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

TUESDAY, DECEMBER 4, 2012

Today’s faculty features:

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

Michele Navazio, Partner, Sidley Austin, New York

Daren R. Domina, Partner, Haynes and Boone, New YorkDaren R. Domina, Partner, Haynes and Boone, New York

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Collateral ProtectionP t L h & MF Gl b lPost-Lehman & MF Global

December 4, 2012

Craig Unterberg, Haynes and Boone, LLPcraig.unterberg@haynesboone.com | 212.659.4987

Miki Navazio, Sidley Austin LLPMiki Navazio, Sidley Austin LLPmnavazio@sidley.com | 212.839.5310

Daren R. Domina, Haynes and Boone, LLPd d i @h b | 212 6 9 4963

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daren.domina@haynesboone.com | 212.659.4963

OVERVIEW

1. Legal Framework of Collateral Protection2. Financial Institution Insolvency3. Applicability to Swap Dealers4. Case Studies: Lehman & MF Global5 Collateral Protection Trends5. Collateral Protection Trends6. Dodd-Frank

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Legal Framework: Article 8

• Our focus will be on the indirect holding systemApplicable to securities intermediaries• Applicable to securities intermediaries

• A person that maintains securities accounts for others is a “securities intermediary”others is a securities intermediary

• Obligations on securities intermediaries are set forth in Article 8forth in Article 8

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Legal Framework: Article 8

• §8-504 requires securities intermediaries to maintain a quantity of financial assets equal tomaintain a quantity of financial assets equal to all securities entitlements it has established

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

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

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Legal Framework: Regulation &Legal Framework: Regulation & Oversightg

• Broker-dealers / FCMsArticle 8– Article 8

– Federal statutes– SEC and SRO oversightSEC and SRO oversight

• Banks (Custodians)– Article 8– Federal and State statutes– FDIC oversight

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Legal Framework: Broker-Dealers

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

• Cap on a broker-dealer’s rehypothecationT f th t t• Terms of the account agreement can impact applicability of the customer

t ti lprotection rules– Rehypothecation

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– 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 investmentsinvestments

• 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

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Legal Framework: B/D and FCM Regulatory ComplianceRegulatory Compliance

• The regulatory oversight for customer t d t ti i h dl d th hassets and protections is handled through

a combination of: – audits (internal and external);– regulatory examinations; and– reporting requirements.

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Legal Framework: BankLegal Framework: Bank Regulatory Complianceg y p

• Periodic FDIC regulatory examinations of trust departmentstrust departments

• Examine policies and account administration to prevent liabilities or loss to the bank’s capital

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Insolvency of FinancialInsolvency of Financial Institutions

• Broker-DealersC t P t ti R l– Customer Protection Rule

– SIPC and SIPA• Custodians/Banks

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

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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 ProtectionsS C otect o s

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

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$250,000 insurance cap on cash (inclusive)

Insolvency Risks: Broker-Dealer

• Net equity claim in excess of pro rata share of customer assets and SIPAshare of customer assets and SIPA insured amounts

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

customer protection rule

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

• Assets held in trust, fiduciary or custodial accounts should not be assets of the bankaccounts 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

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Insolvency Risks:Insolvency Risks: Bank/Custodian and FDIC

• Assets intended to be held in trust, fiduciary or custodial accounts are open to certain riskscustodial 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

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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

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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

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from the SIPC Fund have been made

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

• Results for clients of Lehman Brothers International (Europe) (“LBIE”) were vastlyInternational (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

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LBIE

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

• Counterparties of LBSF and similar US affiliatesgeneral 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

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• Valuation disputes

Case Study: MF Global

• MF Global Inc. had a deficiency in its segregated accounts for certain customerssegregated accounts for certain customers

• As stated in a February release by SIPCAs 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 Itheir 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.”

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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

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

• Diversify relationships with financial institutionsinstitutions

• Concentration limitsConcentration limits

• Limit offshore transactions to avoid t o s o e t a sact o s to a o dunfamiliar bankruptcy law

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Collateral Protection Trends: Segregation

• Segregation issues for financial institutionP f ti d A ti l 9– Perfection under Article 9

– Customer access to collateral – withdrawals d b tit tiand substitutions

– Competing liens, including custodian’s claimsC fli ti i t ti– Conflicting instructions

– Fraudulent acts by customer

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– Reporting on account collateral

Collateral Protection Trends: Segregation

• Segregation issues for customersTi 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

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Collateral Protection Trends:Collateral Protection Trends: Rehypothecationyp

• §8-504 prohibits rehypothecation without authorization and Rule 15c3 3 limitsauthorization 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?

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Collateral Protection Trends:Collateral Protection Trends: Rehypothecation with B/Dyp

• A customer’s net equity claim is equal to the value of its long positions (including cash) minusvalue of its long positions (including cash) minus the value of its obligations

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

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

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not been.

Collateral Protection Trends: DoddCollateral Protection Trends: Dodd-Frank

• Mandate to offer IM for uncleared swaps segregated with custodiancustodian

• Limits on type of permitted collateral– CFTC prosed rule makes type of collateral dependent upon type of

t tcounterparty– 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

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of final rule.