Participants in the global financial services industry have witnessed developments this past week unprecedented since the late 1920s: within the span of several days, a major investment bank (Lehman Brothers) was forced to file for bankruptcy, one of the premier retail and institutional broker/dealers in the United States (Merrill Lynch) was induced to be sold to Bank of America amid concerns of its own solvency and survival, and a major insurance conglomerate (American International Group (AIG)) was rescued by a direct loan and guarantee program that effectively provides for this entity to be owned and operated by the United States government. These developments occurred within weeks of the federal rescue of two crucial government sponsored enterprises (Fannie Mae and Freddie Mac), and only months after the near collapse and government-guaranteed acquisition by JP Morgan Chase of another prominent investment bank (Bear Stearns).

Facing continuing and mounting concerns about remaining participants in the commercial and investment banking industry, and fearing contagion of the risks of insolvency extending to money market investment funds, municipal bonds, retirement plans and other financial market participants, the United States Treasury, the Board of Governors of the Federal Reserve System and the Securities and Exchange Commission have acted in a dramatic fashion to address the systemic risks that appear poised to overwhelm the global financial system.

In light of the significance and impact which the US government's response will have for every participant in the international capital markets and payments system, this Client Alert provides:

·         a brief summary of the proposed actions, both regulatory and legislative, that are pending as of the current date; and,

·         an analysis of potential issues and consequences that may affect your business as a result of these actions.

Given the rapidly evolving nature of the programs described in this Client Alert, we will publish additional Client Alerts as more information becomes available and as further legislative and regulatory action occurs.

The Government Response

As of the date of this Client Alert, there are four critical elements to the US government's response:

·         a legislative proposal, pending before the United States Congress, that would allow the United States Treasury to borrow up to $700 billion to purchase mortgage-related assets from financial institutions headquartered in the United States. This legislation is intended to halt the continued decline in the value of housing and mortgage related assets by removing from the balance sheet of targeted financial institutions the overabundance of such troubled assets that currently prevents these lenders from providing liquidity to other market participants and to underlying investors and consumers;

·         extensive funding commitments provided by the Federal Reserve and other central banks (including the European Central Bank and the Bank of England), providing approximately $180 billion in extra liquidity to the financial system;

·         coordination with the Securities and Exchange Commission and the UK Financial Services Authority in the issuance of a temporary emergency ban on the short selling of the stocks of 799 financial companies in the United States (for a 10-day period of time, up to October 2, 2008, subject to an additional 30-day extension), and 32 companies in the United Kingdom (until January 16, 2009), and the promulgation by the Commission of a further temporary emergency order requiring institutional investment managers to report, on a weekly basis, their daily short positions (such requirements to cease as of October 2, 2008); and

·         a proposed guarantee to be provided through the establishment of a fund under the auspices of the United States Treasury, in the amount of approximately $50 billion, to insure the obligations of money-market mutual funds.

Of these four extraordinary programs, the latter three require only regulatory decision and private sector response. The first listed above, and most significant of these new proposals, permitting the United States Treasury to purchase up to $700 billion of mortgage-related assets, requires the enactment of legislation authorizing such a massive intervention in the private sector mortgage and credit markets. Proposed language was sent to Congress by the Treasury on September 20, 2008. Treasury has expressed its strongly held view that the legislation needs to be enacted into law by the end of this week.

While there is bipartisan consensus on Capitol Hill on the importance and necessity of acting swiftly to avert a further deterioration in the overall financial situation, as of the date of this Client Alert the final substance of the legislation to be passed remains uncertain. Congress may wish to consider additional concerns at this time, including protection for consumers that are subject to mortgage arrangements beyond their financial ability to pay, as well as additional regulatory oversight of the financial services industry. It is also possible that additional assistance to other commercial sectors, including potentially the automobile industry, may be proposed. There has also been consideration given to enacting limitations on executive compensation payable at institutions subject to this purchase plan.

