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Regulatory Reform Www A NEW YORK LAW JOURNAL SPECIAL SECTION Regulatory REFORM WWW. NYLJ.COM MONDAY, MARCH 30, 2009 The Nuances of Securities Reform Renewed commitment to enforcement is needed. BY PHILIP S. KHINDA, of the SEC and the Commodity Futures Trading meaningful reform. JEFFREY E. McFADDEN Commission (CFTC), enhanced regulation of By way of background, CDS are over- AND MICHAEL C. MILLER credit default swaps (CDS) and hedge funds, the-counter (OTC) negotiated contractual HE URGENT drum beat echoing through and renewed emphasis on the use of mark-to- agreements between two parties designed to the halls of Congress, the Securities market accounting. It is equally clear that the transfer credit risk from the buyer to the seller. Tand Exchange Commission (SEC) and required change does not need to come at the The buyer agrees to make a fixed payment, and other agencies is leading Washington’s key end of a sledge hammer. the seller agrees to pay a settlement amount to decisionmakers toward a major restructuring Effective securities reform, as we discuss the buyer if a credit event, usually a bankruptcy of the laws, regulations and institutions that in this article, can be the product of a more or payment default, occurs with respect to a govern our securities markets. The litany of surgical approach to modernizing existing laws specified company (the reference entity) that is woes on Wall Street and the state of our markets unrelated to the buyer or seller. Until recently, these derivatives were hailed by many as a provide ample cause for this urgency. Short sales serve a purpose in Bernard Madoff’s recent guilty plea to valuable credit enhancement, so valuable that maintaining efficient and orderly crimes in connection with his reportedly $65 the total dollar value of CDS bought and sold 2 billion Ponzi scheme was a signature moment markets, but recent events have in 2007 reached $62 trillion. in a signature case, but it is only the latest in shown that the reinstatement Despite the significant role played by CDS in a series of events that has revealed serious of prior safeguards is necessary. our markets, they remain largely unregulated. deficiencies in our securities regulatory system, CDS are not considered a “security” under or, at least, in the enforcement of our current and regulations and, as important, a renewed the Securities Act of 1933 or the Securities regulatory regime. The collapse of Lehman, the commitment to enforcing the laws and rules Exchange Act of 1934 and, as a result, are not fire sale of Bear Stearns, and the government’s already on the books. regulated by the SEC. CDS have also been bailouts of AIG, Citi and other landmark excluded from regulation by the CFTC under Regulating Credit Default Swaps financial institutions are but a few of the the Commodity Futures Modernization Act of Lehman’s bankruptcy last fall threw a other notable events that have played out in 2000, and are similarly exempt from regulation harsh spotlight on the massive, but largely the midst of the most significant fall in our by the Federal Reserve. invisible, presence of CDS in the nation’s securities and real estate markets since the The absence of a regulatory structure to police securities markets and on the absence of either Great Depression. It is clear that change is the CDS market became a serious issue in the a centralized market to ensure their liquidity last year, as rising rates of payment defaults and needed and that it is coming. or a clear regulatory structure to police the bankruptcies among reference entities triggered Reform efforts to date have focused on the conduct of those involved in their purchase an increase in both the number of credit events potential (and, in our view, advisable) merger and sale. and demands for payment from CDS sellers. If the message was missed when Lehman Defaults by sellers soon followed. Many are now PHILIP S. KHINDA and JEFFREY E. McFADDEN are collapsed, it was driven home by the federal convinced that regulatory deficiencies in the partners in the Washington, D.C. office of Steptoe & government’s takeover of AIG, which had oversight of the CDS market, and related fraud Johnson, and MICHAEL C. MILLER is a partner in the 1 firm’s New York office. MICHELLE LEVIN, an associate, sold over $440 billion worth of CDS. The and manipulation, caused an escalating chain assisted in the preparation of this article. CDS marketplace is in desperate need of reaction of defaults and economic loss. MONDAY, MARCH 30, 2009 Reform is underway to bring these Commissioner and a former chair of the Unfortunately, much of that attention has derivatives under regulatory oversight. The CFTC, and well qualified to serve as head of focused on hedge funds, rather than on the SEC, for example, has asked Congress to a consolidated SEC/CFTC. broader market misconduct that the Madoff expressly grant the agency authority to regulate and other recent cases have exposed.15 the CDS market.3 The SEC is also working Short-Selling and the Uptick Rule A number of legislative proposals to regulate with the Federal Reserve and the CFTC to