to engage in a rule-​making process where the Bureau may reconsider the Payday Lending Rule.42 In July 2017, several months before Director Cordray’s departure, the Bureau finalized a rule regulating arbitration clauses in contracts governing certain consumer financial products and services. The rule prohibits covered providers of certain consumer financial products and services from using arbitration agreements that prevent consumers from filing or participating in class action litigation. On November 1, 2017, President Donald Trump signed a joint resolution passed by Congress in disapproving the Arbitration Agreement Rules that were issued by the BCFP based on the Congressional Review Act. As a result, the Arbitration Agreement Rules are currently no longer enforced.43 Such arrangements to cancel the rules were seen as another attempt by the new administration to undo the prior Bureau’s effort to protect financial consumers. A. The Judicial Review of BCFP’s Power

On January 29, 2014, CFPB (as it was called at the time) initiated an administrative proceeding against a New Jersey–​based corporation and its residential

Final Rule Prepaid Accounts under the Electronic Fund Transfer Act (Regulation E) and the Truth in Lending Act (Regulation Z), https://​www.consumerfinance.gov/​policy-​compliance/​rulemaking/​final-​rules/​prepaid-​ accounts-​under-​electronic-​fund-​transfer-​act-​regulation-​e-​and-​truth-​lending-​act-​regulation-​z/​ (last visited Mar. 18, 2018). 41 CFPB Finalizes Rule to Stop Payday Debt Traps, https://​www.consumerfinance.gov/​about-​us/​newsroom/​ cfpb-​finalizes-​rule-​stop-​payday-​debt-​traps/​ (last visited Mar. 19, 2018). 42 Payday Lending Rule https://​www.consumerfinance.gov/​policy-​compliance/​g uidance/​implementation-​ guidance/​payday-​lending-​rule/​, on March 19, 2018. 43 Final Rule Arbitration Agreements, https://​www.consumerfinance.gov/​policy-​compliance/​rulemaking/​final-​ rules/​arbitration-​agreements/​ (last visited Mar. 19, 2018). 40

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mortgage origination subsidiaries—​PHH Mortgage Corporation and PHH Home Loans LLC (PHH), and PHH’s wholly owned subsidiaries, Atrium Insurance Corporation and Atrium Reinsurance Corporation. CFPB concluded that when PHH originated mortgages, it referred consumers to mortgage insurers with which it partnered, and these insurers purchased “reinsurance” from PHH’s subsidiaries as a payment in a manner that violated the Real Estate Settlement Procedure Act of 1974 (RESPA),44 thereby unreasonably increasing the burden on borrowers.45 An administrative judge held that PHH violated RESPA since it did not demonstrate that the reinsurance premium collected was reasonably related to the reinsurance services. He recommended the disgorgement of about $6.4 million, which were the kickbacks connected with loans that closed on or after July 21, 2008.46 However, Director Cordray read the statute in a stricter way and concluded that PHH was liable anyway since it referred valuable business to its subsidiaries. Moreover, the Director concluded that the RESPA’s three-​year statute of limitations did not apply to the agency’s administrative proceeding and the violations accrued every time that PHH accepted each monthly premium (the kickback) on or before July 21, 2008. This led to both an extra $103 million fine and a total disgorgement of more than $109 million.47 In June 2015, PHH challenged the Director’s interpretation of the statute, the additional fine, and the constitutionality of the CFPB on the D.C. Circuit Court. In October 2015, the court agreed with all PHH’s accounts. Regarding the additional fine issue, the court found that PHH acted in reliance upon prior numerous government pronouncements, and the CFPB violated bedrock due process principles by retroactively applying its new interpretation of the statute against PHH. As a result, the court vacated the CFPB’s order and remand for further proceedings consistent with its opinion. 48 However, the court held that the Director’s for-​cause removal protection was unconstitutional since it allows the Director to enjoy significant unilateral power without presidential supervision. As a remedy, the court eliminated the for-​cause provision and the president now will have the power to remove the Director at will in order to supervise and direct the Director.49

12 U.S.C. § 2607. 45 CFPB, CFPB Takes Action Against PHH Corporation for Mortgage Insurance Kickbacks ( Jan. 29, 2014), https://​ www.consumerfinance.gov/​about-​us/​newsroom/​cfpb-​takes-​action-​against-​phh-​corporation-​for-​mortgage-​ insurance-​kickbacks/​. 46 Ben Lane, PHH Wins Landmark Victory: CFPB Ruled Unconstitutional (Oct. 11, 2016), https://​www. housingwire.com/​articles/​38252-​phh-​wins-​landmark-​victory-​cfpb-​ruled-​unconstitutional. 47 Id. 48 Id. 49 Id. 44

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This was the first judicial decision to review CFPB’s rule interpretation power and judge its constitutionality. Based on this decision, the president has the right to arbitrarily replace the Director. In November 2016, CFPB filed a petition with the D.C. Circuit to seek an en banc rehearing of its decision in this case, which the court granted in February 2017.50 During this litigation, the Trump administration filed an amicus brief asking the court to rule the CFPB’s single Director and for-​cause protection structure unconstitutional and allow the president to remove the Director as well.51 In November 2017, the CFPB’s Director Cordray, decided to resign before the end of his term.52 In January 2018, the en banc court concluded that CFPB is an independent institution, and its structure and the for-​cause removal protection are constitutional and reasonable for the CFPB’s intended purpose,53 giving legitimacy to the structure created by Dodd-​Frnak. On the other hand, the en banc court upheld its prior 3-​judge panel opinion that Cordray’s interpretation of the RESPA rules was incorrect and vacated the additional $103 million fine.54 IV. BCFP under President Trump’s Administration After Cordray resigned in November 2017, Deputy Director Leandra English assumed the role of Acting Director. At the same time, President Trump assigned Mick Mulvaney, the director of the White House Office of Management and Budget, as the Acting Director. English sought a preliminary injunction to prevent Mick Mulvaney from being the Acting Director. The D.C. court rejected it since she was unable to show the likelihood of success on the merits or that she would suffer irreparable injury in case an injunction would not be granted.55 Mulvaney leads the

50 Alan S. Kaplinsky, CFPB Asks for Rehearing En Banc in PHH Case (Nov. 21, 2016), https://​www. consumerfinancemonitor.com/​2016/​11/​21/​cfpb-​asks-​for-​rehearing-​en-​banc-​in-​phh-​case/​. 51 Ben Lane, Stunner: Court of Appeals Reverses Earlier Ruling, Declares CFPB Constitutional ( Jan. 31, 2018), https://​www.housingwire.com/​articles/​4 2410-​stunner-​court-​of-​appeals-​reverses-​earlier-​ruling-​declares-​ cfpb-​constitutional. 52 Jeff Cox, CFPB Director Richard Cordray to Step Down at the End of November (Nov. 15, 2017), https://​www. cnbc.com/​2017/​11/​15/​cfpb-​director-​richard-​cordray-​to-​step-​down-​at-​the-​end-​of-​november.html. 53 Lane, supra note 46. 54 Ben Lane, Court of Appeals Rules Against CFPB, Vacates PHH’s $100M Fine for Alleged RESPA Violations ( Jan. 31, 2018), https://​www.housingwire.com/​articles/​42420-​court-​of-​appeals-​rules-​against-​cfpb-​vacates​phhs-​100m-​fine-​for-​alleged-​respa-​violations. 55 Francis Monfort, CFPB Leadership Dispute Rages on ( Jan. 17, 2018), https://​www.mpamag.com/​news/​cfpb-​ leadership-​dispute-​rages-​on-​89580.aspx.

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Bureau until a new Director is nominated by President Trump and confirmed by the Senate.56 In February 2018 Director Mulvaney changed the name on the door of the CFPB from the Consumer Financial Protection Bureau to the Bureau of Consumer Financial Protection. This name changed reflects the name of the Buraeau according to the Dodd Frank legislation. According to the Director, “We changed the name because it’s the name in the statute,” Mr. Mulvaney said on Tuesday. “If your whole theme is going to be to follow the statute, I thought it was a good, small way, but a very visible way, to send a message.”57 In July 2018 CFPB Deputy Director Leandra English announced that she would drop her challenge to Director Mulvaney’s leadership. Her announcement that she was resigning from the BCFP came in the wake of confirmation by the White House that President Trump intended to nominate a permanent director, Kathy Kraninger, to run the Consumer Financial Protection Bureau.58 If confirmed, Kraninger would succeed Mulvaney, the White House budget director, as Director of the agency. Since Mulvaney took office, he has proposed several reforms limiting the BCFP’s previously unfettered powers including: • Suspending disbursements from its Civil Penalty Fund.59 • Requesting no funding from the Federal Reserve for the second quarter.60 • Reconsidering the 2015 Home Mortgage Disclosure Act (HMDA rule) which requires many lenders to report several aspects of data regarding mortgage loans; plans are to re-​examine the criteria to decide whether institutions are required to report mortgage data.61

Sylvan Lane, Mulvaney Unsure of When He Will Leave Consumer Bureau (Mar. 1, 2018, 10:31 a.m.), http://​ thehill.com/​policy/​finance/​376226-​mulvaney-​unsure-​of-​when-​hes-​leaving-​consumer-​bureau. 57 https://​www.nytimes.com/​2018/​06/​12/​business/​consumer-​protection-​bureau-​mulvaney.html (last visited Dec. 1, 2018). 58 https://​www.politico.com/​story/​2018/​07/​06/​consumer-​financial-​protection-​bureau-​leadership-​battle-​ 674254 (last visited Aug. 20, 2018). 59 Sarah O’Brien, Trump Team Is Determined to Rein in the Consumer Financial Protection Bureau (Feb. 5, 2018), https://​www.cnbc.com/​2018/​02/​05/​trump-​team-​is-​determined-​to-​rein-​in-​the-​consumer-​financial-​ protection-​bureau.html. 60 Michael Grunwald, Mulvaney Requests No Funding for Consumer Financial Protection Bureau ( Jan.18, 2018), https://​www.politico.com/​story/​2018/​01/​18/​mulvaney-​funding-​consumer-​bureau-​cordray-​345495. 61 CFPB, CFPB Issues Public Statement on Home Mortgage Disclosure Act Compliance (Dec. 21, 2017), https://​ www.consumerfinance.gov/​about-​us/​newsroom/​cfpb-​issues-​public-​statement-​home-​mortgage-​disclosure-​ act-​compliance/​. 56

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• Postponing the effective date and planning to reconsider the Payday, Vehicle Title, and Certain High-​Cost Installment Loans (“Payday Rule”),62 which requires payday loan lenders to ensure their consumers’ ability to repay. These short-​term loans are usually accompanied by high interest rates. • Freezing the collection of personal information due to concerns about the risk to privacy and cybersecurity.63 • Requesting public opinions on the Bureau’s functions, including on its judicial process and enforcement processes, rule-​making, and supervision process, adopted regulations, new rule-​making authorities, and consumer complaints reporting.64 • Transferring the Office of Fair Lending and Equal Opportunity (OFLEO) from the Supervision, Enforcement, and Fair Lending (SEFL) division to the director’s office as part of the BCFP’s Office of Equal Opportunity and Fairness (OEOF). In February 2018, Mulvaney published his next five-​year (2018–​2022) strategic plan of BCFP. He emphasized that the future goal of the Bureau is to fulfill its statutory responsibilities but go no further.65 Mulvaney set the two main missions of the Bureau directly from the CFPA: “to regulate the offering and provision of consumer financial products or services under the Federal consumer financial laws” and “to educate and empower consumers to make better informed financial decisions.” Furthermore, the Bureau will follow the five objectives set in the CFPA to accomplish these two goals: • Consumers are provided with timely and understandable information to make responsible decisions about financial transactions. • Consumers are protected from unfair, deceptive, or abusive acts and practices and from discrimination. • Outdated, unnecessary, or unduly burdensome regulations are regularly identified and addressed in order to reduce unwarranted regulatory burdens.

CFPB, CFPB Statement on Payday Rule ( Jan. 16, 2018), https://​www.consumerfinance.gov/​about-​us/​newsroom/​cfpb-​statement-​payday-​rule/​. 63 PYMNTS, CFPB Chief Puts Brakes on Personal Data Collection (Dec. 5, 2017), https://​www.pymnts.com/​ news/​cfpb/​2017/​citing-​cybersecurity-​risks-​interim-​cfpb-​chief-​shuts-​down-​data-​collection/​. 64 CFPB, Newsroom, https://​www.consumerfinance.gov/​about-​us/​newsroom/​?page=4&page=1#o-​filterable-​ list-​controls (last visited Apr. 4, 2018). 65 CFPB, Bureau of Consumer Financial Protection Strategic Plan 4 (Feb. 2018), https://​www.consumerfinance. gov/​about-​us/​budget-​strategy/​strategic-​plan/​. 62

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• Federal consumer financial law is enforced consistently in order to promote fair competition. • Markets for consumer financial products and services operate transparently and efficiently to facilitate access and innovation.66 The third strategic goal of the five-​year plan will focus on protecting the Bureau’s information security and increasing the efficiency of the Bureau’s internal management, such as enhancing the accountability and the enterprise risk management system.67 Most recently, in the Bureau’s semi-​annual report published in April 2018, Mulvaney recommends four statutory changes to the Dodd-​Frank Act in order to establish accountability for the Bureau. The comparisons with the current CFPA regulations are shown in the table below. Current CFPA

Mulvaney’s Proposals68

The Funding of the Bureau

The funding of the Bureau is transferred from the earnings of the Federal Reserve.

“Fund the Bureau through Congressional appropriations”

The Review of the Bureau’s Rulemaking Powers

FSOC may review the Bureau’s final regulations if requested.

“Require legislative approval of major Bureau rules”

The Accountability of the Director

The president can only remove the Director for inefficiency, neglect of duty, or malfeasance in office.

“Ensure that the Director answers to the President in the exercise of executive authority.”

The Federal Reserve may not intervene “Create an independent Inspector in any matter or proceeding before the General for the Bureau.” Director.

In general, Mulvaney claimed that he will work closely with other regulatory agencies and allow them to lead the main oversight role, avoiding the duplicating supervision and easing the burden on the financial institutes.69 Mulvaney also emphasized that BCFP will still be “going after bad actors who have really broken the law” but will not “get to decide who the bad guys are.”70 The Bureau highlighted that it is significantly important to ensure that the markets must be fair, transparent, Id. 67 Id. at 4 & 12–​13. 68 CFPB, Semi-​annual Report of the Bureau of Consumer Financial Protection, 2 (Apr. 2018), https://​files. consumerfinance.gov/​f/​documents/​cfpb_​semi-​annual-​report_​spring-​2018.pdf. 69 Kate Berry, CFPB Should Take Back Seat to Bank Regulators on Supervision: Mulvaney (Mar. 1, 2018), https://​ www.americanbanker.com/​news/​cfpbs-​mulvaney-​suggests-​effort-​to-​streamline-​bank-​exams. See also, Barbara S. Mishkin, CFPB to Look to State Ags for More Leadership in Enforcement Arena (Mar. 1, 2018), https://​www. consumerfinancemonitor.com/​cfpb-​enforcement/​. 70 Berry, supra note 69. 66

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and competitive.71 Some observers pointed out that the Bureau may be slowing its paces on the investigations and filing penalties, along with fewer new rules, and tends to deal with the “more mainstream” and less risky issues.72 In a way, by comparing the new Strategic Plan of the Bureau with the previous one, the 2018 Strategic Plan resonates that the Bureau will no longer solely consider their activities for the interest of the consumer but also to consider the financial industry market. On November 29, 2018 Kathy Kraninger the Senate advanced President Trump’s nominee to lead the Bureau of Consumer Financial Protection in a key procedural vote. The chamber voted 50 to 49, along party lines, to advance Kraninger’s nomination. Ironically, in one of her first acts as Director of the CFPB, Kathleen Kraninger, reversed Mick Mulvaney’s attempts to rebrand the C.F.P.B. as the Bureau of Consumer Financial Protection. V. The Judicial BCFP Structures under President Trump’s Administration A. Constitutionality of the Bureau On January 31, 2018, the United States Court of Appeals for the District of Columbia Circuit issued a decision concerning the ongoing case between the Bureau and PHH Corporation that started in 2014.73 This case when the Bureau filed a Notice of Charges against PHH, and its affiliates (Atrium) with the allegation of the application of excessive insurance premium. In response to PHH’s claims on the constitutionality of the Bureau’s Director for-​ cause removal, the court held that the Bureau’s structure is constitutional. The federal law that provides the Director of BCFP with a five-​year term in office, subject to removal by the president only for “inefficiency, neglect of duty, or malfeasance in office,” is consistent with the president’s constitutional authority.74 This issue is still subject to the possibility that the parties will seek Supreme Court review of the remaining issues. B. Single Directorship

In 2016, the House of Republicans introduced legislation to amend the structure of directorship in CFPB into a five-​member commission with a maximum of three members of the same party. The proposed legislation was set to fix accountability in the CFPB. However, there are also some opposing views that the commission structures for the Bureau directorship may cause new issues as a commission split Id. 72 O’Brien, supra note 59. 73 PHH Corp. v. Consumer Fin. Prot. Bureau, 881 F.3d 75 (D.C. Cir. 2018). 74 Id. 71

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among different parties could easily causing deadlock and rendering the Bureau to ineffective in enforcing its role.75 The issues of single directorship in the Bureau has also been used as an argument by the PHH Corporation when arguing the constitutionality of the Bureau. However, the en banc court rejected the idea that the Bureau’s structure is unconstitutionally merely because it is commanded by a single director rather than a multi-​member agency such as the SEC, FTC, and many other independent agencies in the United States.76 VI. Ongoing Enforcement Action Status A. Wells Fargo Case Two weeks after President Trump named Mick Mulvaney as acting director of the Bureau, the president posted a message through his social media account that stated: fines and penalties against Wells Fargo Bank for their bad acts against their customers and others will not be dropped, as has incorrectly been reported, but will be pursued, and if anything, substantially increase. I will cut Regs but make penalties severe when caught cheating.77 The president’s message was setting out an indication that the new administration of the Bureau will continue their investigation against Wells Fargo. The CFPB alleged that from 2011 to 2016, Wells Fargo’s employees used customers’ information and funds to apply for different financial products and services without the customers’ knowledge or consent. Main allegations comprise: (1) opening 1,534,280 unauthorized deposit accounts for existing customers and transferring funds to those accounts from their owners’ other accounts; (2) submitting applications for 565,443 credit card accounts in customers’ names using customers’ information; (3) enrolling customers in online banking services that they did not request; and (4) ordering and activating debit cards using customers’ information.78

The War on Consumer Protection, https://​www.usatoday.com/​story/​opinion/​2016/​03/​10/​consumer-​protection​cfpb-​bank-​regulation-​subprime-​mortgages-​great-​recession-​column/​81084452/​ (last visited Mar. 10, 2018). 76 PHH v. CFPB: Beyond the Headlines, A Big Win for Industry, https://​www.lexology.com/​library/​detail. aspx?g=de5a8e23-​59ad-​48a6-​9571-​6473cb0c3900 (last visited Mar. 12, 2018). 77 Trump’s Wells Fargo Tweet Cited in Court Hearing as Reason to Remove Mulvaney as CFPB Acting Chief, http://​ www.latimes.com/​business/​la-​fi-​cfpb-​mulvaney-​hearing-​20171222-​story.html (last visited Apr. 8, 2018). 78 CFPB, Consumer Financial Protection Bureau Fines Wells Fargo $100 Million for Widespread Illegal Practice of Secretly Opening Unauthorized Accounts (Sept. 8, 2016), https://​www.consumerfinance.gov/​about-​us/​ newsroom/​consumer-​financial-​protection-​bureau-​fines-​wells-​fargo-​100-​million-​widespread-​illegal-​practice-​ secretly-​opening-​unauthorized-​accounts/​. 75

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The Bureau concluded that these acts violated 12 U.S.C. §§ 5531 and 5536(a)(1) (B), the prohibition of unfair, deceptive, or abusive acts or practices (UDAAP). Specifically, by opening unauthorized deposit accounts, transferring funds and opening credit card accounts using customers’ information without their knowl­ edge or consent, Wells Fargo engaged in unfair acts that caused substantial injury to customers. These acts were not reasonably avoidable, because they occurred without customers’ knowledge, and were not outweighed by countervailing benefits to customers or competition. Moreover, all the Wells Fargo Bank employees’ alleged acts also constituted abusive practices by materially interfering with customers’ ability to understand a term or condition of a consumer financial product or taking unreasonable advantage of the consumers’ inability to protect their interests in selecting or using a consumer financial product or service.79 Wells Fargo agreed to refund all unauthorized account expenses to the affected consumers, estimated at least $2.5 million.80 The CFPB also fined Wells Fargo a record $100 million civil money penalty under 2 U.S.C. § 5565(c).81 Meanwhile, Wells Fargo will also pay an additional $35 million penalty to the Office of the Comptroller of the Currency, and another $50 million to the City and County of Los Angeles.82 Furthermore, Wells Fargo is required to select an independent consultant with specialized experience in consumer-​finance-​compliance issues to conduct an independent review of its sales practices. This is an important case to show how BCFP runs its enforcement authority of the “unfair, deceptive, and abusive acts and practices (UDAAP).” Additionally, with regards to Wells Fargo, on April 20, 2018, the BCFP announced a settlement with Wells Fargo with regard to the auto-​ loan administration and mortgage practices, where Wells Fargo will be subject to pay a $1 billion penalty and be credited with a $500 million penalty collected by the OCC toward the satisfaction of the fine.83 This decision was the first enforcement action of the Bureau since Mick Mulvaney become its Acting Director of the Bureau.

CFPB, In the Matter of WELLS FARGO BANK, N.A., Consent Order, paras.16–​37 (Sept. 9, 2016), https://​ files.consumerfinance.gov/​f/​documents/​092016_​cfpb_​WFBconsentorder.pdf. 80 Id. paras. 48–​56. 81 Id. para. 57. 82 Id. 83 Bureau of Consumer Financial Protection Announces Settlement with Wells Fargo for Auto Loan Administration and Mortgage Practices, available at https://​www.consumerfinance.gov/​about-​us/​newsroom/​bureau-​ consumer-​financial-​protection-​announces-​settlement-​wells-​fargo-​auto-​loan-​administration-​and-​mortgage-​ practices/​(last visited Apr. 24, 2018). 79

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I. Background  82 A. The Federal Reserve  82 B. The Federal Reserve Banking System  83 1. Composition  84 2. Purpose  84 3. Responsibilities  85 II. Economic Indicators and Interest Rates  86 A. Key Economic Statistics  86 1. Statistics  88 B. Monetary Policy Objectives  92 C. Inflation Targeting  95 III. Monetary Policy: The Financial Crisis and Beyond  96 IV. Quantitative Easing  97 A. Balance Sheet Normalization  104 B. Fiscal Considerations  106 V. FOMC Minutes  107

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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I. Background The domestic economy is the sum of all the assets, liabilities, and investment decisions made by U.S. investors. The aggregate spending and investing activities of Americans and corporations fuel economic growth. The health of the economy is closely connected to prevailing interest rates, as economic activity is a function, in part, of the availability of money to invest. Lower interest rates encourage spending and fuel growth, whereas rising rates have the opposite effect. A key component of asset valuation is the cost of borrowing funds; the ability to control interest rates directly impacts the value of assets in the economy. Congress mandates that the Board of Governors of the Federal Reserve System and the Federal Open Market Committee “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-​term interest rates.”1 When the Federal Reserve (the Fed) concludes that there is a general slowdown in the economy, it can ease monetary policy by lowering interest rates to stimulate growth, thereby helping the economy to expand. Conversely, when the Federal Reserve detects inflation, it can adjust interest rates higher to slow down expansion. Inflation describes increasing prices coupled with decreasing purchasing power. In a strong economy the price of goods rises. When prices rise there is a level at which the consumer will stop buying, leading to economic contraction and job loss. When inflation threatens the nation’s long-​run potential to increase production, the Federal Reserve tries to head off inflation by raising rates. Increased liquidity (i.e., more money) in the system is an inflationary risk. Since 2008 that risk has been kept in check by sluggish economic growth and high unemployment. A. The Federal Reserve

The Federal Reserve System was created by Congress under the Federal Reserve Act2 “to provide for the establishment of federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more

1 12 U.S.C. § 225a. As added by act of November 16, 1977 (91 Stat. 1387) and amended by acts of October 27, 1978 (92 Stat. 1897); Aug. 23, 1988 (102 Stat. 1375); and Dec. 27, 2000 (114 Stat. 3028)]. 2 Ch. 6, 38 Stat. 251 (1913).

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effective supervision of banking in the United States and for other purposes.”3 The Federal Reserve’s duties include: • Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-​term interest rates; • Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers; • Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets; and • Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system.4 B. The Federal Reserve Banking System

The U.S. Constitution (Article I, Section 8) gives Congress the power over money and the regulation of the value of U.S. currency. As a result of financial panics in the nineteenth and early twentieth centuries, which led to bank failures and business bankruptcies that severely disrupted the economy, Congress created the Federal Reserve and delegated those enumerated responsibilities to it.5 Congress passed the Federal Reserve Act6 in 1913 “to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States and for other purposes.” A network of 12 Federal Reserve banks and their branches currently carry out a variety of Federal Reserve System functions, including operating a nationwide payments system. Each Reserve bank also acts as a depository for the banks in its own district.7 These banks, although heavily regulated, are independent, privately owned, and locally controlled corporations.8 The Federal Reserve banks also provide check clearing and other banking services to financial institutions.9

3 See The Federal Reserve System, Purposes and Functions 2 (Board of Governors of the Federal Reserve System, 9th ed. 2005), available at http://​www.federalreserve.gov/​pf/​pdf/​pf_​1.pdf. 4 Id. at 1. 5 See id. 6 See 12 U.S.C. § 221. et seq. 7 See The Federal Reserve System, supra note 3, at 6. 8 Lewis v. United States, 680 F.2d 1239 (9th Cir. 1982). 9 See generally 12 U.S.C. §§ 221. et seq.

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1. Composition The Federal Reserve System comprises a central Board of Governors appointed by the president of the United States and confirmed by the Senate, and 12 regional Reserve banks. Monetary policy is set by the Federal Open Market Committee (the FOMC), which consists of the members of the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of four other Federal Reserve banks who serve on a rotating basis.10 Monetary policy is implemented through open market operations, that is, the purchase and sale of government securities.11 Open market operations are funded with reserves supplied by participating banks. The FOMC meets eight times each year to discuss monetary policy and implement change when necessary. It can also meet by conference call if necessary in-​ between the eight scheduled meeting dates. As a result of these deliberations, monetary policy is set and Federal Reserve open market participation is determined. Congress mandates that the FOMC work to ensure price stability and the greatest sustainable employment. The FOMC works to encourage sustained growth in the economy without fostering inflation. The FOMC’s main goal is to take appropriate actions and set policy that will steer the economy toward a path of sustainable growth. At times, when the economy is slowing down, the FOMC might lower its target federal fund rate to provide “financial stimulus” to the economy. By reducing the cost of borrowing, the FOMC creates a situation in which endeavors that stimulate economic growth can be undertaken more freely. “Financial stimulus” is not an exact science, but its goal is to encourage households, consumers, and corporations to spend money more freely. A good example of the stimulating effect of lower interest rates can be seen in the U.S. housing market, which grew immensely after 2002 as a result of lower mortgage rates. The increased value in homes allowed consumers to feel richer, to borrow more money on their home equity, and to spend more money. This spending helped the economy to grow. 2. Purpose When the system was founded, its principal legal purpose was to provide “an elastic currency,” meaning a supply of credit that could fluctuate as needed to meet seasonal and other changes in credit demand. In this regard, the Federal Reserve was an immediate success. The seasonal fluctuations that had characterized short-​term

See The Federal Reserve System, supra note 3, at 3. 11 See Sec. IV, infra, for more detailed discussion. 10

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interest rates before the founding of the Federal Reserve were almost immediately eliminated, thereby removing a source of stress from the banking system and the economy. Today, the Federal Reserve retains important responsibilities related to banking and financial stability, and its ability to carry out these responsibilities has been expanded under Dodd-​Frank. Its current mandate, set formally in law in 1977, reaffirmed in 2000, and augmented in 2010, requires that the Federal Reserve pursue three objectives when establishing its monetary policy: maximum employment, stable prices, and moderate long-​term interest rates.12 The Federal Reserve has the responsibility to issue paper money. It serves as a banker for both the government and commercial banks, and acts as the lender of last resort. As the lender of last resort, the Federal Reserve has certain regulatory responsibilities. The Federal Reserve requires member banks to maintain reserve deposits. In managing reserve deposits, the Fed manages monetary policy.13 3. Responsibilities The Federal Reserve has two broad sets of responsibilities. First, it has a mandate from Congress to promote a healthy economy, specifically by fostering maximum sustainable employment, stable prices, and moderate long-​term interest rates. Second, since the Fed’s founding, it has been entrusted with the responsibility of helping to ensure the stability of the financial system; Dodd-​Frank greatly increased the Federal Reserve’s ability to fulfill this second responsibility.14 The Federal Reserve has a range of powers related to financial institutions, including rule-​making powers, supervisory oversight, and a lender-​of-​last resort function made operational by its ability to lend through its discount window. The Federal Reserve focuses its monetary policy instruments on achieving its macro goals of price stability and maximum sustainable employment.15 Historically, the Federal Reserve almost exclusively implemented monetary policy by targeting the overnight interest rate, known as the federal funds rate.16 However, once the federal funds rate was targeted at effectively zero, to implement monetary policy, the

Ben S. Bernanke, The Benefits of Price Stability, Address at the Center for Economic Policy Studies and on the Occasion of the Seventy-​Fifth Anniversary of the Woodrow Wilson School of Public and International Affairs, Princeton University (Feb. 24, 2006). 13 See Sec. IV, infra, for more detailed discussion. 14 See ­chapter 3 “Dodd-​Frank and the Regulation of Depository Institutions Capital Requirements.” 15 Ben S. Bernanke, Asset-​Price “Bubbles” and Monetary Policy, Address Before the New York Chapter of the National Association for Business Economics (Oct. 15, 2002). 16 See id. for more detailed discussion. 12

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Federal Reserve undertook the purchase of long-​term securities to directly affect long-​term interest rates. II. Economic Indicators and Interest Rates In crafting its monetary policy, the Federal Reserve analyzes numerous and often-​ contradictory datapoints, making the task of setting interest rates subtle and often quite difficult. The Federal Reserve studies datapoints reflecting past economic activity, as it is sometimes difficult to determine what is currently happening in the economy. Federal Reserve economists analyze data using statistical probabilities to determine likely outcomes; policymakers, therefore, must rely on economic assumptions and reasonable projections in steering the economy. The actions of the Federal Reserve reflect the best efforts of the Central Bank to determine the correct course of action for the American economy. However, the Federal Reserve cannot guarantee that its adjustments in targeting the federal funds rate or in purchasing longer-​term securities will in fact have the desired impact on economic expansion, contraction, or inflation. The Federal Reserve and market participants carefully watch the release of economic data in order to gauge how the Federal Reserve will adjust its monetary policy. The economic calendar includes Federal Reserve meeting dates, releases of market-​sensitive data, and releases of important economic information and statistics. A. Key Economic Statistics

Each economic datapoint provides a picture of the health of the economy. By analyzing this data, the Federal Reserve determines the current domestic economic condition to decide on monetary policy. At the same time, on the fiscal side, the president and Congress make their own assessments. For example, Larry Kudlow, Director of the National Economic Council under President Trump since 2018, analyzed the recovery in his interpretation of key economic statistics. He said the following in an August 2018 cabinet meeting:17 Here’s the key point I made to the President yesterday and I make it to you today, and I hope we all we keep making it: By far—​by far—​the single biggest

https://​www.whitehouse.gov/​briefings-​statements/​remarks-​president-​trump-​cabinet-​meeting-​10/​ (last visited Aug. 21, 2018). 17

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event, be it political or otherwise, this year is an economic boom that most people thought would be impossible to generate. Not a rise, not a blip—​a genuine economic boom. . . . And the numbers are coming in; they just keep coming in, which is one of the reasons I tried to get a hold of the President on this. I mean, we’ve got 3.1 percent GDP in the first half of the year; 4.1 in the second quarter. The Atlanta Fed is predicting 4.3 in the third quarter. I think it’s a very realistic estimate. Here’s the point: Anybody who does political forecasting using the economy always focuses on a number—​hang with me—​real disposable income. Just think of it as after-​tax pay—​“take-​home pay,” Ronald Reagan used to say (inaudible). So that measure is growing at 3.1 percent the last 12 months. When we came to office, it was less than 1 percent on a 12-​month basis. . . . .This is a measure of the entire economy. Everyone’s wages and salaries, adjusted for taxes and adjusted for inflation, is growing at 3 percent. It’s a tremendous number. And there’s no signs that’s abating. Confidence—​confidence numbers: Large businesses, small businesses, and consumer confidence numbers are at or near record highs, and, from the latest surveys, are continuing to rise. There’s no letup in the increase. And confidence is everything. Confidence is everything. . . . The really wonderful part of the story for. . . . retail sales, industrial production, low inflation, a rock-​steady dollar. Trillions of dollars of capital from all over the world is coming into the United States because our economy, our investors, our workforce are crushing it right now. We are crushing it. And people say this is not sustainable, it’s a one-​quarter blip. It’s just nonsense, absolute nonsense. Any business economist worth his or her salt would look at these trends and tell you we’re going for a while. We have low inventories. We have rising business investment. Productivity is showing the first lift in years; the last number was 1.3 percent for the year. We haven’t seen that in a long time. Businesses are investing. Capital goods is booming. This is a complete turnaround. It’s like, if you give Americans some freedom to run, they will run. . . . we are just in the early stages. We’re in the early innings here. We never had a cap goods boom. We’re now starting. And we’ve never seen income numbers like this—​again, after tax, after inflation. Notwithstanding the assessment of the Fed, the president, or his advisors the market adjusts its perception of how assets should be valued based on various datapoints and economic trends. These datapoints and statistics influence growth and inflation expectations, thereby impacting capital deployment in business and investing.

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5 4 3 2 1 0

Q4 Q1 2014

Q2 Q3 2015

Q4

Q1

Q2 Q3 2016

Q4

Q1

U.S Bureau of Economic Analysis

Q2 Q3 2017

Q4

Q1

Q2 2018

Q3

Seasonally adjusted at annual rates

Figure 7.1  Real GDP: Percent change from previous quarter.

1. Statistics Statistics, including data put out by the Bureau of Economic Analysis, provide a comprehensive view of U.S. production, consumption, investment, exports and imports, and income and saving. These statistics are best known by summary measures such as gross domestic product (GDP), corporate profits, personal income, and spending and personal saving:18 Gross Domestic Product (GDP). GDP is the market value of goods and services produced by labor and property in the United States, regardless of nationality; GDP replaced gross national product (GNP) as the primary measure of U.S. production in 1991. The following is a chart of GDP from the third quarter of 2014 through the third quarter of 2018.19 Personal Income. Personal income is income received by persons from all sources. It includes income from participation in production as well as from government and business transfer payments. It is the sum of compensation of employees (received), supplements to wages and salaries, proprietors’ income with inventory valuation adjustment and capital consumption adjustment, rental income of persons, personal income receipts on assets, and personal current transfer receipts, less contributions for government social insurance. The following shows a graphic representation of the personal income numbers during 2018.20

Definitions and charts included here are taken from the Bureau of Economic Statistics website at: http://​www. bea.gov/​newsreleases/​glance.htm (last visited Aug. 3, 2018). 19 Id. 20 Id. 18

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0.6 0.4 0.2 0.0 –0.2

Mar.

Apr.

Real Disposable Personal Income

May

June

Real Consumer Spending

Figure 7.2  Real Disposable Personal Income and Real Consumer Spending. Source: Bureau of Economics Analysis.

There are several additional key economic releases available from other government sources that are used to analyze the economy, including: Import Price Indexes. Import price indexes measure the average change in import prices of a fixed basket of goods. Depending on the practices of the particular industry, the prices are generally either “free on board” (FOB) foreign port or “cost, insurance and freight” (CIF) U.S. port transaction prices.21 Balance of Trade. The balance of trade reflects the difference in the value of exports and imports in the American economy. When exports exceed imports there is a trade surplus; when imports exceed exports there is a trade deficit. Through the Department of Commerce, the Census Bureau and the Bureau of Economic Analysis release the statistics of the total monthly exports and imports.22 Treasury Monthly Budget. Issued by the Treasury, the treasury monthly budget contains information on the monthly budget deficit. Generally, a growing deficit will increase the yield on government bonds. The effect of a trade deficit is that the Treasury will have to issue more bonds to finance its operations. As the government issues more bonds, the new supply puts pressure on bond prices, thereby pushing interest rates higher. Consumer Price Index (CPI). The CPI, issued by the Bureau of Labor Statistics (BLS), demonstrates changes in retail prices that American consumers paid for a basket of goods. This report provides a measure of domestic economic

See U.S. Bureau of Labor Statistics definition at http://​data.bls.gov/​ (last visited Aug. 3, 2018). 22 See Bureau of Economic Analysis at www.bea.gov (last visited Aug. 3, 2018). 21

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activity. The BLS gathers price information from selected department stores, supermarkets, service stations, doctors’ offices, rental units, and so forth. About 80,000 prices are recorded in 87 urban areas. The information contained in the CPI provides an accurate picture of the increase or decrease in prices that consumers are paying for their goods.23 Initial Jobless Claims. The Department of Labor reports on the number of people who have filed for unemployment insurance or unemployment benefits during the prior week. By analyzing these statistics, the Federal Reserve and the capital markets are better able to understand the employment picture in the United States on a weekly basis. Because maximum employment is a key goal of the Federal Reserve, these statistics provide valuable insight into the health of the economy and the resulting direction of interest rates. Retail Sales. The retail sales report is a monthly report issued by the Census Bureau that measures the cost of all goods sold by retailers based on a sampling of various retail stores. As automobile sales can be quite volatile but are nonetheless included in the monthly retail sales report, many economists look at the retail sales report but exclude automobile sales. This report is a solid indication of the Consumer Confidence Index, a monthly survey issued by the Conference Board, a research organization for businesses. The monthly survey of 5,000 households is designed to measure Americans’ optimism about their current and future situation. Business Inventories. The business inventories report is a monthly report issued by the Department of Commerce that measures the change on a month-​to-​ month basis in manufacturers’, retailers’, and wholesalers’ inventories. These changes are reflected on a percentage basis. The ratio of inventories to sales is particularly important because an increase in the ratio of inventory to sales might indicate a slowdown in the economy. Producer Price Index (PPI). Released monthly by the Bureau of Labor Statistics, the PPI measures changes in prices on the wholesale level. Included in the PPI are prices of food, certain commodities, and energy products. The PPI, therefore, is a direct measure of inflation on a wholesale level. Increases in wholesale prices are likely to carry over into the consumer marketplace and may have an impact on consumer spending and the CPI. The core CPI that excludes food and energy (components that are generally more price volatile) is usually more indicative of macroeconomic inflationary trends. When inflation increases, yields rise and the market will confirm its reaction to the release of the PPI data when the CPI is released.

See U.S. Department of Labor Bureau of Labor Statistics at http://​www.bls.gov (last visited Aug. 3, 2018). 23

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New York Empire State Index. The New York Federal Reserve Bank’s New York Empire State Index reflects the results of a monthly survey of 175 manufacturing CEOs and presidents regarding certain business indicators. Respondents give their views regarding the likely direction of these same indicators six months forward. This index is seasonally adjusted using the Philadelphia Federal Reserve’s seasonal factors because the New York Empire State Index has insufficient historical data of its own to make a meaningful adjustment. Market participants follow the economic indicators reflected in this index to better understand the direction of regional economic activity. Excessive growth in these indicators may indicate inflationary pressure on the markets for capital. Capacity Utilization. Released by the Board of Governors of the Federal Reserve System, the capacity utilization report measures the operating capacity of resources in the economy. This report gauges the use of economic resources throughout the economy and measures the amount of current productive capacity utilized. Industrial production data gives data watchers an indication of actual output relative to potential economic output throughout the domestic economy. These rates will generally rise during economic expansions and fall during recessions. Where capacity utilization is increasing month to month, the market may infer that the economy is expanding, resulting in increased inflation and higher interest rates. Industrial Production. Issued by the Federal Reserve, the report on industrial production measures the total output of U.S. factories and mines. It is considered a key economic indicator measuring all of the goods produced by the economy. Industrial production rises during economic expansions and falls during recessions. Higher levels of industrial production signal growth in the economy. Bond yields will often rise in response to higher industrial production numbers, reflecting capital market inflation concerns. The University of Michigan’s Consumer Survey. The University of Michigan’s Consumer Survey reports on the results of a survey of 500 American households conducted monthly by the University of Michigan. The sentiment of American consumers is directly correlated to consumer spending. Consumer spending has a great influence on asset valuation in that it is a strong influence on demand for goods and services throughout the economy. Consumer spending accounts for more than two-​thirds of the economy; the markets are constantly examining consumer attitude toward spending. The more confident consumers are about their personal economic situation, the more likely they are to spend money to increase economic productivity.24 See http://​www.nasdaq.com/​econoday/​reports/​ (last visited Aug. 3, 2018). 24

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B. Monetary Policy Objectives

During the 1970s, the Federal Reserve had the goal of affecting the growth of the monetary aggregate. The monetary aggregate represents the amount of money in the economy; by affecting the monetary aggregate, the Federal Reserve believed that it could control how much money was available for investment and spending. It was believed that the amount available to the economy had a direct and ongoing relationship with economic activity. Raising and lowering the target federal funds rate can effectively control this aggregate by affecting the amount of money financial institutions have on deposit with the Federal Reserve banks. Lowering interest rates, for example, makes having money on deposit less attractive, thereby influencing the investor’s decision whether to keep money in the bank. The problem with the monetary aggregate goal-​oriented approach was that the Federal Reserve was often forced to make large rate movements to bring the monetary aggregate back into line. Due to the profound impact of substantial moves in the federal funds rate, the Federal Reserve was often unable to react to inflationary pressures resulting from oil price shocks and excessive monetary growth over the decade.25 By the end of the 1970s, the Federal Reserve began to focus on controlling the amount of reserves held in the vaults of depository institutions. The Monetary Control Act of 1980 requires that all depository institutions hold “sterile” reserves with the Fed;26 the implementation of monetary policy may be the sole purpose of these reserve requirements.27 The goal of the Federal Reserve in controlling these reserves was no longer to affect the amount of aggregate money in the economy, but instead to affect the money held on deposit. By targeting a specific amount of money that had not been borrowed, banks would be required to pay a higher interest rate to shore up their reserves, thereby affecting prevailing interest rates. The Federal Reserve could influence the rate that the market would bear for borrowing funds by affecting the borrowing rate of the discount window. The discount window is the vehicle the Federal Reserve uses to extend credit to financial institutions when the institutions have exhausted all other borrowing options. Before the crisis, financial institutions resisted borrowing from the discount window, as this was seen as a sign of weakness from an institution that had no other See The Federal Reserve System, supra note 3, at 28. 26. 12 U.S.C. § 461(c). It should be noted that in 2008 the Federal Reserve implemented a program for the payment of market-​rate interest on these reserves in order to increase bank liquidity and to take up the slack resulting from banks that were unwilling to engage in counterparty transactions with banks whose fortunes could change overnight. The Federal Reserve described its decision in an October 6, 2008, press release: These actions should encourage term lending across a range of financial markets in a manner that eases pressures and promotes the ability of firms and households to obtain credit. 27 Supra note 2, at 48. 25

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sources of capital available. Institutions preferred to increase reserves by borrowing excess reserves from other member banks. Recognizing this dynamic, the Federal Reserve sought to directly influence the interest rates financial institutions charge each other. The attempt to directly influence these rates could be considered a modified monetary policy goal. In July 1995, the Federal Reserve announced that it would directly target the rate banks charge each other to borrow deposits held at Federal Reserve banks.28 Federal funds are reserves held in a bank’s Federal Reserve Bank account. Regulation D imposes uniform reserve requirements on all depository institutions with transaction accounts or nonpersonal time deposits.29 If a bank holds more federal funds than are required to cover its Regulation D reserve requirement, those excess reserves may be lent to other financial institutions with an account at a Federal Reserve bank. To the borrowing institution, these funds are federal funds purchased. To the lending institution, the funds are federal funds sold. Federal funds purchases are not government insured and are not subject to Regulation D reserve requirements or insurance assessments. They can be borrowed only by those depository institutions that are required by the Monetary Control Act of 1980 to hold reserves with Federal Reserve banks: commercial banks, savings banks, savings and loan associations, and credit unions. A unique feature of these federal funds transactions is that the transactions generally occur without a formal written contract.30 Federal reserves are traded between banks in the form of federal funds. The transactions only take place when a bank needs additional reserves in order to be in compliance with Federal Reserve capital requirements. The Federal Reserve is able to affect interest rates by targeting the borrowing rate at which these transactions occur. The process of targeting the federal funds rate is a dynamic process that adjusts in ways necessary to address changes in economic conditions. The FOMC oversees open market operations to ensure that the target federal funds rate is achieved.31 In a March 2005 speech, then Governor Bernanke described the implementation of monetary policy through open market operations in the federal funds market: The funds rate is a market rate, not an administered rate set by fiat—​that is, the funds rate is the rate needed to achieve equality between the demand for 28 Supra note 2, at 29. 29 Regulation D: Reserve Requirements of Depository Institutions, 12 C.F.R. 204. 30 Board of Governors of the Federal Reserve System, Trading and Capital-​Markets Activities Manual § 4005.1. 31 See The Federal Reserve System, supra note 3, at 3, available at http://​www. federalreserve.gov (last visited Aug. 3, 2018).

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and the supply of reserves held at the Fed . . . [T]‌‌he demand for reserve balances arises both because banks must hold required reserves and because reserve balances are useful for facilitating transactions. Because of the scale of and volatility in daily payments flows, the demand for reserve balances can vary substantially from one day to the next. The supply of reserve balances is largely determined by the Federal Reserve—​ at the operational level, by the specialists at the Federal Reserve’s Open Market Desk, located in the Federal Reserve Bank of New York in the New York financial district. For example, to increase the supply of reserves, the Open Market Desk purchases securities (usually government securities) on the open market, crediting the seller with an increase in reserve balances on deposit at the Fed in the amount of the purchase, thus, a purchase of a billion dollars’ worth of securities by the Open Market Desk increases the supply of funds available to lend in the fed funds market by the same amount. Similarly, sales of securities from the Fed’s financial portfolio result in debits against the accounts of commercial banks with the Fed and thus serve to drain reserve balances from the system. Collectively, these transactions are called open-​market operations. Factors outside the control of the Open Market Desk can also affect the supply of reserve balances. . . . In practice, the Open Market Desk uses several methods of performing open-​ market operations. In some cases it purchases securities outright, that is, with the intention of holding the securities in its portfolio indefinitely. Outright purchases are used to offset long-​lasting changes in factors affecting the demand for and supply of reserves. For example, long-​term increases in the private sector’s demand for currency have largely been met by outright purchases of securities. . . . The manager of the Open Market Desk and his team bear the responsibility of adjusting the supply of fed funds to maintain the funds rate at or near the target established by the FOMC. Meeting this objective on a daily basis is technically challenging. To hit the funds rate target, the Desk staff must forecast the daily demand for balances as well as changes in external factors affecting reserves supply. Open-​market operations are then set in motion to balance the supply of and demand for reserves at the target funds rate . . .32

Ben S. Bernanke, Governor, Implementing Monetary Policy, Address at the Redefining Investment Strategy Education Symposium (Mar. 30, 2005). 32

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C. Inflation Targeting

Since the onset of the crisis, the Federal Reserve became increasingly more transparent with regard to its processes and decision-​making. In addition to continuing to influence interest rates via its federal funds targeting approach and its direct purchasing of longer-​term securities, the Federal Reserve has also begun to incorporate announcements regarding its target for inflation. A rich literature in macroeconomics emphasizes that actual inflation and inflation expectations may to some degree evolve independently, and that effective monetary policy stabilizes inflation expectations as well as inflation itself.33 It is far easier to make sense of the term structure of Treasury yields if one assumes that expectations about long-​run inflation adjust in a reasonably adaptive manner.34 Inflation targeting is a process whereby the central bank publicly announces and pursues specific targets for the rate of inflation. Inflation targeting is a framework for monetary policy characterized by the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons. By announcing its target for inflation, the Fed acknowledges that the primary long-​run goals of monetary policy are low and stable inflation. An important part of inflation targeting is effectively communicating with the public about the plans and objectives of the monetary authorities. In many cases, this communication establishes enhanced accountability for the authorities to achieve their stated objectives. Inflation targeting can be described as a form of “constrained discretion.” Under a constrained discretion approach, central banks adhere to a conceptual structure while maintaining flexibility. Inflation targeting represents continuity with the existing approach of the Federal Reserve System. This approach considers maintaining medium-​and long-​term inflation stability to be the primary contribution the Federal Reserve can make to maintain the stability of the general economy. Inflation targeting is an attempt at codifying and strengthening the important commitment of the Federal Reserve to maintain low and stable inflation. One of the most effective ways to do this is to maintain, in the medium-​and long-​term, low and stable inflation and inflation expectations. To the extent that articulating a long-​term inflation objective can help stabilize expectations and keep inflation

Ben S. Bernanke, Inflation Targeting: Prospects and Problems, Address at the 28th Annual Policy Conference: Federal Reserve Bank of St. Louis (Oct. 17, 2003). 34 Ben S. Bernanke, Monetary Policy Modeling: Where Are We and Where Should We Be Going?, Address at the Federal Reserve Board Models and Monetary Policy Conference (Mar. 27, 2004). 33

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under control, it significantly advances the Federal Reserve’s ability to meet its dual mandate and increase employment growth.35 Inflation targeting, at least in its best-​practice form, consists of two parts: a policy framework of constrained discretion and a communication strategy that attempts to focus expectations and explain the policy framework to the public. Together, these two elements promote both price stability and well-​anchored inflation expectations; the latter in turn facilitates more effective stabilization of output and employment. Thus, a well-​conceived and well-​executed strategy of inflation targeting can deliver positive results with respect to output and employment, as well as to inflation.36 The concept of inflation targeting has been introduced to the Federal Reserve’s messaging to indicate to the markets when the Federal Reserve might change its accommodative stance.37 III. Monetary Policy: The Financial Crisis and Beyond In December 2008, the Federal Reserve targeted the federal funds rate at or near zero. In observing the weakness in the economy, the Federal Reserve took this step to spur growth. The FOMC explained its decision as follows: The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/​4%. Since the Committee’s last meeting, labor market conditions have deteriorated and the available data indicate that consumer spending, business investment and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further. Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

35 Hearing Regarding Ben Bernanke’s Nomination to be Chairman of the Board of Governors of the Federal Reserve, U.S. Senate Committee on Banking, Housing and Urban Affairs (Nov. 15, 2005). 36 Ben S. Bernanke, A Perspective on Inflation Targeting, Address at the Annual Washington Policy Conference of the National Association of Business Economists (Mar. 25, 2003). 37 See, e.g., Press Release, Federal Reserve (May 1, 2013): “When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-​run goals of maximum employment and inflation of 2 percent.”

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97

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-​backed securities to provide support to the mortgage and housing markets and it stands ready to expand its purchases of agency debt and mortgage-​ backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-​term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-​Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.38 In December 2008 the Federal Reserve explained that it was considering ways of using an expanded balance sheet to improve economic conditions. In the following years, the Federal Reserve did indeed expand its balance sheet by purchasing securities to directly influence longer-​term rates. As of the end of 2013 the Fed announced that it expects this policy to continue until economic conditions warrant a change. The liquidity provided by a fed funds rate of zero coupled with direct attacks on longer-​term interest rates forces cash into the system and encourages a functioning capital market; it is also designed to help the economy to improve overall.39 IV. Quantitative  Easing Since 2008, the Federal Reserve has taken many steps to provide liquidity to the capital markets. It has primarily done so by expanding its balance sheet by loaning money to banks and by purchasing securities. The Federal Reserve traditionally served as a lender of last resort. However, it has expanded that traditional role with several programs designed to provide liquidity to the capital markets: The traditional discount window, Term Auction Facility (TAF), Primary Dealer Credit Facility (PDCF) and Term Securities Lending Facility

38 Press Release, Federal Reserve (Dec. 16, 2008). 39 See the Federal Reserve’s response to the financial crisis and actions to foster maximum employment and price stability at http://​www.federalreserve.gov/​monetarypolicy/​bst_​crisisresponse.htm (last visited Aug. 3, 2018).

98

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(TSLF) fall into this category. Because bank funding markets are global in scope, the Federal Reserve also approved bilateral currency swap agreements with 14 foreign central banks. These swap arrangements assisted these central banks in their provision of dollar liquidity to banks in their jurisdictions. A second set of tools involve the provision of liquidity directly to borrowers and investors in key credit markets. The Commercial Paper Funding Facility (CPFF), Asset-​ Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), Money Market Investor Funding Facility (MMIFF) and the Term Asset-​Backed Securities Loan Facility (TALF) fall into this category.40 In addition to expanding its role as lender of last resort, “the Federal Reserve expanded its traditional tool of open market operations to support the functioning of credit markets, put downward pressure on longer-​term interest rates and help to make broader financial conditions more accommodative through the purchase of longer-​term securities.” As of January 30, 2019, the Federal Reserve holds approximately $3.822 trillion dollars’ worth of bonds broken down as follows: Security Type

Total (in thousands)

US Treasury Bills (T-​Bills) US Treasury Notes and Bonds (Notes/​Bonds)

2,064,760,611.5

US Treasury Floating Rate Notes (FRN) US Treasury Inflation-​Protected Securities (TIPS)*

18,825,874.1 114,768,909.8

Federal Agency Securities**

2,409,000.0

Agency Mortgage-​Backed Securities***

1,621,808,659.7

Total SOMA Holdings

3,822,573,055.1

41

Change From Prior Week

–​7,086,047.0

* Does not reflect inflation compensation of 21,656,211

** Fannie Mae, Freddie Mac, and Federal Home Loan Bank *** Guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. Current face value of the securities, which is the remaining principal balance of the securities.

40 Id. 41 The Federal Reserve System Open Market Account (SOMA) is a portfolio of U.S. Treasury and Federal Agency securities, foreign currency investments, and reciprocal currency arrangements.

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Understanding Interest Rates and the Economy

99

As a result of the Federal Reserve’s balance sheet expansion, rates on U.S. government IOUs reached historic lows. By late 2008, with the federal funds rates at zero, the Federal Reserve had to resort to a direct attack on longer-​term rates in order to stimulate the economy. To complement efforts of the Troubled Asset Relief Program (TARP)42 to increase available funds for commercial banks, the Federal Reserve initiated a monetary policy known as “quantitative easing.” Quantitative easing means the central bank purchases financial assets from private institutions, thereby injecting a predetermined quantity of money into the economy, increasing the excess reserves of commercial banks, and decreasing the supply of the assets purchased. This decreased supply raises the price of those assets, which decreases their yield.43 At the same time, investors rebalance their portfolios by replacing the assets purchased by the central bank. This behavior drives up prices on the other types of assets those investors select and decreases their yields.44 “Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy.”45 Large-​scale asset purchases can evidence an “accommodative policy stance” on the part of the Central Bank, thereby lowering investors’ expectations regarding the future federal funds rate, which decreases long-​term interest rates.46 The increase in the money supply also facilitates consumer lending by banks.47 As of January 2013, the Fed had announced four rounds of quantitative easing and a similar purchase program known as Operation Twist. The Federal Reserve announced the first round of quantitative easing in November 2008. It entailed a $600 billion allocation to purchase agency mortgage-​ backed securities and agency debt.48 In an attempt to create more liquidity in the consumer credit market, an additional $200 billion would be loaned to holders of securities backed by consumer loans, such as student loans, car loans, and credit cards.49 See ­chapter 1. 43 Larry Elliot, Business Glossary, Quantitative Easing, Guardian, Jan. 8, 2009, http://​www.guardian.co.uk/​ business/​2008/​oct/​14/​businessglossary. 44 Ben S. Bernanke, Monetary Policy Since the Onset of the Crisis, Address at the Federal Reserve Bank of Kansas City Economic Symposium (Aug. 31, 2012), http://​www.federalreserve.gov/​newsevents/​speech/​ bernanke20120831a.htm (last visited Dec. 1, 2018). 45 Id. 46 Id. 47 Elliot, supra note 43. 48 US Fed Announces $800 BN Stimulus, BBC News, Nov. 25, 2008, http://​news.bbc.co.uk/​2/​hi/​business/​ 7748362.stm. 49 Chris Isidore, Fed Bets 800 Billion on Consumers, CNN, Nov 25, 2008, http://​money.cnn.com/​2008/​11/​25/​ news/​economy/​paulson_​consumer/​index.htm. 42

10

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On March 18, 2009, the Fed announced that it would significantly expand the purchasing program by an additional $750 billion for agency mortgage-​backed securities, $100 billion in agency debt, and $300 billion of longer-​term Treasury debt.50 On November 3, 2010, the Fed announced a second round of quantitative easing, known colloquially as QE2, in which it would purchase $600 billion of longer-​term Treasury securities over a period ending in mid-​2011.51 In November 2011, the Fed introduced a variation on earlier purchase programs when it commenced Operation Twist. The Fed agreed to purchase $400 billion of long-​term Treasury Securities (with remaining maturities of 6 to 30 years) and sell an equivalent amount of short-​term Treasury securities (those with maturities of three years or less).52 Purchases of long-​term bonds would drive their prices up and their yields down, while selling short-​term bonds decreases their prices while increasing their yield. The combination of these two actions was intended to “twist” the yield curve, extending the average maturity of securities held on the Fed’s balance sheet but decreasing the average maturity of securities held by the public, thereby placing additional downward pressure on long-​term interest rates.53 The goals of Operation Twist—​ driving down long-​ term interest rates and easing prevalent financial conditions—​were similar to those of quantitative easing, but Operation Twist avoided the injections of money and the expansion of the Fed’s balance sheet that could potentially create inflationary pressure. Concerns about slowing employment growth and a high unemployment rate prompted the FOMC to extend Operation Twist until the end of 2012 by pledging an additional $267 billion for Treasury securities purchases in an effort to keep interest rates low.54 The Federal Reserve has labeled its repurchase programs as successes, with “economically meaningful” evidence that the Fed’s asset purchases lowered yields for longer-​term Treasury securities, corporate bonds, and mortgage-​backed securities, as well as eased broader financial conditions.55 Evidence also suggests that the programs

Bernanke, supra note 44. 51 Id. 52 Id. 53 See id. 54 Press Release, Board of Governors of the Federal Reserve System ( June 20, 2012), http://​www.federalreserve. gov/​newsevents/​press/​monetary/​20120620a.htm; Jeff Kearns & Joshua Zumbrun, Fed Expands Operation Twist by $267 Billion Through 2012, Bloomberg, June 20, 2012, http://​www.bloomberg.com/​news/​2012-​06-​ 20/​fed-​expands-​operation-​twist-​by-​267-​billion-​through-​year-​end.html. 55 Bernanke, supra note 44. 50

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101

boosted the equity markets by lowering discount rates and generally improving the economic outlook, which can encourage consumption and investment.56 The Fed continued to pursue its policy of quantitative easing by adding two new rounds in as economic numbers continued to show lackluster growth in the economy and unacceptable levels of unemployment. On September 13, 2012, the FOMC announced that it would purchase $40 billion of agency mortgage-​backed securities each month.57 On December 12, 2012, the FOMC authorized continuing the purchases of $40 billion of agency mortgage-​backed securities and additional purchases of up to $45 billion worth of longer-​term Treasury Securities each month, essentially extending Operation Twist’s mandate.58 Each round of quantitative easing further expanded the Fed’s $2.8 trillion balance sheet.59 In May 2013, the Federal Reserve announced its assessment of the future of accommodative monetary policy: To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/​4% and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-​1/​2%, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-​run goal and longer-​term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-​run goals of maximum employment and inflation of 2%.60 56 Id. 57 Press Release, Board of Governors of the Federal Reserve System (Sept. 13, 2012), http://​www.federalreserve. gov/​newsevents/​press/​monetary/​20120913a.htm. 58 Press Release, Board of Governors of the Federal Reserve System (Dec. 12, 2012), http://​www.federalreserve. gov/​newsevents/​press/​monetary/​20121212a.htm. 59 Quarterly Report on Federal Reserve Balance Sheet Development (Nov. 2012), http://​www. federalreserve.gov/​monetarypolicy/​quarterly-​balance-​sheet-​developments-​report.htm. 60 Federal Reserve Release Date: May 1, 2013, available at http://​www.federalreserve.gov/​newsevents/​press/​ monetary/​20130501a.htm.

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Capital Markets, Derivatives, and the Law

As economic conditions improved, the Federal Reserve monitored economic data to assess its future direction in terms of bond purchases: The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-​backed securities and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.61 As the economy improved, the prospect of tighter monetary policy loomed over the market. There is much discussion about the impact of the reversal of the Fed’s policy of easy money; the unwinding of the Fed’s efforts to improve the economy presented a new set of challenges. At his June 19, 2013, press conference, Chairman Bernanke discussed continuing the purchase program, saying, “Although the Committee left the pace of purchases unchanged at today’s meeting, it has stated that it may vary the pace of purchases as economic conditions evolve.”62 This so-​called taper comment had a major impact on the capital markets, with the Dow Jones falling almost 500 points in the following five days. As the Chairman’s comments came into better focus, the stock markets improved, but yields continued to rise. In the months after the “taper” comment, the Fed was able to soothe the market with assurances that any policy reversal would be undertaken only as the economy showed real signs of improvement. By the end of 2013 the stock market was at a record high. In January 2014 Chairman Bernanke transitioned power to Janet Yellen as the new Federal Reserve Chair. In advance of that transition, on December 18, 2013, the Fed described the path forward: Taking into account the extent of federal fiscal retrenchment since the in­cep­tion of its current asset purchase program, the Committee sees the

http://​federalreserve.gov/​newsevents/​press/​monetary/​20130619a.htm (last visited Aug. 3, 2018). 62 June 19, 2013 Chairman Bernanke’s Press Conference FINAL 1 of 28, Transcript of Chairman Bernanke’s Press Conference June 19, 2013, available at http://​www.federalreserve.gov/​mediacenter/​files/​FOMC presconf20130619.pdf. 61

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103

improvement in economic activity and labor market conditions over that period as consistent with growing underlying strength in the broader economy. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases. Beginning in January, the Committee will add to its holdings of agency mortgage-​backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-​term Treasury securities at a pace of $40 billion per month rather than $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-​backed securities in agency mortgage-​backed securities and of rolling over maturing Treasury securities at auction. The Committee’s sizable and still-​increasing holdings of longer-​term securities should maintain downward pressure on longer-​term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate. The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-​backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-​run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases. To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/​4 percent will be appropriate at least as long as the unemployment rate remains above 6-​1/​2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-​run goal, and

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longer-​term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-​1/​2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-​ run goal. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-​run goals of maximum employment and inflation of 2 percent.63 A. Balance Sheet Normalization

Under Chair Yellen, the Federal Reserve began the process of tapering its purchasing of longer-​term securities and subsequently reducing the size of its balance sheet. After dramatically increasing the size of its balance sheet—​from about $900 billion at the end of 2007 to about $4.5 trillion at its peak—​the FOMC announced that effective October 2017 it would begin the “balance sheet normalization program” as described in the “Addendum to the FOMC’s Policy Normalization Principles and Plans:”64 The Committee intends to gradually reduce the Federal Reserve’s securities holdings by decreasing its reinvestment of the principal payments it receives from securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps. For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-​month intervals over 12 months until it reaches $30 billion per month. For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-​backed securities, the Committee anticipates

Press Release, Federal Reserve (Dec. 18, 2013), available at www.federalreserve.gov/​newsevents/​press/​monetary/​20131218a.htm (last visited Aug. 3, 2018). 64 https://​www.federalreserve.gov/​econres/​notes/​feds-​notes/​fiscal-​implications-​of-​the-​federal-​reserve-​balance-​ sheet-​normalization-​20180109.htm (last visited Aug. 17, 2018). 63

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Millions of Dollars



105

2,600,000 2,400,000 2,200,000 2,000,000 1,800,000 1,600,000 1,400,000 1,200,000 1,000,000 800,000 600,000 400,000 2004

2006

2005 Shaded areas indicate U.S recessions

2008

2010 2010

2012

2014

2016

2018

2015

Figure 7.3  U.S. Treasury securities held by the Federal Reserve: All maturities. Source: Board of Governors of the Federal Reserve System (US). https://​fred.stlouisfed.org

that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-​month intervals over 12 months until it reaches $20 billion per month. The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.65 While the Fed increased its target for short-​term rates, it continues to reinvest principal and interest (although limited by the caps described in its normalization plan). This has resulted in a reduction in the size of the Fed’s balance sheet from its height.66 The reduction of bonds held by Federal Reserve balance sheet in 2018 has been coincident with a flattening of the yield curve. The impact of the Fed’s normalization can be best understood, in part, in the context of “Operation Twist,” which ran from September 2011 to December 2012. Operation Twist required the Fed to sell short-​term Treasuries and buy long-​term ones. The effect was that the Fed sold or redeemed nearly all of its Treasuries that would have matured before February 2016. This eliminated the need to buy additional bonds for several years. As a result, the

https://​www.federalreserve.gov/​newsevents/​pressreleases/​monetary20170614c.htm (last visited Aug. 17, 2018). 66 https://​fred.stlouisfed.org/​series/​TREAST (last visited August 21, 2018). 65

106

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Capital Markets, Derivatives, and the Law 22M

Millions of Dollars

20M 18M 16M 14M 12M 10M 8M

Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012 Q1 2013 Q1 2014 Q1 2015 Q1 2016 Q1 2017 Q1 2018

Shaded areas indicate U.S. recessions Federal Debt: Total Public Debt

Figure 7.4  Federal Debt: Total Public Debt. Source: U.S. Department of the Treasury, Fiscal Service. https://myf.red/g/kW74

Fed has been reinvesting large amounts in Treasuries at auction even after the initiation of the reduction effort. As the caps on reinvested balance sheet maturities rises, there is increased focus on the impact of the normalization process on the shape of the yield curve. In December 2018, in part a s a result of concerns over rising long-​term interest rates, the S&P 500 declined more than 10 percent. Shortly thereafter the Federal Reserve released a statement on January 30, 2019 stating that “the committee is revising its earlier guidance regarding the conditions under which it could adjust the details of its balance sheet normalisation program,”67 and the current Chairman of the Federal Reserve explicitly left open the door to using balance sheet changes to manage “economic and financial developments.”68 B. Fiscal Considerations

It is worth noting that a substantial portion of the interest received on SOMA securities is remitted to the Treasury. Indeed, after providing for the cost of operations and payment of dividends, the Reserve Banks remitted $80.6 billion to Treasury during 2017.69 This is particularly important when one considers the current size of the national debt and the attendant interest that Treasury is paying on those obligations. Since 2007, the size of the national debt has more than doubled.

https://​www.federalreserve.gov/​newsevents/​pressreleases/​monetary20190130c.htm (last visited February 3, 2019). 68 Id. 69 https://​www.federalreserve.gov/​monetarypolicy/​bsd-​federal-​reserve-​banks-​financial-​information-​201803. htm (last visited Aug. 21, 2018). 67

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Understanding Interest Rates and the Economy

107

In the same period, because of low interest rates, the annual debt service remained largely unchanged until this 2018 wheninterest rates began to rise: Available Historical Data Fiscal Year End70 2018

$523,017,301,446.12

2017

$458,542,287,311.80

2016

$432,649,652,901.12

2015

$402,435,356,075.49

2014

$430,812,121,372.05

2013

$415,688,781,248.40

2012

$359,796,008,919.49

2011

$454,393,280,417.03

2010

$413,954,825,362.17

2009

$383,071,060,815.42

2008

$451,154,049,950.63

While legislatively tasked with monetary policy, the Fed cannot insulate the economy from the effect that rising interest rates and lower remittances would have on the fiscal side. Balance sheet normalization thus requires diligent attention to economic statistics as the interest rates adjust. V. FOMC Minutes Communication is an important part of monetary policy. FOMC minutes provide the opportunity for the markets to review the deliberations that result in Fed action. The FOMC holds eight regularly scheduled meetings during the year and other meetings as needed. It is required by the Federal Reserve Act to keep records of these meetings and to include them in its annual report to Congress. The Federal Reserve releases the minutes of regularly scheduled meetings three weeks after the date of the policy decision. The release of minutes is only one of the means by which the FOMC communicates with the public. When the FOMC meets, they release a statement on the same day they make a policy decision. Also, through speeches by members of the FOMC and through the Chairman’s testimony, the FOMC communicates biases and impressions of the capital markets.71 70 https://​www.treasurydirect.gov/​govt/​reports/​ir/​ir_​expense.htm (last visited Aug. 23, 2018). 71 Deborah J. Danker & Matthew M. Luecke, Background on FOMC Meeting Minutes, Fed. Reserve Bulletin 175 (Spring 2005).

108

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The minutes try to explain in plain language what happened at a particular FOMC meeting; they follow a standard organizational structure: Section I: Lists the Attendees at the meeting. “Members” are the 12 voting Members of the FOMC. “Participants” includes voting and nonvoting Bank Presidents. “Staff ” refers to those economists and other Federal Reserve staff members attending the meeting. The comments of all the participants at the meeting are reflected in the minutes. This section will also describe any organizational changes and approval of any FOMC documents. Section II: Describes the current economic conditions, economic forecasts based on recent data, and any topics that might come before the FOMC. In this section the FOMC will refer to the economic reports described in Section III. E.G. “The information reviewed for the June 12–​13 meeting indicated that labor market conditions continued to strengthen in recent months, and that real gross domes-​tic product (GDP) appeared to be rising at a solid rate in the first half of the year. Consumer price inflation, as measured by the 12-​month percentage change in the price index for personal consumption expenditures (PCE), was 2 percent in April. Survey-​based measures of longer-​run inflation expectations were little changed on balance. Total nonfarm payroll employment expanded at a strong pace, on average, in April and May. The national unemployment rate edged down in both months and was 3.8 percent in May. The unemployment rates for African Americans, Asians, and Hispanics all declined, on net, from March to May; the rate for African Americans was the lowest on record but still noticeably above the rates for other groups. The overall labor force participation rate edged down in April and May but was still at about the same level as a year earlier. The share of workers employed part time for economic reasons was little changed at a level close to that from just before the previous recession. The rate of private-​sector job openings rose in March and stayed at that elevated level in April. . . .”72 Section III: Describes individual participants’ evaluation of current economic data and the macroeconomic situation. This section will vary from meeting to meeting based on the ensuing consideration of the topics at hand.

https://​www.federalreserve.gov/​monetarypolicy/​files/​fomcminutes20180613.pdf (last visited Aug. 21, 2018). 72

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E.G. “In their discussion of the economic situation and the outlook, meeting participants agreed that information received since the FOMC met in May indicated that the labor market had continued to strengthen and that economic activity had been rising at a solid rate. Job gains had been strong, on average, in recent months, and the unemployment rate had declined. Recent data suggested that growth of household spending had picked up, while business fixed investment had continued to grow strongly. On a 12-​month basis, overall inflation and core inflation, which excludes changes in food and energy prices, had both moved close to 2 percent. Indicators of longer-​ term inflation expectations were little changed, on balance. . . .”73 Section IV: Describes any policy decisions made at the meeting and the results of any votes. This section also announces the date of the next FOMC meeting and the results of any actions that were taken between meetings. E.G. “After assessing current conditions and the outlook for economic activity, the labor market, and inflation, members voted to raise the target range for the federal funds rate to 13⁄4 to 2 percent. They indicated that the stance of monetary policy remained accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation. . . . .” Section V: Records the vote by the Committee members. E.G. “Voting for this action: Jerome H. Powell, William C. Dudley, Thomas I. Barkin, Raphael W. Bostic, Lael Brainard, Loretta J. Mester, Randal K. Quarles, and John C. Williams. . . .”

Id. 73

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8 Asset Valuation

I. The Use of Interest Rates in Asset Valuation  111 II. Interest Rate Yield Curve  112 A. Types of Yield Curves  113 B. Why the Yield Curve May Be Flat or Inverted  117 1. Increase in Market Demand for Long-​Term Securities  117 2. Long-​Term Yield Affected by Federal Reserve Monetary Policy  118

I. The Use of Interest Rates in Asset Valuation During the Great Recession, the Federal Reserve navigated U.S. interest rates lower by first reducing the target for the federal funds rate to zero, and then engaging in a process of quantitative easing by purchasing longer-​term securities. The effect of the Federal Reserve’s actions has been to lower interest rates that affect valuation models across all assets and investments. Movements in interest rates affect the pricing of all assets, as interest rates are a vital component of asset valuation. Economic pricing depends on incorporating certain pricing assumptions into valuation models in order to determine the “value” of an asset. Value is determined by the future expected cash flow discounted at a rate that reflects the riskiness of the cash flow. In determining what discount rate to Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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incorporate in a valuation formula, the cost of capital is adjusted for the risk taken in making the investment; applicable interest rates will vary based on investors’ perception of risk.1 Economic pricing depends on incorporating certain pricing assumptions into valuation models in order to determine the “value” of an asset. Investors deploy capital in order to maximize profit and to minimize the risk of loss. The risk an investor takes should be proportional to the expected reward for making an investment. An investor’s perception of risk reflects her perception of the possibility of loss. Portfolio Theory assumes that a rational investor seeks to minimize risk while maximizing reward.2 The true value of an asset is determined by discounting the value of the asset by its attendant risk. In making an investment decision, investors incorporate a “hurdle rate” into their analysis of whether to make an investment. The hurdle rate is the rate of return an investor requires, above which the investment makes sense and below which it does not. The hurdle rate may be a function of the investors’ cost of capital adjusted for risk. Value is determined by “the future expected cash flow discounted at a rate that reflects the riskiness of the cash flow.”3 The relationship of risk and reward are manifest in pricing models by discounting the cash flow or return from an investment by the prevailing interest rate. The present value of an asset is calculated by incorporating the discount rate (i.e., what a dollar is worth at some point in the future). The cost of capital as demonstrated in the discount rate incorporates risk variability. Cost of capital is the essence of risk analysis. What banks charge for capital demonstrates the risk that bank determine in loaning out money. Determining the value of an asset, then, requires an analysis of the return generated by the asset discounted by the cost of money tied up in that investment. Value or pricing of an asset is the sum of risk-​adjusted return. II. Interest Rate Yield Curve In determining what discount rate to incorporate in a valuation formula, the cost of capital must be adjusted for the risk taken in making the investment. Any hurdle

1 See ­chapter 4, supra, for a complete discussion of the Federal Reserve and the federal funds rate. 2 Harry Markowitz, Portfolio Selection, 7 J. Fin. 77 (1952); Robert C. Merton, Theory of Rational Option Pricing, 4 Bell J. Econ. & Mgmt. Sci. 141 (1973); William F. Sharpe, Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk, 19 J. Fin. 425 (1964). 3 See Robert J. Rhee, The Effect of Risk on Legal Valuation, 78 U. Colo. L. Rev. 193 (Winter 2007), citing Thomas E. Copeland et al., Valuation: Measuring and Managing the Value of Companies 73 (2d ed. 1995).

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rate will consider the risk-​free return on investments as manifest in the pricing of obligations issued by the United States Treasury. Affecting that risk-​free return is the current federal funds rate.4 The federal funds rate affects other interest rates but is not the most direct influence on asset valuation and investment decision-​making. In the previous chapter we described the relationship of the federal funds rate to policy stimulus. Ben Bernanke described this relationship when he served as a Federal Reserve Governor: [t]‌‌he current funds rate imperfectly measures policy stimulus because the most important economic decisions, such as a family’s decision to buy a new home or a firm’s decision to acquire new capital goods, depend much more on longer-​term interest rates, such as mortgage rates and corporate bond rates, than on the federal funds rate. Long-​term rates, in turn, depend primarily not on the current funds rate but on how financial market participants expect the funds rate and other short-​term rates to evolve over time. For example, if financial market participants anticipate that future short-​term rates will be relatively high, they will usually bid up long-​term yields as well; if long-​term yields did not rise, then investors would expect to earn a higher return by rolling over short-​term investments and consequently would decline to hold the existing supply of long-​term bonds. Likewise, if market participants expect future short-​term rates to be low, then long-​term yields will also tend to be low, all else being equal. Monetary policy makers can affect private-​sector expectations through their actions and statements . . .5 A. Types of Yield Curves

The yield curve is a graphical representation of a specific type of financial instrument and its corresponding yield over a specified period. Expectations of future monetary policy affect the shape of the yield curve. The horizontal axis of the graph represents the duration of a financial instrument; the vertical axis represents the yield of that instrument. There are three types of yield curves: normal sloping, flat, and inverted, depending on the relationship between the short-​term yield and the long-​term  yield. A normal sloping yield curve (Figure 8.1) represents an interest rate environment where interest rates in the short term are lower than those in the long term:

4 See ­chapter 4, supra, for a complete discussion of the federal funds rate. 5 Ben S. Bernanke, The Logic of Monetary Policy, Address at the National Economists Club (Dec. 2, 2004).

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Normal Sloping Yield Curve 8% 6% 4% 2% 0%

0

5

10

15

20

25

30

20

25

30

25

30

Time Until Maturity

Figure 8.1  Normal sloping yield curve.

Yield to Maturity

Flat Yield Curve 8% 6% 4% 2% 0%

0

5

10

15 Time Until Maturity

Figure 8.2  Flat yield curve.

Yield to Maturity

Inverted Yield Curve 8% 6% 4% 2% 0%

0

5

10

15

20

Time Until Maturity

Figure 8.3  Inverted yield curve.

A flat yield curve (Figure 8.2) reflects an interest rate environment where there is little difference between long-​term and short-​term interest rates. In other words, investors are not rewarded proportionately for holding longer-​term assets, as they would be in a normal yield curve environment. An inverted yield curve (Figure 8.3) reflects economic conditions where investors are paid a higher return on short-​term assets than they are on longer-​term assets. Interest rates vary based on investors’ perception of risk. There is a school of thought that it may be possible to gauge investors’ perception of the economy base on the yield curve. The normal yield may reflect a healthy economy where investors perceive normal growth over the specified time horizon. The flat yield curve may reflect a market environment where investors perceive little or no economic growth.

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3.0 2.5 Percent

2.0 1.5 1.0 0.5 0.0 2014–01 2014–07 2015–01 2015–07 2016–01 2016–07 2017–01 2017–07 2018–01 2018–07 10-Year Treasury Constant Maturity Minus 2-Year Treasury constant maturity

Figure 8.4  Narrowing Spread 2 Year/​10 Year Treasury Yield.

A flat yield curve can reflect the market perception of a transitional phase, where investors perceive a shift from positive to negative growth or vice versa. The inverted yield curve may reflect a negative outlook on the economy. Investors may perceive an economic slowdown or a recession on the horizon. Although there is some credible historical evidence that the yield curve may portend economic growth, stagnation, or recession, there are other interpretations offered to the shape of the yield curve.6 The yield curve has increasingly flattened as the economy is recovering. Indeed the yield spread between 10-​year U.S. Treasury Securities and 2-​year U.S Treasury securities has narrowed dramatically since 2014 from 2.5 percent to under .5 percent7 (Figure 8.4). There has been no definitive explanation for the flattening curve. The author of this book advanced a theory in 2016 for increased flattening of the yield curve, linking the flattening to the Fed’s reinvestment of principal and interest as short-​ term rates rose: THE END OF QE and a rising fed-​funds rate do not necessarily spell the end of easy money. The Fed continues to buy long bonds by reinvesting principal and interest from its maturing securities. Its balance sheet is about $4.5 trillion, of which approximately $1.5 trillion matures in fewer than seven years. An oft-​overlooked paragraph in FOMC statements promises to continue the reinvesting until the normalization of federal funds is “well under way.” It is no surprise that the Fed’s balance sheet grew for over a year after QE ended. Reinvestment can keep pressure on longer-​term rates as the Fed deploys its reinvestment across the curve. Its role in monetary policy will grow as short-​dated bonds mature.8 6 Id. 7 See https://​fred.stlouisfed.org/​series/​T10Y2Y (last visited Aug. 12, 2018). 8 https://​www.barrons.com/​articles/​how-​the-​fed-​fights-​the-​zombie-​economy-​with-​easy-​money-​1460781756 (last visited Aug. 12, 2018).

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In the wake of balance sheet normalization the author continued to advance his thesis that the yield curve would flatten during 2018 in light of the methodology the Fed intended to use to reduce its holdings: . . . because the Fed hasn’t been reinvesting very much since the completion of Operation Twist, the normalization plan offers the Fed the opportunity to go on a bond buying spree the likes of which has not been seen since QE. For example, in in January 2018 approximately $27 billion in U.S. Treasury bonds will come due. With the cap, the Fed will be reinvesting $21 billion in the Treasurys [sic] that Secretary Mnuchin issues. In February, if the cap is not raised, the Fed will buy $42 billion in Treasury bonds, making it a QE-​type purchase even though balance sheet reduction is well under way. Although the exact cap may change depending on other market conditions, the deliberate pace of normalization, at the outset, should cause the yield curve to flatten as the Fed reinvests in long term securities issued by Treasury.9 During a recent press conference, Fed Chairman Powell downplayed the significance of the flattening yield curve without offering an absolute conclusion as to the cause of the trend: . . . the yield curve is something that people are talking about a lot, including FOMC participants. And I—​you have a range of views. It’s something we’re going to continue to be talking about. It’s—​but it’s only one of many things, of course, that we talk about. I think that that discussion is really about what is appropriate policy, and how do we think about policy as we approach the neutral rate. How do we understand what the neutral rate is? How do we know where it is? And what are the consequences of being above or below it? That’s really what—​when people are talking about the slope of the yield curve, that’s really what they’re talking about. We know why—​we know why the yield curve is flattening. It’s because we’re raising the federal funds rate. It makes all the sense in the world that the short end would come up . . . the harder question is, what’s happening with long rates? And there are many things that move long rates around. Of course, there’s an embedded expectation of the path of short rates. There’s the term premium, which has been very low by historical standards. And so arguments are made that a flatter yield curve has less of a

9 https://​www.businessinsider.com/​ubs-​feds-​normalization-​plan-​could-​actually-​be-​a-​win-​for-​the-​economy-​ 2018-​1 (last visited Aug. 12, 2018).

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signal embedded in it. In addition, I think what you saw most recently that you referred to . . . was just risk-​on, risk-​off. In a risk-​off environment, people want to own U.S. Treasuries, and you see—​you know, Treasury prices go up, rates go down quite a lot. So—​but I think ultimately, you know, what we’re—​what we really care about is what’s the appropriate stance of policy. And there’s a—​there may be a signal in that long-​term rate about what is the neutral rate, and I think that’s why people are paying attention to the yield curve.10 B. Why the Yield Curve May Be Flat or Inverted

Bernanke, as chairman of the Board of Governors of the Federal Reserve System, has spoken on the shape of the yield curve and why a yield curve might be flat or inverted. He offered one set of explanations that focus on special factors that may have influenced market demands for long-​term securities per se, independent of the macroeconomic outlook.11 The following discussion is a summary of his remarks. 1. Increase in Market Demand for Long-​Term Securities Each long-​term interest rate has two components: (1) the spot interest rate that market participants currently expect to prevail at the corresponding date in the future, and (2) the additional compensation that investors require for the risk of holding longer-​term instruments, known as the “term premium.” With the economic outlook held constant, changes in the net demand for long-​term securities have their largest effect on the term premium. In particular, if the demand for long-​ dated securities rises relative to the supply, then investors will generally accept less compensation to hold longer-​term instruments—​that is, the term premium will decline. There are four possible reasons the net demand for long-​term issues may have increased, lowering the term premium. (1) Longer-​maturity obligations may be more attractive because of more stable inflation, better-​anchored inflation expectations, and a reduction in general economic volatility. If investors have come to expect this past performance to continue, they might believe that less compensation for risk—​and thus a lower term premium—​is required to justify holding longer-​term bonds.

https://​www.federalreserve.gov/​mediacenter/​files/​FOMCpresconf20180613.pdf (last visited Aug. 15, 2018). 11 Ben S. Bernanke, Address at the Economic Club of New York (Mar. 20, 2006). 10

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(2) Increased intervention in currency markets by a number of governments, particularly in Asia, have put downward pressure on yields, as foreign official institutions, primarily central banks, have invested the bulk of their greatly expanded dollar holdings in United States Treasuries and closely substitutable securities. (3) Reforms have been proposed that encourage pension funds to be more fully funded and to take steps to better match the duration of their assets and liabilities. These changes may have increased the demand for longer-​maturity securities, as pension funds tilt the composition of their portfolios toward long-​duration bonds substantially over time. (4) As investors’ demands for long-​duration securities may have increased over and the supply of such securities seems not to have kept pace.

2. Long-​Term Yield Affected by Federal Reserve Monetary Policy Before the Fed initiated its program of quantitative easing, it needed to consider how to influence long-​term rates by adjusting its target for the short-​term fed funds rate. The influence of short-​term rates on longer-​term rates results from the fact that longer-​term investments can be viewed as a series of short-​term investments strung together, and therefore short-​term monetary policy of the Federal Reserve will have a relative effect on longer-​term asset valuation. Therefore the Federal Reserve watches the yield curve in order to make adjustments to its monetary policy. Chairman Bernanke described the erosion of term premium on monetary policy when the Federal Reserve was operating without the additional tools of quantitative easing:12 If the decline in forward rates can be traced to a decline in the term premium . . . the effect is financially stimulative and argues for greater monetary policy restraint, all else being equal. Specifically, if spending depends on long-​term interest rates, special factors that lower the spread between short-​term and long-​ term rates will stimulate aggregate demand. Thus, when the term premium declines, a higher short-​term rate is required to obtain the long-​term rate and the overall mix of financial conditions consistent with maximum sustainable employment and stable prices. However, if the behavior of long-​term yields reflects current or prospective economic conditions, the implications for policy are quite the opposite. When Id. 12

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low or falling long-​term yields reflect investor expectations of future economic weakness, investors will mark down their projected path of future spot interest rates, lowering far-​forward rates and causing the yield curve to flatten or even to invert. Indeed, historically, the slope of the yield curve has tended to decline significantly in advance of recessions. When drags on the growth of spending do materialize, then a lower real interest rate will be needed to sustain aggregate demand and keep the economy near full employment. To be consistent with a lower long-​term real rate, the short-​term policy rate might have to be lower than it would otherwise be as well. After the events of 2008, the Fed took specific steps to directly affect long-​term interest rates in order to improve asset pricing throughout the economy. By increasing the size of its balance sheet and buying Treasury and Agency securities, the Fed has sought “to promote economic recovery and to preserve price stability.”13 The direct effect is that longer-​term interest rates came down.

Press Release, Federal Reserve (Mar. 17, 2009). See ­chapter 4 for a complete description of the steps the Federal Reserve has taken. 13

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9 United States Treasury Securities

I. Purpose and Goals  122 A. Risk-​Free Nature  123 B. Primary Dealers  124 II. Description of U.S. Treasury Securities  125 A. Types of Treasury Securities  125 1. Treasury Bills  125 2. Treasury Notes and Bonds  126 B. Pricing  126 1. Discounts and Premiums  126 2. Factors Affecting Yield  127 III. Bond Auctions and Price  128 A. Interruption of Supply: SEC v. Davis et al.  129 B. Manipulation of the Auction Process: United States v. Salomon Brothers 130 IV. Interest Rates  132 A. Fixed-​versus Floating-​Rate Securities  132 B. Treasury Inflation-​Protected Securities (TIPS)  132 V. STRIPS  134 A. Description  134

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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Capital Markets, Derivatives, and the Law B. V  aluation  134 C. U  ses  135 D. A  buses: In the Matter of Orlando Joseph Jett 136

I. Purpose and Goals On July 17, 2013, Ben S. Bernanke, chairman of the Federal Reserve, testified to Congress in his Semiannual Monetary Policy Report. During that testimony, he described the Federal Reserve’s policy of purchasing securities to influence long-​ term interest rates: In normal circumstances, the Committee’s basic tool for providing monetary accommodation is its target for the federal funds rate. However, the target range for the federal funds rate has been close to zero since late 2008 and cannot be reduced meaningfully further. Instead, we are providing additional policy accommodation through two distinct yet complementary policy tools. The first tool is expanding the Federal Reserve’s portfolio of longer-​term Treasury securities and agency mortgage-​backed securities (MBS); we are currently purchasing $40 billion per month in agency MBS and $45 billion per month in Treasuries.1 The impact of lower interest rates facilitated by the Fed’s quantitative easing caused prices of Treasury securities to rise and thus interest rates to fall. The Fed’s direct purchase of Treasury securities, and its corresponding impact of lowering interest rates was done “. . . primarily to increase the near-​term momentum of the economy, with the specific goal of achieving a substantial improvement in the outlook for the labor market in a context of price stability.”2 Treasury securities are a type of debt instrument providing limited credit risk. U.S. Treasury bills, notes and bonds (collectively known as “Treasuries”) are issued by the Treasury Department and represent direct obligations of the U.S. government. Treasuries are issued in various maturities of up to 30 years. Treasury securities are offered by the U.S. Treasury Department to meet the needs of investors who wish to “loan” money to the federal government and in return receive a fixed or

1 Chairman Ben S. Bernanke, Semiannual Monetary Policy Report to the Congress Before the Committee on Financial Services, U.S. House of Representatives ( July 17, 2013), available at http://​federalreserve.gov/​ newsevents/​testimony/​bernanke20130717a.htm. 2 Id.

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floating interest rate. The Treasury yield curve is a benchmark for fixed income securities across the spectrum of debt securities. The United States began issuing debt in 1776 to finance the Revolutionary War. In 1789, President George Washington appointed Alexander Hamilton to serve as the first Secretary of the Treasury. As secretary, Hamilton established three goals for the Treasury that still guide the department today: • Achieve the lowest possible debt service cost, • Ensure access to unlimited credit in times of war or emergencies, and • Promote efficient capital markets. Hamilton’s plan for the U.S. economy allowed Treasury securities to become the world’s safest, most liquid financial instruments. Treasury securities are unique in their virtually nonexistent default risk and their tight bid offer spreads. Treasuries have evolved to be the investment of choice for safety. It is because of their universal appeal as a credit risk–​free investment that they have facilitated the expansion of the U.S. economy. Given the size and success of the American economy and the government’s taxing power, financial markets regard treasuries to be default risk–​ free.3 Financial market participants use Treasury securities to approximate the risk-​ free rate of return. A. Risk-​F ree  Nature

Treasuries are backed by the full faith and credit of the U.S. government and have little or no credit risk (the risk that a debtor will be unwilling or unable to meet its obligations under the terms of a loan when that obligation matures). The risk-​ free nature of Treasuries allows them to function as the linchpin of many economic functions in the United States and abroad. The universal appeal of Treasuries allows them to be used in the following ways:

•

by the Federal Reserve to carry out monetary policy, • by foreign currency boards as reserves for dollar-​linked currencies, • as the default risk-​free U.S. benchmark, • as the yield determinate for pension funding adequacy,

3 Garry J. Schinasi, Charles F. Kramer & R. Todd Smith, Financial Implications of the Shrinking Supply of United States Treasury Securities 12 (International Monetary Fund, 2001).

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• by portfolio managers to hedge risk, and • as a benchmark in determining the required return from riskier investments.4 B. Primary Dealers

Primary dealers are banks and securities brokerages that trade in U.S. government securities directly with the Federal Reserve System.5 As of August 2018 there were 23 primary dealers. According to the Federal Reserve Bank of New York: Primary dealers serve as trading counterparties of the New York Fed in its implementation of monetary policy. This role includes the obligations to: (i) participate consistently in open market operations to carry out U.S. monetary policy pursuant to the direction of the Federal Open Market Committee (FOMC); and (ii) provide the New York Fed’s trading desk with market information and analysis helpful in the formulation and implementation of monetary policy. Primary dealers are also required to participate in all auctions of U.S. government debt and to make reasonable markets for the New York Fed when it transacts on behalf of its foreign official account-​holders.6 Primary dealers trade Treasuries with the FOMC trading desk at the Federal Reserve Bank of New York (FRBNY). It is this desk that engages in open market operations to effectuate monetary policy.7 Open market transactions occur through a competitive bidding process among the primary dealers. According to the New York Fed’s current criteria, a primary dealer must be either a broker-​dealer registered with and supervised by the Securities and Exchange Commission (SEC) or a U.S.-​chartered bank (commercial bank, thrift, national bank, or state bank) that is subject to official supervision by bank supervisors. The primary dealer must meet certain minimum capital requirements: • A registered broker-​dealer must have at least $150 million in regulatory net capital as computed in accordance with the SEC’s net capital rule.

4 See Federal Debt: Market Structure and Economic Uses for United States Treasury Debt Securities, ( Joint Economic Committee U.S. Congress, Aug. 2001). 5 See List of the Primary Government Securities Dealers Reporting to the Government Securities Dealers Statistics Unit of the Federal Reserve Bank of New York, available at https://​www.newyorkfed.org/​markets/​ primarydealers.html (last visited Aug. 3, 2018). 6 https://​www.newyorkfed.org/​markets/​primarydealers.html (last visited Aug. 3, 2018). 7 See ­chapter 4, supra.

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• The broker-​dealer must otherwise be in compliance with all capital and other regulatory requirements imposed by the SEC or its self-​regulatory organization (SRO). • A bank must meet the minimum Tier I and Tier II capital standards under the applicable Basel Accord and must have at least $150 million of Tier I capital as defined in the applicable Basel Accord.8 The minimum absolute levels of capital are designed to help insure that primary dealers are able to enter into transactions with the Fed in sufficient size to maintain the efficiency of trading desk operations. Should a firm’s capital position fall below these minimum standards, the FRBNY may suspend its trading relationship until the firm’s capital position is restored to levels corresponding to these minimum standards. In making such determinations, the FRBNY will look to the firm’s primary federal regulator for guidance as to whether the firm has in place an acceptable plan to restore its capital position in a reasonable period of time. II. Description of U.S. Treasury Securities A. Types of Treasury Securities 1. Treasury  Bills Treasury bills are short-​term investments offered by the U.S. government; they are offered at a discount to their face value and mature in less than one year. They are offered to the public via an auction system. Treasury bills (“T-​bills”) are: negotiable, non-​interest-​bearing securities with original maturities of three months, six months and one year. T-​bills are offered by the Treasury in minimum denominations of $10,000, with multiples of $5,000 thereafter and are offered only in book-​entry form. T-​bills are issued at a discount from face value and are redeemed at par value. The difference between the discounted purchase price and the face value of the T-​bill is the interest income that the purchaser receives. The yield on a T-​bill is a function of this interest income and the maturity of the T-​bill. The returns are treated as ordinary income for federal tax purposes and are exempt from state and local taxes.9

8 http://​www.newyorkfed.org/​markets/​pridealers_​policies.html (last visited Aug. 3, 2018). 9 Trading and Capital-​Markets Activities Manual § 4020.1 (Board of Governors of the Federal Reserve System) (first printing 1998, amended 2011).

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The Treasury department determines how much of a particular Treasury bill it wishes to issue on a weekly basis. T-​bills are issued at regular intervals on a yield-​ auction basis. The three-​month and six-​month T-​bills are auctioned every Monday. The one-​year T-​bills are auctioned in the third week of every month. The amount of T-​bills to be auctioned is released on the preceding Tuesday, with settlement occurring on the Thursday following the auction. The auction of T-​bills is done on a competitive-​bid basis (the lowest-​yield bids are chosen because they will cost the Treasury less money). Noncompetitive bids may also be placed on purchases of up to $1 million. The price paid by these bids (if allocated a portion of the issue) is an average of the price resulting from the competitive bids. Treasury bills are zero coupon instruments; they pay no interest and are issued at a discount to face value. They can be redeemed from the Treasury at maturity, or sold in the secondary market. 2. Treasury Notes and Bonds Unlike Treasury bills, Treasury notes and bonds are fixed income, interest-​bearing securities with a fixed coupon payable semiannually until maturity. Treasury notes and bonds can be held until maturity or sold before maturity in the secondary market. Treasury notes are currently issued in maturities of 2, 3, 5, and 10 years on a regular schedule and are not callable. The term “Treasury bonds” is usually associated with the 30-​year bond. The “par value” of a Treasury note or bond is its face amount, which usually differs from the price at which it is trading in the market. For example, a bond with a par value of $1,000 ($1,000 is the lowest denomination sold and is referred to as one bond) may sell for more or less than $1,000 depending on market factors. Treasury bonds are quoted and priced as a percentage of par value to the nearest 1/​32 of 1 percent. For example if a $1,000 Treasury bond were priced at “100,” it would actually sell at $1,000. A bond that sold at 102:16 would bring 102 16/​32 percent for each $100 of par value, or $1,025. B. Pricing

There is a secondary market for Treasury bills and notes once they have been issued. There is also a market for Treasuries trading on a “when-​issued” basis. Bonds trade based on a “yield-​to-​maturity.” 1. Discounts and Premiums Treasury bills are priced at a discount to their face value. For example, a $1 million Treasury bill maturing in six months, trading at a 5 percent discount (to face

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value) would be priced at approximately $975,000 ($1 million x 5 percent is $50,000 for one year of interest and $25,000 for six months of interest). The Treasury bill is said to be trading at a “5% discount.” The discounted value is different than the Treasury bill’s “yield-​to-​maturity.” That is to say, as the investor is earning $25,000 on a $975,000 investment, the investor’s yield or return is higher than 5 percent ($25,000 annualized/​$975,000 is approximately 5.20 percent). Treasury notes trade based on their yield to maturity and are issued and traded as a percentage of face value. For instance, an investor who buys a two-​year Treasury note from the U.S. Treasury might pay 100 percent of face value for a note paying a semiannual interest payment of 5 percent (annualized). The note is therefore deemed to be trading at a “5% yield.” The dollar price is easily determined by virtue of the yield in considering its 5 percent coupon. A 5 percent coupon note trading at a 5 percent yield is obviously trading at 100 percent (of face value). A note trading at 100 percent of face value is called a “par” bond.10 2. Factors Affecting Yield Numerous factors influence the yield and therefore the pricing of Treasury notes. First and foremost, during the years of quantitative easing, the Fed directly affected the price of Treasuries by being a mammoth buyer. When market participants aggressively buy treasuries, the price will rise and the associated yield on that financial instrument will fall. The Fed’s activities in targeting the federal funds rate11 influence the direction of short-​term interest rates but also influence longer-​term investments as well. The 10-​year Treasury yield, for instance, can be viewed as a weighted average of the current one-​year rate and nine one-​year forward rates, with the weights depending on the coupon yield of the security. Current and near-​term forward rates are particularly sensitive to monetary policy actions, which directly affect short-​ term interest rates and strongly influence market expectations of where spot rates are likely to stand in the next year or two. Theoretically, short-​term interest rates influence long-​term rates because any investor has the choice of holding either a long-​term security or a series of short-​ term securities, reinvesting his or her funds in a new short-​term security as the old short-​term security matures. As both short-​term and long-​term Treasury securities are willingly held in the marketplace, investors must be roughly indifferent between short-​term and long-​term securities, implying that (on average and abstracting from

See ­chapter 5, Sec. I, supra, for further discussion of interest rates and asset valuation. 11 See ­chapter 4, Sec. IV.D, supra, for further discussion of targeting the federal funds rate. 10

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any term premiums) expected future short-​term rates must be similar to the current long-​term yield.12 The inverse relationship between Treasury prices and yield can be best understood by thinking of an investment in Treasuries as an investment in a machine generating cash flow every year at a fixed production rate. The machine lasts for a fixed duration and then can be redeemed for a fixed amount of money. If that machine generates $5 bills twice per year and it costs $100, it is a “10% machine.” If that machine can be redeemed in 10 years for $100, it is similar to the structure of a 10-​year Treasury note with a 10 percent coupon. If the Treasury Department (the inventor of the machine) creates a new, improved device that generates $10 bills twice a year, the old $5 machines will become worthless. No one will want to own a 10 percent machine in a 20 percent machine environment unless one can be picked up at a significant discount. Therefore the prices of money machines and bonds are inversely related to their yield. This is also true if the inventor of the money machine stops making money machines. The price will go up as more people want the money machines and there are fewer available. Bonds that pay a fixed rate of return and are now worth more than 100 percent of face value are said to be trading at a “premium.” Bonds trading under face value are described as trading at a “discount.” Figure 9.1 is a graphic representation of the inverse relationship between price and yield: The Price/Yield Relationship 5% Bond 120

Price

100 80 60 40 20

0

5

10

15 Yield

20

25

30

Figure 9.1  The price/​yield relationship on a 5 percent bond.

III. Bond Auctions and Price The U.S. Treasury issues securities by auction. Primary dealers and individuals bid on bonds of particular durations at the auction held by the U.S. Treasury at regular intervals. The Treasury creates the financial instruments. These instruments are See: Remarks by Governor Ben S. Bernanke at the Redefining Investment Strategy Education Symposium, March 30, 2005 available at http://​www.federalreserve.gov/​BoardDocs/​Speeches/​2005/​20050330/​default. htm. (last visited Aug. 3, 2018). 12

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subsequently traded between and among counterparties in the secondary market. The amount of Treasuries issued affects the pricing of outstanding issues in the secondary market; therefore, the Treasury’s issuance and forbearance of issuing securities affects the yields of outstanding securities trading in the secondary market. As yields rise and fall on a particular security, the price of that security moves inversely to the direction of the yield. A. Interruption of Supply: SEC v. Davis et al.

