Chia-Yu Chang @ Law, P.C. 315 W. 70th Street, #12L New York, NY 10023
(212)769-1756 cychang at cychanglaw dot com
Chia-Yu Chang is an attorney admitted to practice in NY and before USPTO, and practices primarily in intellectual property (patent, trademark, copyright, trade secret), corporation, commercial transaction, finance, and estate planning. Before joining the legal profession, Chia-Yu was a fixed-income research analyst with Salomon Brothers. He holds a BS degree in geology from National Taiwan University, MS degrees from Indiana University and Columbia University, and a JD degree from Benjamin N. Cardozo School of Law. On the personal side, Chia-Yu has practiced Tai-Chi for over 20 years, and is currently learning Taiko drumming.
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© 2005-Present Chia-Yu Chang.
Thursday, July 24. 2014
- A work in progress
On 7/17/2014, the Department of Financial Services of the State of New York published a draft of its long-awaited proposal to regulate Bitcoin and other decentralized virtual currencies. The proposed rules was officially published on 7/23/2014, beginning a 45-day comment period before the rules can be finalized.
In essence, the proposed regulations require certain participants in virtual currency activities to apply for a license, and adopt a regulatory framework that combines 6 main component areas: License Application, Consumer Protection, Anti-Money Laundering, Cyber Security, Business Operation, and Records, Reports, & Examination. The table below groups each of the 18 sections of the proposed regulations (except Section 200.1 Introduction, Section 200.2 Definitions, & Section 200.21 Transitional period) into the 6 main component areas.
Note that in the existing regulatory schemes for NY financial service sectors, separate anti-money laundering rules apply to non-banks, such as check cashers or money transmitters, and to banks. By including a separate set of anti-money laundering rules for virtual currencies (in addition to the other component areas), the NY DFS has placed the sector in a distinct category on the same standing as money transmitters, or banks.
Therefore, one can hope that such a regulatory framework can accelerate the acceptance of decentralized virtual currencies as a legitimate financial sector, similar to money transmitters or banks. Such benefits aside, however, the proposed regulations do raise some concerns, particularly the high costs of compliance, the lack of exemptions for small businesses, the broad scope of the definition of virtual currency business activities, the 100% reserve requirement, and the permissible investments for retained earning. These and other potential issues, some of them gathered from internet sources, are briefly summarized in the table below.
Just like any new statutory or regulatory framework, the Bitcoin regulations proposed by NY DFS are a work in progress. It remains to be seen whether and how the final regulations will deviate significantly from the proposed ones. Given that the public has been given the minimally required comment period of 45 days, however, no major revisions are expected.
Thursday, April 10. 2014
- The “separate entity rule” in an increasingly connected world
Does a NY court have the power to order Bank of China, which runs 2 branches in NY, to turn over properties owned by a customer based in Dubai and held in a branch located in China, for the benefit of a US judgment creditor?
Before 2009, a majority of the NY courts that had faced questions similar to the one above answered them consistently with a “No”, based primarily on a court-created doctrine known as the “separate entity rule.” According to the rule, for certain purposes (including garnishment), a NY branch of a foreign bank is treated as a separate entity from the other foreign branches or the parent bank. Consequently, even though NY laws authorize the courts to garnish a debtor’s properties held at a third party bank, for foreign banks, the courts have limited that power to only their NY branches, separate from any other foreign branches or the parent banks.
Four primary policy rationales have been given by these courts in support of the separate entity rule: (1) inconvenience to the bank’s operations; (2) competing claims to the same asset; (3) risks of forum shopping; & (4) international comity. These rationales, however, have evolved over time. Particularly, technology advances have significantly eroded the influence of the “inconvenience to bank” rationale, even leading a court to completely invalidate the rule in 1980. Moreover, opponents of the rule have argued that the rule allows debtors to evade their obligations by removing assets abroad, depriving creditors of a US forum to enforce court judgments. They have also argued that the rule gives a competitive advantage to foreign banks against US banks.
