Commentaries

Bridging the Week by Gary DeWaal: June 9 to 13 and 16, 2014 (Fiduciary Obligations of Directors; Individual Segregation Confusion; BD Capital)

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Published Date : June 15, 2014

Clues, not concrete developments, generally highlighted last week in the financial services industry worldwide as a myriad of regulators provided diverse views on various topics, including boards of directors’ responsibilities, capital requirements for US broker-dealers, position limits for speculative traders and market structure. However, in the UK, the Financial Conduct Authority announced a comprehensive augmentation of its client money and custody rules.

As a result, the following matters are covered in this week’s Bridging the Week:

Diverse US Regulators Address Roles of Boards of Directors in Corporate Governance; Fed Governor Tarullo Suggests Augmenting Directors’ Fiduciary Obligations;
LCH.Clearnet Ltd Authorized as CCP Under EMIR; US FCMs Struggle With Application of EMIR’s Individual Segregation Accounts’ Offer Requirement (includes My View);
FCA Announces Changes in Client Money and Custody Asset Rules to Be Implemented in Stages Beginning July 1;
SEC Commissioner Stein Calls for Review of BD Capital Model;
UK Treasury, Bank of England and FCA to Review Markets Fairness and Effectiveness;
CFTC Publicizes Questions Staff Wants Answered at June 19 Position Limits Roundtable;
ICE Clear Europe Seeks Expedited Payment by Clearing Members for Losses Other Than From a Clearing Member Default; and more.

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Diverse US Regulators Address Roles of Boards of Directors in Corporate Governance; Fed Governor Tarullo Suggests Augmenting Directors’ Fiduciary Obligations

Two senior US regulators addressed boards of directors’ roles in dealing with regulatory concerns last week. In one speech dealing with boards of financial institutions specifically, Daniel Tarullo, a member of the board of governors of the US Federal Reserve (“FRB”), argued that it warrants consideration to amend state laws to change the fiduciary obligations of directors to ensure they are better aligned with regulatory objectives. In a separate speech, Luis Aguilar, a commissioner of the US Securities and Exchange Commission, encouraged boards of all companies to take a heightened role in addressing cyber-risks confronted by their companies.

In his presentation, Mr. Tarullo expressly inquired whether the fiduciary obligations of directors of regulated financial institutions should be expanded to align boards better with regulatory objectives. Although he acknowledged that requiring an expansion was beyond the authority of the FRB (as it would be governed by state laws), he indicated there was merit to considering such an approach:

“[T]he question arises as to whether the fiduciary duties of the boards of regulated financial firms should be modified to reflect what I have characterized as regulatory objectives. Doing so might make the boards of financial firms responsive to the broader interests implicated by their risk-taking decisions even where regulatory and supervisory measures had not anticipated or addressed a particular issue. And, of course, the courts would thereby be available as another route for managing the divergence between private and social interests in risk-taking.”

According to Mr. Tarullo, amending the fiduciary obligation of directors is important to consider in addition to continuing to align corporate governance and financial regulation in more traditional ways. These ongoing measures include: (1) changing the incentives for those making decisions within a financial firm (although he notes that, to date, amended incentive systems have generally better aligned the interests of shareholders and employees, but have intensified the conflict between regulatory and shareholder interests); (2) adding substantial constraints or requirements upon certain decisions (e.g., the regulatory conditioning of the authority of certain large banks to declare a dividend based on their passing financial stress tests); and (3) requiring improvement in the risk-assessment and risk-management capacities of management and boards.

Although he supports requiring directors to better oversee risk management and control functions, Mr. Tarullo cautions that it is somewhat “too reflexive” to require boards to certify compliance with too many regulatory requirements, however:

“There are many important regulatory requirements applicable to large financial firms. Boards must of course be aware of those requirements and must help ensure that good corporate compliance systems are in place... We should probably be somewhat more selective in creating the regulatory checklist for board compliance and regular consideration.”

Separately Mr. Aguilar discussed measures boards of directors can and should take to ensure their organizations are addressing cyber-risks. However, in doing so, he did not suggest any changes to the fundamental relationship between boards and shareholders, although he addressed boards of corporations generally, not just of financial institutions.

According to Mr. Aguilar, boards have been taking on greater responsibility for the risk management of their companies. These risks should be augmented to include cyber-risk, he says:

“Clearly, boards must take seriously their responsibility to ensure that management has implemented effective risk management protocols. Boards of directors are already responsible for overseeing the management of all types of risk, including credit risk, liquidity risk, and operational risk — and there can be little doubt that cyber-risk also must be considered as part of board’s overall risk oversight.”

To date, he believes there have been gaps between the potential magnitude of cyber-risks and “… steps, or lack thereof that many corporate boards have taken to address these risks.” Where boards have considered cyber-risk, they have too often relied exclusively on personnel who have implemented measures purportedly designed to address such risks, notes Mr. Aguillar.