On October 31, 2001, the U.S. Treasury announced that they would no longer issue 30-​year bonds in the auction process. In August 2005, the Treasury announced the reintroduction of the 30-​year bond. The Treasury held its first auction of the bond in five years on February 9, 2006. The prior 30-​year bond auction took place on August 9, 2001. The SEC alleged that when the announcement was made that the Treasury would stop issuing the 30-​year bond, a consultant tipped a number of secondary market traders about this impending announcement. As a result, traders who were “tipped” made money on this “inside information.” The SEC sued all those involved claiming that they had benefited illegally form nonpublic information. In SEC v. Davis et al.,13 the SEC filed a complaint against Peter J. Davis, Jr., John M. Youngdahl, and Steven E. Nothern, for insider trading based on the events of October 31, 2001.14 The case, which was subsequently settled,15 illustrates the effect of the Treasury’s decision to discontinue the 30-​year bond on the price of those bonds in the secondary market. According to the complaint, Davis, a Washington, DC-​ based consultant; Youngdahl, formerly a Vice President and Senior Economist at Goldman Sachs & Co., Inc. (“Goldman Sachs”), a New York broker-​dealer; and Nothern, formerly a mutual fund manager at Massachusetts Financial Services Company (MFS), violated the federal securities laws’ prohibition against insider trading. Davis was a paid consultant to Goldman Sachs and MFS, among others. According to the SEC, Davis tipped off Youngdahl and Nothern with material nonpublic information that the Treasury would suspend issuance of the 30-​year bond. Davis received this information at a Treasury quarterly refunding press conference; these conferences are held at the Treasury to notify the public about how much

13 Civ. Act. No. 03-​CV6672 (NRB) (S.D.N.Y, Sept. 4, 2003). 14 http://​www.sec.gov/​litigation/​complaints/​comp18322.htm. 15 http://​www.sec.gov/​litigation/​litreleases/​lr18322.htm.

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debt will be issued by the Treasury in the coming quarter. This information was announced at 9:25 a.m. and embargoed until 10:00 a.m., when it would be released to the public. Nevertheless, Davis violated the embargo and notified Youngdahl and Nothern between 9:28 and 9:41 a.m. Before the suspension of the 30-​year bond was announced publicly at 10:00 a.m., Youngdahl, Nothern, and other portfolio managers to whom they communicated this information purchased large quantities of the 30-​year bonds. Public announcement that the Treasury will suspend issuance of a particular maturity federal government bond drives up the price of outstanding bonds with that maturity because traders anticipate a shortage. Traders who know about the suspension in advance of the public announcement can realize enormous profit by purchasing the bonds before the announcement and selling immediately afterward. The Treasury Department’s announcement had a dramatic market impact, causing the largest one-​day price movement in the 30-​year bond since October 1987. As a result of their bond purchases, made before the Treasury’s announcement was made public, Nothern and the three other MFS portfolio managers made profits of $3.1 million for the portfolios they managed.

B. Manipulation of the Auction Process: United States v. Salomon Brothers

The Treasury sells Treasury securities through periodic auctions conducted mainly by and through the Federal Reserve System—​especially the FRBNY. At each such auction, the Treasury awards securities to the bidders willing to accept the lowest yield levels (effectively, interest rates) on their cash. When the size of an auction is announced, trading in the securities to be issued begins. These trades are done for securities on a “when-​issued” basis. This trading continues until the day the securities are actually issued by the Treasury. After settlement, trading in the issued Treasury security continues in the secondary market until the maturity date, when the issue is redeemed. With every “when-​issued” transaction, the buyer agrees to buy a specified quantity of the security to issue at an agreed-​upon price from the seller. The seller is said to be “short” the issue and the buyer “long.” On settlement day, the buyer pays for the security it has agreed to purchase and the seller delivers the security by purchasing it from the Treasury in the auction or by borrowing it to deliver to the purchaser. Each Treasury security is unique. If a seller does not purchase a sufficient amount of a particular security in the auction to meet its obligations from “when issued” transactions, that seller must go into the secondary market to meet its demand for

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the particular security. When there is a substantial “short” position in a security, the demand for that security causes its price to rise in the secondary market. There have been attempts to manipulate the auction process to affect the secondary market for Treasury securities. On May 20, 1992, the United States filed a civil antitrust forfeiture complaint16 alleging that Salomon Brothers Inc. (“Salomon”) and others had conspired to restrain competition in markets for U.S. Treasury securities, in violation of the Sherman Act.17 The complaint sought forfeiture of property owned by Salomon pursuant to the alleged conspiracy of the Sherman Act.18 As charged in the complaint, in or about June 1991, Salomon and its co-​ conspirators agreed on a scheme to coordinate their transactions in May 1991 U.S. Treasury notes. This scheme had the effect of limiting the supply of May two-​year notes available in the secondary markets, thereby ensuring that persons who had sold May two-​year notes short in the when-​issued market could not obtain such notes without purchasing them in the secondary market at artificially inflated prices. Through purchases at the auction and in the when-​issued market, Salomon and its co-​conspirators obtained substantial positions in the May two-​year notes. As part of the alleged scheme, Salomon and its co-​conspirators agreed to coordinate limiting the supply of May two-​year notes made available for short selling, also artificially inflating their price in the secondary market. The U.S. government alleges that these anticompetitive actions by Salomon and its co-​conspirators caused substantial damages to sellers and to the United States. As noted in the Joint Report on the Government Securities Market issued by the Treasury, the SEC and the Federal Reserve Board, an acute, protracted squeeze resulting from illegal coordinated conduct, such as the one alleged here, “can cause lasting damage to the marketplace, especially if market participants attribute the shortage to market manipulation. Dealers may be more reluctant to establish short positions in the future, which could reduce liquidity and make it marginally more difficult for the Treasury to distribute its securities without disruption.”19 Salomon and the Department of Justice reached a settlement in this case and Salomon paid $27.5 million plus interest to the United States. On the same date the Department of Justice and the Securities and Exchange Commission reached a global settlement with Salomon to resolve the firm’s liability under the securities

United States v. Salomon Bros. Inc., 57 Fed. Reg. 29,743 ( July 6, 1992). 17 15 U.S.C. § 1 (1890 as amended through 1990). 18 15 U.S.C. § 6 (1890 as amended through 1990). 19 See Department of the Treasury, Securities and Exchange Commission, Board of Governors of the Federal Reserve System: Joint Report on the Government Securities Market 10 ( Jan. 1992). 16

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laws and the common law for its conduct. The terms of that settlement provided that Salomon pay $290 million in fines and forfeitures including $100 million to establish a fund to be used to compensate victims of its misconduct.20 IV. Interest  Rates A. Fixed-​v ersus Floating-​R ate Securities Treasury notes can be either fixed-​income securities or floating-​rate securities. Fixed-​ rate securities will pay a fixed rate of return for a set period of time. The set coupon is fixed at the time of issuance. Yields on fixed-​income financial instruments change as interest rates rise and fall; the attendant price of the underlying financial instrument changes in accord with the interest rate market. The coupon payment, however, remains constant. The Treasury in the auction process also issues floating-​rate securities. Unlike fixed-​income securities, floating rate instruments have coupons that fluctuate based on terms described by the issuer. A floating-​rate note will have a coupon linked to an index or a market interest rate. The coupon of the floating-​rate financial instrument changes as the index or market-​linked interest rate adjusts to market conditions. For example, corporate bonds may have a coupon linked to the U.S. Treasury Bill or federal funds rate. The bond itself might mature in 10 years but the coupon on that bond will readjust as short-​term rates fluctuate. Floating-​rate notes offer some protection in a rising interest rate environment in that their coupon rises when the interest rate on the benchmark index rises. Floating-​rate notes are often subject to a maximum or minimum rate of interest. B. Treasury Inflation-​P rotected Securities (TIPS)

Treasury Inflation-​Indexed Securities (TIIS), more popularly known as Treasury Inflation-​Protected Securities (TIPS), are securities whose principal is linked to the Consumer Price Index (CPI). The coupon on TIPS is fixed while the principal fluctuates as the CPI rises or falls. The U.S. Treasury began issuing TIPS in January 1997. TIPS are a hedge against inflation; as inflation increases the investor is rewarded with greater principal. At maturity the investor receives the greater of the original or adjusted principal. TIPS, like other Treasury notes, pay interest two times per year and are backed by the full faith and credit of the U.S. government. 20 See Press Release, U.S. Dep’t of Justice, Department of Justice and SEC Enter $290 Million Settlement with Salomon Brothers in Treasury Securities Case (May 20, 1992), http://​www.usdoj.gov/​atr/​public/​press_​releases/​ 1992/​211182.htm.

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The interest is a fixed rate calculated based on the adjusted principal. TIPS promise a yield-​to-​maturity that is guaranteed in real terms. To provide the promised real yield, TIPS coupon and principal payments are escalated based on increases in the CPI from the time at which the security was issued.21 The following example illustrates how TIPS work: Suppose an investor purchases a $1,000 note in January. The interest rate set at the time of the auction is 3 percent. Suppose the inflation rate for the first year of the life of the note is 3 percent. At the end of the December of the first year of the life of the note, the $1,000 principal will be $1,030 reflecting the 3 percent inflation rate. The investor does not receive the increase in principal until maturity. The investor will, however, receive a 3 percent interest payment reflecting the interest determined at the time of the note’s original auction. After the first year, the note will continue to pay interest on the increased principal amount of the note (3 percent of $1,030 as opposed to 3 percent of the initial issue price of par). The note’s principal amount is adjusted each year based on the increase or decrease in the inflation rate.22 Although clues about inflation expectations abound in financial markets, inflation-​indexed securities would appear to be the most direct source of information about inflation expectations and real interest rates. The difference between the real yield guaranteed by an inflation-​linked security and the nominal yield provided by a conventional security of the same maturity is known as the break-​even inflation rate or, alternatively, as inflation compensation. The break-​even rate of inflation is often treated as a direct reading of investors’ expectations of inflation.23 An investor might use TIPS as a means of hedging against the erosion of principal due to increases in inflation. Banks also use TIPS for investing, hedging, and speculating. An investor in TIPS is taking a position that benefits when real interest rates fall. Real interest rates reflect the return on an investment minus inflation. Real interest rates are defined as the nominal rate of interest less the rate of inflation. If nominal rates fall, but inflation does not (that is, a decline in real interest rates), TIPS will appreciate because their fixed coupon will now represent a more attractive rate relative to the market. If inflation rises, but nominal rates rise more (that is, an

Ben S. Bernanke, “Constrained Discretion” and Monetary Policy, Address at the Money Marketeers of New York University (Feb. 3, 2003). 22 Trading and Capital-​Markets Activities Manual § 4030.1 (first printing 1998, amended 2011). 23 Ben S. Bernanke, What Policymakers Can Learn from Asset Prices, Address at the Investment Analysts Society of Chicago (Apr. 15, 2004). 21

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increase in real interest rates), the security will decrease in value because it will only partially adjust to the new interest rate environment.24 V. STRIPS A. Description STRIPS—​an acronym for “separate trading of registered interest and principal securities”—​are zero coupon bonds of the U.S. Treasury created by physically separating the principal and interest cash flows. This process is known as “coupon stripping.” Prior to 1985, investment banks had created similar securities by purchasing Treasury securities and depositing them in a trust, which then issued receipts representing separate ownership interests in the coupon and principal payments of the underlying security. In 1985, the Treasury developed its own program for turning their coupon securities into STRIPS. All new Treasury bonds and notes with maturities of 10 years or more are eligible to be stripped under this program and become direct obligations of the U.S. government. The holder of any eligible security can request that the Treasury create separate book-​entry instruments for all of the principal and interest cash flows.25 The coupon and principal components of a U.S. Treasury STRIPS can be reassembled back into a coupon bond. This is possible because the Federal Reserve Board, acting as agents for the U.S. Treasury, stands ready at any time to exchange a Treasury coupon bond for individual STRIPS, or in turn to exchange all of the STRIPS components for a bond. Reassembly of STRIPS into a coupon bond is known as a “reconstitution” or “recon.” B. Valuation

Like Treasury bills, U.S. Treasury STRIPS trade at a discount to their face value. Zero coupons are considered to have an absolute duration of their maturity date. As opposed to coupon securities, which return money to the investor as time marches forward, the zero coupon bond only pays at maturity. Assume, for example, that the United States issues a 10-​year bond with a 5 percent coupon. If the size of the issue is $100 million, the government will have to pay to all its investors $5 million per year, for a total payout of $50 million. The Treasury will allow the coupon part of the bond to be “stripped” off the $100 million principal

. Id. 25 Trading and Capital-​Markets Activities Manual § 4025.1 (first printing 1998). 24

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component of the bond, thereby creating several new zero coupon securities. One security will be the $100 million principal zero coupon STRIPS. The other securities will be zero coupon bonds representing the interest payments with maturities corresponding to interest payment dates. The market for bonds affects the discounted value of the new $100 million zero coupon bond. The government will pay $100 million at maturity on the principal strip; to determine the current value of the zero coupon bond the prevailing interest rates and the lack of cash flow attached to the security must be taken into account. The “Rule of 72” is a valuable shorthand tool for understanding the effect of compound interest on STRIPS. Although not exact, the Rule of 72 gives a reasonable estimate of how long it takes an investment to double in value. The Rule of 72 states that a bond will double in value at a rate of 72 divided by the applicable interest rate. For example, a zero coupon bond that compounds at a rate of 7.2 percent will double the investors’ money in 10 years (72 divided by 7.2 equals 10). If prevailing interest rates dictate that the discounted value of a 10-​year zero coupon STRIPS is 7.2 percent, that bond will trade at 50 percent of face value. In other words a $50,000 investment will mature to be $100,000 in 10 years. Although the investor is not earning any spendable income along the way (as the interest is merely accruing to the bond), the accrual is treated as income for tax purposes even though the money has not reached the pocket of the investor in the form of cash. The prices of STRIPS are quoted on a discount basis, as a percentage of par. Eligible securities can be stripped at any time. For a book-​entry security to be separated into its component parts, the par value must be an amount that, based on the stated interest rate, will produce a semiannual interest payment of $1,000 or a multiple of $1,000. Quotes for STRIPS are quoted in yields-​to-​maturity.26 C. Uses

STRIPS have a known cash-​flow value at specific future dates. Zero coupon bonds have the beneficial effect for an investor of allowing him to receive the same return on interest earned as that which was originally promised by the issuer, thereby eliminating “reinvestment risk.” Reinvestment risk is the risk that an investor will not be able to reinvest income at the same rate as the bond that paid her the interest. STRIPS are a means of restructuring an income security to meet the needs of someone who might wish to purchase a zero coupon bond, such as an investor who wishes to have a certain amount of money at retirement.

Id. 26

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A financial institution might wish to purchase zero coupon government bonds to structure within other securities. For example, consider a bank structuring a certificate of deposit with a guarantee of principal at maturity. The bank might issue a 10-​ year CD with a return linked to the stock market. The financial instrument would be structured as follows: the bank collects $100,000 from an investor. The bank then buys a zero coupon STRIPS with a 7.2 percent yield at a cost of $50,000 and invests the balance in stocks. If the stock market goes up 7.2 percent a year as well, the bank can return to the investor $200,000. If the stock market goes down, the bank returns to the investor $100,000, representing the investment in the STRIPS (minus any fees the bank has built into the security). The bank, therefore, issues the CD while guaranteeing the principal with additional upside potential. A number of mutual funds and futures funds have adopted this strategy in guaranteeing principal and allowing for additional returns. This type of structure is composed of two parts: the zero coupon bonds and the investment in another asset class. D. Abuses: In the Matter of Orlando Joseph Jett

The case of In re Kidder Peabody Securities Litigation27 describes the infamous story of Joseph Jett, an employee of Kidder Peabody, who in 1994 was allegedly responsible for reporting inflated prices on his trading of STRIPS. This was a class action by investors who lost money by relying on certain information released in public documents regarding the profitability of Kidder Peabody, at the time a well-​known Wall Street firm. This information reflected Jett’s misreported trading, thereby allegedly violating the Securities Act of 1934. According to the opinion in a separate SEC proceeding,28 Jett entered into hundreds of millions of dollars of “forward recons” of STRIPS, agreements to exchange a full set of STRIPS for the underlying bond from which they were originally stripped. By devising what he called a “carefully planned trading strategy,” Jett was able to manipulate Kidder’s computer system to create the illusion of profitable securities trading. This strategy brought Jett rich rewards at the firm, including promotions and millions of dollars in bonuses, but in fact, Jett’s “trading strategy” caused the firm a large loss. The decision in Kidder Peabody describes STRIPS trading as follows: Due to the time value of money, in trading with consumers, a STRIPS security will sell for less than its final payment value. This is because the present value 27 In re Kidder Peabody Sec. Litig., 10 F. Supp. 2d 398 (S.D.N.Y. 1998). 28 In the Matter of Orlando Joseph Jett, Admin. Proc. File No. 3-​8919, http://​www.sec.gov/​litigation/​opinions/​ 33-​8395.htm#P45_​1761 (last visited Aug. 3, 2018).

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of the right to receive a future payment is less than the value of receiving that payment immediately. Generally, the greater the length of time between purchase date and final payment date, the greater the gap between current price and final value. The converse is also true: As the payment date approaches the price of a STRIPS security will increase, until payment date, when the two values converge. Purchasers and dealers of STRIPS seek to profit on shifts in interest rates and demand that occur between the sale date of a STRIPS security and its payment date. Dealers also can make profits through “arbitrage,” exploiting small, temporary price discrepancies between bonds and the component STRIPS. Thus, if the demand for individual STRIPS on any given day is higher than their current market value as a fully reconstituted bond, a dealer may be able to make a profit by stripping a bond and selling the individual components. To facilitate the trading of government bonds, the Federal Reserve Board (“Federal Reserve”), acting as agent for the U.S. Treasury, stands ready at any time to exchange a bond for its individual STRIPS, or vice versa. The exchange of a full set of STRIPS for a bond is known as a “reconstitution” or “recon.” The opposite exchange, of a bond for its individual STRIPS, is known as a “strip.” Unlike the sale of STRIPS or bonds to consumers, the exchange of STRIPS for bonds (or bonds for STRIPS) between a broker-​dealer and the Federal Reserve has no economic significance. Such an exchange is merely a non-​cash trade of economically equivalent securities, much like the exchange of one $100 bill for five $20 bills. Only the Federal Reserve can execute a strip or recon exchange and the Federal Reserve does not arrange, agree to, or confirm such exchanges in advance.29 According to the complaint, when Joseph Jett entered into a “recon,” the accounting system treated the transaction as a sale of the STRIPS. As STRIPS accrue interest daily, a sale of STRIPS would necessarily be at a higher dollar price than the day on which the transaction was made. Simply put, the accounting system at Kidder Peabody offset the future recon against the current price of the STRIPS and therefore recorded a false profit. The Kidder accounting system was allegedly set up so that STRIPS recons were treated as a sale of the underlying securities. This accounting for a forward recon

Kidder Peabody, 10 F. Supp. 2d at 403. 29

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would appear as a profit in the accounting system because the computer would immediately record the difference between the future value of the STRIPS, which, of course would be higher because of the accrual of interest and the current price of the recon, which would inevitably be lower. The difference between the two prices was recorded as an immediate profit although no actual transaction had occurred in the recon process. Depending on the size of the STRIPS and the settlement, the system would record profits that were illusory. There was no economic reality or risk in the transaction as the recon of STRIPS does not involve the exchange, receipt, or risk of capital. On the settlement date, the accounting system would record a loss to offset the false profit. The court describes what a trader would have to do to profit from this anomaly in the accounting system: In other words, as the current value of the STRIPS converged with its payment value, the apparent profit decreased, generating an offsetting false loss. By settlement date, the original false profit would be eliminated. As a result, to continue the illusion of profits, a trader would have to continue to enter more and more forward recons, with more and more distant settlement dates.30 This is just what Jett allegedly did, for a period of over two years, until April 1994, when Kidder acknowledged that his trading had generated $350 million in false profits.31 The SEC subsequently found that Jett, with intent to defraud, booked hundreds of millions of dollars in illusory profits, thereby deceiving the firm about his trading performance and obtaining large bonuses and other benefits, and that he had violated several record-​keeping provisions of the Securities Exchange Act.32 Jett was barred from association with a broker or dealer and was ordered to cease and desist from committing or causing any violations of the record-​keeping provisions he was found to have violated. He was also ordered to disgorge $8.21 million (plus prejudgment interest) and to pay a $200,000 civil penalty. This penalty was upheld on appeal.33 The appellate opinion contains a detailed discussion of how STRIPS function and are traded and how Jett was able to capitalize on the anomaly in the Kidder trading system to create such huge false profits through the use of phantom trades. Kidder was sold to another Wall Street firm shortly after the scandal was disclosed.

Id. at 404. 31 Id. at 405. 32 Orlando Joseph Jett, Initial Decision Rel. No. 127 ( July 21, 1998), 67 SEC Docket 1901. 33 In the Matter of Orlando Joseph Jett, Admin. Proc. File No. 3-​ 8919 http://​www. sec.gov/​litigation/ ​opinions/​33-​8395.htm#P45_​1761; http://​www.sec.gov/​litigation/​litreleases/​2007/​lr20273.htm (last visited Feb. 8, 2019). 30

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10 Debt Securities

I. Description  140 A. Features of Bonds  140 B. Types of Bonds  141 C. The Indenture  142 II. Bond-​Rating Agencies  142 A. Independence and Conflicts of Interest  144 B. Regulation of Bond-​Rating Agencies  146 III. Special Types of “Debt” Instruments  146 A. Repos  146 1. Description  146 2. Orange County Case Study  147 B. Mortgage-​Backed Securities  149 1. Mortgage-​Backed Bonds  150 2. Pass-​Through Securities  150 3. Collateralized Mortgage Obligations and Real Estate Mortgage Investment Conduits  151 4. Stripped Mortgage-​Backed Securities (SMBS)  151 5. Subprime Mortgage Crisis  151

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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Capital Markets, Derivatives, and the Law IV. Securities Act Registration  152 A. Government Securities  153 B. Government Agency Securities  153 C. Municipal Securities  154 1. SEC Disclosure Requirements  154 2. MSRB Disclosure Requirements  154 D. Corporate Debt Securities  155 1. Securities Act Requirements  155 2. Trust Indenture Act Requirements  155 E. Private Placements of Debt Securities  156

I. Description Debt instruments obligate an issuer to make interest payments and repay principal to the buyer according to the terms of an agreement between the lender and the borrower.1 The yield, or market price of these debt securities is related to the yield on U.S. Treasury securities. Treasuries remain the benchmark for risk-​free credit investing, and other yields are related to the risk-​free return Treasuries offer. Also known as bonds, debt instruments are attractive to investors because they can provide a reliable stream of cash flows in the form of interest payments and also might provide for the repayment of principal upon maturity. Furthermore, because bondholders are creditors to the issuer, they have claims to assets upon bankruptcy that are superior to the claims of shareholders. Bonds might carry less risk than equities but might also offer a lower potential for returns. For issuers, bonds are an attractive way of raising capital because they do not dilute the equity or ownership interests in a company and because voting rights are not attached to bonds, so purchasers of these securities do not participate in control of the issuer in any way. A. Features of Bonds

Bonds have several important characteristics that affect their structure and therefore their yield. These include the face or par value, interest or coupon rate, maturity, and any special redemption options that may be attached to the bond. The par value is the principal amount of the debt obligation. “Coupon rate” refers to the rate of interest that will be paid on the principal amount. A bond’s maturity is the date

1 The Bond Market Association, available at www.investinginbonds.com (last visited Aug. 3, 2018).

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on which the principal will be repaid to the buyer. Bonds are generally classified into short (30 days to five years), medium (5 to 12 years), and long-​term (12 years or longer). A bond can carry redemption features that provide benefits to either the issuer or the buyer. For example, a call option allows the issuer to repay the principal prior to the maturity date, whereas a put option allows the buyer to redeem his principal prior to maturity. The value of a bond is also affected by the issuer’s credit quality. Credit quality is assessed by various agencies, including Moody’s, Standard & Poor’s, and Fitch. These agencies consider and evaluate the financial position of the issuer of the specific bond in order to rate them from highest credit quality to lowest. B. Types of Bonds

There are various categories of issuers of bonds: government bonds (discussed in ­chapter 9), for instance, corporate bonds, municipal bonds, and federal agency bonds. 1. Corporate bonds. These are debt instruments issued by a corporation as a means of raising capital. If offered for sale to the public, they are subject to federal securities laws. 2. Municipal bonds. Municipal bonds are fixed-​income securities issued by municipal governments as a mechanism for raising revenue to finance public expenditures. A prime feature of these securities is that interest or other investment earnings on them is usually excluded from gross income of the holder for federal income tax purposes.2 Issuers of municipal securities are exempt from most federal securities laws. 3. Federal agency bonds. Federal agency bonds are securities issued by wholly owned government corporations. These include the Government National Mortgage Association (GNMA, or “Ginnie Mae”), Fannie Mae, and Freddie Mac, which are described later in this chapter. They are considered to be low-​risk debt instruments because some are backed by the full faith and credit of the U.S. government (Ginnie Mae); those that are not backed by full faith and credit are nevertheless safe investments as a result of their special priority for borrowing from the U.S. government. 4. Mortgage-​backed and asset-​backed securities: Mortgage-​backed securities (MBS) are debt obligations that represent claims to the cash flows from

2 Municipal Securities Rule Making Board, http://​www.msrb.org/​Glossary/​Letter/​M.aspx (last visited Aug. 3, 2018).

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pools of mortgage loans, most commonly on residential property.3 Most MBSs are issued by government-​sponsored enterprises. These different types of fixed-​income securities and their regulatory frameworks are described in more detail later on in the chapter. C. The Indenture

A trust indenture is a contract entered into between a corporation issuing bonds or debentures and a trustee for the holders of the bonds or debentures, which delineates the rights of the holders and the issuer.4 The Trust Indenture Act of 1939 sets minimum standards for the content of indentures and the qualifications and responsibilities of trustees.5 The indenture sets out the rights and responsibilities of the trustee. In general, the trustee’s responsibilities are ministerial and involve little to no action until an event qualifying as default occurs. At this time, the trustee is generally required to collect all money owed to bondholders. The trustee has a legal duty to effectively protect the rights of bondholders and may not contract out of liability for failure to do so.6 The indenture should include, at least, the following terms: the maturity date of the bonds; the interest rate; redemption, subordination, and convertibility features; registration, transfer and exchangeability of ownership provisions; covenants of the trust; default definitions, provisions, and remedies; and procedures for amending the indenture. II. Bond-​Rating Agencies In the wake of the Great Recession, rating agencies came under scrutiny for their role in the mortgage-​backed securities meltdown. Many of the structured securities, which were blamed for the financial meltdown, had secured high credit ratings from credit rating agencies. Bond ratings focus on the likelihood that debt will be repaid in accordance with the terms of the security. More specifically, the rating “reflects an assessment of the probability that a debt instrument will default and the amount of loss the 3 Securities and Exchange Commission, http://​www.sec.gov/​answers/​mortgagesecurities.htm (last visited Aug. 3, 2018). 4 UPIC & Co. v Kinder-​Care Learning Ctrs., Inc., 793 F. Supp. 448 (S.D.N.Y. 1992). 5 15 U.S.C. § 77aaa–​§ 77bbbb. 6 15 U.S.C. § 77ooo (1933 as amended).

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debt-​holder will incur in the event of default.”7 This information helps investors understand the risk associated with a given security, which is a key element in the valuation of bonds. The Securities and Exchange Commission (SEC) describes why the credit rating process for issuing residential mortgage-​backed securities (RMBS) is vital to an investor’s decision to deploy capital to a particular structure: The issuer of the securities to be rated is a bankruptcy remote entity (typically a trust or a limited liability company) that is created solely to hold a pool of assets that generates cash flows, which are used to pay principal and interest on securities issued by the issuing entity. The securities typically are issued in “tranches” that are assigned priorities in terms of receiving interest and principal payments from the cash flows generated by the asset pool and incurring losses resulting from the failure of the assets in the pool to perform (e.g., because of defaults). The tranche that is the last to incur losses has the highest level of “credit enhancement.” This tranche receives the highest credit rating and, generally, the arranger of the transaction seeks to obtain a credit rating that is in the highest category of credit rating the NRSRO issues (e.g., “AAA”). Usually, the arranger seeks to design a capital structure for the issuer that will result in securities at given tranches receiving specific credit ratings that are demanded by the potential investors in the securities (e.g., the arranger will seek to design a capital structure that results in a “AAA” rating for securities in the most senior tranche). The investors may require specific credit ratings to obtain benefits or relief under statutes and regulations using the term NRSRO [Nationally Recognized Statistical Rating Organization]. They also may require specific credit ratings to meet investment guidelines or contractual requirements.8 All else being equal, bonds with a higher credit rating will be more expensive (lower yield) than those with a lower credit rating. The “discount” on lower-​rated bonds serves to compensate the investor for the increased risk that the investor takes on in purchasing the bond. It is important to remember that credit ratings reflect only the likelihood of repayment and the expected credit loss, and do not reflect

7 U.S. Senate Committee on Banking, Housing and Urban Affairs (Sept. 26, 2007) (testimony of Michael Kanef, Moody’s Investor Service). 8 Report to Congress on Assigned Credit Ratings as Required by Section 939F of the Dodd-​Frank Wall Street Reform and Consumer Protection Act, available at http://​www.sec.gov/​news/​studies/​2012/​assigned-​credit-​ ratings-​study.pdf (last visited Aug. 3, 2018).

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various other key indicators in the value of a bond, such as price, maturity, and interest rate. Ratings are expressed on a scale using letters and numbers that vary from agency to agency. In general, bonds that exhibit the least likelihood of credit loss are assigned a AAA rating and as this likelihood increases, the rating declines down the scale to AA, A, B, and so forth. A. Independence and Conflicts of Interest

Credit-​rating agencies have been subject to allegations that their impartiality and independence is compromised by their relationships with issuers of fixed-​income securities. Because issuers pay credit rating agencies for their ratings, there is an inherent conflict of interest that arises from this relationship. The Credit Agency Reform Act of 20069 was passed in an attempt to address some of these concerns. Rules issued pursuant to that Act attempt to regulate this issue through the prohibition of unfair, coercive, or abusive practices.10 “This law required the SEC to establish clear guidelines for determining which credit rating agencies qualify as Nationally Recognized Statistical Rating Organization (NRSROs). It also gave the SEC the power to regulate NRSRO internal processes regarding record-​keeping and how they guard against conflicts of interest and specifically makes the NRSRO determination subject to a vote by the SEC. The law specifically prohibits the SEC from regulating an NRSRO’s rating methodologies.”11 In 2010, Title IX, Subtitle C of the Wall Street Reform and Consumer Protection Act (widely known as the Dodd-​Frank Act), “Improvements to the Regulation of Credit Rating Agencies,” established new self-​executing requirements applicable to NRSROs, required certain studies, and required that the SEC adopt rules applicable to NRSROs in a number of areas. Bond rating agencies “disseminate information about the relative creditworthiness of financial obligations of corporations, banks, government entities and pools of assets collected in structured finance transactions.”12 These agencies track debt covering corporate issuers, public finance issuers, sovereign nations, and structured finance obligations.13 Their ratings are available to the public free of charge whereas the issuer of a corporate bond or a privately structured security may pay for the

Pub. Law No. 109-​291, 120 Stat. 1327–​1339, amending the Securities Exchange Act of 1934. Credit Rating Agency Reform Act of 2006, SEC Rule 17g-​6. 11 http://​www.sec.gov/​spotlight/​dodd-​frank/​creditratingagencies.shtml (last visited Aug. 3, 2018). 12 Kanef, supra note 7. 13 Moody’s Investor Service, www.moodys.com (last visited Aug. 3, 2018). 9

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rating. The SEC has recognized that the issuer pay-​pricing model can create a conflict of interest for the NRSRO: Under the issuer-​pay model, the NRSRO is paid by the arranger to rate a proposed structured finance product. . . .  investors may not purchase a structured finance product if it is not rated at a specific level because, for example, they are subject to laws or regulations that provide benefits or relief based on credit ratings. Investors also may be subject to investment guidelines that require the instruments they hold to be rated at or above a certain category in a rating scale (e.g., the four highest categories). Arrangers also desire higher credit ratings to lower financing costs of the products they structure as lower ratings generally result in higher interest rates. For these reasons, this payment model presents an inherent conflict of interest because the arranger has an economic interest in obtaining credit ratings that are demanded by investors and that lower the issuer’s financing costs and the NRSRO has an economic interest in having the arranger hire it in the future. This creates the potential that the NRSRO will be influenced to issue the credit ratings desired by the arranger. There are several aspects of the credit rating process for structured finance products that may heighten the effects of the conflicts of interest inherent in the issuer-​pay model. For example, an arranger may have multiple NRSROs analyze a proposed structured finance product and select the one or two NRSROs that provide the desired credit ratings (i.e., engage in “rating shopping”). When this occurs, the arranger provides information about a proposed structured finance product (e.g., a CMBS) to multiple NRSROs that rate the type of product being offered. The NRSROs will provide preliminary estimations of the credit enhancement levels necessary to support a credit rating in the highest credit rating category. The arranger then selects the NRSRO or NRSROs that provide it with the preliminary credit enhancement level it desires. This creates an incentive for the NRSRO or NRSROs to provide preliminary estimations desired by the arranger in order to be hired to produce a final credit rating for the transaction. In addition to the “rating shopping” dynamic, the issuer-​pay conflict may be more acute for structured finance products (as compared to other types of debt instruments) because certain arrangers of these products bring substantial ratings business to the NRSROs. As sources of repeat business, arrangers of structured finance products may exert greater undue influence on an NRSRO than personnel involved in obtaining credit ratings for other types of issuers. Furthermore, in the case of certain structured finance products, there are only

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a few major investment banks that assemble and sell these products. Losing the business of one of these banks could have a substantial impact on an NRSRO’s revenues. Conversely, an arranger potentially could bring repeat rating business to a credit rating agency because the arranger’s own credit rating was determined by the credit rating agency and, therefore, wants to curry favor with that credit rating agency.14 B. Regulation of Bond-​R ating Agencies

Credit-​rating agencies wishing to have their ratings be used by issuers for the purposes of federal securities laws can apply under the Credit Rating Agency Reform Act of 2006 to be recognized as NRSROs. This designation permits the agency’s ratings to be used by issuers of securities for certain regulatory purposes. The SEC administers the Credit Rating Agency Reform Act and oversees NRSROs. The purpose of the Act is “to improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency and competition in the credit rating agency industry.”15 It provides guidelines for the SEC to use in assessing which agencies qualify for NRSRO status as well as some disclosure requirements for the agencies themselves. The concept is to provide more regulatory oversight in an attempt to improve transparency. The SEC rules implementing the Act contain various disclosure and registration requirements, rules for managing conflicts of interest, and prohibitions of unfair, coercive, or abusive practices.16 III. Special Types of “Debt” Instruments A. Repos 1. Description A repurchase agreement (“repo”) is a financial instrument that provides a method of short-​term borrowing. It involves the sale and repurchase of securities. A “reverse repo” is the term used to describe the opposite perspective of the same transaction—​ the purchase and resale of securities. Repos are often used by governments. They can be used as a means of short-​term borrowing or for speculative purposes. A party

Report to Congress on Assigned Credit Ratings as Required by Section 939F of the Dodd-​Frank Wall Street Reform and Consumer Protection Act, available at http://​www.sec.gov/​news/​studies/​2012/​assigned-​credit-​ ratings-​study.pdf (last visited Aug. 3, 2018). 15 Credit Rating Agency Reform Act of 2006, Preamble. 16 SEC Rules 17g-​1 through 17g-​6. 14

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speculates when it reinvests the proceeds from a repo in a different security in an attempt to profit on a positive spread. When used for such speculative purposes, repos can be used to enter highly leveraged complex financial transactions. Economically, a repo is substantively similar to a secured loan, as the sale of securities serves as collateral in the event of default. However, a repo differs from a loan in that legal title to the securities passes from the seller to the buyer. This has implications in bankruptcy proceedings, as bankruptcy stays loans but does not stay securities sold that create a legal claim to the assets of the seller. The bankruptcy of Orange County, California, in 1994 provides an example of repos used for speculative purposes and the legal implications of taking on such high degrees of risk. 2. Orange County Case Study In the early 1990s the treasurer of Orange County, California, entered into several reverse repos that, although successful for some time, ultimately resulted in a loss of $1.7 billion and bankrupted the county. The treasurer’s strategy involved the use of reverse repos to finance floating-​rate notes, specifically “inverse interest only” mortgage-​backed securities (“inverse IOs”).17 While interest rates stayed low, this strategy proved highly profitable for the county. At times, the $7.6 billion portfolio was leveraged to a book value of more than $20.6 billion. However, when interest rates began to rise, the treasurer’s investment strategy resulted in a massive loss. The county’s loss arose from the highly leveraged positions that the treasurer took on the inverse IOs. Inverse IOs have a set principal amount and earn interest at a rate that moves inversely to a specified index rate.18 When leveraged, as they were in the case of Orange County, a small increase in interest rates can cause a significant decrease in the inverse floating rate. When interest rates fall or remain low, inverse IOs earn high returns, but if interest rates rise, they can incur substantial losses. The county’s investment strategy involved the sale of its portfolio of securities through reverse repos with maturity dates of less than 180 days. The proceeds of the repos were then reinvested in inverse IOs with much longer maturity dates—​between two and five years. Furthermore, the treasurer “rolled over” new repo transactions to pay his obligations on old ones (rolling over means issuing new securities at the new interest rate to repay existing obligations). Finally, the repo transactions were “stacked” by using earlier reverse repos as collateral for subsequent reverse repos. As interest rates rose, the county’s debt grew because it had to pay more interest on the reverse repos. At the same time, the return on its inverse IOs was falling as a result of

In re Orange Cnty. v. Fuji Sec. Inc., 31 F. Supp. 2d 768 (C.D. Cal. 1998). 18 See Banca Cremi v. Alex Brown & Sons, 132 F. 3d 1017, 1037 (4th Cir. 1997). 17

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the rise in interest rates. As the investments made by Orange County were backed by mortgages, another effect of rising interest rates was that the duration of the lower interest rate mortgages became extended as homeowners became less willing to pay down or refinance their “cheap” mortgage rates. In other words, as interest rates rose, the return to the investor declined and the time horizon of the investment extended. By December 1994, the county had lost over $1.6 billion and eventually went into Chapter 9 bankruptcy. In an attempt to void the repo transactions that contributed to the county’s need to seek Chapter 9 bankruptcy protection, the county brought a lawsuit against Fuji Securities Inc., a counterparty in some of the reverse repo transactions. The county argued that its former treasurer did not have the authority to enter into these transactions as they exceeded the California constitutional debt limit and as such, they should be considered void. In order to be successful in the lawsuit, the county had to first convince the court that a repo is a structured loan for the purposes of the constitutional debt limit. The California Constitution placed restrictions on the amount of indebtedness a county could incur. This created an incentive to find alternative means of leveraging speculative investments. There was also a state law in place that authorized the county to enter into repo transactions.19 However, the county argued that a repo was, in substance, a structured loan and should qualify as “indebtedness or liability” under the constitutional debt limit, which states: No county, city, town . . . shall incur any indebtedness or liability in any manner or for any purpose exceeding in any year the income and revenue provided for such year, without the assent of two-​thirds of the qualified electors thereof, voting at an election to be held for that purpose . . . 20 The court examined the economic substance and ultimately held that the repos did not create liability or indebtedness because the transactions were not essentially collateralized loans in the context of the constitutional debt limit. Although repos share various characteristics with collateralized loans, they differ in important ways. Specifically, in a loan transaction, there is no transfer of title, whereas in a repo transaction, a buyer acquires title of securities and as such, no loan takes place. Furthermore, the court ruled that within the meaning of the debt limit, the relevant time frame from which to analyze the transaction is at the outset, because the

19 Cal. Gov’t Code § 16480.4 (Repealed and added by Stats. 1978, Ch. 605, Sec. 2.). “The State Treasurer may enter into repurchase agreements or reverse repurchase agreements of any securities described in Section 16430.” 20 Cal. Const. Art. XVI, § 18.

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debt limit does not set performance standards; it only regulates how much may be incurred up front. At the time the transaction was entered into, there were sufficient funds to repurchase the underlying securities, and as such, the acts were within the grant of authority by law and were not ultra vires and void.21 In response to the bankruptcy of Orange County, the California state legislature enacted various amendments to the law that placed restrictions on repo transactions. Specifically, under the new rules, the proceeds of reverse repos can only be used to purchase other securities with maturities of less than 92 days from the settlement date of the reverse repo agreement, unless the agreement contains a written codicil guaranteeing a minimum earning or spread for the entire term of the purchased securities.22 Furthermore, reverse repos cannot exceed 20 percent of the base value of the entire portfolio.23 Finally, stacking is no longer permitted; only securities that have been owned for a minimum of 30 days may act as collateral for a reverse repo agreement.24 The amendments also now hold a trustee to a “prudent person” standard.25 B. Mortgage-​B acked Securities

Mortgage-​ backed securities (MBSs) are financial products that use pools of mortgages as collateral for the issuance of securities.26 MBSs are a type of Collateralized Debt Obligation (CDO). They are created for the purpose of buying mortgage loans from originating banks or mortgage companies, repackaging the accompanying credit risk, and selling that risk to investors. The allotted securities generally consist of a number of different debt tranches, the credit rating of which decreases as the yield increases, and an equity tranche. The Trading and Capital-​Markets Activities Manual, published by the Board of Governors of the Federal Reserve System, describes residential mortgage-​backed securities (RMBSs) follows:27 A mortgage loan is a loan which is secured by the collateral of a specified real estate property. The real estate pledged with a mortgage can be divided The court did note, however, that repos may be characterized differently under different statutes and regulations. 22 Cal. Gov’t Code § 53601(j)(3)(D) (1985). 23 Cal. Gov’t Code § 53601(j)(3)(B). 24 Cal. Gov’t Code § 53601(j)(3)(A) (1985). 25 Cal. Gov’t Code § 53600.3. 26 Trading and Capital-​Markets Activities Manual § 4110.1 (First published 1998 continuously updated). 27 Trading and Capital-​Markets Activities Manual, § 4110.1 ((First published 1998 continuously updated). (Board of Governors of the Federal Reserve System). 21

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into two categories: residential and nonresidential. Residential properties include houses, condominiums, cooperatives, and apartments. Residential real estate can be further subdivided into single-​family (one-​to four-​family) and multifamily (apartment buildings in which more than four families reside). Nonresidential property includes commercial and farm properties. Common types of mortgages which have been securitized include traditional fixed-​rate, level-​ payment mortgages, graduated-​ payment mortgages, adjustable-​ rate mortgages (ARMs), and balloon mortgages. MBSs are products that use pools of mortgages as collateral for the issuance of securities. Although these securities have been collateralized using many types of mortgages, most are collateralized by one-​to-​four family residential properties. MBSs can be broadly classified into four basic categories: • mortgage-​backed  bonds; • pass-​through securities; • collateralized mortgage obligations and real estate mortgage investment conduits; and • stripped mortgage-​backed securities. 1. Mortgage-​Backed  Bonds MBSs are general obligations of an issuer that are credit enhanced through the pledging of specific mortgages as collateral. MBSs involve no sale or conveyance of ownership of the mortgages acting as collateral. 2. Pass-​Through Securities A mortgage-​backed, pass-​through security provides its owner with a pro rata share in underlying mortgages. The mortgages are typically placed in a trust, and certificates of ownership are sold to investors. Issuers of pass-​through instruments primarily act as a conduit for the investors by collecting and proportionally distributing monthly cash flows generated by homeowners making payments on their home mortgage loans. The pass-​through certificate represents a sale of assets to the investor, thus removing the assets from the balance sheet of the issuer.

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3. Collateralized Mortgage Obligations and Real Estate Mortgage Investment Conduits Collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs) securities represent ownership interests in specified cash flows arising from underlying pools of mortgages or mortgage securities. CMOs and REMICs involve the creation, by the issuer, of a single-​purpose entity designed to hold mortgage collateral and funnel payments of principal and interest from borrowers to investors. Unlike pass-​through securities, however, which entail a pro rata share of ownership of all underlying mortgage cash flows, CMOs and REMICs convey ownership only of cash flows assigned to specific classes based on established principal distribution rules.28 The risks associated with mortgage-​backed securities include “prepayment risk”; the option is the homeowner’s right to prepay a mortgage any time, at par. The prepayment option makes mortgage securities different from other fixed-​income securities, as the timing of mortgage principal repayments is uncertain.29 An important feature of mortgage-​backed securities is that they may have the backing of one of three government-​sponsored agencies: the Government National Mortgage Association (GNMA or Ginnie Mae), the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), and the Federal National Mortgage Association (FNMA or Fannie Mae).30 MBSs backed by these government-​ related agencies have very little credit risk; however their sensitivity to interest rate movements can be significant. 4. Stripped Mortgage-​Backed Securities (SMBS) SMBS are securities that include the ownership of the principal or interest cash flow from a pool of mortgages or pass-​through securities. Rights to the “Principal Only” are called as “POs”, and rights to the “Interest Only” cash flow are called “IOs”.31 5. Subprime Mortgage Crisis In mid-​2007, the United States experienced a sharp rise in home foreclosures, resulting in what has been referred to as a subprime mortgage crisis. This crisis led to the decline of many lending institutions and sparked a global credit crisis. Id. 29 Id. 30 See ­chapter 1 for a description of the relationship of Government Sponsored Entities to the U.S. Treasury 31 Supra note 27. 28

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Subprime mortgages are those mortgages that are issued to borrowers with relatively poor credit ratings. These investments are labeled as subprime by lending institutions and entail more risk than “prime” mortgages. Mortgages are issued based on the value of the house and the income and credit history of the borrower. As house prices rise, subprime borrowers can borrow more money as they have more collateral in the form of increased value in their home. However, if house prices fall, this is no longer possible. In 2007, house prices began falling while at the same time, interest rates were rising. This resulted in a situation in which borrowers faced rising interest payments (because many loans were adjustable rate mortgages) while the value of their houses was declining, removing the ability to refinance or to sell the house and use the proceeds to pay off mortgage loans. Thousands of borrowers were forced to default on their mortgages, and lenders had no means of collecting on the billions of dollars lent out to fund the pool of subprime mortgages. The availability of subprime mortgages was significantly increased through the use of CMOs. Because of the increased risk associated with subprime mortgages, a single investor faces a lower probability that the mortgage will be repaid and thus faces a lower expected return. CMOs based on these mortgages allow risk to be spread among investors with different risk tolerance levels, offering a greater potential for high returns. When the CMO is divided into tranches with varying risk profiles, investors with low risk-​tolerance (pension funds, banks) purchase CMOs that ensure that they will be a repaid first while those with higher risk-​tolerance (hedge funds) purchase CMOs that are paid out last. Because financial instruments such as CMOs enable lending practices that might not otherwise occur in the absence of a mechanism for spreading risk, some commentators have called for more government regulation on lending practices in order to avoid a recurrence of the events of the 2007 subprime mortgage crisis. IV. Securities Act Registration Fixed-​income securities are regulated by various federal and state laws. The type of security will determine which agency has jurisdiction to regulate a given security or issuer.32 The SEC regulates many fixed-​income securities in implementing the Securities Act of 1933 (“Securities Act”),33 the Securities and Exchange Act of 1934 (“Exchange Act”),34 and the Trust Indenture Act of 1939 (“Trust Indenture Act”).35 See ­chapter 5, for a discussion of types of securities. 33 15 U.S.C. § 77a. et seq. 34 15 U.S.C. § 78a. et seq. 35 15 U.S.C. § 77aaa–​§77bbbb. et seq. 32

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The Securities Act determines which financial issuers are required to register their instruments with the commission.36 All those that are required to register are also subject to the rules and regulations of the SEC, including all disclosure requirements and antifraud provisions. The registration requirement applies to debt securities in the same manner as it applies to equity securities. It is primarily corporate debt securities that are subject to the requirements of the Securities Act. Some securities are exempt from the Securities Act registration requirements. In some cases, these securities are unregulated, and in other cases, they are regulated by another source, often by a self-​regulatory organization (SRO). The exemption may arise from the issuer’s status, or it may arise from the type of transaction at issue. Exempt securities include U.S. government securities, GSE securities, securities of domestic banks or trust companies, commercial paper, municipal securities, and private placements.37 Although these are exempt from disclosure requirements, they are subject to the antifraud provisions of the Securities Act.38 As such, any material misrepresentation contained in any documents exposes the issuer to liability. A. Government Securities

Government securities, such as Treasury bills, are exempt from the registration and disclosure requirements under the Securities Act and the Exchange Act. They are regulated by the Government Securities Act of 1986.39 This act provides a framework to regulate all government securities brokers and dealers. It grants authority to the U.S. Treasury Department to issue and implement rules to regulate transactions involving government securities. The Government Securities Act also added a section to the Exchange Act, requiring broker-​dealers who trade only in government securities to register with the SEC as government securities broker-​dealers.40 B. Government Agency Securities

Government agency securities, such as those offered by Fannie Mae, Freddie Mac, and Ginnie Mae, are exempt from the registration and disclosure requirements under the Securities Act and the Exchange Act.41 For the purposes of regulation,

See 15 U.S.C. § 77e. et seq. 37 See 15 U.S.C. § 77c. et seq. 38 See 15 U.S.C. § 77q. et seq. 39 Pub. Law No. 99-​571, 100 Stat. 3208. et seq. 40 See 15 U.S.C. § 78o-​5 et seq. 41 See 15 U.S.C. § 77c et seq. 36

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they are considered “government securities.”42 As they do not need to be registered in order to be sold to the public, they do not typically file offering documents with the SEC. They do provide offering documents and make financial statements available to investors via their website.43 C. Municipal Securities

Municipal securities are regulated by the Municipal Securities Rulemaking Board (MSRB), a self-​regulatory organization that operates under the oversight of the SEC to develop rules governing municipal securities activities.44 All rules issued by the MSRB must be approved by the SEC.45 Although the MSRB is highly involved in the regulation of municipal securities, the SEC thus has the ultimate enforcement authority. 1. SEC Disclosure Requirements SEC rules require that underwriters making primary offerings of municipal securities of $1 million or greater obtain an “official statement,” which is a type of disclosure document, disclosing no more than the following information: the offering price, interest rate, selling compensation, aggregate principal amount, principal amount per maturity, delivery dates, any other terms or provisions required by an issuer of such securities to be specified in a competitive bid, ratings, other terms of the securities depending on such matters, and the identity of the underwriter.46 Unlike many other types of securities, the disclosure obligation here is on the underwriter and not the issuer. 2. MSRB Disclosure Requirements The MSRB disclosure rule47 requires, among other things, that the underwriter of a primary securities offering file the official statement required by the SEC with the MSRB. The official statement is subject to the antifraud provisions of the Exchange

Felice B. Friedman, Regulation of Fixed Income Securities Markets in the United States (World Bank Policy Research Working Paper No. 3283, Apr. 21, 2004), available at http://​ssrn.com/​abstract=610328. 43 Id. 44 Municipal Securities Rulemaking Board, http://​www.msrb.org/​Glossary/​Letter/​M.aspx (last visited Aug. 3, 2018). 45 See 15 U.S.C. § 78o-​4 et seq. 46 SEC Rule 15c-​12(b) et seq. 47 MSRB Rule G-​32 et seq. 42

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Act48 and as such must provide complete and true information. The SEC has the ultimate enforcement authority in this situation. D. Corporate Debt Securities

Corporate debt securities are subject to the registration and disclosure requirements under the Securities Act, and the regulatory framework for debt securities is substantially the same as for equity securities. 1. Securities Act Requirements All corporate debt securities sold to the public must be registered with the SEC. Registration requires the filing of the following documents, which together form the “registration statement” required by the Securities Act:49 1. Prospectus: this is a document that contains the offer of securities and is delivered to each purchaser of securities. An issuer can be sued in federal court for any omission or misrepresentation of material fact in the prospectus, and the CEO, CFO, chief accountant, and directors can also be held personally liable for any such misrepresentations. 2. Supplementary Information: this information is filed with the SEC and is available to the public but does not form part of the prospectus that all purchasers of the security receive. Before issuing securities to the public, the SEC must complete its review of the registration statement. However, prior to this, a preliminary prospectus may be circulated to potential purchasers. This may contain most of the same information as the final prospectus but is not official. Once registered, the prospectus and registration statements, along with other filings, are available to the public on the SEC’s Electronic Data-​Gathering, Analysis, and Retrieval (EDGAR) databases. 2. Trust Indenture Act Requirements The Trust Indenture Act is administered by the SEC and is designed to regulate the trust indenture and the appointment of trustees acting for the benefit of holders of securities in principal amounts of $10 million or more.50 It requires that issuers file 48 15 U.S.C. § 78j(b) et seq. 49 Cf. 15 U.S.C. § 77e et seq. 50 15 U.S.C. § 77ddd et seq.

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an indenture with the SEC with an “indenture qualification statement.”51 The purpose of the Trust Indenture Act is to ensure that the indenture, which is the agreement between the issuer and the bondholder setting out their respective rights and obligations, conforms to the standards set by the SEC. E. Private Placements of Debt Securities

Securities not offered to the public or listed on a public exchange—​private placements—​are exempt from the registration requirements under the Securities Act. Smaller issuers often choose to make private placements. By exempting small offerings from the registration process, the SEC seeks to foster capital formation by lowering the cost of offering securities to the public.52 Although debt securities issued in a private placement are generally not eligible for resale as they are not registered with the SEC, Rule 144A provides an exception. Adopted pursuant to the Securities Act, Rule 144A provides a safe harbor by which private placement securities can be resold to qualified institutional buyers (QIBs). QIBs must be certified as such by the SEC and generally include large institutional buyers. This rule is designed to increase liquidity in the corporate debt market. Trading in the Rule 144A market has been significantly enhanced by the introduction of the Private Offerings, Resales and Trading through Automated Linkages (PORTAL) system, created and administered by the National Association of Securities Dealers, Inc. (NASD). This is an automated trading system that facilitates the quoting and trading of unregistered securities eligible to be resold pursuant to SEC Rule 144A.53 Making a private placement under Rule 144A is particularly attractive to foreign issuers who wish to avoid the complications and cost of filing the necessary documents for a public offering, particularly given the necessity that all SEC filings must conform to U.S. Generally Accepted Accounting Principles (GAAP) standards. However, foreign issuers of private placements are required to supply the SEC with information that is required by the issuer’s home country for a public offering of securities there.54 In addition, all Rule 144A issuers must provide basic information to the SEC, including a description of their business and financial statements for the previous two years. Whatever the structure of a particular debt instrument, its primary function is to allow the issuer to access the capital markets. The purchaser of the instrument uses debt security as a means of investing capital and receiving a return on that investment. 15 U.S.C. § 77eee et seq. 52 Securities and Exchange Commission, available at http://​www.sec.gov/​about/​laws.shtml#trustinact1939 (last visited Aug. 3, 2018). 53 NASDAQ PORTAL, available at http://​www.nasdaq.com/​ (last visited Aug. 3, 2018). 54 SEC Rule 12g3-​2. 51

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11 Derivatives

I. Introduction  158 A. Description  158 B. Counterparty Credit Risk  158 C. Over-​the-​Counter versus Exchange-​Traded Derivatives  D. Exchange-​Traded versus OTC Derivatives  162 II. Shifting Risk  163 A. The Concept of Leverage  163 B. Basis Risk  164 C. Market Risk  164 D. Effective Tools of Risk Management  165 III. Types of Derivatives  165 A. Forwards  165 B. Futures  166 1. Reduction of Counterparty Risk  167 2. Suitability as Hedging Instruments  167 C. Distinction between Forwards and Futures  168 D. Foreign Exchange Forwards and Futures  169 E. Options  170

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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Capital Markets, Derivatives, and the Law F. Swaps  172 1. Characteristics of Swaps  172 2. The ISDA Master Agreement  173 G. Credit Derivatives  174 Appendix CME Filing: Self-​Certification for the initial listing of the Bitcoin Futures Contract  176

I. Introduction A. Description Derivatives provide a means for shifting risk from one party to a counterparty that is more willing or better able to assume that risk. The counterparty’s motivation for assuming that risk might be to manage its own risk or to enhance yield (make money). A derivatives transaction is “a bilateral contract or payments exchange agreement whose value derives . . . from the value of an underlying asset or underlying reference rate or index.”1 Derivatives transactions may be based on the value of foreign currency, U.S. Treasury bonds, stock indexes, or interest rates. The values of these underlying financial instruments are determined by market forces like movements in interest rates. Within the broad panoply of derivatives transactions are numerous innovative financial instruments whose objectives may include a hedge against market risks, management of assets and liabilities, or lowering of funding costs; derivatives may also be used as speculation for profit.2 There are four types of derivatives contracts: forwards, futures, swaps, and options.3 Derivatives are used to manage risk by enabling a user to isolate, trade, and transfer one or more distinct risks. Generally they are highly leveraged because they require little or no good faith deposit to secure the counterparties’ obligations under the contract. Many financial institutions are now implementing stricter margin requirements due to the deteriorating credit quality of counterparties, the general tightness in credit conditions, and the wariness of financial market participants. B. Counterparty Credit Risk

In March 2008 the Federal Reserve facilitated the sale of the investment bank Bear Stearns (which was reported to be on the verge of insolvency) to JPMorgan 1 Procter & Gamble Co. v. Bankers Trust Co., 925 F. Supp. 1270, 1275, Blue Sky L. Rep. (CCH) P74108, Comm. Fut. L. Rep. (CCH) P26700, Fed. Sec. L. Rep. (CCH) P99229 (S.D. Ohio 1996), citing Global Derivatives Study Group of the Group of Thirty, Derivatives: Practices and Principles 28 (1993). 2 Id., citing Thomas Singher, Regulating Derivatives: Does Transnational Regulatory Cooperation Offer a Viable Alternative to Congressional Action?, 18 Fordham Int’l. Law J. 1405–​06 (1995). 3 See Sec. III, infra.

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Chase. A major motivating factor for the Federal Reserve’s initiative with regard to Bear Stearns was fear of the effect the implosion of Bear Stearns would have on its counterparties throughout the capital markets. Counterparties rely on the financial ability of the other side of the transaction to meet its obligations under the terms of the contract. If a counterparty fails, the derivative contract is meaningless. If Bear Stearns had disappeared, risk that had been shifted to it through derivatives contracts would have reverted back to its counterparties. This risk dislocation would have had a profound impact throughout the capital markets. The threat posed to the financial system by the interconnectivity of counterparties was previously made apparent in the wake of losses experienced in 1998 at a mammoth hedge fund, Long Term Capital Management (LTCM). Concerns by the Federal Reserve about the impact of a major counterparty’s failure, and the responsibility of the Federal Reserve to ensure that the financial system is not at risk, were the incentives for the Federal Reserve in negotiating the bailout of LTCM. The General Accounting Office (GAO), in analyzing the events surrounding the demise of LTCM, provided insight into the factors that motivated the Federal Reserve to act to prevent systemic risk: The Federal Reserve’s decision to facilitate the private sector recapitalization of LTCM was based on its concern that LTCM’s failure might pose systemic risk. Althougfh a systemic crisis can result from the spread of difficulties from one firm to others, in this case the potential threat was to the functioning of financial markets. According to Federal Reserve officials, they were concerned that rapid liquidation of LTCM’s very large trading positions and of its counterparties’ related positions in the unsettled market conditions of September 1998 might have caused credit and interest rate markets to experience extreme price moves and even temporarily cease functioning. This could have potentially harmed uninvolved firms and adversely affected the cost and availability of credit in the U.S. economy. LTCM’s creditors and counterparties would have faced sizeable losses if LTCM had failed. Estimates are that individual firms might have lost from $300 million to $500 million each and that aggregate losses for LTCM’s top 17 counterparties might have been from $3 billion to $5 billion. However, according to financial regulators, these losses were not large enough to threaten the solvency of LTCM’s major creditors. Among the eight U.S. firms that participated in the recapitalization, equity capital at the end of fiscal 1998 ranged from $4.7 billion to $42.7 billion. The Basel Committee on Banking Supervision noted that these losses could have increased further if the repercussions had spread to markets more generally.

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According to Federal Reserve officials, LTCM’s failure, had it occurred in the unsettled market conditions of September 1998, might have disrupted market functioning because of the size and concentration of LTCM’s positions in certain markets and the related sales of other market participants. As noted previously, the firm had sizeable trading positions in various securities, exchange-​traded futures and OTC derivatives markets. Moreover, LTCM’s counterparties might have faced the prospect of “unwinding” their own large LTCM-​related positions in the event of that firm’s default. Unwinding these positions could have been difficult: according to LTCM officials, about 20,000 transactions were outstanding between LTCM and its counterparties at the time of its near-​collapse. The LTCM crisis illustrated that potential systemic risk can exist in large trading positions. According to Federal Reserve officials, a default by LTCM on its contracts might have set off a variety of reactions. For example, most of LTCM’s creditors and counterparties held collateral against their current credit exposures to LTCM. In the event of LTCM’s default, however, the exposures might have risen in value by the time the collateral was sold, resulting in considerable losses. Also, derivatives counterparties, faced with sudden termination of all their contracts with LTCM, would have had to rebalance their firms’ overall risk positions; that is, they would have had to either purchase replacement derivatives contracts or liquidate their related positions. In addition, firms that had lent securities to LTCM might have had to sell the collateral held and buy replacement securities in the marketplace at prevailing prices. In considering the prospect of these developments, Federal Reserve officials said that a “fire sale” of financial instruments by LTCM’s creditors and counterparties might have set off a cycle of price declines, losses and further liquidation of positions, with the effects spreading to a wider group of uninvolved investors.4 In part, because, like LTCM, Bear Stearns was the counterparty to numerous transactions, its demise posed a risk to the economic system. As derivatives are bilateral contracts, each transaction has a winner and a loser, and the incremental increase in value on one side of a derivatives contract is offset by a corresponding decrease in value to the opposite side of the contract. If a major financial institution such as Bear Stearns were to disappear, its counterparties would need to stand in line with other unsecured creditors to recover the value of any outstanding derivatives

4 United States General Accounting Office, GAO/​G GD-​00-​3 Long-​Term Capital Management (Oct. 1999).

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contracts. Counterparties would likely sustain huge losses. Moreover, uncertainty about whether counterparties would be made whole would have an adverse “ripple effect” on all actors in the financial system. The government applied a similar rationale to the bailout of American International Group (AIG), a counterparty to numerous credit derivatives transactions. AIG’s failure may have caused a chain reaction of failed derivatives transactions, endangering the solvency of the entire financial system. Dodd-​Frank includes provisions designed to address the risk of failure of systemically significant counterparties (“Too Big to Fail”). The provisions of Dodd-​ Frank, described in detail in ­chapter 1, include enhanced transparency and regulatory structures designed to manage these entities in the event of failure. Counterparty credit risk is the risk of economic loss from the failure of an obligor to perform according to the terms and conditions of a contract or agreement.5 In a free market, it is hoped that counterparties can effectively monitor each other’s credit risk. Ben S. Bernanke, chairman of the Federal Reserve, explains that, “in many situations, regulation that relies on the invisible hand of market-​based incentives can complement direct government regulation. For market-​based regulation to work, the incentives of investors and other private actors must align with the objectives of the government regulator. In particular, private investors must be sophisticated enough to understand and monitor the financial condition of the firm and be persuaded that they will experience significant losses in the event of a failure. When these conditions are met, market discipline is a powerful and proven tool for constraining excessive risk-​taking.”6 When certain unpredictable forces affect market positions, however, regulators may be forced to take action. Unfortunately, during the credit crisis the invisible hand appeared to be arthritic as systemically important counterparties failed. C. Over-​t he-​C ounter versus Exchange-​T raded Derivatives

The U.S. Treasury distinguishes between two categories of derivatives: (1) privately negotiated and traded agreements, called over-​the-​counter (OTC) derivatives; and (2) standardized agreements, called exchange-​traded derivatives, which are traded through an organized exchange.7 OTC derivatives are contracts directly negotiated

5 Trading and Capital-​Markets Activities Manual § 2020.1 (First published 1998 Continuously Updated). 6 Ben S. Bernanke, Address at the New York University School of Law (Apr. 11, 2007). 7 U.S. Treasury website, http://​www.treasury.gov/​resource-​center/​faqs/​Markets/​Pages/​derivatives.aspx (last visited Aug. 3, 2018).

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by counterparties on a principal-​to-​principal basis. As such, OTC derivatives permit counterparties to negotiate specific contract terms and thus allow a firm to tailor a contract to its individual needs. However, OTC derivatives tend to be illiquid and subject to counterparty or credit risk. The line between OTC and exchange-​traded derivatives has blurred somewhat from a regulatory perspective as a result of Dodd-​ Frank, which has forced many standard forms of swaps to be cleared through the mechanism of an exchange.8 Exchange-​traded derivatives are designed to virtually eliminate counterparty risk. An organized exchange addresses the counterparty credit risk inherent in bilateral contracting by standardizing derivatives contracts to create a liquid market in the contracts themselves. Essentially, the buyer is entering into a derivative contract with the exchange itself as counterparty. Furthermore, an exchange imposes margin requirements on all open contracts, requiring each market participant to maintain a certain balance with the exchange over the life of an open position. The exchange takes steps to minimize its own counterparty credit risk by regulating its market participants to ensure their financial integrity. First, an exchange’s clearinghouse serves as counterparty to every trade. That is, the clearinghouse guarantees each contract. Thus individual traders never need to conduct individual credit evaluations of a counterparty. The individual counterparty credit risk of OTC derivative contracting is replaced by the risk of a clearinghouse default. The clearinghouse itself is less likely to default compared to any individual trading partner. This is true because of exchange-​imposed margin and mark-​to-​ market requirements, as well as the loss-​sharing provisions an exchange requires of its members. D. Exchange-​T raded versus OTC Derivatives Exchange-​Traded9

otc

Centralized marketplace

Bilaterally negotiated

Standardized terms

Flexible terms

Daily mark-​to-​market

Collateral agreements

Constant maturity

Mature over time

8 See ­chapter 14 for a complete description of Dodd-​Frank Title VII. 9 See ­chapter 14, infra, for further discussion of exchange-​traded derivatives.

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II. Shifting  Risk A firm uses derivatives instead of direct spot transactions in the underlying asset for a number of reasons. For example, when a firm does not have the immediate need or ability to transact in an underlying commodity, but contemplates a future transaction in that underlying asset, it may find it desirable to lock in the price of that commodity today, thereby hedging the risk that changes in the market price of the underlying asset will make a planned future transaction costlier than originally contemplated. Moreover, due to the leveraged nature of derivatives, a firm may lock in the future price of an expected spot transaction without expending the entire cost of the notional value of the underlying asset (“the underlying”). A. The Concept of Leverage

Leverage refers to the concept of making an investment with a small upfront monetary commitment using borrowed funds. Both OTC and exchange-​traded derivatives may be leveraged. For example, an OTC derivative may not require any transfer of funds until a contemplated performance or maturity date. Likewise, exchange-​traded derivatives require only a good faith margin deposit at the time a position is opened. This concept of leverage—​obtaining future control over an asset that has not yet been purchased—​has a number of important implications for derivatives as a tool for risk management. An exchange-​traded derivative’s market price includes more than just the spot price of the derivative’s underlying. Because the derivatives contract essentially transfers the right to future ownership of an underlying before the actual transaction occurs, its market price also reflects the various carry costs that would be incurred in holding the underlying until the future transaction. For example, if the underlying asset is a physical commodity, one such carry cost would be that of storing and protecting the commodity until delivery. Further, because ownership is effectively transferred, leverage in a derivative transaction essentially incorporates a loan lasting from inception to maturity. A derivative’s value thus changes with prevailing interest rates. The carry costs reflected in a derivative’s contract price above the spot price of its underlying will decrease as the contract approaches maturity. As a derivatives contract approaches expiry, carry costs converge toward zero and the market price converges toward the spot market price of the derivative’s underlying. A firm choosing not to offset its position in an exchange-​traded derivative prior to maturity thus effectively holds its position in the underlying at expiry.

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B. Basis  Risk

Exchanges standardize contract terms to promote liquidity and reduce the transaction costs associated with finding a counterparty. An exchange’s value, both to its users and its owners, lies in its trading volume. However, standardized contract terms trading on a dynamic exchange implicate basis risk to a greater degree than do their OTC counterparts. Basis risk is the risk arising from possible changes in the difference between the spot and futures price of a particular underlying.10 Basis risk exists to the extent that changes to a derivative’s value do not completely offset the risk exposure a firm is trying to hedge. Any time a derivative is based on an underlying that is not the exact risk a firm is trying to hedge, basis risk exists. Thrifty Oil Co. v. Bank of America National Trust & Savings Ass’n11 provides an example of basis risk introduced in an OTC derivative. A subsidiary of Thrifty Oil, looking to secure a medium-​term loan at a fixed rate, found that its cheapest option was to obtain a floating-​rate loan and then enter into an interest rate derivative to effectively convert that floating-​rate loan into a fixed-​rate obligation. Because the firm used an interest rate swap based off the London Inter Bank Offered Rate (LIBOR) to hedge against the risk of unpredictable cash flow requirements stemming from its floating federal funds rate loan, it was exposed to the (heretofore nominal) risk of divergence between LIBOR and the federal funds rate.12 The firm, in identifying a risk (in this case, the market risk of interest rate exposure) first considered a non-​derivative solution (simply securing a fixed-​rate loan) but ultimately determined that the use of a derivatives contract more efficiently achieved its risk management objective.13 C. Market  Risk

Because derivatives are contracts whose value is derived from something else, they are inherently forward-​looking, allowing firms to manage market risks associated with the passage of time. Market risk, also known as financial risk, is the potential for changes in the market price of an item. The four most common market-​risk factors are interest rates, foreign-​exchange rates, equity prices, and commodity prices.14 Indeed, derivatives are most commonly used to manage these four market risks.

Oxford Dictionary of Finance and Banking 37 ( John Smullen & Nicholas Hand eds., 3d ed. 2005). 11 322 F.3d 1039 (9th Cir. 2002). 12 See id. at 1045 n.7. 13 See id. at 1044. 14 Trading and Capital-​Markets Activities Manual, supra note 5, § 2010.1. 10

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D. Effective Tools of Risk Management

As derivatives are creatures of contract, they are extremely flexible and can be used to accomplish a broad array of risk management objectives. For example, firms use derivatives to guarantee periodic cash flows or to “synthetically” trade in an underlying. In order to effectively use derivatives as a tool of risk management, a firm must be cognizant of the risks inherent in their use. In fact, the leveraged nature of derivatives often comes with increased exposure to ordinary business risks, such as the operational risk of a so-​called rogue trader, magnifying the potential for financial harm. The following sections discuss risks commonly associated with particular forms of derivatives. III. Types of Derivatives Different derivative structures allow an investor to address a single risk in a number of ways. Although each structure is capable of addressing the same risks, the associated transaction costs differ. Certain structures may be more or less favorable depending upon the circumstances. In order to effectively use derivatives as a tool for risk management, the investor must examine the costs of any particular derivatives structure in light of the risk it would like to transfer. Moreover, the regulatory impact of using a particular financial instrument is also an important consideration in selecting the most suitable particular derivative structure.15 A. Forwards

Forwards are financial contracts in which two counterparties agree to exchange a specified amount of a designated product for a specified price on a specified future date or dates. Forwards differ from futures in that their terms are not standardized and they are not traded on organized exchanges. Because they are individually negotiated between counterparties, forwards can be customized to meet the specific needs of the contracting parties.16 The risks associated with the use of forwards are generally those associated with OTC derivatives contracts, the most significant being counterparty credit risk.17

15 See generally ­chapter 14, infra. 16 Trading and Capital-​Markets Activities Manual, supra note 5, § 4310.1. 17 See Section I.B., supra.

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A typical forward contract is a privately negotiated bilateral contract that is not executed in a standardized marketplace or on an exchange.18 Like any privately negotiated bilateral agreement, the forward contract has an obvious drawback: the forward seller must find a counterparty willing to enter the contract. Because forwards are not executed on an anonymous exchange where brokers match up buyers to sellers, forwards may not be the most reliable and efficient financial instruments for hedging risk. A forward’s “primary purpose is to facilitate the sale and delivery of [a]‌‌ physical commodity and, in particular, to assure the commodity’s availability at a date in the future when it will be needed.”19 Actual delivery of the underlying is contemplated, so there is generally “no established mechanism for offset or cash settlement.”20 In In re Borden Chemicals & Plastics Operating LP v. Bridgeline Gas Marketing, LLC,21 the bankruptcy court established this principle to conclude that payments made by the plaintiff prior to filing for Chapter 11 protection qualified as forward contracts under the U.S. Bankruptcy Code and were thus protected from claims by a trustee. Borden had made prepayments for natural gas it received a month later. Borden’s agent sought return of those payments during a statutory period prior to the bankruptcy filing. Bridgeline, the gas supply company, argued that the payments were protected by the Bankruptcy Code because they were settlement payments pursuant to forward contracts.22 The court acknowledged a distinguishing feature of forward contracts: “the part[y is] expect[ed] to make actual delivery.”23 Because the agreement between Borden and Bridgeline contemplated actual delivery of gas, the court concluded that the agreement constituted a forward agreement. Thus, the court held that the forward payments received by Bridgeline were protected from any of Borden’s bankruptcy claims. B. Futures

Futures contracts are essentially exchange-​ traded forward contracts with 24 standardized terms. Like a forward contract, “[a]‌‌ futures contract is an agreement

18 The Economic Purpose of Futures Markets and How They Work, Commodity Futures Trading Commission website, http://​www.cftc.gov/​ConsumerProtection/​EducationCenter/​economicpurpose (last visited Aug. 3, 2018). 19 CFTC v. Zelener, 2003 U.S. Dist. LEXIS 17660, *8 (N.D. Ill. 2003). 20 Id. at *9. 21 336 B.R. 214 (Bankr. D. Del 2006). 22 Id. at 216–​17 (citing 11 U.S.C. § 546(e)). 23 Id. at 218 (quoting Williams v. Morgan Stanley Capital Grp. Inc., 294 F.3d 737, 741 (5th Cir. 2002) (internal citations omitted)). 24 Trading and Capital-​Markets Activities Manual, supra note 5, § 4320.1.

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between parties for the future delivery of a commodity at a price agreed upon today.”25 However, a futures contract’s “principal purpose is to transfer price risk rather than ownership of the underlying commodity.”26 Thus, although a futures contract will specify the terms of delivery pursuant to contract maturity, actual delivery of the underlying commodity is uncommon, as futures trading “generally involves mechanisms that permit the parties to avoid delivery, either by cash settlement or entering into an offsetting transaction.”27 Futures contracts are required by law to trade on federally licensed contract markets that are regulated by the Commodity Futures Trading Commission (CFTC).28 1. Reduction of Counterparty Risk Three unique features reduce counterparty risk in futures transactions: (1) Futures require a performance bond, that is, a “good faith” margin deposit as collateral for the transaction; (2) Futures are marked-​to-​market on a daily basis with an exchange of cash flow between member firms reflecting the net market movements of aggregated positions. (3) Futures exchanges recognize only exchange members as counterparties to individual transactions. 2. Suitability as Hedging Instruments Futures possess several characteristics that make them more suitable than forwards for hedging purposes and less suitable for merchandising purposes.29 (1) Many types of commodities and other assets are suitable for futures contracts. Historically, the underlying assets for futures contracts were agricultural commodities, but now they include nonagricultural commodities

25 Zelener, 2003 U.S. Dist. LEXIS 17660, *8. 26 Id. 27 Id. 28 Trading and Capital-​Markets Activities Manual, § 4320.1 (First published 1998, continuously updated). See ­chapter 18, infra for a complete discussion of the history of CFTC jurisdiction. 29 The Economic Purpose of Futures Markets and How They Work, Commodity Futures Trading Commission website, http://​www.cftc.gov/​ConsumerProtection/​EducationCenter/​economicpurpose (last visited Aug. 3, 2018).

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such as metals, and other financial instruments such as foreign currencies and even virtual currencies such as bitcoin.30 (2) The terms of the contract are standardized by the exchange in which the future is traded and not by the contract participants. Standardization increases liquidity because many participants can trade the same financial instrument. (3) The exchange or marketplace for futures acts as a clearinghouse—​it “acts as the buyer to all sellers and the seller to all buyers.” Participants may offset their positions—​sell back any positions they bought or vice versa—​without actually having to deliver or take delivery of the underlying commodity. (4) Participants are not required to put up the entire value of a futures contract; rather, the exchange typically requires only a margin, or fraction of the total value of the contract. C. Distinction between Forwards and Futures

Forwards and futures are both non-​cash contractual instruments that enable market participants to both manage risk and enhance yield. In a forward contract, two counterparties “agree to exchange a specified amount of a designated product for a specified price on a specified future date or dates.”31 The terms of forward contracts are individually negotiated and are customized according to the counterparties’ specific needs.32 Forward contracts are not readily tradable on a formalized market platform. Futures contracts serve the same purpose as forwards; however, their terms are standardized and they are traded on organized exchanges.33 The main differences between futures and forwards are: (1) Futures trade on so-​called open outcry exchanges, either electronic or physical, such as the Chicago Mercantile Exchange, the Chicago Board of Trade, or the New York Mercantile Exchange, or via electronic trading systems that match buyers and sellers, such as EUREX. (2) Futures contract specifications are standardized by the exchange (3) Obligations under a futures contract may be readily extinguished by entering into an offsetting transaction.

See Appendix CME Bitcoin Futures Application. 31 Trading and Capital-​Markets Activities Manual, supra note 5, § 4310.1. 32 Id. 33 Id., § 4320.1. 30

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The distinction between a forward and futures contract is significant because a futures contract is regulated by the CFTC. The uncertainty over whether a contract is a forward or a future introduces “legal risk.” Legal risk can impact the efficacy of a hedge if regulatory issues impede the smooth operation of a transaction. Differentiating between a forward contract and a futures contract is not always easy. The Commodity Exchange Act (CEA) does not expressly define a “futures contract” but instead distinguishes “transactions involving contracts of sale of a commodity for future delivery.”34 Therefore, it may not always be clear if the CFTC has regulatory reach into a transaction.35 D. Foreign Exchange Forwards and Futures

Foreign exchange futures are derivative contracts traded on an exchange where the delivery of underlying currency is the subject matter of the contract. Foreign exchange futures contracts are traded in the United States on the International Money Market of the Chicago Mercantile Exchange as well as on various overseas exchanges, including the London International Financial Futures Exchange and the Singapore International Monetary Exchange.36 For futures contracts, the exchange on which the contract is traded determines margin requirements. In an over-​the-​counter (OTC) foreign exchange (FX) forward agreement, two parties agree to exchange a notional amount of capital in one currency valued in a different currency at a designated exchange rate on a specified future date. The exchange rate specified in an FX forward or future normally differs from the spot exchange rate. The divergence in rates typically reflects interest rate differentials between the countries of the two currencies that are being exchanged. If the forward or future rate for a currency is higher than the current spot rate, the currency is said to be trading at a premium.37 If the forward or future rate is lower than the current spot rate, the currency is said to be trading at a discount.38 As with spot transactions, forward and futures contracts enable investors to manage risk and speculate. However, whereas spot transactions require the commitment of capital to convert one currency into the other at the prevailing exchange rate, forwards and futures generally require little or no capital until maturity when the contract is settled and the underlying notional amount of capital is exchanged at the

7 U.S.C. § 2(a)(1)(A). 35 7 U.S.C. §§2(a)(1)(A), 6(a)(1). 36 Trading and Capital-​Markets Activities Manual, supra note 5, § 4320.1. 37 Id. § 4305.1. 38 Id. 34

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specified rate. Counterparties in forward contracts may require initial margin collateral to be placed in an account to secure the transaction. Additional maintenance margin collateral may need to be deposited in the account if the spot rate moves significantly against one of the counterparties. For forwards, the margin requirement is a negotiated term specified in a formalized contractual agreement governing the counterparties’ derivatives transactions, which is called the Credit Support Annex of an International Swaps and Derivatives Association (ISDA) Master Agreement. Normally the amount of collateral required for a forward or futures contract is small relative to the size of the notional amount of capital specified in the contract. Thus, unlike spot transactions, forward and futures contracts give the counterparties a substantial amount of financial leverage, enabling speculation on changes in the value of large amounts of currency with very little commitment of capital. E. Options

Options differ from forward and futures derivatives in that they provide unilateral price protection. Options transfer the right but not the obligation to buy or sell an underlying asset, instrument, or index on or before the option’s exercise date at a specified price (the strike price). A call option gives the option purchaser the right but not the obligation to purchase a specific quantity of the underlying asset (from the call option seller) on or before the option’s exercise date at the strike price. Conversely, a put option gives the option purchaser the right but not the obligation to sell a specific quantity of the underlying asset (to the put option seller) on or before the option’s exercise date at the strike price.39 Although options contemplate a future transaction in an underlying, “in practice settlement is generally effectuated by a cash payment representing the difference between the market price and the strike price.”40 Indeed, in some circumstances an actual transaction in the underlying is impracticable or impossible. For example, an option on an underlying index does not contemplate the purchase or sale of an ownership interest in a pool of securities. It is simply a bet on the future value of the index. If at the expiration date the index is above the value stated in the option contract, the holder of a call option has the contractual right to receive the difference. If at the expiration date the index is

Trading and Capital-​Markets Activities Manual, supra note 5, § 4330.1. 40 Dow Jones & Co. v. Int’l Sec. Exch., Inc., 451 F.3d 295, 298 (2d Cir. 2006). 39

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below the value stated in the option contract, the holder of a put option has the contractual right to receive the difference.41 The price paid by the buyer of an option is referred to as a premium. This premium is a dynamic measure of the factors that affect the option’s value.42 Options are priced using the Black-​Scholes formula, a complex mathematical equation that values the option according to the price and volatility of the underlying security, the option strike price, the time until expiration, and the risk-​free interest rate for the duration of time until maturity of the option.43 The value of an option rises as volatility increases and as the price of the underlying security approaches the strike price.44 Options allow counterparties to hedge or speculate on an asset’s price movement using very little capital (i.e., a high degree of leverage). However, options also allow the buyer to substantially limit downside risk. Because options accord the right—​not the obligation—​to buy or sell, the owner of the option has no market risk beyond the premium that has been paid to purchase the option. The seller of the option receives the premium in exchange for taking on exposure to the underlying security. The seller may hedge out this exposure by accumulating a position in the underlying security that offsets its obligation under the option contract. The size of the position that the seller must assume to compensate for its obligation varies with the option’s delta—the sensitivity of the price of the option to the price of the underlying instrument. Although options, like other derivaitves, might serve the purposes of hedging risk or enhancing yield, they also offer the compelling advantage of enabling the buyer to pay a fee (the premium) to entirely cut off all downside risk by shifting it to the seller. Although options are not considered securities, the SEC is authorized to regulate the public trading of put and call options for securities and indexes.45 In Board of Trade of the City of Chicago v. SEC,46 the Seventh Circuit observed that futures and options were “competing financial instruments often used for hedging.”47 The court examined whether a group of market participants were in fact a clearing agency that must register with the SEC. The group served as a clearinghouse for trading options on government securities. The court found the group was an “exchange” 41 Id. at 301 n.6. 42 Trading and Capital-​Markets Activities Manual, supra note 5, § 4330.1. 43 Id. 44 See Chapter 10, infra, for a complete discussion of option pricing. 45 15 U.S.C. § 77b(a)(1). 46 883 F.2d 525 (7th Cir. 1989). 47 Id. at 526.

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for purposes of the SEC because the group “(1) for a price based on transactions executed, it (2) [brought] together buyers and sellers of (3) fungible instruments (or standardized options), (4) clear[ed] the transactions thus executed, and (5) disseminat[ed] price and other trading information and also: (6) admit[ed] and (7) discipline[d]‌‌ members; and establishe[d] trading rules for (8) members and (9) customers.”48 Thus, although options are not securities, they can be regulated by the SEC if employed by an exchange. F. Swaps

The Bank for International Settlements estimated that the notional value of outstanding OTC derivatives increased from $532 trillion at end-​2017 to $595 trillion at end-​June 2018. The increase in notional amounts outstanding was driven mainly by OTC interest rate derivatives, in particular for US dollar-​denominated contracts, which rose from $157 trillion at end-​2017 to $193 trillion at end-​June 2018.49 A swap may be an OTC derivatives contract in which two parties agree to exchange “cash flows” on a “notional amount” over a period of time in the future. The parties exchange cash flows pursuant to an agreed-​upon payment schedule, made up of one or more payment dates throughout the life of the contract. Cash flows are computed by applying the agreed-​upon formula for each party’s respective “leg” (set of payments) of the swap to a “notional amount” (an underlying sum of capital that does not itself change hands). 1. Characteristics of Swaps Most swaps have the following characteristics: (1) Credit risk exposure similar to that of forward transactions (swaps, like forwards, are privately negotiated), (2) A beginning valuation date, intermediate swap interest exchange dates, and a final termination date; (3) Extreme flexibility allowing them to be crafted to meet the specific needs of the counterparties.50

48 Id. at 534. 49 BIS Statistical Release, available at https://​www.bis.org/​publ/​otc_​hy1810.pdf (last visited Feb. 7, 2019). 50 See also ­chapter 9, infra, for discussion of different types of swaps.

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Dodd-​Frank requires numerous derivatives, including swaps, to be traded through a central clearing facility, thereby limiting counterparty risk in a manner similar to that which futures have traditionally enjoyed. Swaps that are not standardized require extensive negotiation over many terms and provisions. Because parties tend to enter into numerous swap transactions over the course of a business relationship, parties commonly enter into swaps pursuant to a master agreement, which sets out the general terms and conditions that will govern the parties’ relationship, including common representations, covenants, and operating provisions. The parties then memorialize the economic terms of individual transactions in supplements to the master agreement known as “Confirmations.” The ISDA, a financial trade association made up of institutions that deal in OTC derivatives, created the standardized contract (the “ISDA Master Agreement”) this is often used to govern OTC derivatives transactions. 2. The ISDA Master Agreement The ISDA Master Agreement allows parties entering into a swap relationship to document all of their derivatives transactions under a single agreement. Indeed, it specifies that each party enters into individual transactions in reliance on the fact that all such transactions, combined with the Master Agreement, form a single agreement. Thus, although the ISDA Master Agreement provides convenience, its most important function is to provide economic certainty. The ISDA Master Agreement provides convenience by reducing transaction costs. The Master Agreement serves as an industry-​standard contract available for off-​the-​shelf use by counterparties. Further, ISDA provides definitional booklets that may be incorporated into any given transaction. For example, parties entering into an interest rate swap might reference the “2006 ISDA Definitions” in their Confirmation. Such definitions would include various floating rate indices as well as the mechanical operating provisions for establishing fixed and floating payment amounts. Such incorporated definitions and operating provisions reduce the transaction costs of entering into any given transaction. Specific provisions of the Master Agreement are also aimed at reducing transaction costs. For example, the Master Agreement specifies that payments due each party under a single transaction in the same currency are to be “netted.” Thus, instead of each party paying the other what is due under its respective leg of the swap, balances are calculated and only the difference changes hands. This netting feature both increases efficiency and diminishes settlement risk. Further, if the parties enter into numerous different swap transactions that are both in the same currency and on the same payment schedule, the ISDA Master Agreement provides the option

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of netting across all such transactions. If desired, the parties may simply state this intention in individual confirmations. The ISDA Master Agreement’s most important function is to provide economic certainty. Specifically, it provides for close-​out netting in the event of a party default. Should a party default, the agreement provides that the nondefaulting party may elect to designate an early termination date, effective across all outstanding transactions. After such a designation, all outstanding transactions between the parties are terminated and their values are calculated and netted to arrive at a single amount owed to one party. This provides significant protection for the nondefaulting party; had the default been caused by a party entering bankruptcy, the nondefaulting party could find itself liable for a significant sum of money to a defaulting party’s representative in insolvency, with the countervailing sum transformed into a mere claim as an unsecured creditor. G. Credit Derivatives

One of the seminal events of the 2008 economic crisis was the federal bailout and subsequent U.S. government investment in AIG. The implosion at AIG stemmed in large part from its sale of credit derivatives to counterparties. These credit derivatives were said to insure corporate credit and required significant payments to counterparties when a subject credit worsened or defaulted. Because neither counterparty to these contracts needed to have any exposure to the underlying subject credit, AIG was able to write protection for many times the value of the outstanding credit of the subject companies themselves. Credit derivatives are “off-​balance-​sheet arrangements that allow one party (the beneficiary) to transfer credit risk of a reference asset—​which the beneficiary may or may not own—​to another party (the guarantor).”51 Credit derivatives were used by banks to shift their overall credit-​risk exposure through contingent payments based on events of default and the periodic exchange of payments or the payment of a premium.52 There are two major categories of credit derivatives: a credit default swap (CDS), a private contract in which private parties bet on the probability of a debt issuer defaulting; and a collateralized debt obligation (CDO), an asset pool consisting of numerous debt obligations held by a special purpose entity (SPE) whose interests are divided and resold into different tranches based on differences in credit quality of the assets in the pool.53

Trading and Capital-​Markets Activities Manual, supra note 5, § 2110.1. 52 Id. 53 Frank Partnoy & David A. Skeel, Jr., Ninth Annual Corporate Law Symposium: Debt as a Lever of Control: The Promise and Perils of Credit Derivatives, 75 U. Cin. L. Rev. 1019, 1021–​22 (2007). 51

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Historically, because these contracts were negotiated off-​ exchange, credit derivatives were generally unregulated and governed only by the agreement, which most often was one of the standardized agreements promulgated by the ISDA.54 At that time, of course, the Federal Reserve retained some regulatory power over credit derivatives that a member bank may enter into, by monitoring the bank’s capital adequacy, safety, and soundness. For example, the Federal Reserve may promulgate guidelines governing the amount and types of CDOs that can be counted toward a member bank’s minimum capital adequacy requirement.55 As the government became more involved in AIG, the regulatory reach into this marketplace saw a de facto increase and was subsequently directly regulated, in part, by Dodd-​Frank. Indeed, Dodd-​Frank fundamentally overhauled the previous regulatory regime vis-​à-​vis derivatives and derivatives trading. In essence, regulators constructed a central clearing model, subject to exemptions from clearing and exchange requirements for sufficiently nonstandardized derivatives, and for derivatives that either intend to be physically settled or are traded by non-​financial entities hedging commercial risks. Broadly speaking, Title VII of Dodd-​Frank repeals the exemption from regulation of over-​the-​counter derivatives and forces many derivatives products to be cleared through a central clearinghouse and to be traded on an exchange.56 Prior to Dodd-​Frank, most swaps were negotiated under the terms of an ISDA Master Agreement. Today, a counterparty may not have the option to use this agreement to govern swap transactions as many simple swaps gravitate to exchanges. This will be discussed more comprehensively in ­chapter  14.

54 Id. at 1036–​37. 55 Trading and Capital-​Markets Activities Manual, supra note 5, § 2110.1. 56 S. Rep. No. 111-​176, at 32 (2010).

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APPENDIX CME Filing: Self-​Certification for the initial listing of the Bitcoin Futures Contract

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Electronic Communication to CFTC from Christopher Bowen, CME Group Managing Director and Chief Regulatory Counsel for the self-​certification of the initial listing of the Bitcoin Futures Contract December 1, 2017: VIA ELECTRONIC PORTAL Christopher J. Kirkpatrick Office of the Secretariat Commodity Futures Trading Commission Three Lafayette Centre 1155 21st Street, N.W. Washington, D.C. 20581 Re:  CFTC Regulation 40.2(a) Certification. Notification Regarding the Initial Listing of the Bitcoin Futures Contract. CME Submission No. 17-​417 Dear Mr. Kirkpatrick: Chicago Mercantile Exchange Inc. (“CME” or “Exchange”) hereby notifies the Commodity Futures Trading Commission (“CFTC” or “Commission”) that it is self-​certifying the initial listing of the Bitcoin Futures Contract (the “Contract” or “Bitcoin Futures”), for trading on the CME Globex electronic trading platform and for submission for clearing via CME ClearPort effective on Sunday, December 17, 2017, for trade date of Monday, December 18, 2017. In what follows: Section 1:  Summarizes contract terms and conditions; Section 2: Describes administration, governance, and methodology of the index underlying the Contract; Section 3:  Highlights feedback from various customer segments; Section 4: Details historical pricing and volatility in bitcoin compared to other products; and Section 5: Addresses compliance of CME rules and rule amendments certified herein with the pertinent Core Principles for Designated Contract Markets (“Core Principles”) set forth in the Commodity Exchange Act (“Act”).

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Furthermore, the CME Rulebook Chapter governing contract terms and condi­ tions certified herein is set forth in Appendix A. Appendix B provides an analysis of deliverable supply. Appendix C addresses the applicable position limits and reportable position levels pursuant to CME Rulebook Chapter 5. Appendix D sets forth the applicable CME Globex non-​reviewable trading ranges as prescribed in CME Rule 588.H., and Appendix E defines the pertinent special price fluctuation limits pursuant to CME Rule 589. Appendix F outlines proposed daily settlement procedures. Section 1—​Contract Specifications Exhibit 1 summarizes contract specifications for the Contract. Bitcoin is a digital asset transacted peer-​to-​peer that has increasingly garnered public acceptance as a store of value. A substantial number of merchants now accept bitcoin as a medium for the exchange of value; bitcoin is currently the world’s most widely-​traded digital asset; and bitcoin can now be readily exchanged for major currencies. There is currently no designated contract market offering a futures contract on bitcoin. Unit of Trade

The contract unit of the Bitcoin Futures products is 5 bitcoin, as defined by the CME CF Bitcoin Reference Rate (“BRR”). The BRR reflects the value of one bitcoin in U.S. dollars. Delivery and Delivery Months

Trading in the Contract will terminate at 4:00 p.m. London time on the last Friday of each contract month. The listing cycle will be comprised of the nearest 2 months in the March Quarterly cycle (Mar, Jun, Sep, Dec) plus the nearest 2 “serial” months not in the March Quarterly cycle. Each expiring contract will deliver by cash settlement via final mark-​to-​market by reference to the contract final settlement price, equal to the BRR published at 4:00 p.m. London time on the Contract’s last day of trading. Delivery months to be listed for trading initially will be January 2018, February 2018, March 2018, and June 2018. Upon expiration of the January 2018 contract, the April 2018 contract will be listed.

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Price Basis and Minimum Price Increments

Contract prices will be quoted in U.S. dollars. For any futures contract, the minimum price increment for an outright transaction will be $5.00 per bitcoin, equal to $25.00 per contract. For any intramarket calendar spread transaction, the minimum price increment will be $1.00 per bitcoin, equal to $5.00 per contract.

Block Trading

The minimum size threshold for a block trade in the Contract shall be 5 contracts. This represents 25 bitcoin as defined by the BRR.

Price Limits

Trading in the Contract will be subject to price limits both limit-​up and limit-​down. The Exchange proposes a daily price limit at 20% above or below a reference price, which generally will be set at the most recent daily settlement price but may be adjusted to incorporate BRR changes on non-​trading days. Given the volatility of bitcoin, special price fluctuation limits at 7% above or below and 13% above or below the reference price will be implemented. In the event the market hits the 7% or 13% limit, a cooling off period of 2 minutes will begin. If the market is still at limit at the completion of the cooling off period, trading will be temporarily halted for 2 minutes and will reopen at the expanded limit. Trading will not be permitted outside the range of 20% above or below the reference price.

Exhibit 1—​Contract Specifications Bitcoin Futures Trading Unit

The unit of trading shall be 5 bitcoin, as defined by the CME CF Bitcoin Reference Rate (BRR).

Listing Schedule

Nearest 2 months in the March Quarterly cycle (Mar, Jun, Sep, Dec) plus the nearest 2 “serial” months not in the March Quarterly cycle. Delivery months for initial listing: Jan 2018, Feb 2018, Mar 2018, June 2018.

Price Basis and Prices are quoted and traded in U.S. dollar. Minimum price increments—​ Minimum Outright: $5.00 per bitcoin, equal to $25.00 per contract. Price Increment Calendar spread: $1.00 per bitcoin, equal to $5.00 per calendar spread.

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Price Limits

Price limits for a given Business Day are calculated in relation to a reference price, which generally will be set at the most recent Bitcoin Futures settlement price, calculated at 4:00 p.m. London time each Business Day. The reference price may be adjusted at the sole discretion of the Exchange to incorporate BRR changes on non-​trading days. A price limit of 20% above or below the reference price and special price fluctuation limits equal to 7% above or below the reference price and 13% above or below the reference price apply. Trading will not be permitted outside of the 20% range above and below the reference price.

Termination of Trading

Last Day of Trading is the last Friday of the contract delivery month. Trading in expiring futures terminates at 4:00 p.m. London time on the Last Day of Trading.

Delivery

Delivery is by cash settlement by reference to the Final Settlement Price, equal to the CME CF Bitcoin Reference Rate (BRR) on the Last Day of Trading.

Position Limits and Reportable Levels

Spot Position Limits are set at 1,000 contracts. A position accountability level of 5,000 contracts will be applied to positions in single months outside the spot month and in all months combined. The reportable level will be 1 contract.

Minimum Block 5 contracts Trade Threshold Level Trading Hours And Commodity Code

CME Commodity Code: BTC CME Globex and CME ClearPort: 5:00 p.m. to 4:00 p.m., Sun-​Fri. (Central Time)

CME Globex Matching Algorithm

F: First In First Out (FIFO)

Exhibit 2—​Exchange Fees for Bitcoin Futures Membership Type Individual Members Clearing Members Rule 106.J Equity Member Firms & Rule 106.J Qualified Subsidiaries Rule 106.1 Members & Rule 106.1 Qualified Affiliates Rule 106.S Member Approved Funds Rule 106.D Lessees Rule 106.F Employees

Venue/​Transaction Type

Exchange Fee

Open Outcry

n/​a

CME Globex

$2.50

EFP|EFR

$3.75

Block

$3.75

Delivery

$1.25

Exe|Asn|Future From

n/​a

Open Outcry

n/​a

CME Globex

$4.00

EFP|EFR

$6.00

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Derivatives Membership Type

Venue/​Transaction Type

Rule 106.R Electronic Corporate Members (For other than Globex—​Non-​Member rates apply)

Rule 106.H and 106.N Firms

International Incentive Program (IIP) and International Volume Incentive Program (IVIP) Participants (Open Outcry at same rate as Globex for Interest Rate products only) Central Bank Incentive Program (CBIP), Emerging Markets Bank Incentive Program (EMBIP), Latin American Fund Manager Incentive Program (FMIP), Latin American Proprietary Trading Incentive Program (LAPTIP) Participants (For other than Globex—​Non-​Member rates apply) Members Trading Outside of Division (For other than Globex During ETH—Non-​ Member rates apply)

Non-​Members

Processing Fees

Exchange Fee

Block

$6.00

Delivery

$2.00

Exe | Asn | Future From

n/​a

CME Globex

$4.10

CME Globex—​BTIC

n/​a

Open Outcry

n/​a

CME Globex

$4.40

EFP|EFR

$6.40

Block

$6.40

Delivery

$2.20

Exe | Asn | Future From

n/​a

CME Globex

$4.50

CME Globex—​BTIC

n/​a

CME Globex

$4.85

CME Globex—​BTIC

n/​a

CME Globex During ETH Only

$4.75

Open Outcry

n/​a

CME Globex

$5.00

EFP|EFR

$7.50

Block

$7.50

Delivery

$2.50

Exe| Asn| Future From

n/​a

Fee

106.D Lessee/​106.H Brokerage

$0.13

106.F Employee Brokerage

$0.13

Floor/​“New” Brokerage

$0.04

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Fee

Position Adjustments/​Position Transfers

$0.10

Give-​Up Surcharge

$0.05

Facilitation Fee

$0.40

Section 2—​Index Administration, Governance, and Methodology The Contract uses the BRR for final settlement. The BRR, published since November 2016, is calculated by Crypto Facilities, a financial services firm for digital assets, including bitcoin. The BRR is published once per day, every day of the year, at 4:00 p.m. London time on the CME Group Bitcoin website. The BRR is governed by an oversight committee (the “Committee”). The Committee charter and BRR practice standards are available on the CME Group Bitcoin website (see link below). The Committee is comprised of a Crypto Facilities representative, two (2) representatives from CME Group, and at least two (2) independent bitcoin experts (currently 4). The Committee meets at least once per quarter and publishes its minutes publicly on the CME Group Bitcoin website. The BRR is calculated from BTC:USD data transacted on the BRR’s constituent exchanges. In order to become a constituent exchange, the following criteria (also publicly posted on the CME Group Bitcoin website) must be met: 1. The venue facilitates spot trading of bitcoin against U.S. Dollars and makes trade data and order data available through an Automatic Programming Interface (API) with sufficient reliability, detail and timeliness. 2. The venue’s bitcoin vs. U.S. Dollar spot trading volume contributed at least 3% to the total bitcoin vs. U.S. Dollar spot trading volume of all other Constituent Exchanges during each of the last two consecutive calendar quarters. 3. The venue maintains fair and transparent market conditions at all times and has processes in place to identify and impede illegal, unfair or manipulative trading practices. 4. The venue does not impose undue barriers to entry or restrictions on market participants, and utilizing the venue does not expose market participants to undue credit risk, operational risk, legal risk or other risks. 5. The venue complies with all applicable law and regulation, including, but not limited to capital markets regulations, money transmission regulations, client money custody regulations, know-​your-​client (KYC) regulations and anti-​money-​laundering (AML) regulations.