The gradual evolution of the separate entity rule took a quantum leap in 2009, when the NY Court of Appeal decided the case Koehler v. Bank of Bermuda. In Koehler, the highest court of NY, in a divided 4-3 decision, held that as long as a foreign bank (Bank of Bermuda) is subject to the personal jurisdiction of the state, NY courts have the power to order the bank to turn over assets held at its foreign branches.
The majority’s opinion in Koehler did not explicitly mention the separate entity rule, because Bank of Bermuda had consented to NY’s personal jurisdiction. Some courts and commentators, however, have construed Koehler to have implicitly invalidated the rule.
As a result of the increased uncertainties regarding the validity of the separate entity rule, after Koehler, courts in NY have seen a rise in lawsuits against international banks operating in NY to compel the banks to turn over customer assets they held in non-US branches. Many of the plaintiffs in these lawsuits were foreign creditors and the bank customers were foreign debtors. For examples, in these cases, the nationalities of the creditors spread from Korea, Chile, Germany, Norway, and Cayman Island to Lebanon. The debtors’ nationalities included, among others, China, India, Brazil, Philippine, and Mexico. And the assets were held in bank branches located in places as disparate as Germany, Canada, France, Pakistan, Spain, Canada, China, Philippine, and Thailand.
Substantial concerns regarding this new trend arose among the courts and the banking industry. Finally, in 2014, facing fact patterns similar to the one in the Bank of China question raised at the beginning of this posting, the Second Circuit Court of Appeals asked the NY Court of Appeals to answer whether the separate entity rule is still a good law. The Court of Appeals is expected to decide the question in 2015.
Recently, the US Supreme Court has significantly restricted the scope of powers (ie, personal jurisdiction) states can assert over foreign entities doing business in US, based on the constitutional due process requirements. As a result, the NY Court of Appeals is likely to uphold the validity of the separate entity rule. Regardless of how the Court decides, nonetheless, in an increasingly connected world of global economy, the walls erected by the separate entity rule will inevitably become increasingly porous. The battle over the separate entity rule is but a reflection of the globalization trend, where the goals of global banking increasingly conflict with the goals of global judgment enforcement.
Conflicts, however, may motivate searches for resolutions. And if these searches are successful, the policy rationales behind the separate entity rule may lose their significance. For example, with respect to international comity, it will most likely be a long time before nations are willing to give full faith & credit to the judicial judgments of other nations. But some types of bi-lateral or multi-lateral agreements providing for international judicial judgment registration systems, similar to the international patent & trademark registration systems, are potentially feasible within a generation’s time.
Until that happens, the separate entity rule will likely continue to be the mainstay of global banking in US, specifically in NY.
 E.g., NY CPLR §§5222; 5225(b); & 5227.
 See, e.g., Fidelity Partners v. Philippine Export & Foreign Loan Guarantee, 921 F. Supp. 1113, 1119 (SDNY 1996). (“This rule […] provides that ‘each branch of a bank is a separate entity, [and is] in no way concerned with accounts maintained by depositors in other branches or at a home office.’”)
 See, e.g., Geoffrey Sant, The Rejection of the Separate Entity Rule Validates the Separate Entity Rule, 65 SMU L. Rev. 813 (Fall 2012).
 It would be burdensome or impossible for an international bank to perform constant checks and transfers of its global assets.
 The judgment debtor and one or more judgment creditors, through other branches, may claim the same asset.
 NY courts would become the clearinghouse of the world for post-judgment enforcement actions, creating impractical burdens on the court system.
 The law & rules of a country should respect those of another country.
 Digitrex v. Johnson et al., 491 F.Supp. 66, 68 (SDNY 1980) (“We believe that this rule is no longer valid.”)
 See, e.g., Tire Engineering & Distribution v. Bank of China, 13-1519 at pp.22-23 (2nd Cir. 2014).
 Koehler v. Bank of Bermuda, 12 NY3d 533 (2009).
 “[NY law] contains no express territorial limitation barring the entry of a turnover order that requires a garnishee to transfer money or property in New York from another state or country.”
