Category: Financial Services Law

Federal Reserve Board Seeks New Limits on Bank Activities in Physical Commodities

Federal Reserve BoardAs a result of both legislative mandates as well as Congressional and public concern, the Board of Governors of the Federal Reserve System (Board) has been examining whether to impose new restrictions on the activities of banks related to physical commodities. Following these examinations, the Board recently took two actions designed to impose new limits on the activities of banks related to physical commodities: (i) a notice of proposed rulemaking to impose new capital requirements and other limits on such activities of financial holding companies (FHCs[1]) (the “proposed rule”[2]); and (ii) a report, issued pursuant to Section 620 of the Dodd-Frank Act (620 Report),[3] which contains recommendations for legislation to repeal several current authorities for banks to engage in physical commodities activities.

Proposed rule. In brief, the proposed rule would:

  • increase the capital requirements for activities of FHCs involving commodities for which existing laws would impose liability if the commodities were released into the environment;
  • lower the limit on the amount of physical commodities that may be held by banks that conduct commodity trading activities;
  • rescind authority for banks to engage in energy tolling and energy management services;
  • delete copper from the list of precious metals that BHCs are permitted to own and store; and
  • establish new public reporting requirements on the nature and extent of firms’ physical commodities holdings and activities.

620 Report. The 620 Report is divided into three sections, by federal banking regulator. Section I, prepared by the Board, covers state member banks, depository institution holding companies, Edge Act and agreement corporations, and US operations of foreign banking organizations. In its section, with respect to physical commodities, the Board recommends legislative action that would:

  • repeal the authority of FHCs to engage in merchant banking activities; and
  • repeal the grandfather authority for certain FHCs to engage in commodities activities under section 4(o) of the Bank Holding Company Act (BHCA).[4]

Current AuthoritiesAlthough participants in energy and other physical commodity markets have commented to the Board that the imposition of new capital requirements and other restrictions on bank participation in physical commodity markets could reduce liquidity and increase costs for end users, the Board has nonetheless proceeded with the proposed rule and legislative recommendations. The Board estimates that the proposed rule will not have a significant impact on the physical commodity markets or the related derivative markets.

In this article, we summarize and provide key takeaways from the proposed rule and the 620 Report.

The Proposed Rule

Background

Prior to 1999, BHCs were generally barred from participating in “commercial” activities and had very limited authority to engage in physical commodities activities. Pursuant to the BHCA, BHCs could undertake only those commodities activities that were “so closely related to banking as to be a proper incident thereto,” such as buying, selling and storing precious metals and copper, or acting as principals in cash-settled commodities derivative contracts.

The Gramm-Leach-Bliley Act (GLBA) amended the BHCA by allowing BHCs with well-capitalized bank subsidiaries to expand the scope of their activities with respect to commodities. Specifically, three key provisions gave BHCs greater opportunities in this area: (1) the complementary authority under BHCA section 4(k), which allows FHCs to engage in any activity deemed by the Board to be “complementary to a financial activity”; (2) the merchant banking authority, which allows FHCs to invest in nonfinancial companies that engage in commodities activities that FHCs themselves are not permitted to undertake; and (3) the grandfather clause authority under BHCA section 4(o), which permits certain institutions that were conducting physical commodities activities prior to becoming FHCs to engage in a broad range of physical commodities activities, including those beyond the scope of both the complementary and the merchant banking authorities.

To date, the Board has approved three types of complementary activities: (i) physical commodities trading, which includes taking delivery of commodities under derivative contracts and buying and selling in the spot market; (ii) energy management services, such as providing advisory services to or arranging transactions for power plant owners; and (iii) energy tolling agreements, under which firms pay power plant owners fixed payments in exchange for the rights to plant output.

Advance Notice of Proposed Rulemaking. In January 2014, the Board issued an Advance Notice of Proposed Rulemaking to review the scope of physical commodities activities currently permitted by law, and determine whether such activities pose significant risks to the safety and soundness of insured depository institutions or the financial system generally, and whether additional limits or requirements should be imposed on the banks conducting these activities.[5]

Senate testimony on rulemaking. In November 2014, Federal Reserve Board Governor Tarullo testified to Congress that the Board would be issuing a notice of proposed rulemaking and was considering whether to impose more stringent overall caps on complementary and merchant banking activities, as well as stricter capital requirements by increasing the risk weighting for physical commodities activities associated with catastrophic or environmental risks.[6]

Current AuthoritiesThe proposal

On September 23, 2016, the Board issued a proposed rule to (i) adopt new limits on physical commodities trading activity conducted by FHCs under the complementary authority; (ii) impose new risk-based capital requirements on FHC physical commodities activities; (iii) rescind the authorizations for FHCs to engage in energy management services and energy tolling; (iv) remove copper from the list of precious metals that BHCs are permitted to own and store as an activity closely related to banking; and (v) impose new public reporting requirements to increase transparency into physical commodities activities of FHCs.

The higher capital requirements would be imposed through new proposed risk weights for the various types of permissible commodities activities.[7]To determine the risk-weighted asset exposure for covered physical commodities, these proposed risk weights would be multiplied by (i) the market value of all section 4(o) permissible commodities; (ii) the original cost basis of section 4(o) infrastructure assets; (iii) the market value of section 4(k) permissible commodities;[8] and (iv) the carrying value of an FHC’s equity investment in companies that engage in covered physical commodities activities.[9]

The proposed rule would affect each of the GLBA authorities as follows:

Complementary authority

New risk-based capital requirements. A 300% risk weight would apply to physical commodities holdings permissible under complementary physical commodities trading activities. The proposed requirements would apply with respect to physical commodities that are substances covered under federal or relevant state environmental statutes and regulations (“covered physical commodities”). According to the Board, “These physical commodities carry the greatest potential liability under relevant environmental laws.”[10] The Board states that this would provide a level of capitalization for these activities that is “roughly comparable to that of nonbank commodities trading firms.”[11]

Tighten the cap on physical commodities holdings. In order to limit the aggregate risks from physical commodities trading activities that an FHC may face, the limit placed on physical commodities holdings of FHCs under complementary authority (5% of tier 1 capital) would also take into account physical commodities held anywhere in the FHC, subject to a few exceptions.[12] The ability of an FHC to undertake or expand its physical commodities activities under the complementary authority therefore would be constrained by the extent to which the FHC and its subsidiaries engage in physical commodities activities under other authorities.[13]

Clarify prohibition on operations. The proposal would codify in the Board’s Regulation Y the prohibition on owning, operating or investing in facilities for the extraction, transportation, storage or distribution of commodities under the complementary authority. It also would clarify that this prohibits directing the operations of third-party extraction, storage or transportation providers. The proposed list of restrictions is not intended to be exhaustive; the Board states that the purpose of this proposal is to ensure that FHCs refrain from activities related to physical commodities that could impose environmental liability upon the FHC.[14]

Rescind authority for energy management services and tolling. Energy management services and tolling would no longer be permitted under complementary authority. According to the Board, the proposal would affect the actual activity of only one firm and the authority of five FHCs. The Board states that the fact that only one firm is now engaging in these activities indicates that the activities are not “as directly or meaningfully connected to a financial activity as is physical commodities trading,” and that the expected benefits from permitting these activities have not materialized.[15] The Board mentions that the rescission of these authorities would not affect the ability of FHCs to provide derivatives and related financial products and services to power plants or engage in physical trading. The proposal provides a two-year transition period to conform to these new restrictions.

Merchant banking authority

New risk-based capital requirements. The proposal would apply a 1,250% risk weight to a merchant banking investment in a company engaged in physical commodities activities unless all of the physical commodities activities of the portfolio company are permissible under complementary authority (e.g., physical commodities trading). If all the physical commodities activities of the portfolio company are permissible under complementary authority, then: (i) a 300% risk weight would apply to the investment if the company is publicly traded (the same risk weight that would apply to physical commodities trading activities conducted under the complementary authority); and (ii) a 400% risk weight would apply if the company is not publicly traded (this is intended to be consistent with the standardized approach to equity exposures).