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6. The venue cooperates with inquiries and investigations of regulators and the Calculation Agent upon request. 7. Promoting the venue to Constituent Exchange will further the BRR usefulness as transparent, unbiased and representative indicators of the U.S. Dollar price of bitcoin. At the time of submission, the BRR has six (6) constituent exchanges, two (2) of which (Bitfinexand OkCoin) are temporarily suspended from contributing to the assessment due to fiat transfer restrictions. Upon successful correction of the restrictive action, the suspended exchanges may have the potential to resume contribution to the BRR. The four (4) contributing constituent exchanges are: Bitstamp, GDAX, itBit, and Kraken. Together, these four (4) exchanges collectively represent up to 35% of the total BTC:USD trade globally. In the aggregate, the four (4) actively contributing constituent exchanges host several thousand bitcoin transactions on a daily basis within the calculation window described below. The BRR methodology is transparent and publicly available in its entirety on the CME Group Bitcoin website. The methodology is in accordance with market best practices and IOSCO principles. The assessment is calculated based on one hour of BTC:USD trades per day from 3:00 p.m. to 4:00 p.m. London time (the “Observation Period”). The trades are reported through each constituent exchange’s API to Crypto Facilities. The calculation methodology for the BRR is as follows: 1. All Relevant Transactions are added to a joint list, recording the trade price and size for each transaction. 2. The list is partitioned into 12 equally-​sized time intervals of 5 minutes each. 3. For each partition separately, the volume-​weighted median trade price is calculated from trades submitted by each exchange. 4. The BRR is then calculated as the equally-​weighted average of the volume weighted medians of all partitions. Data validation checks are carried out, and any data provided that is outside of a 25% deviation tolerance of the other constituent exchanges results in the entire data set from that particular constituent exchange being discarded. Several measures were approved by the Committee to ensure that the assessment is resistant to manipulation. The use of medians reduces the effect of outlier prices on one or more exchanges and the volume weighting of medians filters out high numbers of small trades. The use of non-​weighted partitions assures price information is sourced equally over the entire Observation Period.

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Statistical analysis indicates that the BRR accurately reflects the underlying spot market. Since the BRR’s publication in November 2016, in comparing the daily BRR to the VWAP of the constituent exchanges’ bitcoin price during the BRR’s calculation window, the average variation has been $1.08. The largest variation to the VWAP of the constituent exchanges’ bitcoin price has been $93.62 (2.5%). While the BRR is not defined as an instantaneous price of bitcoin, when comparing the daily BRR to the constituent exchanges’ price of bitcoin in USD at 4:00 p.m. London, the average variation in prices has been only $0.31.

Section 3—​Customer Feedback Since the publication of the BRR, the Exchange has received multiple inquiries on CME’s potential launch of a bitcoin derivatives contract. Since then, the demand for a regulated trading venue has continued to grow. In the early development stages of the Contract, the Exchange engaged a group of clients that represented a cross-​section of the bitcoin industry. Within this group, contract specifications and other details of a futures contract were discussed and validated over the course of approximately six months. Subsequent to publicly announcing its intention to launch the Contract, the Exchange has fielded hundreds of calls and e-​mails from customers communicating interest, including buy-​ side clients, commercial participants, potential market makers, and Exchange-​Traded Fund (ETF) providers. These customers have spanned the spectrum by both market segment and geography. Several bank and non-​bank Futures Commission Merchants (“FCMs”) have indicated the highest likelihood for early support, and several pledged commitments for day-​one of bitcoin futures trading. While most FCM feedback has been positive, there has also been vocal trepidation accompanying the Exchange’s public announcement. Some clearing firms have expressed concern about the volatility of bitcoin, which is addressed below. Such views propose that bitcoin is best funded, margined and cleared in a separate guarantee fund from other Exchange products. In addressing this issue and to determine the potential impact, the Exchange performed a business analysis of the situation covering the asset’s volatility and corresponding margin requirements. The Exchange’s proposed margin framework for the Contract particularly considered the BRR’s volatility profile, and calculated margin to capture the most extreme one and two-​day price moves since the BRR’s inception. The opening margin level for the Contract would have covered 100% of all one and two-​day price moves in the BRR between 2016 and 2017. The analysis concerning the volatility of bitcoin is covered in Section 4.

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Section 4—​Volatility Bitcoin prices can be highly volatile, but the Exchange has managed both periods of prolonged volatility in commodities as well as unexpected spikes in volatility in financial products. The Exchange is also prepared to deploy proven risk controls on the Contract, including special price fluctuations, daily price limits, and margin levels that appropriately reflect the volatility of bitcoin.57 Though the spikes in bitcoin volatility can look extreme, the daily price movements of the BRR are in line with some other exchange-​listed contracts and reference rates that underlie exchange-​listed contracts. Since the publication of the BRR, and as of November 16, 2017, the average daily BRR price move has been 3%.58 By way of example, in 2016 crude oil experienced an average daily price move of 2.27%. Likewise, the Volatility Index (VIX), a major financial barometer that underlies an array of securities and derivatives, experienced average daily price moves of over 5% in 2016 and 4.53% in 2017. Under comparable timeframes, commodities have experienced realized volatility levels that are in line with bitcoin realized volatility. Crude oil volatility at times hovered near 125% in 2008–​2009, and was consistently above 50% in 2015 and 2016. Silver has also experienced periods of volatility near 100% in late 2008 and 2011. Likewise, natural gas has experienced volatility levels that are often routinely over 50% with highs over 100% in late 2009 and mid-​2014. When compared to the volatility of the VIX, which periodically can reach 250%, bitcoin volatility can be viewed as relatively less significant. During the last decade, let alone during the operational history of CME, the Exchange has multiple instances of successful management of high volatility environments in commodity contracts.

All non-​BRR price data referenced in Section 4 was sourced from Bloomberg data sets. 58 Daily price fluctuations are simply an average, over a selected period, of the percent moves in daily prices of a given product. Volatility measures the dispersion of returns on a given product. Average daily price movements may be related to volatility, but the measures are distinctly different, as volatility measures put more weight on extraordinary outliers of movement. 57

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Exhibit 3—​Comparative Volatilities Realized Volatility in Various Products 300.00%

250.00%

200.00%

150.00%

100.00%

50.00%

0.00% 1/3/2007 1/3/2008 1/3/2009 1/3/2010 1/3/2011 1/3/2012 1/3/2013 1/3/2014 1/3/2015 1/3/2016 1/3/2017 Corn

Crude Oil

Silver

Vix Index

BRR

Other futures contracts, including those based on financial commodities, have experienced bursts of realized volatility. During the 2008–​2009 financial crisis, the S&P 500 futures contract experienced a spike in volatility to nearly 100%, and in 2013 the volatility climbed to almost 50%. The Russian Ruble/​U.S. Dollar futures contract has a volatility that has often routinely hovered near 10%, but has twice seen dramatic upward movements to 90% within the last five years. Likewise, the Japanese Yen/​U.S. Dollar futures contract experienced volatility levels at almost 95% in late 2008. These instances of both physical and financial volatility shows that the Exchange is well adept at handling both prolonged periods of volatility and steep, brief jumps in volatility. Section 5—​Compliance with Core Principles The Exchange has reviewed the Core Principles as set forth in the Act and has identified that the listing of the Contract may bear upon the following Core Principles: Core Principle 2—​C ompliance with Rules

Trading in the Contract will be subject to CME Rulebook Chapter 4, which includes prohibitions against fraudulent, noncompetitive, unfair, and abusive practices. Additionally, trading in these contracts will be subject to the Exchange's

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trade practice rules, the majority of which are contained in Chapter 5 and Chapter 8 of the Rulebook. Trading activity in the Contract will also be subject to monitoring and surveillance by CME Group's Market Regulation Department, which has the authority to exercise its investigatory and enforcement power where potential rule violations are identified. Core Principle 3—​C ontracts Not Readily Subject to Manipulation

As referenced above, the Exchange certifies that the underlying reference rate, the CME CE Bitcoin Reference Rate, is not readily subject to manipulation. The calculation methodology has been created in accordance with the IOSCO principles. The index is calculated from a large number of trades observed during the calculation window. The combination of volume weighting of medians plus non-​weighted partitions prevents manipulation in the reference rate. Ultimately, influencing the BRR would require significant trading activity on several exchanges over an extended period of time. Core Principle 4—​P revention of Market Disruption

Trading in the Contract will be subject to CME Rulebook Chapters 4 and 7, which include prohibitions on manipulation, price distortion, and disruption to the expiration and assignment process. As with any new product listed for trading on a CME Group designated contract market, trading activity in the contracts certified herein will be subject to monitoring and surveillance by CME Group's Market Regulation Department. The Exchange will initially and may on an ongoing basis supplement the monitoring process by providing expiration surveillance reports to the Commission's Division of Market Oversight staff. Core Principle 5—​P osition Limits or Accountability

The speculative position limits for the Contract as demonstrated in this submission are consistent with the Commission's guidance. Core Principle 7—​Availability of General Information

The Exchange will disseminate a Special Executive Report (“SER”) to market participants regarding the launch of the Contract. The SER will also be published on the Exchange's website.

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Core Principle 8—​D aily Publication of Trading Information

The Exchange will publish trading volumes, open interest levels, and price information daily of the Contract on its website and through quote vendors. Core Principle 9—​E xecution of Transactions

The Contract will be listed for trading on the CME Globex electronic trading and for clearing through CME ClearPort. The CME Globex electronic trading venue provides for competitive and open execution of transactions. CME Globex affords the benefits of reliability and global connectivity. Core Principle 10—​T rade Information

All requisite trade information will be included in the audit trail and will suffice for the Market Regulation Department to monitor for market abuse. Core Principle 11—​F inancial Integrity of Transactions

The Contract will be cleared by CME Clearing, which is registered with the Commission as a derivatives clearing organization, and which is subject to all CFTC regulations related thereto. Core Principle 12—​P rotection of Markets and Market Participants

CME Rulebook Chapters 4 and 5 set forth multiple strictures that preclude intermediaries from disadvantaging their customers. These Rules apply to trading in all of the Exchange's competitive trading venues and will apply to transactions in the Contract. Core Principle 13—​D isciplinary Procedures

CME Rulebook Chapter 4 provides for the Exchange to discipline, suspend, or expel members or market participants who violate the rules of the Exchange. Trading in the Contract shall be subject to these provisions. The Exchange's Market Regulation Department has the authority to exercise its powers of enforcement, in the event that rule violations in these products are identified.

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Core Principle 14—​D ispute Resolution

Disputes in respect of the Contract shall be subject to the arbitration provisions set forth in CME Rulebook Chapter 6, which allow all nonmembers to submit to arbitration claims for financial loss resulting from transactions on the Exchange. Pursuant to these provisions, any member named as a respondent in any submitted by a nonmember is required to participate in arbitration proceedings. Additionally, the Exchange requires members to resolve via arbitration all disputes concerning transactions on the Exchange. The Exchange certifies that the Contract complies with the Act including all regulations thereunder. Certain market participants expressed concerns as noted in Section 3. The Exchange considered these concerns and the presented views of market participants. The Exchange certifies that this submission has been concurrently posted on the Exchange’s website at: http://​www.cmeqroup.com/​market-​requlation/​rule-​filinqs. html Should you have any questions concerning the above, please contact the undersigned at (212) 299-​2200 or [email protected]. Sincerely, /​s/​Christopher  Bowen Managinq Director and Chief Regulatory Counsel Attachments: ­ Appendix A Rulebook Chapter 350 Bitcoin Futures Appendix B Deliverable Supply Analysis Appendix C Position Limit, Position Accountability, and Reportable Level Table in Chapter 5 of the CME Rulebook (attached under separate cover) Appendix D CME Rule 588.H.—​(“Globex Non-​Reviewable Tradinq Ranqes”) Table Appendix E CME Rule 589.—​(“Special Price Fluctuation Limits and Daily Price Limits”) Table Appendix F  Daily Settlement Procedures

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Appendix A Chapter 350 Bitcoin Futures 35000. SCOPE OF CHAPTER This chapter is limited in application to Bitcoin Futures. In addition to this chapter, futures shall be subject to the general rules and regulations of the Exchange as applicable. 35001. CONTRACT SPECIFICATIONS

Each futures contract shall be valued at 5 bitcoin as defined by the CME CF Bitcoin Reference Rate (“BRR”). 35002. TRADING SPECIFICATIONS 35002.A. Trading Schedule Futures contracts shall be scheduled for trading during such hours and for delivery in such months as may be determined by the Exchange.

35002.B. Trading  Unit The unit of trading shall be 5 bitcoin. 35002.C. Price Increments The minimum price increment shall be $5.00, equal to $25.00 per contract, except for intermonth spreads executed pursuant to Rule 542.A., for which the minimum price increment shall be $1.00, equal to $5.00 per intermonth spread. 35002.D. Position Limits, Exemptions, Position Accountability and Reportable Levels The applicable position limits and/​or accountability levels, in addition to the reportable levels, are set forth in the Position Limit, Position Accountability and Reportable Level Table in the Interpretations & Special Notices Section of Chapter 5. A Person seeking an exemption from position limits for bona fide commercial purposes shall apply to the Market Regulation Department on forms provided by the Exchange, and the Market Regulation Department may grant qualified exemptions in its sole discretion. Refer to Rule 559 for requirements concerning the aggregation of positions and allowable exemptions from the specified position limits.

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35002.E. Daily Price Limits Futures trading shall be subject to Price Limits as set forth in this Rule. For the purpose of this Rule the Exchange shall determine, in its sole discretion, the futures delivery month that represents the Primary Futures Contract Month and when such Primary Futures Contract Month is limit bid or limit offered. For a given Business Day, Price Limits applicable to a futures contract for a given delivery month shall be calculated on the basis of a reference price, which generally is set at the settlement price of the previous Business Day, but may be adjusted at the sole discretion of the Exchange to account for BRR changes on non-​trading days, as follows: 7% Price Limit = Prior Day's Reference Price plus and minus 7% 13% Price Limit = Prior Day's Reference Price plus and minus 13% 20% Price Limit = Prior Day's Reference Price plus and minus 20% If the lead contract month (as identified by the Exchange) is bid or offered via Globex at the upper or lower price fluctuation limit at the first special price fluctuation limit level, as applicable, it will be considered a triggering event that will begin a two (2) minute monitoring period in the lead contract month. If, at the end of the two (2) minute monitoring period, the lead contract month of the primary futures contract is not bid or offered at the applicable special price fluctuation limit, the special price fluctuation limits shall be expanded an additional increment above and below the relevant reference price for all delivery months of the contract. If, however, at the end of the two (2) minute monitoring period, the lead contract month is bid or offered at the applicable special price fluctuation limit, a two (2) minute temporary trading halt will commence in all contract delivery months of the contract. Following the end of a temporary trading halt, the affected markets shall re-​open simultaneously in all contract delivery months of the contract. When trading resumes, the special price fluctuation limits shall be expanded an additional increment above and below the relevant reference price for all delivery months contract. In the instance in which a second triggering event occurs, the same two (2) minute monitoring period will commence and limits will expand to the daily price limit, followed by either a two (2) minute temporary trading halt or a return to trading as determined by the bid or offer being at limit. Trading will not be permitted outside the 20% above or below the relevant reference price. In the event that the daily price limit of 20% is hit, trading will not be halted. Trading will continue to be permitted within the daily price limit of 20%.

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35002.F. Termination of Trading Trading in expiring futures shall terminate at 4pm London time on the last Friday of the contract month. If that day is not a business day in both the UK and the US, trading shall terminate on the preceding day that is a business day for both the UK and the US. Trading shall terminate at 4pm London time on the Last Trade Date. 35003. SETTLEMENT PROCEDURES

Delivery shall be by cash settlement. 35003.A. Final Settlement Price For a futures contract for a given delivery month, the Final Settlement Price shall be the BRR published at 4pm London time on the Last Trade Date (Rule 35002.F.). In the event that the BRR is not publishable or published on the CME Bitcoin Futures Termination of Trading day, and therefore, CME cannot determine the CME Bitcoin Final Settlement Price, then final settlement of the CME Bitcoin futures contract is at the discretion of the Exchange and may be deferred or postponed for up to 14 consecutive calendar days. 35003.B. Final Settlement Clearing members holding open positions in an expiring futures contract at its termination of trading (Rule 35002.F.) shall make payment to or receive payment from the Clearing House in accordance with normal variation margin procedures based on such expiring contract's Final Settlement Price (Rule 35003.A.). 35004.  RESERVED 35005. POLICY ON DIVISIONS OF BITCOIN ASSET

In the event that a hard fork, user activated soft fork, or other process that results in a division or split of bitcoin into multiple non-​fungible assets is expected, the Exchange shall have the discretion to take action in consultation with market participants to align Bitcoin Futures position holder exposures with cash market exposures as appropriate. Appropriate action could include providing cash adjustments or assigning newly listed futures or options contract positions to Bitcoin Futures position holders. (End Chapter 350)

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Appendix B  Deliverable Supply Analysis Overview: Bitcoin is a digital asset created by an anonymous person or group of people under the name Satoshi Nakamoto. This digital asset is transacted peer-​to-​peer and has grown in acceptance: it is now accepted as a medium for the exchange value by established goods and service providers,59 including Expedia, Overstock, and Microsoft.60 Bitcoin can also be readily exchanged for major currencies. How Bitcoin are Created and Released:

Upon release of bitcoin in 2009, Satoshi Nakamoto coded the creation of 21 million bitcoin. That number has been accepted as the total number of bitcoin that will ever be created. In order to release bitcoin not currently in circulation, the coins need to be mined. Miners are individuals or groups who work to verify bitcoin transactions on the blockchain. Once they have gathered a specific amount of “pending” transactions (the status of a transaction from Holder A to Holder B before certified by a miner), verified that all transactions are legitimate, and posted them as a “block” by solving a hashing function, the miner unlocks new bitcoin into circulation and takes ownership of the new bitcoin. The miners are an important part of preserving the blockchain ledgers and are rewarded with new bitcoin for their work as well as transaction fees paid by parties sending bitcoin. There is a limit to the amount of bitcoin issued when each miner mines a new block. At origination, 50 bitcoin were released into circulation for every block mined. That number halves at given intervals. As of July 2016, the amount of bitcoin released upon successfully mining a block was cut to 12.5, and the next cut to 6.25 is slated to occur in 2020. This system is in place to systematically decrease the rate at which new bitcoin are issued into circulation. Ultimately, as previously stated, the maximum number of bitcoin that will ever be in circulation is the 21 million initially set by Nakamoto. Bitcoin in Circulation:

Of the 21 million bitcoin created, just over 16.6 million bitcoin are in circulation as of October 2017 (Figure 1).61 This represents almost 80% of all the bitcoin supply 59 http://​www.ibtimes.co.uk/​bitcoin-​now-​accepted-​by-​100000-​merchants-​worldwide-​1486613 60 https://​99bitcoins.com/​who-​accepts-​bitcoins-​payment-​companies-​stores-​take-​bitcoins/​ 61 https://​blockchain.info/​charts/​total-​bitcoins?timespan=all

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originally set by Nakamoto. The percent growth of bitcoin in circulation has understandably slowed since its inception. In the January 2009, the first month of bitcoin's life, bitcoin in circulation was growing by an average of 100% day over day. At the conclusion of January 2009, bitcoin in circulation had soared from 50 to over 125,000 coins. Bitcoin in Circulation 18,000,000 16,000,000 14,000,000 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000

20 3/ 1/

20 3/ 1/

17

16

15 20 3/

14

1/

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1/

3/

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11 1/

3/

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09

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0

Figure 1 

The historical supply of bitcoin over the last several years demonstrates that the growth in bitcoin in circulation is slowing. The percent change in circulating bitcoin from 2009 to 2010 was over 250%, and that has slowed to under 10% from 2015 to 2016 (Table 1). Table 1 Year

Total Bitcoin in

Total Percent

Average Bitcoin

Average Percent

Circulation at

Increase

in Circulation

Increase

EOY 2009 2010 2011 2012 2013 2014 2015 2016

1,623,400 5,010,150 8,000,050 10,613,175 12,194,575 13,670,575 15,025,000 16,073,550

208.62% 59.68% 32.66% 14.90% 12.10% 9.91% 6.98%

851,439 3,288,745 6,604,402 9,371,011 11,380,586 12,960,176 14,342,474 15,641,818

286.26% 100.82% 41.89% 21.44% 13.88% 10.67% 9.06%

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Ultimately, the number of bitcoin in circulation as of this submission is over 16.6 million bitcoin. The growth of the bitcoin in circulation is expected to slow with time, eventually ending at 21 million bitcoin. Transactions:

Although there are over 16 million bitcoin in circulation, not every bitcoin is transacted each day. The number of transactions on the blockchain is public and easily trackable, summarized in Table 2 below. However, there is no reliable data source that details the number of bitcoin involved in each transaction, so it is impossible to know the exact number of bitcoin that trade hands each day. Conservatively, each transaction could be for a fraction of a bitcoin; alternatively, each transaction could represent several hundred bitcoin. Therefore, estimating the overall amount of bitcoin changing hands in these transactions cannot be calculated with specificity.62 Table 2 Year 2009 2010 2011 2012 2013 2014 2015 2016

Total Bitcoin

Total Percent

Transactions (per year)

Increase

16,395 93,581 951,980 4,213,325 9,779,597 12,677,842 22,819,112 41,475,007

470.79% 917.28% 342.59% 132.11% 29.64% 79.99% 81.76%

There is evidence that some bitcoin is never transacted, whether because it has been burned63 or because the owners of said coins have desire to simply hold them. Though efforts have been made to identify the total amount of burned bitcoin—​the number has been estimated around 2,700 bitcoin64—​and the amount unlikely to be spent, it is impossible to determine this for the purposes of deliverable supply analysis. https://​blockchain.info/​charts/​n-​transactions 63 Burned bitcoin refer to coins that will never be spent. For example, if the bitcoin were sent to a public address without any party knowing or having a way to compute the private key, the bitcoin associated with that key are considered “burned.” 64 http://​bitcoinwhoswho.com/​blog/​2016/​12/​21/​btc-​burn-​addresses/​ 62

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Deliverable Supply:

As previously laid out, the underlying available supply of bitcoin is over 16.6 million coins. Because the contract will be settled upon the aggregation of four exchanges trading bitcoin versus U.S. dollars (USD), the deliverable supply analysis herein conservatively focuses on the proportion of bitcoin globally traded versus USD, which is estimated at one quarter (25%) of total bitcoin traded.65 Using this as a proxy results in a deliverable supply of 4.15 million bitcoin. Conservatively, even estimating a large number of bitcoin as burned or unlikely to spend leaves an exceedingly large supply of bitcoin in circulation. An acceptable practice for calculating spot month position limits is to link such limits to one-​quarter of the average quantity of the commodity in the lowest months of the previous three years. Table 3 (below) shows the average number of bitcoin in circulation (in millions) for each month since 2014. As bitcoin is a digital asset that keeps growing in supply month over month, January has historically been the month with the lowest number of bitcoin in circulation. The average circulation from 2014-​ 2016 in January has been 13,700,000 bitcoin, which equates to 2.74 million futures contracts (contract size: 5 bitcoins). Taking 25% of that in order to adjust for bitcoin traded versus USD would result in 685,000 contracts. Under the acceptable practice for setting spot position limits, one-​quarter of deliverable supply would result in a spot month position limit of 171,250 contracts. The Exchange does not recommend setting initial position limits at that level. Table 3 Month

2014

2015

2016

2017

January February March April May June July August September October November December

12.27 12.40 12.52 12.65 12.78 12.91 13.03 13.15 13.28 13.39 13.50 13.61

13.73 13.84 13.95 14.06 14.17 14.28 14.39 14.50 14.62 14.73 14.85 14.97

15.09 15.21 15.32 15.44 15.55 15.66 15.76 15.82 15.87 15.93 15.99 16.05

16.11 16.17 16.22 16.28 16.33 16.39 16.45 16.51 16.57 16.62

Average 2014–​2016

65 https://​www.cryptocompare.com/​coins/​btc/​analysis/​USD

13.70 13.82 13.93 14.05 14.17 14.28 14.39 14.49 14.59 14.68 14.78 14.88

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Another acceptable practice for settinq spot month position limits, which is specific to foreiqn exchanqe products, is to set limits at 1% of currency in circulation. Under this practice, position limits would be determined by takinq 1% of bitcoin in circulation, or 166,000 bitcoin, and adjustinq that fiqure downward to approximately 41,500 (8,300 futures contract equivalents) to reflect bitcoin traded versus USD. As with position limits set at 25% of bitcoin deliverable supply, the Exchanqe does not recommend settinq initial position limits at 8,300 contracts (contract size: 5 bitcoin). In accordance with standard procedure, the Exchanqe recommends an initial spot month position limit of 1,000 contracts. The limit of 1,000 contracts is the equivalent of 5,000 bitcoin or 0.036% of the underlyinq deliverable of 13,700,000 bitcoin as defined above. Appendix C Position Limit, Position Accountability, and Reportable Level Table in Chapter 5 of the CME Rulebook (Attached under separate cover) Appendix D CME Rule 588.H. (“Globex Non-​Reviewable Trading Ranges”) Table (Additions underscored.) Outright

Spreads

Instrument Name

Globex Symbol

Globex Non-​ NRR: Reviewable Globex Ranges (NRR) Format

NRR: Ticks

NRR: Globex Format

Bitcoin Futures

BTC

1%

Variable

Each leg is evaluated as an outright

Variable

NRR: Minimum Outright Ticks

Appendix E CME Rule 589. (“Special Price Fluctuation Limits and Daily Price Limits”) Table (Additions underscored.) Product Rulebook Commodity Primary/​Associated Associated Base in Real Level Chapter Code With Economic Value Bitcoin Futures

350

BTC

Primary

Primary

See Rulebook Chapter

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Appendix F Note: In the event the aforementioned calculations described in this advisory cannot be made or if CME Group staff, in its sole discretion, determines that anomalous activity yields results that are not representative of the fair value of the contract, the staff may determine an alternative settlement price. Daily Settlement Procedures Normal Daily Settlement Procedure

CME Group staff determines the daily settlements for Bitcoin futures based on tradinq activity on CME Globex between 15:59:00 and 16:00:00 London Time, the settlement period. Tier 1: Trades on CME Globex All contract months settle to the volume-​weighted average price (VWAP) of outright trades between 15:59:00 and 16:00:00 London Time, the settlement period, rounded to the nearest tradable tick. If the VWAP is equidistant between two ticks it will be rounded towards the prior day settlement price. Tier 2: CME Globex Market Data In the absence of trades during the settlement period, the contract month settles to the midpoint of the Bid/​Ask between 15:59:00 and 16:00:00 London Time, the settlement period. Tier 3: Absence of Two Sided Markets If there are no two sided markets available during the settlement period in a particular contract month, then the settlement price will be the net change of the CME Bitcoin Reference Rate (BRR) added to the prior day futures contract settlement (provided that settlement is within the Bitcoin futures price limits), adjusted to the Bid/​Ask if one side is present.

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12 Types of Swaps

I. “Plain Vanilla” Interest Rate Swaps  200 II. Currency Swaps  202 III. Credit-​Default Swaps  203 A. Purpose and Function  204 B. ISDA Master Agreement  206 C. Importance of Clearly Defined Terms  206 1. Credit Event  207 2. Reference Entity  209 D. Collateralized Debt Obligations  214 E. OTC Derivatives and the Financial Crisis  215 IV. The Move toward Regulatory Reform  220 A. The Central Clearing Model  221 B. The OTC Model  222 C. Confidence in the New Regulatory Regime: The Case of MF Global 223

a swap is a bilateral over-​the-​counter derivatives contract in which two parties agree to exchange cash flows on a “notional amount” over a period of time. The notional amount is a reference amount upon which the payment formula is based. The parties Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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exchange cash flows pursuant to an agreed-​upon payment schedule, made up of one or more payment dates throughout the life of the contract. Cash flows are computed by applying the agreed-​upon formula relating to each party’s respective set of payments of the swap to a notional amount, that is, a hypothetical underlying value that does not necessarily itself change hands. The simplest swap is the so-​called plain vanilla interest rate swap, in which counterparties exchange fixed-​rate risk for floating-​rate risk. I. “Plain Vanilla” Interest Rate Swaps The plain vanilla interest rate swap is described in K3C Inc. v. Bank of America:1 An interest rate swap is a transaction by which a borrower can hedge against the risk of interest rate fluctuations. The borrower and another party agree to exchange cash flows over a period of time. Most commonly, one party exchanges fixed rate payments for floating rate payments based on an underlying index such as LIBOR (London Inter Bank Offer Rate). This effectively converts the party’s floating rate loan to a fixed rate loan. Thus, if the interest rate on a borrower’s adjustable or floating rate loan rises, the increase in interest owed is offset by payments received through the interest rate swap.2 For example, consider a company, MIEMUNAH-​SARACO, Inc., which issues a five-​year bond at a rate of 6 percent per year. A bond purchaser (investor) will receive $6,000 per year on an investment of $100,000. Consider a second company, RONITCO, LLC, which issues a $100,000 bond to investors at a rate of 200 basis points over the LIBOR, a floating-​rate bond. RONITCO’s bond purchasers will earn a return that will float relative to LIBOR. So if LIBOR is at 2 percent, RONITCO will pay its bondholder $4,000 per year on a $100,000 investment if LIBOR remains unchanged, and more or less as LIBOR rises or falls. If RONITCO’s CEO, Eve Temimah, feels that interest rates might go up, thus adversely affecting RONITCO’s liability to its bondholders (because RONITCO’s liabilities float relative to LIBOR), RONITCO could enter into a plain vanilla swap with MIEMUNAH-​SARACO, whereby RONITCO would pay MIEMUNAH-​ SARACO a fixed rate of 6 percent in return for a floating rate of 200 over LIBOR on a notional value of $100,000.

1 204 Fed. Appx. 455 (5th Cir. 2006) (unpublished). 2 Id. at 458.

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Types of Swaps

201

RONITCO and MIEMUNAH-​SARACO have effectively swapped places. RONITCO swaps its floating-​rate obligation to bondholders for a fixed-​rate obligation to MIEMUNAH-​SARACO and will receive a fixed rate to subsequently pay out from RONITCO; both MIERACO and RONITCO will each use the income stream from the swap to pay its obligations to its bondholders. The cost to each party to enter into the transaction will be dictated by market conditions. In other words, if companies with credit ratings identical to that of MIEMUNAH-​SARACO and RONITCO could access capital in the market by either issuing fixed-​rate bonds at 6 percent or floating rate bonds at LIBOR plus 200 basis points, the cost to each party for entering into the transaction will be zero. If the choice to similarly situated companies is to issue bonds at 200 over LIBOR or a fixed rate of 5 percent for an identical duration, the floating leg of the transaction must pay for the privilege of earning 6 percent from its counterparty. The swap will fluctuate in value as market conditions change. The plain vanilla swap contract meets the functional definition of a derivative in that it shifts interest-​rate risk from one counterparty to the other (fixed for floating-​ rate risk). Both counterparties now have undertaken the counterparty risk that the contra party will be unwilling or unable to meet its obligation under the terms of the swap when the obligations ripen. Note that no principal is exchanged between the counterparties, and the notional value is merely a reference amount used to calculate each party’s obligations under the swap agreement. Also, consider that either of the counterparties could have entered into this agreement whether or not they had a related obligation to bondholders. The basic structure of the plain vanilla swap can be used as a template for swaps across a number of asset classes. For example, assume that the counterparties exchange cash flows whereby the counterparty obliged to pay the floating leg of the swap pays based upon a formula tied to the relative performance of a basket of stocks of a specified notional amount. The fixed payer will pay a fixed rate of interest on the same notional value. Although the structure is similar to that of the plain vanilla swap, this swap is considered an “equity swap” because the underlying item upon which the payment stream is based is a basic of stocks. If the same principle were applied to a notional amount of oil, it would be an energy swap. The structure of the plain vanilla swap can be used with any commodity and allows a counterparty who has a floating-​rate financial risk to swap that risk for a fixed-​rate risk as long as she can find a willing counterparty. While the structure of a fixed-​for-​floating-​rate swap can be used to hedge a broad array of financial risks, the structures of the contracts may be layered in a number of financial transactions.

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For example, in Thrifty Oil Co. v. Bank of America,3 a Thrifty subsidiary was seeking fixed-​rate financing. Bank of America provided a floating-​rate loan of $45 million. At the same time, it provided swaps totaling $45 million in notional amount whereby it paid the Thrifty subsidiary a floating-​interest rate in exchange for the fixed-​rate payment the Thrifty subsidiary ultimately sought. The swaps followed an amortization schedule similar to the payment schedule of the floating-​rate loan and terminated on the same date as the term loan’s maturity. The result was effectively a fixed-​rate loan, plus some basis risk (the floating-​interest rate paid by the subsidiary on the term loan was based on the federal funds rate whereas the floating interest received via the swaps was based on LIBOR).4 Regardless, this result was the most economical means for the subsidiary to acquire the fixed-​rate financing it sought. The Ninth Circuit Court of Appeals noted that: the close resemblance between this arrangement and fixed-​rate financing merely confirms that the borrower has successfully exploited the flexibility of a derivative interest rate swap to achieve a specific financial objective. No matter how tightly the borrower integrates the swap with its loan, the payments made under the swap cannot represent interest.5 II. Currency  Swaps Currency swap agreements are mechanisms for hedging foreign exchange risk and taking on exposure to a currency over a set interval of time. A foreign exchange swap is a simultaneous purchase and sale of an amount of foreign currency for two different value dates.6 The parties to the swap contract to pay and receive the same amount of currency on the specified dates.7 According to the Federal Reserve Bank of New York Central Bank Survey of Foreign Exchange and Derivatives Market Activity, a foreign exchange swap “ . . . involves the actual exchange of two currencies (principal amount only) on a specific date at a rate agreed at the time of the conclusion of the contract (the short leg), and a reverse exchange of the same two currencies at a date further in the future at a rate (generally different from the rate applied to the

3 322 F.3d 1039 (9th Cir. 2002). 4 Id. at 1044–​45, 1045 n.7. 5 Id. at 1049. 6 Trading and Capital-​Markets Activities Manual, § 4305.1. 7 Id.

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short leg) agreed at the time of the contract (the long leg).8 The value dates may be any two future dates. Unlike forwards and futures, the buy and sell components of the swap are recorded as a single transaction with the same counterparty.9 The swap allows each party to use a currency for a period of time in exchange for another currency that is not needed during that time.10 Institutions use foreign exchange swaps as efficient mechanisms to invest or hedge temporary idle currency balances.11 A variation on a foreign exchange swap is a foreign currency swap. This is a contract that commits two counterparties to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-​agreed exchange rate at maturity.12 The initial exchange of principal may be omitted and a “difference check” may be paid by one party to the other to cover the net obligation instead of actually exchanging periodic interest payments.13 Foreign exchange swaps and foreign currency swaps are used for a variety of purposes—including shifting the currency of an asset, accommodating outright forward transactions, bridging gaps in the maturity structure of outstanding spot and forward contracts, and hedging or speculating on interest rates in different countries.14 Like forwards and futures, foreign currency swaps can be structured to offer the benefit of significant financial leverage, as there is often no exchange of underlying principal. In contrast, foreign exchange swaps do entail a shift of principal between two currencies for the duration of the contract. Swaps are most useful and efficient for entities that wish to lock in both sides of the foreign exchange transaction. III. Credit-​Default  Swaps Credit derivatives are peculiar (compared to other capital-​market-​based risk transfer instruments) because they are risk management tools that allow the creditor to maintain its credit position in the reference debt instrument.15 A credit derivative, 8 Federal Reserve Bank of New York Central Bank Survey of Foreign Exchange and Derivatives Market Activity, available at http://​www.federalreserve.gov/​reportforms/​forms/​FR_​303620100401_​i.pdf (last visited Aug. 3, 2018). 9 Trading and Capital-​Markets Activities Manual, supra note 6, § 4305.1. 10 Id. 11 Id. 12 Federal Reserve Bank of New York Central Bank Survey of Foreign Exchange and Derivatives Market Activity, supra note 8, at 8. 13 Id. 14 Id.; see also Trading and Capital-​Markets Activities Manual, supra note 6, § 4305.1. 15 See: Andreas A. Jobst A Primer on Structured Finance Journal of Derivatives and Hedge Funds, Vol. 13, No. 3 ICFAI Journal of Risk Management, 2007 21 Pages Posted: 2 Nov. 2005 Last revised: 16 June 2016 “In their basic concept, credit derivatives sever the link between the loan origination and associated credit risk, but leave the original borrower-​creditor relationship intact.”

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however, may be also entered into by a market participant that does not hold a credit position in relation to the reference debt instrument. In this case, the credit derivative is not used to hedge credit risk but to speculate on credit risk.16 The risk to the system from AIG was centered on the fact that numerous counterparties had entered into transactions that effectively “insured” the credit risk of other transactions and investments. This “insurance” was predominantly in the form of credit derivatives such as credit default swaps. Credit derivatives are off–​balance-​sheet financial instruments that permit one party (the beneficiary) to transfer the credit risk of a reference asset, which it typically owns, to another party (the guarantor) without actually selling the asset.”17 A credit derivative is a “contract which transfers credit risk from a protection buyer to a credit protection seller.”18 Protection buyers “can use credit derivatives to manage particular market exposures and return-​on-​investment,” whereas protection sellers “generally use credit derivatives to earn income and diversify their own investment portfolios.”19 A. Purpose and Function

The courts have defined a credit-​default swap (CDS) as a “bilateral financial contract in which ‘a protection buyer makes periodic payments to . . . the protection seller, in return for a contingent payment if a predefined credit event occurs in the reference credit,’ i.e., the obligation on which the contract is written.”20 The main purpose of CDSs is to allow financial institutions, investors, and other market participants the opportunity to isolate and transfer specific credit risk from one party to another at a predetermined cost. The amount of the periodic payments due by the credit protection buyer is determined in relation to the credit quality (or credit risk) of the reference entity. The cash flow due by the protection seller at the occurrence of the credit event is calculated by “the difference between the notional principal and the market price of the underlying bond or the reduced recovery value of the defaulted bank credit.”21 A CDS is not, however, necessarily cash-​settled as it can be also physically settled,

See Kay Giesecke, An Overview of Credit Derivatives (2009), at 4. 17 Trading and Capital-​Markets Activities Manual, supra note 6, § 4350.1. 18 Eternity Global Master Fund Ltd. v. Morgan Guar. Trust Co., 375 F.3d 168, 172 (2d Cir. 2004). 19 Id. 20 Eternity Global, 375 F.3d at 172, n.6 (quoting Joyce A. Frost, Credit Risk Management from a Corporate Perspective, in Handbook of Credit Derivatives 90 ( Jack Clark Francis & Joyce A. Frost eds., 1999). 21 Jobst, supra note 15, at 5, n.4. 16

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in which case the protection seller will accept the delivery of the reference asset in exchange for the payment of its par value.22 From the previous description, we can see that in order to determine the obligations of a CDS and its performances, three elements assume paramount significance: the reference entity, the reference obligation, and the credit event. Although CDS agreements are often compared to insurance contracts, they are not insurance contracts.23 As pointed out by the International Swaps and Derivatives Association (ISDA), a trade group representing large financial institutions and other derivatives players, “there is no requirement that the protection buyer own the asset on which it is buying protection or that it suffer any loss.”24 The notional value covered by the agreement does not need to bear any relationship to the notional value held by the protection buyer.25 Parties are free to use credit-​default swaps as vehicles of speculation. If the predefined credit event occurs in the reference credit as per the agreement, during the period outlined, then the protection seller must fulfill his obligations under the agreement. The majority of credit-​default swap protection buyers use the agreements to hedge specific risks. In these cases, the credit risk being hedged could be identical to the credit risk of the asset the protection buyer has in possession. Alternatively, many sophisticated parties hedge risks that are “reasonably correlated with the performance” of the reference entity, “so that . . . the [protection buyer] may seek to isolate and hedge country risk written on some portion of the sovereign’s outstanding debt.”26 For example, a hedge fund that owns a significant amount of securities in an emerging country may seek to hedge the political risk in the country by entering into a CDS with a counterparty using the sovereign as the reference entity. The hedge fund may have determined that there is a correlation between the credit risk of the securities and the credit risk of the sovereign. In this example, the hedge fund (protection buyer) would be assuming “the risk of how well-​correlated the two defaults will be. That correlation of default is the most important credit risk management issue associated” with CDS.27 Other inherent risks of the agreement are counterparty risk and legal risks, discussed in Sec. 3.E.

Id. at 5–​6, n.4. 23 Aon Fin. Prods. v. Société Générale, 476 F.3d 90, 96 (2d Cir. 2007) (citing brief of amicus curiae Int’l Swaps and Derivatives Ass’n, Inc. (ISDA), at 7). 24 Amicus curiae brief of Int’l Swaps and Derivatives Ass’n, Inc. (ISDA) in Aon, 476 F.3d 90. 25 Id. 26 Eternity Global Master Fund Ltd. v. Morgan Guar. Trust Co., 375 F.3d 168, 172 (2d Cir. 2004). 27 ISDA amicus curiae brief, supra note 24. 22

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B. ISDA Master Agreement

Prior to the crisis the ISDA agreement was the primary means utilized by counterparties to standardize the credit-​default swap market to improve efficiency and reduce transaction costs.28 This standardization helped the market for default swaps expand at a rapid pace. Credit-​default swaps are documented in three parts: (1) the standard ISDA Master Agreement; (2) the negotiated schedules, which outline alterations to the standard ISDA agreement; and (3) the confirmations, which document specific elements of the transaction including defining the “precise risk” each party wishes to transfer.29 The standard ISDA agreement contains standard terms that govern the CDS market, including the “legal and credit relationship between the counterparties . . . representations and warranties, events of default and termination, covenants and choice of law.”30 In one of the most important cases, the ISDA Europe, the Middle East, and Africa (EMEA) Credit Derivatives Determinations Committee was called to decide whether the exercise by the Hellenic Republic of collective action clauses to amend the terms of Greek law governing bonds issued by the Hellenic Republic represented a credit event.31 The issue arose because the amendment to the terms of the bond had reduced the amount of payments that bondholders were entitled to receive. On March 9, 2012, the EMEA Determinations Committee unanimously resolved that the amendment by the Hellenic Republic constituted a Restructuring Credit Event under section 4.7(a) of the ISDA 2003 Credit Derivatives Definitions (as amended by the July 2009 Supplement).32 C. Importance of Clearly Defined Terms

A CDS must specifically and clearly articulate the exact protection being sought or sold; consequently, the credit event and reference entity must be unambiguously defined. If the credit event or reference entity is incorrectly defined or described in the Schedule and Confirmation associated with the ISDA agreement, the protection Frank Partnoy & David Skeel, The Promise and Perils of Credit Derivatives 8, (University of Pennsylvania Law School, 2006, Paper 125), available at http://​lsr.nellco.org/​upenn/​wps/​papers/​125 (last visited Aug. 3, 2018). 29 ISDA amicus curiae brief, supra note 24, at 8–​9. 30 Id. 31 See ISDA Release (Mar. 9, 2012), available at https://​www.isda.org/​a/​wLiDE/​greece-​credit-​event-​occurred-​ 03-​09-​2012.pdf. 32 Id. Determinations Committees have resolved several other important cases, see ex multis: a missed payment by the Argentine Republic of a coupon on some bonds constituted a failure to pay credit event (Aug. 1, 2014), a bankruptcy credit event occurred in respect of Espírito Santo Financial Group S.A. (Aug. 4, 2014), a bankruptcy credit event occurred in respect of ABB International Finance Limited (Aug. 5, 2014), a failure to pay credit event did not occur in respect of Caesars Entertainment Operating Co. (Feb. 9, 2015), a failure to pay credit event occurred in respect of iHeart Communications, Inc. (Dec. 21, 2016). 28

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buyer may not receive the desired and expected protection, or the protection seller could unexpectedly be liable for large sums of money. When sophisticated parties enter into credit-​default swap agreements, courts will examine and enforce the specific language in the agreement, applying the traditional precepts of contract law, and will not consider extrinsic evidence, surrounding circumstances, or industry customs, unless the terms are ambiguous.33 1. Credit  Event The Eternity Global34 case highlights the need to precisely define and articulate what constitutes a “credit event.” In this case, Eternity purchased a series of Argentinean bonds and sought to hedge their credit risk to the Republic of Argentina by purchasing credit protection from Morgan Guaranty Trust Company of New York for a specified time period, beginning in October 2001. The protection was designed using a series of CDS that listed the Republic of Argentina as the reference entity. Under the agreement, Eternity paid Morgan a fixed fee; in exchange, upon the occurrence of a “credit event,” Morgan would be required to purchase the bonds from Eternity for par value. The confirmation list agreed to by the parties listed categories of credit events based on certain Argentinean obligations, including repudiation, moratorium, or restructuring.35 The transactions can be summarized as in Figure 12.1. CDS EXAMPLE 1: Complex Financial Transaction Credit-default Swap b/w Eternity Global and Morgan Guaranty A series of credit-default swap transactions entered into b/w Eternity and Morgan, covering the notional value of the bonds held by Eternity, payable upon a valid Credit Event by the Republic of Argentina

Eternity Global

Purchase bonds

Morgan Guaranty

Issue bonds

Republic of Argentina

Figure 12.1  Example of credit-​default swap.

Eternity Global Master Fund Ltd. v. Morgan Guar. Trust Co., 375 F.3d 168, 177 (2d Cir. 2004). 34 Id. at 168. 35 See Eternity Global Master Fund Ltd. v. Morgan Guar. Trust Co., 2002 WL 31426310, at *3–​*4 (S.D.N.Y.). 33

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On November 1, 2001, the Argentineian president announced a voluntary exchange program for the bonds held by Eternity, which involved exchanging the current bonds Eternity held for newly issued secured bonds that carried a lower interest rate and a longer period maturity. Although this program was labelled voluntary, Eternity viewed it as a coerced exchange, because if it did not exchange the bonds, it would be left with illiquid bonds that were subordinate to the newly issued bonds. In addition, Eternity viewed the newly issued bonds less favorably than the initial bonds it had purchased prior to the announcement. The market reacted by selling off the Argentinean bonds. As a result, Eternity claimed the voluntary exchange represented a restructuring under the credit-​default swap with Morgan and thus, a valid credit event, entitling Eternity to exchange the bonds for their notional par value. However, Morgan claimed that because the exchange was voluntary, there was no restructuring of the bond and therefore, no credit event.36 In this case, the court analyzed whether the voluntary debt exchange program undertaken by Argentina in 2001 constituted a credit event that would trigger the CDS credit-​default swap agreement. To assess ambiguity in a disputed CDS credit-​ default swap, the court outlined a four-​step method:37 (1) The courts will first look at the express terms and language in the credit-​ default swap agreement. (2) If an ambiguity remains, the courts will then look at the ISDA Master Swap Agreement. (3) The court will also look at the version of the ISDA definitions that were “incorporated into the disputed contracts.” (4) Last, if the ambiguity has not been clarified, the court may look at extrinsic evidence, including the “background ‘customs, practices and usages’ of the credit derivatives trade.”

According to the ISDA Agreement: “ ‘Restructuring’ means that, with respect to one or more Obligations, including as a result of an Obligation Exchange . . . any one or more of the following events occurs . . . : 36

(i) a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals; (ii)  a reduction in the amount or principal or premium payable at maturity or at scheduled redemption dates; (iii) a postponement or other deferral of a date or dates for either: (A) the payment or accrual of interest or (B) the payment of principal or premium; (iv) a change in the ranking in priority of payment of any Obligation causing the subordination of such Obligation; or (v) any change in the currency or composition of any payment of interest or principal.” See Eternity Global, 2002 WL 31426310, at 3–​4. Eternity Global, 375 F.3d at 177. 37

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A similar question about the definition of a credit event occurred when the European Union initially bailed out Greece with a 110 billion euro payment and followed up with a second 140 billion euro payment in 2012.38 The Greek government was forced to restructure its outstanding debt. It was unclear whether the restructuring of debt constituted a default. On March 9, 2012, ISDA announced that its EMEA Determinations Committee “resolved unanimously that a “Restructuring Credit Event” had occurred with respect to The Hellenic Republic (Greece). The EMEA Determinations Committee resolved that a Restructuring Credit Event has occurred under Section 4.7(a) of the ISDA 2003 Credit Derivatives Definitions (as amended by the July 2009 Supplement) following the exercise by Greece of collective action clauses to amend the terms of Greek law governed bonds such that the right of all holders of the affected bonds to receive payments has been reduced.”39 In this case, the court upheld Eternity’s breach-​of-​contract claim after determining that sufficient ambiguity existed as to whether a voluntary debt exchange constituted a default under the CDS. 2. Reference  Entity The paramount case illustrating the importance of reference entity clarification is Aon Financial Products, Inc. v. Société Générale.40 In this case, a series of complex credit transactions stemming from a simple loan agreement led to years of litigation and a loss of approximately $10 million for a sophisticated financial institution (Aon Corp.), in addition to countless legal bills. The case stemmed from a basic loan agreement, in which Bear Stearns International Limited (BSIL) agreed to lend Escobel Land, Inc. $9,307,000 to finance the construction of a condominium complex in the Philippines. In conjunction with the loan, BSIL sought and received a surety bond from the Government Service Insurance System (GSIS) that guaranteed the repayment of Escobel’s $10 million obligation in the event Escobel defaulted on the loan. Although GSIS is statutorily backed by the Republic of the Philippines and is considered a government agent, it is its own individual and separate entity (a point of major conflict throughout the litigation).

Peter Spiegel & Alex Barker, Eurozone Agrees on Second Greek Bail-​Out, Fin. Times, Feb. 21, 2012, available at http://​www.ft.com/​intl/​cms/​s/​0/​a3445f64-​5c4c-​11e1-​911f-​00144feabdc0.html#axzz2V4eg16ni. 39 http://​www2.isda.org/​news/​isda-​emea-​determinations-​committee-​restructuring-​credit-​event-​has-​occurred-​ with-​respect-​to-​the-​hellenic-​republic (last visited Aug. 3, 2018). 40 476 F.3d 90 (2d Cir. 2007). 38

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Although the surety bond decreased BSIL’s counterparty default risk, it sought to further limit its exposure to the loan agreement by entering into a credit-​default swap agreement with Aon Financial Products, Inc. (AFP), whose payment was guaranteed by Aon Corp. (together with AFP, AON).41 This credit-​default swap covered the notional value of the $10 million loan. Under this agreement, AON promised to pay BSIL $10 million, plus out-​of-​pocket expenses in the event that GSIS failed to make payment under the surety bond for “whatever reason or cause,” and waived all defenses, in exchange for consideration totaling $425,000 from BSIL. The agreement was covered by New York state law based on a choice-​of-​law provision and comprised three documents: (1) an ISDA Master Agreement listing AFP and BSIL as parties, (2) a schedule elaborating on certain aspects of the Master Agreement, and (3) a confirmation letter from AFP to BSIL setting forth the specific terms and conditions of the transaction.42 AON, uncomfortable with its exposure to $10 million in liability, sought to reduce its risk by, in turn, entering into a credit-​default swap with Société Générale (SG). This credit-​ swap agreement did not make reference to or incorporate the credit-​swap agreement between BSIL and AON. The transactions are illustrated in the exhibit (Figure 12.2). While the BSIL/​AON credit-​default swap agreement listed GSIS as the reference entity, the AON/​SG credit-​default swap listed the Republic of the Philippines as its reference entity. It is unclear whether AON sought to completely hedge its risk and believed that a credit event by GSIS equated to a credit event by the Republic of the Philippines (as a result of the surety bond), or whether it simply wanted to hedge the specific portion of its risk dealing with transacting business in the Philippines and therefore intended there to be this difference. As discussed earlier, one of the benefits of CDS is that a party may hedge or speculate on specifically tailored risks. In retrospect, this difference was crucial throughout the litigation. When it came time to pay back its loan, Escobel defaulted. What historically would have been an isolated loss for the lender instead set off a chain of events set in motion by the above complex financial arrangements and agreements. First, a letter of demand was sent to GSIS. GSIS categorically denied liability under the surety

Throughout the rest of this discussion, AFP and Aon will be referred to as one party, despite the fact that they are two entities, because they retain the same liability and exposure in the litigation and are affiliate entities, and treating them as one does not detract or affect the description of the case. 42 Subsequently BSIL assigned its rights under all of these agreements to Ursa Minor (another institution) who subsequently assigned its rights to Bankers Trust (as part of a larger, complex packaged deal). 41

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211

CDS EXAMPLE 2: Complex Financial Transaction Credit-default Swap between BSIL and AFP, and Credit Default Swap between AFP and Societe Generale

GSIS

Issues Surety bond to local bank, which is assigned to BSIL, guaranteeing payment by Escobel of the Loan

$9,307,000 Loan

BSIL

Escobel

Credit-default Swap entered into between BSIL and AFP, covering the notional amount of $10 million, payable in the event that GSIS fails to satisfy, “for whatever reason or cause,” its obligations under the Surety Bond (payable to BSIL)

BSIL assigned all of its rights to both the Loan and CDS to Ursa Minor

Ursa Minor

$10,000,000 payment expected 3/7/2000

AFP guaranteed by AON

Assigned to Bankers Trustee

Bankers Trustee

Credit-default Swap entered into between AFP and Societe Generals, covering the notional amount of $10 million, payable in the event of a Credit Event by the Republic of the Philippines (payable to AFP)

Societe Generale

Figure 12.2  Complex credit-​default swap.

bond, alleging that the assignment to BSIL was not valid and that the individuals who approved and drafted the surety bond lacked the authority to do so. BSIL (or now Bankers Trustee in its place) then sent a notice of a credit event and demand to AON under its credit-​swap agreement. AON claimed that it also did not have to pay because the credit-​swap agreement was premised on there being a valid surety bond, and if no such surety bond existed, AON was not liable. Despite making this argument, AON informed SG of the situation and made it aware that it might be liable for the $10 million. The first suit brought as a result of this complex transaction43 sought to determine whether AON was liable under its credit-​default swap agreement with BSIL (which was subsequently transferred to Ursa Minor Ltd.). The court interpreted the agreement on its face because the language was clear and unambiguous. The court held that AON had an obligation to pay under the credit-​default swap “irrespective of the [Surety] Bond’s potential invalidity or unenforceability with respect to GSIS.”44 The reference entity in this swap-​agreement was GSIS, and one of the credit events under the agreement was a failure to pay. As long as GSIS failed to

Ursa Minor Ltd. v. Aon Fin. Prods., Inc., 2000 WL 1010278 (S.D.N.Y., 2000). 44 Id. at *7. 43

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pay, AON was liable. AON had explicitly waived all of its defenses in the agreement and was liable to pay as long as Escobel and GSIS did not pay ‘ “for whatever reason or cause’ including where the underlying obligation was illegal or invalid.”45 The court examined the specific language in the agreement and interpreted the language in a matter in which an ordinary businessperson would interpret it. On appeal, the appellate court determined that the credit-​default swap contained “a clear waiver of defenses concerning the invalidity, illegality, or unenforceability of the transaction.”46 Found liable for the $10 million, AON sought to collect under its credit-​default swap agreement with SG. AON claimed that it was straightforward: if AON was liable to BSIL for the $10 million, then SG was liable to AON for the $10 million. However, in the BSIL-​AON credit-​default swap, the reference entity was GSIS, but in the AON-​SG credit-​default swap the reference entity was the Republic of the Philippines. Either AON misinterpreted its protection, or sought to get out of liability via a combination of good lawyering, a lack of judicial precedent in CDS, and/​ or an inexperienced (in CDS) judiciary.47 Their gamble almost paid off. The district court believed that “the clear intent of the parties was that Société Générale would guarantee payment to AON . . . on the condition that they become liable to BSIL upon the occurrence of a ‘Credit Event.’ ”48 One such credit event under the agreement was a “Sovereign Event.” The primary issue the court dealt with was whether the refusal by GSIS and subsequently, the Republic of the Philippines, to repay the loan constituted a Sovereign Event. Was the repayment of the loan an obligation of the Republic of the Philippines under the credit-​default agreement? Here, the court looked at evidence outside of the direct words in the contract (outside the “four corners of the contract”) and determined that although the Republic of the Philippines was not a signatory to the surety bond or any of the underlying agreements, it was nonetheless a guarantor of its agent GSIS’s obligation under Philippine law.49 As a result, the Court held that a credit event occurred and SG’s “refusal to honor its obligations to pay [AON] makes it the defaulting

Id. 46 Ursa Minor Ltd. v. Aon Fin. Prods., 7 Fed.Appx. 129, 131 (2d Cir. 2001) (ruling by Summary Order). 47 It is likely that the business people at Aon intentionally set the swaps up the way they were because they believed that their protection was heavily correlated with the protection they received, but at a cheaper price (They received $425,000 for the protection they provided BSIL, but paid only $300,000 for their protection from Société Générale). In their minds, GSIS would not default or refuse to pay unless the Republic of the Philippines also defaulted. They also likely believed the government would back the debts of GSIS. They were wrong, and it cost them $10 million. 48 Aon Fin. Prods. v. Société Générale, 2005 WL 427535 at *1 (S.D.N.Y. 2005). 49 Id. at *5. 45

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party owing indemnification” in the amount of $10 million plus interest and legal expenses.50 If AON meant to receive 100 percent protection from its exposure to the credit-​ default swap with BSIL, then it should (and likely would have) used the same reference entity in its credit-​default swap with SG. Unlike the district court, the appellate court saw a clear distinction between the two credit-​swap agreements.51 In fact, the Second Circuit determined that the first credit-​swap agreement should not be looked at in conjunction with this subsequent credit-​default swap agreement because they are two separate agreements, made by two different sets of parties, neither of which incorporated the other. The only similarity is that AON is a party in both agreements. CDS are bilateral contracts and only incorporate terms, agreements, or other factors that are explicitly referenced in the document. The International Swaps and Derivative Association, which is responsible for the standardization of CDS agreements, emphasized the need for clarity and uniform standardized interpretations of the basic terms and elements of the CDS. ISDA felt strongly that the ruling by the district court was incorrect and was afraid that the ruling would “threaten the legal certainty inherent in standard ISDA documentation, by reaching outside the [Société Générale] CDS to a separate contract not involving [Société Générale].”52 ISDA felt compelled to send its first ever amicus curiae to the Second Circuit, presenting detailed information about how the credit-​ default swap market operates while highlighting its belief that the district court decision would jeopardize the clarity and expansion of this market in the future. ISDA argued that if the district court’s finding were left intact, “it would have a chilling effect on the financial markets and would eliminate a significant means by which banks, financial institutions and corporations diversify their risks.”53 The Second Circuit clearly took the opinion of ISDA very seriously. In its ruling, it overturned the district court while often quoting ISDA’s amicus curiae. The Second Circuit determined that there was “no reason to assume that the risk transferred to [AON] was precisely the risk that it transferred or sought to transfer to” SG. “GSIS is not the Republic of the Philippines; its obligations are not the Republic of the Philippines’ obligations; and failure by GSIS to make a payment on its obligations is not the equivalent to the failure of the Republic of the Philippines to make a payment on its obligations.”54 To determine what constitutes a credit event, the court Id. at *6. 51 See Aon Fin. Prods. v. Société Générale, 476 F.3d 90 (2d Cir. 2007). 52 Amicus curiae brief of ISDA, supra note 24. 53 Id. 54 Aon, 476 F.3d at 99–​101. The court also pointed out that Aon paid Société Générale nearly $100,000 less than the amount that BSIL paid Aon for protection (which is more than 20 percent less). 50

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will look first to the language of the contract. If it is unambiguous, the court is required to give effect to the contract as written. The terms of each credit-​default swap independently define the risk being transferred. D. Collateralized Debt Obligations

A Collateralized Debt Obligation (CDO) is a special purpose entity whose assets are represented by a pool of different classes of debt instruments (such as bank loans, corporate bonds, credit default swaps, asset-​backed securities, residential mortgage-​ backed securities, commercial mortgage-​backed securities) managed by an asset manager.55 The purpose of the CDO is to transfer the credit risk borne by those assets to investors by issuing (and distributing to investors) notes and equity (“CDO securities”) according to investors’ level of risk appetite and investment horizon. The capital structure of a CDO is articulated in debt and equity tranches, so investors can buy notes related to a debt tranche or equity. The risk associated to each tranche depends on the risk of the class of debt instruments underlying the tranche. A relationship of subordination exists between the different tranches.56 The basic model of CDO has three subordinated debt tranches (senior, mezzanine, and junior) and one equity tranche.57 The senior tranche bears the lowest risk, which gradually increases in correspondence of the mezzanine and junior tranches, while the equity tranche carries the highest risk.58 When investors buy CDO securities (notes or equity issued by the CDO) they assume the credit risk related to the pool of debt instruments underlying the corresponding tranche. In this way, investors sell credit protection to the CDO against default on a portion of the underlying portfolio of debt instruments (that constitute the asset of the CDO and the collateral backing the CDO securities).59 CDO securities may be attractive for investors because they offer the investment opportunity to earn higher returns than those deriving from a direct holding of the underlying pool of debt instruments. This is especially true for those CDO securities with the lowest level of seniority by virtue of the mechanism of leverage.60 55 See Douglas J. Lucas, Laurie S. Goodman & Frank J. Fabozzi, Collateralized Debt Obligations, in 1 The Handbook of Finance 395–​96 (2008). 56 The mechanism of subordination entails that the senior securities are paid before the junior securities. 57 See Lucas, Goodman, & Fabozzi, infra note 62, at 396–​97. 58 Id at 396–​97. The level of risk is measured by the rating of the debt instruments that may range from AAA to non-​rated. 59 See Jobst, supra note 15, at 9. 60 Id. at 9–​10.

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In finance, CDOs are mainly distinguished in four main types: cash-​flow, synthetic, hybrid, and market value. In a cash flow CDO, investors receive the cash flow generated by the debt instruments in the underlying portfolio.61 The synthetic CDO differs from the cash flow CDO because it does not own assets, namely debt instruments, but it assumes credit risk by selling credit protection through credit default swaps and subsequently it buys protection from the same credit risk by selling tranches to investors.62 On the other hand, by buying tranches in a synthetic CDO, investors assume credit risk in return for spread.63 Hybrid CDO mix elements of both cash flow and synthetic CDO. Finally, in a market value CDO, the CDO debt securities are repaid through the liquidation by the asset manager of the asset held by the CDO.64 E. OTC Derivatives and the Financial Crisis

A lax and relatively uninformed regulatory regime exempted OTC derivatives, including CDS agreements, from government oversight as a result of the Commodity Futures Modernization Act (CFMA), passed in 2000.65 Before the enactment of the CFMA, derivatives were governed first by the Grain Futures Act of 1921, which subjected exchange-​traded futures contracts to regulation, and then by the CEA, promulgated in 1936.66 The CEA gave jurisdiction to the CFTC to monitor and impose rules on private commodity exchanges, particularly to preclude market manipulation on these exchanges.67 Vis-​à-​vis OTC derivatives, known as “off-​exchange futures,” the CEA adopted the common law rule that these instruments, aside from forward contracts settled by actual delivery, were illegal and unenforceable.68 This prohibition on OTC derivatives was relaxed when Congress, in 1992, permitted the CFTC to exempt certain derivatives from the CEA through the Futures Trading

61 Id. at 9. 62 See Lucas, Goodman, & Fabozzi, infra note 62, at 406. 63 Id. at 406. 64 Id. at 397–​98. 65 Frank D’Souza et al., Illuminating the Need for Regulation in Dark Markets: Proposed Regulation of the OTC Derivatives Market, 12 U. Pa. J. Bus. L. 493–​94, 498 (2010). 66 Seema Sharma, Over-​the-​Counter Derivatives: A New Era of Financial Regulation, 17 L. & Bus. Rev. Am. 288 (2011). 67 Lynn Stout, Derivatives and the Legal Origin of the 2008 Credit Crisis, 30(12) Banking & Fin. Servs. Pol’y Rep. 13, 17 (2011). 68 Id. A forward contract is the obligation “to exchange an underlying asset at a set price on a stipulated future date and, if physically-​settled, at a specified location.” Norman Feder, Deconstructing Over-​the-​Counter Derivatives, 2002 Colum. Bus. L. Rev. 698 (2002).

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Practices Act;69 the CFTC used this authority to exempt interest rate swaps from the CFTC.70 The CFMA then amended the CEA to exempt clearing and exchange requirements for OTC derivatives if the counterparties were “eligible contract participants,” defined as counterparties with at least $10 million in assets.71 The CFMA also preempted state bucket-​shop laws in the enforcement of OTC derivatives.72 Thus, OTC derivatives no longer faced CEA requirements regarding “capital adequacy, clearing, reporting and disclosure.”73 Congress rationalized this lack of oversight because of a fear that OTC derivatives would move to markets in other countries, eroding the preeminence of U.S. capital markets.74 Moreover, it was assumed that sophisticated market participants would utilize these instruments prudently.75 The OTC derivatives market thus grew to staggering heights with little government oversight. Indeed, from the time the CFMA exempted OTC derivatives from regulation to 2008, in which market participants were permitted to speculate in derivatives, the OTC market had grown from about $88 trillion to over $670 trillion in notional value.76 The size of the OTC market exacerbated its systemic effects once derivatives contracts decreased in value and financial entities experienced losses. In particular, many firms utilized CDS to hedge the risk of asset-​backed securities they owned, such as securities backed by pools of mortgages.77 When these securities fell in value due to a decrease in housing prices, payment obligations on the sellers’ CDS, the size of which regulators and counterparties were unaware, were triggered by the purchasers of the CDS; in CDS alone, the market exploded to about $58 trillion.78 Both counterparties and regulators were ill-​equipped to predict the effects on any one counterparty or the system generally arising from turmoil in these opaque

69 Michael Greenberger, Overwhelming a Financial Regulatory Black Hole with Legislative Sunlight: Dodd-​Frank’s Attack on Systemic Economic Destabilization Caused by an Unregulated Multi-​Trillion Dollar Derivatives Market, 6 J. Bus & Tech. L. 127, 133–​34 (2011). 70 Id. at 18. In a standard interest rate swap, one party makes fixed rate payments to the counterparty and the other party makes floating rate payments that fluctuate based on an interest rate; Feder, supra note 68, at 702. In many cases, this floating rate is based on the London Interbank Offered Rate (LIBOR), which is “the rate offered on interbank deposits for major currencies.” Id. at n. 36. 71 Sharma, supra note 66, at 289. 72 D’Souza et al., supra note 65, at 494. 73 Id. 74 Willa Gibson, Clearing and Trade Execution Requirements for OTC Derivatives Swaps Under the Dodd-​Frank Wall Street Reform and Consumer Protection Act, 38 Rutgers L. Rec. 1, 2 (2011). 75 Evan Turgeon, Boom and Bust for Whom? The Economic Philosophy Behind the 2008 Financial Crisis, 4 Va. L. & Bus. Rev. 139, 163–​4 (2009). 76 Stout, supra note 67, at 19. 77 See, e.g., S. Rep. No. 111-​176, at 29–​30 ; Erik Gerding, Credit Derivatives, Leverage and Financial Regulation’s Missing Macroeconomic Dimension, 8 Berkeley Bus. L.J. 45–​46 (2011). 78 Greenberger, supra note 69, at 144.

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markets.79 Indeed, regulators may not have even known of the existence of certain types of derivatives.80 For example, AIG, particularly through its subsidiary American International Group Financial Products (AIGFP), underwrote about $1.8 trillion in notional value of CDS on mortgage-​backed securities.81 As noted previously, the seller of a credit-​default swap guarantees payment to the buyer if the reference entity, that is, the entity on which the swap is guaranteed, experiences a credit event as defined in the swap contract.82 Thus, when housing prices fell and mortgage-​backed securities experienced losses, AIG’s credit-​default swap portfolio deteriorated, forcing the firm to post billions of dollars in collateral;83 Counterparties to AIG, due to its sterling AAA rating, did not originally require that AIG post adequate collateral on these obligations.84 After the assets under which it wrote insurance depreciated in value, though, margin calls were triggered.85 This caused significant liquidity problems for AIG, as although it likely had sufficient assets to meet margin calls, it could not sell them in time.86 The Fed eventually lent AIG $85 billion, using AIG’s insurance assets as collateral, to stave off a potential run on AIG that would have had profound consequences for the global financial system.87 In testimony before the House Committee on Agriculture on November 20, 2008, Erik Sirri, the director of the SEC’s Division of Trading and Markets, described the credit-​default swap market and the regulators’ interest in it as follows: The current credit-​default swap (CDS) market operates solely on a bilateral, over-​the-​counter basis and has grown to many times the size of the market 79 Id. at 144–​46. 80 OTC Derivatives: Modernizing Oversight to Increase Transparency and Reduce Risks: Hearing Before the S. Banking Committee ( June 21, 2009) (statement of Henry Hu). 81 Sharma, supra note 66, at 293. Notional value is an imperfect measure of the size of derivatives exposure because, in many instances, the notional value of a derivatives contract is only a reference amount, and thus the maximum gain or loss on the contract is only a fraction of this value. Feder, supra note 68, at 684. 82 Jeremy Kress, Credit Default Swaps: Clearinghouses and Systemic Risk: Why Centralized Counterparties Must Have Access to Central Bank Liquidity, 48 Harv. J. Legis. 55 (2011). Credit default swaps are mostly standardized based on a “Master Agreement” constructed by the International Swaps and Derivatives Association, so a “credit event” is defined uniformly in credit-​default swap contracts. Jongho Kim, From Vanilla Swaps to Exotic Credit Derivatives: How to Approach the Interpretation of Credit Events, 13 Fordham J. Corp. & Fin. L. 705, 752–​53 (2008). 83 Sharma, supra note 66, at 293. 84 Charles Murdock, The Dodd-​Frank Wall Street Reform and Consumer Reform Act: What Caused the Financial Crisis and Will Dodd-​Frank Prevent Future Crises?, 64 SMU L. Rev. 1243, 1318 (2011). 85 Id. at 1318. 86 Ben Bernanke, Chairman, Fed. Reserve, The Federal Reserve’s Response to the Financial Crisis, Address at George Washington University School of Business (Mar. 27, 2012). 87 Id.

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for the underlying credit instruments. In light of the problems involving AIG, Lehman, Fannie, Freddie and others, attention has focused on the systemic risks posed by CDS. The ability of protection sellers (such as AIG and Lehman) to meet their CDS obligations has raised questions about the potentially destabilizing effects of the CDS market on other markets. Also, the deterioration of credit markets generally has increased the likelihood of CDS payouts, thus prompting protection buyers to seek additional margin from protection sellers. These margin calls have strained protection sellers’ balance sheets and may be forcing asset sales that contribute to downward pressure on the cash securities markets. In addition to the risks that CDSs pose systemically to financial stability, CDSs also present the risk of manipulation. Like all financial instruments, there is the risk that CDSs are used for manipulative purposes and there is a risk of fraud in the CDS market. The SEC has a great interest in the CDS market because of its impact on the securities markets and the Commission’s responsibility to maintain fair, orderly, and efficient securities markets. These markets are directly affected by CDSs due to the interrelationship between the CDS market and the securities that compose the capital structure of the underlying issuers on which the protection is written. In addition, we have seen CDS spreads move in tandem with falling stock prices, a correlation that suggests that activities in the OTC CDS market may in fact be spilling over into the cash securities markets. OTC market participants generally structure their activities in CDS to comply with the CFMA’s swap exclusion from the Securities Act and the Exchange Act. These CDS are “security-​based swap agreements” under the CFMA, which means that the SEC currently has limited authority to enforce antifraud prohibitions under the federal securities laws, including prohibitions against insider trading. If CDS were standardized as a result of centralized clearing or exchange trading or other changes in the market and no longer subject to individual negotiation, the “swap exclusion” from the securities laws under the CFMA would be unavailable.88

House Committee on Agriculture (Nov. 20, 2008) (testimony of Erik Sirri concerning credit-​default swaps), available at http://​www.sec.gov/​news/​testimony/​ts112008ers.htm. 88

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On November 14, 2008, the President’s Working Group on Financial Markets (PWG) announced a series of initiatives to strengthen oversight and the infrastructure of the OTC derivatives market.89 The initiatives announced include the development of credit-​default swap central counterparties and the establishment of a memorandum of understanding among the Federal Reserve Board of Governors, the SEC, and the CFTC regarding credit-​default swap central counterparties. In its press release, the Treasury described steps toward central clearing of CDS as a means of reducing the systemic risk associated with counterparty credit exposures. At the prompting of the PWG, several potential central counterparty credit providers have developed an approach to clearing CDS. By clearing and settling CDS contracts submitted by participants in the central counterparty (CCP), the CCP could substitute itself as the purchaser to the CDS seller and the seller to the CDS buyer. This novation process by a CCP would mean that the two counterparties to a CDS would no longer be exposed to each others’ credit risk. A single, well-​managed, regulated CCP could vastly simplify the containment of the failure of a major market participant. In addition, the CCP could net positions in similar instruments, thereby reducing the risk of collateral flows. Moreover, a CCP could further reduce risk through carefully regulated uniform margining and other robust risk controls over its exposures to its participants, including specific controls on market-​wide concentrations that cannot be implemented effectively when counterparty risk management is uncoordinated. A CCP also could aid in preventing the failure of a single market participant from destabilizing other market participants and, ultimately, the broader financial system. A CCP also could help ensure that eligible trades are cleared and settled in a timely manner, thereby reducing the operational risks associated with significant volumes of unconfirmed and failed trades. It may also help to reduce the negative effects of misinformation and rumors that can occur during high volume periods, for example when one market participant is rumored to “not be taking the name” or not trading with another market participant because of concerns about its financial condition and taking on incremental credit risk exposure to the counterparty. Finally, a CCP could be a source of records

Press Release HP-​ 1272, PWG Announces Initiatives to Strengthen OTC Derivatives Oversight and Infrastructure (Nov. 14, 2008), available at http://​www.treas.gov/​press/​releases/​hp1272.htm. 89

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regarding CDS transactions, including the identity of each party that engaged in one or more CDS transactions. Of course, to the extent that participation in a CCP is voluntary, its value as a device to prevent and detect manipulation and other fraud and abuse in the CDS market may be limited.90 IV. The Move toward Regulatory Reform The Dodd-​Frank Act91 effectuated a transformational shift in the regulation of financial institutions. Dodd-​Frank, along with prohibiting banks from engaging in proprietary trading (also known as the “Volcker Rule”),92 establishing the Financial Stability Oversight Council to monitor institutions that threaten financial stability,93 and creating a mechanism for the orderly unwinding of systemically important financial institutions,94 fundamentally overhauled the previous regulatory regime vis-​à-​vis derivatives and derivatives trading. In essence, regulators constructed a central clearing model, subject to exemptions from clearing and exchange requirements for sufficiently nonstandardized derivatives and for derivatives that either intend to be physically settled or are traded by non-​financial entities hedging commercial risks. Broadly speaking, Title VII of Dodd-​Frank repeals the exemption from regulation of OTC derivatives promulgated under the Commodity Futures Modernization Act of 200095 and forces many derivatives products to be cleared through a central clearinghouse and to be traded on an exchange.96 For those derivatives that are not required to be centrally cleared, it imposes capital and margin requirements on these trades97 and mandates reporting them to a “swap data repository.”98 Dodd-​Frank also forces certain derivatives market participants to register with the CFTC or SEC.99 Lawmakers intended that these provisions would increase transparency in OTC derivatives markets for both consumers and regulators and diminish the risk of OTC derivatives fomenting a systemic financial and economic collapse.100 90 See Sirri testimony, supra note 88. 91 Dodd-​Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-​203, 124 Stat. 1376 (to be codified in scattered sections of U.S.C.). 92 Id. § 619(a). 93 Id. § 111(a), § 112(a). 94 Id. § 204(a). 95 Sharma, supra note 66, at 279, 294. 96 S. Rep. No. 111-​176, at 32 (2010). 97 Dodd-​Frank Act § 731, § 764(a). 98 Id. § 729, § 766(a). 99 Id. § 731, 764(a). 100 S. Rep. No. 111-​176 at 30.

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Despite attempts to improve oversight of derivatives markets, the importance of financial instruments and their ability to shift risk throughout the capital markets necessitated coordinated involvement by regulatory authorities in previously untouched markets to prevent systemic risk. In drafting new regulations for the derivatives marketplace, lawmakers examined two paradigms that dominate the trading of derivative instruments: the central clearing model and the OTC model.101 A. The Central Clearing Model

In the central clearing model, utilized by the futures market, a clearinghouse positions itself between the underlying buyer (the long position) and the underlying seller of the derivative (the short position)—​in effect, the clearinghouse becomes the seller to the original buyer and the buyer to the original seller.102 The clearinghouse, because it holds offsetting long and short positions, is not exposed to the risk of price movements of the underlying instrument.103 Meanwhile, the parties to the transaction, through the use of the clearinghouse, are no longer exposed to the counterparty risk of the other side.104 The clearinghouse paradigm does not eliminate all counterparty risk because the clearinghouse assumes the possibility of one of the counterparties being unable to fulfill its obligations under the derivatives contract;105 the clearinghouse guarantees the performance of each contract and receives the funds for this guarantee through payments from clearing members.106 Clearinghouses manage this counterparty risk through two primary mechanisms: (1) strict requirements for the eligibility of counterparties to become a member of the clearinghouse, and (2) the posting of original and variation margin.107 Vis-​à-​vis the eligibility requirements, clearinghouses impose minimum capital requirements on their members, to mitigate counterparty risk in the event a derivatives contract subjects a clearing member to losses, and have mechanisms for evaluating their members’ credit strength, to ensure that all members meet a minimum level of

101 Feder, supra note 68, at 681. 102 Darrell Duffee et al., Policy Perspectives on OTC Derivatives Market Infrastructure, in Federal Reserve Bank of New York (2010), available at http://​papers.ssrn.com/​sol3/​papers.cfm?abstract_​id=1534729. 103 Anupam Chandler & Randall Costa, Clearing Credit Default Swaps: A Case Study in Global Legal Convergence, 10 Chi. J. Int’l L. 639, 677 (2010). 104 Paul McBride, The Dodd-​Frank Act and OTC Derivatives: The Impact of Mandatory Central Clearing on the Global OTC Derivatives Market, 44 Int’l Law. 1077, 1099 (2010). 105 Adam Krippel, Regulatory Overhaul of the OTC Derivatives Market: The Costs, Risks and Politics, 6 Ohio St. Entrepreneurial Bus. L.J. 269, 291 (2011). 106 Duffee et al., supra note 102. 107 Kress, supra note 82, at 49, 62–​63.

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financial stability.108 In addition to these membership obligations, clearing members must provide both initial margin and variation margin.109 Initial margin is given to the clearinghouse at the inception of the trade and is used as a good-​faith deposit,110 akin to posting a security deposit for rental housing. Variation margin is updated daily based on price movements in the underlying instrument, ensuring that counterparties account for these fluctuations by posting additional margin if necessary. Due to these minimum capital requirements and the posting of initial and variation margin, the risks stemming from the default of a counterparty on a derivatives obligation are theoretically combined.111 B. The OTC Model

In contrast, OTC derivatives trading does not utilize a central clearinghouse. Counterparties enter into a customized (or “bespoke”) derivatives contract on a bilateral basis, with one party buying the long position and the other buying the short position of the agreed-​upon terms. Thus, both parties to an OTC derivatives contract assume the market risk of the contract, that is, that the value of the contract will diminish based on changes in the value of the underlying asset.112 The counterparties, moreover, are exposed to the credit quality of the other counterparty due to the absence of a guarantee from a clearinghouse—​counterparty risk is not eliminated between the parties in this arrangement.113 As one scholar notes: “the price of contractual freedom is a greater risk of default.”114 These risks can be alleviated through capital and margin requirements imposed by the counterparties themselves, which may be more or less robust than those mandated by a clearinghouse in a cleared transaction. OTC derivatives are also subject, to a greater extent than derivatives traded on an exchange, to “liquidity risk,” that is, the risk that a counterparty will face significant costs “due to a lack of immediately available resources or prospects,” either because of a paucity of cash or due to an inability to unwind a transaction.115 As OTC derivatives are often tailored specifically to the needs of a counterparty, that counterparty may be unable to find another willing party to assume its obligations under the contract and often, these contracts are not assignable without the consent 108 Chandler & Costa, supra note 103, at 653–​54. 109 Id. at 654. 110 Id. at 648. 111 D’Souza et al., supra note 65, at 481. 112 Feder, supra note 68, at 722. 113 Id. 114 Henry Hu, Misunderstood Derivatives: The Causes of Informational Failure and the Promise of Regulatory Incrementalism, 102 Yale L.J. 1457, 1465 (1993). 115 Feder, supra note 68, at 725–​26.

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of the other counterparty.116 Despite these perceived shortcomings, OTC derivatives allow market participants to construct contracts based on their unique risk needs.117 C. Confidence in the New Regulatory Regime: The Case of MF Global

Within a year and half of Dodd-​Frank’s passage, however, a devastating bankruptcy challenged confidence in the new regulatory regime and threatened to repudiate the central clearing paradigm created by it. MF Global was a registered futures commission merchant (FCM) that provided clearing and execution services for derivatives clients.118 It primarily earned money through commission fees in relation to clearing and execution and from interest income on customer accounts.119 Unfortunately even though MF Global was a regulated FCM responsible for segregating customer funds to support exchange-​traded futures transactions, a vast number of customers disappeared. Even the chief executive, Jon Corzine, could not account for what exactly happened to them. An FCM is an individual or organization that solicits or accepts orders to buy or sell futures contracts, options on futures, retail off-​exchange foreign-​exchange contracts, or swaps, and accepts money or other assets from customers to support such orders.120 The FCM then clears the trade through a clearinghouse. When a counterparty trades through an FCM, the FCM holds customer margin funds in a separate account, known as “segregated funds.”121 These customer-​segregated funds are required to be kept separate from the assets of the FCM and thus cannot be commingled with the trading accounts of the FCM;122 the FCM transfers the collateral from the customer to one of the FCM’s customer-​segregated accounts and from there, the collateral is moved to a customer-​segregated account of the clearinghouse, though in many cases, the FCM imposes additional margin requirements beyond those mandated by the clearinghouse.123 These segregated funds may be invested by

116 Id. 117 Id. at 734. 118 Investigative Hearing on the MF Global Bankruptcy: Hearing Before the S. Comm. on Agriculture, Nutrition and Forestry, 112th Cong. (2011) (statement of Jon Corzine, former CEO of MF Global). 119 Id. 120 National Futures Association, Futures Commission Merchant, available at http://​www.nfa.futures.org/​nfa-​ registration/​fcm/​index.HTML December 2, 2018. 121 Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions, 76 Fed. Reg. 78776 (Dec. 19, 2011). 122 Investigative Hearing on the MF Global Bankruptcy: Hearing Before the S. Comm. on Agriculture, Nutrition and Forestry, 112th Cong. (2011) (statement of Terrence Duffy, Executive Chairman CME Group). 123 Id.

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the FCM in certain enumerated assets that have high credit quality and liquidity.124 Specifically, pursuant to Section 4d of the Commodity Exchange Act (CEA) and Regulation 1.25 of the Commodity Futures Trading Commission, FCMs are permitted to invest these funds in obligations of the United States, municipal securities, and certificates of deposit issued by a bank with deposits insured by the Federal Deposit Insurance Corporation (FDIC), to name a few.125 The FCM arm of MF Global was placed into bankruptcy on October 31, 2011,126 due to circumstances reminiscent of those faced by Bear Stearns and Lehman. MF Global experienced losses on assets that caused counterparties to rapidly reduce their exposure to the firm and rating agencies to downgrade the credit quality of the firm, spurring further margin calls.127 Instead of mortgage-​backed securities causing counterparties to pull their money from the firm, though, MF Global’s counterparties were worried in part about its exposure to European debt securities.128 MF Global purchased European debt securities through repurchase transactions to maturity (RTMs) whereby MF Global would purchase a sovereign debt instrument and then sell that same debt instrument to a counterparty, with an agreement to repurchase the instrument at its maturity.129 MF Global hoped to earn the spread between the interest rate on the sovereign debt instrument and the interest rate it paid to the counterparty.130 At the time, FCMs were permitted to invest customer-​segregated funds in these repurchase agreements and in sovereign debt instruments,131 which MF Global did: it entered into RTM transactions on the debt of Belgium, Italy, Spain, Ireland, and Portugal.132 These instruments, however, contributed to MF Global’s demise, as counterparties reduced their exposure to the firm and requested additional collateral in light of MF Global’s exposure to the sovereign debt of Europe.133 The bankruptcy of a financial entity, as evinced in the recent financial crisis, is not in itself a unique event. However, it was discovered on October 30, 2011, that MF 124 Investigative Hearing on the MF Global Bankruptcy: Hearing Before the S. Comm. on Agriculture, Nutrition and Forestry, 112th Cong. (2011) (statement of Commissioner Sommers). 125 Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions, 76 Fed. Reg. 78776 (Dec. 19, 2011). 126 Duffy, supra note 122. 127 Corzine, supra note 118. 128 Id. at 16. Corzine maintains that the large quarterly loss announced a week before MF Global’s bankruptcy was due not to losses on European debt securities but on a write-​off of a deferred tax asset and other losses unrelated to the European securities. 129 Id. at 5. 130 Id. at 6. As long as MF Global earned more on the European debt than it paid in interest on the RTM transaction, it would make money. 131 Id. at 12. 132 Id. at 8. 133 Id. at 16.

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Global could not return all of the margin that customers had deposited with the firm to support their derivatives trades,134 despite that these funds are required to be segregated from the funds of the FCM.135 This represented the first time that CME Group, which is the world’s largest derivatives marketplace, experienced a “shortfall in customer segregated funds” held by a clearing member and that CME Group could not transfer customer property in bankruptcy due to missing customer funds in a segregated account controlled by an FCM.136 Interestingly, a few days before the customer funds were known to be missing, CME Group sent auditors on an unannounced basis to review the segregation of customer accounts and did not notice any discrepancies; CME Group was the designated self-​regulatory organization (DSRO) for MF Global and was responsible for conducting periodic audits of the FCM arm of the firm.137 It remains unclear how these customer funds exited the firm and why MF Global did not properly segment the funds.138 As an FCM, MF Global was required by Dodd-​Frank to segregate customer funds from the assets of the firm139 and, though the precise mechanisms are unknown, it is clear from the large shortfall in customer accounts that strict segregation did not transpire. Certainly, this presents a quandary for regulators; the clearinghouse paradigm utilized in the futures market is the lodestar of the Dodd-​Frank as it relates to derivatives trading. Derivatives were supposed to possess less counterparty and systemic risk through their migration to clearinghouses and exchanges, as opposed to bilateral contracts. FCMs, as the intermediary between the customer and the clearinghouse on some derivatives trades, would deposit with the clearinghouse adequate margin to support the customer’s trade and would protect the customer’s margin with the FCM through segregated funds, investing those funds only in safe and liquid assets that could not be commingled with the other assets of the firm. In the event of an FCM bankruptcy, customer funds would easily be returned to the customer by virtue of their separation from the rest of the assets of the FCM. In contrast

134 Id. at 17. 135 Dodd-​Frank Act § 724(a). The court-​appointed Trustee for the Securities Investor Protection Act of MF Global Inc. estimated the figure to be $1.2 billion or more. Investigative Hearing on the MF Global Bankruptcy: Hearing Before the S. Comm. on Agriculture, Nutrition and Forestry, 112th Cong. (2011) (statement of James Giddens, Trustee for the Securities Investor Protection Act Liquidation of MF Global). This was later revised to $1.6 billion. Ben Protess, MF Global Trustee Sees $1.6 Billion Customer Shortfall, N.Y.Times Dealbook (Feb. 10, 2012), available at http://​dealbook.nytimes.com/​2012/​02/​10/​mf-​global-​trustee-​sees-​1-​6-​billion-​ customer-​shortfall/​. 136 Duffy, supra note 122. 137 Id. at 3. 138 Ben Protess & Azam Ahmed, An MF Global Trustee Defends His Inquiry, N.Y.Times Dealbook (Apr. 24, 2012), available at http://​dealbook.nytimes.com/​2012/​04/​24/​an-​mf-​global-​trustee-​defends-​his-​inquiry/​. 139 Dodd-​Frank Act § 724(a).

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to the ideal system as envisioned by legislators and regulators, MF Global invested in European sovereign debt instruments that have subsequently been downgraded140 and, more disconcertingly, did not properly separate customer funds. Preliminarily, it would be facile to contend that the revisions of Regulation 1.25 undertaken by the CFTC, viz., the elimination of corporate debt obligations and foreign sovereign debt from the list of permitted investments for customer funds,141 as well as the limitations on affiliate transactions through repurchase agreements,142 will solely forestall future FCM bankruptcies. Whether or not the downfall of MF Global was principally due to exposure to European debt securities, FCMs in the future may still face bankruptcies even if they invest customer-​ segregated assets in the safest and most liquid assets. FCMs can invest their own equity (and not those of their customers) in assets that lose value and provoke a run similar to that faced by Bear and Lehman in the recent financial crisis. MF Global, for instance, had a leverage ratio (assets divided by the sum of total equity and preferred shares), of 30 to 1, so that relatively minor deteriorations in asset values on its balance sheet could have jeopardized the solvency of the firm.143 However, these amendments to Regulation 1.25 do limit the ability of FCMs to invest customer funds in relatively risky assets and thus decrease to some extent the probability of a FCM bankruptcy. It is likely premature to proclaim that the bankruptcy of MF Global and the subsequent loss of customer assets demonstrate that the theoretical underpinnings of Dodd-​Frank are flawed, namely, the clearinghouse paradigm. For one, had MF Global engaged in transactions on a bilateral OTC basis with its customers, such that MF Global was the counterparty to its customers in an uncleared trade, its failure may still have resulted in problems for its counterparties—​in the Lehman bankruptcy, the margin of its counterparties in the OTC derivatives market was trapped in the bankruptcy estate, and it may take years to recover these funds.144 Also, although the bankruptcy of MF Global did not transpire in the context of a global financial panic and thus its failure cannot gauge whether systemic risk will be reduced by virtue of Dodd-​Frank, it is noteworthy that MF Global’s

140 For the rating agency S&P’s ratings of sovereign debt, see Sovereigns Rating List, Standard & Poor’s Ratings Services, available at http://​www.standardandpoors.com/​ratings/​sovereigns/​ratings-​list/​en/​us/​ ?sectorName=Governments&subSectorCode=39&start=0&range=50 (last visited Aug. 3, 2018). 141 Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions, 76 Fed. Reg. 78776 (Dec. 19, 2011). 142 Id. 143 Corzine, supra note 118. 144 Chandler & Costa, supra note 103.

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demise did not cause other failures or market panics, despite its having assets of $40 billion.145 The lack of market panic can be examined through the prism of the Act. By virtue of the relevant derivative contracts being cleared by a clearinghouse and traded on an exchange, regulators (including MF Global’s DSRO CME Group, as well as the CFTC) and market participants alike could assess the market repercussions stemming from the failure of MF Global.146 Also, CME Group and other clearinghouses held $2.7 billion in margin from MF Global’s trades, as a requirement for MF Global to utilize the CME’s clearing services to clear its customers’ trades.147 In an example of the mutualization benefits of clearinghouses, the CME Trust covered some of the losses faced by other members of CME Group, in the amount of $50 million; the trust was established to provide protection to customers if a member firm could not meet its obligations.148 CME also provided a guarantee of $550 million to ensure that MF Global’s bankruptcy trustee could disburse funds to MF Global’s customers sooner.149 More fundamentally, the Act focused to a significant extent on the relationship between the counterparty to the clearinghouse (e.g., the FCM) and the clearinghouse, whereas the shortfall in customer funds in the context of MF Global’s bankruptcy, in contrast, involved the relationship between the FCM and its customer. The perceived benefits of the Act as it relates to increasing transparency in derivatives markets and decreasing counterparty risk, through forcing many derivatives to be centrally cleared and subjecting those uncleared swaps to capital and margin requirements, are not invalidated by virtue of the MF Global imbroglio. The clearinghouse model still has the potential to eliminate counterparty risk between the counterparties (managing the counterparty risk it assumes through initial margin and variation margin, capital requirements, multilateral netting, and mutualization), which will in turn decrease systemic risk.150 The failure of MF Global and the subsequent loss of customer funds arose not from a misconception of the advisability of central clearing but from mismanagement of customer funds

145 Roger Lowenstein, Corzine Forgot Lessons of Long-​Term Capital, Bloomberg News (Nov. 1, 2011), available at http://​www.bloomberg.com/​news/​2011-​11-​02/​corzine-​forgot-​lessons-​of-​long-​term-​capital-​roger-​ lowenstein.html. 146 CME Group knew how many assets MF Global should have had in customer-​segregated assets, which assets were held by clearinghouses, and which were subject to MF Global’s sole control. Duffy, supra note 122. 147 Id. 148 Id. at 5. 149 Id. 150 As previously mentioned this is not a unanimous sentiment, because of the concentration of risk in the clearinghouse.

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by a single FCM. MF Global, although it does not command completely rethinking the wisdom of the Act, does demonstrate the necessity of more rigorous monitoring of the relationship between the FCM and its customers so that the principal aims of the Act can be achieved. If MF Global had simply complied with the Act’s mandate to separate customer-​ segregated accounts from the assets of the firm and not dispose of these assets to any entity other than the customer, MF Global’s bankruptcy would not have resulted in losses for its derivatives customers.151 President Obama’s exhortation to “put more cops on the beat”152 to monitor certain markets can be applied in the MF Global context: both the CFTC and the self-​regulatory organizations of FCMs should bolster enforcement efforts to ensure that FCMs segregate customer assets properly. The enumeration of permitted investments with customer accounts is only one facet. In MF Global, the unlawful commingling and disposition of these assets, it appears, was the direct cause of the shortfall, as opposed to the decision to invest customer assets in European debt securities. More frequent and rigorous auditing of FCM financial records could decrease the likelihood of improper segregation, supplemented by civil and criminal penalties for contravention. The CFTC’s recent rule forcing clearinghouses to collect margin on a “gross basis,” that is, FCMs can no longer offset one customer’s collateral against another customer’s collateral when supplying margin to the clearinghouse, may limit the capacity of FCMs to commingle customer assets and may increase the ability of the CFTC and DSROs to monitor FCM activities vis-​à-​vis its customers.153 The CFTC similarly now mandates that both FCMs and clearinghouses segregate customer collateral, so that, in the words of CFTC Chairman Gary Gensler, “customer money must be protected individually all the way to the clearinghouse.”154 These additional safeguards on customer funds may prevent FCMs from commingling customer assets and allowing them to exit the firm unlawfully. If legislators seek to reduce the risk-​taking capacity of FCMs, as opposed to directly policing customer funds, forcing FCMs and similar entities that support derivatives trades to maintain stricter capital requirements and lower leverage ratios could indirectly alleviate the flight of customer-​segregated

151 Dodd-​Frank Act § 724(a) (2010). 152 Barack Obama, Address by the President on Increasing Oversight on Manipulation in Oil Markets (Apr. 17, 2012), available at http://​www.whitehouse.gov/​the-​press-​office/​2012/​04/​17/​remarks-​president-​increasing​oversight-​manipulation-​oil-​markets. 153 Gary Gensler, Chairman, Commodity Futures Trading Comm’n, Address Before the American Bar Association, Committee on Derivatives and Futures Law ( Jan. 27, 2012). 154 Id.

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funds because such requirements would, in theory, result in fewer failures of these firms.155 The MF Global bankruptcy presents challenges for the Act, as confidence in certain derivatives markets has not fully recovered from its impact.156 Nonetheless, the MF Global fiasco does not repudiate the central clearing paradigm created by the Act. The transparency and systemic risk benefits of this paradigm may still be realized provided that regulators focus more extensively on the relationship between FCMs, such as MF Global and their customers. Recent CFTC promulgations limiting permitted investments in customer-​ segregated funds157 and requiring clearinghouses to collect margin on a gross basis158 demonstrate the commitment of regulators in this realm and are beneficial for precluding both customer shortfalls subsequent to an FCM failure and future financial crises.

155 Lowenstein, supra note 145. 156 Elizabeth Dexheimer, Will MF Global Haunt CME in 2012?, Medill Reports (Mar. 8, 2012), available at http://​news.medill.northwestern.edu/​chicago/​news.aspx?id=202901. 157 Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions, 76 Fed. Reg. 78776 (Dec. 19, 2011). 158 Gensler, supra note 153.

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13 Options

I. Characteristics of Options  232 II. How Options Work  233 A. Calls and Puts  234 1. Call Option  234 2. Put Option  235 B. Case Study: Levy v. Bessemer Trust 235 1. Facts  235 2. Theories of Liability in Levy 236 III. The Black-​Scholes Model and Option Pricing  238 A. Assumptions  238 B. Required Data  238 C. Volatility  239 1. Types of Volatility  239 2. Measures of Volatility  240 D. Authority of the Black-​Scholes Model  241 IV. Delta Hedging  242 A. Contracts That Are Economically Options  244 B. OTC versus Exchange-​Traded Options  245 C. Regulation of Options  246

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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Capital Markets, Derivatives, and the Law V. Option Strategies  247 A. Synthetic Call  248 B. Covered Call  248 C. Collar  248

I. Characteristics of Options Section 721 of the Wall Street Reform and Consumer Protection Act (the Dodd-​ Frank Act) added a new Section 1a(47) to the CEA (Commodity Exchange Act), defining “swap” to include not only “any agreement, contract, or transaction commonly known as,” among other things, “a commodity swap,” but also “[an] option of any kind that is for the purchase or sale, or based on the value, of 1 or more . . . commodities . . .”1 An option is a derivative because it derives its value from another underlying asset, instrument, or index. Options “transfer the right but not the obligation to buy or sell the underlying asset, instrument or index on or before the option’s exercise date at a specified price (the strike price).”2 A contract that gives a purchaser such a right is inherently an option even if it called something else. For example, if a consumer agrees to purchase a specified amount of home heating oil at a specified price in six months, that contract is a forward contract. If the contract allows the purchaser to buy oil after the six-​month period (at the same price) at the consumer’s discretion, that part of the contract is an option contract. A transaction’s name is not dispositive as to its economic reality. How a contract works economically is determinative of whether it is, indeed, an option or rather some other derivative. Options generally have six characteristics.3 Underlying security. “An option is directly linked to and its value is derived from a specific security, asset, or reference rate.”4 Strike price. It contains a strike price or an exercise price, which is the price for which an option contract permits its owner to buy or sell the underlying instrument. Expiration date. Options contain an expiration date; they are wasting assets in that they are only good for a pre-​specified period of time and cannot be exercised after the expiration date. 1 Commodity Futures Trading Commission 17 CFR Parts 3, 32 and 33 (Apr. 27, 2012). 2 Trading and Capital-​Markets Activities Manual § 4330.1 (Board of Governors of the Federal Reserve System) (First Printing, February 1998, Last update: July 2011). 3 Id. 4 Id.

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Long or short position. Every option has a long and short position; the buyer is said to have a long option position while the seller is said to have a short option position. American or European. An option purchaser may have the right to purchase the underlying asset at any time between the date the option is purchased and the date of the option expiration (American option) or the right to purchase the underlying asset only on a specified date (European option). Because of the greater flexibility in an American option, it typically will have a greater premium. The majority of listed options traded on American exchanges are American options. Premium. Every option has a premium, which is the price paid for the option. There are two major factors that determine an option’s premium, time value and intrinsic value. “The intrinsic value of an option is the difference between the actual value of [an underlying asset] and the exercise price of the option. Thus if ABC stock is trading at $50 per share and the exercise price of the call option is $40 per share, then the intrinsic value of the option is $10. The time value of an option ‘refers to whatever value the option has in addition to its intrinsic value’. The time value ‘reflects the expectation that, prior to expiration, the price of [the underlying asset] will increase by an amount that would enable an investor to sell or exercise the option at a profit.’ ”5 Options can trade over the counter or on an exchange. Regulatory jurisdiction will be defined by the underlying asset negotiated under the terms of the option, by the location where the options are traded, and by the counterparties to an option transaction. II. How Options Work Options are contracts that give the purchaser a right to buy or sell an underlying asset at a specified price at some time in the future. The important element of options is that the purchaser has the right, but not an obligation, to purchase or sell the underlying asset. This differs from other derivatives where both parties may be obligated to settle the transaction.

