Financial Services Law Archives - Page 11 of 12

Mexico’s Unified Secured Transactions Registry Offers New Opportunities for Secured Lending

A big thank you to recent featured bloggers at the National Law Review from Strasburger & Price LLP. John E. Rogers wrote a helpful post about commercial lending changes in Mexico.

Mexican companies have historically encountered difficulties in attracting secured lending from U.S. and other foreign banks, mainly because of concerns as to the reliability of Mexican laws governing secured transactions and of its systems for filing and perfecting security interests (garantías reales) in personal (movable) property or goods (bienes muebles). Mexican banks have shared these concerns and have tended to rely on real property collateral in most of their secured lending. As a result, many Mexican companies whose primary assets are inventory, receivables and equipment have lacked access to adequate financing on competitive terms.

In order to encourage lenders to finance the operations of Mexican borrowers, Mexico has enacted significant reforms of its secured transactions laws. Most recently, dramatic steps have been taken to improve its public registry system to make it easier to search for existing liens on a debtor’s property and to perfect new security interests.

Mexican Bankruptcy Considerations

The importance to creditors of taking collateral security from Mexican debtors has arguably been increased by certain difficulties in the application of the Mexican Bankruptcy Law (the Ley de Concursos Mercantiles or LCM) enacted in 2000 and subsequently amended.¹ As a practical matter, the LCM does not ensure the “cram down” of secured creditors to the extent possible under the U.S. Bankruptcy Code, which allows a debtor, under a reorganization plan, to pay a secured creditor less than its full claim if it is under-collateralized. The secured claim can be “crammed down” to the value of the collateral by paying under the plan, over time, the value of the collateral, with the remainder of the claim being treated as unsecured.²

The LCM provides that a secured creditor may proceed with the enforcement of its collateral security if the reorganization plan does not provide for full payment of the secured debt, or the payment of the value of the collateral.³ On the surface, the latter option suggests the possibility of a cram down, but the absence of clear valuation procedures and criteria in the LCM, combined with the fact that bankruptcy judges often have limited experience with the LCM and few precedents to rely upon, means that it is more difficult than it would be under the U.S. Bankruptcy Code to prevent the secured creditor from proceeding (or threatening to proceed) with an action to enforce its collateral. Depending on the importance of the collateral to the future operation of the debtor, any such enforcement action could in effect jeopardize the success of the reorganization plan.

This gives the secured creditor significant negotiating leverage in a restructuring under the LCM, and has implications not only for secured bank lending but also for Mexican corporate bond financings, as to which bond investors may have a strong argument based on the LCM to insist on collateral security when the bonds are issued. If an issuer must provide such collateral, for example to support a high-yield bond offering, it may be less costly for the issuer to provide collateral consisting of personal property than to mortgage its real property, partly because of high mortgage recording costs and the related notarial fees. In order to obtain the advantages of treatment as a secured creditor under the LCM, having personal property collateral is as effective as having real property collateral of comparable value.

Like the U.S. Before the UCC

Mexico has a bewildering variety of personal property security interests, including among others the pledge (prenda), the industrial mortgage (hipoteca industrial) and the specialized security interests tied to the crédito refaccionario and the crédito de habilitación y avío, that brings to mind the personal property collateral devices (chattel mortgages, trust receipts etc.) that were commonly used in the U.S. prior to the adoption of the Uniform Commercial Code. Although Mexico has had the advantage of a single Commercial Code (and other federal secured transactions laws) that apply to the entire country, rather than a system of separate State laws as in the U.S., each of the 32 States and the Federal District has its own Civil Code establishing a Public Registry system for real property deeds and mortgages (each such registry is a Registro Público de la Propiedad) and, although personal property security filings are governed by the federal Commercial Code, they have previously been required to be made in the commercial registry (Registro Público de Comercio or “RPC”), which is normally managed by a unit of the related State or municipal government, in the place of the debtor’s domicile. Some of these locally managed commercial registries are less reliable than others, and significant delays are common in searching for existing liens and filing new security interests on collateral of companies domiciled in remote locations.

The Nonpossessory Pledge and the Guaranty Trust

On the substantive side, Mexico has made significant progress since 2000 by amending the Mexican Commercial Code and the General Law of Credit Instruments and Transactions (the Ley General de Títulos y Operaciones de Crédito or LGTOC) to permit personal property security interests to be created more easily on a “floating lien” basis. A new type of nonpossessory pledge called theprenda sin transmisión de posesión allows a debtor to pledge all of its inventory and receivables, for example, generically described (rather than described by reference to specific items), to a secured party without requiring that possession of the collateral be transferred to the secured party. This pledge can permit the debtor to sell the pledged collateral in the ordinary course of business without obtaining a case-by-case release from the secured party, and can automatically subject newly acquired property to the pledge without any further filing, which effectively results in a floating lien. A similar effect can be achieved through a guaranty trust (fideicomiso de garantía) with respect to the same or similar types of property, whereby title to the collateral is transferred to a Mexican trustee (typically a Mexican bank).⁴ Although these new devices resemble a security interest created in the U.S. under Article 9 of the UCC, lenders have remained reluctant to significantly expand their secured lending activities in Mexico because of ongoing concerns about their ability to perfect these security interests against third parties through the public registry system.

UNCITRAL and the OAS Encourage Registry Reforms

Recently, in an attempt to provide guidance for emerging market countries like Mexico that wish to improve access by borrowers to secured lending, the United Nations Commission on International Trade Law (UNCITRAL) has promoted reforms of the bankruptcy laws and secured transactions laws in such countries. Its 2008 Legislative Guide on Secured Transactions indicated the importance of a country having a “registry in which information about the potential existence of security rights in movable assets may be made public.”⁵ In 2010, UNCITRAL decided to expand its work in this field by preparing a “model registry regulation,” which is still in the process of preparation.

The previous efforts of the Organization of American States (OAS) to adopt a Model Inter-American Law on Secured Transactions (the “Model Law”)⁶ appear to have influenced Mexico in its adoption of the nonpossessory pledge concept. The OAS has also been tackling the registry issue; in October 2009, it held its Seventh Inter-American Conference on Private International Law, which approved Model Registry Regulations to “provide the legal foundation for implementing and operating the registry regime contemplated by the Model Law.”⁷ Among other things, the Model Registry Regulations contemplate the adoption of electronic filing systems and acknowledge that most of their features were recommended in UNCITRAL’s 2008 Guide and included in the registry systems recently developed in some Latin American countries, including Mexico, as well as in the U.S. (the UCC), Canada (the Personal Property Security Act) and some European countries.

Mexico’s 2009 Commercial Code Amendments and Creation of the RUG

Mexico has been receptive to the objectives reflected by the UNCITRAL and OAS efforts. Not only did Mexico enact secured transactions law reforms in 2000 and subsequent years to reflect many of the changes contemplated by the OAS’ Model Law, but Mexico’s initiatives with respect to public registry reforms have actually preceded the formal adoption of model rules by UNCITRAL and the OAS. In August 2009, a few months prior to the adoption of the OAS Model Registry Regulations, the Mexican Congress approved amendments to the federal Commercial Code that provide for the establishment of a Unified (or Sole) Registry of Movable Property Collateral (the Registro Único de Garantías Mobiliarias or “RUG”).⁸ The new Article 32 bis of the Code provides for the RUG (pronounced “roog”) to be a centralized registry for all types of security interests granted in favor of any creditor that carries out commercial activities (a comerciante) in personal property. The RUG will be a section of the PRC under the supervision of the Ministry of Economy (Secretaría de Economía), in which all filings are to be carried out electronically, through the RUG website, www.rug.gob.mx.

The stated Congressional purpose of the RUG is to strengthen the system for personal property secured transactions “as an effective tool for access to credit.” Its main functions are to create a mechanism that allows public disclosure of security interests created on personal property and to establish priority rules for secured creditors. Filings through the RUG have immediate effect, without requiring any approval by any authority. Such filings can be made by financial institutions, public officials, public notaries (notarios públicos) or brokers (corredores públicos) and others authorized by the Ministry of Economy. Under Article 32 bis 4 of the amended Commercial Code, a debtor is generally deemed to have authorized any secured party creditor that is acomerciante to file evidence of the applicable security interest in the RUG. Article 32 bis 7 allows “any interested party” to request the issuance of a certification as to the filings that have been made in the RUG with respect to any debtor.

New Registry Regulations

On September 23, 2010, an executive decree was issued by Mexican President Felipe Calderón implementing the 2009 Commercial Code amendments by amending the Regulations governing the PRC to provide specifically for the inclusion of the RUG as a section of the overall PRC.⁹ The amendments clarify how the RUG will operate through the electronic system called the Integrated System of Registry Procedures (Sistema Integral de Gestión Registral or SIGER) and the procedures to be followed for the use of the RUG by those who wish to (i) search it for the existence of existing security interests and (ii) perfect their own security interests as against third parties by filing notices. Anyone who registers with the RUG can initiate a search, but filings of security interests directly by an institutional creditor can only be done if the creditor entity has arranged to utilize an electronic signature for this purpose which satisfies the technical requirements contemplated by the Commercial Code¹⁰. Otherwise the security interest must by filed on the creditor’s behalf by someone else authorized under the RUG to do so.

The provisions of the amended Regulations (the “Amended Registry Regulations”) impose certain formalities which do not seem to be contemplated by the new Article 32 bis of the Commercial Code and may contravene the policy guidelines recommended by the OAS and UNCITRAL. For example, Article 10 of the Amended Registry Regulations provides for the RUG registrar or officer to verify that a filing has been properly made “in accordance with applicable legal and regulatory provisions,” which would seem to prevent the filing from becoming immediate and automatic, as provided in Article 32 bis 4 of the amended Commercial Code. Also, Article 10 bis of the Amended Registry Regulations specify that filings can only occur through a public authenticating officer (fedatario), i.e. a public notary (notario público) or broker (corredor público), although Article 30 bis seems to permit others, including financial entities, to make filings without using a fedatario. As a practical matter, until changes are made in Article 10 bis to allow filings to be made otherwise, it seems advisable to use a fedatario to carry out the filing. A number of law firms in Mexico employ fedatarios, so this should not be a significant impediment to the filing process or impose a significant additional cost. The use of a fedatario has the advantage of avoiding the requirement under Article 10 that the RUG registrar or officer verify the propriety of the filing; under Article 10 bis a filing by a fedatario has immediate effect.

Preventive Filings

Prior to the closing of a secured lending transaction, the proposed lender may wish to have the comfort that there will be no last-minute filings by other lenders of security interests that would have priority (based on time of filing) over any security interest to be filed to secure the transaction in favor of the proposed lender. To obtain such comfort, Articles 32 bis 5 of the Commercial Code amendments and 33 bis of the Amended Registry Regulations permit the proposed lender to make a filing prior to the scheduled closing, which will have the effect of preventing any other lender from making a filing that would have priority over the later definitive filing by the proposed lender of its own security interest. If the closing does not take place, the debtor need not seek removal of the preventive filing from the records of the RUG, because such filing would automatically cease to be effective after the passage of a specified period, normally two weeks.

Information to be Provided in Filings through the RUG

Article 33 Bis 2 of the Amended Registry Regulations provides that the information that must be provided in the filing of the security interest will be (i) the name of the debtor or debtors granting the security interest, (ii) the name of the creditor or secured party, (iii) the type of security device utilized to create the security interest, (iv) the personal property securing the relevant obligations, (v) the secured obligations, (vi) the term or time frame during which the filing will be effective, and (vii) anything else contemplated by Article 33 of such regulations, i.e. anything else that may be required by the forms to be used in order to effect such filings, which are to be specified in a publication in the official Gazette (Diario Oficial) of the Republic.