At its heart, the government's proposal would simply allow the purchase by the Treasury of any residential or commercial mortgages and any securities, obligations or instruments "based on or related to" such mortgages originated or issued on or before September 17, 2008, from any financial institution "having its headquarters in the United States." While the proposed language does not contain, as of the date of this Client Alert, a precise definition of the term "financial institution," other provisions of federal law dealing with financial regulation have included within this concept commercial and savings banks, thrifts, investment banks and broker/dealers, insurance companies and registered investment funds. The Treasury has been encouraging its counterpart agencies overseas to develop and implement comparable asset purchase programs. The ability to extend the availability of the US purchase program to additional foreign entities having a significant presence in the US may, in turn, depend on the extent to which comparable programs are established overseas.

Overall, the proposed legislation, while simple and straightforward in its elements, conveys extraordinary and broad authority to Treasury for the two year period during which the plan remains in effect. These characteristics of the proposal, as well as the objective of providing oversight, may cause Congress to engage in significant revisions to the plan.

Potential Implications of the Government Response

In light of the broad ranging and dramatic nature of the proposals promulgated by the regulators and contemplated for passage by the Congress, the impact upon individual businesses and their counterparties will be significant and beyond the scope of this Client Alert. As an indication of the range of possible issues that may be involved, we note the following in the case of each of the legislative and regulatory activities taken or underway:

Legislative Issues

With reference to the pending actions in Congress, the proposed legislation, as noted previously, raises a number of questions and considerations:

The nature of the entities that are covered under the concept of a "financial institution" for purposes of this statutory purchase program. It remains to be determined whether the full range of institutions (that is, commercial banks, savings and loans, thrifts, broker/dealers, investment advisers and insurance companies), which have been held under the umbrella of such a definition for other purposes under federal law, will be deemed eligible to participate in the purchase program established in this new legislation.

Whether a US subsidiary of a foreign entity (that is, an entity that is headquartered outside of the United States) qualifies for this program. This determination may turn on whether such US vehicle is deemed to have its headquarters in the local US jurisdiction where its offices are located, or whether the substance of its decisions are undertaken at the foreign parent's headquarters overseas. A series of Treasury talking points seemingly broadens the availability of the program by indicating that the program may be made available to foreign entities that have a significant presence in the United States. Accordingly, it would appear that a financial institution chartered or registered under state or federal law, even if foreign owned, should be covered under the terms of the proposed legislation. We will need to review additional language and clarifications on these issues before offering definitive guidance on the scope of eligibility under this legislative program.

Transfer by a foreign entity of its mortgage-related assets to a US subsidiary or US purchaser to be eligible for the purchase program. To this end, as noted, the statute limits the availability of the purchase program to mortgage related assets that were originated or issued on or before September 17, 2008. This concept may affect the ability of a foreign holder of otherwise eligible securities to transfer these positions to a US holder after such date, with the objective of qualifying such assets for purchase under the proposed legislative plan.

Mortgage-related assets issued by a trust or pass-through entity organized under foreign law as eligible for the purchase program if held by a US financial institution. In principle, it should not matter that the issuer of the mortgage-related securities is a foreign issuer, provided that these obligations were originated or issued on or before September 17, 2008, and that the holder is a financial institution with its headquarters in the US. It remains to be determined whether limitations will be imposed that would restrict the applicability of the purchase program to assets related to mortgages originated or issued in the United States.

Mutual funds, pension vehicles and hedge funds organized under the laws of a state of the United States, and managed by an advisor headquartered in the United States, as eligible for the program. The answer to the question of whether these institutions are covered by the legislation will turn not only on the scope of the definition of "financial institution" alluded to previously, but the way in which the concept of "headquarters" will be applied to these investment vehicles.