The capital requirements would not apply to certain end user physical commodities activities where the portfolio company uses covered physical commodities to operate businesses otherwise unrelated to physical commodities. The proposed capital requirements would not apply to a merchant banking investment solely because the portfolio company owns or operates a facility or vessel that purchases, stores, or transports a covered physical commodity only as necessary to power or support the facility or vessel.[16]

The Board explains that these risk weights are designed to address the risks from merchant banking investments generally, “the potential reputational risks associated with the investment, and the possibility that the corporate veil may be pierced and the FHC held liable for environmental damage caused by the portfolio company.”[17] In the Board’s view, a higher risk weight for privately traded portfolio companies is warranted because an FHC “may not be able to gain access to markets for a privately held portfolio company after an environmental catastrophe” involving that company.[18]

Grandfather authority

New risk-based capital requirements. A 1,250% risk weight would apply to physical commodities and related assets (e.g., infrastructure assets) permitted to be owned solely under the statutory grandfather provision. This risk weight would be applied to the market value of all commodities permitted to be held only under the grandfather authority, as well as to the original cost basis of section 4(o) infrastructure assets.

A 300% risk weight would apply to activities that are conducted under the grandfather provision or through merchant banking authority but that are also permissible under complementary authority. The 300% risk weight would apply only, however, to the extent that the market value of the amount of physical commodities held under this authority, when aggregated with the market value of other physical commodities owned by the FHC that the proposal would not already subject to a 1,250% risk weight, does not exceed 5% of the consolidated tier 1 capital of the FHC.[19]

The Board states that the 1,250% risk weight, which is the highest risk weight currently specified by the Board under its standardized approach, is “intended to address the risk of legal liability resulting from the unauthorized discharge of a covered substance in connection with the infrastructure asset.”[20] The Board notes that this risk weighting is not intended to require capital against the full potential liability that might result from a catastrophic event, but rather is intended to reflect “the higher risks of physical commodity activities permissible only under section 4(o) grandfather authority without also making the activities prohibitively costly by attempting to capture the risks of the largest environmental catastrophes.”[21]

Reclassification of copper

Copper would be deleted from the list of precious metals that BHCs are permitted to own and store for their own accounts or the accounts of others. The Board explains that although in 1997 copper was added to the list that included gold, silver, platinum and palladium bullion, coins, bars and rounds, over time copper has “become most commonly used as a base or industrial metal, and not as a store of value in the same way as gold, silver, platinum, and palladium.”[22] The Board notes, and we discuss below, that the Office of the Comptroller of the Currency (OCC) has recently proposed a similar reclassification of copper under the National Bank Act.

Public reporting

The proposed rule would impose new public reporting requirements for commodities holdings of FHCs in order to increase transparency, allow better monitoring by regulators and improve firm management of these activities.[23] The proposed rule would require the reporting of the total fair values of various commodities held in inventory, as well as the risk-weighted asset amounts associated with an FHC’s covered physical commodities activities, section 4(o) infrastructure assets or investments in covered commodity merchant banking investments.

FHCs also would be required to identify whether they own any covered physical commodities, any section 4(o) infrastructure assets or any investments in covered commodity merchant banking investments; whether they are engaged in the exploration, extraction, production or refining of physical commodities; and whether they own facilities, vessels or conveyances for the storage or transportation of covered physical commodities. Further, FHCs would be required to report the total fair value of section 4(k)- and section 4(o)-permissible commodities owned, the original cost basis of any section 4(o) infrastructure assets, and the carrying value of investments in covered commodity merchant banking investments.

Board analysis of impacts

The Board believes the proposal will not have a material impact on the markets for physical commodities or derivative instruments related to those commodities.[24] According to the Board, the amount of additional capital required to be held by FHCs under the proposal would be approximately $4.1 billion in the aggregate. The Board estimates the proposal would result in an “insignificant” increase of 0.7% in total risk-weighted assets and a 7.1% increase in risk-weighted assets attributable to trading business. The Board concludes that, among FHCs that engage in physical commodities activities, this increase in risk weighting “would not cause any FHC to breach the minimum capital requirements.”[25]

The Board observes that “if FHCs consider their physical commodities trading on a standalone basis, the proposed increases in capital requirements could make this activity significantly less attractive based on its return on capital, and could result in decreased activity.”[26] The Board states, however, that such a reduction in activity “is not likely expected to have a material impact on the broader physical commodity markets.”[27]Although the Board acknowledges that information on the markets covered by the proposal is “relatively scarce,” the Board states that it appears that Board-regulated entities account for a small fraction of the physical markets for these commodities.

Using data from the Commodity Futures Trading Commission’s (CFTC’s) Bank Participation Report, the Board finds that the market share of banks in derivative contracts involving physical commodities ranges from 2% to 15% and therefore that any reduction in bank activity in these financial markets that might result from the proposal “should not materially impact” these derivative markets.[28] The Board also estimated that, in light of the relatively small share of FHCs in the commodity markets, the impact of the proposed increase in capital requirements upon merchant banking investment activities “appears insignificant.”[29]

Section 620 Report

Overview

Enacted in the shadow of the public debate over the Volcker Rule, Section 620 of the Dodd-Frank Act was intended to address activities not covered by the Volcker Rule’s restrictions on proprietary trading and covered fund activities, in particular longer-term risky holdings and trading.[30] Section 620 requires the three federal banking regulators[31] to conduct a study and report to Congress within 18 months of the enactment of Dodd-Frank. The report must address the appropriate activities and investments for banking entities under federal and state law, as well as review and consider (i) the types of permissible activities or investments; (ii) any financial, operational, managerial or reputation risks associated with or presented as a result of the banking entity engaged in the activity or making the investment; and (iii) risk mitigation activities undertaken by the banking entity with regard to the risks. The banking regulators submitted the 620 report on September 8, 2016, over six years after enactment of the statute. The 620 Report is divided into three sections, one for each regulator, covering those entities subject to its supervision:. The Board prepared Section I, the FDIC Section II, and the OCC Section III.

The three regulators have taken markedly different approaches in the 620 Report. Consistent with its approach under the proposed rule, the Board, in Section I of the 620 Report, has made a series of recommendations for legislative repeal of several of the authorities that currently allow banking entities to engage in commercial activities, calling for a greater separation of banking and commerce. The Board’s recommendations all require congressional action.

The OCC, which supervises national banks, federal savings associations, and federal branches and agencies of foreign banks does not recommend legislative action but plans to take action itself, through rulemaking or guidance, to enhance its prudential regulatory scheme. It intends to issue unilaterally rules and guidance that could have a significant and more immediate effect on banks’ asset-backed securities, derivatives, commodities and structured products activities.[32]

The FDIC, which supervises state-chartered insured banks and savings associations, has identified several areas for potential action but has taken the least drastic approach by adopting a wait-and-see posture to consider how certain activities interact with existing and new FDIC regulations and supervisory approvals.

The Board: Section I

The Board’s recommendations in its section of the 620 Report are sweeping, calling for the repeal of authorities and exemptions that currently allow FHCs and SLHCs to engage in a broad range of commercial activities. With respect to banks’ authorities to engage in physical commodities activities, the Board recommends the repeal of the merchant banking and Section 4(o) authorities under the BHCA that had been added by the GLBA.[33]

Repeal of merchant banking authority. As discussed above, under current merchant banking authority, FHCs may make investments in nonfinancial companies as part of a bona fide merchant or investment banking activity, including in any type of nonfinancial company, including portfolio companies engaged in physical commodities activities. In addition, ownership investments in a portfolio company may be in any amount. Current regulations require that corporate separateness be maintained to help ensure the limited liability of the FHC’s investment. Thus, an FHC generally may not participate in the day-to-day management of a portfolio company. FHCs are also required to establish risk management policies and procedures for these merchant banking activities. Under the GLBA, however, an FHC may manage or operate a portfolio company as may be necessary to obtain a reasonable return on the resale or disposition of the investment. According to the Board, this exposes the FHC to increased risks of being liable for operations of the portfolio company (e.g., if the portfolio company were involved in an environmental event). In the Board’s view, its regulatory authority to limit the potential risks to the FHC is not sufficient to manage the safety and soundness concerns, leading the Board to call for the wholesale legislative repeal of merchant banking authority.