 See, e.g., Geoffrey Sant, Supra at 829-835.
 Tire Engineering & Distribution, Supra.
 Specifically, in Daimler v. Bauman, 571 US ___ (January 14, 2014), the US Supreme Court unanimously held that a German company could not be sued in CA by Argentine plaintiffs for acts committed in Argentina, even though the German company had conducted business in CA through a US subsidiary. This decision may be a critical factor in the NY separate entity rule case, even if not binding.
Thursday, February 16. 2012
- Augmenting shareholder activism
In recent years, institutional investors concerned with climate risks, particularly public pension funds, have sought to leverage their financial prowess to effect changes in climate-related regulations and corporate governance. For example, they petitioned SEC to require expanded disclosures of public corporations’ exposures to climate risks and their contingency plans, resulting in the promulgation by SEC in 2010 of a set of guidelines regarding such disclosure requirements. (See here.) Furthermore, investors have undertaken shareholder activism via resolutions and proxy votes to influence corporate policies regarding climate risks, for example to demand greater disclosure. (See here.)
These efforts have placed in the public domain more and more information related to the climate risk exposures and policies of publicly traded companies, which can spawn further public scrutiny and analyses, increase public awareness, encourage broader participation, and induce further disclosures in a benign cycle. There are, however, limitations to both approaches. On the one hand, regulators are reluctant to impose stringent regulations on the private sectors due to the weak economy. On the other hand, unlike public pension funds, shareholder activism is generally not viable for mutual funds, because of regulatory requirements on diversification, costs, and conflicts of interests; or for hedge funds, because of their short-term time horizons. (See here.)
Therefore, it may be useful to augment shareholder activism with bondholder activism to effect changes in corporate climate risk practices. US corporate bond market is sizeable, exceeding $7 trillion as of Q2 2011 according to Wikipedia, dominated primarily by institutional investors. Corporate bondholders as a whole, consequently, can exert significant influences on bond-issuing corporations.
As I mentioned previously, equity shareholders affect corporate governance primarily through shareholder resolutions, proxy votes, or even derivative actions. This means the influences of shareholders arise primarily after the purchase of the shares. Bondholders, on the other hand, affect corporate governance primarily through the terms of the bond indentures and therefore can assert influences both before and after the purchase of the bonds. For example, if prospective buyers are concerned with potential negative impacts from climate-related events (hurricane, flood, coastal line erosion, drought, etc) on the payment capability of an issuer corporation, the prospective buyers may negotiate to modify the interest rate, maturity, call/put features, or other numerical terms of the bonds. Or, they can negotiate to add a climate risk covenant to the bond indenture that is linked to certain climate risk factors such as enactment of climate legislation, inclusion of US in an international climate treaty, or the occurrence of some physical events. The threat of the inclusion of such climate-related provisions in the bond offering may impose significant influence on the borrower corporation’s climate policies.
Since such pre-purchase negotiations improve the performance of the bonds, mutual fund managers should be more willing to participate in the negotiations, without being overly concerned with the possibility of upsetting the corporate managers and thus losing future businesses from the corporation. Hedge funds may also find it easier to agree to terms that comport with their short-term profit strategies, as well as other long-term climate concerns. As a result, the aggregate influence of all potential bondholders can be much greater than that of shareholders. Finally, post-purchase/issuance, monitoring & enforcement of the terms and covenants of the bond indentures may be performed by hedge funds, which have gained tremendous experience in enforcing bondholder rights in recent years. (See here.)
As far as I know, this idea of augmenting shareholder activism with bondholder activism in affecting corporate climate policies has not been practiced before. Will it work? I am hoping to find out soon.
Thursday, January 26. 2012
- Making the case for the formation of national climate-change insurance markets
In mitigating the impacts of climate change, market-based regulations (aka, cap-&-trade) have been championed as the preferred policy tool. (See my previous post on regulations, markets, & innovations.) EU has adopted cap-&-trade regulations for carbon emissions and established carbon credit markets, under the Kyoto Protocol, since 2005. And the northeastern states in US have been auctioning off carbon emission allowances to the power generators under the RGGI (Regional Greenhouse Gas Initiative) platform since 2008. California is set to begin emission trading soon.