5 Custom Chrome, Inc. v. Comm’r, 217 F.3d 1117, 1125 (9th Cir. 2000).

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A. Calls and Puts

An option that confers the right to purchase an underlying asset at a specified price, at or by a specific date, is referred to as a call option, and an option to sell an underlying asset is referred to as a put option. A call option is said to be in the money if the price of the underlying asset exceeds the strike price. A put option is in the money when the price of the asset is less than the exercise price. Every option contract has an option writer, or person selling the option, and an option purchaser. It is important to distinguish between writing and purchasing an option because they have very different risks, profiles, and obligations. A call option gives the buyer (who pays a premium for this right) the right to purchase the underlying asset. The option contract will specify the strike price at which the asset can be purchased at or prior to the option’s maturity date. Buyers may choose not to exercise this right if the market conditions are not favorable. A put option gives the buyer the right to sell an underlying asset at a specific strike price at or prior to the option’s maturity date. An option gives the purchaser the right to buy or sell an asset at a specified price. The price at which the option purchaser may exercise the right is referred to as the strike price. In return for the right, the option purchaser will pay to the option writer a fee, which is referred to as a premium. 1. Call  Option The value of a call option is directly correlated to the value of the underlying asset. As the share price of the underlying asset increases, so does the intrinsic value component of the option contract. The relationship of the price of the underlying item to the price of the option is called the option’s “delta.” When a call option is very far “out of the money”—​that is to say, when the value of the underlying asset is far below the strike price of the option—​the relationship of asset price movement to option price movement may be de minimus. The potential profitability of a call option is unlimited because, in theory, the value of the underlying asset can increase infinitely. Although a call option has infinite potential gain, the maximum amount a purchaser of a call option can lose is the premium paid for the option. An option writer is obligated to deliver the underlying asset when the option purchaser exercises the option. Just as an option purchaser has unlimited potential gain, the option writer has exposure to unlimited loss. If the share price rises to $10,000 for example, the option writer who has committed to selling the item for $100 would still be required to deliver the shares. In return for writing the option, the option seller receives a premium, similar in concept to an insurance premium, in which the option seller is analogous to an insurance

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Right to buy 100 shares of ABC Co. at $50 Purchaser of call option

Writer of call option Option premium

Figure 13.1  Right to buy 100 shares of ABC Co. at $50.

underwriter. The price of the option premium is dependent on components of the Black-​Scholes model and on market value (Figure 13.1). 2. Put  Option A put option gives the option purchaser the right to sell an asset at a specified price at some point in time. With regard to a put option, the value of the option has an inverse relationship to the value of the underlying asset. The relationship of the value of the put option to the underlying asset is described as the “delta” of that option. Although the value of a call option can increase infinitely, the value of a put option is limited because the share price can only fall to zero. Put options obligate the option writer to buy the underlying asset at the agreed-​ upon price from the option purchaser. Unlike the call option, the put option has limited exposure because the underlying asset cannot go below zero in value. B. Case Study: Levy v. Bessemer Trust

Levy v. Bessemer Trust Company6 demonstrates the structure of simple options, option collar strategies, and the risks involved in adequately failing to utilize the options market. 1. Facts David Levy signed an investment management agreement and opened an investment management account with Bessemer Trust (BTC). Levy was enticed to enter into this arrangement because of BTC’s representations to him that they were experts in providing financial services and investment advice to high net worth individuals. Levy had received 257,000 shares of Corning stock that could not be sold for one year. At the time that Levy received the shares the Corning stock was at 31 3/​8 per share and was worth approximately $8 million. BTC agreed to monitor and manage 6 1997 U.S. Dist. LEXIS 11056 (S.D.N.Y. 1997).

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the shares and to notify him as to any action that should be taken with regard to the shares. Levy specifically informed BTC that he wanted to ensure that the shares were protected against possible downward movement in the price of the shares during the period during which he was prohibited from selling the shares. In response, BTC notified Levy that there was no possible way to obtain immediate protection against downward price movement in light of the restrictive nature of the shares. Levy was subsequently advised by a broker at Paine Webber (a U.S. stock brokerage firm later acquired by UBS) that there were various hedging strategies available to persons who held restrictive shares of a company that could afford downward price protection. Levy specifically learned that he could protect the shares by entering into a transaction known in the industry as a “European Options Collar.” In a European Options Collar transaction, Levy’s shares could be protected by simultaneously purchasing a European put option and selling a European call option that could only be exercised on a certain date after the end of the period during which Levy was prohibited from selling his shares. This would hedge his risk, because the purchase of the European put option would guarantee a floor price for the shares on the day of the exercise, and the sale of the European call option would set a ceiling on the price of the shares that would exceed the current market price. The call option would also produce income to cover the purchase price of the put option. Upon learning of this transaction, Levy called BTC and informed them of this transaction. BTC replied by saying that they had never heard of this transaction. Levy then closed his account with BTC and purchased the above-​mentioned European Option Collar through Merrill Lynch. At the time that Levy first directed BTC to protect his shares against downward price movement, Corning shares had risen in excess of $37 per share. At that time, Levy learned that he could have entered into a European Options Collar by purchasing a European put option at $33.33 and simultaneously selling a European call option at $44. This would have insured that the value of the shares would never have been less than $33.33 per share. At the time that Levy arranged a European Options Collar through Merrill Lynch, the price of Corning shares had declined to 27 3/​4 from its previous high of 37 3/​8. Levy was able to hedge his shares with a downside protection of $24.75 with a possible upside value of $31.90. With this arrangement, the maximum possible value of the shares was now less than the floor on their value would have been had BTC arranged this transaction when Levy had first inquired about it. 2. Theories of Liability in Levy Levy filed a lawsuit against BTC claiming negligence, gross negligence, breach of a fiduciary duty, negligent misrepresentation, breach of duty to supervise, breach of

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contract, and fraud. The court found that all of these claims had merit except the breach of contract claim. Negligence. The court found that there were sufficient allegations to establish proximate cause for the damages that Levy sustained in the form of a decreased maximum share value. The court also found that BTC’s unawareness regarding a strategy of which Merrill Lynch was aware and about which Levy repeatedly inquired may be sufficient to amount to recklessness. Negligent misrepresentation. Levy claimed that BTC’s misrepresentation regarding its expertise in asset management and investment advice, as well as its misrepresentation that no mechanism existed to protect the shares against downward price movement, induced him to keep his account with BTC. The court found merit in Levy’s claim that this misrepresentation caused him to forgo purchasing a European Collar Option at a time when the value of his Corning shares was higher than it was when he ultimately purchased the option, causing a loss in the value of the shares due to BTC’s misrepresentation. Breach of fiduciary duty. The court found (1) that BTC did have a fiduciary duty to Levy; (2) that despite repeated inquiries, BTC gave Levy erroneous investment information in breach of that fiduciary duty; (3) that BTC made misrepresentations to induce Levy to maintain his account with BTC and forgo other investment advisors; and (4) that if BTC had given Levy the correct information when he first inquired about downside protection of his Corning shares, he would have taken appropriate action that would have increased the value of his shares. Breach of duty to supervise. The court found that Levy had sufficiently alleged that BTC failed to supervise the account and maintain a proper system of supervision and control to prevent the account representative from giving erroneous advice. This erroneous advice caused Levy to (1) forgo investment options that he expressly desired at a time when such an option would have increased the value of his shares, and (2) belatedly take advantage of the European Option Collar, which resulted in a decrease in the value of the shares. Breach of contract. The court found that Levy failed to properly allege this claim because he failed to specify whether the representations that BTC made were part of a contract, what the terms of the agreement were, and which provisions were breached. Fraud. The court found that the fraud claim had merit in that Levy had alleged that BTC knowingly made false statements about its services and expertise to induce Levy to retain BTC, and that Levy relied upon these misrepresentations in retaining BTC.

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III. The Black-​Scholes Model and Option Pricing The Black-​Scholes model was developed in 1973 by Fisher Black, Robert Merton, and Myron Scholes as a relatively simple method for traders, portfolio managers, and arbitrageurs to determine the theoretical value of an option.7 Prior to the Black-​ Scholes model, there was no standard method for pricing options. The development of this model paved the way for the growth of the derivative market. The fact that the Black-​Scholes model can quantify risk makes it an invaluable resource in determining the value of an option for those wishing to use an option for either hedging or speculative purposes. A. Assumptions

The significance of the Black-​Scholes model is that it can take information regarding an option, use it to calculate the volatility of an option, and, based upon the results of this calculation, determine what the option is worth. In this model the following assumptions are made: “(1) that the variance of return on the common stock is constant over the life of the option contract and known by market participants; (2) that the short term interest rate is known and constant throughout the life of the contract and that this rate is the borrowing and lending rate for market participants; (3) that the option holder is completely protected against distributions that affect the price of the common stock; and (4) that over a finite time interval, the returns on a common stock are normally distributed. Given these assumptions, the value of an option contract is only a function of the common stock price and time.”8 With these assumptions, “a model was established for determining the equilibrium value of an option.”9 B. Required  Data

The mathematical formula developed by Black, Merton, and Scholes is fairly simple in that it requires five pieces of information: (1) The strike price; (2) the amount of time remaining to expiration of the option;

7 Fischer Black & Myron Scholes. The Pricing of Options and Corporate Liabilities, 81 J. Pol. Econ. 637 (1973). 8 Fischer Black & Myron Scholes, The Valuation of Option Contracts and a Test of Market Efficiency, 27 J. Fin. 399, 400 (May 1972). 9 Id. at 416.

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(3) the current price of the underlying asset; (4) the risk-​free interest rate; and (5) the volatility. Items 1 through 4 are easily observed and can be obtained from a wide variety of market vendors. Item 5, the option volatility, requires an estimation of the future volatility of the underlying asset. Of course, the future volatility of an underlying asset can never be known for certain. This is one of the limitations of the Black-​ Scholes’ equation: it assumes that future volatility is known. C. Volatility 1. Types of Volatility

When referring to options, there are four types of volatility that are most commonly discussed: future volatility (discussed in Sec. III.B), historical volatility, forecast volatility, and implied volatility.10 Historical volatility measures how the price of the underlying asset has moved in the past. For example, ABC Co. stock is trading at $100. A look at the historical pricing over the past year reveals that the stock price has traded as low as $80 and as high as $120. This indicates that the historical volatility of ABC Co. is 20 percent. The forecast volatility is what is perceived to be the volatility, in the future, based on the historical volatility and other market factors. Finally, there is the implied volatility. This is the volatility that is being perceived in the market, which is reflected in the selling price of the option. The impact of volatility on the value of an option as quantified by the Black-​ Scholes model will depend in part upon the intrinsic value of the option. The intrinsic value of an option will depend upon the value of the option versus the current value of its underlying asset. For example, a $50 call option will have an intrinsic value of $10 when the underlying stock is trading at $60. It stands to reason that the greater the intrinsic value, the lower the effects on the Black-​Scholes model; as intrinsic value increases and other factors such as the closeness in time to the option’s expiration date are taken into account, the likelihood decreases that the option will fall out of the money barring significant volatility. This brings the discussion full circle by demonstrating the need for a determination of volatility, as well as why the Black-​Scholes model is a groundbreaking formula for ascertaining the value of an option.

See Sheldon Natenberg, Option Volatility & Pricing, 68–​73 (1994). 10

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The element of volatility captured by the Black-​Scholes model, when factored into the value of an option, makes the valuation more reliable. This has resulted in significant growth in the use of options since the introduction of the model. Other option models have arisen since the Black-​Scholes model came on the scene in 1973, but it remains the foundation for the other models that have followed. The Black-​ Scholes model has been one of the major reasons for the proliferation of option and derivatives trading during the last 30 years. 2. Measures of Volatility “Given the complexity of the market risk arising from options and the different models of option valuation, a set of terms has evolved in the market and in academic literature that now serves as common language for discussing options risk.”11 Delta measures the rate of change in the option price relative to the change in the price of the underlying asset,12 and is an output of the Black-​Scholes model described earlier. Delta is measured between 0 and 1.00; however, when referring to delta, the market expresses delta without a decimal point (e.g., delta of 50). If an option has a delta of zero, it means that a movement in the price of the underlying asset will have very little impact on the price of the option. An option with a delta of 100 will move up or down in concert with the movement in the price of the underlying asset. For each one-​point move in the underlying asset, the option price will also move one dollar in the same direction. Gamma measures the sensitivity of the delta to movements in the asset price.13 If an option has a gamma of five, that means that for each one-​point movement in the underlying asset, the delta will move five points.14 Gamma is an important tool for managing risk. A large gamma position means that the trader is exposed to a high degree of risk, because the trader’s directional risk can rapidly shift. A low gamma position means that the trader will be less exposed to risk, because the delta will be less sensitive to changes in the market. Understanding the gamma will also help determine the rate at which a trader would need to adjust her position in order to maintain a delta-​neutral position.

11 Trading and Capital-​Markets Activities Manual, supra note 2, § 4330.1. 12 Id. 13 Id. 14 Natenberg, supra note 10, at 105.

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Theta measures the option’s value relative to change in the time left until expiration.15 As time to expiration declines, so does the option value. Options have what is referred to as intrinsic value and time value.16 Intrinsic value = Share price − Exercise Pr ice Time value = Call option price − Intrinsic value



As the option gets closer to expiration, the time value of the option will decrease. Vega measures the sensitivity of the option value to changes in the market’s expectations for the volatility of the underlying instrument (the implied volatility).17 As discussed earlier, the value of an option increases as the volatility increases. Rho measures the sensitivity of the option price relative to changes in the short-​ term interest rate.18 An estimation of the delta of an instrument can be used to determine the appropriate hedge ratio for an unhedged position in that instrument. The existence of gamma risk means that the use of delta hedging19 techniques is less effective against large changes in the price of the underlying instrument. “While a delta-​hedged short position is protected against small changes in the price of the underlying asset, large price changes in either direction will produce losses (though of a smaller magnitude than would have occurred had the price moved against a naked written option).”20 D. Authority of the Black-​S choles Model

Courts consider the Black-​Scholes model to be an authoritative measure of proof of the value of options, and have allowed it as evidence in various cases as a model accepted by modern finance theory for the valuation of options. In Mathias v. Jacobs,21 the court accepted the Black-​Scholes model as evidence of the value of the options at issue, reiterating that this model is accepted by modern finance as a method for valuing options and describing the essential components of the model: “(1) the price on the date of the valuation; (2) the exercise price at which the option

15 Trading and Capital-​Markets Activities Manual, supra note 2, § 4330.1. 16 See generally Guy Cohen, Options Made Easy, 164–​67 (2005). 17 Trading and Capital-​Markets Activities Manual, supra note 2, § 4330.1. 18 Id. 19 See infra Sec. IV. 20 Trading and Capital-​Markets Activities Manual, supra note 2, § 4330.1. 21 238 F. Supp. 2d 556 (S.D.N.Y. 2004).

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holder can purchase the stock; (3) the amount of time over which the option will be valid and outstanding; (4) the volatility of the underlying stock; and (5) the risk-​free rate of interest rates at the time the option is being valued.”22 In Seinfeld v. Bartz,23 the court also accepted the Black-​Scholes model as evidence of the value of the options at issue, calling the Black-​Scholes model “reliable” for this purpose and describing this model as one that, in order to determine the value an option, “relies on values such as the volatility of the underlying stock, the risk free rate of interest, the expiration date of the option, the dividends on the underlying stock, the exercise price of the option and the market price of the underlying stock.”24 As demonstrated by these two examples, the courts consider the Black-​Scholes model to be an essential piece of evidence in helping the court determine the value of options. IV. Delta Hedging Delta hedging refers to the process of minimizing market exposure of a position or a portfolio. A delta-​neutral hedge refers to having a position that has an unbiased view or that is not exposed to fluctuations in the market in the short term. If someone has positive delta, that means he or she is taking the position that the market will increase. If someone has negative delta, it means he or she is taking the position that the market will decrease. The case of Caiola v. Citibank25 demonstrates how delta hedging is used to manage risk. Louis Caiola regularly traded millions of shares and options on Philip Morris. Because of the size of his transactions, Citibank recommended that Caiola expose himself to Phillip Morris risk using over-​the-​counter and synthetic transactions to recreate the positions he would hold if he acquired the positions on the exchange. In this way, the process of acquiring a position would not affect the exchange prices of the stocks and options. A synthetic transaction is typically a contractual agreement between two counterparties, usually an investor and a bank, that seeks to economically replicate the ownership and physical trading of shares and options. The counterparties establish synthetic positions in shares or options, the values of which are pegged to the

Id. at 574 n.12. 23 322 F.3d 693 (9th Cir. 2003). 24 Id. at 696. 25 295 F. 3d 312 (2d Cir. 2002). 22

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market prices of the related physical shares or options. The aggregate market values of the shares or options that underlie the synthetic trades are referred to as “notional” values and are treated as interest-​bearing loans to the investor. As Citibank explained to Caiola, synthetic trading offers significant advantages to investors who heavily concentrated on large positions of a single stock by reducing the risks associated with large-​volume trading. Synthetic trading alleviates the necessity of posting large amounts of margin capital and ensures that positions can be established and unwound quickly. Synthetic trading also offers a solution to the “footprint” problem by permitting the purchase of large volumes of options in stocks without affecting their price.26 Caiola agreed to engage in synthetic trading; it was understood that Citibank would hedge its market risk in being the counterparty to his transactions by engaging in delta hedging. Delta hedging required Citibank to calculate its net exposure to Phillip Morris shares based on its contra position to Caiola, and then purchase or sell a position on an exchange that would neutralize that risk. For example, if Citibank sold an over-​the-​counter call option on 100 shares of Phillip Morris stock to Caiola and that option had a delta of 10 (i.e., for every dollar move in the stock the option would fluctuate in value by 10 cents) Citibank would buy 10 shares of Citibank stock on the exchange in order to hedge its position. Although the transaction in the option would not be recorded on the exchange, the smaller hedge would be. As the delta of the option changed, Citibank would sell shares of Phillip Morris or add to its position. Because the delta of a position is constantly changing, a delta hedge is also referred to as a “dynamic hedge.” At some point, however, contrary to its representations and unbeknownst to Caiola, Citibank secretly stopped delta hedging and transformed Caiola’s synthetic portfolio into a physical one by executing massive trades in the physical markets, which mirrored Caiola’s synthetic transactions. These transactions, Caiola alleged, exposed him to the risks that synthetic trading was intended to avoid. Caiola brought federal securities fraud and state law claims against Citibank arising from extensive physical and synthetic investments. The District Court dismissed Caiola’s complaint, but the Second Circuit reversed, holding that Caiola sufficiently alleged both purchases and sales of securities and material misrepresentations for purposes of Rule 10b-​5.

Id. at 315–​16. 26

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A. Contracts That Are Economically Options

A transaction or series of interconnected transactions may economically be options even if not described as such. The economic reality of a transaction, not its name, determines whether a transaction is an option. The transaction at the heart of Korea Life Insurance Co. v. Morgan Guaranty Trust27 is illustrative of this point. In Korea Life, a number of contracts were entered into which in aggregate comprised the economics of an option, in particular, a put option on the Thai baht currency. This case involved contracts in foreign currencies with no specific reference to options. Morgan Guaranty, a commercial bank, set up a special purpose entity, Frome Company Limited, which then issued one-​year notes to European investors, raising $25 million. These notes were guaranteed by Morgan, which promised the investors repayment with interest at the London Interbank Offered Rate (LIBOR). Frome then gave this $25 million to Morning Glory, a limited liability investment company created by Korea Life as its special purpose entity specifically to engage in the transactions at issue, in exchange for 2.5 million of Morning Glory’s common shares. Morning Glory then purchased a one-​year certificate of deposit issued by Korea Exchange Bank (KEB), maturing in one year and paying interest at 6.05 percent, and paid a fee of $70,000 to KEB. One year later, at maturity, Morning Glory was entitled to receive $26,512,500 in principal and interest on the certificate of deposit issued by KEB and obligated to redeem its shares that it had issued to Frome by paying Morgan Guaranty either (1) $24,187,500, which is 96.75 percent of the $25 million Frome had contributed; or (2) depending upon the conditions relating to the rise and fall of the Thai baht in relation to the Japanese yen, they agreed to discount the $25 million, plus or minus the product of two interrelated formulas quantifying those currency relationships. If the yen and the baht both depreciated, Morning Glory would be obligated to pay a “Baht Payment Amount” to KEB, and KEB would be obligated to pay the same amount to Morgan. At the same time, Morgan would be obligated to pay KEB and KEB to pay Morning Glory a “Yen Payment Amount” serving as a hedge to Morning Glory’s risks. Thus, if the baht and the yen both depreciated at the historical rate of 5:1, Morning Glory would owe money to KEB and KEB to Morgan, but any amount owed would be cancelled out by the amount Morgan owed to KEB and KEB to Morning Glory. If the yen were to appreciate, no payment obligation would be due from either party to the other, but if the baht were to appreciate, Morgan would have to pay KEB, and KEB in turn would have to pay Morning Glory an amount proportional to the baht’s appreciation. There would be no hedge if the baht

269 F. Supp. 2d 424 (S.D.N.Y. 2003). 27

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depreciated and the yen remained stable against the dollar or appreciated. Despite this, Morning Glory’s obligation to pay KEB and KEB’s obligation to pay Morgan was absolute. In order to guard against the contingency that the yen remained stable or appreciated while the baht depreciated, the Morning Glory/​KEB Agreement gave Morning Glory the right to demand that its position be unwound upon two days written notice. The transaction and agreements involving the Thai baht are the economic equivalent of Morgan Stanley buying a put option from Korea Life. The economic reality of this transaction is hidden in a convoluted series of transactions. The transaction was set up so that Korea Life sold to Morgan a put option through special purpose entities. Morning Glory/​Korea Life would receive a $1.4 million premium (the difference between the amounts that Morning Glory would receive at maturity, $26,512,500, minus the $24,187,500 that they would have to pay to Morgan if the ratio of the baht to the yen stayed within the historical 5 to 1 ratio). In return they would accept the risk that if the baht did not stay within its historical ratio norms with the yen they could end up paying, based upon the formulas listed above, up to five times the change in the ratio from the historical norm, which in this case could be up to $125 million. These transactions reflect the elements of a put option/​currency swap. Korea Life accepted a premium and assumed the downside risk of the change in price of an underlying asset based upon an agreed-​to formula, which in this case was the Thai baht in relation to its historical ratio to the Japanese yen. Although the transactions described in the case are not described as options, they economically function as such. Korea Life had unlimited exposure when the Thai baht went down in value relative to the yen, and collected a fee for entering into the transaction by collecting interest on $25,000,000 using Frome’s capital. As the unlimited upside exposure inured to Morgan’s benefit, the transactions are structurally similar to Morgan buying a put option from Korea Life through various special purpose entities. B. OTC versus Exchange-​T raded Options

Options can be traded over-​the-​counter (OTC) or on organized exchanges. An OTC option is a bilateral option contract that is entered into by two parties away from an exchange. The terms such as strike, settlement date, and quantity of underlier are subject to negotiation by the counterparties. In an OTC option, the counterparties deal directly with each other, and the option writer has an obligation to deliver the underlying asset directly to the option’s purchaser. In addition to option risk, counterparties to an

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OTC option are taking on counterparty credit risk, which refers to the ability of the counterparty to meet its obligations under the option contract. With an exchange traded option, terms such as the strike price and the expiration date are specified by the exchange on which the option is trading. Option exchanges provide liquidity to the marketplace by creating a location where buyers and sellers can come to purchase standardized products that do not require negotiating terms. C. Regulation of Options

Options that are traded on an organized exchange are regulated by the Commodity Futures Trading Commission (CFTC)28 and the Securities and Exchange Commission (SEC).29Although both of these federal agencies had rights to a claim of jurisdiction over the regulation of options, disputes over these claims between these agencies increased as the number of options and the volume of trades involving options increased. This tension resulted in a number of resolutions to help clearly define the role of each agency in the regulation of options.30 This generally led to the CFTC regulation of options on futures not involving securities, while the regulation of options that involved securities was left to the SEC. The Commodity Futures Modernization Act of 2000 (CFMA) drew new jurisdictional lines, redefined certain terms, and altered the levels of regulation of futures options. This has resulted in a three-​tiered layer of regulation. In addition, recent court cases have affirmed the CFTC’s jurisdiction over options involving foreign currencies,31 off-​exchange foreign currency transactions,32 and transactions involving contracts of sale of a commodity for future delivery.33 The Commodity Exchange Act specifically grants to the CFTC the authority to regulate commodity options: No person shall offer to enter into, enter into or confirm the execution of, any transaction involving any commodity regulated under this chapter which is of the character of, or is commonly known to the trade as, an “option,” “privilege,” “indemnity,” “bid,” “offer,” “put,” “call,” “advance guaranty,” or “decline guaranty,” contrary to any rule, regulation, or order of the Commission prohibiting

See ­chapter 17, infra. 29 See ­chapter 15, infra. 30 See ­chapter 14, infra. 31 CFTC v. Premium Income Corp., 2007 U.S. Dist. LEXIS 11430. 32 CFTC v. Madison FOREX Int’l, LLC, 2006 U.S. Dist. LEXIS 96294. 33 CFTC v. Matthew Reed, 481 F. Supp. 2d 1190 (2007). 28

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any such transaction or allowing any such transaction under such terms and conditions as the Commission shall prescribe. Any such order, rule, or regulation may be made only after notice and opportunity for hearing and the Commission may set different terms and conditions for different markets.34 Through this provision, Congress has given the Commission jurisdiction over all commodity option transactions.35 In its final rules with regards to options after Dodd-​Frank, the CFTC reaffirms its role as commodity option regulator and describes the impact of the commodity option provisions of Dodd-​Frank: . . . [u]‌‌nder this final rule, commodity options will be permitted to transact subject to the same rules applicable to any other swap. This general authorization is necessary because the Commission’s plenary rulemaking authority over commodity options provides that: “[n]o person shall offer to enter into, enter into or confirm the execution of, any transaction involving any commodity regulated under this chapter which is [a commodity option transaction], contrary to any rule, regulation, or order of the Commission prohibiting any such transaction or allowing any such transaction under such terms and conditions as the Commission shall prescribe.” By adopting this final rule, the Commission provides the required general authorization for commodity options that are subject to the swap definition, and removes any uncertainty as to whether CEA section 4c(b) would otherwise prohibit such commodity options.36 The Dodd-​Frank Act expressly excludes equity options from the definition of “swap” and “security-​based swap.”37 V. Option Strategies Options can be employed with stocks and other options to create various option strategies.

See CEA § 4c(b). 35 Commodity Futures Trading Commission 17 CFR Parts 3, 32, and 33 (Apr. 27, 2012). 36 Id. 37 See 7 U.S.C. §§ 1a(47)(B)(i) and 1a(47)(B)(iii). 34

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A. Synthetic  Call

A synthetic call is created when a trader buys an underlying stock and buys a put as well. The risk profile of a synthetic call is very similar to that of a straight call. The trader is long in the stock and at the same time, through purchase of a put, has hedged the position against a drop in the share price. B. Covered  Call

A covered-​call strategy is one where the trader buys the underlying stock and sells a call. The writer of an option (i.e., the seller of a call) has not a choice but rather an obligation to deliver the shares at the agreed-​upon price. C. Collar

A collar is an option strategy where a trader who owns the stock or an underlying asset buys a put and sells a call. In this strategy the profit range has been locked in. If the price goes above the strike price of the call, the option will be exercised. If the share price goes below the strike price of the put, the put will be exercised. As the put has been purchased, the loss is limited to the amount paid for the put less the premium received for the call. There are many option strategies that can be combined in sophisticated and complex ways to create other derivative instruments. As demonstrated in the Korea Life case, the first step in understanding a particular transaction is to identify who bears the risk and what are the limitations on that risk. Within that analysis will be a determination of the economic realities and consequence of the agreement at hand. Whether structured within swap agreements or as part of debt securities, the basic components of the option can be analyzed and priced applying models such as the Black-​Scholes formula.

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14 Regulation of Swaps

I. The Dodd-​Frank Regulatory Regime  250 A. Dodd-​Frank and Derivatives Trading  250 B. Jurisdiction and Registration  252 C. Clearing Requirements, Exchange Requirements, and the End-​User Exemption  254 D. Capital and Margin Requirements  259 E. Reporting Requirements  260 1. Commodity Position Limits  261 F. Futures Commission Merchants, Dodd-​Frank, and Regulation 1.25  262 1. Title VII Enforcement  263 2. Updated Enforcement Advisory on Self-​Reporting and Full Cooperation 263 3. Enforcement Actions for Data Reporting Violations  265 4. Action for Failure to Submit Accurate Large-​Trader Commodity Swap Reports  266 5. Increase of CFTC’s Enforcement Actions following the Change of CFTC Chairman  267 6. R  eduction of Counterparty and Systemic Risk  267 a. Counterparty Risk  268

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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b. Systemic Risk  270 G. R  ationale behind Exemptions and Exclusions  271 1. The End-​User Exemption  271 2. Physical Settlement Exclusion  273 3. Customization Exceptions  273 H. The Lincoln Rule  274 1. Futures Commission Merchants  275 I. Criticisms of Dodd-​Frank’s Derivatives Trading Provisions  276 1. Concentration of Systemic Risk in Clearinghouse and “Too Big to Fail”  276 2. Exceptions Swallowing the Rule: Incentivizing of Customization and De Minimis Exceptions  277 3. Lack of Global Harmonization  278 4. The Impact of the Change of U.S. Administration  279 5. The Change of CFTC Chairman  279 a. CFTC’s New Priorities  280 b. Improving SEF rules  280 c. Fixing Data Reporting  280 d. Achieving Cross-​Border Harmonization  281 e. Project KISS  281 6. Recent Actions of the CFTC and Announcements of Further Actions to Come  282 a. Amendment of Swap Trading Rules  282 b. Review of Swap Dealers De Minimis Threshold  283 c. Review of Position Limits  283 d. Improvement of Clearinghouse Stress Testing  283 7. Propositions of Reforms from the U.S. Treasury Report on Capital Markets  284

I. The Dodd-​Frank Regulatory Regime A. Dodd-​F rank and Derivatives Trading Ben S. Bernanke, the former Chairman of the Federal Reserve, classified derivatives as a “vulnerability” of the financial system that led to the financial crisis. He explained that derivatives concentrated risk within particular financial institutions and markets without sufficient regulatory oversight.1 The Wall Street Reform and 1 Ben Bernanke, Chairman, Fed. Reserve, The Federal Reserve’s Response to the Financial Crisis, Address at George Washington University School of Business (Mar. 27, 2012).

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Consumer Protection Act—​Dodd-​Frank —​constituted a seismic shift in the regulation of financial institutions and markets in a massive effort to address regulatory shortcomings in derivatives markets. As articulated by Senator Chris Dodd (one of the law’s namesakes) in a Senate report on the law’s passing: [O]‌‌ver-​the-​counter derivatives will be regulated by the SEC and the CFTC, more transactions will be required to clear through central clearing houses and traded on exchanges, un-​cleared swaps will be subject to margin requirements, swap dealers and major swap participants will be subject to capital requirements and all trades will be reported so that regulators can monitor risks in this vast, complex market.2 Through Dodd-​Frank, Congress sought to increase transparency and efficiency in the derivatives markets, enhance regulatory oversight of derivatives and derivatives users, and reduce counterparty risk and systemic risk.3 At the time, Congress and the Obama administration averred that poor counterparty risk management by financial institutions led to enormous losses when derivative instruments depreciated in value: losses for which institutions had not allotted sufficient capital.4 As regulators had inadequate authority vis-​à-​vis OTC derivatives, they could not “identify or mitigate the enormous systemic threat that had developed.”5 Thus, through Dodd-​ Frank, legislators attempted to address these concerns. Dodd-​Frank also imposes an exchange requirement whereby swaps that are required to be cleared must also be executed on a “board of trade designated as a contract market” or on a “swap execution facility,” unless no board of trade or swap execution facility will accept that particular swap, in which case the swap does not need to be traded on an exchange;6 security-​based swaps subject to the clearing requirement must be executed on an exchange or on a “security-​based swap execution facility.”7 Dodd-​Frank defines a swap execution facility as a trading system “in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants.”8 Swaps and security-​based swaps thus, unless they are sufficiently illiquid or nonstandardized that no exchange will accept them, 2 S. Rep. No. 111-​176, at 32. 3 Id. 4 Id. 5 Id. 6 Id. 7 Id.§ 763(a). 8 Id. § 721(a)(21) For the definition of security-​based swap execution facility, see § 761(a)(6).

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must be executed on an exchange.9 These nonstandardized swaps are still subject to the clearing requirements of the Act, as well as to capital and margin requirements.10 B. Jurisdiction and Registration

Dodd-​ Frank repealed the exemptions from CEA requirements that OTC derivatives had under the Commodity Futures Modernization Act.11 It establishes jurisdiction over derivatives by bestowing regulatory authority over “swaps” to the CFTC and giving the Securities and Exchange Commission (SEC) authority over “security-​based swaps”;12 both commissions will have authority over “mixed swaps,”13 which are swaps with both commodities and securities features.14 In Dodd-​Frank, amending the CEA, a swap is broadly defined in the first instance and includes a list of “commonly known” swaps such as credit-​default swaps, currency swaps, and total-​return swaps that are explicitly subject to its provisions.15 There is an exclusion in Dodd-​Frank, however, for “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled.”16 It is clear that the exclusion applies only to the sale of physical commodities contracts, such as oil and grains, which expect to be settled with the underlying commodity; all other swaps are subject to CFTC oversight.17 A “security-​based swap,” as defined in the Securities Exchange Act of 1934, encompasses swaps that are based on an index, a single security, or loan, or the occurrence or non-​occurrence of an event of an issuer or group of issuers if that event affects the finances of the issuer.18 As both the swap and security-​based swap definitions are extensive, many derivative instruments that were previously unregulated by the SEC Greenberger, Michael, Derivatives in the Crisis and Financial Reform, in The Political Economy of Financial Crises, available at http://​www.michaelgreenberger.com/​files/​Professor_​Greenberger_​ Oxford_​New_​Intro.pdf (last visited Dec. 8, 2018). 10 Id. 11 Seema Sharma, Over-​the-​Counter Derivatives: A New Era of Financial Regulation, 17 L. & Bus. Rev. Am. 279, 294 (2011). 12 Dodd-​Frank, Wall Street Reform and Consumer Protection Act Public Law 111-​203, July 21, 2010 § 712. [hereinafter Dodd-​Frank Act]. 13 Sharma, supra note 11, at 282. 14 Willa Gibson, Clearing and Trade Execution Requirements for OTC Derivatives Swaps Under the Dodd-​Frank Wall Street Reform and Consumer Protection Act, 38 Rutgers L. Rec. 6 (2011). 15 Dodd-​Frank Act § 721(a)(21). A currency swap is an exchange of periodic payments whereby counterparties pay one another in different currencies Norman Feder, Deconstructing Over-​the-​Counter Derivatives, 2002 Colum. Bus. L. Rev. 705 (2002). 16 A total return swap is a swap in which the seller of the swap agrees to pay the total return of a reference asset to the buyer; total return refers to “interest plus fees and appreciation in market value at maturity.” Id at 711. 17 Greenberger, supra note 9, at 17. 18 Securities Exchange Act of 1934, Pub. L. No 73-​291, 48 Stat. 881 § 3(a) (1934) (hereinafter Exchange Act). 9

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and the CFTC by virtue of the CFMA, as well as derivative instruments not yet in existence, will be subject to regulatory oversight.19 In addition to regulating the derivatives products themselves, Dodd-​Frank forces certain entities to register with the CFTC or the SEC. First, “swap dealers” and “security-​based swap dealers” must register with the CFTC and SEC respectively by filing an application with the respective commission.20 A swap dealer is any person who (1) “holds itself out as a dealer in swaps,” (2) is a market-​maker, (3) enters into swaps for its own account with counterparties “regularly,” or (4) is known as a dealer or market maker.21 Dodd-​Frank includes a de minimis exception to the swap dealer determination, to be promulgated by the CFTC.22 A security-​based swap dealer is similarly defined but encompasses those entities that deal in security-​based swaps;23 this also has a de minimis exception.24 Along with registration, these persons are subject to margin, capital, and business conduct requirements, as mandated by Dodd-​Frank.25 It also requires “major swap participants” and “major security-​ based swap participants” to register with the CFTC and SEC respectively. These definitions are distinct from the aforementioned dealer definitions because “participants” concentrates on the potential for affecting market risk, whereas “dealers” refers to the activities of the entity.26 A major swap participant is a person, excluding a swap dealer, who (1) has a “substantial position” in swaps (with substantial position to be defined by the CFTC), excluding those entities holding positions for hedging commercial risk; (2) has outstanding swaps that “create substantial counterparty exposure” with potentially systemic concerns for the financial system; or (3) is a “highly leveraged” institution not subject to capital requirements and has a substantial position in swaps.27 A major security-​based swap participant is similarly defined, except it encompasses those entities that deal in security-​based swaps as opposed to swaps.28

19 Paul McBride, The Dodd-​Frank Act and OTC Derivatives: The Impact of Mandatory Central Clearing on the Global OTC Derivatives Market, 44 Int’l Law 1102 (2010). 20 Dodd-​Frank Act § 731, § 764(a). 21 Id. § 721(a)(21). 22 Id. The CFTC and SEC defined this de minimis quantity as $3 billion in aggregate gross notional amount over a 12-​month period. Commodity Futures Trading Commission, Proposed Rules Further Defining “Swap Dealer,” “Major Swap Participant” and “Eligible Contract Participant” (Apr 18, 2012) (not yet in Federal Register). 23 Exchange Act § 3(a). 24 Id. The CFTC and SEC defined this de minimis quantity as $3 billion in aggregate gross notional amount over a 12-​month period. Commodity Futures Trading Commission, supra note 22. 25 Further Definition of “Swap,” “Security-​Based Swap,” and “Security-​Based Swap Agreement”; Mixed Swaps; Security-​Based Swap Agreement Recordkeeping, 76 Fed. Reg. 29818 (proposed May 23, 2011). 26 Id. 27 Dodd-​Frank Act § 721(a)(16). 28 Exchange Act 3(a).

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Finally, Dodd-​Frank requires derivatives clearing organizations (DCOs), that is, those entities that will clear swaps trades, to register with the CFTC29 and requires clearing agencies, entities that will clear security-​based swaps trades, to register with the SEC.30 C. Clearing Requirements, Exchange Requirements, and the End-​U ser Exemption

Dodd-​ Frank subjects derivatives to a bifurcated regulatory system, in which standardized derivative contracts with sufficient liquidity must be cleared by a clearinghouse and traded on an exchange, whereas customized derivative contracts are exempt from the clearing and exchange mandates but are nonetheless subject to capital and margin requirements.31 The clearing requirement is located in section 723(a) (3) of Dodd-​Frank, which reads in relevant part that “[i]‌‌t shall be unlawful for any person to engage in a swap unless that person submits such swap for clearing to a derivatives clearing organization . . . if the swap is required to be cleared;”32 Section 763(a) contains a similar provision for security-​based swaps, with these instruments to be cleared by a “clearing agency,”33 defined in the Exchange Act as an intermediary “in making payments or deliveries or both in connection with transactions in securities.”34 For determining whether a particular swap or security-​based swap is subject to clearing requirements, the relevant commission considers five factors: (1) outstanding notional exposures, liquidity, and pricing data; (2) availability of framework, capacity, expertise, and infrastructure to clear the trade; (3) the effect on mitigating systemic risk; (4) the effect on competition; and (5) reasonable legal certainty in the event of insolvency.35 The DCO and the clearing agency are required to submit to the CFTC and SEC respectively any class of swap it wishes to clear.36 DCOs must also, pursuant to Section 723(a)(3), ensure that equivalent swaps are treated equally within the DCO and “provide for non-​discriminatory clearing” of swaps for nonmembers.37 To further facilitate national authorities in determining the type of over-​the-​counter derivative products to subject to a mandatory clearing obligation, in 2012, the Technical Committee of the International Organization of Securities Commissions (IOSCO) Dodd-​Frank Act § 725(a). 30 Id § 763(b). 31 Gibson, supra note 14, at 4. 32 Dodd-​Frank Act § 723(a)(3). 33 Dodd-​Frank Act § 763(a). 34 Exchange Act § 3. 35 Dodd-​Frank Act § 723(a)(3), § 763(a). 36 Sharma, supra note 11, at 300–​01 (2011). 37 Dodd-​Frank Act § 723(a)(2). 29

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issued a report in which two “complementary” approaches were endorsed, the “bottom-​ up” and the “top-​down” approaches.38 As reported in the IOSCO document: [t]‌he bottom up approach refers to a process through which products that a CCP clears or proposes to clear are made subject to a mandatory clearing requirement by the relevant authority. The top down approach is the process by which the relevant authority has the power to identify OTC derivatives contracts where mandatory clearing is desirable, irrespective of whether a CCP has yet proposed to clear them or not.39 Both approaches are based on a set of assumptions that are expected to help national authorities in identifying the derivative contracts to subject to mandatory clearing obligations. The bottom-​up approach is based on the simple consideration that if an over-​the-​counter derivative product is already cleared by a clearinghouse then it means that it is sufficiently standardized, thus the clearing status should be maintained. In addition, the bottom-​up approach relies on the economic incentive that clearinghouses have to look for new over-​the-​counter derivative contracts to clear.40 Finally, the top-​down approach allows the national authority to identify new products to subject to the clearing requirement without having to depend exclusively on the economic incentives of the clearinghouses. The two approaches are complementary and envisioned to enable “authorities to respond to developments in the OTC derivatives markets and to adapt mandatory clearing obligations accordingly.”41 One threshold issue for the application of the above provisions concerns the distinction between non-​security-​based swap (or simply swaps) and security-​based swap. Section 3(a)(68)42 defines the term security-​based swap as a swap43 that is based on—​(I) an index that is a narrow-​based security index, including any interest therein or on the value thereof; (II) a single security or loan, including any interest therein or on the value thereof; or (III) the occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issuer of a security or the issuers of See OICV-​IOSCO, Requirements for Mandatory Clearing (Feb. 2012), available at https://​www.iosco.org/​ library/​pubdocs/​pdf/​IOSCOPD374.pdf. 39 Id. at 12. IOSCO’s definitions of both approaches are the same previously formulated in the report of the Financial Stability Board, OTC Derivatives Market Reforms—​Progress Report on Implementation (Apr. 15, 2011), n.9, available at http://​www.fsb.org/​wp-​content/​uploads/​r_​110415b.pdf. 40 Id. at 13. 41 Id. at 11. 42 15 U.S.C. 78c(a)(68). 43 The term swap is defined in Section 1a of the CEA. 38

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securities in a narrow-​based security index, provided that such event directly affects the financial statements, financial condition, or financial obligations of the issuer. In order to determine whether a Credit Default Swap (CDS) falls within one of the three prongs, the CFTC and the SEC have adopted specific joint rules and interpretations.44 In particular, Rule 3a68-​1b specifies the characteristics that an index on which a CDS is based must have in order to qualify the index as a “narrow-​based security index” and the corresponding CDS as a “security-​based swap.”45 So far, the SEC has not yet determined—​under the authority provided by Section 3C(b) of the Exchange Act—​which CDS that qualify as security-​based swaps are required to be cleared. To the contrary, as we will see in the second paragraph following, the CFTC has made its own determination on which CDS that qualify as “non-​ security-​based swaps” are required to be cleared. It is important to note, however, that the Dodd-​Frank Act has expressly excluded from the definitions of “swaps” and “security-​based swaps” physically settled non-​ financial forward contracts.46 The exclusion rests on the assumption that this type of swap is generally not used for speculation but rather for hedging purposes.47 So far, the CFTC has issued two determinations. In the first determination, the Commission has identified two classes of CDS and four classes of interest rate swaps.48 The second determination has expanded the classes of interest rate swaps that are required to be cleared.49 The CFTC has made its determination on the basis of the quantitative and qualitative analysis of the factors specified in section 39.5(b)(3)(ii) of the Commission’s regulations,50 and the general motivation has been that: “[those] corporate indices have the most net notional outstanding, the most trading volumes, and the best available pricing. The risk management 44 See Further Definition of “Swap,” “Security-​Based Swap,” and “Security-​Based Swap Agreement”; Mixed Swaps; Security-​Based Swap Agreement Recordkeeping (Final Rule), 77 Fed. Reg. 48,208 (Aug. 13, 2012), 17 C.F.R. 230, 240 and 241 [hereinafter “Swap Definitions Release”]. 45 17 C.F.R. § 240.3a68-​ 1b. Further, in the Swap Definitions Release, the Commissions also provided interpretations on security-​based swaps based on a single security or loan and single-​name credit default swaps (48,267-​8) and on narrow-​based security index criteria for index credit default swaps (48,273-​48,285). 46 7 U.S.C. § 1a(47); 15 U.S.C. § 78c(a)(68). 47 See Rechtschaffen, Capital Markets, supra note 1, at 235–​36. 48 See First Determination Release. 49 See Clearing Requirement Determination Under Section 2(h) of the Commodity Exchange Act for Interest Rate Swaps (Final Rule), 81 Fed. Reg. 71,202 (Oct. 14, 2016), 17 C.F.R. 39 and 50. 50 17 C.F.R. 39.5. Specifically, the factors are: (A) The existence of significant outstanding notional exposures, trading liquidity, and adequate pricing data; (B) The availability of rule framework, capacity, operational expertise and resources, and credit

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frameworks for the corporate index swaps are the most well-​established, and have the most available data in terms of CDS spreads and corporate default studies for analysis of the underlying constituents of the indices. Agreements based on these indices are also widely accepted and use standardized terms.”51 The trade execution requirements for swaps and security-​based swaps are subject to an exception that applies if no DCM or Swap Execution Facility (SEF) (for swaps) and no national securities exchange or SB SEF (for security-​based swaps) makes the swaps “available to trade.” This means that the trade execution requirements postulate a determination by DCM, SEF, exchanges, and SB SEF that certain types of swaps are made “available to trade” in their exchanges or platforms. As to swaps, the CFTC has adopted regulations that establish the process that DCM and SEF will have to use in order to determine whether a swap is available to trade (so-​called made available to trade process or MAT process).52 The determination made by a registered entity53 is a trading protocol, which qualifies (according to section 40.1 of the CFTC regulations54) as a rule issued by the registered entity.55

support infrastructure to clear the contract on terms that are consistent with the material terms and trading conventions on which the contract is then traded; (C) The effect on the mitigation of systemic risk, taking into account the size of the market for such contract and the resources of the derivatives clearing organization available to clear the contract; (D) The effect on competition, including appropriate fees and charges applied to clearing; and (E) The existence of reasonable legal certainty in the event of the insolvency of the relevant derivatives clearing organization or one or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds, and property.” 51 First Determination Release, supra note 48, at 74,291. For the CFTC’s analysis of the factors under Section 39.5, see id. at 74,294–​74,300. For an analysis of the effect of the clearing requirement, see Ilya Beylin, A Reassessment of the Clearing Mandate: How the Clearing Mandate Affects Swap Trading Behavior and the Consequences for Systemic Risk, 68 Rutgers L. Rev. 1143 (2016) (reporting an increase in transaction costs as a consequence of the clearing requirement, with a corresponding reduction in swaps volume). 52 See 17 C.F.R. §§ 37.10 and 38.12 prescribing the process for SEF and DCM respectively to make a swap available to trade. SEF are subject to section 37 of the CFTC regulations, see release Core Principles and Other Requirements for Swap Execution Facilities (Final Rue), 78 Fed. Reg. 33,476 ( June 4, 2013), 17 C.F.R. 37 (2013) DCM are subject to section 38 of the CFTC regulations; see release A New Regulatory Framework for Trading Facilities, Intermediaries and Clearing Organizations (Final Rule), 66 Fed. Reg. 42,256 (Aug. 10, 2001), 17 C.F.R. 1, 5, 15, 36, 37, 38, 40, 41, 100, 166, 170, and 180. 53 Both DCM and SEF qualify as a registered entity under section 1.3 of the CFTC regulations; see 17 C.F.R. § 1.3. 54 See 17 C.F.R. § 40.1. 55 See Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade, Swap Transaction Compliance and Implementation Schedule, and Trade Execution Requirement Under the Commodity Exchange Act (Final Rule), 78 Fed. Reg. 33,606 ( June 4, 2013), 17 C.F.R. 38 and 39 [hereinafter, “MAT Process Release”], at 33,607, note 6 and 33,620.

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The registered entity must submit its rule to the CFTC either for approval56 or self-​certification.57 In making their determinations (rules), the registered entities have to consider, in particular, the following factors, as specified in sections 37.10(b) and 38.12(b): (1) Whether there are ready and willing buyers and sellers; (2) The frequency or size of transactions; (3) The trading volume; (4) The number and types of market participants; (5) The bid/​ask spread; or (6) The usual number of resting firm or indicative bids and offers.58 One exception to the clearing and exchange requirements under Dodd-​Frank is the so-​called end-​user exception.59 If one of the counterparties to a swap is (1) not a “financial entity,” (2) is “using swaps to hedge or mitigate commercial risks,” and (3) notifies the CFTC as to how it utilizes swaps, that swap is not subject to the clearing and exchange requirements.60 A financial entity, as defined in section 723(a) (3), includes major swap and security-​based swap participants as well as firms engaged in banking, so those parties with large swap positions cannot rely on this exception and are still subject to the clearing and exchange requirements.61 However, those firms not considered major swap participants that rely on derivatives to hedge business risks, for example, to hedge against fluctuations in input prices, will not

See 17 C.F.R. § 40.5. When the registered entity submits a rule to the CFTC for approval, the Commission has a period of 45 days to review the rule. After that period the rule is deemed approved unless the registered entity is notified otherwise. The CFTC may extend the review period for an additional 45 days or, upon an agreement in writing with the registered entity, for any period beyond the additional period. 57 See 17 C.F.R. § 40.6. When the registered entity submits a rule to the CFTC for self-​certification, the Commission has a period of 10 days to review the rule. After that period the rule is deemed certified and can be made effective, unless during the same period the Commission issues a stay of the certification. Once a stay is issued, the Commission has a period of 90 days to conduct the review, during which it shall provide a public comment period of 30 days. Upon expiration of the 90-​day review period the rule becomes effective, unless the CFTC objects that the rule in inconsistent with the CEA and the CFTC regulations. 58 See 17 C.F.R. §§ 37.10(b) and 38.12(b). The registered entity that submits the rule must also explain how the rule is in compliance with the CEA, and the CFTC core principles and regulations; see 17 C.F.R. §§ 40.5(a)(5) and 40.6(a)(7)(v). 59 The Dodd-​Frank Act also added Section 2(h)(7) to the CEA, which provides that the clearing requirement of Section 2(h)(1) shall not apply to a swap if one of the counterparties to the swap: “(i) is not a financial entity; (ii) is using swaps to hedge or mitigate commercial risk; and (iii) notifies the Commission, in a manner set forth by the Commission, how it generally meets its financial obligations associated with entering into non-​ cleared swaps.” The exception provided in Section 2(h)(7) is commonly referred to as the “end-​user exception.”. 60 Dodd-​Frank Act § 723(a)(3). The end-​user exception excepts these swaps from clearing requirements, and the exchange requirement only applies “[w]‌‌ith respect to transactions involving swaps subject to the clearing requirement.” 61 Id. 56

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be required to trade these contracts through a clearinghouse or on an exchange. A party benefiting from the commercial end-​user or inter-​affiliate exception may elect to clear or not swap transactions notably based on cost and liquidity considerations. With reference to costs, a commercial end user electing not to clear should normally not be subject to the substantial costs of margin requirements for cleared derivatives. Nonetheless, margin requirements will be applicable to the dealers or counterparties of the commercial end user. Consequently, commenters predict that margin requirements may increase the costs of such transactions or may lead such counterparties to require initial and variation margin similar to the margins they have to post. Therefore, the difference of cost between electing to clear or not may be small.62 Regarding liquidity, commenters opine that OTC clearing facilitates the ability of a commercial end user to conclude a transaction. Notably, clearing enhances the liquidity and transparency of derivatives markets, which ultimately may narrow the spreads between bids and offers and therefore benefit users of cleared derivatives. Consequently, a commercial end user may prefer to clear certain products to benefit from this liquidity.63 D. Capital and Margin Requirements

Dodd-​Frank imposes minimum capital and margin requirements on both entities that engage in swaps trading and the swaps themselves. Swap dealers and major swap participants, as well as their security-​based swap counterparts, must meet minimum capital requirements and minimum initial and variation margin requirements.64 A “prudential regulator” (including the Fed, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration, and the Federal Housing Finance Agency) will impose these requirements, with the prudential regulator varying based on the identity of the dealer or swap participant.65 For nonbank swap dealers and swap participants, the SEC and the CFTC will set capital and margin requirements.66 Vis-​à-​vis the derivatives trades themselves, the relevant clearing organization will impose its own margin requirements on the counterparties for contracts that are cleared pursuant to the clearing requirements of Dodd-​Frank.67 Those swaps that are not Id. at 16–​17. 63 Id. at 17. 64 Id. § 731, 764. 65 Id. § 721(a)(17). 66 Id. § 731, §764. 67 Id. § 725(c), § 764. 62

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centrally cleared will be subject to capital and margin requirements.68 In promulgating these requirements for uncleared trades, the relevant regulator must consider the “greater risk” to the counterparty itself and to the financial system generally arising from the lack of an intermediary to clear the trade.69 Indeed, the CFTC has stated, albeit in a proposed rule, that margin requirements for these uncleared swaps should be “at least as stringent as those for cleared swaps . . . to fulfill the statutory mandate.”70 The margin rules are divided among regulators depending on the type of counterparties: i. Prudential bank margin rules apply to SDs, MSPs, SBSDs,71 and MSBSPs72 regulated by any US prudential bank regulators; ii. CFTC margin rules apply to SDs and MSPs that are not covered by the prudential rules; and iii. SEC margin rules will apply to SBSDs and MSBSPs that are not covered by the prudential rules. Nevertheless, the SEC margin rules remain in the proposal stage.73 CFTC’s variation margin requirements came into effect in 2017.74 Differing from these are the initial margin requirements, which are still in a phase-​in process until September 2020.75 In contrast, SEC rules on uncleared SBS margin are not yet final and there is no date scheduled to implement such regulation.76 E. Reporting Requirements

Dodd-​Frank requires that both cleared swaps and uncleared swaps publish trading data, with the responsibility given to “swap data repositories” and DCOs.77 A swap data repository is defined as an entity that “collects and maintains information  .  .  .  with Id. § 731, § 764. 69 Id. 70 Margin Requirements for Uncleared Swaps for Swaps Dealers and Major Swap Participants, 76 Fed. Reg. 23732 (proposed Apr. 28, 2011). 71 “Swap Dealer,” “Security-​Based Swap Dealer,” “Major Swap Participant,” respectively. 72 “Major Security-​Based Swap Participant.” 73 The Dodd-​Frank Act: Margin Posting and Collection Rules for Uncleared Swaps, Practical Law Finance (2018). 74 Derivatives & Structured Products: A Corporate End User’s Handbook for Dodd-​Frank Derivatives Compliance, at 20, Shearman & Sterling, Jan. 31, 2018. 75 12 C.F.R. § 45.1(e) and 17 C.F.R. § 23.161(a); see also The Dodd-​Frank Act: Margin Posting and Collection Rules for Uncleared Swaps, supra note 73. 76 The Dodd-​Frank Act: Margin Posting and Collection Rules for Uncleared Swaps, supra note 73. 77 Dodd-​Frank Act § 727, § 725(c). 68

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respect to transactions or positions in, or the terms and conditions of, swaps entered into by third parties for the purpose of providing a centralized record-​keeping facility for swaps.”78 Swap data repositories are required to confirm the accuracy of the data submitted by the counterparties to the swap, provide electronic access of the data to the CFTC, make publicly available the data submitted by the counterparties, and establish “emergency procedures, backup facilities and a plan for disaster recovery that allows for the timely recovery and resumption of operations.”79 The requirement to furnish public information on the swaps applies both to those swaps subject to mandatory clearing, including those swaps that are exempt from clearing due to the end-​user exception, and to swaps that are accepted by a DCO but are not required to be cleared.80 Swaps not accepted for clearing by a DCO must be reported to a swap data repository or furnished to the Commission if a swap data repository will not accept the swap. 1. Commodity Position Limits The CFTC tried to establish non-​security-​based swap position limits rules in 2011. However, in 2012 a federal district court repealed these rules.81 The CFTC then proposed new rules on speculative position limits, yet these rules are still in a proposal stage.82 Moreover, due to the changes in the CFTC chairman, the adoption of this position limits proposal is not certain. Indeed, the CFTC chairman has recently announced that the CFTC was currently working on new propositions for position limits rules.83 In any case, it should be noted that a report from the U.S. Department of Treasury (“U.S. Treasury”), discussed in Sec. I.H.9, supports the implementation by the CFTC of position limit rules.84 In contrast, the SEC has not yet proposed any rule regarding security-​based swap position limits.85

Id. § 721(a)(21). 79 Dodd-​Frank Act § 728. 80 Sharma, supra note 11, at 305–​06. 81 International Swaps and Derivatives Association, et al. v. United States Commodity Futures Trading Comm’n, No. 11-​cv-​2146 (RLW) (D.D.C. Sept. 28, 2012); see also Summary of the Dodd-​Frank Act: Swaps and Derivatives, at 14, Practical Law Finance and Practical Law Corporate & Securities (2018). 82 Summary of the Dodd-​Frank Act: Swaps and Derivatives, at 14, Practical Law Finance and Practical Law Corporate & Securities (2018). 83 CFTC Chairman J. Christopher Giancarlo, Remarks to the ISDA Regulators and Industry Forum (Nov. 13, 2017). 84 A Financial System That Creates Economic Opportunities: Capital Markets, at 143, United States Department of the Treasury (Oct. 2017); see also Derivatives & Structured Products, supra note 74, at 30. 85 Summary of the Dodd-​Frank Act: Swaps and Derivatives, at 14, Practical Law Finance and Practical Law Corporate & Securities (2018). 78

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F. Futures Commission Merchants, Dodd-​F rank, and Regulation 1.25

An FCM, as defined in Dodd-​Frank, is any entity that solicits or accepts orders for commodities and other derivatives and collects assets to support those orders.86 FCMs are required to register with the Commission as an FCM; it is unlawful for any entity that is unregistered to accept assets on behalf of a customer to margin, guarantee, or secure a swap transaction.87 Vis-​à-​vis their customers, the FCM is not permitted to commingle customer funds used for margin or security for a derivatives trade with the assets of the FCM and cannot use those customer funds to guarantee or secure the derivatives contracts of any other customer.88 Dodd-​Frank imposes an affirmative duty on the FCM to segregate customer assets, and prohibits the disposition of these assets by any entity other than the customer.89 The FCM is permitted, though, to invest these segregated customer assets in obligations of the United States and any state or political subdivision of a state, as well as in any other investment prescribed by the CFTC.90 The CFTC, in Regulation 1.25 under the CEA, lists the permitted investments for segregated funds; in addition to the investments articulated in Dodd-​Frank, it includes certain types of commercial paper and corporate debt instruments fully guaranteed by the FDIC and interests in money market mutual funds.91 In the most recent revision of Regulation 1.25, the CFTC opted to exclude from the enumerated permitted investments both foreign sovereign debt, that is, debt obligations issued by foreign countries, and corporate debt obligations not guaranteed by the United States, which had been permitted before the latest revisions.92 The newest revision of Regulation 1.25 also eliminates the ability FCMs previously had to invest customer-​segregated funds in an affiliate of the FCM through repurchase agreements.93 In a repurchase agreement (“repo”), a party sells an asset to another party, with an agreement to repurchase that instrument at a later date; repo transactions function essentially like a collateralized loan.94 The CFTC felt that affiliate transactions through repurchase agreements concentrate credit risk. Although affiliates often have independent legal status, the affiliate is often still

Id. § 721(a)(13). 87 Id. § 724(a). 88 Id. 89 Id. 90 Id. 91 Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions, 76 Fed. Reg. 78776 (Dec. 19, 2011). 92 Id. 93 Id. 94 Id. 86

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exposed to the financial vicissitudes of the FCM.95 The CFTC also expressed concern about conflicts of interest between the affiliate and the FCM.96 Finally, since the FCM will clear trades on behalf of its customers through a DCO, it will be subject to the capital and margin requirements imposed by the DCO.97 1. Title VII Enforcement The CFTC’s Division of Enforcement enquires and prosecutes potential violations of the CFTC regulations. This division has recently created two dedicated Dodd-​ Frank regulation enforcement teams, namely, the Swaps Squad and the Manipulation and Disruptive Trading Squad. Commenters have emphasized that it is the first time that the CFTC has formed dedicated enforcement teams. The goal of such teams is to develop a focused expertise to address the increase in swaps enforcement activities linked to the Dodd-​Frank Act.98 Commenters remark that funding decided by Congress for the CFTC and the SEC is essential for an efficient enforcement of Dodd-​Frank derivatives regulation. Nevertheless, the funding levels for these agencies are not guaranteed, as opponents of Dodd-​Frank in Congress attempt to decrease their funding to limit the effect of the Dodd-​Frank regulation.99 However, the CFTC has been able to increase its Title VII enforcement in recent years. We will discuss that CFTC-​issued updated enforcement advisory on self-​ reporting and full cooperation (i), and we will consider cases in which the CFTC imposed fines for data reporting violations (ii). Eventually, we will mention the increase of CFTC enforcement actions following the change of CFTC chairman (iii). 2. Updated Enforcement Advisory on Self-​Reporting and Full Cooperation In September 2017 the CFTC issued an enforcement advisory that describes standards to comply with for individuals and companies willing to benefit from voluntarily disclosure of misconduct and full cooperation with CFTC’s investigations.100

95 Id. This concern about the concentration of credit risk similarly led the CFTC to limit the concentration of counterparty risk in one entity via repurchase transactions to 25 percent. 96 Id. 97 Dodd-​Frank Act § 725(c). 98 Summary of the Dodd-​Frank Act: Swaps and Derivatives, at 21 and 22, Practical Law Finance and Practical Law Corporate & Securities (2018). 99 Id. at 22. 100 Enforcement Advisory Updated Advisory on Self-​Reporting and Full Cooperation, Division of Enforcement of the CFTC (Sept. 25, 2017); see also CFTC Issues Updated Enforcement Advisory on Self-​Reporting and Full Cooperation, Practical Law Finance (Oct. 5, 2017).

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The CFTC had already issued two other enforcement advisories on cooperation earlier in 2017 in January. In these first two enforcement advisories, the CFTC stated the factors it ponders when assessing the cooperation by individuals and companies in CFTC’s investigations.101 The September 2017 enforcement advisory specifies complementary information for individuals and companies to gain benefit from self-​reporting and cooperation. It states that the most mitigation benefits in a CFTC’s enforcement action will be attributed to entities that, at the same time, self-​report the misconduct, cooperate with the investigation, and remediate any deficiencies. Nonetheless, the CFTC indicated that it may reduce fines in case of cooperation and remediation even if the entity fails to self-​disclose.102 In sum, the CFTC seeks to provide incentives for self-​reporting and cooperation with investigations in order to achieve the ultimate goal of promoting voluntary compliance with the Dodd-​ Frank regulation.103 Accordingly, in order for a company or individual to receive full self-​reporting and cooperation credit, they must: i. Disclose voluntarily the misconduct to the CFTC before an imminent threat of exposure occurs and within a reasonably time after the company or individual becomes aware of the misconduct; ii. Fully disclose all relevant facts known at the time of the disclosure, including relevant information about individuals involved in the misconduct; iii. Fully cooperate with the investigation; and iv. Quickly and properly correct flaws in compliance with reporting obligations.104 When a company or individual fully complies with these requirements the CFTC specified that it will demand the most substantial reduction in fines available. In addition, the CFTC announced that it might also, in some circumstances, decide not to prosecute.105

101 CFTC Releases Advisories on Enforcement Cooperation, Practical Law Finance ( Jan. 26, 2017). 102 CFTC Issues Updated Enforcement Advisory on Self-​Reporting and Full Cooperation, supra note 101. 103 Id. 104 Enforcement Advisory Updated Advisory on Self-​Reporting and Full Cooperation, supra note 101. 105 Id.

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3. Enforcement Actions for Data Reporting Violations In September 2017, the CFTC settled charges against the swap dealers Citibank, N.A. and Citigroup Global Markets Limited (collectively “Citi”) for reporting violations.106 The CFTC’s order inflicted a $550,000 civil fine to Citi and ordered compliance with certain measures to improve Citi swap data reporting. Citi’s misconducts included: i. Failure to accurately report information to a swap data repository; ii. Failure to implement the systems and processes necessary to properly report data; iii. Failure to correct mistakes in previously reported data; and iv. Failure to efficiently perform supervisory duties concerning proper data reporting.107 The obligations of Citi stemmed from parts 45 and 46 of the CFTC Regulations, which require data reporting for each counterparty to a swap, as well as the timely correction of mistakes or omissions.108 According to the aforementioned order, Citi’s reporting system had a flaw in which it did not re-​report some trades following a counterparty’s change of identification. This flaw led to failure to accurately report tens of thousands of transactions, and failure to timely correct mistakes or omissions in its reporting. The order also established that Citi’s reporting failures were due in part to Citi’s failure in properly performing its supervisory duties with respect to reporting obligations. Eventually, the CFTC accepted a settlement offer from Citi and acknowledged that Citi significantly cooperated in the investigation.109 This action reflects a renewed CFTC emphasis on proper reporting, considering the amount of penalty imposed in spite of significant cooperation from Citi.

In the Matter of Citibank, N.A. and Citigroup Global Markets Limited, Respondents, CFTC No. 17-​26, 2017 WL 4280594, Sept. 25, 2017; see also CFTC Fines Swap Dealers for LEI Swap Data Reporting Violations, Practical Law Finance (Sept. 28, 2017). 107 CFTC Fines Swap Dealers for LEI Swap Data Reporting Violations, supra note 106. 108 See supra notes 59 and 60. 109 CFTC Fines Swap Dealers for LEI Swap Data Reporting Violations, supra note 106. 106

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4. Action for Failure to Submit Accurate Large-​Trader Commodity Swap Reports In September 2016, the CFTC settled charges against Wells Fargo Bank, N.A. (“Wells Fargo”) for failure of compliance with the requirements to submit accurate large trader reports (LTRs).110 Wells Fargo, as a swap dealer, is compelled to submit LTRs to the CFTC. These reports allow the CFTC to effectively oversee physical commodity futures and economically equivalent swaps markets.111 The CFTC established that: a. From 2013 to 2015, Wells Fargo submitted LTRs which failed to meet requirements provided in CFTC Regulations 20.4 and 20.7.112 b. Wells Fargo submitted inaccurate LTRs with numerous mistakes, including: i. missing data; ii. data in a format which did not comply with CFTC requirements; iii. failure to use the adequate identification for reporting entity and clearing member; iv. failure to provide a value for some swaps notional position; and v. use of inaccurate values.113 It is important to note that Wells Fargo cooperated with the CFTC as soon as it was contacted by the CFTC for inconsistent reporting. It notably analyzed past reports, self-​disclosed additional issues with its LTRs, and improved its data processing and reporting systems to appropriately comply with LTR reporting obligations.114 As a consequence of the CFTC order, Wells Fargo agreed to pay a $400,000 civil monetary penalty.115 Again, considering the amount of penalty imposed, and given the fact that Citi cooperated with the CFTC right from the start of the investigation, this action reflects an emphasis from the CFTC on proper reporting and timely self-​disclosure in case of mistake.

110 In the Matter of Wells Fargo Bank, N.A., Respondent, CFTC No. 16-​32, 2016 WL 5582342, Sept. 27, 2016; see also CFTC Fines Wells Fargo for Failure to Submit Accurate Large-​Trader Commodity Swap Reports, Practical Law Finance (Oct. 4, 2016). 111 CFTC Fines Wells Fargo for Failure to Submit Accurate Large-​Trader Commodity Swap Reports, supra note 110. 112 17 C.F.R. §§ 20.4 and 20.7. 113 CFTC Fines Wells Fargo for Failure to Submit Accurate Large-​Trader Commodity Swap Reports, supra note 110. 114 Id. 115 Id.

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5. Increase of CFTC’s Enforcement Actions following the Change of CFTC Chairman In March 2017, the newly appointed CFTC chairman, J. Christopher Giancarlo, announced his willingness to maintain a high level of enforcement of the law and punishment of wrongdoing in derivatives markets.116 A year later, in March 2018, the CFTC chairman underlined that the CFTC Division of Enforcement filed almost as many fraud and manipulation cases in the five months prior to his speech as it had in any prior fiscal year. The CFTC chairman notably discussed an increase in enforcement actions in collaboration with the FBI regarding criminal charges involving commodities fraud and spoofing schemes. The CFTC chairman also discussed that the CFTC filed a series of civil enforcement actions against perpetrators of fraud, market manipulation, and disruptive trading involving virtual currency linked to potential commodity fraud and misappropriation.117 6. Reduction of Counterparty and Systemic Risk Leading up to the financial crisis, market participants did not know the extent of their counterparties’ exposures to failing institutions such as Bear, Lehman, and AIG, but feared that counterparties may be unable to satisfy their obligations.118 This uncertainty, coupled with the interconnectedness of these ostensibly failing firms, led counterparties to pull funding from any financial institution that was perceived to be weak, resulting in the dysfunction of important financial markets.119 The Act sought to achieve a reduction in counterparty risk to stave off a future crisis in the OTC derivatives market that leads to the disruption of other markets. In the most recent crisis, counterparty risk “intensified systemic fears” due to the interrelatedness of financial institutions and markets. The central clearing model, with its concomitant capital and margin requirements, is the centerpiece of that effort to reduce counterparty and systemic risk.120 116 Acting Chairman J. Christopher Giancarlo, Remarks Before the 42nd Annual International Futures Industry Conference (Mar. 15, 2017). 117 CFTC Chairman, J. Christopher Giancarlo, Keynote Address Before FIA Annual Meeting (Mar. 14, 2018). 118 Jeffrey Gordon & Christopher Muller, Confronting Financial Crisis: Dodd-​Frank’s Dangers and the Case for a Systemic Emergency Insurance Fund, 28 Yale J. Reg. 151, 160 (2011) As the authors articulate, “all it takes to trigger a run is the necessary quantum of uncertainty”—​participants were not sure whether Bear and other financial firms were insolvent and would fail, but the mere chance that it would led counterparties to reduce their exposures. 119 Ben Bernanke, Chairman, Fed. Reserve, The Federal Reserve’s Response to the Financial Crisis, Address at George Washington University School of Business (Mar. 27, 2012) Indeed, LIBOR spiked in October 2008 to 3.5 percent when it is usually less than 1 percent, reflecting extreme panic in financial markets. 120 S. Rep. No. 111-​176, at 30.

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a. Counterparty  Risk Congress sought to force most derivatives trading through clearinghouses because it thought that utilizing clearinghouses would “substantially reduce counterparty risk and provide an organized mechanism for clearing transactions.”121 Clearinghouses are interposed between the buyer and the seller of a derivatives contract, receiving and distributing payments on behalf of the counterparties.122 Instead of a bilateral contract between the buyer and the seller in which the parties themselves exchange payments and impose margin requirements on one another, in the clearinghouse model there are two distinct contracts: one between the buyer of the derivatives contract and the clearinghouse and another between the seller of the contract and the clearinghouse, with the clearinghouse imposing its own margin requirements on the parties.123 There are a number of advantages to this trading device. For one, the clearinghouse is not exposed to the market risk of the derivative, as the two contracts with the buyer and the seller are cancelled against one another124—​irrespective of the swings in the contract itself, the clearinghouse is hedged against those price movements. Similarly, clearinghouses can reduce counterparty risk through the process of “multilateral netting.”125 Bilateral netting is the process whereby two counterparties exchange cash flows based on their net exposure to one another, as opposed to exchanging cash flows for each outstanding transaction.126 This process is much simpler and has the additional benefit of decreasing how much cash must be transferred, which is useful for liq­ uidity reasons.127 In multilateral netting, the clearinghouse allows for netting among all of its clearing members, which reduces the amount of cash that must change hands and thus reduces the likelihood of a default on an obligation of a clearing member.128 Finally, in the clearinghouse model, the clearinghouse, as opposed to the individual counterparties, bears the risk of a counterparty being unable to fulfill its obligation, that is, counterparty risk.129

121 Id. 122 Jeremy C. Kress, Credit Default Swaps, Clearinghouses, and Systemic Risk: Why Centralized Counterparties Must Have Access to Central Bank Liquidity, 48 HARV. J. ON LEGIS. 51 (2011). 123 Id. at 61. 124 Id. at 61–​62. 125 Zachary Gubler, The Financial Innovation Process: Theory and Application, 36 Del. J. Corp. L. 55, 90 (2011). 126 Id. 127 Id. 128 International Monetary Fund, Global Financial Stability Report: Meeting New Challenges to Stability and Building a Safer System 98 (2010). 129 Adam Krippel, Regulatory Overhaul of the OTC Derivatives Market: The Costs, Risks and Politics, 6 Ohio St. Entrepreneurial Bus. L.J. 269, 291 (2011).

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The clearinghouse engages in management of this counterparty or credit risk through a number of measures. First, it restricts admission for its services based on capitalization and liquidity requirements, ensuring that the clearinghouse can adequately monitor its members and that its members meet a basic level of financial health.130 Second, in addition to access restrictions, the clearinghouse imposes initial margin requirements for derivatives trades as well as variation margin;131 these requirements limit the amount that a clearinghouse could lose on a trade if a member does not fulfill its obligations under the contract because the clearinghouse will keep the initial and variation margin after default.132 The clearinghouse will also not bear the full force of any default on its own: instead, the loss is “mutualized,” that is, spread out, among all of the members of the clearinghouse.133 The members of the clearinghouse contribute to a “default fund” that is utilized upon the default of a counterparty, such that in effect, the losses stemming from the default of one counterparty are distributed among all of the clearinghouse members.134 As applied to the most recent financial crisis, clearing requirements could have decreased counterparty risk concerns, for one, through margin requirements. As many derivatives were not centrally cleared and thus were conducted on a bilateral basis, a number of trades were backed by insufficient margin, or, as articulated by Congress, “under-​collateralization.”135 Insufficient collateral was endemic in the credit-​default swap market, in particular vis-​à-​vis AIG, because counterparties did not request adequate margin due to AIG’s then-​sterling credit ratings.136 If credit-​ default swaps had been required to be centrally cleared and thus subject to capital and margin requirements, AIG itself may not have allowed its portfolio of credit-​ default swaps to balloon to inflated heights, and its counterparties would not have experienced losses to the same extent due to initial and variation margin.137 Indeed, the counterparty in a cleared swap is not affected directly when the party on the other side of the transaction defaults on an obligation because the actual counterparty to the failing party is the clearinghouse.138 These losses would have been spread and

130 Kress, supra note 122, at 49, 62–​63. 131 Anupam Chandler & Randall Costa, Clearing Credit Default Swaps: A Case Study in Global Legal Convergence, 10 Chi. J. Int'l L. 639, 677 (2010). at 639, 654. 132 Kress, supra note 122, at 49, 63. 133 Id. 134 Id. at 64. 135 S. Rep. No. 111–​76, at 33. 136 Chandler & Costa, supra note 131, at 639, 649. 137 Id. at 650 138 Id.

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shared by all of the members of the clearinghouse, potentially mitigating the effect of a default on the financial system as a whole.139 b. Systemic  Risk Legislators felt that counterparty risk arising out of OTC derivatives exposure of market participants rose to the level of systemic risk, that is, the risk that an institutional failure triggers either the failure of a “chain of markets or institutions” or a “chain of significant losses to financial institutions” that leads to a decrease in the availability of capital.140 Counterparty risk can intensify into systemic risk when, for example, a market participant with significant derivatives exposure fails, leading to losses on its derivatives trades that fall on its counterparties—​if the counterparties are unable to absorb these losses, this can lead to a financial panic.141 In the most recent financial crisis, when market participants became concerned about counterparties fulfilling their contractual obligations, they stopped contracting with one another, which decreased the amount of credit in the system.142 Simultaneously, when derivatives and other assets backed by mortgages decreased in value, investors ceased to invest in not only mortgage-​backed securities but in other debt securities more generally, exacerbating the freezing of credit markets.143 It is instructive to view the merits of the counterparty model, as it relates to the diminution of systemic risk, through the lens of the most recent financial crisis. Preliminarily, financial market regulators presumably would have at least been aware of the exploding OTC derivatives market, in particular the size of the credit-​default swap market, because these swaps are now explicitly required by Dodd-​Frank to be cleared by a clearinghouse and traded on an exchange. When mortgage assets began to decline in value as a result of a decrease in housing prices, derivatives contracts based on the value of housing prices would have similarly decreased. This would have led to variation margin calls by the clearinghouse on a mark-​to-​market basis. However, the counterparties would have already posted initial margin and variation margin in an amount sufficient before the fall in the price of the derivatives contract,

139 Kress, supra note 122, at 49, 64. 140 For legislators’ opinions on the crisis, see S. Rep. No. 111-​176. For definition of systemic risk, see Iman Anabtawi & Steven Schwarcz, Regulating Systemic Risk: Towards an Analytical Framework, 86 Notre Dame L. Rev. 1349, 1353 (2011). 141 See generally Darrell Duffee et al., Policy Perspectives on OTC Derivatives Market Infrastructure, Federal Reserve Bank of New York (2010), available at http://​papers.ssrn.com/​sol3/​papers.cfm?abstract_​ id=1534729. 142 Anabtawi & Schwarcz, supra note 140, at 1349, 1360. 143 Id. at 1360–​61.

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mitigating the losses suffered by the clearinghouse and thus its members (who are required to mutualize any losses faced by the clearinghouse) in the event of default on derivatives contracts. The Act, as envisioned by legislators, would have contained the turmoil in the financial markets resulting from losses in the housing sector, through monitoring of financial institutions and markets by regulators and the spreading of losses among market participants, reducing the systemic impact of the failure of any one individual firm.144 Legislators acknowledged that “large losses are to be expected in derivatives trading” but maintained that if the contracts are “fully margined,” then counterparty risks will not devolve into a systemic crisis.145 By contrasting the experience of Lehman’s counterparties in the centrally cleared futures markets and in the bilateral, uncleared, OTC derivatives market, one can make an argument for the clearing of derivatives trades.146 The utilization of a clearinghouse in the futures market mitigated the interconnectedness problem faced by counterparties when Lehman failed. The clearinghouse imposed margin requirements and, when that margin was insufficient, the mutualization procedure was utilized whereby all members of the clearinghouse supported the losses due to a counterparty failing to fulfill its obligations.147 In contrast, in the OTC derivatives market, counterparties worried about the stability and possible insolvency of Lehman and thus pulled their funds, engendering a run on Lehman.148 This helped to foment a systemic crisis as participants withdrew funds from important credit markets in an attempt to minimize risks.149 G. Rationale behind Exemptions and Exclusions 1. The End-​User Exemption

The aforementioned “end-​user exemption” exempts certain swaps from the clearing and exchange requirements of Dodd-​Frank. Specifically, if one of the counterparties to a swap is (1) not a “financial entity,” (2) is “using swaps to hedge or mitigate commercial risks,” and (3) notifies the CFTC as to how it utilizes swaps, that swap is not subject to the clearing and exchange requirements of Dodd-​Frank.150 Congress, in enacting this exemption, worried that American consumers would face higher

Id. at 1395. 145 S. Rep. No. 111–​76. 146 Chandler & Costa, supra note 131, at 639, 655–​58. 147 Id. at 658. 148 Id. at 657. 149 Id. 150 Dodd-​Frank Act § 723(a)(3). 144

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prices if the cost of hedging for non-​financial firms increased. Congress felt that bespoke derivatives transactions were beneficial for hedging unique commercial risks151 and that capital and margin requirements may force these firms to post additional collateral—​collateral that does not earn any interest.152 Entities seeking to hedge business risks may have individuated risk management needs that are incapable of standardization, such that exchange trading and clearing would be impracticable or unduly expensive.153 Concurrently, derivatives utilized for hedging purposes by non-​financial entities, it is argued, did not contribute meaningfully to the recent financial crisis154 since the types of derivatives primarily employed by these firms did not have nearly the systemic effect on financial markets as did credit derivatives, in particular credit-​default swaps.155 Apart from the specific derivatives used, the reasons market participants trade in derivatives can have a profound effect on financial markets, namely, whether the derivatives are employed for hedging or speculative purposes. For one, it is unlikely that the OTC derivatives market would have exploded in size to nearly the same extent had derivatives been used only for hedging purposes and thus, the OTC market likely would not have affected the financial system to the degree it did. Moreover, speculative derivatives aggregate risk, as by definition derivatives used for speculation, do not offset a countervailing risk. Derivatives utilized for hedging can decrease systemic risk, through the diversification of risk;156 hedges can result in both the buyer and the seller being better off if the risk inherent in the contract is transferred to a party more able and willing to bear that risk.157 In contrast, speculation often increases risk without any offsetting diversification benefit. The end-​user exemption, if written and executed properly, can be justified because derivatives used for hedging purposes were not thought to be a central factor in the financial crisis, and thus, legislators did not want to impose the costs of stringent margin and capital requirements on entities merely attempting to hedge their business risks.

151 Ariail, infra note 154, at 189. 152 Id. at 190. 153 Frank D’Souza et al., Illuminating the Need for Regulation in Dark Markets: Proposed Regulation of the OTC Derivatives Market, 12 U. Pa. J. Bus. L. 473, 504 (2010). 154 Laurin C. Ariail, The Impact of Dodd-​Frank on End-​Users Hedging Commercial Risk in Over-​the-​Country Derivatives Markets, 15 N.C. Banking Inst. 175 (2011). Available at: http://​scholarship.law.unc.edu/​ncbi/​ vol15/​iss1/​10, at 191. 155 Id. A credit derivative is a derivative that “transfer[s]‌‌ credit exposure vis-​à-​vis specific obligors.” Feder, supra note 15, at 677, 706. 156 Steven Schwarcz, Systemic Risk, 97 Geo L.J. 193, 221 (2008). 157 Lynn Stout, Derivatives and the Legal Origin of the 2008 Credit Crisis, 30(12) Banking & Fin. Servs. Pol’y Rep. 13, 14 (2011).

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2. Physical Settlement Exclusion The Act excludes from its definition of swaps any non-​financial commodity that is intended to be physically settled. The rationale for this exclusion is similar to that for the end-​user exemption: Dodd-​Frank seeks to subject derivatives used for speculative purposes to the requirements of Dodd-​Frank, namely, the clearing and exchange requirements and the capital and margin requirements, while relieving derivatives used for hedging purposes from its burdens.158 Swaps based on an underlying physical commodity, settled by delivery of the actual commodity, are generally not used for speculative purposes and thus, legislators did not want to impose the requirements of Dodd-​Frank on parties merely engaged in derivatives trading to hedge market risks.159 3. Customization Exceptions The Act excludes certain swaps from the central clearing requirements, based on a number of factors that include liquidity, operational expertise, and the effect of the swap on the mitigation of systemic risk.160 These uncleared swaps will be subject to margin requirements that are “at least as stringent” as those for cleared swaps, according to a CFTC proposed rule.161 The Act thus permits entities to trade swaps bilaterally, allowing firms to engineer derivatives contracts based on risk preference. At the same time, Dodd-​Frank seeks to reduce the systemic effects of these trades through margin requirements. The Act also excludes particular swaps from exchange trading if they are sufficiently illiquid and nonstandardized that no exchange will execute them.162 However, these swaps that are not executed must still be cleared by a DCO and must be backed by sufficient capital and margin.163 The Act thus seeks to preserve the viability of bespoke derivatives contracts, so that market participants may customize trades based on their idiosyncratic risk profiles. An absolute requirement that derivatives be traded on an exchange would effectively eliminate their use—​without other willing buyers and sellers of a derivative contract, the exchange-​trading paradigm is impracticable, so if the exchange requirement were applied to all derivatives, there would not be a viable customization option. However, these OTC derivatives will still be subject to capital

158 Greenberger, supra note 9, at 18. 159 Id. 160 Dodd-​Frank Act § 723(a)(3), § 763(a). 161 Margin Requirements for Uncleared Swaps for Swaps Dealers and Major Swap Participants, supra note 70. 162 Dodd-​Frank Act § 763. 163 Greenberger, supra note 9, at 20.

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and margin requirements, in an attempt to reduce their impact on the stability of the financial system. H. The Lincoln Rule

The Lincoln Rule (named after Sen. Blanche Lincoln, who promulgated the provision) bars the provision of federal assistance to “swaps entities,” such as access to the Federal Reserve discount window, limiting that entity’s ability to borrow money from the central bank and ensure liquidity in times of financial disruption, and to Federal Deposit Insurance Corporation (FDIC) deposit insurance, making the entity less attractive to depositors.164 In effect, insured depository institutions that fall under the rule’s purview must “push out” certain derivatives trading from under the umbrella of their FDIC-​insured depository institution subsidiaries and into subsidiaries that are separately capitalized, thus buffering a bank’s deposits and other assets from riskier derivatives activities. If the derivatives market suffers or transmits a financial shock, the damage is limited to the separately capitalized entities and does not bleed over into bank assets such that the government and its taxpayers must step in and prop up the bank. The affiliate that is an insured depository institution must be part of a bank holding company or savings and loan association that is supervised by the Federal Reserve (and may access both the discount window and FDIC insurance), whereas the separate capitalized entity must meet various requirements in the Federal Reserve Act and is subject to supervision by the Commodity Futures Trading Commission (CFTC), the Securities and Exchange Commission (SEC), or the Federal Reserve Board of Governors, as appropriate.165 The Pushout Rule has been phased in over a period of years, with an effective date of July 2013.166 A further limitation on the rule’s application is Section 716’s exemption of a variety of swap activities that may be performed by insured depository institutions without losing federal assistance, including hedging or risk-​mitigation and acting as a swaps entity for credit-​default swaps.167 The rule will impact only those banks that have not already separated their derivatives activities into legally distinct entities.

Dodd-​Frank § 716. 165 See id. § 716(c). 166 See id. § 716(h) and (f ). 167 Dodd Frank § 716(d). 164

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1. Futures Commission Merchants With respect to FCMs, the transparency and reduction of counterparty and systemic risk objectives of Dodd-​Frank apply as well. In a derivatives trade involving an FCM, the obligations between counterparties who are not members of the clearinghouse are replaced by two sets of obligations: (1) obligations between both FCMs (the FCM representing the long position and the FCM representing the short position) and the DCO, and (2) obligations between both FCMs and their customers.168 Economically, the FCM is the guarantor of its customers’ obligations to the DCO while the DCO is a guarantor to the FCM.169 Each FCM in a derivatives transaction thus acts as an intermediary between its customer and the DCO. To effectively reduce counterparty and systemic risk, therefore, it is necessary to consider both the transaction between the FCM and the DCO and the transaction between the FCM and its customer. Vis-​à-​vis the FCM and the DCO, Dodd-​Frank imposes registration requirements on both entities170 and requires DCOs to impose capital and margin requirements on FCMs.171 The registration requirements are hoped to increase transparency of both entities to regulators. Capital and margin requirements are imposed to reduce counterparty and systemic risk—​if a FCM defaults on its obligations to the DCO, the DCO will have margin to cover part of its losses and will mutualize the remaining losses among its other clearing members. As previously mentioned, regulators intend that these mechanisms will diminish the impact on the financial system of the failure of a financial institution. Vis-​à-​vis the FCM and its customers, Dodd-​Frank regulates their relationship through the segregation of customer funds, along with the enumeration of permitted investments with the customer-​segregated funds. If, for instance, an FCM becomes insolvent, customers should still have access to all of their funds deposited with the FCM because of the segregation of customer accounts from the other assets of the FCM. The permitted investments requirements diminish the probability of the FCM being unable to return a customer’s funds due to a decrease in the value of assets invested with the segregated funds. At the margin, this requirement may also limit the risk-​taking ability of an FCM, as customer-​segregated funds can account for a significant proportion of the assets of an FCM.172

168 Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 77 Fed. Reg. 6336 (Feb. 7, 2012). 169 Id. 170 Dodd-​Frank Act § 724(a), § 725(a). 171 Dodd-​Frank Act § 725(c). 172 Investigative Hearing on the MF Global Bankruptcy: Hearing Before the S. Comm. on Agriculture, Nutrition and Forestry, 112th Cong. 4 (2011) (statement of Terrence Duffy, Executive Chairman CME Group). MF

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I. Criticisms of Dodd-​F rank’s Derivatives Trading Provisions 1. Concentration of Systemic Risk in Clearinghouse and “Too Big to Fail”

The Act constructs a model for derivatives trading in which many derivatives must be centrally cleared by a clearinghouse. Although this paradigm has a number of advantages as articulated previously, including ostensibly diminishing systemic risk by spreading losses through the process of mutualization across clearing members, it is possible that the clearing model will actually result in the magnification of systemic risk. Clearinghouses bear the counterparty risk that market participants would otherwise face in an OTC bilateral derivatives trade by interposing itself between the buyer and seller of the contract.173 Thus, the counterparty risk otherwise borne by counterparties is concentrated in the clearinghouse, such that the clearinghouse becomes a “singular point of failure.”174 In this conception, the clearinghouse is a source of systemic risk—​the failure of a clearinghouse would lead to losses for all members that were exposed to the clearinghouse, as opposed to the failure of a counterparty, which will only directly affect its counterparties (though of course the failure of one counterparty can indirectly affect many other market participants).175 If the clearinghouse employs a robust risk management apparatus that actively monitors its credit risks and imposes margin requirements that will diminish the effects on the clearinghouse of a counterparty defaulting on its obligations,176 the likelihood of a clearinghouse insolvency is reduced. However, clearinghouses may not be incentivized to implement a robust risk management regime because of the “too big to fail” problem.177 This argument progresses as follows: the possible failure of a clearinghouse, by virtue of the size of its balance sheet, would have massive implications for the financial system. Accordingly, the government would be compelled to bail out the clearinghouse to mitigate a financial crisis; the clearinghouse, ex ante, understands the government’s calculus and thus will not manage its risks appropriately. Economists describe this as “moral hazard,” which transpires “when insurance coverage causes a party to engage in behavior that actually increases the likelihood of incurring losses.”178 As applied to clearinghouses, the “insurance”

Global, at the time of its bankruptcy, should have held $5.5 billion in customer-​segregated funds. Id. Its assets were worth $41 billion at its filing. Tiffany Kary et al, Corzine’s MF Global Seeks to Reorganize as Broker-​ Dealer Unit to Liquidate, Bloomberg News (Nov 1, 2011). 173 Krippel, supra note 129, at 269, 291. 174 Chandler & Costa, supra note 131, at 639, 677. 175 Kress, supra note 122, at 49, 72–​73. 176 Dodd § 725(c) (mandates that DCOs monitor its credit exposure and impose margin requirements that are “sufficient to cover potential exposures in normal market conditions”). 177 Kress, supra note 122, at 49, 73–​74. 178 Gubler, supra note 125, at 55, 100–​01.

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is the possibility of the government bailing out the clearinghouse in the event of insolvency. The bailout therefore decreases the incentives of the clearinghouse to monitor its risks adequately. As a result, clearinghouses and counterparties to the clearinghouse may shirk their risk-​management duties, including by decreasing collateral requirements or mutualization fund contributions, insufficient monitoring by counterparties of the clearinghouses’ capitalization, and insufficient insurance purchases by the clearinghouse to protect against counterparty insolvency.179 In sum, it is still an open question as to whether the clearinghouse model constructed by Dodd-​Frank will increase or decrease systemic risk. 2. Exceptions Swallowing the Rule: Incentivizing of Customization and De Minimis Exceptions Given that Dodd-​Frank constructs a bifurcated regulatory model, in which only standardized contracts with sufficient liquidity are subject to clearing and exchange-​ trading requirements, market participants may eschew these products by creating hyper-​ customized derivatives that will not need to be cleared and traded on an exchange, effectively circumventing the centerpiece of Dodd-​Frank as it relates to derivatives trading.180 In 2009, an overwhelming majority of Fortune 500 companies utilized bespoke derivatives contracts to manage business risks;181 many of these derivatives may not be subject to the clearing and exchange-​trading requirements of Dodd-​Frank due to their lack of standardization. The extent of evasion through customization will also be a function of the capital and margin requirements imposed by regulators on uncleared, customized swaps. If these requirements are more stringent than for cleared swaps, market participants may opt to exploit the cleared derivatives markets to avoid the liq­ uidity problems of posting large amounts of margin. If not, participants may continue to favor OTC derivatives such that Dodd-​Frank’s objective of limiting counterparty and systemic risk through the clearinghouse model may not come to fruition. In addition to the customization exception, one other potentially problematic exemption is the de minimis exemption from the definition of swap and security-​ based swap dealers in Dodd-​Frank, which exempts from designation as a swap or security-​based swap dealer “an entity that engages in a de minimis quantity of swap dealing.”182 The CFTC and SEC defined this de minimis quantity as $3 billion or less in aggregate gross notional amount over a 12-​month period.183 If a significant 179 Kress, supra note 122, at 49, 74. 180 Gibson, supra note 14, at 1, 3. 181 Id. at 4. 182 Dodd-​Frank Act § 721(a)(21), § 761(a)(6). 183 Commodity Futures Trading Commission, supra note 22.

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number of firms are thus exempted from registration by virtue of this exemption, it may diminish the important aims of the Act, namely, transparency and diminution of systemic risk.184 3. Lack of Global Harmonization According to ISDA, many of the challenges regarding Dodd-​Frank derivatives regulation stem from a lack of coordination and cooperation between global legislators and regulators. This lack of coordination and cooperation entails discrepancies in implementation schedules and in the substance of the regulation in different jurisdictions and ultimately lead to the fragmentation of derivatives markets and of liquidity.185 Indeed, ISDA underlines that market participants of derivatives markets are often choosing to trade with counterparties in their own jurisdictions in order to avoid being subject to multiple and potentially inconsistent requirements.186 According to ISDA, this fragmentation of liquidity limits the choice of derivatives available, increases the cost of the transactions, and makes it more challenging for derivatives users to conclude or unwind large transactions, especially in the case of stressed derivatives markets.187 Consequently, ISDA considers that regulators have to work to harmonize rules to avoid liquidity fragmentation. To this goal, ISDA deems that the best way to enable cross-​border harmonization would be for regulators to establish transparent compliance determinations based on broad outcomes. ISDA thus suggests that U.S. counterparties should be permitted to apply overseas rules when trading in foreign jurisdictions as long as the overseas regulatory regime is similar to U.S. regulations.188 ISDA also elaborates more specifically on consistent reporting requirements. ISDA thus indicates that regulators, even if they now have access to a huge amount of transaction data in their own jurisdictions, are not able to clearly identify on a global scale the potential concentrations of risk and exposures to risk due to disparities in the content of reporting obligations across borders.189

184 See, e.g., Ben Protess, Regulators Defend Derivatives Rule, N.Y. Times Dealbook (Apr. 18, 2012), available at http://​dealbook.nytimes.com/​2012/​04/​18/​regulators-​defend-​derivatives-​rule/​. 185 Cross-​Border Fragmentation of Global Interest Rate Derivatives: Second Half 2015 Update, ISDA, May 2016; Cross-​Border Fragmentation of Global Interest Rate Derivatives: The New Normal? First Half 2015 Update, ISDA, Oct. 2015; and Cross-​Border Fragmentation of Global Derivatives: End-​Year 2014 Update, ISDA, Apr. 2015. 186 The Dodd-​Frank Act: Five Years On, at 8, ISDA, July, 2015. 187 Id. 188 Id. at 9. 189 Id. at 10.

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In order to harmonize reporting requirements, ISDA advises regulators to agree, as a first step, on the trade data they need to oversee derivatives markets and thus to issue consistent global reporting requirements. In addition, ISDA recommends regulators to develop and adopt more standardized product, transaction identifiers, and formats of reporting.190 ISDA also more recently advised the CFTC to adopt reporting obligations for which the definition and format of the data elements are aligned with the recommendations of the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO), to enhance reporting harmonization across jurisdictions.191 The CPMI and IOSCO are international organizations that work notably on the regulation of derivatives markets worldwide. According to ISDA, the harmonization of the definition and format of reporting would enable to reduce compliance costs for market participants, minimize the complexity of reporting, and facilitate the global combination of the reporting data.192 4. The Impact of the Change of U.S. Administration The change of U.S. administration might entail modifications to the regulation of derivatives, both at the legislative and regulatory level.193 Nevertheless, commenters consider that the change of administration has not yet resulted in significant changes in the Dodd-​Frank derivatives regulation. However, certain aspects of Dodd-​Frank have been modified, and it remains possible that more significant parts of the derivatives regulation will be amended. Notably, and as discussed in Sec. I.I.10, a U.S. Treasury report on capital markets recommends a number of reforms for derivatives regulation. In addition, the CFTC has recently consulted market participants and the broad public for suggestions to reduce the regulatory burden from the existing regulation. Nonetheless, the prospects for adoption of new regulation is uncertain.194 5. The Change of CFTC Chairman The change of CFTC chairman entails a change in the priorities of the CFTC (a). In addition, the CFTC decided to engage in a specific process of rule simplification

190 Id. 191 ISDA response to CFTC project KISS, at 18, ISDA, September 29, 2017. 192 Id. 193 Derivatives & Structured Products, supra note 74, at 1. 194 Id. at 3.

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named project KISS (b). Eventually, we will review that the CFTC modestly started to modify some parts of the derivatives regulation and announced some further actions to come (c). a. CFTC’s New Priorities The CFTC’s acting chair announced that the new CFTC’s priorities are to improve SEF rules (1), to fix swap data reporting (2), and to achieve cross-​border harmonization (3). b. Improving SEF rules According to the CFTC chairman the trading obligations should allow market participants to freely elect the manner of trade execution that best suits their swaps trading and liquidity needs. The government should not decide this issue for them.195 Notably, the CFTC chairman considers that the CFTC swaps trading and SEF rules have been unsuccessful. According to the CFTC chairman, the current approach of the CFTC is over-​engineered.196 The CFTC chairman also states that the CFTC swaps trading rules have caused foreign market participants to limit their transactions with the entities that have to comply with CFTC swaps regulation. 197 Eventually, the CFTC chairman considers that these rules have divided global markets into separate liquidity pools that are weaker in case of market shocks and less supportive of the worldwide economic growth.198 As a consequence, we will review in Section I.I.6 what the CFTC chairman aims at in modifying the SEFs regulation in the near future. c. Fixing Data Reporting The CFTC chairman deems that, despite the data reporting requirements, regulators currently lack sufficient quality information notably to better understand risk exposures in global markets. According to the CFTC chairman, data requirements are currently not efficient tools to assess and quantify the overall counterparty credit risks within swap markets.199 In addition, the CFTC chairman states that the CFTC is facing many issues to improve swaps data reporting. The CFTC has notably to work on the standardization

195 Keeping It Simple, interview of the CFTC’s acting chair, J. Christopher Giancarlo, 3(1) ISDA Q. 18 (May 2017). 196 Id. at 20. 197 Id. 198 Id. 199 Id. at 18 and 21.

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of data fields, the implementation of automated analysis of data, and the question of the aggregation and sharing of cross-​border data. 200 According to the CFTC chairman, an important problem for data reporting is that market participants diverge significantly in their reporting of the same information. There are discrepancies in reporting from market participants to swap data repositories and, in turn, differences in the way swap data repositories report to the CFTC.201 To address these issues the CFTC adopted rules to clarify reporting requirements and solicited comments from the public regarding improvement of the standardization of the information reported.202 d. Achieving Cross-​Border Harmonization The CFTC chairman considers that it is essential for the CFTC to avoid conflicts between its rules and foreign regulators rules that would fragment the global derivatives markets. To avoid such conflicts the CFTC chairman contemplates for the CFTC to embrace an outcome-​based approach for cross-​border equivalence determinations. The CFTC chairman considers that the CFTC’s substituted compliance regime, based on a rule-​by-​rule analysis of CFTC and foreign rules, was inefficient.203 Consequently, the CFTC chairman announced that the CFTC would follow a new approach that would defer more to foreign regulators, where appropriate, and would set clear limits on the cross-​border application of its swaps rules.204 e. Project  KISS The CFTC chairman stated that derivatives markets currently suffer from CFTC rules that are unnecessarily complex. According to the CFTC chairman, such inappropriate regulation eventually impacts the price of commodities such as groceries, heating oil, and airline tickets as the prices of production of these commodities become harder to hedge.205 To tackle the unnecessary complexness of these rules, the CFTC chairman launched a project called KISS. This project stands for “keep it simple, stupid” and

Id. at 21. 201 Id. at 21. 202 Id. 203 Id. at 18 and 19. 204 Id. at 20. 205 Press Release, CFTC, CFTC Requests Public Input on Simplifying Rules “Project KISS” Enters New Phase (May 3, 2017). 200

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mandates an internal review by the CFTC of its rules, regulations, and practices to make them simpler, less burdensome, and less costly for market participants.206 In this context, in May 2017, the CFTC organized a public consultation of the derivatives users, of the stakeholders, and of the broader public to obtain suggestions to simplify and make less costly current CFTC rules.207 However, the CFTC chairman emphasized that this project would not lead to repeal or rewriting of rules but only aimed at applying the current rules in ways that are simpler, less burdensome, and less costly.208 This consultation ended on September 30, 2017, and as a consequence the CFTC chairman announced, in March 2018, that the CFTC was currently looking for a series of rule improvements over the course of the year 2018 to implement the results of the consultation linked to the aforementioned proj­ ect KISS. Unfortunately, the CFTC chairman did not specify what these rule improvements could be.209 6. Recent Actions of the CFTC and Announcements of Further Actions to Come The CFTC started to modify parts of the Dodd-​Frank derivatives regulation in line with the CFTC chairman’s priorities. Notably, the CFTC announced cross-​ border developments with the EU regulators (1) and started to review data reporting requirements (2). Furthermore, we will discuss several actions that the CFTC chairman announced for the near future of Title VII (3). Recently, the CFTC chairman underlined several actions that the CFTC would take in the near future to improve Title VII. We will thus discuss proposals for the evolution of swap trading rules (a), de minimis threshold for swap dealer registration (b), positions limits (c), and improvement of clearinghouse stress testing (d). a. Amendment of Swap Trading Rules In 2017, as mentioned previously, the CFTC chairman largely criticized the swap trading rules enacted previously by the CFTC. Notably, the CFTC chairman denounced the fact that these rules sought to dictate the business models of the SEFs and turned SEFs into platforms that do not help the formation of liquidity.210

Keeping It Simple, supra note 195, at 18 and 19. 207 Project KISS, Fed. Reg., Vol. 82, No. 99, May 24, 2017; see also Press Release, supra note 205. 208 IT refers to both Id. 209 Project KISS, supra note 207; Giancarlo, supra note 117. 210 Giancarlo, supra note 83. 206

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The CFTC chairman indicated that the CFTC would therefore consider actions to improve current swap trading rules. According to the CFTC chairman, the CFTC should regulate swap trading by heightening the professional conduct of swaps execution through the implementation of licenses, additional testing, and adoption of approved codes of conduct. It should also reshape SEFs to foster liq­ uidity formation, price discovery, and trade execution. Furthermore, the CFTC chairman envisages raising the professional standards and regulatory transparency of SEFs.211 More recently, in 2018, the CFTC chairman added that the CFTC was working on reconsidering the current swaps trading rules to adapt these regulations to enable U.S. swap market participants to compete globally. 212 To address these issues, the CFTC chairman announced that he would promptly put before the CFTC rule proposals.213 b. Review of Swap Dealers De Minimis Threshold The CFTC chairman declared that the CFTC should normally be able to establish definitive rules on de minimis levels for swap dealer registration this year. The CFTC chairman affirmed that the CFTC had now sufficient current swap dealing data and analysis to implement a definitive threshold.214 c. Review of Position Limits The CFTC chairman recently announced that the CFTC staff was currently working on revisions of positions limit proposals. Unfortunately, the CFTC chairman did not elaborate on a precise date for the implementation of such proposals. 215 d. Improvement of Clearinghouse Stress Testing The CFTC chairman highlighted recently that the efficacy of the clearing requirements of Dodd-​Frank, which is a clearinghouse-​based risk management system, depends notably on several factors such as sufficient margin requirements to insure against default scenarios and sufficient access to liquidity to meet cash calls of counterparties.216 In brief, the CFTC chairman recognizes that resiliency of clearinghouses is key for the risk management of derivatives markets.