Repeal of Section 4(o) grandfathering. The 620 Report also calls for a repeal of the grandfather authority under BHCA Section 4(o). The Board is concerned that this authority raises safety and soundness concerns largely because certain environmental laws impose strict liability on the owners and operators of certain physical commodities facilities for environmental releases or other events. Liability arising from environmental catastrophes can, in the Board’s view, create material financial, legal, reputational and market access harm for these firms. The Board is also concerned that lack of separation between banking and commerce creates a risk of undue concentration that could have a disproportionate effect on financial markets, production and employment if failure occurs. In addition, the Board argues that, because the Section 4(o) authority applies to only two firms, it raises competiveness concerns, including access to important industry-related information to which other FHCs do not have access, such as the amount and timing of production. The Board is also critical of the automatic nature of the Section 4(o) grandfather, which allows a covered company to engage in physical commodities activities without notice to or approval of the Board.

The OCC: Section III[34]

The OCC does not recommend any congressional action in its section of the 620 Report. Instead, it notes its intention to take regulatory action in each of the four areas it reviewed, namely physical commodities, derivatives, securities and structured products. We discuss its approach to physical commodities and derivatives below.

Physical commodities. Like FHCs, national banks currently may buy and sell coin and bullion, which, under OCC precedent, include gold, silver, platinum, palladium and copper. Banks may store these precious metals for themselves and their customers and may transport the metals to or from their customers. Banks may also serve as custodian for an exchange-traded fund that invests in these precious metals. Consistent with the proposed rule issued by the Board, the OCC plans to solicit comment on whether it should treat copper as a base metal rather than as “coin and bullion.” The OCC’s proposal will define “coin and bullion” to exclude copper cathodes and will conclude that buying and selling copper is generally not part of or incidental to the business of banking.

National banks may also buy and sell physical commodities (within limits) to hedge commodity price risk in connection with customer-driven commodity derivative transactions. The 620 Report notes that the OCC published supervisory guidance in 2015 to clarify how national banks should calculate how much of their hedging involves physical settlement so that they remain within the current precedent that requires that physical hedges be no more than 5% of a bank’s hedging activity.[35] The 620 Report notes that this guidance implements the OCC’s recommendation that physical hedging limits be clarified.

National banks may also acquire exposure, up to a limit of capital and surplus, to physical commodities through investment in renewable fuel capital investment companies, up to 5% of capital and surplus and certain investments that promote primarily the public welfare, such as in companies that generate renewable energy. In addition, national banks may acquire physical commodities in satisfaction of a debt previously contracted (e.g., the bank could foreclose on grain collateral pledged for a loan to a farmer). The 620 Report does not contain recommendations relating to these activities.

Derivatives. National banks may enter into derivatives transactions with payments based on bank-permissible holdings (e.g., tied to interest rates, foreign exchange, credit, precious metals and investment securities). With OCC-written non-objection, banks may deal in derivatives on certain other assets if part of customer-driven financial intermediation. National banks may not conduct proprietary trading in these derivatives. The OCC notes that Congress has approved national banks’ ability to offer swaps in connection with originating a loan. However, the OCC is concerned with what it views as smaller national banks’ interest in expanding their swap dealing business, particularly in commodity swaps. In 2014, the OCC enhanced its procedures for examining activities in which the bank enters into derivatives as an end user rather than as a dealer. The OCC now intends to “clarify minimum prudential standards” that apply to national banks engaging in certain swap dealing activities.[36]

The OCC is also reviewing the risks to federal banking entities of the entities’ membership in clearinghouses, particularly where their liability is not capped by the rules of the clearinghouse. The OCC may decide to issue guidance on clearinghouse membership.

Conclusion

Despite substantial input from market participants to the effect that physical commodities activities of banks have been conducted in a safe and sound manner and do not pose a significant potential for catastrophic liability or systemic risk, the proposed rule and the Board’s legislative recommendations in the 620 Report indicate the Board’s ongoing commitment to make significant changes in this area and suggest that the Board is unlikely to be receptive to overall philosophical opposition to its proposed direction. While the Board has previously floated broad ideas on reform, the proposed rule represents the first time the Board has offered specifics on how it intends new limitations to work and an estimate of the market impacts of such proposals. The Board therefore may be more receptive to comments concerning the effects of the specific measures it has proposed, including its estimates of the market impacts from these specific proposals. Comments on the proposed rule must be submitted by December 22, 2016.

The Board’s preferred direction with respect to changes to the BHCA is also clear. However, the impending election makes it impossible to predict the likelihood of legislative movement in this regard.

ARTICLE BY Dan M. Berkovitz & Gail C. Bernstein of WilmerHale
© 1994-2016 Wilmer Cutler Pickering Hale and Dorr LLP

[1] An FHC is a bank holding company (BHC) with well-capitalized subsidiaries that, pursuant to the Gramm-Leach Bliley Act (GLBA), may engage in financial activities, including securities underwriting and dealing, insurance activities, and merchant banking activities.

[2] Notice of proposed rulemaking, Risk-based Capital and Other Regulatory Requirements for Activities of Financial Holding Companies Related to Physical Commodities and Risk-based Capital Requirements for Merchant Banking Investments (Sept. 23, 2016) (hereinafter referred to as “NPRM”); available at https://www.federalreserve.gov/newsevents/press/bcreg/bcreg20160923a2.pdf.

[3] Report to the Congress and the Financial Stability Oversight Council Pursuant to Section 620 of the Dodd-Frank Act (September 2016), available at https://www.federalreserve.gov/newsevents/press/bcreg/bcreg20160908a1.pdf.

[4] The Board also makes legislative recommendations with respect to other types of activities. It recommends the repeal of (i) the exemption that permits corporate owners of industrial loan companies (ILCs) to operate outside of the regulatory and supervisory framework applicable to other corporate owners of insured depository institutions; and (ii) the exemption for grandfathered unitary savings and loan holding companies (SLHCs) from the activities restrictions applicable to all other SLHCs.

[5] Complementary Activities, Merchant Banking Activities, and Other Activities of Financial Holding Companies Related to Physical Commodities, 79 Fed. Reg. 3330 (Jan. 21, 2014). In response to the notice, critics of bank involvement in commodities argued that financial holding companies participating in these markets had an unfair competitive advantage, presented serious conflicts of interest and, most important, exposed the financial system to serious risk in the event of a catastrophic event. They believed that further regulation would help mitigate these risks, thereby protecting the financial system. Citing benefits such as increased convenience and competition, efficiency gains, more readily available liquidity, and lower commodity prices, proponents of bank involvement in physical commodities claimed that financial holding companies provide valuable services to end users, such as municipalities, that would be difficult to replace in the event of stricter regulation that might preclude banks from participating in physical commodities activities. Proponents pointed to the robust risk management processes that banks have established to ensure the safety of physical commodities activities, and further cited the sound safety record to date as evidence that these activities do not pose undue risks to financial holding companies or the financial system.

[6] Wall Street Bank Involvement with Physical Commodities: Hearing before the Perm. Subcomm. on Investigations of the S. Comm. on Homeland Sec. and Governmental Affairs, 113th Cong., 2d Sess. (Nov. 2014) (testimony of Gov. Tarullo).

[7] In general, the amount of capital an institution subject to capital requirements is required to hold is calculated by multiplying the minimum capital adequacy ratio (e.g., 4% or 8%) by the risk-weighted asset exposures. Thus, for example, if the minimum capital adequacy ratio is 8%, a risk weight of 1,250% applied to the market value of section 4(o)-permissible commodities would mean that for these activities the FHC would be required to hold an amount of capital equal to the total market value of the commodities held under that authority.