As a result, the SEC commissioner encourages directors proactively to heighten their oversight of cyber-risk, by among other things, considering their firms’ cyber-security measures against objective standards such as those published by the National Institute of Standards and Technology in February 2014 in its Framework for Improving Critical Infrastructure Cybersecurity (for a copy, click here). Mr. Aguilar also recommends that boards be involved in corporations’ preparedness plans to address how to respond when a cyber-attack might occur.

And briefly

LCH.Clearnet Ltd Authorized as CCP Under EMIR; US FCMs Struggle With Application of EMIR’s Individual Segregation Accounts’ Offer Requirement: The Bank of England on June 12 approved LCH.Clearnet Ltd’s application as a central counterparty under the European Market Infrastructure Regulation (EMIR). As a result, amendments to LCH’s rulebook designed to help the clearinghouse comply with EMIR became effective on the same date (LCH is also a derivatives clearing organization designated by the Commodity Futures Trading Commission). These rules appear to go beyond the expectations of the industry, however, as they imply that futures commission merchant clearing members of LCH must offer a choice of individual or omnibus segregation (“EMIR Client Clearing”) to all their clients, except for those where the application of laws or rules in a client’s formation jurisdiction, or where in the context of activity on a relevant trading platform, such offer would be prohibited. This would appear to require that FCM clearing members offer EMIR Client Clearing to most customers (known as “affected clients”), other than US clients; only European Union clients were anticipated to be caught up in this offer requirement. If an affected client elects EMIR Client Clearing, an FCM must refer the customer to an affiliated non-FCM clearing member or another clearing member. In addition, an EU-based client that trades through an FCM on a designated contract market may have to affirmatively consent to give up EMIR Client Clearing rights -- even though a DCM is prohibited to offer EMIR Client Clearing -- although specific requirements regarding this consent appear unclear at this time.

My View: This is another example of the growing failure of international regulators adequately to consider the practicalities of clients seeking to conduct business internationally. The CFTC’s implementation of Part 30 for so many years was a beacon of light in the international financial arena because the Commission readily accepted US persons (1) trading most non-US futures and related products generally after they received appropriate disclosures; and (2) accessing non-US futures and related options through certain qualified non-US brokers subject to comparable (not equivalent) regulations as FCMs.

FCA Announces Changes in Client Money and Custody Asset Rules to Be Implemented in Stages Beginning July 1: The FCA published amended rules related to its client assets protection regime (“CASS”). This follows FCA’s publication of a consultation paper in July 2013 regarding proposed rules and its analysis of feedback received. New requirements impact custodial and collateral arrangements (including the need to document all third-party custodial arrangements); the bank exemption from application of FCA’s client money rules; the treatment of client money during delivery versus payment transactions; firm due diligence and documentation requirements (including the use of a required template) in connection with third parties holding client money; and the payment of interest to customers and the investment of client money, among many other matters. FCA also issued additional guidance on obligations of firms operating under a CFTC Part 30 order related to their FCA regulated business. FCA’s new CASS rules and guidance come into effect at various times from July 1, 2014, to June 1, 2015, with FCA’s objective being that those measures imposing the least regulatory burden or being optional coming into effect first, while those imposing the greatest burden coming into effect the latest. Requirements involving the revision of existing documents typically are effective December 1.
SEC Commissioner Stein Calls for Review of BD Capital Model: SEC Commissioner Kara Stein said last week that it may be time to reconsider the US capital model for broker dealers. While historically that model principally served to enhance customer protection, she argues that perhaps it should endeavor also to minimize systemic risk. This is because of the danger of contagion if a significant broker deal fails. As a result, Ms. Stein argues the SEC should reconsider what constitutes good capital for broker dealers (among other things she argues against continuing to permit no haircuts for securities lending and repo transactions even with high quality assets). According to Ms. Stein, “[t]he SEC needs to examine its capital, leverage and liquidity requirements, and modernize them to reflect the current funding ecosystem and our post-crisis understanding of systemic risks.” (For more on this matter, see a related article in last week’s Katten Muchin Rosenman Corporate & Financial Weekly Digest, by clicking here.)
UK Treasury, Bank of England and Financial Conduct Authority to Review Markets Fairness and Effectiveness: In response to “recent serious allegations of misconduct in financial markets,” HM Treasury, the Bank of England and the FCA announced last week the initiation of a study into the way wholesale financial markets operate. This review is expected to last 12 months and result in recommendations on principles to govern the operation of financial markets fairly and effectively; measures to ensure standards of conduct to conform with recommended principles; and tools to enhance the oversight of market conduct, among other measures. According to Martin Wheatley, FCA Chairman, “[c]onfidence and trust are critical to financial markets – and robust, reliable benchmarks are the bedrock of market integrity. I welcome this review, which will ensure that key markets operate with the highest standards of integrity.”