Using the RUG

As contemplated by the Amended Registry Regulations, to provide further guidance on using the RUG, the Ministry of Economy published a User’s Guide (Guía de Usuario) in Spanish providing additional guidance as to how the search and filing processes will operate.¹¹ The User’s Guide shows how (i) a user can become registered with the RUG, (ii) searches can be performed, (iii) search certificates can be obtained, (iv) secured party creditors (whether organized or resident within or outside of Mexico) can be registered and (v) the creditor’s representatives can be registered in order to be entitled to submit filings on behalf of the creditor.

Mexican creditors can be registered online by including their Mexican tax ID numbers in the creditor information they provide. In the case of foreign creditors not having such numbers, the registration may be carried out at one of the designated offices of the Ministry or through a fedatario. Foreign creditors that wish to avoid delays at the closing of a secured loan may wish to become pre-registered before the closing. For cases involving multiple creditors, such as a syndicated loan, there is a separate procedure for entering the names of the additional creditors. As for the debtor, the filing form contemplated by the User’s Guide mandates that it be filed electronically in such a way that the debtor’s name is accompanied by an indication of whether the debtor is an individual or an entity and his or its nationality, registration file (folio) number and taxpayer ID or CURP number. A debtor that is an individual may be registered by a fedatario at the time of the filing of the security interest, but a debtor that is a company or other entity will have to have been registered in the PRC prior to the time of filing.

According to the User’s Guide, the filing of a security interest is to be effected by making entries in the electronic equivalent of a document akin to a UCC financing statement, which should specify

(i) the name and address of the person requesting the registration of the security interest,
(ii) a description of the type of property subject to the security interest, such as “machinery and equipment” (the applicable type is to be selected from alternatives that appear on the screen),
(iii) the type of security document under which the security interest was created, i.e. whether it was a nonpossessory pledge, guaranty trust etc. (again, the selection is from the types indicated on the screen),
(iv) the date of the relevant security agreement,
(v) the maximum amount secured, specifying the applicable currency,
(vi) a more detailed description of the property subject to the security interest,
(vii) a description of the public deed issued before the fedatario which formalized the security agreement,
(viii) a description of the agreement under which the secured obligation arose,
(ix) optionally, any terms and conditions established by the documents, and
(x) the period of time for which the filing is to remain effective.

The User’s Guide provides examples of entries that are to be made in the online “financing statement,” and indicates how the electronic signature is to be applied to the document in order to affect its filing.

The User’s Guide includes similar instructions for related procedures, such as amendments, assignments, renewals or reductions of the effective term of the filing, corrections of errors, cancellations and “annotations” (anotaciones). The annotations might include information on any enforcement action with respect to the security interest, and would be made pursuant to instructions from a court or other authority. An annotation might result from a debtor challenging the propriety of the filing.

Effect of the Reforms: Better than the UCC?

The RUG is now the exclusive method in Mexico for perfecting security interests in inventory, receivables, equipment and many other types of personal property, whether created through a possessory or nonpossessory pledge, guaranty trust or other device, superseding all of the local public registries. However, security interests previously filed in the local registries will continue to be effective, so lenders must undertake searches as to any debtor in the locally-managed public registry responsible for such debtor’s domicile until such time as the previously filed security interests are no longer effective (for example, because they have been released or the related debt has been repaid), or otherwise satisfy themselves that no such filings have occurred (for example, by obtaining representations and warranties from the debtor to this effect). Similar transition issues were encountered in the U.S. during the implementation of the UCC and its associated filing systems.

Two features are present in the Mexican situation which did not exist in the case of the adoption of the UCC. First, the RUG will be the sole registry in Mexico for filing security interests in personal property, unlike the separate filing systems in the 50 States of the U.S. and in the District of Columbia, and many local filing places such as the offices of County Clerks. Thus, the sometimes thorny question in the U.S. of where to file will not apply in Mexico. Secondly, the RUG is exclusively electronic, as opposed to the recordation systems in the U.S., which initially relied entirely on paper filings and have only recently began to transition to electronic systems, gradually, on a State by State basis.

It will still be necessary to comply with the relevant requirements for creating security interests, which in Mexico often requires that the security agreement or pledge agreement be formalized by the preparation by afedatario of a formal deed (escritura). Instead of being recorded in the locally managed public registry, such deed should now be recorded in the RUG. Filings as to some types of collateral, such as vessels and aircraft, will continue to be made in specialized registries. Also, some of the enforcement remedies available under the UCC are not available under Mexican law, and the enforcement process in Mexico is likely to be more time-consuming than it is in the U.S.

But with those exceptions, and despite some uncertainty created by the amended Regulations, the establishment of the RUG represents a huge step forward by Mexico in making secured lending an attractive option for borrowers and lenders alike. Even a lender that remains skeptical about the enforcement of security interests in Mexico may be persuaded that it is worth perfecting security interests pursuant to a filing in the RUG in order to obtain the important practical advantages under the Mexican bankruptcy law of being a secured lender.

^*The authors gratefully acknowledge the collaboration of Fernando Barrita of Strasburger & Forastieri and the helpful comments of Steve Roberts and John Dorsey in Austin and of Professor Alejandro Garro of Columbia Law School in New York. The authors are, however, solely responsible for the contents of this article.

¹ Published in the Diario Oficial de la Federación (the “D.O.F.”) on May 12, 2000. Amendments to the LCM were published in the D.O.F. on December 27, 2007.

² 11 U.S.C. § 1129(b)(2)(A).

³ See LCM Articles 158, 160.

⁴ Published in the D.O.F. on May 23, 2000, with amendments published in the D.O.F. on June 13, 2003.

⁵ Legislative Guide on Secured Transactions of the United Nations Commission on International Trade Law, GA Res. 63/121, UN GAOR, 63rd Sess., 17 December 2008.

⁶ Adopted on February 8, 2002, by the Sixth Inter-American Specialized Conference on Private International Law (known as “CIDIP-VI”, for its Spanish acronym) [CIDIP-VI, Final Act 3(f), OEA/Ser.K/XXI.6/ CIDIP-VI/doc.24/02 rev.3 (March 5, 2002)].

⁷ Approved by the Seventh Inter-American Specialized Conference on Private International Law (CIDIP-VII)
at its second plenary session of October 9, 2009); quoted language appears in the Introduction.

⁸ Published in the D.O.F. on August 27, 2009.

⁹ Published in the D.O.F. on September 23, 2010.

¹⁰ Art. 11 of the Amended Registry Regulations.

¹¹ See http://www.rug.gob.mx/Rug/resources/pdf/
guia%20de%20usuario/Manual%20de%20Usuario%20RUG.pdf.

Not Your Father's Insurance Coverage: Using Transactional Insurance to Drive Business Opportunities

Posted at the National Law Review last week by Daniel J. Struck and Neil B. Posner of Much Shelist – a review of different type of insurance products that can be helpful in facilitating certain types of financial transactions:

Insurance coverage as a commercial risk management tool has been around for centuries, but there are a number of newer transactional insurance products that can actually help drive business opportunities and close deals. Developed in the last decade or so and becoming more widely available, these products—including representations and warranties (R&W), tax liability, litigation liability and environmental stop-loss insurance—are decidedly not your father’s insurance coverage. Rather, these less traditional types of coverage can help facilitate the purchase or sale of a business or a significant business asset by reducing the uncertainties associated with potential indemnification obligations and liability exposures.

Traditional Insurance Coverage: Still an Important Corporate Asset

For many businesses, standard commercial insurance is treated as a routine expense in which premiums are the deciding factor in evaluating largely interchangeable form policies. In previous articles, we have discussed why this approach is often short-sighted.

The types of insurance coverage purchased by most businesses are predictable. General liability insurance protecting against liabilities owed to third parties resulting from bodily injury, personal injury and property damage is a given. Some kind of first-party property coverage for loss to owned or rented premises, damage to inventory and equipment, and resulting business interruptions also is generally necessary. Because most businesses have employees, insurance related to workers’ compensation and employee benefits programs is essential. Depending on the particular business, additional lines of insurance—such as management liability, employee dishonesty/fidelity, fiduciary liability, cyber-liability and professional liability—may be necessary as well.

For all their differences, these types of coverage all serve as a means to manage risk and reduce the exposure to potential “fortuitous” first-party losses or third-party liabilities, ranging from slip-and-fall accidents at a retail location to a devastating explosion at a factory or an alleged breach of duty by a company’s directors. Although traditional insurance coverage may help protect the financial health and solvency of a business and its individual partners, officers or directors, it does not often operate as an actual driver of business opportunities.

Transactional Insurance: A Tool for Facilitating Corporate Transactions

Transactional insurance policies, on the other hand, generally insure against risks that fall outside the scope of more traditional coverage and have the potential to drive, or at least facilitate, certain corporate transactions. Examples include:

R&W insurance, which provides coverage for the contractual indemnification obligations resulting from breaches of the representations and warranties of a specific agreement (often a contract for the purchase/sale of a business or a significant corporate asset);
Tax liability insurance, which provides coverage for an identified potential tax liability or penalty, or for the liability resulting from an adverse determination in a specified ongoing tax dispute;
Litigation liability insurance, which may provide coverage if an award of damages in an identified piece of litigation exceeds a threshold specified in the insurance policy; and
Environmental stop-loss insurance, which may provide coverage for the costs of an ongoing environmental remediation project that exceeds a specific cost threshold.

Although commercial insurance policies of every type should be tailored to the particular needs of the insured, the levels of detail and specific underwriting and negotiation involved in placing transactional insurance are generally even greater. For example, the process tends to be fact specific and often involves extensive manuscripting (i.e., the negotiation of customized coverage terms applicable to the specific risks insured against).

But how can transactional insurance facilitate the completion of corporate transactions? Even in the best of times, potential buyers and sellers may find it difficult to agree on price. In the current economic environment, however, distressed sellers may be reluctant to discount the value of their businesses in hopes of a return to better days, while value-conscious purchasers are determined to buy at a substantial discount. Assuming that agreement can be reached on price, the parties must still negotiate the representations and warranties provided by both the buyer and the seller, and then reach acceptable indemnity terms for breaches of those representations. But the challenges don’t end there. A buyer with concerns about the ability of the seller to satisfy its indemnification obligations naturally will want the indemnification provision to be backstopped by a substantial escrow. A seller, however, likely will not want a substantial portion of his or her personal wealth tied up in an escrow account to pay for liabilities related to a business with which he or she is no longer associated.

In this challenging context, R&W insurance might help bridge differences and facilitate the successful closing of the transaction. For example, a potential buyer can use R&W insurance as a means to avoid relying solely on the seller for indemnification. A potential buyer might be able to make an offer more appealing by incorporating R&W insurance into its bid to reduce the portion of the purchase price that will be held in escrow. Similarly, for a seller that is eager to divest a business and minimize the scope of its continuing obligations relating to that business, a carefully tailored R&W insurance policy may provide a greater level of comfort that the seller will not be forced to pay out of pocket to satisfy potential indemnification obligations.

The following scenarios illustrate some of the ways in which transactional insurance might be used effectively to facilitate a transaction or to make a particular proposal more financially appealing.

Scenario One: Show Me the Money

After spending 25 years building a successful manufacturing business, Jacob Marley has decided to retire and tour the world on a yacht purchased with the proceeds from the sale of his company. He retains an investment banker to put the business up for auction and receives interest from a number of private equity firms, including HavishamCo. Rather than grossly over-bidding its competitors, Havisham distinguishes its offer by including an escrow requirement that is dramatically lower than would normally be expected (subject only to Havisham’s ability to secure R&W coverage). While putting its bid together, Havisham negotiated terms of an R&W insurance policy to insure over the seller’s representations and warranties. The bid prices from the various private equity firms were roughly equivalent, but Havisham’s escrow holdback was several million dollars lower than in any of the competing bids. Thanks to this creative use of R&W insurance, Marley accepts Havisham’s bid and sails off into the sunset.