[8] The proposal provides for an FHC to use daily averages for physical commodities quantities and rolling month-end, end-of-day spot prices over a 60-month period to determine the market value of its covered physical commodities. NPRM, at p. 32.

[9] Id., at pp. 31–32.

[10] Id., at p. 25.

[11] Id., at p. 27.

[12] The proposal would exclude from the cap the physical commodities activities of portfolio companies held under the merchant banking authority, assets related to the satisfaction of debts previously contracted and insurance company investments held under BHCA § 4(k)(4)(I).

[13] Examples of such other authorities cited by the Board are the authority for certain national banks to hold physical commodities to hedge customer-driven, bank-permissible derivative transactions, and the authority to possess physical commodities provided as collateral in satisfaction of debts previously contracted in good faith. NPRM, at p. 20.

[14] Id., at p. 23.

[15] Id., at p. 42.

[16] Id., at p. 30.

[17] Id.

[18] Id.

[19] The proposal calls this the “section 4(k) cap parity amount,” which excludes commodities owned pursuant to the merchant banking authority, similar insurance investment authority, and authority to acquire assets and voting securities in satisfaction of debts previously contracted.

[20] NPRM, at p. 27.

[21] Id.

[22] Id., at p. 46.

[23] Memorandum from Staff to Board of Governors, Re: Proposed Rule Implementing Strengthened Prudential Requirements, including Risk-based Capital Requirements for Physical Commodity Activities and Investments of Financial Holding Companies, at p. 2.

[24] NPRM, at pp. 34–35.

[25] Id., at p. 34.

[26] Id.

[27] Id.

[28] Id., at p. 35.

[29] Id.

[30] See 156 Cong. Rec. S5895 (July 15, 2010) (statement of Sen. Merkley).

[31] The three federal banking regulators are the Board, the Federal Deposit Insurance Corporation (FDIC) and the OCC.

[32] Specifically, the OCC plans to:

  • issue a proposed rule that restricts national banks from holding as type III securities asset-backed securities, which may be backed by bank-impermissible assets, and to issue an analogous proposed rule for federal savings associations;
  • address concentrations of mark-to-model assets and liabilities with a rulemaking or guidance;
  • clarify minimum prudential standards for certain national bank swap dealing activities;
  • consider providing guidance on clearinghouse memberships;
  • clarify regulatory limits on physical hedging;
  • address national banks’ authority to hold and trade copper; and
  • incorporate the Volcker Rule into the OCC’s investment securities rules.

[33] The Board also recommends the repeal of the exemption that allows corporate owners of ILCs to operate outside of the regulatory and supervisory framework applicable to non-ILC corporate owners and the exemption for grandfathered unitary SLHCs from activities restrictions applicable to other SLHCs.

[34] Since the FDIC did not make any recommendations, we do not discuss Section II of the Report.

[35] OCC Bulletin 2015-35, “Quantitative Limits on Physical Commodity Transactions” (Aug. 4, 2015).

[36] 620 Report at 86.

© 1994-2016 Wilmer Cutler Pickering Hale and Dorr LLP

Schnucks Shakes Card Issuer Data Breach Class Action, For Now

A relatively new breed of data breach class action involves financial institutions suing merchants for expenses associated with credit card data breaches. Although merchants may not have contractual privity with the card issuers (and instead may have contractual privity with the credit card brands or payment processors), the financial institutions in these cases claim that the retailers should still compensate the financial institutions for costs associated with fraudulent charges and reissuance of credit cards as a result of a data breach. In the most recent decision involving these sorts of claims, an Illinois federal judge found the financial institutions’ claims against the Shnucks grocery store chain too vague to survive Rule 12 dismissal. See Cmty. Bank of Trenton v. Schnuck Mkts., 2016 U.S. Dist. LEXIS 133482 (S.D. Ill. Sept. 28, 2016). The court reasoned that although “the parties are charting relatively new territory in the data breach context by presenting a case between financial institutions and a merchant (as opposed to customers and a merchant), . . . the Court notes that the generality made it difficult to assess the plausibility of such claims.” Id.at *8-9.

Cop, Robber, data breach class actionThe financial institutions asserted 13 counts, which were addressed by the court as follows:

  • The court dismissed without prejudice the first three counts (RICO claims) for failure to allege predicate RICO acts with sufficient particularly. Id. at *19. According to the court, the financial institutions “rely on two theories of fraud–misrepresentation and cheating–but they do not allege with specificity what it was about Schnucks’s conduct that constituted these things.” Id. The court found the RICO conspiracy allegations similarly infirm.

  • As to breach of fiduciary duty, the court found insufficient allegations of a special relationship under Illinois law or a dominant/subservient relationship under Missouri law and thus dismissed that claim without prejudice. Id. at *31-32.

  • The court dismissed the negligent misrepresentation claim without prejudice because the plaintiffs had asserted insufficient allegations of concrete misrepresentations and duty and had not sufficiently addressed the economic loss doctrine under Illinois law, and the plaintiffs’ assumptions of and reliance on compliance with VISA and MasterCard security protocols were insufficient to plead the elements of negligent misrepresentation under Missouri law. Id. at *33-34.

  • As to negligence/gross negligence, the court found no duty to protect data owed by the defendant to the plaintiffs under the FTC Act or common law and thus dismissed the claim without prejudice. Id. at *36-37.

  • The court dismissed the negligence per se claim (with prejudice under Illinois law and without prejudice under Missouri law) because the plaintiffs failed to identify a statute violated, much less one imposing strict liability. Id. at *39-40.

  • As to breach of implied contract, the court dismissed without prejudice because of insufficient allegations of implicit contractual privity between the financial institutions and grocery store chain, and the allegations of pre-existing duty to VISA and MasterCard undercut an implied contract claim under Missouri law. Id. at *43-44.

  • The court dismissed without prejudice the breach of contract damaging third parties claim because of insufficient allegations that the plaintiffs were intended third-party beneficiaries of the grocery store chain and any other participants in the financial network, and the plaintiffs appeared to be incidental beneficiaries that could not recover under Missouri law. Id. at *44-47.

  • As to the Illinois Consumer Fraud and Deceptive Business Practices Act claim, the court dismissed without prejudice because of insufficient allegations of misrepresentation content, timing and nature of communication. Id. at *47-48.

  • The court dismissed the unjust enrichment/assumpsit claim because there were insufficient allegations that the defendant received some benefit from payment via credit card above and beyond payment by some other means. Id. at *48-49. Nor did the plaintiffs adequately articulate what they would have done had they known about the allegedly poor data security practices. Id. at *49-50.

  • As to equitable subrogation, the court dismissed without prejudice because of inadequate allegations that the plaintiffs had paid a third-party debt by reimbursing customers for fraudulent charges. Id. at *51-52.

  • Finally, because the court dismissed all the claims, it did not opine on the claim for declaratory and injunctive relief.

These sorts of cases are in their infancy, and it remains to be seen how they’ll ultimately fare in the face of Rule 12 Rule 23, and Rule 56 challenges. Stay tuned.

ARTICLE BY Blaine C. Kimrey of Vedder Price

© 2016 Vedder Price

New York Proposes First-Ever Cybersecurity Regulation for Financial Institutions

cybersecurity regulationThe New York Department of Financial Services recently announced a new proposed rule, which would require financial institutions and insurers to implement strong policies for responding to cyberattacks and data breaches.  Specifically, the rule would require insurers, banks, and other financial institutions to develop detailed, specific plans for data breaches; to appoint a chief privacy security officer; and to increase monitoring of the handling of customer data by their vendors.

Until now, various regulators have been advancing similar rules on a voluntary basis.  This is reportedly the first time that a state regulatory agency is seeking to implement mandatory rules of this nature.