211 Id. 212 Giancarlo, supra note 117. 213 Id. 214 Id. 215 Id. 216 Giancarlo, supra note 195.

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The CFTC mentioned that it largely assesses the efficacy of the clearinghouse risk management system through the use of clearinghouse stress testing. In this context, the CFTC even stated that it recently concluded satisfactory clearinghouse stress testing.217 Nevertheless, the CFTC announced that it contemplated to improve and heighten its program of clearinghouse stress testing notably by implementing a recurrent clearinghouse stress testing.218 7. Propositions of Reforms from the U.S. Treasury Report on Capital Markets On October 6, 2017, the U.S. Treasury released a report making proposals to reform capital markets regulations. This report notably proposes several reforms of the current U.S. derivatives regulation.219 The recommendations of this report were in line with a number of concerns identified by market participants, such as unjustified costs of some obligations or lack of coordination between the CFTC and the SEC. However, this report is not deemed to propose major changes in the overall Dodd-​Frank Act derivatives regulation according to several commenters.220 Key recommendations in the U.S. Treasury report include: –​ Harmonization of international margin requirements and adoption of other gradual changes to the uncleared swap margin rules with the goal to reduce the size of initial margin requirements for certain products and to provide more flexibility as to the timing of margin requirements; –​ Greater deference to non-​U.S. regulatory regimes and implementation of an outcomes-​based substituted compliance regime; –​ Maintenance of the swap dealer de minimis registration threshold at $8 billion; –​ Changes to capital requirements for cleared transactions to facilitate clearing of derivatives; –​ Adoption of swap trading rule changes to provide greater flexibility as to the trading execution and to limit market fragmentation;

217 Id. 218 Id. 219 A Financial System That Creates Economic Opportunities—​Capital Markets, U.S. Department of the Treasury, Oct. 6, 2017. 220 Financial Services Regulatory Reform in 2018, at 30, Davis Polk, Mar. 29, 2018; see also Treasury Issues Report and Recommendations on Capital Markets, Shearman & Sterling, Oct. 2017.

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–​ Improvement of swap reporting requirements and processes, in line with the CFTC’s new priority on fixing data reporting; –​ Resolution of unnecessary inconsistencies and duplication between swap and security-​based swap rules, including granting interagency substituted compliance for areas where effective harmonization is deemed unfeasible and completion of the SEC’s derivatives rule-​makings; –​ Comprehensive review of guidance and relief provided by the CFTC and SEC over the past several years to formalize reliefs from these agencies into rule-​making;  and –​ Greater authority for the CFTC and SEC to exempt parties from Dodd-​ Frank requirements.221 Nevertheless, commenters note that the U.S. Treasury’s recommendations are mainly outside of its jurisdiction. Therefore, only actions by the SEC, the CFTC and, in certain cases, other financial regulators will conclude whether these recommendations might lead to new regulation.222 Nonetheless, it should be noted that the CFTC has supported this report. The CFTC chairman thus emphasized that the implementation of the U.S. Treasury recommendations would help foster financially sound markets.223

221 CFTC Backgrounder on the Department of Treasury’s Report on Capital Markets, CFTC, complementary documents to the Statement of Chairman Giancarlo on Treasury Report on Capital Markets, CFTC Chairman, Oct. 6, 2017; see also Treasury Issues Report and Recommendations on Capital Markets, supra note 220. 222 Treasury Issues Report and Recommendations on Capital Markets, supra note 21. 223 Statement of Chairman Giancarlo on Treasury Report on Capital Markets, CFTC Chairman, Oct. 6, 2017.

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I. Regulatory Overview  288 A. The Securities and Exchange Commission  288 1. Jurisdiction  288 B. What Constitutes a Security  290 1. Stocks  290 2. Notes  292 3. Investment Contracts—​The Howey Test  298 a. Control and Splitting the Transaction  304 b. Prepurchase Efforts  307 c. State Regulation and the Hawaii Market Test  308 C. Sellers’ Representations  310 D. Consequences of Securities Violations  311 1. Preliminary Injunction  312 2. Disgorgement  313 3. Permanent Injunction  313 4. Antifraud Statutes  314 5. Attorney’s Potential Liability  314 E. Hedge Funds  315 1. Post-​crisis Hedge Fund Regulation  319

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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2. Other Regulations  320 II. Derivatives Regulation: The SEC after Dodd-​Frank  321 Appendix A: Implementing the Dodd-​Frank Wall Street Reform and Consumer Protection Act  323 Appendix B: Checklist for Stocks, Notes, and Investment Contracts  323

I. Regulatory Overview Prior to the financial crisis, financial regulation was compartmentalized along lines of segmented financial instruments. With the exception of the regulation of swaps as described in Chapter 14, post-​crisis regulatory reform maintains this bifurcation of regulation along product lines between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The original reason for the regulatory bifurcation reflected the market conditions, as they existed at the time of the enactment of the Commodity Exchange Act (CEA) and the federal securities laws in the 1930s. This bifurcation operated effectively until the 1970s when futures trading expanded beyond agricultural commodities to encompass the rise and eventual dominance of nonagricultural commodities.1 The SEC and the CFTC have begun to issue rules establishing a coordinated approach to regulating certain derivatives under the Wall Street Reform and Consumer Protection Act (widely known as the Dodd-​Frank Act) in particular as they relate to swaps. However, the proliferation of newer technologies such as blockchains have facilitated the creation of investment “opportunities” and “instruments” that behave like securities but could fall into the definition of derivatives. These new technologies may necessitate structural changes in the way regulators coordinate. A. The Securities and Exchange Commission 1. Jurisdiction

The SEC was established by Congress under the Securities Exchange Act of 1934.2 It is vested with regulatory jurisdiction over securities markets, the companies issuing

1 Id. 2 15 U.S.C. § 78(d)(a) ( June 6, 1934, ch. 404, title I, § 4, 48 Stat. 885; Oct. 28, 1949, ch. 782, title XI, § 1106(a), 63 Stat. 972; Pub. L. 86–​619, § 3, July 12, 1960, 74 Stat. 408; Pub. L. 86–​771, Sept. 13, 1960, 74 Stat. 913; Pub. L. 88–​426, title III, § 305(20), Aug. 14, 1964, 78 Stat. 425; Pub. L. 98–​38, § 1, June 6, 1983, 97 Stat. 205; Pub. L. 100–​181, title III, § 307, Dec. 4, 1987, 101 Stat. 1254; Pub. L. 101–​550, title I, § 103, title II, § 207, Nov. 15, 1990, 104 Stat. 2713, 2721; Pub. L. 104–​290, title IV, § 406, Oct. 11, 1996, 110 Stat. 3444; Pub. L. 105–​353, title II, § 203,

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securities, and purchasers and sellers of securities under the Securities Act of 1933 (the “Securities Act”)3 and the Securities Exchange Act of 1934 (the “Exchange Act”).4 The jurisdiction of the SEC extends to all financial instruments that are covered by the definition of a “security” under these statutes. According to the Securities Act: The term “security” means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-​sharing agreement, collateral-​trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-​trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof ), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.5 The definition of a security is “sufficiently broad to encompass virtually any instrument that might be sold as an investment.”6 It is broad because it was adopted to restore investors’ confidence in the financial markets. In addition to typical instruments that fall within the ordinary concept of a security, it also includes any uncommon and irregular instruments.7 The securities laws cannot be avoided by calling a security by a term that is not listed in the statute because “Congress’ purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.”8 However, “it is also important to bear in mind that Congress, in enacting

Nov. 3, 1998, 112 Stat. 3234; Pub. L. 107–​123, § 8(d)(2), Jan. 16, 2002, 115 Stat. 2399; Pub. L. 111–​203, title IX, §§ 915, 919D, 965, 991(e)(1), July 21, 2010, 124 Stat. 1830, 1840, 1911, 1954). 3 15 U.S.C. § 77a et seq May 27, 1933, ch 38, title I, § 1, 48 Stat 74. 4 15 U.S.C. § 78a et seq. 5 15 U.S.C. §77(b)(1). The definition under the Exchange Act, 15 U.S.C. § 78(c)(a)(10), is identical except that the Exchange Act exempts notes having a maturity of less than nine months The Supreme Court has treated the two definitions as functionally indistinguishable in virtually all cases See Reves v. Ernst & Young, 494 U.S. 56, 61 n.1 (1990); Tcherepnin v. Knight, 389 U.S. 332, 335 (1967). 6 SEC v. Infinity Grp. Co. 212 F.3d 180, 186 (3d Cir. 2000), quoting Reves. 7 Marine Bank v. Weaver, 455 U.S. 551, 555 (1982). 8 Reves, 494 U.S. at 56.

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the securities laws, did not intend to provide a federal remedy for all common law fraud.”9 B. What Constitutes a Security

In every securities case, it is necessary to prove that the financial instruments sold are securities as defined in the Act.10 That proof may come from the face of the financial instrument itself or through external information.11 Proof from the face of the instrument itself is appropriate with notes, stocks, and bonds as these instruments are generally standardized and the name alone has a well-​settled meaning.12 External proof is appropriate where the financial instrument embodies some of the significant characteristics associated with a type of security but is not called by a standard name.13 Regardless, the legal terminology describing the financial instrument is not determinative of whether it is considered a security.14 A financial instrument may be a security if, under its terms, or through the course of business, its character is established as “any interest or instrument commonly known as a security.”15 In determining whether a particular financial instrument is a security, the focus is on the substance of the transaction with an emphasis on the economic reality.16 1. Stocks A financial instrument does not become a security simply by being called one.17 For example, even though the statutory definition includes “any . . . stock,” the “stock” purchased by tenants of a low-​income cooperative housing project that gave them the right to lease a state-​subsidized and supervised apartment was found not to be a security because the court focused on the economic reality of the transaction, and substance triumphed over form.18 The sole purpose of the “stock” was to enable the 9 Rivanna Trawlers Unlimited v. Thompson Trawlers, Inc., 840 F.2d 236, 241 (4th Cir. 1988); see also Marine Bank, 455 U.S. at 556, which states that Congress did not “intend to provide a broad federal remedy for all fraud.” 10 SEC v. Joiner, 320 U.S. 344, 355 (1943). 11 Id. 12 Id. at 351. 13 United Housing Found. v. Forman, 421 U.S. 837, 850 (1975). 14 Joiner, 320 U.S. at 351. See also Nat’l Bank of Yugoslavia v. Drexel Burnham Lambert, Inc., 768 F. Supp. 1010, 1015 (S.D.N.Y. 1991). 15 Joiner, 320 U.S. at 351. 16 See Tcherepnin v. Knight, 389 U.S. 332, 336 (1967). As one would assume, all financial instruments are analyzed as they existed at the time of the original agreement. See El Khadem v. Equity Sec. Corp., 494 F.2d 1224, 1228 (9th Cir. 1974). 17 Robinson v. Glynn, 349 F.3d 166, 172 (4th Cir. 2003). 18 United Housing, 421 U.S. at 848.

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purchaser to obtain an apartment—​the shares were explicitly tied to the apartment, they were not transferable, did not possess any voting rights, and only descended to a surviving spouse. Moreover, upon termination of occupancy, a tenant could only resell the shares to the managing company at the initial selling price.19 It is the economic reality, not the label attached to the financial instrument, which determines whether the instrument falls within the reach of the federal securities laws.20 Purchasers intending to acquire a residential apartment in a state-​subsidized housing project do not believe they are purchasing securities simply because the transaction instrument is called a “stock.”21 The economic reality of the transaction is determinative, but it is not necessary to conduct a case-​by-​case analysis of every financial instrument.22 Some instruments, such as stock, are investments by their nature and are securities if they have the normal characteristics associated with stock.23 “Stock” has a limited meaning and refers to a narrow set of instruments with a common name and common characteristics.24 The traditional common features of stock are (1) the right to receive dividends upon an apportionment of profits, (2) negotiability, (3) the ability to be hypothecated or pledged, (4) the conferring of voting rights in proportion to the stock owned, and (5) the capacity for value appreciation.25 For example, purchasers of all the outstanding stock of a lumber business in a privately negotiated transaction were entitled to bring a federal securities claim.26 It did not matter that the purchasers intended to purchase the whole business and operate it themselves.27 The financial instrument was called “stock”: it plainly fell within the statutory definition, and there was no need to analyze the economic reality to determine if the Exchange Act or the Security Act (together the “Securities Acts”) should apply.28 Stock, providing it has the normal characteristics of

Id. at 842. 20 Robinson, 349 F.3d at 172. 21 United Housing, 421 U.S. at 851. 22 Reves v. Ernst & Young, 494 U.S. 56, 62 (1990). 23 Id. at 62. 24 Robinson, 349 F.3d at 173. 25 United Housing, 421 U.S. at 85, which notes that the touchstone of an investment is the reasonable expectation of profits from the efforts of others; therefore, in scenarios where the purchaser is motivated by a desire to use or consume the item, the securities laws will not apply. See also Landreth Timber Co. v. Landreth, 471 U.S. 681, 686 n.2 (1985), which clarifies that these are the usual characteristics of common stock but that various types of preferred stock may have different characteristics and still be covered by the Act. 26 Landreth Timber, 471 U.S. at 692, in which the buyers wanted to rescind the purchase because the business was not as profitable as the sellers had led them to believe. 27 Id The court applied the Securities Acts where control passed to the purchaser and explicitly rejected the sale of business doctrine that held the securities laws do not apply to the sale of 100 percent of the stock of a closely held corporation. 28 Id. at 690. 19

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stock, is per se a security regardless of the manner and transaction in which it is used.29 Indeed, stock is viewed in a category by itself when the scope of a security under the Securities Acts in being interpreted.30 For example, a note that is a unique agreement negotiated on a one-​to-​one basis will not be a security; however, a paradigm security (such as those on the level of stock) can be offered to only one person and still be a security.31 Instruments that bear both the name “stock” and possess all of its normal characteristics obtain the full protection of the Securities Acts.32 Although the name of a financial instrument is not dispositive, it is relevant whether the traditional name “stock” justifiably leads the purchaser to conclude that he is purchasing a security.33 In a similar vein, warrants are per se securities, regardless of the transaction and manner in which they are used.34 Thus, a purchase warrant on common stock that was part of the consideration for a bridge loan subjected the transaction to the securities laws.35 The court noted that the parties could have structured the transaction as a straight loan, which would not have triggered the securities laws, but once a warrant (with the label “warrant” and its associated characteristics) is used, that is per se a security and the securities laws apply.36 Options, like warrants, have likewise been held to be per se securities.37 Other courts have suggested that “debentures” and “bonds” are traditional securities, and when they have the associated characteristics, are per se securities.38 2. Notes Although common stock is considered the quintessence of a security and investors may justifiably assume a stock is protected by the Securities Acts, this same assumption may apply to notes, which are used in a wide variety of settings without necessarily involving investments.39

Bass v. Janney Montgomery Scott, Inc., 210 F.3d 577, 586 (6th Cir. 2000). 30 Landreth Timber, 471 U.S. at 694. 31 See Bass, 210 F.3d at 585. 32 Landreth Timber, 471 U.S. at 693. 33 United Housing Found. v. Forman, 421 U.S. 837, 850 (1975). 34 Bass, 210 F.3d at 586. 35 Id. at 581–​82. 36 Id. at 586. 37 See One-​O-​One Enters., Inc. v. Caruso, 848 F.2d 1283, 1288 (D.C. Cir. 1988). 38 See Developer’s Mortgage Co. v. TransOhio Sav. Bank, 706 F. Supp. 570, 577 (S.D. Ohio 1989). 39 Reves v. Ernst & Young, 494 U.S. 56, 62 (1990) (explains that a note is not per se a security, despite the statutory language “any note”) See also id. at 63, where the Court rejected the investment versus commercial approach, which distinguishes notes that are securities based on the circumstances surrounding the transaction (i.e., whether they are issued in a commercial or consumer context). 29

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The U.S. Supreme Court has adopted a modified version of the “family resemblance” test developed by the Second Circuit to determine whether a note is a security (the so-​called Reves test).40 The Reves test starts with the presumption that every note is a security.41 This presumption is rebuttable by proving a strong resemblance to the family of notes that are not securities.42 The four factors used to rebut the presumption are: 1. What is the reasonable motivation that prompts a reasonable buyer and seller to enter into the transaction? If the seller’s purpose is to raise money for a general business purpose or to finance its investments and the buyer’s purpose is primarily for profit, then it is likely a security.43 2. What is the plan of distribution, and is it an instrument for which there is common trading for speculation or investment?44 3. Whether the reasonable expectations of the investing public are that it is a security, and 4. Whether there exists a factor, such as an alternative regulatory scheme, that significantly reduces the riskiness of the investment and makes the protection of the Securities Acts unnecessary.45

40 Id. at 63. 41 Id. See also id. n.3, where the court declined to decide whether that presumption extends to notes with a payout term of less than nine months, which appear to be exempt under the literal language of the statute. Many circuits, including the Second Circuit, have not applied the literal language of the nine-​month exemption and have limited the nine-​month exemption to certain prime-​quality commercial paper. See, e.g., Nat’l Bank of Yugoslavia v. Drexel Burnham Lambert, Inc., 768 F. Supp. 1010, 1017 (S.D.N.Y. 1991). 42 Reves, 494 U.S. at 65. 43 However, if the purpose of the note was to facilitate the purchase or sale of a minor asset or consumer good, or for some other commercial or consumer purpose, then it is not likely to be a security Id. at 66. 44 This factor is easily satisfied when the notes are offered to a broad segment of the public, but the exact boundaries of this requirement are unclear. For instance, an offering and sale to 13 customers was held not to be a broad segment of the public. Stoiber v. SEC, 161 F.3d 745, 751 (D.C. Cir. 1998) However, an employee of a broker-​dealer firm who sold promissory notes to only six individuals may have sold securities because they were sold to private individuals who needed the protection of the Act. McNabb v. SEC, 298 F.3d 1126, 1132 (9th Cir. 2002) See also Nat’l Bank of Yugoslavia, 768 F. Supp. at 1015, which notes that other courts have held that a distribution to one investor may still cause the instrument to be a security; Resolution Trust Corp. v. Stone, 998 F.2d 1534, 1539 (10th Cir. 1993) holds that notes sold to sophisticated market weighs against finding the existence of common trading. Thus, it appears that both the breadth of the offering and the sophistication of the purchasers are factored into determining whether there was common trading. Cf. Marine Bank v. Weaver, 455 U.S. 551, 559–​60 (1982), which explains that Congress intended the securities laws to cover those instruments that are ordinarily considered securities (even in a private transaction), and that the unusual instruments found to be securities involved offerings to a large number of potential investors. 45 Reves, 494 U.S. at 66.

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None of these four factors are dispositive; rather, they are considered as a whole.46 The types of notes that are not securities are: notes delivered in consumer financing, notes secured by a home mortgage, short-​term notes secured by a lien on a small business or some of its assets, notes evidencing a “character” loan to a bank customer,47 short-​term notes secured by accounts receivable, notes given in connection with loans by a commercial bank for the current operations of a business,48 or notes that formalize an open-​account debt incurred in the ordinary course of business (especially if it is collateralized).49 If the note is not sufficiently similar to one of the nonnote classes, then the same four-​factor test is applied to decide if a new class of nonnote should be added.50 For example, a farmers co-​op sold promissory notes that were payable on demand of the holder in order to raise money for its general business operations.51 The notes were offered both to members and nonmembers, were marketed as an “Investment Program,” were supposedly backed by co-​op assets (but in reality were uncollateralized and uninsured) and paid a variable interest rate that was above the prevalent local interest rate.52 After the co-​op’s bankruptcy, the noteholders sued under the securities laws.53 Applying the Reves test, the court found that the promissory demand notes were securities because they did not strongly resemble any of the nonnote classes and the four factors did not suggest the demand notes should be a new category of nonnotes.54 The co-​op sold the notes for its general business purposes and the purchasers bought them to earn a profit at higher interest rates

See, e.g., Wallenbrock, 313 F.3d at 537. 47 Generally, these bank character loans are loans that a bank makes to cement or maintain its commercial relationship with a customer. See McNabb v. SEC, 298 F.3d 1126, 1131 (9th Cir. 2002). 48 These commercial loans are made to allow the borrower to smoothly continue its business operations during periods where cash inflows and outflows do not match up. See id. The reason they are exempted is because normally the bank obtains extensive documentation, scrutinizes the business’ operations, and even obtains some control over the operations, thereby reducing the riskiness of the loans and eliminating the need for the protection of the Securities Acts. See, e.g., Nat’l Bank of Yugoslavia, 768 F. Supp. at 1014–​15 (citing cases). See also Payable Accounting Corp. v. McKinley, 667 P.2d 15, 20 (Utah 1983), which explains that commercial loans are usually private transactions between a few individuals whereas securities are usually open to a general class of investors). In addition, the lender is usually a bank that has substantial lending expertise and has less of a need for protection from fraud than the average individual investor. 49 Reves, 494 U.S. at 65. It is important to realize that no labels are dispositive and the court looks at the economic realities to see if it fits into one of the nonnote categories. SEC v. Wallenbrock, 313 F.3d 532, 538 (9th Cir. 2002). 50 Reves, 494 U.S. at 67. Although this is technically a two-​step analysis (i.e., whether it strongly resembles a nonnote category and whether a new category should be added), both steps involve the same four-​factor test, and it is essentially a single inquiry. See Wallenbrock, 313 F.3d at 537. 51 Reves 494 U.S. at 58. 52 Id. at 58–​59. 53 Id. at 59. 54 Id. at 67. 46

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(indeed, that rate was constantly revised to keep it above the prevalent local interest rate), which signifies an investment rather than a commercial or consumer transaction.55 Additionally, the plan of distribution was to a broad segment of the public; it was unnecessary for the notes to be traded on an exchange in order for them to be considered securities.56 The public’s reasonable perception was that the note constituted an investment, and it was thus advertised to the public.57 Last, no risk-​ reducing factor was present.58 In another case, a company that factored medical accounts receivable offered “investment agreements” that the court found to be notes.59 The “investment agreements” were offered publicly to raise capital to finance the purchase of the accounts receivable (which was its general business purpose), the purchasers earned profits in the form of high interest rates, the reasonable expectation was that they were securities, and there was no risk-​reducing factor present.60 In a case involving privately negotiated promissory notes that provided operating capital for the debtor to continue his business operations, the court applied the Reves test and found they were not securities.61 There were two factors in favor of a finding that the notes were securities: the notes were investments in a business venture rather than commercial or consumer transactions, and the notes were uncollateralized and uninsured. Two factors argued against a finding that the notes were securities: there was no offering to a broad segment of the public, and the reasonable expectation was that they were only promissory notes and not securities.62 Based largely on the fact

Id. at 67–​68. 56 Id. at 68. 57 Id. 58 Id. at 69. 59 SEC v. Current Fin. Servs., 100 F. Supp. 2d 1, 4–​5 (D.D.C. 2000). The company purchased the discounted receivables from various healthcare providers and planned on collecting all or most of the face value. See id. at 3 In order to raise capital, the company entered into “investment agreements” with public investors, which were essentially debt securities with a high interest rate. There were also separate companies formed with the sole purpose of purchasing the original company’s debt and then issuing its own debt to the public. 60 Id. at 5. See also Majors v. S.C. Sec. Comm’n, 644 S.E.2d 710, 712 (S.C. 2007), which holds that an investment contract existed where a company entered into agency contracts with investors to purchase tax lien certificates (which the company reasonably believed would not be redeemed), the company did all the work and exercised full control, and the company and investors split the profits when the tax lien certificates were not redeemed; Payable Accounting Corp v. McKinley, 667 P.2d 15, 16–​17 (Utah 1983), which holds that an investment contract existed where investors contributed funds to the company, the funds were used to run its business, the investors received profits in the form of a fixed monthly payment, and the profits were derived from the company’s managerial skills. Thus a company must be wary of raising funds for its general business purposes through issuing notes and through contractual agreements. 61 LeBrun v. Kuswa, 24 F. Supp. 2d 641, 642 (D. La 1998). 62 Id. at 647–​49. 55

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that there was no plan of distribution to a broad segment of the public, the court found the promissory notes not to be securities.63 The Ohio Supreme Court adopted the Reves test for state law matters and held that an unconditional promissory note to provide funds for a sports arena with an obligation to pay a specified sum on a certain date was a security.64 Interestingly, the first Reves factor was inconclusive because the motivations of the parties were different—​the lender entered into the transactions as an investment, while the borrower entered into it as a commercial transaction.65 Regarding the second Reves factor, there was a private agreement between two sophisticated parties and no evidence of common trading implying that the note should not be a security.66 However, as the promissory notes were called investments, the reasonable public would have believed they were securities, and there was no alternative risk-​reducing regulatory scheme present. Therefore, the presumption that a note is a security held. The fourth factor of the Reves test is whether there exists a factor, such as an alternative regulatory scheme, which significantly reduces the risk of the financial instrument.67 The mere existence of an alternative regulatory scheme is not sufficient—​it must be a comprehensive scheme that significantly reduces the risk of the financial instrument, making it unnecessary to have protections under securities laws.68 For example, certificates of deposit (CDs) offering a fixed rate of return were insured by the FDIC and subjected to the comprehensive regulations of the banking system; therefore, the notes were not securities because the comprehensive regulatory and insurance schemes already in place eliminated the risk of loss to the investor.69 Likewise, pension plans are already federally regulated by the Employee Retirement

Id. at 649 See also Bass v. Janney Montgomery Scott, Inc., 210 F.3d 577, 585–​86 (6th Cir. 2000), which applies the Reves test and finds that a bridge loan is not a security because it was a unique privately negotiated transaction (no plan of distribution) and there was significant collateral (risk-​reducing factor is present). 64 Perrysburg Twp. v. City of Rossford, 814 N.E.2d 44, 47–​49 (Ohio 2004). 65 Id. at 50. See also Bass, 210 F.3d at 585, which explains that the first Reves factor does not help decide whether it is a security if on one side of the transaction the motivation is for a typical commercial loan (such as raising interim funds for a new enterprise) and on the other side of the transaction the motivation is for an investment (i.e., to make a profit). 66 Perrysburg, 814 N.E.2d at 50. 67 This factor is important because the foremost threat to the investor is to lose her investment, but the factor is still not dispositive because many commercial transactions are extremely risky and are not governed by the securities laws. 68 See SEC v. Wallenbrock, 313 F.3d 532, 540 (9th Cir. 2002); accord LeBrun v. 2d 641, 649 (D. La. 1998), which requires a federal regulatory scheme that affords investors a sufficient level of protection. 69 Marine Bank v. Weaver, 455 U.S. 551, 557–​58 (1982). The CD was different from long-​term debt because the investors were “abundantly protected under the federal banking laws.” Id. at 559. 63

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Income Security Act (ERISA), and such existing comprehensive regulation weighs against extending the Securities Acts to cover pension plans.70 Reinsurance contracts were also found not to be securities because they are subject to the comprehensive regulation of the insurance laws.71 However, a federal regulatory scheme may be required to satisfy the risk-​reducing factor of the Reves test; the presence of state law relief may be insufficient.72 Collateral, such as a note secured by a mortgage on the property, significantly weighs against the note being found to be a security because the collateral is a risk-​reducing factor.73 The securing of an investment by collateral does not automatically remove the investment from regulation under the securities laws, but if an instrument is not clearly a security then the presence of collateral can be a probative factor because the collateral may be seized in case of default.74 Last, a note that promises a fixed rate or is short term may have a reduced risk, but the note may still be a security if it is not afforded protection comparable to the safeguards of the securities laws.75 The case of SEC v. Wallenbrock76 illustrates the presence of all four Reves factors in a transaction. A company issued promissory notes that were supposedly secured by accounts receivable of Malaysian latex glove manufacturers. The goal of the company was to use its cash and the funds raised from the sale of the promissory notes to purchase the accounts receivable at a discount.77 Ostensibly the company and the holders of the promissory notes would hold equal ownership of the receivables and split the profits after collecting the full amount from the buyers. In fact, the entire transaction was a high-​stakes pyramid scheme and the funds from the promissory

Int’l Brotherhood of Teamsters, Chauffeurs, Warehousemen & Helpers of America v. Daniel, 439 U.S. 551, 569–​70 (1982). 71 See Am. Mut. Reins Co. v. Calvert Fire Ins. Co., 367 N.E.2d 104 (Ill. App. 1977). 72 See, e.g., LeBrun v. Kuswa, 24 F. Supp. 2d 641, 649 (D. La. 1998). See also Manns v. Skolnik, 666 N.E.2d 1236, 1246 (Ind. 1996), which specifically requires another federal regulatory scheme, despite the existence of a state civil remedy; Wallenbrock, 313 F.3d at 540 comments that a “patchwork of state regulation” cannot displace the federal regime). 73 See Eagle Trim, Inc. v. Eagle-​Picher Indus., Inc., 205 F. Supp. 2d 746, 753 (D. Mich. 2002); although the mortgage did not cover the full amount claimed, the court still considered it to satisfy the fourth factor because it did reduce the overall risk of the investment; Bass v. Janney Montgomery Scott, Inc., 210 F.3d 577, 585 (6th Cir. 2000), in which the existence of collateral is significant as a risk-​reducing factor; Wallenbrock, 313 F.3d at 539, in which collateral does mitigate the risk of the investment, but where the collateral is a fiction it cannot be a risk-​reducing factor. 74 See State v. Crofters, 525 F. Supp. 1133, 1137 (S.D. Ohio 1981). 75 See Nat’l Bank of Yugoslavia v. Drexel Burnham Lambert, Inc., 768 F. Supp. 1010, 1015–​16 (S.D.N.Y. 1991), which notes that short-​term instruments may still contain substantial risk, and that many notes undoubtedly covered by the Securities Acts have fixed rates See also Wallenbrock, 313 F.3d at 539–​40, which explains possible risks, such as default because of a lack of funds, which exist under fixed rate instruments also). 76 313 F.3d 532 (9th Cir. 2002). 77 Id. at 535. 70

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notes went to pay off earlier investors or to finance other risky start-​up companies.78 The Ninth Circuit held that the promissory notes were securities. The lenders/​ investors invested to earn a profit, they provided the company with cash for its gen­ eral business enterprise, the notes were offered to a broad segment of the public (there were over 1,000 investors and the company even wanted to broaden its marketing plan), a reasonable investor would think this was an investment, and there was no risk-​reducing factor present.79 3. Investment Contracts—​The Howey Test The fundamental purpose of the Securities Acts is to eliminate serious abuses in the financial markets.80 Congress enacted broad statutes to cover the “virtually limitless scope of human ingenuity, especially in the creation of ‘countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.’ ”81 Congress intended catch-​all phrases such as “investment contracts” to encompass the wide range of novel and unusual instruments created by individuals where the economic realities of the transaction lend themselves to the application of the federal securities laws.82 “Nevertheless, we do not believe every conceivable arrangement that would fit a dictionary definition of an investment contract was intended to be included within the statutory definition of a security.”83 Whether a particular financial instrument constitutes an “investment contract,” and therefore also a security, is determined using the “Howey test.”84 The Howey test is a tripartite test:85 (1) the investment of money, (2) in a common enterprise, and Id. at 536. 79 Id. at 538–​39. Note that the promissory notes here seem to fall into one of the nonsecurity categories, “short-​ term notes secured by a lien on a small business or some of its assets,” yet the court found them to be securities because the collateral promises were largely a fiction. However, one could question whether the test for a security should be applied to the financial instrument that was promised (what the parties thought the transaction involved) or to the financial instrument that was the reality of the transaction. See also SEC v. Pickney, 923 F. Supp. 76, 80–​81 (E.D.N.C. 1996), which holds that the analysis of whether a financial instrument is a security is dependent on the reality of the investment and not on the promised instrument, if the promises are found to be false. 80 Reves v. Ernst & Young, 494 U.S. 56, 60–​61 (1990). 81 Id., quoting SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946). 82 Robinson v. Glynn, 349 F.3d 166, 172–​73 (4th Cir. 2003). 83 Milnarik v. M-​S Commodities, Inc., 457 F.2d 274, 275–​76 (7th Cir. 1972). 84 Howey, 28 U.S. 293 The Howey test is both necessary and sufficient to determine if a financial instrument is an investment contract See Developer’s Mortg. Co. v. TransOhio Sav. Bank, 706 F. Supp. 570, 575–​76 (S.D. Ohio 1989). 85 Some courts have interpreted Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985), as requiring an initial two-​part analysis for an investment contract: whether a security has (1) a title traditionally associated with securities, and (2) its typical associated characteristics; if not, then the court should apply the Howey test, which would be dispositive. See, e.g., Developer’s Mortg., 706 F. Supp. at 577; All Seasons Resorts, Inc. v. Abrams, 78

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(3) with an expectation of profits to be derived solely from the efforts of others (a promoter or other third party).86 In compliance with the spirit of the securities laws, the Howey test must be applied in light of the economic reality of the transaction.87 In Howey, a Florida citrus company sold land interests in citrus groves that were coupled with management service contracts. The promoters retained complete control over the land, cultivated and marketed the citrus crops, and allocated net profits to the purchasers. The company used the proceeds from the sales to finance its citrus-​growing operation.88 The Court held this was an investment contract because the investors provided the investment capital, the sellers managed and controlled the enterprise for the benefit of all the investors, and the investors’ expectation was that they would receive the profits (as evidenced by the fact the investors had a claim only for their percentage of the net profits and not to the actual produce).89 The Court explained that the purchasers were attracted solely by the opportunity for profits and the land sales were merely a “convenient method” by which to apportion profits.90 The Court had previously held that the sales of leasehold rights were investment contracts where the purchasers obtained leasehold rights and also shares in the discovery value of well-​drilling explorations for oil that were currently being conducted by the promoters, which was the real economic enterprise being offered for investment.91 The Court found it was not a mere sale of a leasehold; rather the exploration enterprise was woven into the leasehold in an economic and legal sense.92 The Howey test embodies a flexible principle that is capable of adaptation to meet the virtually limitless scope of human ingenuity, especially in the creation of “countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”93 To demonstrate the flexibility of the Howey test, it has 68 N.Y.2d 81, 88 (N.Y. 1986) (applying federal securities law to state blue sky laws). However, this analysis appears to be wrong. The Landreth test is reserved for traditional securities such as stock. See supra notes 23–​34 and accompanying text. Investment contracts are determined using the Howey test exclusively. See infra notes 98–​166 and accompanying text, which cites many cases applying the Howey test. 86 Howey, 328 U.S. at 298–​99. When analyzing these factors, the court considers both the actual agreement between the parties and any promotional materials See, e.g., SEC v. Prof ’l Assoc., 731 F.2d 349, 354 (6th Cir. 1984); Hocking v. Dubois, 885 F.2d 1449, 1457 (9th Cir. 1989), in which the court must examine all the representations of the promoter, such as the promotional materials, merchandising approaches, oral assurances, and contractual arrangements. 87 United Housing Found., Inc. v. Forman, 421 U.S. 837, 851–​52 (1975). 88 Howey, 328 U.S. at 295–​97. 89 Id. at 300–​01. 90 Id. at 300. 91 SEC v. Joiner Corp., 320 U.S. 344, 348–​49 (1943). 92 Id. at 349 (the land itself was purely an incidental consideration in the transaction; the financial instruments sold contained all the evils inherent in the securities transactions that the Securities Acts sought to end). 93 Howey, 328 U.S. at 299.

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been applied to the purchase of a life partnership in an evangelical community,94 a cattle-​feeding and consulting agreement,95 a chinchilla-​breeding and resale agreement,96 and even to a virtual organization making use of blockchain technology.97 The first prong of the Howey test requires the investment of money, which means only that the investor must commit her assets to the enterprise in a manner where they are subject to a monetary loss.98 This does not mean the investors must actually incur the monetary loss; it is sufficient that they were subject to the risk of monetary loss.99 The second prong of the Howey test requires an investment in a common enterprise. There is broad disagreement over what degree of commonality is required.100 One approach requires horizontal commonality, meaning the fortunes of each investor in the pool of investors must be tied to the success of the overall venture.101 The other approach, vertical commonality, requires only a tying of fortunes between the investor and the promoter, as in a one-​on-​one arrangement between a lender and a customer.102 Horizontal commonality focuses on the relationship among multiple investors; vertical commonality focuses on the relationship between the promoter and the individual investor.103 Some circuits have adopted the narrower horizontal commonality requirement because the vertical commonality approach effectively excises the common enterprise requirement; it does not require a link between multiple investors, and allows, for example, the relationship between a stockbroker and

94 Teague v. Bakker, 35 F.3d 978, 981, 990 (4th Cir. 1994). 95 Long v. Shultz Cattle Co., 881 F.2d 129, 132 (5th Cir. 1989). 96 Miller v. Cen. Chinchilla Grp., 494 F.2d 414, 415, 418 (8th Cir. 1974). For a listing of varied transactions that were held to be investment contracts, see SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 481 n.6 (9th Cir. 1973) (citing cases). 97 Securities Exchange Commission (2017). Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, available at https://​www.sec.gov/​litigation/​investreport/​34-​81207.pdf (last visited Aug. 16, 2018). 98 See SEC v. Rubera, 350 F.3d 1084, 1090 (9th Cir. 2003); accord SEC v. Pickney, 923 F. Supp. 76, 80 (E.D.N.C. 1996); SEC v. Int’l Mining Exch., Inc., 515 F. Supp. 1062, 1067 (D. Colo. 1981). 99 Rubera, 350 F.3d at 1090. 100 See, e.g., SEC v. SG LTD., 265 F.3d 42, 49–​50 (1st Cir. 2001) (citing cases); Majors v. S.C. Sec. Comm’n, 644 S.E.2d 710, 716–​17 (S.C. 2007) (citing cases). 101 Deckebach v. La Vida Charters, Inc. of Fla., 867 F.2d 278, 282 (6th Cir. 1989). Another court explained horizontal commonality as the pooling of interest and funds among the investors only Majors, 644 S.E.2d at 716. 102 Deckebach, 867 F.2d at 282. Another court explained vertical commonality as the pooling of interests between the promoter and the investor only. See Majors, 644 S.E.2d at 716. 103 SEC v. Pickney, 923 F. Supp. 76, 80–​81 (E.D.N.C. 1996). It is important to realize that horizontal commonality would exclude from the securities laws a case of multiple parallel frauds between investors and the promoter.

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customer in a discretionary trading account104 to satisfy the common enterprise requirement.105 Notably, the Second Circuit has adopted a strict106 vertical commonality requirement because it has reasoned that a broad vertical commonality renders the third prong of Howey superfluous: the “common enterprise and profits derived from the efforts of others” requirements would be merged into a single inquiry, that is, whether the success of the enterprise collectively is dependent on the promoter’s expertise.107 The case of Deckebach v. La Vida Charters, Inc. of Florida108 illustrates the difference in the commonality level required. In Deckebach, investors purchased a yacht and entered into a management service agreement that gave the management company significant day-​to-​day control over the yacht.109 The management company had a number of yachts that it managed together, but the income generated from each yacht was segregated and applied to its own maintenance and expenses.110 There was no pooling of funds among the various yacht owners.111 The court noted that only vertical commonality was satisfied and not horizontal commonality, because there was no pooling of funds, even though the company attempted to uniformly allocate income among all the yacht owners through sequential chartering, and some expenses were divided pro rata.112 The purchasers were essentially hiring an independent contractor to perform management services and to produce rental income.113 The third prong of the Howey test appears to require investors to expect profits “solely” from the efforts of others; however the courts generally do not interpret

See Milnarik v. M-​S Commodities, Inc 457 F.2d 274 (7th Cir. 1972), which holds that a broker who entered into discretionary trading arrangements with many customers had not created investment contracts because the success or failure of one account had no effect on the other accounts and was lacking commonality. 105 Deckebach, 867 F.2d at 281 notes that the vertical approach would effectively mean the adoption of an expansive “risk capital” approach. See also SEC v. Lauer, 52 F.3d 667, 670 (7th Cir. 1995) (adopting horizontal commonality); Salcer v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 682 F.2d 459, 460 (3d Cir. 1982) (adopting horizontal commonality). 106 Broad vertical commonality requires a showing only that all the investors’ fortunes are dependent on the expertise and efforts of the promoter. Pickney, 923 F. Supp. at 81. Strict vertical commonality requires that the investor’s profits be directly related to the promoter’s profits (the fortunes of the investor and promoter are linked). Id. at 80–​81. 107 Revak v. SEC Realty Corp., 18 F.3d 81, 87–​88 (2d Cir. 1994). 108 867 F.2d 278 (6th Cir. 1989). 109 Id. at 279. Note that the agreement was structured as a purchase rather than as an investment of funds in a charter business, which would have triggered the securities laws. 110 Id. at 280. 111 Id. 112 Id. at 282. 113 Id. at 283. The court did acknowledge that a de facto “tie-​in” of the management services with the purchase of the yachts would constitute an investment contract (similar to the situation in Howey). 104

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“solely” literally114 because the Supreme Court has omitted the word “solely” from its restatements of the Howey test and a literal compliance would exclude any agreement that involved the slightest efforts of the investors from the protection of the securities laws.115 A number of courts have phrased the question as whether the efforts of the promoter are the undeniably significant ones and are the essential managerial efforts that affect the failure or success of the enterprise.116 Moreover, one court has held that even if the investors’ own efforts could produce limited profits from certain activities, but the profit-​generating business that is essential to the business’ success must come from the efforts of others, then it is an investment contract.117 The “expectation of profits” required by the Howey test is satisfied by the returns that investors seek on their investments, such as dividends, other periodic payments, or the increased value of their original investment.118 Profits may be capital appreciation from the development of the initial investment or from earnings contingent on the profits earned from the investors’ funds.119 Furthermore, profits from an investment may also come in the form of tax benefits.120 An example that did not satisfy “expectation of profits” was a company that marketed memberships in outdoor resort campgrounds for the personal enjoyment of the members; there were significant restrictions on the transferability of the memberships, and the members were not entitled to share in any gain of the company’s business.121 This arrangement did not constitute an investment contract because there was no potential for financial gain.122

114 See, e.g., Robinson v. Glynn, 349 F.3d 166, 170 (4th Cir. 2003), which notes that no federal circuit has required “solely”; Bailey v. J.W.K. Prop., Inc., 904 F.2d 918, 920 (4th Cir. 1990): “a program requiring some effort from the investor may still constitute an ‘investment contract’, but the most essential functions or duties must be performed by others and not the investor.” 115 See id. See also Long v. Shultz Cattle Co., Inc., 881 F.2d 129, 133 (5th Cir. 1989) (citing cases). 116 See, e.g., SEC v. Rubera, 350 F.3d 1084, 1091–​92 (9th Cir. 2003), which follows the modification of “solely” as construed in SEC v. Glenn W. Turner Enters., 474 F.2d 476 (9th Cir. 1973); accord Majors v. S.C. Sec. Comm’n, 644 S.E.2d 710, 718 (S.C. 2007). 117 Ball v. Volken, 741 P.2d 958, 959–​60 (Utah 1987) A purchaser of a district license agreement was allowed to sell franchises for area sales offices, but the purchaser was not allowed to make sales directly to the public (which constituted the bulk of his potential profits) and had to rely on the seller to generate the sales to the public. 118 SEC v. Edwards, 540 U.S. 389, 394 (2004). 119 SEC v. Infinity Grp. Co., 212 F.3d 180, 189 (3d Cir. 2000); accord SEC v. Rubera, 350 F.3d 1084, 1093 (9th Cir. 2003). 120 See, e.g., Long v. Shultz Cattle Co., Inc., 881 F.2d 129, at 132 n.2 (5th Cir. 1989) (citing cases). See also SEC v. Int’l Mining Exch., Inc., 515 F. Supp. 1062, 1068–​69 (D. Colo. 1981), which notes that a 500 percent tax write-​ off was the linchpin of the investment program, and that tax consequences may be the sole inducement to enter into an investment so it satisfies “expectation of profits.” 121 See All Seasons Resorts, Inc. v. Abrams, 68 N.Y.2d 81, 85–​86 (N.Y. 1986). 122 Id. at 92.

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The adaptability of this test can be seen through its application to a DAO (Decentralized Autonomous Organization), a term used to describe a “virtual” organization embodied in computer code and executed on a distributed ledger or blockchain.123 In 2016, one such DAO was created by Slock.it and Slock.it’s cofounders, with the objective of operating as a for-​profit entity that would create and hold a corpus of assets through the sale of DAO Tokens to investors, which assets would then be used to fund “projects.”124 However, the DAO’s code was exploited before it could even begin operations, prompting the SEC to investigate into the question of the DAO founders’ obligations under securities laws.125 To understand whether investors had any expectation of profits, the SEC looked into the promotional documents disseminated by the DAO founders.126 The SEC nevertheless came to the conclusion that any investment in DAO tokens was made for the purpose of earning a return on investment, meaning that a reasonable investor would have been motivated, at least in part, by the prospect of profits on her investment.127 While it did not initiate any action against the founders, the SEC nevertheless came to the conclusion that DAO tokens constituted securities.128 Regarding expectation of profits, there is no difference between promises of fixed returns or of variable returns because that would allow any promoter to evade the securities laws by promising a fixed rate of return.129 “The definition of security does not turn on whether the investor receives a variable or fixed rate of return.”130 In one fixed-​return case, investors loaned money to a corporation in exchange for a high fixed interest rate and the return of the principal after three years.131 The court found it was an investment contract because the investors risked losing all of their

123 Christoph Jentzsch, Decentralized Autonomous Organization to Automate Governance (2016), https://​ download.slock.it/​public/​DAO/​WhitePaper.pdf at 1. 124 Id. 125 Vitalik Buterin, CRITICAL UPDATE Re: DAO Vulnerability, Ethereum Blog ( June 17, 2016), https://​ blog.ethereum.org/​2016/​06/​17/​critical-​update-​re-​dao-​vulnerability/​; Nathaniel Popper, A Hacking of More than $50 Million Dashes Hopes in the World of Virtual Currency, N.Y. Times ( June 17, 2016), https://​www. nytimes.com/​2016/​06/​18/​business/​dealbook/​hacker-​may-​have-​removed-​more-​than-​50-​million-​from-​ experimental-​cybercurrency-​project.html. 126 Securities Exchange Commission, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (2017), available at https://​www.sec.gov/​litigation/​investreport/​34-​81207. pdf (last visited Aug. 16, 2018). 127 Id. 128 Id. 129 SEC v. Edwards, 540 U.S. 389, 394–​95 (2004). See also Payable Accounting Corp v. McKinley, 667 P.2d 15, 19 (Utah 1983) (citing cases where a promise for a fixed return was an investment contract). 130 SEC v. Infinity Grp. Co., 212 F.3d 180, 189 (3d Cir. 2000). 131 Suave v. K.C., Inc., 591 P.2d 1207, 1208 (Wash. 1979).

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investments if the company was not profitable.132 Other examples of fixed-​return investments that were considered investment contracts are: an investment that promised guaranteed profit of 30 percent per year with no chance of loss,133 a sale and lease-​back arrangement where investors received a fixed return of 2 percent each month for 10 years,134 and time deposits made for investment purposes in exchange for a fixed rate of interest.135 Indeed, investments promising fixed returns (e.g., those marketed as a low-​risk, guaranteed return) often are especially attractive to individuals who are particularly vulnerable to investment fraud, such as the elderly and less sophisticated investors.136 In another case, a company that offered a bonus to open an account was found not to have created an investment contract, even though there was a risk of nonpayment of the bonus (i.e., the risk of insolvency), because the expectation of profits from the efforts of others means the successful investment of the investors’ funds and is not just based on the solvency of a company.137 Similarly, a company that offered silver bars for sale, guaranteed their purity, offered free storage for one year, agreed to delivery upon full payment, and represented that it would buy back the silver bars at any time at the current spot market price of silver was not offering an investment contract because the investors profits depended on the fluctuations of the market price of silver and not on the company’s managerial expertise or efforts.138 The insolvency risk did not create an investment contract because the solvency of a company is a risk that any buyer takes when he pays in advance expecting delivery at a later date, and the viability of a company is not enough to create an investment contract.139 a. Control and Splitting the Transaction The degree of control exercised by an investor may determine whether the transaction is found to constitute an investment contract. In one case,140 an investor in a limited 132 Id. at 1210, which applies the Howey test for state securities law The court adopted the reasoning of the Ninth Circuit in El Khadem v. Equity Sec. Corp., 494 F.2d 1224 (9th Cir. 1974), that even if only the risk of loss is dependent on the promoter’s management skills and the gain is fixed, that is sufficient for the expectation of profits requirement of the Howey test. The court reasoned that a risk of loss or a possible gain is the difference between a corporate bond and a common stock, yet both are considered securities. Id. at 1229. 133 See SEC v. Universal Serv. Ass’n, 106 F.2d 232, 234, 237 (7th Cir. 1939). 134 See SEC v. Amer Trailer Rentals Co., 379 U.S. 594, 598 (1965). 135 See Nat’l Bank of Yugoslavia v. Drexel Burnham Lambert, Inc., 768 F. Supp. 1010, 1016 (S.D.N.Y. 1991). 136 SEC v. Edwards, 540 U.S. 389, 394 (2004). 137 See Reiswig v. Dep’t of Corp. for State of Cal., 144 Cal. App. 327, 339 (2006). 138 Noa v. Key Futures, Inc., 638 F.2d 77, 79 (9th Cir. 1980). See also Reiswig, 144 Cal. App. 327, which holds that the fluctuation of interest rates of CDs was not dependent on the efforts of others. 139 Noa, 638 F.2d at 79. 140 Robinson v. Glynn, 349 F.3d 166 (4th Cir. 2003).

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liability company (LLC) sued the LLC and its chairman for misrepresentations made to convince the investor to purchase a membership interest in the LLC. The court held there was no investment contract because “profits derived solely from the efforts of others” means the investor (whether as a result of the investment agreement or from the factual circumstances) is unable to exercise meaningful control over his investment. The investor in the LLC was an active and knowledgeable investor and had negotiated for a level of control (regarding incurring additional indebtedness, diluting shares, etc.) that was antithetical to the passive investor required for an investment contract. The managerial control was sufficient to prevent the transaction from being an investment contract, even though the investor lacked the technical knowledge to understand the business and also lacked decisive control over major decisions, because the investor had the type of influence that provided access to information and protection against a dependency on others.141 Thus, this was an ordinary commercial venture and it would be an unjustifiable expansion of the securities laws to consider it an investment contract.142 In contrast, investors who purchased pay telephones from a corporation and leased them back to the corporation to manage on their behalf in exchange for a monthly payment were considered to have entered into investment contracts.143 The investors possessed limited contractual rights under the lease, were inactive in the company’s operation, were inexperienced in that business, and lacked access to important information.144 The investors retained minimal control over their investments and relied on the corporation to provide all the essential managerial functions (such as phone placement, collection, and maintenance). Accordingly, those investors were dependent on the efforts of others in a manner that the investor in the LLC was not dependent.145 Therefore, the more control the investor retains, the less likely the contract will be a security.146 Despite contractual terms that appear to retain control for the investor,

141 A lack of specialized knowledge alone will not create an investment contract; rather a lack of specialized knowledge and a lack of control causing the investors to rely on the efforts of others will create an investment contract, as opposed to the present case where the investor obtained sufficient control over the LLC despite his lack of technical expertise. See id. at 172. The investor’s expertise must be considered in light of the venture, and generalized business experience does not preclude a finding that the investor lacked the knowledge or ability to exercise meaningful control over the venture. Long v. Shultz Cattle Co., Inc. 881 F.2d 129, 134–​35 (5th Cir. 1989). 142 Robinson, 349 F.3d at 168. 143 SEC v. ETS Payphones, Inc., 408 F.3d 727, 732 (11th Cir. 2005). 144 SEC v. ETS Payphones, Inc., 300 F.3d 1281, 1282 (11th Cir. 2002). 145 See Robinson, 349 F.3d at 175 n.4. 146 Similarly, a general partnership is typically not an investment contract because the partners have sufficient power to protect their own interests and do not need the protection of the securities laws. See SEC v. Prof ’l

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the court will consider who has discretion over the investment funds, and the focus will be on the actual relationship between the parties.147 If the investor has legal control, then he must prove practical dependence and an inability to exercise meaningful control or find another person to manage his investment.148 In a case with similar facts, investors purchased pay telephones from a corporation and simultaneously entered into service agreements whereby the corporation agreed to manage and maintain the pay telephones.149 The corporation offered various packages with different levels of service, and approximately 90 percent of the investors chose the package with the highest service level (which made themselves passive investors and left operation of the telephones solely in the corporation’s control). This constituted an investment contract: the court refused to split the transaction into two distinct transactions (a purchase of assets (the pay telephones) and a service agreement for the telephones, which would remove it from the securities laws) because they were marketed as one package.150 The court pointed out that Howey also involved an investment scheme that could have been characterized as a purchase of land and a management service agreement, but the Supreme Court refused to separate the transactions because the investors were attracted solely by the returns on their investments and the transaction satisfied the requirements for an investment contract. Likewise, an investment package that offered a contract to purchase a condominium along with a service agreement (the promoter would maintain and rent out the condominium) was held to be an investment contract, and the two transactions were not separated.151 However, the court noted the condominium was offered as a package with the service agreement; it would not be an investment contract if someone already owned a condominium and wanted to purchase a service agreement for the condominium.

Assoc., 731 F.2d 349, 356 (6th Cir. 1984). In addition, the profits in a general partnership require each partner’s efforts and are not dependent on the efforts of others. 147 See ETS Payphones, 408 F.3d at 732–​33, which calls the control retained by investors under contractual terms “illusory” and finds that an investment contract existed. 148 Hocking v. Dubois, 885 F.2d 1449, 1460 (9th Cir. 1989). See also Long v. Shultz Cattle Co., Inc., 881 F.2d 129, 131 (5th Cir. 1989), which holds that theoretical control does not suffice if the investors did not exercise that power of control and instead relied on the promoters to make the management decisions. 149 SEC v. Rubera, 350 F.3d 1084, 1087 (9th Cir. 2003). The profit split was 70 percent for the corporation and 30 percent for the investor; however, the corporation agreed to reduce its share to ensure the investors would receive a base amount equaling a 14 percent annualized return. 150 Id. at 1090–​91. 151 Hocking, 885 F.2d at 1458.

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b. Prepurchase Efforts The question also arises whether prepurchase efforts by the promoters can satisfy the “expectation of profits to be derived solely from the efforts of others” prong of the Howey test. One court has held viatical settlements152 contracts purchased from a promoter are not investment contracts because the post-​transaction ministerial functions did not affect the investors’ profits; therefore, the “expectation of profits” prong was missing as prepurchase efforts by themselves do not satisfy the expectation of profits that arise predominantly from the efforts of others.153 Other courts have disagreed and held that significant prepurchase activities that ensure the success of the enterprise may satisfy the “expectation of profits” prong.154 However the prepurchase activities must consist of significant efforts that require the expertise or specialized skill of the promoters in selecting an asset or negotiating its price.155 For example, the prepurchase activities in viatical settlements were sufficient because they required substantial skills to identify terminally ill patients, select insurance policies, negotiate and pay premiums, and perform the critical life expectancy evaluations.156 In another case that further illustrates the significant prepurchase activities required, a company offered yields on CDs greater than any other bank, but the investor had to first personally meet a company representative and the offer was limited to a $5,000 investment.157 The goal was to entice customers and then convince them to purchase annuities from the company. If the customer insisted on purchasing the CD, the company provided a list of institutions offering the current highest CD yields that were FDIC-​insured and told the customer to apply for a CD directly to one of the institutions on the list. The company would then pay the customer the difference between the yield advertised by the company and the yield paid by the institution. The difference was paid in the form of a bonus check that was issued within seven days after the customer submitted proof that he had opened a CD with

152 “A viatical settlement is a transaction in which a terminally ill or chronically ill insured (‘viator’) sells the benefits of his life insurance policy to a third party in return for a lump-​sum cash payment equal to a percentage of the policy’s face value. Viatical settlement providers purchase the policies from individual viators. Once purchased, these viatical settlement providers typically sell fractionalized interests in these policies to investors.” SEC v. Mut Benefits Corp., 323 F. Supp. 2d 1337, 1338 (S.D. Fla. 2004). This appears similar to how mortgage-​backed securities and other collateralized debt obligations operate, and raises the same concern as to whether their prepurchase activities suffice to create an investment contract. 153 SEC v. Life Partners, Inc., 87 F.3d 536, 548 (D.C. Cir. 1996). 154 SEC v. Mut. Benefits Corp., 408 F.3d 737, 743 (11th Cir. 2005); accord SEC v. Eurobond Exch., Ltd., 13 F.3d 1334 (9th Cir. 1994). 155 Mut Benefits, 408 F.3d at 744. 156 Id. at 744–​45. 157 Reiswig v. Dep’t of Corp. for State of Cal., 144 Cal. App. 327, 332 (2006).

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one of the institutions. In this case the bonus checks were not paid from the profits earned from investor funds because the bonus checks were paid by the company (as an inducement to hear its sales pitch for the annuities), and the profits from investor funds were earned by the institution who offered the CD.158 The passive task of compiling the daily list of institutions paying the highest CD rates was not a significant prepurchase effort, nor was the profit dependent on the company’s expertise or efforts; rather, it was dependent on the fluctuation in interest rates for CDs.159 Although the Howey test constitutes a flexible approach to determining what is a security, it is not without limitations.160 As in the case of the Reves test,161 the existence of a comprehensive alternative federal regulatory scheme that obviates the need for the protection of the federal securities laws will weigh against creating an investment contract. c. State Regulation and the Hawaii Market Test It is important to note that the federal securities laws were not intended to preempt a state’s blue sky laws.162 The Hawaii Market test163 is a test used by many states to 158 Id. at 338–​39. The court distinguished this case from a seemingly factually similar one, Safeway Portland Emps.’ Federal Credit Union v. C.H. Wagner & Co., Inc., 501 F.2d 1120 (9th Cir. 1974), because in that case the investors’ profit was dependent on the success of the broker (who solicited both the CD purchasers and the borrowers willing to pay the above-​market rates), the investment was not guaranteed by any bank, and the CD funds were fully integrated into the enterprise. 159 Id. at 341. See also Noa v. Key Futures, Inc., 638 F.2d 77, 79 (9th Cir. 1980), which holds that the fluctuation of the market price of silver is not dependent on the efforts of others. 160 Payable Accounting Corp. v. McKinley, 667 P.2d 15, 19 (Utah 1983). 161 Reves v. Ernst & Young, 494 U.S. 56 (1990); see supra notes 38–​40 and accompanying text. See also SEC v. Infinity Grp. Co., 212 F.3d 180, 189 (3d Cir. 2000); accord Reiswig v. Dep’t of Corp. for State of Cal., 144 Cal. App. 327, 336 (2006). 162 See 15 U.S.C. § 77(r). Additionally, the federal and state securities laws were enacted to serve different purposes. See King v. Pope, 91 S.W.3d 314, 319 (Tenn. 2002). The states enacted securities laws to protect their investors (so a broader, more protective test is warranted); federal securities laws were enacted for the broader purpose of protecting the integrity of the financial markets. See King, 91 S.W.3d at 320. This presumption that the federal and state securities laws serve different purposes is questionable. See, e.g., Payable Accounting Corp v. McKinley, 667 P.2d 15, 18 (Utah 1983): “The federal securities acts were adopted and designed to restore investors’ confidence in the financial markets, as was the Utah Act.” See also United Housing Found. V. Forman, 421 U.S. 837, 849 (1975): “The focus of the Acts is on the capital market system: the sale of securities to raise capital for profit-​making purposes, the exchanges on which securities are traded and the need for regulation to prevent fraud and to protect the interest of investors” (emphasis added); El Khadem v. Equity Sec. Corp., 494 F.2d 1224, 1227 (9th Cir. 1974): “The Acts must be interpreted liberally to ensure their purpose of ensuring full and fair disclosure to purchasers of securities and protecting the public from speculative or fraudulent schemes of promoters.” (emphasis added) and quoting the Senate Report of the 1933 Act, “The aim is to prevent further exploitation of the public by the sale of unsound, fraudulent and worthless securities through misrepresentation; to place adequate and true information before the investor; to protect honest enterprise, seeking capital by honest presentation, against the competition afforded by dishonest securities offered to the public through crooked promotion.” 163 See State v. Haw. Mkt., 485 P.2d 105 (Haw. 1971).

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determine whether a financial instrument is an investment contract for purposes of state securities laws.164 The Hawaii Market test is based on an earlier state test, the risk capital test, which requires that risk capital be invested with a reasonable expectation of a valuable benefit, but without the right to control the enterprise.165 The Hawaii Market test requires four prongs for an investment contract to exist: (1) the offeree furnishes an initial value to the offeror; (2) a portion of the initial value is subject to the risk of the enterprise; (3) the initial value was given over because of the offeror’s representations, which led to the reasonable expectation of the offeree that there would be an additional valuable benefit, above the initial value, accruing to the offeree from the enterprise; and (4) the offeree has no practical and actual control over the management decisions of the enterprise.166 In comparing the Hawaii Market test to the Howey test: (1) the first prong is similar to the investment prong of the Howey test, (2) the second prong focuses on a risk capital concept while the Howey test focused on commonality (vertical or horizontal), (3) the third prong allows an expectation of “benefits” (a more liberal concept) as opposed to the stricter “profits” required by the Howey test, and (4) the fourth prong explicitly requires that the investor does not exercise managerial control, which is also true according to the subsequent court interpretations of the Howey test.167 The Hawaii Market test was applied to a company that offered a pay telephone sale-​leaseback program, which consisted of three documents being executed simultaneously: a purchase agreement, a telephone lease agreement, and an option to sell agreement.168 The investors purchased the pay telephones from the company, entered into the lease agreement (which gave the company exclusive control over managing the payphones and its profits in exchange for a fixed monthly fee), and also entered into the option to sell agreement (which gave the investors the right to sell the pay phone to the company with the appropriate notice, less any termination fee). The court applied the Hawaii Market test and found it was an investment contract.169 The first prong was satisfied by the purchase of the telephones, which See, e.g., State v. Brewer, 932 S.W.2d 1, 13 n.13 (Tenn. Crim. App. 1996), notes that 17 jurisdictions had adopted the Hawaii Market test. 165 See SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476 (9th Cir. 1973); see also All Seasons Resorts, Inc. v. Abrams, 68 N.Y.2d 81, 93–​94 (N.Y. 1986) lists various states following the risk capital approach. Under this test, the risk capital cannot be invested for immediate benefits, a portion of the risk capital must be at risk, and the expectation is for future benefits in excess of the original investment. Id. at 93. 166 See Haw. Mkt., 485 P.2d at 109. 167 See, e.g., Brewer, 932 S.W.2d at 13–​14. See also All Seasons, 68 N.Y.2d at 93, which differentiates between the Howey test that requires an expectation for financial gain (profits) and the risk capital test that requires only an expectation of future benefits in excess of the initial value. See supra Sec I.B.3.a., explaining control under the Howey test. 168 King v. Pope, 91 S.W.3d 314, 316 (Tenn. 2002). 169 See id. at 316. 164

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was furnishing initial value for an investment and was not the ordinary purchase of consumer goods.170 The second prong was satisfied because the promoter relied on the investors for a substantial portion of the capital necessary to launch the enterprise and the investors expected a return on their investment.171 The third prong was satisfied because the investors reasonably expected a benefit from the successful operation of the enterprise.172 The fourth prong was satisfied because the investors had no managerial control, and their right to termination is not the equivalent of exercising practical control.173 C. Sellers’ Representations

The validity of the sellers’ representations regarding the proposed instrument must also be examined, because if those representations turn out to be false then the instrument may be a security even though as proposed it would not have been a security. For example, in one case174 where the promoters contractually promised to keep the investors’ funds in a guaranteed bank account175 so the funds would not be at risk (and thus appear not to be a security), the contract was a security because the representations were false and the funds, in truth, were at risk.176 Similarly, investors gave their funds to a trust and in exchange received a prop­ erty transfer agreement that was purportedly risk free and guaranteed extremely high rates of return (the promised rates ranged from 138 to 181 percent annually).177 The guarantee was supposedly based on the trust’s superior historical returns on its investment, financial connections, and ability to pool large amounts of money.

170 See id. at 326. Initial value has been explained as value “given in consideration for the right to receive future income from the corporation.” Haw. Mkt., 485 P.2d at 110. 171 See King, 91 S.W.3d 314, at 324. See also id. at 324–​25, which explains that a performance bond that was essentially worthless does not reduce the riskiness, and that the court focuses on substance over form. 172 See id. at 325. 173 See id. at 325. See also In re Trivectra v. Ushijima, 144 P.3d 1 (Haw. 2006), which applies the Hawaii Market test and finds an investment contract existed where an internet-​based company marketed and sold online “shopping malls” that allowed individuals to host a customized website that contained links to brand-​name retailers. The potential profits were from commissions of the internet sales and from recruiting additional mall owners, which was by far the more lucrative method to earn profits. 174 SEC v. Pickney, 923 F. Supp. 76 (E.D.N.C. 1996). 175 These were called “prime bank instruments,” which are nonexistent according to the SEC, and purported to be bank letters of credit or bank guarantees that could be traded for a profit. See Pickney, 923 F. Supp. at 78. This particular scheme promised to yield a 9 percent weekly return and to be guaranteed by a “top five U.S. bank,” which made it a virtually risk-​free investment. 176 See id. at 80–​81. 177 SEC v. Infinity Grp. Co., 212 F.3d 180, 184–​85 (3d Cir. 2000).

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However, the trust operated like a Ponzi scheme178 and substituted new investor money as a return on old investor money. There was no prudent investment strategy, and the funds were used for the personal expenses of the trust (and its officers) or in ill-​advised investments. The court held the property transfer agreements, which in reality were subject to substantial risk, satisfied the Howey test and were investment contracts.179 Moreover, virtual shares in fictional companies that were sold on a virtual stock exchange may be considered securities.180 The virtual stock exchange was created and operated as an investment game for the personal entertainment of internet users, and the company emphasized its game-​like nature.181 However, if the transaction fits the criteria of a security, then placing an emphasis on the game-​like nature of transacting in virtual shares will not remove the transaction from the long reach of the securities laws. “It is equally immaterial whether the promoter depicts the enterprise as a serious commercial venture or dubs it a game.”182 The securities laws contain no exception for “games.” D. Consequences of Securities Violations

It is possible for a promoter to have offered or sold a security without realizing that she was offering a security, or what the consequences of that offering would be.183 If financial instruments are determined to be securities, then their offer or sale will be a violation of section 5 of the Securities Act184 (assuming they were not registered securities).185 Section 5 of the Securities Act is the linchpin of the Securities Acts and requires all securities to be registered unless they qualify for an exemption.186 The

178 There are two common financial arrangements employed by scheming individuals, which essentially rob Peter to pay Paul, and they are both dependent on a continuous influx of new money See SEC v. SG Ltd., 265 F.3d 42, 51 n.3 (1st Cir. 2001). A Ponzi scheme, named after the notorious swindler Charles Ponzi, is run by using the money tendered by later investors to pay the returns for the earlier investors. In contrast, pyramid schemes run by using a recruiting element in which earlier investors are paid based on their ability to recruit new members who pay fees to enter the scheme. 179 Infinity Grp., 212 F.3d at 191. 180 See SG Ltd., 265 F.3d 42. Obviously, the investors in the virtual stocks invested real money, which provided the necessary investment of funds to satisfy the first prong of the Howey test. 181 Id. at 44–​45. 182 Id. at 48. 183 This section is meant only to provide a brief overview of the ramifications of SEC regulation A more extensive discussion of the litigation issues may be found in ­chapters 13 and 16, infra. 184 15 U.S.C. § 77e. 185 See, e.g., SEC v. Prof ’l Assocs., 731 F.2d 349, 358 (6th Cir. 1984). Note that there may also be state securities violations and sanctions. See, e.g., Manns v. Skolnik, 666 N.E.2d 1236, 1246–​51 (Ind. 1996). 186 See, e.g., SEC v. Current Fin. Servs., Inc., 100 F. Supp. 2d 1, 5 (D.D.C. 2000).

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requirements of the Securities Acts are intended to prevent fraud before it arises; therefore, it is possible to violate the Securities Acts even if no investor has been harmed.187 Moreover, section 5 is a strict liability statute and the promoter is liable even though he did not believe that he was selling a security.188 For example, one defendant relied on an opinion letter from a senior attorney in the state securities division that he was not selling a security, yet the court held that the reliance on the opinion letter was irrelevant because section 5 is a strict liability statute.189 The prima facie case of a section 5 violation is: (1) the defendant, directly or indirectly, offered or sold securities; (2) the offer or sale used interstate transportation, communication, or the mails; and (3) no registration statement was effective.190 The individual is considered to have sold securities if the individual is a “necessary participant” or “substantial factor” in the sale.191 Additionally, there is joint and several liability when there is a close relationship between two parties in conducting the illegal transaction.192 There are various consequences as a result of an intended or unintended securities violation. 1. Preliminary Injunction A federal court may not issue an asset freeze (as in the form of a preliminary injunction) in an action for money damages; however, in an action under the Securities Acts a court may issue an asset freeze to preserve funds for the disgorgement claim (an equitable remedy).193 Despite a concurrent civil damages claim, the court may issue the asset freeze to preserve funds for the equitable remedy. The inclusion of a civil remedy does not render it a legal action rather than an equitable action. The amount and scope of the asset freeze extends to a reasonable approximation of the ill-​gotten gains; exactitude is not required.194

187 See SEC v. Life Partners, 87 F.3d 536, 538–​39 (D.C. Cir. 1996), which holds that a section 5 violation may occur even though no individual is claimed to have been harmed. 188 SEC v. Calvo, 378 F.3d 1211, 1215 (11th Cir. 2004). 189 Current Fin. Servs., 100 F. Supp. 2d 1, 5 (D.D.C. 2000). 190 Calvo, 378 F.3d at 1214. 191 Id. at 1215. 192 Id., which notes that joint and several liability will apply even though one party was more culpable than the other party. 193 SEC v. ETS Payphones, Inc., 408 F.3d 727, 734 (11th Cir. 2005). 194 Id. at 735.

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2. Disgorgement Disgorgement is an equitable power of the court to disgorge any profits obtained through a violation of the Securities Acts.195 The purpose of disgorgement is to deprive the wrongdoer of her ill-​gotten gains, rather than to compensate investors who lost their investments. The reach of the disgorgement is to any profit, with interest, that the defendant gained by her wrongdoing.196 The amount of the disgorgement need only be a reasonable approximation of the ill-​gotten gains; again exactitude is not required.197 “So long as the measure of the disgorgement is reasonable, any risk of uncertainty should fall on the wrongdoer whose illegal conduct created that uncertainty.”198 3. Permanent Injunction The SEC also has the power to sue for injunctive relief.199 Permanent injunctive relief is granted when the SEC establishes a prima facie case of prior violations of the securities laws and a reasonable likelihood of future violations.200 The critical question is whether the defendant’s past conduct indicates a reasonable likelihood of a future violation, and the proof must come from something other than the mere fact of past violations.201 The courts evaluate the likelihood of a future violation by considering the totality of the circumstances, which includes the “egregiousness of the defendant’s actions, the isolated or recurrent nature of the infraction, the degree of scienter involved, the sincerity of the defendant’s assurances against future violations, the defendant’s recognition of the wrongful nature of the conduct and the likelihood that the defendant’s occupation will present opportunities for future violations.”202 Additionally, even a single violation may be so reprehensible that a

195 SEC v. Blatt, 583 F.2d 1325, 1335 (5th Cir. 1978). 196 Id. notes that disgorgement is a remedial remedy and not punitive. 197 Calvo, 378 F.3d at 1217. 198 Id., which quotes SEC v. Warde, 151 F.3d 42, 50 (2d Cir. 1998). 199 15 U.S.C. § 77(t) (b) (under the Securities Act) and 15 U.S.C. § 78(u) (d) (under the Exchange Act) (granting the power to sue for an injunction when it appears a person has engaged or will engage in a violation of the Securities Acts). 200 Calvo, 378 F.3d at 1216. Unlike a private litigant who is seeking an injunction, the SEC is not required to show an irreparable injury or a balance of equities in its favor. See SEC v. Unifund SAL, 910 F.2d 1028, 1035 (2d Cir. 1990). The burden on the SEC is to show a strong likelihood of success if the goal of the injunction is to preserve the status quo and a more substantial likelihood of success if the injunction is likely to have “grave consequences.” See id. at 1039. 201 SEC v. Blatt, 583 F.2d 1325, 1334 (5th Cir. 1978). 202 Calvo, 378 F.3d at 1216, which quotes SEC v. Carriba Air, Inc., 681 F.2d 1318, 1322 (11th Cir. 1982).

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likelihood of committing future violations can be inferred and an injunction may be warranted.203 The collateral consequences of an injunction can be severe. For example, an injunction can cause the loss of employment for an officer of a public company.204 An injunction may also serve as the basis for an enforcement action by a self-​regulatory organization. 4. Antifraud Statutes The antifraud statutes of the Securities Acts prohibit fraudulent conduct in connection with the offer or sale of securities. Injunctions for violations of the antifraud statutes of the securities laws, section 17(a)(1) of the Securities Act205 and sections 10(b)206 (and Rule 10b-​5)207 and 14(e) of the Exchange Act208 require proof of scienter and materiality.209 Scienter is “a mental state embracing intent to deceive, manipulate, or defraud.”210 Scienter requires the possession of material nonpublic information that was used in a trade.211 The test for materiality is whether there is a substantial likelihood that a reasonable investor would consider the missing information an important representation when making the decision to invest.212 5. Attorney’s Potential Liability Attorneys as well as promoters can be found liable for securities violations if due care is not exercised. In one cautionary case, a lawyer serving as bond counsel for a school district was found liable under sections 17(a)(2) and 17(a)(3) of the Securities Act for his negligence in misrepresenting the risk of the bond issue; the SEC sanctions were upheld by the court.213 The lawyer, an experienced bond counsel, served as bond Blatt, 583 F.2d at 1335. 204 SEC v. Ginsburg, 362 F.3d 1292, 1306 (11th Cir. 2004) (footnote in concurrence). 205 15 U.S.C. § 77q. 206 15 U.S.C. § 78j. 207 17 C.F.R. § 240.10b-​5. 208 15 U.S.C. §78n. 209 Ginsburg, 362 F.3d at 1297. See also Aaron v. SEC, 446 U.S. 680, 702 (1980), holds that scienter is required for an injunction under § 17(a) (1) of the Securities Act and § 10(b) (and Rule 10b-​5) of the Exchange Act, but not for §§ 17(a) (2) and (3) of the Securities Act Note that scienter is not required for section 5 violations because it is a strict liability statute See, e.g., SEC v. Current Fin. Servs., Inc., 100 F. Supp. 2d 1, 5–​6 (D.D.C. 2000). 210 Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n.12 (1976) Scienter may also be established by proving extreme recklessness. See SEC v. Rubera, 350 F.3d 1084, 1094–​95 (9th Cir. 2003), which explains the level of recklessness needed to satisfy the scienter requirement. 211 Ginsburg, 362 F.3d at 1297–​98. 212 See Basic v. Levinson, 485 U.S. 224, 231 (1988). 213 Weiss v. SEC, 468 F.3d 849, 850, 856 (D.C. Cir. 2006). Sections 17(a)(2) and 17(a)(3) require proof only of negligence and not scienter. See Aaron v. SEC, 446 U.S. 680, 697 (1980). 203

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counsel and wrote the bond opinion letter. The lawyer examined the documents regarding the proposed projects from the board of the school district and found they mostly consisted of the board’s “wish list.” The lawyer gave the impression to the board that to ensure the tax-​exempt status of the bonds it only needed to intend to complete the proposed projects (a subjective test), rather than to have a reasonable need for the funds (an objective test). The lawyer also wrote an unqualified opinion letter to be sent to the investors that the bonds would be exempt from federal taxes. The lawyer further warranted that nothing came to his attention that would lead him to change his opinion about the federal tax-​exempt status of the bonds. There was no reasonable basis to conclude the board had decided to undertake any projects. An opinion letter implies that there was a reasonable investigation into the underlying facts that provided a reasonable basis for the opinion. Thus, the lawyer was negligent in writing the opinion letter, and that suffices for liability under sections 17(a)(2) and 17(a)(3) of the Securities Act. 214 The goals of the securities laws were to provide investors with accurate information and to protect them from the misrepresentations of other parties that would induce them to purchase worthless securities. If a lawyer does her due diligence and the investors receive fair disclosure and are aware of the risks, then the courts will be less likely to find a violation of securities laws. E. Hedge  Funds

“Hedge fund” has become the umbrella term used to describe a type of loosely regulated private investment vehicle engaged in a variety of complex investment strategies with the goal of producing absolute returns for its investors.215 The term encompasses “any pooled investment vehicle that is privately organized, administered by professional money managers and not widely available to the public.”216 The term was first applied to Alfred Winslow Jones’s private investment fund, widely described as the first hedge fund. By combining both long and short positions in stocks that would rise faster than the market would in strong markets and fall slower than the market in declining markets, this would, in theory, ensure that the investment fund would always make a profit while at the same time minimizing, or “hedging” against the risk of loss.

214 Weiss, 468 F.3d at 354–​56. 215 “Absolute return” refers to producing a positive return regardless of market conditions and not as compared to an index. 216 The President’s Working Group on Financial Markets, Hedge Funds, Leverage and the Lessons of Long-​Term Capital Management 1 (Apr 1999).

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Prior to the financial crisis, hedge funds enjoyed exemptions from the somewhat interlocking reporting and registration requirements of the Securities Act, the Exchange Act, the Investment Advisers Act of 1940 (“Advisers Act”), and the Investment Company Act of 1940 (“Investment Company Act”). The legal status of hedge funds permitted them to engage in highly leveraged trading, short selling, and risky hyperconcentrated investments. The issue of whether the lack of specific regulatory oversight of hedge funds increases systemic risk was a matter of debate as Ben S. Bernanke, chairman of the Board of Governors of the Federal Reserve Board, observed in April 2007 at the New York University Global Economic Policy Forum: Regulatory oversight of hedge funds is relatively light. Because hedge funds deal with highly sophisticated counterparties and investors and because they have no claims on the federal safety net, the light regulatory touch seems largely justified. However, the growing market share of hedge funds has raised concerns about possible systemic risk. The complexity and rapid change inherent in the strategies of many funds make them relatively opaque to outsiders and so the concern arises that the collapse of a hedge fund might come with little warning. In addition, many hedge funds are either highly leveraged or hold positions in derivatives or other assets that make their net asset positions very sensitive to changes in asset prices (the functional equivalent of high leverage). Highly leveraged investors are intrinsically more vulnerable to market shocks, of course, but leverage also increases the risks to the broader financial system. The failure of a highly leveraged fund holding large, concentrated positions could involve the forced liquidation of those positions, possibly at fire-​sale prices, thereby imposing heavy losses on counterparties. In the worst scenarios, these counterparty losses could lead to further defaults or threaten systemically important institutions. In addition, market participants that were not creditors or counterparties of the defaulting firm might be harmed indirectly through changes in asset prices, liquidity strains and increased market uncertainty.217 Public sentiment toward the financial industry during the crisis coupled with headlines about fraud at one infamous hedge fund made regulatory initiative after the crisis inevitable. Events surrounding a pool of funds managed by the legendary Wall Street titan Bernard Madoff underscored the necessity of seeing beyond the

217 Chairman Ben S Bernanke, Financial Regulation and the Invisible Hand, New York University Law School (Apr. 11, 2007).

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black box of managed investing. The complaint filed by the SEC against Madoff in 2008 alleged that his returns were based on a Ponzi scheme with little basis in transactional sophistication. According to the complaint: From an indeterminate period through the present [December 11, 2008], Madoff . . . has committed fraud through the investment adviser activities of BERNARD L.MADOFF INVESTMENT SECURITIES LLC, (BMIS) . . . Madoff admitted to one or more employees of BMIS that for many years he has been conducting a Ponzi scheme through the investment adviser activities of BMIS and that BMIS has liabilities of approximately $50 billion.218 On March 12, 2009, Madoff pled guilty to defrauding investors of as much as $65 billion in the biggest Ponzi scheme in history. On December 30, 2009, the SEC required “registered investment advisers that have custody of client funds or securities to, among other things: undergo an annual surprise examination by an independent public accountant to verify client assets; have the qualified custodian maintaining client funds and securities send account statements directly to advisory clients; and unless client assets are maintained by an independent custodian, obtain or receive a report of the internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the PCAOB (Public Company Accounting Oversight Board).”219 As recently as July 31, 2013, SEC Commissioner Luis A. Aguilar made a public statement describing additional steps the SEC is taking to oversee broker-​dealers to prevent future Ponzi schemes: . . . I am pleased to support the adoption of the amendments regarding broker-​ dealer custody. These amendments, in conjunction with the 2009 rules regarding the custody practices of investment advisers, are designed to create a framework to ensure that investor assets are safely held. This framework is critical to cultivating early detection and to preventing the type of fraud Madoff perpetuated. This framework has several components, of which I will highlight just a few: First, broker-​dealers that carry customer assets must file with the Commission a compliance report stating that they are in compliance with certain of the 218 http://​sec.gov/​litigation/​complaints/​2008/​comp-​madoff121108.pdf (last visited Nov. 28, 2013). 219 See Custody of Funds or Securities of Clients by Investment Advisers, Release No IA-​2968 (Dec. 30, 2009).

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financial responsibility rules. The report must also certify that the broker-​ dealer has effective internal controls to ensure compliance with those rules. This will enhance early detection of misappropriated or lost assets and identify weaknesses in a broker-​dealer’s internal controls that could jeopardize the safety of customer assets. Second, broker-​dealers must identify in the compliance report any instances of non-​compliance with certain of the financial responsibility rules and any material weaknesses in their internal controls. Importantly, the compliance report must be examined by independent public accountants registered with the Public Company Accounting Oversight Board (“PCAOB”). Of course, for these rules to be meaningful, it is important to highlight the roles played by accountants and broker-​dealers in implementing these amendments. First, it will be critical for broker-​dealers to promptly notify the Commission of non-​compliance, as required under the rules.[13] Second, accountants must notify the Commission of a broker-​dealer’s non-​compliance if the broker-​dealer is required but fails to do so and accountants should enact measures to confirm that a broker-​dealer has notified the Commission of such non-​compliance.220 On January 7, 2014 the U.S. Justice Department announced a prosecution agreement with JPMorgan Chase Bank, N.A., in connection with Bernard L. Madoff ’s multibillion dollar Ponzi scheme. The settlement has two key components: 1. JPMorgan is criminally charged with two violations of the Bank Secrecy Act. 2. Those criminal charges will be deferred for two years under an agreement requiring JPMorgan to admit to its conduct; pay $1.7 billion to victims of Madoff ’s fraud, and reform its anti-​money laundering policies. The $1.7 billion payment by JPMorgan is the largest ever bank forfeiture and Department of Justice penalty for a Bank Secrecy Act violation.221

220 Strengthening Oversight of Broker-​Dealers by Instituting a Framework to Prevent Another Madoff, Commissioner Luis A Aguilar, U.S. Securities and Exchange Commission ( July 31, 2013). 221 Press Release, Department of Justice, U.S. Attorney’s Office for the Southern District of New York, Manhattan U.S. Attorney and FBI Assistant Director-​In-​Charge Announce Filing of Criminal Charges Against and Deferred Prosecution Agreement with JPMorgan Chase Bank, N.A., in Connection with Bernard L. Madoff ’s Multi-​Billion Dollar Ponzi Scheme ( Jan. 7, 2014) http://​www.justice.gov/​usao/​nys/​pressreleases/​ January14/​JPMCDPAPR.php.

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1. Post-​crisis Hedge Fund Regulation Post-​crisis, hedge funds have become a focus of renewed regulatory initiative. The Dodd-​Frank Act now requires hedge funds to register with the SEC.222 By amending the Investment Company Act of 1940, Dodd-​Frank requires hedge funds to disclose information regarding business operations and conflicts of interest. The SEC is also now required to collect information on the risk profiles of registered hedge funds. In addition, the Commission recently proposed a rule that requires hedge funds to provide information about offerings, including general solicitation and advertising.223 According to the Chair of the SEC, Mary Jo White: This proposal is designed, in part, to provide more transparency to enable us to better monitor the private placement market. It would enable us to learn more about the size of the market, those who conduct offerings, and the characteristics of those who are unsuccessful in completing an offering. It also would provide us access to the solicitation materials that are being used and better assure that investors are getting some baseline level of information about risks.224 Enhanced regulation of hedge funds will change how hedge funds operate, as Chairman White describes: Of course, the new era of transparency and openness includes more than just registering with the SEC, filing information publicly and communicating more freely with the public. Transparency also means being subject to an occasional visit by a team of our professional compliance examiners—​who will review your records and sit with you to evaluate whether your firm is being run in compliance with these business conduct rules and other requirements.225

Section 403 of the Dodd-​Frank Act (codified at Section 203(b) of the Investment Advisers Act of 1940, as amended. 223 Amendments to Regulation D, Form D and Rule 156, Securities Act Release No 9416 ( July 10, 2013) [78 F.R. 44806 ( July 24, 2013)], available at http://​www.sec.gov/​rules/​proposed/​2013/​33-​9416.pdf. 224 Hedge Funds—​A New Era of Transparency and Openness Chair Mary Jo White Managed Funds Association Outlook 2013 Conference, New York, New York, available at http://​www.sec.gov/​News/​Speech/​Detail/​ Speech/​1370539892574#.UsG1P2p3v3g (last visited Aug. 3, 2018). 225 Id. 222

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2. Other Regulations In addition to the new requirements under Dodd-​Frank, hedge funds face reporting and registration requirements based on their investment activity. Although the funds were not required to make periodic reports under the Exchange Act prior to Dodd-​Frank, hedge funds were always required to report to the SEC all nontrivial holdings in public companies.226 Further, many hedge funds trade commodity options and futures, which bring them under the purview of the CFTC, to the extent that a hedge fund trades derivatives, subject to regulation under the Commodity Exchange Act.227 Such fund advisers are required to register as a “Commodity Pool Operator” (CPO) or a “Commodity Trading Adviser” (CTA), and registered CPOs are “subject to periodic reporting, recordkeeping, and disclosure requirements.”228 The Commission does not directly regulate the commodity pools, but rather the advisers.229 Furthermore, CPOs and CTAs must complete an annual self-​audit and must submit to periodic audits conducted by the National Futures Association.230 However, many hedge fund managers can now qualify for exemptions from CPO and CTA registration if they engage in limited commodity futures activities and sell interests solely to “accredited investors” as defined in the Securities Act or “qualified purchasers” as defined in the Investment Company Act.231 Further, the CEA provides a de minimis exemption from CTA registration very similar to that of the Advisers Act exemption.232 Therefore, fund managers exempt under the Advisers Act’s de minimis exemption are likely exempt from registration as a CTA.233 See 15 U.S.C. § 78m(d), (g), which requires entities that own greater than 5 percent of the class of equity securities of any equity security registered under section 12 of the Exchange Act to file a beneficial ownership statement); 15 U.S.C. § 78p (disclosures required of directors, officers, and principal stockholders). 227 Jane Kang Thorpe, Director, Division of Clearing and Intermediary Oversight, CFTC, Assessment of the Current Regulatory Framework, Address at the SEC Hedge Fund Roundtable; Panel 7: “Assessment of the Current Regulatory Framework” (May 15, 2003). 228 The President’s Working Group on Financial Markets, supra note 216, at 3. 229 Thorpe, supra note 227: (“[T]‌regulatory scheme for CPOs and CTAs is based on investor protection—​it is designed to protect investors against fraud and other abuses. To achieve this purpose the CFTC sets forth registration and other requirements for CPOs and CTAs designed to ensure their qualifications and fitness. . . . This will normally include information on the investment program, principal risk factors, past performance, fees and expenses and conflicts of interest CPOs also must provide periodic account statements as well as an annual audited financial statement for any pool they operate and both CPOs and CTAs must comply with sales practice requirements as well as various reporting and recordkeeping requirements. Finally, they are subject to requirements on antifraud and anti-​manipulation.”). 230 See: 76 FR 71127 “Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF” hereafter cited as “SEC Report.” 231 See CFTC Rule 4.13(a)(3), (4). 232 SEC Report, supra note 230. 233 Id. 226

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Hedge fund managers are also considered fiduciaries under the Investment Advisers Act, the same as mutual fund advisers, which requires fund managers to put the interests of their funds above their personal interests. Thus, hedge funds are actually required to make substantial disclosures to investors in order to discharge fiduciary duties and avoid violating antifraud rules prohibiting “misleading statements and omissions.” Managers typically fulfill this obligation by providing investors with “a private placement memorandum that discloses information about the investment strategies the hedge fund is permitted to use and an overview of how the hedge fund operates.”234 II. Derivatives Regulation: The SEC after Dodd-​Frank As discussed in ­chapter 1, the Volcker Rule prohibits banks from owning or sponsoring “covered funds” (hedge and private equity funds). This measure is designed to separate traditional banking activities from riskier “investing.” In addition to restrictions on banks ownership of hedge funds, Dodd-​Frank affects bank transactions by increasing the regulation of derivatives. Dodd-​Frank has given the SEC broad powers to implement new rules with regards to security-​based derivatives transactions. The SEC describes the evolution of derivatives regulation culminating in its rule-​making authority under the Act:235 In 2000, Congress passed the Commodity Futures Modernization Act (CFMA) to provide legal certainty for swap agreements. The CFMA explicitly prohibited the SEC and CFTC from regulating the over-​the-​ counter (OTC) swaps markets, but provided the SEC with antifraud authority over “security-​based swap agreements,” such as credit default swaps. However, the SEC was specifically prohibited from, among other things, imposing reporting, recordkeeping, or disclosure requirements or other prophylactic measures designed to prevent fraud with respect to such agreements. This limited the SEC’s ability to detect and deter fraud in the swaps markets. Title VII of Dodd-​Frank Wall Street Reform and Consumer Protection Act addresses the gap in U.S. financial regulation of OTC swaps by providing a comprehensive framework for the regulation of the OTC swaps markets.

Id. at ix. 235 http://​www.sec.gov/​spotlight/​dodd-​frank/​derivatives.shtml (last visited Aug. 3, 2018). 234

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The Dodd-​Frank Act divides regulatory authority over swap agreements between the CFTC and SEC (though the prudential regulators, such as the Federal Reserve Board, also have an important role in setting capital and margin for swap entities that are banks). The SEC has regulatory authority over “security-​based swaps,” which are defined as swaps based on a single security or loan or a narrow-​based group or index of securities (including any interest therein or the value thereof ), or events relating to a single issuer or issuers of securities in a narrow-​based security index. Security-​based swaps are included within the definition of “security” under the Securities Exchange Act of 1934 and the Securities Act of 1933. The CFTC has primary regulatory authority over all other swaps, such as energy and agricultural swaps. The CFTC and SEC share authority over “mixed swaps,” which are security-​based swaps that also have a commodity component. In addition, the SEC has anti-​fraud enforcement authority over swaps that are related to securities but that do not come within the definition of “security-​based swap.” These are called “security-​based swap agreements.” The Dodd-​Frank Act provides the SEC with access to information relating to security-​based swap agreement in the possession of the CFTC and certain CFTC-​regulated entities, such as derivatives clearing organizations, designated contract markets and swap data repositories. There are a number of rulemakings required under Title VII. The CFTC and SEC are required to act jointly to define key terms relating to jurisdiction (such as swap, security-​based swap and security-​based swap agreement) and market intermediaries (such as swap and security-​based swap dealers and major swap and security-​based swap participants), as well as adopt joint regulations regarding mixed swaps and prescribe trade repository recordkeeping requirements and books and records requirements for swap entities related to security-​based swap agreements. The SEC is required to consult with the CFTC and the Federal Reserve Board on non-​joint rulemakings and with the other prudential regulators on capital and margin rules. The CFTC, SEC and U.S. prudential regulators also are consulting with non-​U.S. regulatory authorities on the establishment of consistent international standards for products and entities in this area.

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Securities Regulation 236

Appendix A:

323

I mplementing the Dodd-​Frank Wall Street Reform and Consumer Protection Act:

Mandatory Rulemaking Provisions

The SEC has adopted final rules for 67 mandatory rulemaking provisions of the Dodd-Frank Act.

Private Funds

Executive compensation

Volcker Rule

Asset-Backed Securities

Security-Based Swaps

Credit Rating Agencies

Clearing Agencies

Specialized Disclosures

Municipal Securities Advisors

Other

Complete (8 rulemaking provisions)

7 adopted, 5 proposed

Complete (1 rulemaking provision)

6 adopted, 1 proposed

21 adopted, 8 proposed

12 adopted

Complete (2 rulemaking provisions)

Complete (2 rulemaking provisions)

Complete (1 rulemaking provision) Adopted

7 complete, 1 proposed, 4 remaining Proposed

Appendix B: Checklist for Stocks, Notes, and Investment Contracts The following is a helpful checklist for a lawyer who is representing a company to determine if financial instruments used in a transaction are governed by the securities laws. • Remember that the focus is on the substance of the transaction and its eco-

nomic reality and not the legal terms that define the financial instruments. Stocks • Is it called “stock” and does it have the traditional characteristics of stock to be considered a per se security? • Is the justifiable expectation of investors that it is a security and has the protection of the Securities Acts? https://​www.sec.gov/​spotlight/​dodd-​frank.shtml (last visited Aug. 16, 2018). 236

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• Warrants to purchase stock, options, bonds, and debentures may also be per se securities. Notes Apply the four-​factor Reves test, beginning with the presumption that a note is a security. • Presumption is rebuttable by proving a strong resemblance to a category of notes that is not a security. • Is there an alternative comprehensive regulatory scheme that makes the protection of the Securities Acts unnecessary?

•

Investment Contracts

• • • • • •

Apply the tripartite Howey test, which is a very flexible test. Determine the level of commonality required in the jurisdiction. Fixed profit may also support the finding of an investment contract. Strong investor control may prevent it from being an investment contract. Prepurchase efforts may suffice to create an investment contract. Check if it is an investment contract under state law.

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16 Suitability

I. The Suitability Doctrine  326 A. Suitability Duty  326 B. Scope and Applicability  327 C. Control and Enforceability  327 D. Investment Advisors  328 1. Rule: A Fiduciary Standard  328 E. Scope and Applicability  329 F. Control and Enforceability  330 G. Basis of the Suitability Doctrine  331 H. Special Circumstances  333 I. FINRA and Self-​Regulated Organizations (SROs)  334 1. Financial Industry Regulatory Authority Creation of the Agency  334 J. Rule: A Suitability and Know-​Your-​Customer Duty  335 K. Scope and Applicability  336 L. Control and Enforceability  337 M. NYSE Know-​Your-​Customer Rule  337 1. Consumer Financial Protection Bureau  339 2. Scope and Applicability  340 3. Control and Enforceability  341

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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4. Department of Labor  342 a. Employee Retirement Income Security Act  342 5. Scope and Applicability  343 a. The Antifraud Provisions of the Federal Securities Laws—​Section 10b Cause of Action  343 II. Futures and Options: Suitability  345 A. Commodity Futures Trading Commission Disclosure Rules  345 1. Commodity Futures Trading Commission  345 a. Commodity Exchange Act  345 b. Rule: A Suitability and Fair-​Dealing Duty  346 c. Scope and Applicability  348 d. Control and Enforceability  348 B. National Futures Association  349 1. Rule: Suitability and Know-​Your-​Customer Duty  349 a. Scope and Applicability  350 b. Control and Enforceability  350 C. CEA Antifraud Provision  351 D. Municipal Securities Rule-​Making Board  351 Appendix A: Various Suitability Rules and Diagrams of Applicability  352 Appendix B: Survey of Rules Adopted by the SEC under Dodd-​Frank​  360







I. The Suitability Doctrine A. Suitability  Duty The duty owed by broker-​dealers when doing business with the general public is one of suitability, and it was added to the Exchange Act with the adoption of the Securities Act of 1993. The duty owed by broker-​dealers is not a fiduciary one, it is the duty to make recommendations that are suitable to their client based on the client’s personal situation. The suitability duty of the Exchange Act finds its source in the antifraud section 10(b)-​5 of the Exchange Act. Other duties have also been defined by the SEC as deriving from the antifraud section 10(b)-​5 of the Exchange Act. These duties include the duty of fair dealing. This fundamental duty derives from the Act’s antifraud provisions mentioned previously. This duty includes the requirement “to execute orders promptly, disclose certain material information (i.e., information the customer would consider important as an investor), charge prices reasonably related to the prevailing market, and fully disclose any conflict of interest.” In addition to the suitability and fair-​dealing duty owed by broker-​dealers to their clients, courts have found them to have a fiduciary duty under certain circumstances. For example, when a broker-​dealer exceeds his/​her traditional role, he/​she is subject

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to “heightened disclosure requirements.” Furthermore, the fiduciary duty provided for in the Advisers Act may also be applied to broker-​dealers when two conditions are met: the investment advice provided by the broker-​dealer must be incidental, and the broker-​dealer must receive no special compensation for such advice. B. Scope and Applicability

The Exchange Act, and the suitability duty, are applicable to brokers and to dealers. Section 3(a)(4)(A) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others,” and section 3(a)(5)(A) of the Exchange Act defines a “dealer” as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.” C. Control and Enforceability

The SEC’s Division of Enforcement investigates potential securities law violations, and it recommends that the SEC brings civil actions or institutes administrative proceedings, and prosecutes these cases on behalf of the SEC before the courts. The SEC may seek remedial sanctions such as censures, suspensions, injunctions, and limitations on business, and violators may be required to pay disgorgement and civil penalties. To validly invoke a broker-​dealer’s violation of the duty of suitability, three elements must be established. First, the broker-​dealer must have recommended a security to the investor. It is indeed widely believed that “in the absence of a recommendation, broker-​dealers owe their customers no more than prompt, fair, and effective execution of purchase orders as and when they are received.” Second, it must be established that the broker-​dealer acted with scienter, that “there was a material misrepresentation or omission and that this misrepresentation or omission was made with scienter,” defined as “intent to deceive, manipulate, or defraud.” Proving scienter can be extremely difficult, which is why certain jurisdictions have relaxed this requirement and now only require “reckless disregard for the truth.” Third, it must be demonstrated that the investor reasonably relied on the broker-​ dealer’s advice to invest. In determining whether such reliance exists, the most important factor to consider is the level of plaintiff ’s sophistication as an investor. Other factors considered by courts include: the investor’s access to relevant information when making purchase decisions, discretionary versus non-​discretionary account

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status, the extent of a fiduciary relationship between the investor and the broker, the possibility of fraud, and the generality or specificity of the misrepresentations. The SEC for example instituted enforcement actions against broker-​dealers that provided unsuitable investment advice in breach of their suitability duty. In SEC v. Gorsek, the broker-​dealer had recommended to its clients to invest in stock by using promotional materials. The promotional material however contained material misrepresentations and omissions. In SEC v. Hasho, the broker-​dealers operated a boiler room operation and recommended speculative securities to mostly unsophisticated investors using high pressure and fraudulent sales pitches via long distance telephone solicitations. Finally, in SEC v. Platinum Investment Corp., the broker-​dealer was reckless in dealing with his its clients because he “failed to take even the most rudimentary steps to make sure his recommendations to his clients were responsible and reasoned,” “did nothing to confirm his price or performance predictions,” “did nothing to familiarize himself with private placements,” and failed even to read the materials going to his customers.