The prices of the carbon credits traded in EU and under RGGI, however, have plunged precipitously. (See here & here.) Moreover, the Chicago Climate Exchange ceased trading carbon credit products in 2010. Recently, Canada withdrew from the Kyoto Protocol, and New Jersey broke away from RGGI. These developments raised serious doubts whether markets can be an effective policy tool with respect to climate change.
If not viewed as a policy tool, nonetheless, the carbon markets have done exactly what they are supposed to do. – Efficiently reflecting the aggregate balance of supply and demand. The decline in carbon prices reflects (among others) the over supply of credits issued by the EU governments, and the under demand in US & China for lack of policy supports (and also in EU for the weak economy). Therefore, as much as policy-makers and businesses engage in the wishful thinking that the markets would do the works on their behalf, the markets know better to call their bluff.
The lessons: Markets cannot function as an effective regulatory tool without adequate policy supports or implementation. On their own, however, markets can function as an efficient signal as to the aggregate impacts of supply and demand factors, including policy supports and economical conditions.
These lessons learned from the market-based efforts in climate change mitigation may have some important bearings on climate change adaptation. Adaptation has taken a back seat to mitigation in the climate change debates. This is understandable. After all, it makes sense to target directly the root of the problems (free emission of carbon). Moreover, reducing carbon emissions is associated with one clear objective, finite risk parameters (atmospheric CO2 concentration, mean temperature, & mean sea level), acceptable predictive models with large data sets, quantifiable risk levels and reduction targets, tangible commercial products, well-articulated technological solutions, and a definable timeframe.
Adapting to climate change, on the other hand, has none of these characteristics. There is not one central theme, but rather a murky set of sundry tasks that must be performed locally in response to unpredictable local conditions (eg, hurricane, flood, drought, extreme precipitation, sea level rise, heat wave, biodiversity changes, vegetation shifts, disease spread, healthcare, allocation of water & food, etc). And, other than water, there is no easily identifiable tangible commercial products associated with climate change adaptation. Adaptation, in short, is simply a tough sale!
The falling carbon prices, however, attests to the difficulties in achieving the mitigation goals considered necessary to maintain the atmospheric CO2 concentration at comfortable levels. Adaptation, therefore, is increasingly becoming an inevitable reality in the 21st century. And yet, even though the public sectors have taken initiatives to address adaptation needs (see eg here), for the private sectors, adaptation remains a murky set of ill-defined speculative sundry tasks, and very little concrete actions have been taken to address the issues. (Eg, see here.) Without the extensive participation of the private sectors, public sector efforts in adaptation will not likely to be effective.
This is where I think markets may play a useful policy role in stimulating private sector adaptation efforts, not as a regulatory tool but by providing a signal as to the aggregate balance of the supply & demand factors, including climate science developments, policy supports, or economic conditions. Specifically, the market I have in mind is the catastrophe insurance market.
Currently, climate sciences are still unable to reliably forecast local climate variations (city or town) for more than a few days into the future. (Even if some high-resolution modeling tools may exist, my guess is they are likely to be extremely pricy and not widely available.) As a result, the most common way for businesses or individuals to manage their climate change risks is to purchase catastrophe insurances. These insurance markets thus provide a signal as to the aggregate supply & demand for climate change risk shifting, which in turn point to the aggregate supply & demand for adaptation.
If these insurance market prices are widely accessible to the general public, like the prices of Treasury and other debt securities widely available to the public through the media or internet, they may serve to better inform the public of the state of climate change risks, and thus stimulate more concrete actions. In most markets in US, both private insurance carriers and public governments (states & federal) offer climate-related insurance coverage, such as flood or hurricane insurance policies. (Eg, see here.) In fact, in some markets, the federal government plays a significant role. For example, by 2007, the federal National Flood Insurance Program (NFIP), established in 1968, has become the primary flood insurer in US. (See here.)