“New York, the financial capital of the world, is leading the nation in taking decisive action to protect consumers and our financial system from serious economic harm that is often perpetrated by state-sponsored organizations, global terrorist networks, and other criminal enterprises,” said New York Governor Cuomo. He added that the proposed regulation will ensure that the financial services industry upholds its commitment to protect customers and take more steps to prevent cyber-attacks.

The rule would go into effect in 45 days, subject to notice and public comment period.  Among other detailed requirements, it will mandate a detailed cybersecurity program and a written cybersecurity policy.  While larger financial institutions already likely have such policies in place, the rule puts more pressure on them to fully comply.  It also mandates the hiring of a Chief Privacy Officer at a time when privacy professionals are already in a very high demand.  To attract top talent, the financial institutions will need to allocate appropriate budgets for such hiring.

Additionally, the rules outline detailed requirements for the hiring and oversight of third-party vendors.  Regulated entities who allow their vendors to access nonpublic information will now have to engage in appropriate risk assessment, establish minimum cybersecurity practices for vendors, conduct due diligence processes and periodic assessment (at least once a year) of third-party vendors to verify that their cybersecurity practices are adequate.  More detailed specifications can be found here.  Other requirements include employment and training of cybersecurity personnel, timely destruction of nonpublic information, monitoring of unauthorized users, and encryption of all nonpublic information.  As DFS Superintendent Maria Vullo explained: “Regulated entities will be held accountable and must annually certify compliance with this regulation by assessing their specific risk profiles and designing programs that vigorously address those risks.”

Among other notable requirements, the regulations further mandate that banks notify New York’s Department of Financial Services of any material data breach within 72 hours of the breach.  The regulations come at the time when cybersecurity attacks are on the rise.  The proposed rules also follow on the heels of recent legislative initiatives in 4 other states to bolster their cybersecurity laws, as we previously discussed.

The regulations are sweeping in nature in that they potentially affect not only New-York-based companies but also insurers, banks, and financial institutions who conduct business in New York or have customers who are New York residents.  If you are unsure about your company’s obligations and the impact of the proposed rules on your industry, contact Mintz Levin privacy team for a detailed analysis.

ARTICLE BY Cynthia J. Larose & Natalie A. Prescott of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

©1994-2016 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. All Rights Reserved.

Ninth Circuit Weighs In: Nevada “Superpriority” Law for HOA Superliens Violates Due Process

HOA superliensIn a 2-1 decision, the United States Court of Appeals for the Ninth Circuit overruled the 2014 decision from the Nevada Supreme Court about which we previously wrote. In Bourne Valley Court Trust v. Wells Fargo Bank, N.A., (August 12, 2016), the federal appellate court holds that the non-judicial foreclosure of Nevada HOA superliens cannot constitutionally extinguish a mortgage lender’s security interest.

In 2014, the Nevada Supreme Court held that, as a matter of lien priority, the foreclosure of a superlien for HOA assessments can extinguish a first mortgage. However, the Nevada Supreme Court did not address whether the provisions of Nevada state law governing notice to purported junior lienholders, including mortgagees, were constitutional.

In Bourne Valley, the home in question had a mortgage loan for $174,000 from Plaza Home Mortgage. The beneficial interest in the noted and deed was subsequently assigned to Wells Fargo, N.A. in 2011.  After the homeowner fell behind on her HOA payments, the HOA recorded a notice of delinquent assessment lien for $1,298.57 in August 2011.  In October 2011, the HOA recorded a notice of default and election to sell the home. Then, on April 9, 2012, the HOA recorded a notice of trustee/foreclosure sale against the property.  The Horse Pointe Avenue Trust then paid $4,145 for the home at a foreclosure sale, before conveying its interest in the property to the Bourne Valley Court Trust, which then filed an action to quiet title and extinguish any other junior liens.

In Bourne Valley, the Ninth Circuit panel notes that Nevada state law requires a purported junior lienholder to “opt in” before receiving notice of an HOA foreclosure sale, which the Court calls a “peculiar scheme” for providing mortgage lenders with information about when an HOA intended to foreclose on a property.  “Even though such foreclosure forever extinguished the mortgage lenders’ property rights, the [Nevada] statute contained “opt in” provisions requiring that notice be given only when it had already been requested,” the Court noted.  “Thus, despite that only the homeowners’ association knew when and to what extent a homeowner had defaulted on her dues, the burden was on the mortgage lender to ask the homeowners’ association to please keep it in the loop regarding the homeowners’ association’s foreclosure plans,” the Court continued. “How the mortgage lender, which likely had no relationship with the homeowners’ association, should have known to ask is anybody’s guess.”

Therefore, the Court concludes, Nevada’s laws violate the Due Process Clause of the U.S. Constitution.  From the Court’s decision:

Nevada Revised Statutes section 116.3116 et seq. strips a mortgage lender of its first deed of trust when a homeowners’ association forecloses on the property based on delinquent HOA dues. Before it was amended, it did so without regard for whether the first deed of trust was recorded before the HOA dues became delinquent, and critically, without requiring actual notice to the lender that the homeowners’ association intends to foreclose.

We hold that the Statute’s “opt-in” notice scheme, which required a homeowners’ association to alert a mortgage lender that it intended to foreclose only if the lender had affirmatively requested notice, facially violated the lender’s constitutional due process rights under the Fourteenth Amendment to the Federal Constitution. We therefore vacate the district court’s judgment and remand for proceedings consistent with this opinion.

The Court gets specific:

But that the foreclosure sale itself is a private action is irrelevant to Wells Fargo’s due process argument. Rather than complaining about the foreclosure specifically, Wells Fargo contends—and we agree—that the enactment of the statute unconstitutionally degraded its interest in the property. Absent operation of the statute, Wells Fargo would have had a fully secured interest in the property. A foreclosure by a homeowners’ association would not have extinguished Wells Fargo’s interest. But with the statute in place, Wells Fargo’s interest was not secured. Instead, if a homeowners’ association foreclosed on a lien for unpaid dues, Wells Fargo would forfeit all of its rights in the property.

For now, the Bourne Valley opinion is binding on all Nevada federal courts. It will also serve as strong persuasive authority (at the very least) in actions pending in Nevada state court, as well as throughout the U.S. in states with similar paradigms.

Delta, Boarding Line

“HOA liens, the elderly, and those with military service may now board.”

Copyright © 2016 Womble Carlyle Sandridge & Rice, PLLC. All Rights Reserved.

Tax Treatment of Bitcoin Has Many Open Questions

bitcoinIt has been over two years since the IRS came out with its initial position on the tax treatment of Bitcoin and other virtual currencies, but there has yet to be any follow-up on questions that this initial position has raised. The American Institute of Certified Public Accountants has written a letter to the IRS urging the Service to publish additional guidance to provide more certainty on these open issues.

IRS Notice 2014-21 stated that virtual currencies are to be treated as property, not as currency. This was potentially good news to Bitcoin investors, since it would allow them to pay the lower long-term capital gains tax rate on profits if they held the Bitcoin for over a year. On the other hand, this position was  inconvenient for consumers and merchants who use and accept virtual currencies as a means of exchange, because each transaction, no matter how small, must be reported in order to determine the amount of gain  or loss every time a consumer uses the virtual currency as a means of exchange, and every time the merchant converts the virtual currency received in a transaction into U.S. currency.

In the two years since the IRS published Notice 2014-21, this classification of virtual currencies as property rather than a currency, many other questions have been raised, but have not been addressed. The letter from the AICPA sets them out:

(1) Determining Fair Market Value of the Virtual Currency: The IRS should publish guidance on whether a taxpayer can use any published exchange rate to determine the fair market value of virtual currencies, and whether the taxpayer must use the same published exchange rate for all other transactions. The letter notes that there are  wide variance in the fair market value of Bitcoin on four Bitcoin published rates (Google, Bitcoin exchange rate, Bitstamp, CEX and Winkdex), citing an example selected at the same time, reflecting a range of value from a low of $227.84 to a high of $231.14.