Scenario Two: Good Intentions and a Token Will Get You on the Subway

CogswellCorp is experiencing financial difficulty because its “visionary” CEO has begun expanding the company beyond its core cog-manufacturing business. In order to finance its ambitious growth strategy, Cogswell decides to sell its cog-manufacturing operations. SpacelyCo seizes the opportunity to purchase the operations of a longtime competitor, and the parties easily agree on price. In an effort to close the deal quickly, Spacely proposes a modest escrow of only $1 million. However, the cap on Cogswell’s indemnification obligations for breaches of its representations and warranties is significantly higher at $30 million. Although Spacely believes it is purchasing the fundamentally sound operations of one of its largest competitors at a bargain price, Spacely’s management team fears that Cogswell’s expansion efforts will fail, leaving the company unable to honor its indemnification obligations if called upon to do so. In order to address this concern, Spacely obtains an R&W policy that provides coverage above a retention amount equal to the escrow of $1 million, and the deal closes successfully.

Scenario Three: The Long Goodbye

Forty years ago, ApexCo was the world’s largest electronics manufacturer. The company also maintained one of the foremost R&D departments in the world and now holds patents for inventions that are widely used in data storage devices, computer chips and consumer electronics. Over time, Apex discovered that the licensing of its patents was far more lucrative than its manufacturing operations. After being acquired by a private equity firm, Apex shut down its manufacturing and marketing operations in order to focus on licensing its patents and vigorously protecting its intellectual property. Today, the company continues to own a number of shuttered manufacturing facilities and distribution centers in populous suburban locations. There is extensive environmental contamination at several of these sites, which makes them difficult to sell without providing broad, open-ended indemnifications to the buyers. In an effort to control the financial obligations associated with these facilities, Apex seeks the placement of stop-loss insurance that will apply to each of the properties. The underwriting process requires significant due diligence, testing and the preparation of estimates for the remediation cost at each property. Ultimately, Apex is able to secure a stop-loss policy that generally covers remediation costs above a threshold specified for each site. As a result, Apex is now able to market the properties knowing that its financial obligations will be fixed but that buyers will enjoy a level of assurance that additional remediation costs will be paid for under the stop-loss policy.

Scenario Four: Death and Taxes

Holding company Jarndyce & Sons consolidated a number of its subsidiaries into a new subsidiary, BleakCo. Based on the tax opinion of its law firm, Kenge & Carboy, Jarndyce believed that the roll-up had been accomplished through a series of tax-free transactions. Eventually, Jarndyce decided to sell Bleak and entered into negotiations with private equity firm PickwickPip. During due diligence, however, PickwickPip’s law firm, Dodson & Fogg, raised concerns about whether the roll-up transactions had indeed been tax free. Despite these concerns, PickwickPip felt strongly that Bleak would be a valuable addition to its portfolio. Because it disagreed with the tax position taken by PickwickPip’s counsel, Jarndyce was unwilling to place the full amount of the potential tax liability in escrow or to provide a full indemnity. Jarndyce, however, was willing to pay a portion of the premium for a tax insurance policy that would cover PickwickPip for any tax liability above an escrow amount agreed to by the parties in the purchase agreement.

A Strategic Solution

As these scenarios illustrate, transactional insurance can be used strategically by both buyers and sellers to overcome obstacles that might otherwise make it difficult to complete an acquisition or divesture. It is not, however, an off-the-shelf product. The underwriting often requires its own due diligence, and the terms under which coverage is provided frequently require intense negotiations. Accordingly, whether transactional insurance products might be useful in bridging obstacles to a transaction should be an early strategic consideration. Given the myriad issues and financial interests at stake, it is important that a potential purchaser of transactional insurance pay close attention to the risks for which coverage is sought, the extent to which the proposed coverage terms respond to those risks and the legal effects of the negotiated coverage terms.

Can a 401(k) Plan Member Recover Damages to His Individual Account Caused By a Plan Administrator’s Breach of Fiduciary Duty?

Recently posted at the National Law Review by guest blogger David B. Cosgrove – a question many unhappy 401(k) plans members may have pondered:

An ERISA Plaintiff cannot seek individual monetary damages for a Plan Administrator’s breach of fiduciary duty to the plan. Importantly, however, seeking damages on behalf of the 401(k) Plan as a result of a Plaintiff’s losses in his individual account is explicitly permitted under LaRue v. DeWolff, Boberg & Associates, Inc., 552 U.S. 248 (2008), which held that ERISA Section 502(a)(2) authorizes recovery by a plan participant for fiduciary breaches “that impair the value of plan assets in a participant’s individual account.” 522 U.S. at 256. The Supreme Court in LaRue made clear its reasoning for this holding:

Whether a fiduciary breach diminishes plan assets payable to all participants and beneficiaries, or only to persons tied to particular individual accounts, it creates the kind of harms that concerned the draftsmen of § 409. Id. at 256.

For instance, a Plaintiff may rely upon ERISA Section 502(a)(1)(B) for a Defendant’s failure to provide the Plaintiff with the full 401(k) benefits owed to him under the 401(k) Plan at issue. And the Plaintiff may also rely upon ERISA Section 502(a)(2) for a Defendant’s breaches of fiduciary duties. A plain reading of Sections 502(a)(1)(B) and 502(a)(2) establishes that the two sections provide for different relief. Indeed, as the 9th Circuit explicitly noted in Harris v. Amgen, Inc.:

Section 502(a)(1)(B) allows a plan participant “to recover benefits due to him under the terms of his plan.” By contrast, Section 502(a)(2) encompasses claims based on breach of fiduciary duty and allows for the more expansive recovery of “appropriate relief,” including disgorgement of profits and equitable remedies. 573 F.3d 728, 734, n. 4 (9th Cir. 2009) (citations omitted).

Regardless, some defendants incorrectly assert that “the Eighth Circuit and other courts alike have repeatedly held that participants cannot state claims for breach of fiduciary duty under ERISA Section 502(a) when they are also seeking to recover the same benefits under ERISA Section 502(a)(1)(B).” The falsity of this assertion is clear upon a review of the federal caselaw. Indeed, the cases usually cited are inapplicable in that each is either irrelevant or is limited in scope to claims brought under ERISA Sections 502(a)(1)(B) and 502(a)(3), not Sections 502(a)(1)(B) and 502(a)(2). See Geissal ex rel. Estate of Geissal v. Moore Medical Corp., 338 F.3d 926, 933 (8th Cir. 2003) (narrowly holding that a beneficiary cannot bring a claim for benefits under Section 502(a)(1)(B) and Section 502(a)(3)(B));Conley v. Pitney Bowes, 176 F.3d 1044, 1047 (8th Cir. 1999) (citing Wald v. Southwestern Bell Corporation Customcare Medical Plan, 83 F.3d 1002, 1006 (8th Cir. 1996) in holding that “where a plaintiff is ‘provided adequate relief by [the] right to bring a claim for benefits under [Section 502(a)(1)(B)],’ the plaintiff does not have a cause of action to seek the same remedy under [Section 502(a)(3)(B)]”). Some defendants also cite Coyne & Delaney Co. v. BCBS of Va., Inc., 102 F.3d 712 (4th Cir. 1996). However, Coyne is not relevant in that it analyses whether aplan fiduciary can bring a claim for benefits under ERISA Section 502(a)(3). 102 F.3d at 713.

Some plan defendants also rely upon the U.S. Supreme Court’s holding in LaRue v. DeWolff, Boberg & Assoc., Inc., 552 U.S. 248 (2008) for the proposition that duplicative claims under ERISA Section 502(a)(1)(B) and 502(a)(2) are inappropriate. Specifically, defendants may rely upon commentary by Chief Justice Roberts in that case, without revealing that Justice Roberts wrote the concurring opinion rather than the opinion of the Court. Accordingly, his analysis is not binding. Id. at 249. In fact, at the conclusion of his concurring opinion, Justice Roberts acknowledged that his analysis is not binding on the issue: “In any event, other courts in other cases remain free to consider what we have not—what effect the availability of relief under § 502(a)(1)(B) may have on a plan participant’s ability to proceed under § 502(a)(2).” Id. at 260.

Indeed, in Crider v. Life Ins. Co. of N. Am., 2008 WL 2782871 (W.D. Ky. 2008), the Western District of Kentucky acknowledged that Justice Roberts’ analysis inLaRue is not binding, and therefore noted that in deciding whether to allow a claim under both ERISA Section 502(a)(1)(B) and Section 502(a)(2), the question for the court is whether the facts the plaintiff alleges “state a claim for breach of fiduciary duty under Section 502(a)(2) which is separate from her claim for benefits under Section 502(a)(1)(B).” Id. at *2. The court further noted that in deciding this question, the Sixth Circuit has on at least three occasions “allowed plaintiffs to pursue both a claim for benefits under Section 502(a)(1) and also to attempt to hold a plan responsible for breaches of fiduciary duty under a separate Section 502(a) action.” Id. Finally, In Hill v. Blue Cross & Blue Shield of Mich., the Sixth Circuit observed that plan-wide claims are distinct from claims seeking to correct the denial of individual benefits. 409 F.3d 710, 718 (6th Cir. 2005).

Finally, it is well-established that “[i]n ruling on a motion to dismiss, a court must view the allegations of the complaint in the light most favorable to the plaintiff.”Guarantee Co. of North America, USA v. Middleton Bros., Inc., 2010 WL 2553693, at *2 (E.D. Mo. June 23, 2010). To survive a motion to dismiss, a claim need only be facially plausible, “meaning that the factual content…allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.”Id. (quoting Cole v. Homier Dist. Co., Inc., 599 F.3d 856, 861 (8th Cir. 2010)).

Beware of Fiduciary Duties to Creditors Different for Corporations and LLCs

Posted yesterday at the National Law Review by Jennifer Feldsher, Robb Tretter and Jonathan P. Gill of Bracewell and Giuliani details about a recent ruling in Delaware concerning creditors of LLC’s which contradicts widespread assumptions and runs contrary to common commercial practice:

In a recent decision, CML V, LLC v. Bax, et al., C.A. No 5373-VCL (Del. Ch. Nov. 3, 2010), the Delaware Court of Chancery held that, unlike Delaware corporations, creditors of an insolvent Delaware limited liability company cannot bring derivative actions against the members or managers of the company unless they specifically contract for such rights. The decision effectively precludes creditors of insolvent limited liability companies from suing members and managers for breaches of fiduciary duties owed to the company, unless they amend the company’s limited liability operating agreement to provide directly that such duties are owed to creditors.

The Chancery Court noted that the ruling contradicts widespread assumptions held by both academics and the Delaware courts themselves. In fact, this ruling runs contrary to common commercial practice, in which the form of an entity, whether a corporation, limited liability company or limited partnership, is most often selected for tax or corporate control reasons, with the expectation that the general tenets of the Delaware corporate law apply.

Background

According to the decision, JetDirect Aviation Holdings, LLC was highly leveraged and had volatile cash flows and internal control deficiencies. In April 2007, CML V, LLC loaned JetDirect approximately $34 million. Subsequently, in late 2007, JetDirect’s board of managers undertook four major acquisitions allegedly without the benefit of current information on the company’s financial condition. JetDirect defaulted on its loan obligations to CML in June 2007 and was insolvent by January 2008, at which time JetDirect’s managers began liquidating some of JetDirect’s assets, including selling certain assets to manager controlled entities. CML alleges that such sales were approved by JetDirect’s board without an adequate review of the fairness of such transactions and, thus, breached fiduciary duties owed indirectly to CML. Such duties are indirect because at the juncture of insolvency creditors, rather than the company’s equity holders, become the residual stakeholders.

Each of JetDirect’s operating subsidiaries eventually commenced bankruptcy cases and CML brought claims both directly against JetDirect on account of JetDirect’s defaults under the loan and derivatively against JetDirect’s mangers for breach of fiduciary duties owed to CML. The derivative claims were based on allegations that JetDirect was either in the zone of insolvency or insolvent by April 2007, thus, the managers owed fiduciary duties to its creditors, including CML, and the managers breached those duties. The alleged fiduciary duties breached by the managers were (i) their duty of care, by approving the 2007 acquisitions while “lacking critical information relating to JetDirect’s financial condition,” (ii) their duty of loyalty, by acting in bad faith when “failing to implement and monitor an adequate system of internal controls” and (iii) their duty of loyalty by “benefiting from self interested asset sales.” JetDirect’s mangers moved to dismiss CML’s derivative claims against them, arguing that CML lacks standing to bring derivative suits under the LLC Act.