Regulatory Issues

With reference to the actions already taken by the regulators and identified above, as well as with respect to other pending matters on the regulatory agendas of the agencies in question, a number of critical considerations arise as well, including:

Exceptions that exist to the Commission's ban on short selling, particularly in the context of avoiding mass terminations under equity-related swap documentation. For example, as broker/dealers in the over-the-counter (OTC) market must be able to hedge long trading positions with short positions, it may be possible for OTC market-makers to engage in short-selling arrangements in the context of hedging commitments.

Concerns that arise in the context of the municipal securities markets. Funds and investment vehicles holding such instruments increasingly face the consequences of the Lehman Brothers bankruptcy and of the potential default by other counterparties in this market.

Establishment of the money-market guarantee fund, and the fee structure to be provided for participation in such program. As individual funds will need to participate in this program, and guarantee fee rates are established, potential participants will need to evaluate the merits of such a guarantee arrangement when measured against the costs and other consequences of such involvement.

Suspension of the provisions of Sections 23A/23B for certain purchases of asset-backed commercial paper. By permitting member banks to purchase these securities from their affiliates, the Federal Reserve intends that the market for these instruments may stabilize and broaden as a result.

Liberalization of the rules on regulatory capital treatment by banks to permit incorporation of "goodwill" as an asset. As banks face an increasing need for capital, the benefits of such new provisions by banking regulators allowing some portion of "goodwill" to be treated as an asset may lead to a strengthening of the financial positions of such institutions, as well as greater success in raising additional capital from new investors.

Possible relaxation of the regulations defining a "passive investment" in a bank, permitting hedge funds and other investment vehicles to take an increased stake in such institutions without engendering regulation as a bank holding company. In general, an investment that exceeds 25 percent of the economic interests and capital of the financial institution in question runs a significant risk of being deemed to constitute a "controlling influence" over the bank in question, and causing the investor to become a bank holding company with its attendant constraints on business and investment activities under the Bank Holding Company Act. By allowing hedge funds or other investors to hold amounts greater than 25 percent of the total contributions to the capital of a banking entity, without becoming subject to regulation as a bank holding company, banking regulators may create the potential of opening a significant amount of new sources of capital for investment in the banking industry.

Participants in the global financial services industry have witnessed developments this past week unprecedented since the late 1920s: within the span of several days, a major investment bank (Lehman Brothers) was forced to file for bankruptcy, one of the premier retail and institutional broker/dealers in the United States (Merrill Lynch) was induced to be sold to Bank of America amid concerns of its own solvency and survival, and a major insurance conglomerate (American International Group (AIG)) was rescued by a direct loan and guarantee program that effectively provides for this entity to be owned and operated by the United States government. These developments occurred within weeks of the federal rescue of two crucial government sponsored enterprises (Fannie Mae and Freddie Mac), and only months after the near collapse and government-guaranteed acquisition by JP Morgan Chase of another prominent investment bank (Bear Stearns).

Facing continuing and mounting concerns about remaining participants in the commercial and investment banking industry, and fearing contagion of the risks of insolvency extending to money market investment funds, municipal bonds, retirement plans and other financial market participants, the United States Treasury, the Board of Governors of the Federal Reserve System and the Securities and Exchange Commission have acted in a dramatic fashion to address the systemic risks that appear poised to overwhelm the global financial system.

In light of the significance and impact which the US government's response will have for every participant in the international capital markets and payments system, this Client Alert provides:

·         a brief summary of the proposed actions, both regulatory and legislative, that are pending as of the current date; and,

·         an analysis of potential issues and consequences that may affect your business as a result of these actions.

Given the rapidly evolving nature of the programs described in this Client Alert, we will publish additional Client Alerts as more information becomes available and as further legislative and regulatory action occurs.