(2) Expenses of Obtaining Virtual Currencies: Are the expenses to mine virtual currencies currently deductible, or are they to be added to the basis of the mined currency? This would normally be an easy call – costs would normally be added to the basis of the property that is manufactured – but the 2014 guidance intimates that this might not be the case.

(3) Tracking Basis of Virtual Currency: Because virtual currencies are treated as property, the taxpayer must track the cost of purchasing each unit acquired, in order to determine the taxable gain when it is sold (including every time a consumer uses it to purchase goods and services).  The AICPA letter says that tracking the basis for virtual currency is virtually impossible when it is used in everyday commerce, and asked for the IRS to consider alternative means to determine basis.

(4) General Transaction Rules Applicable to Property: The AICPA letter asks whether the general tax rules applicable to property (rather than currencies) would apply to virtual currencies. For example, the letter asks whether a taxpayer would be able to take advantage of the tax free like-kind exchange rules of section 1031 if one type of virtual currency is exchanged for a different type of virtual currency (for example, a Bitcoin for Ethereum exchange).

(5) Character of Virtual Currencies Held By Merchants: How should virtual currencies that are accepted by a merchant be classified for tax purposes – as a capital asset or as an ordinary income asset?

(6) Charitable Contributions: Does a contribution of virtual currencies to a charitable organization require a formal appraisal? The general rule is that if a taxpayer donates property worth more than $5,000 to a charitable organization, the taxpayer must obtain a formal appraisal to support the amount to be deducted as a charitable contribution. There is an exception, where an appraisal is not needed for the donation of securities that are traded on a published exchange. The letter asks whether the donation of virtual currency should be subject to the same exception, since they are traded on published exchanges.

(7) Is Virtual Currency a Commodity: If virtual currencies are treated as a commodity, would it be subject to the mark-to-market rules for commodity traders?

(8) How About a De Minimus Exception For Small Transactions: The letter asks the IRS for an exception to the rule requiring a taxpayer to report each virtual currency transaction as a taxable sale of property when used to make small consumer purchases.

(9) Retirement Accounts: Can virtual currencies be held as an investment in a qualified retirement plan (like a 401(k) plan)? The rules for eligible investments in such plans limit the types of property than can be held in a qualified retirement plan.

(10) Foreign Reporting Requirements: Are virtual currencies subject to Foreign Bank Account Reports (FBAR) and/or Foreign Bank Account Tax Compliance Act (FATCA) reporting?

As these issues get worked out, others are likely to arise. Until they are addressed by the IRS, the uncertainty will likely inhibit the growth of virtual currencies in the U.S. economy.

To see a copy of the AICPA letter to the IRS, please click here.

ARTICLE BY Marvin A. Kirsner of Greenberg Traurig, LLP

©2016 Greenberg Traurig, LLP. All rights reserved.

“Brexit” Dominates, as Financial Markets Roil

brexit financial marketsSecretary Kerry Heads to Brussels and London; President Obama Heads to Canada for the North American Leaders’ Summit; While the House is in Recess, Senate Committees Will Focus on the State-Foreign Operations Appropriations Measure and the Full Chamber May Consider the Zika Compromise Measure

President Barack Obama acknowledged from San Francisco early Friday morning that the British had exercised their sovereign rights and chosen to exit the European Union.  Washington awoke to the news and the corresponding negative reaction of the international financial markets soon after. Secretary of State John Kerry changed his travel schedule, adding a stop in Brussels and London to a trip that had him in Italy over the weekend. Meanwhile, President Obama travels to Canada this week to attend the annual North American Leaders’ Summit.

Democratic Members of the House staged a 24-hour sit-in on the floor of the chamber last week, protesting what they believed was the Republican leaders’ unwillingness to address gun control through legislation.  On Thursday, Speaker Paul Ryan (R-Wisconsin) abruptly adjourned the House until after the July Fourth holiday.

Senate Majority Leader Mitch McConnell (R-Kentucky) cut off an effort to keep suspected terrorists from buying guns last Thursday after Republicans and Democrats failed to reach an agreement on the issue, effectively ending debate of gun control in that chamber ahead of the November elections.  The Senate will be in session this week.

Brexit: British Vote to Exit the EU

Washington awoke to news Friday morning that the British had decided to exit the EU, a development that promptly caused international markets to slump.  Many expect market uncertainty will eventually impact the anemic economic growth in the United States.  After traveling to London in April and speaking in favor of Britain remaining in the EU, President Obama released a statement on Friday saying:

“The people of the United Kingdom have spoken, and we respect their decision.  The special relationship between the United States and the United Kingdom is enduring, and the United Kingdom’s membership in NATO remains a vital cornerstone of U.S. foreign, security, and economic policy.  So too is our relationship with the European Union, which has done so much to promote stability, stimulate economic growth, and foster the spread of democratic values and ideals across the continent and beyond.  The United Kingdom and the European Union will remain indispensable partners of the United States even as they begin negotiating their ongoing relationship to ensure continued stability, security, and prosperity for Europe, Great Britain and Northern Ireland, and the world.”

Senate Foreign Relations Committee Chairman Bob Corker (R-Tennessee) also issued a statement on Friday recognizing the British decision, while emphasizing the “special relationship” and importance of trade between the two countries:

“[The] referendum will not change our special relationship with the United Kingdom.  That close partnership will endure, and we will continue to work together to strengthen a robust trade relationship and to address our common security interests.”

Secretary of State Kerry said on Friday of the U.K. Referendum:

“I want to emphasize that although the U.K. will be leaving the European Union, the British are in no way departing from the principles and values that undergird the Transatlantic Partnership or from the important role the U.K. plays in promoting peace and stability in the world. The special relationship that has long existed between the United States and the U.K. endures. Our two countries remain strong and vigilant NATO Allies, permanent members of the UN Security Council, commercial partners, and close friends.”

He added:

“I also want to reaffirm the U.S. commitment to the European Union and the common agenda we share with Europe on such issues as Ukraine, nuclear nonproliferation, climate change, trade, and human rights.”

Secretary Kerry will be in Brussels and London today, meeting this morning with EU High Representative for Foreign Affairs and Security Policy Federica Mogherini, and later today with U.K. Foreign Secretary Philip Hammond.  In speaking with reporters in Italy over the weekend, Secretary Kerry said,

“The most important thing is that all of us as leaders work together to provide as much continuity, as much stability, as much certainty as possible in order for the marketplace to understand that there are ways to minimize disruption, there are ways to smartly move ahead in order to protect the values and interests that we share in common.”

North American Leaders’ Summit This Week

President Barack Obama, Mexican President Enrique Pena Nieto, and Canadian Prime Minister Justin Trudeau will meet on Tuesday in Ottawa for the annual North American Leaders’ Summit.  President Obama will also address a joint session of the Canadian Parliament.

Upcoming Presidential Trip – NATO, Poland and Spain

From 7-11 July, President Obama will travel to Poland and Spain. He will participate in the NATO Summit in Warsaw from 7-9 July.  The summit is expected to underscore the Alliance’s solidarity and to advance efforts to bolster security along NATO’s eastern and southern fronts. While in Warsaw, President Obama will hold a bilateral meeting with Polish President Andrzej Duda. He will also meet with the Presidents of the European Council and the European Commission to discuss U.S.-EU cooperation across a range of shared priorities, including countering terrorism, fostering economic growth and prosperity, and addressing the global refugee crisis. The U.K. referendum will also likely be a topic of discussion, as well as ongoing free trade agreement negotiations between the United States and EU.

From 9-11 July, President Obama will visit Spain, where he will meet with King Felipe VI and Acting President Mariano Rajoy.  This visit to another NATO member country will highlight security cooperation between the United States and Spain as well.

SelectUSA Investment Summit & GES

President Obama started last week out at the SelectUSA Investment Summit in Washington, which focused on attracting investments to the United States.  In addressing the forum, President Obama spotlighted, “Over the last four years, no other country has been named by CEOs around the world more frequently as the best place to invest with confidence.”