The Chancery Court’s Decision

In ruling that the creditors of a limited liability company lack standing to bring an action in right of the limited liability company against its members and managers for breaches of fiduciary duties or otherwise, the Chancery Court held that the plain language of Section 18-1002 of the LLC Act, entitled “Proper Plaintiff,” only allows a member or an assignee of an interest in such limited liability company to bring a derivative claim.

The Chancery Court went on to distinguish the rights of creditors of insolvent Delaware corporations from the rights of creditors of insolvent limited liability companies. The Court acknowledged that a combination of Section 327 of the DGCL and case law have provided creditors of insolvent Delaware corporations with standing to bring derivative claims against directors on behalf of the corporations for breaches of fiduciary duties.¹ However, in CML, the Court determined that no such right exists for a creditor of a limited liability company given that the language of Section 18-1002 of the LLC Act is exclusive to “a member or assignee of a limited liability company interest,” while the language of Section 327 of the DGCL is not exclusive to shareholders of the corporation, but simply dictates the qualifications required to be met by shareholders instituting derivative suits.

In support of its decision, the Chancery Court recognized that the LLC Act provides flexibility so that creditors may negotiate certain rights and protections for themselves. Consistent with other recent cases, the Court notes that “LLCs are creatures of contract, designed to afford the maximum amount of freedom of contract, private ordering and flexibility to the parties involved.”² Creditors can protect themselves through the covenants, asset liens, and other negotiated contractual protections customarily contained in a loan agreement and can also bargain for express contractual rights in the borrower’s LLC agreement. Such rights may include, among other things, (i) penalties and other consequences for members triggered by the occurrence of specific events, (ii) personal liability of members for the debts of the limited liability company, and (iii) creation or expansion of fiduciary duties of members and managers to preserve assets for creditors, which would be triggered by insolvency.

Take-Aways for Creditors of LLCs

Unlike rights afforded to creditors of Delaware corporations, creditors of Delaware limited liability companies are barred from bringing claims based upon breaches of fiduciary duties by the members or mangers of such companies unless, among other things, they amend the LLC agreement to directly provide for them. Thus, in order to fully protect themselves, creditors of limited liability companies will need to bargain for specific rights in the loan agreement or demand amendments to the borrower’s LLC agreement as a pre-condition to extending credit or making a loan.

_____________________
¹See CML V, 6 A.3d at 240, citing N. AM. Catholic Educ. Programming Found, Inc. V. Gheewalla, 930 A.2d 92, 101 (Del. 2007); see also § 320 DGCL

²CML V, 6 A.3d at 249 (quoting Travel Centers of Am., LLC v. Brog, 2008 WL 176987, at *1 (Del.Ch. Apr. 3, 2008) (quoting In re Grupo Dos Chiles, LLC, 2006 WL 668443, at *2 (Del.Ch. Mar. 10, 2006)); see also Kelly v. Blum, 2010 WL 629850 (Del. Ch. Feb. 24, 2010).

Milestone or Millstone? Financing, that is.

The National Law Review included a great post this week about the challenges for Milestone Financing from Paul A. Jones of Michael Best & Friedrich LLP:

As a lawyer, I’ve counseled many an entrepreneur, and even an occasional angel or venture investor, who thought so-called milestone-based financing rounds might bridge an especially irksome entrepreneur-investor gulf on valuation. And, indeed, if you’ve been around the high-impact startup game awhile, you are bound to have seen some of these deals done. You might even have seen some of them work out. But as attractive as the idea of punting on valuation and/or funding timing pending the future achievement (or not) of some pre-defined milestone can be, more than a few words of caution are in order.

The kind of milestone financing I am talking about typically looks something like the following. An investor agrees to put in some money up front, with the valuation thereof, and/or the provision of an additional sum of money, determined at some later time, when the company has (or has not) accomplished some defined milestone(s). In theory, this structure can be a good mechanism for bridging otherwise intractable differences about valuation and funding requirements between entrepreneurs and investors. In practice, though, this approach can be quite problematic.

The problems with milestone funding are basically as follows. First, the parties too often leave the definition of what constitutes achieving the milestone subject to interpretation. Some milestones are in fact hard to define with precision. Beyond that, precision itself in terms of defining a milestone can be problematic if, as is often the case, success or failure in achieving a milestone can take forms not contemplated at the beginning of the enterprise. Second, and particularly where the milestone is more distant in time, market conditions can change so that one party or the other inevitably ends up feeling like they are being held to a deal that no longer makes sense. Finally – and this, for me, is the biggest issue with milestone funding – is that what seem like the best/most pressing milestones today might be overtaken by events before they are achieved. Most technology-based startups evolve rapidly: what looks like the best use of limited resources at, say, the first closing of a milestone financing, might look like a less than optimal use of resources a day, week, month or quarter later. But with a milestone financing clock ticking, the various parties – founders, managers and investors – can find themselves with confused and conflicting priorities. At best, in this situation, you will have a serious management distraction on your hands.

Milestone financing structures can be good tools in the right situations. Considering the real world risks, however, they should be considered as if not last at least late-in-the-day resorts. And, when used, both sides should be careful to pick milestones that can be achieved sooner, rather than later, and defined, appropriately, with precision. And then everyone should still cross their respective fingers that the business – technology, markets, competition, etc. – stays reasonably stable at least until the milestone is achieved.

Lender Liability and the Exception to CERCLA

Recently posted at the National Law Review by Joanne M. Schreiner and Matthew A. Whitlow of Dinsmore & Shohl LLP – explain possible liability under CERCLA for lenders in certain situations:

Lenders are making loans again. Lenders are much more cautious about the loans they are making and much more thorough with their due diligence on every piece of property. Perhaps the biggest concern for a lender (aside from whether its borrower will default) is the environmental condition of the property. Now more than ever, lenders are fearful (and rightfully so) of exposure to liability for violations of environmental laws following foreclosure and transfer of possession of a commercial property. Generally, Lenders are insulated from such liability; however, they must be careful not to overstep the boundaries of the protections afforded them.

What is CERCLA?

It is mentioned in many commercial real estate loan documents, typically in connection with a representation by a borrower that they are in material compliance with it. “CERCLA” is an acronym for the Comprehensive Environmental Response, Compensation and Liability Act of 1980. This is the primary piece of federal legislation governing events related to the exposure of real estate to hazardous materials in the United States. Most state environmental laws are based on this law. When it comes to commercial real estate (or any real estate for that matter), the last place anyone wants to be is on the wrong side of CERCLA because CERCLA imposes strict liability upon “owners and operators” of real property for penalties and costs related to hazardous waste contamination and clean up. A lender can become an “owner and operator” of real property under CERCLA in several ways, with potential exposure to CERCLA strict liability. There are three exceptions to CERCLA strict liability: (i) an Act of God; (ii) an Act of War; or (iii) Secured Creditor Safe Harbor.

Initially, the Secured Creditor Safe Harbor allowed that a lender who owned or possessed real property for the sole purpose of protecting its security interest in the real property, and who did not “participate in the management of the real property,” was excluded from strict liability under CERCLA. Unfortunately, courts disagreed on how to interpret the Secured Creditor Safe Harbor (specifically, when did a lender “own or possess” the real property and what constituted “participating in the management” of the real property?). The Secured Creditor Safe Harbor was later narrowed and more clearly defined.

The U.S. EPA adopted guidelines (which were later codified in CERCLA) to test whether a lender and a lender’s actions were protected by the Secured Creditor Safe Harbor. These guidelines attempted to clarify what “participating in the management” of a property means. A two-part test was established to determine whether lenders met this factor:

Did the lender exercise control over the management of the borrower’s environmental compliance program? In other words, did the lender tell the borrower what to do to comply with applicable environmental laws?
Did the lender participate in the Borrower’s day-to-day decision-making process with respect to environmental compliance and other business operations? Simply collecting rent from tenants or advising the borrower on financial matters related to the property is not considered “participation in management.” Other lender activities that do not satisfy this second part include: (i) pre-loan investigations; (ii) loan servicing; (iii) loan workouts; and (iv) foreclosures.

If a lender can prove that: (i) it holds a security interest in real property to secure repayment of money or some other obligation; and (ii) it did not actually participate in management of the property, then the lender is protected by the Secured Creditor Safe Harbor.

What happens after a lender forecloses and becomes the actual owner of the property?

Under CERCLA, a lender must establish it has made commercially reasonable efforts to divest itself of the real property in a commercially reasonable time and on commercially reasonable terms, taking into account market conditions and legal and regulatory requirements. CERCLA does not define “commercially reasonable;” however, lenders can look to the EPA for guidance. The EPA provides that a lender makes “commercially reasonable” efforts to divest the property when the lender lists the property with a broker or advertises the property for sale in an “appropriate publication” (publication of general circulation) within 12 months of foreclosure. It is important to note that lenders who were not protected by the Secured Creditor Safe Harbor pre-foreclosure cannot be protected by the Secured Creditor Safe Harbor after foreclosure. A lender’s own acts or omissions during ownership or control of the real property are not protected by the Secured Creditor Safe Harbor provision.

A lender considering making a commercial real estate loan should consider the following “best practices” to avoid CERCLA liability:

document everything;
avoid active participation in the operational affairs of the Borrower and the property;
if practical, have a receiver appointed to manage the property during default and foreclosure;
conduct pre-foreclosure environmental due diligence;
ensure good environmental management post-repossession or post-foreclosure; and
carefully document efforts to market the property for sale

Rise in Foreclosures + An Increase in Mortgage Fraud = More Homeowner Fires

A recent posting at the National Law Review by Rick Hammond of Johnson & Bell Ltd. highlights some of many problems related to mortgage fraud.

According to recent reports, many insurers have experienced an increase in the number of fire claims since the onset of the subprime mortgage crisis. Allegedly, many of these fires were intentionally set by homeowners facing foreclosure. Not surprisingly, when homeowners’ monthly mortgage payments increase after their low introductory rates expire or when falling home values and stricter lending practices reduce the possibility of restructuring or refinancing loans, the natural result is an increase in the number of foreclosures and an increase in homeowner fires.

That’s not the only problem facing the insurance industry. Insurers are also experiencing an increase in fires associated with the rise in mortgage fraud, which is also running rampant across the United States. Mortgage fraud is generally defined as the intentional misstatement, misrepresentation, or omission by an applicant or other interested party relied on by a lender or underwriter to provide funding for a mortgage loan.

Victims of mortgage fraud include borrowers, mortgage industry entities, and those living in the neighborhoods affected by mortgage fraud. As properties affected by mortgage fraud are sold at artificially inflated prices, properties in surrounding neighborhoods also become artificially inflated. When property values are inflated, property taxes increase as well. Legitimate homeowners also find it difficult to sell their homes. When properties foreclose as a result of mortgage fraud, neighborhoods deteriorate and surrounding properties depreciate.

Legal Issues and Developing Law

Insurable Interest by the Insured

The threshold question in many cases involving mortgage fraud and its effect on insurance coverage is whether the insured has an insurable interest in the property at the time of a loss. An insurable interest at the time of loss is essential to the validity of an insurance policy. Hawkeye Security Ins. Co. v. Reeg, 128 Ill. App. 3d 352, 470 N.E.2d 1103 (Ill. App. Ct. 1984). Generally speaking, a person has an insurable interest in property whenever he or she would profit or gain some advantage by a property’s continued existence, and suffer loss or disadvantage by its destruction. Lieberman v. Hartford Fire Ins. Co., 6 Ill.App.3d 948, 287 N.E.2d 38 (Ill. App. Ct. 1972).