Therefore, the federal government should establish an agency to oversee and underwrite all federal climate-related insurances, and also ensure the establishments of sound and secure secondary markets in these insurance products and extensive distribution of the pricing information to the general public. Just like the Treasury securities markets, such national climate-related insurance markets may serve as a benchmark for the creation and pricing of other related markets, and as the basis for the creation of other analysis and decision-making tools. These national markets, pricing information, and additional tools should hopefully raise the public awareness of the risks of climate change, and thus the needs for adaptation, and facilitate informed and educated concrete actions in adaptation.
Of course, this is a very primitive idea. Many further considerations need yet to be worked out. For example, many insurance policies are not standardized, unlike Treasury securities. The premiums may not properly reflect the market supply & demand because of government subsidies. The markets may lack liquidity if the risks rise above a certain threshold. But, hopefully this will be a start!!!
Tuesday, August 30. 2011
- Public interests v private interests
Just read a scathing opinion piece on Bloomberg.com advocating the shuttering of SEC. (See here.) Why? The fast spinning revolving door between the regulator and the industry it regulates, and the resulting festering conflicts of interest. The author, William Cohan, cited another article published in the recent Rolling Stone issue by Matt Taibbi, detailing a whistleblower’s allegations that the agency had been destroying internal investigation records at least for the past 17 years. (See here.)
On the spinning revolving door, the Rolling Stone article listed the names of the 5 past directors of the Enforcement Division at SEC from 1985-2009, and their employers directly after their SEC tenures. I have copied the list below.
Everyone knows that revolving doors create severe conflicts of interest issues, and should be properly regulated. Regulators at SEC should particularly know that best. But when it comes to regulating one’s own private interests, public interests unfortunately still have to take a back seat, even for regulators.
Thursday, July 28. 2011
It was reported recently that the hedge funds founded by George Soros, the fabled money manager, had decided to close themselves to outside investors and return about $1b of outsider money. (See, eg, here.) According to the news reports, the Soros fund managers stated in a letter to investors that they made the decision to avoid registering with the SEC. The letter indicated that the funds previously were able to avoid registration through some exemptions, but those exemptions are no longer available subsequent to the Dodd-Frank Act.
Prior to Dodd-Frank, the Investment Adviser Act required investment advisers ("IA") to register with the SEC, but provided several exemptions, including the “private fund” exemption, which exempted IAs having less than 15 clients during the past 12 months and not holding themselves out generally to the public as IAs. (See footnote 1.c.) Since Dodd-Frank eliminated only the private fund exemption, leaving the other exemptions intact, it is fair to conclude that the Soros funds avoided registration through the private fund exemption. In place of the “private fund” exemption, however, Dodd-Frank introduces a “family office” exemption (§409), allowing IAs that are “family offices” to be exempted from registration. Thus, by returning the outsider money, the Soros fund will supposedly qualify as a “family office” and continue to be exempted from registration.
It is not possible to know for sure why the Soros fund manager would rather turn away money than register with the SEC. But I would guess it’s because they want to avoid the disclosure & record keeping requirements. In terms of disclosure, an IA registers with the SEC by submitting Form ADV, which includes 2 parts, Part I and Part II. (See here.) Part I is primarily form-based, whereas Part II is narrative-based. Without going into the details, I have listed in the table below the main disclosure items in each part.
Of these items, Item #8 of Part II is probably of the greatest concern to the Soros fund managers, because it involves the fund’s proprietary trading strategies. The instruction for the item requests the IA to disclose: (1) the methods of analysis and investment strategies you use in formulating investment advice or managing assets.; (2) the material risks involved for each significant investment strategy or method of analysis; & (3) the material risks involved in a particular type of recommended security.