D. Investment Advisors

Investment advisers also needed to be regulated after the stock market crash of 1929 but, unlike broker-​dealers, they were considered as actually providing their clients with investment advice. Envisioned as having superior knowledge than their customers, Congress considered that they should have greater responsibilities, be more directly regulated, and be subject to more onerous duties. The Advisers Act was therefore adopted. 1. Rule: A Fiduciary Standard The Advisers Act does not provide per se a rule imposing on investment advisers a set of business conduct standards. As the SEC reminds, “the [United States] federal securities laws do not prescribe minimum experience or qualification requirements for persons providing investment advice. They do not establish maximum fees that advisers may charge. Nor do they preclude advisers from having substantial conflicts of interest that might adversely affect the objectivity of the advice they provide. Rather, investors have the responsibility, based on disclosure they receive, for selecting their own advisers, negotiating their own fee arrangements, and evaluating their advisers’ conflicts.” The Advisers Act only imposes on investment advisers a broad fiduciary duty to act in the best interest of their clients. This fiduciary duty is enforceable on investment

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advisers through the antifraud provisions of Section 206 of the Advisers Act and disclosure requirements indirectly incorporated in the Advisers Act. The broad fiduciary duty of investment advisers is derived from the very nature of the relationship they entertain with their client, which is intrinsically fiduciary. As the Supreme Court stated in SEC v. Capital Gains Research Bureau, Inc., its seminal decision on the fiduciary duties of an adviser under the Advisers Act, “[t]‌he Advisers Act of 1940 reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser—​ consciously or unconsciously—​to render advice which was not disinterested.” E. Scope and Applicability

The Advisers Act, and the duty of suitability, apply to investments advisers when rendering investment services to clients. Section 202(a)(11) of the Advisers Act defines an investment adviser as any person or firm that (1) in exchange for compensation (2) is engaged in the business of (3) providing advice to others or issuing reports or analyses regarding securities. A person must satisfy all three criteria to fall within the definition of “investment adviser.” Certain persons, who would presumably satisfy all three criteria, are expressly excluded from the scope of the Advisers Act such as broker-​dealers when the financial advice given is incidental and that no “special compensation” is perceived. Unlike section 10(b) of the Exchange Act, section 206 of the Advisers Act is not limited to fraud in connection with the purchase or sale of a security. Accordingly, once an advisory relationship is formed, the investment adviser’s fiduciary obligation extends “to all services undertaken on behalf of the client.” Several obligations flow from an investment adviser’s broad fiduciary duty among which is the duty of suitability. “As fiduciaries, investment advisers owe their clients a duty to provide only suitable investment advice. This duty generally requires an investment adviser to determine that the investment advice it gives to a client is suitable for the client, taking into consideration the client’s financial situation, investment experience, and investment objectives.” The other obligations are (1) an obligation of utmost good faith and of full and fair disclosure of all facts material necessary for the client to engage the adviser, as well as a duty to avoid misleading them; (2) a duty of care, which requires that an adviser have a reasonable, independent basis for its recommendations; (3) the obligation to seek best execution of clients’ securities transactions; and (4) the obligation, when voting a client’s proxy, to vote the proxy in the best interest of its clients and not to subrogate its client’s interests to its own.

30

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Capital Markets, Derivatives, and the Law Securities Offering Inv. Adviser/Inv. Company

Issuer Reporting/Audit & Accounting Broker Dealer Insider Trading Market Manipulation Public Finance Foreign Corrupt Practices Act Miscellaneous Transfer Agent NRSRO SRO/Exchange 0

20

40

60

80

100

120

140

Actions Filed 2018

2017

Figure 16.1  Graphic Representation of SEC Enforcement Proceedings.

F. Control and Enforceability

As illustrated by the graph in Figure 16.1, the SEC is actually faced with more securities law violations by investment advisers then by broker-​dealers.1 As the below chart illustrates, a signifcant number of the Commission’s 490 stand alone cases in FY 2018 concerned securities offerings (approximately 25%), investment advisory issues (approximately 22%), and issuer reporting/​accounting and auditing (approximately 16%). The Commission also continued to bring actions relating to broker-​dealer misconduct (13%), insider trading (10%), and market manipulation (7%).2 The SEC has for example instituted enforcement actions against investment advisers that provided unsuitable investment advice in breach of their fiduciary duty. In In the Matter of George E. Brooks & Associates, Inc., the investment adviser failed to appropriately diversify the portfolio of its clients and effected unsuitable trades of speculative high-​risk stocks in the discretionary accounts of clients. His clients however had conservative investment objectives and many of them were elderly and had little investment experience. In In the Matter of Philip A. Lehman, an investment adviser recommended a risky investment for a client’s retirement account, despite the fact that its client had a conservative investment objective and was a senior citizen.

1 U.S. SEC Annual Report, https://​www.sec.gov/​files/​enforcement-​annual-​report-​2018.pdf (last visited February 3, 2018). 2 Id. at p.10.

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G. Basis of the Suitability Doctrine

The suitability doctrine requires that the broker must have a reasonable basis for believing the recommendation to have been suitable for the customer, in light of the customer’s financial condition and understanding of the investment and its risks. The Government Securities Act of 1993, which amended the Exchange Act, is the impetus for the suitability rule. There are two requirements for a successful suitability claim under Rule 10b-​5 and under the Exchange Act. First, a plaintiff must establish that the defendant acted with scienter. It must be proven that “there was a material misrepresentation or omission and that this misrepresentation or omission was made with scienter,” defined as “with intent to deceive, manipulate, or defraud.”3 Many jurisdictions have relaxed this scienter requirement and now require only reckless disregard for the truth. Indeed, Financial Industry Regulatory Authority (FINRA) and other SRO rules do not require proof of scienter to establish a suitability violation.4 In a civil litigation, plaintiffs have a significant obstacle to overcome, as successfully proving this element of a Rule 10b-​5 suitability claim remains very difficult. The SEC has a similar uphill battle in establishing a violation of the antifraud provision of the Securities Act section 17(a): “the Commission must establish that the broker’s unsuitable recommendation was a misrepresentation (or material omission) made with scienter (i.e., with a mental state embracing intent to deceive, manipulate or defraud). Scienter can be knowing misconduct as well as reckless misconduct—​conduct that is at the least, conduct which is ‘highly unreasonable’ and which represents ‘an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.’ ”5 The second requirement is that a plaintiff must demonstrate that he or she reasonably relied on the defendant’s advice to invest. In determining whether such reliance exists, the most important factor to consider is the level of plaintiff ’s sophistication as an investor. Other factors considered by courts include: the investor’s access to relevant information when making purchase decisions, discretionary versus non-​discretionary account status, the extent of a fiduciary relationship between the investor and the broker, the possibility of fraud, and the generality or specificity of the misrepresentations.6

3 See Clark v. John Lamula Inv., Inc., 583 F.2d 594, 600 (2d Cir. 1978), which cites Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976) for the proposition that scienter is required; Brown v. E.F. Hutton Grp., Inc., 991 F.2d 1020 (2d Cir. 1993). 4 Study on Investment Advisers and Broker-​Dealers as Required by Section 913 of the Dodd-​Frank Wall Street Reform and Consumer Protection Act (SEC 2011) [hereinafter The Study]. 5 Id. at 61 6 See Banca Cremi v. Brown, 955 F. Supp. 499, 511 (D. Md. 1997), aff ’d, 132 F.3d 1017 (4th Cir. 1997), which notes that the level of an institutional investor’s sophistication and expertise is significant and highly dispositive in determining whether the investor justifiably relied on the misrepresentations of the derivatives dealer; see also

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Whether reliance is “reasonable” depends primarily upon the level of sophistication of the investor.7 When an investor’s sophistication is high, the chance of that investor reasonably relying on the broker is lower and makes a suitability claim harder to prove. This is because the doctrine of suitability is designed to protect unsophisticated investors from making investments that they did not fully understand. However, courts have held that an investor’s sophistication alone is not enough to bar an unsuitability claim. The Third Circuit has concluded: Even sophisticated investors deserve the protection of the securities laws, including protection from intentionally or recklessly fraudulent conduct by securities salesmen: a salesman cannot deliberately ignore that which he has a duty to know and recklessly state facts about matters of which he is ignorant. . . . The fact that his customers may be sophisticated and knowledgeable does not warrant a less stringent standard.8 The Second Circuit’s view is similar: A sophisticated investor is not barred [from] reliance upon the honesty of those with whom he deals in the absence of knowledge that the trust is misplaced. Integrity is still the mainstay of commerce and makes it possible for an almost limitless number of transactions to take place without resort to the courts.9 The SEC describes how it determines whether a broker-​dealer has violated its obligations under the suitability doctrine as follows: The determination of whether a broker-​dealer has made a recommendation that triggers a suitability obligation is based on the facts and circumstances of the particular situation and, therefore, whether a recommendation has taken place is not susceptible to a bright line definition. Factors considered in determining whether a recommendation has taken place include whether the communication is a “call to action” and “reasonably could influence” the customer to enter into a particular transaction or engage in a particular trading strategy. Platsis v. E.F. Hutton & Co., 642 F. Supp. 1277, 1299 (W.D. Mich. 1986), aff ’d, 829 F.2d 13 (6th Cir. 1987), which holds that investor sophistication is dispositive. 7 See, e.g., Renner v. Chase Manhattan Bank, N.A., No. 03-​7319, 2004 U.S. App. LEXIS 144 (2d Cir. 2004); see also Emergent Capital Inv. Mgmt., LLC v. Stonepath Group, Inc., 343 F.3d 189 (2d Cir. 2003). 8 AES Corp. v. Dow Chem. Co., 325 F.3d 174, 182 (3d Cir. 2003). 9 Hanly v. SEC, 415 F.2d 589, 596 (2d Cir. 1969); see also Lehigh Valley Trust Co. v. Cent. Nat’l Bank, 409 F.2d 989, 992 (5th Cir. 1969).

3

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333

The more individually tailored the communication to a specific customer or a targeted group of customers about a security or group of securities, the greater likelihood that the communication may be viewed as a “recommendation.”10 The suitability obligation derives from a number of sources, including the rules of industry SROs, the antifraud provisions of the federal securities laws, and common law fiduciary duty. Each of these sources is considered later on in this chapter. Although violations of SRO suitability rules may subject industry members to disciplinary sanctions, the rules do not provide a private cause of action for customers. They may, however, be considered in arbitrations/​lawsuits alleging negligence or breach of fiduciary duty on the part of members, as evidence of the standards of conduct that should be applied to those members.11 In instances where an investment professional acts as principal (as in most transactions in the over-​the-​counter market) the professional will not be considered a fiduciary of the customer, and any suitability claim based on a breach of such a duty will not survive. Furthermore, most courts hold that industry professionals acting as agents for customers do not owe a duty to determine suitability, unless the customer’s account is discretionary, or some other “special circumstances” apply to the relationship. H. Special Circumstances

In the case of De Kwiatkowski v. Bear, Stearns & Co., Inc.,12 the plaintiff argued that negligence on the part of Bear was evidenced by industry practice and internal Bear rules indicating that the firm should have provided more than it did in the way of risk warnings and account monitoring. Kwiatkowski alluded to the New York Stock Exchange’s Know-​Your-​Customer rule13 and its requirement that brokers “use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account” (emphasis added).14 The Second Circuit expressly stated, however, that “deviation from industry or internal standards for monitoring risk and suitability does not necessarily amount to the breach of a duty.”15 The court held that it made no sense, as a policy matter,

The Study, supra note 3, at 60. 11 The SROs in both the securities and futures industries maintain arbitration forums for the resolution of customer disputes. Mandatory arbitration clauses are now contained in most customer agreements. 12 306 F.3d 1293 (2d Cir. 2002). See description of the case in c­ hapter 2. 13 See Sec. II.B.2., infra. 14 Although not applicable to commodities brokers, Kwiatkowski’s broker at Bear had testified that in practice the firm adhered to the rule in the commodities context. 15 306 F.3d at 1311. 10

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to discourage the adoption of higher standards than the law required by treating them as predicates for liability. Noncompliance with such standards could only be considered as evidence of a failure to exercise due care where a separately identifiable duty of care was owed and a breach of that duty was alleged by other circumstances. I. FINRA and Self-​R egulated Organizations (SROs) 1. Financial Industry Regulatory Authority Creation of the Agency

The SEC’s supervisory authority proved to be inadequate regarding the regulation of over-​the-​counter securities. An amendment was brought to the Exchange Act with the Malony Act in 1938 that provided for the organization and registration of associations of over-​the-​counter dealers.16 The association that was created was the National Association of Security Dealers (NASD).17 NASD was charged with regulating over-​the-​counter markets and the National Association of Securities Dealers Automated Quotations (NASDAQ) stock market. Operating under the supervision of the SEC, NASD formulated rules governing selling abuses in order “to prevention fraudulent and manipulative acts and practices, [and] . . . to protect investors and the public interests.”18 In 2007, NASD merged with the regulation committee of the New York Stock Exchange to form the FINRA.19 FINRA describes itself as a nonprofit organization authorized by Congress to protect investors by making sure that the broker-​dealer industry operates fairly and honestly through effective and efficient regulation.20 FINRA describes its oversight role as follows: The Financial Industry Regulatory Authority (FINRA) is the largest non-​ governmental regulator for all securities firms doing business in the United States. All told, FINRA oversees nearly 5,000 brokerage firms, about 173,000 branch offices and approximately 656,000 registered securities representatives . . . FINRA is dedicated to investor protection and market integrity through effective and efficient regulation and complementary compliance 16 K. Connelly, The Suitability Rule: Should a Private Right of Action Exist?, 55(3) St. John’s L. Rev. 55, 497 (1981) (updated 2012). 17 Id. 18 15 U.S.C. § 780-​3(b)(6)(1976). 19 http:// ​ w ww.finra.org/ ​ n ewsroom/​ 2007/​ nasd-​ and-​ nyse-​ m ember-​ regulation-​ c ombine-​ f orm-​ f inancial-​ industry-​regulatory-​authority (last visited Dec. 9, 2018). 20 FINRA, About FINRA, https://​www.finra.org/​about (Last visited Dec. 9, 2018).

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and technology-​based services. . . . FINRA touches virtually every aspect of the securities business—​from registering and educating industry participants to examining securities firms; writing rules; enforcing those rules and the federal securities laws; informing and educating the investing public; providing trade reporting and other industry utilities; and administering the largest dispute resolution forum for investors and registered firms. It also performs market regulation under contract for The NASDAQ Stock Market, the American Stock Exchange, the International Securities Exchange and the Chicago Climate Exchange.21

J. Rule: A Suitability and Know-​Your-​C ustomer Duty

When FINRA was still NASD, the duty of suitability of NASD’s Rules of Fair Practice imposed only a minimal ethical constraint and general duties on its members. It was to be applied flexibly so as to not inhibit standard and legitimate sales practices.22 The NASD standard offered far less protection to investors when dealing with registered broker-​dealers than when dealing with non-​registered broker-​dealers. Non-​registered broker-​dealers were indeed required to abide by the fair-​dealing duty provided for in the Exchange Act, and enforced by the SEC, which included the disclosure requirements from the customer. Registered dealers on the other hand were only required to make a recommendation based upon “reasonable grounds for believing that the recommendation is suitable for [the] customer on the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation.”23 With the creation of FINRA, new rules were proposed by FINRA and adopted in 2011 by the SEC. These formed a manual of rules that were based in part and replaced provisions of the NASD Rules of Fair Practice and the NYSE rules.24 Amongst others, two new rules were of notable importance. The Rule 2090 entitled “Know Your Customer” is generally modeled after the NYSE rule that had the same name. It provides that “Every member shall use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.” FINRA rules are each accompanied http://​www.finra.org/​AboutFINRA/​index.htm (last visited Dec. 3, 2013). 22 Connelly, supra note 15. 23 NASD Rules of Fair Practice article III, § 2 (Version of 1979). 24 FINRA, Regulatory Notice 11-​ 02, Jan. 2011, https://​www.finra.org/​sites/​default/​files/​NoticeDocument/​ p122778.pdf. 21

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by Supplementary Material that comments on the rule and facilitates its understanding. The Supplementary Material for Rule 2090 specifies that facts that are “essential” to “knowing the customer” are those required to (1) effectively service the customer’s account, (2) act in accordance with any special handling instructions for the account, (3) understand the authority of each person acting on behalf of the customer, and (4) comply with applicable laws, regulations, and rules.25 The second notable rule of the FINRA Manual is Rule 2111 entitled “Suitability.” It is modeled after the NASD requiring that a firm or associated person “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.”26 The rule further explains that a “customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.”27 K. Scope and Applicability

The FINRA Manual is applicable to every firm and broker, without exception, that sells securities to the public in the United States. To guarantee the Manual’s applicability, FINRA requires that before engaging in the activity of selling securities, every firm and broker must be licensed and registered by FINRA. The Member Regulation department of FINRA (Risk Oversight and Operational Regulation and Sales Practice) regularly examines all firms and brokers to determine compliance with FINRA’s rules and those of the SEC and the Municipal Securities Rulemaking Board. All firms and brokers are examined no less than once every four years.28

FINRA, Rule Manual—​Rule 2090 “Know Your Customer,” http://​finra.complinet.com/​en/​display/​display_​ viewall.html?rbid=2403&element_​id=5502&record_​id=6903&filtered_​tag= (Last visited Dec. 9, 2018). 26 FINRA, Rule Manual—​ Rule 2111 “Suitability,” http://​finra.complinet.com/​en/​display/​display_​viewall. html?rbid=2403&element_​id=5502&record_​id=6903&filtered_​tag= (last visited Dec. 9, 2018). 27 Id. 28 FINRA, Member Regulation, http://​www.finra.org/​industry/​member-​regulation (last visited Dec. 9, 2018). 25

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L. Control and Enforceability

FINRA is entrusted with the authority to control its members respect of the FINRA Manual and federal securities laws and rules. FINRA’s Enforcement Department has the task of investigating potential securities violations and, when warranted, bringing formal disciplinary actions against firms and their associated persons. When firms and their associated persons breach a rule of the FINRA Manual or a security law or rule, FINRA has the authority to fine, suspend, or bar brokers and firms from the industry. Enforcement handles a broad range of investigations and cases. FINRA’s Enforcement Department works closely with other FINRA departments and offices, such as Market Regulation and Member Regulation. FINRA may initiate investigations from many varied sources, including examination findings, filings made with FINRA, customer complaints, anonymous tips, automated surveillance reports, and referrals from other regulators or other FINRA departments, among others. When disciplinary action must be brought, FINRA has two separate procedures: a settlement or a formal complaint. With a settlement, a firm or broker can opt to settle with FINRA through a Letter of Acceptance, Waiver and Consent. A formal complaint will have to be filed with and heard before FINRA’s Office of Hearing Officers. The case is heard by a three-​person panel made up of the hearing officer and two industry panelists. FINRA for example, in Enforcement Department v. Newport Coast, Douglas A. Leone and Andre V. Labarbera,29 expelled a brokerage firm from FINRA membership and barred two brokers from association with any FINRA member firm, and both the firm and the brokers were also ordered to pay restitution and a fine. This decision was taken after FINRA’s investigation showed that the brokerage firm and the brokers had churned the accounts of customers, engaged in quantitatively unsuitable trading in the accounts of customers, recommended qualitatively unsuitable investments to customers, misrepresented the value of a customer’s account, and failed to supervise this activity. M. NYSE Know-​Y our-​C ustomer  Rule

Stock exchanges over the country have adopted their own version of the duty of suitability. The extent of the standard depended on whether suitability of an investment

Enforcement Department v. Newport Coast, Douglas A. Leone and Andre V. Labarbera, Disciplinary Proceeding No. 20120305647-​01 (Oct. 17, 2016). 29

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was being discussed. Generally speaking, a member of the exchange is required when discussing the suitability of a standard “to seek (or obtain) information about a customer’s financial and tax situation and their investment objectives and needs on the basis of which they have reasonable grounds to believe the investment is suitable for that customer.” For example, the NYSE has adopted rules that together form the Regulation of the Exchange and its Member Organizations. Among these is rule 2090, entitled “Know Your Customer.” This rule was adopted in May 2016, and it is virtually identical to the FINRA “Know Your Customer” rule. To properly abide by this rule, a member or member organization of the NYSE must gather the information that is required to “(a) effectively service the customer’s account, (b) act in accordance with any special handling instructions for the account, (c) understand the authority of each person acting on behalf of the customer, and (d) comply with applicable laws, regulations, and rules.”30 On the basis of the information gathered pursuant to rule 2090, members of the NYSE are required to abide by rule 2111, entitled “Suitability.” The NYSE Regulation (NYSER) is responsible for monitoring the activities of the NYSE’s members and for addressing noncompliance with the NYSE’s rules and federal securities laws. It enforces both the NYSE and its members’ compliance with NYSE’s rules and applicable federal securities requirements. It also monitors and enforces listed companies’ compliance with applicable listing standards of the NYSE. By performing these duties, NYSER supports the NYSE Exchanges’ efforts to promote just and equitable principles of trade, encourage free and open markets, and protect investors and the public interest. Many of these regulatory functions are performed directly by NYSER; others are performed by FINRA or other SROs pursuant to a regulatory services agreement, national market system plans, or other arrangements.31 Prior to the formation of FINRA, the New York Stock Exchange, in its role as an SRO, imposed a “know your customer” rule on brokers. NYSE Rule 405 required its member firms “to use due diligence to learn the essential facts relative to every customer [and] every order.”32 However, application of this rule has been limited by courts. Rule 405 violations in disciplinary proceedings have been charged only

Adopted by SR-​FINRA-​2010-​039 and amended by SR-​FINRA-​2011-​016 eff. July 9, 2012. Available at http://​finra.complinet.com/​en/​display/​display_​main.html?rbid=2403&element_​id=9858 (last visited Dec. 9, 2018). 31 NYSE, Regulation, https://​www.nyse.com/​regulation (last visited Dec. 9, 2018). 32 NYSE Rule 405, 2 N.Y.S.E. Guide (CCH) 4057 [hereinafter NYSE Guide]; see also G. Thomas Fleming III & Usman S. Mohammed, NYSE Rule 405, the “Know Your Customer” Rule: Current Application and Limitations, Sec. Arb. Commentator at 1, (Mar. 2002); see also Barbara Black, Economic Suicide: The Collision of Ethics and Risk in Securities Law, 64 U. Pitt. L. Rev. 483, 493–​94 (2003). 30

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when the customer’s information was not recorded accurately, so that the firm was unable to “know the customer.”33 Rule 405 provided that: Every member organization is required through a principal executive or a person or persons designated under the provisions of Rule 342(b)(1) [¶ 2342] to (1)  Use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization and every person holding power of attorney over any account accepted or carried by such organization.34 1. Consumer Financial Protection Bureau The Dodd-​Frank Act was adopted in 2010 in reaction to the financial crisis of 2008. The Dodd-​Frank Act contains a provision entitled the “Consumer Financial Protection Act of 2010” that creates a new consumer protection agency within the Federal Reserve System. This agency is called the Consumer Finance Protection Bureau (the CFPB), and it is entirely independent from any other government agency including from the Federal Reserve. The CFPB was created for “the purpose of ensuring that all consumers have access to markets for consumer financial products and services and that [such] markets (. . .) are fair, transparent, and competitive.”35 It holds most of the authority to oversee consumer financial protection and enforce “Federal consumer financial law” that was previously spread among a number of federal authorities, with the notable exception of chartered banks that remain supervised by bank regulators.36 The “Federal consumer financial law” includes, among other things, Dodd-​Frank Act’s Title X, which prohibits unfair, deceptive, or abusive acts and practices in connection with consumer financial products and services.37

33 See In re Silberman, NYSE Disc. Action 01-​229, 2001 NYSE Disc. Action LEXIS 165 (Dec. 19, 2001). 34 FINRA Manual Rule 405, available at http://​finra.complinet.com/​ (last visited Dec. 9, 2018). 35 Dodd-​Frank Act, 111 P.L. 203, § 1021(a). 36 M. Jickling, & E.V. Murphy, Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for Banking and Securities Markets, CRS Report for Congress, Dec. 8, 20120, https://​fas.org/​sgp/​crs/​ misc/​R43087.pdf 37 The “Federal consumer financial law” also includes the following statutes: Consumer Leasing Act of 1976 (15 U.S.C. 1667 et seq.); Electronic Fund Transfer Act (15 U.S.C. 1693 et seq.); Equal Credit Opportunity Act (15 U.S.C. 1691et seq.); Fair Credit Billing Act (15 U.S.C. 1666 et seq.); Fair Credit Reporting Act (15 U.S.C. 1681et seq.); Home Owners Protection Act of 1998 (12 U.S.C. 4901 et seq.); Fair Debt Collection Practices Act (15 U.S.C. 1692 et seq.); Truth in Lending Act (15 U.S.C. 1601 et seq.); etc.

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The Dodd-​Frank Act makes it unlawful to “engage in any unfair, deceptive, or abusive act or practice,”38 and it empowers the CFPB to take enforcement actions to prevent any person or entity subject to its jurisdiction from engaging or committing such acts or practices.39 The CFPB was granted the authority to define and regulate unfair, deceptive, or abusive acts or practices (UDAAP). An act or a practice is deemed “unfair” if the CFPB has a reasonable basis to believe that: (1) it causes or is likely to cause substantial injury to consumers, (2) the injury is not reasonably avoidable by consumers, and (3) the injury is not outweighed by countervailing benefits to consumers or competition.40 The Dodd-​Frank Act does not define “deceptive,” but the CFPB has adopted a standard stated in its Examination Manual according to which a representation, omission, act, or practice is deceptive if: (1) it is material, (2) it is likely to mislead a consumer; and (3) the consumer’s interpretation is reasonable.41 Finally, the Dodd-​Frank Act considers an act or practice to be “abusive” if it “materially interferes with the consumer’s ability to understand a term or condition of a consumer financial product or service and takes unreasonable advantage of: (1) the consumer’s lack of understanding of the material risks, costs, or conditions of the product/​service; 2) the consumer’s inability to protect his or her interests in selecting or using the product/​service; or 3) the consumer’s reasonable reliance on a covered person to act in his/​her interests.”42 The “abusive” standard seems to create a certain “suitability” standard with the burden on financial institutions to demonstrate what the consumer actually understood at the time of the transaction. 2. Scope and Applicability The prohibition against engaging in any unfair, deceptive, or abusive act or practice applies to all “covered persons” and “service providers.” The term “covered person” is defined by the Dodd-​Frank Act as “any person that engages in offering or providing a consumer financial product or service; and any affiliate of a person described in subparagraph (A) if such affiliate acts as a service provider to such person.”43 The term “service provider” is defined as “any person that 12 U.S.C. § 5536. 39 12 U.S.C. § 5531(a). 40 12 U.S.C. § 5531(c)(1); Morrison & Foerster, The CFPB & UDAAP: A “Know It When You See It” Standard?, June 2014, p. 2, http://​media.mofo.com/​docs/​pdf/​140604-​CFPB-​UDAAP/​78832877987E1A622ECDA8D 3385A85AC/​140604-​CFPB-​UDAAP.pdf. 41 CFPB Examination Manual v.2, UDAAP.1, n.2 (Oct. 2012), https://​files.consumerfinance.gov/​f/​201210_​ cfpb_​supervision-​and-​examination-​manual-​v2.pdf; Morrison & Foerster, supra note 39. 42 12 U.S.C. § 5531(d); Morrison & Foerster, supra note 39. 43 12 U.S.C. § 5481(6). 38

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provides a material service to a covered person in connection with the offering or provision by such covered person of a consumer financial product or service, including a person that—(i) participates in designing, operating, or maintaining the consumer financial product or service; or (ii) processes transactions relating to the consumer financial product or service (other than unknowingly or incidentally transmitting or processing financial data in a manner that such data is undifferentiated from other types of data of the same form as the person transmits or processes).”44 3. Control and Enforceability The Bureau of Consumer Financial Protection45 is authorized to conduct investigations to determine whether any person is, or has, engaged in conduct that violates federal consumer financial law. Investigations may be conducted jointly with other regulators, and may include subpoenas or civil investigative demands for testimony, responses to written questions, documents, or other materials.46 When the CFPB identifies a violation of federal consumer financial law it may enforce the law by filing an action in federal district court or by initiating an administrative adjudication proceeding. For example, in In Re Zero Parallel, LLC,47 the CFPB found that a lead aggregator (which buys consumer information—​called leads—​from other lead generators who operate websites that market payday and installment loans) committed an abusive practice by selling loan applications to lenders in a manner that prevented consumers from understanding the risks, costs, or conditions of the loans they were offered. The CFPB considered this practice to be an unfair, deceptive, or abusive act or practice that violated federal consumer financial laws, ordered the aggregator to stop the practice, and required it to pay a civil monetary penalty. In In re Think Finance, LLC,48 the CFPB took action against a recovery company for its role in deceiving consumers into repaying loans that were not legally owed. The CFPB filed a suit alleging that the company illegally collected on loans that were void under state laws 12 U.S.C. § 5481(26)(A). 45 Originally colloquially referred to as the Consumer Financial Protection Bureau (“CFPB”) and subsequently (in accord with the statute and by designation of the Director referred to as the “Bureau of Consumer Financial Protection” or “BCFP” (as discussed in Chapter 6). In this chapter reference will be made to the “CFPB” as it was called until 2017. 46 CFPB, Rules Relating to Investigations, Docket No.: CFPB-​2011-​0007, https://​files.consumerfinance.gov/​f/​ documents/​cfpb_​rfi_​enforcement-​processes_​022018.pdf (last visited Dec. 9, 2018). 47 CFPB—​Investigation Actions, CFPB Takes Action Against Zero Parallel, https://​www.consumerfinance.gov/​ policy-​compliance/​enforcement/​actions/​zero-​parallel-​llc/​. 48 CFPB—​Investigation Actions, CFPB Takes Action Against Think Finance, https://​www.consumerfinance. gov/​policy-​compliance/​enforcement/​actions/​think-​finance-​llc-​formerly-​known-​think-​finance-​inc/​ (last visited Dec. 9, 2018). 44

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governing interest rate caps or the licensing of lenders. In doing so the company made deceptive demands and illegally took money from consumers’ bank accounts for debts that were not legally owed. These acts and practices are according to the CFPB unfair, deceptive, or abusive, and they violate federal consumer financial laws. 4 Department of Labor a. Employee Retirement Income Security Act There is no uniform standard of care required from retirement advisors. The Employee Retirement Income Security Act (ERISA), which is the federal law adopted in 1974 to protect the interests of investors in the retirement plan market, falls short in efficiently establishing such a standard.49 The language used in the standard of care provided by ERISA is extremely narrow and de facto excludes from its scope broker-​dealers and investment advisers so long as they do not meet one of the ERISA five-​prongs test.50 Since its adoption, ERISA has been amended numerous times to expand the protections available such as to apply to health and benefit plans and retirement plans. The last modification of ERISA was in 2016. The DOL amended ERISA to expand its “investment advice fiduciary” definition (the Final Rule). On March 13, 2018, in Market Synergy Group, Inc. v. United States Department of Labor,51 the Tenth Circuit Court of Appeals upheld the DOL’s authority to promulgate the Fiduciary rule. On March 15, 2018, in Chamber of Commerce of the United States of America, et al. v. United States Department of Labor,52 a divided Fifth Circuit Court of Appeals vacated the Fiduciary rule in its entirety. The DOL could appeal the Fifth Circuit’s decision however, the Trump administration’s DOL announced that it will not enforce the Fiduciary rule “pending further review.” Under ERISA, fiduciaries are required to abide by four duties when rendering services to participants and beneficiaries of employee benefit plans. In other words, ERISA requires a fiduciary, among other duties, to “discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries” and according to four standards of conduct: (1) a duty of loyalty, (2) a duty of prudence, (3) a duty to diversify investments, and (4) a duty to follow plan documents to the extent that they comply with ERISA. DOL—​EBSA, Retirement Plans and ERISA FAQs, https://​www.dol.gov/​agencies/​ebsa/​about-​ebsa/​our-​ activities/​resource-​center/​faqs/​retirement-​plans-​and-​erisa-​consumer (last visited Dec. 9, 2018). 50 The ERISA defines a fiduciary as a person who does not have discretionary authority over plan assets and who, for compensation (i) Renders advice as to the value of securities or other property; (ii) On a regular basis; (iii) Pursuant to a mutual agreement; (iv) The advice serves as the primary basis for investment decisions; and (v) The advice is individualized. 51 Market Synergy Group, Inc. v. U.S. Dep’t of Labor et al., No. 17-​3038. 52 Chamber of Commerce et al. v. U.S. Dep’t of Labor et al., No. 17-​10238. 49

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5. Scope and Applicability Under existing ERISA rules, a person was classified as a “fiduciary” by applying a five-​ criteria regulatory test. Because of the narrow language of the five-​criteria regulatory test, many advisers were precluded from the fiduciary scope. This test defines a fiduciary as a “person who does not have discretionary authority over plan assets and who, for compensation:

i. Renders advice as to the value of securities or other property; ii. On a regular basis; iii. Pursuant to a mutual agreement; iv. The advice serves as the primary basis for investment decisions; and v. The advice is individualized. To be deemed a fiduciary, all five prongs of the test must be met.

a. The Antifraud Provisions of the Federal Securities Laws— ​Section 10b Cause of Action The SEC will itself pursue a suitability claim under section 10b of the Exchange Act if it considers the conduct of the broker so egregious as to amount to a fraud perpetrated on the customer.53 Section 10b of the Exchange Act and Rule 10b-​ 5 promulgated thereunder make it unlawful for any person, directly or indirectly, in connection with the purchase or sale of any security to (1) employ any device, scheme, or artifice to defraud; (2) make any untrue statement or omission of a material fact; or (3) engage in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any person. Although not enumerated therein, private claimants also have an implied right of action under section 10b. Suitability claims are analyzed either as “misrepresentation/​omission” cases under Rule10b-​5(b), or “fraudulent conduct” cases under Rules 10b-​5(a) and (c).54 An The Second Circuit was the first to hold that a broker’s recommendation of unsuitable securities could amount to a violation of Section 10b of the Exchange Act and Rule 10b-​5 promulgated thereunder. Clark v. John Lamula Inv., Inc., 583 F. 2d 594 (2d Cir. 1978). The SEC may initiate either federal district court proceedings, or an administrative proceeding under the provisions of the Exchange Act. The forum selected will generally depend upon the seriousness of the broker’s conduct and the nature of the relief sought. 54 O’Connor v. R.F. Lafferty & Co., 965 F.2d 893, 897 (10th Cir. 1992): ”Some courts examining a 10(b), Rule 10b-​ 5 unsuitability claim have analyzed it simply as a misrepresentation or failure to disclose a material fact. . . . In such a case, the broker has omitted telling the investor the recommendation is unsuitable for the investor’s interests. The court may then use traditional laws concerning omission to examine the claim. . . . In contrast, [the plaintiff ] asserts an unsuitability claim based on fraud by conduct. She does not assert [that the broker] omitted to tell her the stocks he purchased were unsuitable for her investment needs. Rather, she claims that his purchase of the stocks for her account acted as a fraud upon her.” 53

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unsuitability claim based on a misrepresentation/​omission theory is considered a subset of an ordinary misrepresentation or omission claim brought under Section 10b.55 In order to prevail, the SEC will be required to prove: (1) that the securities purchased were unsuited to the customer’s needs, (2) that the broker knew or reasonably believed that the securities were unsuitable, (3) that the broker recommended or purchased the unsuitable securities anyway, and (4) that, with scienter, the broker made material misrepresentations or failed to disclose material information relating to the suitability of the securities.56 A private claimant must prove a fifth element: justifiable detrimental reliance.57 Institutional investors, in particular, face difficulties establishing claims both under the misrepresentation/​omission theory of liability and the fraudulent conduct theory of liability. Under the misrepresentation/​omission premise, justifiable reliance on the alleged misstatements or omissions of the broker must be proven. The courts have considered various factors to be relevant in determining justifiable reliance in such cases, including the sophistication and expertise of the claimant in financial and securities matters, the existence of long-​standing business or personal relationships, access to relevant information, the existence of a fiduciary relationship, and concealment of, and opportunity to detect, the fraud.58 The sophistication of the investor is often the critical element in determining whether the investor is entitled to relief under section 10b. If a commercial entity is considered sophisticated with regard to, for example, its business expertise, or its employment of experienced financial personnel for the purpose of assessing financial investments or strategies, the court will not find reliance placed by the entity on a broker’s misstatements to be justified. In Banca Cremi, S.A. v. Alex. Brown & Sons, Inc.,59 a Mexican bank filed suit against a Maryland securities brokerage firm alleging, inter alia, a section 10b/​Rule 10b-​5 violation after the bank suffered losses on a number of collateralized mortgage obligations (CMOs) when the market in CMOs collapsed in 1994.60 The bank claimed that the brokers had violated the Exchange Act by making material

Brown v. E.F. Hutton Grp., Inc., 991 F. 2d 1020, 1031 (2d Cir. 1993). 56 In re Dale E. Frey, 2003 SEC Lexis 306 (Feb. 5, 2003). 57 Brown, 991 F. 2d at 1031. 58 See, e.g., Banca Cremi, S.A., v. Alex. Brown & Sons, Inc., 132 F. 3d 1017, 1028 (4th Cir. 1997). 59 132 F. 3d 1017, 1028 (4th Cir. 1997). 60 The Bank had invested in “inverse floater” CMOs that earned interest at rates that moved inversely to specified floating index rates. The inverse floaters thus earned high returns while interest rates declined or remain constant, but would lose substantial value if interest rates increased. The market for CMOs collapsed in 1994 when the Federal Reserve Board increased short-​term interest rates by a total of 2.5 percent over a nine-​month period. CMO holders flooded the market and CMO liquidity dried up. 55

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misstatements and omissions regarding the CMOs sold to the bank, and by selling the bank investments that it knew to be unsuitable. The Fourth Circuit affirmed the district court’s finding that the bank was a sophisticated investor capable of investigating the investment risk. It took into account both the bank’s employees—​hired for their business expertise—​and the access that the bank had to a wealth of information regarding CMOs, which illustrated that although the investments were potentially very profitable, they were also highly risky.61 In any action for fraud, reliance on false statements needs to be accompanied by a right to rely. Here, the bank lost its right to rely by its own recklessness. It continued to purchase CMOs after it had sufficient information, given its sophistication, to be well apprised of the risks it faced in investing in CMOs. Given that the bank was aware of the risks involved, it was not justified in relying on the broker’s alleged omissions and misstatements. Establishing an unsuitability claim under the lesser-​litigated fraudulent conduct theory requires proof that the broker recommended or, in the case of a discretionary account, purchased unsuitable securities with an intent to defraud or with reckless disregard for the customer’s interests, and that the broker exercised control over the customer’s account.62 This latter element would be a “substantial, if not insuperable” obstacle for an institutional investor to overcome in establishing a suitability claim.63 A firm may face liability under the control person provisions of the Exchange Act if it fails to properly supervise the conduct of its members with respect to their suitability obligations under the securities laws.64 II. Futures and Options: Suitability A. Commodity Futures Trading Commission Disclosure Rules 1. Commodity Futures Trading Commission a. Commodity Exchange Act The Commodity Exchange Act (“the Commodity Act”) regulates the trading of commodity futures in the United States. Adopted in 1936, the Commodity Act

In finding that the bank was sophisticated, the court referred to the factors specifically promulgated by the NASD to measure the sophistication of institutional investors, that is, the “institutional investor’s ‘capability to evaluate investment risk independently, and the extent to which the [investor] is exercising independent judgment,’ ” and concluded that it was “clear that the Bank would also qualify as a highly sophisticated institutional investor under the NASD standards.” Banca Cremi, 132 F. 3d at 1029. 62 O’Connor v. R.F. Lafferty & Co., 965 F. 2d 893, 898 (10th Cir. 1992). 63 Norman S. Poser, Liability of Broker-​Dealers for Unsuitable Recommendations to Institutional Investors, 2001 B.Y.U. L. Rev. 1493, 1552 (2001): at 1552. 64 Exchange Act § 20; 15 U.S.C. § 78t. 61

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establishes the statutory framework under which the Commodity Futures Trading Commission (CFTC) operates.65 The authority to establish regulations applicable to futures was granted by the Commodity Act to the CFTC. For years however, and as early as 1978, the CFTC refused to adopt a “suitability” rule, stating that it was unable “to formulate meaningful standards of universal application.”66 With the adoption of the Dodd-​Frank Act, the CFTC was no longer able to sustain such a refusal. In 2012, the CFTC adopted final rules (“Final Rules”) to implement section 4s(h) of the Commodity Act pursuant to section 731 of Title VII of the Dodd-​Frank Act. These Final Rules prescribe external business conduct standards for swap dealers and major swap participants. The Final Rules were adopted by the CFTC in consultation and coordination with the SEC and the DOL with respect to certain special definitions and with respect to the intersection of their regulatory requirements with the Dodd-​Frank Act business conduct standards provisions.67 The CFTC’s objective was to establish requirements with those of the SEC and DOL. b. Rule: A Suitability and Fair-​Dealing Duty The section of the Final Rules that implement a suitability standard is section 23.434 entitled ”Recommendations to counter-​parties—​institutional suitability.” It was drafted in harmonization with the FINRA’s suitability duty (see hereafter) and in an aim to reduce risk, increase transparency, and promote market integrity within the financial system. The suitability duty of the CFTC requires a swap dealer to (1) understand the swap that it is recommending, and (2) make a determination that the recommended swap is suitable for the specific counterparty. It is not sufficient for swap dealers to reasonably believe that the swap is suitable, they must first understand the swap that they are recommending. The CFTC included in the Final Rules two safe harbors to enable swap traders to meet their suitability duty:

b) Safe harbor. A swap dealer may fulfill its obligations under paragraph (a) (2) of this section with respect to a particular counter-​party if:

CFTC, History of the CFTC, https://​www.cftc.gov/​About/​HistoryoftheCFTC/​index.htm (last visited Dec. 9, 2018). 66 NFA, Interpretive Notices, https://​www.nfa.futures.org/​rulebook/​rules.aspx?Section=9&RuleID= (last visited Dec. 9, 2018). 67 Section 712(a)(1) of the Dodd-​Frank Act. 65

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(1) The swap dealer reasonably determines that the counter-​party, or an agent to which the counter-​party has delegated decision-​making authority, is capable of independently evaluating investment risks with regard to the relevant swap or trading strategy involving a swap; (2) The counter-​party or its agent represents in writing that it is exercising independent judgment in evaluating the recommendations of the swap dealer with regard to the relevant swap or trading strategy involving a swap; (3) The swap dealer discloses in writing that it is acting in its capacity as a counter-​party and is not undertaking to assess the suitability of the swap or trading strategy involving a swap for the counter-​party; and (4) In the case of a counter-​party that is a Special Entity, the swap dealer complies with §23.440 where the recommendation would cause the swap dealer to act as an advisor to a Special Entity within the meaning of §23.440(a). (c) A swap dealer will satisfy the requirements of paragraph (b)(1) of this section if it receives written representations, as provided in §23.402(d), that: (1) In the case of a counter-​party that is not a Special Entity, the counter-​ party has complied in good faith with written policies and procedures that are reasonably designed to ensure that the persons responsible for evaluating the recommendation and making trading decisions on behalf of the counter-​party are capable of doing so; or (2) In the case of a counter-​party that is a Special Entity, satisfy the terms of the safe harbor in §23.450(d). In addition to the duty of suitability, swap dealers or major swap participants also have a duty of fair dealing similar to the one applicable to broker-​dealers by the Exchange Act. The duty of fair dealing is defined in section 23.433 entitled “Communications—​fair dealing” as follows: “With respect to any communication between a swap dealer or major swap participant and any counterparty, the swap dealer or major swap participant shall communicate in a fair and balanced manner based on principles of fair dealing and good faith.” With regard to this duty and when determining whether a communication with a counter-​party is fair and balanced, the CFTC stated that it expects “a swap dealer or major swap participant to consider whether the communication: (1) Provides a sound basis for evaluating the facts with respect to any swap; (2) avoids making exaggerated or unwarranted claims, opinions or forecasts; and (3) balances any statement that refers to the potential

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Capital Markets, Derivatives, and the Law

opportunities or advantages presented by a swap with statements of corresponding risks.”68 c. Scope and Applicability The Final Rules, and more specifically the duty of suitability and of fair dealing, apply to both swap dealers or major swap participants when dealing in swaps or security-​based swaps.69 The Final Rules apply to all transactions in swaps or security-​based swaps. Swaps “are derivative financial products that have underlying assets that, inter alia, are commodities, interest rates, government securities, and broad-​based security indices. Whereas security-​based swaps are based on single securities, loans and reference assets, or narrow-​based security indices.”70 d. Control and Enforceability Under the Dodd-​Frank Act, the CFTC received authority to regulate swaps, and the SEC received regulatory authority over security-​based swaps.71 The CEA does not require brokers to determine if a transaction is suitable for a customer, and brokers may recommend commodities futures trading without making any determination as to its suitability.72 However, courts can consider the totality of the circumstances in order to determine whether the FCM acted properly. In United States CFTC v. Calvary Currencies,73 the court said: The U.S. Commodity Futures Trading Commission regulates “transactions.” In order to determine the nature of a transaction, it is often necessary to look beyond the written contract. In order to gain the fullest understanding possible of the parties’ agreement and their purpose, courts often must consider the course of dealings between the parties and the totality of the business relationship. It is appropriate, then, to look to both the client agreement and the subsequent currency trades to determine the nature of the transaction.74

G. Scopino, Regulating Fairness: The Dodd-​Frank Act’s Fair Dealing Requirement for Swap Dealers and Major Swap Participants. 93 Neb. L. Rev. 31, 45 ( June 9, 2014), https://​ssrn.com/​abstract=2424292. 69 Unless specified otherwise in the Final Rules. 70 Scopino, supra note 67. 71 CFTC, Mission and Responsibilities, https://​www.cftc.gov/​About/​MissionResponsibilities/​index.htm (last visited Dec. 9, 2018). 72 Black, supra note 31, at 493. 73 473 F. Supp. 2d 453 (D. Md. 2006). 74 Id. at 63–​64. 68

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349

Furthermore, an affirmative misrepresentation of suitability would constitute fraud, assuming scienter and reliance.75 However, this still falls short in comparison to the SEC’s hard-​line approach, which implements intense oversight of the securities exchanges. B. National Futures Association

When Congress created the CFTC, it simultaneously authorized the CFTC to establish registered futures associations with authority to regulate the practices of its members.76 The CFTC created the National Futures Association (NFA), which is the sole registered futures association. Operating under the control of the CFTC, NFA is the industrywide, self-​regulatory organization for the derivatives industry. It describes itself as striving every day to safeguard the integrity of the derivatives markets, to protect investors, and to ensure that its members meet their regulatory responsibilities.77 1. Rule: Suitability and Know-​Your-​Customer Duty The NFA Compliance Rule 2-​4 entitled “Just and Equitable Principles of Trade” requires all “Members and Associates [to] observe high standards of commercial honor and just and equitable principles of trade in the conduct of their commodity futures business and swaps business.”78 This general standard of conduct is further defined in NFA Compliance Rule 2-​30 entitled “Customer Information and Risk Disclosure.” Before the adoption of Rule 2-​30, the futures industry did not have a “suitability” or a “know-​your-​customer” duty, contrary to those found in the regulation of the securities industry. This was because the “suitability” and “know-​your-​customer” duties in the securities industry were “all based on the same premises: that different type of securities can have widely varying degrees of risk potential and serve very different investment objectives. For that reason, the securities suitability rules are cast in terms of the suitability of a particular transaction.”79 This was not the case of the futures industry because all futures contracts are considered to be highly volatile.

75 Id. 76 NFA, CFTC Oversight, https://​www.nfa.futures.org/​about/​cftc-​oversight.html (last visited Dec. 9, 2018). 77 NFA, About NFA, https://​www.nfa.futures.org/​about/​index.html. 78 NFA, Rulebook, https://​www.nfa.futures.org/​rulebook/​rules.aspx?RuleID=RULE%202-​4&Section=4 (last visited Dec. 9, 2018).). 79 NFA, Interpretive Notice 9004—​Customer Information and Risk Disclosure, https://​www.nfa.futures.org/​rulebook/​rules.aspx?Section=9&RuleID=9004 (last visited Dec. 9, 2018).

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Capital Markets, Derivatives, and the Law

There is therefore little sense in determining that certain futures are appropriate to a particular customer while others are not. In the futures industry, the question really is whether trading in futures in the first place is or is not appropriate for a particular customer. This is why the key feature of the futures industry code of conduct was the “risk disclosure” requirement. It was essential that the futures advisor disclose to all new customer the risks associated with trading in futures contracts so that the customer would be able to make an informed decision as to whether futures trading was suitable for that customer. To properly disclose risks, the trading advisor would have to learn about the new customer. This duty was not considered to be a “suitability” or a “know-​your-​customer” duty as such but rather a risk disclosure duty combined with a duty to get acquainted with the personnel circumstances of a potential customer.80 NFA was however always concerned that, without standards effectively set in its regulatory framework, a poorly defined or inappropriate duty would be fashioned on a case-​by-​case basis. NFA therefore adopted the Rule 2-​30, which contains uniform industry-​wide standards. The rule offers guidance to its members while nevertheless recognizing that customers themselves are in the best position to determine the suitability of futures trading so long as the customer has received an understandable disclosure of risk from a futures professional who “knows the customer.”81 a. Scope and Applicability The NFA Compliance Rules are applicable to all of NFA’s members, which are firms and individuals that conduct business in the derivatives industry. NFA members are divided in six categories: Commodity Pool Operator, Commodity Trading Adviser, Futures Commission Merchant, Forex Dealer Member, Introducing Broker, and Swap Dealer. b. Control and Enforceability The duty enacted by the NFA is a business conduct standard promulgated by an SRO. It therefore does not create a private right of action. Only the NFA can control and enforce in respect to the conduct by its members. NFA’s enforcement and disciplinary actions are executed under the oversight of CFTC’s Division of Swap Dealer and Intermediary Oversight (DSIO).82 DSIO

80 Id. 81 Id. 82 NFA, CFTC Oversight, https://​www.nfa.futures.org/​about/​cftc-​oversight.html (last visited Dec. 9, 2018).

351

Suitability

351

regularly assesses whether NFA is adequately meeting its obligations to examine futures and swap markets intermediaries for compliance with the relevant provisions of the Commodity Exchange Act, CFTC regulations, and NFA rules.83 NFA works very closely with the CFTC, and all of NFA’s most significant actions such as rule changes, enforcement actions, and registration actions, are subject to review and approval of the CFTC.84 C. CEA Antifraud Provision

The CFTC made clear in its 1986 decision in Phacelli v. ContiCommodity Services, Inc.85 that a futures professional does not violate the antifraud provision of the CEA (section 4b) merely because he fails to determine whether a customer is suitable for futures trading. Subsequent CFTC and federal court decisions have consistently followed this view, holding that no legal duty to recommend only suitable futures transactions arises under section 4b of the CEA.86 The CFTC will, however, find fraud where there is a failure on the part of the futures professional to disclose the risks involved in futures trading. Again, such decisions tend to involve clearly unsuitable and unsophisticated investors.87 D. Municipal Securities Rule-​M aking Board

The Municipal Securities Rulemaking Board (MSRB) is the SRO established by the SEC under the Exchange Act to regulate the activities of dealers in municipal securities.88 It has a suitability rule similar to the NASD rule and places an affirmative duty of inquiry on the dealer with respect to recommendations to noninstitutional accounts.89 Furthermore, a dealer is required to make a suitability determination before recommending a municipal security transaction to any account, including an institutional account.

83 Id. 84 Id. 85 No. 80-​385-​80-​704, 1986 WL 68447 (Sept. 5, 1986). 86 See, e.g., Dyer v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 928 F.2d 238 (7th Cir. 1991). 87 See Andrew M. Pardieck. Kegs, Crude, and Commodities Law: On Why It Is Time to Reexamine the Suitability Doctrine, Nevada Law Journal, 2007,at 301, for an analysis of CFTC engagement in suitability determinations “under the rubric of disclosure.” 88 See 15 U.S.C. 78o-​4. 89 Security Rulemaking Bd., MSRB Rule G-​19, MSRB Manual (CCH) P 3591.

352

352

Capital Markets, Derivatives, and the Law

Appendix A: Various Suitability Rules and Diagrams of Applicability Finra Rule 2111. Suitability (a) A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation. (b) A member or associated person fulfills the customer-​specific suitability obligation for an institutional account, as defined in Rule 4512(c), if (1) the member or associated person has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities and (2) the institutional customer affirmatively indicates that it is exercising independent judgment in evaluating the member’s or associated person’s recommendations. Where an institutional customer has delegated decisionmaking authority to an agent, such as an investment adviser or a bank trust department, these factors shall be applied to the agent. Finra Rule 2360. Options—​S uitability (19) Suitability

(A) No member or person associated with a member shall recommend to any customer any transaction for the purchase or sale (writing) of an option contract unless such member or person associated therewith has reasonable grounds to believe upon the basis of information furnished by such customer after reasonable inquiry by the member or person associated therewith concerning the customer’s investment objectives, financial situation and needs, and any other information known by such member or associated person, that the recommended transaction is not unsuitable for such customer. (B) No member or person associated with a member shall recommend to a customer an opening transaction in any option contract unless the person

35

Suitability

353

making the recommendation has a reasonable basis for believing, at the time of making the recommendation, that the customer has such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating the risks of the recommended transaction, and is financially able to bear the risks of the recommended position in the option contract. Section 10 of the Securities Exchange Act 1934

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange • To effect a short sale, or to use or employ any stop-​loss order in connection

with the purchase or sale, of any security registered on a national securities exchange, in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. • Paragraph (1) of this subsection shall not apply to security futures products. • To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-​based swap agreement (as defined in section 206B of the Gramm-​Leach-​Bliley Act), any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. Rules promulgated under subsection (b) that prohibit fraud, manipulation, or insider trading (but not rules imposing or specifying reporting or recordkeeping requirements, procedures, or standards as prophylactic measures against fraud, manipulation, or insider trading), and judicial precedents decided under subsection (b) and rules promulgated thereunder that prohibit fraud, manipulation, or insider trading, shall apply to security-​based swap agreements (as defined in section 206B of the Gramm-​Leach-​Bliley Act) to the same extent as they apply to securities. Judicial precedents decided under section 17(a) of the Securities Act of 1933 and sections 9, 15, 16, 20, and 21A of this title, and judicial precedents decided under applicable rules promulgated under such sections, shall apply to security-​based swap agreements (as defined in section 206B of the Gramm-​Leach-​Bliley Act) to the same extent as they apply to securities.

354

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Capital Markets, Derivatives, and the Law

Rule 10B-​5 Employment of Manipulative and Deceptive Devices

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, • To employ any device, scheme, or artifice to defraud,



•

To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or • To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. Section 4B of the Commodity Exchange Act (as Amended)

1. (a) Unlawful Actions—​It shall be unlawful—​ (1) for any person, in or in connection with any order to make, or the making of, any contract of sale of any commodity in interstate commerce or for future delivery that is made, or to be made, on or subject to the rules of a designated contract market, for or on behalf of any other person; or (2) for any person, in or in connection with any order to make, or the making of, any contract of sale of any commodity for future delivery, or other agreement, contract, or transaction subject to paragraphs (1) and (2) of section 5a(g), that is made, or to be made, for or on behalf of, or with, any other person, other than on or subject to the rules of a designated contract market—​ 2. (A) to cheat or defraud or attempt to cheat or defraud such other person; 3. (B) willfully to make or cause to be made to such other person any false report or statement or willfully to enter or cause to be entered for such other person any false record; 4. (C) willfully to deceive or attempt to deceive such other person by any means whatsoever in regard to any order or contract or the disposition or execution of any order or contract, or in regard to any act of agency performed, with respect to any order or contract for or, in the case of paragraph (2), with such other person; or 5. (D) (i) to bucket an order if such order is either represented by such person as an order to be executed, or is required to be executed, on or subject to the rules of a designated contract market; or

35

Suitability

6. (ii) to fill an order by offset against the order or orders of any other person, or willfully and knowingly and without the prior consent of such other person to become the buyer in respect to any selling order of such other person, or become the seller in respect to any buying order of such other person, if such order is either represented by such person as an order to be executed, or is required to be executed, on or subject to the rules of a designated contract market unless such order is executed in accordance with the rules of the designated contract market. 7. (b) Clarification—​Subsection (a)(2) shall not obligate any person, in or in connection with a transaction in a contract of sale of a commodity for future delivery, or other agreement, contract or transaction subject to paragraphs (1) and (2) of section 5a(g), with another person, to disclose to such other person nonpublic information that may be material to the market price, rate or level of such commodity or transaction, except as necessary to make any statement made to such other person in or in connection with such transaction, not misleading in any material respect.

355

356

356

Capital Markets, Derivatives, and the Law

Schedule 1. Venn-​diagram of the Broker-​Dealer’s Duty of Care

UDAAP Prohibition—Dodd-Frank Act

Suitability and Fair-Dealing Duty— Exchange Act Suitability and Know-YourCustomer Duty—FINRA

Suitability and Know-YourCustomer Duty—NYSE Regulation

OTC Securities Traded Securities Retirement Plans Suitability and Fair-Dealing Duty—Commodity Act Commodities and Futures

Fiduciary Duties (Limited in scope)—ERISA/DOL

Suitability and Know-YourCustomer Duty—NFA Compliance Rules

357

Suitability

Schedule 2. Venn-​diagram of the Investment Adviser’s Duty of Care

UDAAP Prohibition—Dodd-Frank Act

Fiduciary Duty—Adviser Act

Suitability and Know-YourCustomer Duty—NYSE Regulation

Suitability and Know-YourCustomer Duty—FINRA

OTC Securities Traded Securities Retirement Plans Suitability and Fair-Dealing Duty—Commodity Act Commodities and Futures

Fiduciary Duties (Limited in scope)—ERISA/DOL

Suitability and Know-YourCustomer Duty—NFA Compliance Rules

357

358

358

Capital Markets, Derivatives, and the Law

Schedule 3. Chart of the Broker-​Dealer’s Duty of Care

Authority Legislative Act

Rule

Scope

Control & Enforceability

All broker-​dealers

SEC Division of Enforcement

SEC

Exchange Act

Suitability and Fair-​ Dealing Duty

CFPB

Dodd-​Frank

UDAAP Prohibition All financial CFPB professionals, including broker-​ dealers, when dealing with consumers

CFTC

Commodity Act

Suitability and Fair-​ Dealing Duty

All financial professionals, including broker-​ dealers, when recommending investing in futures

DOL

ERISA

Fiduciary duties

Certain financial EBSA professionals very narrowly defined and identified by the five-​ prong test

FINRA

Manual

Suitability and Know-​Your-​ Customer Duty

All financial professionals, including broker-​ dealers, that sell securities to the public

FINRA Enforcement Department

NFA

Compliance Rules

Suitability and Know-​Your-​ Customer Duty

All financial professionals, including broker-​ dealers, when recommending investing in futures

NFA under the oversight of CFTC’s DSIO

NYSE

Regulation of the Exchange and its Member Organizations

Suitability and Know-​Your-​ Customer Duty

All financial professionals, including broker-​ dealers, that are members of the NYSE

NYSE Regulation

CFTC Division of Enforcement

359

Suitability

359

Schedule 4. Chart of the Investment Adviser’s Duty of Care

Authority

Legislative Act

Rule

Scope

Control & Enforceability

SEC

Advisers Act

Fiduciary Duty

All financial advisers SEC Division of Enforcement

CFPB

Dodd-​Frank

UDAAP Prohibition

All financial professionals, including financial advisers, when dealing with consumers

CFTC

Commodity Act

Suitability and Fair-​ All financial Dealing Duty professionals, including financial advisers, when recommending investing in futures

DOL

ERISA

Fiduciary duties

Certain financial EBSA professionals very narrowly defined and identified by the five-​prong test

FINRA

Manual

Suitability and Know-​Your-​ Customer Duty

All financial professionals, including financial advisers, that sell securities to the public

FINRA Enforcement Department

NFA

Compliance Rules

Suitability and Know-​Your-​ Customer Duty

All financial professionals, including financial advisers, when recommending investing in futures

NFA under the oversight of CFTC’s DSIO

NYSE

Regulation of the Exchange and its Member Organizations

Suitability and Know-​Your-​ Customer Duty

All financial professionals, including financial advisers, that are members of the NYSE

NYSE Regulation

CFPB

CFTC Division of Enforcement

360

360

Capital Markets, Derivatives, and the Law

Appendix B:  Survey of Rules Adopted by the SEC under Dodd-​Frank

Dodd-​Frank Wall Street Reform and Consumer Protection Act Mandatory Rule-​Making Provisions. The SEC has adopted final rules for 67 mandatory rule-​making provisions of the Dodd-​Frank Act. Based on Information from https://​www.sec.gov/​spotlight/​dodd-​frank.shtml# as of February 24, 2019 404

Records to be maintained and reports to be provided by private funds

Adopted

406

Disclosure rules on private funds

Adopted

407

Exemption of venture capital fund advisers, definition of “venture capital fund”

Adopted

408

Exemption from registration by certain private fund advisers/​requirement of records for such advisers

Adopted

409

Family office

Adopted

410

State and federal responsibilities/​asset threshold for registration of federal advisers

Adopted

413

Adjustment of the accredited investor standard

Adopted

418

Qualified client standard, inflation adjustment

Volcker Rule 619

Prohibiting prop trading and certain hedge fund and PE relationships (joint rule-​making)

Adopted

712

Joint CFTC and SEC rule-​making regarding mixed swaps

Adopted

712(d)(1)

CFTC/​SEC rule-​making: trade repositories recordkeeping re security-​based swap agreement

Adopted

712(d)(1)

Joint CFTC and SEC rule-​making concerning swaps-​related definitions

Adopted

712(d)(2)(B)

Joint CFTC and SEC rule-​making regarding record-​keeping by trade repositories with respect to security-​based swap agreement transactions

Adopted

712(d)(2)C

Joint CFTC and SEC rulemaking regarding recordkeeping by security-​based swap dealers, swap dealers, major security-​based swap participants and major swap participants for security-​based swap agreement transactions

Adopted

Security-​Based Swaps

361

Suitability Dodd-​Frank Wall Street Reform and Consumer Protection Act 761(a)(6)

Rules to facilitate identification of major security-​ Adopted based swap participants

761(a)(6)

Exemption from the definition of security-​based swap dealer for de minimis activity

Adopted

763(a)

Rules providing process for clearing agencies to request to clear security-​based swaps

Adopted

763(a)

Rules for providing process for staying clearing requirement and reviewing clearing for approved swaps

Adopted

763(a)

Rules to prevent evasion of clearing requirements

Adopted

763(a)

SEC transition reporting rules for security-​based swaps

Adopted

763(b)

Rules governing clearing agencies for security-​ based swaps

Adopted

763(i)

Rules providing public availability of security-​ Adopted based swap pricing data to enhance price discovery

763(i)

Rules regarding the type of data to be collected with respect to security-​based swap transactions

Adopted

763(i)

Duties of security-​based swap data repositories

Adopted

763(i)

Rules governing registered security-​based swap data repositories

Adopted

764

Rules regarding the registration of security-​ based swap dealers or major security-​based swap participants

Adopted

764(a)

Business conduct standards applicable to security-​ Adopted based swap dealers and security-​based swap major participants

764(a)

Rules relating to documentation of security-​based Adopted swap transactions

764(a)

Duties of security-​based swap dealers and major security-​based swap participants related to monitoring of trading, risk management procedures, disclosure of general information, ability to obtain information, conflicts, and antitrust considerations

Adopted

766(a)

Reporting of uncleared security-​based swap transactions

Adopted

763(c)

Data collection and reporting rules for security-​ based swap execution facilities

Proposed

361

362

362

Capital Markets, Derivatives, and the Law Dodd-​Frank Wall Street Reform and Consumer Protection Act

763(c)

Rules governing security-​based swap execution facilities

Proposed

763(g)

Rules regarding fraud in the security-​based swap market

Proposed

764(a)

Reporting and recordkeeping rules applicable to security-​based swap dealers and major security-​ based swap participants

Proposed

764(a)

Rules regarding daily trading recordkeeping

Proposed

764(a)

Rules, including capital and margin, governing security-​based swap dealers and major security-​ based swap participants that are not banks

Proposed

765(a)

Conflicts of interest

Proposed

766(a)

Recordkeeping for certain security-​based swaps

Proposed

Clearing Agencies 805(a)(2)(A)

Authority to prescribe risk management standards Adopted for designated clearing entities

806(e)(1)

Changes to rules, procedures, or operation of designated financial market utilities

Adopted

Municipal advisor regulation

Adopted

952 (Exchange Act 10C(a))

Compensation committee independence—​ Commission to direct SROs to prohibit listing of certain securities unless issuers are in compliance with compensation committee independence requirements

Adopted

952 (Exchange Act 10C(b))

Compensation committee independence—​ Commission to identify factors that may affect independence

Adopted

952 (Exchange Act 10C(c)(2))

Compensation committee independence—​ Commission to issues rules relating to proxy disclosure regarding compensation consultants

Adopted

952 (Exchange Act 10C(f ))

Compensation committee independence—​ Commission to direct SROs to prohibit listing of securities of an issuer that is not in compliance

Adopted

955

Disclosure regarding employee and director hedging

Adopted

Municipal Securities Advisors 975 Executive Compensation

36

Suitability

363

Dodd-​Frank Wall Street Reform and Consumer Protection Act 972

Chairman/​CEO structure disclosure in annual proxy

Adopted

953(b)

Additional executive compensation disclosure (pay ratio)

Adopted

951

Shareholder approval of executive compensation

Adopted in Part

953(a)

Pay versus performance disclosure

Proposed

954

Recovery of executive compensation

Proposed

956(a)

Compensation structure reporting (joint rule-​making)

Proposed

956(b)

Prohibition on certain compensation arrangements (joint rule-​making)

Proposed

Credit risk retention (general) (joint rule-​making)

Adopted

Credit risk retention (residential mortgages) (joint rule-​making)

Adopted

941(b)

Credit risk retention exemptions (joint rule-​making)

Adopted

942(b)

ABS disclosure

Adopted

943

ABS reps and warranties

Adopted

945

ABS due diligence disclosure

Adopted

621

Conflicts of interest regarding certain securitizations

Proposed

932(a)(2)(B)

Internal controls governing the implementation of and adherence to policies, procedures. and methodologies for determining credit ratings

Adopted

932(a)(4)

Separation of ratings from sales and marketing

Adopted

932(a)(4)

Policies and procedures relating to look-​back reviews

Adopted

932(a)(8)

Fines and penalties

Adopted

932(a)(8)

Transparency of ratings performance

Adopted

932(a)(8)

Transparency of ratings performance

Adopted

932(a)(8)

Transparency of ratings performance

Adopted

Asset-​backed Securities 941(b)

Credit Rating Agencies

364

364

Capital Markets, Derivatives, and the Law Dodd-​Frank Wall Street Reform and Consumer Protection Act

932(a)(8)

Form and certification to accompany credit ratings

Adopted

932(a)(8)

Third-​party due diligence services for asset-​ backed securities

Adopted

936

Standards of training, experience, and competence for credit rating analysts

Adopted

938

Universal ratings symbols

Adopted

939

Removal of statutory references to credit ratings

Adopted in Part

939A

Review of reliance on credit ratings

Adopted in Part

A small set of references to credit ratings in Commission statutes, rules, and forms remain to be addressed as directed by s 939 and 939A. Specialized Disclosures 1502

Conflict minerals

Adopted

1504

Disclosure of payment by resource extraction issuers.

Adopted

The Commission’s rule implementing 1504 was invalidated on February 14, 2017, by a joint resolution of disapproval enacted pursuant to the Congressional Review Act. Other 916

Streamlining of filing procedures for self-​ regulatory organizations

Adopted

924

Whistle-​blower provisions

Adopted

926

Disqualifying felons and other “bad actors” from Reg. D offerings

Adopted

929W

Notice to missing security holders

Adopted

939B

Elimination of exemption from fair disclosure rule

Adopted

989G

Exemption for nonaccelerated filers

Adopted

1088(a)(8)

Red flag guidelines and regulations (joint rules)

Adopted

205(h)

Orderly liquidation of covered brokers and dealers (joint rule-​making)

Proposed

365

Suitability

365

Dodd-​Frank Wall Street Reform and Consumer Protection Act 165

Stress tests

Remaining

915

Regulations for Office of Investor Advocate

Remaining

929X(a)

Short sale reforms

Remaining

984(b)

Increased transparency of information available to brokers, dealers, and investors, with respect to loan or borrowing of securities

Remaining

36

367

17 The History of the CFTC I. Role of the CFTC  369 II. Structure  369 III. Disciplinary Action  370 IV. Regulatory Background  371 A. Commodity Exchange Act (CEA) of 1936  371 B. Commodity Futures Modernization Act (CFMA) of 2000  372 C. Jurisdictional Disputes  373 D. The Commodity Futures Modernization Act  373 E. Exclusions  374 F. Forwards  375 G. Options  376 H. Futures  376 I. Regulatory Distinctions between Forwards and Futures  378 J. Swaps  381 K. Hybrid Instruments  383 L. Foreign Exchange Products  384 1. The Treasury Amendment  384 2. CFTC Reauthorization  385 Appendix A: Enforcement Case Study: CFTC v. Amaranth Advisors, LLC 388 Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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Appendix B: Case Study: CFTC v. Zelener 391 Appendix C: Structure of CFTC  393 Appendix D: Case Study: CFTC v. Patrick McDonnell  394

To appreciate the impact of Dodd-​Frank on the derivatives industry, it is necessary to understand the history of CFTC regulation and the confusion over where historically the CFTC could assert jurisdiction. When President Obama signed the Dodd-​Frank Wall Street Reform and Consumer Protection Act into law, Title VII of the Dodd-​Frank Act amended the Commodity Exchange Act to create a comprehensive regulatory framework for swaps.1 This framework is described in-​depth in chapter 14. The CFTC was a natural regulatory authority for the implementation of Dodd-​Frank because of its historical role in regulating a remote corner of the derivatives market place (i.e., futures). The Commodity Futures Trading Commission (CFTC) has come a long way in regulating the multi-​trillion-​dollar derivatives marketplace from its origins as the regulator of agricultural transactions for farmers and agricultural speculators. The Commodity Exchange Act of 1936 (CEA)2 set forth the first federal regulatory framework for futures trading in agricultural commodities.3 In 1974 Congress passed the Commodity Futures Trading Commission Act,4 overhauling the CEA and establishing the Commodity Futures Trading Commission (CFTC), an independent agency with powers greater than those of its predecessor agency, the Commodity Exchange Authority. Whereas the Commodity Exchange Authority regulated only agricultural commodities enumerated in the Commodity Exchange Act, the 1974 act granted the CFTC exclusive jurisdiction over futures trading in all commodities.5 The agency’s mandate has been renewed and expanded several times since then, extensively by the Commodity Futures Modernization Act of 20006 and most recently by the CFTC Reauthorization Act of 20087. Although not a “Reauthorization,” the Wall Street Reform and Consumer Protection Act of 2010 substantially added to the CFTC’s powers and will be the backdrop for the CFTC’s future reauthorization legislation.

1 See History of the CFTC ( Jan. 2014), available at http://​www.cftc.gov/​About/​HistoryoftheCFTC/​history_​ 2010s. 2 Ch. 545, 49 Stat. 1491 (1936) (current version at 7 U.S.C. § 1 et seq.). 3 CFTC, Futures Regulation Before the Creation of the CFTC, available at http://​www.cftc.gov/​About/​ HistoryoftheCFTC/​index.htm (last visited Dec 3, 2013). 4 Pub. Law No. 93-​463, 88 Stat. 1389 (1974). 5 See “About the CFTC,” available at http://​www.cftc.gov/​About/​index.htm (last visited Aug. 12, 2018). 6 Pub. Law No. 106-​554, 114 Stat. 2763 (Dec. 21, 2000). 7 Food, Conservation and Energy Act of 2008, Pub. Law No. 110-​246 (2008).

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I. Role of the CFTC The commission states its mission succinctly: “The CFTC’s mission is to protect market users and the public from fraud, manipulation, abusive practices and systemic risk related to derivatives that are subject to the Commodity Exchange Act and to foster open, competitive and financially sound markets.”8 Providing government oversight for the entire industry, the CFTC delegates responsibility for regulation of futures trading among self-​regulatory organizations such as the National Futures Association (NFA) and various exchanges. The CFTC also oversees the activities of firms and individuals who act as intermediaries between customers and markets. These include: futures commission merchants (FCMs) and introducing brokers (IBs), who are required to register with the NFA; commodity pool operators (CPOs) and commodity trading advisers (CTAs), who are not required to register with the NFA but who are still subject to disclosure requirements; principals and employees of these firms; and floor brokers and floor traders. II. Structure The CFTC consists of a maximum of five commissioners appointed by the president, with the advice and consent of the Senate, to serve staggered five-​year terms. The president designates one of the commissioners to serve as chairman. No more than three commissioners at any one time may be from the same political party.9 The organization chart attached as Appendix C shows the current structure of the CFTC and the four main divisions within the organization: 1. The Division of Clearing and Intermediary Oversight oversees market intermediaries, including derivatives-​clearing organizations, financial integrity of registrants, customer fund protection, stock index margin, sales practice reviews, foreign market access by intermediaries, and NFA activities related to intermediaries. 2. The Division of Market Oversight is responsible for fostering markets that accurately reflect the forces of supply and demand for the underlying commodity and that are free of abusive trading activity, overseeing trade

8 See “About the CFTC,” supra note 5. 9 See id.

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execution facilities, and performing market surveillance, market compliance, and market and product review functions. 3. The Division of Enforcement investigates and prosecutes alleged violations of the Commodity Exchange Act and commission regulations. Violations may involve commodity futures or option trading on U.S. futures exchanges or the improper marketing and sales of commodity futures products to the general public. 4. The Office of the Chief Economist provides economic support and advice to the commission, conducts research on policy issues facing the agency, and provides education and training for Commission staff.10 III. Disciplinary  Action When the CFTC takes action, it publishes lists of sanctions.11 The Proceedings Bulletin includes information about the commission’s administrative and injunctive enforcement actions and its statutory disqualification-​from-​registration proceedings. It lists individuals and firms charged with violations of the Commodity Exchange Act and CFTC rules and those that the commission claims are statutorily disqualified from registration. If charges are dismissed or no sanctions were imposed, the matter is not included in the Bulletin unless it is on appeal. The lists of reparations sanctions in effect provides information about firms or individuals who have violated the Commodity Exchange Act or the commission’s regulations and have not paid awards made through its reparations program, resulting in the suspension of the registrations of these individuals or firms. The list of administrative sanctions in effect contains the registration and trading sanctions currently in effect as a result of administrative enforcement or statutory disqualification proceedings. Federal regulation of futures trading in the United States began as early as the 1880s, when the first futures exchanges were founded. Futures were designed to serve as an alternative to forward transactions. As discussed, forwards are financial contracts in which two counterparties agree to exchange a specified amount of a designated product for a specified price on a specified future date or dates. Forwards differ from futures in that their terms are not standardized and they are not traded on organized exchanges. Because they are individually negotiated between counterparties,

10 Id. 11 Available at http://​www.cftc.gov/​ConsumerProtection/​DisciplinaryHistory/​index.htm (last visited Aug. 12, 2018).

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forwards can be customized to meet the specific needs of the contracting parties.12 The risks associated with the use of forwards are generally those associated with OTC derivatives contracts, the most significant being counterparty credit risk. Although structurally similar to a forward transaction, the exchange and clearing mechanism of futures transaction virtually eliminated counterparty risk.13 In 1921, Congress enacted the Future Trading Act, imposing a tax on grain futures trades made independent of an exchange designated by the secretary of agriculture. However, the Supreme Court found the Future Trading Act to be an improper exercise of the federal taxing authority.14 Congress quickly tried again with the Grain Futures Act, which was upheld under the commerce power of the Constitution,15 and with it the self-​policing of exchanges was codified into law. IV. Regulatory Background A. Commodity Exchange Act (CEA) of 1936 In 1936 Congress expanded the Grain Futures Act and changed the name to the Commodity Exchange Act (CEA),16 extending federal regulation to a list of enumerated commodities that included cotton, rice, mill feeds, butter, eggs, Irish potatoes, and grains. The CEA added provisions prohibiting fraud by parties to a futures contract and authorizing a Commodity Exchange Commission to limit speculative trading and require registration of futures merchants and brokers. Futures commission merchants were required to segregate customer funds that were deposited for purposes of margin; fictitious and fraudulent transactions such as wash sales and accommodation trades were prohibited; all commodity option trading was banned (until 1981). The regulatory power of the CEA did not extend to require exchanges to set their own speculative position limits. Further amendments to the CEA added a number of commodities under the ambit of its regulatory power, imposed federal limits on speculative positions, and instituted minimum net financial requirements for futures commission merchants. The CEA was overhauled in 2000 by the Commodity Futures Modernization Act of 2000 (CFMA).17 In addition to CFTC enforcement actions, the Supreme Court has interpreted the CEA to include an implied right of action for private 12 Trading and Capital-​Markets Activities Manual § 4310.1 (Board of Governors of the Federal Reserve System). 13 See ­chapter 8 for a complete description of forwards and futures and their distinctions. 14 Hill v. Wallace, 259 U.S. 44 (1922). 15 Chicago Bd. of Trade v. Olsen, 262 U.S. 1 (1923). 16 7 U.S.C. § 1 et seq.. 17 Pub. Law No. 106-​554, 114 Stat. 2763, Appendix E (Dec. 21, 2000).

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parties, permitting parties harmed for violations of the Act to bring private suits for damages.18 B. Commodity Futures Modernization Act (CFMA) of 2000

The stated goals of CFMA include: 1. streamlining and eliminating unnecessary regulations of commodity futures exchanges and other entities registered under the CEA; 2. transforming the role of the CFTC to oversight of the futures markets; 3. providing a statutory and regulatory framework for allowing the trading of securities futures; and 4. clarifying the regulatory jurisdiction of the CFTC.19 The further purposes of the CFMA are to serve the public interest in liquid, fair, and secure trading facilities through a system of self-​regulation, to prevent price manipulation or any other disruptions of the market integrity, to protect against systemic risk and fraud, and to promote innovation and fair competition. Following adoption of the CFMA, the CFTC adopted new rules for derivatives-​clearing organizations. It also undertook internal restructuring to ensure better adaptation of CFMA. The CFTC was vested with the regulation of commodities contracts. Section 1a of the CEA defines “commodity” as a number of agricultural products “and all other goods and articles, exception onions . . . and all services, rights and interests in which contracts for future delivery are presently or in the future dealt in.”20 The CEA gives the CFTC exclusive jurisdiction of “transactions involving contracts of sale of a commodity for future delivery, traded or executed on a contract market designated or derivatives transaction . . . exchange, or market.”21 “Contract of sale” broadly includes “sale, agreement of sale and agreements to sell.”22

Merrill Lynch, Pierce, Fenner & Smith v Curran, 456 U.S. 353 (1982). 19 Pub. Law No. 106-​554, 114 Stat. 2763, Appendix E, Sec. 2. 20 7 U.S.C. § 1a(4). 21 Id § 2(a)(1)(A): (“The Commission shall have exclusive jurisdiction, . . ., with respect to accounts, agreements (including any transaction which is of the character of, or is commonly known to the trade as, an ‘ “option’,” ‘ “privilege,’ ” ‘ “indemnity,’ ” ‘ “bid,’ ” ‘ “offer,’ ” ‘ “put,’ ” ‘ “call,’ ” ‘ “advance guaranty,’ ” or ‘ “decline guaranty’ ”) and transactions involving contracts of sale of a commodity for future delivery, traded or executed on a contract market designated or derivatives transaction execution facility registered . . .”). 22 Id. § 1a(7). 18

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C. Jurisdictional Disputes

An issue emerged when the market saw the creation of new derivative products with securities as underlying assets. Despite the broad jurisdiction-​granting language in the CEA, the CFTC faced challenges from the Securities and Exchange Commission (SEC) regarding jurisdiction over security derivatives. In 1982, a basic jurisdictional agreement, commonly known as the “Shad-​Johnson Accord,” was reached between the CFTC and the SEC on the regulatory responsibility of each agency for a variety of financial instruments, in particular stock index futures.23 The agreement established jurisdictional boundaries for the CFTC and the SEC: The accord prohibited futures contracts on individual stocks and narrow-​based stock indexes. Instead, the agreement authorized the SEC to regulate options on individual securities and gave the CFTC the authority to regulate futures contracts on broad-​based stock indexes and individual government securities and options on such future contracts.24 D. The Commodity Futures Modernization Act

The jurisdictional framework under the Shad-​Johnson Accord remained in effect until the enactment of the Commodity Futures Modernization Act of 2000.25 The CFMA provided a new jurisdictional framework by making significant changes in derivatives regulations. First of all, it solved the long-​time dispute over securities-​ related futures contracts by granting overlapping jurisdiction to both the CFTC and the SEC of securities futures. The CFMA also mandated a time frame for the two agencies to establish trading rules for such products.26 Additionally, the CFMA created a three-​tiered system, under which there are exchanges, less-​regulated organized markets, and unregulated derivative markets. Under the new CFMA regime, exchanges (denominated “contract markets” by the Act) will be designated to trade all commodities, except for special requirements for securities futures. The CFMA also allows trading of certain commodities and derivatives on certain derivatives transaction execution facilities (DTEFs), which are subject to fewer regulatory requirements than are designated contract markets.27 In addition to contract markets and DTEFs, the CFMA created a new category of

23 The Shad-​Johnson Jurisdictional Accord, Pub. Law No. 97-​3033, 96 Stat. 1409 (Oct, 13, 1982) (codified in scattered sections of 15 U.S.C.). 24 Thomas Lee Hazen, Disparate Regulatory Schemes for Parallel Activities: Securities Regulation, Derivative Regulation, Gambling and Insurance, 24 Ann. Rev. Banking & Fin. L. 375, 389 (2005). 25 Pub. Law No. 106-​554, 114 Stat. 2763 (Dec. 21, 2000). 26 C.F.M.A. § 202(a)(5), (which amends 15 U.S.C. § 78f(g)(5). 27 7 U.S.C. § 7a(b)(3).

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market known as an exempt board of trades (XBOT), in which trading is limited to eligible contract participants and contracts not susceptible to manipulation or having no cash market. An XBOT is prohibited from trading securities futures. The CEA, other than the antifraud provisions, does not apply to XBOTs. E. Exclusions

Prior to Dodd-​Frank, the CFMA provided that the CFTC did not have jurisdiction over bilateral transactions involving either excluded commodities or exempted commodities.28 Excluded Commodities. The CEA as amended by the CFMA, provided that “eligible contract participants”29 may engage in bilateral transactions involving “excluded commodities” by trading manually30 or trading on an electronic trading facility.31 If the parties choose to trade through an electronic trading facility, the transaction had to be done on a principal-​to-​principal basis.32 The definition of “excluded commodities” is very broad.33 Exempted Commodities. Similarly, the CEA as amended by the CFMA provided that “eligible contract participants” could engage in bilateral transactions involving “exempted commodities” by trading manually34 or trading on an electronic trading facility.35 An exempted commodity is defined as any commodity that is not an excluded commodity or an agricultural commodity.36 Therefore it covered all other assets such as crude oil, gold, construction material, and various economic measures not eligible for excluded status under section 2(d) of the CEA. These exemptions gave the market participants in derivatives products a great deal of flexibility in structuring their transactions to avoid the regulation of the CFTC. Any participant constructing such a transaction should be fully aware of these exemptions. The gaps created by CEA regulatory authority were outlined in The

7 U.S.C. § 2(d)–​( g). 29 7 U.S.C. § 1a(12). 30 7 U.S.C. § 2(d)(1)(B). 31 7 U.S.C. § 2(d)(2)(C). 32 7 U.S.C. § 2(d)(2)(A). However, it is still possible to operate a “futures dealership” in excluded commodities because the CFTC stated that the principal-​to-​principal requirement is satisfied even if a single party undertakes to act as universal counterparty to other transactions. See Thomas Lee Hazen, The Law of Securities Regulation § 1.02[2]‌‌[A] (citing A New Regulatory Framework for Multilateral Transaction Execution Facilities, [2000–​01] Transfer Binder Comm. Fu. Law Rep. (CCH) 28,413 (CFTC Dec. 13, 2000)). 33 7 U.S.C. § 1a(13). 34 7 U.S.C. § 2(h)(1). 35 7 U.S.C. § 2(h)(3). 36 7 U.S.C. § 1a(14). 28

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Treasury’s Blueprint of financial regulation.37 In its recommendations, the Treasury describes the ideal of a synthesis of the need for coordination of the CFTC and the SEC: Globalization and the increasing need to present a unified regulatory front on futures and securities regulation in the international policy arena also encourage a merger. Two separate agencies handling futures and securities inhibit the ability of the United States to negotiate with foreign regulators and harmonize international regulatory standards. Perhaps the most significant difference in approach is with respect to the concept of mutual recognition, whereby financial intermediaries registered or supervised in a foreign jurisdiction are permitted access to U.S. markets without registering in the United States, a concept embraced by the CFTC in the 1980s and a concept currently being considered by the SEC.38 F. Forwards

Forward contracts are financial contracts in which two counterparties agree to exchange a specified amount of a designated product for a specified price on a specified future date or dates.39 Although the CEA gives the CFTC exclusive jurisdiction over transactions involving the sale of a commodity for future delivery on exchanges,40 the statute provides that “future delivery does not include any sale of any cash commodity for deferred shipment or delivery” (commonly known as cash forward contracts).41 Therefore, cash forward contracts are not within the regulatory purview of the CEA and are allowed to be traded off-​exchange or over the counter.42

The Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure (Mar. 2008). 38 Id. at 109. 39 Trading and Capital-​Markets Activities Manual § 4310.1 (Board of Governors of the Federal Reserve System). 40 7 U.S.C. § 2(a)(1)(A) (“The Commission shall have exclusive jurisdiction, . . ., with respect to accounts, agreements (including any transaction which is of the character of, or is commonly known to the trade as, an ‘option’, ‘privilege’, ‘indemnity’, ‘bid’, “offer’, ‘put’, ‘call’, ‘advance guaranty’, or ‘decline guaranty’) and transactions involving contracts of sale of a commodity for future delivery, traded or executed on a contract market designated or derivatives transaction execution facility registered . . .”). 41 7 U.S.C. § 1a(19). 42 See Willa E. Gibson, Are Swap Agreements Securities or Futures? The Inadequacies of Applying the Traditional Regulatory Approach to OTC Derivatives Transactions, 24 J. Corp. L. 379 (1999). 37

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G. Options

An option contract refers to the right, but not the obligation, to buy or sell an underlying asset, instrument, or index on or before the exercise date at a given price.43 Pursuant to the Futures Trading Act of 1986, the trading of options on domestic agricultural commodities and other physicals is subject to the jurisdiction of the CFTC.44 The CFTC also has the power to regulate foreign options.45 On the other hand, the SEC is authorized to regulate the public trading of put and call options for securities and indexes, because those options are also considered as securities.46 H. Futures

A futures contract is an obligation to buy or sell a specified quantity of an underlying asset at a specified price at a specified time in the future.47 The CFTC has jurisdiction over futures on commodities, but there has been a great deal of contention regarding futures contracts on individual stocks and securities indexes. The jurisdiction of the CFTC over futures on exempt securities48 (e.g., U.S. Treasury securities) and broad stock indexes has long been permitted.49 Until the CFMA of 2000, however, the Shad-​Johnson Accord prohibited futures contracts on individual stocks and narrow-​based stock indexes. However, those financial products had been effectively traded as “synthetic security futures.” Synthetic security futures refer to a complex series of options trades through which a single stock futures contract can be created synthetically50—​for example, by buying a call option on a single stock and selling a put option on the same stock. In this way, options on single stocks could be used to replicate futures on single stocks, which were prohibited before the CFMA. Synthetic security futures incur twice the transactional costs but effectively avoid regulation under the accord. Because the CFMA now permits

Trading and Capital Markets Activities Manual § 4330.1. 44 52 Fed. Reg. 777. 45 17 C.F.R. § 30. 46 15 U.S.C. § 77b(a)(1). 47 National Futures Association, Glossary of Futures Terms, http://​www.nfa.futures.org/​BasicNet/​Glossary.aspx (last visited Dec. 3, 2013). 48 Under § 3(a) of the Securities Act of 1933 or § 3(a)(12) of the Securities Exchange Act of 1934. 49 McDermott, Will & Emery LLP, Congress Makes Changes to the Regulation of Futures and Derivatives Transactions, McDermott Newsletters ( Jan. 2001), available at http://​www.mwe.com/​index.cfm/​fuseaction/​ publications.nldetail/​object_​id/​eab1d60e-​c2ce-​47dc-​beb4-​2d6b54759878.cfm. 50 See U.S. General Accounting Office, Report to Congressional Requesters, Issues Related to the Shad-​Johnson Jurisdictional Accord at 9–​10 (Apr. 2000). 43

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nonsynthetic security futures to be traded, there is now no need for investors to conduct such complex and expensive transactions.51 As one of its significant changes, the CFMA of 2000 allowed the trading of futures contracts on narrow-​based securities indexes as well as future contracts on individual securities. It defines a security futures contract as “a contract of sale for future delivery of a single security or of a narrow-​based security index, including any interest therein or based on the value thereof, except an exempted security under . . . the Securities Exchange Act of 1934.”52 The Act further provides that a narrow-​based security index is one that meets the following criteria: 1. It has nine or fewer component securities; 2. a component security comprises more than 30 percent of the index’s weighting; 3. the five highest weighted component securities in the aggregate comprise more than 60 percent of the index’s weighting; or 4. in which the lowest weighted component securities comprising, in the aggregate, 25 percent of the index’s weighting have an aggregate dollar value of average daily trading volume of less than $50,000,000 (or in the case of an index with 15 or more component securities, $30,000,000), except that if there are two or more securities with equal weighting that could be included in the calculation of the lowest weighted component securities comprising, in the aggregate, 25 percent of the index’s weighting, such securities shall be ranked from lowest to highest dollar value of average daily trading volume and shall be included in the calculation based on their ranking starting with the lowest ranked security.53 Security futures (including futures on narrow-​based securities indexes) are co-​ regulated by the CFTC and the SEC and are subject to standards and requirements found in both the federal securities and commodity laws. Therefore, security futures can be traded either on a national securities exchange registered with the SEC or a commodities market registered with the CFTC.54 However, any commodities market or security exchange where security futures are traded must be cross-​ registered with the SEC and the CFTC, respectively.55 David B. Esau, COMMENT: Joint Regulation of Single Stock Futures: Cause or Result of Regulatory Arbitrage and Interagency Turf Wars?, 51 Cath. U. L. Rev. 917, 925 (2002). 52 7 U.S.C. § 1a(31). 53 7 U.S.C. § 1a(25). 54 See Thomas Lee Hazen, Derivatives Regulation § 1.18[8]‌[C] (2004). 55 Id § 1.18[8]‌‌[C]. 51

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Futures on broad-​based security indexes, however, are regulated by the CFTC.56 The CEA provides a safe harbor that protects an index from being characterized as a narrow-​based index if (1) it has at least nine component securities, (2) no component security comprises more than 30 percent of the index’s weighting, and (3) each component security is (a) registered pursuant to the Securities Exchange Act of 1934, (b) one of 750 securities with the largest market capitalization, and (c) one of 675 securities with the largest dollar value of average daily trading volume.57 I. Regulatory Distinctions between Forwards and Futures

The Dodd-​Frank Act58 establishes that where a retail transaction does not result in actual delivery within 28 days, or creates an enforceable obligation to deliver, it will not be considered a forward.59 Under the CEA, the distinction between a forward contract and a futures contract60 became a deciding factor in determining whether a derivative product was subject to CFTC regulation. Courts struggled to develop a clear-​cut definition or list of elements distinguishing forwards and futures. The CEA governs transactions involving contracts for the purchase or sale of a commodity for “future delivery,” except “any sale of any cash commodity for deferred shipment or delivery.”61 The key words defining the scope of the CEA’s authority are: for future delivery. Thus, whether or not the agreement in question contemplates actual future delivery determines whether it is subject to regulation under the CEA. In practice, it is frequently difficult to tell whether a particular agreement contemplates actual delivery or whether it is a mechanism for price speculation.62 Courts of appeal confronted with the issue have historically applied a totality of the circumstances approach to determine whether a contract is a futures contract and thus subject to regulation by the CFTC under the CEA. In CFTC v. Co Petro Marketing Group, Inc.,63 the Ninth Circuit adopted a multifactor approach that looked at the totality of circumstances surrounding the transaction. In Co Petro, a gasoline broker entered into agency agreements with customers, under which the 56 7 U.S.C. § 2(a)(1)(C). 57 7 U.S.C. § 1a(31). 58 See ­chapter 8 for more on the distinctions between forwards and futures. 59 See Dodd-​Frank Section 742 (codified at CEA § 2(c)(2)(D)(ii)(III)). 60 “Futures contracts are exchange-​traded agreements for delivery of a specified amount and quality of a particular product at a specified price on a specified date. Futures contracts are essentially exchange-​traded forward contracts with standardized terms.” Trading and Capital-​Markets Activities Manual § 4320.1. 61 7 U.S.C. § 1a(19); see Lachmund v. ADM Investor Servs., 191 F.3d 777, 785–​86 (7th Cir. 1999). 62 See CFTC v. Zelener, 387 F.3d 624, 625 (7th Cir. 2004) (Ripple, C.J., dissenting from the denial of rehearing en banc). 63 680 F.2d 573 (9th Cir. 1982).

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customers would purchase a specified quantity and type of fuel at a fixed price for future delivery at an agreed future date and pay a deposit based upon a fixed percentage of the purchase price. The broker did not require its customers to take delivery of the fuel; rather, the broker would sell the fuel for the customers and refund (or deduct from the deposit, if the difference results in a loss) the difference between the previously agreed price and the actual sale price. The gasoline broker argued that the CFTC lacked jurisdiction over those transactions because they were cash forward contracts. The court, however, held that those agency agreements were futures contracts based on the overall surrounding circumstances, such as the uniformity in the basic units of volume and relevant dates and the fact that the customers used those standardized agency agreements to participate in offsetting and liquidating transactions. In Nagel v. ADM Investor Services, Inc.,64 the Seventh Circuit held that the totality of the circumstances approach dictated that an agreement is a forward contract when (1) the contract specifies individualized terms such as place of delivery and quantity, such that the contract is not fungible with other contracts for the sale of the commodity, except for cases in which the seller promises to offset the contract; (2) parties to the contract are industry participants contracting in the commodity rather than non-​industry speculators trading for the contract’s price; and (3) delivery cannot be deferred indefinitely.65 Later in CFTC v. Zelener,66 the U.S. District Court for the Northern District of Illinois questioned the totality of circumstances approach and instead focused on the “technical meanings” of the statutory language and forms of the transactions. In that case, the customers entered into contracts with defendant companies with regard to the delivery of foreign currencies at a given price within 48 hours. The contracts, however, contained rollover provisions to allow the customers to constantly roll over their position instead of taking actual delivery of the foreign currency after 48 hours. Once the customers wanted to exit those transactions, their positions were simply canceled out by selling foreign currencies back to the defendant companies and their loss/​gain would be calculated accordingly. The court looked at the contracts to find that the defendant companies did not have the obligation to buy back the foreign currencies and could choose to execute delivery to the customers. Based on the rationale that the contracts were technically forward contracts, the court held that the fact that the customers’ contracts contained rollover provisions and that the gain or loss was magnified over a longer period did not turn the transactions into future 64 217 F.3d 436 (7th Cir. 2000). 65 Id. at 441. 66 373 F.3d 861 (7th Cir.), rehearing denied en banc, 387 F.3d 624 (7th Cir. 2004).

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contracts. The Zelener majority opinion has been criticized as a marked departure from the traditional “totality of the circumstances approach” that courts had previously used to determine whether a transaction constituted a forward or futures contract.67 A dissent to the court’s refusal to reconsider the case en banc described the traditional approach: when the following circumstances are present, a contract will be deemed a forward contract: (1) the contract specifies individualized terms such as place of delivery and quantity, so that the contract is not fungible with other contracts for the sale of the commodity, except for cases in which the seller promises to offset the contract; (2) parties to the contract are industry participants contracting in the commodity rather than non-​industry speculators trading for the contract’s price; (3) delivery cannot be deferred indefinitely.68 “If one or more of these features is missing, the contract may or may not be a futures contract.”69 It seems that the approaches differ in that the recent approach looks for indicia of a futures contract, that is, whether the derivatives contract itself has become like an asset, whereas the traditional approach assumed a futures contract absent a showing the contract to indeed be a forward or spot transaction. In CFTC v. Intertrade Forex, Inc.,70 the Magistrate District of Florida found that Intertrade traded illegal off-​exchange futures contracts because the financial instruments had the characteristics indicative of futures contracts. Intertrade offered to buy and trade forex options contracts through its website on behalf of Intertrade’s retail customers. The contracts bore the hallmarks of futures contracts because they represented contracts for future delivery of foreign currencies, the prices were established at contract initiation, and the contracts were settled in order to avoid delivery. The court found that the contracts were illegally traded because Intertrade was not a regulated entity. In CFTC v. National Investment Consultants, Inc.,71 the Northern District of California found that defendants illegally marketed and traded futures contracts regulated by the CEA. The defendants marketed “standardized contracts for the purchase or sale of commodities for future delivery at prices [established at initiation] and could be fulfilled through . . . means to avoid delivery.”72 The court held Zelener, 387 F.3d at 626–​27 (Ripple, C.J., dissenting from the denial of rehearing). 68 Id. 69 Id. 70 2005 WL 332816 (M.D. Fla. 2005). 71 2006 WL 2548564 (N.D. Cal. Sept. 1, 2006). 72 Id. at *4. 67

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that violations of the CEA occur when (1) such transactions are not conducted on a regulated board of trade, (2) such transactions are not conducted through a contract market, and (3) such transactions are not recorded in a writing that complies with the CEA.73 Thus, defendants engaged in the sale and trade of illegal futures contracts. The CFMA of 2000 explicitly excludes over-​the-​counter derivative transactions, including forward contracts or off-​exchange future contracts, between two eligible contract participants regarding excluded commodities (financial instruments) and exempted commodities (crude oil, gold, etc.). The CFMA of 2000 preserved the distinction between agricultural commodities and all other kinds of commodities. J. Swaps

As a result of the 1992 amendment to the CEA, the CFTC was given the authority to exempt “classes of swap agreements that are not part of a fungible class of agreements that are standardized as to their material economic terms, to the extent that such agreements may be regarded as subject to [the Act].”74 In 1993, the CFTC adopted 17 C.F.R. 35, known as Part 35, which provides safe-​haven exemptions from the CEA’s exchange trading requirements for certain swap transactions75 and allows the CFTC to grant additional exemptions on a case-​by-​case basis.76 The swap agreements on the exempted list include any agreement that is: a rate swap agreement, basis swap, forward rate agreement, commodity swap, interest rate option, forward foreign exchange agreement, rate cap agreement, rate floor agreement, rate collar agreement, currency swap agreement, cross-​currency rate swap agreement, currency option, any other similar agreement (including any option to enter into any of the foregoing), any combination of the foregoing, or a master agreement for any of the foregoing.77 Part 35 limits the exempted swap transactions to certain institutional investors, corporations meeting certain criteria, government entities, broker-​ dealers,

73 Id. at *5. 74 7 U.S.C. § 6(c)(5)(B). 75 17 C.F.R. § 35.1(b)(1). 76 17 C.F.R. § 35.2. 77 17 C.F.R. § 35.1(b)(1)(i)–​(ii).

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and high net worth persons.78 In addition to the limitation on eligible swap participants,79 the regulations impose three additional conditions: 1. The swap agreement is not part of a fungible class of agreements that are standardized as to their material economic terms; 2. The creditworthiness of any party having an actual or potential obligation under the swap agreement would be a material consideration in entering into or determining the terms of the swap agreement, including pricing, cost, or credit enhancement terms of the swap agreement; and 3. The swap agreement is not entered into and traded on or through a multilateral transaction execution facility.80 After the CFMA, and prior to the passage of Dodd-​Frank, the CFTC had no jurisdiction over bilateral swap contracts entered into by eligible contract participants regarding a commodity other than an agricultural commodity.81 Therefore, if a swap contract was structured as between eligible contract participants, it was exempted from the CFTC’s regulation. In addition, the SEC did not have jurisdiction over non-​security-​based swap agreements,82 but the SEC has limited authority to regulate security-​based swap agreements. Security-​based swap agreements are excluded from the definition of security83 but are still subject to the antifraud provisions in the securities law.84 Therefore, the SEC’s authority was limited to insider trading, fraud, and market manipulation regarding security-​based swap agreements.85

78 17 C.F.R. § 35.1(b)(2). 79 17 C.F.R. § 35.2 (a). 80 17 C.F.R. § 35.2 (b)–​(d). The CFTC issued a detailed policy statement on swaps in 1989 and recognized “a non-​exclusive safe harbor for transactions satisfying the requirements set forth herein.” The CFTC relied on multiple rationales for exempting swaps from regulation. See CFTC Policy Statement Concerning Swap Transactions, 54 Fed. Reg. 30,694 ( July 21, 1989). Some commentators argue that market participants should still look at the 1989 policy statement to determine whether a swap transaction is exempt or not. See Frank Partnoy, The Shifting Contours of Global Derivatives Regulation, 22 U. Pa. J. Int’l Econ. L. 421, 438–​39 (2001). 81 7 U.S.C. § 2(g). 82 See 15 U.S.C. §§ 77b-​1(a), 78c-​1(a) (excluding “non–​security-​based swap agreements” from the definition of “security”). 83 15 U.S.C. § 77b-​1(b)(1), 78c-​1(b)(1) (excluding “security-​based swap agreements” from the definition of “security”). 84 15 U.S.C. § 77q(a), 78j(b) (providing that it is unlawful “to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-​based swap agreement . . . , any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors”). 85 Hazen, supra note 54, § 1.02[2]‌‌[E].