President Obama ended the week in San Francisco, attending the annual Global Entrepreneurship Summit (GES), which focuses on innovation.  The President signed an Executive Order on Friday to institutionalize key entrepreneurship programs of his Administration highlighting entrepreneurship is a hallmark of American leadership in the world.  The White House released a fact sheet on the GES, available here.

North Korea – Censured Again

After a failed attempt early last week, North Korea claimed on Thursday to have conducted a successful test-firing of a ballistic missile, swiftly drawing the censure of the United Nations Security Council.  In a press statement, the Security Council urged all countries “to redouble their efforts” to fully implement sanctions against North Korea, particularly those imposed in March, which were the toughest in two decades.  U.S. Ambassador Samantha Power sharply criticized North Korea’s “inherently destabilizing behavior” on Wednesday.

Venezuela Dialogue – U.S. Participates

Secretary General of the Organization of American States (OAS) Luis Almagro cited the current Government in Caracas as responsible for the near-collapse of Venezuela’s economy and called for the recall of President Nicolás Maduro.  Under Secretary of State for Political Affairs Tom Shannon joined the mediation efforts underway in Caracas last week, saying that a follow-on meeting date has yet to be determined.

Zika Funding Compromise Reached – Veto Threat Issued

Last week, House and Senate Republicans reached a compromise on funding a response to the Zika virus without Democrats’ input.  Before adjourning, House Republicans advanced (239-171) a spending measure that includes a $1.1 billion plan for the Zika virus.  The measure would provide $230 million for the National Institutes of Health to develop a vaccine and $476 million for the Centers for Disease Control and Prevention for mosquito control efforts.

Democratic Senator Bill Nelson (Florida) objected to the compromise, citing the $750 million in budget cuts to other health care programs.  The bill would cut $543 million in unused funds for implementing the Affordable Care Act, $107 million from funds used to fight Ebola, and $100 million in administrative funds from the Health and Human Services Department.  The $1.1 billion is also short of President Obama’s request for $1.9 billion to combat the virus.  The Senate is expected to take up the bill before it leaves Washington this week for its July 4 recess, but its prospects are unclear at best.

TPP – Implementing Bill Reportedly Being Drafted

Despite the public backlash to trade in an election year, U.S. Trade Representative Michael Froman said last Monday that the Obama Administration has begun drafting an implementing bill for a potential lame-duck vote on the Trans-Pacific Partnership (TPP) under Trade Promotion Authority (TPA). Ambassador Froman acknowledged that Majority Leader McConnell “has made clear publicly that he doesn’t want to see a vote [on TPP] before the [November] election,” which leaves the lame-duck session as the best window of opportunity for trying to advance a TPP implementing bill.

Privacy Shield – Agreement Reached

The European Commission and U.S. negotiators wrapped up their discussions over the transatlantic data-flow “privacy shield” agreement late on Thursday.  A Commission official reported the deal contains “additional clarifications regarding the Ombudsperson mechanism, onward transfers and data retention, as well as on an additional U.S. document on the bulk collection of data.”  The Article 31 Committee will next vote on the text of the agreement.

NDAA – Pre-Conferencing Stage

Senate Armed Services Committee Chairman John McCain (R-Arizona) reported last week that the leaders of the House and Senate Armed Services Committees met on Thursday to begin the process of reconciling the differences in their versions of the National Defense Authorization Act (NDAA).  A formal House-Senate conference does not begin until the two chambers appoint their conferees, which has yet to occur.

Congressional Hearings This Week

  • On Tuesday, 28 June, the Senate Armed Services Committee is scheduled to hold a hearing titled, “Improving Strategic Integration at the Department of Defense.”

  • On Tuesday, 28 June, the Senate Foreign Relations Committee is scheduled to hold a hearing titled, “Global Efforts to Defeat ISIS.”

  • On Tuesday, 28 June, the Senate Appropriations Subcommittee on State-Foreign Operations (SFOPs) is scheduled to hold a mark-up of the Fiscal Year (FY) 2017 SFOPs measure.

  • On Wednesday, 29 June, the Senate Commerce, Science, and Transportation Committee is scheduled to hold an executive session, where they will consider S. 3084, The American Innovation and Competitiveness Act, among other matters.

  • On Thursday, 30 June, the Senate Foreign Relations Committee is scheduled to hold a hearing titled, “Corruption: Violent Extremism, Kleptocracy, and the Dangers of Failing Governance.”

  • On Thursday, 30 June, the Senate Armed Services Committee is scheduled to hold a closed hearing titled, “National Security Cyber and Encryption Challenges.”

  • On Thursday, 30 June, the Senate Appropriations Committee is scheduled to markup the FY 2017 SFOPs measure.

Looking Ahead

Washington is expected to focus on the following upcoming events:

  • 29 June: North American Leaders Summit in Ottawa, Canada.

  • 7-11 July: President Obama travels to Poland and Spain

  • 8-9 July: NATO Summit in Warsaw, Poland

  • 18-21 July: Republican National Convention in Cleveland, Ohio

  • 25-28 July: Democratic National Convention in Philadelphia, Pennsylvania

  • 4-5 September: G-20 Leaders’ Summit in Hangzhou, China

  • 13 September: 71st Session of the U.N. General Assembly (UNGA) Begins

  • 20 September: UNGA General Debate Commences

  • 19-20 November: Asia-Pacific Economic Cooperation (APEC) Leaders’ Summit in Peru

ARTICLE BY Stacy A. Swanson of Squire Patton Boggs (US) LLP

© Copyright 2016 Squire Patton Boggs (US) LLP

Lehman Brothers Wins Stock Drop Lawsuit

Lehman brothers stock dropA New York federal appeals court once again rejected a breach of fiduciary duty claim against the now bankrupt Lehman Brothers brought by its employee stock ownership plan (ESOP) participants. In In Re: Lehman Bros. Sec. and ERISA Litig., No. 15-2229 (2d Cir. 2016), the US Court of Appeals for the Second Circuit on March 18 ruled that participants “failed to allege sufficiently” that plan fiduciaries violated their duties under the Employee Retirement Income Security Act (ERISA). The appeals court upheld an earlier July 15, 2015 decision by a US district court in New York to dismiss the complaint.

Soon after Lehman Brothers declared bankruptcy in September 2008, the ESOP participants sued, claiming that ESOP fiduciaries breached their fiduciary duties under ERISA “by continuing to permit investment in Lehman stock in the face of circumstances arguably foreshadowing its eventual demise,” the Second Circuit said. The New York district court dismissed the complaint for the first time in 2011, and the Second Circuit court upheld the dismissal in 2013. Both courts cited a long-held legal principle applicable to ESOPs—the presumption of prudence—to support the defendants’ request for dismissal.

However, in June 2014, the US Supreme Court nullified this long-standing presumption of prudence principle in a unanimous decision inFifth Third Bancorp, et. al. v Dudenhoeffer, et. al. According to the Supreme Court in the Dudenhoeffer decision, fiduciaries that evaluate an investment in employer stock may rely on its market price unless there are “special circumstances.” Specifically, the court held that “where a stock is publicly traded, allegations that a fiduciary should have recognized, from publicly available information alone, that the market was over or undervaluing the stock are implausible as a general rule, at least in the absence of special circumstances.” This means that the stock market price is the best estimate of employee stock value. But the Supreme Court did not address what it means by “special circumstances,” so, as a result, lower courts will need to determine when a plan fiduciary should have considered the market price as questionable.

Following Dudenhoeffer, the Lehman employees tried to establish special circumstances by pointing to orders issued by the US Securities and Exchange Commission (SEC) in summer 2008 that prohibited the short-selling of Lehman securities. They argued both that the orders described market conditions that constituted special circumstances and that the orders themselves qualified as special circumstances. The Second Circuit rejected this argument, explaining that the SEC orders “speak only conditionally” about the market effects of short sales.