The Government Response

As of the date of this Client Alert, there are four critical elements to the US government's response:

·         a legislative proposal, pending before the United States Congress, that would allow the United States Treasury to borrow up to $700 billion to purchase mortgage-related assets from financial institutions headquartered in the United States. This legislation is intended to halt the continued decline in the value of housing and mortgage related assets by removing from the balance sheet of targeted financial institutions the overabundance of such troubled assets that currently prevents these lenders from providing liquidity to other market participants and to underlying investors and consumers;

·         extensive funding commitments provided by the Federal Reserve and other central banks (including the European Central Bank and the Bank of England), providing approximately $180 billion in extra liquidity to the financial system;

·         coordination with the Securities and Exchange Commission and the UK Financial Services Authority in the issuance of a temporary emergency ban on the short selling of the stocks of 799 financial companies in the United States (for a 10-day period of time, up to October 2, 2008, subject to an additional 30-day extension), and 32 companies in the United Kingdom (until January 16, 2009), and the promulgation by the Commission of a further temporary emergency order requiring institutional investment managers to report, on a weekly basis, their daily short positions (such requirements to cease as of October 2, 2008); and

·         a proposed guarantee to be provided through the establishment of a fund under the auspices of the United States Treasury, in the amount of approximately $50 billion, to insure the obligations of money-market mutual funds.

Of these four extraordinary programs, the latter three require only regulatory decision and private sector response. The first listed above, and most significant of these new proposals, permitting the United States Treasury to purchase up to $700 billion of mortgage-related assets, requires the enactment of legislation authorizing such a massive intervention in the private sector mortgage and credit markets. Proposed language was sent to Congress by the Treasury on September 20, 2008. Treasury has expressed its strongly held view that the legislation needs to be enacted into law by the end of this week.

While there is bipartisan consensus on Capitol Hill on the importance and necessity of acting swiftly to avert a further deterioration in the overall financial situation, as of the date of this Client Alert the final substance of the legislation to be passed remains uncertain. Congress may wish to consider additional concerns at this time, including protection for consumers that are subject to mortgage arrangements beyond their financial ability to pay, as well as additional regulatory oversight of the financial services industry. It is also possible that additional assistance to other commercial sectors, including potentially the automobile industry, may be proposed. There has also been consideration given to enacting limitations on executive compensation payable at institutions subject to this purchase plan.

At its heart, the government's proposal would simply allow the purchase by the Treasury of any residential or commercial mortgages and any securities, obligations or instruments "based on or related to" such mortgages originated or issued on or before September 17, 2008, from any financial institution "having its headquarters in the United States." While the proposed language does not contain, as of the date of this Client Alert, a precise definition of the term "financial institution," other provisions of federal law dealing with financial regulation have included within this concept commercial and savings banks, thrifts, investment banks and broker/dealers, insurance companies and registered investment funds. The Treasury has been encouraging its counterpart agencies overseas to develop and implement comparable asset purchase programs. The ability to extend the availability of the US purchase program to additional foreign entities having a significant presence in the US may, in turn, depend on the extent to which comparable programs are established overseas.

Overall, the proposed legislation, while simple and straightforward in its elements, conveys extraordinary and broad authority to Treasury for the two year period during which the plan remains in effect. These characteristics of the proposal, as well as the objective of providing oversight, may cause Congress to engage in significant revisions to the plan.

Potential Implications of the Government Response

In light of the broad ranging and dramatic nature of the proposals promulgated by the regulators and contemplated for passage by the Congress, the impact upon individual businesses and their counterparties will be significant and beyond the scope of this Client Alert. As an indication of the range of possible issues that may be involved, we note the following in the case of each of the legislative and regulatory activities taken or underway:

Legislative Issues

With reference to the pending actions in Congress, the proposed legislation, as noted previously, raises a number of questions and considerations:

The nature of the entities that are covered under the concept of a "financial institution" for purposes of this statutory purchase program. It remains to be determined whether the full range of institutions (that is, commercial banks, savings and loans, thrifts, broker/dealers, investment advisers and insurance companies), which have been held under the umbrella of such a definition for other purposes under federal law, will be deemed eligible to participate in the purchase program established in this new legislation.