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The CEA provided that the CFTC shall not have any jurisdiction over “covered swap agreements” offered, entered into, or provided by a bank.86 A covered swap agreement is defined as a swap agreement on a commodity other than an agricultural commodity entered into between eligible contract participants manually or through an electronic trading facility. However, the Federal Reserve, along with other banking regulators, had the jurisdiction to monitor swap agreements entered into by member banks, in order to detect any unsafe and unsound practices. Unfortunately companies such as AIG did not fall within the scope of this authority. K. Hybrid Instruments

Certain derivative products may have characteristics shared by traditional financial products such as securities or bank notes. Under the CFMA, hybrid instruments that are predominantly securities or banking products are completely excluded from all CEA requirements. A hybrid instrument is defined by the CFMA as a security or banking product with a payment indexed to a commodity value or rate or providing for delivery of a commodity.87 The CFMA sets forth a fairly straightforward predominance test that is not difficult to apply. A hybrid instrument will be considered predominantly a securities or banking product, as applicable, if the following applies: 1. the issuer of the hybrid instrument receives payment in full of the purchase price of the hybrid instrument, substantially contemporaneously with delivery of the hybrid instrument; 2. the purchaser or holder of the hybrid instrument is not required to make any payment to the issuer in addition to the purchase price during the life of the hybrid instrument or at maturity; 3. the issuer of the hybrid instrument is not subject by the terms of the instrument to mark-​to-​market margin requirements; and 4. the hybrid instrument is not marketed as a futures contract or option on a futures contract subject to the CEA.88

7 U.S.C. § 27e. 87 7 U.S.C. § 1a(24). 88 7 U.S.C. §§ 2(f )(2), 27a, 27b. 86

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Those hybrid instruments, however, may still fall under the regulatory jurisdiction of various other agencies, such as the SEC or the Federal Reserve, depending on the nature of such hybrid instruments. L. Foreign Exchange Products

Trading in foreign exchange instruments has posed a complex set of regulatory issues. Prior to 1974, regulation under the CEA was restricted to agricultural contracts.89 Foreign exchange contracts were not subject to CEA regulation. The post-​1974 reformed version of the CEA vested the CFTC with limited antifraud and anti-​ manipulation jurisdiction over off-​exchange (OTC) foreign currency futures and options transactions offered to or entered into with retail customers.90 Under the CFMA, only certain regulated entities may be counterparties to off-​exchange currency trades with retail customers. These regulated entities include registered futures commission merchants (FCMs) and certain affiliates. All other off-​exchange futures and options transactions with U.S. retail customers are unlawful unless transacted on or subject to the rules of a regulated exchange.91 1. The Treasury Amendment The issue of whether and how foreign exchange transactions should be regulated pursuant to the CEA has been hotly debated. The 1974 Commodity Futures Trading Commission Act incorporated a provision (dubbed the Treasury Amendment) mandating that transactions in foreign currency would not be regulated under the CEA unless they involved contracts for future delivery on a board of trade.92 The Treasury Amendment was intended to protect individuals and small traders involved in foreign exchange transactions.93 As such, the CFTC interpreted the Amendment to authorize it to regulate all foreign exchange transactions except those between banks and other sophisticated, informed institutions.94 In the following years, the implications of the Treasury Amendment for CFTC regulation of foreign exchange contracts were litigated in a number of prominent cases. In the 1993 case CFTC v. Standard Forex,95 the U.S. District Court for the 89 “About the CFTC,” supra note 5. 90 NFA, Forex Transactions: A Regulatory Guide, at 1, available at http://​www.nfa.futures.org/​compliance/​ publications/​forexRegGuide.pdf (last visited Dec 3, 2013). 91 Id. 92 Trading and Capital-​Markets Activities Manual 191. 93 Id. 94 Id. 95 1993 WL 809966 (E.D.N.Y.).

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Eastern District of New York evaluated whether Standard Forex’s foreign exchange trading contracts were subject to regulation under the CFTC. Standard Forex characterized its offerings as spot or forward contracts; however, the contracts were standardized, had no performance date, and were always offset by the customer.96 The court held that Standard’s foreign exchange offerings were de facto futures contracts and thus subject to CFTC regulation.97 The court also concluded that the “board of trade” language of the Treasury Amendment authorized the CFTC to regulate formal platforms created for private unsophisticated investors to trade currencies, such as Standard Forex’s trading operation.98 However, in a subsequent case, CFTC v. Frankwell Bullion,99 the Ninth Circuit Court of Appeals interpreted “board of trade” more narrowly, holding that only currency transactions consummated on organized exchanges should be regulated by the CFTC. In practice, it is often extremely difficult to distinguish between organized exchanges and informal OTC trading platforms. As the Standard Forex case demonstrates, there is no bright-​line distinction between forwards and futures contracts.100 2. CFTC Reauthorization The Supreme Court addressed the issue of CFTC regulation of currency transactions in Dunn v. Commodity Futures Trading Commission.101 In Dunn, the CFTC alleged that Dunn and others violated the antifraud provisions of the CFTC by soliciting investments, including options, to buy or sell foreign currencies in the OTC market or off-​exchange rather than through a board of trade or regulated exchange. The CFTC argued that an option in foreign currency is not a transaction “in” foreign currency but rather a contract right to engage in such a transaction at a future date, bringing it within the jurisdiction of the CFTC. The Supreme Court sided with Dunn, finding that foreign currency options are “transactions in future currency” within the meaning of the statute102 and therefore exempt from the CFTC’s jurisdiction. This was a significant holding, as it means that brokers handling these OTC foreign currency options are exempt from CFTC liability, because the transactions are deemed outside the scope of CFTC regulation. The CFTC Reauthorization Act of 2008 amends the Commodity Exchange Act (CEA), addressing the jurisdictional

96 Id. at *4–​*5. 97 Id. at *20. 98 Id. 99 99 F.3d 299 (9th Cir. 1996). 100 See also Section IV.D., supra, for a discussion of the distinction between forwards and futures. 101 519 U.S. 465 (1997). 102 7 U.S.C. § 2(ii).

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issues of the Dunn case and provides, in part, for CFTC jurisdiction over retail OTC foreign currency transactions: . . . [T]‌he Commission shall have jurisdiction over, an agreement, contract, or transaction in foreign currency that—​is a contract of sale of a commodity for future delivery (or an option on such a contract) or an option . . . and . . . is offered to, or entered into with, a person . . . that is not an eligible contract participant, unless the counterparty, or the person offering to be the counterparty, of the person is—​. . . a financial institution; . . . a broker or dealer . . . or an associated person of a broker or dealer. The CFTC was reauthorized on June 18, 2008 when Congress enacted the CFTC Reauthorization Act of 2008 as Title XIII of the Food, Conservation and Energy Act of 2008.103 The CFTC Reauthorization Act of 2008 (the Act) amended the Commodity Exchange Act and provides, in part, for: • the reauthorization of the CFTC through fiscal year 2013; • CFTC jurisdiction over retail over-​ the-​ counter foreign currency transactions; • CFTC’s oversight authority with respect to any “significant price discovery contract” listed on an electronic trading facility; and • increased penalties for market manipulation and related activities. The CFTC Reauthorization Act of 2008 strengthened CFTC oversight powers concerning foreign exchange transactions by clarifying the CFTC’s authority over retail currency trading, in direct response to the Zelener line of cases. Specifically, the Act provides that: . . . [T]‌‌he Commission shall have jurisdiction over, an agreement, contract, or transaction in foreign currency that—​is a contract of sale of a commodity for future delivery (or an option on such a contract) or an option . . . and . . . is offered to, or entered into with, a person . . . that is not an eligible contract participant, unless the counterparty, or the person offering to be the counterparty, of the person is—​. . . a financial institution; . . . a broker or dealer . . . or an associated person of a broker or dealer.104

103 Food, Conservation and Energy Act of 2008, Pub. Law No. 110-​246 (2008). 104 CFTC Reauthorization Act of 2008 7 U.S.C, 1 § 13101.

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In 2013 the U.S. Senate Committee on Agriculture, Nutrition and Forestry began the process of CFTC reauthorization. Senator Debbie Stabenow (D-​MI), Chairwoman of the Committee, commented that the stakes for the CFTC have risen greatly since it was last reauthorized in 2008: [T]‌‌he Committee must examine lessons from past market failures as it reauthorizes the Commodity Futures Trading Commission (CFTC) to avoid repeat crises like the 2008 near-​collapse of global financial markets that left 8 million men and women without jobs. . . .We cannot forget that 8 million hard-​working men and women lost their jobs. Pensions and retirement savings went up in smoke. A record wave of home foreclosures swept across the country, leaving devastated communities in its wake. There was no question that we needed serious market reform. As this Committee begins the process of reauthorizing the CFTC, we need to examine lessons from the past and consider ongoing challenges to the system. We want to make sure the agency that is responsible for protecting these markets has the authority, staff, and modern technology it needs to do its job.105 Clearly identifying the role of the CFTC in regulating financial transactions has been historically difficult. The regulatory authority of the CFTC and other federal agencies may overlap. As the CFTC approaches reauthorization, there are still calls for greater legal clarity. The broad reach of the CFTC after the passage of Dodd-​ Frank will be reviewed as new rules are established and implemented. It will be those rules coupled with the vigor of CFTC enforcement that will define the evolution of the CFTC after the financial crisis.

105 See https://​www.agriculture.senate.gov/​newsroom/​press/​release/​chairwoman-​stabenow-​says-​committee-​ must-​examine-​lessons-​from-​the-​past-​throughout-​cftc-​reauthorization-​process (last visited Dec. 9,  2108).

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Appendix A: Enforcement Case Study: CFTC v. Amaranth Advisors, LLC106 The following case study provides an example of the complexities that can (and did) arise in an enforcement action brought by the CFTC against a trader of natural gas futures: In 2007 the CFTC charged the hedge fund Amaranth Advisors, L.L.C. and its former head natural gas trader, Brian Hunter, with attempting to manipulate the price of natural gas futures, a violation under the Commodity Exchange Act, and with making false statements to the New York Mercantile Exchange (NYMEX). The following day, FERC issued an order to show cause in the same matter. The CFTC complaint alleges that the defendants intentionally and unlawfully attempted to manipulate the price of natural gas futures contracts on the NYMEX on two days in 2006, specifically, February 24, 2006, and April 26, 2006, the last days of trading (“expiry days”) for the March 2006 and May 2006 (respectively) NYMEX natural gas futures contract. The value or “settlement price” of each NYMEX natural gas futures contract is calculated based on the volume-​weighted average of trades executed from 2:00–​2:30 p.m. (the “closing range”) on the expiry day of such contracts. CFTC contends that the defendants acquired more than 3,000 NYMEX natural gas futures contracts in advance of the closing range, which they sold during the closing range. The CFTC also alleges that Amaranth held large natural gas swaps positions on the Intercontinental Exchange (ICE). The settlement price of the ICE swaps is based on the NYMEX natural gas futures settlement price determined by trading done during the closing range on the expiry day. The Complaint alleges that Amaranth intended to lower the prices of the NYMEX natural gas futures contracts to benefit its larger swaps positions on ICE. A. Opinion

On July 25, 2007, the Commodity Futures Trading Commission (the “CFTC”) brought this action against Amaranth Advisers, LLC and others (collectively, “Amaranth”), alleging price manipulation with respect to natural gas futures contracts and seeking injunctive relief and civil penalties. The very next day, July 26, 2007, the Federal Energy Regulatory Commission (“FERC”) commenced an administrative enforcement proceeding against Amaranth, based essentially on Excerpted from the opinion of Judge Chin in the U.S. District Court, Southern District of New York, in CFTC v. Amaranth Advisors, LLC., 2007 Civ. 06682 (D.C.) (S.D.N.Y. Nov. 1, 2007). 106

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the same transactions, for civil penalties and the disgorgement of profits. Hence, Amaranth is being pursued by two federal regulatory agencies in two separate proceedings in two different jurisdictions, based on the same alleged conduct. Amaranth moves for a preliminary injunction to enjoin FERC—​which is not a party to the instant lawsuit—​from proceeding with its administrative action pending the outcome of this case. Amaranth contends that because this suit was filed by the CFTC, which has primary, if not exclusive, jurisdiction over the natural gas futures contracts market, the FERC administrative proceeding should be stayed to avoid inconsistent outcomes and to relieve Amaranth of the burden of defending itself in two different proceedings. Although I agree that it would be prudent for FERC to defer to this lawsuit, for the reasons that follow, I decline to order FERC to stay its administrative action. Amaranth’s motion for a preliminary injunction is denied. B. Facts

Federal Regulation of Natural Gas. Two federal agencies regulate the trading of natural gas. The CFTC is responsible for overseeing commodity futures markets, including the natural gas futures market, under the Commodity Exchange Act, 7 U.S.C. § 1 et seq. (the “CEA”). FERC regulates the interstate transmission of electricity, natural gas and oil pursuant to the Natural Gas Act, 15 U.S.C. § 717 et seq. (the “NGA”). In 2005, Congress enacted the Energy Policy Act, Pub. Law No. 109-​58, 119 Stat. 594 (codified as amended in scattered sections of U.S.C. (“EPAct 2005”), which “broadened FERC’s authority over natural gas commodity markets to include, among other things, more authority to police natural gas markets, punish manipulation and impose greater penalties for other types of violations.” U.S. Gov’t Accountability Office, Report to the Permanent Subcomm. on Investigations, Comm. on Homeland Security and Governmental Affairs, Roles of Federal and State Regulators in Overseeing Prices, GAO-​06-​968, at 2 (Sept. 2006) (citing EPAct 2005) (FERC Ex. 5). Recognizing that their jurisdictions may overlap, Congress required the CFTC and FERC to enter into a memorandum of understanding (MOU), “relating to information sharing, which shall include, among other things, provisions ensuring that information requests to markets within the respective jurisdiction of each agency are properly coordinated to minimize duplicate information requests” (15 U.S.C. §717t-​ 2(c)(1)). On October 12, 2005, the CFTC and FERC entered into a MOU, which acknowledged FERC’s exclusive jurisdiction over the transportation and certain interstate sales of natural gas and the CFTC’s exclusive jurisdiction over accounts, agreements

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and transactions involving futures contracts. At the same time, recognizing that their oversight and enforcement activities might overlap, the agencies agreed to “coordinate on a regular basis oversight, investigative and enforcement activities of mutual interest” by sharing information. (MOU at 3) (FERC Ex. 3). Also pursuant to EPAct 2005, FERC promulgated Rule 1c.1, known as the Anti-​ Manipulation Rule. The Rule prohibits “any entity, directly or indirectly, in connection with the purchase or sale of natural gas,” from engaging in deception or fraud. 18 C.F.R. § 1c.1 (2007). C. Prior Proceedings

This Lawsuit After a year-​long investigation, the CFTC commenced this action on July 25, 2007, alleging that Amaranth and Hunter attempted to manipulate the prices of natural gas futures contracts for March 2006 and May 2006 during the last half hour that those contracts traded on NYMEX. (CFTC Mem. 1). The CFTC’s complaint also alleged that Amaranth violated section 9(a)(4) of the CEA by making false statements to NYMEX regarding the May 2006 trades in question. (Id.). The CFTC seeks to enjoin defendants from trading commodity interests and from engaging in business activities related to commodity interest trading, as well as civil penalties not exceeding $130,000 for each violation of the CEA. (FERC Mem. 17). On August 16, 2007, Amaranth moved in this case for a preliminary injunction enjoining FERC from pursuing administrative action against defendants until final resolution of the instant lawsuit. Although FERC is not a party in this action, it has appeared and submitted arguments, orally and in writing, opposing the motion. *** In this case, Judge Chin denied Acaranth’s motion, but indicated that “Amaranth’s concern in having to defend itself in two separate actions for the violations of two Acts based on the same underlying conduct” was “understandable.” He concluded his remarks by urging the CFTC and FERC to coordinate their efforts in the two proceedings.107

See case study of Amaranth Advisors in c­ hapter 14, infra, for further discussion of the substantive issues involved. 107

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Appendix B: Case Study: CFTC v. Zelener In CFTC v. Zelener,108 the Seventh Circuit found that certain foreign currency transactions were spot transactions rather than futures contracts and thus outside of the CFTC jurisdiction. The case involved foreign currency speculative transactions. It appears that in direct response to the Zelener case, Congress passed the provisions of the CFTC Reauthorization Act of 2008, regulating retail foreign exchange contracts. The Zelener Court began its analysis by noting that forwards rolled forward indefinitely were not futures contracts, as established by Nagel v. ADM Investor Services, Inc.109 Furthermore, the CEA defines a futures contract as a contract for future delivery, but excludes from the definition of future delivery any sale of any cash commodity for deferred shipment or delivery, that is, any forward contract.110 The court traced several cases to establish a test based on the presence of the following circumstances, indicating whether a contract could be deemed a forward: 1. The contract specifies idiosyncratic terms regarding place of delivery, quantity, or other terms and so is not fungible with other contracts for the sale of the commodity, as securities are fungible. But there is an exception for the case in which the seller of the contract promises to sell another contract against which the buyer can offset the first contract, which creates a futures contract.111 2. The contract is between industry participants, such as farmers and grain merchants, rather than arbitrageurs and other speculators who are interested in transacting in contracts rather than in the actual commodities. 3. Delivery cannot be deferred forever, because the contract requires the farmer to pay an additional charge every time he rolls the hedge. As long as all three features are present, the contract is a forward; however, if one or more of the factors are absent, the contract may or may not be a futures contract. Applying the factors, the Court reached the conclusion that the foreign exchange transactions were spot and not futures contracts and thus outside the regulatory power of CFTC.

108 373 F.3d 861 (7th Cir. 2004). 109 217 F.3d 436 (7th Cir, 2000); rollover of grain sales do not turn them into futures. 110 7 U.S.C. § 1a(11). 111 See In re Bybee, 945 F.2d 309, 313 (9th Cir. 1991); In re Co Petro Mktg. Grp., Inc., 680 F.2d 566 (9th Cir. 1982).

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The decision provoked numerous proposals to grant CFTC antifraud authority over retail foreign exchange “futures look-​alike” contracts and thus specifically override the Zelener decision. The proposed language, however, would apply only to certain retail foreign currency transactions—​futures and “futures look-​alike” contracts as were involved in the Zelener case. Legitimate spot transactions (such as the purchase of foreign currency at a currency exchange) are not included within the jurisdiction of the CFTC.

Clearing and Risk

General Counsel

Public Affairs

Chicago

Enforcement

Chairman Giancarlo

Kansas City

Regional Offices

Legislative Affairs

Inspector General

Data and Technology

Commissioner Behnam

Figure 17.1  The History of the CFTC.

Chief Economist

Commissioner Quintenz

9/07/2018

New York

International Affairs

Market Oversight

Commissioner Stump

Executive Director

Office of Minority and Women Inclusion

The CFTC Organization

Swap Dealer and Intermediary Oversight

Commissioner Berkovitz

Appendix C: Structure of CFTC: The Figure below shows the current organizational structure as of September 7, 2018:​

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Appendix D The following case study demonstrates the flexibility of laws governing commodities to innovative financial instruments—​specifically, spot market virtual currency transactions. Case Study: CFTC v. Patrick McDonnell

The CFTC sued the defendant, alleging that his company, CabbageTech, Corp. violated the Commodities Exchange Act (CEA) by operating a fraudulent scheme involving virtual currency trading and misappropriating investor funds.112 The allegation was that the defendant induced customers to send money and virtual currencies in exchange for purported virtual currency trading advice about virtual currency spot trades. However, to look into a possible violation of the CEA, the court first would have to determine whether (1) virtual currency may be regulated by the CFTC as a commodity, and (2) the CEA permits the CFTC to exercise jurisdiction over fraud in connection with commodities that do not directly involve futures or derivative contracts. Virtual Currencies as Commodities. The court held that the term “commodity” was wide enough to encompass virtual currencies based on their economic function as well as under the language of the statute. According to the court, virtual currencies are “ ‘goods’ exchanged in a market for a uniform quality and value.” As a result, they were commodities not just in the common sense but also under CEA’s broad definition, which includes “all other goods and articles and all services, rights, and interests . . . in which contracts for future delivery are presently or in the future dealt in.” CFTC Jurisdiction. The Court recognized that CFTC jurisdiction typically applies to future contracts. However, it noted that the CFTC had recently expanded this jurisdiction to fraud related to spot markets underlying the derivative markets. Unlike the full regulatory authority the CFTC exercises over the derivative markets, the court explained that the CFTC’s authority over the spot markets extended only to “manipulation or fraud.” However, CabbageTech’s activities sufficiently fell under this limited jurisdiction. What is notable is that the court made it clear that the CFTC does not have sole jurisdiction over the issue of virtual currencies due to their dynamic nature. In this 112 Commodity Futures Trading Comm’n v. McDonnell, No. 1:18-​cv-​00361-​JBW-​RLM, slip op. (E.D.N.Y. Mar. 6, 2018) (mem.).

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connection, the Court noted that other federal agencies could have jurisdiction over the virtual currencies —​ this in and of itself is not a limitation on CFTC’s authority. This judgment is a particularly important milestone for the CFTC, who under Chairman Giancarlo’s leadership are pushing for regulatory effort to promote innovation while at the same time protecting the derivatives markets from fraud, manipulation, and other abusive practices. It also shows that while market chatter may be prominent about newer technologies falling outside the purview of current regulations, thorough legal analysis of established law usually proves that they generally aren’t.

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18 Fiduciary Obligation to Manage Risk

I. Controlling Risk  398 A. Duty to Manage Risk  398 1. Risk Management for Financial and Non-​financial Institutions 400 B. Financial Risk  401 C. Quantifying Financial Risk  402 1. Value at Risk  402 2. Volatility Risk  403 3. Stress Testing  403 D. Portfolio Dynamics  405 II. Operational Risk Management  405 A. Directors’ and Officers’ Understanding of Financial Instruments  406 B. Risk Policy  407 C. Reporting Lines and Audit Techniques  408 D. Empowering Board Members  409 E. Reporting Structures  410 F. Information Flow  411 1. Daily Exception Report  411 2. Red Flags  412

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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Capital Markets, Derivatives, and the Law G. E  thical Concerns  412 1. Compensation  412 2. Code of Conduct  413 3. Free Flow of Information  414 H. Flexibility  414 III. Executive Protection  414 A. Responsibility for Risk Management  415 B. Business Judgment Rule  415 C. Education at Financial Institutions  416 D. Disclosure under Sarbanes-​Oxley Act  416 1. Disclosures in Management’s Discussion and Analysis (MD&A)  416 2. Off-​Balance-​Sheet Transactions  417 Appendix A: Case Study: JPMorgan and the London Whale  419

I. Controlling  Risk A. Duty to Manage Risk Directors and officers have a duty to participate in risk management. Internal protocols and procedures are a subset of operational risk management. When there is a breakdown in internal controls, directors and officers will be held accountable for operational failures contributing to trading losses. The Bank for International Settlements (BIS), an international organization fostering international monetary and financial cooperation that serves as a bank for central banks, issued recommendations for the supervision of operational risk management practices by central banks. In Sound Practices for the Management and Supervision of Operational Risk,1 the BIS outlines a set of principles that provide a framework for the effective management and supervision of operational risk, for use by banks and supervisory authorities when evaluating operational risk management policies and practices. When evaluating operational risk management standards at banks, the BIS advances fundamental principles of operational risk management: Principle 1: The board of directors should take the lead in establishing the “tone at the top” which promotes a strong risk management culture. The board of directors and senior management should establish a corporate culture that is guided by strong risk management and that supports and provides

1 Basel Committee on Banking Supervision, June. 2011, https://​www.bis.org/​publ/​bcbs183.pdf (last visited Aug. 12, 2018).

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appropriate standards and incentives for professional and responsible behaviour. In this regard, it is the responsibility of the board of directors to ensure that a strong operational risk management culture exists throughout the whole business. Principle 2: Banks should develop, implement and maintain a Framework that is fully integrated into the bank’s overall risk management processes. The Framework for operational risk management chosen by an individual bank will depend on a range of factors, including its nature, size, complexity and risk profile. Principle 3: The board of directors should establish, approve and periodically review the Framework. The board of directors should oversee senior management to ensure that the policies, processes and systems are implemented effectively at all decision levels. Principle 4: The board of directors should approve and review a risk appetite and tolerance statement for operational risk that articulates the nature, types, and levels of operational risk that the bank is willing to assume. Principle 5: Senior management should develop for approval by the board of directors a clear, effective and robust governance structure with well defined, transparent and consistent lines of responsibility. Senior management is responsible for consistently implementing and maintaining throughout the organisation policies, processes and systems for managing operational risk in all of the bank’s material products, services and activities, consistent with the risk appetite and tolerance. Principle 6: Senior management should ensure the identification and assessment of the operational risk inherent in all material products, activities, processes and systems to ensure the inherent risks and incentives are well understood. Principle 7: Senior management should ensure that there is an approval process for all new products, activities, processes and systems that fully assesses operational risk. Principle 8: Senior management should implement a process to regularly monitor operational risk profiles and material exposures to losses. Appropriate reporting mechanisms should be in place at the board, senior management, and business line levels that support proactive management of operational risk. Principle 9: Banks should have a strong control environment that utilises: policies, processes and systems; appropriate internal controls; and appropriate risk mitigation and/​or transfer strategies.

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Principle 10: Banks should have business resiliency and continuity plans in place to ensure an ability to operate on an ongoing basis and limit losses in the event of severe business disruption. Principle 11: A bank’s public disclosures should allow market participants to assess its approach to operational risk management.2 Although the Basel Committee, the BIS’s standards-​setting body, addresses operational risk in the context of financial institutions, the principles approach can be utilized by non-​financial enterprises in managing operational risk. 1. Risk Management for Financial and Non-​financial Institutions As a result of the passage of the Sarbanes-​Oxley Act,3 corporate directors and officers of all financial and non-​financial domestic publicly traded corporations must attest to the efficacy of a company’s internal controls. Specifically, under section 404 of Sarbanes-​Oxley, a company’s annual report must contain “an internal control report” that states that management is responsible not only for the establishment and maintenance of financial reporting controls and procedure, but is further charged with assessing the effectiveness of those controls and procedures over the prior year.4 By requiring management to sign off on the effectiveness of the company’s internal financial controls and by mandating attestation by independent auditors of those controls,5 compliance with Section 404 is necessarily a burdensome undertaking in both terms of time and expense,6 and therefore Title IX of Dodd-​Frank permanently exempts public companies with a market capitalization of $75 million dollars or less from the auditor attestation requirements of section 404(b).7 The corporate officer or director who attests to the efficacy of the internal controls may find him or herself personally liable under federal securities laws. In In re Scottish Re Group Securities Litigation,8 a class action was brought by 2 Id. 3 Pub. Law No. 107-​204, 116 Stat. 745, enacted July 30, 2002, amending various sections of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940. 4 Thomas O. Gorman & Heather J. Stewart, Is There a New Sheriff in Corporateville? The Obligations of Directors, Officers, Accountants and Lawyers After Sarbanes-​Oxley of 2002, 56 Admin. L. Rev. 135, 153–​54 (Winter 2004). 5 Robert Schroeder, Paulson Calls for Some Sarbanes-​Oxley Changes, Thomson Fin. News (Nov. 20, 2006). 6 Floyd Norris, Watching America: Will It Listen to Foreigners, or Do as It Pleases? N.Y. Times, ( Jan. 28, 2005). 7 Title IX of the Dodd-​Frank Act amends the Sarbanes-​Oxley Act by adding a new subsection (c) to Section 404 of the Sarbanes-​Oxley Act. Subsection (c) reads in its entirety as follows: (c) EXEMPTION FOR SMALLER ISSUERS. Subsection (b) shall not apply with respect to any audit report prepared for an issuer that is neither a “large accelerated filer” nor an “accelerated filer” as those terms are defined in Rule 12b-​2 of the Commission (17 C.F.R. 240.12b-​2). 8 2007 WL 3256660 (S.D.N.Y. Nov. 2, 2007).

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shareholders of Scottish Re alleging, among other things, that the officers of Scottish Re violated federal securities laws in connection with the company’s accounting for deferred tax assets in its financial statements and its certification of the adequacy of the company’s internal controls. The district court denied the officers’ motion to dismiss the Sarbanes-​Oxley claim against them, finding that there were sufficient facts alleged to support the claim that they violated the securities laws by providing false Sarbanes-​Oxley certifications in connection with the company’s Forms 10-​K and Forms 10-​Q filings. These certifications stated that to the best of their knowledge, each Form “does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading.” Furthermore, under section 404, every report filed under section 13(a)9 or section 15(d)10 of the Exchange Act must include not only a proclamation that management is responsible for establishing and maintaining the controls and procedures of financial reporting, but also the independent auditors’ assessment of the performance of those controls for the previous year.11 Section 404 gives rise to personal liability under the securities laws to directors and officers who sign Forms 10-​K and 10-​Q. Accordingly, the section is distasteful to corporate officers because it holds them personally accountable and liable for the proper function of the company’s internal controls and may force the officers to disclose embarrassing assessments by independent auditors. Indeed, Section 404 is a significant concern to any company, foreign or domestic, that lists its stock on the American exchanges, and to its officers who are personally liable for the efficacy of the controls to which they have attested.12 In attesting to the establishment and maintenance of financial reporting controls and procedure, management must, de facto, demonstrate knowledge of the financial risks to the enterprise. B. Financial  Risk

Financial or market risks are those that stem from economic uncertainty and volatility. Financial risks include unpredictable movements in interest rates, exchange

15 U.S.C. § 78m(a). 15 U.S.C. § 78o(d). 11 Gorman & Stewart, supra note 4, at 157. 12 Clyde Stoltenberg, Kathleen A. Lacey, Barbara Crutchfield George & Michael Cuthbert, A Comparative Analysis of Post–​Sarbanes-​Oxley Corporate Governance Developments in the US and European Union: The Impact of Tensions Created by Extraterritorial Application of Section 404, 53 Am. J. Comp. L. 457 (Spring 2005). 9

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rates, asset valuation, and stock and commodity prices. The risk of market movements in individual financial instruments or complex portfolios can be a function of one, several, or all these risk factors. The relationship between a particular derivative and a corresponding market risk can be quite complex. The market risks arising from positions with options, either explicit or embedded in other instruments, can be especially difficult. There are complex formulas designed to quantify the risks associated with derivatives. The process of adequately measuring, monitoring, and controlling these market risks is called “operational risk management.” There are several types of market risks. They include: Delivery risk, which is the risk that a counterparty will not deliver the physical commodity, or, that when it is delivered it will be of an unsuitable grade. Swing risk, which reflects day-​to-​day volume and price volatility that can result from production variation or flexible customer needs contracts. Curve risk, which relates to the relationship of spot prices to future or forward delivery prices. Directors must understand and be able to control the management of unique financial risks affecting their business and trading activities.13 C. Quantifying Financial Risk

Companies use so-​called Value at Risk (VAR) measurements to calculate normal market risks over a defined period of time. By using VAR analyses in conjunction with stress tests, directors and senior managers can assess the impact of financial risks on the enterprise and its trading operation. 1. Value at Risk VAR is a widely used method of calculating a firm’s risk across all its financial activities. It takes the market value of a firm’s positions and then estimates what the firm’s market exposure is to those positions. The estimates are based on probabilities of market moves, using historical data. VAR can compute a firm’s maximum market exposure with a high degree of accuracy. However, it cannot compute the exposure to extreme market conditions. Fluctuations in price and the underlying market conditions that drive price are described in terms of volatility risk.

See also Sec. II.B, infra, for a discussion of other types of market risk. 13

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2. Volatility  Risk Volatility risk reflects the speed at which asset prices fluctuate. The more rapidly prices change, the more volatile an asset is said to be. Financial risk managers factor volatility variables into complex VAR formulas to predict price ranges of a derivative portfolio. Volatility analysis is based on statistical data. As past performance is not necessarily an indication of the future, volatility analyses, although interesting, are not necessarily predictive. 3. Stress Testing Stress testing is used to test the effects of extreme conditions on a portfolio of financial instruments. Such testing estimates what effects a series of adverse conditions might have on financial positions and pricing models. Stress testing affords management the opportunity to deal with new risks, before the moment of crisis reveals them. Risk managers can use stress testing as a means of independently verifying model data and mark-​to-​market pricing assumptions. Stress testing can take two forms: 1. Asking questions and plugging in variables that existed during times of market crises; 2. Asking questions about what it would take for a portfolio to decline by a certain percent. In 2009 the Federal Reserve began stress testing banks to assess their viability in times of crisis. The “Supervisory Capital Assessment Program” (SCAP) marked the first time the U.S. bank regulatory agencies conducted a supervisory stress test simultaneously across the largest banking firms. On April 24, 2009, the Federal Reserve released a white paper intended to assist analysts and other interested members of the public in understanding the results of the Supervisory Capital Assessment Program, the stress tests applied to bank holding companies:14 The Federal Reserve currently has two distinct but related supervisory programs that rely on stress testing: The first is the stress testing required by the Dodd-​Frank Act, which we have shortened to the acronym DFAST—​the Dodd-​Frank Act stress tests. The purpose of DFAST is to quantitatively assess how bank capital levels would

See Press Release, Federal Reserve (Apr. 24, 2009), available at http://​www.federalreserve.gov/​newsevents/​ press/​bcreg/​20090424a.htm (last visited Aug. 12, 2018). 14

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fare in stressful economic and financial scenarios. The second program, called the Comprehensive Capital Analysis and Review, or CCAR, combines the quantitative results from the stress tests with more-​qualitative assessments of the capital planning processes used by banks. For example, under CCAR, supervisors evaluate the ability of banks to model losses for various categories of loans and securities and to estimate earnings and capital requirements in alternative scenarios. We recently completed the first set of DFAST stress tests and disclosed the results, followed a week later by the disclosure of our CCAR findings, which included our qualitative assessments of firms’ capital planning.15 The results of several rounds of stress testing by the Federal Reserve demonstrated how the U.S. banking system has improved since 2009: Over the past four years, the aggregate tier 1 common equity ratio of the 18 firms that underwent the recent tests has more than doubled, from 5.6 percent of risk-​weighted assets at the end of 2008 to 11.3 percent at the end of 2012—​in absolute terms, a net gain of nearly $400 billion in tier 1 common equity, to almost $800 billion at the end of 2012. Indeed, even under the severely adverse scenario of the latest stress test, the estimate of these firms’ post-​stress tier 1 common capital ratio is more than 2 percentage points higher than actual capital levels at the end of 2008. Higher capital puts these firms in a much better position to absorb future losses while continuing to fulfill their vital role in the economy. In addition, a majority of the 18 CCAR firms already meet new internationally agreed-​upon capital standards (the proposed Basel III capital requirements), and the others are on track to meet these requirements as they are phased in over time.16 The risk that a market situation might undermine basic assumptions contained in pricing models used by banks is of grave concern to regulators. Such faulty assumptions can impact the system in the event of market stress involving systemically important institutions.

Chairman Ben S. Bernanke, at the “Maintaining Financial Stability: Holding a Tiger by the Tail” financial markets conference sponsored by the Federal Reserve Bank of Atlanta, Stone Mountain, Georgia, Apr. 8, 2013, available at http://​www.federalreserve.gov/​newsevents/​speech/​bernanke20130408a.htm (last visited Aug. 12, 2018). 16 Id. 15

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Stress testing is a means for teasing out faulty assumptions before a time of stress actually occurs. In the corporate context, portfolio stress test can be conducted so pricing models might be updated. By understanding the effects of market stress on a portfolio, directors can better understand how to manage portfolio risks and update pricing models in a timely and responsible manner.

D. Portfolio Dynamics

Risk must be measured and managed comprehensively. That is, the focus should be on the dynamics of the portfolio rather than on specific instruments, which can ignore the interplay among various instruments. Past crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios, which would have been revealed if the portfolio had been stress tested and analyzed in a more comprehensive manner. In considering the risks across a portfolio of various financial instruments, including leveraged derivatives transactions, risk managers must consider the accumulated credit risks inherent in those transactions. The risks of counterparty failure must be managed in the same comprehensive manner as the financial risks inherent to the portfolio. II. Operational Risk Management Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events. Where a corporation is involved in financial transactions, it is incumbent upon its corporate leadership to manage the operational risks that attach to the use of complex financial instruments. The primary goal of operational risk management is to manage the enterprise’s trading, position taking, credit extension, and operational activities in a timely manner. Operational risk management provides a means for investment fiduciaries to monitor the investment of assets that have been entrusted to them. By clearly defining risk tolerance, implementing monitoring techniques, and designing effective reporting structures, directors can reduce their potential liability. Operational risk management allows directors to oversee front-​line traders and salesmen. Holistic risk management involves setting the strategic direction of the enterprise and the company’s risk tolerance levels for each of these classes of risk. The operational risk to any trading operation is extremely high. Operational risk is not

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limited to traditional back office activities, but also encompasses front-​line managerial decisions as to trading lines, credit limits, and liquidity parameters. The risks of operational failure in enterprises that conduct significant trading activities has been demonstrated by some of the headline cases of losses attributed to rogue traders or tracking inadequacies. The risks associated with human misfeasance and malfeasance can expose the corporation and its executives to liability. The goal of operational risk management is to shield the enterprise, including its directors and executives, from losses and liability by developing and implementing a flexible and prudent risk-​management system. A. Directors’ and Officers’ Understanding of Financial Instruments

The complexity of financial transactions, whether they are effectuated through special purpose entities or through stand-​alone transactions, requires in-​depth understanding by those who use those financial instruments. In the corporate context, directors, officers, and risk managers are required not only to understand the complex nature of risk and financial instruments used to control or take advantage of those risks, but also to understand the steps that can be taken to manage the risks that arise from the use of specific financial instruments. Officers and directors can be held liable for failing to understand the nature of financial instruments and for failing to oversee those they have put in charge of managing those instruments. In c­ hapter 2 we looked at Brane v. Roth,17 in which an Indiana court held directors of a grain co-​op liable when the co-​op lost money as a result of an unhedged grain position. The directors had relied on an accountant who suggested hedging the company’s market exposure to grain. The directors hired a manager to implement a hedging strategy, but neglected to oversee the manager or his implementation of the hedging strategy. The manager, inexperienced in hedging, hedged only a small percentage of the co-​op’s total grain exposure; $20,000 of grain sales was hedged although the company had over $7,000,000 of potential exposure. As a result, the co-​op suffered a substantial loss on the unhedged position. The directors were held liable for the loss. The court reasoned that the directors breached their duty to their shareholders by hiring a manager inexperienced in hedging, failing to maintain reasonable supervision over him, and failing to acquire knowledge of the basic fundamentals of hedging to be able to properly supervise the manager.

590 N.E. 2d. 587 (Ind. App. 1992). 17

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As Brane demonstrates, directors and officers need to acquire sufficient knowledge regarding financial instruments to make informed decisions about risk management. Once informed, directors and officers can fulfill their fiduciary duties by implementing protocols and procedures to manage enterprise risks. B. Risk  Policy

The first step in managing operational risk is to formulate an enterprise-​wide risk policy. This risk policy should be a comprehensive summary of the will of the board with regard to capital market trading activities and risk management. It will describe, among other things, acceptable investments, position limits, procedures, reporting structures, credit and liquidity rules, and settlement guidelines. There are several categories of risk that the board should address in its risk policy statement. These include, but are not limited to: • Operational Risk relates to how the transaction is recorded and monitored. The risk policy statement should describe the reporting structure of front office, back office, and compliance personnel. The board should require sufficient information to monitor firm-​wide trading activities. The definition of operational risk includes legal risk, which is the risk of loss resulting from failure to comply with laws and contractual obligations. It also includes the exposure to litigation from all aspects of an institution’s activities. The definition does not include strategic or reputational risks,18 although operational risk can affect reputational risk. • Financial Risk relates to risks of price movements in commodity and financial markets. The risk policy statement might include specific “Value at Risk” calculations to describe the board’s risk tolerance. • Credit Risk relates to an analysis of whether a counterparty will fulfill its contractual obligations to the enterprise. Credit or counterparty risk may result from overexposure to a single counterparty or customer across all the enterprise’s financial activities (not limited to derivatives trading). The risk policy statement should include specific directives for analyzing the creditworthiness of counterparties. Directors must set exposure limits for each major counterparty.

Supervisory Guidance on Operational Risk Advanced Measurement Approaches for Regulatory Capital OCC Release 2003-​53c at 5 ( July 2, 2003). 18

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• Legal Risk relates to whether a counterparty will be required by law to honor its contractual obligations (questions of authority, ultra vires, legality, etc.). The risk policy statement might list certain required documentation. • Liquidity Risk relates to the ability of the enterprise to liquidate positions when the need arises. The risk policy statement might limit transactions to markets that meet specific liquidity criteria. • Settlement Risk relates to the timing of the exchange of assets under the terms of a contract. The counterparty paying out the asset is exposed to the extent that a counterparty has not remitted the contra asset or consideration as agreed. The risk policy statement might require “netting agreements” between the enterprise and its counterparties, which allow the enterprise to aggregate liabilities and obligations across the spectrum of its financial activities. • Delivery Risk is the risk that a counterparty will not deliver the physical commodity, or, that when it is delivered it will be of an unsuitable grade. C. Reporting Lines and Audit Techniques

Qualitatively, effective operational risk management requires designing reporting lines and audit techniques to help the board maintain control over trading activities, sales practices, and money management. The goal of operational risk management is to put in place procedures that prevent anyone from exceeding the board’s mandate for acceptable risk. The board can adopt several techniques to accomplish this by: • drafting a specific risk policy statement that describes, in a quantitative and qualitative way, the board’s risk-​tolerance levels; • requiring employees to abide by a code of ethical conduct; • requiring qualitative reports on a regular basis; • designing reporting structures and compensation incentives that are consistent with the board’s risk policy • empowering certain directors to share primary responsibility for setting risk management policies and overseeing firm-​wide compliance with the risk policy statement. The risk of noncompliance with the standards set by the board can be limited by implementing an effective risk management program. Critically important to managing operational risk throughout the enterprise is to establish management information systems that are transparent enough to allow managers to monitor all corporate activities with regards to the use of financial

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instruments. These information systems must capture all trades, including new products and innovations. Because of the high-​speed nature of financial innovation, there may be some lag time before tracking systems are able to monitor their use. The board should be aware of this technology limitation and might require a daily exception report for new products. The primary goals of management information systems are to: 1. prevent traders from concealing trades; 2. prevent traders from falsely recording trades; 3. prevent traders from intentionally manipulating pricing data and/​or pricing models; 4. track and monitor on a daily exception basis any violations by traders of delegated authority levels. D. Empowering Board Members

Boards should consider establishing a Risk Management Committee (RMC) whose specific charge is the active management of risk on an enterprise-​wide basis. The RMC will provide the board with a forum for open discussions about risk issues and risk policy. This committee will work with other board and senior management committees, such as the Market Risk Committee and the Credit Risk Committee, to develop a holistic approach to managing the risks associated with a portfolio of derivatives and financial instruments. The RMC will have primary responsibility for adopting standards and procedures for dealing with specific risk management tasks. An alternative to establishing a specific RMC is for the board to charge the Finance Committee or the Audit Committee with the risk management function. As a comprehensive approach to managing risks requires multiple risk disciplines, businesses, and support units, the Finance Committee may be the most appropriate committee for handling enterprise-​wide risk management issues. The committee reporting to the board on risk issues should have an agenda that addresses:

• • • • • • •

credit exposure, significant financial commitments, capital adequacy, new opportunities, implementation of enterprise policies, any risk management issues, education and lectures on derivatives and risk management.

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The Audit Committee of the board will bear primary responsibility for ensuring that board risk policies are implemented and adhered to throughout the firm. E. Reporting Structures

In the operational risk management context, the key to a successful reporting structure is the complete segregation of front office and back office duties and responsibilities. Traders must be prevented from having access to the systems that might allow them to manipulate trade information, price data, or pricing models. By separating front office trading from back office settlement functions, senior management can prevent traders from hiding trades or exceeding acceptable risk parameters. The ideal framework or organizational structure for overseeing capital market trading activities requires three distinct operating groups: • The Front Office’s primary role is making trading decisions, putting on trading positions, and originating transactions. Although the Front Office is primarily responsible for implementing trading strategies, it is required to comply with the board’s risk policy. • The Back Office’s primary role is supporting the transactions initiated by the traders and ensuring that all trades are recorded for administrative and oversight purposes. The Back Office is responsible for accounting and reconciliation of all transaction flows. • The Compliance Group’s primary role is monitoring the trades initiated by the Front Office. The Compliance Group is responsible for independently pricing transactions, monitoring portfolios, reviewing trading strategies, and generally reporting to senior management on the Front Office’s level of compliance with enterprise risk policy. Each of these operating groups should report independently to senior management. The information collected from these groups will form the contents of the board reports. A chief risk officer should prepare and present this information to the appropriate board members. These three independent groups should be in place at all locations where derivatives and/​or financial products are traded. This is particularly true for remote locations far removed from the home office or principal trading location. Although the internet and technology have made management information systems a vital tool of effective operational risk management, it is difficult, at best, to manage trading risks in a remote location far removed from the home office.

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F. Information  Flow

Senior managers need to be kept informed about firm-​wide risk and capital market trading activities. Unlike other types of operational risk, capital market trading activities place intense time pressure on the board of directors. The risk to the enterprise from financial products representing huge notional values that may, overnight, become illiquid or impossible to hedge must be constantly monitored by the board and its risk managers. Because many financial instruments contain derivative components, which may be highly leveraged, and because some financial instruments can become illiquid overnight, they can jeopardize the financial stability of the enterprise. Directors must be kept informed, on a real-​time basis, if a position threatens the enterprise. Because of the time-​sensitive nature of derivatives trading, information flow is critical for directors and officers whose companies engage in “real time” management information reporting. Information needs to be summarized for the board in a timely and consistent manner. The board should require frequent updates and reports on how its risk policies are being implemented throughout the enterprise. In doing so, the board can better insulate itself and the enterprise from shareholder liability when trading losses affect the financial health of the enterprise. 1. Daily Exception Report When a position is large enough to have a material effect on the enterprise, the board should be provided with real-​time information in a more consistent manner. Daily reports that describe the firm’s trading activities should be presented to the board. These reports should be designed to help directors understand the current activity in the trading operation. There should be an enterprise liaison that is available if a director has any questions, and the production of these reports should not preclude any ad hoc information flow or inquiry. Generally, board reports should include: • a list of current positions; • a plain-​English description of the goals that the positions are trying to achieve (e.g., enhancing yield or hedge); • a description of the economic effects of current positions; • specific names of traders, their market performance, and current positions; • a plain-​English analysis of the firm’s current risk profile; • a description of what market factors could affect current positions;

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•

an explanation of any market disruptions; an explanation of how a particular market headline will affect the enterprise; • mark-​to-​market valuation of current positions; • an explanation of any exceptions, limit breaches, or violations of risk-​tolerance policies. •

2. Red  Flags In analyzing reports to the board, directors should look for unusual trading activities identified by the firm’s senior risk managers. Unusual trading activities include:

•

large and highly concentrated positions; • increased volatility; • excessive activity by one trader or group of traders; • trades that do not settle on time (i.e., “fails”); • excessive trading with one counterparty; • unusual wire transfer activity; • trading strategies that are inconsistent with the board’s risk policy; • large losses; • large profits; • excessive growth in profits or losses from any product (old or new) or any trading desk (i.e., emerging markets or equity derivatives).

G. Ethical Concerns 1. Compensation

Firm-​wide compensation should be based on furthering the board’s goals and not only on a trader’s profitability. Where trading serves as a firm profit center, compensation is often directly linked to a trader’s success or failure. There are inherent risks to directors where firms grant incentives to traders that can cause them to value profits above all. Therefore, this direct link needs to be tempered by the board’s risk appetite to discourage unethical behavior. Former U.S. treasury secretary Timothy F. Geithner’s reaction to compensation at AIG highlights the dangers of compensation encouraging inappropriate risk-​taking: I share the anger and frustration of the American people, not just about the compensation practices at AIG and in other parts of our financial system, but

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that our system permitted a scale of risk-​taking that has caused grave damage to the fortunes of all Americans.19 Geithner elucidated this sentiment in subsequent testimony: Innovation and complexity overwhelmed the checks and balances in the system. Compensation practices rewarded short-​term profits over long-​term return.20 A means of achieving a balance between risk policies and trading activities is to adjust compensation formulas to reflect the risk taken to achieve a particular result. This risk-​adjusted approach will help deter traders from taking overly risky positions. By the same token, compliance personnel should not restrict the front office personnel to such an extent that they are unable to trade. In general, enterprise-​wide compensation should be flexible and based on: • contribution to the overall profitability of the firm and • efforts to work within the risk parameters set by the board. 2. Code of Conduct The conduct of an enterprise and its employees must mirror the level of the integrity of its managers or leaders. Compensation policy is only one means of achieving ethical behavior in capital market trading activities. The key to a successful risk management program is a corporate culture reflecting the attitudes and dispositions of the board. The board of directors and senior managers set the tone or culture of the institution. Management must convey the message of ethical values and integrity to the employees of the company. These issues cannot be compromised. Management has to demonstrate, through its actions and its communications, that it is committed to high ethical standards. The board should distribute, and employees should confirm receiving, a code of conduct describing enterprise risk policy. This code should describe an employee’s responsibility to the firm and to its shareholders. Employees should sign an acknowledgment that they will abide by firm-​wide risk policies. By anchoring risk

19 The prepared testimony of Treasury Secretary Tim Geithner on American International Group at a hearing of the House Financial Services Committee, Mar. 24, 2009. 20 House Financial Services Committee Hearing (Mar. 26, 2009), tg-​71 (written testimony of Treasury Secretary Tim Geithner).

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policy in ethical goals, directors demonstrate business ethics that may be echoed throughout the firm. By creating a sense of a high standard of leadership among the firm’s employees, directors can feel more comfortable that they are being provided with timely, material, and accurate information. 3. Free Flow of Information Ethical leadership encourages employees to support the board’s efforts to manage operational risk. Employee-​initiated communications are an important part of the risk management process. When the board creates a sense of integrity throughout the enterprise, employees will be more willing to provide ad hoc information about positions, events, and market risks. This information reflects what the staff feels the board should know, and are offered without the board requesting them. A free flow of information to the board is the goal of ethics in operational risk management. It will generally happen when employees feel a sense of commitment to the board’s values and risk policies.

H. Flexibility

Within broad parameters, risk policy must evolve and develop while the board remains flexible and responsive to change. In a constantly changing world, no system of control and review can remain valid for all time in all circumstances. Needs will change as available technologies do. Whatever review system is adopted, it must be regularly assessed and changed as the organization’s risk management needs change. Care must be taken during regular reviews of the control systems. Tracking systems should be modernized as changes occur in the marketplace. It becomes increasingly apparent that new business techniques and continuing aspects of deregulation make new review procedures essential. New business lines will often evolve very quickly, and old business lines will diminish in importance. It is certain that business will be conducted over new geographic areas, as electronic commerce and the internet render the traditional geographic restrictions on a business’s market increasingly irrelevant. This dynamic environment requires regular refinement of a firm’s risk management strategy. III. Executive Protection Directors can take specific steps to protect themselves and their firm from operational risks. In managing these risks, directors have an obligation to understand

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and participate in the risk management process to reduce their potential liability when losses occur. Directors do not need to become number crunchers, but their legal obligations to make informed decisions will require them to understand how risk management and derivatives transactions work. The board should require all directors and officers to be informed of the company’s risk exposure and of the effects adverse market and interest rate conditions may have on the company’s financial risk profile. Directors may reduce their personal financial exposure by monitoring risks, seeking information, educating themselves, disclosing trading risks to shareholders, and seeking insurance to cover derivatives-​related losses. A. Responsibility for Risk Management

Directors and officers can delegate their functional responsibility for risk management, but they cannot delegate their ultimate legal liability. Corporate fiduciaries can rely on experts, but must become fully informed before they make important decisions. The business judgment rule protects a director when an informed business decision proves unsuccessful, as directors are generally not held liable for making the wrong decision. It is unsettled whether the business judgment rule protects directors who fail to take any action. Ignorance is not a defense available to directors and officers. A clear-​cut information and reporting trail provides an evidentiary trail that the directors and officers are informed when they rely on the advice of experts and senior managers. It is therefore vitally important to create a clear-​cut reporting chain of material and relevant information from senior management to the board. B. Business Judgment Rule

Directors need information before they can make decisions regarding risk management. The business judgment rule is a legal presumption that, in making a business decision, the directors of a corporation acted on an informed basis, in good faith, and in honest belief that the action taken was in the best interests of the company. The business judgment rule allows directors to make decisions without a court second-​ guessing their judgment. This presumption, however, will not protect directors who fail to become informed before they make a decision.21

See Brane v. Roth, 590 N.E. 2d. 587 (Ind. App. 1992), discussed in Sec. II.A, supra. 21

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C. Education at Financial Institutions

Education is a key focus of operational risk management, and it may play a key role in the relationship of regulators to financial institutions. By encouraging education in the area of operational risk management, bank supervisors can encourage effective risk management in the derivatives marketplace without directly regulating derivatives market participants. Education is a means of analyzing successful protocols, procedures, and best practices. This analysis can help improve operational risk management and encourage the implementation of successful risk management techniques for financial institutions and capital market participants. D. Disclosure under the Sarbanes-​Oxley Act 1. Disclosures in Management’s Discussion and Analysis (MD&A)

Public companies must adequately disclose their capital markets trading activity. Section 401(a) of the Sarbanes-​Oxley Act22 amended the Securities Exchange Act of 1934, adding section 13(j), which directed amendments to the SEC rules to require disclosure of off–​balance sheet transactions. A registrant is now required to provide an explanation of its off–​balance sheet arrangements in a separately captioned subsection of the registrant’s required disclosure documents entitled “Management’s Discussion and Analysis.” The SEC has long recognized the need for a narrative explanation of financial statements and accompanying footnotes and has developed MD&A over the years to fill this need. The disclosures in the MD&A are necessary to increase the transparency of a company’s financial performance and provide investors with the disclosure necessary to evaluate a company and make informed investment decisions. The MD&A provides an opportunity to give investors a clear understanding of what the financial statements show and do not show and also provides an opportunity to alert investors to the important trends and risks that have shaped the past or are reasonably likely to shape the future. Events, variables, uncertainties, and other corporate events that would not otherwise be required to be disclosed under the Generally Accepted Accounting Principles (GAAP) are required to be disclosed by the MD&A rules, such as (1) information necessary to an understanding of the registrant’s financial condition, changes in financial condition, and results of operations; (2) any known trends, demands, commitments, events, or uncertainties that will result in, or that are reasonably likely to result in, the registrant’s liquidity Pub. Law No. 107-​204 § 401(a), codified at 15 U.S.C. § 78m(j). 22

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increasing or decreasing in any material way; (3) the registrant’s internal and external sources of liquidity and any material unused sources of liquid assets; (4) the registrant’s material commitments for capital expenditures as of the end of the latest fiscal period; (5) any known material trends, favorable or unfavorable, in the registrant’s capital resources, including any expected material changes in the mix and relative cost of capital resources, considering changes between debt, equity, and any off–​balance-​sheet financing arrangements; (6) any unusual or infrequent events or transactions, or any significant economic changes that materially affected the amount of reported income from continuing operations and, in each case, the extent to which the income was so affected; (7) significant components of revenues or expenses that should, in the company’s judgment, be described in order to understand the registrant’s results of operations; (8) known trends or uncertainties that have had, or that the registrant reasonably expects will have, a material favorable or unfavorable impact on net sales or revenues or income from continuing operations; (9) matters that will have an impact on future operations and have not had an impact in the past; and (10) matters that have had an impact on reported operations and are not expected to have an impact upon future operations.23 The SEC intentionally rendered the MD&A rules so that they would be flexible [in order] to avoid boilerplate discussions. Therefore, while only one item in [the] current MD&A rules specifically identifies off–​balance sheet arrangements, the other requirements clearly require disclosure of off–​balance sheet arrangements if necessary to an understanding of a registrant’s financial condition, changes in financial condition and results of operations.24 The disclosure threshold is “reasonably likely” to have a material current or future effect. It is not necessary to disclose “if the likelihood of either the occurrence of an event implicating an off–​balance sheet arrangement, or the materiality of its effect, is remote.”25 2. Off-​Balance-​Sheet Transactions An off-​ balance-​ sheet-​ transaction is defined as any transaction, agreement, or other contractual arrangement to which an entity that is not consolidated with the registrant is a party, under which the registrant, whether or not a party to the

23 Regulation S-​K , Item 303(a). Codified at 17 C.F.R. 229.303(a). 24 SEC Release Nos. 33-​8144, 34-​46767 (Nov. 4, 2002). 25 Id.

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arrangement, has, or in the future may have: (1) any obligation under a direct or indirect guarantee or similar arrangement, including guarantees that may be a source of potential risk to a registrant’s future liquidity, capital resources, and results of operations, regardless of whether or not they are recorded as liabilities; (2) contracts that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying (i.e., a derivative) asset; (3) a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement; (4) derivatives, to the extent that the fair value thereof is not fully reflected as a liability or asset in the financial statements (as the impact of such derivatives is often not transparent to investors because those derivative instruments are classified as equity, and subsequent changes in the fair market value may not be periodically recognized in the financial statements); or (5) any obligation or liability, including a contingent obligation or liability, to the extent that it is not fully reflected in the financial statements, which includes a contingent obligation, arising out of a material variable interest held by the registrant in an unconsolidated entity, where such entity provides financing, liquidity, market risk, or credit risk support to, or engages in leasing, hedging, or research and development services with, the registrant.26 The Sarbanes-​Oxley Act refers to off-​balance-​sheet transactions that “may” have a material future effect on the registrant. Accordingly, the supporting SEC rules require that the disclosure is required where the likelihood is higher than remote that a future event will occur implicating an off-​balance-​sheet arrangement or that a future event will have a material effect on such an arrangement.

Id. 26

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Appendix A: Case Study: JPMorgan and the London Whale JPMorgan Chase is the largest financial holding company in the United States, with more than $2.4 trillion in assets. It is also the largest derivatives dealer in the world and the largest participant in global credit derivatives markets. In the first quarter of 2012, despite extensive risk-​management strategies and a supposedly secure “fortress” balance sheet, the bank’s chief investment office (CIO) and its London traders lost more than $6.2 billion through a series of high-​risk synthetic credit derivatives27 trades that eluded proper supervision by bank management and the bank’s regulators.28 These “London Whale” trades, so named because their sheer size caused waves in the international credit derivatives markets, constituted a perfect storm of blatant misconduct by individual traders, regulatory arbitrage, manipulation of risk modeling, and disclosure requirements and systemic institutional and regulatory failure. The trades triggered intense scrutiny by the investing public, media attention, a nine-​month investigation by the Senate Permanent Subcommittee on Investigations, congressional hearings held by the Senate Committee on Banking, Housing and Urban Affairs, and renewed calls for more stringent financial regulation. The Subcommittee on Investigations’ report noted that: The JPMorgan Chase whale trades provide a startling and instructive case history of how synthetic credit derivatives have become a multi-​billion-​ dollar source of risk within the U.S. banking system. They also demonstrate how inadequate derivative valuation practices enabled traders to hide substantial losses for months at a time; lax hedging practices obscured whether derivatives were being used to offset risk or take risk; risk limit breaches were routinely disregarded; risk evaluation models were manipulated to downplay risk; inadequate regulatory oversight was too easily dodged or stonewalled; and derivative trading and financial results were misrepresented to investors, regulators, policymakers and the taxpaying public who, when banks lose big, may be required to finance multi-​billion-​dollar bailouts.29

A credit derivative separates default risk from the underlying loan and then transfers that risk to a party more willing to bear it. 28 JP Morgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses, Permanent Subcommittee on Investigations of the U.S. Senate, Majority and Minority Staff Report (Carl Levin, Chairman), Released in Conjunction with the March 15, 2013 hearing, at 1. 29 Id. 27

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In early 2012, the chief investment office, a separate unit within JPMorgan Chase charged with investing the bank’s excess deposits, allowed traders in its London office to triple the size of its Synthetic Credit Portfolio, the formal title for the bank’s credit derivatives trading portfolio, even as the portfolio itself lost value. One such series of trades in March included the purchase of $40 billion in notional long positions. By March 2012, the SCP was of “a perilous size” such that a small drop in price could effect enormous losses in the portfolio.30 The sheer size of the trades sparked the interest of the investing public, which began speculating about the identity of the “London Whale,” later revealed to be the CIO and Bruno Iksil, the supervisor of the SCP. In subsequent months, the SCP lost staggering amounts of money on its credit derivatives, with losses reaching $4 billion by June and over $6 billion by the end of 2012.31 Subsequent investigations revealed a range of factors that contributed to the catastrophe. First, although the SCP was originally formed to hedge the bank’s credit risks, JPMorgan Chase was unable to provide any specifics regarding the SCP’s hedging strategies during its entire five years of existence. It quickly became clear to the Subcommittee on Investigations that the SCP was in fact a high-​risk trading group.32 The CIO also hid the SCP’s losses by changing its asset valuation methods and assigning more favorable prices to the portfolio’s credit derivatives, thus inflating their value and decreasing the losses the SCP reported.33 Third, despite JPMorgan Chase’s carefully cultivated reputation as a stalwart of risk management, the London Whale trades revealed utter disregard for risk-​related practices. The SCP frequently breached its risk limits and stress test limits and yet no systematic review or remedy was ever attempted; instead, the bank often simply raised the risk limits. CIO traders also ignored and manipulated risk metrics and risk models, instead substituting their own more optimistic risk analyses and models without seeking approval by the Office of the Comptroller of the Currency (OCC), the bank’s primary regulator.34 Additionally, the OCC conspicuously failed in its regulatory directive. The bank failed to follow disclosure requirements and even provided incorrect information to the OCC, but the OCC failed to notice and follow up on indicators of high-​risk activity. In 2011, for example, the bank never informed the OCC that the notional size

Id. at 4. 31 Id. 32 Id. 33 Id. at 5. 34 Id. at 7–​8. 30

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of the SCP increased form $4 billion to over $51 billion, but the OCC also failed to respond to notifications from JPMorgan that the CIO had breached its stress limits eight times in 2011 alone, sometimes for weeks at a time.35 Finally, JPMorgan simply misinformed investors, the public, and regulators. The whale trades and subsequent losses were not disclosed to the public until April 2012, and JPMorgan actively dismissed concerns raised earlier in 2012 by investors. In an earnings call in April 2013, JPMorgan Chief Executive Jamie Dimon famously called the incident “a complete tempest in a teapot,” despite being in possession of documents indicating three months of significant losses and future massive risks facing the SCP. A host of other mischaracterizations to investors have raised significant questions about systemic financial disclosure requirements and the ease with which a financial institution can avoid them.36 In August 2013, the U.S. Department of Justice charged two former JPMorgan traders with wire fraud, and several other offices in conjunction with the Whale trades. Iksil is reportedly cooperating with the U.S. government in its investigation of JPMorgan. It is unclear yet what impact the Whale trades will have on banking regulation, though it does seem to suggest that efforts following the financial crisis of 2007–​ 2008 to rein in large financial institutions, improve risk management, and prevent regulatory arbitrage have fallen short.

Id. at 8–​9. 36 Id. at 10–​11. 35

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I. Federal Securities Laws  424 A. The Retail Investor: Broker-​Dealers and Investment Advisers  424 B. Securities Exchange Act of 1934 Rule 10b-​5 Claim  426 C. Securities Act of 1933  428 D. Liability under the Commodity Exchange Act  430 1. Antifraud Provision  430 2. Disclosure  431 II. Common Law Theories  432 A. Breach of Fiduciary Duty  435 B. Common Law Fraud  438 C. Shingle Theory  438 D. Tort Theory  439 E. Contract Theory  439 III. State Blue Sky Laws  439 IV. Swaps Case Study  440

Litigation can be an inevitable consequence of losses in the capital markets. In the trading context, liability stems from the nature of the relationship of the parties involved in a particular transaction. The plaintiff in litigation will look to common Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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law as well as to the federal securities and commodity laws to find a violation that might support a private cause of action. Recommending suitable investments, discussed at length in c­ hapter 13, is an example of a duty defined by regulation. Another example is where a duty is defined for certain market participants. For instance, Dodd-​Frank mandated the SEC explore the specific duties that stem from the relationship of retail investors to “broker-​ dealers” and “investment advisers.”1 I. Federal Securities Laws A. The Retail Investor : Broker-​D ealers and Investment Advisers In 2011, the SEC conducted a review of the broker-​dealer and investment adviser industry under Section 913 of Title IX of the Dodd-​Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-​Frank Act”). Investment advisers are defined under the Investment Advisers Act of 1940 (“Advisers Act”) Section 202(a)(11): “Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities . . . The SEC describes investment advisers as fiduciaries to their clients. Their actions are governed under the Advisers Act. They have a high standard of loyalty and care. This is in contrast to the regulation of broker-​dealers who operate for commissions “through the Commission’s antifraud authority in the Securities Act of 1933 (‘Securities Act’) and the Securities Exchange Act of 1934 (‘Exchange Act’), specific Exchange Act rules, and SRO rules based on Exchange Act principles, including (among others) principles of fairness and transparency.” Broker-​dealers are specifically exempted from the fiduciary standards of investment advisers. The SEC in its Study on Investment Advisers and Broker-​Dealers describes the regulatory scheme surrounding broker-​dealers:

1 Study on Investment Advisers and Broker-​Dealers as Required by Section 913 of the Dodd-​Frank Wall Street Reform and Consumer Protection Act (SEC 2011) [hereinafter The Study].

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Broker-​ dealers that do business with the public generally must become members of FINRA. Under the antifraud provisions of the federal securities laws and SRO rules, including SRO rules relating to just and equitable principles of trade and high standards of commercial honor, broker-​dealers are required to deal fairly with their customers. While broker-​dealers are generally not subject to a fiduciary duty under the federal securities laws, courts have found broker-​dealers to have a fiduciary duty under certain circumstances. Moreover, broker-​dealers are subject to statutory, Commission and SRO requirements that are designed to promote business conduct that protects customers from abusive practices, including practices that may be unethical but may not necessarily be fraudulent. The federal securities laws and rules and SRO rules address broker-​dealer conflicts in one of three ways: express prohibition; mitigation; or disclosure. An important aspect of a broker-​dealer’s duty of fair dealing is the suitability obligation, which generally requires a broker-​dealer to make recommendations that are consistent with the interests of its customer. Broker-​dealers also are required under certain circumstances, such as when making a recommendation, to disclose material conflicts of interest to their customers, in some cases at the time of the completion of the transaction. The federal securities laws and FINRA rules restrict broker-​dealers from participating in certain transactions that may present particularly acute potential conflicts of interest. At the state level, broker-​dealers and their agents must register with or be licensed by the states in which they conduct their business.2 Under the authority granted it by Dodd-​Frank, the SEC intends to standardize the fiduciary standard of investment advisers and broker-​dealers: . . . that would apply expressly and uniformly to both broker-​dealers and investment advisers, when providing personalized investment advice about securities to retail customers, a fiduciary standard no less stringent than currently applied to investment advisers under Advisers Act Sections 206(1) and (2).3  . . . the

2 Id. at iv. 3 SEC. 206. It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly—​ (1)  to employ any device, scheme, or artifice to defraud any client or prospective client; (2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;

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standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide), shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.4 On April 18, 2018, the SEC under the Trump administration proposed “Commission Interpretation Regarding Standard of Conduct for Investment Advisers” with the goal of enhancing investment adviser regulation. The proposal requires “ . . . all broker-​dealers and natural persons who are associated persons of broker-​dealers to act in the best interest of retail customers when making a recommendation of any securities transaction or investment strategy involving securities to retail customers (“Regulation Best Interest”). The SEC also proposes to require “ . . . registered investment advisers and registered broker-​dealers to deliver to retail investors a relationship summary, which would provide these investors with information about the relationships and services the firm offers, the standard of conduct and the fees and costs associated with those services, specified conflicts of interest, and whether the firm and its financial professionals currently have reportable legal or disciplinary events.”5 B. Securities Exchange Act of 1934 Rule 10b-​5  Claim

In addition to duties resulting from specific regulations, when a defendant’s conduct has violated a specific provision of the securities laws, liability can be found. The principal federal laws regulating securities transactions are the Securities Act of 1933 (the “Securities Act”)6 and the Securities Exchange Act of 1934 (the “Exchange Act”).7 Rule 10b-​5,8 promulgated pursuant to authority granted under the Exchange Act, is the principal antifraud rule of the SEC. It prohibits deceptive conduct and misstatements and omissions of material fact by any person in connection with the purchase or sale of a security. Although it does not explicitly allow for a private right of action, the U.S. Supreme Court has held that an implied private right of action exists for Rule 10b-​5 violations.9

4 The Study, supra note 1, at iv. 5 https://​www.sec.gov/​rules/​proposed/​2018/​ia-​4889.pdf (last visited Aug. 12, 2018). 6 15 U.S.C. § 77a et seq. 7 15 U.S.C. § 78a et seq. 8 17 C.F.R. § 240.10b-​5. 9 Herman & MacLean v. Huddleston, 459 U.S. 375, 380 (1983).

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For a plaintiff to establish a Rule 10b-​5 violation, all of the following elements must be proven:

1. a misstatement or omission, or other fraudulent device; 2. a purchase or sale of a security in connection with the fraud; 3. scienter by the defendant; 4. materiality of the misstated or omitted fact; 5. justifiable reliance by the plaintiff; and 6. damage resulting from the misstatement, omission, or fraudulent device.10

Where a transaction involves derivatives, plaintiffs might avail themselves of provisions defining duties contained in the securities laws when the plaintiff claims that the derivatives transaction is, indeed, a security.11 The definition of security is “sufficiently broad to encompass virtually any instrument that might be sold as an investment.”12 The definition of security includes not only the typical instruments that fall within the ordinary concept of a security but also any uncommon and irregular instruments.13 The securities laws cannot be avoided by calling a security by a term that is not listed in the statute because “Congress’ purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.”14 For instance, the federal securities laws have been held to apply to over-​the counter (OTC) cash-​settled option agreements.15 The Second Circuit concluded that the plaintiff sufficiently pled fraud in connection with the purchase or sale of securities under Rule 10b-​5.16 Noncompliance in executing such transactions could be a basis for a finding of liability against a broker. However, “it is also important to bear in mind that Congress, in enacting the securities laws, did not intend to provide a federal remedy for all common law fraud.”17 Rule 10b-​5 actions are most often based on a suitability claim.18

Platsis v. E.F. Hutton & Co., 946 F.2d 38, 40 (6th Cir. 1991). 11 See ­chapter 4, Section I.B, supra, for a complete discussion of this issue. 12 SEC v. Infinity Grp. Co., 212 F.3d 180, 186 (3d Cir. 2000), quoting Reves v. Ernst & Young, 494 U.S. 56, 61 (1990). 13 Marine Bank v. Weaver, 455 U.S. 551, 555 (1982). 14 Reves, 494 U.S. at 61. 15 Caiola v. Citibank, N.A., 295 F.3d 312, 333 (2d Cir. 2002): “The parties dispute whether cash-​settled over-​the-​ counter options on the value of a security are covered by section 10(b). We hold that they are.” 16 Id. 17 Rivanna Trawlers Unlimited v. Thompson Trawlers, Inc., 840 F.2d 236, 241 (4th Cir. 1988); see also Marine Bank, 455 U.S. at 556, which states that Congress did not “intend to provide a broad federal remedy for all fraud”). 18 See ­chapter 13, infra, for a complete discussion of suitability. 10

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Where a defendant has violated Rule 10b-​5, the Supreme Court has held that an investor who is partially at fault is not necessarily barred from recovery.19 A private action for damages in these circumstances may be barred on the grounds of the plaintiff ’s own culpability only where (1) the plaintiff ’s misconduct is at least substantially equal to that of the defendant, and (2) “preclusion of suit would not significantly interfere with the effective enforcement of the securities laws and protection of the investing public.”20 The court noted that “implied private actions provide ‘a most effective weapon in the enforcement’ of the securities laws and are ‘a necessary supplement to Commission action.’ ”21 C. Securities Act of 1933

An alternative to bringing a claim under Rule 10b-​5 is to bring such a claim under Section 12(2) of the Federal Securities Act of 1933. Any person who—​ . . . . (2) offers or sells a security . . . by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untrust or omission, shall be liable to the person purchasing such security from him.22 The benefit of using Section 12(2) is that scienter, that is, the intent to deceive, is not required to violate this section.23 Without the scienter requirement, it is much easier to prevail in such actions. All that is required is proof that the broker made unsuitable recommendations.

Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299 (1985). 20 Id. at 310–​11. 21 Id. at 310, quoting J.I. Case Co. v. Borak, 377 U.S. 426, 432 (1964). See also Norman S. Poser, Liability of Broker-​ Dealers for Unsuitable Recommendations to Institutional Investors, 2001 B.Y.U. L. Rev. 1493, 1549 (2001). 22 15 U.S.C. § 77l. 23 See, e.g., O’Connor v. R.F. Lafferty Co., 965 F. 2d 893, 899 (10th Cir. 1992); MidAmerica Fed. Sav. & Loan Ass’n v. Shearson, 886 F.2d 1249, 1256 (10th Cir. 1989); “It is a firmly entrenched principle of 12(2) that the ‘availability elsewhere of truthful information cannot excuse untruths or misleading omissions’ by the seller.” See also Sanders v. John Nuveen & Co., Inc., 619 F.2d 1222, 1229 (7th Cir. 1980). 19

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In addition to the prohibition against misleading investors, Rule 10b-​5 has been used effectively to prosecute a claim against a defendant who churned a customer’s account.24 Churning is excessive trading in an account, done not to affect the investor’s trading strategy but to generate brokers’ commissions. Churning is often referenced as “quantitative unsuitability,” and requires proof that the broker controlled the account.25 Therefore, excessive trading alone is not enough to establish churning without proof of control. Churning does not require that a transaction be done with the authorization of a customer. In Caiola v. Citibank, N.A.,26 the plaintiff, Louis S. Caiola, brought federal securities fraud and state law claims against the defendant bank arising from extensive physical and synthetic investments; the court held that Citibank had indeed engaged in “churning” despite a lack of authorization to engage in the securities transactions that were done on behalf of Caiola without his authorization. Caiola had an extensive relationship with Citibank. Caiola and Citibank entered into numerous derivatives transactions derived from Phillip Morris stock. In the context of these transactions, Caiola relied on Citibank to synthetically create economic exposure to Phillip Morris stock using derivatives (for instance by structuring equity swaps and options). Caiola specifically did not want to own the actual securities that were traded on exchanges, and relied on Citibank to hedge its risk using “delta hedging” strategies, thereby not fully recreating synthetic positions in the physical market.27 In engaging in off-​exchange transactions, Caiola hoped to eliminate the “footprints” that are left on exchanges when transactions are recorded on-​exchange. Furthermore, by synthetically creating positions, Caiola hoped not to move markets when buying or selling large amounts of Phillip Morris stock and options. Despite the fact that Caiola did not authorize Citibank to engage in physical transactions, Citibank went ahead and purchased the underlying securities of Phillip Morris stock and options on exchange rather than creating economic exposure synthetically. Although the transactions in the physical securities were unauthorized (in that Citibank was only authorized to create risk for Caiola synthetically while hedging its own risk by delta hedging), this lack of authorization with regards to the specific physical transactions did not deprive Caiola of standing to assert that Citibank had violated Rule 10b-​5. The National Association of Securities Dealers (NASD) has identified excessive trading activity as a violation of a broker’s responsibility of fair dealing. NASD Rule 2310, NASD Manual (CCH) 4261 (2000) [hereinafter NASD Rule 2310] at Rule IM-​2310-​2(b)(2) (2002). 25 In re Howard, 2000 WL 1736882 (N.A.S.D.R.), at *6 (Nov. 16, 2000) (Nat’l Adjudicatory Council); In re Bruff, Exchange Act Release No. 34-​40583, 68 SEC Docket 562, 565 (SEC Oct. 21, 1998), which states that “excessive trading is itself a form of unsuitability”). 26 295 F.3d 312 (2d Cir. 2002). 27 See ­chapter 10, infra, for a discussion of delta hedging. 24

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Indeed, it is well-​settled that claims under Rule 10b-​5 arise when brokers purchase or sell securities on their clients’ behalf without specific authorization. For example, a claim for unauthorized trading, which occurs when a broker intentionally places trades without obtaining the customer’s approval, historically has been well-​established under Rule 10b-​5. . . . By definition, a broker who is liable for making unauthorized trades makes them without the customer’s authorization. Churning claims, which depend on a broker’s liability for excessive trading, also have been recognized under Rule 10b-​5.28 D. Liability under the Commodity Exchange Act 1. Antifraud Provision

When a provision of the Commodity Exchange Act is violated, a plaintiff might use that violative activity as the basis of a private cause of action. Section 753 of Dodd-​Frank amends the CEA to include a Rule 10B-​5–​like antifraud provison: It shall be unlawful for any person, directly or indirectly, to use or employ, or attempt to use or employ, in connection with any swap, or a contract of sale of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity, any manipulative or deceptive device or contrivance, in contravention of such rules and regulations as the Commission shall promulgate by not later than 1 year after the date of enactment of the Dodd-​Frank Wall Street Reform and Consumer Protection Act, provided no rule or regulation promulgated by the Commission shall require any person to disclose to another person nonpublic information that may be material to the market price, rate, or level of the commodity transaction, except as necessary to make any statement made to the other person in or in connection with the transaction not misleading in any material respect.29 Under this provision, the CFTC has advanced Final Rule 180.1 implementing new CEA section 6(c)(1). Plaintiffs may now use this rule as a basis of a cause of action when a loss occurs. Before Dodd-​Franks’ expansion of the CFTC’s original

Caiola, 295 F.3d 312, 323–​24 (citations omitted). 29 Dodd Frank Act Section 753 ANTI-​MANIPULATION AUTHORITY. 28

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antifraud provision,30 the CFTC had to prove “(1) the making of a misrepresentation, misleading statement, or a deceptive omission; (2) scienter; and (3) materiality”31 to prove an act was indeed fraudulent. 2. Disclosure The CFTC requires a broker to provide a risk disclosure statement to the customer and obtain the customer’s signature acknowledging receipt of the statement before engaging in futures or options transactions.32 Failure to disclose may be another basis for a cause of action. Many courts have considered mere delivery of the risk disclosure statements sufficient as long as the broker did not tell the customer to disregard the warning.33 However, the Sixth Circuit took a different approach in 2007. In Nashery v. Carnegie Trading Group, LTD.,34 plaintiffs contended that the defendant broker misrepresented the reliability of his investment strategy for commodity options. They claimed that they relied to their detriment on the misrepresentations, and these misrepresentations drove them to invest with defendants. Although the Sixth Circuit held for the defendant, the court imposed a “facts and circumstances” test to determine broker liability under the CEA. The court held: The mere presentation of a risk disclosure statement does not relieve a broker of any obligation under the Commodity Exchange Act, 7 U.S.C.S. §§ 1–​25, to disclose all material information about risk to customers. The extent of disclosure necessary to provide full information about risk will vary depending on the facts and circumstances of trading as well as on the nature of the relationship between the broker and customer.35 7 U.S.C. § 6b(a) makes it unlawful for any person, in or connection with any order to make, or the making of, any contract of sale of any commodity for future delivery, made, or to be made, for or on behalf of any other person . . . (i) to cheat or defraud or attempt to cheat or defraud such other person; . . . (iii) willfully to deceive or attempt to deceive such other person. 31 323 F. Supp. 2d 482, 499, citing CFTC v. R.J. Fitzgerald & Co., 310 F.3d 1321, 1328 (11th Cir. 2002); see also CFTC v. AVCO Fin. Corp., 28 F. Supp. 2d 104, 115 (S.D.N.Y. 1998), aff ’d in relevant part sub nom. CFTC v. Vartuli, 228 F.3d 94, 101 (2d Cir. 2000). 32 CFTC Regulation of Domestic Exchange-​Traded Commodity Options Transactions, 17 C.F.R. § 33.7 (2002). CFTC Rules generally require the customer’s signature before opening the account. See 17 C.F.R. § 1.55(a)(1) (ii) (2002). 33 See Purdy v. CFTC, 968 F.2d 510 (5th Cir. 1992); Hill v. Bache Halsey Stuart Shields, Inc., 790 F.2d 817, 824 (10th Cir. 1986) (commodities futures); Clayton Brokerage Co. v. CFTC, 794 F.2d 573 (11th Cir. 1986). But see Crook v. Shearson Loeb Rhoades, Inc., 591 F. Supp. 40, 44 (N.D. Ind. 1983), which ruled that even if a customer received the risk disclosure statement, he would not have understood commodities futures trading. 34 2007 U.S. App. LEXIS 15677 (6th Cir. 2007). 35 Id. at *7. 30

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II. Common Law Theories Common law theories of recovery typically include breach of fiduciary duty, common law fraud, negligence, and the shingle theory. These theories of liability are the backbone for state actions (as opposed to federal actions, where Rule 10b-​5 serves as the typical impetus for a claim). Often, common law theories are added to a Rule 10b-​5 claim against a defendant. The plaintiff will claim that a defendant owed some special duty to its counterparty. In presenting the facts of the case, the plaintiff will attempt to demonstrate the defendant was in a superior position of knowledge and that the plaintiff relied on the defendant. The complaint in Gibson Greeting Cards v. Bankers Trust36 is illustrative of many of these common law theories. In 1994, following a series of interest rate increases by the Federal Reserve, a number of clients sued their counterparty investment banks for losses related to derivatives transactions. One of those plaintiffs, Gibson Greeting Cards, sued Bankers Trust for losses associated with a series of derivatives transactions. The facts that Gibson presented in its complaint37 demonstrate a disparity of knowledge and experience with regards to these transactions. In addition, Gibson sought to demonstrate that a “special relationship” existed between itself and Bankers Trust that required a greater duty than one between two arm’s-​length counterparties. The tone of the following selection of the complaint demonstrates the tenor of the facts that a derivatives plaintiff might present: Gibson has had a banking relationship with Bankers Trust dating back to when Gibson first became a publicly traded company in 1983. What began as a traditional commercial banking relationship developed over the years into a close and multifaceted business relationship. Bankers Trust became and remains the lead bank and agent for Gibson’s primary source of working capital, a $210 million revolving credit agreement. In addition, Bankers Trust advised Gibson on various merger and acquisition opportunities and solicited Gibson’s participation in transactions and joint ventures in which Bankers Trust was also to be a principal. As the result of serving as Gibson’s advisor and principal source of working capital borrowings, Bankers Trust came to occupy a position of the highest trust and confidence with Gibson. Officers and agents from Bankers Trust’s Chicago and New York offices made numerous visits to Gibson’s offices

Civ. No. 1-​94-​620 (S.D. Ohio 1994). 37 Gibson Greetings, Inc. v. Bankers Trust Co., Civil Action Complaint Filed U.S. District Court Southern District of Ohio, Western Division, Civ. No. 1-​94-​620 (Oct. 11, 1994). 36

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in Cincinnati. They were given extensive access to Gibson management personnel and to Gibson’s confidential financial and operating information, including financial management philosophies and risk tolerances. Bankers Trust became well aware that Gibson is a conservatively managed company with relatively little debt. Bankers Trust had a long history of knowing that Gibson did not engage in speculative financial investments or transactions but instead maintained a conservative financial investment and planning philosophy intended to protect the Company’s assets and to assure that financing for its manufacturing and marketing activities would be available at all times.38 Disputes over derivatives are governed under the terms of the contract. In Gibson Greeting Cards v. Bankers Trust, disputes arose when Gibson lost money. The International Swaps and Derivatives Association (ISDA) Master Agreement39 was used to document the transactions; notwithstanding the terms of the ISDA agreement, which provide for numerous counterparty protections in the event of a dispute, several causes of action may nonetheless be prosecuted. The tort theories, usually based on an asymmetry of information, generally fall under one of the following claims: • Breach of fiduciary duty, • Negligent misrepresentation, and • Fraud and fraudulent concealment. The contracts claims included in derivatives-​related litigation also focus on the asymmetry of information and include:

•

Implied contractual duty of disclosure, • Mutual mistake, • Unilateral mistake, and • Duress.

The complaint and answer in Gibson Greeting Cards v. Bankers Trust demonstrate the nature of interest rate swaps and the claims that may be brought when a loss occurs as a result of asymmetrical information. It is interesting to note the differing perspectives as to the nature of the relationship of the counterparties to the transactions. In the complaint, Gibson describes Bankers Trust as its partner and adviser. Bankers Trust, in its answer to Gibson’s complaint, describes their

Id. at 3. 39 See ­chapter 9, Sec. III.B, supra. 38

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relationship as one conducted at arm’s length as counterparties with no fiduciary duty attached: Bankers Trust has been one of Gibson’s many bank lenders since 1983; . . . prior to September 30, 1994, Bankers Trust was the Agent Bank for the group of eleven banks who provided Gibson with a $210 million revolving credit facility by agreements dated as of August 2, 1993; . . . Gibson has employed investment banking firms to act as financial advisor to Gibson in connection with merger and acquisition opportunities, but has not retained Bankers Trust for that purpose; . . . Bankers Trust contacted Gibson to see if Gibson might be interested in investing in some transactions in which Bankers Trust might also invest, but . . . Gibson declined to do so, and . . . Bankers Trust was not acting as a financial advisor to Gibson in any such instance; . . . Bankers Trust’s transactions with Gibson have always been arm’s-​length commercial transactions between sophisticated enterprises. . . . Employees of Bankers Trust and employees of BT Securities visited Gibson’s offices in Cincinnati from time to time (although mostly for purposes unrelated to the transactions that are the subject of the Complaint); . . . Bankers Trust and BT securities were given access only to such information about Gibson as was appropriate in light of the credit extended by Bankers Trust and the arm’s length commercial relationships between Bankers Trust, BT securities and Gibson. . . . Gibson solicited proposals in the fall of 1991 regarding a potential interest rate swap in which Gibson wished to engage. . . . Clients such as Gibson enter into derivatives contracts to serve many different objectives of their own choosing, based on their own assessments of what future interest rate movements, currency exchange movements or other market movements might be . . . Bankers Trust does not act as a financial advisor to Bankers Trust’s counterparties.40 Bankers Trust is quite clear in presenting itself as an arm’s-​length counterparty in derivatives transactions. In fact, Bankers Trust describes itself as one of Gibson’s many bankers and not an advisor at all. Shortly after the suit was filed, Gibson and Bankers Trust reached an out-​of-​court settlement, which ended Gibson’s exposure to losses of as much as $27.5 million. According to company officials, Gibson paid Banker’s Trust $6.18 million, part of which would come from the $3.4 million Bankers Trust paid to Gibson in earnings on earlier derivative contracts.41 40 Gibson Greetings, Inc. v. Bankers Trust Co., Civil Action Answer Filed U.S. District Court Southern District of Ohio, Western Division, Civ. No. 1-​94-​620 (Oct. 11, 1994). 41 See http://w ​ ww.fundinguniverse.com/​company-​histories/​Gibson-​Greetings-​Inc-​Company-​History.html (last visited Dec. 3, 2013).

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A. Breach of Fiduciary Duty

Although various states interpret relationships between brokers and their customers differently, there is a general consensus among states that a broker has a duty not to recommend unsuitable investment options for the customer.42 The leading case in this area is Twomey v. Mitchum.43 In Twomey, the court held that “the relationship between broker and principal is fiduciary in nature and imposes on the broker the duty of acting in the highest good faith toward the principal. . . . The duties of the broker, being fiduciary in character, must be exercised with the utmost good faith and integrity.”44 This duty was defined more narrowly in Banca Cremi, S.A. v. Alex. Brown & Sons, Inc.,45 where the court refused to find a fiduciary duty owed to the customer by the defendant brokerage firm because the defendants conducted their business at arm’s length in a principal-​to-​principal relationship. The lack of a formal relationship between the parties made the court unwilling to find a fiduciary duty. In Procter & Gamble Co. v. Bankers Trust Co.,46 the court reasoned: No fiduciary relationship exists . . . [where] the two parties were acting and contracting at arm’s length. Moreover, courts have rejected the proposition that a fiduciary relationship can arise between parties to a business relationship.47 More recently, in Lehman Bros. Commercial Corp. v. Minmetals International Non-​Ferrous Metals Trading Co.48 the court also concluded that “[a]‌‌ fiduciary duty does not arise in the normal course of an arm’s-​length business transaction.” In De Kwiatkowski v. Bear Stearns & Co.,49 the Second Circuit held that a broker must undertake a specific role to trigger a duty to volunteer advice and warnings between transactions. Absent negligence in performing transaction execution, liability cannot rest on a broker’s failure to give ongoing market advice that it had no duty to give. The Court held that although a broker has no general ongoing duties to a customer holding a non-​discretionary account, in certain “special circumstances” an

Poser, supra note 21, at 1493, 1496. 43 69 Cal. Rptr. 222 (Cal. Dist. Ct. App. 1968). 44 Id. at 236 (quoting Abrams v. Bendat, 331 P.2d 657, 661 (Cal. Dist. Ct. App. 1958)); see also Roger W. Reinsch, J. Bradley Reich & Nauzer Balsara, Trust Your Broker?: Suitability, Modern Portfolio Theory, and Expert Witnesses, 17 St. Thomas L. Rev. 173, 180 (2004). 45 132 F.3d 1017 (4th Cir. 1997). 46 925 F. Supp. 1270 (S.D. Ohio 1996). 47 Id. at 1289 (quoting Beneficial Commerce Corp. v. Murray Glick Datsun, Inc., 601 F. Supp. 770, 772 (S.D.N.Y. 1985)). 48 179 F. Supp. 2d 118, 150 (S.D.N.Y. 2000). 49 306 F.3d 1293 (2d Cir. 2002). 42

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ongoing duty can arise. Special circumstances may arise, for example, when a broker takes advantage of an unsophisticated or incapacitated customer, or when a customer is so unsophisticated or incapacitated that the broker is deemed to have de facto control over the account. Henryk de Kwiatkowski made and lost hundreds of millions of dollars betting on the U.S. dollar by trading in currency futures. Kwiatkowski traded on a governmental scale: at one point, his positions accounted for 30 percent of the total open interest in certain currencies on the Chicago Mercantile Exchange. After netting over $200 million in the first trading weeks, Kwiatkowski’s fortunes turned; between late December 1994 and mid-​January 1995, Kwiatkowski suffered single-​day losses of $112 million, $98 million, and $70 million. He continued losing money throughout the winter. Having lost tens of millions over the preceding several days, Kwiatkowski liquidated all his positions starting on Sunday, March 5, 1995, and finishing the next day. In all, Kwiatkowski had suffered net losses of $215 million. In June 1996, Kwiatkowski sued the brokerage firm (and related entities) that had executed his trade orders: Bear, Stearns & Co., Inc., Bear, Stearns Securities Corporation, and Bear Stearns Forex Inc. (collectively, “Bear Stearns” or “Bear”), as well as his individual broker, Albert Sabini, alleging (inter alia) common law negligence and breach of fiduciary duty. At trial, Kwiatkowski contended that Bear and Sabini failed adequately to warn him of risks, failed to keep him apprised of certain market forecasts, and gave him negligent advice concerning the timing of his trades. The court recognized that size alone does not make a client “special” in terms of additional obligations required by the broker. In fact, the size of an account might demonstrate the relative sophistication and experience of the client. A client such as de Kwiatkowski is “the very opposite of the naive and vulnerable client who is protected by ‘special circumstances.’ ”50 The court held that no special circumstances exist between a broker and its customer absent evidence to the contrary: A broker ordinarily has no duty to monitor a nondiscretionary account, or to give advice to such a customer on an ongoing basis. The broker’s duties ordinarily end after each transaction is done, and thus do not include a duty to offer unsolicited information, advice, or warnings concerning the customer’s investments. A nondiscretionary customer by definition keeps control over the account and has full responsibility for trading decisions. On a transaction-​ by-​transaction basis, the broker owes duties of diligence and competence in

Id. at 1309. 50

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executing the client’s trade orders, and is obliged to give honest and complete information when recommending a purchase or sale. The client may enjoy the broker’s advice and recommendations with respect to a given trade, but has no legal claim on the broker’s ongoing attention.51 The giving of advice triggers no ongoing duty to do so.52 Under agency law, there is a well-​established duty of an agent to provide material information to the principal that is relevant to the agency relationship.53 A broker is generally considered to be an agent of its customer and is therefore often a defendant in such cases. However, a common defense by a broker in a lawsuit is that the broker was a “specific” agent for as opposed to a “general” agent of the customer. “A general agent is one authorized to conduct a series of transactions,” whereas a special agent is only “authorized to conduct a single transaction, or a series of transactions” that do not entail continuity of service.54 A general agency endures continuously until terminated, whereas a special agency relationship is presumed to start and stop with each unrelated transaction.55 Therefore, if a broker is a specific agent to a customer, Id. at 1302, citing Press v. Chem. Inv. Servs. Corp., 166 F.3d 529, 536 (2d Cir. 1999), which states that a broker’s fiduciary duty is limited to the “narrow task of consummating the transaction requested;” Independent Order of Foresters v. Donaldson, Lufkin & Jenrette, Inc., 157 F.3d 933, 940–​41 (2d Cir. 1998), in a non-​discretionary account, “the broker’s duties are quite limited,” including the duty to obtain the client’s authorization before making trades and to execute requested trades; Schenck v. Bear, Stearns & Co., 484 F. Supp. 937, 947 (S.D.N.Y. 1979), which notes that the “scope of affairs entrusted to a broker is generally limited to the completion of a transaction;” Robinson v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 337 F. Supp. 107, 111 (N.D. Ala. 1971), which states: “The relationship of agent and principal only existed between [broker and nondiscretionary customer] when an order to buy or sell was placed, and terminated when the transaction was complete.”; Leib v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 461 F. Supp. 951, 952–​54 (E.D. Mich. 1978), which says the same, drawing a distinction between discretionary and nondiscretionary accounts; accord Paine, Webber, Jackson & Curtis, Inc. v. Adams, 718 P.2d 508, 516–​17 (Colo. 1986), which observes the same distinction, and holds that existence of a broad fiduciary duty depends on whether the broker has “practical control” of customer’s account. 52 Id., Caravan Mobile Home Sales, Inc. v. Lehman Bros. Kuhn Loeb, Inc., 769 F.2d 561, 567 (9th Cir. 1985), in which a securities broker had no duty to provide customer with information about stock after purchase was complete; Leib, 461 F. Supp. at 953, which states that a broker has no duty to keep non-​discretionary customer abreast of “financial information which may affect his customer’s portfolio or to inform his customer of developments which could influence his investments”; Robinson, 337 F. Supp. at 112: “The broker has no duty to relay news of political, economic, weather or price changes to his principal, absent an express contract to furnish such information.”; Puckett v. Rufenacht, Bromagen & Hertz, Inc., 587 So.2d 273, 280 (Miss. 1991) states: “If a broker were under a duty to inform all of its customers of every fact which might bear upon any security held by the customer, the broker simply could not physically perform such a duty.”; Walston & Co. v. Miller, 410 P.2d 658, 661 (Ariz. 1966) states: “Any continuing duty to furnish all price information and information of all facts likely to affect the market price would be so burdensome as to be unreasonable.” 53 See Frederick Mark Gedicks, Suitability Claims and Purchases of Unrecommended Securities: An Agency Theory of Broker-​Dealer Liability, 37 Ariz. St. L.J. 535, 574–​75 (2005). 54 Cheryl Goss Weiss, A Review of the Historic Foundations of Broker-​Dealer Liability for Breach of Fiduciary Duty, 23 J. Corp. L. 65, 72 (1997) 55 Id. at 67; see also Gedicks, supra note 53, at 576–​77. 51

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the broker has a strong defense that he or she did not owe a duty to the customer if the transaction at issue was not the specific transaction on which the broker assisted the client. B. Common Law Fraud

Dealers may have a duty to disclose material information regarding risks associated with derivatives trades. Failure to disclose such information can constitute fraud.56 In order to establish a common law fraud claim, every element of fraud must be proven, including reasonable reliance, which is often the most difficult to prove.57 Currently, common law fraud claims can be included with unsuitability claims, but the area of law has not yet been separately developed. As a result, common law fraud claims are often included as a factor of claims brought under Rule 10b-​5.58 C. Shingle  Theory

Under the “shingle theory,” identifying oneself as a broker or dealer in securities is held to implicitly represent that such person will deal fairly and equitably with a customer. Under this theory, one who poses as a broker or dealer cannot recommend unsuitable transactions for the customer even if that person is not actually a broker or dealer. The basis for the theory is statutory (pursuant to the Exchange Act’s requirement that a broker/​dealer may not solicit securities transactions unless he is a member of a “registered securities association” or a registered “national securities exchange”59 and is reinforced by the common law doctrine of “holding out.”60 The “holding out” doctrine provides that one who represents himself as possessing expert knowledge and skill is held to the higher standard of care consistent with the representation.61

See Procter & Gamble Co. v. Bankers Trust Co., 925 F. Supp. 1270 (S.D. Ohio 1996). 57 See Poser, supra note 21, at 1540–​42; see also Reinsch et al., supra note 44, at 182. 58 See Clark v. John Lamula Inv., Inc., 583 F.2d 594 (2d Cir. 1978); Matthew J. Benson, Online Investing and the Suitability Obligations of Brokers and Broker-​Dealers, 34 Suffolk U. L. Rev. 395 (2001); see also Reinsch et al., supra note 44, at 182. 59 Broker-​dealers who are members of a registered national exchange but not a registered national securities association are authorized to effect or solicit “transactions solely on that exchange.” 15 U.S.C. § 78o(b)(1)(B). 60 See Gedicks, supra note 53, at 558–​59. 61 Id. 56

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D. Tort  Theory

For plaintiffs attempting to assert a negligence claim against a broker, tort principles support the use of the industry’s professional standards to establish a standard of care. The Second Restatement of Torts requires individuals to exercise the degree of care and skill “normally possessed by members of that profession or trade in good standing in similar communities.”62 However, the rule does not apply when an individual represents that she has greater or lesser skill or knowledge. Therefore, if a plaintiff can prove a broker failed to meet the standard in the industry, the plaintiff might have a strong negligence claim if he can prove the remaining elements of negligence (duty, breach, causation, damages). E. Contract  Theory

One important aspect of contract law in derivatives transactions is the unenforceability of contractual waiver, merger, no-​reliance, and other clauses restricting rights and remedies under the securities laws. Congress voided these contractual waivers under the securities laws because of the concern that the investor protection goals of the Acts would be easily frustrated by such provisions, especially when directed toward unsophisticated investors. Another often litigated issue arises when a customer and broker enter into a contractual agreement and the customer trades irrationally. This may demonstrate that the customer has an addictive personality and perhaps lacks the requisite mental capacity to enter into contracts.63 Some courts have held that a broker has a duty to know the mental competence of his customers and take action in such situations.64 III. State Blue Sky Laws In addition to the federal securities laws, states have their own securities laws. These are referred to as “Blue Sky Laws.” State laws differ, but one common thread among

62 Restatement (Second) of Torts § 299A (Am. Law Inst.1965). 63 Barbara Black, Economic Suicide: The Collision of Ethics and Risk in Securities Law, 64 U. Pitt. L. Rev. 483, 493 (2003). 64 See id., citing Beckstrom v. Parnell, 730 So. 2d 942 (La. App. 1998). In Beckstrom, the court emphasized the full service broker’s knowledge of his customer’s incapacity in finding the broker liable for failing to warn the customer of the unsuitable transaction (but did not suggest that the broker could not follow the customer’s instructions if he had been warned).

