Collateral Protection for Collateral Protection for Financial Assets: - - PowerPoint PPT Presentation

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Collateral Protection for Collateral Protection for Financial Assets: Current Legal Trends

Best Practices for Protecting Collateral in a Post‐Lehman and MF Global World

T d ’ f l f

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUES DAY, DECEMBER 4, 2012

Today’s faculty features:

Craig S . Unterberg, Partner, Haynes & Boone, New Y

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Michele Navazio, Partner, Sidley Austin, New Y

• rk

Daren R. Domina, Partner, Haynes and Boone, New Y

• rk

Daren R. Domina, Partner, Haynes and Boone, New Y

• rk

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Collateral Protection P t L h & MF Gl b l Post-Lehman & MF Global

December 4, 2012

Craig Unterberg, Haynes and Boone, LLP

craig.unterberg@haynesboone.com | 212.659.4987

Miki Navazio, Sidley Austin LLP Miki Navazio, Sidley Austin LLP

mnavazio@sidley.com | 212.839.5310

Daren R. Domina, Haynes and Boone, LLP

d d i @h b | 212 6 9 4963

5

daren.domina@haynesboone.com | 212.659.4963

OVERVIEW

• 1. Legal Framework of Collateral Protection
• 2. Financial Institution Insolvency
• 3. Applicability to Swap Dealers
• 4. Case Studies: Lehman & MF Global

5 Collateral Protection Trends

• 5. Collateral Protection Trends
• 6. Dodd-Frank

6

Legal Framework: Article 8

• Our focus will be on the indirect holding system

Applicable to securities intermediaries

• Applicable to securities intermediaries
• A person that maintains securities accounts for
• thers is a “securities intermediary”
• thers is a securities intermediary
• Obligations on securities intermediaries are set

forth in Article 8 forth in Article 8

7

Legal Framework: Article 8

• §8-504 requires securities intermediaries to

maintain a quantity of financial assets equal to maintain a quantity of financial assets equal to all securities entitlements it has established

• Compliance with §8-504 contains exceptions to

Compliance with §8 504 contains exceptions to the “perfect match” rule

• Example: a temporary shortfall due to failure to

Example: a temporary shortfall due to failure to deliver by a counterparty in trade settlement

8

Legal Framework: Regulation & Legal Framework: Regulation & Oversight g

• Broker-dealers / FCMs

Article 8 – Article 8 – Federal statutes – SEC and SRO oversight SEC and SRO oversight

• Banks (Custodians)

– Article 8 – Federal and State statutes – FDIC oversight

9

Legal Framework: Broker-Dealers

• Rule 15c3-3 limits broker-dealer’s use of

customer’s securities customer s securities

• Cap on a broker-dealer’s rehypothecation

T f th t t

• Terms of the account agreement can

impact applicability of the customer t ti l protection rules

– Rehypothecation

10

– Cross-collateralization

Legal Framework: FCMs

• FCMs must segregate customer funds pursuant to CEA § 4d(a)(2)

– FCM may not grant any lien on customer collateral (other than to DCOs)

• FCMs may invest customer collateral in “permitted investments”

under CFTC rule 1.25 and retain gains

– Since MF Global, CFTC has revised rule 1.25 to limit list of permitted investments investments

• LSOC (for cleared swaps)

– collateral legally segregated, but commingled in one account mitigates “fellow customer” risk – mitigates fellow customer risk

• FCM not permitted to use one customer’s collateral to satisfy another

customer’s obligations or the FCMs obligations – balances benefits and costs in protecting market participants and the public

11

Legal Framework: B/D and FCM Regulatory Compliance Regulatory Compliance

• The regulatory oversight for customer

t d t ti i h dl d th h assets and protections is handled through a combination of:

– audits (internal and external); – regulatory examinations; and – reporting requirements.

12

Legal Framework: Bank Legal Framework: Bank Regulatory Compliance g y p

• Periodic FDIC regulatory examinations of

trust departments trust departments

• Examine policies and account

administration to prevent liabilities or loss to the bank’s capital

13

Insolvency of Financial Insolvency of Financial Institutions

• Broker-Dealers

C t P t ti R l – Customer Protection Rule – SIPC and SIPA

• Custodians/Banks

– FDIC – Trust/fiduciary accounts – Assets inside/outside the estate

14

Insolvency: Broker Dealers & Insolvency: Broker-Dealers & SIPA

• Federal court appoints a SIPA trustee
• Trustee tasked to return customer assets

(in whole or pro rata based on net equity)

• Net equity fixed as of SIPC filing date
• SIPC Protections

S C

• tect o s

– $500,000 insurance cap – $250 000 insurance cap on cash (inclusive)

15

$250,000 insurance cap on cash (inclusive)

Insolvency Risks: Broker-Dealer

• Net equity claim in excess of pro rata

share of customer assets and SIPA share of customer assets and SIPA insured amounts ff ff

• Assets moved to offshore affiliates
• Failure of broker-dealer to abide by

customer protection rule

16

Insolvency: Bank/Custodian and Insolvency: Bank/Custodian and FDIC

• Assets held in trust, fiduciary or custodial

accounts should not be assets of the bank accounts should not be assets of the bank