Furthermore, the Investment Adviser Act requires IAs to maintain records, which are subject to examination by the SEC. The Dodd-Frank Act imposes additional record-keeping requirements, requiring IAs to maintain records needed to assess systemic risks. (§404(2)) The required information include:
(A) the amount of assets under management and use of leverage, including off-balance-sheet leverage;
(B) counterparty credit risk exposure;
(C) trading and investment positions;
(D) valuation policies and practices of the fund;
(E) types of assets held;
(F) side arrangements or side letters, whereby certain investors in a fund obtain more favorable rights or entitlements than other investors;
(G) trading practices; and
(H) such other information as the Commission, in consultation with the Council, determines is necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk, which may include the establishment of different reporting requirements for different classes of fund advisers, based on the type or size of private fund being advised.
Needless to say, these disclosure and record-keeping requirements raised genuine concerns within the hedge fund industry. As a consequence, Dodd-Frank also provides that “proprietary information” received by the SEC or other government agencies will not be accessible to the public through the Freedom of Information Act. These safeguard measures, however, obviously were not enough for the Soros fund managers to submit to registration.
If the family office exemption were not available, I wonder whether they would have considered patenting their previously secret strategies! (See my previous post on patenting trade secrets here.)
 For example:
a. All clients of IA resides in same state as the IA (§203(b)(1), Investment Adviser Act);
b. All clients of IA are insurance companies (§203(b)(2));
c. IA has less than 15 clients in past 12 months, does not hold itself out as an IA to the public, & does not advise investment companies or business development companies (the private fund exemption, §203(b)(3));
d. IA is a charitable organization (§203(b)(4));
e. IA is a church plan under §414(e) of the Internal Revenue Code (§203(b)(5));
f. IA is registered with CFTC (§203(b)(6));
g. IA is subject to state regulations and manages less than $25m (§203A(a)(1)(A));
h. IA is subject to state regulations and does not advise an investment company (§203A(a)(1)(B)).
 The SEC has defined a “family office” as one that (a) has only family clients; (b) is wholly owned by family clients and exclusively controlled by family members/entities; and (c) does not hold itself out as an investment adviser. 17 CFR 275.202(a)(11)(G)-1 (adopted on 6/22/2011, effective 60 days after publication on Federal Register)
 The term “records” is defined as “accounts, correspondence, memorandums, tapes, discs, papers, books, and other documents or transcribed information of any type, whether expressed in ordinary or machine language.” §3(a)(37), Securities Exchange Act.
 “Proprietary information” includes “sensitive, non-public information regarding-- (i) the investment or trading strategies of the investment adviser; (ii) analytical or research methodologies; (iii) trading data; (iv) computer hardware or software containing intellectual property; and (v) any additional information that the Commission determines to be proprietary.” §404(2), the Dodd-Frank Act.
Monday, July 11. 2011
- Mindful of the limits
The movie Transformer 3 was a huge box office hit this summer. I haven’t seen it yet, but have seen the previous two. Honestly, I didn’t really like them that much. The kid characters were way too serious and the visuals were way too crowded and unfocused. However, I must admit that that “transformation” theme common in most super-hero movies has its psychological allures. Watching those cars and trucks transform into giant robots (or batman don on the black tight outfit and mask, or superman unbutton his shirt to reveal the V letter, or the supermarion puppets in the Thunderbirds series slide through high-tech tunnels and gear up to operate the marvel rescue planes) is utterly satisfying to us mortal beings. Transformation is dreams-come-true, is hope.
And therefore in the Dodd-Frank Act (Wall Street Reform and Consumer Protection Act), we (or, rather, the Congress) transformed the federal regulatory schemes and rested our hope of safeguarding the integrity of the financial system on the newly-transformed regulators. That is, if the free markets championed by capitalism failed, regulations will come to the rescue.
I’ve always believed that markets without regulations will not work. However, to think that regulations will solve all our problems is also unrealistic. Attesting to this limit are two insightful studies on the performance of the Office of Currency Controller and the Federal Reserve at the task of separating banking and commerce during the decades leading to the financial crisis, conducted by Prof Omarova of U of N Carolina. In the first study published in 2009, Prof Omarova investigated how OCC broadly interpreted the “business of banking” restrictions on commercial banking activities to eventually allow commercial banks to enter into various types of derivative markets. (See here.) In the second study, Prof Omarova turned to the Federal Reserve’s use of its exemptive authority to permit insured banks to engage in transactions with affiliates that exposed the banks to tremendous credit risks of the affiliates. (See here.)