To determine whether an individual has an insurable interest in property, a court will usually examine whether an economic benefit or detriment inures to the named insured under any set of circumstances. In cases involving a straw person, a close examination of the facts might reveal that in every conceivable manner an insured did not contribute a single cent towards the purchase of the insured property or its maintenance. That is, an investigation might reveal that every payment towards the purchase or maintenance of the insured premises was made by a straw person, that is, the property’s unidentified buyer-in-fact.

Therefore, a proper investigation would seek to determine whether a buyer-in-fact paid for the insurance, paid the initial down payment, the mortgage payments, and for all upkeep and necessary expenses, and whether he or she paid for every attendant cost for the property. In these cases, the actual insured will likely not incur economic loss due to the damage suffered by the insured premises, nor gain economically from any recoverable insurance proceeds. Simply put, the primary question is whether there was an actual relationship between the insured and the insured premises, or whether the insured’s relationship to the insured premises is illusory.

Mortgagee’s Duty to Notify Insurer of Foreclosure Proceedings

An insurer is often unaware of a pending foreclosure on property that it insures until after a fire has occurred. Must a mortgagee, as a condition to receiving coverage, give notice to the insurer when that mortgagee initiates foreclosure? A recent case in Tennessee is instructive in analyzing this question (See: U.S. Bank, N.A. v. Tennessee Farmers Mut. Ins. Co., 2007 WL 4463959).

In this case, a homeowner and insured fell behind on her monthly mortgage payments and the mortgagee, U. S. Bank, N.A., initiated foreclosure. The bank sent a letter to the homeowner stating that it started foreclosure, but the bank neglected to give notice of the foreclosure to the property insurer, Tennessee Farmers Mutual Insurance Company. Before the foreclosure process was completed, the homeowner and her husband filed for bankruptcy, which stayed the foreclosure proceedings. Shortly thereafter, the house was destroyed by fire.

U.S. Bank filed a claim with the insurers, Tennessee Farmers, for the fire loss, but the insurer denied the claim because the bank had failed to notify Tennessee Farmers that a foreclosure had been initiated. Tennessee Farmers stated that the foreclosure filing constituted an increase in hazard and, as such, the bank was required to notify the insurance company, and the bank’s failure to provide this notice was a breach of the policy’s mortgage clause, which stated:

We will:

(a) protect the mortgagee’s interest in the insured building. This protection will not be invalidated by any act or neglect of any insured person, breach of warranty, increase in hazard, change of ownership, or foreclosure if the mortgagee has no knowledge of these conditions

The trial court denied Tennessee Farmers’ motion for summary judgment and granted summary judgment to the bank. The insurance company then filed an appeal. On appeal, Tennessee Farmers argued that the foreclosure proceedings was an “increase in hazard” under the terms of the policy of insurance, and contended that the bank’s bad faith claim was unfounded. On the other hand, U.S. Bank argued that commencing foreclosure proceedings did not constitute an increase in hazard, and asked the court to adopt the Kentucky’s court’s opinion in Anderson v. Kentucky Growers Ins. Co., Inc., 105 S.W.3d 462 (Ky. Ct. App. 2003).

In Anderson, the policy’s mortgage clause stated that the insurance company’s denial of the insured’s claim would not apply to a mortgagee’s claim if the mortgagee had notified the insurer of a “substantial change in risk of which the mortgagee becomes aware.” In that case, the house was destroyed by fire, and the insurance company argued that the filing of foreclosure proceedings constituted a “substantial change in risk of which the mortgagee became aware.”

The court in Anderson ruled against the insurer, noting that insurance contracts are liberally construed in favor of the insured: “While we agree that the filing of foreclosure proceedings constitutes a ‘change of risk,’ we do not agree that such a change is necessarily ‘substantial.” The court then concluded that the policy did not “clearly and unambiguously” require the mortgagee to give the insurer notice when foreclosure was initiated. The court in Anderson further held that commencing foreclosure proceedings, while certainly a “change of risk,” did not constitute a “substantial change of risk” within the meaning of the mortgage clause.

The Tennessee Farmers’ court rejected the Anderson court’s analysis, noting that the mortgage clause in the Tennessee Farmer’s policy required notification of “any” increases in hazard, not just a “substantial” increase in hazard. However, this issue remains a moving target. Thus, after the Tennessee Court of Appeals agreed with the insurance company and reversed the trial court’s decision, U.S. Bank then appealed to the Tennessee Supreme Court. The state’s high court held that the bank’s commencement of foreclosure proceedings was not an increase of hazard requiring notification to insurance company under the standard mortgage clause in a fire insurance policy, and the bank’s commencement of foreclosure proceedings was not an increase of hazard requiring statutory notification to insurance company.

Mortgage Fraud and the Insurer’s Right of Rescission

By its very nature, mortgage fraud involves the intentional misstatement and misrepresentation of material information to a mortgagee. Often, the same misrepresentations made to the mortgagee are also made to an insurer on an insurance application and give rise to a rescission action. For an insurer to rescind a policy due to misrepresentation, the insured’s statement must be false, and the false statement must have been made with the intent to deceive ormaterially affect the acceptance of the risk or hazard by the insurer. Illinois State Bar Assn. Mut. Ins. Co. v. Coregis Ins. Co., 335 Ill. App. 156, 821 N.E.2d 706 (Ill. App. Ct. 2004). In such circumstances, an insurance policy becomes voidable, not void ab initio, and an insurer can waive its right to void if it does not invoke it promptly.

However, in some states an insurer has no general duty to investigate the truthfulness of answers to questions asked on an insurance application. Those states have recognized that “an insurance company has the right to rely on the truthfulness of the answers given by an insurance applicant, and the insured has the corresponding duty to supply complete and accurate information to the insurer.” Commercial Life Insurance v. Lone Star Life Insurance, 727 F. Supp. 467, 471 (N.D. Ill. 1989).

However, an insurer is generally estopped from voiding a policy for untrue representations in the application if the insured discloses facts to the agent and the agent, in filling out the application, does not state the facts as disclosed to him, but instead inserts conclusions of his own or answers inconsistent with the facts. See Boyles v. Freeman, 21 Ill. App. 3d 535, 539, 315 N.E.2d 899 (Ill. App. Ct. 1974). Typically, an insurer cannot rely on incorrectly recorded answers, even when the insured knows that the agent has entered answers different from the ones he or she provided, if the incorrect answers are entered under the agent’s advice, suggestion, or interpretation. Loganv. Allstate Life Insurance Co., 19 Ill. App. 3d 656, 660, 312 N.E.2d 416 (Ill. App. Ct. 1974).

Thus, the agent’s knowledge of the truthfulness of the statements is imputed to the insurer. Generally, only when an applicant has acted in bad faith, either on his or her own or in collusion with the insurer’s agent, will a court refuse to impute the agent’s knowledge to the insurance company.

Most laws that are enacted to regulate rescission actions are designed to prevent insurance companies from rescinding policies based on cursory or unintended misstatements by an insured. However, in cases involving straw persons, an argument can be made that the buyers-in-fact act as puppet masters and typically arrange to have the insureds’ names placed on the mortgage and the insurance policies to shield him or herself from exposure, while still enjoying potential profits from sales or insurance proceeds. In these cases, a court will likely recognize this deceptive arrangement, and that the buyer-in-fact elicited an insurance policy using the purported insured as a front. Arguably, a court should order rescission of the insurance policy in these types of cases.

Rescission of the Mortgagee’s Right of Recovery

Most policies’ mortgage clause does not address rescission of the contract, nor does it describe the mortgagee’s rights in the context of rescission, because these rights are, in fact, extinguished by rescission. Therefore, a novel approach in cases involving fraud in the application for insurance is to file a declaratory judgment action seeking rescission and voiding of the policy, which will possibly render the mortgage clause inapplicable, and asking a court to bar the mortgagee from receiving any benefits of that clause. Thus, rescission could potentially wipe the entire policy away, and the insurer would owe no contractual duties to either the insured or the mortgagee. Assuming rescission is granted, in effect, the policy will have never legally existed, and all parties that had any putative rights under that policy would have none.

Importantly, some courts have held that an insurer’s right to rescind or deny coverage on the basis of fraud only applies to the claims of the insured, not to claims of innocent third-parties that are injured by the insured’s tortuous acts. However, this argument is inapplicable here, since a mortgagee is not a third party but is tantamount to a first-party insured. Moreover, contract law governs the alleged wrongful acts of the insured rather than tort law.

Increasing the Effectiveness of an Insurance Claims Investigation

To conduct a more effective investigation when faced with mortgage fraud and foreclosure issues, the author encourages insurers, as part of their investigations, to check the sales history of the insured premises because several sales within a short period of time could indicate false, inflated values. Also, it is advisable to conduct a title search, checking with the local tax assessment office or recorder of deeds, to analyze the property’s ownership history and to ensure that the insured owns the property. Interviewing and completing background checks on the appraisers and real-estate brokers that were involved in a transaction are also advisable.

Finally, review information regarding recent comparable sales in the area, and other documents, such as tax assessments, to verify the property’s value. Reviewing a title history can help determine if a property has been sold multiple times within a short period, which could indicate that the property has been “flipped” and that the value is falsely inflated.

An Overview of the Hedge Fund Industry and What’s Coming Next for Hedge Funds

The National Law Review‘s winner of the Fall Student Legal Writing Contest is Karol C. Sierra-Yanez of Suffolk University Law School. Karol’s article provides some background on the hedge fund industry and where experts think regulation of this industry may be going. Read on:

This paper aims to provide the reader with a better understanding of what the term hedge fund means, their history and development, and how hedge funds differ from traditional investment vehicles, such as mutual funds. It will focus on the future of the hedge fund industry, specifically, the changes proposed in the Hedge Fund Transparency Act. While some critics and experts in the financial industry see this Act as a way to regulate an investment vehicle capable of affecting the economy, others see it as an invasion into the freedom of hedge fund advisers to develop creative strategies to hedge the risks of their investments and enhance returns.

I. WHAT IS A HEDGE FUND?

To begin with, there is no universally accepted definition of hedge funds. The various definitions refer to hedge funds as private investment vehicles that are subject to less regulation in comparison with more traditional forms of investment, such as mutual funds.[1] Hedge funds are not defined by the Securities and Exchange Commission (SEC), in fact, there is no regulatory or statutory definition of hedge funds.[2]

While the first hedge fund was started in 1949 when Alfred W. Jones developed a system to protect investments against market risk[3] that incorporated various techniques including the use of leverage[4] and short selling[5], other financially creative hedge fund managers also came along and developed new hedging strategies such as the use of futures and options, strategies that did not exist when Jones developed his fund.[6] With the use of these new strategies, hedge funds started to generate favorable returns again and increasingly grew in popularity, to the point that by 2002, there were an estimated 6,500 hedge funds operating in the United States, managing approximately $600 billion in capital.[7]

II. HOW DO HEDGE FUNDS DIFFER FROM TRADITIONAL INVESTMENTS?

To begin, a major characteristic difference between hedge funds and mutual funds is that mutual funds and their managers are required to register with the United States Securities and Exchange Commission (SEC), whereas hedge funds are unregistered investment vehicles. [8] Mutual funds must register as investment companies under the Investment Company Act of 1940 and their managers must register under the Investment Advisers Act of 1940[9]; these funds are considered to be “public” investment funds, meaning they are open to the general public and any investor possessing the required capital may invest, regardless of their net worth or level of sophistication. [10] Hedge funds, on the other hand, are considered “private” investment funds, and are not registered with any government body, and are only open to qualified or accredited investors, including high-net-worth investors, institutions, endowments, family offices and pension programs.[11]