Whether a US subsidiary of a foreign entity (that is, an entity that is headquartered outside of the United States) qualifies for this program. This determination may turn on whether such US vehicle is deemed to have its headquarters in the local US jurisdiction where its offices are located, or whether the substance of its decisions are undertaken at the foreign parent's headquarters overseas. A series of Treasury talking points seemingly broadens the availability of the program by indicating that the program may be made available to foreign entities that have a significant presence in the United States. Accordingly, it would appear that a financial institution chartered or registered under state or federal law, even if foreign owned, should be covered under the terms of the proposed legislation. We will need to review additional language and clarifications on these issues before offering definitive guidance on the scope of eligibility under this legislative program.

Transfer by a foreign entity of its mortgage-related assets to a US subsidiary or US purchaser to be eligible for the purchase program. To this end, as noted, the statute limits the availability of the purchase program to mortgage related assets that were originated or issued on or before September 17, 2008. This concept may affect the ability of a foreign holder of otherwise eligible securities to transfer these positions to a US holder after such date, with the objective of qualifying such assets for purchase under the proposed legislative plan.

Mortgage-related assets issued by a trust or pass-through entity organized under foreign law as eligible for the purchase program if held by a US financial institution. In principle, it should not matter that the issuer of the mortgage-related securities is a foreign issuer, provided that these obligations were originated or issued on or before September 17, 2008, and that the holder is a financial institution with its headquarters in the US. It remains to be determined whether limitations will be imposed that would restrict the applicability of the purchase program to assets related to mortgages originated or issued in the United States.

Mutual funds, pension vehicles and hedge funds organized under the laws of a state of the United States, and managed by an advisor headquartered in the United States, as eligible for the program. The answer to the question of whether these institutions are covered by the legislation will turn not only on the scope of the definition of "financial institution" alluded to previously, but the way in which the concept of "headquarters" will be applied to these investment vehicles.

Regulatory Issues

With reference to the actions already taken by the regulators and identified above, as well as with respect to other pending matters on the regulatory agendas of the agencies in question, a number of critical considerations arise as well, including:

Exceptions that exist to the Commission's ban on short selling, particularly in the context of avoiding mass terminations under equity-related swap documentation. For example, as broker/dealers in the over-the-counter (OTC) market must be able to hedge long trading positions with short positions, it may be possible for OTC market-makers to engage in short-selling arrangements in the context of hedging commitments.

Concerns that arise in the context of the municipal securities markets. Funds and investment vehicles holding such instruments increasingly face the consequences of the Lehman Brothers bankruptcy and of the potential default by other counterparties in this market.

Establishment of the money-market guarantee fund, and the fee structure to be provided for participation in such program. As individual funds will need to participate in this program, and guarantee fee rates are established, potential participants will need to evaluate the merits of such a guarantee arrangement when measured against the costs and other consequences of such involvement.

Suspension of the provisions of Sections 23A/23B for certain purchases of asset-backed commercial paper. By permitting member banks to purchase these securities from their affiliates, the Federal Reserve intends that the market for these instruments may stabilize and broaden as a result.

Liberalization of the rules on regulatory capital treatment by banks to permit incorporation of "goodwill" as an asset. As banks face an increasing need for capital, the benefits of such new provisions by banking regulators allowing some portion of "goodwill" to be treated as an asset may lead to a strengthening of the financial positions of such institutions, as well as greater success in raising additional capital from new investors.

Possible relaxation of the regulations defining a "passive investment" in a bank, permitting hedge funds and other investment vehicles to take an increased stake in such institutions without engendering regulation as a bank holding company. In general, an investment that exceeds 25 percent of the economic interests and capital of the financial institution in question runs a significant risk of being deemed to constitute a "controlling influence" over the bank in question, and causing the investor to become a bank holding company with its attendant constraints on business and investment activities under the Bank Holding Company Act. By allowing hedge funds or other investors to hold amounts greater than 25 percent of the total contributions to the capital of a banking entity, without becoming subject to regulation as a bank holding company, banking regulators may create the potential of opening a significant amount of new sources of capital for investment in the banking industry.