Separation of banking and commerce is one of the fundamental cornerstones of US banking and financial law. The National Bank Act of 1863 limited commercial banks to engage in activities “necessary to carry on the business of banking”, excluding dealing and underwriting securities as amended by the Glass-Steagall Act. The Bank Holding Act of 1956 extended the restrictions to bank holding companies and affiliates.
OCC, as the regulators for federally chartered banks, is responsible for interpreting the “business of banking” clause. Prof Omarova’s study showed that since 1960’s, OCC had adopted a broad interpretation of the clause, which was given a nod by the Supreme Court in 1995.
With respect to derivatives, OCC first opened the doors to those referencing conventionally permissible assets (eg, interest rates, currencies, or gold) by relying on the “look through” doctrine. When this doctrine became too restrictive, however, OCC switched instead to the “functional equivalency” doctrine. Under the “functional equivalency” approach, an activity would be permissible as long as it performed similar functions as other permissible activities, regardless of the underlying assets. This approach opened the door for commercial banks to matched commodity swaps, commodity-linked deposits, unmatched commodity swaps, swap warehousing, and eventual equity swaps. Finally, by defining “business of banking” as virtually all forms of financial intermediations in an approach named “elastic definition” by Prof Omarova, OCC permitted banks to engage in physical hedging of commodity and equity derivatives, cash settled commodity derivatives (eg, electricity), physically settled commodity derivatives, and derivatives on various underlying indices (eg, inflation property, and catastrophe indices).
Therefore, by the time the financial crisis broke loose in 2007-2008, US commercial banks had gained the power to enter into virtually all kinds of derivative transactions. Post-crisis, however, the Dodd-Frank Act limits permissible derivative activities for commercial banks to those taken for hedging purposes and those referencing a permissible underlying asset. (That is, those permissible under the “look through” approach.)
The wall separating commercial banking from investment banking was significantly narrowed / lowered / weakened after the repeal of Glass-Steagall in 1999, permitting bank holding companies to enter into virtually all types of financial service businesses under the holding company umbrella. What’s left of the wall is primarily Sections 23A and 23B of the Federal Reserve Act, which set forth restrictions on transactions between commercial banks and their affiliates.
23A and 23B aim to achieve two goals: (1) protecting a bank from losses suffered in transactions with affiliates; and (2) restricting banks from transferring to affiliates the subsidies derived from the federal safety net. To achieve these goals, 23A generally limits the transactions between a bank and its affiliates to 10% of the bank’s capital stocks and surplus for each affiliate, and to 20% of capital stocks and surplus for all affiliates. The section additionally prohibits the bank from purchasing low-quality assets from affiliates, requires transaction terms to be consistent with safe and sound practices, and sets collateral requirements. 23B, on other hand, requires affiliate transactions to be made according to prevailing market terms.
The Federal Reserve is responsible for enforcing 23A & 23B, and is authorized to exempt affiliate transactions from the statutory restrictions if such exemptions are “in the public interest” and “consistent with the purposes” of these sections. According to Prof Omarova, however, it turned out the public interest in providing desperately needed liquidity to the non-banking sector during the crisis decisively outweighed the public interests in protecting the deposits of the public from speculative activities.
In his study, Prof Omarova examined the interpretive letters issued by the Federal Reserve between 1996 and 2010 in response to requests to exempt proposed affiliate transactions from 23A requirements. The table below summarizes those instances listed in Prof Omarova’s paper when the Federal Reserve granted exemptions to the 23A requirements. As shown in the table, Prof Omarova found that during the crisis, when protections of commercial banks afforded under 23A seemed most needed and justified, the decision-making processes at the Federal Reserve were actually dominated by the imminent need to provide emergency liquidity to the non-banking sector. At the time of market crises, the public interest in achieving the twin goals of 23A (protecting banks from losses from affiliates and preventing transfer of federal subsidies) proved to be illusive against the competing interest in providing funding to all.