From a sales and marketing standpoint, mutual funds can be purchased in any number of ways, with common examples including directly through a fund management company (e.g. Fidelity), through a mutual fund ‘supermarket’ (e.g. Charles Schwab) or through a broker or financial planner (e.g. Ameriprise Financial).[12] Advertisements for mutual funds can often be found in a variety of published sources, including magazines, newspapers, and on the internet.[13]Hedge funds, meanwhile, are much different in terms of sales and marketing; to be free from certain restrictions, “hedge funds limit access to investors who regulators deem rich and savvy enough to handle the risk.”[14] This is closely related to the fact that hedge funds are referred to as “private placement” vehicles, which refers to the offer and sale of a security not involving a public offering and therefore not subject to filing a registration statement with the SEC under the Securities Act of 1933.[15]

From the standpoint of fees and expenses, mutual funds have what is called an “expense ratio”, which is the percentage of fees paid by investors to the company to cover the costs of managing and operating the fund, as well as marketing and distribution costs. [16] The expense ratio is the total fee that the investor will pay, besides any transaction costs that are incurred at the time of purchase or sale of the shares.[17] The average equity mutual fund charges an expense ratio somewhere between 1.3% and 1.5%. [18] Hedge funds, meanwhile, in addition to a management fee (similar to the expense ratio of mutual funds), also charge a percentage of profits earned by the fund. [19]The popular fee arrangement in the hedge fund industry, commonly referred to as “2 & 20”, is to charge 2% of assets under management (the management fee) as well as 20% of profits over a stated benchmark (the performance or incentive fee). [20]

Any person who possesses the required capital is generally allowed to invest in the mutual fund of their choice, and most funds have a minimum investment of $1000, making them a relatively accessible investment for most people.[21] In addition, mutual funds stand ready to redeem an investor’s shares at any point in time, a concept called liquidity, making it relatively easy for an investor to get their money back when they would like.[22] Minimum investments for hedge funds are quite steep, and vary from fund to fund, ranging from $100,000 to $1,000,000 or more. [23] Liquidity, or the ability of an asset to be converted into cash quickly,[24]is quite different between hedge funds and mutual funds. With mutual funds, a net asset value (or “NAV”) is computed every single business day, and investors can redeem their shares at the NAV on a daily basis. [25] Based on a review of several articles, with hedge funds, like mutual funds, the liquidity depends on the frequency with which they issue and redeem shares, but just much less frequently. Most hedge funds have monthly liquidity with a 35-day notice period, but some are much less liquid, depending on the type of assets invested in and the strategies employed by the fund.[26] Hedge funds are also subject to a “lock-up period”[27], which is the time period that an investor must hold their assets within a fund before they can be removed. In other words, mutual fund shares have a readily ascertainable market and a fair price, while hedge fund investors have a contract with the manager that essentially allows the manager to dictate the frequency and manner of redemption.[28]

Traditional mutual funds are generally segmented into a few basic categories, such as stock (growth, value, blend), bond (municipal, corporate, government), and money market (cash, t-bills),[29] according to the types of investments they will make as outlined in their prospectus. They do not deviate from their prescribed investment approach, and are generally limited to the types of investments they can make. Hedge funds, however, generally employ sophisticated trading methods, including short selling (when the investor sells borrowed securities), options (financial contracts between two parties), and leverage (the use of borrowed capital to purchase additional assets with the objective of increasing returns). [30]

According to a Morningstar Methodology Paper published in 2007 titled “The Morningstar Category Classifications for Hedge Funds”, hedge fund managers typically focus on specific areas of the market and/or specific trading strategies. Morningstar states, as an example, “that some hedge funds buy stocks based on broad economic trends, while others search for arbitrage profits by pairing long and short positions in related securities.”[31]

III. PRESENT REGULATORY FRAMEWORK

As discussed briefly in the section outlining the key differences between hedge funds and more traditional investment vehicles, regulatory differences, most of which stem from the fact that participation in hedge funds is mainly the “preserve of sophisticated investors who possess the required knowledge to assess the risks associated with investing in this asset class”[32] are of the utmost importance. Under this sophistication premise, it is maintained that wealthy investors can better fend for themselves[33] and are thus more suited for hedge fund investments, whereas the everyday, less sophisticated investor may not be.

Two of the primary statutory exclusions for hedge funds from the definition of “Investment Company” come from the Investment Company Act of 1940: §3(c)(1) and §3(c)(7).[34] The §3(c)(1) exemption is satisfied when the issuer sells their securities to no more than 100 persons and does not make or will not plan to make a public offering of those securities;[35] the §3(c)(7) exemption, meanwhile, is satisfied when the securities are being sold only to “qualified purchasers” and also like §3(c)(1) the issuer does not make or does not plan to make a public offering of those securities. As one may note, §3(c)(7) makes no reference to the number of investors in a fund in the manner that §3(c)(1) does, and this is where the Securities Exchange Act of 1934 comes into play. Under §12(g) of the Exchange Act, it states that an issuer must “register, disclose information and submit periodic reporting” if the issuer has $10 million or more in assets under management and 500 or more investors.[36] Due to this fact, it comes as no surprise that many hedge funds elect to issue securities to less than 500 investors in order to avoid triggering this requirement.[37] Similarly, those fund managers that operate as Commodity Pool Operators (“CPO”) are able to rely on regulations contained in the Commodity Exchange Act (“CEA”) that “provide an exemption from registration to CPOs that engage in limited commodity futures activities and sell interests solely to certain qualified individuals and that sell interests to highly sophisticated pool participants.[38]

Finally, the Investment Advisers Act of 1940 (not to be confused with the Investment Company Act of 1940), which regulates the activities of investment advisers, also contains one registration exemption that hedge funds commonly rely upon. The registration exemption is called the “private adviser exemption” and is found under §203(b) of the Advisers Act and states that the exemption is satisfied if the adviser “1) has fewer than fifteen clients during the preceding twelve months; 2) [nor] holds himself out to the public as an investment adviser nor acts as an investment adviser to any investment company.”[39] This exemption at first may seem rather difficult to achieve, as it would seem that most hedge funds would have 15 or more investors, but there is a catch. Under the law, hedge fund advisers are able to meet this exemption by satisfying a safe harbor whereby they treat each legal entity (e.g. a single fund, limited partnership, etc) as a single client and are able to invoke the small adviser exemption.[40] As such, many hedge fund advisers avoid registering with the SEC by relying on this de minimis exemption and have fewer than 15 “clients” during the preceding 12 months and do not hold themselves out to the public as investment advisers.[41] This specific exemption will be touched upon further in the paper as it has been the focal point of recent regulation changes affecting the hedge fund industry.

IV. PAST PROPOSED HEDGE FUND REGULATIONS

While hedge funds themselves have been around for decades, they did not grow to such prominence until much more recently. For example, during the post-technology bear market era around 2000 through late 2002 the popularity of hedge funds grew very quickly, and by 2006 there were approximately 8,000 hedge funds globally with assets under management in excess of $1 trillion compared to 1990 when there were only 600 hedge funds with under $40 billion in combined assets under management.[42]

This tremendous outgrowth, which directly results in a significant amount of power and influence within the capital markets, is one of the factors often cited by the SEC as rationale for regulatory action against the hedge fund industry. Other factors include the fact that government agencies generally lack meaningful and reliable data and information about the hedge fund industry as well as the increased “retailization” of hedge funds.[43] An example of such “retailization” would be the fact that U.S. hedge fund of funds that do not meet the aforementioned exemptions and are registered with the SEC do not need to require that all investors be accredited and may accept investments for as little as $25,000.[44] Pension plans, university endowments, and charitable organizations have been investing money in hedge funds, sometimes exposing unsophisticated investors to risky investment strategies.[45] This has led to concerns that unsophisticated investors have invested in vehicles they do not understand.[46]Besides, some hedge funds have been using television commercials to advertise their investment services to unsophisticated investors.[47]

In response to these factors, a 2003 SEC Staff Report investigated the hedge fund industry and concluded that the SEC should require hedge fund advisers to register under the Advisers Act.[48] The SEC had concluded that a number of existing hedge funds were using the private adviser exemption in contradiction of its intended purpose and that a change of the interpretation of the term “client” was justified.[49] Accordingly, in 2004, the SEC, by a vote of 3-2, adopted regulation 203(b)(3)-2, which was an amendment to §203(b)(2) of the Advisers Act, which would require many hedge fund advisers to register with the SEC for the first time.[50] This amendment is referred to as the 2004 Hedge Fund Rule, and defined each investor within a private hedge fund as a “client” for the purpose of determining whether the adviser satisfied the previously discussed private adviser exemption.[51] This Rule applied a “look-through” to hedge funds (in contrast to the previously mentioned safe harbor rule which counted each fund or legal entity as a “client”), whereby each individual investor would be counted as one client, thereby many hedge fund advisers were no longer able to satisfy the private adviser exemption under the Advisors Act and were legally required to register with the SEC.[52] Not surprisingly, the SEC, in support of the passing of this amendment, argued that the registration of hedge fund advisers is necessary “to protect investors in hedge funds and to enhance the Commission’s ability to protect our nation’s securities markets.”[53]

It seemed, however, that from the very beginning there were those who felt the passing of the “Hedge Fund Rule” would do little to no good in actually improving the hedge fund industry. One of the articles used for this research states that “the implementation of this mandatory disclosure will probably have little or no impact in practice” and even continues by saying that “the implementation of this rule might ultimately be counterproductive to the SEC’s goal of the abolishment of the “retailization” of hedge funds.[54]

Unfortunately for the SEC, their efforts aimed at hedge fund regulation were short-lived, as in 2004 hedge fund manager Philip Goldstein, his firm Opportunity Partners LLC, and their general partner Kimball & Winthrop filed suit against the SEC, arguing that the “Commission lacked any power to regulate the hedge fund advisor industry and that only Congress may change the Advisers Act.[55] In doing so, Goldstein et al challenged the enforcement of the recently passed Hedge Fund Rule, arguing that Congress “unambiguously intended the term “client” to mean the fund, and not the investors in the fund.[56] The challenge also claimed that the SEC “drastically exceeded the term’s “probability of meaning” and the SEC’s adoption of the rule was arbitrary and capricious.[57] A three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit heard arguments in the case of Goldstein v. SEC, and in 2006 they vacated and remanded the Hedge Fund Rule and held that the SEC’s interpretation of the word “client” was “outside the founds of reasonableness”, “arbitrary” and “inconsistent with Congressional intent.”[58] Adding insult to injury, the court even went as far as to say that “the Hedge Fund Rule came close to violating the plain language of the Advisers Act.”[59]

V. RECENTLY PROPOSED HEDGE FUND REGULATIONS

Despite a lack of early success, the U.S Government did not give up on the subject of hedge fund industry regulation. Looking back at the many concerns related to the hedge fund industry and the financial industry overall, the use of the term “systemic risk” has become rather commonplace when describing the perceived risk inherent in hedge funds. In a paper entitled “Unnecessary Reform: The Fallacies With and Alternatives to SEC Regulation of Hedge Funds”, author Evan M. Gilbert defines systemic risk as “the potential for a modest economic shock to induce substantial volatility in asset prices, significant reductions in corporate liquidity, potential bankruptcies and efficiency losses.”[60] Many including regulators are concerned that the sudden and powerful downfall of large and influential investment funds and/or firms could have drastic and far-reaching effects throughout the entire financial system.

As such, and particularly in the wake of the financial crisis that occurred between 2007 and 2008, regulators sprung into action in 2009 and quickly introduced new measures aimed at the hedge fund industry. The first came on January 29, 2009, when two United States politicians, Senators Chuck Grassley of Iowa and Carl Levin of Michigan, introduced the “Hedge Fund Transparency Act of 2009.” This act would amend the Investment Company Act of 1940 and aim to regulate hedge funds in two specific ways: first, it would require any funds with assets equal to or greater than $50 million to register with the SEC and second it would impose more stringent anti-money laundering obligations.[61] The Act would encompass all §3(c)(1) and §3(c)(7) exempted funds, not just “hedge funds” per se; as such, all privately-held investment funds ranging from hedge funds to venture capital and private equity funds would be affected.[62]

As mentioned, all “large” funds with $50 million or more in assets would be required to register with the SEC; in addition, they would be required to maintain books and records with the SEC, and also comply with any requests for information or examination by the SEC.[63] Finally, periodic electronic reporting (minimum once per year) to the SEC would also be required of all funds.