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them is that where the customer places her trust and confidence in the broker, the broker owes the customer a fiduciary duty, and making an unsuitable recommendation may be a breach of this duty.65 However, this does not mean that states agree that every broker-​customer relationship is fiduciary in nature. For example, in New York, the broker-​customer relationship is considered to be a fiduciary one, but the broker’s fiduciary obligation is limited to the matters entrusted to the broker by the customer.66 On the other hand, Massachusetts courts state that a “simple stockbroker-​customer relationship” is a business relationship unless the customer has given the broker discretionary authority to trade the account and the broker has consented to such authority.67 Therefore, depending on the facts and jurisdiction of the case, a plaintiff in a derivatives action may sue based on the federal security laws and under the state laws as well. IV. Swaps Case Study Korea Life Insurance Co. v. Morgan Guaranty Trust Co.68 illustrates several of the litigation issues that may arise in a swaps transaction. The plaintiff, a foreign insurer and an investment bank, entered into a series of complicated swap agreements in January 1997 with the defendant trust company. The effect of the transactions was that plaintiff sold a put option to defendant on Thai currency, the baht. The plaintiff entered into this agreement in order to circumvent Korean laws that did not allow it, as a life insurance company, to invest in currencies in this way. The plaintiff incurred the risk that the baht could depreciate significantly against the dollar. However, the agreement allowed for plaintiff to terminate the transaction at fair market value if it gave the defendants two business days’ notice. By July 1997, the value of the baht had deteriorated significantly and plaintiff notified defendants it wanted to unwind the transactions. Defendants were concerned about unwinding at that time because of market liquidity problems and did not unwind the transaction until 23 days before maturity, which was the following January. Defendants demanded payment for the entire amount. Korea Life then asserted legal claims including negligent

See Poser, supra note 21, at 1496; see also Norman S. Poser, Broker-​Dealer Law and Regulation 2.02 (3d ed. 2000). 66 Conway v. Icahn & Co., 16 F.3d 504, 510 (2d Cir. 1994): “The relationship between a stockbroker and its customer is that of principal and agent and is fiduciary in nature, according to New York law.” 67 Brine v. Paine, Webber, Jackson & Curtis, Inc., 745 F.2d 100, 103 (1st Cir. 1984). 68 269 F. Supp. 2d 424 (D.N.Y. 2003). 65

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misrepresentation, illegality, breach of contract, unjust enrichment, commercial frustration, and impracticability. The court addressed each of these claims. The court found that, in order for a negligent misrepresentation claim to be successful, a plaintiff has to prove that: 1. the defendant had a duty, as a result of a special relationship, to give correct information; 2. the defendant made a false representation that it should have known was incorrect; 3. the information supplied in the representation was known by the defendant to be desired by the plaintiffs for a serious purpose; 4. the plaintiffs intended to rely and act upon that representation; and 5. the plaintiffs reasonably relied on it to their detriment.69 In this case, Korea Life alleged that Morgan Guaranty misrepresented the nature of the transaction and the stability of the baht, and that Korea Life relied on those misrepresentations when entering the transaction. However, the court did not find sufficient evidence to support Korea Life’s assertion here, and dismissed the claim. The court stated, “[I]‌‌t cannot be said that [plaintiff ] did not understand the nature of the transaction; both its Equity Department and the International Department did analyses of the transaction, and fairly identified the risks involved.”70 Korea Life’s next claim was that a security agreement that was part of the transactions was illegal under Korean law. Although the agreement may have been illegal under Korean law, the court held that the effect of illegality upon a contractual relationship is determined, not by Korean law, but by the law of the jurisdiction that is selected under conflicts analysis.71 The transaction was legal under New York law (the jurisdiction that was selected between the parties), and the court subsequently dismissed the illegality claim. Korea Life’s next claim, breach of contract, was based on the assertion that there was a right to unwind the transaction if it gave Morgan Guaranty two business days’ notice. The defendant claimed no duty to unwind existed because that responsibility was not in both swap agreements. Korea Life argued that the agreements should be read as one integrated set of transactions and part of the same bargain, which would lead to the conclusion that the duty to unwind was part of the agreement.

69 Id. at 436. 70 Id. 71 Id. at 440.

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The court, applying the general rules of contract construction in the context of swap transactions, agreed and held that Korea Life was entitled to summary judgment on the issue of whether Morgan Guaranty had to unwind the transaction.72 Korea Life also brought claims for unjust enrichment, commercial frustration, and impracticability, but failed in this case on all three.73 The unjust enrichment claim failed because the court found a valid and enforceable written contract governing the subject matter in dispute. Furthermore, the claim was based on the baht depreciation, a known risk to the parties. The court held that “a claim for unjust enrichment cannot be premised on a known risk.”74 As to the commercial frustration and impracticability claims, the court held that “claims based on theories of commercial frustration and impracticability also must fail. The potential devaluation of the Thai baht was a risk of the deal, and not a ground of rescission.”75

Id. at 446. 73 Id. at 447. 74 Id. 75 Id. 72

43

20 Synthesis and Conclusion

I. Synthesis  443 II. Structured Note Case Study: Securities and Exchange Commission v. Goldman, Sachs & Co. & Fabrice Tourre 445 III. Historical Example: Erlanger “Cotton” Bonds  447 IV. Range Notes  450 V. Internal Leverage and Market Risk  452 VI. Risks Involved  455 A. Interest Rate Risk  455 B. Liquidity Risk  455 C. Reinvestment Risk  456 D. OCC Warning  456

I. Synthesis Throughout this work we have described products and participants in the capital markets. The various component pieces described throughout this work, and the tapestry of regulation, come together within individual transactions. The appeal of purchasing a particular security may be enhanced by incorporating derivative Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

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components. For example, if a bond obligation includes a provision allowing the issuer to repurchase the bond on or by a date certain, at a fixed price, it has built into its structure a “call option.” The issuer has purchased the option from the investor and in return pays a premium in the form of a higher interest rate. Incorporating derivatives into structures may enhance yield and encourage market participation. For instance, an issuer may not issue a security without the flexibility provided by an option. On the flip side, the investor may not have purchased the bond without the added premium paid to him for selling the option. By incorporating derivative components into debt instruments, issuers can access capital from investors who might have specific financial goals that go beyond a credit-​related yield or a defined and fixed return on capital. Debt instruments can be structured so that interest to investors is contingent on some variable other than the credit of the issuer or an agreed-​upon fixed coupon. For example, a mortgage-​backed bond is an obligation that has been linked to the pledge of specific mortgages as collateral; interest is paid based on the payment stream derived from underlying mortgages. Similarly, a note might be structured so interest payments are linked to the increasing value of an underlying asset or index. In that such a structure affects the payment obligation of the issuer, it has within it an embedded derivative. Structured notes are specifically tailored securities that contain both elements of debt instruments and derivative instruments.1 They are often referred to as “hybrid” securities. Most structured notes contain “embedded options.” These options can be embedded to enhance the note’s yield, or to decrease the cost of funding for the issuer.2 Structured notes provide an efficient means of shifting risk. By isolating and assuming specific risks, market participants that ordinarily could not provide an investment vehicle to meet the needs of an investor or provide capital for a company might be able to make an investment when that investment contains built-​in derivative components. Structured notes allow the parties to hedge or speculate in specifically identifiable risks, tailored to meet the particular needs of the parties involved. Because these instruments contain derivative components, it may be difficult to price these securities. The embedding of a derivative into a structured note requires a Black-​Scholes3 analysis to determine appropriate pricing. For example, if a structured note pays interest contingent on an index such as the London Interbank Offered Rate (LIBOR)

1 Karen McCann & Joseph Cilia, Structured Notes 2 (Federal Reserve Bank of Chicago, Financial Markets Unit, Nov. 1994). 2 Id. 3 See ­chapter 10, Sec. III, supra.

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remaining in a particular range, the note might be deconstructed into its component parts: that is, the debt obligation and the option collar on LIBOR inherently contained in the range contingency of the issuer’s obligation. Although a structured note may have a unique market risk resulting from its derivative components, the attendant credit risk remains unchanged. Credit risk is a measure of the issuer’s ability to meet its obligations under the terms of the note. If, for example, a structured note is issued by a triple-​A rated (“AAA”) issuer the ability of the issuer to pay under the terms of its obligation may be of minimal concern. However, the market risk of the derivative component of the issue is factored into the rating of the underlying security only to the extent of inquiring as to whether the issuer will be able to meet its obligations under the terms of the instrument. Therefore, the investor must apprehend the market risk of the structure in addition to the credit risk of the issuer.4 II. Structured Note Case Study: Securities and Exchange Commission v. Goldman, Sachs & Co. & Fabrice Tourre On April 16, 2010, the Securities and Exchange Commission filed securities fraud charges against Goldman Sachs and its employee, Fabrice Tourre, for making material misstatements and omissions in connection with a synthetic collateralized debt obligation (CDO). A CDO is a type of bond representing claims to specific cash flows. The streams of payments might be contingent on a credit event or another market force. According to the complaint, Goldman marketed to investors a cash flow based on the creditworthiness of a pool of mortgages. For all intents and purposes the cash flow was a simple IOU from a Goldman-​related entity, but the cash flow was contingent on the creditworthiness of a pool of underlying mortgages. This synthetic CDO, ABACUS 2007-​AC1, was tied to the performance of subprime residential mortgage-​ backed securities (RMBS) and was structured and marketed in early 2007 when the U.S. housing market and the securities referencing it were beginning to show signs of distress. Although the cash flows from Goldman’s IOU were tied to the pool of mortgages, Goldman neither owned the mortgages nor was there any actual interest in the mortgages except for the contingency built into the deal” . . . the marketing materials for ABACUS 2007-​ AC1—​ including the term sheet, flip book and offering memorandum for the CDO—​all represented that

4 McCann & Cilia, supra note 1, at 2.

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the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC (“ACA”), a third party with expertise in analyzing credit risk in RMBS.5 Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. (“Paulson”), with economic interests directly adverse to investors in the ABACUS 2007-​AC1 CDO played a significant role in the portfolio selection process. After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (“CDS”) with GS&Co to buy protection on specific layers of the ABACUS 2007-​AC1 capital structure. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future. GS&Co did not disclose Paulson’s adverse economic interest or its role in the portfolio selection process in the term sheet, flip book, offering memorandum or other marketing materials.” The Commission alleges that Tourre was principally responsible for ABACUS 2007-​AC1. According to the Commission’s complaint, Tourre devised the transaction, prepared the marketing materials and communicated directly with investors. Tourre is alleged to have known of Paulson’s undisclosed short interest and its role in the collateral selection process. He is also alleged to have misled ACA into believing that Paulson invested approximately $200 million in the equity of ABACUS 2007-​ AC1 (a long position) and, accordingly, that Paulson’s interests in the collateral section process were aligned with ACA’s when in reality Paulson’s interests were sharply conflicting. The deal closed on April 26, 2007. Paulson paid GS&Co approximately $15 million for structuring and marketing ABACUS 2007-​AC1. By October 24, 2007, 83% of the RMBS in the ABACUS 2007-​AC1 portfolio had been downgraded and 17% was on negative watch. By January 29, 2008, 99% of the portfolio had allegedly been downgraded. Investors in the liabilities of ABACUS 2007-​AC1 are alleged to have lost over $1 billion. Paulson’s opposite CDS positions yielded a profit of approximately $1 billion. The Commission’s complaint, which was filed in the United States District Court for the Southern District of New York, charges GS&Co and Tourre with violations of Section 17(a) of the Securities Act of 1933, 15 U.S.C. § 77q(a), Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) and Exchange Act Rule 10b-​5, 17 C.F.R. § 240.10b-​5. The Commission seeks injunctive relief, disgorgement of profits, prejudgment interest and civil penalties from both defendants.

5 SEC Litigation Release No. 21489/​Apr. 16, 2010, available at http://​www.sec.gov/​litigation/​litreleases/​2010/​ lr21489.htm.

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On July 15, 2010, the Securities and Exchange Commission announced that Goldman Sachs had settled its case with regards to Abacus for $550 million and agreed to reform its business practices. In agreeing to the SEC’s largest-​ever penalty paid by a Wall Street firm, Goldman also acknowledged that its marketing materials for the subprime product contained incomplete information.6 In settlement papers submitted to the U.S. District Court for the Southern District of New York, Goldman made the following acknowledgment: Goldman acknowledges that the marketing materials for the ABACUS 2007-​ AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was “selected by” ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson’s economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure.7 In August 2013 Fabrice Tourre was found liable in six of seven SEC fraud claims. He faces potential fines and a possible ban from the financial industry. III. Historical Example: Erlanger “Cotton” Bonds Although structured notes and their pricing may seem like twenty-​first century rocket science, they have actually been around for some time. For example, during the Civil War, the Confederate States of America (hereinafter, the “Confederacy” or “South”) to compete effectively with the Union’s well-​financed military needed a creative financial solution to raise money. The southern states, unlike their brethren in the North, lacked an industrial economy. Their only true asset was cotton, and that asset became increasingly difficult to convert into currency because the South refused to sell it to the North, and southern ports were faced with a naval blockade limiting the South’s ability to trade with Europe. To address this difficulty, the Confederacy dispatched James Slidell to France to negotiate a loan with European investors.8 The European investors were extremely wary about investing money in the Confederacy for multiple reasons. First, the South had no track record as a government and therefore no credit history of repaying debt. In fact, their elected

6 U.S. Securities and Exchange Commission Litigation Release No. 21592/​July 15, 2010, available at http://​www. sec.gov/​litigation/​litreleases/​2010/​lr21592.htm. 7 Id. 8 Marc Weidenmier, Comrades in Bonds: The Subsidized Sale of Confederate War Debt to British Leaders 5 (Claremont McKenna College, Feb. 2003), http://​www.stanford.edu/​group/​sshi/​ Conferences/​2002-​2003/​Debt2003/​weidenmier.pdf.

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Figure 20.1  Erlanger (Cotton) Bond.

president “openly advocated the repudiation of state debts while a member of the U.S. Senate.”9 The current Civil War placed an enormous risk of default on the bonds. If the Confederacy were to lose the war, as many expected, there would be little chance the bonds would be honored by the Union. The Confederacy also faced enormous inflation on its currency, creating a large currency risk, as well as an inconsistent revenue stream.10 These risks and uncertainties, as well as others, created a massive credit risk premium to secure financing. Normally this massive risk premium would be prohibitive for (widespread) debt financing, but the South had one extremely valuable asset: cotton. As a result of the war, the price of cotton skyrocketed.

9 Id. at 4. Barto Arnold et al., The Erlanger Cotton Loan, The Denbigh Project, http://​nautarch.tamu.edu/​PROJECTS/​ denbigh/​erlanger.htm (last visited Dec. 3, 2013). 10

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The bankers of the time used cotton to create a structured note that allowed the South to find financing. The bankers created a specifically tailored note for European investors that consisted of a 20-​year security that paid 7 percent interest annually (payable semiannually).11 To eliminate currency exposure, the interest and principal on the note were payable in British sterling or French francs.12 In order to provide value to the bond, and thus reduce the interest rate paid by the South, the note was convertible into cotton on demand for 6 pence per pound. At the time, cotton was selling for 24 pence in Liverpool, England, an amount 400 percent higher than the convertible rate. This was the equivalent of the Confederacy selling a deep “in-​the-​ money” call (derivative) to purchase cotton.13 The risk premium was born by the discounted option premium built into the note. Although the interest rate on the bond appeared to be reasonable for the Confederacy, a deeper look into this structured note will illustrate why the effective obligations of the Confederacy were far greater than a 7 percent yield would suggest. First, the conversion of the note into cotton at six pence per pound represented a deep “in-​the-​money” call option sold by the Confederacy to the European investors. Second, the note contained a sinking-​fund provision, requiring the Confederacy to pay back a portion of the principal on the note. This was a benefit that added value to the investors. Third, the note contained a currency swap feature that transferred all of the currency risk to the Confederacy. Last, the notes were sold at a discount of 90 percent of face value.14 Overall, the effective interest rate the Confederacy was paying to its European note holders was much higher than the 7 percent on the face of the note. The 7 percent, as well as the discounted face value of the notes, represented the netted rate after factoring the above derivatives and features against the default risk (which could not be shifted).15 This debt instrument was specifically tailored through the use of derivatives to enable this structured note to satisfy the goals of both sides. In this example, the market risk of cotton price fluctuation served as a support to the Confederacy’s financial obligations. The credit risk of the South being unable to meet its obligations,

See Weidenmier, supra note 8, at 5. 12 Id. 13 The catch was that the cotton would be delivered in the Confederacy, and thus one would have to run the blockade to retrieve the cotton, or wait until the war was over, when the bond would be redeemable for cotton for six months following the war. However, this assumed a risk that the Confederacy would remain intact, or that the Union would honor the Confederacy’s debts if peace were reached. 14 Arnold et al., supra note 10. 15 The default risk includes political risk. In addition, the Confederacy believed that if enough European investors purchased Confederacy debt, it would cause them to pressure their governments in favor of the Confederacy. This may have affected the price of the bonds as well. 11

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however, was a separate and distinct consideration from the financial implications of the attendant transaction, but was compensated for with a deeply discounted premium paid by investors for the built-​in cotton option. Below is an illustration of this transaction (Figure 20.2):

Erlanger (Cotton) Bond

CONFEDERATE STATES OF AMERICA (CSA)

3,000,000 British Pound notes, bearing 7% annually, payable in sterling or francs, convertable on demand into cotton at 6 pence per pound EUROPEAN INVESTORS 2,160,000 British pounds

Figure 20.2  Erlanger (Cotton) Bond Structure.

IV. Range  Notes Range notes are types of structured bonds that normally pay two separate yields, depending on whether the reference entity (usually a rate index) is within or outside of a certain range. The reference entity is predominately an index linked to interest rates, but it could also be linked to currency exchange rates, commodity values, and equity indexes.16 The purchaser of a range note is often paid a higher-​than-​normal rate of interest if the reference rate remains within the range specified, and is often paid less interest or no interest at all if the reference rate falls or rises outside of the range. It makes no difference whether the rate moves up or down; the only factor is by how much. For example, if the reference entity is LIBOR, the note may pay the investor 8 percent interest as long as the three-​month LIBOR remains between 4 percent and 6 percent, but if it is below 4 percent or above 6 percent then the note might not pay any interest at all. The risk of the transaction varies tremendously depending on how wide the range is, and this is usually incorporated into the value of the difference between the two assigned yields. If the reference range is narrower, there will likely be a greater spread between the two separate yields, and if the range is wide, there will likely be a narrower spread between the two separate yields. Another factor includes how close the present reference rate is to each boundary of the designed range. The two Id. at 2. 16

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Synthesis and Conclusion

451

parties can design the note to accrue interest by assessing the yield at designed times. In practice, parties usually choose to accrue interest daily, quarterly, semiannually, or annually, or even over the entire life span of the note.17 The yield can be assessed based upon the closing price of the index on a specific date, or it can be averaged out over the period. Given the disparity between the two yields received, it is extremely difficult to predict or anticipate the value of such an investment. This leads to a high degree of price risk. In addition, range notes contain the same risks evident in structured notes in general, including primarily interest rate risk, liquidity risk, and reinvestment risk. Range notes have options built into them that allow the investor to benefit so long as an index stays within a certain range. In Proctor & Gamble v. Bankers Trust18 a similar structure was created using a swap; it is described as follows: In late January 1994, P&G and BT negotiated a second swap, known as the “DM swap,” based on the value [**12] of the German Deutschemark. The Confirmation for this swap is dated February 14, 1994. For the first year, BT was to pay P&G a floating interest rate plus 233 basis points. P&G was to pay the same floating rate plus 133 basis points; P&G thus received a 1% premium for the first year, the effective [*1277] dates being January 16, 1994 through January 16, 1995. On January 16, 1995, P&G was to add a spread to its payments to BT if the four-​year DM swap rate ever traded below 4.05% or above 6.01% at any time between January 16, 1994, and January 16, 1995. If the DM swap rate stayed within that band of interest rates, the spread was zero. If the DM swap rate broke that band, the spread would be set on January 16, 1995, using the following formula: Spread = 10 * [4 − year DM swap rate 4.50%]

The leverage factor in this swap was shown in the formula as 10.19 In the Proctor & Gamble swap, so long as the four-​year DM swap rate stayed within a specified range (i.e., between 4.05 percent and 6.01 percent), Proctor & Gamble would receive 1 percent of the notional value of the agreement. If the DM swap traded outside of that range, additional payment would need to be made. This structure is similar to a range note, where payments are contingent on an index remaining in a specified range for payments to continue.

Id. 18 Procter & Gamble Co. v. Bankers Trust Co., 925 F. Supp. 1270, 1276 (S.D. Ohio 1996). 19 Id. at 1276. 17

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Structuring securities can be accomplished by incorporating derivatives structures in which payments are contingent on a specified contingency. By understanding the function and utility of various financial instruments, investors and issuers can access capital using innovative financial solutions to accomplish specific goals. The capital markets play an essential role in the world economy, providing a means for individuals and institutions to access capital, shift risk, and enhance return on their investments. Financial instruments allow market participants to manage risk by shifting unwanted risk to a counterparty who might be more willing or able to manage or capitalize on that risk. It is by understanding the economic needs and the instruments filling those needs that capital market participants, attorneys, and end users might facilitate capital access and risk transference to accomplish fiscal goals. V. Internal Leverage and Market Risk The Abacus CDO incorporated credit risk as a contingency that enhanced its return. Because risk can be packaged in derivative structures, credit risk can be virtually eliminated in a structured note leaving only the market risk. A range note may have a AAA credit and yet retain extreme financial risk. Although credit risk might be low, other risks, such as interest rate risk or liquidity risk, are often unsuspectingly high.20 The danger of the internal leverage contained in structures became apparent in 1991, when low interest rates encouraged the Treasurer of Orange County, California, to seek high-​yielding securities. In a search for yield he purchased structured notes backed by the credit of government-​sponsored entities such as Fannie Mae. These structures offered high yields due to their structure, with little or no credit risk.21 The Treasurer used reverse repurchase transactions (“repos”) to take advantage of the low interest rates and to add extreme leverage to the portfolio. “The repo market allows investors to finance short-​term positions.”22 The Federal Reserve’s Trading and Capital-​Markets Activities Manual describes repos as follows: A repurchase agreement (repo) involves the sale of a security to a counterparty with an agreement to repurchase it at a fixed price on an established future date. At initiation of the transaction, the buyer pays the principal amount to the seller, and the security is transferred to the possession of the buyer. At McCann & Cilia, supra note 1, at 2. 21 Floyd Norris, Market Place; In Orange County, Strategies Sour, N.Y. Times, Dec. 5, 1994, available at http://​ query.nytimes.com/​gst/​fullpage.html?res=9506E3DC1739F936A35751C1A962958260. 22 See Trading and Capital-​Markets Activities Manual § 4215.1, at 2. 20

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expiration of the repo, the principal amount is returned to the initial buyer (or lender) and possession of the security reverts to the initial seller (or borrower). Importantly, the security serves as collateral against the obligation of the borrower and does not actually become the property of the lender. . . . In a repurchase agreement, a bank borrows funds when it “sells” the security and commits to “repurchase” it in the future. In a reverse repurchase agreement, the bank lends funds when it “buys” the security and commits to “resell” it in the future. A reverse repo is sometimes termed a resale agreement or a security purchased under agreement to resell (SPAR). The terms “repo” and “reverse repo” thus describe the same transaction, but from the perspective of each counterparty.23 An examination of the securities purchased by Orange County and how they used repos to fund these transactions illustrates how these complex financial instruments are structured, and highlights the associated risks of these types of instruments. Orange County purchased a structure known as an inverse interest only (IO) floater.24 Under this structure, the yield of the note will vary inversely with changes in the reference rate. The purchaser of an inverse floating note is taking a position that interest rates will remain low or move lower.25 The purchaser of this instrument uses this instrument to speculate on the direction interest rates are heading by earning a higher rate of interest as long as interest rates stay low. Orange County purchased inverse I/​O floaters and was thereby speculating on interest rates remaining low. Orange County leveraged its positions using reverse repo transactions by “selling” the securities on a short-​term basis with a promise to repurchase them and using the proceeds to purchase more securities.26 Leveraging the portfolio in this way greatly increased the stakes for this structured note position and compounded the problem as interest rates increased.27 The inverse IO floater bonds structured for Orange County paid a 7 percent annualized interest rate for the first three months, and then paid a rate of 10 percent minus the three-​month LIBOR rate.28 There was a step-​up feature in the note that kicked in two years later, which raised the formula to 11.25 percent minus LIBOR.29 Although this step-​up appeared to benefit Orange County,

Id. at § 4015.1. 24 See Trading and Capital-​Markets Activities Manual § 4040.1. 25 Id. 26 A reverse repo is a transaction in which a counterparty buys a security and commits to resell it in the future. See Trading and Capital-​Markets Activities Manual §4015.1. 27 See Norris, supra note 21. 28 Id. 29 Id. 23

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Fannie Mae retained a call option that allowed them to repurchase the notes at par value upon step-​up. This way, if Fannie Mae thought it was paying too high a rate, it could buy the notes back. Below is an illustration of this transaction (Figure 20.3): Inverse I/O Floating-Rate Note (5-year note) $100 million; option sold to FM to call loan upon rate reset Orange County (rated AAA)

Fannie Mae (rated AAA) 7.00% annualized interest for first 3 months, then (10% minus 3-month LIBOR), then in 1996, (11.25% minus 3-month LIBOR)

Figure 20.3  Inverse I/​O Floating-​Rate Note (5-​year note).

When Orange County purchased these notes, the three-​month LIBOR and three-​ month treasury notes were both yielding around 3.25 percent.30 As a result, a yield of 7 percent for Orange County was a superior yield at that time, especially considering the notes came from a GSE that had an AAA credit rating. If the formula kicked in immediately, the notes would have yielded 6.75 percent, which still would have been a superior rate. Orange County was funding these purchases by rolling over reverse repo transactions every three to six months, which initially allowed them to borrow at about 3.31 percent.31 Initially, by borrowing at 3.31 percent and receiving 7.00 percent, the county earned a sizeable profit. Although this transaction seemed like a sure thing in the short term, it contained enormous risk. In particular, if rates moved higher, the county would be hit on both sides of the transaction: the yield that it would have to pay to finance the transaction through repo agreements would go up, and, simultaneously, the yield on the inverse IO floater notes it purchased would go down, squeezing the county’s profit at a rapid rate. This is exactly what occurred. Over the course of 1994, three-​month LIBOR went from 3.25 percent on February 1 to 6.5 percent on December 30.32 As a result, in less than a year, the yield on these structured notes went from 7 percent to 3.5 percent, while the borrowing costs on the repo transactions used to finance the

Three-​month historic treasury note rates found at http://​research.stlouisfed.org/​fred2/​data/​TB3MS.txt; LIBOR rates found at “http://​research.stlouisfed.org/​fred2/​release?rid=253 (last visited Dec. 3, 2013). 31 See Norris, supra note 21. 32 See supra note 33. 30

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structured notes skyrocketed to about 6 percent.33 Orange County’s easy profit rapidly deteriorated into massive losses. Because the money used to fund these notes was borrowed and highly leveraged, the county’s losses were magnified, and eventually resulted in the bankruptcy of the AAA-​rated county. VI. Risks Involved The Orange County case highlights the enormous risks inherent in certain structured notes. Although the credit risk in these types of transactions can be almost nonexistent, as it was in this case where the issuers were AAA-​rated government-​ sponsored entities, other types of risk exist. A. Interest Rate Risk

The obvious risk associated with the structured note entered into by Orange County was interest rate risk. The yield in the repo transaction and the yield in the structured note transaction both depended on interest rates remaining low. Any investor entering into a structured note agreement must evaluate the expected results at various changes in interest rates (or changes in their structured note-​specific reference entity). B. Liquidity  Risk

The second risk Orange County faced was liquidity risk. The original note was tailored specifically for the two initial parties: Fannie Mae and Orange County. These specific notes are not prevalent and do not trade on a daily basis. In order to undo this transaction, Orange County would have had to find a buyer or would have had to enter into a mirror image of the same transaction. At the time Orange County would be looking for a buyer, the note would be trading at a below-​market interest rate. Therefore, no rational investor would buy the note unless it was sold for less than its par value, further increasing the county’s losses. If Orange County instead chose to enter into the mirror image transaction, it would face a similar problem in that any rational counterparty would require a reduction in face value to enter the transaction. In addition, the county would face additional transaction costs.

33 Id.

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C. Reinvestment  Risk

A third risk assumed by Orange County in this example was reinvestment risk. The note contained an option for Fannie Mae to repay the loan and end the transaction for par value. Fannie Mae would do this only if the interest rates remained low. If Fannie Mae did end the transaction, Orange County might have had difficulty finding other high-​yielding securities without taking on additional risk, especially in a climate of low interest rates. Considering that Orange County used leveraged and borrowed money to fund these transactions, even a few days between investments could cost the county considerably. Anyone investing in structured notes must be fully aware of all inherent risks involved in these instruments. D. OCC Warning

The more things change, the more they stay the same. Almost 25 years ago, during the low interest period in 1993 and early 1994, various financial institutions and sophisticated market participants (like Orange County) entered into these types of structured note transactions to enhance yield above the prevailing low market interest rates. As rates unexpectedly moved higher in 1994, these market participants lost a considerable amount of money on their assets because they failed to grasp their risk exposure. From the end of 2001 until 2004, prevailing interest rates remained below 2 percent, and even hovered around 1 percent, a historically low level. As rates moved lower, and many market participants refinanced their debts, bank yields rapidly declined. Once again, banks, with little memory of 1994, sought out higher-​ yielding securities, turning to structured note investments. To remind financial institutions about the levels of risk these transactions could entail, the Office of the Comptroller of the Currency (OCC) issued a bulletin on May 22, 2002, to all national bank CEOs and all federal branches and agencies in regard to risky “yield-​chasing” strategies that were once again returning to the markets.34 Although these financial institutions are (generally) run by some of the most sophisticated and educated market players, it was important for these banks to be reminded of the most basic of financial tenets: “there is no ‘free lunch.’ To obtain higher yields, banks must take more credit risk, interest rate risk, liquidity risk, or combinations thereof.”35 The OCC specifically highlighted the risks in structured note products:

34 Unsafe and Unsound Investment Portfolio Practices: Supplemental Guidance (OCC Bulletin, Office of the Comptroller, 2002) OCC CB LEXIS 27. 35 Id. at 3.

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In 1993, many banks acquired large volumes of structured notes, focusing on the excellent credit quality of agency issuers and high yields, but overlooking the complex structures, embedded options and resultant price sensitivity. . . . When interest rates increased sharply in 1994, many of these investment portfolios suffered severe depreciation. . . . Such structures [specifically “long maturities” with “short non-​call periods”] often leave a bank vulnerable to interest rate movements in either direction” [because even if rates fall, then the issuer is likely to exercise their option and call the note].36 Regulators have warned market participants for decades about the risks from complex financial instruments.37 There is convincing evidence that these warnings did little to prevent the economic failures of the period of 2008 to 2009. As the markets evolve after the crisis, the Federal Reserve has been quite clear that its accommodative stance will be measured and monitored in accord with economic data. Unfortunately, as investors seek higher returns they are often drawn to riskier assets. It bears some consideration what the effects of liberal monetary policy and an unclear fiscal track will have on the markets on the 10th anniversary of the financial crisis. The result of the weaknesses inherent in the pre-​crisis global economy led to the undoing of the American capital markets. Credit froze, markets tumbled, and institutions failed. We are in a post-​crisis world; markets are focused on how to undo the steps that were taken to save the imploding economy. The financial crisis led to the creation of new regulation, but also laid the groundwork for revolutionary technologies designed to undermine the historic reliance on a human ability to make a decsions.

Id. at 10. 37 The OCC originally warned banks and purchasers of structured notes on July 14, 1994, when they issued Advisory Letter AL 94-​2. In this letter, the OCC defined six types of common structures and pronounced structured notes to be “inappropriate investments for most national banks.” Other regulators followed suit. On August 5, 1994, the Federal Reserve issued SR letter 94-​45, entitled “Supervisory Policies Relating to Structured Notes.” This letter highlighted valuable uses of structured notes, including the ability to hedge particular risks, but emphasized the “importance of bank management’s ability to . . . understand and manage the risks associated with structured notes.” The Office of Thrift Supervision (OTS) also weighed in by issuing Thrift Bulletin 65 on August 16, 1994. The OTS emphasized the importance of modeling different interest rate scenarios to determine what would result if interest rates moved quickly one way or the other. Last, the Federal Deposit Insurance Corporation (FDIC) enhanced their supervision and regulatory approach to structured notes. As the insurer of $100,000 per account in each FDIC insured bank, the FDIC had a tremendous amount at stake in ensuring that banks employ appropriate risk management. In late 1994, the FDIC instituted a policy requiring examiners of state-​chartered banks that are not members of the Federal Reserve System to classify as “substandard” “structured notes that could experience loss of principal.” All “mark-​to-​market” losses must be classified as a “loss” by the examiners. See McCann & Cilia, supra note 1. 36

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Unfortunately, even with history as a guide and computers as a resource, humans are still capable of creating macroeconomic imbalances, mistakes and misfits. No legislation or regulatory authority can replace ethics, prudence and thoughtful analysis in reacting to the latest opportunities and events -​even where decision is recreated as the latest technologies. With the backdrop of fortified markets and economies, America is experiencing a period of growth. Many of the crisis era regulations seem less necessary now that America is by many accounts economically “great again.” Unfortunately the lessons of the past often do not necessarily prevent pain in the future. Our behavior needs to reflect that a lesson has been learned. In his 1987 novel, Bluebeard, Kurt Vonnegut warned, “we’re doomed to repeat the past no matter what. That’s what it is to be alive.” It may be best for the evolution of the capital markets to shun Vonnegut and follow the advice of Jiminy Cricket: “Let conscience be your guide.”38

38 See generally Jiminy Cricket, from the movie Pinocchio (Walt Disney 1940).

459

Index Page numbers followed by f indicate figures; page numbers followed by t indicate tables. AAA credit rating, 16, 23–​24, 143, 144, 452 ABACUS 2007-​AC1 (synthetic CDO), 445–​47,  452 abusive acts and practices. See unfair, deceptive, or abusive acts or practices accounting principles (GAAP), 8, 156, 416–​17 “actual future delivery,” 378–​79 ADM Investor Services, Inc., Nagel v., 379, 391 Advisers Act. See Investment Advisers Act of 1940 AFP. See Aon Financial Products, Inc. v. Société Générale AIG (American International Group), xxvii, 4, 5, 18 Bernanke on, 18–​19 CDS obligations of, 204 compensation practices at, 412–​13 credit-​default swaps (CDSs) and, 217–​18,  269–​70 credit derivatives and, 160–​61, 174 liquidity crisis and federal bailout, xxvii, 4, 18–​19, 160–​61, 174, 175, 204, 217,  269–​70 Alex. Brown & Sons, Banca Cremi v., 344–​45,  435 Amaranth Advisors LLC, CFTC v., 388–​89, 390

American Greetings Corporation. See Gibson Greeting Cards v. Bankers Trust American International Group. See AIG American Recovery and Reinvestment Act (ARRA),  21–​23 antifraud provisions. See under fraud Aon Financial Products, Inc. v. Société Générale,  209–​14 arbitration, 333 Arbitration Agreement Rules, 71 ARS. See auction rate securities Ashanti Goldfields Securities Litigation, In re,  43–​44 asset-​backed securities,  141–​42 asset pricing, 119 asset sales, 14–​15 asset valuation, 91, 367 interest rate yield curve and, 112–​19 long-​term yield affected by monetary policy,  118–​19 use of interest rates in, 111–​12 valuation formula, 111–​13 attorneys evolving role of, 61–​63 potential liability to securities violations,  314–​15 auction process, manipulation of, 130–​32

Capital Markets, Derivatives, and the Law. Alan N. Rechtschaffen. © Alan N. Rechtschaffen 2019. Published 2019 by Oxford University Press.

460

460

Index

auction rate securities (ARS), 50–​51 auction system, T-​bill offered to public via, 125 auctions,  50–​51 Term Auction Facility (TAF), 16, 97–​98 Back Office (operating group), 410 bailout, 8, 9 balance of trade, 89 balance sheet normalization, 104–​5 Banca Cremi, S.A. v. Alex. Brown & Sons, Inc., 344–​45,  435 Bank for International Settlements (BIS), 172, 398 bank holding companies (BHCs), 26, 30–​32, 33, 35 Bankers Trust, Gibson Greeting Cards v.,  432–​34 Bankers Trust Co., Procter & Gamble Co. v., 435 banking system, 52. See also commercial banks; Federal Reserve Dodd-​Frank Act and, 321 and financial crisis, 5–​6, 14–​15, 19–​21, 26–​27 securities regulation and, 296–​97 stress testing to determine viability of institutions (see stress testing) “too big to fail,” 26–​29, 276–​77 traditional banking activities vs. riskier “investing,” 321 banks commercial, 18, 26–​27, 85, 93, 94, 99, 244, 294,  432–​33 investment, 14–​15, 27, 48–​49, 134, 145–​46,  432–​33 basic ownership approach (discerning equity from debt), 57 basis risk, 164, 202 Bear Stearns International Limited (BSIL), 209–​10,  436 Aon Financial Products (AFP) and, 210 (see also Aon Financial Products, Inc. v. Société Générale) Bernanke on, 14, 16–​17 De Kwiatkowski v. Bear, Stearns & Co., Inc., 333,  435–​36 derivatives and, 158–​59, 160–​61 Escobel Land and, 209 Fed bailout and sale to JPMorgan Chase, 14, 15, 16–​17,  158–​59 financial crisis and, 14, 16–​17 Government Service Insurance System (GSIS) and,  209–​13

private-​label mortgage-​backed securities created by, 14 Bernanke, Ben S. on AIG, 18–​19 on Bear Stearns, 14, 16–​17 on derivatives, 250–​51 on erosion of term premium on monetary policy,  118–​19 on federal funds rate and policy stimulus, 113 on Federal Reserve, 14, 15–​17, 18, 19, 93–​94, 102, 122, 404 Federal Reserve and, 102, 113, 117, 118–​19, 122, 250–​51, 316,  403–​4 on financial crisis of 2007–​2008, xxvii, 3–​4, 5, 14–​17, 18,  250–​51 on hedge funds, 316–​17 on interest rates, 122 on labor market, 22 on Lehman Brothers, 18–​19 on liquidity, 14–​17 on moral hazard, 17 on open market operations, 93–​94 on regulation, 161, 316 speeches, xxviii, 3, 14–​17, 22, 117, 118–​19, 122, 161, 316, 403–​4 on TARP, 20–​21 on Term Auction Facility (TAF);, 16 on yield curves, 117 Bessemer Trust, Levy v. See Levy v. Bessemer Trust bilateral netting, 268 bitcoin, xxix in circulation, 193–​95 deliverable supply of, 196–​97 how bitcoin are created and released, 193 volatility, 185–​86, 188 Bitcoin Final Settlement Price, 192 Bitcoin Futures Contract (“Bitcoin Futures”/​ ”Contract”), 177 block trading, 179 CME Bitcoin Futures application, 176–189 compliance with core principles, 186–​89 contract specifications, 178, 179 customer feedback, 184 delivery and delivery methods, 178 exchange fees, 180 index administration, governance, and methodology,  182–​84

461

Index price basis and minimum price increments, 179 price limits, 179 settlement procedures, 192, 198 trading specifications, 190–​92 unit of trade, 178 Bitcoin Futures position holders, 192 Bitcoin Futures products, contract unit of trade of, 178 Bitcoin Reference Rate (BRR), 178, 179, 182, 183, 190, 198 calculation, 182, 183 changes on non-​trading days, 191 constituent changes, 182, 183 daily price movements, 184, 185 influencing/​manipulation,  187 oversight committee governing, 182 publishing/​publication of, 178, 182, 184, 192 volatility and, 184, 185 bitcoin transactions, 195–​96 Black–​Scholes model and option pricing, 238 assumptions, 238 authority,  241–​42 required data, 238–​39 volatility and, 239–​41 blue sky laws, state, 439–​40 Blueprint for a Modernized Financial Regulatory Structure (Treasury’s Blueprint),  374–​75 Board of Governors of the Federal Reserve System. See Federal Reserve Board bond auctions interruption of supply, 129–​30 price and, 128–​29 bond-​rating agencies,  142–​46 conflicts of Interest, 144–​46 role in mortgage-​backed securities meltdown, 142 bonds, 126. See also debt-​based financial instruments; debt instruments/​debt securities; STRIPS description,  140–​42 features,  140–​41 par value, 126 price–​yield relationship, 128 tax exempt status, 314–​15 trading under face value, 128 types of, 141–​42 Argentinean bonds, 207 illiquid bonds, 208

461

long-​term bonds,  140–​41 mortgage-​backed bonds, 3, 150, 444 (see also mortgage-​backed securities) 30-​year bonds, 126, 129–​30 valuation,  142–​43 yield to maturity in, 126, 132–​33 Brane v. Roth, 61, 406–407 breach of contract, 237 breach of duty to supervise, 237 breach of fiduciary duty, 237, 333, 433, 435–​38,  439–​40 broad-​based securities indexes, 378 broker, defined, 327 broker-​dealers, 124, 129, 137, 153, 317–​18 duty of care chart of, 358 Venn diagram of, 356 FINRA and, 334–​35 litigation issues, 424–​26 NASD and, 335 SEC enforcement actions against, 328 suitability duty, 326–​28, 332–​33 (see also suitability) Brooks, George E., 330 BSIL. See Bear Stearns International Limited Bureau of Consumer Financial Protection (BCFP). See Consumer Financial Protection Bureau (CFPB)/​Bureau of Consumer Financial Protection (BCFP) burned bitcoin, 195 Bush, George W., 18, 19–​20 business inventories report, 90 business judgment rule, 415 Caiola v. Citibank, N.A., 242–​43, 429 call options, 141, 170–​72, 234–​35, 443–​44. See also options covered call, 248 defined, 141 synthetic call, 248 Calvary Currencies, United States CFTC v., 348 capacity utilization report, 91 Capital Gains Research Bureau, Inc., SEC v., 329 capital markets, 48–​51. See also specific topics confidence and positivity regarding, xxv long-​term vs. short-​term, 50 primary vs. secondary, 49–​50 propositions of reforms from Treasury report on,  284–​85

462

462

Index

capital requirements depository institutions, 25–​26 under Dodd-​Frank,  259–​60 carry costs, 163 CBOT (Chicago Board of Trade), 168 CCP (central counterparty), 219–​20, 255 CDOs. See collateralized debt obligations CDSs. See credit-​default swaps CEA. See Commodity Exchange Act of 1936 central clearing model, 221–​22 central counterparty (CCP), 219–​20, 255 CFMA. See Commodity Futures Modernization Act CFTC (Commodity Futures Trading Commission), 368. See also specific topics action for failure to submit accurate large-​ trader commodity swap reports, 266 and capital and margin requirements, 259–​60 CFMA and, 59, 246, 256, 321, 368, 372, 373, 374, 382 change of CFTC chairman, 279–​80 and achieving cross-​border harmonization, 281 and CFTC’s new priorities, 280 and fixing data reporting, 280–​81 and improving SEF rules, 280 project KISS, 279–​80, 281–​82 propositions of reforms from Treasury report on capital markets, 284–​85 and recent actions of CFTC and announcements of future actions,  282–​84 Clearing and Intermediary Oversight Division, 369 Commodity Exchange Act (CEA) and, 215–​16, 262–​63, 351, 368, 372–​73, 375, 378–​79, 380–​81, 383, 384, 385–​86, 389, 390, 394, 430–​31 commodity position limits and, 283–​84 disciplinary actions, 350–​51, 370–​71 disclosure rules, 345–​351, 369 Division of Enforcement, 370 Division of Market Oversight, 369–​70 enforcement actions on data reporting violations, 265 Final Rules, 247, 346–​48, 430–​31 increased enforcement actions following change of chairman, 267

jurisdictional issues and, 373, 378–​79, 382–​83, 384–​88,  394–​95 Office of the Chief Economist, 370 role of, 369 rules of, 372, 388 Regulation 1.25, 223–​24, 226, 262–​63 structure of, 369–​70, 393 Division of Enforcement, 263, 267, 327, 370 Division of Market Oversight, 369–​70 Division of Swap Dealer and Intermediary Oversight (DSIO)., 350–​51, 369 swap agreements and, 321–​22, 381–​83 Title VII enforcement and, 263–​66 (see also Dodd-​Frank Act: Title VII) updated enforcement advisory on self-​ reporting and full cooperation, 263–​64 CFTC Reauthorization Act of 2008 (CRA), 368, 385–​87, 391 CFTC v. Amaranth Advisors LLC, 388–​89, 390 CFTC v. Co Petro Marketing Group, Inc.,  378–​79 CFTC v. Intertrade Forex Inc., 380 CFTC v. National Investment Consultants,  380–​81 CFTC v. Patrick McDonnell,  394–​95 CFTC v. Standard Forex,  384–​85 CFTC v. Zelener,  391–​92 Chicago Board of Trade (CBOT), 168 Chicago Mercantile Exchange (CME), 176–​78 CME Rulebook, 178, 186–​87, 188–​89, 197 Market Regulation Department, 186–​87, 188, 190 self-​certification for initial listing of Bitcoin Futures Contract, 176–189 churning, 429, 430 Citibank, Caiola v., 242–​43, 429 Citibank, N.A. and Citigroup Global Markets Limited, In the Matter of, 265 Civil Penalty Fund, 70 Clearing and Intermediary Oversight Division (CFTC), 369 clearing obligations and OTC derivatives, 175, 215–​16, 251, 254–​55, 271 clearing requirements, 269–​70, 273 Dodd-​Frank Act and, 254–​59 clearinghouse stress testing, improvement of,  283–​84 CMOs (collateralized mortgage obligations), 151, 152, 344–​45 Co Petro Marketing Group, Inc., CFTC v.,  378–​79

463

Index codes of conduct of enterprises and employees,  413–​14 collars, 248, 444–​45. See also European Collar Option collateralized debt obligations (CDOs), 174–​75, 214–​ 15, 445–​46, 447, 452. See also mortgage-​ backed securities credit-​default swaps (CDSs) and, 214–​15 synthetic (see ABACUS 2007-​AC1) collateralized mortgage obligations (CMOs), 151, 152, 344–​45 commercial banks, 18, 26–​27, 85, 93, 94, 99, 244, 294,  432–​33 commercial paper, 14–​15, 52, 82–​83, 98, 153,  262–​63 Committee on Payments and Market Infrastructures (CPMI), 279 commodities-​based derivatives, 163, 167–​68 commodity, defined, 372 Commodity Exchange Act of 1936 (CEA/​ Commodity Act), 345–​46, 348, 368, 371–​72. See also Grain Futures Act of 1921 amendments to, 371–​72, 374, 381 antifraud provision, 351, 430–​31 CFMA and, 215–​16, 220, 252, 371–​72, 374, 383 CFTC and, 215–​16, 262–​63, 351, 368, 372–​73, 375, 378–​79, 380–​81, 383, 384, 385–​86, 389, 390, 394, 430–​31 Dodd-​Frank Act and, 58–​59, 247, 252, 258–​59,  430–​31 exclusions, exemptions, and, 374–​75 foreign exchange transactions and, 384 futures, forwards, and, 375, 378–​79, 380–​81 hybrid instruments and, 383 liability under, 430–​31 over-​the-​counter (OTC) derivatives and, 215–​16,  252 as providing de minimis exemption from CTA registration, 320 Section 4b (antifraud provision), 351, 354–​55, 371, 384, 430–​31 Section 6(c)(1), 430–​31 Section 9(a)(4), 390 swap agreements and, 381, 383 terminology in, 169, 232, 247, 252, 372, 391 XBOTs and, 373–​74 Commodity Exchange Commission, 371 commodity futures markets. See futures contracts

463

Commodity Futures Modernization Act (CFMA), 373–​74, 376–​77, 381 CFTC and, 59, 246, 256, 321, 368, 372, 373, 374, 382 Commodity Exchange Act (CEA) and, 215–​16, 220, 252, 371–​72, 374, 383 Dodd-​Frank Act and, 252, 374 Exchange Act and, 218 foreign currency trades and, 384 goals/​purposes, 321, 372 hybrid instruments and, 383 jurisdictional disputes and, 252, 382 jurisdictional issues and, 373–​74 over-​the-​counter (OTC) derivatives and, 215–​16, 220, 252, 321, 381 ramifications, 215–​16, 246, 371–​72 SEC and, 59, 321, 373 Shad–​Johnson Accord and, 373, 376–​77 swap agreements and, 218, 321 Commodity Futures Trading Commission. See CFTC Commodity Futures Trading Commission Act. See Treasury Amendment commodity options, 246–​47, 320 Commodity Pool Operators (CPOs), 320, 350, 369 commodity position limits, 283–​84 CFTC review of, 283 commodity trading advisers (CTAs), 320, 350, 369 common law fraud, 427, 438 common law theories of recovery, 432–​39. See also breach of fiduciary duty; Levy v. Bessemer Trust: theories of liability in common stock, 51–​52 vs. corporate bonds, 303–​4 compensation practices, ethics in, 412–​14 Compliance Group (operating group), 410 Comprehensive Capital Analysis and Review (CCAR), 33–​35, 403–​4, 408 Comptroller of the Currency. See Office of the Comptroller of the Currency concentration limits, 24, 33, 45 conflicts of interest, 8–​9, 262–​63 Advisers Act and, 328, 329 of bond-​rating agencies, 144–​46 broker-​dealers’ recommendations (see suitability) of hedge funds, 319

46

464

Index

conflicts of interest (Cont.) for NRSRO, pay-​pricing model and, 144–​45 Constitution, U.S., 83, 371 Constitution of California, 148 Consumer Confidence Index, 90 Consumer Financial Civil Penalty Fund, 70 Consumer Financial Protection Act of 2010 (CFPA), 65–​66, 70, 75–​76 Consumer Financial Protection Bureau (CFPB)/​Bureau of Consumer Financial Protection (BCFP), 77, 341–​42 authority enforcement, 70 judicial review of BCFP’s power, 71–​73 regulatory,  68–​69 supervisory, 69 CFPA and, 65–​66, 70, 75–​76 changes in financial consumer protection by,  70–​73 creation of, 65–​66, 339 Dodd-​Frank Act and, 58–​59, 65–​66, 68,  339–​40 final rules, 70–​71 judicial BCFP structures under Trump’s administration constitutionality of the BCFP, 77 single directorship, 77–​78 Mick Mulvaney and, 73–​77 name change, 74, 340–​41 ongoing enforcement action status, 78–​79 overview, 65–​66,  339–​40 proposed reforms limiting the powers of,  74–​75 purpose, objectives, and functions, 59–​60, 65–​66, 68–​70,  339 single directorship, 77–​78 strategic plan, 75–​77 structure,  66–​67 under Trump’s administration, 73–​77 Wells Fargo account fraud scandal and,  78–​79 Consumer Price Index (CPI), 89–​90, 132–​33 consumer protection. See Dodd-​Frank Act consumer spending, 4–​5, 22, 119 interest rates and, 84–​91, 367 University of Michigan’s Consumer Survey, 91 ContiCommodity Services, Inc., Phacelli v., 351 contract law, 439 contract theory, 439

control by investor, as determination of investment contract status, 304–​6 Cordray, Richard, 71, 72, 73–​74 corporate bond rates, 113 corporate bonds, 53, 100–​1, 113, 141, 144–​45 vs. common stock, 303–​4 corporate debt securities, 152–​53, 155 Security Act requirements, 155 Trust Indenture Act requirements, 155–​56 Corzine, John, 223, 224 “cotton” bonds, 447–​50 counterparties OTC derivatives and, 46, 222–​23, 226–​27, 251, 267, 270, 276, 277, 370–​71 shifting of risk to (see shifting risk) counterparty credit risk, 158–​61, 165, 267–​70 counterparty risk. See also counterparties; counterparty credit risk swaps and, 267–​71 coupon bonds, 134–​36. See also STRIPS reassembly of STRIPS into, 134 coupon rate, 140–​41 covered call, 248 “covered persons” (Dodd-​Frank Act), 340–​41 covered swap agreements, 383 CPI (Consumer Price Index), 89–​90, 132–​33 CPOs (commodity pool operators), 320, 350, 369 Credit Agency Reform Act of 2006, 144, 146 credit crisis, 151, 161 low interest rates and, 4, 6, 452, 455–​57 credit-​default swaps (CDSs), 174, 203–​4 AIG and, 217–​18, 269–​70 CDS agreements, 205, 206–​7, 208, 210–​13,  215–​16 CDS spreads, 218, 256–​57 CFTC and, 256–​57 collateralized debt obligations (CDOs) and, 214–​15 (see also collateralized debt obligations) defined, 204 importance of clearly defined terms in,  207–​14 ISDA Master Agreement and, 206 and the move toward regulatory reform,  220–​29 OTC derivatives, the financial crisis, and,  215–​20 purpose and function, 204–​5

465

Index SEC and, 256 credit derivatives, 174–​75 AIG and, 160–​61, 174 defined, 174 as off-​balance sheet arrangements, 174, 204 credit event, 207–​9 credit exposure, 33 credit exposure reports, 32 credit markets, 4, 7, 21, 52–​53, 98, 99, 217–​18, 270, 271 credit rating agencies, 142, 144, 146 credit risk, 5, 14–​15, 33, 445–​46, 447–​49. See also credit-​default swaps; risk counterparty,  158–​61 debt securities and, 149 derivatives and, 165, 174 financial instruments and, 46 internal leverage and, 452–​55 nature of, 407 options and, 245–​46 suitability and, 370–​71 swaps and, 172, 262–​63, 269, 276–​77 Treasury securities, 122–​23 Crypto Facilities, 182, 183 cryptocurrencies, 40–​41, 57–​58, 61. See also bitcoin definition and nature of, 54 ways to obtain, 54 CTAs (commodity trading advisers), 320, 350, 369 currency swap agreements, 202–​3 currency swaps, 202–​3 defined,  202–​3 leverage, 253 currency transactions. See also Office of the Comptroller of the Currency OTC foreign, 384–​86 spot market virtual, 394–​95 curve risk, 402 customization exceptions under Dodd-​Frank, 273–​74,  277–​78 daily exception report, 411 items to include in, 411–​12 DAO (decentralized autonomous organization), 303 data reporting violations, CFTC enforcement actions on, 265 Davis et al., SEC v.,  129–​30 DCM,  257–​58

465

de Kwiatkowski, Henryk, 333, 436 De Kwiatkowski v. Bear, Stearns & Co., Inc., 333,  435–​36 de minimis exception(s) under Dodd-​Frank,  277–​78 to swap dealer determination, 59, 253, 277–​78 de minimis threshold, swap dealers’, 283 dealer. See also broker-​dealers defined, 327 debentures, 142 debt and equity, distinction between, 54–​57 debt-​based financial instruments, 52–​53 debt instruments/​debt securities. See also bonds; corporate debt securities; mortgage-​ backed securities Securities Act registration, 152–​56 special types of, 146–​52 decentralized autonomous organization (DAO), 303 deceptive acts and practices. See unfair, deceptive, or abusive acts or practices deliverable supply analysis (bitcoin), 193–​97 delivery risk, 402, 408 delta (volatility measure), 240, 241 delta hedging, 241, 242–​43 Department of Housing and Urban Development, U.S., 6–​7 Department of Labor (DOL), U.S., 90, 342 depository institutions’ capital requirements, as critical facet of Dodd-​Frank, 25–​26 deregulation, Donald Trump and, xxix, 1–​2 derivatives, xxvii, 38–​39, 53–​54. See also over-​ the-​counter (OTC) derivatives; specific topics defined, 158 description, 158 misuse of, 39, 45 and near-​collapse of financial markets,  250–​51 types of, 38, 53, 158, 165–​75 derivatives market, xxvii. See also specific topics derivatives transaction execution facilities (DTEFs),  373–​74 designated self-​regulatory organization (DSRO), 224–​25, 227,  228–​29 DFAST. See Dodd-​Frank Act stress tests digital assets, 53. See also cryptocurrencies Dimon, Jamie, 421 directors. See executive officers and directors

46

466

Index

disciplinary actions CFTC, 350–​51,  370–​71 CME Rulebook and, 188 FINRA and, 337 disclosure rules, 154–​55, 369 disclosure(s). See also Management’s Discussion and Analysis Commodity Exchange Act (CEA) and, 431 Commodity Futures Trading Commission (CFTC) and, 431 risk disclosure statements, 349–​50, 431 under Sarbanes–​Oxley Act, 416–​18 discount rate, 100–​1, 111–​13 discount to face value structured notes sold at, 449–​50 Treasury bills issued at, 125–​26 Treasury notes trading at, 126–​27 Treasury STRIPS trading at, 134, 135 discount window, 16–​17, 27, 85–​86, 92–​93, 97–​98,  274 disgorgement, 72, 313, 327, 388–​89, 446 distributed ledger technology (DLT), 53 distributed ledgers, 53 Dodd-​Frank Act (Dodd-​Frank Wall Street Reform and Consumer Protection Act),  23–​24 CFMA and, 252, 374 Commodity Exchange Act (CEA) and, 58–​59, 247, 252, 258–​59, 430–​31 Consumer Financial Protection Bureau (CFPB) and, 61, 65–​66, 68, 339–​40 counterparty risk and, 267–​70 customization exceptions and, 273–​74 depository institutions’ capital requirements as critical facet of, 25–​26 derivatives regulation after, 321–​22 Federal Reserve Board (FRB) and, 31–​32, 33–​34,  35 futures commission merchants (FCMs) and, 275 leverage and, 24, 25–​26, 33–​34 Lincoln Rule, 274 OTC derivatives and, 173, 175, 220, 251, 252, 267, 270–​71, 277 physical settlement exclusion, 273 purpose and objectives, xxv SEC after, 321–​22 SEC powers under, 321 Section 165, 33–​34

swap agreements and, 321–​22 systemic risk and, 276–​77 Title VII, 175, 220, 263, 282, 321, 322, 346, 368 transparency and, 24, 275, 277–​78 Dodd-​Frank Act stress tests (DFAST), 33–​35 problems with, 34 Dodd-​Frank regulatory regime. See also Dodd-​ Frank Act; Dodd-​Frank’s derivatives trading provisions capital and margin requirements, 259–​60 clearing requirements, exchange requirements, and end-​user exemption, 254–​59 derivatives trading and, 250–​52 futures commission merchants (FCMs) and,  262–​71 jurisdiction and registration, 252–​54 rationale behind exemptions and exclusions,  271–​75 reporting requirements, 260–​61 swaps and, 250–​85 Dodd-​Frank’s derivatives trading provisions, criticisms of change of CFTC chairman, 263, 279–​82 concentration of systemic risk in clearinghouse and “too big to fail,”  276–​77 exceptions swallowing the rule: incentivizing of customization and de minimis exceptions,  277–​78 impact of the change of U.S. administration, 279 lack of global harmonization, 278–​79 drafting financial instruments, 62 DSROs (designated self-​regulatory organizations), 224–​25, 227, 228–​29 dynamic hedge. See delta hedging economic crisis. See financial crisis of 2007–​2008 Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCPA),  28–​29 economic indicators interest rates and, 86–​96 key economic statistics, 86–​91 education (at financial institutions) in operational risk management, 416 EMEA Determinations Committee, 206, 209

467

Index Emergency Economic Stabilization Act (EESA),  19–​21 Employee Retirement Income Security Act (ERISA), 342 scope and applicability, 343 employment. See jobless claims end-​user exemptions to Dodd-​Frank regulations, 254–​59,  260–​61 Enforcement Department v. Newport Coast, Douglas A. Leone and Andre V. Labarbera, 337 equities,  51–​52 bonds and, 140 equity and debt, distinction between, 54–​57 equity swaps, 172, 201 Erlanger “cotton” bonds, 447–​50 Ernst & Young, Reves v. See Reves test Escobel Land, Inc., 209, 210–​12 Europe, the Middle East, and Africa Credit Derivatives Determinations Committee (EMEA DC), 206, 209 European Collar Option, 236, 237 European vs. American options, 233 Exchange Act. See Securities Exchange Act of 1934 exchange fees for Bitcoin Futures, 180 exchange requirements under Dodd-​Frank,  254–​59 excluded commodities, 374, 381 executive officers and directors responsibility for risk management, 415 steps for protection from operational risks,  414–​18 understanding of financial instruments,  406–​7 Executive Order 13772, 2–​3, 28 Executive Order 13789, 2 exempt board of trades (XBOT), 373–​74 exempted commodities, 374–​75, 381 exempted transactions and swaps, 254–​59,  271–​74 expiration date (options), 232 Fabrice Tourre. See SEC v. Goldman, Sachs & Co. & Fabrice Tourre Fadem v. Ford Motor Co., 43 fair-​dealing duty, 326–​27, 335, 346, 347–​48, 425 Fannie Mae (FNMA), xxviii–xxix, 6–​10, 141, 151, 153–​54, 217–​18, 453–​54,  455

467

FDIC. See Federal Deposit Insurance Corporation federal agency bonds, 141 Federal Deposit Insurance Corporation (FDIC), 21, 27, 32, 33, 52–​53, 223–​24, 262–​63, 274, 296–​97,  307–​8 federal funds rate, 16, 92, 99, 112–​13 Federal Reserve and, 16, 17, 18, 20, 92, 93, 96–​97, 99, 111, 116–​17, 122, 127 FOMC and, 93, 96–​97, 101, 103–​4 LIBOR and, 164 and policy stimulus, 113 federal funds target rate, 16–18, 20, 103–​4, 109, 111, 122, 127 Federal Home Loan Mortgage Corporation (FHLMC). See Freddie Mac Federal Housing Finance Agency (FHFA), 7, 8–​9,  11–​12 Federal Mortgage Insurance Corporation (FMIC),  10–​11 Federal National Mortgage Association (FNMA). See Fannie Mae Federal Open Market Committee (FOMC),  4–​5 balance sheet normalization program, 104–​5 federal funds rate and, 93, 96–​97, 101, 103–​4 Federal Reserve Bank of New York (FRBNY) and, 124 labor market and, 4–​5, 96, 101–​4, 108, 109 minutes of meetings, 107–​9 monetary policy and, 84, 93, 94, 96, 100, 101, 124 overview, 84 purpose and goals, 82, 84, 93 federal regulation. See also specific topics of commodities, 371 of financial instruments, 57​ of futures trading, 370–​71 Federal Reserve, 82–​83. See also under Bear Stearns International Limited; federal funds rate activities, 86 balance sheet, 97 banking system, 83–​86 Bernanke and, 102, 113, 117, 118–​19, 122, 250–​51, 316,  403–​4 Bernanke on, 14, 15–​17, 18, 19, 93–​94, 102, 122, 404

468

468

Index

Federal Reserve (Cont.) borrowing from, 92–​93 communication strategy, 95 communication with public, 95 composition, 84 courses of action, 86 duties,  82–​83 economic calendar, 86 economic indicators and, 86–​96 emergency lending authority, 16–​17 federal funds rate and, 16, 17, 18, 20, 92, 93, 96–​97, 99, 111, 116–​17, 122, 127 FOMC (Federal Open Market Committee) minutes,  107–​9 government securities held by, 98 inflation targeting process, 95–​96 liquidity crisis and, 15–​18 long-​term yield affected by, 118–​19 monetary policy of, 92–​94, 96–​97 short-​term,  118 nature of, 82 open-​market operations of, 94 preventing systemic failure, 37–​38 primary dealers and, 124–​25 providing liquidity and stabilizing the financial markets, 18–​19, 97–​98 purpose,  84–​85 quantitative easing and, 18, 97–​107 responsibilities,  84–​86 Term Auction Facility, 16, 97–​98 tools available to, 97 Federal Reserve Act, 82–​83 Federal Reserve Bank, 52 Federal Reserve Bank of New York (FRBNY), 84, 94, 124, 130, 202–​3 Federal Reserve banks, 82–​83, 84, 92, 93 Federal Reserve Board (FRB), 25–​26, 30, 131, 134, 137, 219, 274, 316, 322 Comprehensive Capital Analysis and Review (CCAR) and, 33–​35 Dodd-​Frank Act and, 31–​32, 33–​34, 35 systemically significant nonbanks and, 30,  31–​32 Federal Reserve discount window. See discount window Federal Reserve System. See Federal Reserve federal securities laws, 424–​31. See also specific topics

Federal Stability Oversight Council (FSOC), 29–​31 fiduciary, defined, 343 fiduciary duty. See breach of fiduciary duty; risk management broker-​dealers’ recommendations to clients (see suitability) Fin Hay Realty v. United States,  55–​56 Financial Accounting Standards Board (FASB), 43, 57 financial advisers. See commodity trading advisers; investment advisers financial crisis of 2007–​2008, 1–​12, 35, 174. See also Great Recession banking system and, 5–​6, 14–​15, 19–​21, 26–​27 Bernanke on, xxviii–xxix, 3–​4, 5, 14–​17, 18,  250–​51 Dodd-​Frank Act and, xxv–​xxvi interest rates, monetary policy, and, 96–​97 leverage and, 41 origins, 3–​4, 5, 18, 23–​24, 151 OTC derivatives and, 215–​20 post-​crisis hedge fund regulation, 319 recovery, xxv, 21–​23, 102, 109, 119 regulatory reaction at height of crisis, 19–​23 financial engineering, 45 Financial Industry Regulatory Authority. See FINRA financial innovation, 6, 408–​9 financial instruments. See also specific topics defined, 51 directors’ and officers’ understanding of, 61–62 drafting, 62 economy’s impact on, 40–​41 managing risk, 45–​46 purposes/​objectives of, 38, 43–​45 accessing capital from investors, 37–​38, 48, 50 enhancing yield, 38, 39–​40 hedging, 38, 39, 49, 61–62 (see also hedging) making money, 158 managing risk, 48 regulation, 57​ types of, 51–​54 complex products, xxvii short-​vs. long-​term, 50 valuation,  40–​41 financial market regulators, xxvii–​xxx, 3–​4 , 30

469

Index financial markets. See also specific topics stability of, 30–​31 Financial Research, Office of, 31 financial risk, 401–​2, 407, 452. See also market risk; risk defined, 407 quantifying,  402–​5 financial stimulus, 84 FINRA (Financial Industry Regulatory Authority), 331. See also National Association of Securities Dealers broker-​dealers and,  334–​35 creation,  334–​35 described,  334–​35 Enforcement Department, 337 Member Regulation Department (Risk Oversight and Operational Regulation and Sales Practice), 336 Office of Hearing Officers, 337 rules proposed by, 335–​36 control and enforceability, 337 Rule 2090 (Know-​Your-​Customer), 335–​36,  338 Rule 2111 (Suitability), 336, 338, 352 Rule 2360 (Options-​-​Suitability),  352–​53 scope and applicability, 336 FINRA Manual (Rule Manual),  335–​37 fixed-​income securities, 122–​23, 132, 144, 151 regulatory framework, 152–​53 types of, 141–​42 fixed-​rate-​financing,  202 fixed-​rate vs. floating-​rate securities, 132, 199–​202 “Flash Crash,” 48 flat yield curve, 114–​17 floating interest rate, 202, 451 floating rate, inverse, 147. See also “inverse floater” CMOs; inverse IO (interest only) floaters floating-​rate loans, 164, 200, 202 floating-​rate notes/​floating-​rate bonds, 132, 147, 200–​1, 209. See also inverse IO (interest only) floaters; LIBOR floating-​rate vs. fixed-​rate securities, 132, 199–​202 FOMC. See Federal Open Market Committee forecast volatility, 239 foreign currency swap, 203 foreign currency transactions, OTC, 384–​86 foreign exchange (FX) contracts, 384, 391

469

foreign exchange (FX) forward agreements,  169–​70 foreign exchange (FX) futures, 169–​70 foreign exchange (FX) instruments, 384 foreign exchange (FX) products, 384–​88 foreign exchange (FX) swap, 202–​3 forward contracts (forwards), 91, 165–​66 defined, 165 foreign exchange, 169–​70 vs. futures, 168–​69, 378–​81, 384–​85, 391 primary purpose, 166 typical, 166 fraud, 237. See also scienter antifraud provisions of CEA, 351, 354–​55, 371, 384,  430–​31 antifraud provisions of federal securities laws, 314, 331, 343–​45, 353–​54, 446 common law, 427, 438 FRBNY (Federal Reserve Bank of New York), 84, 94, 124, 130, 202–​3 Freddie Mac, xxviii–xxix, 6–​10, 141, 151, 217–​18 free flow of information, 411 Front Office (operating group), 410 FTPA (Futures Trading Practices Act), 215–​16 “future delivery,” 378 futures commission merchants (FCMs), 275 bitcoin futures trading and, 184 Dodd-​Frank Act and, 262–​71 leverage and, 226, 228–​29 swaps and, 262–​63, 275 futures contracts (futures), 91–​94, 166–​67. See also CFTC; Commodity Futures Modernization Act; specific topics characteristics,  167–​68 defined, 391 foreign exchange, 169–​70 vs. forwards, 168–​69, 378–​81, 384–​85 reduction of counterparty risk, 167 suitability as hedging instruments, 167–​68 trading of, 377 “futures look-​alike” contracts, 392 Futures Trading Act of 1986, 376 Futures Trading Practices Act, 215–​16 gamma (volatility measure), 240, 241 gas futures market, 388–​90 GDP (gross domestic product), 88 Geithner, Timothy F., 23–​24, 399–​400

470

470

Index

General Accounting Office (GAO), 159 Generally Accepted Accounting Principles (GAAP), 8, 156, 416–​17 Gensler, Gary, 228–​29 George E. Brooks & Associates, Inc., In the Matter of, 330 Giancarlo, J. Christopher, 267, 395 Gibson Greeting Cards v. Bankers Trust,  432–​34 Ginnie Mae (GNMA), 141, 151 global capital marketplace, 6 global economies, 3–​6, 48 goal-​oriented investing, 37–​41, 92 Goldman Sachs & Co. (GS&Co), 129 SEC v. Goldman, Sachs & Co. & Fabrice Tourre,  445–​47 Gorsek, SEC v., 328 government agency securities, 153–​54 Government National Mortgage Association (GNMA), 141, 151 government securities, 84, 124, 131, 153–​54, 171–​72,  373 Government Securities Act of 1986, 153–​54 Government Service Insurance System (GSIS),  209–​14 government-​sponsored entities (GSEs), xxviii–xxix, 6–​9, 141–​42, 452, 454, 455 bailout for, 9 legislative reforms and, 9–​11 purpose, 10 Grain Futures Act of 1921, 215–​16, 371. See also Commodity Exchange Act of 1936 Section 4d, and futures commission merchants (FCMs), 223–​24 Great Moderation, xxviii Great Recession, xxix–xxx, 35, 111, 142. See also financial crisis of 2007–​2008 origins, 3, 5 gross domestic product (GDP), 88 GSEs. See government-​sponsored entities Hasho, SEC v., 328 Hawaii Market test, 308–​10 hedge funds, 315–​18 post-​crisis hedge fund regulation, 319 transparency and, 319 hedging, 61–62, 132–​33 delta, 241, 242–​43 with structured notes, 444–​45

hedging instruments, suitability of derivatives as,  167–​68 hedging risk, 38, 39, 41–​43, 49, 166, 171–​72. See also forward contracts; futures contracts; Options financial instruments used for, 49 historical volatility, 239 Home Mortgage Disclosure Act of 1975 (HMDA), 70–​71, 74 household spending. See consumer spending Housing and Urban Development Department (HUD), U.S., 6–​7 housing market, 7–​8, 84, 97, 445. See also Federal Housing Finance Agency Howey Co., SEC v., 299, 306 Howey test, 298–​303 hybrid instruments, 383–​84, 444 defined, 383 ICE (Intercontinental Exchange), 388 illiquid assets, 14–​15 implied volatility, 239 import price indexes, 89 income, personal, 88–​89 indenture, 50, 142 Trust Indenture Act of 1939, 152–​53, 155–​56 industrial production, Federal Reserve report on, 91 inflation-​indexed Treasury securities. See Treasury Inflation-​Indexed Securities inflation targeting, 95–​96 communication strategy, 95 policy framework, 96 information flow. See under operational risk management Initial Jobless Claims, 90 injunctive relief, permanent, 313–​14 insider trading, 129–​30, 218, 353, 382 insurance look-​a-​like products, xxvii. See also derivatives Intercontinental Exchange (ICE), 388 interest rate contracts. See swaps interest rate risk, 455 interest rate swaps, 164, 173, 202, 215–​16, 256,  433–​34 described, 200 “plain vanilla,” 200–​2 interest rate yield curve, 112–​19

471

Index interest rates, 82, 449–​51. See also under asset valuation; Federal Reserve; mortgage rates asset valuation and, 111–​19 Bernanke on, 122 consumer spending and, 84–​91, 367 economic indicators and, 86–​96 FOMC minutes and, 107–​9 long-​term, 82, 85, 99, 100, 117, 122 longer-​term, 97, 98, 99, 102–​3, 113, 119 low, 4, 6 market risk and, 453–​54 monetary policy, the financial crisis, and,  96–​97 quantitative easing and, 97–​107 short-​term, 17, 84–​85, 113–​14, 127–​28, 241 international economies. See global economies International Organization of Securities Commissions (IOSCO), 183, 187, 254–​55,  279 International Swaps and Derivatives Association. See ISDA Intertrade Forex Inc., CFTC v., 380 “inverse floater” CMOs, 344–​45 inverse IO (interest only) floaters, 453–​54 inverse IOs (“inverse interest only” mortgage-​ backed securities), 147 inverted yield curve, 114–​15, 117 investment advisers, 424–​26 defined, 329, 424 duty of care chart of, 359 Venn diagram of, 357 Investment Advisers Act of 1940 (Advisers Act), 316, 320–​21, 327, 328, 424, 425–​26 fiduciary duty and, 326–​27, 328–​29 scope and applicability, 329 SEC and, 424, 425–​26 Investment Company Act of 1940, 316, 319 investment contracts. See also specific topics checklist for determining if they are governed by securities laws, 324 securities regulation and, 298–​302, 303–​11 investment goals, achieving, 41. See also financial instruments: purposes/​objectives of investor’s perspective, 41–​43 investment-​grade securities, 17 IOUs, government, 99

471

ISDA (International Swaps and Derivatives Association), 205, 278–​79 ISDA Master Agreement, 173–​74, 206 Jett, Orlando Joseph, 136–​38 jobless claims, 90 JPMorgan Chase, 14, 16–​17, 158–​59, 318 2012 trading loss, 419–​21 chief investment office (CIO), 419, 420–​21 “London Whale” trades and, 419–​21 Synthetic Credit Portfolio (SCP), 420, 421 jurisdiction and jurisdictional issues, 215–​16, 233, 246, 440. See also Commodity Futures Modernization Act; Korea Life Insurance Co. v. Morgan Guaranty Trust Co. CFTC and, 372–​73, 374, 375–​77, 378–​79, 382–​83, 384–​88,  394–​95 Dodd-​Frank Act and, 252–​54 SEC model, 252, 288–​90, 373 swaps and, 252–​54 Justice, U.S. Department of, 131–​32, 318, 421 K3C Inc. v. Bank of America, 200 Kidder Peabody Securities Litigation, In re,  136–​38 KISS (“keep it simple, stupid”), project, 279–​80,  281–​82 Know-​Your-​Customer (FINRA Rule 2090), 335–​36,  338 know-​your-​customer duty. See also under New York Stock Exchange suitability and, 349–​50 Korea Life Insurance Co. v. Morgan Guaranty Trust Co.,  244–​45 Kraninger, Kathy, 74, 77 Kudlow, Larry, 86–​87 Kwiatkowski, Henryk de. See de Kwiatkowski, Henryk Labor, U.S. Department of, 90, 342 labor market, 4–​5, 22, 122 FOMC and, 4–​5, 96, 101–​4, 108, 109 large trader reports (LTRs), 266 legal risks, 205, 408. See also liability legal tender, defined, 53 legislative reforms, 9–​11 Lehman, Philip A., 330

472

472

Index

Lehman Bros. Commercial Corp. v. Minmetals International Non-​Ferrous Metals Trading Co., 435 Lehman Brothers, 4, 217–​18, 224, 226–​27, 271 Bernanke on, 18–​19 leverage, 5, 146–​47, 148, 163, 169–​70, 171, 203, 214, 226, 228–​29, 316, 451 concept of, 163 credit risk and internal, 452–​55 defined, 46, 163 derivatives and, xxvii, 41, 46, 54, 158, 163, 165, 228–​29, 405, 411 Dodd-​Frank Act and, 24, 25–​26, 33–​34 financial crisis and, 41 foreign currency and, 203 futures commission merchants (FCMs) and, 226,  228–​29 hedge funds and, 316 internal, and market risk, 452–​55 Orange County case study and, 452, 453, 454–​55,  456 repos and, 452, 453, 454–​55 swaps and, 253 Levy v. Bessemer Trust, 235 facts of, 235–​36 theories of liability in, 236–​37 liability. See also Levy v. Bessemer Trust under Commodity Exchange Act (CEA),  430–​31 of directors and officers, 415 LIBOR (London Interbank Offered Rate), 164, 200–​1, 202, 244, 444–​45, 450, 453–​55 limited liability companies (LLCs), 304–​5 Lincoln Rule, 274 liquidity, Bernanke on, 14–​17 liquidity crisis, 15–​18. see also under AIG Bernanke on, 14, 16–​17 Federal Reserve, 15–​18 liquidity risk, 14–​15, 17, 204–​5, 207, 222–​23, 455, 456 Bernanke on, 14–​15, 17 nature of, 222–​23, 408, 455 litigation issues, 423–​24. See also common law theories of recovery; specific topics associated with swaps, 209–​14 broker-​dealers and,  424–​26 federal securities laws and, 424–​31 living wills, 32, 33

London Interbank Offered Rate (LIBOR), 164, 200–​1, 202, 244, 444–​45, 450, 453–​55 London International Financial Futures Exchange, 169 “London Whale” trades, 419–​21 Long Term Capital Management (LTCM),  159–​61 long-​term interest rates, 82, 85, 99, 100, 117, 122. See also longer-​term interest rates long-​term securities, increase in market demand for, 117 reasons for, 117–​18 long-​term vs. short-​term marketplaces, 50 long-​term yield affected by monetary policy,  118–​19 long vs. short position (options), 233 longer-​term interest rates, 97, 98, 99, 102–​3, 113, 119. See also long-​term interest rates LTCM (Long Term Capital Management),  159–​61 macroeconomic imbalances, xxvi Madoff, Bernard L., 316–​17 Malony Act of 1938, 334 management information systems, 408–​9 goals,  408–​9 Management’s Discussion and Analysis (MD&A), disclosures in, 416–​17 Management’s Discussion and Analysis (MD&A) rules, 417 margin initial, 169–​70, 221–​22, 227–​28, 260, 269, 270–​71,  284 variation, 192, 227–​28, 259, 267, 269–​71 margin requirements, 383. See also margin of derivatives, 158, 162, 169–​70 of swaps, 220, 222–​26, 227–​28, 251, 259–​60 market failures, 37–​38, 387 market manipulation, 131, 187, 215–​16, 382, 386 Market Oversight Division (CFTC), 369–​70 market price (derivatives), 163 market risk. See also financial risk; risk derivatives and, 158–​59, 164 internal leverage and, 452–​55 managing (see risk management) types of, 401–​2 market turmoil, 216–​17 Mathias v. Jacobs,  241–​42

473

Index MBSs. See mortgage-​backed securities MD&A. See Management’s Discussion and Analysis MF Global, 223–​29, 275 mining (cryptocurrency), 54 mixed swaps, 58–​59, 252, 322 Mnuchin, Steven, xxv Monetary Control Act of 1980, 92, 93 monetary policy. See also federal funds rate; Federal Open Market Committee; Federal Reserve asset valuation and, 113, 118 implementation, 92 inflation targeting, 95 policy stimulus, 113 Semiannual Monetary Policy Report, 122 moral hazard, 17, 29, 276–​77 Morgan Guaranty Trust Co., Korea Life Insurance Co. v.,  244–​45 mortgage-​backed bonds, 3, 150, 444 mortgage-​backed securities (MBSs), 10–​11, 141–​42, 149–​50, 217, 224, 270. See also mortgages, pools of backing by government sponsored agencies, 151 categories of, 150–​52 defined, 149 as financial instruments, 97 MBS purchase program, 122 residential mortgage-​backed securities (RMBS),  445–​46 risks associated with, 151 stripped mortgage-​backed securities (SMBS), 151 mortgage-​derived securities, 14 mortgage investment conduits, real estate, 151 mortgage loans, 141–​42, 149–​50, 152 See also mortgage-​backed securities mortgage meltdown, 6 mortgage rates, 6, 13, 84, 113, 147–​48 mortgage-​related assets, 18, 19–​20 mortgages. See also collateralized mortgage obligations; Federal Housing Finance Agency pools of, 5, 14, 141–​42, 149, 150, 151, 152, 216–​17, 445 (see also mortgage-​backed securities) multilateral netting, 268

473

multiple guarantor model, 10–​12 multiple insurer model, 1–​5 multiple issuer model, 11–​12 Mulvaney, Mick, 73–​77 municipal bonds, 53, 141 municipal securities, 154, 223–​24 disclosure requirements, 154–​55 registration requirements, 153–​54 Municipal Securities Rulemaking Board (MSRB), 154, 336, 351 disclosure requirements, 154–​55 Nagel v. ADM Investor Services, Inc., 379, 391 narrow-​based securities indexes, 255–​56, 376–​77 defining criteria, 377–​78 NASD. See National Association of Securities Dealers NASDAQ,  334–​35 Nashery v. Carnegie Trading Group, LTD., 431 National Association of Securities Dealers (NASD), 156, 334. See also FINRA Rule 2310, 429 Rules of Fair Practice, 335 National Futures Association (NFA), 349, 369 categories of NFA members, 350 CFTC and, 349, 350–​51, 369 compliance rules, 349–​50 Compliance Rule 2-​30, 349–​50 control and enforceability of, 350–​51 scope and applicability of, 350 overview, 349 National Investment Consultants, CFTC v.,  380–​81 national securities exchanges, 289, 353–​54, 377, 438 Nationally Recognized Statistical Rating Organizations (NRSROs), 143, 144–​46 Nationwide Life Insurance Co. v. St. Clair Mobile Home Parks LLC,  44–​45 natural gas, federal regulation of, 389–​90 natural gas futures market, 388–​90 negligence, 237 negligent representation, 237 netting, 173–​74, 268 netting agreements, 408 New York Empire State Index, 91 New York Mercantile Exchange (NYMEX), 168, 388, 390

47

474

Index

New York Stock Exchange (NYSE), rules of Regulation of the Exchange and its Member Organizations, 338 Rule 405 (know-​your-​customer), 333, 335–​36,  337–​39 New York Stock Exchange Regulation (NYSER), 338 NFA. See National Futures Association normal sloping yield curve, 113 notes (securities). See also specific types of notes checklist for determining if they are governed by securities laws, 324 securities regulation and, 292–​98 notional amount/​notional value, 169–​70, 172, 199–​200,  201 defined, 199–​200 of derivatives, xxvii, 215–​16, 217 swaps and, 201–​2, 204–​5, 208, 210, 215–​16, 217 underlying synthetic trades, 242–​43 NRSROs (Nationally Recognized Statistical Rating Organizations), 143, 144–​46 NYMEX (New York Mercantile Exchange), 168, 388, 390 Obama, Barack, 22, 228–​29 off-​balance sheet arrangements, 416–​17 credit derivatives as, 174, 204 off-​balance sheet transactions, 30–​31, 174, 416,  417–​18 defined,  417–​18 Office of Financial Research (OFR), 31 Office of the Comptroller of the Currency (OCC), 79, 420–​21 OCC warning, 456–​57 officers. See executive officers and directors open market desk, 94 open market operations, 15–​16, 84, 93–​94, 97, 98, 124 See also Federal Open Market Committee Bernanke on, 93–​94 defined, 94 methods of performing, 94 open outcry exchanges, 168 Operation Twist, 105–​6 operational risk, 407 operational risk management, 45–​46, 405–​6 education in, 416 empowering board members, 409–​10 ethical concerns, 412–​14

and executive officers/​directors’ understanding of financial instruments,  406–​7 executive protection and, 414–​18 flexibility, 414 goal of, 408 information flow, 411 daily exception report, 411–​12 free flow of information, 414 red flags, 412 reporting lines and audit techniques,  408–​9 reporting structures, 410 risk disclosure statements, 349–​50 risk policy, 407–​8 opinion letters from attorneys to clients regarding implications of transactions, 63 option agreement/​contract. See options option premium, 171, 233, 234–​35, 248, 443–​44,  449 defined, 171, 233, 234 option pricing. See Black–​Scholes model and option pricing option strategies, 247–​48 option writer, 234 options, 170–​72, 376. See also call options; collars; put options; volatility American vs. European, 233 characteristics of, 232–​33 contracts that are economically, 244–​45 defined, 232 delta hedging, 241, 242–​43 example, 232 how they work, 233–​37 regulation,  246–​47 regulatory jurisdiction, 233 strike price, 170–​71, 232, 234, 238, 248 Orange County case study, 147–​49 leverage and, 452, 453, 454–​55, 456 Orlando Joseph Jett, In the Matter of,  136–​38 OTC. See over-​the-​counter transactions over-​the-​counter (OTC) clearing, 259. See also over-​the-​counter (OTC) derivatives: clearing obligations and over-​the-​counter (OTC) derivatives, 46, 53, 172, 222–​23, 254–​55, 277. See also swaps capital and margin requirements, 273–​74 CFMA and, 215–​16, 220, 252, 321, 381

475

Index CFTC and, 215–​16, 251 clearing obligations and, 175, 215–​16, 251, 254–​55,  271 Commodity Exchange Act (CEA) and, 215–​16,  252 counterparties and, 46, 222–​23, 226–​27, 251, 267, 270, 276, 277, 370–​71 Dodd-​Frank Act and, 173, 175, 220, 251, 252, 267, 270–​71, 277 vs. exchange-​traded derivatives, 53, 161–​62 and the financial crisis, 215–​20 leverage and, 163 nature of, 161–​62, 215–​16 risk and, 46, 161–​62, 164, 165, 222–​23, 267, 270–​71, 276, 277, 370–​71 over-​the-​counter (OTC) derivatives market, 255, 267, 271 credit-​default swaps (CDS) and, 218 growth of, 215–​16, 270–272 PWG initiatives to strengthen oversight and infrastructure of, 219 transparency in, 220 over-​the-​counter (OTC) foreign currency transactions,  384–​86 over-​the-​counter (OTC) foreign exchange (FX) forward agreement, 169 over-​the-​counter (OTC) markets, NASD and, 334 over-​the-​counter (OTC) model,  222–​23 over-​the-​counter (OTC) options, 233, 243, 385–​86,  427 vs. exchange-​traded options, 245–​46 nature of, 245–​46 over-​the-​counter (OTC) securities, SEC and, 334 over-​the-​counter (OTC) swap markets, 321. See also swaps over-​the-​counter (OTC) transactions, 24. See also swaps foreign exchange forward agreements and, 169 ownership-​settlement approach (discerning equity from debt), 57 par value, 125, 126, 135, 140–​41, 204–​5, 207–​8, 209,  210–​12 pass-​through securities, 14, 150–​51 Patrick McDonnell, CFTC v.,  394–​95 Paulson & Co. Inc. (“Paulson”), 445–​46, 447

475

Payday, Vehicle Title, and Certain High-​Cost Installment Loans (Payday Lending Rule/​Payday Rule), 71, 75 Payments and Market Infrastructures, Committee on, 279 PDCFs (Primary Dealer Credit Facilities), 17,  97–​98 per se securities, 117, 292 Phacelli v. ContiCommodity Services, Inc., 351 PHH Corporation, 71–​72, 77, 78 Philip A. Lehman, In the Matter of, 330 physical settlement exclusion, 273 “plain vanilla” interest rate swaps, 200–​2 described, 200 Platinum Investment Corp., SEC v., 328 Ponzi schemes, 310–​11, 316–​18 portfolio dynamics and risk, 405 position limits. See commodity position limits Powell, Jerome H., 28–​29, 116 PPI (Producer Price Index), 90 preferred stock, 51–​52 preliminary injunctions, 312 premium. See also option premium; term premium; Treasury securities: pricing risk, 117 trading at a, 128, 169 prepayment risk, 151 prepurchase efforts, 307–​8 President’s Working Group on Financial Markets (PWG), 219 price limits, daily, 191 price–​yield relationship, 128 pricing, asset. See asset valuation Primary Dealer Credit Facilities (PDCFs), 17,  97–​98 primary government security dealers (primary dealers), 17, 97–​98, 124–​25 capital standards, 125 compliance with Tier I and Tier II, 125 defined, 124 trading relationship, 125 primary vs. secondary markets, 49–​50, 126,  128–​29 private placements of debt securities, 156 Procter & Gamble Co. v. Bankers Trust Co., 435 Producer Price Index (PPI), 90 project KISS (“keep it simple, stupid”), 279–​80,  281–​82 prospectus, 155

476

476

Index

prudential standards intended to mitigate systemic risk, 29–​32 put options, 234, 235. See also options quantitative easing, 18, 97–​104 balance sheet normalization, 104–​6 fiscal considerations, 106–​7 interest rates and, 97–​107 nature of, 18, 99 Quarles, Randal, 28 range notes, 450–​52 rating agencies. See bond-​rating agencies real estate mortgage investment conduits (REMICs), 151 real estate prices and financial crisis, 5 Real Estate Settlement Procedure Act of 1974 (RESPA), 71–​72, 73 reassessed expected outcome (REO) approach (discerning equity from debt), 57 reconstitution (“recon”) of STRIPS into coupon bonds, 134 reference entity, 209–​14, 450 registration requirements Dodd-​Frank Act and, 252–​54 municipal bonds and securities, 153–​54 Securities Exchange Act, 152–​54, 155 swaps and, 252–​54 Regulation 1.25 (CFTC), 223–​24, 226, 262–​63 Regulation D (Federal Reserve Board), 93 regulatory reform, 288. See also Dodd-​Frank Act American Recovery and Reinvestment Act (ARRA),  21–​23 the move toward, 220–​29 regulatory regime, confidence in the new, 223–​29 reinvestment risk, 456 REMICS (real estate mortgage investment conduits), 151 repos (repurchase agreements) description,  146–​47 leverage and, 452, 453, 454–​55 maturing repurchase agreements, 14–​15 Orange County case study, 147–​49 transactions,  146–​47 residential mortgage-​backed securities (RMBS),  445–​46 RESPA (Real Estate Settlement Procedure Act), 71–​72,  73 Restructuring Credit Event, 206, 209

retail investors, 424–​26 retail sales, 90 “reverse repo,” 146 Reves test (Reves v. Ernst & Young), 293–​98, 308 rho (volatility measure), 241 risk. See also market risk; systemic risk; specific topics basis, 164, 202 categories of, 407–​8 OTC derivatives and, 46, 161–​62, 164, 165, 222–​23, 267, 270–​71, 276, 277, 370–​71 risk disclosure statements, 349–​50, 431. See also disclosure(s) risk management, 45–​46. See also derivatives; operational risk management; shifting risk; specific topics controlling risk, 398–​405 for derivatives, effective tools of, 165 duty to manage risk, 398–​400 for financial and non-​financial institutions,  400–​1 financial instruments used for, 48 holistic,  405–​6 principles of, 398–​400 red flags in, 412 responsibility for, 415 risk-​free nature of Treasury securities, 123–​24 Risk Management Committees (RMCs), 409 risk policy, 407–​8 risk premium, 117 risks involved in structured notes, 455–​58 Roth, Brane v., 61–62, 406–407 “Rule of 72,” 135 salaries. See compensation practices Salomon Brothers, United States v.,  130–​32 Sarbanes–​Oxley Act of 2002, 400–​1 disclosure under, 416–​18 off-​balance sheet transactions and, 416–​18 SCAP (Supervisory Capital Assessment Program), 403 Scholes, Myron, 238 scienter, 313–​14, 331, 343–​44, 349, 427, 428,  430–​31 defined, 314, 331 SEC (Securities and Exchange Commission), 57–​58, 124–​25, 131–​32, 274, 288 Advisers Act and, 424, 425–​26 CFMA and, 59, 321, 373

47

Index disclosure requirements, 154 Dodd-​Frank Act and, 252, 321–​22 jurisdiction and authority, 252, 288–​90, 373 options trading and, 246 Rule 10b-​5 (employment of manipulative and deceptive devices), 314, 331, 343–​44, 354, 430 security-​based swaps and, 252 swap agreements and, 321–​22, 382 SEC v. Capital Gains Research Bureau, Inc., 329 SEC v. Davis et al.,  129–​30 SEC v. Goldman, Sachs & Co. & Fabrice Tourre,  445–​47 secondary vs. primary markets, 49–​50, 126,  128–​29 securities, defined, 288–​90, 298–​99, 427 Securities Act of 1933 (Securities Act), 152–​53, 288–​89, 322, 353, 424, 428–​30, 446 registration requirements, 152–​54, 155 Securities and Exchange Commission. See SEC Securities Exchange Act of 1934 (Exchange Act) corporate debt securities and, 155 government agency securities and, 153–​54 government securities and, 153 municipal securities and, 154–​55 private placements of debt securities and, 156 Rule 10b-​5 (employment of manipulative and deceptive devices), 314, 331, 343–​44, 354, 426–​28,  430 scope and applicability, 327 Section 10(b), 314, 326, 343–​44, 353, 446 Section 17(a), 331 suitability duty and, 326–​27 securities laws, checklist for determining if financial instruments are governed by,  323–​24 securities markets, 48, 218, 288–​89 security-​based swap agreements, 218, 321, 322, 353, 382 security-​based  swaps defined,  255–​56 Dodd-​Frank Act and, 251–​52, 256 security futures, 377 security futures contract, defined, 377 Seinfeld v. Bartz,  241–​42 self-​regulatory organizations (SROs), 125, 153, 314 Municipal Securities Rulemaking Board (MSRB), 351

477

rules, 331, 333, 424–​25 suitability requirements, 331, 333 sellers’ representations regarding proposed securities instruments, 310–​11 Semiannual Monetary Policy Report, 122 Senior Preferred Stock Purchase Agreements, 8 separate trading of registered interest and principal securities. See STRIPS “service providers” (Dodd-​Frank Act), 340–​41 settlement risk, 408 Shad–​Johnson Accord, 373, 376–​77 shifting risk, 48, 163, 221 derivatives and, 163–​65 structured notes and, 444 shingle theory of recovery, 438 short vs. long position (options), 233 Slappey Drive Industrial Park v. United States,  56–​57 SMBS (stripped mortgage-​backed securities), 151 Société Générale (SG). See Aon Financial Products, Inc. v. Société Générale special circumstances rule, 333–​34 special purpose entities, 406 speculating with structured notes, 444–​45 spending. See consumer spending split transactions, 304–​6 spot market virtual currency transactions, 394–​95 spot price (derivatives), 163 spot transactions, 163, 169–​70, 380, 391, 392 SROs. See self-​regulatory organizations St. Clair Mobile Home Parks LLC, Nationwide Life Insurance Co. v.,  44–​45 Standard Forex, CFTC v.,  384–​85 state regulation of securities blue sky laws, 439–​40 Hawaii Market test and, 308–​10 stocks. See also New York Stock Exchange checklist for determining if they are governed by securities laws, 323–​24 vs. corporate bonds, 303–​4 securities regulation and, 290–​92 stress capital buffer (SCB), 34–​35 stress testing, 403–​5 Dodd-​Frank Act,  33–​35 Federal Reserve supervisory programs that rely on, 403–​4 forms of, 403 strike price, 170–​71, 234, 238, 248 nature of, 170, 232

478

478

Index

stripped mortgage-​backed securities (SMBS), 151 STRIPS (separate trading of registered interest and principal securities) abuses,  136–​38 current value, 135 dealers of, 137 defined, 134 description, 134 exchange of, 134, 136, 137–​38 as means of restructuring an income security, 135 prices of, 135 purchasers of, 137 quotes for, 135 sale of, 137–​38 uses,  135–​36 valuation,  134–​35 structured finance products, 144–​46. See also specific topics structured investment vehicles, 14–​15 structured notes, 444–​57 embedded options, 444–​45 risks involved in, 455–​58 structuring securities, 452 subprime lending, 6 subprime mortgage crisis, 151–​52 subprime mortgages availability of, 152 defined, 152 increased risk associated with, 152 suitability antifraud provisions of federal securities laws,  343–​45 FINRA and, 334–​37 MSRB and, 351 special circumstances and, 333–​34 suitability doctrine basis of, 331–​33 control and enforceability, 327–​28, 330 investment advisers and, 328–​29 scope and applicability, 327, 329 suitability duty, 326–​27 safe harbors to enable swap traders to meet their,  346–​48 suitability rules, 352–​55. See also specific rules Supervisory Capital Assessment Program (SCAP), 403 supplemental information (Securities Act requirement), 155

swap agreements. See also currency swap agreements; Korea Life Insurance Co. v. Morgan Guaranty Trust Co.; swaps CFMA and, 218, 321 CFTC and, 321–​22, 381–​83 covered, 383 credit-​default, 206–​7, 208,  210–​13 Dodd-​Frank Act and, 321–​22 SEC and, 321–​22, 382 security-​based, 218, 321, 322, 353, 382 swap dealers capital and margin requirements, 259 CFMA and, 59 CFTC and, 59, 253, 259, 346, 350–​51 CFTC Final Rules and, 346–​48 de minimis threshold, CFTC review of, 283 defined, 59, 253 Dodd-​Frank Act and, 253, 259, 277–​78 review of swap dealer de minimis threshold, 283 SEC and, 60, 253, 259 security-​based, 59, 253 suitability duty and, 346 swap execution facility (SEF), 257–​58 swap reporting requirements under Dodd-​Frank,  260–​61 swap trading rules, CFTC’s amendment of,  282–​83 swaps, 172, 199–​200, 381–​83. See also credit-​ default swaps; currency swaps; interest rate swaps; specific topics case study, 440–​42 characteristics,  172–​74 defined, 58–​59, 172, 199–​200, 232, 247, 252, 256, 348 mixed, 58–​59, 252, 322 physical settlement exclusion and, 273 swing risk, 402 synthetic call, 248 synthetic CDOs. See ABACUS 2007-​AC1 Synthetic Credit Portfolio (SCP), 420, 421 synthetic security futures, 376–​77 synthetic trading, 242–​43 systemic risk, 270–​71 concentration in clearinghouse, 276–​77 prudential standards to mitigate, 29–​32 swaps and, 270–​71, 276–​77 systemically significant nonbanks (SSNBs), 29, 30–​32, 33, 35

479

Index T-​bills. See Treasury bills TAF (term auction facility), 16, 97–​98 taper, 102 TARP. See Troubled Asset Relief Program tender, legal, 53 Term Auction Facility (TAF), 16, 97–​98 term premium, 116–​17, 118–​19, 127–​28 increased net demand and lowered, 117–​18 Term Securities Lending Facility (TSLF), 16,  97–​98 theta (volatility measure), 241 Think Finance, LLC, In re,  341–​42 TIIS (Treasury Inflation-​Indexed Securities),  132–​33 TIPS. See Treasury inflation-​protected securities “too big to fail,” 24, 26–​29, 160–​61, 276–​77 tort theory of recovery, 439 transparency, 60, 146, 160–​61, 416–​17 Dodd-​Frank requirements and, 24, 35, 251, 275,  277–​78 hedge funds and, 319 swaps and, 227–​28, 229 “Treasuries,” as collective name, 122–​23 Treasury, U.S. Department of the (U.S. Treasury), 122–​23, 126, 128, 130, 153 authority granted by Congress, 7–​8 monthly budget report, 89 Office of Financial Research (OFR), 31 report on capital markets, 284–​85 reports providing review of financial system,  2–​3 Treasury Amendment (Commodity Futures Trading Commission Act), 368,  384–​85 Treasury bills (T-​bills), 125–​26. See also Treasury securities defined, 131 face value, 125–​26 par value, 125 purchase price, 125 Treasury Inflation-​Indexed Securities (TIIS),  132–​33 Treasury Inflation-​Protected Securities (TIPS),  132–​34 defined,  132–​33 example, 133 hedge against inflation, 132–​33 maturity, 133 use,  133–​34

479

Treasury notes, 126. See also Treasury securities Treasury securities, 122–​23. See also STRIPS appeal of, 123 auctions and, 130–​32 defined,  122–​23 factors affecting yield, 127–​28 interest rates and, 132–​34 issued,  122–​23 pricing, 126 discounts and premiums, 126–​27 primary dealers, 124–​25 purpose and goals, 122–​23 risk and, 123 Treasury securities as credit risk-​free investment,  123–​24 types of, 125–​26 ways of using, 123–​24 Treasury’s Blueprint (Blueprint for a Modernized Financial Regulatory Structure),  374–​75 Troubled Asset Relief Program (TARP), 18, 99 troubled assets, 19–​20, 99 Trump, Donald Arbitration Agreement Rules and, 71 election, 1, 22–​23 executive orders, 2–​3, 28 “make America great again,” 28, 458 nominations,  73–​74 principles for regulation of financial system, 2 regulation, deregulation, and, xxix, 1–​2 on Wells Fargo account fraud scandal, 78 Trump administration, xxv, 73 Trust Indenture Act of 1939, 152–​53, 155–​56 trust indentures, defined, 142 Turner, Adair, 4 Twomey v. Mitchum, 435 underlying security (options), 232 unemployment, 90 unfair, deceptive, or abusive acts or practices (UDAAP) CFPB and, 340 prohibitions against, 66, 79 scope and applicability of, 340–​41 University of Michigan’s Consumer Survey, 91 unrestrained entities, xxvi–​xxvii unsecured obligations, 14–​15 value at risk (VAR), 402, 407 value at risk (VAR) formulas, 403

480

480

Index

vega (volatility measure), 241 virtual currencies, 54. See also cryptocurrencies as commodities, 394 virtual currency transactions, spot market,  394–​95 volatility bitcoin, 185–​86, 188 Black–​Scholes model and, 239–​41 measures of, 240–​41 types of, 239–​40 volatility risk, 403 Volcker, Paul, 26 Volcker Rule, 26–​29 traditional banking activities vs. riskier “investing,” 321 Vonnegut, Kurt, 458 wages. See compensation practices Wall Street Reform and Consumer Protection Act. See Dodd-​Frank Act Wallenbrock, SEC v.,  297–​98 Warsh, Kevin, 48

Wells Fargo account fraud scandal, 78–​79 Wells Fargo Bank, N.A., In the Matter of, 266 world economy. See global economies writing options, 234 Yellen, Janet, 102 yield chasing, xxvi yield curve defined, 113 interest rate, 112–​19 shape of flat or inverted, 117–​19.(see also flat yield curve) interpretations of the, 113–​17 types of, 113–​17 yield enhancement with financial instruments, 38,  39–​40 yield–​price relationship, 128 Zelener, CFTC v.,  391–​92 zero coupon bonds, 134–​36. See also STRIPS Zero Parallel, LLC, In re, 341–​42

481

482