This Second Circuit ruling marks the first time that a circuit court has applied the Supreme Court’s recent decision reaffirming the high hurdle facing employees who challenge company stock losses under ERISA (SeeAmgen Inc. v. Harris 136 S. Ct. 758 (US 2016)). This special circumstances requirement has derailed several lawsuits in the last two years, with courts dismissing claims involving the company stock plans of various major companies.

ARTICLE BY Brian D. Hector & Jason C. Ray of Morgan, Lewis & Bockius LLP
Copyright © 2016 by Morgan, Lewis & Bockius LLP. All Rights Reserved.

Insight into Future of Financial Technology Companies – Swimming with “Fintechs”

Fintech financial technologyImagine applying for a mortgage or commercial loan on Amazon or shopping for a checking account via an App on your Iphone. As many in the financial services industry may already know, there are a new brand of startups known as “Fintech” companies who are rapidly becoming viable alternatives to traditional wealth management. “Fintech,” which is abbreviated from financial technology, are various startup companies who are utilizing technology to make traditional financial services more efficient – for example, mobile payments, money transfers, loans, fundraising and asset management. Fintech companies can provide users with a variety of financial services that were once exclusively within the purview of a traditional bank (from facilitating investments, financial planning to underwriting). Fintech startups are geared towards giving the consumer a more personalized and efficient product than currently exists. If the trends continue, Fintech companies will cause the technological areas of consumer banking to undergo significant changes.

Fintech companies are capitalizing on digital technology to transform the way consumers access financial services and information.

As many Lenders know, consumers are increasingly demanding customer centric solutions that give instantaneous, tailored responses based on that individual consumer’s needs. A Fintech company can use technology to create a personalized solution for the demanding consumer.

Fortunately for the industry, the emergence of Fintech companies may not be all bad. Lenders who play their cards right may even be able to use a Fintech startup to their advantage. Cooperation between a lender and one or more of these startups could lead to symbiotic relationships. For example, some Fintech companies eliminate the need for financial advisors by providing apps that enable users to keep track of their spending and stay on budget. A Lender with foresight could partner with a Fintech company and offer this service on its own banking platform.

There are three things to look forward to with regards to how Fintech companies will revolutionize the financial services industry:

  • Fintech companies will cut costs and improve the quality of certain financial services as they are unburdened by regulators (so far…).

  • Fintech companies will create new ways of assessing risk. By utilizing machine learning and logistics, Fintech startups will change the landscape of risk assessment.

  • Fintech companies will lead to a more diverse credit landscape. Most Fintech firms are internet based, meaning they are less geographically concentrated than traditional lenders.

Cooperation and partnership will be crucial to a lender/ Fintech relationship. Clearly, Fintech startups will benefit from the reputation, stability, experience and client base of a traditional lender. However, the lenders must be acutely aware of possible legal repercussions of a Fintech partnership. It will be incumbent upon lender to assess the legal risks and regulatory challenges of partnering with these startups.

If in the end a lender can successfully navigate the risks, the upside will likely be worth it. After all, if history has taught us anything, it is that technology should be embraced rather than repudiated.

Article By Alena C. Gfeller & Donald Griffith II of Murtha Cullina

© Copyright 2016 Murtha Cullina

New Opportunities for Credit Union Ownership of Real Estate in Massachusetts

Proposed changes to National Credit Union Administration’s rule on federal credit union (FCU) ownership of real estate and to the Massachusetts credit union parity rules, promise to open new areas of credit union investment in real estate as an ancillary business line. Assuming both proposed rule changes take effect this summer, FCUs and MA state charters will have the ability to buy, develop, own and sell commercial real estate, provided that the FCU eventually (within six years of purchase or such longer period as NCUA may allow) occupies at least half of each property. The remaining space in each property may be leased by the FCU to unaffiliated tenants or to a developer entity, for re-leasing to third parties. In calculating how much of a property a specific CU occupies, space occupied by a CUSO that is controlled – through voting rights, without necessarily majority economic ownership – by the CU may be included.House, Real Estate

Combined with last year’s NCUA action which eliminated the 5% cap on fixed asset ownership by non-RegFlex FCUs, NCUA is now about to allow FCUs to acquire commercial properties they can never fully utilize, by treating up to half the property for investment/rental purposes. This will allow FCUs to consider ownership of small strip malls and other income-producing properties which were previously off-limits, and could signal a shift away from leasing and toward ownership as FCUs site their branches and operations centers.

The financial benefit from this major regulatory change can be enhanced if FCUs are able to create CUSO-based joint ventures with private real estate capital sources to reduce the portion of the equity investment required from the credit union. Further regulatory guidance on this potential aspect of FCU real estate investment is needed, but insofar as all FCUs and many state CUs (soon to include Massachusetts, through the currently proposed amendments to its CU parity rules, to allow state chartered Massachusetts CUs to partner with non-credit union co-owners of CUSOs, just as FCUs have been able to do for more than a decade) can through CUSOs partner with non-credit union co-owners/capital sources, it is possible that through a CUSO credit unions may  acquire commercial property partly for use and partly for investment/rental, and raise at least a portion of the acquisition’s equity capital  from non-CU third party equity sources. Of particular interest is the ability of CU executives to share ownership of CU real estate as partners in a CU-led CUSO, an arrangement that would allow select individuals to co-invest privately in these new real estate ventures. Completing the financing picture could be a commercial first mortgage loan from the sponsor credit union to the CUSO, perhaps with customary limited guaranties from some of the non-CU co-investors in the CUSO.

While this action by NCUA is a welcome step toward more rational, flexible facility ownership and management practices for affected credit unions, and offers those institutions a new ancillary revenue source, NCUA is clear that its action does not allow real estate speculation or full-scale CRE investment by credit unions. All acquired properties must eventually, typically within six years, be at least 50% devoted to housing the CU-owner and/or any CUSO controlled by it.

Whatever deal structures ultimately emerge, NCUA is about to open the door to limited but meaningful credit union equity investment in the kind of commercial real estate deals that previously CUs could finance only on the debt side. And with Massachusetts about to allow state charters to partner with non-credit union co-investors through CUSOs, we can expect to see both federal and state charters here explore equity co-investment opportunities with more traditional real estate investors and developers, and possibly even individual CU executives, as CUs move into this newest investment arena.

© 2016 SHERIN AND LODGEN LLP

New York Court Has Sufficient Jurisdiction Over Foreign Bank Where Bank Purposefully Uses Correspondent Bank Account in New York

In a recent New York  District Court decision in Official Comm. Of Unsecured Creditors of Arcapita Bank B.S.C. v. Bahr, Islamic Bank, 2016 U.S. Dist Lexis 42635 (S.D.N.Y. 2016), the court considered whether the use of a correspondent bank account provides a sufficient basis to exercise personal jurisdiction over a foreign bank. There, the Bahraini banks set the terms of investment placements and designated New York correspondent bank accounts to receiver the funds. The banks then actively directed the funds at issue into the New York accounts.

The Committee’s cause of action for the avoidance of preferential transfers arose from the use of the correspondent bank accounts. Hence, the heart of the claim was the receipt of the transferred funds in the New York correspondent bank accounts. The Bahraini banks deliberately chose to receive funds in US dollars and designated the correspondent bank accounts in New York to receive the funds. This deliberate choice made the exercise of jurisdiction constitutional. “Where, as here, the defendant’s in-forum activity reflects its ‘purposeful availment’ of the privilege of carrying on its activities here, the defendant has established minimum contacts sufficient to confer a court with jurisdiction over it, even if the effects of the defendant’s conduct are felt entirely outside of the United States.”

Thus, if a foreign party deliberately choses to use the US banking system to effectuate a transaction and a cause of action arises from that transaction, the foreign party can be forced to defend itself in the US courts.

Article By Eric (Rick) S. Rein of Horwood Marcus & Berk Chartered
© Horwood Marcus & Berk Chartered 2016. All Rights Reserved.