Besides the Hedge Fund Transparency Act of 2009, other regulatory developments were underway in 2009. In a paper published in March, 2010 entitled “New Developments in Securities Litigation”, author Elizabeth P. Gray, a partner at Willkie Farr & Gallagher LLP, states that “financial regulation of advisers to hedge funds and other private funds is expected to increase substantially during 2010.”[64] She goes on to add that “financial reform bills that would require the registration of advisers to hedge funds as investment advisers with the SEC under the Advisers Act appear to have significant momentum behind them.”[65] Of particular interest is a bill that was sponsored by Congressman Paul Kanjorski of Pennsylvania and approved by the U.S. House of Representatives in December, 2009 which would, if enacted, effectively eliminate the private adviser exemption from registration under §203(b)(3) of the Advisers Act.[66] This particular bill is clearly reminiscent of the previously discussed, and unsuccessful, Hedge Fund Rule of 2004 in that it seeks to amend the meaning of “client” under the Advisers Act and forcibly require advisers with 15 or more clients to require with the SEC. In doing so, these changes in regulation would have many effects similar to those proposed within the Hedge Fund Transparency Act as well as those presently in place for funds abiding by §3(c)(1) and §3(c)(7) of the Advisers Act. Such regulatory requirements would include, among other things, extensive record-keeping requirements, disclosure requirements, rules of conduct, subjectivity to examination processes, and standing ready to provide information to the SEC about the adviser themselves and the funds they manage.[67]

VI. THE FUTURE OF HEDGE FUND REGULATION

While it is difficult to say with any real certainty at this time exactly what the future holds for the hedge fund industry, no less trying to predict what future regulations may or may not be enacted, it can certainly be said that many experts and academics alike favor some degree of regulation or another. Long before the term ‘systemic risk’ became everyday vernacular from Wall Street to Main Street, progressive minds felt new regulation would be done. If and when it was done, most would likely agree that future regulation “must reduce the likelihood and potential costs of the failure of systemically important hedge funds whilst at the same time preserving the wider market benefits of hedge funds’ ongoing activities.”[68] It is important that any regulation that is enacted in the years ahead should somehow provide additional transparency, awareness, protection and overall risk management while at the same time allowing hedge fund companies and managers to invest and operate with the degree of anonymity which they deserve and to contribute to overall market efficiency. While some feel that new hedge fund regulations would “create a stable regulatory environment, bring parts of the industry in from the cold, and help lift the veil of secrecy that currently surrounds hedge funds,” others still maintain their rightful concerns.[69]Take for example former US Federal Reserve Board Chairman Alan Greenspan. With his traditionally “laissez-faire” approach to financial markets, he for one might be more inclined to believe that “hedge funds should not be regulated at all because of the efficiency they provide to the financial system.”[70]In a paper he published recently for The Brookings Institute entitled “The Crisis”, Greenspan continues down the “less is more” path, adding that “regulation by its nature imposes restraints on competitive markets. The elusive point of balance between growth and stability has always been a point of contention, especially when it comes to financial regulation.[71] Others, while cognizant of the systemic implications associated with the failure of one or more large hedge funds, agree, too, that the benefits hedge funds provide to the financial system are substantial and that “the trading behavior of hedge funds can improve market efficiency, price discovery and consumer choice.[72] Going even further, and somewhat contrary to what others may say or feel, some believe that “hedge funds may help in alleviating financial crisis.[73]

Others, meanwhile, are taking a much more middle-of-the-road approach, with beliefs that hedge fund regulations can and will help both sides. David Langguth, of EACM Advisors, LLC, a leading investment advisory firm and subsidiary of BNY Mellon Corporation, was quoted in a hedge fund roundtable as saying that “while regulatory initiatives such as increased transparency or registration may affect hedge funds, we do not anticipate measures that will significantly limit most managers’ ability to implement their strategies. Clearly, well designed measures intended to limit potential market abuses generally will be positive for market participants, including hedge funds.”[74]

Looking back again at the failed 2004 Hedge Fund Rule, some feel that “it would be an understatement to say that the Goldstein ruling was a setback for the SEC,”[75] and I cannot say that I disagree. Author Joshua Hess, in a paper entitled “How Arbitrary Really Was the SEC’s Hedge Fund Rule?” argues that the Goldstein decision resulted in a regulatory black hole to which the SEC found itself inadequately able to regulate a financial industry whose continuing growth will have a substantial impact on U.S. financial markets.[76] And, following the series of recent events that have roiled global financial markets, including the outright collapse of Lehman Brothers, the rescue of Merrill Lynch, countless lending institution bankruptcies, and bailout after bailout by central government banks, it feels to many that something, anything, needs to be done. Furthermore, Evan Gilbert, in his paper entitled “Unnecessary Reform: The Fallacies With and Alternatives to SEC Regulation of Hedge Funds” writes that “there appears to be a strong emotional component behind the calls for subjecting hedge funds to SEC registration and disclosure requirements…this fear-based response is understandable, especially in light of the growing number of established institutions either on the brink of collapse, or in some cases actually failing.[77]Once again, something, anything, needs to be done.

Two main ideas that I have come across in my research that stand out as possible solutions include: First, to establish legal limits and/or regulations related to the amount of credit that can be extended to hedge funds by financial institutions. Previously mentioned author Gilbert in his “Unnecessary Reform” paper states, “one of the more straight-forward solutions would be to limit the amount of credit public financial institutions are permitted to extend to hedge funds. Perhaps the most significant concern expressed by those critical of the hedge fund industry is systemic risk…one of the principal causes of systemic failure is failure amongst credit institutions, or more specifically, banks…if banks are limited in the credit they are permitted to extend to hedge funds, any failure of such funds would be less likely to instigate a liquidity crisis.”[78] As previously discussed in the earlier stages of this paper, financial leverage is something specifically available to hedge funds, and a variety of the well-known hedge fund collapses have been attributed to excess amounts of leverage. Therefore, some believe that limiting the amount of credit extended to hedge funds, which is then used to achieve leverage, could help stem systemic risk.

The second recommendation I have come across that I also agree with would be to impose more strict requirements for so-called “accredited investors”. Author David Schneider in his papered titled “If at First You Don’t Succeed: Why the SEC Should Try and Try Again to Regulate Hedge Fund Advisors” argues that the SEC could discourage hedge funds from allowing investors to invest in the hedge fund by changing the definition of an accredited investor.[79] By definition under the Securities Act, an accredited investor is any individual with a net worth that exceeds $1 million or any person with an income in excess of $200,000 in each of the two most recent years. Amazingly, however, Schneider points out an almost unbelievable fact, which is that this net worth/income benchmark has not changed since 1982, and that due to the presence of inflation (rising prices, incomes, etc) and increasing net worth, more and more investors have been satisfying the accredited investor benchmark.[80] It seems to me that it would be worthwhile to adjust the “accredited investor” threshold every year based on inflation rates, so that as incomes and net worth levels continue to rise, more and more individuals do not suddenly qualify as potential hedge fund investors. The income and net worth thresholds should be increased each and every year, so that it remains equally difficult with each passing year for individuals to become qualified as hedge fund investors.

Apart from the aforementioned recommendations, there is one additional point that continues to stand out as something that the government, at least it would appear, should tend to be more concerned with. As I have come to recognize through my research, hedge funds were originally an activity generally for the ultra rich – those with upper-tier income levels, high net worth, and money to spare, and lose. It was the last condition – the fact that they could essentially bare to lose some part of their net worth – that made them suitable hedge fund investors. But yet, over time, so-called institutional investors, such as pension plans, endowments, foundations, schools, hospitals, and so on, have all started to gradually wade further and further into the hedge fund waters. Institutional investors have pensioners and retirees to take care of, and if hedge fund investments go too far and returns go too astray, then those depending on the long-term benefits their retirement assets will provide are the ones who will lose. As such, I believe it is the government’s responsibility and duty to make sure that pension plans and other institutional investors, both public and private, have a strong handle on their investment choices and that they are fully informed as to the possible risks that hedge funds can present.

VII. CONCLUSION

Hedge funds have enjoyed almost complete anonymity for a number of years, and it has become very evident over the past few years that while hedge funds are not to blame for the various problems our financial system has been dealing with, they certainly do play a very large part. Having more information about them, their actions, their clients, their assets, and so forth, will only help to add a much needed layer of transparency within our fragile financial system. There is also a need to let the financial system be a free flowing system, one that is not encumbered by over-bearing rules and regulations.

[1]Houman B. Shadab, The Challenge of Hedge Fund Regulation, Regulation, Vol. 30, No.1, Spring 2007, at 36, 41.

[2] Mark J. P. Anson, CAIA Level I: An Introduction to Core Topics in Alternative Investments 119 (John Wiley & Sons 2009).

[3]Id. at 2. See also James E. McWhinney, A Brief History of the Hedge Fund,http://www.investopedia.com/articles/mutualfund/05/HedgeFundHist.asp.

[4]Financial leverage is essentially the borrowing of capital in order to invest additional assets in a company, hoping that the company’s return is higher than the loan’s interest rate, thus generating excess return on equity. Gabelli, supra, at 2. See also, The Layman’s Finance crisis Glossary,http://news.bbc.co.uk/2/hi/uk_news/magazine/7620678.stm(last updated Sept. 19, 2008).

[5]After reading about short selling and put in rather simple words, short selling is the act of borrowing assets (such as securities) from a third party after which point they are sold in the hope that the value of the assets will go down before repurchasing them again after which point they are then returned to the third party, thus making a profit on the price difference. Securities and Exchange Commission, http://www.sec.gov/news/press/2008/2008-235.htm(last visited Oct. 1, 2008) (Statements of the SEC regarding short selling and issuer stock repurchases. The SEC was explaining the implication of short selling in the light of the current financial crisis and actions taken to control operation).

[6]Implications of the Growth of Hedge Funds, Sep. 2003,http://www.sec.gov/news/studies/hedgefunds0903.pdf.

[7]Id. at 11.

[8]Slutz, supra, at 179.

[9]Craig T. Callahan, Hedge Funds vs. Mutual Funds (2009), http://www.iconadvisers.com/WebContent/Public/PDFDocuments/Hedge_vs_Mutual_Funds.pdf.

[10]Id. at 2.

[11]EurekaHedge.com, http://www.eurekahedge.com/database/faq.asp(last visited Apr. 5, 2010).

[12]WSJ.com, http://guides.wsj.com/personal-finance/investing/how-to-buy-a-mutual-fund/ (last visited Apr. 6, 2010).

[13]Id.

[14]Alistair Barr, How to Buy…Hedge Funds, Sept.11, 2007,http://www.marketwatch.com/story/how-to-buy-hedge-funds.

[15]Mark J. Astarita, Introduction to Private Placements,http://www.seclaw.com/docs/pplace.htm(last visited Apr. 6, 2010).

[16]Lee McGowan, What is a Mutual Fund Expense Ratio?,http://mutualfunds.about.com/od/mutualfundglossary/g/expense_ratio.htm(last visited Apr. 6, 2010).

[17]Id.

[18]Investopedia.com,http://www.investopedia.com/university/mutualfunds/mutualfunds2.asp(last visited Apr. 6, 2010).

[19]Mark Hulbert, 2+ 20, and Other Hedge Fund Math, Mar. 4, 2007,http://www.nytimes.com/2007/03/04/business/yourmoney/04stra.html?_r=1.

[20]Id.

[21]Sec.State.MA.Us, http://www.sec.state.ma.us/sct/sctprs/prsamf/amfidx.htm(last visited Apr. 6, 2010).

[22]Sec.gov, http://www.sec.gov/investor/pubs/inwsmf.htm(last visited Apr. 6, 2010).