• FDIC will attempt to transfer accounts to a

successor institution

• Cash is typically held in deposit accounts

subject to certain levels of FDIC insurance

17

Insolvency Risks: Insolvency Risks: Bank/Custodian and FDIC

• Assets intended to be held in trust, fiduciary or

custodial accounts are open to certain risks custodial accounts are open to certain risks

– Determination that assets are not held in appropriate account – Inability to trace the assets

• If assets are not held in appropriate account or

non-traceable, then upon failure the customer is subject to FDIC receivership / conservatorship

18

Applicability to Swap Dealers

• Swap collateral is posted under the CSA
• Need to determine applicability of laws to

swap dealer

• Self-help remedies may be limited
• Collateral subject to regulatory/bankruptcy

Co ate a subject to egu ato y/ba uptcy regime that overlays the counterparty

19

Case Study: Lehman Brothers

• In the insolvency of Lehman Brothers Inc.

(“LBI”), SIPA and the SEC moved customer ( ) assets out of the failed brokerage

• Pre-insolvency, LBI followed the segregation

and reserve requirements

• Customers were made whole and no advances

from the SIPC Fund have been made

20

from the SIPC Fund have been made

C St d L h B th Case Study: Lehman Brothers (UK) (U )

• Results for clients of Lehman Brothers

International (Europe) (“LBIE”) were vastly International (Europe) ( LBIE ) were vastly different

• Customers of LBIE became general unsecured

creditors and their assets were frozen in the insolvency proceeding. insolvency proceeding.

• Untangling customers’ assets from those of

LBIE

21

LBIE

C St d L h B th Case Study: Lehman Brothers (swap affiliates) (s ap a a es)

• Counterparties of LBSF and similar US affiliates

general unsecured creditors – general unsecured creditors – assets subject to insolvency proceeding (albeit under US bankruptcy law).

• Competing claims over customer assets had to

be resolved (LBIE and other Lehman affiliates, be resolved (LBIE and other Lehman affiliates, bondholder claims, etc.) V l ti di t

22

• Valuation disputes

Case Study: MF Global

• MF Global Inc. had a deficiency in its

segregated accounts for certain customers segregated accounts for certain customers

• As stated in a February release by SIPC

As stated in a February release by SIPC,

“Nearly all securities customers have received 60% or more of th i t l d l d 194 f f MF Gl b l I their account value and already 194 of former MF Global Inc. securities customers have received the entirety of their account balances because of a Securities Investor Protection Corporation guarantee.”

23

Collateral Protection Trends

• Segregate IA collateral in connection with swap

transactions

Assets held by custodians subject to tri party – Assets held by custodians subject to tri-party arrangements

• Utilize cash sweeps to limit cash deposits

Move excess collateral to third party accounts in

• Move excess collateral to third party accounts in

non-swap transactions

24

Collateral Protection Trends Collateral Protection Trends (cont’d) ( )

• Diversify relationships with financial

institutions institutions

• Concentration limits

Concentration limits

• Limit offshore transactions to avoid

t o s o e t a sact o s to a o d unfamiliar bankruptcy law

25

Collateral Protection Trends: Segregation

• Segregation issues for financial institution

P f ti d A ti l 9 – Perfection under Article 9 – Customer access to collateral – withdrawals d b tit ti and substitutions – Competing liens, including custodian’s claims C fli ti i t ti – Conflicting instructions – Fraudulent acts by customer

26

– Reporting on account collateral

Collateral Protection Trends: Segregation

• Segregation issues for customers

Ti d f – Time and expense of process – Credit risk of the custodian – Ability to make withdrawals/substitutions – Ability to access collateral post-default – Release of excess collateral

27

Collateral Protection Trends: Collateral Protection Trends: Rehypothecation yp

• §8-504 prohibits rehypothecation without

authorization and Rule 15c3 3 limits authorization and Rule 15c3-3 limits rehypo by broker dealers f

• Authorization is typically found in the

customer agreement

• Limiting rehypo increases borrowing costs
• Is the risk worth the cost?

28

Collateral Protection Trends: Collateral Protection Trends: Rehypothecation with B/D yp

• A customer’s net equity claim is equal to the

value of its long positions (including cash) minus value of its long positions (including cash) minus the value of its obligations

• Applies whether or not the customer’s assets

Applies whether or not the customer s assets have been rehypothecated.

• A customer whose assets have been

A customer whose assets have been rehypothecated stands in the same position/priority as a person whose assets have

29

not been.

Collateral Protection Trends: Dodd Collateral Protection Trends: Dodd-

Frank

• Mandate to offer IM for uncleared swaps segregated with

custodian custodian

• Limits on type of permitted collateral

– CFTC prosed rule makes type of collateral dependent upon type of t t counterparty – Prudential regulators proposed rule contains fewer types, but not dependent on counterparty

Fi l l t b bli h d b CFTC d d ti l l t

• Final rule to be published by CFTC and prudential regulators
• ISDA working group – dealers & buy-side – to address CSA

and tri-party agreement with adjustments following publication

30

• f final rule.