HOUSE PASSES HISTORIC FINANCIAL REGULATORY REFORM BILL

On Friday, December 11, 2009, the House of Representatives passed the Wall Street Reform and Consumer Protection Act. This is a comprehensive piece of legislation aimed at responding to the worst economic crisis since the Great Depression. This legislation seeks to address the many causes that led to the crisis, including predatory lending and unregulated derivatives.

Among the many reforms included in the Act are the creation of two new federal agencies. The Consumer Financial Protection Agency (CFPA) is an independent federal agency solely devoted to protecting Americans from unfair and abusive financial products and services. The Financial Stability Council will be made of of regulators that will identify financial firms so large, interconnected, or risky that their collapse would put the entire financial system at risk. This Council would have the power to break up these financial companies even when healthy if it is believed they pose a risk to the financial system.

The Act also focuses on various areas which are aimed at minimizing systematic risk. Although not a comprehensive list, the Act:

• Establishes an orderly process for shutting down large, failing financial institutions like AIG or Lehman Brothers in a way that ends bailouts and prevents adverse effects spreading to the rest of the financial system.
• Enables regulators to ban inappropriate or imprudently risky compensation practices, and requires financial firms to disclose incentive-based compensation structures.
• Strengthens the SEC's powers so that it can better protect investors and regulate the nation's securities markets.
• Regulates the $600 trillion over-the-counter (OTC) derivatives marketplace by requiring all standardized swap transactions between dealers and "major swap participants" to be cleared and traded on an exchange or electronic platform. A "major swap participant" is defined as anyone that maintains a substantial net position in swaps, exclusive of hedging for commercial risk, or whose positions create such significant exposre to others that it requires monitoring.
• Incorporates the tough mortgage reform and anti-predatory lending bill the House passed earlier this year. This legislation outlaws many of the industry practices that led to the subprime lending boom.
• Requires registration of hedge funds by forcing all advisers to private pools of capital to register with the SEC. These advisers will be subject to systematic risk regulation by the Financial Stability regulator.

Large financial companies will be greatly affected by the Act. Not only will there by additional restrictions on operations, but the firms will be charged billions of dollars in new fees as a result of the creation of a fund to pay for future failures of large financial institutions.

For more information, the House Committee on Financial Services issued a press release which can be found here. A Wall Street Journal article addressing the Act can be found here.

EXECUTIVES' STOCK DEALS: THE NEXT BACKDATED STOCK OPTION SCANDAL?

A recent article in the Wall Street Journal indicated that new research has found a correlation between variable prepaid forward contracts, which are in essence complex executive stock-sale deals designed to protect executives from declines in their company's stock prices, and a disproportionate decline in company stock prices shortly after executives enter into such deals. Typically, the contracts involve arrangements between executives and brokerage firms whereby the executives agree to deliver to the brokerage firms a variable amount of shares at some future date in exchange for up-front cash equal to approximately 75% to 85% of the market value at the time of the arrangement.

Variable prepaid forward contracts are an attractive investment for executives because they protect them from a decline in company stock prices while allowing the executives to enjoy appreciation in stock prices up to a threshold limit established by the agreement. Some companies have banned these arrangements, noting that executives who enter into such deals are doing so against the interests of the company.

The discovery of a correlation between the execution of variable prepaid forward contracts and a subsequent decline in companies' stock prices now reveals the emergence of yet another executive compensation scandal. Although not illegal in and of itself, stock options backdating raises a number of legal issues. For instance, in the past few years there have been countless civil enforcement actions, criminal prosecutions and class action lawsuits brought against companies that have engaged in stock options backdating on behalf of their executives without properly disclosing the agreements in their financial records or their SEC filings.

Ultimately, the new developments may create another round of civil and criminal litigation as investors and governments at all levels try to crack down on securities fraud engaged in by company executives. The most common notion is that executives who enter into variable prepaid forward contracts have inside knowledge of a troublesome future for their company and are looking for a way to protect themselves. By in effect hiding the sale of their company stock through forward-looking sales contracts, executives create a false sense of stability. As the WSJ article indicated, these arrangements are also drawing the attention of the IRS and the SEC because they allow executives to gain up-front cash but defer the taxes on their capital gains until the termination of the contract.