[23]Ben McClure, Taking a Look Behind Hedge Funds,http://www.investopedia.com/articles/02/111302.asp(last visited Apr. 19, 2010).

[24]Investorwords.com, http://www.investorwords.com/2837/liquidity.html(last visited Apr. 19, 2010).

[25]Callahan, supra, at 2.

[26]Maintlandgroup.com, http://www.maitlandgroup.com/default.aspx?pid=53(last visited Apr. 19, 2010).

[27]Lock-up period is basically the time period that you must hold your assets (“lock-up” your money) within a fund before they can be removed. What is a Lock-Up Period?, http://www.eurekahedge.com/database/faq.asp#16(last visited Apr. 19, 2010).

[28]Callahan, supra, at 2.

[29]Richard Loth, Mutual Fund Categories,http://www.investopedia.com/university/quality-mutual-fund/chp3-invest-obj/mf-categories.asp(last visited Apr. 19, 2010).

[30]Slutz, supra, at 194.

[31]Morningstar.com,http://corporate.morningstar.com/US/documents/MethodologyDocuments/MethodologyPapers/MorningstarHedgeFundCategories_Methodology.pdf(last visited Apr. 19, 2010).

[32]Vikrant Singh Negi, Legal Framework for Hedge Fund Regulation,http://www.hedgefund-index.com/Legal%20Framework%20for%20Hedge%20Fund%20Regulation.pdf(last visited Apr. 19, 2010).

[33]Tamar Frankel, Private Investment Funds: Hedge Funds’ Regulation by Size, 39 Rutgers L.J., 657, 661 (2008).

[34]Negi, supra, at 3.

[35]David Schneider, If at First You Don’t Succeed: Why the SEC Should Try and Try Again to Regulate Hedge Fund Advisers, 9 J. Bus. & Sec. L. 261, 276 (2009).

[36]Id. at 273-274.

[37]Id.

[38]Negi, supra, at 5.

[39]Schneider, supra, at 277-278.

[40]Thierry Olivier Desmet, Understanding Hedge Fund Adviser Regulation, 4 Hastings Bus. L.J. 1, 15 (2008).

[41]Id.

[42]Id. at 8.

[43]Justin Asbury Dillmore, Leap Before You Look: The SEC’s Approach to Hedge Fund Regulation, 32 Ohio N.U. L.Rev. 169, 177 (2006).

[44]Desmet, supra, at 9.

[45]Id.

[46]Id.

[47]Id. at 10.

[48]Schneider, supra, at 280.

[49]Id.

[50]Janie Casello Bouges, Why the SEC’s First Attempt at Hedge Fund Adviser Registration Failed, J. of Alternative Investments, Vol. 9, No.3, 89 (2006).

[51]Schneider, supra, at 280.

[52]Id. at 281.

[53]Franklin R. Edwards, New Proposals to Regulate Hedge Funds: SEC Rule 203(b)(3)-2, http://www0.gsb.columbia.edu/faculty/fedwards/papers/New%20Prop%20to%20Reg%20Hedge%20Funds%2001.pdf(last visited Apr. 27, 2010).

[54]Dillmore, supra, at 182.

[55]Desmet, supra, at 22.

[56]Schneider, supra, at 281.

[57]Id.

[58]Desmet, supra, at 22.

[59]Id.

[60]Evan M. Gilbert, Unnecessary Reform: The fallacies with and Alternatives to SEC Regulation of Hedge Funds, 2 J. Bus. Entrepreneurship & L. 319, 328 (2009).

[61]Proposed Hedge Fund and Private Equity Fund Regulation,http://www.orrick.com/fileupload/1633.pdf(last visited Apr. 27, 2010).

[62]Id.

[63]Anita K. Krug, The Hedge Fund Transparency Act of 2009,http://www.law.berkeley.edu/files/Hedge_Fund_Transparency_Act_Comments_A.Krug.pdf(last visited Apr. 27, 2010).

[64]Elizabeth P. Gray, Heightened Government Prosecution and Anticipated Regulation of Private Hedge Funds, 2010 WL 894714 (aspatore).

[65]Id. at 2.

[66]Id.

[67]Id.

[68]Ashley Taylor, et al., Highwaymen or Heroes: Should Hedge Funds be Regulated? A Survey, http://www.ashleytaylor.org/hf_jfs2005.pdf(last visited May 13, 2010).

[69] The Future of Hedge Fund Regulation: Q & A with Ezra Zask and Gaurav Jetley of Analysis Group,http://www.analysisgroup.com/uploadedFiles/News_and_Events/News/AnalysisGroup_Release_Zask_Jetley_HedgeFunds_2009-07-16.pdf((last visited May 13, 2010).

[70]Taylor, supra, at 7.

[71] Alan Greenspan, The Crisis,http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2010_spring_bpea_papers/spring2010_greenspan.pdf(last visited May 13, 2010).

[72]Taylor, supra, at 2.

[73] Id.at 3.

[74]Hedge Fund Roundtable,https://privatewealth.mellon.com/en_US/public_content/Resources/documents/CIONewsHedgeFundArticle.pdf(last visited May 13, 2010).

[75]Joshua Hess, How Arbitrary really was the SEC’s “Hedge Fund Rule”? The Future of Hedge Fund Regulation in Light of Goldstein, Amaranth Advisors, and Beyond, 110 W. Va. L. Rev. 913, 940 (2008).

[76] Id.

[77] Gilbert, supra, at 343.

[78]Id. at 345.

[79] Schneider, supra, at 308.

[80]Id.

Legal Risks Facing New Media Publishers

A new post from the National Law Review’s featured guest bloggers Neil M. Rosenbaum and Seth A. Stern of Funkhouser Vegosen Liebman & Dunn Ltd details some of the legal pits falls of social media platforms. Read On:

The rise of online media means that many businesses are doubling as publishers, with all the attendant benefits and risks. Every day, courts and lawmakers face the challenge of applying legal principles conceived in the era of periodic publications featuring bylines and mastheads to the unlimited, instantaneous, and often anonymous content communicated via the Internet.

Below are brief synopses of some of the issues facing online publishers that courts have discussed in recent months.

Anonymous Defamation

Federal law generally precludes defamation liability for websites based on third-party content. This, however, does not mean that third-party content cannot land a webmaster in court. Plaintiffs often issue subpoenas to websites for identifying information regarding anonymous commenters. While companies may be reluctant to spend their money protecting someone else’s First Amendment right to speak anonymously, website operators — particularly those that have promised to protect users’ privacy — may face liability for turning over identifying information.

Businesses that have themselves been anonymously defamed and seek to identify the defamer must jump through a number of procedural hurdles designed to protect the commenter’s constitutional right to speak anonymously. Some courts have suggested that these hurdles may be easier to clear when the anonymous defamer acted for commercial purposes.

Jurisdiction

Internet postings can be accessed anywhere and courts have suggested that Internet posters can therefore be sued anywhere. A federal appellate court sitting in Chicago recently rejected the Arizona domain registrar GoDaddy’s argument that, absent specific intent to direct its Internet activities toward Illinois, Illinois courts should not hear a cybersquatting suit against it.

Additionally, at least three recent appellate courts have held that online defamers can be sued in states other than the one from which the content was published. This means that companies with online presences must be prepared to defend themselves in jurisdictions that may apply varying legal standards. Savvy plaintiffs are sure to choose the jurisdiction most favorable to them.

Privacy and Confidentiality

Many social media users assume that by setting posts to “private” they control their audience. This is not always the case. A New York court recently held that “private” Facebook and MySpace posts are discoverable during litigation and that there is “no legitimate reasonable expectation of privacy” in such posts. Additionally, the United States Supreme Court decided this year that an officer’s privacy rights were not violated when the police department searched his text messages while auditing the department’s texting plan. But some courts have found privacy violations where employers used false pretenses to access employees’ “private” content.

In another recent case a federal court decided that a company’s client list could not be protected as a trade secret because the same information could easily be found on sites such as LinkedIn.

Intellectual Property

While website operators can limit their copyright liability for third-party content by following statutory procedures, websites’ own content is fair game. Online publishers, particularly bloggers, often quote and expand on content created by others. While some perceive this as an opportunity to reach new audiences, others denounce the practice as free-riding. Some media outlets have sold their copyrights to companies that have filed hundreds of suits against alleged online infringers. Others have threatened to sue bloggers formisappropriation of “hot news.”

Courts have suggested that those who misuse an entity or individual’s name to bring attention to online gripes, for instance by impersonating their target, may be liable under trademark statutes, particularly when acting with a profit motive. California has banned “e-personation” outright.

Harassment

A federal court dismissed an employee’s suit alleging that her employer subjected her to a “hostile work environment” by failing to act after coworkers posted inappropriate comments regarding her race on a personal Facebook page. The court left open the question of whether a company can be liable for improper comments on a company-monitored social media site.

Excerpted from FVLD’s blog, http://www.postorperish.com, which regularly discusses these and other issues facing online publishers.

ABA 13th Annual National Institute of Banking Law Basics Oct 27 -29 Boston, MA

The National Law Review is proud to support the American Bar Association Business Law Section, the ABA Center for Continuing Legal Education, and the Morin Center for Banking and Financial Law of Boston University School of Law‘s two-and-one-half day primer on banking law. If you need the basics, you can’t afford to miss this program. Attendance is limited.

Attend this program and learn what you need to know about:

· Who regulates whom, why and how

· The structure and intent of bank regulation

· The impact of Gramm-Leach-Bliley and Dodd-Frank

· The role of capital

· Prudential limitations

· Permitted investments and activities of banks, bank holding companies and financial holding companies

· Insurance, securities and capital market activities of banks and bank affiliates

· Geographic expansion and mergers and acquisitions

· Supervision and enforcement

· Failing banks and actions against affiliated persons

This fundamental banking law course was developed to provide practitioners with an understanding of the basic laws and regulations governing banks and bank holding companies. This course is a comprehensive introduction to banking law regulation for attorneys, consultants, and bank professionals who intend to work in the field. It is also a refresher course for experienced banking law practitioners whose practice has not provided an opportunity for the broad exposure that this course offers. This course includes a two-hour segment on ethical considerations in the representation of banking organizations.

Date:	October 27 — 29 2010
Location:	Boston University School of Management Fl 4 – Executive Leadership Ctr 595 Commonwealth Ave Boston, MA 02215-1704 USA
Requested CLE Credit:	18.50

For More Information and to Register: Click Here.

Mexican Bankruptcy Considerations

Like the U.S. Before the UCC

The Nonpossessory Pledge and the Guaranty Trust

UNCITRAL and the OAS Encourage Registry Reforms

Mexico’s 2009 Commercial Code Amendments and Creation of the RUG

New Registry Regulations

Preventive Filings

Information to be Provided in Filings through the RUG

Using the RUG

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Traditional Insurance Coverage: Still an Important Corporate Asset

Transactional Insurance: A Tool for Facilitating Corporate Transactions

Scenario One: Show Me the Money

Scenario Two: Good Intentions and a Token Will Get You on the Subway

Scenario Three: The Long Goodbye

Scenario Four: Death and Taxes

A Strategic Solution

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Background

The Chancery Court’s Decision

Take-Aways for Creditors of LLCs

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What is CERCLA?

What happens after a lender forecloses and becomes the actual owner of the property?

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Legal Issues and Developing Law

Insurable Interest by the Insured

Mortgagee’s Duty to Notify Insurer of Foreclosure Proceedings

Mortgage Fraud and the Insurer’s Right of Rescission

Rescission of the Mortgagee’s Right of Recovery

Increasing the Effectiveness of an Insurance Claims Investigation

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I. WHAT IS A HEDGE FUND?

II. HOW DO HEDGE FUNDS DIFFER FROM TRADITIONAL INVESTMENTS?

IV. PAST PROPOSED HEDGE FUND REGULATIONS

VII. CONCLUSION

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Anonymous Defamation

Jurisdiction

Privacy and Confidentiality

Intellectual Property

Harassment

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