Therefore, the logical construct of 23A was turned upside down by the empirical experiences gathered during this crisis. The exemptive authority under 23A proved to be too powerful for the whole design to work. Post-crisis, the Dodd-Frank Act amended 23A by, among others, giving FDIC the power to veto exemptions granted by the Federal Reserve.
Regulations, no matter how extensively and carefully constructed, will not likely prevent the occurrence of the next market crisis. Prof Omarova’s studies show that regulators are liable to mistakes, as are all mortal beings. After Glass-Steagall, however, for almost 75 years, the US financial system prospered without a major crisis. If we want to pull off another record, however, lots more than the Dodd-Frank Act will be necessary!
 Omarova, Saule T., The Quiet Metamorphosis: How Derivatives Changed the “business of Banking”, 63 U. Miami L. Rev. 1041 (2009).
 Omarova, Saule T., From Gramm-Leach-Biliey to Dodd-Frank: The Unfulfilled Promise of Section 23A of the Federal Reserve Act, North Carolina Law Review, Vol. 89, 2011; UNC Legal Studies Research Paper No. 1828445.
 12 USC §24(Seventh).
 Nations Bank of North Carolina v. Variable Annuity Life Insurance, 513 U.S. 251 (1995).
 12 USC §§371c & 371c-1.
 Transactions Between Member Banks and Their Affiliates, 67 Fed. Reg. at 76,560.
 12 USC 371c(f)(2).
Wednesday, March 28. 2007
The influential private equity firm, Blackstone Group, disclosed in its recent IPO prospectus that it planned to establish a charitable foundation after it goes public and would contribute up to $150m in the foundation. (See here.) This got me thinking about the combination of for-profit and not-for-profit corporations.
Will such kind of plans work? It seems so. Will it actually happen? Maybe, although probably not any time soon!
Tuesday, February 20. 2007
In recent years, a secondary market for life insurance policies has grown rapidly, accompanied by similarly exponential growth in the securitization of life insurance policies. The market is supported by a group of organizers who purchase eligible policies from the original owners, re-package them, and then sell interests in these policies to investors. (See here or NY Times 12/17/2006 article "Late in Life, Finding a Bonanza in Life Insurance" for more details.)
Thursday, February 15. 2007
COLI (Corporate-owned life insurance) has been around for a while. A company purchases life insurance policies (as owner and beneficiary) covering the lives of its employees for two main purposes: (1) to fund employee benefit plans; and (2) to compensate itself for the loss of covered key employees. In the former case, if the company sets up a retiree health care benefit plan for its employees, it can buy life insurances on its employees with face amounts equal to the estimated health care costs of the employees. The life insurance proceeds can subsequently be used to cover those health care costs. In the latter case, the insurance policy is called a "key-man" policy. A company buys key-man insurance policies sufficient to compensate for the losses and expenses to the company, or to buy back an employee-shareholder's shares, if a current key employee-shareholder passes away.
Part of the reasons behind this regulation is that the company's stock price should reflect the insurance proceeds to be received by the company. That means the insured person's estate is taxed once already on the higher value of the stocks. Paying estate tax on the insurance proceeds would have been double taxation.
(Page 1 of 2, totaling 11 entries) » next page
Freedom of Speech
Friday, July 14 2017
Treasure and preserve what we have
Tuesday, July 19 2016
Bitcoin regulations proposed by New York regulator
Thursday, July 24 2014
Treasure and preserve what we have
Wednesday, June 4 2014
Global banking v global judgment enforcement
Thursday, April 10 2014
Expanded “prior use” defense under AIA
Monday, March 31 2014
Bondholder activism in affecting corporate climate policies
Thursday, February 16 2012
Climate change adaptation & market-based regulation
Thursday, January 26 2012
11/14/2011 Presentation on Climate Change
Friday, December 9 2011
Software patents and venture capital
Monday, September 5 2011