And even more briefly:

CFTC Grants First No Action Under Expedited Process for Certain CPO Relief: The CFTC granted its first ten no action letters to certain commodity pool operators pursuant to its recently adopted expedited process for obtaining relief from registration requirement where such CPOs delegate their investment management authority to another registered CPO. If an affiliated natural person deemed a CPO desires to take advantage of this relief he or she must agree to joint and several liability with the designated, registered CPO as a condition for such relief, among other requirements. (For details regarding this expedited process, see “CFTC Implements Streamlined Way for Certain CPOs to Apply for Registration Relief” in Between Bridges (May 13, 2014) by clicking here.)

CFTC Publicizes Questions Staff Wants Answered at June 19 Position Limits Roundtable: The CFTC has published specific questions for which it seeks comments during the position limits roundtable to be held at the Commission’s office this June 19. The general topics for the roundtable are (1) hedges of a physical commodity; (2) process for non-enumerated exemptions; and (3) spot-month limits and conditional exemptions. The list of specific questions suggests that staff may be considering conditions to permit market participants to rely on a filing for a non-enumerated hedge exemption prior to the Commission reviewing the filing (e.g., if there is exchange review and approval), and to permit hedges based on anticipatory merchandising, among other matters.

ICE Clear Europe Seeks Expedited Payment by Clearing Members for Losses Other Than From a Clearing Member Default: ICE Clear Europe has submitted to the CFTC a proposed rule that would expedite the time clearing members must make contributions to cover clearinghouse investment losses that exceed its so-called “loss assets.” Contributions will now be required when demanded by the clearinghouse and are not subject to a two-day notice as is currently provided. Last month FIA raised various concerns regarding ICE Clear’s investment loss coverage proposal with which the clearinghouse disagreed. Absent CFTC objection, the proposed amendments may be effective as soon as June 20 or at such later date the clearinghouse may decide.

For more information, see:

CFTC Grants First No Action Under Expedited Process For Certain CPO Relief:
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-75thru14-84.pdf

CFTC Staff Questions for June 19 Position Roundtable:
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/staffquestions061214.pdf

Federal Reserve’s Tarullo: Boards of Directors’ Role in Financial Firm Oversight:
http://www.federalreserve.gov/newsevents/speech/tarullo20140609a.htm

FCA Announces Changes in Client Money and Custody Asset Rules to Be Implemented in Stages Beginning July 1:
http://www.fca.org.uk/static/documents/policy-statements/ps14-09.pdf

ICE Clear Europe Seeks Expedited Payment by Clearing Members for Losses Other Than From a Clearing Member Default:
https://www.theice.com/publicdocs/regulatory_filings/ICEU_CFTC_060614.pdf

See also:
FIA Objection to ICE Clear Europe’s Investment Loss Coverage:
http://www.futuresindustry.org/downloads/ICE_Clear_Europe_Proposed_Rule_on_Investment_Losses.pdf

LCH.Clearnet Ltd Authorized as CCP under EMIR:
http://www.esma.europa.eu/news/ESMA-adds-European-Commodity-Clearing-and-LCH-Clearnet-Ltd-list-authorised-CCPs-under-EMIR?t=326&o=home

See also:
LCH.Clearnet Ltd Rulebook (see in particular, Chapter III, Regulation 7):
http://www.lchclearnet.com/Images/FCM%20Regulations_tcm6-65214.pdf
ESMA Questions and Answers regarding Implementation of Regulation (EU) No 648/2012 on OTC Derivatives, central counterparties and trade repositories (last updated May 21, 2014; particularly CCP Question and Answers No. 8):
http://www.esma.europa.eu/system/files/2014-550.pdf

SEC’s Aguilar Encourages Boards of Directors to Heighten Oversight of Cyber-Risks:
http://www.sec.gov/News/Speech/Detail/Speech/1370542057946#.U5pjIhZvl_g

SEC Commissioner Stein Calls for Review of BD Capital Model:
http://www.sec.gov/News/Speech/Detail/Speech/1370542076896

UK Treasury, Bank of England and Financial Conduct Authority to Study Wholesale Financial Markets:
https://www.gov.uk/government/news/fair-and-effective-markets-review-announced-by-chancellor-of-the-exchequer

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of June 14, 2014. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP and/or Gary DeWaal may represent one or more entities mentioned in this article.

Circular 230 Disclosure: Pursuant to regulations governing practice before the Internal Revenue Service, any tax advice contained in this article is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.

All quotations are from published statements.

Bridging the Week by Gary DeWaal: June 9 to 13 and 16, 2014 (Fiduciary Obligations of Directors; Individual Segregation Confusion; BD Capital)

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