Short sales serve a purpose in maintaining hedge funds have been introduced and, while establish a central, unified clearinghouse for efficient and orderly markets, but recent events they vary in certain respects, the bills generally the sale of CDS, known as a CDS central have shown that the reinstatement of prior call for the registration of hedge funds with counterparty (CCP).4 safeguards is necessary. the SEC in a manner similar to that already The SEC believes that a CCP will reduce Until the current downturn, short-selling was required of mutual funds and advisers. the risk of individual sellers being exposed generally permitted, but with certain important In the Senate, Carl Levin (D., Mich.) and to the credit risk of other sellers, and permit restrictions, such as the need to borrow the Charles Grassley (R., Iowa) have proposed the netting of individual CDS against one stock prior to the sale (preventing “naked the Hedge Fund Transparency Act,16 which another, reducing the liquidity issues posed by shorts”) and the need to sell at a higher price would require hedge funds to formally register an increasing number of defaults and requests than the previous trade (pursuant to the SEC’s with the SEC, file annual disclosure forms with for settlement in the CDS market. A CCP “uptick rule,” Rule 10a-1 of the Exchange Act). the agency, comply with its recordkeeping can also facilitate greater market transparency When the uptick rule was adopted in 1938, the requirements and cooperate with agency and encourage a more competitive trading SEC’s stated goal was a sound one: to prevent investigations or requests for information, environment, says the SEC, which could short sellers from manipulating stock prices, among other provisions. The bill would expand decrease transaction costs, improve price causing successively lower share prices, and to the definition of “investment company” under transparency, and contribute to an increase stop related predatory trading practices, such the Investment Company Act of 1940 to in market liquidity.5 On Jan. 14, 2009, the as “bear raids” where a particular stock is sold include funds that had previously been exempt, SEC issued a temporary rule to facilitate the short in an effort to drive down the price of either because they had 100 or fewer beneficial clearing and settling of CDS by CCPs.6 the security to permit raiders to acquire the owner (“3(c)(1) funds”), or because all of their stock at artificially deflated prices. equity securities was owned by “qualified Merging the SEC and CFTC In 2005, the SEC instituted a pilot program purchasers” (“3(c)(7) funds”). The deepening economic crisis and the role to test the market impact of relaxing the uptick Notably, the Act would cover not only hedge that CDS have played in the crises here and rule for a select group of 1,000 securities.10 funds, but also venture capital funds, private overseas have also reignited talk of merging the Based on that study, the SEC concluded at equity funds, and funds-of-funds, all of which CFTC with the SEC (or bringing both agencies the time that there was little evidence that the have relied on §§3(c)(1) and 3(c)(7) to avoid under a larger financial regulatory umbrella) removal of the short selling restrictions would investment company status. to regulate complex financial products traded have a negative impact on market volatility, On the House side, in January 2009, on the OTC market more efficiently and price efficiency or liquidity11 and, as a result, Representatives Michael Castle (R., Del.) effectively. Former Treasury Secretary Henry eliminated the uptick rule in June 2007.12 and Michael Capuano (D., Mass.) introduced M. Paulson’s call for such a merger, part of his The 18 months that have followed, however, three related bills. In general terms, their “blueprint” for reforming financial regulation have seen the most volatile trading in the bills seek to compel hedge fund registration in early 20087 was hardly the first.8 For many modern era and since the advent of leveraged under the Investment Advisors Act of 1940 good reasons, the time for this merger may trading strategies.13 It seems clear that the SEC (pursuant to the proposed Hedge Fund have come. had it right the first time, and that the uptick Advisor Registration Act of 2009), require First, a merger of the two agencies would rule should be reinstated. pension plans to disclose their hedge fund facilitate more consistent and enhanced investments (pursuant to the proposed regulation of financial instruments that have The Call for Hedge Fund Regulation Pension Security Act of 2009), and direct developed along the interstices between The government has had an uneasy the President’s Working Group on Financial the historical jurisdiction of both regulators, relationship with hedge funds for some time, Markets to study and report to Congress on such as stock index futures and other equity- wary of their perceived market influence, the hedge fund industry (as provided by the based derivatives.9 exclusive nature and, until the recent downturn, proposed Hedge Fund Study Act).
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